Introductory Financial Accounting Accounting for Current Assets

Learning outcomes Discuss the significance of stock valuation for profit measurement and asset valuation. Explain and discuss the various accounting principles and conventions governing stock valuation in the UK. Calculate stock valuations using FIFO, LIFO and AVCO and demonstrate the impact of these methods on balance sheet values and profit figures in periods of changing prices. Explain the problem of recognising profit or loss on long-term contracts. Discuss the limitations of historical cost accounting and the concept of capital maintenance.

Stock Valuation Why is the valuation of stock important? It affects the calculation of (gross) profit (opening stock + purchases – closing stock = cost of goods sold) It affects balance sheet assets as closing stock is recorded there Stock valuation requires consideration of The cost of stock The flow of stock

Ascertaining the cost of stock Cost = all the expenditure incurred in bringing the product or service to its present location and condition trading company = cost of purchase purchase price plus all expenses incurred in bringing goods to place of sale e.g. including carriage in, insurance, duties manufacturing company = cost of conversion a manufacturing company holds three different types of stock: raw materials work-in-progress finished goods Cost includes all costs of production (conversion), both direct costs e.g. raw materials, direct wages and overheads (indirect costs) e.g. depreciation of machinery and overheads, rent of factory (see manufacturing accounts)

Ascertaining the flow of costs There is a problem with the costing of goods sold and valuing stock when (a) the physical flow of stock cannot be directly observed and matched, and (b) there is a change in the price of the goods Accounting requires assumptions to be made about the physical flow of stock to allow costing and valuation to take place: FIFO – first in first out LIFO – last in first out AVCO – weighted average cost

Example – Jacques Over an accounting year Jacques purchases 2,000 litres of a chemical fluid for resale. Three separate purchases were made: Lot 1: 500 litres @ £8.00 /litre Lot 2: 1000 litres @ £10.00/litre Lot 3: 500 litres @ £12.00/litre Jacques stored the chemical in one special container. If 1,700 litres were sold over the year at a selling price of £12.00/litre, what was: The business’s gross profit? The value of the closing stock?

Adopting FIFO Cost of sales: 500 @ £8.00 4,000 1000 @ £10.00 10,000 1000 @ £10.00 10,000 200 @ £12.00 2,400 16,400 Turnover 1,700 @ 12.00 20,400 Cost of sales 16,400 Gross profit 4,000 Balance sheet: Closing stock: 300 @ £12.00 3,600

Adopting LIFO Cost of sales: 500 @ £12.00 6,000 1000 @ £10.00 10,000 1000 @ £10.00 10,000 200 @ £8.00 1,600 17,600 Turnover 1,700 @ £12.00 20,400 Cost of sales 17,600 Gross profit 2,800 Balance sheet: Closing stock: 300 @ £8.00 2,400

Adopting weighted average cost Total purchase costs: (500 x 8) + (1,000 x 10) + (500 x 12) = 20,000 Weighted average cost/litres: 20,000= 10 2,000 Cost of sales: 1,700 x 10 17,000 Turnover 1,700 @ 12.00 20,400 Cost of sales 17,000 Gross profit 3,400 Balance sheet: Closing stock: 300 @ £10.00 3,000

Comment When prices are rising, FIFO gives highest gross profit and LIFO lowest FIFO gives highest stock value and LIFO the lowest when prices are falling the reverse applies

FIFO Advantages: flow assumption often reflects reality balance sheet values more likely to reflect reality acceptable to tax authorities Disadvantages: with rising prices COGS will not reflect cost of replacing stock if the whole of the profit calculated on this assumption were to be distributed there would be insufficient funds retained to replace the same number of items sold i.e. capital maintenance would be affected e.g. Jacques Ltd

Example with further assumptions all transaction are for cash and all profits are withdrawn from the business (ii) the business was started with £20,000 capital which was spent on stock The business’s opening balance sheet would be: Assets Capital Stock £20,000 Capital £20,000 Subsequent cash flows from above example and assuming FIFO: Cash in: Sales £20,400 Cash out: Drawings 4,000 Cash balance: £16,400

To what extent would Jacques be able to replace his stock? £16,400/£12 = 1,366 units could be purchased. Original stock = 2,000 units New stock = 300 (closing stock) 1,366 (new purchases) 1,666 Shortfall = 2,000 – 1,666 = 334

Which means….. The business has effectively ‘shrunk’ and while the original financial capital has been maintained (nominal financial capital maintenance), the business’s operational capital, as represented by its assets (physical capital maintenance), has not. The use of NIFO or replacement cost would resolve this physical capital maintenance problem The historical cost measurement system and the maintenance of nominal financial capital have been the traditional approaches to financial accounting in the UK. There are a number of advantages and disadvantages to such a system (see reading).

LIFO Advantages: more accurate profit measurement less of a capital maintenance problem Disadvantages: with rising prices balance sheet stock value will not reflect current values flow assumption less likely to reflect reality not acceptable to tax authorities in the UK

Which method of stock valuation should be adopted? UK accounting standards (SSAP 9 Stocks and long term contracts) allow FIFO, average cost or ‘unit’ cost and reject LIFO. The UK Companies Act allows FIFO, LIFO, weighted average price or ‘any other similar method’ (not defined) International accounting standards (IAS 2 Inventories) requires unit cost and ‘benchmarks’ (a statement of preference) FIFO or weighted average, but includes LIFO as an allowable alternative Accounting standards and the law also apply the prudence principle with the basic valuation rule, for each group of similar items of stock, of: LOWER OF COST OR NET REALISABLE VALUE (Net realisable value = sales revenue – all selling costs)

Long-term contract costing Applying the realisation principle is problematic therefore matching takes precedence profit is recognised as estimated to have occurred throughout the life of the contract Example: Ash has, in the current financial year, undertaken a long-term contract. The contract value is £100. At the end of this financial year the state of the contract is: £ Costs to date 45 Estimated costs to completion 35 Progress payments 46 % complete 50%

Workings Calculation of foreseeable profit: Contract value 100 Costs to date 45 Estimated costs 35 80 Foreseeable profit 20 (ii) % complete recognised in the profit and loss account: Turnover to date (50%) 50 Cost of sales to date 40 Attributable profit 10 (iii) Work-in-progress recognised in the balance sheet (stock) Costs to date 45 Less transfer to p/l 40 WIP 5 (iv) Amounts recoverable on contracts recognised as debtors in the balance sheet: 50 – 46 = 4

How does the balance sheet balance? Assets Capital Stocks 5 Debtors 4 Cash (46-45) 1 Profit 10 10 10 Although profit is only recognised on the basis of percentage of completion, the influence of prudence requires that when a contract is expected to make a loss, the whole of that loss is recognised immediately, whatever stage of completion of the contract.

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