Chapter 14

 Applying the Historical cost principle means that stock should be valued at its original purchase price, as this is verifiable by reference to a source document. In turn, this ensures Reliability in our reports, because our valuation will be free from bias.  Note, however, there may be other costs associated with the purchase, and these must be accounted for in determining the cost price of the stock.

 What is the ‘cost’ of the bed? Let’s start by eliminating the selling price as a possibility, because this figure is not the purchase price; a valuation based on selling price would directly breach the Historical cost principle. To value the bed at its selling price would breach the principle of Conservatism: it would recognise a gain (the profit on the sale of the stock) before it is certain, which would overstate the value of assets (namely, stock).  Obviously the supplier’s price of (of $800) is included as this is the key cost of the bed. However, we must also consider that without the delivery charges (of $100), the stock would not be available to sell to customers; it is part of the purchase price, and must be included in the cost of stock.

 In fact, any costs incurred in order to bring the stock into a condition and location ready for sale must be included in its cost price. These may include:  supplier’s price  freight in (delivery to the firm from the supplier)  Modifications  customs/import duties  any other buying expenses.  Thus, the cost of the bed is $900 – the bed is worth $900.

 Note: The GST has no effect whatsoever on the valuation of stock because it is not a cost incurred by the business. Any GST on the purchase of stock will be debited to the GST Clearing account, and will simply reduce the liability the business owes to the ATO.  Items like Advertising, Wages or Freight out (the cost of delivering stock to our customers) are excluded, as they are not incurred to get the stock ready for sale, but are only incurred after the sale.

 Calculating an accurate cost price for stock is important not only in terms of valuing stock in the Balance Sheet, but also in terms of earning profit. Many businesses determine their selling price by applying some sort of mark-up, which is itself based on the cost price. (For example, if a firm applies a 100% mark-up, its selling price will be twice its cost price.) If the firm calculates the cost price of its stock incorrectly, then it may set its selling prices too high (leading to a loss of sales volume) or too low (leading to an insufficient mark- up).

 We have already established that the cost of stock includes all costs incurred in order to bring stock into a condition and location ready for sale, but to calculate the cost per item, it is also necessary that we are able to allocate those costs to individual units of stock.  Note product cost is a cost incurred in order to bring stock into a condition and location ready for sale, which can be allocated to individual units of stock on a logical basis.  See MacEvoy example p  An absence of a logical basis to allocate costs would mean that a cost cannot be treated as a product cost, and must be treated as a period cost (see page 315).

 Product costs are treated as part of the unit cost of each item of stock. As a result, they are not recorded separately, but rather as part of the value of stock.  Figure 14.1 shows how the purchase of the golf bags would be recorded in the Cash Payments Journal.  As with all payments, the entire amount paid would be entered in the Bank column.  The amount in the Stock column ($3000) would be calculated by multiplying the cost price of the stock ($200) by the number of units purchased (15). Thus the cartage in would not be itemised nor recorded separately; it is included in the cost of each bag (each product, hence the term product cost).

 The Cash Payments Journal would be posted to the General Ledger as usual, leaving the Stock Control account as shown on p There is no separate ledger account for Cartage in – it has been included in the amount shown in the Stock Control account.  See stock card on p  Note that if the purchase was on credit, the effect on the stock card and the Stock Control account would be the same, but the transaction would be recorded in the Purchases Journal, and credited to Creditors Control instead of Bank.

 The treatment of product costs is the same even when a different supplier provides the service of delivering or modifying our stock. The only difference is we would need to recognise that two payments are included in the purchase of the stock.  Figure 14.3 shows how the two payments related to the purchase of the stock would be recorded in the Cash Payments Journal.  If the purchase is made on credit, with additional costs paid in cash, simply record the two transactions in their appropriate journal, and show them both in the stock card as is shown in Figure 14.4.

 Review Questions  All q’s.

 In cases where there is no logical basis for allocation, the cost must be treated as a period cost.  In the golf example there are two different types of stock ordered – golf shirts and golf hats – both of which would incur cartage in. We cannot simply assume that the cartage in would be the same for shirts as it is for hats (and simply divide the cost between the 30 items – 20 bags and 10 buggies), so we do not know the per item cost of the cartage. We have no choice but to treat the cartage in as a period cost, and value the stock only at the price charged by the supplier ($23 per shirt and $8 per hat).

 Period costs are unable to be treated as part of the unit cost of each item of stock, so they must be recorded and reported separately from the stock itself.

 Figure 14.7 shows how the purchase of the golf shirts (referred to earlier) would be recorded in the journals.

 There would be a separate ledger account for Cartage in in the General Ledger as is shown on p  In terms of the stock card, the golf shirts would be valued only at their supplier’s price of $23, as is shown in Figure 14.6.

 Only costs that are incurred to get stock ready for sale can be classified as product or period costs. Costs that are not related to the purchase of stock are neither product costs nor period costs; they are classified as ‘Other expenses’.  For these Other expenses, the issue of a logical basis for allocation does not apply. As a consequence, it should not be given as a reason for excluding a particular item from the calculation of a unit cost for stock; their defining characteristic is that they are ‘not incurred to bring stock into a condition and location ready for sale’, but rather incurred after the sale.

 Review Questions  All q’s.

 Treating costs as product costs is the more accurate way of valuing stock, because all the costs incurred to get stock ready for sale are allocated directly to the items of stock themselves. If the stock is unsold, the product costs are included in the value of the asset, Stock. When the stock is sold, the product costs are simply included in the Cost of sales figure. In fact, product costs are recognised as being incurred – and their benefit consumed – in the Reporting Period when stock is sold.

 Period costs are recorded separately in the ledger, and reported under the heading ‘Cost of Goods Sold’ in the Profit and Loss Statement.  Further, they are recognised as being incurred in the period in which the stock is purchased, regardless of whether stock is sold or not. Unless all the stock is sold, this will overstate Cost of Goods Sold and understate profit as well as understating the value of stock on hand.

 Product costing recognises the expense as being incurred in the period when the stock is sold; because only 4 out 10 CD players have been sold, only 4/10 of the $350 spent on modifications ($140) has been recognised as being incurred in October. (This is included in the Cost of sales figure of $620.) The remaining 6/10 of the modifications cost – the cost yet to be incurred – is included in the value of Stock on hand in the Balance Sheet at the end of October

 Assuming the same data but using period costing would produce very different reports.  Period costing would not allocate the modifications to each CD player, and hence value them at only their supplier’s price of $120 each. However, it would recognise the entire $350 spent on modifications as incurred in the period when the stock is purchased (i.e. all would be reported as an expense in October). See p. 319.

 Product costing gives a more accurate calculation of the cost price of stock, and hence a more accurate Profit and Loss Statement and Balance Sheet, and wherever possible, product costing should be used. This will ensure Relevance in the reports, because the owner has all the information which may be useful for decision- making (in this case, regarding setting selling prices).  Only when product costing cannot be used – where there is no logical basis on which to allocate costs amongst individual items – should period costing be used.

 Do questions  All q’s.

 In some situations the selling price of the stock will fall below the cost price, and instead of generating a profit on the sale, it is probable that a loss will occur. (For instance, if stock is damaged it may end up being sold for less than its original purchase price.) In cases such as these, continuing to value stock at is cost price would breach Conservatism.  To avoid breaching Conservatism, stock must be valued at whichever is lower – its cost price, or what is known as its ‘Net Realisable Value’. This is known as the ‘Lower of cost and Net Realisable Value’ rule.

 The selling price of stock is also known as its ‘realisable value’ – what it can realise in dollar terms on its sale. However, the owner must take into account that there are direct costs involved in the sale of particular stock items, such as marketing and distribution.  These must be subtracted to determine a particular stock item’s net worth, hence the term Net Realisable Value (NRV). NRV is the estimated selling price of the stock less any costs involved in its selling, marketing or distribution. In essence, it means what we can sell it for, less what it will cost us to carry out the selling.

 Note: GST, as it applies to either the selling price or the cost price, is not a factor to be considered in the valuation of stock, as it affects GST clearing, not Stock or profit.  Cost is calculated with the GST excluded, and so is NRV.

 The ‘Lower of cost and Net Realisable Value’ rule states that:  Stock must be valued at the lower of cost and Net Realisable Value.  Applying the rule thus upholds Conservatism: by recognising losses (on the stock) as soon as they are probable, it ensures that stock (an asset) is not overstated. In the process, a more realistic valuation of stock will be derived, and Relevance will be upheld, as the information in the reports will be more useful for decision-making. This rule must be applied on an individual basis, because the cost price of some lines of stock may still be lower than their NRV.

 When the NRV of a stock item falls below its cost price:  an expense will be incurred (in the form of a loss on the sale of the stock)  the asset stock must be ‘written down’ to reflect its lower value.  This is recognised by recording a stock write down, which is the expense that is incurred when the NRV of an item falls below its cost price. The amount of the stock write down can be calculated as the difference between its cost and the NRV.

 The amount of the stock write down is calculated by deducting the NRV from the cost. If this figure turns out to be negative, the NRV is greater than the cost; a stock write down is not necessary!

 Remember, ignore the GST.  After the release of the new model, their cost ($500) is higher than their NRV ($430), so the dishwashers must be written down by $70 per unit. Given that six dishwashers are still on hand, each of which must be written down by $70, the total stock write down is $420 (6 ✕ $70).

 Remember, at the time of purchase stock is recorded at its cost. If the stock must be written down to its NRV, then both the stock card and the General Ledger must be adjusted. The stock card (for dishwashers) must record the write down per item, as is shown in Figure  Notice that even though this entry is recorded in the OUT column of the stock card, no units of stock are actually leaving the business; stock has been reduced in value, not in quantity. Each dishwasher is written down by $70, leaving each one valued at its NRV of $480 ($550 cost price less $70 stock write down).

 The General Journal entry to record the write down of stock its NRV is shown in Figure  Stock write down is debited to recognise the expense – the loss of an economic benefit in the form of a reduction in assets (stock), which decreases owner’s equity. At the same time, the asset Stock Control is credited to recognise that the asset is no longer worth its Historical cost.

 This General Journal entry would be posted to the General Ledger as is shown in Figure  Stock write down is debited to recognise the expense, then the asset Stock Control is credited to recognise that the asset is no longer worth its Historical cost.  The amount used in the General Journal entry is the amount of the write down, not the new balance of stock on hand.

 This General Journal entry would be posted to the General Ledger as is shown in Figure  As an expense account, Stock write down ($420) would be closed to the Profit and Loss Summary account at the end of the Reporting period (with all the other expense accounts). However, it is the new stock balance ($11 580) that must be reported in the Balance Sheet.

 Review Questions  All q’s.

 Because Stock write down is not a cost involved in getting the stock into a position or condition ready for sale, it should not be classified under Cost of Goods Sold: it will not effect the mark-up on stock which is reflected in Gross profit. However, it is related to stock, and will effect the overall margin that the business will earn from the sale of stock. In this way, Stock write down has the same effect as a stock loss or gain, and so it is reported as a deduction from Gross profit, to determine Adjusted gross profit.

 Figure shows how stock write down would appear in the Profit and Loss Statement.  A stock write down is reported in the same place as a stock loss or gain.  Now that the dishwashers have been written down, all stock is valued at the ‘Lower of cost and NRV’, and the balance of stock on hand will be reported in the Balance Sheet as it normally would.

 Review Questions  Both of them!  Read Summary.  Do (minimum) five end of chapter exercises.  Read Chapter 15 Where are We Headed.