1. Introductory Financial Accounting
Accounting for Current Assets

2. 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.

3. 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

4. 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)

5. 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

6. 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 £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?

7. Adopting FIFO Cost of sales: 500 @ £8.00 4,000 1000 @ £10.00 10,000
£ ,000
£ ,400
16,400
Turnover ,400
Cost of sales ,400
Gross profit ,000
Balance sheet:
Closing stock: £ ,600

8. Adopting LIFO Cost of sales: 500 @ £12.00 6,000 1000 @ £10.00 10,000
£ ,000
£ ,600
17,600
Turnover £ ,400
Cost of sales ,600
Gross profit ,800
Balance sheet:
Closing stock: £ ,400

9. 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=
2,000
Cost of sales: 1,700 x ,000
Turnover ,400
Cost of sales ,000
Gross profit ,400
Balance sheet:
Closing stock: £ ,000

10. 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

11. 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

12. 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

13. 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 = (closing stock)
1,366 (new purchases)
1,666
Shortfall = 2,000 – 1,666 = 334

14. 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).

15. 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

16. 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)

17. 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
Estimated costs to completion 35
Progress payments 46
% complete %

18. Workings Calculation of foreseeable profit: Contract value 100
Costs to date 45
Estimated costs 35 80
Foreseeable profit
(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
(iv) Amounts recoverable on contracts recognised as debtors in the balance sheet: 50 – 46 = 4

19. How does the balance sheet balance?
Assets Capital
Stocks 5
Debtors 4
Cash (46-45) Profit 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.

20. Stock Valuation Longer Example Stock Valuation.doc
Stock valuation ans.xls