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Introductory Financial Accounting

Accounting for Current Assets

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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.

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Stock ValuationWhy 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

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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)

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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

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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?

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Adopting FIFO • Cost of sales: 500 @ £8.00 4,000• 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

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Adopting LIFO• Cost of sales: 500 @ £12.00 6,000• 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

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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

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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

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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

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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

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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

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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).

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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

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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)

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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%

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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

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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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Stock Valuation

• Longer Example

• Stock Valuation.doc

• Stock valuation ans.xls