erty companies and distilleries, where stock may be held for a number of years) has changed significantly. The stock now appears on the accounts of the party who benefits from the stock and who has all the risks associated with ownership.
● VALUING STOCK
To calculate the value of goods used in sales companies have to measure the volume of units that have been used in sales, and calculate their value.
Measuring the volume of goods used in sales is theoretically very simple, all companies use some form of stocktaking. This would follow the procedure shown below:
Opening stock
Plus Purchases
Equals Goods available
Less Closing stock shown on the balance sheet
Equals Goods used in sales charged to the profit and loss account
However, anyone who has been involved in stocktaking knows just how imprecise this measurement can be!
Once the company has measured how many units it has in stock, it then has to value them. Valuing stock accurately is important, small changes in the stock values can have a disproportionate impact on reported profits in businesses where the materials cost is a large proportion of the total costs.
Whilst it is important, in practice valuing stock can be difficult. Some guidance is given in SSAP 9. It defines the cost of stock as the ‘cost of purchase … such costs of conversion … as are appropriate to that location and condition’. The accounting standard says that the costs of conversion comprise:
● costs which are specifically attributable to units of production (e.g. direct labour, direct expenses and sub-contracted work);
● production overheads;
● other overheads, if any, attributable in the particular circumstances of the business to bringing the product or the service to its present location and condition.
Production overheads are subsequently defined in SSAP 9 to be those ‘overheads incurred in respect of materials, labour, or services for production, based on the normal level of activity, taking one year with another’.
Therefore, the cost of stock must include the direct costs, a proportion of production over- heads relating to normal activities, and may include a proportion of other overheads as well.
It may also include interest on any capital borrowed to finance the production of the stock.
The accounting standard argues that the principle of prudence should be applied through the requirement to show stock at the lower of cost and net realisable value, not through the exclusion of relevant costs. This is a logical argument that relies on the auditor’s ability to verify net realisable value, and to find his way through the minefield of cost apportionment.
Any manager who has worked in a manufacturing company understands the difficulties involved in allocating overheads. It is an area fraught with difficulties, involving many, often arbitrary, judgements. If you asked four accountants how a cost should be appor- tioned, you would probably have five different views! Thus, the allocation of overheads to stock involves judgement and so gives scope for creativity.
Any interest capitalised must be disclosed in the notes to the accounts. This is illustrated in Extract 10.2 below from Guinness’s 1996 accounts, where the relatively high costs of financing maturing whisky are clearly disclosed.
To illustrate the difficulties of stock valuation we will consider three different types of company:
(1) a retailer who is holding goods for resale;
(2) a manufacturer which has raw materials stock, work in progress and finished goods stock;
(3) a construction company that has long-term contracts.
●
The retailer
The retailer has fewer problems as there is only one type of stock, the goods that are held for resale. A number of retailers, for example Marks & Spencer, find it useful to show stock at resale value in their internal accounts. When they publish their accounts they adjust this figure to arrive at ‘cost’, by deducting the gross margin they would expect to make on the product. For instance if they had a dress that would retail at £70.00 and the estimated gross margin was 50 per cent, the stock value would be £35.00. The accounting standard requires companies using the estimated margin method of valuing stock to test that this is a ‘reason- able approximation of the actual cost’ before using it in their published accounts.
●
The manufacturer
Manufacturing businesses have more problems when trying to determine the cost of goods sold and the value of stock. These problems can be classified as relating to:
● differential prices:most manufacturers carry their stock for much longer than retailers, and so are more likely to have goods in stock that have been bought at different prices;
● complex valuation:they have different types of stock. At the year end they are likely to have raw materials stock, work in progress and finished goods stock. Labour and overhead costs need to be added to the value of the materials as they move through the production process.
1996 1995
£m £m
Raw materials and consumables 131 151
Work in progress 16 19
Stocks of maturing whisky and other spirits 1516 1498
Finished goods and goods for resale 204 231
1867 1899
Stocks of maturing whisky and other spirits include financing costs amounting to £563m (1995 –
£563m). The adjustment to stocks credited to the profit and loss account amounted to £Nil (1995 –
£Nil) within net trading costs, comprising £112m (1995 – £111m) of interest incurred during the year less £112m (1995 – £111m) in respect of sales during the year.
STOCKS (GUINNESS) Extract 10.2
10 Valuing stock To cope with these difficulties accountants have developed a number of different approaches to valuing stock. The most common methods are valuing stock on:
● a first-in first-out basis (FIFO)
● an average cost
● a last-in first-out (LIFO).
Whatever method is chosen for valuing stocks, companies must disclose any material dif- ference between the cost shown on the balance sheet and the replacement cost of stock.
We will use the following example to illustrate the impact of using the different methods.
Units Unit cost Total
£ £
1 January Opening stock 1 500 1.00 1 500
28 February Purchases 2 000 1.05 2 100
1 April Purchases 1 500 1.06 1 590
30 June Purchases 2 000 1.08 2 160
31 August Purchases 2 200 1.10 2 420
30 November Purchases 11 500 1.13 11 695
10 700 11 465
31 December Closing stock 1 000
To determine the cost of sales we must ascertain the value of the closing stock.
First in, first out
This applies the principle of stock rotation to stock valuation. The first goods into the warehouse are assumed to be the first despatched to the customer, therefore, it will be the latest deliveries that will be in stock.
The value of stock shown on the balance sheet will be £1130 (1000 units times the latest price of
£1.13) and the cost of sales charged to the profit and loss account will be £10 335 (11 465 – 1130).
Average cost
A weighted average cost is used, as unfortunately a simple average will not give the degree of accuracy required. This is illustrated below.
A simple average cost per unit would be:
£1.00 + £1.05 + £1.06 + £1.08 + £1.10 + £1.13 = £1.07 per unit 6
This would mean that £10 379 (9700 x 1.07) would be charged to the profit and loss account and stocks would be £1070. Unfortunately, when we use a simple average the addition of the stock and the cost of sales does not equal the total cost of purchases, £11 465. The stock and the cost of sales total £11 449. To be exactly right a weighted average must be used.
A weighted cost per unit would be:
(1500 x £1.00)+(2000 x £1.05)+(1500 x £1.06)+(2000 x £1.08)+(2200 x £1.10)+(1500 x £1.13) 10 700
= £1.0714953
The extra decimal places ensure the accuracy! Using the weighted average gives cost of sales of £10 393.504 and closing stock of £1071.4953. These add up to the total cost of purchases,
£11 465.
EXAMPLE
Last in, first out
Last in, first out charges the most recent deliveries into the profit and loss account. From our ear- lier example, the closing stock on the balance sheet will be shown at £1000 and the cost of sales in the profit and loss account will be £10 465. As this does not reflect the commercial reality, where the oldest will be used first, SSAP 9 only allows this if it is necessary to ensure the accounts show a true and fair view.
Continuing with our example, the cost of sales would be £10 465 and the stock £1000. How- ever, our example is too simple, to operate LIFO properly companies would have to calculate the last in at the time of making the sale. This means that they would have to have a complicated accounting system to cope with the demands of operating LIFO. It also has the additional dis- advantage that it is not allowed for tax purposes in the UK.
The three methods of valuing stock will give different profits and different stock values on the balance sheet:
Cost of sales Stock values
£ £
First in, first out 10 335.00 1130.00
Weighted average 10 393.50 1071.50
Last in, first out 10 465.00 1000.00 If we consider the effect on the profit and loss account:
FIFO Average LIFO
£ £ £
Turnover 18 000.00 18 000.00 18 000.00
Materials (10 335.00) (10 393.50) (10 465.00) Staff costs (4 000.00) (4 000.00) (4 000.00) Other costs 1(2 000.00) ,1(2 000.00) 1(2 000.00) Operating profit 1 665.00 1 606.50 1 535.00
Last in, first out gives us the smallest profit, but is unlikely to be seen in a UK company, as LIFO should only be used if it is the only method that would show a true and fair view, and is not allowed for tax purposes.
Other costing methods
There are other methods of costing that may be used to value stock that will be found in accounts. Whilst they may not be widely used in the UK, they are more common overseas.
The main alternative methods of costing are discussed below.
Base stock
The base stock level is the minimum amount of stock that a company would need to oper- ate, and it is shown at a fixed price. Any amounts of stock above the base stock are valued differently. Effectively the base stock is treated as though it is a fixed asset as a fixed quan- tity of stock is shown at a fixed price. This is an allowable method under the Companies Act (s 4 para 25) for valuing raw materials and consumables if:
● the overall value of the stock is not material in assessing the company’s state of affairs;
● the quantity, value and composition of the stock is not subject to material variation.
However SSAP 9 implies that using base stock is likely to make the presentation of current assets misleading. Base stock is not allowed for tax purposes in the UK.
10 Valuing stock Standard cost
This type of costing creates standard costs for the materials, labour and production overhead costs of products. It is part of a company’s budgeting process, as it calculates what each pro- duct should cost, given some detailed assumptions. These standards are often subsequently revised in the light of the company’s performance. The use of standard costing for stock val- uation is acceptable under SSAP 9, as long as the standards are reviewed frequently to ensure that they are a reasonable approximation to the actual cost.
Replacement cost
This is where the stock is valued at what it would cost to replace at the balance sheet date.
Replacement cost is not an acceptable method of stock valuation if the company is prepar- ing its accounts using the historical-cost convention. However, it is one of the factors to be considered if the company is preparing its accounts under the current-cost convention.
Current cost
This is the lower of replacement cost and net realisable value, and should be used where the costs are being prepared under the current-cost convention. Any resulting profit or loss should be taken through the revaluation reserve.
Including overheads in stock values
These methods give us the basis for calculating the costs of goods used in sales, but do not cope with the problem of including labour and production overhead costs into the value of work in progress and finished goods stock. Our earlier example was very simple, as it showed stock valuation based purely on the materials cost. Direct labour costs, direct manufacturing expenses and manufacturing overheads also have to be included in the valuation of stocks.
Most companies’ accounting procedures allow them to build in the cost of labour and pro- duction overheads as the materials move through the production process. But problems can arise when production falls or rises dramatically, as the procedures assume ‘normal’ produc- tion levels.
We have to define ‘the normal level of activity’. The accounting standard gives some guid- ance in its appendix. It says that companies should consider the plant capacity, the budgeted level of activity, and current and previous year’s performance. The problems start when the company has a fall in sales. It then has to determine whether this is a short-term problem or a continuing one. This is illustrated in the following example.
A company has a production facility that has been designed to produce 100 000 units a year. In the first year it produced, and sold 94 000 units, in the second 95 000 units, and in the third 96 000 units. This year the company produced 90 000 units, 10 000 of which are still in stock.
They have almost achieved their budgeted production of 95 000 units but achieving budget sales has proved more elusive, as they only managed to sell 80 000. The company was operating close to budget until the last quarter, when sales fell off dramatically. The production overheads for the period were £2 million.
The real problem here is trying to define the level of normal activity. The plant has never oper- ated at maximum capacity, although in most businesses 100 per cent efficiency is probably an impossible dream! Average production over the first three years is 95 000 units, the same as the budgeted production and sales for this year. If the overheads were apportioned across 95 000 units, there would be a unit overhead cost of £21.053 (2 000 000 95 000) and the overheads allo- cated to stock would be £210 530. This would be an appropriate allocation if it was believed that EXAMPLE
the fall in sales was only temporary (for example, customers could have been de-stocking towards the year end and the sales will return to normal levels next year). However, if the fall in sales is thought to be permanent, then the 80 000 units sold would be a more appropriate basis for appor- tioning the overheads. This would give a unit charge of £25, a total overhead charge to stock of
£250 000, an increase of nearly 19 per cent. So, should the overheads be apportioned over 95,000 units or 80,000? This does not just have implications for stock values, it also has implications for the profit and loss account. The company has incurred the £2 million overhead cost, part of which will be charged to stock, and the balance to the profit and loss account (Table 10.1).
Reducing the level of normal activity flatters profits. The more overhead that is included in the stock value, the higher the profit for the year (but the lower the profit for the next year, unless the company can have a price increase to reflect the increased ‘costs’). Whilst the auditors would want to see some consistency, the company could argue that it was taking a prudent view!
Net realisable value
We have been looking at what costs should be assigned to stock, but we must not forget that stock should be shown at the lower of cost or net realisable value. Charging all these costs to stock does not help if the ‘cost’ then exceeds the net realisable value! But what is net realis- able value? The definition, in the accounting standard, has been given in the introduction to this chapter. However, trying to ascertain whether the stock has fallen below its market value, in its current state, is an area for discussion. Small companies, in particular, are loath to make provisions for obsolete stock. Provisioning reduces both profits and net worth.
There is considerable scope for creative accounting in stock valuation. Stock and profits can be flattered by:
● changing the method – in our previous example a move from average cost to FIFO increased profits by £58.50, a number not significant on its own, but it increased operat- ing profits by nearly 4 per cent. The percentage improvement in profits would increase as the materials cost percentage increases. Companies would have to disclose a change in the valuation method in their accounting policies;
● reducing the level of ‘normal activity’– in the example illustrated above, reducing the normal activity improved profits and stock values;
● overstating the net realisable value– companies are required to show stock at the lower of cost and net realisable value, with any writedown in values being charged to the profit and loss account, but net realisable value is a matter of judgement. These provisions are only disclosed separately if it is necessary in order to show a true and fair view.
Analysts in fact have limited information about stock valuations, as the note from the accounting policies of the engineering group IMI’s 1996 accounts illustrates (Extract 10.3).
Overheads charged to profit and loss account and stock Table 10.1
Overhead allocated Amount charged to:
to stock based on:
the profit and loss Stock account
95 000 units 1 789 470 210 530
80 000 units 1 750 000 250 000
2 + 2 = 5
Therefore, we are forced to rely on our common sense. Is the stock number believable when we look at the company’s history of managing stock and the performance of other compa- nies in the industry?
●
The construction company
Construction companies have different problems in stock valuation, as large construction contracts often span a number of years. The normal accounting rules are fine when the sales and the purchases are close together, but may be inappropriate when the company is incur- ring costs over a number of years. If the company waited until the completion of the project before including the contract in the profit and loss account, the accounts would not reflect a true and fair view of their financial performance. They could have high stocks one year and nothing in the following year, as they complete nothing in one year and three contracts in the following year. Both stocks and profits would become very erratic. Treating companies which are involved in long-term contracts in the same way as other companies would render their accounts meaningless.
In view of this, SSAP 9 allows construction companies, and others with long-term con- tracts, to include both turnover and profit from uncompleted long-term contracts in their profit and loss account. As the contracts are valued on a percentage of completion basis, with profit being taken before completion, the asset is often recorded as a debtor (amounts recov- erable on contracts) rather than stock. The amount shown as long-term contract balances as part of stock will have been determined by taking the costs that have been incurred and deducting:
● cost of sales
● foreseeable losses
● payments on account that are not matched by turnover.
The notes to the balance sheet should separately disclose:
● the net cost less any foreseeable losses
● the applicable payments on account.
As profit is taken on percentage of completion, and any unmatched payments on account are deducted for the contract work in progress, it may well mean that there is little or noth- ing included stock. This illustrated in the following example:
A company with a long-term contract has certified work completed of £590 000 during a year.
This will be shown as the turnover of the project. It has received a total of £630 000 payments on account from its customer. The total costs incurred on the project during the year are £550 000, of which £500 000 has been transferred to cost of sales.
10 Valuing stock
EXAMPLE STOCKS
Stocks are valued at the lower of cost and net realisable value. In respect of work in progress and finished goods, cost includes all direct costs of production and the appropriate proportion of production overheads.
STOCKS (IMI) Extract 10.3