1.0
INTRODUCTION
At the end of any
financial period, it is necessary to value the stock in hand, which will be
handed on by the current period to the next period at the agreed valuation. The
purchase of stock during the year is a revenue expenses, because it is the
purchase of goods for resale, but at the end of the year, the
balance in hand
has, for a few hours, to be capitalized and handed on to the next year as an
asset of the business. As soon as the business commences on the first day of
the new period, the customers start once again to purchase the goods and the
revenue activities of selling goods and replacing them with new stock begins
again, for a further trading period.
The process of
valuing stock is one, in which adjustments have to be taken into account at the
end of the financial year. These are dealt with more fully in this note.
2.0
OBJECTIVES
At the end of this note,
you should be able to:
• explain the methods
of valuing stock
• compute the value
of stock at the end of the accounting year using variation methods.
3.0
MAIN CONTENT
3.1
Valuation of Stock
The method used in
valuing the close-of-period stock that is brought into the Trading Account is
extremely important because of the effect it has on the gross profit. An over
valuation has the effect of increasing the gross profit and thereby creating a
distorted image of the financial position of the business. Under-valuation has
the reverse effect of reducing the gross profit margin.
The question then is:
What price should be placed on the unsold goods at the close of the period?
The first logical
answer that comes to mind is to value the unsold goods at what the businessman
paid for their purchase (i.e. at cost). This means that if 15 articles were
unsold at the end of the season and the articles cost N3 each, the value of the
unsold stock is (15 x N3) = N45.00. For this method to be useful, the unsold
stock must be physically counted and compared with the figures on the stock
card. This is very important because the stock card may show 15 articles as
unsold when in fact only 13 are left in the warehouse. This later figure is the
one that goes into the Trading Account so that the stock will be (13 x N3) =
N39.00 and not N45.
Another method of
valuing stock is to think of the price the stock would fetch on the last day of
the period in the ordinary course of business (i.e. the market value). If this
price is considered less than the cost prices, it should be value of stock for
the purpose of the Trading Account.
If using the previous
example, the 15 articles can fetch N2.50 each, the stock value should be N37.50.
If, on the other hand, the articles can fetch N3.25 each, stock should be
valued at cost, i.e. N3.00 each.
The principle
established by this is that valuation should be based on lower of "cost'
or "market value'.
The estimation of the
possible market value is definitely not the responsibility of a clerk in the
office. The proprietor of the business must decide what price he thinks the
remaining goods can realize if sold on the last day of the period.
A third method of
valuing stock is to think of the price, which the proprietor will pay if he
were to buy similar goods to replace the unsold ones. This is called the
'replacement price' If this price is lower than both the cost price and the
'market value', then stock should be valued at it.
Illustration 1
No.
of Articles
|
Cost
Price
|
Market
Value
|
Replacement
Price
|
Valuation
(i.e. the lowest of the values)
|
|||
N
|
N
|
N
|
N
|
||||
20
|
40
|
38
|
41
|
38
|
|||
40
|
80
|
83
|
81
|
80
|
|||
25
|
79
|
75
|
82
|
75
|
|||
50
|
120
|
119
|
128
|
119
|
|||
160
|
2,080
|
2,200
|
2,000
|
2,000
|
|||
200
|
6,000
|
6,050
|
6,500
|
6,000
|
|||
What is being advised
in the final analysis is that stock should be valued at a price which reflects
prudence and helps in making the accounts give a true and fair view of the
trading results of the period under review.
In a fluctuating
market, prices vary constantly where there is an inflationary trend, prices
tend to rise. Under such circumstances, price paid for the same items vary
several times during the trading period. Faced with this difficulty of changing
prices, the trader would be in difficulty on how to value his closing stock,
since it will not be possible to identify prices paid for individual items, all
of which look alike.
Therefore, the cost
to be placed on such stock can be any of the prices paid during the year. There
are three main methods of valuing closing stock in these circumstances. These
are:
1) First In, First
Out Method (FIFO)
2) Last In, Fist Out
Method (LIFO)
3) Average Stock
Method
1)
First In First Out Method (FIFO)
This method implies
that earlier goods purchased are the first to be sold. Using this method, the
closing stock represents the most recent purchases, and the cost price would be
related to current values. This method is most factual, and is used by many
businesses. It is most suitable in cases of perishable goods.
Illustration
2
A. Dapo, who makes up
his account on 31m December, made purchases as follows during December.
i. 10th December 700
items at N1.00k each
ii. 21st December 200
items at N1.25k each
iii. 38th December
200 items at N2.00k each
On 31st December, his
closing stock was 300. Show the valuation to be included in his account under
the above method.
Computation of
Closing Stock under FIFO
Stock U/Price Value
N N
Purchases on 28th
Dec. i.e. 200 2.00 400.00
Purchases on 21st
Dec. i.e. 100 1.25 125.00
300 1.75 525.00
Using this method,
the purchases of 10th December, i.e. 700 items and 100 items of those purchased
21st December had been sold off (i.e. 800 items).
2.
Last In Fist Out Method (LIFO)
This method assumes
that the latest items purchased are the first to be sold. This method is used
by those who advocate the principle that cost should relate as closely as
possible to current price levels. Therefore, cost of sales should be at current
prices.
Computation
of Closing Stock under FIFO (Using the above
illustration)
Using this method,
the purchases made on 28th and 21st December of 200 items each have been sold
off Also, 400 of the items purchased on 10th December have also been sold,
making a total of 800 items sold. Therefore, the balance of 300 items unsold
relate entirely to the purchases of 10th December at N1.00 each. Valuation of
closing stock i.e. 300 @ N1.00 = N300.00. Computation under (1) and (2) above
have assumed that items were sold after the last purchase.
Average
Stock Method
Under this method,
upon the purchase of new items, a new value is computed by adding the total
items purchased to the total of old stock with their monetary values. The
resultant quantity is used to divide the resultant value to obtain the new note
price. The advantage of this method is that the valuation lies somewhere
between two extremes of FIFO and LIFO, and is more realistic. However,
complicated computations (involving fractions) are involved in using this
method.
Before computing
under this method, it is necessary to state the sales made with dates. Items
sold would be deducted to arrive at a balance to which purchases would be
added.
Assuming the
following sales:
12th December 200
23rd December 300
29th December 300
Note that (i) and
(ii) above give new valuation of N1.07 and N1.38 respectively arrived on the
purchase of new items on 21st and 28th December, which represents "new
cost' of sales on those respective days. The realistic value of closing stock
under this method is N415, and lies between FIFO and LIFO methods.
The various
computations are as follows:
1) FIFO Method N525
2) LIFO Method N300
3) Average Stock
Method N415
The highest valuation
is obtained by FIFO Method while the lowest is obtained by the LIFO Method.
4.0
CONCLUSION
The situation of each
type of stock note can be likened to reservoirs in which the opening account is
mingled with the year's purchases. The stock remaining at the end of the year
cannot, in theory, be allocated to a particular batch. Therefore, the cost to
be placed on this stock can be any of the prices paid during the year.
5.0
SUMMARY
There are various
methods of valuing stock. The most popularly used are FIFO (First In First
Out). Under this method, it is assumed that the goods remaining in our store
represent those goods that were lately bought. LIFO (Last In First Out), Under
this method, it is assumed that the goods in our store represent those of
earlier purchases and Average Stock Method were it is assumed that the goods in
our store represent goods from all our purchases at different prices thus, the
price of all our purchases is computed and an average is taken.
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