Valuation of stock

All businesses hold supplies of raw materials, components and goods which they need to carry out their production processes. Some types of business will also hold stocks of semi-finished and finished goods. The quantity of the stock held by a business will depend on the type of business, its size, the amount of capital it has available and the supply of stock. In this text we are concerned with the way in which a business allocates value to existing stock for accounting purposes.

In January 2004 a building contractor was offered a quantity of timber sufficient to supply his normal requirements for twelve months. He decided to take advantage of this bargain. In June 2004 he was preparing an estimate for the renovation of a house, his building insurance was due to be renewed and he was hoping to float a bank loan to extend the business. He was faced with the problem of placing a value on the remaining stock of timber for each of these reasons. Should he value the timber at the price paid for it, that is its historic cost, or the cost of replacing it, which was 20 per cent greater?

There are three basic methods the builder might use to solve this problem.

1. Valuation using a weighted average. This is the simplest method and can be used successfully when the cost of buying stock does not vary greatly over time. Look at the following example:

Value of stock bought on 1 January £2000 (200 x £10)

Value of stock bought on 1 February £3000 (200 x £15)

Value of stock bought on 1 March £1800 (150 x £12)

The total quantity of stock held on 1 March is 550 at a historic cost of £6800. The value of each unit of stock held can therefore be calculated as:

£6800/550=£12.36

2. Last in first out (LIFO). Using this method all stocks of a similar nature are valued at the last price paid for those stocks. This is a useful method when prices are rising as it takes into account the fact that the stocks used must be replaced at the current market price. Failure to do this might give an artificially high profit in the accounts of the business and result in the payment of too much tax.

3. First in first out (FIFO). FIFO values all stock at the purchase price of the oldest unit used. In the example given above all stock would be valued at £10 per unit until the supplies bought on 1 January were used up, then at £15 per unit until the stocks bought on 1 February were exhausted, and so on.

2. Comprehension check.

Read the text again more carefully. Choose the correct answer from a, b, c.

1. What stock(s) do all business hold?

a) components, goods and raw materials

b) raw materials, machinery and goods

c) semi – finished and finished goods

2. What supplies do some enterprises have in stock?

a) raw materials and components

b) semi – finished and finished goods

c) machinery and equipment

3. What will the quantity of the stock held by a business depend on?

a) the type of business and the amount of capital

b) the size of business and the amount of capital

c) the size of business, its type and the amount of capital

4. What problem did a building contractor face with on backing of a loan?

a) the problem of placing a value on the dead stock of timber

b) the problem of placing a value on the available stock of timber

c) the problem of placing a value on the remaining stock of timber

5. Which method of valuation of stock is the easiest?

a) last in first out

b) valuation using a weighted average

c) first in first out

6. When is the valuation using a weighted average method employed?

a) when the cost of buying stock does not vary greatly over time

b) when there is a falling tendency in prices

c) when there is a rising tendency in prices

7. When can the LIFO method be used?

a) when prices are going down

b) when prices remain firm

c) when prices are rising

8. FIFO method presumes that:

a) the stocks used must be replaced at the current historical cost

b) the stocks used must be replaced at the current market price

c) the stocks used must be replaced at the current final cost

9. Which of the stocks should be written off first when using FIFO method?

a) at £ 10

b) at £ 15

c) at £ 12,36

d) at £ 12

3. Solve the problem.

A business buy stock to the value of £ 4000 on 1 August, £6000 on 12 August and £ 10000 on 15 August. It buys no more stock for the rest of the month. The stock is valued as follows:

500 items at £20

300 items at £10

200 items at £35

What is the average value of stock held?

Discussion

Work in pairs.

The price of raw materials in rising rapidly. Under these circumstances which method of stock valuation would you advise a business to use?

*Review¹

1. A machine costs £30 000 and has a useful life of five years. At the end of that time it will have a residual value of £5000. The business decides to use the declining balance method of depreciation. The figures are as follows:

Year Depreciation provision Net book value

1. 9035 20965

2. 6314 14651

3. 4412 10239

4. 3084 7155

5. 2155 5000

a. What is meant by the terms:

І residual value?

ІІ depreciation?

ІІІ net book value?

b. From the data given and using the same axes draw graphs to show the effect on the book value of using:

i the straight line method of depreciation,

ii the declining balance method.

c. Give one reason why the business might have decided to use the declining balance method of depreciation.

d. State and explain three factors which influence the life of an asset.

2. The information given below is a summary of the transactions of a small business during its first year of trading.

	£		€
Cash received	Cash paid
Proprietor's funds	15000	For stock	25000
Loan from bank	5000	For rent of premises	3000
Sales revenue	40000	For fixtures & fittings	15000
		For rates	1500
		For administration	500
		Owner's drawings	5000
		Heating & lighting	1000

The following information is also available at the end of the accounting period:

• the business is owed £2000 by its customers.

• there is a stock of goods worth £5000.

• cash and bank balances total £1000.

• the business owes suppliers £4000.

• cost of lease £10 000.

1. Draw up the profit and loss account for the firm at the end of the first year of trading.

2. Draw up the balance sheet of the business at the end of the first year of trading,

3. What other information would you need in order to estimate the business’s chances of survival?

3. A business buys a machine at the beginning of an accounting period for £50 000. It is expected to have a useful life of ten years and a scrap value at the end of the period of £5000.

a. Compare the book value of the machine at the end of five years using both the straight line and declining balance methods of depreciation at 21 per cent (actual percentage 20.567 to three decimal places).

b. In what circumstances might the declining balance method of depreciation be

preferable to the straight line method?

c. The machine was sold for scrap after eight years. Assuming that the business is still operating profitably, give three reasons why it might have taken this course of action.

UNIT 6

Costs and costing