Stock (inventory) valuation
For many firms, the value of stock can represent a large proportion of its asset value, which means that valuing it accurately in the balance sheet is very important.
Stock is often purchased in batches, and because the market tends to fluctuate significantly, especially in the case of commodities, it is not unusual for a firm to pay varying amounts for stock which may make it more complex to value unsold stock. If we can identify each unit of stock then we could apply the relevant cost price. However, some stocks will be very hard to distinguish - the goods may be very uniform and we may not be able to tell which stocks were purchased when. For example, with coal or oil purchased on different dates we would not be able to distinguish between different purchases. The firm is unlikely to keep separate purchases in different areas of the firm and it would be time consuming for firms to keep track of every purchase. This means that the stock left over at the end of the period may have been purchased on several different occasions.
If there is any stock left at the end of the trading period, then which cost price should we use for the valuation? Should we use the earliest cost we paid, or should we use the latest cost price that was paid? The underlying concept is that we should refer to the concept of prudence (lower of cost or net realisable value), but if there are different cost values then we need a method of deciding which cost value to use.
In stock valuation there are two major methods used. These are as follows:
- FIFO (First In, First Out method)
- LIFO (Last In, Last Out method)
Example
We will use the following data to calculate the value of the closing stock at the end of January 2011 using each of the three methods for stock valuation.
Then we can draw up the trading accounts under each method to see what the gross profit is for the month. Note that the selling price of the stock is irrelevant as far as the stock valuation is concerned. We only concern ourselves with the selling price when drawing up the trading account.
| Bought | Sold |
|---|
| 2011 | $ | 2011 | $ | ||
|---|---|---|---|---|---|
| Jan 5 | 20 units @ $20 each | 400 | Jan 11 | 12 units for $35 each | 420 |
| Jan 18 | 10 units @ $25 each | 250 | Jan 24 | 9 units for $38 each | 342 |
| 650 | 762 |
Method 1 - First in, first out method (FIFO)
This method assumes that the stock used in a transaction (e.g. a sale) will be the earliest stock purchased. The first stock into the firm is the first stock to be issued. Any stock remaining at the end of the period will be the most recent purchases.
| Date | Bought | Issued | Stock held after transaction | ||
|---|---|---|---|---|---|
| 2011 | $ | $ | |||
|
Jan 5 |
20 units @ $20each | 20 units@ $20 | 400 | ||
|
Jan 11 |
12 units @ $20 each |
8 units@ $20 |
160 |
||
| Jan 18 | 10 units @ $25 each |
8 units @ $20 10 units @ $25 |
160 250 |
410 |
|
| Jan 24 |
8 units @ $20 each 1 unit @ $25 each |
9 units @ $25 |
225 |
Method 2 - Last in, First out method (LIFO)
This method assumes that the stock used in a transaction (e.g. a sale) will be the most recent stock purchased. The last stock into the firm is the first stock to be issued. Any stock remaining at the end of the period will be the earliest purchases.
| Date | Bought | Issued | Stock held after transaction | ||
|---|---|---|---|---|---|
| 2011 | $ | $ | |||
|
Jan 5 |
20 units @ $20each | 20 units@ $20 | 400 | ||
|
Jan 11 |
12 units @ $20 each |
8 units@ $20 |
160 |
||
| Jan 18 | 10 units @ $25 each |
8 units @ $20 10 units @ $25 |
160 250 |
410 |
|
| Jan 24 | 9 units @ $25 each |
8 units @ $20 1 unit @ $25 |
160 25 |
185 |
The closing stock values at the end of January are as follows:
FIFO $225
LIFO $185
Impact of stock valuation on final accounts
The final accounts will be affected in the following way:
| Trading account for month ended 31 January 2011 |
|---|
| FIFO | FIFO | LIFO | LIFO | |
|---|---|---|---|---|
| $ | $ | $ | $ | |
| Sales | 762 | 762 | ||
| Less Cost of goods sold | ||||
| Purchases | 650 | 650 | ||
| Less Closing stock | 225 | 425 | 185 | 465 |
| Gross profit | 337 | 297 |
As long as the method is consistently applied (used year after year), then the effects on the final accounts will cancel each other out over time. This is because the closing stock in one year will become the opening stock the year after.
Advantages and disadvantages of each method
| FIFO |
|---|
| Advantages | Disadvantages |
|---|---|
| It is probably the method that would be used if intuition was called for | In times of rising prices it shows higher profit figures earlier - which is not prudent |
| It is allowable for taxation by many tax authorities | |
| It is legally acceptable under accounting standards in many countries |
| LIFO |
|---|
| Advantages | Disadvantages |
|---|---|
| Issues of stock are valued at the most recent prices | The balance sheet contains out of date values for stock |
| It is often not allowed for taxation purposes or by accounting standards in many countries |
