Accounts & Finance

Intangible AssetsHL ONLY

Learning Objectives

To be able to calculate stock valuations

Stock Valuation

• Value of closing stock on a balance sheet is a major factor influencing:– The value of a company’s balance sheet– Profit recorded – higher the value given to closing

stock, lower the cost of goods sold

Valuation of stocks can vary greatly depending on the method used and the rate of inflation

• Stocks are constantly being bought, and processes change frequently

• Accepted methods of stock valuation

First in first outFIFO

• The goods first added to inventory (stock) are assumed to be the first goods removed from inventory for sale

• It is the logical flow of many inventories, especially with products that expire or become outdated

• Ensures that any unsold stock is more realistically valued at its current or replacement cost

Last in first out (LIFO)

• Goods last added to inventory are assumed to be the first goods removed from inventory for sale

• Valuing stocks by using the most recent batches of stocks first since there is no “sell by” date

• Coal, copper• Older stock is usually valued at a lower cost• This method is not permitted in many countries

because of the tax benefits

Last in first out (LIFO)• Tax benefits• Using LIFO accounting for inventory, a

company generally reports lower net income and lower book value, due to the effects of inflation. This generally results in lower taxation

LIFO• Cost of goods sold

COGS = opening stock + purchases – closing stock

AND

Gross profit = sales revenue - COGS

So when declaring Gross Profit, it would seem lower when using LIFO, therefore not having to pay as much tax

Comparing the 2 methods – An Example

Choosing between the two

• If there were no increases of prices over time (inflation) it wouldn’t matter which method was chosen

• But inflation makes the choice of stock valuation methods important as it can affect the level of reported profits and therefore the amount of tax a company has to pay

• Some laws prevent switching between the two • Some laws prevent businesses from using LIFO because

of tax benefits• At the moment LIFO is only used in Japan and the USA

• See word document – Worked examples