The Valuation of Current Assets

The valuation of current assets

Current assets consist of cash and other assets, such as debtors and inventories, which are expected to be converted into cash or to be used in the operations of the enterprise within one year. The most complex problems lie in the valuation of the different types of inventories existing at the end of an accounting period. In Part 5, we shall see that closing inventories consist of three types-raw materials, work-in-progress and finished goods. The production process may be viewed as a process of adding value to successive categories of inventories, that is, from raw material to finished goods. Inventories' values, therefore, affect the income statement as well as the balance sheet. Since they are an important constituent of the expenses chargeable against sales revenue, they occupy a key position in the determination of periodic income. -

The valuation of inventories

Inventories are traditionally stated at historical cost. SSAP 9 'Stocks and Work in Progress' requires that the cost of inventory 'should comprise that expenditure which has been incurred in the normal course of business in bringing the product or service to its present location and condition'. With respect to the acquisition costs reflected in inventory values, they should be added to the cost of purchasing, the cost of packaging and transport. Where applicable, trade discounts should be deducted from the purchase price.

There are, however, many different methods for determining the cost value of inventories, and these methods produce valuations which differ markedly from each other. A simple example serves to illustrate how three different valuation methods lead to .divergent values.

Example

A firm has an opening inventory of 100 items valued at £1.00 each. During the accounting period, 100 units were purchased for £1.20 each and a further 100 units were purchased for £1.30 each. There remained 100 units in inventory at the end of the accounting period, that is, after 200 units had been sold for £300.

The firm is considering the effects of the under-mentioned three methods of inventory valuation:

(a) The FIFO method assumes that the oldest j items in inventory are used first, so that the items in inventory are assumeC w be the remnants of more recent purchases. The result of the application of FIFO to the given data is that the cost of goods sold during the year is taken to be £220, and the value of the closing inventory is £130.

Advocates of the FIFO method argue that its underlying assumption is in accordance with conventional practice that goods purchased first are sold first, and that this method eliminates the opportunities for management to manipulate income results and inventory values by selecting out of the existing inventory the values which serve their purposes best. Under conditions of rising prices, FIFO requires that the inventory of the earliest date and prices be deemed sold first, with the effect that the income statement reflects a higher level of income than would have been the case if current replacement costs had been used. Closing inventory values are shown at the more recent acquisition prices and approximate current replacement costs.

(b) The LIFO method assumes that the most recently purchased inventories are used first, so that the items remaining in inventory at the end of the year are assumed to be the remnants of earlier purchases. Under this method, the cost of goods sold during the year is taken to be £250, and the value of the closing inventory is £100. The LIFO method has the reverse effect, therefore, to FIFO on the measurement of income and the valuation of closing inventories.

Though LIFO approximates the replacement cost basis of valuation as regards the input of resources to the income earning process, it does not necessarily correspond with replacement cost valuation. LIFO reflects the latest cost price of the specific commodity, which may or may not be the actual replacement cost. In the case of seasonal buying, for example, the cost of the last purchase may not be equivalent to the current replacement cost. As a result, LIFO eliminates only an indeterminate part of the effects of specific price changes. Indeed, when sales exceed purchases, that is, when inventories are being depleted, the gap between replacement cost and LIFO may become very great. A classic example of this situation arose in the United States during the Korean War, which resulted in inventory reduction on such a scale that Congressional approval was given for Next-In-First-Out inventory valuation as a relief for taxpayers who were on the LIFO basis (Fremgen, 2015.)

A further disadvantage of the LIFO method of inventory valuation is that it leads to distortions in balance sheet valuations. This is defended on the grounds that the income statement is the more important document since income measurement is the major point of interest among shareholders. According to Moonitz ( 2015), however, 'this leaves unanswered the important query as to how it is possible to have reasonably accurate statements of income accompanied by admittedly inaccurate balance sheets. Where is the difference buried and what is its significance?'

(c) The weighted average cost method requires the calculation of the unit cost of closing inventory by means of a formula which divides the total cost of all inventory available for sale during the accounting period by the physical units of inventory available for sale.


Interested in Current Cost Accounting

Read on: The Valuation of Plant and Machinery and Other Fixed Assets

The valuation of plant and machinery and other fixed assets

Plant and machinery, furniture and fittings, motor vehicles, tools and sundry equipment are usually valued at historic cost with proper allowance for depreciation. Cost includes purchase price, freight charges, insurance- in transit and all installation costs. The purpose of depreciation in accounting is to allocate the cost of fixed assets to the several years of their useful life to the firm.

The valuation of natural resources

Natural resources, such as oil, gas, coal and other minerals as well as forests... see: The Valuation of Plant and Machinery and Other Fixed Assets