Stock valuation (also called inventory valuation) is the process of assigning a monetary value to the goods a business holds for sale or for use in production. The method chosen directly affects the cost of goods sold, gross profit, and the value of current assets on the balance sheet.
Under FRS 102 (Section 13), stock must be measured at the lower of cost and net realisable value (NRV). The accounting standard also prescribes which cost formulas are permitted.
The Lower of Cost and NRV Rule
Every item of stock must be valued at whichever is lower:
| Measure | Definition |
|---|---|
| Cost | All costs of purchase, conversion, and other costs incurred in bringing stock to its present location and condition |
| Net realisable value (NRV) | The estimated selling price less all estimated costs of completion and costs necessary to make the sale |
If NRV falls below cost, the stock must be written down to NRV. This typically arises when stock is damaged, becomes obsolete, or when selling prices have declined.
Example
A retailer holds 100 units of a product:
| Per Unit (£) | Total (£) | |
|---|---|---|
| Cost | 15 | 1,500 |
| Estimated selling price | 12 | 1,200 |
| Selling costs | 1 | 100 |
| NRV | 11 | 1,100 |
Stock is valued at £1,100 (NRV), not £1,500 (cost). The £400 write-down is charged to the income statement as part of cost of goods sold.
Components of Cost
The cost of stock includes all expenditure incurred in bringing the stock to its present location and condition:
| Component | Examples |
|---|---|
| Purchase price | Amount paid to the supplier, net of trade discounts |
| Import duties | Customs duty on imported goods |
| Transport and handling | Freight, carriage inwards |
| Direct labour | Wages of production workers (for manufactured goods) |
| Production overheads | Factory rent, depreciation of production equipment, utilities (allocated on a normal capacity basis) |
Costs that are excluded from stock valuation:
| Excluded Cost | Reason |
|---|---|
| Selling and distribution costs | Costs of selling, not of acquiring or producing |
| Administrative overheads (not related to production) | General management costs |
| Abnormal waste | Costs of inefficiency should not inflate stock values |
| Storage costs (after production) | Unless storage is part of the production process |
Permitted Valuation Methods
FRS 102 permits the following cost formulas for assigning cost to items of stock:
FIFO (First In, First Out)
FIFO assumes that the items purchased or produced first are sold first. The remaining stock is valued at the most recent purchase prices.
AVCO (Weighted Average Cost)
AVCO calculates the weighted average cost of all units available for sale during the period. Each time a new purchase is made, the average cost per unit is recalculated.
Specific Identification
For items that are not interchangeable (such as bespoke goods, works of art, or high-value individual items), the actual cost of each specific item must be used.
LIFO (Last In, First Out) is not permitted under FRS 102.
FIFO Versus AVCO: Worked Example
A business makes the following purchases and sales during January:
| Date | Transaction | Units | Unit Cost (£) | Total (£) |
|---|---|---|---|---|
| 1 Jan | Opening stock | 200 | 10.00 | 2,000 |
| 10 Jan | Purchase | 300 | 11.00 | 3,300 |
| 18 Jan | Sale | 350 | – | – |
| 25 Jan | Purchase | 150 | 12.00 | 1,800 |
Total units available: 650. Units sold: 350. Closing stock: 300 units.
FIFO Valuation
Under FIFO, the 350 units sold are assumed to come from the oldest stock first:
- 200 units at £10.00 = £2,000
- 150 units at £11.00 = £1,650
- Cost of goods sold: £3,650
Closing stock consists of the most recent purchases:
- 150 units at £11.00 = £1,650
- 150 units at £12.00 = £1,800
- Closing stock: £3,450
AVCO Valuation
Before the sale on 18 January, the weighted average cost is:
(£2,000 + £3,300) / 500 units = £10.60 per unit
- Cost of goods sold: 350 x £10.60 = £3,710
- Remaining stock before 25 Jan purchase: 150 x £10.60 = £1,590
After the 25 January purchase, the new average is:
(£1,590 + £1,800) / 300 units = £11.30 per unit
- Closing stock: 300 x £11.30 = £3,390
Comparison
| Method | Cost of Goods Sold (£) | Closing Stock (£) | Gross Profit Impact |
|---|---|---|---|
| FIFO | 3,650 | 3,450 | Higher gross profit |
| AVCO | 3,710 | 3,390 | Lower gross profit |
When prices are rising, FIFO produces a higher closing stock value and lower cost of goods sold, resulting in higher reported profit. The difference reverses when prices fall.
Stock Valuation and Profit
The relationship between stock and profit is expressed in the cost of goods sold formula:
Cost of goods sold = Opening stock + Purchases - Closing stock
| Change | Effect on COGS | Effect on Profit |
|---|---|---|
| Closing stock value increases | COGS decreases | Profit increases |
| Closing stock value decreases | COGS increases | Profit decreases |
This means that the choice of valuation method and the accuracy of the stock count directly affect reported profit.
Stock Count and Verification
At the end of each financial year (and often more frequently), businesses must conduct a physical stock count to verify the quantities on hand. The count is reconciled to the stock records, and any discrepancies are investigated.
Common causes of stock discrepancies:
- Theft or pilferage
- Damage not yet written off
- Recording errors in goods received or dispatched
- Obsolescence not yet identified
Stock Write-Downs and Provisions
When NRV falls below cost, a write-down is required. Businesses often maintain a stock provision for slow-moving, obsolete, or damaged items. The provision is reviewed at each reporting date and adjusted as necessary.
| Category | Cost (£) | NRV (£) | Provision (£) |
|---|---|---|---|
| Fast-moving lines | 80,000 | 95,000 | 0 |
| Slow-moving lines | 25,000 | 18,000 | 7,000 |
| Obsolete lines | 8,000 | 1,500 | 6,500 |
| Total | 113,000 | 114,500 | 13,500 |
The stock is reported on the balance sheet at £99,500 (£113,000 - £13,500).
Stock on the Balance Sheet
Stock is presented within current assets on the balance sheet:
| Current Assets | £ |
|---|---|
| Stock | 99,500 |
| Trade debtors | 62,000 |
| Prepayments | 4,200 |
| Cash at bank | 18,300 |
| Total | 184,000 |
The notes to the accounts should disclose the accounting policy for stock valuation, the cost formula used (FIFO or AVCO), and any material write-downs during the period.
Stock Valuation and Tax
For corporation tax, HMRC generally accepts the stock valuation method used in the accounts provided it is consistent with FRS 102 and applied consistently from year to year. A change in valuation method must be disclosed and may trigger a tax adjustment for the transitional difference.
Stock write-downs are normally allowable deductions for tax purposes, but HMRC may challenge provisions that appear excessive or not supported by evidence.