Year end stock valuation issues

[Rob-Ed]

Hi
Last financial year we used a new accounting and stock management system which calculates stock valuation in a way that I'm not happy with. It performs a simple calculation of quantity on hand multiplied by current cost price. The previous system used an 'average' purchase price. As costs are inevitably increasing, the valuation of stock which we have held for several years, having purchased at a much lower price, will now be reported as much higher than the actual cost.
As I understand it, we will effectively have to pay CT on this growth in stock value. In reality the stock is aging and should technically have a lower value (depreciating). It is not an 'investment'.

Apart from the depreciation aspect, we've had to increase the selling price of affected items (we would have to pay the current, higher cost price to replace our older shelf stock) this means higher CT liability at year end.

In summary, if we use our system's stock valuation calculation we will be liable for CT on an increase in value which should actually be depreciation.

Overall this seems unfair. I'm hoping for some advice as to how we can more fairly calculate our year end stock valuation.
Thanks
Rob

 

[UK Contractor Accountant]

Stocks should be valued at the lower of cost or net reliable value (NRV).

Determination of cost - basically there are 3 methods:

1. Last in first out (LIFO)
2. First in first out (FIFO)
3. Average Cost (AC)

For you number 1 (LIFO) I guess will give you lowest stock value at the year end, however, if your stock mgmt system does not facilitate this method then number 3 is your next best option.

Cant you export the end of year stock report into excel showing the quantities held for each stock item and then play around with various unit cost price of each item based on the purchases made in the year to get an average cost price.

Of course, slow moving, shop soiled or obsolete items should be reduced down to estimated realisable values.

 

[pentel]

Of course, slow moving, shop soiled or obsolete items should be reduced down to estimated realisable values.

There is some wiggle room here.

You could account for the likelihood of selling the stock in a reasonable length of time before it becomes obsolete / unsellable, the length of time being very different between a banana and an electric motor.

You can also take into account the likelihood of it selling. e.g. if you sell individual door numbers and have lots of stock of 0-9's these would be likely to sell. If however you only have 4's left then the likelihood of selling just a 4 is much reduced.

 

[UK Contractor Accountant]

Last financial year we used a new accounting and stock management system which calculates stock valuation in a way that I'm not happy with

Which accounting software are you now using?

 

[DontAsk]

You value the stock higher which increases CT at year end but decreases profit and CT when you sell, or you value it lower which leads to lower CT now but higher profit and CT when you sell.

It all comes out in the wash eventually.

Having said that, accounting software should not force you to accept only its stock valuation.

 

[Argentum Tax]

You value the stock higher which increases CT at year end but decreases profit and CT when you sell, or you value it lower which leads to lower CT now but higher profit and CT when you sell.

It's called a 'timing difference'.

It all comes out in the wash eventually.

Yes, it does, but for both company accounts reporting and Corporation Tax purposes the company is legally obliged to report the true profit (or loss) for any particular accounting period in accordance with accounting standards.

Any materially incorrect reporting in any accounting period could give rise to a penalty charge by HMRC.

 

[Bobbo]

Stocks should be valued at the lower of cost or net reliable value (NRV).

Determination of cost - basically there are 3 methods:

1. Last in first out (LIFO)
2. First in first out (FIFO)
3. Average Cost (AC)

For you number 1 (LIFO) I guess will give you lowest stock value at the year end, however, if your stock mgmt system does not facilitate this method then number 3 is your next best option.

Cant you export the end of year stock report into excel showing the quantities held for each stock item and then play around with various unit cost price of each item based on the purchases made in the year to get an average cost price.

Of course, slow moving, shop soiled or obsolete items should be reduced down to estimated realisable values.

Of course LIFO is specifically not permitted by accounting standards (FRS 102/105) so that should be disregarded immediately.

 

[UK Contractor Accountant]

Of course LIFO is specifically not permitted by accounting standards (FRS 102/105) so that should be disregarded immediately.

good point - forget about that. Back to SSAP 9 study days!

Weighted average cost method is the best option then.

 

[Rob-Ed]

Wow! Some great information there, thanks so much to everyone who replied.

We're using a lightweight ERP solution, the name isn't important but suffice to say I don't trust it or its calculations. It allegedly has accounting to UK regulation standards built in but I'd sooner use a pen and paper tbh. I've linked it to Xero to make the accounts manageable, for the most part this works ok, but the stock management is done on the ERP side.

There is no way to track the actual cost we paid for the stock on a SKU by SKU basis. The only calculation available to us is current price*quantity.

Some stock is 10 years or more old. We might have only paid pence for it but it would now cost us pounds to replace.

Using current cost price when reporting stock value to HMRC sounds like a sensible option if we were likely to sell our aging stock, but if it sits on the shelf for another 10 years we're going to be paying CT on its 'growth' in value each year where in actual fact it may prove to be valueless/obsolete. It only works in our favour when the stock is actually sold.

In actual fact, because we're using Xero for accounting and our ERP system for stock management, the profit per item sold is not even considered, none of this detail is imported into Xero, it's simply invoices minus bills = profit. Our catalogue is too large (100K) and our business too small to dedicate the resources needed to deal with this manually.

I'm thinking the average of this year's and the previous year's opening stock with an adjustment for aging stock that may never sell would be a good place to start (?)
Thanks again
Rob

 

[DontAsk]

Any materially incorrect reporting in any accounting period could give rise to a penalty charge by HMRC.

Of course, but calculating NRV is not and exact science.

 

[pentel]

Using current cost price when reporting stock value to HMRC sounds like a sensible option if we were likely to sell our aging stock, but if it sits on the shelf for another 10 years we're going to be paying CT on its 'growth' in value each year where in actual fact it may prove to be valueless/obsolete

Stocks should be valued at the lower of cost or net reliable value (NRV

 

[Gyumri]

I can't see what the value of your stock has to do with CT. The value of the stock is necessary to give an idea of what the assets of the company are at the year end - but if it's not accurate depending on the current values of items that is of academic interest.

CT is of course based on what expenses you have incurred in any financial period and what you have sold - there is no other basis.

Your stock value is only relevant to the value of your company's assets and has no bearing on corporation tax.

 

[Bobbo]

I can't see what the value of your stock has to do with CT. The value of the stock is necessary to give an idea of what the assets of the company are at the year end - but if it's not accurate depending on the current values of items that is of academic interest.

CT is of course based on what expenses you have incurred in any financial period and what you have sold - there is no other basis.

Your stock value is only relevant to the value of your company's assets and has no bearing on corporation tax.

Completely incorrect.

In simple terms, the cost of sales/cost of goods sold is opening stock plus purchases in the year less closing stock.

The higher that closing stock figure, the lower the COS/COGS is thus higher profit thus higher tax charge.

 

[Gyumri]

I'm sorry but in 40 years of doing business CT is definitely NOT based on the value of opening and closing stock. CT has nothing to do with that factor whatsoever.

It may be used as a balancing check but CT is based upon profits and profits will obviously not just depend on what stock you have apparently sold. This is commonsense.

What sales have you made less business expenses - that is the only factors that matter.

Stock valuations are only for the purpose of determining the assets of a company at the year end - which is an imperfect assessment at the best of times.

 

[Bobbo]

Prepare a set of accounts with a closing stock figure included and calculate the corporation tax.

Then amend those accounts by reducing the closing stock figure to zero and recalculate the corporation tax.

You will find you get different figures.

 

[Rob-Ed]

I've always understood the growth in stock value over the year to have precisely the same effect on the CT calculation as would an increase in profit of the same amount. If this wasn't the case we could simply invest any profits in stock at year end and pay no CT, which would be nice, I don't think HMRC would see it that way though.
Thanks again

 

[UK Contractor Accountant]

What sales have you made less business expenses - that is the only factors that matter.

so how do arrive at cost of the goods sold?

 

[Argentum Tax]

What sales have you made less business expenses - that is the only factors that matter.

Stock valuations are only for the purpose of determining the assets of a company at the year end - which is an imperfect assessment at the best of times.

This is just nonsense and anyone with a knowledge of bookkeeping will tell you.

Stock valuation does indeed affect profit and hence Corporation Tax. It is a timing difference but it is important in calculating the profit of any accounting period. It’s basic bookkeeping and double entry.

 

[Gyumri]

It’s basic bookkeeping and double entry.

That's all it is - unless there is an asset which is being depreciated and appears in the P&L, the opening and closing balances of stock in trade have absolutely nothing to do with CT.

This is plain commonsense.

 

[Gyumri]

so how do arrive at cost of the goods sold?

You look at what you have spent out in the course of the financial period on stock and other expenses. The opening and closing balances of the value of your stock from year to year is totally irrelevant to calculating CT.

Every business accumulates stock in trade and may keep it stored in a warehouse. So the OP may have bought £1m worth of stock. That's an expense which he would have claimed or will be claiming over time. The OP may be adding to that stock as time goes on. CT will be based on the value of his sales. Both expenditure and sales are recorded in the "cash book" ie the book itemising the bank entries.

This has nothing to do with how the stock is valued at the end of each financial period. The value may have doubled in price which would be reflected on the balance sheet - but it won't affect CT.

 

[Argentum Tax]

The value may have doubled in price which would be reflected on the balance sheet - but it won't affect CT.

Which is why stock is valued at cost price not replacement price. The cost of the stock will remain the same until it is sold. Unless, of course, the net realisable value of the stock is lower, when the company is then able to recognise this in the balance sheet and there is a corresponding reduction in profit.

Basic double entry which any accountant will understand.

 

[LPB 123]

You look at what you have spent out in the course of the financial period on stock and other expenses. The opening and closing balances of the value of your stock from year to year is totally irrelevant to calculating CT.

Every business accumulates stock in trade and may keep it stored in a warehouse. So the OP may have bought £1m worth of stock. That's an expense which he would have claimed or will be claiming over time. The OP may be adding to that stock as time goes on. CT will be based on the value of his sales. Both expenditure and sales are recorded in the "cash book" ie the book itemising the bank entries.

This has nothing to do with how the stock is valued at the end of each financial period. The value may have doubled in price which would be reflected on the balance sheet - but it won't affect CT.

Disclaimer: I'm not an accountant.

What about Cost of Goods Sold (COGS)? This will affect the P&L.

You say the £1m of bought stock is an expense, but it isn't. It's an asset. It's only an expense when it's sold (COGS).

For simplicity no stock was sold in the year. If the NRV on the original £1m stock is now calculated as £800K then you have a £200K expense.

So how can the stock value at year end not affect the P&L?

 

[numbersrule]

All else being equal, a higher Closing Stock value will reduce the Cost of Sales and thereby increase the Gross Profit and thereby increase the Operating Profit and CT.

Rob-Ed, consider the important Accounting Principle of Consistency. If you are not Consistent in your Accounting from year to year, then for example 'Profits' can arise that are not true profits.

Gyumri, your posts give me the impression that you believe the Balance Sheet is somehow detached from the P&L. This is a false perception, because the Balance Sheet and the P&L are two parts of an Integrated Whole. Any change to any amount on the Balance Sheet will have a corresponding effect on an amount in the P&L.

 

[numbersrule]

Rob-Ed, when you have settled on your new method of valuation, you could deal with the inconsistency between years by recalculating last year's closing stock based on your new method. A note in the Accounts would be required.

 

[Scalloway]

the opening and closing balances of stock in trade have absolutely nothing to do with CT.

At one of my early accounting jobs I used to encounter strange stock adjustments done by the partner. He was fiddling stock valuations to reduce client's tax bills.

 

[DontAsk]

I'm sorry but in 40 years of doing business CT is definitely NOT based on the value of opening and closing stock. CT has nothing to do with that factor whatsoever.

Nonsense.

What sales have you made less business expenses - that is the only factors that matter.

I currently have less stock than I had at the start of my accounting period so my closing stock figure in the P&L is positive and increases my cost of sales, reducing gross profit. If I revalue some stock then the cost of sales changes and CT will change.

 

[numbersrule]

Rob-Ed, when you have settled on your new method of valuation, you could deal with the inconsistency between years by recalculating last year's closing stock based on your new method. A note in the Accounts would be required.

Rob-Ed, further to the above, I should add that Consistency is a very important principle in accounting as you are probably aware.
This means that if you were to frequently change your method of stock valuation it would probably adversely affect your company's financial credibility.
Please note Scalloway's comment above. It is well known that Stock Value can be manipulated.
You should settle on a change of method that you will be able to stick to for the foreseeable future.
It also goes without saying that you really must agree any change of method with your Accountants.

 

[UK Contractor Accountant]

At one of my early accounting jobs I used to encounter strange stock adjustments done by the partner. He was fiddling stock valuations to reduce client's tax bills.

20% slow moving stock reduction provisions!

 

[Gyumri]

As costs are inevitably increasing, the valuation of stock which we have held for several years, having purchased at a much lower price, will now be reported as much higher than the actual cost.
As I understand it, we will effectively have to pay CT on this growth in stock value. In reality the stock is aging and should technically have a lower value

As stated above, the valuation you place on your stock is totally irrelevant to CT, whether your stock doubles in value or is not worth a brass farthing.

You will have accounted for your stock purchases in the financial period that you acquired them and paid CT on your profits made from selling some of that stock.

What remains is only relevant to the value of your company's current assets and will have no bearing on future CT even if each item of stock is now worth only a penny or on the contrary has increased in value.

 

[Gyumri]

Nonsense.



I currently have less stock than I had at the start of my accounting period so my closing stock figure in the P&L is positive and increases my cost of sales, reducing gross profit. If I revalue some stock then the cost of sales changes and CT will change.

Stock valuation does not appear in the P&L but on the balance sheet under current assets. The cost of sales in any financial period has nothing to do with the change in valuation of the opening and closing stock.

Depreciation shown on the P& L relates to assets- not stock in trade.

Maybe I have been filing my accounts wrong for the last 40 years and now owe a whopping amount of CT!

 

[UK Contractor Accountant]

Maybe I have been filing my accounts wrong

It's your lack of understanding of the link between the P&L account and the Balance sheet in relation to closing stocks.

So back to basic book-keeping tips provided by AAT.

From AAT Study Tips - the basics

In this article we’re going to focus in-depth on closing inventory.

What is it? Closing inventory is the amount of stock that an organisation has at the end of an accounting period.

It is a combination of raw materials, work in progress (WIP) and finished goods. For a manufacturing business that is what’s left in the stock room, on the factory floor and in the warehouse. However, for a retailer it is more likely to be a stockroom full of goods bought for resale and for a service business, like an accountants, it might partially complete contracts.

Why is it important to value it? It is included in the financial statements and has an impact on both an organisation’s profits and the value of its assets.

Monitoring and controlling inventory levels and costs throughout the year is generally seen as a management accounting function. However, year-end financial accounting standards require a value to be placed on the closing inventory for inclusion in the financial statements. It forms part of the ‘cost of goods sold’ (COGS) calculation on the Statement of profit or loss (SoPL) due to the accruals concept. It is also a current asset on the Statement of financial position (SoFP) as it is owned by the organisation but its value will change within a 12 month period.

 

[numbersrule]

Stock valuation does not appear in the P&L but on the balance sheet under current assets. The cost of sales in any financial period has nothing to do with the change in valuation of the opening and closing stock.

Depreciation shown on the P& L relates to assets- not stock in trade.

Maybe I have been filing my accounts wrong for the last 40 years and now owe a whopping amount of CT!

Firstly, as you have several posts now about stock, I assume that means you do have stock to buy and sell for your business.
As you are insisting that you have never recorded opening and closing stock in your P&L, whilst at the same time recognising that a stock value appears in your Balance Sheet, I can only conclude from this that your year end stock has been constant for 40 years and your stock variance has been zero for 40 years.
If this is true then the constant stock value would have resulted in zero additional CT liability.
However, if this is not true, then I would conclude that your Balance Sheet has not been consistent with your P&L. It would mean that your accounts are not reconciled as a result of the absence of stock values in the P&L. Unless, of course, you haven't included a stock value in your Balance Sheet either.
That would mean that you would have been excluding stock entirely from your accounts, which as it happens, is exactly what I do. But that is because none of my businesses have any stock to report.
I think I will start another thread about what conditions trigger a requirement for reporting stock values.

 

[UK Contractor Accountant]

Unless you are booking stocks bought for resale straight to stocks on the balance sheet and then releasing back to costs of sale in the P&L each time an item is sold.

 

[Gyumri]

It forms part of the ‘cost of goods sold’ (COGS) calculation on the Statement of profit or loss (SoPL) due to the accruals concept

"Cost of sales" should never include a valuation of stock at the year but rather on what the actual cost of purchase of that stock has been.

So if in Year 1 you buy £2 worth of stock and sell £1 worth by the year end you've made a profit of £1.

In year 2 if you buy no extra stock your cost of sales will be nil. Your "cost of sales" will not be £1, or whatever value you want to put on your remaining stock.

The value of your remaining stock in year 2 might still be £1, but your cost of sales will still be zero for year 2.

The value of £1 will be shown on the balance sheet but it will not be shown on the P&L for obvious reasons.

This is plain commonsense and is not worth further debate.

 

[UK Contractor Accountant]

This is plain commonsense and is not worth further debate.

Are you of the opinion that the AAT study material is wrong?

it is worth further debate as you clearly don't grasp the fundamentals of the impact of closing stock value on the P&L A/c and B/Sheet. I will again show the below the extract from the AAT study material so all readers can make up their own mind whose opinion they can trust.

However, year-end financial accounting standards require a value to be placed on the closing inventory for inclusion in the financial statements. It forms part of the ‘cost of goods sold’ (COGS) calculation on the Statement of profit or loss (SoPL) due to the accruals concept. It is also a current asset on the Statement of financial position (SoFP) as it is owned by the organisation but its value will change within a 12 month period.

Study tips: how to prepare closing inventory for financial statements - AAT Comment

We focus in-depth on closing inventory, and its impact on both an organisation’s profits and the value of its assets.

www.aatcomment.org.uk

 

[Bobbo]

"Cost of sales" should never include a valuation of stock at the year but rather on what the actual cost of purchase of that stock has been.

So if in Year 1 you buy £2 worth of stock and sell £1 worth by the year end you've made a profit of £1.

In year 2 if you buy no extra stock your cost of sales will be nil. Your "cost of sales" will not be £1, or whatever value you want to put on your remaining stock.

The value of your remaining stock in year 2 might still be £1, but your cost of sales will still be zero for year 2.

The value of £1 will be shown on the balance sheet but it will not be shown on the P&L for obvious reasons.

This is plain commonsense and is not worth further debate.

If you buy £2 of stock in year 1 and sell £1 worth of it how have you made a profit of £1? (Did you miss out stating "if you sell £1 worth of it for £2"?

Another way of looking at year 1 is
Opening stock £nil
Purchases in the year £2
Less Closing stock £(1)
= Cost of Sales £1

In your Year 2 example where presumably no sales are made, what you have is:
Opening stock £1
Purchases in the year £nil
Less Closing stock £(1)
= Cost of Sales £nil

Essentially we are comparing a seller that has a full stock management system detailing every stock line and quantities linked to their accounting system with a seller that does not have that and simply records whatever stock they buy in the year in 'Cost of Sales' with an adjustment for opening and closing stock.

However OP's original question was where the accounting system was using a different cost basis so the *exact same stock items* were being given a value higher at the year end than the previous year. Which is obviously incorrect.

 

[Argentum Tax]

Are you of the opinion that the AAT study material is wrong?

it is worth further debate as you clearly don't grasp the fundamentals of the impact of closing stock value on the P&L A/c and B/Sheet. I will again show the below the extract from the AAT study material so all readers can make up their own mind whose opinion they can trust.

I admire your tenacity @UK Contractor Accountant.

However I fear you won’t succeed in the face of such obstinacy. From my own experience some people just won’t listen to either common sense or technical argument, even when clearly explained. Very entertaining though!

 

[NortonBishop]

I'll try an example to explain why the balance sheet is linked to the p&l.

I buy cars at £10k each which I can sell for 50% more than what I paid for them.

So each time I sell a car I make £5k.

Each time I sell a car:

The sales total on the P&L goes up £15k

The cost of sales on the P&L goes up by £10k.

The retained profits on the Balance sheet goes up £5k.

The stock figure on the balance sheet goes down £10k.

The P&L is always linked to the Balance sheet.

It doesn't matter how many cars I buy or sell each year, the profit always goes up £5k per car as does the balance sheet.

If you don't account for the change in number of cars held in stock then the profit will be wrong

(cash accounting is of course different)

 

[NortonBishop]

(I could just have said, "I'm sorry Gyumri, you are wrong in this instance")

 

[Rob-Ed]

Well, after all that, I feel my understanding of the effects of closing stock valuation on CT was, and still is, correct, though my understanding of why this is so is far simpler than the explanation from the accounting professionals.
Up until previous year end (2023) I'd always used an 'average stock valuation' report, which calculated the valuation based on each historic purchase and current cost. I wasn't over confident in this figure but it was the best option available. As referenced in several posts on this thread, I'd at least been consistent with this approach.
The downfall of the new system I'm using is the lack of flexibility when reporting stock valuation. The only figure available is current cost multiplied by quantity.

Without wanting to cause any further argument; does my earlier suggestion of taking an average of 2023 and 2024 closing stock valuation figures and making a small adjustment for depreciation, perhaps 2%, seem sensible?

Thanks for all the input, I've learned quite a bit from this thread.
Kind regards
Rob