18.9 Stock write downs and theory
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The document discusses stock write downs and the accounting theories around inventory valuation. It explains that inventory should be valued at the lower of cost or net realizable value, which may result in a stock write down being recorded as an expense. This is due to the conservative theory of recognizing losses when expected to occur rather than overstating assets. However, the historical cost theory argues that items should be recorded at original prices without write downs, prioritizing reliability over relevance. Real companies must determine which accounting theory to apply in their inventory valuations.
18.9 Stock write downs and theory
- 1. 18.9 STOCK WRITE DOWNS AND THEORY
- 2. © Michael Allison, Trinity Grammar School. Author’s permission required for external use 18.9 STOCK WRITE DOWNS AND THEORY In Accounting, the rule for inventory valuation is: Inventory should be valued at the lower of: Cost Net Realisable Value (NRV)or orCost = $50 NRV = $38 This is called a Stock Write Down of $12
- 3. © Michael Allison, Trinity Grammar School. Author’s permission required for external use 18.9 STOCK WRITE DOWNS AND THEORY Income Statement Revenue $ $ Cash sales 100000 Credit sales 20000 120000 less Cost of Goods Sold Cost of sales 48000 Import duties 2000 50000 Gross Profit 70000 less Stock loss 900 Stock write down XXXX Adjusted Gross Profit 68700 less Other Expenses Rent 3000 Insurance 2400 5400 Net Profit 63300 Stock Write Down is an Expense Hence, it must be reported in the Income Statement It is listed in between Gross Profit and Adjusted Gross Profit along with stock loss/gain Income Statement Revenue $ $ Cash sales 100000 Credit sales 20000 120000 less Cost of Goods Sold Cost of sales 48000 Import duties 2000 50000 Gross Profit 70000 less Stock loss 900 Stock write down XXXX Adjusted Gross Profit 68700 less Other Expenses Rent 3000 Insurance 2400 5400 Net Profit 63300
- 4. © Michael Allison, Trinity Grammar School. Author’s permission required for external use Theory behind stock write downs… 18.9 STOCK WRITE DOWNS AND THEORY Conservatism Caution must be used when preparing financial reports • Losses are recorded when they are expected to occur • Gains are only recognised once they are certain to happen (i.e. they have been earned) This is done so: • Assets and revenues are not overstated (too high) • Liabilities and expenses are not understated (too low)
- 5. © Michael Allison, Trinity Grammar School. Author’s permission required for external use Theory behind stock write downs… 18.9 STOCK WRITE DOWNS AND THEORY Conservatism • A business should apply caution and recognise losses when they are expected to occur • There is an expected loss as stock will be sold for less than its cost • Hence, a stock write down loss must be recognised so that: • Assets are not overstated (Stock Control) • Expenses are not understated (Stock Write Down) • Net Profit is not overstated
- 6. © Michael Allison, Trinity Grammar School. Author’s permission required for external use Theory behind stock write downs… 18.9 STOCK WRITE DOWNS AND THEORY Relevance Information is relevant if it influences the decision-making of the user by helping them: • Evaluate past, present or future decisions • Confirm or correct past decisions
- 7. © Michael Allison, Trinity Grammar School. Author’s permission required for external use Theory behind stock write downs… Relevance • A stock write down loss must be recorded as it is relevant to decision-making • The historical cost of the stock is irrelevant as it can’t be sold for more than that. • Assets and Profit will be incorrect if a stock write down isn’t recorded Balance Sheet • The value of Assets (Stock Control) is less than reported • The value of Owner’s Equity is less than reported Income Statement • Expenses (Stock Write Down) are higher than reported • Net Profit is less than reported 18.9 STOCK WRITE DOWNS AND THEORY
- 8. © Michael Allison, Trinity Grammar School. Author’s permission required for external use But some theory says cost should not be written down to the lower of cost and net realisable value… Historical Cost • All transactions are recorded at their original cost (purchase price) • All items are listed in the firm’s accounting reports at their historical (original) price Reliability • Information must be free of estimates and verifiable with source documents • Calculation of NRV breaches this as estimates are made on selling price and there may be no document to verify the NRV 18.9 STOCK WRITE DOWNS AND THEORY
- 9. © Michael Allison, Trinity Grammar School. Author’s permission required for external use So which theory applies? Historical Cost ReliabilityRelevance Conservatism Stock SHOULD be written down to the lower of cost and NRV Stock SHOULD NOT be written down to the lower of cost and NRV 18.9 STOCK WRITE DOWNS AND THEORY
- 10. © Michael Allison, Trinity Grammar School. Author’s permission required for external use How do real companies value their inventory? 18.9 STOCK WRITE DOWNS AND THEORY
- 11. © Michael Allison, Trinity Grammar School. Author’s permission required for external use TASK In-class Homework SQ11 X SQ12 X Ex18.7 X Ex18.8 X Case Study X