BIM33135 - Stock: valuation: lower of cost and net realisable value: cost

One of the acceptable basis of stock valuation is the lower of cost and net realisable value. The meaning of cost is discussed below and net realisable value is at BIM33140.

In general, the term ‘cost' should be interpreted as meaning the total historical cost of bringing the relevant stock to its existing condition and location; and where this is not precisely ascertainable, the aim should be to arrive at the closest approximation to historical cost that is practically attainable.

The Companies Act 1981 introduced some new rules which are currently found in Companies Act 1985, Schedule 4, Paragraph 26 provides:

1. The purchase price of an asset shall be determined by adding to the actual price paid any expense incidental to its acquisition.

2. The production cost of an asset shall be determined by adding to the purchase price of the raw materials and consumables used the amount of the costs incurred by the company which are directly attributable to the production of that asset.

3. In addition there may be included in the production cost of an asset - ‘A reasonable proportion of the costs incurred by the company which are only indirectly attributable to the production of that asset but only to the extent that they relate to the period of production …...'.
   Thus, where expenditure is properly classified as within paragraph 26 (2), its inclusion, denoted by the word ’shall', is mandatory whereas in paragraph 26 (3) the use of the word ’may' merely permits the company to include expenditure of a type therein described.

Overheads

Overhead charges, if any, should be included in the cost valuation to the extent that is appropriate having regard to recognised accounting practice and to the principle of consistency.

The provisions of the Companies Act are reflected in generally accepted accounting practice, SSAP9 (paragraphs 19 and 20 of Part 2 and paragraphs 1- 10 of Appendix 1).

Overheads are classified, under SSAP9 (see paragraph 20 of Part 2), according to their function, for example, production, selling or administration. Into which category a particular expense falls and whether a cost is directly attributable to the production process and must be included, or rather is an expense which may be included, will depend on the precise facts.

Broadly, however:

• Overhead expenses which vary directly with the volume of production are considered to be ’directly attributable' to the production process and should be included.
• The fact that an overhead accrues on a time basis is not in itself a reason for its exclusion from the stock valuation (see paragraph 20 of Part 2 of SSAP9). But generally the classification of such overheads is less certain.
• Overheads accruing on a time basis may be more remote from the production process. An accounts treatment that has consistently excluded such overheads from a stock valuation may be within the range of generally accepted accounting practice for the specific industry and may still be a valid basis in the particular circumstances.

A valuation basis that excludes substantial costs which are clearly directly related to production is incorrect, as it would not be within UK GAAP.

Discounted selling price

In some cases, where such large numbers of rapidly changing individual items are held, the only practical method of arriving at a figure to represent cost is to value the items at current selling price less the normal gross profit margin. For example, in the case of a department store, a valuation by reference to the ticketed selling price of the stock reduced by the appropriate departmental mark-up. This method of valuation is acceptable if it can be demonstrated that it gives a reasonable approximation of the actual cost. Whilst this method may lead to some undervaluation where the original ticketed selling price has already been reduced, other stock may never reach its ticketed selling price and to that extent would be overvalued.

This method may be described by accountants as the ’retail method’.

Replacement cost method

Stock can only be valued at replacement cost in exceptional circumstances, such as:

• Where the value of the raw material content forms a high proportion of the total value of stock in process of production and the price of the raw materials is liable to considerable fluctuation, it is common practice to make rapid changes in selling prices to accord with the changes in the price of the raw material. In cases of this kind the replacement cost basis may be extended to cover stock in process of production and finished stock as well as to the stocks of raw material.
• In the case of traders such as motor and caravan dealers who acquire stock in part exchange transactions at a price that in substance includes a discount on the new vehicle sold. There is more detailed guidance on motor dealers stock at BIM52001.

Consumables

Valuation should be at cost for any unused but useable consumables held at the balance sheet date. The circumstances would be rare and unusual to justify any valuation below cost. The trader would have to be in the position of knowing that the sale of the end product would result in a loss. Consumables are realised by being used and incorporated into or converted into the normal products the taxpayers sells. So unless they have deteriorated into unuseability, are obsolete or otherwise unuseable, they should only be valued at less than cost if the business expects to realise losses on selling their normal produce.