Stock And Works In Progress General Practice Finance Essay - Free Essay Example

Matching Principle stock unsold at the balance sheet date is carried forward into the next period and matched against the revenue when sold instead of being charged immediately to the Profit and Loss account which would diminish the Operating Profit. Consistency the method of valuing stock must be consistent from one year to another and any deviations explained, as they will directly affect operating profit. Valuation the stock must be valued accurately. Obsolete stock should be written off against profit and not carried forward. Diminished value stock should be written down accordingly. In dealing with Inventory, where stock is continuously purchased over the accounting period at different prices, a choice two systems prevail: First in First Out (FI-FO) i.e. the stock carried forward is the latest purchased reflects good storemanship. Weighted Average i.e. the amounts purchased in the period and used in the period are weighted against their respective prices and an Average or Weighted price used for the period. Retail Companies Stock is purchased at a stated figure and sold at a stated figure, the difference is trading profit. The stock sold minus stock purchased seldom equals stock held due to losses by theft and spoiling etc. Thus the need for regular stock-taking and re-valuation of stock in hand. Large groups of outlets can suffer excessive pilfering and manipulation of stock values, for this reason they value stock at its standard store selling price: Theoretical Closing Stock at selling price = Opening Stock at Selling Price + Deliveries at selling price Takings (sales) The Theoretical Closing Stock may then be compared and adjusted to the Actual Stock, with the losses written off accordingly. The final Stock Value at selling price is then reduced by a standard margin to arrive at the Stock Value in the accounts. Stock in Manufacturing Business Can significantly affect operating profit. Manufacturing business has: Variable costs of production materials used, wages, consumption of power etc. Fixed costs of production lease costs on factory, rent, lighting etc Fixed and variable costs of management, distribution, marketing, etc. Accounting policy may allow a stock valuation and WIP valuation of completed and near completed goods to be based on a) and b) but would not include c). Cost of Stock in the accounts It is normal for a stock taking exercise to be conducted at the end of one accounting period to provide a closing stock figure and a corresponding opening stock figure. The opening stock is put into the new trading account / profit and loss account. New stock purchase values over the period are added, values of stock sales are deducted, and the closing stock is determined less losses. The closing stock is an asset and is taken to the balance sheet. Cost of Closing stock = Cost of Opening stock + cost of goods purchased cost of goods sold in the period. For most business, the closing stock is physically counted and a cost determined. The Closing stock is an asset and is taken with the net profit to the balance sheet. Example: The importance of correct stock valuation  £000  £000 Sales 2,000 Cost of Goods Sold: Opening Stock 600 Purchases in period 1,500 2,100 Closing Stock (to B/S) 400 1,700 Gross Profit 300 Wages, overheads, etc 200 Operating Profit 100 Note: if the Opening Stock was overstated by 10% to 660,000 and the closing stock understated by 10% to 360,000, the profit would be wiped out The closing stock of  £400,000 is an asset and is taken to the balance sheet. Example: Taxation on increased stock valuation: Assume the stock when purchased cost  £1,000,000 but due to inflation the company believes it is now worth  £1,100,000. The additional  £100,000 would increase taxable profit by  £100,000 and create an additional taxation demand of 100,000 times the percentage rate of tax (20% x  £100,000 =  £20,000). Alternatively, if the company had a taxable profit of say  £250,000, but prior to the final account, purchased an asset for say  £150,000 and took it into stock without doing any work on it, then the taxable profit may fall to  £100,000, reducing the tax demand, but the following year if the asset is sold on for say  £120,000, then tax will be due on the  £120,000 less expenses tax is delayed but not removed by such manipulation. Over valuing stocks e.g. land In property, as in other goods, expected price increases can cause an over valuation of stock. E.g. land and house prices may have risen 10% p.a year on year. A developer may have many millions in land stocks and several millions in WIP or completed houses. These could be valued up in anticipation of a further 10% rise in the market and to boost profits in a difficult year. However, in the following period changes in the economy, or stamp duty, or interest rates may cause a flattening of the market and a consequent increase in the time taken to sell property, causing increased interest charges , marketing and sales costs etc. A reduction in working capital may force the developer to attempt to sell over valued land stocks into a market experiencing a depressed demand. Subsequent right down of land values may cause significant losses to be recorded in the following year. This standard is at the heart of the Quantity Surveyors work in Cost and Value Reconciliation (see CORP 35 for more detailed information). Stock It has been seen that Stock normally represents a significant amount in a businesss balance sheet. Over or under valuation can result in material distortions of profit and tax positions. One of the major problems for independent auditors is establishing a true and fair value for stocks. Stocks comprise: Goods or other assets purchased for resale; Consumable stores; Raw materials and components purchased for incorporation into products for sale; Products and services in progress; Long term contract balances; Finished goods Matching Principle Fundamental is the matching of cost and revenue in the year in which the revenue arises, rather than in the year that the cost is incurred. If the revenue anticipated to arise (i.e. the net realisable value) is less than the cost incurred, then the irrecoverable cost (i.e. the loss) should be written off to revenue in the year under review. This could happen due to obsolescen ce, deterioration or lowered demand. Cost To determine the lower of net realisable value and cost, a consistent approach must be applied. The principle is, or method used should, provide the fairest possible approximation to the expenditure actually incurred in bringing the product to its present location and condition. The cost of an article is the purchase cost plus any further delivery charges, import duty etc less discounts etc. However, some businesses buy and sell multiples of the same item purchased at different times at different prices. Here it may be permissible to use the FIFO Rule (first in first out i.e. the earlier stock is assumed to be sold first which is normal in retail and so the later band variation of purchase cost apply). Specific difficulty arises in valuing stock upon which all or some work has been performed by the entity. Example: Purchased steel stock is extruded into standard glazing bars which are then galvanised before dispatch. Three catagories of stock arise: un-fabricated steel stock, fabricated bars before galvanising, and galvanised stock. For the un-fabricated steel stock, the cost is the purchase price plus delivery and handling costs (plus buying costs if not a general overhead) less discount. For the galvanised stock, the purchase price of steel, plus delivery, less discount, plus the cost of direct expense in fabrication and in the case of the galvanising, the subcontract cost of galvanising, plus an addition for production overheads (not general overheads). Production Overhead difficulty arises in establishing that part of total production overhead to be attributed to each batch of glazing bars being valued. This should be established based on the normal annual through put of components e.g. cost per tonne fabricated based on average annual tonnage. In some businesses (large retai l chains) the only way to establish the cost is the selling price less the gross margin but this is in general not a universally accepted method. The Standard provides an appendix to discuss techniques of acceptable stock valuation and those which it considers are not acceptable. In summary, Cost of Purchase includes the purchase price, import duty, transport, handling costs etc less trade discounts. Cost of conversion includes: Costs directly attributable to units of production, e.g. direct labour, direct expenses and sub-contracted work; Production overheads; Other overheads, if any, attributable to bringing the product or service to its present location and condition. Production Overheads are those which accrue in respect of materials, labour and services for production, based on the normal level of activity taken one year with another. It is recommended to group overheads into function groups i.e. production, purchasing, selling, administration, and inclu de them as they apply to the circumstance. Depreciation of stock may also be considered. All abnormal costs or inflated overhead allocation due to e.g. a failing market, abnormal spoilage, idle capacity etc. are not to be included. Net realisable Value is calculated as the actual or estimated selling price net of trade discount (not net of settlement discount) less: All further costs to completion; and All costs to be incurred in marketing, selling and distributing. Methods of Costing: Unit Cost cost of making an identifiable unit of stock. Average Cost total cost of making a number or range of units divided by the total number of units. FIFO the assumption that stocks in hand represent the latest stock purchased or produced Standard Costs using predetermined costs calculated from managements estimates of expected levels of cost (must be reviewed regularly to ensure the standard cost bears a reasonable relationship to actual costs). The following are generally not acceptable: LIFO earlier cost may not reflect current stock cost. Replacement cost only in very exceptional circumstances see standard appendix. Selling price less estimated profit only if it can be shown to give a reasonable estimation of actual cost. Latest purchase price may not be the same as the actual cost of the stock item. Works in Progress Work in Progress is a type of stock, i.e. stock upon which work is being undertaken. Most accounts will group Stock and Works in Progress together and then provide a separate schedule grouping the different types of stock and work in progress and their relative value. In accounts, Opening Stock is normally stated and added to purchases to give a total value for the period, from which is deducted a value for closing stock. This gives the amount of stock used or sold in the period relative to Sales or Turnover. Opening Work in Progress and closing Work in Progress can be entered in a similar manner. An alternative, which avoids negative numbers when closing stock is larger than opening stock, is to state the opening stock to the left of the Profit and Loss Account and the Closing Stock under the Sales or Turnover figure, as if the Closing Stock was sold to the owner. Work in Progress is entered net of any profit because profit has not yet been realised. In Construction and manufacturing work in progress values can be very considerable sums affecting profitability and taxation. Many contracts will run over considerable periods of time and payments may be made on an Interim basis. It would therefore be unreasonable to continue to purchase labour and material in terms of work continually in progress and receive interim payments without taking some profit into account within each financial year. SAPP 9 allows for an attributable profit to be taken into the accounts in order to give a realistic picture of the affairs of the firm under certain prudent circumstances. The basic rule is that if a profit cannot be forecast with reasonable accuracy, no profit is admitted to the accounts until the work is completed or a profit can be forecast with reasonable certainty. Where a profit can be forecast, a conservative attributable profit may be included. If this were not the case, profits would only be accounted for when long term contracts were actually completed and the profit realised, causing surges in the profit figures from one year to the next. This has been a reason for Construction Company share values trading at a discount because of risk, uncertainty and a lack of stability in year on year returns. Long Term Contracts This is a very important part of construction accounting and is discussed in full in CORP 35. The following is the basis of accounting for profit on long term contracts. Definition: A contract entered into for the design, manufacture or construction of a single substantial asset or provision of a serviceÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ÃƒÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦..where the time taken substantially to complete the contract is such that the contract activity falls into different accounting periods. A contract that is required to be accounted for as a long term by this standard is will usually extend for a period exceeding one year. However, a duration exceeding one year is not an essential feature of a long term contract. Some contracts with shorter duration than one year should be accounted for as long term contracts if they are sufficiently material to the activity of the period that not to record turnover and attributable profit would lead to a distortion of the periods turnover and results such that the financial statements would not give a true and fair view, provided that the policy is applied consistently within the reporting entity and year to year. The normal principle is that profit is only recognised and brought into the accounts when it is certain, and this is normally when the contract is substantially complete. Such profit may be reduced by provisions to allow for possible expense of e.g. finalising the account or remedial works. Thus most construction contracts do not report profit until the contract is complete. Where a contract programme covers more than one accounting period and the contract expenditure and interim payments may be substantial, then material distortion may arise when zero profit is reported in one period against a material expenditure and total profit is reported in another period against a possibly lower expenditure. Where a company has contracts which come under the definition above; and: their outcome can be assessed with reasonable certainty before their conclusion, the standard allows it to record a proportion of turnover and profit arising while the contract is in progress. Such prof it calculated on a prudent basis and take account of any inequality in profit forecast for each stage of the contract. An appropriate proportion of the turnover may be taken into the accounts but matched by the relevant costs. Where the profit is uncertain (most construction contracts) then no profit is taken into the Profit and Loss account until it is certain. If no loss is expected, but the profit is uncertain, then it may be appropriate to take the proportion of turnover into the account against a zero profit margin. However, in every case, losses must be fully accounted for in the period that they are foreseen, not when they occur. Thus if a loss is anticipated at a future date it must be recognised and a provision made in the current account. Where the foreseen loss is significant to the performance of the company as a whole and may cause significant overhead to be diverted to its containment, then addition provision may need to be made to account for that overh ead expense. The accounting treatment of long-term contracts can be summarised as follows: Long term contracts should be assessed on a contract by contract basis and reflected in the profit and loss account by recording turnover and related cost as contract activity progresses. Turnover is ascertained in a manner appropriate to the stage of completion of the contract, the business and the industry in which it operates. Where it can be considered that the outcome of a long-term contract can be assessed with reasonable certainty before its conclusion, the prudently calculated attributable profit should be recognised in the profit and loss account as the difference between the reported turnover and related costs for that contract. Attributable profit that part of total profit currently estimated to arise over the duration of the contract, after allowing for likely estimated remedial and maintenance costs and increases in costs so far as not recoverable under the terms of the contract, that fairly reflects the profit attributable to that part of the work performed at the accounting date. (there can be no attributable profit until the profit outcome can be determined with reasonable certainty). Foreseeable losses losses which are currently estimated to arise over the duration of the contract, allowing for estimates of remedial, maintenance and increased costs not recoverable under the contract terms. The estimate of loss is required to be entered as a provision: whether or not the work has commenced; the proportion of work carried out at the accounting date; the amount of profits expected to arise on other contracts. Rule applied If a Long-Term Contract is incomplete at the end of the accounting period and it is reasonably certain it will yield a profit, then the portion of that profit which is attributable to the work done to date may be recognised in the profit and loss account. This is achieved by: Crediting Profit and Loss Account with the recorded turnover to date (typically the amount certified by the Architect being t he value of the work done) and; Debiting profit and loss account with the related costs (i.e. the costs incurred to date which relate to the recorded turnover). Any remaining costs incurred to date are shown as work in progress on the balance sheet. If a long term contract is incomplete at the end of an accounting period and the contract is expected to yield an overall loss, the whole of this loss should be provided for immediately. This is achieved by deducting the amount of the anticipated loss when calculating the value of the work in progress at the end of the accounting period. (Melville A.) We can break the figures down into parts as follows: The contractor has a turnover valuation of  £3.0 million in total certified by the Architect. The costs matched against this  £3.0m in turnover amount to  £1.8 million. The contractor has invoiced and is owed  £2.4m to-date and has a further receivable pending of (3.0-2.4 = 0.6),  £0.6m. So the amount imm ediately owed is 2.4 (Debtors) and a Long Term Balance receivable of  £0.6m. The total costs amounting on the contract are  £2.0m. So the costs to be matched against future Invoices amount to (2.0-1.8 = 0.2)  £0.2 million and constitute WIP/Stock at cost.