Stock Valuation
Every human being, male or female, lives this life with an ultimate aim of settling down in a career and earning livelihood. Ever since the child is born, he or she is brought up with initially, the parents acting as teacher. The child then goes to school and starts learning various subjects, language, art, activities, sports etc.
With age and growth, the child develops a passion and interest in a particular field. This lead them to choose career of their interest, take specialized courses and coaching for perfection. There can never be an absolute perfection, as with changing time, there is always a scope of grasping more knowledge. Once they find themselves confident, they look for a career, either working for somebody or working for self. Working for self means getting involved into own business, either a running family business or starting a new venture.
Business is a commercial venture, be it small, medium or in large scale, it is run with the sole aim of making profits. Business can never be run for charity. One has to calculate the substitute value of time, money and energy utilized in the business compared with the compensation received if working for someone else. Salary received in employment is the compensation of time and energy. One has to add the return on capital employed in the business, and the value of risk. One should be making a profit i.e. the excess of income over the expenditure incurred, an amount more than the collective substitute cost. For successful running of business, the profitability has to be monitored at regular intervals. Corrective measures and decisions are required to be taken, in case the profit ratio is less than required.
Now, how do we calculate profit Profits are calculated by making financial statements. The financial statements comprise of one, the profit and loss account or income and expenditure account and second, the Balance sheet or statement of assets and liabilities.
The profit and loss account or income and expenditure account, as the name suggest, is a statement showing the incomes or receipts on one side and the expenditure incurred on the other side. But just the comparison of income and expenditure can not give a conclusive picture of profit or loss incurred. A very important aspect is the stock of goods manufactured or traded. The position of stock at the beginning and at the end of the period is very important. But is it so simple. What stock valuation should be considered The value of purchase or the value of sale. The value of purchase normally would be less than the value of sale. As the business is a going concern, the sale value of stock seems more appropriate. But, that would be a notional figure and lead to inflated profits. There could be number of contingencies and happenings in the market trends.
The valuation of stock is therefore an important phenomenon in calculating the profit of the business. The valuation has to be taken considering factors which give a true and fair view of the earnings of the business. Similarly, it would also give a true and fair picture of the assets and liabilities in the Balance Sheet, stock valuation being a part of the asset.
The basic principle of valuation of stock is the cost (of purchase) or market value, whichever is less. Taking into account this principle, the stock can be valued in number of ways. The various methods popular and prevalent are
First in First out (FIFO)
Last in First out (LIFO)
Average
Last purchase cost
FIFO, as the name suggest, it is considered that in stock valuation of a particular item, quantity received first is sold out first and the stock remaining is of the last purchases. Now, the basic purpose and difference in value on last purchase price is that there could be stock in quantity which is more than the quantity of the last purchase. In case of difference in the value of the last purchases, it has to be valued accordingly.
LIFO, again as the name suggest, works on the same principle as FIFO, but in the reverse manner. Here, it is considered that the latest purchase is sold out first, and the remaining stock comprises of the earlier purchase.
Average method, as the name suggests, the purchase price over a period of time is averaged and taken into account for valuation. This does not take into account the factors of change in price of purchase which at times could be highly variant.
In Last purchase cost, irrespective of the quantity of stock valuation, it is valued at the value of the last purchase price.
These methods, by and large, give a true and fair view of the profitability of the concern. Once a method is adopted, it should be followed every time for consistency. Changing of methods, according to need, would just give an arbitrary satisfaction. Consistency in following the methods is one of the basic principles of accounting. This is also important because in a large business, having huge quantities of stock, a change in the method can lead to tremendous variation in the profits. The higher profits due to wrong stock valuation could lead to lower profits in the subsequent period. The comparisons as such would not be real.
The principle of valuation of cost or market value whichever is less, is based to make the position of business more realistic. Market trends are unpredictable. A downward or upward trend can lead to an exorbitant loss or profit. As such, the principle is based, that in an emergency conditions, if the stock has to be disposed off, the statement prepared earlier on the sale value or on a higher value would show a collapse of the concern. Not only that, the higher notional profits would mean paying of higher taxes to the exchequer, as that profit is in fact unrealized profit on the stock.
To conclude, business is for profits, profits are based on income and expenditures, and the difference in the opening and closing stock of the period. And most important aspect is the proper valuation of the stock.
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