Understanding Business Accounting For Dummies, 2nd Edition (100 page)

Suppose that a retailer sold 100,000 units during the year and normally would have replaced all units sold. Instead, it purchased only 90,000 replacement units. Therefore, the other 10,000 units were taken out of stock, and the accountant had to reach back into the old cost layers of stock to record some of the cost of goods sold expense. To see the impact of LIFO liquidation gain on the gross margin, check out what the gross margin would look like if this business had replaced all 100,000 units versus the gross margin for replacing only 90,000. In this example, the old units in stock carry a LIFO-based cost of only £30, and the current purchase cost is £65. Assume that the units have a £100 price tag for the customer.

Gross margin if the business replaced all 100,000 of the units sold

Sales revenue £10,000,000(100,000 units at £100 per unit)

Cost of goods sold expense
6,500,000
(100,000 units at £65 per unit)

Gross margin £3,500,000

Gross margin if the business replaced only 90,000 of the units sold

Sales revenue £10,000,000(100,000 units at £100 per unit)

Cost of goods sold expense:

Units replaced £5,850,000(90,000 units at £65 per unit)

Units from stock
300,000
(10,000 units at £30 per unit)
6,150,000

Gross margin £3,850,000

The LIFO liquidation gain (the difference between the two gross margins) in this example is £350,000 - the £35 difference between the old and the current unit costs multiplied by 10,000 units. Just by ordering fewer replacement products, this business padded its gross margin - but in a very questionable way.

Of course, this business may have a good, legitimate reason for trimming stock by 10,000 units - to reduce the capital invested in that asset, for example, or to anticipate lower sales demand in the year ahead. LIFO liquidation gains may also occur when a business stops selling a product and that stock drops to zero. Still, we have to warn investors that when you see a financial statement reporting a dramatic decrease in stock and the business uses the LIFO method, you should be aware of the possible profit manipulation reasons behind the decrease.

Note:
A business must disclose in the footnotes to its financial statements any substantial LIFO liquidation gains that occurred during the year. The outside auditor should make sure that the company includes this disclosure. (Chapter 15 discusses audits of financial statements by auditors.)

The average cost method

Although not nearly as popular as the FIFO and LIFO methods, the average cost method seems to offer the best of both worlds. The costs of many things in the business world fluctuate; business managers focus on the average product cost over a time period. Also, the averaging of product costs over a period of time has a desirable smoothing effect that prevents cost of goods sold from being overly dependent on wild swings of one or two purchases.

To many businesses, the compromise aspect of the method is its
worst
feature. Businesses may want to go one way or the other and avoid the middle ground. If they want to minimise taxable income, LIFO gives the best effect during times of rising prices. Why go only halfway with the average cost method? Or if the business wants its ending stock to be as near to current replacement costs as possible, FIFO is better than the average cost method. Even using computers to keep track of averages, which change every time product costs change, is a nuisance. No wonder the average cost method is not popular! But it
is
an acceptable method.

Identifying Stock Losses: Net Realisable Value (NRV)

Regardless of which method you use to determine stock cost, you should make sure that your accountants apply the
net realisable value (NRV)
test to stock. (Just to confuse you, this test is sometimes called the
lower of cost or market (LCM)
test.) A business should go through the NRV routine at least once a year, usually near or at year-end. The process consists of comparing the cost of every product in stock - meaning the cost that's recorded for each product in the stock asset account according to the FIFO or LIFO method (or whichever method the company uses) - with two benchmark values:

The product's
current replacement cost
(how much the business would pay to obtain the same product right now)

The product's
net realisable value
(how much the business can sell the product for)

If a product's cost on the books is higher than either of these two benchmark values, your accountant should decrease product cost to the lower of the two. In other words, stock losses are recognised
now
rather than
later
,
when the products are sold. The drop in the replacement cost or sales value of the product should be recorded now, on the theory that it's better to take your medicine now than to put it off. Also, the stock cost value on the balance sheet is more conservative because stock is reported at a lower cost value.

Buying and holding stock involves certain unavoidable risks. Asset write-downs, explained in the ‘Decision-Making behind the Scenes in Profit and Loss Accounts' section of this chapter, are recorded to recognise the consequences of two of those risks - stock shrinkage and losses to natural disasters not fully covered by insurance. NRV records the losses from two other risks of holding stock:

Replacement cost risk:
After you purchase or manufacture a product, its replacement cost may drop permanently below the amount you paid (which usually also affects the amount you can charge customers for the products, because competitors will drop their prices).

Sales demand risk:
Demand for a product may drop off permanently, forcing you to sell the products below cost just to get rid of them.