Each year is a separate year for ascertaining profit or loss of the year. The value of closing stock as on the last day of immediately preceding year is brought forward as cost of opening stock for the current year and it is a charge in the profit and loss account of current year. Any loss accounted for on stock valuation in earlier year was loss of earlier year. [There should generally be no such profit on valuation, as explained later]. This aspect is equally applicable for accounting purposes as well as for tax purposes.
Cost, actual cost and cost of acquisition:
Cost is different from actual cost or cost of acquisition. Therefore, value of stock brought forward is 'cost' for the current year. 'cost' in relation to any accounting year means what is debited as cost in the P & l account and not any historical cost, actual cost or cost of acquisition.
Conservative theory:
Conservative theory of accounting is to be followed any contingent income should not be accounted for. Therefore, valuing stock at a higher price and booking unrealized profit in the P & l account is not recommended. However, in some situations, one may try to take advantages of booking early and notional profit, but that is against the theory of conservative theory and may not be acceptable.
High fluctuations in prices:
In era of open economy, fast communication and transportation, organized market and availability of market information we find that now-a-days there is very high fluctuations in prices of commodities, securities, and properties therefore who knows price will not fall below the book value brought forward, therefore, there is no justification in revising upwardly value of stock not yet sold.
Provisions of Companies Act, 1956:
As per part II of the Schedule VI to the companies Act, 1956 the profit and loss account should reflect results of working of the period of account/ year. Therefore, for arriving at working results for the accounting period, the cost debited in the P & L account is to be considered for valuing stock lying in inventory as on closing day of the accounting period. For ready reference para 2 [a] is reproduced below:
"Schedule VI
Part II
1. xxxxx
2. The profit and loss account�
[a] shall be so made out as clearly to disclose the result of the working of the company during the period covered by the account ; and
[b] shall disclose every material feature, including credits or receipts and debits of expenses in respect of non-recurring transactions or transactions of an exceptional nature."
From reading of the above provision it is clear that profit or loss for the period covered by the account is to be worked out. Therefore, naturally cost for the period is to be considered. In case a credit of notional profit on upward revision of stock value is made, it will be in nature of exceptional nature.
Cost for the year:
The closing stock of last year is carried forward as opening stock of current year- this is debited as a charge for the current year as opening stock. Therefore, for the purpose of current year the opening stock at carried forward value of last year, which is brought forwarded and debited is 'cost of such stock' for the current year and the same need to be considered as 'cost' while valuing the stock, if brought forward stock or any item out of last years inventory remain unsold/ unconsumed at the closing day of current year.
Cost or market value whichever is less:
This is general method of stock valuation. In method of stock valuation usually we write 'cost' and we have to consider 'cost' and not 'actual cost' or 'cost of acquisition'.
Therefore, 'cost' for the year is relevant and not cost of any earlier year being 'actual cost' or historical cost.
Therefore, comparison should be with the value brought forward being 'cost' or 'charge' for the year on account of stock brought forward from previous year and the market value as on balance sheet date of current year/ period. The historical cost thus loses importance in this regard.
The concepts of 'cost', 'actual cost', 'cost of acquisition', are different. In context of preparing profit and loss account of any period, cost debited to the p/l account of relevant period is important. Otherwise, there will be booking of unrealized and contingent income in case market value as on closing day is higher than the brought forward value.
Illustration:
Item of stock A
Year Ended 31.03.2005:
Cost on average basis as on 31.03.05 Rs.1000 per pc.
Market value as on 31.03.05 Rs. 800 per pc.
Valuation as on 31.03.05 Rs. 800 per pc.
Stock 1000 units.
Loss on valuation @ 200 per pc x 1000 = 200000/-
Year Ended 31.03.2006:
Opening stock b/f 1000 units @ 800
Sale during the year out of opening stock 900 units @ 750, resulted into further loss actually suffered @ 50 per pc.
Stock remaining as on 31.03.2006 is 100 units.
Market value as on 31.03.2006 is @ Rs.1100 per pc.
Figures to be compared:
Actual cost of the stock remaining unsold as on 31.03.06 is @ 1000 per pc.
B/f value that is cost for the year is 800 per pc.
Market value is 1100 per pc. This is more than cost b/f as well as actual cost.
We are concerned with ascertaining profit for the year ended 31.03.2006.
The question is what should be considered as cost of 100 items lying in inventory out of stock b/f from YE 31.03.2005.
If the valuation is made on comparison of actual cost [1000 per pc.] and market value [1100 per pc.] then valuation will be @ 1000 being actual cost which is less than market value. This will mean that an unrealized profit of @200 per pc is booked in YE 31.03.2006 because cost debited is @ 800 and closing stock is valued @ 1000/-. In this case Rs.200 per pc will be profit and that will be included in totalincome as well as book profit.
Therefore, unrealized profit of 200 x 100 pcs = 20000 is included in the profit of YE 31.03.2006. This is a contingent income and it should not be included in the profit following conservative theory [contingent income not to be considered] as well as matching principal of accounting [matching debit in P & l account to be considered].
Therefore comparison should be of the cost for the year that is b/f value and market value as on 31.03.2006 that is 800 and 1100. Cost for the year being 800 per pc. being lower should be adopted as value of stock as on 31.03.2006 under the method 'cost or market value whichever is less'. By this way there will be no booking of unrealized profit. Thus conservative theory and prudence both will be satisfied in preparation of the p & l account.
Proper representation of method:
To make the stand clear, the valuation basis can be stated as 'cost [or book value] and market value whichever is lower'.
Or
Alternatively cost can be defined as brought forward book value of stock in case of old stock brought forward from earlier years and remaining unsold/ unused as on closing day.
Sold vs. stock:
My view will also be justified if we consider hypothetical situation that instead of stock being carried forward it was sold in last year, then the real loss in last year would be based on market price realized. The same loss is booked when stock valuation is lower because market value is lower than cost. Thus the loss booked due to lower market valuation is loss of last year.
Unless the stock is actually sold in current year any notional profit should not be regarded as profit of current year.
In case the stock is sold the profit [above brought forward value] is realized and booked. In case it is sold at less than b/f value, there will be loss for current year computed on the basis of value realized being lower than b/f value.
In case it is not sold the profit or loss should also be determined only on the basis of brought forwarded value which is the cost for the year and not on the basis of actual cost, incurred in earlier year. The fact that a part of old stock is sold and a part of old stock remain in stock should not make a difference on operating profit of current year.
High fluctuations - lowest price can be considered:
Due to globalization and increased worldwide speculation, the price fluctuations have increased and therefore, one has to consider changed circumstances also while preparing accounts and adopting accounting policies. In view of high fluctuations in prices, conservative theory suggest that the lowest price during 52 weeks should be adopted for valuation purposes. This is because stock-in-trade is expected to be sold within a short period [generally not to exceed one year], taking advantage of price behavior of last 52 weeks the lowest price during such period provide a good guidance of minimum price which the stock may fetch within a period of one year. In case of old stock b/f from earlier year, it is clear that the stock is a slow moving item and therefore, extra precautions are required while valuing such stock, in fact chances of obsolescence, out dating, damages, remaining useful life and other quality factors should also be considered and mere market value may not be suitable. Market value need to be further discounted for such reasons.
Historic cost convention:
As per my understanding about the concept of 'historic cost convention'. I feel that it appropriately apply to assets other than stock-in-trade- fixed assets, investments, intangible assets etc. In case value of stock-in-trade falls , it cannot / should not be accounted for at historic cost furthermore if its book value [after reduction due to lower market value] is lower than market value, the book value should not be increased to historic cost.
Accounting standards:
In my view in generally accepted accounting policies and Accounting Standards also cost means the cost for the year that is what is debited in the P & l account. Author has again read the AS 2, after downloading the same afresh on 08.02.2010 and he observes that the standard is silent about a situation in which earlier years stock is b/f and again c/f to next year.
AS 2 is basically meant for inventories namely traded items and raw materials, process materials, packing material and power and fuels items, stores and consumables etc. which are usually consumed in a short period of time according to the nature of the same and the process and seasonality involved etc.
The AS 2 is not applicable to spares of plant and machinery and shares and securities held as inventories.
In case it is considered as historical cost, then in case of need relevant accounting Standards should be revised so as to take note of developments, and changing ground realities. Accounting Standards are derived from basic accounting theories.
Readers are requested to post their views, opinions, comments and suggestions on this issues for further brain storming and improvement of knowledge.