Factors affecting the stock valuation decision

29.10 Factors affecting the stock valuation decision

Obviously the overriding consideration applicable in all circumstances when valuing stock is the need to give a ‘true and fair view’ of the state of affairs of the undertaking as at the balance sheet date and of the trend of the business’s trading results. There is, however, no precise definition of what constitutes a ‘true and fair view’ and it rests on the judgement of the persons concerned. It would be necessary to study the behavioural sciences to understand the factors that affect judge- ment. However, it should be possible to state that the judgement of any two persons will not always be the same in the differing circumstances of various businesses.

you learnt about in Chapter 10) should be applied, i.e. once adopted, the same basis should be

In fact, the only certain thing about stock valuation is that the concept of consistency (which

used in the financial statements until some good reason occurs to change it. A reference should then be made in the notes that accompany the financial statements as to the effect of the change on the reported profits, if the amount involved is material.

It will perhaps be useful to look at some of the factors which cause a particular basis to be chosen. The list is intended to be indicative rather than comprehensive, and is merely intended as

a first brief look at matters which will have to be studied in depth by those intending to make a career in accountancy.

1 Ignorance. The personalities involved may not appreciate the fact that there is more than one possible way of valuing stock.

2 Convenience. The basis chosen may not be the best for the purposes of profit calculation but it may be the easiest to calculate. It must always be borne in mind that the benefits which flow from possessing information should be greater than the costs of obtaining it. The only

Chapter 29 l The valuation of stock difficulty with this is actually establishing when the benefits do exceed the cost but, in some

circumstances, the decision not to adopt a given basis will be obvious.

3 Custom. It may be the particular method used in a certain trade or industry.

4 Taxation. The whole idea may be to defer the payment of tax for as long as possible. Because the stock figures affect the calculation of profits on which the tax is based the lowest possible stock figures may be taken to show the lowest profits up to the balance sheet date. (But doing this will result in a higher profit in the following period!)

5 The capacity to borrow money or to sell the business at the highest possible price. The higher the stock value shown, the higher will be the profits calculated to date and, therefore, at first sight the business looks more attractive to a buyer or lender. Either of these considerations may be more important to the owners than anything else. It may be thought that those in business are not so gullible, but all business people are not necessarily well acquainted with accounting customs. In fact, many small businesses are bought, or money is lent to them, without the expert advice of someone well versed in accounting.

6 Remuneration purposes. Where someone managing a business is paid in whole or in part by reference to the profits earned, then one basis may suit them better than others. They may therefore strive to have that basis used to suit their own ends. The owner, however, may try to follow another course to minimise the remuneration that he/she will have to pay out.

7 Lack of information. If proper stock records have not been kept, then such bases as the aver- age cost method or the LIFO method may not be calculable using the approaches you learnt at the start of this chapter. Of course, a lack of proper stock records makes it very difficult to detect theft or losses of stock. If for no other reason than to enable these factors to be con- trolled, proper stock records should be kept by all trading businesses. As a result, this barrier to adopting AVCO and LIFO should not arise very often.

8 Advice of the auditors. Auditors are accountants who review the accounting records and the financial statements in order to report whether or not the financial statements present a true and fair view of the financial performance and financial position of a business. Many businesses use a particular basis because the auditors advised its use in the first instance. A different auditor may well advise that a different basis be used.