Methods of Valuing Trading Stock

8.123. The valuation of trading stock is discussed here in the context of general business. The special provisions of the Act in respect of livestock are dealt with separately in Chapter 18.

8.124. Under the present provisions of the Act each article of trading stock may, at the option of the taxpayer, be valued at its cost price or market selling value or the price at which it can be replaced. There is also provision for valuing trading stock at a lower figure where the taxpayer requests this and the Commissioner can be satisfied that, due to obsolescence or other special circumstances, a lower value is more appropriate.

8.125. The terms ‘cost price’, ‘market selling value’ and ‘the price at which it can be replaced’ are not defined in the Act and have been the subject of litigation and discussion over the years. It is therefore proposed to consider each term separately and the problems associated with it.

8.126. Cost price. Cost is regarded as identifiable or historical cost and the elements which make up cost are:

  • (a) The purchase price of goods and, in the case of manufactured stock, materials used in manufacture.
  • (b) Direct expenditure incurred in bringing the stock into its existing condition and location.
  • (c) Depending upon the circumstances, indirect or overhead expenditure attributable to the stock.

In large businesses it is often either impossible or impracticable for the actual cost of each article of stock on hand to be ascertained. This is recognised by both the accounting profession and the Revenue, and certain methods or formulae have been devised which produce an estimate of the cost of trading stock. These include:

  • (i) First-in-first-out (FIFO).
  • (ii) Average cost.
  • (iii) Standard cost.
  • (iv) Adjusted selling value.
  • (v) Last-in-first-out (LIFO).
  • (vi) Base stock.

The accounting literature on stock valuation is extensive, and it is not therefore proposed to describe each of these methods in detail.

8.127. The Revenue does not accept the LIFO and base stock methods, and, understandably, accepts standard costs only where the standards are reviewed regularly to equate with current prices.

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8.128. The major area of disagreement between the taxpayer and the Revenue as regards valuation at cost is the extent and nature of overhead expenses which need to be included in the cost of manufactured products and items in process of manufacture. Other problems include the meaning of ‘cost’ in special situations: for example, in relation to imported goods when foreign exchange rates change in the interval between purchase and payment; in relation to second-hand cars when discount on a new car is given by higher trade-in on a second-hand car (recently solved but only by Commissioner's compromise); and in relation to by-products. These problems arise out of the many possible interpretations of ‘cost’ when applied to different businesses.

8.129. In practice there is quite often disagreement of a technical nature regarding costs to be included. Because of the variety of methods of valuation applicable to particular types of businesses, it would not be possible to lay down statutory definitions. This was the view reached by the Spooner and Ligertwood Committees, and also by the Carter Commission in Canada.

8.130. A number of submissions have drawn attention to the difficulties currently being experienced in valuing stocks at cost figures acceptable for income tax purposes. These are some of the points which have been raised:

  • (a) There is some inconsistency in the rulings given by departmental officers as to the extent that overheads are to be included in determining cost.
  • (b) The appropriate method of calculating manufacturing cost depends on the nature of the business.
  • (c) The valuation of trading stock which is in accordance with accepted accounting standards consistently applied should be acceptable for tax purposes.

8.131. Generally the Commissioner requires, when the basis of valuation of a taxpayer's stock comes under review, that cost be determined on a full absorption basis that takes to account all production overhead expenses whether they be fixed or variable. However, it seems that many taxpayers for both financial accounting and tax purposes use a direct cost basis which allows only for production overheads varying according to volume of production. Direct costing excludes a value for many overhead costs normally brought to account on a full absorption cost basis. When the basis adopted is consistently applied from year to year in the case of a continuing business, the effect of the method used on net income of a year is not usually significant.

8.132. Having regard to the many and varying factors which need to be given due weight in determining the appropriate method for arriving at cost, particularly of manufactured stock, the consistent application of a generally accepted method of valuation may well be an adequate test of the reasonableness of the value. It would be most undesirable, from an efficiency viewpoint, were a large body of taxpayers to find it necessary to value their stock on two different bases, one for financial accounting and the other for tax accounting.

8.133. The Committee makes no recommendations for amendment of the present provisions relating to the valuation of trading stock at cost. It believes, however, that many taxpayers in business would benefit were the Commissioner to publish information dealing with the interpretation and operation of the law on stock valuation. This should help to remove some of the uncertainty that now exists.

8.134. It would be helpful if there were a requirement that where the valuation of trading stock has an important bearing on the determination of net income, taxpayers should disclose their methods of valuation and whether or not the method has been

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consistently applied. This raises the question of special provisions to cope with situations where taxpayers decide it is necessary or appropriate to vary their method of valuation.

8.135. Where a taxpayer changes his method, it has been the practice to require that the new method be also applied to valuation of stock at the commencement of the year of income. Where this results in opening stocks being valued at below the closing value of the previous year, the taxpayer loses a deduction for the amount by which the opening stock value in the year of change is decreased. The Committee recommends that special provision be made so that differences such as these arising from a change in method of valuation will be spread and brought to account over a period of, say, five years. A somewhat similar recommendation has been made in respect of a change in the basis of taxation from cash to accruals (paragraph 8.25).

8.136. Market selling value. By market selling value is meant the price at which the item could be expected to be sold in the market in which the trade of selling by the taxpayer is conducted. It contemplates a sale in the ordinary course of business and not a forced sale. No allowance is made for a possible fall in market price in the future, even when such an eventuality is reasonably anticipated.

8.137. Market selling value ceased to be an acceptable method of stock valuation for financial accounting purposes many years ago when it was replaced by the concept of valuation at ‘net realisable value’, provided it is less than cost. Net realisable value has been defined as the price at which it is estimated that the stock can be realised in the normal course of business, either in its existing condition or as embodied in the product normally sold, after allowing for expenditure to be incurred before and in the process of disposal. In estimating this price, regard is to be had to excess and obsolete stocks, the trend of the market and the prospects of disposal.

8.138. The main ground for rejecting net realisable value as a basis for tax treatment is that it involves estimates which would be difficult for the Revenue to confirm. However, the problems in this area should be no greater than currently apply in computing net income under the accruals method (for example, in estimating the liability of a general insurance company for outstanding claims). The Committee therefore recommends that the Act be amended to substitute net realisable value for market value as one of the alternative bases of valuation of trading stock.

8.139. Replacement price. Replacement price means the price at which the taxpayer can buy the goods on the last day of the year of income. This basis appears to be a satisfactory alternative and the Committee believes it should be retained.