Objections to Valuation at Less than Cost
The effect of valuing the stock-in-trade at a lower market than cost is to bring into the period’s results a loss which may never be realized, either because the change in the purchase market may not be reflected in the sale market, or because, if so reflected, the market may swing back before actual sale of the stock is made. If valuation is to be at the market when that is lower than cost, consistency would seem to demand that, when the market is higher than cost at the time of preparing the balance sheet, market value should be used and the profit occasioned thereby be credited to the current period. The answer to this argument is that operation would thus be placed on a speculative basis.
Again, it is sometimes argued that good buying is just as essential to profit-making as good selling. Accordingly, the purchasing department, with the foresight to buy in a favorable market, should receive the credit for it; if conditions are reversed, it should bear the blame, i.e., the loss. In other words, the period in which the purchase effort is expended should be credited or charged with the gain or the loss brought about by a favorable or unfavorable condition of the current market as compared with its condition at the time the purchase was made.
Anticipation of Profits or Losses Undesirable
In answer to these various contentions, it may be stated that though good buying is an essential factor in profit-making, no refinement of logic can obscure the obvious fact that goods are bought to be sold and that no profit arises until the sale takes place. All effort before the sale, whether directed towards good buying, careful storing and display, the placing of advertising, or the selection of a sales force, will come to naught unless sales are made. It would seem, therefore, that potential profit or loss on any or all effort preliminary to the actual sale has no place in the current record. From the standpoint of the profit and loss statement, this conclusion as to the policy of valuation of stock-in-trade at cost can be stated without fear of contradiction. In support of this is a direction of the Treasury Department in connection with the federal income tax returns. This reads, as revised in October, 1916: “In case the annual gain or loss is determined by inventory, merchandise must be inventoried at the cost price, as any loss in salable value will ultimately be reflected in the sales during the year when the goods are disposed of.”
From the viewpoint of the balance sheet, objection is sometimes raised—and supported by conservative practice and legal requirement as indicated above—that a balance sheet showing stock-in-trade at cost may thus very obviously under-or over-value the item, a situation not at all desirable. In this discussion, the whole problem of valuation is being treated from the point of view always of a going concern and not of one facing dissolution and the forced sale of its properties. Under these circumstances, such a balance sheet must frequently be used as the basis for asking credit, and credit extended on inflated values of current assets is not properly extended.
Method of Treatment and Summary
To meet this situation, particularly in the case of large fluctuations in the market, the true status of affairs is disclosed by appending to the balance sheet a footnote in which is stated the present market value of the inventory. Without this information, oftentimes, when the market is showing steadily rising values, as much harm and financial ruin may result through the extension of insufficient credit, as under other conditions might arise from an ill-advised inflation of credit. Sometimes the present market value is indicated by setting up a reserve out of profits, called “Reserve for Market Fluctuations in Merchandise”—or other similar title—when the market is lower than cost. This method retains the inventory on the books at cost value and so does not burden the current profit and loss, although it does lessen the amount of profits available for dividend distribution. Without doubt the policy is good in cases of extreme and somewhat permanent changes in the market.
To sum up, therefore, the valuation formula of cost or market, whichever is the lower, while based on conservatism may unnecessarily and improperly burden the current income account. Valuation at cost, on the other hand, while placing the profit or the loss in the period when realized may cause the balance sheet to present an entirely inadequate and even misleading story as the basis for credit. To remedy this, three courses are open, viz.:
1. Carry the market valuation, whether more or less than cost, in a footnote to the balance sheet.