CHAPTER XIII. Merchandise Stock-in-Trade

MERCHANDISE STOCK-IN-TRADE

Definition and Scope of Term

Stock-in-trade, as the term is usually understood, comprises all commodities purchased for resale. Thus, assets, which in one concern belong to the fixed asset group, may be the stock-in-trade of other concerns. In stating the principles of valuation for these assets, it is definitely to be understood that they apply only to such as are used as stock-in-trade, and not to the same items when used as fixed assets. Oftentimes the process of manufacture intervenes between the purchase of a commodity and its sale. In such a case the commodity, at the time of valuation, may be in different stages of completion. It is then usually so listed on the balance sheet under suitable titles, such as Raw Material, Goods in Process, and Finished Goods, all of which are treated as current assets. Included in the problem of valuation of stock-in-trade is the treatment of goods out on consignment, goods of others held for sale on a commission basis, and scrap material. Finally, some points to be observed in taking the physical inventory will be considered.

Valuation at Market or Cost Price

Inasmuch as stock-in-trade is purchased solely for resale or ultimate conversion into cash, it is desirable for the balance sheet to reflect the proper value of what remains on hand unsold. Such goods may have a realizable value higher or lower than cost value, from the standpoint of the market in which they were purchased, and will usually have a higher value in the market where they are to be sold. The value of all current assets to be shown on balance sheet is usually stated at the present realizable value. As applied to stock-in-trade, that must not be understood to mean sale or retail value. To value the stock-in-trade on such a basis would result in taking into the current period the profits on sales not effected until the next period; furthermore, these profits would not even be offset by the costs of making the sale. It may be laid down as a principle of business practice based on sound reason, that the period in which the sale is made should be given credit for it. Stock-in-trade must therefore be valued on the basis of its purchase or wholesale market price and according to well-established practice, either at cost or market, whichever is the lower. This principle has the support of conservative practice throughout the world.

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. 2. In case market value is less than cost, set up a reserve out of profits equal in amount to the difference. 3. Carry in an inner column in the body of the balance sheet the present market value.

It would seem, therefore, that valuation at cost with the present market value shown on the face of the balance sheet, is the most desirable practice from every viewpoint.

Depreciation of Stock-in-Trade

Quite apart from this discussion of the proper basis for valuation, which concerns itself with marketable merchandise, is the problem of the method of handling deterioration or depreciation of stock-in-trade as distinguished from fluctuations in value. Such deterioration may result from shelf wear, use of goods for display purposes, changes in style and shape, overstocking which causes an accumulation of goods which soon are out of date or of sizes and qualities seldom used, broken lots where such will injure the sale value, and so on. Many devices, such as the “spiff” or the offer of a premium to salesmen, are employed by up-to-date merchants to keep their stocks free from these items of deterioration; but in spite of all that can be done, it usually proves impossible to keep the stock live in every particular. A valuation at cost under these circumstances would be an obvious inflation of values. If the concern had purchased that quality of goods originally with the expectation of resale, valuation at cost, under the limitations suggested above, would be the correct basis for showing. Since, however, such is not usually the case, the proper basis of valuation is now the market price—the present price at which goods of similar kinds and qualities can be bought.

It may be objected that the effect here also is unduly to burden the current period with unrealized losses, but this is not the case. The deterioration in value is a very real loss which is entirely independent of any fluctuations in the market. If goods are shelf-and window-worn from display usage, the deterioration is just as much an expense incurred for advertising as a display advertisement in a daily paper. The deterioration due to overstocking is a penalty which the current period should bear because of its poor buying effort or its inadequate sales efficiency. Thus, valuation of the inventory of any stock of goods must have regard to the effect of its present condition on its marketability. Any deterioration which renders the stock less salable is an expense to be borne by the present period and not the period in which the sale is made.

Full Costs of Stock-in-Trade

Cost having been established as the basis for valuing a stock of marketable merchandise, there must next be considered the elements of cost and their application to different classes of goods. By cost of goods is meant full cost, i.e., not only invoice price but all additional costs, needed to place them ready for sale. All costs, therefore, up to the point where goods are ready to create income are proper charges against the stock-in-trade. Customary costs of this kind are freight, drayage, insurance during transit and storage, duty, seasoning or aging costs, warehouse charges, and all similar items. The information as to these costs is usually recorded separately, but at a summary period they are loaded on the invoice cost of stock-in-trade.

In connection with this question of the proper composition of cost, attention is called to two other items sometimes requiring consideration. The first deals with the handling of cash discounts. The point at issue is as to whether the invoice figure should be recorded at the price quoted on a cash basis or on a credit basis. This point is discussed at length in Chapter XXXVI of the first volume where the conclusion reached is that the credit policy of each concern must govern the manner of making the record. If the concern has a fixed policy of buying at a cash price, that price should be the price of record; whereas if all financial and other related policies are based on a 30-or 60-day credit term, the credit price for that term should be the price of record. Particularly is this true when viewed from the sales standpoint where the fixing of the selling price is a part of the financial policy. The second point requiring consideration in connection with cost is the item of interest on the money invested in stock. At the close of the fiscal period should the stock sold and that left on hand be burdened with interest on the average amount of capital tied up in it during the period? The student is referred to