Professional Scheme
Relevant to Paper 2.5, Paper 2.6

In any business enterprise, a significant loss of stock is not a normal recurring feature although it can, and sometimes does, happen under unexpected and unfortunate circumstances. Such a risk of loss caused by fire, theft etc., may be avoided with the help of proper insurance cover. If the enterprise does not arrange any insurance, it has to absorb the entire impact of the loss should there be such an occurrence.

The accounting treatment for abnormal loss of stock would be different depending on whether the items were insured or not. This article seeks to clarify accounting treatments under different scenarios with the help of a hypothetical examination question. It will also discuss some of the fundamental principles of physical stock-taking.

It is strongly recommended that students independently answer the question first before referring to the suggested solution.

Question:
Three friends, B. Brave, C. Conservative and D. Doubtful started separate businesses from 1 January 1999 with initial capital of ?10,000 each. In view of their similar backgrounds and business interests, they decided to trade in similar products but from different rented premises, adjoining one another. For the purpose of determining sales price, they followed a standard formula of “cost plus 25%”.

They adopted similar business policies and accounting principles for their respective businesses. In anticipation of severe pressure from the competitors, the three friends wanted to keep capital expenditure to the minimum, each spending only ?4,000 towards old office furniture and equipment that could be used for 5 years.

They also engaged A. Auditor to conduct an audit of their accounts for the year 1999.The only item they could not agree on was pertaining to fire insurance coverage for stocks. This is what they came up with:

• Brave — The probability of loss of stock due to fire was remote. Why, therefore, unnecessarily increase business cost? He decided not to buy any insurance cover. He would rather save the premium and utilise it for more profitable deals.
• Conservative — Regardless of the probability, he decided to arrange full coverage. Although he had to pay the annual premium of ?500, this would protect him from any unforeseen loss and, what is more important, would provide him with peace of mind.
• Doubtful — After listening to his other two friends, he was totally confused and undecided. Finally he went for a partial (50%) coverage at a premium of ?260 for 1999. Although he still had some “risk exposure”, this would give him the opportunity of saving capital from the insurance premium. In case there is a loss, he would still be able to claim half of it.

During the year they were reasonably successful in their trading activities. They arranged for a stock-take late afternoon of 31 December 1999 that was also attended by Auditor. After the stock-take, they headed back for a grand new-year celebration. Unfortunately a devastating fire destroyed many factories including the business premises of Brave, Conservative and Doubtful on that night.

On receipt of the bad news, Brave, Conservative and Doubtful rushed to the scene but it was too late. By then all their stocks were completely destroyed with no hope of any salvage. Immediately, they wanted to know the quantum of loss arising out of this fire. As the stock-take work-papers were in their briefcases, this was not a difficult task.

Conservative took the lead as he was already thinking of making a claim from the insurance company. He had used the standard Customer Order Form to record actual stock quantity as at 31 December 1999. As there were not too many items in stock, he entered physical stock in the “Quantity ordered” column and then used the “Extended value” column to arrive at the total stock valuation. His final total for the entire stock thus came to ?9,800 at selling price.

Although Doubtful had little, and Brave had no interest in “insurance”, it appeared that they had also followed a similar approach to determine the year-end stock valuation for their respective businesses. They had different items in their inventory but, by a strange coincidence, their total figures also came to ?9,800 at selling price.

All transactions were in cash and the three friends had the same level of business activities, as below, for the whole of 1999:

3 January 2000, the first workday of the new millennium, was indeed a very hectic day for them. As an accounting specialist and a good friend of Brave, Conservative and Doubtful, you have been summoned to assist them on various accounting/insurance matters. You have asked for, and received permission to meet up with Auditor before providing specific advice to the three friends.

Required:

1. State what further information you would request from Auditor to add credibility to the insurance claim. (5 marks)
2. Calculate the amount and state the basis of the insurance claim that you would recommend to Conservative and Doubtful. (5 marks)
3. Advise Brave, Conservative and Doubtful on the accounting treatment for loss of stock by fire. (5 marks)
4. Prepare draft Trading and Profit & Loss Account for 1999 and a Balance Sheet as at 31 December 1999 assuming insurance claims, where applicable, have been submitted. (15 marks)
   (30 marks)

End of question.

Stop reading and start answering the question now.

Do not refer to the suggested solution until you have had an opportunity to think it through.

Suggested solution:

(a) Although the entire stock was destroyed, the three friends were lucky to have counted the stock in the presence of their auditor, just before the fire. This would add credibility to the insurance claim (where applicable) assuming there is no unfavourable comment from the Auditor. Therefore it is necessary to seek following information:

1. Stock-take procedure — If a systematic and meaningful procedure was followed to determine the existence, ownership and valuation of stock.
2. Cut-off procedure — If items recorded as purchases and sales in 1999 were in fact physically received and issued before the fire.
3. Third party stock — If there were any third-party inventory left in the warehouse and if so whether such items were excluded from the recorded quantity.
4. Physical state and age of stock — If any old, damaged, slow-moving and obsolete stocks were identified and if so, their estimated net realisable value.
5. Valuation — If estimated net realisable value of “good” stock was likely to be less than cost.
6. Integrity — If Auditor has any doubt about the integrity of the actual stock-take.
7. General — If the Auditor has any other comments/concerns that would raise serious doubts about accuracy of stock quantity and its valuation.

(b) Insurance is a contract of indemnity which means that the insurer indemnifies (or reinstates) the actual loss suffered by the insured. Therefore the claim can only be made for the actual cost of the goods excluding any element of anticipated profit. In this example, the stock-take worksheet used selling price for stock valuation that must be converted into cost by eliminating profit margin.

A contract of insurance works on the assumption of “uberrimae fidei” i.e., utmost good faith. If there is any deliberate misstatement or suppression of material facts, the insurer has the right to repudiate the contract. Based on the facts of the case and information available from Auditor, there is no such reason for the insurance company to refuse the claim of Conservative and Doubtful.

Since the selling price is “cost-plus 25%”, the cost of stock destroyed by fire is re-computed at ?7,840 (100/125 x ?9,800). Therefore the insurance claim will be made for this amount of ?7,840 for Conservative. For Doubtful it would be ?3,920 as he took a reduced coverage of only 50%. Students may be interested to know that any consequential loss due to stock-out/manufacturing disruption for loss of stock may be insured by a separate business interruption policy — that is not covered in this article.

(c) As a general rule, a trading account is prepared to show the gross trading result of the organisation “under normal circumstances”. This facilitates a comparison of gross profit with what was budgeted for, assuming there were no abnormal stock loss. If indeed there was any abnormal loss, it would be charged to Profit and Loss Account like any other business expenses/losses.

For these reasons, any major stock destruction by fire (as in our scenario) would be credited to Trading account as though the items were still there. The corresponding debit would go to Profit and Loss Account to the extent it is not covered by insurance. The amount claimed/due from the insurers would be debited to the insurance company’s account and shown as an asset like any other debtor.

In our case, all three friends’ Trading Accounts will have a credit of ?7,840. Since Brave did not opt for any insurance, the entire loss would be debited to his Profit and Loss Account. Conservative’s Profit and Loss account will not have any impact as he was fully insured. For Doubtful, only half the amount (?3,920) will be charged to his Profit and Loss account, the other half being shown in the Balance Sheet.

(d) Draft Trading and Profit & Loss Account

For the year ended 31 December 1999

Draft Balance Sheet
As at 31 December 1999