BUS 3061 Unit 5 Assignment 1 Ratio Analysis
Ensuring Accurate Inventory Valuation for Financial Reporting
One of the critical aspects of maintaining accurate financial statements for a merchandising company is proper inventory valuation. The organization’s income statements, statements of retained earnings, and balance sheets heavily rely on having an inventory value that reflects the actual cost of goods.
To achieve this, the company follows a periodic inventory procedure, which involves conducting physical inventory counts to determine the cost of goods sold (COGS). The recorded COGS figure is then included in the income statement.
It’s important to note that the COGS figure directly impacts the company’s net income. Any discrepancies or inaccuracies in inventory valuation can affect the reported ending inventory and the retained earnings on the balance sheet. These inaccuracies can distort the company’s financial picture and lead to misleading financial statements.
BUS 3061 Unit 5 Assignment 1 Ratio Analysis
The physical inventory process entails a comprehensive assessment of the entire inventory. This may involve physically counting, weighing, measuring, or estimating the quantities of goods in stock. While some companies may use perpetual inventory systems that rely on computerized tracking, a physical inventory is still necessary to ensure accuracy and identify potential discrepancies. It helps in reconciling the recorded inventory with the actual physical quantities.
Although the physical inventory process may not be traditionally considered an accounting procedure, the company’s financial representative often oversees the inventory count. Their involvement ensures the process is conducted diligently, following established guidelines and best practices.
Furthermore, when preparing goods for sale, it is crucial to consider the specific needs of each inventory item. Perishable goods, for example, should be sold on a first-in, first-out (FIFO) basis to minimize spoilage. In this method, merchandisers first rotate their stock, selling the oldest units. On the other hand, non-perishable items, like coal, may be valued using a last-in, first-out (LIFO) basis. Each inventory item requires careful consideration to determine the appropriate valuation method based on its characteristics.
Understanding the Flow of Goods
The physical flow of goods is crucial for proper inventory valuation. It involves tracking how goods move within the company from when they are acquired to when they are sold. This physical flow is separate from the financial flow of costs associated with those goods.
Cost flow assumptions allocate costs from the company’s inventory to the COGS. The most common cost flow assumptions in the United States are FIFO (first-in, first-out), LIFO (last-in, first-out), and average cost. It’s important to note that the cost of goods shipped does not necessarily match the price paid for each item. The physical flow of goods recognizes that the costs associated with shipped items may differ due to various factors such as bulk discounts, transportation charges, and handling fees.
Determining the cost of goods sold requires considering various components. These include the seller’s invoice price, sale discounts, insurance coverage during transit, transportation charges, and handling costs. The unit purchase price of each inventory item is calculated by combining these components with the actual purchase cost. This method ensures that the costs of acquiring goods prepared for sale are accurately accounted for in the inventory valuation.
Overview of Inventory Valuation Methods
Several inventory valuation methods are commonly used, each with advantages and disadvantages. These methods include specific identification, FIFO, LIFO, and weighted average.
The specific identification method attaches the actual cost to each identifiable inventory unit. This method is beneficial for large inventory items, such as automobiles, where it is feasible to track the price of each unit. Companies utilizing this method must identify and record the cost of each team in their inventory, often through identification tags or serial numbers. The specific identification method provides the most.
BUS 3061 Unit 5 Assignment 1 Ratio Analysis
Accurate matching of costs and revenues since it directly associates the price of each unit sold with the revenue generated from its sale.
Under the periodic inventory procedure, the FIFO method assumes that the costs of the first goods purchased are charged to the COGS when the company sells goods. This method aligns with the natural inventory flow, where older units are sold first.
In contrast, in a perpetual inventory system, the ending balance in the merchandise inventory account reflects the most recent purchases, as the required entries are made during the accounting period. This ensures that the COGS is recorded in real-time, based on the most recent acquisitions.
The advantages of the FIFO method include its simplicity of application and the alignment of cost flow with the typical physical flow of goods. Additionally, FIFO minimizes the potential for income manipulation since it does not allow for the recognition of paper profits. Furthermore, the balance sheet amount for inventory is likely to approximate its current market value.
In the periodic inventory procedure, the LIFO method assumes that the costs of the most recent purchases are charged to the COGS when goods are sold. This method is based on the assumption that the last items acquired are the first ones sold. In a perpetual inventory system, the inventory composition and balance are continuously updated with each purchase and sale, ensuring the accuracy of the LIFO valuation.
Supporters of the LIFO method argue that, historically, prices have risen steadily. By using LIFO, companies can avoid potential inventory or paper profits that may result from using FIFO during periods of inflation.
BUS 3061 Unit 5 Assignment 1 Ratio Analysis
The weighted average method calculates ending inventory using an average unit cost. It falls between LIFO and FIFO in terms of COGS figures. However, each technique has disadvantages:
- Specific identification allows income manipulation.
- FIFO can result in paper profits and higher taxes.
- LIFO can underestimate inventory value.
- The weighted average can be manipulated by timing purchases.
- Influence of Economic Factors on Inventory Valuation Methods
Various economic factors, including price levels and market conditions, influence the choice of an inventory valuation method. If an inventory is valued at cost and the price level steadily rises, the LIFO method will yield the lowest annual after-tax net income. This is because the most recent and higher-cost items are charged to the COGS, reducing net income. On the other hand, if the price level is steadily declining, the FIFO method will yield the highest after-tax net income. This is because the lower-cost items are charged to the COGS, resulting in higher net income. Furthermore, the FIFO method will yield an inventory cost that closely approximates current replacement costs.
The choice of inventory valuation method requires careful consideration of these economic factors, as it directly impacts the financial results and profitability of the company. Companies must assess the prevailing market conditions and select the most appropriate method that aligns with their goals, financial reporting requirements, and the nature of their inventory items.
Alternative Methods for Valuing Merchandise Inventory
In situations where historical cost methods are not feasible, alternative plans can be employed to determine the value of merchandise inventory. The net realizable value and the lower-of-cost-or-market (LCM) method are two.
The net realizable value is calculated by subtracting the estimated costs of preparing and selling an item from its estimated selling price. For example, a grocery store may have a clearance bin where things are priced lower due to being damaged or close to their expiration date. The store reduces the price to a level that can be sold based on its estimated value.
BUS 3061 Unit 5 Assignment 1 Ratio Analysis
The LCM method values inventory lower than its historical cost or current market (replacement) value. A loss is recognized if the stock’s market value is lower than its cost. However, if the market value is higher than the cost, the increase in value is realized at the time of sale.
Other methods include the gross margin method, which estimates ending inventory by deducting the estimated cost of goods sold from the cost of goods available for sale, and the retail inventory method applies a cost/retail price ratio to ending inventory stated at the retail price. These methods are helpful when a physical inventory count is not feasible, such as in the case of a warehouse fire.
It’s important to note that while these alternative methods can estimate inventory value, conducting a physical inventory count remains the best practice for an accurate valuation.
Inventory Ratio as a Financial Analysis Tool
The inventory ratio is a valuable tool used by companies for financial analysis. It is calculated by dividing the cost of goods sold by the average inventory. This ratio measures the efficiency of a company in managing and selling its stock. A high inventory turnover ratio indicates efficient inventory management, while a low ratio suggests that the company may be tying up too many resources in inventory.
For example, let’s consider the inventory turnover trends of the grocery store chain Lincoln Company:
In 2014
– Cost of goods sold: $1,043,000
– Beginning inventory: $283,000
– Ending inventory: $264,000
– Inventory turnover ratio: 2.5
In 2013
– Cost of goods sold: $820,000
– Beginning inventory: $311,000
– Ending inventory: $283,000
– Inventory turnover ratio: 2.76
Comparing the two years, we observe that in 2013 the company managed its inventory more effectively compared to 2014. This is indicated by a higher inventory turnover ratio, which suggests that the company could sell its merchandise more efficiently and have less tied-up capital in inventory.
References
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Bostwick, E. D., Lane Lambert, S., & Donelan, J. G. (2016). A Wrench in the COGS: An
Analysis of the Differences between Cost of Goods Sold as Reported in Compustat and
the Financial Statements. Accounting Horizons, 30(2), 177–193.
https://doiorg.library.capella.edu/10.2308/acch-51336
J.D. Edwards, R. H. (2011). Accounting principles: A business perspective, financial accounting
(Chapters 1–8). Textbook Equity.
Murdoch, B., Dehning, B., & Krause, P. (2013). Further evidence of the ability of FIFO and
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