1. ACF 101-102 Introductory Financial Accounting Introductory Financial Statement Analysis
Lecture 11

2. Learning Outcome
Demonstrate knowledge and understanding of types of analysis and also the accounting treatment of stock. Understand the usage of external financial reports. Understand the accounting concepts and conventions present in accepted accounting principles and their application in financial statements analysis.

3. Topics Inventory valuation Cost of sales (Cost of goods sold)
Gross Profit

4. Gross Profit and Cost of Goods Sold
Balance Sheet
Income Statement
Sales
Minus
Cost of Goods Sold
(an expense)
Merchandise Purchases
Merchandise Sales
Merchandise
Inventory
Equals Gross Profit Minus
Current Asset
Selling Expenses and Administrative Expenses
Equals operating Income

5. Link inventory valuation to gross profit.

6. The initial step in assessing profitability in most firms examines gross profit.

7. Gross Profit = Sales – Cost of Goods Sold.

8. Gross Profit must be large enough to cover all other expenses as well as a desired profit.

9. Cost of goods sold is determined by subtracting the cost of goods not sold during the period (ending inventory) from the cost of goods available for sale (beginning inventory plus purchases during the period).

10. Use both perpetual and periodic inventory systems.

11. The two main systems for keeping inventory records are perpetual and periodic.

12. The perpetual inventory system keeps a continuous record of inventories and cost of goods sold that helps managers control inventory levels and prepare interim financial statements.

13. Purchase Systems Record revenue when inventory is sold
Purchase inventory
Record revenue when inventory is sold
Merchandise Inventory 960
Accounts Payable
Accounts Receivable 1,740
Sales Revenue ,740

14. Purchase Systems Cost of Goods Sold (COGS) 870
Perpetual System – at each sale
Beginning balance 100
Purchases
Available for sale 1,010
Cost of goods sold –870
Ending balance (Derived)
__________________________________________________________________
Ending inventory count identifies spoilage, theft, etc.
Cost of Goods Sold (COGS) 870
Merchandise Inventory 870

15. Perpetual and Periodic Systems
Ending inventory count
Required under a periodic system
A good control practice in a perpetual systems
Firms often choose fiscal accounting periods so that the year ends when inventories are low
External auditors usually observe a sample of the client’s physical count to confirm its accuracy

16. Cost of Merchandise Acquired
Possible costs added to the inventory costs besides the purchase price itself
Transportation (freight) in
Handling
Insurance
Discounts that reduce these costs
Quantity
Early/quick payment
Vendor rebates
Purchase returns and allowances

17. Cost of Merchandise Acquired
Returns, Allowances
Accounts Payable
Purchase Returns/Allowances *
* Contra account to inventory or purchases
Discounts
Merchandise Inventory (Purchases)
Accounts Payable
Accounts Payable
Discounts on Purchases
Cash

18. Cost of Merchandise Acquired

19. Inventory Valuation Methods
If inventory prices were not changing, all methods would produce the same COGS and ending inventory amounts.
Since prices do change, which are assigned to COGS and ending inventory?
Four methods are generally accepted:
Specific identification - IFRS acceptable
First-in, first-out (FIF0) - IFRS acceptable
Weighted-average - IFRS acceptable
Last-in, first out (LIFO)

20. Inventory Valuation Methods Specific Identification
The cost of each inventory item is known
When an inventory item is sold, its cost becomes part of COGS. Bar codes facilitate identifying units and costs. Physical flow matches the accounting flow
Relatively easy to use, especially for expensive low- volume merchandise
COGS/ending inventory easily manipulated if inventory prices are changing

21. Inventory Valuation Methods FIFO – First In, First Out
Oldest costs are assigned to the income statement (COGS)
Latest costs are assigned to the balance sheet (Inventory), making ratios computed there from more reflective of current market value
Perpetual and periodic systems produce the same COGS and ending inventory amounts
COGS can not be manipulated
In periods of rising prices, FIFO leads to higher taxes paid and net income (by placing the lower costs in COGS)

22. Inventory Valuation Methods LIFO – Last In, First Out
Oldest costs are assigned to the balance sheet (Inventory).
Latest costs are matched to revenue on the income statement (COGS), making ratios computed there from more reflective of current market value
Perpetual and periodic systems produce different COGS and ending inventory amounts
COGS can be manipulated by buying inventory at year-end
In periods of rising prices, LIFO leads to lower net income and lower taxes paid
The Internal Revenue Code requires LIFO users for tax purposes to also use LIFO for financial reporting purposes
Not permitted for IFRS users

23. Inventory Valuation Methods Weighted Average
Computes a unit cost by dividing the total acquisition cost of all items available for sale by the number of units available for sale
The weighted-average method produces gross profit somewhere between that obtained under FIFO and LIFO
Perpetual and periodic systems produce different COGS and ending inventory amounts

24. Inventory Valuation Methods Example
Assume a vendor of soft drinks starts out the week with no inventory
He buys and sells cola as follows:
Buys one can on Monday for 30 cents
Buys one can on Tuesday for 40 cents
Buys one can on Wednesday for 56 cents
Sells one can on Thursday for 90 cents

25. Inventory Valuation Methods Example

26. Inventory Valuation Methods Miscellaneous
Accountants often refer to inventory methods as cost flow assumptions
May choose any of the four flows. Over long run, all produce essentially the same end results
Three out of the four flows are not linked to the physical flow of merchandise
Consistency suggests the cost flow assumption cannot be changed unless a substantive reason surfaces (must be disclosed)

27. Lower of Cost or Market
Ending inventory should be valued at the lower of its cost ($45) or market value ($43) (Rarely record holding gains – conservatism)
Market value
Input market – replacement cost (i.e. LIFO cost)
Output market – net realizable value (NRV) or NRV less a normal profit margin
Market value – middle of those three numbers
Loss on write-down of inventory
Merchandise Inventory

28. Inventory Errors
Revenue – recognized in the period when earned, realized, realizable
Expenses – recognized in the period when they helped to produce revenues
Types of Errors
Accidental (wrong amounts, accounts, GAAP, etc.)
Intentional – Profit pressures may cause managers to
Delay the recording of purchases/expenses
Accelerate incomplete sales orders

29. Inventory Errors

30. Inventory Gross Profit and Turnover
Gross profit – Sales Revenue less COGS
Expressed in dollar or percentage terms
Sales Revenue $100,000, %
COGS $60,000, %
Gross Profit Margin $40,000, %
Varies significantly by industry, wholesaler (lower due to volume) versus retailer (higher), presence of R&D, etc.

31. Inventory Gross Profit and Turnover
Can also be used to save time counting ending inventory, assuming GPM is a constant 40%
Sales Revenue $100 $100
Cost of Goods Sold ? $60
Gross Profit Margin (40% x $100) $40
Beginning Inventory $50
Purchases +$70
Ending Inventory – ?? = $60
Cost of Goods Sold $60

32. Inventory Gross Profit and Turnover
Gross profit percentage can be used to check the accuracy of the accounting records
Unusually lower percentage may mean the company has tried to avoid taxes by failing to record all sales
Some other factors that may cause a decline in the percentage are
Price wars that reduce selling prices
Shifting of the product mix sold
Increase in shoplifting or embezzlement

33. Inventory Gross Profit and Turnover
Inventory turnover
Cost of goods sold ,000
Average Inventory 20, ,000 = 4 2
On average inventory is being stocked/sold four times per year
Higher turnover is associated with greater efficiency (lower costs associated with stocking/handling inventory)
Effective in assessing companies in the same industry
Days in inventory 365 days / 4 = 91.25
On average inventory is held days before it is sold

34. Inventory Valuation Methods Miscellaneous
Inventory shrinkage can result from many factors, including shoplifting or employee embezzlement
The best deterrent for shoplifting is an alert employee at the point of sale
Retail stores also use
Sensitized tags on merchandise
Surveillance cameras

35. Inventory Valuation Methods Miscellaneous
Shrinkage Example
Cost of inventory from a physical count ($8,000)
Inventory balance in the general ledger ($8,200)
Periodic system
Perpetual system
Already included in COGS
Inventory Shrinkage
Merchandise Inventory
Cost of Goods Sold 200
Inventory Shrinkage 200