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Financial Statement Analysis

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Financial Statement Analysis-FIN621
VU
Lesson-19
NOTES TO FINANCIAL STATEMENTS
(Continued)
Charging Costs of Inventory to Income Statement
This is also known as cost flows of inventory. Inventory units may be acquired at
different costs because of different purchase dates or different suppliers. Question is: Which of these
costs are to be used as "cost of goods sold"?
Purchase/  → Balance sheet sale of goods cost of Income
Manufacture  current assets.
Good
Statement
Cost of inventory
sold
(?)
Measuring "cost of goods sold" involves valuation and pricing of Inventory and this is
determined by Inventory Accounting Policies.
As on example consider that 2 ACs were purchased in January @ Rs.20, 000 each, and 3
@ Rs.25, 000 each in February. One AC was sold in March. What would be the cost of goods sold:
Rs.20, 000 or Rs.25, 000?
Two approaches can be adopted in this case i.e. specific identification and cost-flow
assumptions. Either is acceptable but an approach once selected, is to be applied consistently.
In specific identification approach, the Units are identified specifically, which clearly
shows as to which particular unit is being sold and what was its cost, which would be its "cost of goods
sold".
A Note on the Impact of Inventory Levels on Net Income
Fluctuations in inventory levels can cause profit variations when inventory is valued according to
GAAP standards. GAAP standards require that all manufacturing costs must be capitalized in inventory
regardless of whether the costs are variable or fixed.
The inclusion of fixed costs in the unit cost causes profits to rise as inventory levels raise because the
fixed cost in inventory is stored on the balance sheet instead of being carried over to the income
statement. When the inventory level falls, this fixed cost that has been stored on the balance sheet is
moved over to the income statement thereby causing net profit to fall.
To illustrate this phenomenon I first present a one month income statement constructed using only
variable costs in inventory (in this case, materials only).
Sales
$1,837,380
Cost of materials
458,000
Margin
1,379,380
Expenses
Labor
224,000
Overhead
344,288
Depreciation
270,000
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Financial Statement Analysis-FIN621
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Administrative
210,000
Marketing
175,000
Total expenses
1,223,288
Profit before taxes
156,092
Income taxes @ 35%
54,632
Net Profit
$101,460
Computation of Unit Values
Sales
Flow
Valves
Pumps
Controllers
Total
Units
7,500
12,500
4,000
24,000
Selling Price  $57.78
$81.26
$97.07
$1,837,380
20.00
22.00
458,000
Material cost  16.00
Unit margin  41.78
61.26
75.07
Total margin
$313,350
$765,750
$300,280
$1,379,380
Next I show two income statements for two months with the identical sales as in the first income
statement that uses only variable costs in inventory. However, in these two income statements the
inventory levels change; in the Month 1 statement the inventory of Valves rises by 1,000 units, and in
the Month 2 statement Valve inventory falls by 1,000 units.
Month 1
Flow
Valves
Pumps
Controllers
Total
Unit Sales
7,500
12,500
4,000
24,000
Units Produced
8,500
12,500
4,000
25,000
Ending Inv.
1,000
0
0
1,000
Unit cost
37.75
48.87
100.57
Sales Price
$57.78
$81.26
$97.07
Dollar sales
433,350
1,015,750
388,280
1,837,380
Income Statement
Sales
$1,837,380
Cost of goods sold
Begin inv.
0
Costs added
Materials
474,000
Labor
155,600
Overhead
682,688
Total costs added
1,312,288
Goods available
1,312,288
Ending inv.
1,000
37,749
Cost of goods sold
1,274,539
Gross Profit
562,841
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Financial Statement Analysis-FIN621
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Administrative
210,000
Marketing
175,000
Total expenses
385,000
Profit before taxes
177,841
Income taxes @ 35%
62,244
Net Profit
$115,597
Month 2
Flow
Valves
Pumps
Controllers
Total
Unit Sales
7,500
12,500
4,000
24,000
Units Produced
6,500
12,500
4,000
23,000
Unit cost
37.75
48.87
100.57
Sales Price
$57.78
$81.26
$97.07
Dollar sales
433,350
1,015,750
388,280
1,837,380
Income Statement
Sales
$1,837,380
Cost of goods sold
Begin inv.
37,749
Costs added
Materials
442,000
Labor
155,600
Overhead
682,688
Total costs added
1,280,288
Goods available
1,318,037
Ending inv.
0
0
Cost of goods sold
1,318,037
Gross Profit
519,343
Administrative
210,000
Marketing
175,000
Total expenses
385,000
Profit before taxes
134,343
Income taxes @ 35%
47,020
Net Profit
$87,323
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Financial Statement Analysis-FIN621
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Notice how the net incomes changed from one month to the next even though sales remained the same.
This example used activity based costs for costing the units of product, but any costing method that
assigns fixed costs to units will give the same result.
To more clearly show why the incomes differ, consider the following table that shows variable unit
costs and the unit fixed costs assigned to the units by the ABC costing system.
Flow
Valves
Pumps
Controllers
ABC unit cost
$37.75
$48.87
$100.57
20.00
22.00
Unit variable cost
16.00
Fixed cost per unit
21.75
28.87
78.57
Times
x
Inventory change in units  1,000
Equals--Difference in pre$21,749
tax income
Profit  before  taxes--unit$156,092
variable costs
Profit before taxes--ABC177,841
unit costs Month 1
Difference in profit before(21,749)
taxes
Profit  before  taxes--unit$156,092
variable costs
Profit before taxes--ABC134,343
unit costs Month 2
Difference in profit before$21,749
taxes
The difference between the net income before taxes for the income statement with variable costs and the
one with the ABC costs is always explained by the unit change in inventory multiplied by the fixed
overhead per unit.
Inventory Errors and Financial Statements
Income statement effects.
An incorrect inventory balance causes an error in the calculation of cost of goods sold and,
therefore, an error in the calculation of gross profit and net income. Left unchanged, the error has
the opposite effect on cost of goods sold, gross profit, and net income in the following accounting
period because the first accounting period's ending inventory is the second period's beginning
inventory. The total cost of goods sold, gross profit, and net income for the two periods will be
correct, but the allocation of these amounts between periods will be incorrect. Since financial
statement users depend upon accurate statements, care must be taken to ensure that the inventory
balance at the end of each accounting period is correct. The chart below identifies the effect that
an incorrect inventory balance has on the income statement
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Financial Statement Analysis-FIN621
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Impact of Error on
Error in Inventory Cost of Goods Sold Gross Profit Net Income
Ending Inventory
Understated
Overstated
Understated
Understated
Overstated
Understated
Overstated
Overstated
Beginning Inventory
Understated
Understated
Overstated
Overstated
Overstated
Overstated
Understated
Understated
Balance sheet effects.
An incorrect inventory balance causes the reported value of assets and owner's equity on the
balance sheet to be wrong. This error does not affect the balance sheet in the following accounting
period, assuming the company accurately determines the inventory balance for that period.
Impact of Error on
Error in Inventory Assets =
Liabilities + Owner's Equity
Understated
Understated No Effect
Understated
Overstated
Overstated
No Effect
Overstated
Financial Statements with Inventory
The statement of owner's equity and the statement of cash flows are the same for merchandising
and service companies. Except for the inventory account, the balance sheet is also the same. But a
merchandising company's income statement includes categories that service enterprises do not use.
A single-step income statement for a merchandising company lists net sales under revenues and
the cost of goods sold under expenses.
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