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Financial Statement Analysis

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Financial Statement Analysis-FIN621
VU
Lesson-20
NOTES TO FINANCIAL STATEMENTS
(Continued)
In cost-flow assumptions, three methods for measuring "cost of good sold", under GAAP are used.
In these three methods, assumptions are made as to the sequence in which units were
withdrawn from inventory. The three flow assumptions are:-
i)
Average cost: Values all merchandise (units sold and in balance) at the
Average per-unit cost, under the assumption of random withdrawal of inventory units.
Average cost in the above example: Rs.23, 000 per AC. That would be the cost of goods
sold. Ending Inventory to be recorded on balance sheet would also take into account this
figure of reduction in Inventory.
ii)
First-in-First - out (FIFO): goods sold are assumed to be the first units
that were purchased.
iii)
Last-in-First-Out (LIFO): units sold are assumed to be those which were most recently
acquired.
During Inflation, FIFO shows less expense on income statement and higher inventory
valuation on balance sheet and values ending inventory at current cost, whereas LIFO shows higher
expenses on income statement and lower inventory valuation on balance sheet.
It should be noted that Inventory valuation significantly affects both b/sheet and income
statements. Each valuation method/cost-assumption produces different results in financial statements
and tax returns.
Valuation of Stock
Any manufacturing organization purchases different material through out the year. The prices of
purchases may be different due to inflationary conditions of the economy. The question is, what item
should be issued first & what item should be issued later for manufacturing. For this purpose, the
organization has to make a policy for issue of stock. All the issues for manufacturing and valuation of
stock are recorded according to the policy of the organization. Mostly these three methods are used for
the valuation of stock:
·
First in first out (FIFO)
·
Last in first out (LIFO)
·
Weighted average
First in first out (FIFO)
The FIFO method is based on the assumption that the first merchandise purchased is the first
merchandised issued. The FIFO uses actual purchase cost. Thus, if merchandise has been purchased at
several different costs, the inventory (stock) will have several different cost prices. The cost of goods
sold for a given sales transaction may involve several different cost prices.
Characteristics
·
This is widely used method for determining values of cost of goods sold and closing stock.
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Financial Statement Analysis-FIN621
VU
·
In the FIFO method, oldest available purchase costs are transferred to cost of goods sold. That
means the cost if goods sold has a lower value and the profitability of the organization becomes
higher.
·
As the current stock is valued at recent most prices, the current assets of the company have the
latest assessed values.
Last in first out (LIFO)
As the name suggests, the LIFO method is based on the assumption that the recently purchased
merchandise is issued first. The LIFO uses actual purchase cost. Thus, if merchandise has been
purchased at several different costs, the inventory (stock) will have several different cost prices. The
cost of goods sold for a given sales transaction may involve several different cost prices.
Characteristics
·
This is alternatively used method for determining values of cost of goods sold and closing stock.
·
In the LIFO method recent available purchase costs are transferred to cost of goods sold. That
means the cost of goods sold has a higher value and the profitability of the organization
becomes lower.
·
As the current stock is valued at oldest prices, the current assets of the company have the oldest
assessed values.
Weighted average method
When weighted average method is in use, the average cost of all units in inventory, is computed after
every purchase. This average cost is computed by dividing the total cost of goods available for sale by
the number of units in inventory. Under the average cost assumption, all items in inventory are assigned
the same per unit cost. Hence, it does not matter which units are sold; the cost of goods sold is always
based on current average unit cost.
Characteristics
·
Under the average cost assumption, all items in inventory are assigned same per unit cost (the
average cost). Hence it does not matter which units are sold first. The cost of goods sold is
always on the current average unit cost.
·  Since all inventories are assigned same cost, this method does not make any effect on the
profitability and does not increase/decrease any asset in the financial statements.
·  This is the alternatively used method for determining values of cost of goods sold and closing
stock.
Example
·  Receipts:
01 Jan 20--,
10 units @ Rs. 150 per unit
02 Jan 20--,
15 units @ Rs. 200 per unit
10 Jan 20--,
20 units @ Rs. 210 per unit
·  Issues:
05 Jan 20--,
05 units
06 Jan 20--,
10 units
15 Jan 20--,
15
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Financial Statement Analysis-FIN621
VU
FIFO Method of Stock Valuation
Date
Receipts
Issues
Value of Stock
01-01-20--
10 @ Rs. 150
10 x 150 = 1500
02-01-20--
15 @ Rs. 200
10 x 150 = 1500
15 x 200 = 3000
4500
05-01-20--
5 @ 150 = 750
750
5 x 150 = 750
15  x  200
=
3000
3750
06-01-20--
5 @ 150 = 750
0 x 150 =
0
5 @ 200 = 1000 1750
10  x  200
=
2000
2000
10-01-20--
20 @ Rs. 210
10 x 200 = 2000
20  x  210
=
4200
6200
15-01-20--
10 @ 200 = 2000
0 x 200 =
0
5 @ 210 = 1050 3050
15  x  210
=
3150
3150
Weighted Average Method of Stock Valuation
Date
Receipts
Issues
Value of Stock
Average Cost
01-01-20-- 10x150 = 1500
1500
1500/10=150
02-01-20-- 15x200 = 3000
1500 + 3000 = 4500
4500/25=180
05-01-20--
5x180 = 900
4500 ­ 900 = 3600
3600/20=180
06-01-20--
10x180 = 1800
3600 ­ 1800 = 1800
1800/10=180
10-01-20-- 20x210 = 4200
1800 + 4200 = 6000
6000/30=200
15-01-20--
15x200 = 3000
6000 ­ 3000 = 3000
3000/15=200
Effects of valuation method on profit
FIFO Method
·  Cost of Sales
= 750 + 1750 + 3050
= 5,550
Gross Profit
= 7500 ­ 5550
= 1,950
Weighted Average Method
·  Cost of Sales  = 900 + 1800 + 3000
= 5,700
Gross Profit
= 7500 ­ 5700
= 1,300
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Financial Statement Analysis-FIN621
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Illustration
XYZ Company is a manufacturing concern. Following is the receipts & issues record for the month of
May, 2002
Date
Receipts
Issues
May 7
200 units @ Rs. 50/unit
May 9
60 units
May 13
150 units @ Rs. 75/unit
May 18
100 units @ Rs. 60/unit
May 22
150 units
May 24
100 units
May 27
100 units @ Rs. 50/unit
May 30
200 units
Calculate the value of closing stock by
·  FIFO Method
·  Average Method
Solution
Valuation of Stock by FIFO Method
Date
Receipts
Issues
Value of Stock Total
Remaining
Net Balance
Amount
No. of units
May 7
200 units @
200 x 50 = 10,000
200
10,000
Rs. 50/unit
10,000
May 9
60 units @ Rs. 60 x 50 = 3,000 (3,000)
140
7,000
50/unit
May 13
150 units @
75 x 150 = 11,250
290
18,250
Rs. 75/unit
11,250
May 18
100 units @
60 x 100 = 6,000
390
24,250
Rs. 60/unit
6,000
140 units @ 50 x 140 = (7,750)
240
16,500
May 22
Rs. 50/unit
7,000
10 units @ Rs.
75/unit
10 x 75 =
750
May 24
100 units @ 75
x
100 (7,500)
140
9,000
Rs. 75/unit
=7,500
May 27
100 units @
50 x 100 = 5,000
240
14,000
Rs. 50/unit
5,000
40 units @ Rs. 75 x 40 = 3,000 (12,000)
40
2,000
May 30
75/unit
100 units @ 60 x 100 =
6,000
Rs. 60/unit
60 units @ Rs.
50 x 60 = 3,000
50/unit
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Financial Statement Analysis-FIN621
VU
Valuation of Stock by Weighted Average Method:
Date Receipts Issues Value
of Total
Total Units
Average
Net
Stock
Amount(Rs.)
Cost(Rs.)/unit
Balance
(Rs.)
May 200 units
200 x 50
10,000
200
50
10,000
7
@
Rs.
=
50/unit
10,000
May
60
60 x 50
(3,000)
140
7,000
9
units
=
3,000
May 150 units
150 x 75
7,000+11250
140+150=290 18250/290=62.9 18,250
13  @
Rs.
=
=
75/unit
11,250
18250
May 100 units
100 x 60
18250+6000
290+100
24250/390
24,250
18  @
Rs.
=
=
=
=
60/unit
6,000
24250
390
62.2
May
150
150 x 62.2
(9,330)
390-150
14,920
22
units
=
=
9330
240
May
100
100 x 62.2
(6,220)
240-100
8,700
24
units
=
=
6220
140
May 100 units
100 x 50
8,700+5,000
140+100
13700/240
13,700
27  @
Rs.
=
=
=
=
50/unit
5,000
13,700
240
57.1
May
200
200 x 57.1
(11,420)
240-200
2,280
30
units
=
=
11,420
40
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