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Financial Statement Analysis

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Financial Statement Analysis-FIN621
Notes to Financial Statements:
These are integral part of the Financial Statements, which provide summary of accounting
policies, adopted by Management in preparation of Accounts and preparing Financial Statements there
from. These also present details about particular accounts (e.g. inventory, investments etc). Notes to
Financial Statements also include other information e.g. leasing arrangements, pending legal
proceedings, income taxes etc.
Information by segment for firms with several lines of business is also given in these Notes.
Notes to the accounts are the explanatory notes of all the items shown in the profit and loss account and
the balance sheet. It is the requirement of the Companies Ordinance and the International Accounting
Standards. Following are explained in Notes to the accounts:
o  Nature of business of the company
o  Accounting Policies of the company
o  Details and explanation of items given in the Profit and Loss Account and Balance
Accounting Policies
The two major areas of Accounting Policies are Inventory and Depreciation of Plant Assets.
Inventory:  This consists of items held for sale or used in manufacture of products that would be sold.
Inventory in merchandising business consists of goods owned and held for sale. This is called
Merchandise. Inventory in manufacturing business consists of three parts i.e. raw material, work-in-
process and finished goods. Inventory is an Asset which is shown at cost in balance sheet.
Inventory Accounting Policies
Before we discuss Accounting Policies regarding Inventory, let us discuss the following
three types of maintaining and recording inventory:-
a) Perpetual inventory system. This is most widely used: In this, the transactions are recorded
as they occur. The flow would be as follows:-
Purchase of Dr. Current Merchandise Dr. Cost of Cr. Inventory
good sold
Cr. Cash or
Cr. Revenue
Dr. Cash or
A/C payable
A/C Receivable
In a perpetual inventory system, merchandising transactions are recorded as they occur. The system
draws its name from the fact that the accounting records are kept perpetually up-to-date. Purchase of
merchandise is recorded by debiting an asset account entitled inventory. When merchandise is sold, two
entries are necessary: One to recognize the revenue earned and the second to recognize the related cost
of goods sold. This second entry also reduces the balance of inventory account to reflect the sale of
some of the company's inventory.
A perpetual inventory system uses an inventory subsidiary ledger. This ledger provides company
personnel with up-to-date information about each type of product that the company buys and sells,
including the per-unit cost and the number of units purchased, sold, and currently on hand.
Financial Statement Analysis-FIN621
Periodic inventory system: In this case, accounting records are updated periodically ­ usually
at year's end: "Cost of goods sold" is also determined at year's end. The flow in this case
would be as follows:-
Purchase of Dr. Purchase
Merchandise No entry for "cost of goods sold"
or inventory. This is done at years end.
Cr. Cash or
Cr. Revenue
Dr. Cash or A/C
A/C Payable
Complete physical inventory is taken at year's end as follows:-
Opening balance (year's beginning)
+ Purchases.
Inventory available.
Less closing balance (year's end).
Inventory used/sold.
This i.e. Rs.134, 000 is "cost of goods sold", charged to Income Statement, and closing
inventory is Rs.8, 000 recorded on balance sheet. Both entries are recorded at year's end.
Assumptions under this method are that all units of inventory were acquired at the same unit
costs. "Taking physical inventory" at or near year-end also takes into account Inventory
Shrinkage (breakage, spoilage, theft), which is written off to Income Statement in the form of
A periodic inventory system is an alternative to a perpetual inventory system. In a periodic inventory
system, no effort is made to keep up-to-date records of either the inventory or the cost of goods sold.
Instead, these amounts are determined only periodically, usually at the end of each year.
A traditional periodic inventory system operates as follows. When merchandise is purchased, its cost is
debited to an account entitled purchases, rather than to the inventory account. When merchandise is
sold, an entry is made to recognize the sales revenue, but no entry is made to record the sost of goods
sold or to reduce the balance of the inventory account. As the inventory records are not updated as
transactions occur, there is no inventory subsidiary ledger.
The foundation of the periodic inventory system is the taking of a complete physical inventory at year-
end. This physical count determines the amount of inventory appearing in the balance sheet. The cost of
goods sold for the entire year then is determined by a short computation.
Just in time (JIT) Inventory System. In this case, the purchase of merchandise or raw
materials and component parts is done just in time for sale or for use in manufacture; often a
few hours, before the manufacture or sale. It involves completing the manufacturing process
just in time to dispatch finished goods. It reduces money "tied-up" in inventory of raw material
and finished goods. There is no need to maintain large inventory storage facilities. But the
disadvantage is that delay in arrival of raw material may halt operations.
Just-in-time (JIT) inventory systems are not a simple method that a company can adopt; it has a whole
philosophy that the company must follow in order to avoid its downsides. The ideas in this philosophy
come from many different disciplines including statistics, industrial engineering, production
management and behavioral science. In the JIT inventory philosophy there are views with respect to
how inventory is looked upon, what it says about the management within the company, and the main
principle behind JIT.
Financial Statement Analysis-FIN621
Inventory is seen as incurring costs, or waste, instead of adding value, contrary to traditional thinking.
This does not mean to say that JIT is unaware that removing inventory exposes manufacturing issues.
Under the philosophy, businesses are encouraged to eliminate inventory that doesn't compensate for
manufacturing issues, and to constantly improve processes so that inventory can be removed. Secondly,
allowing any stock habituates the management to stock and it can then be a bit like a narcotic.
Management is then tempted to keep stock there to hide problems within the production system. These
problems include backups at work centers, machine reliability, and process variability, lack of flexibility
of employees and equipment, and inadequate capacity among other things.
In short, the just-in-time inventory system is all about having "the right material, at the right time, at the
right place, and in the exact amount" but its implications are broad for the implementors.
JIT emphasizes inventory as one of the seven wastes, and as such its practice involves the philosophical
aim of reducing input buffer inventory to zero. Zero buffer inventories means that production is not
protected from exogenous (external) shocks. As a result, exogenous shocks reducing the supply of input
can easily slow or stop production with significant negative consequences.
Transaction Cost Approach
JIT reduces inventory in a firm, however unless it is used throughout the supply chain, then it can be
proposed that firms are simply outsourcing their input inventory to suppliers.
Some of the initial results at vehicle manufacturing company were horrible, but in contrast to that a huge
amount of cash appeared, apparently from nowhere, as in-process inventory was built out and sold. This
by itself generated tremendous enthusiasm in upper management.
Another surprising effect was that the response time of the factory fell to about a day. This improved
customer satisfaction by providing vehicles usually within a day or two of the minimum economic
shipping delay.
Also, many vehicles began to be built to order; completely eliminating the risk they would not be sold.
This dramatically improved the company's return on equity by eliminating a major source of risk.
As most companies use an inventory system best suited for their company, the Just-In-Time Inventory
System (JIT) can have many benefits resulting from it. The main benefits of JIT are listed below.
Set up times is significantly reduced in the warehouse. Cutting down the set up time to be more
productive will allow the company to improve their bottom line to look more efficient and focus time
spent on other areas that may need improvement.
The flows of goods from warehouse to shelves are improved. Having employees focused on
specific areas of the system will allow them to process goods faster instead of having them vulnerable to
fatigue from doing too many jobs at once and simplifies the tasks at hand.
Employees who possess multiple skills are utilized more efficiently. Having employees trained
to work on different parts of the inventory cycle system will allow companies to use workers in
situations where they are needed when there is a shortage of workers and a high demand for a particular
Financial Statement Analysis-FIN621
Better consistency of scheduling and consistency of employee work hours. If there is no
demand for a product at the time, workers don't have to be working. This can save the company money
by not having to pay workers for a job not completed or could have them focus on other jobs around the
warehouse that would not necessarily be done on a normal day.
Increased emphasis on supplier relationships. No company wants a break in their inventory
system that would create a shortage of supplies while not having inventory sit on shelves. Having a
trusting supplier relationship means that you can rely on goods being there when you need them in order
to satisfy the company and keep the company name in good standing with the public.
Supplies continue around the clock keeping workers productive and businesses focused on
turnover. Having management focused on meeting deadlines will make employees work hard to meet
the company goals to see benefits in terms of job satisfaction, promotion or even higher pay.