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SYLLABUS
1. Overview and Introduction to Financial Statements
2. Overview of business types (legal and accounting framework)
3. The Accrual Accounting Process of Preparing Financial Statements
4. US GAAP: assumptions, principles & constraints
5. The income statement
6. The Balance Sheet
7. The Cash Flow statement
8. Introduction to management accounting
9. Depreciation methods
10. Inventory methods
11. CVP Analysis
12. ABC Costing
13. Working Capital Management
14. performance ratios
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1. OVERVIEW AND INTRODUCTION TO FINANCIAL
STATEMENTS
The three major financial statements produced by accounting are the income statement,
the balance sheet, and the cash flow statement.
Cash accounting records cash inflows and outflows in the period in which they occur.
Accrual accounting records income and expenses in the period to which they are
attributable rather than when cash payments come and go.
For example, a check written in April for March's utilities would appear as a March
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expense under the accrual method and as an April expense under the cash method.
TYPES & USERS OF ACCOUNTING
There are two kinds of users of accounting information: internal users and external
users.
• Internal users are usually company managers who use accounting information to
decide how to plan and control operations on a daily and long-term basis.
Auditors-review the company’s books and look for errors and discrepancies (could be
internal or external)
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FINANCIAL STATEMENTS: INCOME STATEMENT
Shows your revenues and expenses over a period of time (month, year)
Expenses are the cost of assets consumed or services used in the process of earning
revenue.
Examples of expenses include utility expense, rent expense, and supplies expense.
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FINANCIAL STATEMENTS: BALANCE SHEET
Tangible assets-this you can touch like machinery, buildings, land, computers, etc.
Liabilities: Are things you owe, future obligations of the business, Creditor claims
Examples include a bank loan or car loan, or buying supplies for your business on credit
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FINANCIAL STATEMENTS: BALANCE SHEET
Assets=Claims
Assets=Liabilities + Equity
ABC Company has assets of $20,000 and liabilities of $5,000. How much is
stockholder’s equity?
A=L+OE 9
20,000=5,000+?
20,000-5,000=15,000
FINANCIAL STATEMENTS: BALANCE SHEET
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FINANCIAL STATEMENTS: CASH FLOW STATEMENT
Cash Flow Statement: Explains how a company obtained and used cash during the
accounting period.
There are three sections to the cash flow statement: operating, investing and financing.
Operating section is first. Operating activities include receiving cash from revenue
and paying cash for expenses.
Investing section includes paying cash to buy productive assets (like machinery or
equipment) or receiving cash when you sell productive assets.
Financing section includes receiving cash from owners or paying cash to owners
(dividends) It can also include borrowing cash from the bank or repaying the cash.
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GAAP ( GENERALLY ACCEPTED ACCOUNTING PRINCIPLES)
Generally Accepted Accounting Principles, also called GAAP or US GAAP, is the
accounting standard adopted by the U.S.
To achieve basic objectives and implement fundamental qualities GAAP has three basic
assumptions, four basic principles, and five basic constraints.
Assumptions
• Business Entity: The business is separate from its owners and other businesses. Revenue
and expense should be kept separate from personal Expense
• Monetary Unit: A stable currency is the unit of record.
• Periodicity: The economic activities of an enterprise can be divided into artificial time
periods. The time period (or periodicity) assumption assumes that the economic life of a
business can be divided into artificial time periods — generally a month, a quarter, or a
year.
• Periods of less than one year are called interim periods.
• The accounting time period of one year in length known as a fiscal year.
Principles
• Historical cost principle: Companies must account for and report the acquisition costs of
assets and liabilities rather than their fair market value. This principle provides
information that is reliable (removing the opportunity to provide subjective and potentially
biased market values), but not very relevant.
For example, say the main headquarters of a company, which includes the land and building,
was bought for $100,000 in 1980, and its expected market value today is $2 million. The asset
is still recorded on the balance sheet at $100,000. 13
While depreciation will lower the net value of an asset appearing on the balance sheet over
time, there is no change to the historical cost. A contra asset account, accumulated
depreciation, is used in the calculation of the asset's net value.
GAAP ( GENERALLY ACCEPTED ACCOUNTING PRINCIPLES)
• Revenue recognition principle: Companies should record revenue when earned but
not when received. The flow of cash does not have any bearing on the recognition of
revenue. This is the essence of accrual basis accounting. Conversely, however, losses must
be recognized when their occurrence becomes probable, whether or not it has actually
occurred (bad debt). This comports with the constraint of conservatism, yet brings it into
conflict with the constraint of consistency, in that reflecting revenues/gains is inconsistent
with the way in which losses are reflected. The revenue recognition principle states that
revenue should be recognized in the accounting period in which it is earned.
• In a service business, revenue is usually considered to be earned at the time the
service is performed.
• In a merchandising business, revenue is usually earned at the time the goods are
delivered.
• Full disclosure principle: The amount and kinds of information disclosed should be
decided based on trade-off analysis as a larger amount of information costs more to
prepare and use. Information disclosed should be enough to make a judgment while
keeping costs reasonable. Information is presented in the main body of financial
statements, in the notes or as supplementary information 14
GAAP ( GENERALLY ACCEPTED ACCOUNTING PRINCIPLES)
Constraints:
• Consistency principle: It means that the company uses the same accounting
principles and methods from period to period.
• Conservatism principle: when choosing between two solutions, the one which has the
less favorable outcome is the solution which should be chosen. The conservatism
principle can also be applied to recognizing estimates. For example, if the collections
staff believes that a cluster of receivables will have a 2% bad debt percentage because of
historical trend lines, but the sales staff is leaning towards a higher 5% figure because
of a sudden drop in industry sales, use the 5% figure when creating an allowance for
doubtful accounts, unless there is strong evidence to the contrary.
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• Cost Constraint: The benefits of reporting financial information should justify and be
greater than the costs imposed on supplying it.
OVERVIEW OF BUSINESS TYPES
After deciding to establish a business, you must choose the type of legal structure that
best suits your business. Most small businesses start out as either a sole proprietorship or
partnership, but other options may be better for your particular business. Each structure
has trade-offs briefly discussed below.
• Sole Proprietorship
This is the simplest and least regulated form of organization with minimal legal start-
up costs. One person owns and operates the business. The profits and business income
are taxed as personal income. The major disadvantages are unlimited personal liability
of the owner for all claims, taxes and debts against the business and the potential
dissolution of the business upon the owner’s death.
• A sole proprietorship is a business owned by only one person. It is easy to set-up and is
the least costly among all forms of ownership.
• The owner faces unlimited liability; meaning, the creditors of the business may go after
the personal assets of the owner if the business cannot pay them.
• The sole proprietorship form is usually adopted by small business entities.
• Partnership
A partnership is relatively easy to form and can provide additional financial and
managerial resources. Each partner is an “agent” for the partnership and can
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individually hire employees, borrow money and operate the business. Profits are still
taxed as personal income and the partners are still personally liable for all partnership
debts and taxes.
OVERVIEW OF BUSINESS TYPES
• Limited Liability Company (LLC)
A Limited Liability Company (LLC) is composed of one or more “members”, which
provides the owner(s) protection of personal assets. Members invest in an LLC in
exchange for a percentage ownership interest. An Operating Agreement states what
share of the LLC profits and losses each member will receive and spells out the
internal arrangements of the business
• Corporation
The most complex of business organizations, the corporation, acts as a legal entity
which exists separately from its owners. While limiting the owners form personal
liability, it is creates a “double taxation” on earnings.
• The corporation also allows capital to be raised through the sale of stocks and bonds
and can continue to function as a business even without key individuals.
• It also enables employees to participate in various types of insurance and profit-
sharing plans.
• Corporations must be registered with the Secretary of State and there are considerable
costs associated with creating a corporation.
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TRANSACTION ANALYSIS
BANK
Softb
yte
TRANSACTION ANALYSIS
TRANSACTION 1
On September 1, he invests $15,000 cash
in the business, which he names Softbyte.
1. An income statement presents the revenues and expenses and resulting net
income or net loss of a company for a specific period of time.
2. A balance sheet reports the assets, liabilities, and owner’s equity of a business
enterprise at a specific date.
SOFTBYTE
Income Statement
For the Month Ended September 30, 2002
Revenues
Service revenue $ 4,700
Expenses
Salaries expense $ 900
Rent expense 600
Advertising expense 250
Utilities expense 200
Total expenses 1,950
Net income $ 2,750
SOFTBYTE
Statement of Owner's Equity
For the Month Ended September 30, 2002
Cash of SOFTBYTE
$8,050 on the Cash Flow Statement
balance For the Month Ended September 30, 2002
sheet and Cash flows from operating activities
cash flow Cash receipts from customers $ 3,300
statement is Cash payments to suppliers and employees (1,950) $ 1,350
shown as the Net cash provided by operating activities
final total of Cash flows from investing activities
the cash Purchase of equipment $ (7,000)
column of Net cash used by investing activities (7,000)
the Summary Cash flows from financing activities
of Investments by owner $ 15,000
Transactions Drawings by owner (1,300)
Net cash provided by financing activities 13,700
Net increase in cash $ 8,050
Cash, September 1 -
Cash, September 30 $ 8,050
Exercise
Mr. Carl decided to start a shoe firm. On January 1, he invests 1 million Dh cash in the business.
The cost per shoe is 40 Dh, and selling price is 100 Dh.
The following transactions took place from the 1st of January til the 31st of January 2018.
1- Merchandise inventory that cost 250,000 Dh is reported on the balance sheet at 300,000, the
expected selling price. The following entry was made to record this increase in value:
Merchandie inventory 60,000
Income 60,000
2- The company is being sued for 400,000 Dh by a customer who claims damages for personal injury
apparently caused by a defective product. Company attorneys feel extremely confident that the
company will have no liability for damages resulting from the situation. Nevertheless, the company
decides to make the following entry:
Loss from lawsuit 400,000
Liability for lawsuit 400,000
3- materials were purchased on 1/1/2017 for 80,000 Dh and this amount was entered in the
materials account. On 31/12/2017, the materials would have cost 94,000 Dh, so the following entry is
made:
Inventory 14,000
Gain on inventories 14,000
4- on 20/12/2017, an order of 40,000 Dh has been received from a customer for products on hand.
This order was shipped on 1/9/2018.The company made the following entry in 2017:
Accounts receivable 40,000
Sales 40,000
5- A building purchased by the company 10 years ago for 1.5 MDH, can now be sold for 2 MDH. The
controller instructs that the new value of 2 MDH be entered in the accounts.
Exercise
Discuss the appropriateness of the journal entries in terms of GAAP.
6- Material included in the inventory that cost 120,000 Dh has become obsolete. The controler
contends that no loss can be recognized until the goods are sold, and so the material is included in
the inventory at 120,000 DH
8- Company ABC has paid a large sum for advertising campaign to promote a new product that will
not be placed on the market until the following year. The controller has charged this amount to a
prepaid expense account.
April 1: invested 32,000 USD cash and equipment value at 13,000 USD in the business
April 11: completed an assignment and billed client 1500 USD for services rendered.
April 30: A count of supplies indicated that 120 USD of supplies had been used
Prepare the income statement and balance sheet for ABC as of 31/04.
ANSWER
Balance Sheet Income Statement
Assets Revenue
Cash 24 990,00 Service provided 2 400,00
Accounts receivable 1 500,00 Expenses
Inventory supplies 700,00
PP&E 22 000,00 insurance 110,00
Total assets 48 490,00 rent 800,00
Liabilities & OE salary 1 200
Accounts payable 700,00 EBT - 410,00
unearned revenue 3 200 Taxes
Common stock 45 000,00 Net income - 410,00
Retained earnings - 410,00 Dividends
Total Liab + OE 48 490,00 Retained Earnings - 410,00
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THE ACCOUNT / DEBIT & CREDIT
The terms debit and credit mean left and right, respectively.
When the debit amounts exceed the credits, an account has a debit
balance; when the reverse is true, the account has a credit balance.
THE ACCOUNT / DEBIT & CREDIT
DEBITING AND ACCOUNT
Cash
15,000
Cash
7,000
Cash
15,000 7,000
8,000
3. It helps to prevent or locate errors because the debit and credit amounts for each
entry can be readily compared.
JOURNALIZING
GENERAL JOURNAL J1
Date Account Titles and Explanation Ref. Debit Credit
2002
Sept. 1 Cash 15,000
M. Doucet, Capital 15,000
Invested cash in business.
1 Equipment 7,000
Cash 7,000
Purchased equipment for cash.
TECHNIQUE OF JOURNALIZING
GENERAL JOURNAL J1
Date Account Titles and Explanation Ref. Debit Credit
2002
Sept. 1 Cash 15,000
M. Doucet, Capital 15,000
Invested cash in business.
1 Equipment 7,000
Cash 7,000
Purchased equipment for cash.
TECHNIQUE OF JOURNALIZING
GENERAL JOURNAL J1
Date Account Titles and Explanation Ref. Debit Credit
2002
Sept. 1 Cash 15,000
M. Doucet, Capital 15,000
Invested cash in business.
1 Equipment 7,000
Cash 7,000
Purchased equipment for cash.
TECHNIQUE OF JOURNALIZING
GENERAL JOURNAL J1
Date Account Titles and Explanation Ref. Debit Credit
2002
Sept. 1 Cash 15,000
M. Doucet, Capital 15,000
Invested cash in business.
1 Equipment 7,000
Cash 7,000
Purchased equipment for cash.
TECHNIQUE OF JOURNALIZING
GENERAL JOURNAL J1
Date Account Titles and Explanation Ref. Debit Credit
2002
Sept. 1 Cash 15,000
M. Doucet, Capital 15,000
Invested cash in business.
1 Equipment 7,000
Cash 7,000
Purchased equipment for cash.
TECHNIQUE OF JOURNALIZING
GENERAL JOURNAL J1
Date Account Titles and Explanation Ref. Debit Credit
2002
Sept. 1 Cash 15,000
M. Doucet, Capital 15,000
Invested cash in business.
1 Equipment 7,000
Cash 7,000
Purchased equipment for cash.
SIMPLE & COMPOUND JOURNAL
ENTRIES
GENERAL JOURNAL J1
Date Account Titles and Explanation Ref. Debit Credit
2002
Oct. 2 Delivery Equipment 14,000
Cash 14,000
Purchased truck for cash.
COMPOUND JOURNAL ENTRY
GENERAL JOURNAL J1
Date Account Titles and Explanation Ref. Debit Credit
2002
Oct. 2 Delivery Equipment 34,000
1 Cash 8,000
Note Payable 26,000
2 Purchased truck for cash
and note payable.
3
COMPOUND JOURNAL ENTRY
GENERAL JOURNAL J1
Date Account Titles and Explanation Ref. Debit Credit
2002
Oct. 2 Cash 8,000
Delivery Equipment 34,000
Note Payable 26,000
Purchased truck for cash
and note payable.
57
THE GENERAL LEDGER (LE GRAND LIVRE)
GENERAL
LEDGER
THE GENERAL LEDGER
A trial balance does not prove that all transactions have been recorded or
that the ledger is correct.
Numerous errors may exist even though the trial balance columns agree.
The trial balance may balance even when
1. a transaction is not journalized,
2. a correct journal entry is not posted,
3. a journal entry is posted twice,
4. incorrect accounts are used in journalizing or posting,
EXERCISE
Mr. Tarik decides to start a furniture business. On January 1, he invests 5 million Dh cash in
the business. Tarik decides to apply a 20% mark-up on the furniture. His cost per furniture is
1000 Dh.
The following transactions took place from the 1st of January til the 31st of January 2018.
January 1: Issues capital stock of 5 million Dh
January 1: purchases computer/furniture equipment for 60,000 Dh cash.
January 5: buys furniture ( inventory) for 3 million Dh
January 13: sells 240,000 dh of furniture. Receives 130,000 cash and the remaining on account.
January 14: received a reparation bill of 4,500 Dh. Pays 2000 dh cash and the remaining on
account.
January 15: signs a yearly furniture maintenance contract with one client for 24,000 Dh. He
received 6,000 dh, and the remaining on account.
January 17: buys a phone prepaid card for 500 Dh cash.
January 27: Expenses paid in cash for January salaries of employees, 17,000 Dh
January 28: The sum of 30,000 Dh in cash is received from customers who have previously
been billed for in January 13.
January 31: calculates depreciation: 1,000 Dh
1) record the entries using the double entry system, and prepare a general ledger for the Cash
and Account receivable. 64
2) Prepare a balance sheet as of 31/01/2018
3) Prepare a profit and loss statement covering January 2018
January 1
D C Solution
Cash 5 000 000
Capital 5 000 000
January 1
D C
Fur/Equi 60 000
cash 60 000
January 5
D C
January 17
D C
prepaid expense ( assets) 500
Cash 500
January 27
D C
salaries expense 17 000
cash 17 000
January 28
D C
Cash 30 000
accounts receivable 30 000
January 31
D C
Depreciation expense 1 000 66
accumulated depreciation ( Contra-asset) 1 000
Solution
Cash
1st jan 5 000 000 1st jan 60 000
13 jan 130 000 5 jan 3 000 000
15 jan 6 000 14 jan 2 000
28 jan 30 000 17 jan 500
27 Jan 17 000
31 Jan 2 086 500
Accounts receivable
13 Jan 110 000 28 Jan 30 000
31 Jan 80 000
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Solution
Balance Sheet Income Statement
Assets Revenue
Cash 2 086 500,00 Service provided 240 000,00
Accounts receivable 80 000,00 Expenses
Inventory 2 800 000,00 COGS 200 000,00
Computer/furniture 60 000,00 reparation 4 500,00
(accumulated depreciation) - 1 000,00 Salaries 17 000,00
prepaid expense 500,00 depreciation 1 000,00
Total assets 5 026 000,00 EBT 17 500,00
Liabilities & OE Taxes -
Accounts payable 2 500,00 Net income 17 500,00
unearned revenue 6 000,00 Dividends
Common stock 5 000 000,00 Retained Earnings 17 500,00
Retained earnings 17 500,00
Total Liab + OE 5 026 000,00
68
EXERCISE
Ms. Imane began professional practice as a system analyst on July 1. She plans to prepare
a monthly financial statement. During July, the owner completed these transactions:
July 1. Owner invested Dh 500,000 cash along with computer equipment that had a
market value of Dh120,000.
July 2. Paid Dh 15,000 cash for the rent of office space for the month.
July 4. Purchased Dh 12,000 of additional equipment on credit (due within 30 days).
July 8. Completed a work for a client and immediately collected the Dh 32,000 cash.
July 10. Completed work for a client and sent a bill for Dh 27,000.
July 12. Purchased additional equipment for Dh 8,000 in cash.
July 15. Paid an assistant Dh 6,200 cash as wages for 15 days.
July 18. Collected Dh 15,000 on the amount owed by the client.
July 25. Paid Dh 12,000 cash to settle the liability on the equipment purchased.
July 28. Owner withdrew Dh 5,000 cash for personal use.
July 30. Completed work for another client who paid only Dh 40,000 for 50% of the system
design.
July 31. Received utilities bill, Dh 1,800 and AC maintenance bill Dh 3,800.
Required:
69
Prepare the T accounts and general ledger for the cash and retained earnings.
Prepare the income statement and Balance sheet.
SOLUTION
July 1 July 15
D C D C
Cash 500 000 salaries expense 6 200
Equipment 120 000 cash 6 200
Capital 620 000 July 18
July 2 D C
D C cash 15 000
accounts receivable 15 000
rent expense 15 000
cash 15 000 July 25
D C
July 4
equipment payable 12 000
D C cash 12 000
equipment 12 000
July 28
equipment payable 12 000
D C
July 8 Drawing account ( Equity) 5 000
D C cash 5 000
cash 32 000 July 30
revenue 32 000 D C
July 10 Cash 40 000
Accounts receivable 40 000
D C
revenue 80 000
Accounts receivable 27 000
July 31
revenue 27 000
D C
July 12 utilities expense 1 800
D C accounts payable 1 800
equipment 8 000 AC maintenance expense 3 800
cash 8 000 accounts payable 3 800
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SOLUTION
Cash
1 july 500 000 2 july 15 000
8 july 32 000 12 july 8 000
18 july 15 000 15 july 6 200
30 july 40 000 25 juily 12 000
28 july 5 000
Retained earnings
2 july 15 000 8 july 32 000
15 juily 6 200 10 july 27 000
31 july 5 600 30 july 80 000
31/07 112 200
71
SOLUTION
income statement 31/7
Revenues 139 000
rent expense 15 000
salaries expense 6 200
utilities expense 1 800
AC maintenance expense 3 800
EBT 112 200
Tax 0
Net profit 112 200
Balance Sheet
Assets
Cash 540 800,00
Accounts receivable 52 000,00
Inventory -
PP&E 140 000,00
Total assets 732 800,00
Liabilities & OE
Accounts payable 5 600,00
Common stock & Drawing acc. 615 000,00 72
Retained earnings 112 200,00
Total Liab + OE 732 800,00
MANAGEMENT ACCOUNTING
Focus:
Financial accounting focuses on the company as a whole.
Management accounting provides detailed and disaggregated information about
products, individual activities, divisions, plants, operations and tasks.
DEPRECIATION METHODS
Example:
Consider a piece of equipment that costs $25,000 with an estimated useful
life of 5 years and a $5,000 salvage value. The depreciation expense per year
for this equipment would be as follows:
Example:
Consider a piece of equipment that costs $25,000 with an estimated useful life of 5
years and a $2,000 salvage value. The depreciation expense per year for this
equipment would be as follows:
Periodic Depreciation Expense = Beginning book value x Rate of
depreciation
Year 1 depreciation= (25,000)*2/ 5= 10,000 $ ; Book Value= 25,000 – 10,000=
15,000 $
Year 2 depreciation = 15,000 * 2/5= 6,000 $; Book value= 15,000 – 6,000= 9,000 $
Year 3 depreciation= 9,000* 2/5= 3,600$; Book value= 9,000 – 3,600= 5,400$
Year 4 depreciation= 5,400*2/5= 2,160$; Book value= 5,400 – 2,160= 3,240$
Year 5 depreciation= 1240 $ ; Book value= 3,240-1,240= 2,000$
DEPRECIATION METHODS- SUM OF YEARS DIGITS
Sum-of-the-years-digits method is one of the accelerated depreciation methods. A higher
expense is incurred in the early years while lower expense is incurred in the latter years of
the asset.
In sum-of-the-years digits depreciation method, the remaining life of an asset is divided by
the sum of the years and then multiplied by the depreciating base to determine the expense.
The depreciation formula for the sum-of-the-years-digits method:
Depreciation Expense = (Cost – Salvage value) * (Remaining life / Sum of the years
digits)
Example:
Consider a piece of equipment that costs $25,000 with an estimated useful life of 5 years and
a $5,000 salvage value. The depreciation expense per year for this equipment would be as
follows:
Sum of the years= 1+2+3+4+5= 15 years
Year 1 depreciation= (25,000 – 5,000) *5/ 15= 6,667 $
Year 2 depreciation = (25,000 – 5,000) *4/ 15= 5,333 $
Year 3 depreciation= (25,000 – 5,000) *3/15= 4,000 $
Year 4 depreciation= (25,000 – 5,000) *2/15= 2,666 $
Year 5 depreciation= (25,000 – 5,000) *1/15= 1,333 $
DEPRECIATION METHODS – UNITS OF PRODUCTION
Units-of-production depreciation method depreciates assets based on the total
number of hours used or the total number of units to be produced over its useful
life.
The formula for the units-of-production method:
Depreciation Expense = (Cost – Salvage value) * (Number of units
produced / Life in number of units)
Example:
Consider a machine that costs $25,000 with an estimated total unit production of
100 million and a $5,000 salvage value. During the first year of activity, the
machine produced 4 million units, 12 million units in year 2, 50 million units in
year 3, and 34 million units in year 4.
Exercise:
Company ABC purchased an equipment for 150,000 USD. The expected life
of the asset is 5 years, and the expected salvage value is 10,000 USD. The
company expects that the equipment will produce 10,000 units the first year,
24,000 units the second year, 30,000 units the third year, 20,000 units the
fourth year, and 16,000 units the fifth year.
DEPRECIATION 1 2 3 4 5 Total
Straight line 28 000 28 000 28 000 28 000 28 000 140 000
double declining 60 000 36 000 21 600 12 960 9 440 140 000
sum of years digits 46 667 37 333 28 000 18 667 9 333 140 000
units of production 14 000 33 600 42 000 28 000 22 400 140 000
INVENTORY METHODS
An inventory valuation allows a company to provide a monetary value for items
that make up their inventory. Inventories are usually the largest current asset of
a business, and proper measurement of them is necessary to assure accurate
financial statements. If inventory is not properly measured, expenses and
revenues cannot be properly matched and a company could make poor business
decisions.
The two most widely used inventory accounting systems are the periodic and the
perpetual.
The perpetual system records revenue each time a sale is made. The most
commonly used inventory valuation methods under a perpetual system are:
First-in-First-Out(FIFO)
Last-in first-out (LIFO)
Weighted average cost
These methods produce different results because their flow of costs are based
upon different assumptions. The FIFO method bases its cost flow on the
chronological order purchases are made, while the LIFO method bases it cost
flow in a reverse chronological order. The average cost method produces a
cost flow based on a weighted average of goods.
INVENTORY METHODS
The entries to record these transactions during the current year are shown in
the following slide:
INVENTORY METHODS
INVENTORY METHODS
During any given fiscal period it is very likely that merchandise will be
purchased at several different prices. If inventories are to be priced at cost
and numerous purchases have been made at different unit costs, which of the
various cost prices should be used?
To illustrate, assume that Call-Mart Inc. had the following transactions in its first
month of operations
From this information, we can compute the ending inventory of 6,000 units and the
cost of goods available for sale (beginning inventory purchases) of $43,900 [(2,000@
$4.00) (6,000 @ $4.40) (2,000 @ $4.75)]. The question is, which price or prices should be
assigned to the 6,000 units of ending inventory? The answer depends on which cost
flow assumption is employed
INVENTORY METHODS – AVERAGE COST
As the name implies, the average cost method prices items in the inventory
on the basis of the average cost of all similar goods available during the
period. To illustrate, assuming that Call-Mart Inc. used the periodic
inventory method, the ending inventory and cost of goods sold would be
computed as follows using a weighted-average method.
INVENTORY METHODS – FIRST IN FIRST OUT FIFO
The FIFO method assumes that goods are used in the order in which they
are purchased. In other words, it assumes that the first goods purchased are
the first used (in a manufacturing concern) or sold (in a merchandising
concern). The inventory remaining must therefore represent the most recent
purchases.
If a perpetual inventory system in quantities and dollars is used, a cost
figure is attached to each withdrawal. Then the cost of the 4,000 units
removed on March19 would be made up of the items purchased on March 2
and March15. The inventory on a FIFO basis perpetual system for Call-Mart
Inc. is shown below!
The ending inventory in this situation is $27,100, and the cost of goods sold
is $16,800[(2,000 @ 4.00)(2,000 @ $4.40)]
INVENTORY METHODS – FIRST IN FIRST OUT FIFO
One objective of FIFO is to approximate the physical flow of goods. When the
physical flow of goods is actually first-in, first-out, the FIFO method closely
approximates specific identification. At the same time, it does not permit
manipulation of income because the enterprise is not free to pick a certain
cost item to be charged to expense.
Another advantage of the FIFO method is that the ending inventory is close
to current cost. Because the first goods in are the first goods out, the ending
inventory amount will be composed of the most recent purchases. This is
particularly true where the inventory turnover is rapid. This approach
generally provides a reasonable approximation of replacement cost on the
balance sheet when price changes have not occurred since the most recent
purchases.
The basic disadvantage of the FIFO method is that current costs are not
matched against current revenues on the income statement. The oldest costs
are charged against the more current revenue, which can lead to distortions
in gross profit and net income.
INVENTORY METHODS – LAST IN FIRST OUT LIFO
The LIFO method first matches against revenue the cost of the last goods
purchased.
If a periodic inventory is used, then it would be assumed that the cost of the
total quantity sold or issued during the month would have come from the
most recent purchases. The ending inventory would be priced by using the
total units as a basis of computation and disregarding the exact dates of
sales or issuances. Table below assumes that the cost of the 4,000 units
withdrawn absorbed the 2,000 units purchased on March 30 and 2,000 of the
6,000 units purchased on March 15. The inventory and related cost of goods
sold would then be computed.
INVENTORY METHODS – EFFECT ON INCOME STATEMENT,
BALANCE SHEET AND CASH FLOW STATEMENT
• Calculate the Ending Inventory and the COGS under FIFO and LIFO
• Discuss the effects of using FIFO and LIFO on the income statement, balance
sheet and cash flow statement
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SOLUTION
LIFO FIFO
COGS Ending Inventory COGS Ending Inventory
476 000,00 889 000,00 397 000,00 968 000,00
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