E-learning MBA Master Degree online from distance
- Economics for Business and Management - Microeconomics
- Economics for Business and Management - Microeconomics
- Marketing Management - Strategic Marketing Planning
- Financial Management - Financial Accounting
- Strategic Management - Strategy and Competitive Advantage
- Economics for Business and Management - Macroeconomics
- General Management - Core Management Competencies
- The Art of Effective Business Negotiation
Revenue And Monetary Assets - Cost Of Goods Sold And Inventories
Revenue And Monetary Assets
STUDENT: Hi, Teacher. What do you have on hold for me now?
TEACHER: From here to the end of this Course we will discuss more thorough1y certain balance sheet and income statement items that were treated in an introductory fashion in the preceding Modules.
In this Module we first discuss the application of the two aspects of the realization concept; namely the timing of revenue recognition and the amount of revenue recognized in a given accounting period. Because of the close connection of these matters with the measurement of monetary assets, we also discuss monetary assets.
We will also cover later in this Module how to deal with cost of goods sold and inventories.
STUDENT: A rather ambitious task, Teacher. Anyway, let’s begin!
Timing Of Revenue Recognition
TEACHER: You will recall the one basic part of the realization concept is that revenues are generally recognized in the accounting period in which goods are shipped or services rendered. But some problems arise in apply1ng this concept and there are some important exceptions to it, and these we will discuss right now.
Presumably, most of the activities in a business company are intended to contribute to its objective of making a profit. These activities may include a long sequence of events: the purchase of materials, the manufacture of goods from these materials, the sale of these goods, shipment of goods to the customer, and the collection of amounts due from the customer.
But in accounting, revenue is recognized at a single point in this sequence.
STUDENT: Why is this so?
TEACHER: The basic reason is complying with the criterion of objectivity. There is no objective way of knowing how much profit is created during the manufacturing process. Only when the products are sold and a given revenue can be expected to be collected, do we know with reasonable certainty what profit the business has made.
STUDENT: This being so, why don’t we wait until the customer actually paid for the good or service?
TEACHER: You have a point. If the sale were not recognized until the customer actually paid his bill, there would be an even greater degree of certainty that revenue actually was realized. Conversely, it could be argued that when the company receives a firm order for goods, the revenue-generating process has essentially been completed, and that the actual shipment of the goods to the customer is relatively incidental. Certainly, this is the way a salesman feels after he has succeeded in booking an order. Neither of these views prevails in general, however.
STUDENT: A while ago you mentioned "exceptions", didn’t you?
TEACHER: An exception to the general rule occurs in companies that mine precious metals, such as gold, silver, and uranium. Many of these companies recognize revenue in the period in which the metal is mined, rather than in the period in which it is shipped. They reason that once the metal has been refined, it: is as readily exchangeable as is cash, and that the revenue process has essentially ended at that time. Some farmers recognize revenue on wheat, corn, peanuts, cotton, and similar commodities in the period in which their crop is harvested, even though it may be sold in a later period. They feel that because the government guarantees a certain price for these commodities under its price support programs, revenue is assured at the earlier time.
Consumers who pay for their purchases in installments are, as a class, poor credit risks. For that reason some companies use the installment method of accounting; that is, they recognize revenue only when the installment payments are received. The FASB states that sales revenue should "ordinarily" be accounted for when the sale is made, and that the installment method is acceptable only when "the circumstances are such that the collection of the sales price is not reasonably assured."
The effect of the installment method is to postpone the recognition of revenue and income to later periods, as compared with the method that recognizes the full amount of revenue when the sale is made. If a company wants to report as much income as it legitimately can in the current period, it will therefore prefer to record the full amount of the transaction at the time of sale. If it wants to postpone the recognition of taxable income for as long as feasible, it will prefer the installment method. For this reason, many companies use the installment method for income tax purposes.
Interest Component Of A Sale - When buyers purchase goods on an installment plan, they pay both for the goods themselves and for the interest which the seller charges on the amount of the unpaid balance. Revenue from the sales value of the merchandise should be recorded separately from interest revenue. In most sales to consumers, this separation is easy to recognize since Federal regulations require that the amount of interest be specified in the sales contract. Although the full sales value may be recorded at the time of the sale (unless the installment method is used), the interest revenue is recorded in the period to which it applies, that is, it is spread over the life of the installment contract.
When, under a firm contract, a business works for several years on a single product, a portion of the revenue is often recognized in each of these years rather than solely in the year in which the product is completed and shipped. Shipbuilding and major construction projects are examples of situations in which this percentage-of-completion method is used. The revenue recognized for a period can easily be estimated when the product is constructed under a straight cost-plus contract, since the revenue is a specified percentage of the costs incurred in the period. In the case of fixed-price contracts, and certain other types of contracts, the total amount of profit, and hence the amount applicable to each. accounting period, cannot be known exact1y until the total costs have been determined at the completion of the job. In these situations, an estimated revenue may nevertheless be assigned to each of the accounting periods in the same proportion to the cost for the period that total revenue is expected to be of total cost, the proportion being estimated conservatively so as to avoid overstatement of interim profits.
In accordance with the matching principle, when revenue is measured by the percentage-of-completion basis, the expenses for the period are the costs associated with the revenue.
STUDENT: Are there cases when revenue is only recognized at the end of the contract?
TEACHER: The alternative to the percentage-of-completion method is the completed-contract method, under which all revenue is recognized at the time the contract is completed. Until that time, the costs incurred are held on the balance sheet as an asset, construction in progress. A company can use either the completed contract method or the percentage-of completion method, as it chooses.
Shipments on consignment are not sales, and no revenue should be recognized at the time merchandise is shipped to the consignee.
STUDENT: What is a consignment agreement?
TEACHER: The consignor delivers a good to the consignee but the former retains title to consignment merchandise, and the sale is not consummated until the consignee actually sells the merchandise to the final customer. Some businesses treat consignment shipments as if they were sales on the grounds that they have learned through experience that the consigned merchandise ordinarily is not returned, and that the sale for all practical purposes is therefore consummated at the time of shipment.
Amount Of Revenue Recognized
We have discussed the timing aspect of the realization concept. The other aspect is that the amount of revenue recognized in a period is the amount that is reasonably certain to be collected from sales transactions that are properly recorded in that period. This concept requires that certain adjustments be made to the gross sales value of goods sold. We have already mentioned two of these adjustments, those for sales discounts and for sales returns and allowances. Two others, for bad debts and warranties, are discussed below.
The bulk of sales of merchandise to customers is made on credit. They give rise to the sales revenue and also to the asset, Accounts Receivable.
Let us assume that the ABC Company in its first year of operations made sales of $300,000, all on credit. Let us also assume that none of the customers had paid his bill by the end of the year. The record made of these transactions would show Accounts Receivable in the amount of $300,000 and Sales Revenue of $300,000. This would be correct if, but only if, it is believed that every customer eventually will pay the full amount of its obligation to the ABC Company. Sadly, some of these customers may never pay their bills; if they do not, their accounts become bad debts.
Accounting Recognition Of Bad Debts. The company probably does not know which of the obligations carried as accounts receivable will never be collected. An estimate of the amount of bad debts can nevertheless be made, and it is customary to adjust the accounting records at the end of each accounting period to reflect this estimate.
dr. Bad Debt Expense ... 200
cr. Accounts Receivable ............ 200
An alternative procedure is to estimate the total amount of uncollectible accounts, and to show this estimated amount as a deduction from Accounts Receivable on the balance sheet, and as an expense on the income statement. Instead of reducing the Accounts Receivable figure directly, the estimate is often shown as a separate number on the balance sheet, so that the reader can observe both the total amount owed by customers and that portion of the amount which the company believes will not be collected.
The vast majority of retailers and service establishments have contracted with an outside agency to handle their accounts receivable, for sales made to customers holding a credit card. So far as the merchant is concerned, this type of transaction is not a credit sale at all. No accounts receivable appear in the merchant's accounts. The only difference between a credit card sale and a cash sale is that in the former case the bank deducts a fee for the service of handling the accounts receivable paperwork and assuming the risk of bad debts. This fee is in the nature of a sales discount, and is recorded as such in the merchant's accounts, thus:
dr. Cash.................................... 960
Sales Discount (Credit Cards)...... 40
cr. Sales ..................................................1,000
When sales are made over the phone or via internet, and due to the higher risk of fraud, the credit card companies usually do not assume the risk of a bad debt and if the buyer disputes the charge, they normally deduct the amount paid to the merchant plus a handling fee.
Many companies agree to repair or replace merchandise that the customer finds to be defective. When this agreement is an explicit part of the sales contract, it is called a warranty. Other companies may respond to a customer's complaint, even though they have no legal obligation to do so. In either case, the amount of revenue originally recorded for the sales transaction turns out to be an overstatement of the amount of revenue that ultimately results. If it is estimated that a significant amount of costs will be incurred in a future period in order to repair or replace merchandise sold in the current period, the realization concept requires that an adjustment be made to the current period's revenue with an entry such as:
dr. Estimated Warranty Expense ... 1,000
cr. Allowance for Warranties ................... 1,000
When costs are incurred in the future in order to carry out the warranty obligation, the Allowance for Warranties is debited and Cash, Accrued Wages, Inventory, or a similar account is credited.
Revenue Adjustment versus Expense
The transactions described above have been analyzed in accordance with the realization concept, that is, they were adjustments made in order to show the net amount of revenue "almost certainly" to be realized in an accounting period.
Student, we already mentioned these types of assets. Can you tell me what they are?
STUDENT: Monetary assets are assets that are cash or items that will be converted into cash, as contrasted with nonmonetary assets, which are items that will be used in the future in the production and sale of goods and services.
TEACHER: Good. No separate classification for monetary assets appears on the balance sheet; the important distinction on the balance sheet is between current assets and noncurrent assets.
STUDENT: And if so, why do we distinguish monetary from nonmonetary assets?
TEACHER: The reason for calling attention to the distinction between monetary and nonmonetary assets is that the concepts governing the amounts at which they appear on the balance sheet differ for these two categories.
In general, and with the notable exception of inventory which is discussed later, nonmonetary assets appear on the balance sheet at unexpired cost.
STUDENT: Unexpired cost?
TEACHER: These items, when acquired, were recorded at cost, and the amount shown on the balance sheet at any time thereafter is the amount that has not yet been written off as an expense. If a machine was acquired some years ago at a cost of $1,000,000 and if $400,000 of its cost has been written off as depreciation expense in the intervening period, the balance sheet for the current period will report the asset amount of this machinery at $600,000, regardless of its market value at that time.
For monetary assets, the idea of "unexpired cost" is not appropriate. As we have seen above, the accounts receivable item is in effect reported at its estimated realizable value (adjusted for eventual bad debts). Cash, of course, is reported at its face amount, whether on hand or deposited in banks. Certificates of Deposit are reported at face value.
As for Marketable securities (stocks and bonds of other companies which are traded on a securities market) and which are held for the purpose of producing income in the form of interest, dividends, or capital gains, they may be classified on the balance sheet either as current assets or as noncurrent assets, depending on whether the company's intention is, or is not, to convert them to cash within the next year or other operating cycle.
Marketable securities are reported either at their cost or at their current market value, whichever is lower. This is consistent with the conservatism concept.
STUDENT: Time for a short summary, Teacher?
TEACHER: Sure. The realization concept states that revenues are generally recognized in the accounting period in which goods are shipped or services are rendered. When goods are sold on an installment plan, however, and when the likelihood that a significant number of installment contracts will not be completed is quite high, revenues may be recognized when installment payments are received; this is the installment method. As another exception, in the case of a long-term construction contract, revenue may be recognized over the life of the contract; this is the percentage-of-completion method.
The realization concept also states that the amount of revenue recognized in a period is the amount that is reasonably certain to be earned. Accordingly, the gross sales revenue is reduced by the estimated amount of bad debts that are hidden in credit sales. A corresponding reduction is made in the asset, accounts receivable. Similar reductions may be made for warranty costs and for sales returns and allowances.
Monetary assets are assets other than unexpired costs. They are reported on the balance sheet in various ways. Cash, certificates of deposit, and accounts receivable are reported at realizable amounts (which in the case of cash and certificates of deposit is the same as the face amount). Marketable securities are reported at the lower of cost or current market value unless the decline below cost is temporary.
And now, let us progress to....
Cost Of Goods Sold And Inventories
We will describe the principles and procedures for measuring the cost of goods sold in merchandising companies and in manufacturing companies and the related measurement of inventory on the balance sheet. These costs may be accounted for either by the periodic inventory method or the perpetual inventory method.
The cost of individual units of inventory and of individual goods sold can be measured by any of several methods, including specific identification, average cost, FIFO, and LIFO; each of these methods is described, and they are compared.
We shall start with a brief general description of cost of sales and inventory procedures in three types of companies: service companies, merchandising companies, and manufacturing companies. Next we shall describe in detail the procedure in merchandising companies.
Types of Companies
A single company may conduct service, merchandising and/or manufacturing activities. For convenience, we shall assume that each company described here conducts only one type. If a company does conduct more than one type of activity, for each type it will use the appropriate accounting method.
Service Companies. A service company, such as a motel or a beauty parlor, provides intangible services rather than tangible goods. It therefore reports no cost of goods sold, as such, on its income statement, and no inventory of goods on its balance sheet. Some service companies report as cost of sales the costs directly associated with the services they provide, such as the labor costs of beauticians in a beauty shop. Others do not separate these costs from other operating expenses; instead, they report individual items of operating expense in a single list. Companies that follow the latter practice cannot develop a gross margin number, which is the difference between sales and cost of sales.
Merchandising Companies. A merchandising company sells goods in substantially the same physical form as that in which it acquires them. Its cost of goods sold is therefore the acquisition cost of the goods that are sold. On the balance sheet, a current asset, merchandise inventory, shows the cost of goods that have been acquired but not yet sold as of the balance sheet date.
Manufacturing Companies. A manufacturing company converts raw materials into finished goods. Its cost of goods sold includes the conversion costs as well as the raw material costs of the goods that it sells. A manufacturing company has three types of inventory accounts:
1. Raw materials inventory;
2. Goods in process inventory; and
3. Finished goods inventory.
Supplies. In addition to inventory accounts for goods direct1y involved in the merchandising or manufacturing process, a company may have one or more inventory accounts for supplies. Supplies are tangible items such as fuel, office supplies, and repair parts for machinery, that will be consumed in the course of normal operations. They are distinguished from merchandise in that they are not sold as such, and they are distinguished from raw materials in that supplies are not accounted for separately as an element of the cost of goods manufactured. Paper for sale is merchandise inventory in a stationery store; paper is raw material inventory in a company that manufactures books; and paper intended for use in the office is supplies inventory in any company.
Retail stores, wholesalers, distributors and similar companies that offer tangible goods' for sale are merchandising firms. Think of merchandise inventory as a tank or a reservoir. At the beginning of an accounting period, there is a certain amount of goods in :he reservoir; this is the beginning inventory. During the period additional merchandise is purchased and added to the reservoir. Also, during the period merchandise sold is withdrawn from the reservoir. At the end of the accounting period, the amount of goods remaining in the reservoir is the ending inventory. The flows through the reservoir during the period and the amount of inventory in the reservoir at the end of the period can be accounted for by either of two methods, the periodic inventory method or the perpetual inventory method. Before describing these methods, we shall. discuss the measurement of acquisition cost.
Goods are added to inventory at their cost, in accordance with the basic cost concept. Cost includes the expenditures made to make the goods ready for sale. The word "purchases" refers not to the placing of a purchase order, but rather to the receipt of merchandise purchased. No accounting entry is made when merchandise is ordered, only when it is received.
Periodic Inventory Method
Suppose we have $4,000 of goods in the "reservoir" (warehouse) at the beginning of the period and that $7,400 was added during the period. Of these $11,400 of goods available, some were shipped to customers and hence became cost of goods sold and others remain in the reservoir at the end of the period as ending inventory. How can we determine each of these two amounts? There are two approaches:
1. We can find the amount of ending inventory (the amount in the reservoir at the end of the period) and obtain cost of goods sold by 'subtraction. Or,
2. We can measure the amount actually delivered to customers, and obtain the ending inventory by subtraction. This is the perpetual inventory method.
In the periodic inventory method, a physical count is made of merchandise in the ending inventory, that is, the amount remaining in the reservoir at the end of the period. Assume this amount is $2,000. Cost of goods sold is obtained by subtracting the ending inventory from the amount of goods available for sale, thus:
Beginning inventory ..................... 4,000
Plus: Purchases ......................... 7,400
Equals: Goods available for sale ....... 11,400
Less: Ending inventory................... 2,000
Cost of Goods Sold ...................... 9,400
The amount of beginning inventory in the above calculation is, of course, the amount found by the physical inventory taken at the end of the preceding period.
Perpetual Inventory Method
In the perpetual inventory method, a record is maintained of each item carried in the inventory.
In essence, this record is a subsidiary ledger account and Merchandise Inventory is its control account. Purchases are entered directly on this record and also debited to Merchandise Inventory. Shipments are entered on this record and are credited to Merchandise Inventory; the offsetting debit is to Cost of Goods Sold. The balance at the end of the period is the amount of that item in the ending inventory, and the sum of the balances for all the items is the ending inventory for the business.
A manufacturing company has as a major function the conversion of raw materials into finished goods. In any company, cost of goods sold is the total of the purchase price plus conversion costs, if any, of the products that are sold. The manufacturer, therefore, includes in cost of goods sold the cost of raw material used, the cost of labor, and other costs incurred in the manufacture of the goods that are sold. The difference between accounting for the cost of goods sold in a merchandising company and in a manufacturing company arises because the merchandising company usually has no conversion costs; its cost of goods sold is practically the same as the purchase price of these goods.
The measurement of cost of goods sold is therefore more complicated in a manufacturing company than in a merchandising company. In a merchandising company, this cost is normally obtained direct1y from invoices. In a manufacturing company it must be obtained by collecting and aggregating the several elements of manufacturing cost.
A manufacturing company has three types of inventory accounts. Their names and the nature of their content as of a balance sheet date are as follows:
1. Raw Materials Inventory: Items of material which are to be used in the manufacturing process. They are costed at acquisition cost, with the same types of adjustments as those made in calculating the net purchase cost of merchandise inventory, described above.
2. Goods in Process Inventory: Goods that have started through the manufacturing process but which have not yet been finished. They are costed as the sum of (1) the raw materials used in them, plus (2) the labor and other manufacturing costs incurred on these items up to the end of the accounting period.
3. Finished Goods Inventory: Goods whose manufacture has been completed but which have not been shipped to customers as of the balance sheet date. They are costed at the total cost incurred in manufacturing them. This account is essentially the same as the Merchandise Inventory account in a merchandising company, except that the items are costed at the cost of manufacturing them rather than at their acquisition cost.
INVENTORIES AND COST CALCULATIONS AT MANUFACTURING COMPANIES
The Flow Of Costs Through Inventories
At the end of an accounting period –using August as illustration-, the objective is to calculate the cost of goods sold. To begin with we have to calculate the flow of costs from the raw materials inventory to the goods in process inventory to the finished goods inventory.
A simple example (all figures are monetary values):
1) RAW MATERIALS INVENTORY
Balance on August 1: 308
+ Purchased in August: 546
New Balance August 31: 326 (Arrived at by physical inventory count)
Raw materials used: 308 + 546 – 326 = 528
2) GOODS IN PROCESS INVENTORY
Balance on August 1: 38
+ Raw Materials received 528 (from 1)
+ Other manufacturing costs 660
New Balance August 31: 86 (Arrived at by physical inventory count)
Cost of goods manufactured: 38 + 528 + 660 – 86 = 1140
3) FINISHED GOODS INVENTORY
Balance on August 1: 138
Goods manufactured: 1140 (from 2)
Balance on August 31: 132 (Arrived at by physical inventory count)
Cost of goods sold: 138 + 1140 – 132 = 1146
Waste And Spoilage
The determination of the cost of raw materials used can be arrived at by keeping a log of each material and registering movements and balances, or just by difference in physical inventory. If the first method is used, physical inventory can be taken less frequently, but it will always be necessary to do it periodically to compare reality with the written registers.
In any company there is always some waste and spoilage. This is not taken into account here. In a separate calculation, based on standard consumption of raw materials per unit produced, a theoretical consumption of raw materials (and also of other manufacturing costs) is determined. The difference between the standards and the actual consumption is information for management. Usually an acceptable percentage is fixed and if the losses are higher they are investigated. In a "continuous improvement" environment management will constantly pressure to reduce this amount, including changes in the "acceptable" standards.
As said before, in many instances companies keep track of each individual "movement" between inventories. Say, if manufacturing receives a case with 100 No. 3 screws from raw materials, the transaction is recorded and the inventory quantities updated. This is not too complicated nowadays using computers and bar coding of the materials. But at the end of the period we always have the same situation: comparing consumption recorded by the computers, actual quantities counted by hand, and theoretical standard consumption, and deciding how to interpret the information.
Other Manufacturing Costs
Typical component of manufacturing costs other than raw materials are:
Direct labor (actually engaged in manufacturing)
Indirect labor (cleaning, security, equipment maintenance, etc)
Inputs such as spare parts, electricity, gas, fuel oil, etc.
Non-productive supplies (pencils, writing paper, toilet supplies)
Miscellaneous such as insurance, local taxes on the facilities
Plant and equipment depreciation
Plant overhead (management)
If a single product is manufactured, the above calculations are easy. If different products are made, the way other manufacturing costs are distributed between products is to a high degree a question of judgment.
Cost Of Goods Sold: Plant Cost And Management Decisions
The cost of goods sold as calculated above is the Total Plant Cost or Full Factory Cost. Since many of the factors that are part of this cost are fixed, it becomes apparent that variations in volume produced have a great influence in the unit cost of the final goods.
Raw materials are basically a variable cost, and power consumption can also be considered variable. This means that these costs will be proportional to the quantity of product manufactured.
But other costs are to a high degree fixed: plant depreciation, for example, is usually the same whether we produce at full capacity or half of the machines are idle. The same applies to insurance, property taxes, and plant management. Labor may be totally fixed or variable to a certain degree depending on the type of factory.
TEACHER: OK, Student, let’s assume our factory is working at 70 % of capacity. Our unit plant cost is $ 10, result of $ 6 of raw materials and other variable costs, and $ 4 from distributing $4,000 of fixed costs to 1000 units produced. Do you follow me?
STUDENT: I sure do, Teacher.
TEACHER: OK, let’s see. Now a tough customer comes in and asks for a quotation on 300 units. What price would you quote?
STUDENT: Simple. My unit cost is $10, and since he is a miser (I mean, a cost conscious customer) I would add only 20% as gross margin, and quote $ 12 a piece.
TEACHER: Not too bad, if the customer agrees. But what if the customer refuses? Would you lower your quoted price?
STUDENT: No, I would not lower my gross margin percentage, and I am not willing to sell below cost.
TEACHER: Are you sure?
STUDENT: Well, on second thought, I realize that the unit cost would go down if we produce 300 more units!
TEACHER: Good for you. You are leading us into different concepts of unit cost. At the beginning our average unit cost was $10 for an output of 1000 units. If we produce 1300, we still have $ 6 for variable costs. But dividing the $ 4000 fixed costs by 1300 units, we add only approximately $ 3 to the unit cost, resulting on a plant cost per unit of $ 9, not $ 10.
STUDENT: I see your point. OK, I would accept a price of $ 10.80; my cost of $ 9 plus 20% gross margin.
TEACHER: And what about your total gross profit in this case?
STUDENT: Guess it would improve. If I can continue selling the basic 1000 units at the same price as before this new customer came in, since my average unit cost dropped by $ 1, my gross profit would increase by $ 1000, plus the $ 540 (300 units times $ 1.80) of gross profit I would get from the new order. Where is that customer?
TEACHER: Just a fictional character in this case. But we will find many of them in real life. Now suppose your fictional customer offers to purchase the 300 units at $ 8. What would you tell him?
STUDENT: How could it possibly be convenient to sell to him below my cost of $ 9 per unit as we calculated before?
TEACHER: And if I tell you that it would still be advantageous for you to make this sale?
STUDENT: What for, to lose $ 1 per unit? What am I, a freak?
TEACHER: Not really. Because $ 9 was the new average cost by adding 300 units of output. But the marginal cost, the extra cost of these 300 units, is only the variable cost, $ 6. Fixed costs we would have to pay for anyway. So, if we accept the price of $ 8, we would still make an extra gross profit of $ 2 per unit, or $ 600 in total. If there is not a better customer in sight, we should take the order!
Average method - In this method, individual "batches" received or dispatched are not individualized. Example:
Beginning inventory: 1000 units $ 1000
Purchases.............300 units $ _350
Sub-total........... 1300 units $ 1350
Unit cost: 1350 / 1300, $ 1.03846
Out to manufacturing:
500 units x 1.03846 = $ 519.23 (to manufacturing cost)
New balance : 800 units $ 830.77
FIFO (First In, First Out) Method - In this method the individual batches are individualized. Example:
Batch 1 300 units @ $1.00 ... $ 300
Batch 2 350 units @ $ 0.90, ..$ 315
Batch 3 350 units @ $ 1.10,.. $ 385
Purchased during the period:
Batch 4 300 units @ $ 1.1666 .$ 350
Sub-total 1300 units .......,$ 1350
Out to manufacturing:
300 units of batch 1,........ $ 300
200 units of batch 2,........ $ 180
......(200 x $0.90)
Transferred to manufacturing
500 units ....................$ 480
Batch 2 150 units @ $ 0.90 ...$ 135
Batch 3 350 units @ $ 1.10,.. $ 385
Batch 4 300 units @ $ 1.1666, $ 350
Total New Balance:
........800 units, ...........$ 870
Conclusion: the physical quantities purchased and used, and the new balance in units are of course the same in both methods. In our example, using FIFO the cost of raw materials transferred to manufacturing is lower and the new inventory balance in value is higher by the same amount of $ 39.23.
It could easily have been the other way around, depending on the prices of the different batches over time.
LIFO (Last in First Out) method
In FIFO we subtracted from inventory the "oldest" batches. In LIFO we do the contrary, we subtract from inventory the "newest" batches.
STUDENT: I see. Which method is best?
TEACHER: Depends. In times of rising prices, using LIFO will mean showing a higher cost of goods earlier, since we are using the batches purchased at higher prices first. This means lower "accounting" profits and less income tax.
St : I notice that in the long run the aggregate profits and taxes will be the same. What we get is simply a delay in the income tax we pay. Sure, this delayed tax disbursements mean interest income on deposits or interest saved on loans. But on the other hand showing a lower profit in the short run may discourage shareholders and potential investors.
TEACHER: True, but remember that taxes paid later in inflationary times are lower taxes in real terms. In general tax authorities accept all three methods; all they ask for is consistency. Once you begin using one system, you better keep using it. Changing the method means making adjustments to previous financial reports and tax returns, and this will of course require the agreement of tax authorities and in the case of public companies, the SEC in the US or a similar body in other countries.
- Sem1.Effective Business Negotiation (8)
- Sem10.General Management - Core Management Competencies (5)
- Sem2.Economics for Business and Management - Macroeconomics (8)
- Sem3.Economics for Business and Management - Microeconomics (3)
- Sem4.Strategic Management-Strategy and Competitive Advantage (8)
- Sem6.Financial Management-Financial Accounting (8)
- Sem8.Marketing Management-Strategic Marketing Planning (8)