Question

"Accounting for Inventories"

Please respond to the following:

As a Financial Accountant, determine the best type of income statement a retailer should use. Defend your suggestion.

Analyze the different inventory valuation methods discussed in the textbook. Based on your analysis, recommend the most accurate valuation method that reflects current economic conditions. Provide a rationale for your recommendation.

Answer 1

A retailer should use MULTI STEP INCOME STATEMENT.

A multiple step income statement separates income, expenses, gains, and losses into two meaningful sub-categories called operating and non-operating. The multiple step statement lists these activities in separate sections, so users can better understand of the core business operations.

This is particularly helpful for analyzing the performance of the business. Investors and creditors can evaluate how well a company performs its main functions separate from any other activities the business is involved in. For instance, a retailer’s main function is to sell merchandise. Investors and creditors want to know how efficiently the retailer sells its merchandise without diluting the numbers with other gains and losses from non-merchandise related sales.

Multi-step income statement is divided into two main sections: the operating section and the non-operating sections.

The operating section contains information about revenues and expenses of the principle business activities. The gross profit and the operating profit figures are calculated in the operating section of a multi-step income statement. The operating expenses are sub-classified into cost of goods sold, selling expenses and administrative expenses.

The non-operating section of a multi-step income statement, usually labeled as 'other incomes and expenses' contains those revenues and expenses which are not earned directly through principle business activities but are incidental to them. For example gains/losses on sales of investments or fixed assets, interest revenue/expense etc.

A retailer should use the Multi Step Income Statement as:-

A major benefit of a multi-step income statement is the demonstration of gross profit. Gross profit equals sales for the period minus cost of goods sold. This allows the retailer to see how much the firm is earning on sales before operating income is considered. Seeing detailed gross profit also allows retailer to calculate gross margin, which is gross profit divided by sales. Retail business mostly work on margins and thus a demarcated calculation of margins in the income statement helps the retailer to plan in advance.

Additionally, the multi-step income statement segregates operating and non-operating income. This enables you to analyze how much of net income for the period derived from normal business activities and how much is from non operating income and thus can be reduced mentally for actual profit figures.

The three main types of inventory valuation methods are:-

(a) First-in, First-out (FIFO): Under FIFO, the cost of goods sold is based upon the cost of material bought earliest in the period, while the cost of inventory is based upon the cost of material bought later in the year. This results in inventory being valued close to current replacement cost. During periods of inflation, the use of FIFO will result in the lowest estimate of cost of goods sold among the three approaches, and the highest net income.

(b) Last-in, First-out (LIFO): Under LIFO, the cost of goods sold is based upon the cost of material bought towards the end of the period, resulting in costs that closely approximate current costs. The inventory, however, is valued on the basis of the cost of materials bought earlier in the year. During periods of inflation, the use of LIFO will result in the highest estimate of cost of goods sold among the three approaches, and the lowest net income.

(c) Weighted Average: Under the weighted average approach, both inventory and the cost of goods sold are based upon the average cost of all units bought during the period. When inventory turns over rapidly this approach will more closely resemble FIFO than LIFO.

Firms often adopt the LIFO approach for the tax benefits during periods of high inflation, and studies indicate that firms with the following characteristics are more likely to adopt LIFO - rising prices for raw perishable materials and labor, more variable inventory growth, an absence of other tax loss carry forwards, and large size.

Current economic conditions in India are decent healthy inflation and thus based on industry dynamics LIFO (mostly) or FIFO method of valuation of inventory can be applied.