Question

1. a. Explain the various categories of a multi-step income statement.

b. Explain the financial statement effects and tax effects of each of the inventory cost flow assumptions.

Answer 1

Ans. 1a

Definition of multi step incopme statement

A multi step income statement formats income and expense into subtotals and comprehensive categories to provide more detail to financial statement readers. In other woard, a multi-step statement breaks the entire report into three main sections :

i) Gross profit,

ii) Income from operations, and,

iii) Net Income.

All three of these sections are subtotaled and listed, so internal and external users can analyze the company's performance. Let's take a look at each section in more detail.

i) Gross Profit :-

The gross profit section lists the sales for the period and subtracts the dicounts and returns followed but a bubtotaled called net sales. The cost of good sold is listed separately from the operating costs and is subtracted from the net sales to arrive at the gross profit.

ii) Income from Operations  :-

The second section lists the income from operations. This section takes the gross profit from the previous section and subtracts the operating expenses to arrive at the income or loss profit from operations. The operating expenses are usually broken out into two main categories A) Selling expenses and B) General and administrative expenses

A) Selling expenses consist of any costs required to produce a sale like salesmen's salaries, advertising, and sales floor rent.

B) General and administrative expenses on the other hand, consist of costs that don't directly attribute to sales like office, insurance, and depreciations expenses.

iii) Net Income :-

The income of loss from operations is then carried down to the third section called the net income section. In this section, the other income and expenses are combined with the operating income to sum the overall net income for the period. Some common other income and expenses items include interest income, interest expense, and gain or loss from the sale of an asset.

For Example :  

Ans. 1b

- The phrse cost flow assumptions often refe to the methods available for moving the costs of a campany's products from its inventory to its cost of goods sold. In the U.S. cost flow assumptions include FIFO, LIFO, and average (If specific identification is used, there is no need to make an assumption.)

- The inventory cost flow assumption states that the cost of an inventory item changes from when it is acquired or built and when it is sold. Because of this cost defferential, management needs a formal system for assigning costs to inventory as they trasition to sellable goods.

For example :

ABC International buys a widget on january 1 for $50. On july 1, it buys an identical widget for $70, and on november 1 it buys yet another identical widhet at three defferent prices, so what cost should it report for its cost of goods sold ? there are a multitude of possible ways to interpret the cost flow assumption.

• FIFO cost flow assumption  

Under the First In, First Out method, you assume that the first item purchased is also the first one sold. Thus, the cost of goods sold would be $50. Since this is the lowest-cost item in the example, profit would be highest under FIFO.

• LIFO cost flow assumption

Under the Last In, First Out methode, you assume that last item purchased is also the first one sold. Thus, the cost of goods sold would be $90. Since this is the highest-cost item in the example, profit would be lowest under LIFO.

• Spefic Identification Method  

Under the specific identification method, you can physically identify which specific items are purchased and then sold, so the cost flow moves with the actual item sold. this us a rare situstion, since most items are not individually identifiable.

• Weighted average cost flow assumption

Under the weighted average method, the cost of goods sold is the average cost of all three units, or $70. this cost flow assumption tends to yield a mid-range cost, and therefore also a mid-range profit.

- The cost flow assumption does not necessarily match the actual flow of goods (if that were the case, most companies would use the FIFO method). Instead, it is allowable to use a cost flow assumption that actual usage. For this reason, companies tand to select a cost flow assumption that either minimizes profits (in order to minimize income taxes) or minimize profits

- In periods of rising materials prices, the LIFO method results in a higher cost of goods sold, lower profit, and therefore lower income taxes. In periods of declining materials prices, the FIFO method yields the same results.

So, these are the inventory cost flow assumptions, and it's directly effects to your financial statements and tax, Because it's directly affect to the profit.