Question

1. Explain the concepts in an essay-format

   1. Explain the link between the Income statement, Statement of Retained earnings, and the Balance sheet.

   2. Explain the Inventory methods and how the methods differ on the financial statements.

Answer 1

The financial statements are comprised of the income statement, balance sheet, and statement of retained earnings. These three statements are interrelated in several ways.

An income statement or profit and loss account is one of the financial statements of a company and shows the company’s revenues and expenses during a particular period. It indicates how the revenues are transformed into the net income or net profit.

  A balance sheet is a financial statement that reports a company's assets, liabilities and shareholders' equity at a specific point in time, and provides a basis for computing rates of return and evaluating its capital structure. It is a financial statement that provides a snapshot of what a company owns and owes, as well as the amount invested by shareholders.

The statement of retained earnings (retained earnings statement) is a financial statement that outlines the changes in retained earnings for a company over a specified period. This statement reconciles the beginning and ending retained earnings for the period, using information such as net income from the other financial statements, and is used by analysts to understand how corporate profits are utilized.The statement of retained earnings is also known as a statement of owner's equity, an equity statement, or a statement of shareholders' equity. Boilerplate templates of the statement of retained earnings can be found online. It is prepared in accordance with generally accepted accounting principles (GAAP).

The net income figure in the income statement is added to the retained earningsline item in the balance sheet, which alters the amount of equity listed on the balance sheet.The net income figure also appears as a line item in the cash flows from operating activities section of the statement of cash flows.Changes in various line items in the balance sheet roll forward into the cash flow line items listed on the statement of cash flows. For example, an increase in the outstanding amount of a loan appears in both the liabilities section of the balance sheet (as an ongoing balance) and in the cash flows from financing activities section of the statement of cash flows (in the amount of the incremental change).The ending cash balance in the balance sheet also appears in the statement of cash flows.The purchase, sale, or other disposition of assets appears on both the balance sheet (as an asset reduction) and the income statement (as a gain or loss, if any).

In short, the financial statements are highly interrelated. Consequently, when reviewing the financial statements of an organization, one should examine all of the financial statements in order to obtain a complete picture of its financial situation.

Every business that manages inventory must use an inventory accounting process to determine the value of the company’s inventory assets. There are several common inventory accounting methods that companies rely on to assign value to their inventory and maintain appropriate record-keeping. Inventory valuation is a critical business process that directly impacts profit and taxation.

Types of inventory methods are as follows:

1.FIFO Inventory Accounting Method – When using the FIFO method, accountants assume the items purchased or manufactured first are used or sold first, so the items remaining in stock are the newest ones. The FIFO method aligns with inventory movement in many companies, which makes it a common choice. Prices also rise each year, so accountants who assume the earliest items are the first used can charge the least expensive units to the cost of goods sold first. As a result, the cost of goods trends lower and leads to a higher amount of operation earnings and more taxes to pay. It also means that companies use oldest items first and don’t have to worry about expiration dates or inventory that does not move.

2.LIFO Inventory Accounting Method – Accountants who opt for the LIFO method assume items purchased or manufactured last are sold first, so the items remaining in stock are the oldest. As such, this method does not follow most companies’ natural inventory flow and is banned by International Financial Reporting Standards. When prices rise, the last units purchased are the first used, so the cost of goods trend higher and results in a lower amount of operating earnings and fewer income taxes to pay. Companies using the LIFO method also struggle with obsolete inventory.

3.Weighted Average Accounting Method – Companies opting for the weighted average method have just one inventory layer. They also roll the cost of new inventory purchases into the cost of existing inventory to determine a new weighted average cost that is readjusted as more inventory is purchased or manufactured.

4.Specific Identification Method – The specific identification method requires companies to track the cost of each inventory item separately and charge the specific cost of an item to the cost of goods sold when you sell the specific item. Because this inventory accounting method requires a great deal of data tracking, it is best suited to high-cost items.

Choose an inventory accounting method that suitable for your business needs to maximize revenue potential while effectively managing record-keeping for tax purposes.

Generally, companies use the inventory method that best fits their individual circumstances. However, this freedom of choice does not include changing inventory methods every year or so, especially if the goal is to report higher income. Continuous switching of methods violates the accounting principle of consistency, which requires using the same accounting methods from period to period in preparing financial statements. Consistency of methods in preparing financial statements enables financial statement users to compare statements of a company from period to period and determine trends. If we switch inventory methods, we must restate all years presented on financial statements using the same inventory method.