Notes to Financial Statements

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Financial Statement Analysis-FIN621

Lesson-18

NOTES TO FINANCIAL STATEMENTS

(Continued)

Notes to Financial Statements:

These are integral part of the Financial Statements, which provide summary of accounting

policies, adopted by Management in preparation of Accounts and preparing Financial Statements there

from. These also present details about particular accounts (e.g. inventory, investments etc). Notes to

Financial Statements also include other information e.g. leasing arrangements, pending legal

proceedings, income taxes etc.

Information by segment for firms with several lines of business is also given in these Notes.

Notes to the accounts are the explanatory notes of all the items shown in the profit and loss account and

the balance sheet. It is the requirement of the Companies Ordinance and the International Accounting

Standards. Following are explained in Notes to the accounts:

o Nature of business of the company

o Accounting Policies of the company

o Details and explanation of items given in the Profit and Loss Account and Balance

Sheet.

Accounting Policies

The two major areas of Accounting Policies are Inventory and Depreciation of Plant Assets.

Inventory: This consists of items held for sale or used in manufacture of products that would be sold.

Inventory in merchandising business consists of goods owned and held for sale. This is called

Merchandise. Inventory in manufacturing business consists of three parts i.e. raw material, work-in-

process and finished goods. Inventory is an Asset which is shown at cost in balance sheet.

Inventory Accounting Policies

Before we discuss Accounting Policies regarding Inventory, let us discuss the following

three types of maintaining and recording inventory:-

a) Perpetual inventory system. This is most widely used: In this, the transactions are recorded

as they occur. The flow would be as follows:-

Purchase of → Dr. Current → Merchandise → Dr. Cost of → Cr. Inventory

Merchandise

Assets

sold

good sold

"Inventory"

Cr. Cash or

Cr. Revenue

Dr. Cash or

A/C payable

A/C Receivable

In a perpetual inventory system, merchandising transactions are recorded as they occur. The system

draws its name from the fact that the accounting records are kept perpetually up-to-date. Purchase of

merchandise is recorded by debiting an asset account entitled inventory. When merchandise is sold, two

entries are necessary: One to recognize the revenue earned and the second to recognize the related cost

of goods sold. This second entry also reduces the balance of inventory account to reflect the sale of

some of the company's inventory.

A perpetual inventory system uses an inventory subsidiary ledger. This ledger provides company

personnel with up-to-date information about each type of product that the company buys and sells,

including the per-unit cost and the number of units purchased, sold, and currently on hand.

Financial Statement Analysis-FIN621

Periodic inventory system: In this case, accounting records are updated periodically usually

at year's end: "Cost of goods sold" is also determined at year's end. The flow in this case

would be as follows:-

Purchase of → Dr. Purchase

→

Merchandise → No entry for "cost of goods sold"

Merchandise

A/C

sold

or inventory. This is done at years end.

Cr. Cash or

Cr. Revenue

Dr. Cash or A/C

A/C Payable

Receivable

Complete physical inventory is taken at year's end as follows:-

Opening balance (year's beginning)

12,000

+ Purchases.

130,000

Inventory available.

142,000

Less closing balance (year's end).

8,000

Inventory used/sold.

134,000

This i.e. Rs.134, 000 is "cost of goods sold", charged to Income Statement, and closing

inventory is Rs.8, 000 recorded on balance sheet. Both entries are recorded at year's end.

Assumptions under this method are that all units of inventory were acquired at the same unit

costs. "Taking physical inventory" at or near year-end also takes into account Inventory

Shrinkage (breakage, spoilage, theft), which is written off to Income Statement in the form of

"losses".

A periodic inventory system is an alternative to a perpetual inventory system. In a periodic inventory

system, no effort is made to keep up-to-date records of either the inventory or the cost of goods sold.

Instead, these amounts are determined only periodically, usually at the end of each year.

A traditional periodic inventory system operates as follows. When merchandise is purchased, its cost is

debited to an account entitled purchases, rather than to the inventory account. When merchandise is

sold, an entry is made to recognize the sales revenue, but no entry is made to record the sost of goods

sold or to reduce the balance of the inventory account. As the inventory records are not updated as

transactions occur, there is no inventory subsidiary ledger.

The foundation of the periodic inventory system is the taking of a complete physical inventory at year-

end. This physical count determines the amount of inventory appearing in the balance sheet. The cost of

goods sold for the entire year then is determined by a short computation.

Just in time (JIT) Inventory System. In this case, the purchase of merchandise or raw

materials and component parts is done just in time for sale or for use in manufacture; often a

few hours, before the manufacture or sale. It involves completing the manufacturing process

just in time to dispatch finished goods. It reduces money "tied-up" in inventory of raw material

and finished goods. There is no need to maintain large inventory storage facilities. But the

disadvantage is that delay in arrival of raw material may halt operations.

Just-in-time (JIT) inventory systems are not a simple method that a company can adopt; it has a whole

philosophy that the company must follow in order to avoid its downsides. The ideas in this philosophy

come from many different disciplines including statistics, industrial engineering, production

management and behavioral science. In the JIT inventory philosophy there are views with respect to

how inventory is looked upon, what it says about the management within the company, and the main

principle behind JIT.

Financial Statement Analysis-FIN621

Inventory is seen as incurring costs, or waste, instead of adding value, contrary to traditional thinking.

This does not mean to say that JIT is unaware that removing inventory exposes manufacturing issues.

Under the philosophy, businesses are encouraged to eliminate inventory that doesn't compensate for

manufacturing issues, and to constantly improve processes so that inventory can be removed. Secondly,

allowing any stock habituates the management to stock and it can then be a bit like a narcotic.

Management is then tempted to keep stock there to hide problems within the production system. These

problems include backups at work centers, machine reliability, and process variability, lack of flexibility

of employees and equipment, and inadequate capacity among other things.

In short, the just-in-time inventory system is all about having "the right material, at the right time, at the

right place, and in the exact amount" but its implications are broad for the implementors.

Criticisms

Shocks

JIT emphasizes inventory as one of the seven wastes, and as such its practice involves the philosophical

aim of reducing input buffer inventory to zero. Zero buffer inventories means that production is not

protected from exogenous (external) shocks. As a result, exogenous shocks reducing the supply of input

can easily slow or stop production with significant negative consequences.

Transaction Cost Approach

JIT reduces inventory in a firm, however unless it is used throughout the supply chain, then it can be

proposed that firms are simply outsourcing their input inventory to suppliers.

Implementation

Effects

Some of the initial results at vehicle manufacturing company were horrible, but in contrast to that a huge

amount of cash appeared, apparently from nowhere, as in-process inventory was built out and sold. This

by itself generated tremendous enthusiasm in upper management.

Another surprising effect was that the response time of the factory fell to about a day. This improved

customer satisfaction by providing vehicles usually within a day or two of the minimum economic

shipping delay.

Also, many vehicles began to be built to order; completely eliminating the risk they would not be sold.

This dramatically improved the company's return on equity by eliminating a major source of risk.

Benefits

As most companies use an inventory system best suited for their company, the Just-In-Time Inventory

System (JIT) can have many benefits resulting from it. The main benefits of JIT are listed below.

Set up times is significantly reduced in the warehouse. Cutting down the set up time to be more

productive will allow the company to improve their bottom line to look more efficient and focus time

spent on other areas that may need improvement.

The flows of goods from warehouse to shelves are improved. Having employees focused on

specific areas of the system will allow them to process goods faster instead of having them vulnerable to

fatigue from doing too many jobs at once and simplifies the tasks at hand.

Employees who possess multiple skills are utilized more efficiently. Having employees trained

to work on different parts of the inventory cycle system will allow companies to use workers in

situations where they are needed when there is a shortage of workers and a high demand for a particular

product.

Financial Statement Analysis-FIN621

Better consistency of scheduling and consistency of employee work hours. If there is no

demand for a product at the time, workers don't have to be working. This can save the company money

by not having to pay workers for a job not completed or could have them focus on other jobs around the

warehouse that would not necessarily be done on a normal day.

Increased emphasis on supplier relationships. No company wants a break in their inventory

system that would create a shortage of supplies while not having inventory sit on shelves. Having a

trusting supplier relationship means that you can rely on goods being there when you need them in order

to satisfy the company and keep the company name in good standing with the public.

Supplies continue around the clock keeping workers productive and businesses focused on

turnover. Having management focused on meeting deadlines will make employees work hard to meet

the company goals to see benefits in terms of job satisfaction, promotion or even higher pay.

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