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Running Head: Financial Accounting Work 1
- Determine whether or not Large Mart would legally be allowed to change its inventory cost flow assumption from FIFO to Weighted-Average-Cost, and what (if any) legal requirements would limit Large Mart’s ability to make this change.
Large Mart is legally allowed to change its inventory accounting system from FIFO to weighted average cost method. According to International Financial Reporting Standards, an entity shall change its policies only if the change results in financial statements providing reliable and more efficient information about effects of transactions, events or conditions on entity’s financial position and cash flows. The change should be adopted retrospectively meaning adjustments should be made as if the new policy has always been in existence (Hussey, 2010). Disclosure should be made on the reason for change in policy, amount of change for current period and prior periods.IRS allows one to choose an inventory accounting policy but requires the entity to use it consistently year to year.
Nonetheless, the IRS mandates the company to apply inventory changes method. In such a case, the IRS must be informed in order to acquire permission for tax year when the initial implementation of the new method of inventory cost was done (Elliott & Elliott, 2008). As such, it is required that Form 3115 of the IRS be completed and submitted at the beginning of the year when the change was initiated (Elliott & Elliott, 2008). The change should be attached to tax return for the year in order for the changes to take place. More so, the business must have been ongoing for at least one year.
- Discuss what impact (if any) a change from the FIFO cost flow assumption to the Weighted-Average cost flow assumption would have on the financial position (balance sheet) of Large Mart. PLEASE NOTE: You are NOT required to calculate the amount of impact of this change on the balance sheet. Instead, please discuss the POTENTIAL impacts of such a change in general.
FIFO normally considers that the inventory bought is the inventory that should be sold first. As internal operations of the company continues, the FIFO calculates the actual cost. This is important for products that have a relatively shorter shelf life, such products are groceries. As such FIFO allows realization of both cost and profit incurred on a product. This also applies in the manufacturing industry because FIFO helps in accounting for the cost of the raw materials as well as the cost incurred in selling every product and hence the profit (Elliott & Elliott, 2008).
If FIFO is used but the inventory is damaged or destroyed in any way, one should know exactly the loss in order to account for its value. Nonetheless, FIFO gives the product cost for each product manufactured. If the raw materials for the two units vary, then each of these units will have different cost. If the cost of marked up to get the selling price, the units will have varying selling process(Elliott & Elliott, 2008).
Average Costing Method
The prices can be set based on the average inventory cost by increasing the price of the average. This allows for a lower profit margin for expensive inventory. Despite the fact that there will be a lower profit margin, this will be addressed by the higher profit margin on the side of lower-cost inventory. This is specifically good for companies that are used to mixing their inventories as they come.
This method is applied for average profit levels as well as mean taxable income. It also works well in assigning the average cost of production of a given product as well as when the inventories are mixed this not possible to assign a given cost to a unit.
One main disadvantage of the average costing method is the mixing of the inventory and hence making it difficult to account for every product especially products which cost higher (Elliott & Elliott, 2008). In the event that some inventory bought has to be returned, the mean will be inaccurate using this method. As such, the existing inventory may be sold for a lower price mark in order to make a reasonable price. Further to this, in the event that some inventory is to be disposed by applying discounts, it should be based on the average cost. Notably, some will be sold at a loss because their buying price will be higher than others. In this event, the entire inventory must be sold in order to get the average cost back.
Impact on The Balance Sheet
FIFO normally reports higher inventory in current assets and therefore a higher current ratio. In the period of declining cost of materials. FIFO leads to a higher cost of goods sold, lower profit and consequently lower income tax. The inventory method that is employed by a company in the event of a profitability ratio, the balance sheet is affected. As a result, the current ratio is higher, (the current ratio is computed by dividing the current assets with the current liabilities) (Elliott & Elliott, 2008).. On the contrary, a company employing the average weighted cost on the other hand reports an average ending inventory. This produces current ration. More so, the shareholders equity is higher in this case under FIFO method since the average weighted method yields a mean asset base (asset less liabilities leads to a higher FIFO). In addition, other balance sheet ratios to consider include, asset turnover (sales divided by assets), return of equity (net income divided by mean sum of assets), and inventory turnover (COGS divided by the mean inventories) (Elliott & Elliott, 2008).
a) Explain how Large Mart must account for the depreciation of the equipment that was used in the building of the new machinery AND explain why this treatment is required.
Large Mart should treat depreciation as a business expense for the year and thus charge it to the profit and loss account. This is because it was incurred in the course of expansion of business. Since the depreciation expense belongs to 4 months of business, every month is allocated an expense using the straight line method (Hussey, 2010). This is necessary so that the correct expense of depreciation is charged every month
- Explain how Large Mart must account for the loan as well as the payment of interest during the time that the new machinery was built AND explain why this treatment is required.
Large Mart should account and record the load in general ledger. Firstly, it should debit the vase for the amount of load which were given out by the company as well as the credit short-term notes which are payable for the portion that is not to be paid during that financial year (Hussey, 2010).Because the total amount of loan is due to be paid back in less than a year, there is no need for long-term note payable. Normally, there will be occasional monthly payments. When these payments are made, two variables to be considered are interest and principle (Elliott & Elliott, 2008). Principle refers to the original amount borrowed while the interest is the cost incurred as a result of the borrowing which is calculated based on the outstanding amount each year. Entries are normally made by debiting notes payable for the principle amount (Hussey, 2010). As such this is achieved by debiting interest expense for the amount payable and crediting for the total payments.
- (0.5 marks)
1/5/201x Dr Computer a/c 5000
Cr Cash a/c 3500
Cr Discount received 1500
To record purchase of computer in cash
2/5/201x Dr. Cash a/c 3500
Dr. discount received 1500
Cr Computer 5000
To record return of computer to seller and forfeiture of discount
2) (1 mark) –
Cost of car= 45000 + 1000
11/5/201x Dr. Car a/c $46000
Cr. Creditor/Vendor a/c $46000
To record purchase of a car on credit
20/5/201x Dr. Car a/c $48000
Cr. Creditor $46000
Cr. Cash(painting logo) $2000
To record purchase of car and delivery
1/6/201x Dr. Creditor a/c $46000
Cr. Discount received $2300
Cr. Cash $43700
To record payment to creditor.
3) (1.5 marks) –
Cost of the car= $48000
Depreciation = 48000-2000
= $ 6571 per annum
Cost of the car = $46000
= $6286 per annum
Revaluation therefore has an effect on depreciation as it has decreased depreciation expense from sh. 6571 to sh. 6286 per annum
To record effect of revaluation
1/7/201x Dr Car a/c $46000
Dr. Loss on revaluation $2000
Cr. Car $ 48000
Elliott, B., & Elliott, J. (2008). Financial Accounting and Reporting. New York, NY: Financial Times Prentice Hall.
Hussey, R. (2010). Fundamentals of International Financial Accounting and Reporting. Michigan: World Scientific.