Taqi Shah Blogspot

Straight Line Depreciation Method

The simplest and most commonly used method of depreciation is the straight line method.

The straight line depreciation method takes the purchase or acquisition price, subtracts the salvage value and then divides it by the total estimated life in years.

For example, an equipment worth $1m with an estimated life of five years and salvage value of $100,000 would have the following depreciation schedule and asset value after each year as shown below.

Inventory Valuation Methods in Accounting

Inventory can make up a large amount of the assets on the balance sheet and so knowing how to analyze the inventory, and the method used by management is crucial.

A large part of stock valuation comes from being able to understand how inventory is valued and built.

To put it in the most basic form, inventory is what you have in stock. If you expand on this definition to look at what is involved on the other side of the scale to get the ending inventory amount, the equation for inventory is

Beginning Inventory + Net Purchases – Cost of Goods Sold = Ending Inventory

In words, your beginning inventory along with your purchases and then subtracting what you have sold, results in ending inventory.

But this is where it gets tricky with GAAP rules. Depending on the inventory valuation  method used by the company, the COGS can vary considerably which ultimately affects the ending inventory.

Sadly, it is not as easy as counting what is left on the shelf at the end of the day to get the ending inventory value.

Three inventory valuation methods are used in the US.

1. Average cost method

2. First In First Out (FIFO) method

3. Last in First Out (LIFO) method

1.    Average Cost Method

To put it real bluntly, the average cost method is rarely used. This method does not offer any real convenience or added accuracy.

The equation for average cost method is as follows.

Average Cost = (Total Quantity of Inventory Units) / (Total Quantity of Units)

where

Cost of Goods Sold = (Average Unit Cost) x (Number of Units Sold)

For example if 1,000 toys are produced on Monday at a cost of $1 and then on Tuesday another 1,000 toys are manufactured at a price of $1.05, the average cost method would value the inventory at $1.025 a piece.

2.    FIFO Method

As mentioned previously on aggressive and conservative accounting policies, the FIFO method of valuing inventory is considered to be the aggressive method.

FIFO works like how you maintain your fridge at home. After you have bought some groceries, you tend to place what you just bought at the back of the fridge in order to finish off the older food before it spoils.

In other words, under FIFO, the oldest goods are sold first and the newest goods are sold last.

As a formula it would look like this

Unit Cost per batch = (Cost/Quantity) for each batch

where

Cost of Goods Sold = (Unit Cost x Quantity) for each batch

Using the toy example above, if 1,000 toys were then sold on Wednesday, the COGS would be $1 per unit. The remaining inventory on the balance sheet would then be worth $1.05 each.

3.    LIFO Method

LIFO is the opposite of FIFO. Instead of the oldest inventory being considered as sold first, the newest product is sold first. While the factory analogy works for the FIFO, consider a bakery. By lunch or evening, the bread baked from the morning will not sell as well as the fresh ones from the afternoon batch.

This means that cost of the latest inventory now becomes the COGS with the cost of the oldest inventory being assigned to the inventory value on the balance sheet.

The equation is essentially the same as FIFO since both are calculated based on batches of unit sold.

Unit Cost per batch = (Cost/Quantity) for each batch

where

Cost of Goods Sold = (Unit Cost x Quantity) for each batch

Using the toy example, the 1,000 units sold on Wednesday would have a COGS of $1.05 per unit, with the remaining 1,000 toys being valued at $1 each.

5.    How Inventory Valuation Affects Profits and Assets

As you can see from above, despite ending with the same 1,000 toys, FIFO assigns the inventory value to be $1,050 compared to the LIFO $1,000.

But another point is that the method of inventory valuation does not just affect the balance sheet. Gross profit also varies considerably. How?

Gross Profit = Sales – COGS

COGS differ under FIFO and LIFO, and if your COGS is low, then that means gross profit will increase.

The table below sums up how each of the three inventory valuations vary.

Financial Statement Analysis

 Helping You with Financial Statement Analysis

Accounting is the language of business and to become a successful investor, you also have to think like a businessman.

Warren Buffett said that

“I am a better investor because I am a businessman and a better businessman because I am an investor.”

In other words, business and investing is so closely intertwined that you can not separate it. In order to be a great investor, understanding accounting and performing financial statement analysis is a top priority in your growth as an investor.

I personally struggled a lot with financial statement analysis. Coming from a background with no financial degree or any education in finance, it was difficult to self learn how to analyze financial statements.

But because I went through the hardship of reading many books, magazines, articles and tutorials to improve my knowledge of accounting and the analysis of financial statements, the following articles will make your journey somewhat easier.

1.    How to Master Analyzing the Income Statement

The financial statement is divided into three sections. The income statement is the first part of the financial statement and gets the most attention because it is where the numbers for revenue, net income and earnings per share lives.

This tutorial of the income statement analysis will provide you with insight on how to not just read the income statement, but provide insights on what other points you have to consider as you analyze the income statement in your financial statement analysis.

2.   How to Master Analyzing the Balance Sheet

By understanding the balance sheet, you will be able to gain valuable insight into the financial health of the company. This article uses Circuit City as an example to see why the company went bankrupt.

3.    How to Master Analyzing the Cash Flow Statement

The cash flow statement is a little different than the income statement and balance sheet, because while you can easily compare income statements by quarter, the cash flow statement is more “accrual”. This means that numbers in the cash flow statement add up or accrue throughout the fiscal year.

Best to go read the final section of the financial statement analysis.

4 Timeless Articles on Financial Statement Analysis