ACCT11081 Steps 7 - 11 - Making Cents of Accounting



ACCT11081 INTRODUCTORY FINANCIAL ACCOUNTINGASSIGNMENT: Steps 7 - 11Step 7China Ting Group Holdings Ltd: Inventory Analysis For manufacturing companies, like China Ting Group Holdings Ltd. (China Ting), keeping an accurate record of inventory is a complex, but essential process. Accurate recording of inventory, ensures the inventory items are valued correctly on the balance sheet and accurately reflects the company’s gross profit. Furthermore, accurate recording of inventory leads to efficient and successful inventory management. Managing inventory correctly is essential as too much inventory can increase expenses (and decrease profit) e.g., interest on loans and insurance, and too little inventory can lead to customer dissatisfaction and loss of sales (therefore, decreasing profit). In China Ting’s 2017 Annual Report, management infer that ‘in 2018 they will be “expanding stores and implementing inventory control appropriately”. This statement makes me wonder if China Ting has had difficulties with its inventory management in the past? Examining China Ting’s annual reports, over the last three years, will help me to discover if they are successfully, or unsuccessfully managing their inventory to create a profit for their equity owners. Inventory refers to the products that a company purchases, or makes, but have not yet been sold. For a manufacturing company it includes raw materials, work in process (or progress) and finished goods, all of which must be disclosed in the annual report. China Ting’s inventory includes raw materials (silks, wools, linens, cottons, synthetics), work in progress (fabric design, weaving, printing, dyeing and sewing) and finished goods (retail clothing under the brand names of FINITY, ELAINIE RIESE, RIVERSTONE, CALVIN KLEIN PERFORMANCE, VINCE CAMUTO, as well as home décor, with a focus on fashion bedding and window coverings). Inventory also includes the cost of labour and any other expenses, incurred up to the point of sale, or transfer of ownership. Inventory is classified as a current asset on the balance sheet, as it is easily converted to cash once it is sold, and it is often the largest current asset and the main way a company utilises its cash. On the balance sheet, inventory is reported at the lower of cost price or net realisable value (or market value), so a company does not overstate the value of its inventory, which will affect its gross profit. Cost price includes the purchase cost and any other costs directly involved in the production of the inventory, such as labour and overheads. Cost price generally does not include administrative costs and selling and distribution costs, which are expensed separately on the income statement. Net realisable value (or market value) is the estimated selling price of the product less the costs incurred to sell the inventory. In note 2.13 (note 2.14 in 2015) of the financial statements (summary of significant accounting policies) China Ting states that “inventories are stated at the lower of cost and net realisable value”, as well as giving a definition of net realisable value. Furthermore, they list the variable costs that have been included in inventory as raw materials, direct labour, other direct costs and related production overheads, as well as highlighting the exclusion of borrowing costs from inventory. The breakdown of China Ting’s inventory can be seen in the following table: Note 4(e) in the notes to the financial statements is a subsection devoted to net realisable value. I found it interesting that note 4(e) states that estimates are based not only on the current market condition, but also on the historical experience of manufacturing and selling similar products, which may “change significantly as a result of changes in customer taste and competitor actions”. It makes sense that customers and competitors can influence market value, but I am a little confused about how ‘historical experience’ affects costing estimates, as market value reflects what is happening in the present day. Perhaps China Ting is referencing cost price, rather than net realisable value, when they are mentioning historical experience? Maybe, they are inferring that their historical experience is more accurate, and they do not necessarily use the lower of cost or net realisable value in all cases? However, failing to write down inventory to net realisable value would result in overstated assets. China Ting uses the weighted average method for costing (note 2.13 and note 2.14 in 2015). The weighted average cost method smooths out price changes that may occur when a company is purchasing inventory. This is particularly relevant to China Ting who, in their 2017 annual report, state that high inflation and unstable economies have been affecting their international trade. Also, as a manufacturing company they have a large amount of raw materials that would be purchased at various prices throughout the year. The weighted average method allows China Ting to source cheaper raw materials, which will reduce their overall expenses. The weighted average method is calculated by dividing the total cost of inventory by the total inventory quantity. As China Ting are using the weighted average cost method for their inventory they may be using either the perpetual or periodic method of recording inventory. If they are using the perpetual method, they will be calculating the average cost of inventory after each purchase. If they are using the periodic method they will calculate the average cost much less frequently, for example, at the end of each month. With the perpetual method of recording inventory, all purchases and sales of inventory are constantly monitored in the general ledger account and are constantly changing. This means at the end of the financial year when a stock take is performed the inventory should not be ‘too different’ to the physical inventory in the factories and warehouse. The periodic method of recording is cheaper to utilise as only the purchases of inventory are recorded, so the cost of sales is not known until the financial statements are prepared. There is no mention in the annual reports of whether China Ting uses the perpetual or periodic method to record their inventory. When discussing net realisable value, management states in note 4(e) that they “will reassess the estimations by the balance sheet date”. This makes me wonder if they are using the periodic method of recording inventory, rather than the perpetual method. However, the notes to the income statements tend to suggest that they are using the perpetual method, rather than the period method, as starting and finishing inventory is not recorded in notes. If China Ting are using the perpetual method of recording inventory I am not convinced that they are using it well, as in 2017 their provision for inventories increased by 52%, from 2016. Even though their inventories recorded a 29.4% increase, from 2016, this still seems like a lot of ‘wastage’, compared to previous years (as seen in the table below). Despite the high rate for provisions for inventories in 2017, China Ting are finally making a profit, after three years of losses. They have also taken on two new major clients, so perhaps they are ‘writing off’ old stock and replacing it with new stock? Provisions for inventories is the amount of inventory that a company writes off because of theft, spoilage, obsolete or damaged inventory. Companies use provision for inventories to ensure the inventory amounts in their ledgers accurately reflect the physical stock. As a manufacturing company I imagine China Ting would also be susceptible to inventory loss through theft, and damage during the production process. Having a large provision for inventories does have its advantages for China Ting, as they will be able to get a tax deduction for their losses, which will decrease their tax expense, which was the case in 2017. However, in 2018 I would suspect a much lower provision for inventories if China Ting is managing its inventories well. Too much inventory remaining on the balance sheet puts a company at risk of having obsolete products and increases cost of sales as provisions for inventories are recorded as an expense. As well as their provision for inventories increasing in 2017, China Ting’s total inventories was also 29.4% higher than in 2016, after accounting for provisions for inventories, and their finished goods increased by 28.6%. However, despite the increase in inventory China Ting’s revenue only increased by 8% from 2016. This suggests that a change in sales may be partly responsible for the build-up of inventory in 2017. A build-up of inventory generally indicates a slowing sales pace. Slower sales will generally result in a decline in gross profits. However, this is not the case with China Ting’s gross profits (gross profits = net sales – cost of goods sold) which increased by 2.2% in 2017 (as seen below). By working out the inventoryturnover ratio I will be able to ascertain if sales have been slowing down, as the ratio will show how long it is taking China Ting to turn its inventory into sales. A higher inventory turnover ratio is better as it shows a company is effectively using its inventory to generate income. China Ting’s inventory turnover ratio has been decreasing slightly in the last three years (as seen below) and is lower than the industry average of 5%. Similarly, the days of inventory ratio alsoindicates that it is taking longer each year to sell their finished products. Holding unsold inventory can be costly for a company, as their cash is tied up and cannot be used to generate revenue in other ways. It is also costly to store inventory, and the longer inventory remains unsold it is more likely to become obsolete. I would expect to see an increase in China Ting’s inventory ratio’s in 2018 because of the new clients they have taken on in 2017, and their expansion domestically which includes a new children’s line of clothing. China Ting’s inventory to sales ratio (shown below) also suggests that sales are decreasing, as the ratio has increased by 19.2% from 2016 to 2017. The inventory ratio’s, along with the large provision for inventories in 2017, and inventory build-up, all suggest that China Ting could manage their inventories better. However, their comments in the 2017 annual report suggest that they are aware of the need to implement “inventory control appropriately” so it will be interesting to see if this occurs in the 2018 financial year. While inventory could be managed better, I am a little confused with regards to how the inventory increases are affecting the income statement. The cost of sales (or cost of goods sold) on the income statement includes all the costs associated with getting the inventory ready for sale, e.g., the cost of raw materials and direct labour costs. As shown in the table below, in 2017, China Ting’s cost of sales increased by 11.3%, from 2016, and they made a net profit of $309,435, after three years of making a loss. Their gross profit (revenue minus cost of sales) also increased by 2.2%. Furthermore, China Ting’s inventory (averaged) is rising faster (13.6%) than their revenue (8.5%) and total assets (averaged) (1.9%), as shown below.China Ting’s increase in inventory in 2017 also increased their cost of sales (expenses). However, when cost of sales increases gross profit should decrease, but this has not happened with China Ting’s figures, which show an increase in both gross profit and net income. However, in 2017 China Ting’s cash, along with their trade and other receivables has also increased substantially from 2016, so perhaps this explains the increase in net profit. Analysing China Ting’s inventory in the financial statements has been revealing and slightly confusing, and I look forward to looking at my peer’s inventory analysis of their firms for comparison. As I learn more about financial accounting I am sure I will gain a better understanding of the financial statements, and China Ting’s statements will make more sense. The figures in the financial statements really do tell a ‘story’ about what is going on in a business, and it is fun trying to figure out the ‘plot’. Step 8Learning how to use MYOB AccountRightStep 9China Ting Group Holdings Ltd: MYOB AccountsTen hypothetical business transactions for China Ting Group Holdings LtdDateTransactionAug 2Purchased wool from Fox and Lillie, Australia for $50,000Aug 3Sold $60,000 of women’s active performance wear to Calvin Klein stockistsAug 4Sold $40,000 of women’s casual sportswear to Bernard Chaus Inc. USAAug 15Purchased silk worms from local silk worm farm for $10,000Aug 15Purchased flax plant from Belgium for $22,000 Aug 16Sold $75,000 of designer clothing to Vince Camuto, Hong KongAug 18Sold $60,000 of men’s clothing to RiverstoneAug 24Purchased cotton from local cotton farm for $8,000Aug 25Purchased silk worms from local silk worm farm for $10,000Aug 26Sold $55,000 of women’s active performance wear to Calvin Klein stockists LINK Excel.Sheet.12 "Book2" "Sheet1!R3C1:R50C5" \a \f 4 \h All Journals1/08/2018 To 7/09/2018China Ting Group Limited27th FloorID No. Account No. Account NameDebitCredit Job No.PJ 2/08/2018Purchase; Fox and Lillie Wool, Australia00000006 2-1000Trade Creditors$50,000.0000000006 6-3000Cost of Goods Sold$45,454.5500000006 2-4000GST Paid$4,545.45?SJ 3/08/2018Sale; Calvin Klein USA00000001 1-5000Trade Debtors$60,000.0000000001 4-1000Revenue$54,545.4500000001 2-3000GST Collected?$5,454.55SJ 4/08/2018Sale; Bernard Chaus Inc. USA00000002 1-5000Trade Debtors$40,000.0000000002 4-1000Revenue$36,363.6400000002 2-3000GST Collected?$3,636.36PJ 15/08/2018Purchase; Flax plant merchant, Belgium00000003 2-1000Trade Creditors$22,000.0000000003 6-3000Cost of Goods Sold$20,000.0000000003 2-4000GST Paid$2,000.00?PJ 15/08/2018Purchase; Silk worm farm, Hong Kong00000007 2-1000Trade Creditors$10,000.0000000007 6-3000Cost of Goods Sold$9,090.9100000007 2-4000GST Paid$909.09?SJ 16/08/2018Sale; Vince Camuto, Hong Kong00000003 1-5000Trade Debtors$75,000.0000000003 4-1000Revenue$68,181.8200000003 2-3000GST Collected?$6,818.18SJ 18/08/2018Sale; Riverstone, Hong Kong00000004 1-5000Trade Debtors$60,000.0000000004 4-1000Revenue$54,545.4500000004 2-3000GST Collected?$5,454.55PJ 24/08/2018Purchase; Cotton farm, Hong Kong00000004 2-1000Trade Creditors$8,000.0000000004 6-3000Cost of Goods Sold$7,272.7300000004 2-4000GST Paid$727.27?PJ 25/08/2018Purchase; Silk worm farm, Hong Kong00000005 2-1000Trade Creditors$10,000.0000000005 6-3000Cost of Goods Sold$9,090.9100000005 2-4000GST Paid$909.09?SJ 26/08/2018Sale; Calvin Klein USA5Trade Debtors$55,000.005Revenue$50,000.005GST Collected?$5,000.00?Grand Total:$390,000.00$390,000.00????Analysing China Ting Group Holdings Ltd.’s Financial StatementsChina Ting’s financial statements are not very exciting because I only entered purchases and sales transactions, in this hypothetical scenario. Therefore, I will assume that August is China Ting’s first month of business, and they have started a risky venture by not having any cash in the bank. However, analysing the purchases and sales that China Ting has made can still tell me a lot about their current financial standing, and their ability to perform in the future, in the manufacturing and retail industry.China Ting’s balance sheet gives me a snapshot of their financial position for the month of August 2018. As I only entered hypothetical sales and purchases transactions for China Ting, the only current asset they have is accounts receivable (trade debtors). The balance sheet shows that China Ting is still owed money for all its sales made during the month of August ($290,0000). Furthermore, it shows that the accounts receivable are debits (an increase in an asset is a debit) because the firms who bought China Ting’s products have an obligation to pay their bill to China Ting. I would expect that China Ting would receive all its money from its sales by the end of September. If money remains owing on the balance sheet it could indicate that China Ting are not very efficient at collecting their debts or are extending credit which could result in a cash flow problem. China Ting’s current liabilities include payments it owes to its suppliers for inventory (accounts payable or trade creditors). I am hypothesizing that Hong Kong businesses must pay GST. The GST collected amount shows a liability that is owed to the government, whereas the GST paid amount is the amount refunded by the government for payments made to suppliers. By looking at China Ting’s assets and liabilities I can determine if they can pay their liabilities (accounts payable and GST) with their assets (accounts receivable), by working out the current ratio (current ratio = current assets/current liabilities). 290,000/117,272.74 = 2.47China Ting’s current ratio indicates that it has plenty of current assets to cover its liabilities. It shows that for every $1 of current debt, it has $2.47 available to pay for its debt. China Ting’s equity amount is equivalent to what it has earnt during the month of August, which can be seen in the fundamental accounting equation (assets = liabilities + equity).290,000 = 117,272.74 + 172727.26290,000 = 290,000China Ting have had a great first month of business and have earnt $172,727.26 for their equity owners. China Ting’s income statement is very simple and shows the total revenue they earnt from sales ($263,636.36), which is equivalent to their accounts receivable ($290,000) minus their GST collected ($26363.64), as seen on their balance sheet. China Ting’s expenses (cost of goods sold) ($90,909.10) is equivalent to their total liabilities ($117,272.74) minus their GST collected amount ($26363.64) on their balance sheet. This leaves China Ting with a net profit of $172,727.26, which equals the total equity for the owners (on the balance sheet). I am glad I chose to only include sales and purchases in my hypothetical transaction list because it makes it really clear how the balance sheet and income statement interrelate. This is something I never saw so clearly before doing this exercise.By looking at China Ting’s income statement I can work out the net profit margin for the month, by dividing net profit by sales.172,727.26/263,636.36 = 0.66 or 66%The net profit margin shows how much profit has been made after expenses and indicates that China Ting are off to a good start in their business. In my example of China Ting’s cash flow statement, it is clear to see that the amounts are simply a juxtaposition of the income statement. The net income, or net profit, is broken down to reflect what is currently happening in China Ting’s business. This is the first time I have used MYOB software and I haven’t really enjoyed the experience. However, I do like how it can produce the financial statements, and I can see the benefit of how quick it is to record purchases and sales once the card list is set up. I thought I might use it for paying invoices to my daughter’s NDIS suppliers (which is why I practiced creating an account for her, in Step 8) but at this stage I am not sure I will. Perhaps, with more practice I will choose to use it over using excel. Step 10China Ting Group Holdings Ltd: Depreciation Policies and Journal EntriesDepreciation of non-current assets, such as property, plant and equipment are an important expense item for most firms and must be considered carefully by management as depreciation is a non-cash transaction based on assumptions. Depreciation refers to the process of allocating a cost to a tangible asset, or turning an asset into an expense, to reflect the changes in its value over time. This prevents a significant expense being charged when the asset is initially purchased, which would significantly reduce a firm’s net income (profitability). It also helps firms to match the amount of expense that occurs from using an asset, with the amount of revenue the asset is likely to generate, thereby giving a more accurate representation of expenses incurred during the year. Furthermore, depreciation helps firms report property, plant and equipment (fixed assets) correctly at their net book value (original purchase cost minus total accumulated depreciation expense from previous years). Depreciation also has tax advantages for a firm, as it can claim the depreciation expense as a business expense, which reduces the firm’s taxable income. The balance sheet reports the net book value (original cost minus accumulated depreciation) of its fixed assets. Accumulated depreciation is recorded in a contra asset account with a credit balance to reflect that the assets value is decreasing over time. Each time a depreciated expense is debited the accumulated depreciation asset account is credited. Recording depreciation this way on the financial statements allows interested parties to see how much of the cost of an asset has been depreciated, or used up, and how much future economic benefits remain. China Ting Group Holdings Ltd.’s. (China Ting’s) net book value (net amount or carrying amount) is reported on its balance sheet in Property, plant and equipment, with a reference to Note 6 in its 2015 to 2017 annual reports. Note 6 lists the original cost of each group of assets, minus the accumulated depreciation, which gives the net amount, which is transferred to the balance sheet, as shown in Table 1. Note 6 also lists the breakdown of the net book, or carrying amount of accumulated depreciation, and includes values attributed to exchange differences, additions, transfers, disposals, transfer to investment properties, as well as the depreciation expense for the current financial year. Table 1Table 1 shows that China Ting’s total accumulated depreciation is increasing from 2014 to 2017, and its net book value, or net amount, is decreasing as the asset is being used up. I found it interesting that plant and machinery, vehicles and furniture, fittings and equipment do not increase/decrease in the same way as the total depreciation amounts. I suspect that this is because of disposals made throughout the year, which results in the accumulated depreciation and cost being removed to profit or loss, and when I look at Note 6 I can see that disposals have been made, that correspond with the highlighted amounts. Furthermore, Note 2.5 (2015), and Note 2.7 (2016, 2017) states that “gains and losses on disposals are determined by comparing proceeds with the carrying amount and are included in consolidated profit or loss”. However, disposals have been made in other groups and years also, which leaves me a little confused. Perhaps, the group increases/decreases are partly due to the depreciation standards being amended at the beginning of the 2016 financial year (Note 2.1, 2016 Annual Report). I suspect this amendment or “clarification of acceptable methods of depreciation and amortisation” mentioned in Note 2.1/2016, may be a result of the resignation, on the 3rd March 2016 of Dr. Cheng, an independent non-executive director and chairman of the audit committee. On the 18th December 2015, the Disciplinary Committee of the Hong Kong Institute of Certified Public Accountants reprimanded and fined Dr. Cheng for breaches in auditing, which included “recognition of depreciation and disclosure of the carrying amount of the plant and machinery” (Pg. 27, 2015 Annual Report). Construction in progress is also included in Note 6, but it has not been allocated a depreciation amount because it is an asset that is not yet ready for its intended use. China Ting state in Note 2.5 (2015), and Note 2.7 (2016, 207), that when the construction in progress is complete, and ready for its intended use, the costs will be transferred to the respective property, plant and equipment and depreciated from that time forward. At first, I thought it was strange for China Ting to include construction in progress along with the depreciated fixed assets, but after reading Note 2.5 it makes sense because it is ‘depreciation waiting to happen’. It also shows how China Ting are using assets to create more revenue for the firm. The income statement shows China Ting’s depreciation expense, which is the amount of depreciation that is charged to expenses for fixed assets, during one financial year. This amount is considerably less than the depreciation amount on the balance sheet which is the total depreciation accumulated over many years. Like the balance sheet, China Ting does not include depreciation as a separate entry on its income statement. Rather, it is included in its Cost of sales, and Administration expenses, with reference to the notes which gives a further breakdown of expenses (Note 6, all years and Note 27, 2017, Note 28, 2015, 2016). Depreciation expense that is allocated to Cost of sales should only include assets that are directly related to the production of goods, such as overhead costs China Ting incurs in its factory, and any other costs directly related to their manufacturing business. When depreciation is included in Cost of Sales, it is also included in a firm’s gross profit. However, an adjustment to depreciation is made so the depreciation expense gets added back to the net income, so the statement of cash flows can be prepared accurately (Note 31, 2017, Note 32, 2015, 2016). Depreciation does not account for a large amount of China Ting’s expenses as identified in Note 6 (3.39% to 13.02%) and seen in Table 2. However, I thought the depreciation expenses would be higher for the cost of sales items, rather than administrative items because of the manufacturing nature of China Ting’s business. Table 2Additionally, when depreciation expense is broken down into manufacturing (OEM) and Retail expenses, as listed in Note 5, the percentage of depreciation allocated to OEM is significantly higher, as seen in Table 3. This clearly suggests that China Ting’s depreciation expenses are mainly attributed to its OEM business. Furthermore, it suggests to me that China Ting must have many expenses, attributed to Cost of Sales, that cannot be depreciated. However, it is still a little confusing as Property, plant and equipment is the largest non-current asset on the balance sheet, as seen in Table 4. Therefore, shouldn’t the depreciation expense be much more than approximately 16% across all years, as seen in Table 2? Table 3Table 4In Note 2.5, China Ting states that Property, plant and equipment are stated at historical cost, less accumulated depreciation and accumulated impairment losses. They also highlight that historical cost refers to all the costs necessary to bring the asset into use. They go on to state that other costs incurred by the asset are generally included in the carrying cost, and any replacement parts are derecognised. I presume they derecognise replacement parts because they are not part of the original cost. Note 2.5 also states that China Ting use the straight-line method of depreciation to allocate costs to the residual values of their assets and state the estimated useful lives of the different categories of Property, plant and equipment. China Ting’s method of depreciation has not changed from 2014 to 2017, even though in 2016 they note that they are amending/clarifying their depreciation methods (Pg. 27, 2015 Annual Report).The straight-line depreciation method reduces the cost of a fixed asset uniformly over its useful life, so the depreciation expense on the income statement will be the same in all years. This is the most common depreciation method and it is suitable for most assets. As illustrated in Table 5, if China Ting purchased a van for $19,000, which had a residual value of $4000, and was depreciated over 3 years, the van would have a depreciation expense of $5000 each financial year.$19,000 – $4,000 = $15,000$15,000/3 = $5000 per yearTable 5However, I still find myself thinking that China Ting would be better using a different depreciation method for its vehicles, as their value decreases more rapidly in its initial years of purchase. I must remind myself that depreciation does not reflect market value, but rather a cost that illustrates how the asset is benefiting the firm over time or being used productively to generate revenue. It is hard to debunk a firmly entrenched myth one has learnt, such as depreciation reflects a decline in market value. Depreciation expenses are recorded in a firm’s general ledger, and recorded in a contra asset account, called ‘accumulated depreciation’. Using the example above in Table 5, where China Ting purchased a van their journal entry would be recorded as:This same journal entry will be posted at the end of each financial year, until the end of its useful life (2016) because under the straight-line method of depreciation the same amount is charged to expenses each year. When China Ting sells the van at the end of its useful life for $4000, the journal entry would be recorded as:. Other examples of journal articles that China Ting’s accountants would have entered to arrive at the net book amount, or carrying amount, as seen in Note 6 are listed below:?China Ting appear to be following all the accounting standards when calculating depreciation, and after the disciplinary action taken against Dr Cheng for incorrectly recognising and disclosing depreciation, I imagine they will be even more careful with their calculations. However, depreciation, like inventory, is susceptible to manipulation. Fictitious fixed assets can be entered in the journal and the useful life can be extended to inflate the value of an asset. It seems odd to me that China Ting have stated an amendment to their depreciation policy in the 2015 and 2016 Annual Report, but none of their wording has changed in any of the notes from 2014 to 2017. This makes me wonder if they made any changes at all, as mentioned in my blog post ‘More Reasons to Doubt China Ting’s Ethical Behaviour’. When I completed an income tax course at H & R Block several years ago, I struggled with the concept of depreciation. I have now discovered it was difficult to work out the depreciation schedules, at the course, without understanding the concepts behind depreciation. Depreciation is not a scary word to me anymore, and I can see the real benefit in writing so many key concepts and questions in this course. ................
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