Year-End Financial Statements Are on The Way
By Juanita Schwartzkopf, Managing Director
Stakeholders are beginning to review financial statements for companies with December year-ends. Receipt of this annual financial statement provides stakeholders of a business with an opportunity to gain additional insight regarding the performance of the business. The year-end financial statement provides a fully updated, and, in many cases, audited, report on the company’s operating performance. While the information in the year-end statement may be expanded over what is received monthly or quarterly, the year-end financial statement is sometimes difficult to understand due to the amount of adjustments which occur during the preparation of the year-end financial statements. In this article, the inventory and gross profit impact of various standard costing methodologies will be discussed.
The information presented in this article will assist a stakeholder in understanding why there are differences between interim and year-end financial statements, and will help the stakeholder determine the true operating performance of the company. Changes in inventory values and margin performance directly relate to advance rates and financial covenants stakeholders have implemented with the company.
What is Standard Costing?
First, let’s discuss costing and define standard costing. Any business that hopes to achieve profitability must be able to monitor and track costs pertaining to materials, labor and overhead, and understand how these costs relate to its revenue. Most businesses use standard costing as an efficient method of determining the cost of each item produced. The decisions made surrounding standard costing directly impact the value of inventory and the level of gross profit reported – values which in turn impact collateral value and the business’ performance relative to loan covenants.
Why Does Standard Costing Matter?
The standard costing method establishes a run rate for the costs incurred to manufacture a given product at an established level of production. This production level is assumed to be fixed during an accounting period. As production levels or actual costs fluctuate, it is imperative that the company evaluates its variances to understand and correct its costing and/or methods of production giving rise to the variances. Therefor, standard costs must be periodically compared and adjusted to actual costs in order to ensure that accurate financial reporting is occurring and that management decisions are based upon actual, rather than estimated data. The testing of actual and standard costing must occur at least annually, during the preparation of the annual financial statement.
Financial performance is impacted when management continues to base decisions on the original cost assumptions while the underlying costs, efficiencies or production levels change. The strength of using standard costs is in being able to identify the changes or variances very early in the accounting process so that management can respond and make corrections. These strengths can be negated by a lack of variance reporting and necessary accounting adjustments.
The problem is that during the accounting period, the standard cost will be utilized to set selling strategies while the impact of the inefficient labor and material usage will not be evident to the manufacturer until a review of standard costs, actual costs, and inventory is undertaken. Ideally variance reporting is part of the monthly financial closing, however, in some cases management may elect not to record the variances or may not review the variances until the preparation of the year-end financial statements.
What is the Impact on Inventory Values?
Inventory quantity growth may mask inefficient production or inefficient inventory management and purchasing processes. This impact would be more pronounced for companies that use a physical count inventory system, rather than perpetual inventory system, or for companies with problems with the accuracy of the perpetual inventory system.
- A physical inventory system requires management to physically count each item in inventory, and assign a value to the item, in order to determine the total inventory value.
- By contrast, a perpetual inventory system tracks the receipt and consumption of inventory, typically based on standard usage levels, to arrive at the total quantity and value on hand.
If the company uses more inventory than expected to produce its product, management and stakeholders would be anticipating a higher inventory value than the actual value on hand. Under such circumstances, if the company funds itself via a revolving line of credit under which its lender has set advance rates ties to inventory, the company may find itself in an over advance position with its lender. In some cases, management may be aware of a problem but chooses to record the variance adjustment only at the end of the year-end.
What is the Impact on Profitability?
An adjustment to reduce inventory levels would also directly reduce profitability by the amount of the inventory reduction. Therefor, the stakeholder would see both a lower collateral value than expected and a reduction in profitability.
Under-allocated standard costs would produce a lower cost of goods sold, a higher gross margin and a higher gross profit during an accounting cycle. This situation would perpetuate until a variance analysis of standard to actual costs for materials, labor and overhead is completed. The results of the variance analyses would be reflected in the income statement only after a variance analysis is completed and may result in significant adjustments to the profits reported on an interim basis.
Taking Apart the Financial Statement
The incorrect use of standard costing may create misperceptions as to a company’s efficiency and profitability, leading management and stakeholders to potentially make poor decisions.
When reviewing the year-end financial statements, stakeholders will need to understand the details surrounding the following:
- The cost of goods sold calculations should be provided in sufficient detail to allow an understanding of the adjustments to inventory and labor applied during the preparation of the year-end financial statement. Variances are to be expected, however, the timely correction of variances and the recording of any required adjusting entries improves the ongoing financial reporting to stakeholders.
- Inventory reporting should be provided in sufficient detail to develop an understanding of the quantity adjustments applied as related to a physical inventory count. Again, variances are to be expected, however, the amount of those variances and the speed with which accounting records are corrected is critical.
When the year-end financial statement is received, stakeholders should test the following ratios to determine if there have been problems with the standard costing methods – which in turn indicate financial and operating performance issues:
- Compare the monthly or quarterly gross margins to the year-end gross margin.
- Compare the raw material inventory at each quarter-end to the raw material inventory at year-end – both quantity and overall value assigned.
- Compare work in process inventory – both quantity and overall value assigned.
- Compare finished goods inventory – both quantity and overall value assigned.
- Test invoice purchase prices against inventory values.
- Compare the value of finished goods with their recent selling prices.
Once a Potential Problem is Uncovered
As a stakeholder, reviewing year-end financial statements provides insight related to collateral values and financial performance. If the review described in this article uncovered inconsistencies between interim period and year-end financial reporting, the stakeholder should pursue a more detailed understanding of the intricacies associated with standard costing. Standard costing methods are intended to provide an early warning system with respect to the company’s operating and financial performance. If implemented properly, the company will record appropriate variances monthly or as incurred. These variances should be recorded separately on the financial statements and should be a primary focus for the stakeholder. The review of the year-end financial statements provides the stakeholder with an opportunity to gain insight into the standard costing methods used at a company, as well as the impact those processes have on the collateral value, cash flow, and true operating performance of the client company.
If a stakeholder uncovers inconsistencies in the interim and year-end financial statements related to gross profit and inventory, a thorough review of the company’s costing and inventory systems must be undertaken. If problems are uncovered that require additional oversight and review, Focus Management Group has experience in manufacturing management, standard costing processes and implementation, and financial and operating performance of a client company.
Tags: Financial Statements, Focus Management Group, Operating Performance, Stakeholder, Standard Costing, Year-End Financial Statements
Leave a Reply
Click here to cancel reply.