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Accounting for Managerial Decision-Making
To start a new business and remain in business profitably, many critical decisions must be made when the foundation of a new business is formed. These decisions affect the company in the long run and often make or break an organization. Methods of inventory control and capitalization policies are among these critical decisions that will affect any business bottom line.
Our team has investigated these policies and will present our recommendation for the method of inventory and capitalization policy for the XYZ Mattress Store in the remainder of this paper.
Selecting the valuation method for reporting and valuing is based on key issues relating to the relevance and reliability of the method of accounting for that item. According to finetuning.com (2005) "how you identify items in inventory and determine which have been sold will depend on the nature of the products, the volume of the products, how they are tracked, and inventory rotation." Key factors to consider under the inventory policy are: location of storage facilities, temperature, security, rotation of stock, cost, training, periodic inventories, and control.
caycon.com (2005) wrote: "Valuing a startup is intrinsically different from valuing established companies. Because of the high level of risk and often little or no revenues, traditional quantitative valuation methods like (P/E) per-share earnings comparables or discounting free cash flows are of little use. Startup valuations are largely determined based on qualitative attributes." To select an inventory valuation method, the options are FIFO, LIFO and Weighted Average.
The valuation method for (FIFO) First-in, first out: Answers.com (2005) defines this as a "common method for recording the value of inventory. It is appropriate where there are many different batches of similar products." This method describes the first item coming in will be the first item going out of the inventory. Retailinventories.com (2005) wrote "cost flow assumption assumes that the oldest inventory is sold first. The ending balance of inventory is valued at the most recent purchase price. FIFO produces a more relevant balance sheet since the ending balance in inventory reflects its current value." An example of this would be: Ending balance in inventory would be 30 units of the most recent purchases. 30 x 300=9,000 E/B = 9,000.
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The valuation method for (LIFO) Last-in, first out: Moneycentral.com (200 describes LIFO as "a method of valuing your inventory that assumes any inventory you sold was from the last inventory you purchased." Retailinventories.com (2005) wrote "the cost flow assumption assumes that the newest inventory is sold first." The ending balance in inventory is valued at the oldest purchase price. When the cost lowers, this method will give results of a higher cost of sales. The strength of LIFO is used to save money in taxes. The weakness of LIFO will produce the lowest net income in inflationary times.
The valuation method for Weighted Average is best suited for companies that carry like items in their inventory similar to our mattress retail store. Realinventories.com (2005) wrote, "Weighted average divides the total cost of goods available for sale by total units available for sale, then multiplying by the ending balance. Average is assigned a weight. These weightings determine the relative importance of each quantity on the average. Weightings are the equivalent of having that money like items with the same value involved in the average." The strength of weighted average method is that there is no way to manipulate income. The weakness of a weighted average method is not good to be used on the different types of inventory (Marshall, 2003).
The current economic environment (Inflation/Deflation) plays a major role in the selecting the correct method of inventory valuation. "In the time rising cost, LIFO results in lower ending inventory and higher cost of goods sold than FIFO. These changes occur because the LIFO assumption results in most recent, and higher, costs being transferred to cost of goods sold. When purchase costs are falling, the opposite is true" (Marshall, 2003). After carefully examining the above inventory methods, considering the current rebounding economy, Team A Consulting recommendation is the use of LIFO inventory method.
One of the most important aspects to reporting and valuing assets is a company's capitalization policy. Investopedia.com (2005) defines capitalization as "where costs to acquire an asset are included in the price of an asset or the sum of a corporation's stock, long-term debt and retained earnings." An example of capitalization would be our mattress retail store spending $10,000 for purchasing several mattresses then spending an additional $2,000 on proper storage equipment for these items. In accordance with capitalization the company must include both costs in the corporation's total assets.
According to Investopedia.com (2005) the definition of capitalizing is a "method used to delay the recognition of expenses by recording the expense as a long-term asset." A mattress retail store would want to capitalize long-term items such as cash registers, additional storage space, and distribution vehicles. Yes, the company could attempt to capitalize on new economic mattresses but these items are normally not kept in stock for long periods of time. This would create a false representation of the corporation's actual revenue.
Developing a capitalization threshold is a simple process. We must first look at what items we will have on hand for a long period. These items would include exotic mattresses, high-dollar headboards, and waterbeds. The one important aspect to remember is to ensure the organization includes these items as well as permanent property such as machinery, buildings, and other durable items. The organization must then determine the average price of the elements in order to determine an accurate threshold (Marshall, 2003).
The next step in ensuring that the company has developed an effective capitalization policy is to determine when to use different depreciation methods. Marshall (2003) wrote, "For purposes of reporting to stockholders, most firms use the straight-line depreciation method because in the early years of an assets life it results in lower depreciation expense and hence a higher reported net income than accelerated depreciation." Related to the fact that straight-line depreciation decreases the net worth of a product slowly over time as opposed to the expedient depreciation, which is caused by the usage of the accelerated format the straight-line method is the best course of action for a retail mattress company.
The rationale for this is that modern technology does not allow for many items to be continuously sold to the public over a certain length of time. When an item remains close to its original value for the beginning of its life span it is cost-effective to the organization. In conclusion, since all items will either be sold or outdated shortly after their original manufacturing date the straight-line depreciation method is recommended.
Justifications for an Inventory and Capitalization Policy
Capitalization and inventory policies are necessary in order to ensure compliance with Generally Accepted Accounting Principles (GAAP); to establish procedures for the management and control of assets owned. The purpose of a fixed asset inventory policy is to have an understanding of the method used to gather and maintain information needed for the preparation of the company's financial statements as well as providing control over the accounting systems. An asset capitalization policy is necessary to establish a reasonable capitalization threshold for all types of assets. A threshold on the asset capitalization would assist a company in determine whether an asset should be reported on a balance sheet (Capitalization, 2005).
Alternative methods of Valuation
There is a distinction between price and value. Price reflects what investors expect to collect and value implies that the investor believes something different from what the market believes. It would be important for the investor to understand where the market stands as to value. Valuation could be described as investors trading cash today for future claims on the cash flow (Credit, 2001). Two alternative approaches are used for valuing capital-investment decisions. "The first and most widely used for project-oriented capital investments discounts the after-tax free cash flows by the weighted-average cost of debt and equity (capital) to determine if the results will yield a positive net present value" (Harris, 2000). The main alternative used is known as the equity residual (ER). This method values the remaining cash flow (after debt-service) to equity, which is discounted by the cost of equity.
The significant difference in the 2 methods is the treatment of financial leverage and the effects the debts use on value. "When determining the value of a business enterprise, there are three general approaches available to the valuation professional: the market approach, the income approach, and the asset approach. These are also commonly referred to as the market capitalization, discounted cash flow and adjusted book value approaches, respectively. The choice of which approach to use in a particular situation will depend upon the specific facts and circumstances associated with the company, as well as the purpose for which the valuation analysis is being conducted" (Valuation, 2005).
The XYZ Mattress Store faces many challenges as it makes the many decisions that are required when starting up a new business. When evaluating the mattress business one must decide on what method of inventory control and capitalization will be used. The inventory method that we encouraged was the LIFO (Last In, First Out) method, which allows for the company to lower the impact of taxes owed. This is crucial to a start up as most start up companies expect losses in the first year. When determining a capitalization threshold for the store, we chose to use the straight-line method of depreciation to utilize the value of our products over a period of time. These decisions and other variables will determine if XYZ Mattress Store will survive this very competitive market.
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