What Is Average Cost Method?

Average cost method assigns a cost to inventory items based on the total cost of goods purchased or produced in a period divided by the total number of items purchased or produced. Average cost method is also known as weighted-average method.

Understanding the Average Cost Method

Businesses that sell products to customers have to deal with inventory, which is either bought from a separate manufacturer or produced by the company itself. Items previously in inventory that are sold off are recorded on a company’s income statement as cost of goods sold (COGS). COGS is an important figure for businesses, investors, and analysts as it is subtracted from sales revenue to determine gross margin on the income statement. To calculate the total cost of goods sold to consumers during a period, different companies use one of three inventory cost methods:

Average cost method uses a simple average of all similar items in inventory, regardless of purchase date, followed by a count of final inventory items at the end of an accounting period. Multiplying the average cost per item by the final inventory count gives the company a figure for the cost of goods available for sale at that point. The same average cost is also applied to the number of items sold in the previous accounting period to determine the COGS.

Example of Average Cost Method

For example, consider the following inventory ledger for Sam’s Electronics:

What Is an Annual Report?

An annual report is a document that public corporations must provide annually to shareholders that describes their operations and financial conditions. The front part of the report often contains an impressive combination of graphics, photos, and an accompanying narrative, all of which chronicle the company’s activities over the past year and may also make forecasts about the future of the company. The back part of the report contains detailed financial and operational information.

Understanding Annual Reports

Annual reports became a regulatory requirement for public companies following the stock market crash of 1929 when lawmakers mandated standardized corporate financial reporting. The intent of the required annual report is to provide public disclosure of a company’s operating and financial activities over the past year. The report is typically issued to shareholders and other stakeholders who use it to evaluate the firm’s financial performance and to make investment decisions.

Typically, an annual report will contain the following sections:

In the U.S., a more detailed version of the annual report is referred to as Form 10-K and is submitted to the U.S. Securities and Exchange Commission (SEC). Companies may submit their annual reports electronically through the SEC’s EDGAR database. Reporting companies must send annual reports to their shareholders when they hold annual meetings to elect directors. Under the proxy rules, reporting companies are required to post their proxy materials, including their annual reports, on their company websites.

Special Considerations

The annual report contains key information on a company’s financial position that can be used to measure:

• A company’s ability to pay its debts as they come due
• Whether a company made a profit or loss in its previous fiscal year
• A company’s growth over a number of years
• How much of earnings are retained by a company to grow its operations
• The proportion of operational expenses to revenue generated

The annual report also determines whether the information conforms to the generally accepted accounting principles (GAAP). This confirmation will be highlighted as an “unqualified opinion” in the auditor’s report section.

Fundamental analysts also attempt to understand a company’s future direction by analyzing the details provided in its annual report.

Mutual Fund Annual Reports

In the case of mutual funds, the annual report is a required document that is made available to a fund’s shareholders on a fiscal year basis. It discloses certain aspects of a mutual fund’s operations and financial condition. In contrast to corporate annual reports, mutual fund annual reports are best described as “plain vanilla” in terms of their presentation.

A mutual fund annual report, along with a fund’s prospectus and statement of additional information, is a source of multi-year fund data and performance, which is made available to fund shareholders as well as to prospective fund investors. Unfortunately, most of the information is quantitative rather than qualitative, which addresses the mandatory accounting disclosures required of mutual funds.

All mutual funds that are registered with the SEC are required to send a full report to all shareholders every year. The report shows how well the fund fared over the fiscal year. Information that can be found in the annual report includes:

• Table, chart, or graph of holdings by category (e.g., type of security, industry sector, geographic region, credit quality, or maturity)
• Audited financial statements, including a complete or summary (top 50) list of holdings
• Condensed financial statements
• Table showing the fund’s returns for 1-, 5- and 10-year periods
• Management’s discussion of fund performance
• Management information about directors and officers, such as name, age, and tenure
• Remuneration or compensation paid to directors, officers, and others

The Bottom Line

Public companies must produce annual reports to show their current financial conditions and operations. Annual reports can be used to examine a company’s financial position and, possibly, understand what direction it will move in the future. These reports function differently for mutual funds; in this case, they are made available each fiscal year and are typically simpler.

What Is Accrual Accounting?

Accrual accounting is a financial accounting method that allows a company to record revenue before receiving payment for goods or services sold and record expenses as they are incurred.

In other words, the revenue earned and expenses incurred are entered into the company’s journal regardless of when money exchanges hands. Accrual accounting is usually compared to cash basis of accounting, which records revenue when the goods and services are actually paid for.

Learn more about accrual accounting and how it differs from the other popular accounting method, cash accounting.

How Accrual Accounting Works

The general concept of accrual accounting is that accounting journal entries are made when a good or service is provided rather than when payment is made or received. Entries are also made for debts and payments due.

This method allows the current and future cash inflows or outflows to be combined to give a more accurate picture of a company’s current and long-term finances.

Accrual accounting follows the matching principal, which states that revenues and expenses should be recorded in the same period.

Accrual accounting is encouraged by International Financial Reporting Standards(IFRS) and Generally Accepted Accounting Principles (GAAP). As a result, it has become the standard accounting practice for most companies except for very small businesses and individuals.

Qualifying for Accrual Accounting

Larger companies are required to use the accrual method of accounting if their average gross receipt of revenues is more than $25 million over the previous three years. If a company does not meet the average revenue requirement, it can choose to use cash basis or accrual as its accounting method.

Accrual accounting is always required for companies that carry inventory or make sales on credit, regardless of the company size or revenue.

Benefits of Accrual Accounting

The accrual method does provide a more accurate picture of the company’s current condition, but its relative complexity makes it more expensive to implement.

This method arose from the increasing complexity of business transactions and a desire for more accurate financial information. Selling on credit, and projects that provide revenue streams over a long period, affect a company’s financial condition at the time of a transaction. Therefore, it makes sense that such events should also be reflected in the financial statements during the same reporting period that these transactions occur.

Under accrual accounting, firms have immediate feedback on their expected cash inflows and outflows, making it easier for businesses to manage their current resources and plan for the future.

Accrual Accounting vs. Cash Accounting

Accrual accounting can be contrasted with cash accounting, which recognizes transactions only when there is an exchange of cash. Additionally, cash basis and accrual differ in the way and time transactions are entered.

Cash Basis of Accounting

Cash accounting uses transactions when payments are made. For example, consider a consulting company that provides a $5,000 service to a client on Oct. 30. The client received the bill for services rendered and made a cash payment on Nov. 25. Under the cash basis method, the consultant would record an owed amount of $5,000 by the client on Oct. 30, and enter $5,000 in revenue when it is paid on Nov. 25 and record it as paid.

Accrual Basis of Accounting

In contrast, accrual accounting uses a technique called double-entry accounting. When the consulting company provided the service, it would enter a debit of $5,000 in accounts receivable (debits increase an asset account). When the payment is made on Nov. 25, the consultant credits (credits decrease an asset account) the accounts receivable by $5,000 and credits the service revenues account, a revenue account (credits increase a revenue account ) with $5,000.

The received capital can then be moved to other accounts, such as free cash, if needed—the company uses the same double-entry method to enter which account the capital came from and is moved to.

The Bottom Line

Accrual accounting is an accounting method in which payments and expenses are credited and debited when earned or incurred. Accrual accounting differs from cash basis accounting, where expenses are recorded when payment is made and revenues recorded when cash is received.

Accrual accounting uses double-entry accounting, where there are generally two accounts used when entering a transaction. This method is more accurate than cash basis accounting because it tracks the movement of capital through a company and helps it prepare its financial statements.