In the context of applying Lean Accounting in manufacturing companies, there have been some arguments that Lean Accounting practices do not comply with Generally Accepted Accounting Principles (GAAP). I decided to write this blog to try to explain from a GAAP perspective, how and why Lean Accounting does comply.
This is a long blog. I considered splitting this up into a series of blogs, but decided otherwise.
The arguments as to why Lean Accounting doesn’t comply with GAAP usually are made around the methods used in Lean Accounting to value inventory and cost of goods sold and how different these methods are from conventional practices.
Conventional inventory valuation is usually done using an ERP system. Here is a simple explanation of how this works. ERP production reporting systems track the movement of materials from receipt, through the production process and finally to shipment. These ERP systems allow for a cost to be assigned to each item in a company’s inventory item master. When costs are assigned, the inventory movement transactions also values inventory and cost of goods sold.
Most of the time a “standard cost” is assigned to each item in inventory, which is why this type of inventory valuation is simply called “standard costing.” And for the sake of simplicity, I’m going to use the term “standard costing” when referring to these conventional inventory valuation systems.
Lean companies using Lean Accounting take a different approach to inventory valuation. Lean Accounting is concerned primarily with the total value of inventory on the balance sheet, rather than the specific value of each individual item held in inventory. Lean Accounting simply employs the “leanest” method possible to value inventory.
Let’s first look at what accounting principles require in regards to inventory valuation, then we will discuss how Lean Accounting complies with all accounting principles.
The valuation of inventory and cost of goods sold is one of most important issues for financial reporting because it is material to the proper determination of income. Inventory valuation is one of most unique components of accounting because GAAP requires companies that carry inventory to capitalize a portion of production costs into inventory to determine the proper reporting of income.
Here is what US GAAP states (note: International Financial Reporting Standards basically say the same thing): “Inventory has significance because revenues may be obtained from its sale. Normally such revenues arise in a continuous repetitive process of cycle of operations in which goods are acquired, created and sold, and further goods are acquired for additional sales. Thus, inventory at any given date is the balance of costs applicable to goods on hand remaining after the matching of absorbed costs with concurrent revenues. In practice, this balance is determined by the process of pricing articles included in inventory.”
What this means in layman’s terms is that a portion of a company’s expenses are moved from the income statement to the balance sheet. Expenses are reduced and this increases profits. So it’s easy to understand how important inventory valuation is for financial reporting.
There are two issues related to inventory valuation – the value of inventory on the balance sheet and the determination of cost of goods sold.
GAAP states that inventory must be valued at cost, which is the same as all other assets on a balance sheet. Cost is defined as the actual expenses incurred to get goods (products that are sold) in condition for sale. These expenses are the actual cost of materials plus a portion of the actual costs of production. GAAP also recognizes the inherent complexity of inventory valuation: “it is understood to mean acquisition costs and production cost, and its determination involves many considerations.”
Proper valuation of cost of goods sold is related to the matching principle, which states that all expenses recognized in any period should be the expenses incurred to generate the revenues recognized. Because cost of sales is often times the largest expense on the income statement of a manufacturing company, it is material to the proper determination of income. GAAP states this as follows: “A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues.”
The issues in a manufacturing company in determining cost of goods sold are related to continuous nature of manufacturing. Products produced in one period may not be sold until a subsequent period. The prices paid for purchased items may change. And finally, actual production costs change over time. This makes matching the specific, actual production costs to the revenue reported quite difficult.
GAAP recognizes that calculating the exact, specific cost of an item in inventory and cost of goods sold really cannot be done because of the timing issues of good produced and sold, material costs changes and determining the exact manufacturing costs incurred for goods in inventory. ASC 330 states: “although the principles for the determination of inventory costs may be easily stated, their application, particularly to such inventory items as work in process and finished goods, is difficult because of the variety of considerations in the allocation of costs and charges.”
To overcome this problem, GAAP allows companies to use a cost flow assumption to value inventory and cost of goods sold in a consistent and systematic manner that best reflects income.
Companies must use a consistent method over time, which means a company can’t simple switch cost flow assumptions year-to-year. If a company changes its cost flow assumption it is considered a change in accounting method and must be disclosed in audit reports.
There are 4 cost flow assumptions that can be used: FIFO, LIFO, average cost or specific identification. FIFO (First-in-First Out) means the most recent costs are assigned to ending inventory. LIFO (Last-in-First Out) means most recent costs are assigned to cost of good sold, which usually results in less income reported than under FIFO. Average cost means that inventory and cost of goods sold are valued at the average costs of all goods available for sale. Specific Identification means a company can accumulate the exact, specific costs of each item in inventory, which is rare but possible if a company doesn’t have many different types of products it sells. (Note: IFRS does not allow the use of LIFO, which is one of the most significant differences between it and US GAAP. There are currently discussions going on about how to basically merge US GAAP with IFRS and have one worldwide set of accounting standards.)
By consistently applying a cost flow assumption to value inventory, it will also mean that cost of goods sold is also properly stated.
This is because cost of goods sold is really the difference between goods available for sale (beginning inventory + purchases) and ending inventory. Here is the method to determine cost of goods sold, based on the following equation:
Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold
- Beginning inventory in any period is known, and would be properly valued using the cost flow assumption.
- Purchases in any period are known and it’s easy to determine the value of purchases in any period.
- Ending inventory based on the cost flow assumption. The capitalization of production costs between the balance sheet and income statement is adjusted at the end of each period based on the change in inventory quantities during the period
- Cost of goods sold is then considered correct because the other 3 components of the equation are correct
What the accounting principles mean in practice is that as long as a company’s method of inventory valuation approximates cost, and is applied in a consistent manner, the company’s financial statements are compliant with GAAP. Determining if inventory approximates cost and is applied in a consistent manner is usually determined by the company’s outside auditors, who will issue an unqualified opinion on the financial statements.
During the audit, the auditors will test company’s inventory valuation methodology to determine if it approximates cost. If it “passes” the audit tests, inventory is considered properly valued. If the tests are “not passed” the auditors will tell the company what adjustments need to be made to “pass” the test.
How Lean Accounting Complies with GAAP
Lean Accounting uses the cost flow assumption of average cost to value inventory and cost of goods sold. Accounting principles require inventory to be valued at cost, which is composed of the cost of material and a portion of the production costs. Let’s look at how Lean Accounting calculates average material costs and average production costs.
Calculating average material cost is dependent on three factors: the number of purchased items, price stability and rate of flow of materials.
For a company with thousands of items calculating the average material cost per unit should be done at either the individual item level or by common product families. A company with few items of purchased raw material or components can do an overall average material cost.
For stable material prices, the average cost may be calculated less frequently (annually or semi-annually). In cases where material prices are highly volatile, the average cost may have to be calculated more frequently, such as monthly.
The final factor in calculating average material cost is the rate of flow of materials, which is typically measured in days of inventory. The rate of flow helps determine which costs to average. For example, a company has 30 days of inventory on hand this means, on average, the inventory was purchased in the last 30 days, and average cost would be calculated based on cost changes over the last 30 days.
The actual mechanics of calculating the material value of inventory is usually dependent on the number of purchased items a company has in its inventory item master. For companies that have hundreds or thousands of purchased items, it’s probably easiest to maintain the quantities of these items in your ERP system. In the cost field for each item the average cost will be entered, rather than a standard cost that remains frozen for one year.
For companies with few purchased items a simpler method could be employed.
- All purchases are recorded as expenses in the period (to cost of goods sold).
- At the end of each period, the ending inventory value of material would be calculated as follows:
Finished Goods = quantity on hand X average cost per unit
Work in Process = quantity on hand X average cost per unit X average % complete.
- Adjust material value on the balance sheet to ending inventory using a journal entry
The capitalization of production costs can be done at a macro level, in total using a journal entry, rather than item-by-item, regardless of the number of items of inventory.
- Average cost per unit for the month is calculated using the actual production costs (all costs but material) from the value stream income statement divided by the actual units produced.
- The amount of production costs that need to be capitalized as ending inventory is calculated as follows:
Finished Goods = quantity on hand X average cost per unit
Work in Process = quantity on hand X average cost per unit X average % complete
- Adjust inventory production cost value on the balance sheet to ending inventory value calculated in #2 above using a journal entry.
As stated earlier, determination of a “consistent method” that “properly reflects income” is really up to the company and its auditors. As long as the auditors are OK with the inventory valuation methodology, it meets GAAP requirements. The key is to understand what type of cost flow assumption is being used.
Benefits of Lean Accounting Inventory Valuation
The process of inventory valuation is simpler, easier and much waste is eliminated under Lean Accounting compared to conventional product costing methods.
There is much less maintenance of costs in Lean Accounting as compared to other methods. The average material cost is relatively simple to calculate and probably doesn’t need to be updated too often unless the material is a commodity. The process of calculating standards and analyzing actual to standards can be eliminated.
In standard costing systems, production costs are gathered item by item using labor and overhead rates. Every time a finished good is completed, its labor an overhead costs are capitalized into inventory. And when a finished good is sold, its cost is transferred from inventory to cost of goods sold. Since Lean Accounting calculates capitalized production costs at a macro level all labor and overhead rates can be set to zero, as they are no longer needed.