The Accounting Process, Part Two - Module 3 of 6

The Accounting Process, Part Two

Inventory

A significant topic in financial accounting is the valuation of inventory as current assets. Its computation involves three steps.[1] The first is to tally the number of items in the company’s inventory. Second, one must assign a unit cost to each item.  Finally, one must determine whether the value of any inventory is lower than its historical cost, which is the amount at which it was recorded.  Under the rules of accounting, inventory must be shown at the lesser of its cost or market value, called LCM. Therefore, an adjusting entry in the company’s books may be necessary at times to correct the inventory’s value.[2]  With any inventory system, the primary goal is to determine the cost of goods sold for an accounting period, that will, in turn, affect net income and owner’s equity. This effectively measures the profitability of a business.

In a periodic inventory system,[3] a company will carry its ending inventory over from the previous accounting period and compare it to the inventory at the conclusion of the current accounting period.  The difference is the inventory consumed during the accounting period. Assigning a unit cost to the inventory consumed yields the cost of goods sold.  

In a perpetual inventory system,[4] the quantity of inventory is immediately updated as it changes. This usually requires computerized inventory tracking systems.  A company thus knows its cost of goods sold at any moment and can use such a system to satisfy operational needs, such as establishing reordering triggers when inventory supplies are low.

When assigning unit values to inventory, many of which are acquired at different costs, specific identification of each unit and its associated cost is often difficult.  This may be more practical under a perpetual inventory system which can immediately record the cost of a good when it is sold. However, for many businesses, this sort of tracking each unit would be impractical, in which case they might rely on cash flow assumptions.[5] 

LIFO and FIFO Cash Flow Assumptions  

One such cash flow approach assumes that the first items stocked in inventory are the first ones sold.  This is called the FIFO method, which stands for “first in, first out.”[6]  This method assumes that the company is carrying the newest inventory on its books.  FIFO is often compared to a pipeline.[7]  The first to enter the pipeline is the first out. 

For example, Acme Corporation acquires 110 “widgets” at $5 each, then a subsequent shipment of 55 widgets at $7 each.  Acme sells 125 widgets.  In a FIFO system, we assume Acme has sold all of its initial 110 widgets that it bought for $5 each because they were the first in.  It then sold 15 more widgets that were purchased for $7 each.  Its cost of goods sold is $550 (110 times 5) plus $105 (15 time 7), for a total of $655.  Note that these are merely assumptions – the actual widgets sold may differ, but that doesn’t matter. The assumptions are merely for valuation purposes, not for tracking specific inventory.  

Another cash flow approach to inventory is to assume that the company is selling its most recently acquired inventory first, and this is called the LIFO method,[8] which stands for “last in, first out.”  Since the inventory carried under the LIFO method will always be assumed to be the oldest inventory, LIFO inventory amounts may only reflect old values and thus be inaccurate.  LIFO is often compared to a barrel.[9]  The last items placed into the barrel are at the top and are thus the first ones out. 

For example, Acme acquires its two shipments of 110 widgets for $5 each and 55 widgets for $7 each. It then sells 125 widgets.  This time we will use LIFO.  Since the last group of widgets obtained are the first ones sold, Acme sold all 55 widgets that it bought for $7 each and the remaining 70 widgets are taken from the first shipment, bought for $5 each.  Acme’s cost of goods sold is therefore $385 (55 times 7) plus the 70 from the first shipment at $5 each, or $350, for a total cost of goods sold of $735.   

Another approach to valuing inventory is the “average cost method,” which relies on an average cost of all units sold during the accounting period. This method typically yields results that are between FIFO and LIFO valuations.[10]

The results of using a FIFO system is unaffected by whether a company uses a periodic or perpetual approach.  A company would ordinarily only employ a LIFO system under a periodic inventory structure, not a perpetual one.[11]  When the average cost approach is used with a perpetual system, the average price of goods sold is updated as soon as a new sale occurs.   

According to the rules of accounting, inventory is carried at the lower amount of cost or market value.  Inventory is reduced in value on a company’s books if its value is less than its cost.  The value is how much the company would have to spend to replace the inventory under current conditions.[12]    

Managing perpetual inventory to minimize both stocking time and idle inventory is called just-in-time inventory and it effectively reduces production costs.  In the inevitable situation where inventory is damaged, lost or stolen, an adjustment is made to a company’s ledgers called shrinkage, which is the difference between what the inventory count should be at a given time and the lower amount reflected in a physical count.

Depreciation

When a company acquires fixed assets, such as property, plant or equipment, they are recorded at cost.  When a fixed asset is exchanged for something other than cash, the asset is recorded at market value, unless the exchange “lacks commercial substance.”[13]  An exchange of commercial substance means a transaction that affects future cash flows, such as acquiring a new machine that will increase future productivity and revenue. A transaction lacks commercial substance if it does not affect future cash flows, such as when a company exchanges an old (but functioning) truck with a new one that will last longer but may not be more productive.

In an exchange of assets lacking in commercial substance that does not involve cash, the newly acquired asset will be recorded as having the value of the asset it replaces.  Typically, this valuation is the asset’s historical cost minus any accumulated depreciation. This is the asset’s “book value.”  The rules become more complex if the exchanges involve dissimilar assets or cash.[14]

Fixed assets are assets that cannot be readily converted into cash and typically include property, plant and equipment.  While real estate tends to increase in value, plant and equipment eventually wear out.  Therefore, a company’s records must show the gradual decline in value of these fixed assets, a process called “depreciation.”[15]  The depreciation amount is periodically recorded in an account called “depreciation expense” and the amount depreciated accumulates in an “accumulated depreciation” tally. Deducting the accumulated depreciation amount from the cost of the asset produces the asset’s book value.[16]

For example, Acme Corporation purchases a plant for $1,000,000. Assume that applicable rules allow it to depreciate the asset at the rate of 3% per year. Each year, it thus allocates a depreciation expense of $30,000 and these increases are added to the asset’s accumulated depreciation.  At the end of the third year, the accumulated depreciation account has a balance of $90,000 and the book value of the plant is $1,000,000 minus $90,000, or $910,000.

Note that there is no attempt here to revalue an asset according to its current market value.  Rather, depreciation is merely a way to record an asset’s eventual decline in value without regard to its market value.[17]  

Tax rules and treasury regulations determine the useful life assumptions and depreciation methods that may be used in taking tax deductions based on depreciating assets.[18]

Depreciation Methods

Three factors determine the depreciated value of a fixed asset.[19]   First is the asset’s “useful life.”  Note that it is not the overall life of the asset, but its useful life.  For example, a company may purchase a plant with 30-year life span, but it will only be useful for 20 years.  Another factor is the “salvage value” of the asset, which is how much the company can get from the sale of the asset at the expiration of its useful life.  The final factor is the method a business mathematically depreciates an asset.  Several formulas are available.

The “straight-line method” is the simplest approach and it merely requires that the company subtract the salvage value of an asset from its cost and divide the result by the number of years in the asset’s useful life.[20]

For example, Acme Corporation acquires a building to produce widgets for $1,000,000 and calculates its salvage value to be $200,000 in ten years, when it can no longer function as a manufacturing facility for Acme.  Subtracting $200,000 from $1,000,000 equals $800,000, which is the total value to be depreciated.  If the asset’s useful life is ten years, Acme will depreciate the building at $80,000 annually.    

Another method, the “sum-of-the-years-digit method,” considers that assets typically depreciate more at the outsets of their lives than later on (consider a $25,000 car, which may lose $2,000 or more of its value in the first year, but may only lose a couple of hundred dollars in value, if that, during its 12^th year). Here the company totals the digits in the years that comprise the asset’s useful life.[21]  For each year of the asset’s useful life, the company multiplies the difference of the cost and salvage times a fraction, the numerator of which is the remaining years of the asset’s useful life and the denominator is the sum of the digits in that useful life.  Because large amounts are subtracted from the value of an asset early in its useful life, this method is commonly referred to as an “accelerated depreciation method.”[22]

For example, Acme acquires a production facility for $1,000,000, with a salvage value of $200,000 and a useful life of ten years.  The sum of ten years is 55 (1+2+3, etc.). So, during the first year Acme would deduct 10/55 of $800,000 or $145,455.  The second year Acme would deduct 9/55 of $800,000 or $130,909, then 8/55 of $800,000 or $116,364 the following year, and so on.

A third depreciation method is the “declining balance method,” which is also an accelerated depreciation method.  With this method, the asset is depreciated from its full value down to its salvage value.[23]  The company multiplies the remaining book value of the asset, which is its cost minus any accumulated depreciation, by a predetermined percentage.  The balance will, over time, decline, hence the name “declining balance” method.  Frequently, the percentage used is 20%, which is called the “double-declining balance method.”[24]  Note that in this approach no initial subtraction of salvage value occurs and therefore, the only role of the salvage value is the stopping point of the depreciation deductions, since an asset cannot be depreciated below its salvage value.[25]      

For example, we will again return to Acme’s $1,000,000 plant and assume that Acme will deduct 20% of the plant’s book value every year.  The first year, Acme deducts $200,000 as a depreciation expense, leaving a residual value of $800,000.  In the second year, Acme deducts $160,000, which is 20 percent of $800,000 and leaves a residual value of $640,000, and so on.  Note that Acme must stop taking deductions once a deduction would reduce the asset below its $200,000 salvage value.

A fourth method is the “units of production method,” where the difference between the cost of the asset and its salvage value is divided by the expected total units of production the asset generates for that accounting period.[26] This approach is also used in the depletion of natural resources, such as mines.  In this case, the units mined are used for the units of production in the formula.[27]

For example, the Acme’s $1,000,000 plant has a book value of $800,000 and it is expected to produce 1,600,000 widgets over the course of its useful life.  800,000 divided by 1,600,000 shows a depreciation rate of 50 cents per widget.  If Acme produces 120,000 widgets in the first year of its newly acquired plant’s operations, then it would depreciate the plant by $60,000, which is 120,000 times fifty cents.

This method considers that newer plants and assets are often more efficient than older plants and so more of their values are used early-on in their lives.  

The final method, provided by the US Tax Code, is called the “Modified Accelerated Cost Recovery System” or MACRS.  It eliminates the concepts of useful life and salvage value, and instead sets up a declining balance schedule.  The schedule classifies assets into categories and specifies the amounts that may be expensed annually as depreciation.[28]   

Capitalization of and Disposal of Assets

Another transaction that can affect depreciation accounts are improvements, which are also capitalized, and increase the allowance for depreciation.  Note that repairs are merely recorded as expenses and cannot be capitalized or depreciated.  A cost that is capitalized is included as part of the cost of the asset.[29] An example of an improvement might be adding a wing to an existing factory. Replacing the burnt-out air conditioning system would merely be a repair and does not change the accounting value or cost-basis of the property.   

When a company disposes of an asset, it removes the depreciation amounts from its books and records any gain or loss realized from its disposal.  Special complex accounting rules dictate how to record an asset that becomes impaired.  Essentially, it is recorded as a loss that will affect shareholder equity because it reduces the overall value of the business.[30]  

After looking at inventory and depreciation methods, we may wonder which is best.  LIFO tends to report lower income and it is favored for income tax purposes (because it typically results in higher costs of goods sold since inventory acquired more recently is usually more expensive).  Under the rules of accounting, a company cannot use one inventory valuation method for its financial accounting statements and a different inventory valuation method for its tax statements.  However, it may do so for depreciation methods.[31]

For example, Acme Corporation uses the LIFO method for both its financial statements and tax reporting obligations.  However, it uses straight-line depreciation for its financial reporting because the straight-line method tends to report higher earnings, while it uses the double-declining balance method of accelerated depreciation for tax purposes because it tends to lower income.

The methods that a company elects to use can have a profound influence on its measures of profitably and tax liability, and these methods that a company chooses can be found in the footnotes of its financial statements.[32] 

In our next module, we’ll continue with our discussion of the accounting process.