Accounting: The Language of Business - Vol. 2 (Intermediate: Part 23)

And just remember, every dollar we spend on outsourcing is spent on U.S. goods or invested back in the U.S. market. That's accounting.

Arthur Laffer

Judgment and Applied Financial Accounting Research (Part H)

by

Charles Lamson

Applying the Research Process

Building research skills is critical to success in the accounting profession. The significant volume of accounting standards makes it impossible to commit them to memory. In addition, the business environment is constantly changing, requiring revisions of accounting standards. Nonetheless, professionals must be able to find the answers to technical accounting questions in order to function effectively on a day-to-day basis. Acquiring research skills takes a great deal of practice. To illustrate, let's take the case of deciding whether to capitalize or expense certain costs incurred during the production process (Example 3.2).

EXAMPLE 3.2

The Financial Reporting Research Process

PROBLEM: Tough Guy Enterprises, a U.S. GAAP reporter, manufactures high quality jeans for little boys. The cost to produce one pair of jeans includes $10 of material and $5 for labor. Tough Guy produced the following number of genes over the last 5 years:

Additional data are available for the current year (Year 6):

Search the Codification to determine how to record each type of cost. Write a memo to the file to communicate your results.

SOLUTION: We will follow the steps in the financial accounting research process.

1. Establish and understand the facts.

The facts are straightforward, as captured in the problem statement. In real-world problems, the facts are typically more difficult to identify. 

Tough Guy Enterprises is a U.S. GAAP reporter that manufactures jeans. It produced the following number of jeans over the past five years:

 Additional facts for the current year or Year 6:

2. Identify the issue: What is the research question?

The accounting issue is whether Tough Guy should record expenditures as an expense (expensed) or as an asset (capitalized as part of the cost of inventory) and included in cost of goods sold when the inventory is sold. As a result, the research question is which of these expenditures should Tough Guy allocate to inventory and which should it expense immediately?

3. Search the authoritative literature.

We begin our search using Codification Topic 330 – Inventory (Appendix A from part 20). None of the industry subtopics is relevant (agriculture, airlines, contractors, entertainment, extractive activities, real estate, software). Next, we review the Overall subtopic, ASC 330–10. Because we are interested in the way Tough Guy will initially record inventory, we will use Section 30 – Initial Measurement of ASC 330–10.

4. Evaluate the results of the search.

A thorough review of Section 30 identifies the relevant parts of the Codification to use in developing a conclusion, as summarized next.

5. Develop conclusions.

The conclusions are clear in this case with one exception: fixed overhead allocation. The allocation of the fixed production overhead is more complex than the other costs. According to ASC 330-10-30–3, the allocation of fixed production overhead is based on the normal capacity of the production facility. Normal capacity is the production expected to be achieved over a number of periods and under normal circumstances. In this case, we estimate normal capacity at 5 million pairs of jeans per year, which is the average of the prior five years of production (5.0, 5.1, 4.9, 4.8, and 5.2 million). Thus, we would allocate $1 per pair of jeans to inventory (the fixed overhead of $5 million dollars divided by the normal capacity of 5 million pairs of jeans). The total amount of fixed overhead allocated to inventory is $4.2 million ($1 per pair * 4.2 million pairs produced during the current year).

The following table lists the expenditures and their proper accounting treatment (expense versus capitalize).

6. Communicate the results of the research.

     The following memo to the file documents the results of the research.   

MEMORANDUM TO THE FILE

FACTS

Tough Guy Enterprises manufactures jeans and is a U.S. GAAP reporter. The company produced 4.2 million pairs of jeans in the current year and the following number of jeans over the preceding five years:

Tough Guy has incurred the following expenditures related to its gene production during the current year: 

ISSUE

Which of these expenditures should Tough Guy allocate to inventory and which should it expense immediately?

ANALYSIS

ASC 330-10-30–1 indicates that inventory is typically stated at cost (i.e., the cost incurred to bring the inventory to its existing condition and location).

ASC 330–10-30-3 states that variable production overhead costs are allocated to each unit of production on the basis of the actual use of the production facilities. The allocation of fixed production overhead is based on the normal capacity of the production facility where normal capacity is defined as the production expected to be achieved over a number of periods and under normal circumstances. ASC 330–10-30–6 allows the actual level of production to be used if it approximates normal capacity.

ASC 330–10-30-6 explains that the amount of fixed overhead allocated to each unit of production should not be increased in periods of abnormally low production.

ASC 330–10-30–7 requires that unallocated overhead costs be recognized in the period they are incurred and that wasted materials (spoilage) be recognized in the period they are incurred.

ASC 330–10-30-8 stipulates that general and administrative expenses should typically be recognized as expenses if they are not clearly related to production. Also, selling costs should not be included in inventory.

CONCLUSION

The conclusions are clear in this case with no exception: fixed overhead allocation. The allocation of the fixed production overhead is more complex than the other costs. According to ASC 330-10-30–3, the allocation of fixed production overhead is based on the normal capacity of the production facility. Normal capacity is the production expected to be achieved over a number of periods and under normal circumstances. In this case, we estimate normal capacity at 5 million pairs of jeans per year, which is the average of the prior five years of production (5.0, 5.1, 4.9, 4.8, and 5.2 million). Thus, we would allocate $1 per pair of jeans in inventory (the fixed overhead of $5 million divided by the normal capacity of 5 million pairs of jeans).

In conclusion, Tough Guy should allocate $73.5 million to inventory and expense $6.25 million immediately. Specifics of this allocation are detailed in the following table.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 71-75*                          

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