Some people in the accounting profession make an argument that Lean Accounting is not compliant with GAAP/IFRS (for the rest of this article I will simply use GAAP instead of GAAP/IFRS). This argument usually occurs in manufacturing companies and centers around the Lean Accounting practices of simplified inventory valuation and using a value stream income statement.
In this blog, I will look at two accounting principles – Inventory Valuation and the Matching Principle, and explain how simplified inventory valuation and a value stream income statement both meet GAAP requirements.
Capitalization of Inventory
The Accounting Principle: A portion of actual manufacturing costs must be capitalized on the balance sheet for financial reporting purposes to properly value inventory. GAAP states that actual costs be capitalized for financial reporting. GAAP does not require that a standard costing system be used to do this.
The Argument for Standard Costing: Standard costing proponents cite 2 reasons why using standard costing to capitalize inventory is better than using value stream income statements – accuracy and automation.
The accuracy reasoning is based on thinking that if each individual product cost is determined, inventory accuracy will be realized. The automation reasoning is that an ERP system can do this work, all you have to do is set up standards and report production.
This reasoning is usually developed in an environment of high inventories.
When completed production is reported in an ERP system-using standard costing, the value of that inventory is posted as finished good inventory and changes the inventory balances on the balance sheet. Because the standard cost is composed of material, labor, and overhead it capitalizes manufacturing costs and the inventory valuation principle is met.
Standard costing is not wrong, as long as standards are “accurate”. But this is not a simple task because of all the time & effort that goes into maintaining a standard costing system and all the effort to report transactions. And we all know that this creates even more work – reporting and analyzing variances. Accuracy in standard costing is an ever-moving target.
So the automation “benefit” of a standard costing system comes at a cost of being “accurate”. Also, the benefit of automation also requires a fully integrated ERP system to do all the transactions automatically. I’ve seen too many companies where this doesn’t exist. Because of various “system limitation issues” finance departments must often employ work-arounds, such as using spreadsheets and/or transferring information between systems that don’t talk to each other. So automation comes at a tremendous cost of time and effort.
The Argument for Lean Accounting: Now let’s think of inventory valuation is a lean company.
In a company with 30 days of inventory, it’s possible to adjust the inventory balance on the balance sheet with a simple journal entry. The value stream income statement expenses represent the actual cost of production for products produced in the period. These products have either been shipped or are in WIP or finished goods inventory.
The proper inventory balance for any period on the balance sheet is simply the actual cost of production multiplied by the ratio of quantity on hand to total quantity produced.
The process to record the proper inventory balance is simply a journal entry that adjusts the balance sheet to the new ending balance with the offsetting entry posted to cost of good sold.
This method of inventory valuation meets GAAP requirements and is accepted by auditors. Typically a company must have around 30 -60 days of inventory to simplify the capitalization of manufacturing costs onto the balance sheet for financial reporting purposes
The Matching Principle & the Value Stream Income Statement
The Accounting Principle: The matching principle means the income statement expenses must be matched to related revenues for any reporting period. To understand this better think of a cause-effect relationship. The expenses recorded for any period should be the costs associated with generating the revenues recorded.
The Argument for Standard Costing: Standard costing proponents argue that a standard costing system does this quite well. Let me explain.
When products are shipped in a standard costing system, the standard cost of the product is credited from inventory and debited to cost of sales. So the cost of production of each product shipped (its standard cost) is matched to the related revenue. Finally, the variances and absorption numbers, which appear as part of cost of sales, are assumed to “adjust” the standard cost of sales to actual cost of sales. Therefore actual cost of sales (standard cost of good sold + variances) equals actual costs of products shipped.
But the flaw in this reasoning is the sum of standard cost of goods sold + variances equals actual cost of goods sold. The variances are based on the current month’s production, not products shipped. In a high inventory environment, the products shipped in any period may not have been made in that period.
The Argument for Value Stream Income Statements: Now let’s look at a lean company with 30 days of inventory, which means the actual costs on a value stream income statement represent the total cost of products produced in the period. So, the relevant costs for the revenue recognized on the income statement are the actual value stream costs for the month, plus or minus the change in inventory valuation. Matching principle met, end of discussion.
I realize I’ve made my arguments based on lean companies with 30 days of inventory, and when most companies begin lean journeys inventory levels are higher. That is why when you begin Lean Accounting inventory valuation is still an important issue for financial reporting purposes. But it doesn’t mean you can’t begin using Lean Accounting.
You can begin using the Box Scores for weekly operational performance review and business decision making if you have Lean practices in place, but still have high inventories. It’s important in the beginning of the Lean journey for accounting to turn away from using traditional variance-style analyses and start using Lean Accounting.
But accounting still must deal with inventory valuation.
Accountants must understand inventory valuation is a finance issue and not an operations issue. If accounting must continue to use standard costing to value high levels of inventory, simplify it as much as possible.
Accounting can reduce the number of labor and overhead rates, flat bills of material, simple routers. Simplify transactional reporting. Take as much work out of standard costing as possible.
Accounting & Lean Operations must work together to understand how & when inventory will be reduced. Experienced lean people can usually tell you how much they think inventories will be reduced and by when. This will give accounting a good idea when your company will get to 30 days of inventory and accounting can reap their benefits of a Lean Accounting – simplified inventory valuation and turning off labor and overhead rates in a standard costing system.