I spoke last month at a CFO Conference about Lean Accounting. After explaining the use of actual costs on a value stream income statement, we had a good discussion about whether a value stream income statement complies with the matching principle of financial accounting.
This question has actually come up quite regularly over the years that I have been involved in lean accounting, so I decided to write a short blog on this topic.
The Matching Principle – defined & explained for manufacturing companies
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. (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.
To summarize, what this means 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.
The Value Stream Income Statement – Mature Lean Company
Lean Accounting practices state a value stream income statement should show the actual material and production costs for the period being reported. In a lean company with 30-60 days of inventory, the actual costs on a value stream income statement will closely align with the associated revenue, since the products sold were produced within the last 30-60 days. In this case, a value stream income statement does comply with the matching principle.
The Value Stream Income Statement – Early Stage Lean Company
In an early stage lean company, inventory is usually high, so a value stream income statement will not comply with the matching principle because it’s probable that the units sold in any period were produced in a prior period and the actual production costs of the period are not reflective of the cost to produce the products sold.
When accounting professionals make the argument that a value stream income statement doesn’t comply with the matching principle, this is the situation they are talking about. And they are correct in making this point.
However, a value stream income statement is an internal document, so strict GAAP compliance is not necessary. Also, the intended use of a value stream income statement must be maintained as a priority – for lean operations and accounting to jointly identify the root causes of actual costs to better manage costs.
Wrap Up: It’s an Evolution
It’s important for accounting professionals to understand that the value stream income statement evolves over time to meet the matching principle as lean practices reduce inventory. At the beginning of the lean journey, a value stream income statement may not fully comply with the matching principle. But as inventories are reduced, it eventually will comply.
The accounting function in a lean manufacturing company should create & produce value stream income statements at the beginning of the lean journey to learn the true drivers of actual production costs, which relate to flow, pull & waste. This is the information that your internal customers, lean operations, need to manage its costs. Lean operations cannot do this with a standard costing based income statement, expense report or variance analysis.