Once the appraiser understands what type of cost method and reporting system a company is using, an investigation must be undertaken as to the makeup of that cost. In other words, the appraiser needs to understand fully the company’s inventory price structure. One question an appraiser would ask of a company is “How do you account for reserves?” A reserve is an adjustment against an inventory, which is typically for slow-moving or obsolete items. If a company has accounted for reserves in their balance sheet against its inventory, an appraiser would need to know if that amount has been deducted from the value of the actual items contained in the inventory, or recorded as a period cost adjustment. If reserves have been deducted from an item’s unit cost that deduction may need to be added back into the cost structure for the appraiser to begin his value analysis.
Another question an appraiser would ask is “What are your return policies and penalties concerning factors such as restocking fees and freight charges”? Some companies have agreements with their vendors regarding returns. What agreement they have, and what penalties and/or fees are involved would depend on the vendor/client relationship, as well as many other factors. In any event, there is rarely any guarantee that a vendor’s return policy would remain in force if a company were to fail. If the vendor did allow merchandise to be returned, even under failure conditions, the merchandise credit would not only be used to offset any outstanding receivables, but would also be adjusted for any penalties or restocking fees. Therefore, the appraiser must clarify this very real issue during his cost analysis.
The same is true for freight charges; as such, charges may have been recorded as period costs, and not applied against the actual items contained within the inventory. A period cost is a cost that occurs within a finite period, and is associated with that particular defined period. Following are several terms, considerations, and adjustments that may need to be analyzed by the appraiser on each inventory.
1. Inward Freight and Trucking: These charges are the responsibility of either the seller or the buyer of the goods. Freight terms are typically expressed as F.O.B. Shipping Point or F.O.B. Destination. F.O.B. or Free on Board means the seller will place the merchandise sold on board a freight carrier at no charge. Whether it is the seller or the buyer who incurs the freight charges from this stage depends upon the "shipping point" or "destination”. These terms refer to that point in which the seller is relieved of the responsibility for transportation charges. If the freight terms were F.O.B. Shipping Point, the seller’s responsibility for freight would stop when the goods are loaded for shipment. If the freight terms were F.O.B. Destination, the seller would be relieved of responsibility when the goods arrive at their ultimate destination.
Assume that Lauren Jeans, which is in Atlanta, Georgia, sold $2,800 in merchandise on account to Kaelin Pants in Nashville, Tennessee. Freight charges amounted to $160, and terms were F.O.B. Nashville, i.e., F.O.B. Destination. Lauren would record the following entries:
|
Accounts Receivable |
$2,800 |
|
Sales |
$2,800 |
|
Sale On Account To Kaelin Pants |
|
|
Freight-Out |
|
|
Cash Payment To Freight Company |
$ 160 |
Since Lauren is responsible for the cost of freight, an expense is recorded by debiting the freight-out account. The "out" in the account title refers to freight on outgoing shipments. The freight-out account contains the costs incurred in completing the sale, and is listed with Lauren’s expenses on the income statement.
Occasionally, the seller might not want to pay the necessary cash to the freight company, even under terms of F.O.B. Destination. Therefore, the seller will ship the goods freight collect; meaning, the buyer must pay the freight company for the transportation charges. Subsequently, because the freight is still the seller's responsibility, the buyer simply deducts the freight payment when paying the seller for the merchandise acquired.
Every sale of goods is represented by a purchase of those goods by another business, organization, or individual consumer. Therefore, accounting for the purchaser is just the other side of accounting for the seller. The purchaser must account for the basic purchase as before, plus any related returns, discounts, and freight charges.
2. Trade Discounts: Goods are rarely purchased at their list price, as discounts are typically offered to the customer. The level of that discount depends on the motive of the seller, which is driven by whom the customer is, and how much that customer is purchasing.
Sometimes goods are offered at a discount to obtain new business, or to introduce a new product into the market. Other times, an existing product is used as a “Loss Leader” to draw interest to other products. The theory behind this is that the voluntary loss sustained on a “Loss Leader” product creates a greater alternative benefit. Therefore, quantity discounts are used as an incentive to sell more goods.
Sellers frequently offer discounts to purchasers, more so to businesses than to individual consumers, and only one type of discount is a trade discount. Meaning, manufacturers and wholesalers spend considerable time and money to publish catalogs of the merchandise they offer for sale. These catalogs often show the merchandise at a basic catalog or list price.
However, purchasers rarely pay list price but rather invoice price, which is the list price less applicable trade discounts. Trade discounts are a convenient means of reducing list prices to invoice prices. This procedure may seem rather anomalous, since it would seem easier just to print the invoice price in the first place. The fact is, the use of trade discounts offers several distinct benefits; one of which is that if a change in market conditions necessitates price changes, quoting a different trade discount is much easier and cheaper than updating and reprinting an entire catalog. In addition, trade discounts can be altered on an as needed basis to give customers more incentive to purchase larger quantities, e.g., the larger the quantity purchased, the greater the discount. Trade discounts are not entered in the accounting records, as a trade discount is used only to arrive at the invoice price; that is, the actual amount of the sale by the seller. To illustrate the proper method of record keeping, assume that Lauren Jeans stocks a particular style of jeans with a list price of $25. If Lauren received an order for 600 pairs and granted a 30% trade discount, the invoice price would be computed as follows:
|
List Price |
600 Pairs x $25 |
$15,000 |
|
Less |
30% Trade Discount |
$ 4,500 |
|
Invoice Price |
$10,500 |
An invoice would be prepared for $10,500. This amount would then be recorded to the accounts receivable and sales accounts. A separate trade discount account is not established.
3. Cash Discounts: When cash discounts are offered to a customer, the intent of the seller is to improve its collection ratio and cash flow. The customers are enticed by a cash discount, as that allows them to secure the product at a lesser amount. However, the terms of payment attached to the cash discount may not be sufficient to entice the customer to pay the invoice earlier than the standard terms.
When merchandise is sold on account, the seller usually gives the buyer a certain period to settle their account balance. Often, sales on account must be paid within thirty days of the invoice date. However, sellers normally desire to collect the amounts due more rapidly to cover expenses, and for purposes of investment. Therefore, to encourage prompt payment, incentives called cash discounts are offered. From the seller's point of view, the cash discount is termed a sales discount. The use of sales discounts not only stimulates rapid collections, but also tends to reduce the likelihood of losses resulting from un-collectible accounts. The sales discount offers the purchaser a financial incentive to pay the balance owed promptly, thus reducing the probability that a given customer will not pay.
Cash discounts are normally expressed in the following format:
2/10, n/30
Or perhaps as:
3/10, n/eom
In both examples, the first set of numbers indicates the discount rate and the discount period. The second discloses the invoice due date.
The terms of sale are read as follows: 2/10, n/30. A 2% discount from the invoice amount is allowed if payment is made within 10 days of the invoice date; otherwise, the total invoice amount is due within 30 days. 3/10, n/eom. A 3% discount from the invoice amount is allowed if payment is made within 10 days of the invoice date; otherwise, the total invoice amount is due by the end of the month.
Among many alternatives of accounting for sales discounts, the most popular method records both accounts receivable and sales at the total invoice amount as if a cash discount was not involved. The rationale is that, at the time of sale, the seller does not know whether the discount will be taken. Subsequently, if a cash discount is taken, the difference between the cash received and the original amount owed is recorded as a discount. If the cash discount is not utilized, the amount paid by the customer is recorded in the same manner as any other receipt on account.
As an example, assume that Lauren Jeans sold $1,500 of merchandise on account to a customer on April 10, terms 2/10, n/30. The sale and payment by the customer are shown below:
April 10 accounts receivable 1,500
Sales 1,500
Sale on account: terms 2/10, n/30
Example A: Customer pays on Apr. 19 and takes the discount.
|
Apr. 19 |
|
Cash |
$1,470 |
|
Sales Discounts |
$ 30 |
|
Accounts Receivable |
$1,500 |
|
Collection On Account: Discount Taken |
Example B: Customer pays on April 26 and forgoes the discount.
|
Apr. 26 |
|
Cash |
$1,500 |
|
Accounts Receivable |
$1,500 |
|
Collection On Account: Discount Missed |
Therefore, the sale is recorded at the total invoice amount of $1,500. If the customer settles the account by April 20, a $30 discount, [$1,500 X 0.02], can be taken, and the customer will pay $1,470, [$1,500 - $30]. Though only $1,470 is received, accounts receivable is credited for the full $1,500. This reduces accounts receivable to zero, thus, indicating the customer has no further obligation to Lauren. The $30 is debited to sales discounts, and reduces the total revenues earned by the firm. Like sales returns & allowances, sales discounts appear on the income statement as a reduction from the sales account.
4. Interest on Investment: In industries that involve an aging process, which in turn involves slow turnover of goods, it would be reasonable for a company that has borrowed money against those goods to include the interest on that money as part of its cost of goods. One example is a manufacturer of seasonal merchandise.
In other industries where the inventory turns more rapidly, it would simply be considered as one of the many costs of doing business. This is because the cost of carrying those goods gives no added value or direct benefit. However, some companies book these costs as period costs on the grounds of conservatism, or when these costs cannot be tied to specific goods and would require some kind of arbitrary assignment that could not be quantified. This would be the case when the loan includes the financing of assets other than the inventory. If an aging process is required before selling, a company could buy aged products from another source.
An example of this could be a manufacturer of scotch or food products. Of course, this would be a management decision, as it would require a measurement of the cost of money and potential profit.
5. Purchasing, Handling, Storing, & Accounting for Materials: Some manufacturing companies record these costs as period costs, since they do not add value to the goods. Conversely, other manufacturing companies add these costs to work-in-process and finished goods to maintain a more accurate product cost picture. Most wholesalers, distributors, and retailers treat these elements as period costs.
6. Labor: Either including the cost of labor as part of the product cost individually, by batch, or product line most often requires an element of judgment, which may often be conducive to an arbitrary allocation due to factors such as overtime, shift premiums, fringe benefits, and downtime. It would also depend on a company’s method of wage payment, the nature of its production process, and its system of cost accounting. If a company were using a stock-keeping-unit, the issue of variances between actual and standard cost would need to be addressed. The question is whether maintaining detailed cost accounting records to apply labor costs to the cost of goods is economically feasible for a company.
7. Material Overhead: The costs of purchasing, handling, storing, and accounting for material overhead are typically addressed as period costs, and are not included in the cost of raw materials or purchased parts. However, some companies include material costs as factory burden when the raw materials or purchased parts are moved into production. Another method would be to develop a factory burden rate and allocate that rate by product or department. However, this method is not considered accurate, as an overall rate includes burden that is not related to material handling costs. It also assumes the same rate would apply for all departments and products, which is often not the case.
8. Factory Burden: Factory burden includes many fixed and variable costs such as supervision, indirect labor, heat, light, power, supplies, repairs, maintenance, depreciation, property taxes, and fire insurance. Therefore, it is feasible that the stated cost for an identical product can vary between companies due to the method of accounting for those costs. This is because some companies include those costs in the cost of goods sold, and some include them as period costs. Understanding how these costs are addressed is important for an appraiser.
One of the more clearly defined practices in this area is the use of period costing, which is where goods in an inventory are charged with a variable factory burden, but all fixed costs are charged to the period. After this is the use of standard costs, which include a share of fixed factory burden costs for inventory valuation purposes, while variances between actual and standard costs are treated as period gains or losses.
1. Prime Costs: Generally accepted accounting practice is opposed to the exclusion of all overhead from the cost of goods. This viewpoint rules out costing at prime cost only, but does not eliminate independent decisions on what is or should be included as factory burden.
2. Direct Costing: With this method, products are only charged for costs that are directly related to their production, which leaves all other manufacturing costs to be treated as period costs. As with prime cost, direct costing is not considered as a generally accepted accounting practice.
3. Full Costing: This method is at the opposite end of the spectrum from direct costing, in that all indirect manufacturing costs are allocated to the goods sold, ending inventories of work-in-process, and finished goods. This method might seem reasonable if it is assumed that the production volume and indirect costs have minimal fluctuation. However, this is not often the case, as production volume has its peaks and valleys. To what extent this occurs would depend on the seasonality and demand for the end product.
4. Full Costing with Indirect Manufacturing Costs Charged at Standard Rates: To account for fluctuating production capacity, some companies apply factory burden to the product cost by developing standard burden rates. In a standard cost, material and labor rates are applied to the work-in-process and finished goods at their actual cost, and the factory burden is applied to the cost by using burden rates. As an example, a labor/hour burden rate can be calculated by dividing the projected manufacturing costs by product, department, or as a whole for a given period by the expected direct labor hours for that same period.
When a business experiences extreme production volume fluctuations, this rate is calculated on what would be considered the average or normal expected volume. What this does is burden the product based on standard rates, by its actual facility use and manufacturing costs, which flattens high and low production variances in expected volume. Therefore, the goal of using burden rates based on the expected volume for a given period is to spread the cost of seasonal idleness or cyclical production fairly to all products. The result of this is that burden overages and shortages for each period are accounted for as a period gain or loss. Period results suffer when the production volume is below average, and benefit when the production volume is above average. However, these differences are sometimes carried over to the end of the year in hopes that they would ultimately be offset.
5. Full Costing at Standard Costs: With this method, standard burden rates are applied to a standard number of hours that should have been spent on a product. The difference between the hours spent and the hours that should have been spent are an efficiency variance caused by fluctuations in production volume, and is treated as period losses or gains. Of course, the standard cost used should be current and based on normal volume.
6. Selling and Administrative Expenses: These costs are rarely included in the product cost of work-in-process and finished goods and, therefore, are treated as period costs. The only reasonable circumstance for adding these costs is where they are directly tied to production activity as having added either cost or value to these goods.
7. Cost Fluctuations: Even when an appraiser understands the type of cost and what makes up that cost, there is still the issue of possible cost fluctuations. This is a legitimate concern, as there could be extreme swings averaged in the cost of an item. These swings could be due to the economic strength of a company, or the economics of an industry. However, if the source of these swings is due to a short-term stimulant or depressant, those items affected should be adjusted accordingly.
8. Reserves: If a company has accounted for reserves on their balance sheet against their inventory, it is important for the appraiser to know if that amount has been deducted from the value of the actual items contained in their inventory. This is due to the basis that the value for inventory is its cost and if that cost is not accurately stated the value opinion would not be accurate. Therefore, if reserves have actually been deducted from an item’s cost, that deduction would need to be added back into the cost structure for the appraiser to begin his value analysis.
