asset

Lean manufacturers: Reap the benefits of lean accounting

Standard cost accounting doesn’t necessarily work for lean operations. Instead, lean accounting offers a simplified reporting alternative that generates more timely, relevant financial data. But it’s not right for every situation.

What’s lean manufacturing?

Lean manufacturers strive for continuous improvement and elimination of non-value-added activities. Rather than scheduling workflow from one functional department to another, these manufacturers organize their facilities into cross-functional work groups or cells.

Lean manufacturing is a “pull-demand” system, where customer orders jumpstart the production process. Lean companies view inventory not as an asset but as a waste of cash flow and storage space.

Why won’t traditional accounting methods work?

From a benchmarking standpoint, liquidity and profitability ratios tend to decline when traditional cost accounting methods are applied to newly improved operations. For example, to minimize inventory, companies transitioning from mass production to lean production must initially deplete in-stock inventories before producing more units. They also must write off obsolete items. As they implement lean principles, many companies learn that their inventories were overvalued due to obsolete items and inaccurate overhead allocation rates (traditionally based on direct labor hours).

During the transition phase, several costs — such as deferred compensation and overhead expense — transition from the balance sheet to the income statement. Accordingly, lean manufacturers may initially report higher costs and, therefore, reduced profits on their income statements. In addition, their balance sheets initially show lower inventory.

Alone, these financial statement trends will likely raise a red flag among investors and lenders — and possibly lead to erroneous business decisions.

How does lean accounting work?

Standard cost accounting is time consuming and transaction-driven. To estimate cost of goods sold, standard cost accounting uses complex variance accounts, such as purchase price variances, labor efficiency variances and overhead spending variances.

In contrast, lean accounting is relatively simple and flexible. Rather than lumping costs into overhead, lean accounting methods trace costs directly to the manufacturer’s cost of goods sold, typically dividing them into four value stream categories:

  1. Materials costs,
  2. Procurement costs,
  3. Conversion costs, such as factory wages and benefits, equipment depreciation and repairs, supplies, and scrap, and
  4. Occupancy costs.

These are easier to understand and evaluate than the variances used in standard cost accounting. In addition, box score reports are often used in lean accounting to supplement profit and loss statements. These reports list performance measures that traditional financial statements neglect, such as scrap rates, inventory turns, on-time delivery rates, customer satisfaction scores and sales per employee.

Should your company abandon standard cost accounting?

Most companies are required to use standard cost accounting methods for formal reporting purposes to comply with U.S. Generally Accepted Accounting Principles (GAAP). But lean manufacturers may benefit from comparing traditional and lean financial statements. Such comparisons may even highlight areas to target with future lean improvement initiatives. Contact us for more information.

© 2019

Measuring “fair value” for financial reporting purposes

The balance sheet usually reflects the historic cost of assets and liabilities. But certain items must be reported at “fair value” under U.S. Generally Accepted Accounting Principles (GAAP). Here’s a closer look at what fair value is and which balance sheet accounts it affects.

Fair value vs. fair market value

Accounting Standards Codification (ASC) Topic 820 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” This definition is similar in many respects to “fair market value,” which is defined in IRS Revenue Ruling 59-60.

The main difference is that fair market value focuses on the universe of hypothetical buyers and sellers. Conversely, FASB uses the term “market participants,” which refers to buyers and sellers in the asset’s or liability’s principal market. The principal market is entity specific and may vary among companies.

Hierarchy of value

Under ASC Topic 820, fair value is most often associated with business combinations and subsequent accounting for goodwill and other intangibles after the deal closes. Other examples of items that are reported at fair value include:

  • Impairment or disposals of long-lived assets,
  • Asset retirement or environmental obligations,
  • Stock compensation, and
  • Certain financial assets and liabilities.

When measuring fair value, the FASB provides a hierarchy of methods that may not necessarily apply to valuations performed for other purposes. GAAP gives top priority to market-based methods, such as quoted prices in active markets for identical assets or liabilities.

When market data isn’t readily available for a specific company, GAAP looks to quoted prices in active markets for similar assets or liabilities — in other words, comparable public stock prices or sales of controlling interests in comparable companies. The least desirable level of inputs under GAAP is unobservable data, such as cash flow or cost estimates prepared by management (which may be used to estimate value under the income or cost approach).

Changes in value

Decreases in the fair value of an asset (or increases in the fair value of a liability) may result from, say, poor company performance, changes in economic conditions and inaccurate estimates made in the past. Companies aren’t allowed to overstate the value of assets (or understate the value of a liability) under GAAP, so changes in fair value may lead to write-offs or restatements.

Outside expertise

Auditors are specifically prohibited from providing valuation services for their public audit clients. Private companies may follow suit to prevent independence issues during audits. So, companies often turn to valuation experts who are independent from their auditors to make fair value estimates — and then their auditors can evaluate whether those estimates appear reasonable. Contact us if you have any questions about fair value, including how it’s estimated or when it applies.

© 2017