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CONTENTS
Chapter Title
Page
No.
1 Researching GAAP Implementation Problems ................................. 1
2 Cash, Receivables, and Prepaid Expenses ........................................ 9
3 Short-Term Investments and Financial Instruments ......................... 34
4 Inventory ........................................................................................... 40
5 Revenue Recognition ........................................................................ 74
6 Long-Lived Assets ............................................................................ 113
7 Investments ....................................................................................... 150
8 Current Liabilities and Contingencies ............................................... 177
9 Long-Term Debt ............................................................................... 200
10 Leases ................................................................................................ 230
11 Stockholders’ Equity ......................................................................... 252
12 Foreign Currency .............................................................................. 292
Index ........................................................................................................................ 304
PREFACE
There is a considerable amount of literature dealing with the rules of generally accepted
accounting principles (GAAP). In all cases, they specify the rules to be applied to various
accounting situations and present cogent examples to assist the reader. However, they do
not give any advice regarding how to implement GAAP. This means that accountants have
no way of knowing what controls, policies, procedures, forms, reports, or archiving requirements
they should install that properly mesh with the latest GAAP. This book fills that void.
Though there is a brief summarization of GAAP comprising about one-third of each
chapter, the primary intent of this book is to add new categories of information designed to
assist the accountant in properly applying GAAP. Some of the following sections can be
found in each chapter:
Definitions of Terms. Contains the terms most commonly used in the following Concepts
and Examples section.
Concepts and Examples. A summary form of the more detailed GAAP found in the
Wiley GAAP 2004 guide.
Decision Trees. Shows the decision factors required to interpret multiple options in the
GAAP rules.
Policies. Identifies specific accounting policies a company can adopt in order to comply
with GAAP, especially in terms of creating controls that mesh with GAAP.
Procedures. Lists specific procedures for the most common accounting transactions,
modified to work within GAAP restrictions. These procedures can be easily modified for
inclusion in a company’s accounting procedures manual.
Controls. Itemizes specific controls allowing a company to retain the maximum level
of control over its accounting systems while remaining in compliance with GAAP.
Forms and Reports. Gives templates for forms and reports that can be used in a
GAAP-compliant accounting system.
Footnotes. Gives numerous examples of footnotes that can be used to describe GAAPmandated
financial disclosures.
Journal Entries. Shows hundreds of GAAP-compliant journal entries for most accounting
transactions.
Recordkeeping. Notes the types of reports and other information to be retained as part
of a comprehensive accounting system.
Chapters are sequenced in the same manner used for the GAAP 2004 guide published
by John Wiley & Sons, covering such topics as receivables, investments, inventory, revenue
recognition, liabilities, debt, leases, stockholders’ equity, and foreign currency. The more
rarely addressed GAAP topics are not included in this volume in the interests of conserving
space, but the reader will find that the bulk of the GAAP issues that arise in daily accounting
situations are covered.
The GAAP Implementation Guide is an ideal companion volume for the Wiley GAAP
guide. It provides the practical application information needed to ensure that a company’s
accounting systems are fully capable of incorporating the most recent GAAP.
If you have any comments about this book, please contact the author at brasto@aol.com.
Thank you!
Steven M. Bragg
Centennial, Colorado
March 2004
ABOUT THE AUTHOR
Steven Bragg, CPA, CMA, CIA, CPIM, has been the chief financial officer or controller
of four companies, as well as a consulting manager at Ernst & Young and auditor at
Deloitte & Touche. He received a master’s degree in finance from Bentley College, an
MBA from Babson College, and a Bachelor’s degree in Economics from the University of
Maine. He has been the two-time President of the 10,000-member Colorado Mountain Club,
and is an avid alpine skier, mountain biker, and rescue diver. Mr. Bragg resides in Centennial,
Colorado. He has written the following books:
Accounting and Finance for Your Small Business (Wiley)
Accounting Best Practices (Wiley)
Accounting Reference Desktop (Wiley)
Advanced Accounting Systems
Business Ratios and Formulas (Wiley)
Controllership (Wiley)
Cost Accounting (Wiley)
Design and Maintenance of Accounting Manuals (Wiley)
Essentials of Payroll (Wiley)
Financial Analysis (Wiley)
Just-in-Time Accounting (Wiley)
Managing Explosive Corporate Growth (Wiley)
Outsourcing (Wiley)
Planning and Controlling Operations (Wiley)
Sales and Operations for Your Small Business (Wiley)
The Controller’s Function (Wiley)
The New CFO Financial Leadership Manual (Wiley)
ACKNOWLEDGMENTS
A special note of thanks to the acquisitions editor of this project, John DeRemigis, who
has been so enthusiastic about it from the start.
1 RESEARCHING GAAP
IMPLEMENTATION PROBLEMS
Overview 1
The GAAP Hierarchy 1
Researching GAAP 3
Researching Accounting Terminology 4
Researching Accounting Policies and
Procedures 4
Researching Accounting Controls 5
Researching Accounting Forms and
Reports 6
Researching Accounting Footnotes 6
Researching Accounting Journal
Entries 7
Researching Accounting Recordkeeping
7
OVERVIEW
This chapter is designed to give pointers to additional information in areas besides
GAAP concepts. Though there are Concepts and Examples sections in each of the following
chapters that give summarized versions of the relevant GAAP issues, the primary focus of
this book is to provide information about ancillary topics that allow one to implement
GAAP, such as accounting policies and procedures, controls, and reporting footnotes. Unfortunately,
there are no authoritative sources for these GAAP implementation topics. Instead,
the sections of this chapter devoted to each implementation topic list some organizations
that can provide additional information, as well as key books that summarize or discuss
related topics, including the name of each book’s author, publisher, and date of publication.
But first, we will address the GAAP hierarchy of accounting standards and rules, followed by
the general approach for researching GAAP-related issues.
The GAAP Hierarchy
Generally accepted accounting principles (GAAP) are standards and rules for reporting
financial information, as established and approved by the Financial Accounting Standards
Board.
There are three primary players in the promulgation of GAAP. First is the Financial
Accounting Standards Board (FASB), which plays the lead role in establishing GAAP. Its
Web site is located at www.fasb.org. Its mission is to “establish and improve standards of
financial accounting for the guidance and education of the public, including issuers, auditors,
and users of financial information.” A subset of the FASB is the Emerging Issues Task
Force (EITF), which (as its name implies) handles emerging accounting issues as soon as
they become apparent, so that a standard approach can be created before any competing approaches
come into use. This group typically deals with only very narrowly defined accounting
issues, and its opinions are considered to be GAAP only if it can first reach a consensus
opinion among its members. Finally, the American Institute of Certified Public Accountants
(AICPA) is the principal representative body for certified public accountants
within the United States. Its Web site is located at www.aicpa.org. It periodically issues research
bulletins, audit and accounting guides, statements of position, and practice bulletins
that, if approved by the FASB, are considered to be GAAP. Some GAAP is still ascribed to
the Accounting Principles Board (APB), though this entity was phased out in 1973.
2 Wiley GAAP 2004
There are many documents issued by these three accounting entities that are considered
part of GAAP. Each one is described in the following bullet points:1
• FASB Statements of Financial Accounting Standards. The highest form of GAAP,
the SFAS series is the primary publication of the FASB, and is the most carefully
formulated (and debated) of all GAAP documents.
• FASB Interpretations. Used to clarify Statements of Financial Accounting Standards
or the pronouncements made by prior accounting entities that are still considered to be
GAAP.
• APB Opinions. The primary publication of the old Accounting Principles Board, this
was the equivalent of an SFAS prior to the formation of the FASB.
• FASB Technical Bulletins. Provide guidance on issues not covered by existing standards,
and where the guidance is not expected to be costly or create a major change.
• AICPA Statements of Position. Provide guidance on financial accounting and reporting
issues.
• AICPA Industry Audit and Accounting Guides. Provide guidance to auditors in examining
and reporting on financial statements of entities in specific industries and
provide standards on accounting problems unique to a particular industry.
• EITF Consensus Positions. Provide positions on the correct treatment of emerging
accounting issues.
• AICPA Practice Bulletins. Provide guidance on narrowly defined accounting topics.
• FASB Implementation Guides. Provide notes on how to implement specific Statements
of Financial Accounting Standards, written by the FASB staff. The guides are
organized in a question, background, and answer format.
GAAP is organized in a descending pyramid of authoritative sources, as shown in Exhibit
1-1. It contains the following four categories:2
1. Category A is the most authoritative GAAP, containing the Statements of Financial
Accounting Standards and related Interpretations (as promulgated by the FASB), as
well as AICPA Accounting Research Bulletins and Opinions of the Accounting
Principles Board.
2. Category B contains all FASB Technical Bulletins, as well as all AICPA Statements
of Position and AICPA Industry Audit and Accounting Guides that have
been approved by the FASB.
3. Category C includes consensus positions of the FASB’s EITF, as well as those
Practice Bulletins created by the AICPA’s Accounting Standards Executive Committee
that have been approved by the FASB. The positions of the EITF tend to
cover such specialized topics that there is no more authoritative form of GAAP in
Categories A or B, so these positions tend to be the most senior form of GAAP in
their topical areas.
4. Category D includes implementation guides published by the FASB staff, as well as
AICPA accounting interpretations and prevalent accounting practices.
1 Adapted with permission from pp. 5-6 of Delaney, et. al., Wiley GAAP 2003 (John Wiley & Sons,
Inc., Hoboken, NJ, 2002).
2 Adapted with permission from p. 3 of Delaney, et. al., Wiley GAAP 2003 (John Wiley & Sons, Inc.,
Hoboken, NJ, 2002).
Chapter 1 / Researching GAAP Implementation Problems 3
Exhibit 1-1: The GAAP Source Pyramid
Most
FASB SFAS
FASB Interpretations
AICPA ARB
APB Opinions
FASB Technical Bulletins
AICPA SOP
AICPA Industry Guides
EITF Positions
AICPA Practice Bulletins
FASB Implementation Guides
AICPA Interpretations
Prevalent Accounting Practices
Authoritative
A x x x x
x x x
x x
Least x x x
Authoritative
ARB = Accounting Research Bulletin
SFAS = Statement of Financial Accounting Standards
SOP = Statement of Position
B
C
D
Researching GAAP
The simplest approach to researching GAAP is to review the Concepts and Examples
sections in this book. If this does not yield a detailed answer, a more comprehensive source
of summarized GAAP information is the Wiley GAAP 2004 guide. The Wiley GAAP 2004
guide contains a more comprehensive Concepts section than this book, and also contains a
list of authoritative pronouncements at its beginning, as well as the applicable page reference
leading to a more complete discussion of the issues within the text. If this approach still does
not yield a clear answer to a GAAP problem, one should review selected GAAP source
documents, of which the most comprehensive is the FASB’s Original Pronouncements and
Accounting Standards three-volume series (noted in the following book list). It lists all
FASB Statements of Standards, as well as AICPA Pronouncements, FASB Interpretations,
FASB Concepts Statements, and FASB Technical Bulletins. Of particular use is the topical
index located at the end of the third volume, which cross-references each topic to a GAAP
source. Other more narrowly defined topics are covered by the other GAAP sources noted in
the following book list. If these sources still do not yield a clear answer, one can ask other
entities in the same industry how they are handling the issue (if only to obtain alternative
solutions). If all else fails, use basic accounting theory to resolve the issue, or consult with a
technical expert at a CPA firm. The most useful GAAP source documents are noted in the
following book list:
Audit and Accounting Guides
Author: AICPA
Publisher: AICPA
Publication Date: Various
4 Wiley GAAP 2004
Emerging Issues Task Force Abstracts
Author: FASB
Publisher: FASB
Publication Date: Annually
FASB Staff Implementation Guides
Author: FASB
Publisher: FASB
Publication Date: Annually
Original Pronouncements and Accounting Standards
Author: FASB
Publisher: FASB
Publication Date: Annually
Statements of Position
Author: AICPA
Publisher: AICPA
Publication Date: Various
Researching Accounting Terminology
The best source of information about accounting terminology is the Statements of Financial
Accounting Standards (SFAS), as published by the FASB. These Statements generally
begin with a definitions section that provides both clear and comprehensive definitions.
However, definitions are provided only for the limited topics covered in each SFAS, so it can
take some time to locate a specific definition from the various SFAS documents. Definitions
are also provided in a variety of lower-level GAAP documents. Another source of definitions
is an online glossary of definitions maintained by the AICPA, which can be accessed at
www.aicpa.org/members/glossary. Given the minimal time most accountants will allocate to
researching accounting definitions, simpler forms of access are the accounting dictionaries
noted in the following book list:
Dictionary of Accounting Terms
Author: John Clark
Publisher: AMACOM
Publication Date: 2003
Dictionary of Accounting Terms
Author: Joel Siegel and Jae Shim
Publisher: Barron’s Education Series, Inc.
Publication Date: 1995
Researching Accounting Policies and Procedures
There is no standard set of policies and procedures related to GAAP. This information
can be found within the Policies and related Procedures sections of each chapter in this book.
Another source is books listing sample policies and procedures for generic company operations,
as described in the first two books in the following list. An alternative is to use documentation
manuals as guides for the construction of company-specific policies and procedures;
the last two books in the following list can assist with this effort:
Chapter 1 / Researching GAAP Implementation Problems 5
Best Practices in Policies and Procedures
Author: Stephen Page
Publisher: Process Improvement Publishing
Publication Date: 2002
Bizmanualz Accounting Policies, Procedures, and Forms
Author: Bizmanualz.com Inc.
Publisher: Bizmanualz.com Inc.
Publication Date: 2002
Design and Maintenance of Accounting Manuals
Author: Steven Bragg
Publisher: John Wiley & Sons, Inc.
Publication Date: 2003
Documentation Improvement Methods
Author: Athar Murtuza
Publisher: John Wiley & Sons, Inc.
Publication Date: 2002
Researching Accounting Controls
There is no standard source document itemizing the key control areas related to all types
of GAAP. Instead, controls are either described in general terms through the reports issued
by various accounting review committees (see the COSO Implementation Guide below) or
else one must infer the correct types of controls to use based on various types of fraud that
may occur (several examples are noted below). A good source for controls-related publications
is the Institute of Internal Auditors, whose Web site is www.theiia.org. It is located in
Altamonte Springs, Florida, and its phone number is 407-937-1100. Several reference books
related to this topic are as follows:
COSO Implementation Guide
Author: James P. Roth
Publisher: Institute of Internal Auditors
Publication Date: 1995
Financial Crime Investigation and Control
Author: K. H. Spencer Pickett, Jennifer M. Pickett
Publisher: John Wiley & Sons, Inc.
Publication Date: 2002
Financial Reporting Fraud
Author: Charles Lundelius Jr.
Publisher: AICPA
Publication Date: 2003
Financial Statement Fraud
Author: Zabihollah Rezaee
Publisher: John Wiley & Sons, Inc.
Publication Date: 2002
6 Wiley GAAP 2004
Fraud 101
Author: Howard Davia
Publisher: John Wiley & Sons, Inc.
Publication Date: 2000
Internal Control Integrated Frameworks
Author: Coopers & Lybrand
Publisher: AICPA
Publication Date: 1994
Internal Control: A Manager’s Journey
Author: K. H. Spencer Pickett
Publisher: John Wiley & Sons, Inc.
Publication Date: 2001
Process Development Life Cycle
Author: Albert Marcella Jr.
Publisher: Institute of Internal Auditors
Publication Date: 2001
Researching Accounting Forms and Reports
There is no single book or periodical containing a comprehensive set of forms or reports
linked to GAAP. The best source is the Forms and Reports sections within this book. Another
alternative is to review publications describing how to construct these documents.
Such information can then be used to design forms and reports based on the specific accounting
structures unique to a company. The following source book provides information
about constructing forms and reports:
Design and Maintenance of Accounting Manuals
Author: Steven Bragg
Publisher: John Wiley & Sons, Inc.
Publication Date: 2003
Some examples of forms and reports can be found scattered through some of the larger
accounting “how to” books, an example of which follows:
Controllership
Author: James Willson, et al.
Publisher: John Wiley & Sons, Inc.
Publication Date: 2003
Researching Accounting Footnotes
Source documents for GAAP will describe the general contents of footnotes to financial
statements, but rarely give more than a few limited examples. A better source of information
is a selection of examples culled from financial reports. One of the best sources is the GAAP
Financial Statement Disclosures Manual listed in the following references. Another option
is to access the Web site of the Securities and Exchange Commission at www.sec.gov and
review the individual filings of various public companies, which can be accessed through the
“Search for Company Filings” option on that Web page. The following source books can be
used for additional information about footnote disclosures:
Chapter 1 / Researching GAAP Implementation Problems 7
Financial Statement Presentation and Disclosure Practices for Employee Benefit Plans
Author: AICPA
Publisher: AICPA
Publication Date: 2000
Financial Statement Presentation and Disclosure Practices for Not-for-Profit Organizations
Author: Richard F. Larkin
Publisher: AICPA
Publication Date: 1999
GAAP Financial Statement Disclosures Manual
Author: George Georgiades
Publisher: Aspen Law & Business
Publication Date: 2002
The Coopers & Lybrand SEC Manual
Author: Robert Herz, et al.
Publisher: John Wiley & Sons, Inc.
Publication Date: 1997
Researching Accounting Journal Entries
Examples of journal entry formats are listed in the Journal Entry sections of each chapter
in this book. In addition, one can consult the Wiley GAAP guide for the most recent year,
which may include different examples of journal entries for a specific topic. Another good
source is the most recent edition of the standard textbooks for intermediate accounting, advanced
accounting, and cost accounting. The following books can be consulted for this information:
Intermediate Accounting
Author: Donald Keiso, et.al.
Publisher: John Wiley & Sons, Inc.
Publication Date: 2001
Advanced Accounting
Author: Debra Jeter et al.
Publisher: John Wiley & Sons, Inc.
Publication Date: 2001
Accounting Reference Desktop (Appendix B)
Author: Steven Bragg
Publisher: John Wiley & Sons, Inc.
Publication Date: 2002
Cost Accounting
Author: Steven Bragg
Publisher: John Wiley & Sons, Inc.
Publication Date: 2001
Researching Accounting Recordkeeping
Information about the proper time period over which to retain accounting documents is
difficult to find, as are procedures and documentation for organizing and destroying docu8
Wiley GAAP 2004
ments. The principal organization concerning itself with these issues is the Association for
Information Management Professionals, whose Web site is located at www.arma.org. It is
located in Lenexa, Kansas, and its phone number is 800-422-2762. Some of its publications
are as follows:
Records Retention Procedures
Author: Donald S. Skupsky
Publisher: Information Requirements Clearinghouse
Publication Date: 1995
Retention 6.0
Author: Zasio Enterprises
Publisher: Zasio Enterprises
Publication Date: 2002
Records Center Operations
Author: ARMA International Standards Task Force
Publisher: ARMA International
Publication Date: 2002
2 CASH, RECEIVABLES, AND PREPAID
EXPENSES
Definitions of Terms 9
Concepts and Examples 10
Cash 10
Prepaid Expenses 10
Receivables—Presentation 11
Receivables—Collateral, Assignments,
and Factoring 11
Receivables—Sales Returns 12
Receivables—Early Payment
Discounts 13
Receivables—Long-Term 13
Receivables—Bad Debts 13
Decision Trees 14
Receivables—Ownership Decision 14
Policies 15
Cash 15
Prepaid Expenses 15
Receivables 16
Procedures 16
Cash—Apply Cash to Accounts
Receivable 16
Cash—Receive and Deposit Cash 17
Cash—Process Credit Card Payments 17
Cash—Reconcile Petty Cash 18
Cash—Reconcile Bank Account 18
Receivables—Print and Issue Invoices 18
Receivables—Calculate the Bad Debt
Reserve 20
Receivables—Authorize Bad Debt
Write-offs 20
Controls 20
Cash 20
Prepaid Expenses 22
Receivables 23
Forms and Reports 23
Cash—Mailroom Remittance Receipt 23
Cash—Bank Reconciliation 24
Cash—Cash Forecasting Model 25
Receivables—Bad Debt Authorization
Form 27
Receivables—Collection Actions
Taken 27
Receivables—Aging Report 28
Receivables—Loan Collateralization
Report 28
Footnotes 29
Cash—Restrictions on Use 29
Cash—Restrictions Caused by Compensating
Balance Agreements 29
Cash—Excessive Concentration in
Uninsured Accounts 30
Receivables—Bad Debt Recognition 30
Receivables—Separation of Types 30
Receivables—Used as Collateral 30
Journal Entries 31
Cash 31
Bank reconciliation 31
Receivables 31
Accounts receivable, initial entry 31
Accounts receivable, recording of longterm
payment terms 31
Accounts receivable, sale of 31
Accounts receivable, payment due from
factor 31
Accounts receivable, establishment of
recourse obligation 32
Accounts receivable, write-off 32
Accrue bad debt expense 32
Account for receipt of written-off
receivable 32
Accrue for sales returns 32
Early payment discounts, record receipt
of 32
Recordkeeping 32
DEFINITIONS OF TERMS
Accounts receivable. A current asset on the balance sheet, representing short-term
amounts due from customers who have purchased on account.
Assignment. Creating a loan document using accounts receivable as the collateral. If
the debtor is unable to pay back the loan, the creditor can collect the accounts receivable and
retain the proceeds.
10 GAAP Implementation Guide
Cash. All petty cash, currency, held checks, certificates of deposit, traveler’s checks,
money orders, letters of credit, bank drafts, cashier’s checks, and demand deposits that are
held by a company without restriction, and which are readily available on demand.
Collateral. Assets that have been pledged to secure debtor repayment of a loan. If it
cannot repay the loan, the creditor can sell the assets and retain the proceeds.
Factoring. The sale of accounts receivable to a third party, with the third party bearing
the risk of loss if the accounts receivable cannot be collected.
Factor’s holdback. That portion of the payment for an accounts receivable sale retained
by the factor in expectation of product returns by customers.
Net realizable value. The expected revenue to be gained from the sale of an item or
service, less the costs of the sale transaction.
Pledging. Assigning accounts receivable as collateral on company debt.
Recourse. The right of a creditor under a factoring arrangement to be paid by the debtor
for any uncollectible accounts receivable sold to the creditor.
CONCEPTS AND EXAMPLES1
Cash
If there is a short-term restriction on cash, such as a requirement that it be held in a
sinking fund in anticipation of the payment of a corresponding debt within a year, then it
should still be itemized as a current asset, but as a separate line item. If there is a long-term
restriction on cash, such as a compensating balance agreement that is linked to debt that will
not be paid off within the current year, then the cash must be itemized as a long-term asset.
Alternatively, if a compensating balance agreement is tied to a loan that matures within the
current period, then it may be recorded separately as a current asset.
If a company issues checks for which there are not sufficient funds on hand, it will find
itself in a negative cash situation as reported on its balance sheet. Rather than show a negative
cash balance there, it is better to shift the amount of the excess checks back into the accounts
payable liability account, thereby leaving the reported cash balance at or near zero.
Cash held in foreign currencies should be included in the cash account on the balance
sheet, subject to two restrictions. First, it must be converted to US dollars at the prevailing
exchange rate as of the balance sheet date. Second, the funds must be readily convertible
into US dollars; if not (perhaps due to currency restrictions by the foreign government), the
cash cannot properly be classified as a current asset, and instead must be classified as a longterm
asset. This latter item is a key issue for those organizations that want to report the highest
possible current ratio by shifting foreign currency holdings into the cash account.
Prepaid Expenses
Prepaid expenses are itemized as current assets on the balance sheet, and should include
early payments on any expenditures that would have been made during the next 12 months.
For example, prepayments on key man life insurance, rent, or association fees would be
charged to this account. There should be a supporting schedule for this account, detailing
each line item charged to it and the amortization schedule over which each item will be ratably
charged to expense (see the sample report in the Recordkeeping section).
The prepaid expense account does not include deposits, since they are typically not converted
back to cash until the end of the agreements requiring their original payment, which
may be some years in the future. For example, the usual one-month rent deposit required
1 Some portions of this section are adapted with permission from Chapters 13 and 15 of Bragg,
Accounting Reference Desktop, John Wiley & Sons, Inc., Hoboken, NJ, 2002.
Chapter / 2 Cash, Receivables, and Prepaid Expenses 11
with a building lease agreement cannot be paid back until the lease term has expired. Instead,
deposits are usually recorded in the Other Assets or Deposits accounts, which are
listed as noncurrent assets on the balance sheet.
Receivables—Presentation
The accounts receivable account tends to accumulate a number of transactions that are
not strictly accounts receivable, so it is useful to define what should be stored in this account.
An account receivable is a claim that is payable in cash, and which is in exchange for the
services or goods provided by the company. This definition excludes a note payable, which
is essentially a return of loaned funds, and for which a signed note is usually available as
documentary evidence. A note payable should be itemized in the financial statements under
a separate account. It also excludes any short-term funds loaned to employees (such as employee
advances), or employee loans of any type that may be payable over a longer term.
These items may be more appropriately stored in an Other Accounts Receivable or Accounts
Receivable from Employees account. Also, one should not create an accrued account receivable
to offset an accrued sale transaction (as may occur under the percentage-of-completion
method of recognizing revenue from long-term construction projects); on the contrary, the
accounts receivable account should contain only transactions for which there is a clear, shortterm
expectation of cash receipt from a customer.
Receivables—Collateral, Assignments, and Factoring
If a company uses its accounts receivable as collateral for a loan, then no accounting
entry is required. An assignment of accounts receivable, where specific receivables are
pledged as collateral on a loan and where customer payments are generally forwarded
straight to the lender, also requires no accounting entry. However, if a company directly
sells receivables with no continuing involvement in their collection, and with no requirement
to pay back the creditor in case a customer defaults on payment of a receivable, then this is
called factoring, and a sale transaction must be recorded (see the Decision Tree section for
more information). Typically, this involves a credit to the Accounts Receivable account, a
debit to the Cash account for the amount of the buyer’s payment, and a Loss on Factoring
entry to reflect extra charges made by the factor on the transaction. The amount of cash received
from the factor will also be reduced by an interest charge that is based on the amount
of cash issued to the company for the period when the factor has not yet received cash from
the factored accounts receivable; this results in a debit to the Interest Expense account and a
credit to the Accounts Receivable account.
A variation on this transaction is if the company draws down cash from the factor only
when needed, rather than at the time when the accounts receivable are sold to the factor.
This arrangement results in a smaller interest charge by the factor for the period when it is
awaiting payment on the accounts receivable. In this instance, a new receivable is created
that can be labeled “Due from Factoring Arrangement.”
Another variation is when the factor holds back payment on some portion of the accounts
receivable, on the grounds that there may be inventory returns from customers that
can be charged back to the company. In this case, the proper entry is to offset the account
receivable being transferred to the factor with a holdback receivable account. Once all receipt
transactions have been cleared by the factor, any amounts left in the holdback account
are eliminated with a debit to Cash (being paid by the factor) and a credit to the Holdback
account.
A sample journal entry that includes all of the preceding factoring issues is shown in
Exhibit 2-1. In this case, a company has sold $100,000 of accounts receivable to a factor,
12 GAAP Implementation Guide
which requires a 10% holdback provision. The factor also expects to lose $4,800 in bad
debts that it must absorb as a result of the transaction, and so pays the company $4,800 less
than the face value of the accounts receivable, which forces the company to recognize a loss
of $4,800 on the transaction. Also, the company does not elect to take delivery of all funds
allowed by the factor in order to save interest costs; accordingly, it only takes delivery of
$15,000 to meet immediate cash needs. Finally, the factor charges 18% interest for the
thirty-day period that it is expected to take to collect the factored accounts receivable, which
results in an interest charge of $200 on the $15,000 of delivered funds.
Exhibit 2-1: Sample Factoring Journal Entry
Cash 15,000
Accounts receivable—factoring holdback 10,000
Loss on factoring 4,800
Interest expense 200
Due from factoring arrangement 70,000
Accounts receivable 100,000
If the company factors its accounts receivable, but the factor has recourse against the
company for uncollectible amounts (which reduces the factoring fee) or if the company
agrees to service the receivables subsequent to the factoring arrangement, then the company
still can be construed as having retained control over the receivables. In this case, the factoring
arrangement is considered to be a loan, rather than a sale of receivables, resulting in
the retention of the accounts receivable on the company’s balance sheet, as well as the addition
of a loan liability. When receivables are sold with recourse, one should shift the expected
amount of bad debts to be incurred from the Allowance for Bad Debts account to a
Recourse Obligation account, from which bad debts will be subtracted as incurred.
Receivables—Sales Returns
When a customer returns goods to a company, the accountant should set up an offsetting
sales contra account, rather than backing out the original sale transaction. The resulting
transaction would be a credit to the Accounts Receivable account and a debit to the Contra
account. There are two reasons for using this approach. First, a direct reduction of the original
sale would impact the financial reporting in a prior period, if the sale originated in a prior
period. Second, a large number of sales returns charged directly against the sales account
would be essentially invisible on the financial statements, with management seeing only a
reduced sales volume. Only by using (and reporting) an offsetting contra account can management
gain some knowledge of the extent of any sales returns. If a company ships products
on approval (i.e., customers have the right of return) and there is a history of significant
returns, then it should create a reserve for sales returns based on historical rates of return.
The offsetting sale returns expense account should be categorized as part of the cost of goods
sold.
Example of reserve for sales made on approval
The Dusty Tome Book Company issues new versions of its books to a subscriber list that has
purchased previous editions. Historically, it has experienced a 22% rate of return from these sales.
In the current month, it shipped $440,000 of books to its subscriber list. Given the historical rate
of return, Dusty Tome’s controller expects to see $96,800 worth of books returned to the company.
Accordingly, she records the following entry:
Sale return expense 96,800
Reserve for sales returns 96,800
Chapter / 2 Cash, Receivables, and Prepaid Expenses 13
Receivables—Early Payment Discounts
Unless a company offers an exceedingly large early payment discount, it is unlikely that
the total amount of this discount taken will have a material impact on the financial statements.
Consequently, some variation in the allowable treatment of this transaction can be
used. The most theoretically accurate approach is to initially record the account receivable at
its discounted value, which assumes that all customers will take the early payment discount.
Any cash discounts that are not taken will then be recorded as additional revenue. This results
in a properly conservative view of the amount of funds that one can expect to receive
from the accounts receivable. An alternative that results in a slightly higher initial revenue
figure is to record the full, undiscounted amount of each sale in the accounts receivable, and
then record any discounts taken in a sales contra account. One objection to this second approach
is that the discount taken will be recognized only in an accounting period that is later
than the one in which the sale was initially recorded (given the time delay usually associated
with accounts receivable payments), which is an inappropriate revenue recognition technique.
An alternative approach that avoids this problem is to set up a reserve for cash discounts
taken in the period in which the sales occur, and offset actual discounts against it as
they occur.
Receivables—Long-Term
If an account receivable is not due to be collected for more than one year, then it should
be discounted at an interest rate that fairly reflects the rate that would have been charged to
the debtor under a normal lending situation. An alternative is to use any interest rate that
may be noted in the sale agreement. Under no circumstances should the interest rate be one
that is less than the prevailing market rate at the time when the receivable was originated.
The result of this calculation will be a smaller receivable than is indicated by its face amount.
The difference should be gradually accrued as interest income over the life of the receivable.
Example of a long-term accounts receivable transaction
The Carolina Furniture Company (CFC) sells a large block of office furniture in exchange for
a receivable of $82,000 payable by the customer in two years. There is no stated interest rate on
the receivable, so the CFC controller uses the current market rate of 6% to derive a present value
discount rate of 0.8900. She multiplies the $82,000 receivable by the discount rate of 0.8900 to
arrive at a present value of $72,980, and makes the following entry:
Notes receivable 82,000
Furniture revenue 72,980
Discount on notes receivable 9,020
In succeeding months, the CFC controller gradually debits the discount on the notes receivable
account and credits interest income, so that the discount is entirely eliminated by the time the
note receivable is collected. Also, note that the initial debit is to a notes receivable account, not
accounts receivable, since this is not considered a current asset.
Receivables—Bad Debts
The accountant must recognize a bad debt as soon as it is reasonably certain that a loss is
likely to occur, and the amount in question can be estimated with some degree of accuracy.
For financial reporting purposes, the only allowable method for recognizing bad debts is to
set up a bad debt reserve as a contra account to the accounts receivable account. Under this
approach, one should estimate a long-term average amount of bad debt, debit the bad debt
expense (which is most commonly kept in the operating expenses section of the income
statement) for this percentage of the period-end accounts receivable balance, and credit the
14 GAAP Implementation Guide
bad debt reserve contra account. When an actual bad debt is recognized, the accountant
credits the accounts receivable account and debits the reserve. No offset is made to the sales
account. If there is an unusually large bad debt to be recognized that will more than offset
the existing bad debt reserve, then the reserve should be sufficiently increased to ensure that
the remaining balance in the reserve is not negative.
There are several ways to determine the long-term estimated amount of bad debt for the
preceding calculation. One is to determine the historical average bad debt as a proportion of
the total credit sales for the past twelve months. Another option that results in a more accurate
estimate is to calculate a different historical bad debt percentage based on the relative
age of the accounts receivable at the end of the reporting period. For example, accounts aged
greater than ninety days may have a historical bad debt experience of 50%, whereas those
over thirty days have a percentage of 20%, and those below thirty days are at only 4%. This
type of experience percentage is more difficult to calculate, but can result in a considerable
degree of precision in the size of the bad debt allowance. It is also possible to estimate the
bad debt level based on the type of customer. For example, one could make the case that
government entities never go out of business, and so have a much lower bad debt rate than
other types of customers. Whatever approach is used must be backed up quantitatively, so
that an auditor can trace through the calculations to ensure that a sufficient bad debt reserve
has been provided for.
Example of a bad debt reserve calculation
The Granny Clock Company has $120,000 of outstanding accounts receivable. Of that
amount, $20,000 is more than ninety days old, while $41,000 is in the sixty- to ninety-day category.
The company has historically experienced a loss rate of 25% on receivables more than
ninety days old, a loss rate of 10% on receivables in the sixty- to ninety-day category, and 2% on
all other receivables. Based on this information, the controller calculates a reserve of $1,180 on
the current receivables ($59,000 x 2%), $4,100 for receivables in the sixty- to ninety-day category
($41,000 x 10%), and $5,000 for receivables older than ninety days ($20,000 x 25%), which totals
$10,280. The company already has a reserve of $2,000 left over from the previous month, so the
new entry is a debit to bad debt expense and a credit to the reserve for bad debts of $8,280
($10,280 total reserve less the existing balance).
If an account receivable has been already written off as a bad debt and is then collected,
the receipt should be charged against the bad debt reserve or to earnings. Incorrect treatment
would be to create a new sale and charge the receipt against that, since this would artificially
show a higher level of sales than really occurred.
DECISION TREES
Receivables—Ownership Decision
The main issue involving the use of accounts receivable as collateral or for assignment
or factoring is how to treat these activities in the financial statements. The illustration in
Exhibit 2-2 may be of some assistance. As shown in the exhibit, if receivables are pledged
as collateral on a loan, or if they are assigned with recourse, or if the company has some
means of forcing their return, then the company essentially has control over the receivables,
and should continue to record them as such on its balance sheet. However, if the receivables
purchaser has assumed the risk of loss, and can pledge or exchange the receivables to a third
party, and the company or its creditors can no longer access the receivables for any reason,
then the purchaser has control over the assets, and the selling company must record the sale
of the receivables and remove them from its balance sheet. Thus, if there is any evidence
that the selling company retains any aspect of control over the receivables, they must conChapter
/ 2 Cash, Receivables, and Prepaid Expenses 15
tinue to be recorded on the selling company’s balance sheet, with additional footnote disclosure
of their status as collateral on a loan.
Exhibit 2-2: Reporting Status of Accounts Receivable
Receivables Used as Collateral
Receivables pledged as collateral
Report receivable on balance
Receivables assigned, lender has recourse
Receivables assigned, company can repurchase or force their return
Receivables factored, lender assumes risk of loss
Record asset sale, do not
list receivable on balance Receivables factored, factor can pledge or exchange receivables
sheet
Receivables factored, company or its creditors cannot access them
Receivables Have Been Sold
sheet, footnote collateral
status
POLICIES
Cash
• No accounts payable personnel shall be authorized to sign checks or approve
money transfers. This policy is designed to separate the preparation of accounts
payable documents from their approval, thereby keeping a single person from falsely
creating a payable and authorizing its payment to himself.
• All check or money transfers exceeding $_____ shall be countersigned by the
_____ position. This policy provides for a second review of very large payments to
ensure that they are appropriate, and to reduce the incidence of fraudulent transfers.
Unfortunately, many banks do not review the existence of a second signature on a
check, making this a less effective policy.
• All check signers shall be adequately bonded. This policy requires a company to
retain an adequate level of bonding on its check signers to ensure that it will suffer no
loss if a signer commits fraud. Bonding companies usually conduct a background review
on check signers before agreeing to provide bond, which may give a company
warning of previously unknown fraudulent employee activities, thereby allowing it to
remove check signing authority from someone before they have the opportunity to
commit fraud again.
Prepaid Expenses
• All advances to employees must be repaid within three months. This policy keeps
a company from becoming a bank for employees. In addition, it rapidly draws down
the balances due from employees, so there is a minimal risk of loss to the company if
an employee quits work without having paid off the entire balance of an advance.
16 GAAP Implementation Guide
• Employee advances shall be limited to __% of their annual pay. This policy is designed
to reduce the amount of money a company can have due from its employees,
which mitigates its risk of nonpayment in the event of an employee departure.
Receivables
• Allow the accounting staff to write off accounts receivable balances under $___
without management approval. Though one could require management approval of
all receivable write-offs in order to reduce the risk of false write-offs, this is not an efficient
control point for very small balances. Instead, it is common to allow the writeoff
of small balances by the accounting staff, thereby avoiding time otherwise wasted
by the management staff investigating these write-offs.
• Require credit manager approval for all prospective sales exceeding customer
credit limits. A common problem for the credit department is to be rushed into
granting credit when a salesperson lands a large sale, which tends to result in excessively
large credit limits being granted. A better approach is to require an advance review
of prospective sales by the credit manager, who can then tell the sales staff the
maximum amount of credit the company is willing to grant before any sale is finalized.
• Require formal annual reviews of all customer credit limits exceeding $______.
Customer financial situations change over time, making the initial credit limits
granted to them incorrect. This is a particular problem when a customer is spiraling
down toward bankruptcy, while the company blithely continues to grant it large
amounts of credit. Annual reviews of large credit limits can mitigate this problem,
though feedback from the collections staff will warn of possible customer problems
well before any formal annual review would do so.
• No factoring arrangements are allowed when receivables are used as collateral
for other debts. This policy prevents a company from violating the terms of a loan
agreement under which it must retain its receivables as collateral, rather than reduce
them through sale to a factor. Otherwise, the company could be seen as selling assets
to the detriment of a secured lender, who would then have the right to call its loan to
the company.
PROCEDURES
Cash—Apply Cash to Accounts Receivable
Use this procedure to apply cash received from customers to open accounts receivable
balances:
1. Add up all daily cash receipts and match the paper tape of the summarization to the
individual payments to ensure that the total is correct.
2. Go to the accounting software and access the cash application screen. At the top of
the screen, enter today’s date and the total amount to be applied.
3. For each customer payment, enter the customer number, individual check amount,
the check number and date, and then tab to the detail section of the screen. The list
of all open invoices for the customer will appear. Click on each invoice being paid
and enter any discounts taken. After identifying all invoices paid by each customer,
complete the transaction and move to the next customer from whom a check was received.
Continue in this fashion until all receipts have been entered.
Chapter / 2 Cash, Receivables, and Prepaid Expenses 17
4. Print a daily cash receipts report and verify that the total on the report matches the
total amount of cash received on the initial paper tape. Compare the remittance advices
attached to individual checks to the daily cash receipts report to find the error,
and correct it.
5. Press the “post cash” button to transfer all the receipts information to the general
ledger.
6. Photocopy all checks received. Then staple the cash receipts report to the photocopies,
and file the set of documents in the applied cash filing cabinet.
Cash—Receive and Deposit Cash
Use this procedure to receive cash from a variety of sources and deposit it into the company
bank account.
1. Summarize all cash on an adding machine tape.
2. Enter all checks and cash received on a deposit slip. Verify that the deposit slip total
and the adding machine tape total are the same. If not, recount the cash and
checks.
3. Give the deposit slip and attached cash and checks to a second cash clerk, who compares
the check total to the summary sheet forwarded from the mailroom. Reconcile
any differences.
4. Photocopy all checks, including attached remittance advices, as well as the deposit
slip. Verify that this packet of information matches the total to be sent to the bank
in the deposit. Then send the photocopies to the accounts receivable staff, which
will apply these payments to outstanding accounts receivable.
5. Send the completed deposit to the bank by courier.
Cash—Process Credit Card Payments
This procedure is useful for processing credit card payments through an Internet-based
processing site.
1. Verify that the customer has supplied all information required for the credit card
processing: name on the card, credit card number, expiration date, and billing address.
Also retain the customer’s phone number in case the payment is not accepted,
so corrected information can be obtained.
2. Access the Internet credit card processing site and log in.
3. Enter all customer-supplied information on the Web screen, as well as the invoice
number, amount to be billed, and a brief description of the billing.
4. If the transaction is not accepted, call the customer and review all supplied information
to determine its accuracy. As an alternative, obtain information for a different
credit card from the customer.
5. If the transaction is accepted, go to the accounting computer system and log in the
cash receipt associated with the transaction. Date the transaction one day forward,
since this more closely corresponds to the settlement date and corresponding receipt
of cash.
6. Copy the invoice, stamp it with a “Paid in Full” stamp, and initial the stamp. Mail it
to the person whose name was on the credit card (not the person listed on the invoice,
if any), since this person will need it as a receipt.
18 GAAP Implementation Guide
Cash—Reconcile Petty Cash
Use this procedure to conduct a manual reconciliation of the petty cash balance in any
petty cash box.
1. Access the general ledger account for the petty cash box and determine the amount
of cash it should contain as of the last reconciliation.
2. Go to the petty cash box and add up all cash contained in the box. Subtract this
amount from the box balance as of the last reconciliation and add any amounts deposited
into the box during the interval since the last reconciliation. This calculation
reveals the amount of missing cash that should be accounted for by expense
vouchers.
3. Add up all vouchers in the box and compare this amount to the predetermined
amount of missing cash. If they do not match, review petty cash procedures with
the person responsible for it.
4. Create a journal entry summarizing the expenses represented by all vouchers in the
box, as well as the amount of any shortfalls or overages. Staple the vouchers to this
journal entry and give the packet to the general ledger accountant for entry into the
general ledger.
5. Calculate the amount of cash that should be added to the petty cash box, based on
usage levels, and recommend to the assistant controller in charge of accounts payable
that this amount of cash be forwarded to the person responsible for the petty
cash box.
Cash—Reconcile Bank Account
Use this procedure to reconcile any differences between the bank and company records
of cash transactions. This procedure assumes that a computerized reconciliation module is
available through the accounting software.
1. Verify that the beginning bank balance matches the beginning book record, net of
reconciling items. If not, go back and fix the bank reconciliations for earlier periods.
2. Enter the ending bank balance on the computer screen.
3. Check off all company records of deposits in the computer system if they match the
bank record of receipts. As you progress through this list, check off the deposit records
on the bank statement that have also been checked off in the computer system.
If there are any deposits that cannot be immediately reconciled, pull out the detailed
deposit records for the days in question and determine which deposits are in error.
Fix any deposit record differences and verify that the total book record of deposits
matches the total bank record of deposits.
4. Scan the bank statement for any special charges levied by the bank that have not already
been recorded in the company books. Enter these adjustments as a journal
entry, and check off all recorded expenses of this type on the bank statement.
5. Check off all company checks in the computer system if they match the amount of
checks recorded as having cleared on the bank statement. It is not good enough to
just match check numbers! You must also verify the amount of each cleared
check on the bank statement, since this can be a source of discrepancy.
6. If there are checks still listed on the bank statement that do not appear in the company
records, then these are most likely manual checks that were not initially recorded
in the company records. Also review these unrecorded checks to see if any
Chapter / 2 Cash, Receivables, and Prepaid Expenses 19
were fraudulently created. Enter these items in the computer system as manual
checks.
7. If the bank statement reveals transfers between bank accounts, verify that these entries
have been recorded in the computer system. If not, make journal entries to
match the bank transaction record.
8. Verify that the bank ending balance now matches the company’s records, net of any
deposits or checks in transit. If not, repeat the foregoing steps. Then print two
copies of the reconciliation report, filing one copy in the journal entry binder for the
applicable month and one copy in the bank statement binder, next to the applicable
bank statement.
Receivables—Print and Issue Invoices
Use this procedure to verify shipment of goods and then create invoices based on the
shipments. This procedure assumes that the shipping department is logging out shipped
goods from the computer system and tracking back orders, rather than the accounting staff.
1. Locate the shipping paperwork in the “shippers” box in the mailroom. The paperwork
should include a copy of the shipping log and a copy of the bill of lading.
2. Verify that there is a bill of lading for every order listed on the shipping log, and
also that all bills of lading are listed on the log. Then put the bills of lading in order,
first by customer number and then by order number (if there is more than one order
per customer). Next, check the “carrier” column on the shipping log—some will
indicate shipment pickups by customers. For all other deliveries, the shipping department
should have turned in a freight worksheet containing the cost of additional
freight for each shipment. Locate these sheets, which will be used to determine the
freight charge on each invoice.
3. Locate on each freight sheet the method of delivery, as well as the weight of the order.
Cross-reference this information against the standard freight charge table, and
write on the freight sheet the price of the freight to be billed to the customer.
4. Locate the signed customer order, which contains the pricing for the items shipped,
as well as the bill-to customer name and address and the name of the salesperson to
whom a commission will be paid.
5. Go to the computer system and access the customer information screen. Call up the
customer name and verify that the invoice-to address and contact name are correct.
If not, either change the existing information or add a new invoice-to address for the
customer.
6. Go to the invoicing screen in the computer system and enter the customer name
verified in the last step. Verify that the default salesperson listed on the screen is
correct, or change it to match the salesperson name listed on the signed customer
order. Enter the part numbers and quantities shipped that are listed on the shipping
log, as well as the prices noted on the customer order. Enter the freight charge
listed on the freight sheet.
7. Print two copies of the invoice and mail one to the customer. If the order is complete,
also file the bill of lading, invoice, customer order, and freight sheet in the
customer file. If the order is not complete, store the customer order form in a
pending orders file for cross-referencing purposes when back-ordered items are
shipped at a later date.
20 GAAP Implementation Guide
Receivables—Calculate the Bad Debt Reserve
Use this procedure to alter the bad debt reserve to reflect new billing and bad debt activity
in a reporting period.
1. Print the accounts receivable aging report and review all invoices on the report that
are at least sixty days old with the collections staff.
2. If the collections staff deems a reviewed invoice to be uncollectible, complete a bad
debt authorization form for it and charge it off to the bad debt reserve account (see
following procedure).
3. Once all receivables designated as bad debts have been cleared from the aging report,
summarize the total amount written off during the reporting period, which can
be obtained from the list of written-off invoices listed in the bad debt reserve account
in the general ledger.
4. Enter the period’s bad debt total as a running balance in an electronic spreadsheet
alongside the remaining accounts receivable balance for the reporting period. Calculate
the rolling three-month bad debt percentage of accounts receivable on this
spreadsheet.
5. Multiply the rolling three-month bad debt percentage calculated from the spreadsheet
by the remaining accounts receivable balance to determine the estimated
amount of bad debt reserve required.
6. If the amount of estimated bad debt reserve is greater than the actual amount listed
in the general ledger, make an entry crediting the bad debt reserve account for the
difference, with the offsetting debit going to the bad debt expense account.
Receivables—Authorize Bad Debt Write-Offs
Use this procedure to formalize the process of writing off bad debts from the accounts
receivable aging report.
1. At least once a month, review all outstanding accounts receivable on the accounts
receivable aging report with the collections staff to see which invoices or portions
of invoices must be written off, taking into account customer bankruptcy, history of
collection problems, and the size of the amounts owed.
2. Complete the Bad Debt Write-Off Approval Form (see the Forms section). In particular,
note on the form the reason for the write-off. If there is a systemic problem
that is causing the write-off to occur, forward a copy of the completed form to the
appropriate department for review.
3. Forward the form to the general ledger accountant, who will create a credit based on
the information in the form and offset the credit against the outstanding customer
invoice.
4. Summarize all completed bad debt forms at the end of each month and send the results
to the general manager, showing the total write-off amounts attributable to
each type of systemic problem.
5. Store the completed bad debt write-off forms in a separate binder and store them in
the archives after year-end.
CONTROLS
Cash
The following controls can be used to reduce the risk of asset theft through the illegal
transfer of cash:
Chapter / 2 Cash, Receivables, and Prepaid Expenses 21
• Control check stock. This is a key control. All check stock must be locked up when
not in use. Otherwise, it is a simple matter for someone to take a check from the bottom
of a check stack (where its loss will not be noticed for some time), forge a signature
on it, and cash it. Be sure to keep the key or combination to the lock in a safe
place, or else this control will be worthless.
• Control signature plates. This is a key control. Many companies use either signature
plates or stamps to imprint an authorized signature on a check, thereby saving the
time otherwise required of a manager to sign checks. If someone obtains access to a
signature plate and some check stock, that person can easily pay himself the contents
of the entire corporate bank account. The best control is to lock up signature plates in
a different storage location than the check stock, so a perpetrator would be required to
break into two separate locations in order to carry out a really thorough check fraud.
• Separate responsibility for the cash receipt and cash disbursement functions. If a
person has access to both the cash receipt and disbursement functions, it is much easier
to commit fraud by altering the amount of incoming receipts, and then pocket the
difference. To avoid this, each function should be handled by different people within
the organization.
• Perform bank reconciliations. Though widely practiced and certainly necessary,
this is not a preventive control, and so should be implemented after the control of
check stock and signature plates. Bank reconciliations are most effective when completed
each day; this can be done by accessing the daily log of cash transactions
through the company bank’s Internet site. By staying up-to-date on reconciliations,
evidence of fraudulent check activity can be discovered more quickly, allowing for
faster remedial action.
• Reconcile petty cash. There tends to be a high incidence of fraud related to petty
cash boxes, since money can be more easily removed from them. To reduce the incidence
of these occurrences, unscheduled petty cash box reconciliations can be initiated,
which may catch perpetrators before they have covered their actions with a false
paper trail. This control can be strengthened by targeting those petty cash boxes that
have experienced unusually high levels of cash replenishment requests.
• Require that bank reconciliations be completed by people independent of the
cash receipts and disbursement functions. The bank reconciliation is intended to be
a check on the activities of those accounting personnel handling incoming and outgoing
cash, so it makes little sense to have the same people review their own activities
by completing the reconciliation. Instead, it should be done by someone in an entirely
different part of the department, and preferably by a senior person with a proven record
of reliability.
• Require that petty cash vouchers be filled out in ink. Anyone maintaining a petty
cash box can easily alter a voucher previously submitted as part of a legitimate transaction,
and remove cash from the petty cash box to match the altered voucher. To
avoid this, one should require that all vouchers be completed in ink. To be extra careful,
one can even require users to write the amount of any cash transactions on vouchers
in words instead of numbers (e.g., “fifty-two dollars” instead of $52.00”), since
numbers can be more easily modified.
• Compare the check register to the actual check number sequence. If checks are
prenumbered, one can compare the check numbers listed in the computer’s check
register to those on the checks. If a check were to be removed from the check stock,
then this action would become apparent when the check number on the check stock no
longer matches the check number in the computer system.
22 GAAP Implementation Guide
If the check stock is on a continuous sheet, as is used for sheet-fed dot matrix
printers, then the more likely way for a perpetrator to steal checks would be to detach
them from the top or bottom of the stack of check stock. In this case, one can detect
the problem by keeping separate track of the last check number used, as well as of the
last check number on the bottom of the stack. Unfortunately, many accounting clerks
like to keep this list of check numbers used with the check stock, so a perpetrator
could easily alter the last number listed on the sheet while stealing checks at the same
time. Consequently, the list of check numbers used should be kept in a separate location.
• Review uncashed checks. Review all checks that have not been cashed within ninety
days of their check dates. In a few cases, it may be possible to cancel the checks,
thereby increasing the available cash balance. This review can also highlight checks
that have gone astray. By placing stop payment orders on these checks, one can keep
them from being incorrectly cashed by other parties, while new checks can be issued
to the proper recipients.
• Route incoming cash payments through a lockbox. When customers are told to
send payments directly to a bank lockbox, this eliminates a number of control points
within a company, since it no longer has to physically handle any forms of cash.
Some payments will inevitably still be mailed directly to the company, but the proportion
of these payments will drop if customers are promptly asked to send future
payments to the lockbox address.
• Verify amount of cash discounts taken. A cash receipts person can falsely report
that customers are taking the maximum amount of early payment discounts when they
have not actually done so, and pocket the amount of the false discount. This can be
detected by requiring that photocopies of all incoming checks be made, and then
tracing payments on which discounts have been taken back to the copies of the
checks. This is a less common problem area, since it requires a perpetrator to have
access to both the receipts and payments aspects of the accounting operation, and so is
a less necessary control point.
Prepaid Expenses
The largest problem with prepaid expenses is that they tend to turn into a holding area
for payments that should have been converted into expenses at some point in the past. There
is also a potential for advances to be parked in this area that should have been collected. The
following controls address these problems:
• Reconcile all prepaid expense accounts as part of the month-end closing process.
By conducting a careful review of all prepaid accounts once a month, it becomes
readily apparent which prepaid items should now be converted to an expense. The result
of this review should be a spreadsheet that itemizes the nature of each prepaid
item in each account. Since this can be a time-consuming process involving some investigative
work, it is best to review prepaid expense accounts shortly before the end
of the month, so that a thorough review can be conducted without being cut short by
the time pressures imposed by the usual closing process.
• Review all employee advances with the payroll and payables staffs at least once a
month. A common occurrence is for an employee to claim hardship prior to a
company-required trip, and request a travel advance. Alternatively, an advance may
be paid when an employee claims that he or she cannot make it to the next payroll
check. For whatever the reason, these advances will be recorded in an employee advances
account, where they can sometimes be forgotten. The best way to ensure reChapter
/ 2 Cash, Receivables, and Prepaid Expenses 23
payment is a continual periodic review, either with the accounts payable staff that
process employee expense reports (against which travel advances should be netted) or
the payroll staff (which deducts pay advances from future paychecks).
• Require approval of all advance payments to employees. The simplest way to reduce
the burden of tracking employee advances is not to make them in the first place.
The best approach is to require management approval of any advances, no matter how
small they may be.
Receivables
• Confirm payment terms with customers. Receivable collections can be particularly
difficult when the sales staff has established side agreements with customers that alter
payment terms—especially when the sales staff does not communicate these new
terms to the collections department. One can discover the existence of these deals by
confirming payment terms at the time of invoice creation with selected customers, and
then working with the sales manager to reprimand those sales staff who have authorized
special terms without notifying anyone else in the company.
• Require approval of bad debt write-offs. A common form of fraud is for a collections
person to write off an invoice as a bad debt and then pocket the customer payment
when it arrives. This can be avoided by requiring management approval of all
bad debt write-offs (though staffs are usually allowed to write off small balances as an
efficiency measure). Management should be particularly wary when a large proportion
of bad debt requests come from the same collections person, indicating a possible
fraud pattern.
• Require approval of credits. Credits against invoices can be required for other reasons
than bad debts—incorrect pricing or quantities delivered, incorrect payment
terms, and so on. In these cases, management approval should be required not only to
detect the presence of false credit claims, but also to spot patterns indicating some underlying
problem requiring correction, such as inaccurate order picking in the warehouse.
• Match invoiced quantities to the shipping log. It is useful to spot-check the quantities
invoiced to the quantities listed on the shipping log. By doing so, one can detect
fraud in the billing department caused by invoicing for too many units, with the accounting
staff pocketing the difference when it arrives. This is a rare form of fraud,
since it generally requires collaboration between the billing and cash receipts staff,
and so the control is needed only where the fraud risk clearly exists.
• Verify invoice pricing. The billing department can commit fraud by issuing fake invoices
to customers at improperly high prices, and then pocketing the difference between
the regular and inflated prices when the customer check arrives. Having someone
compare the pricing on invoices to a standard price list before invoices are mailed
can spot this issue. As was the case for the last control, this form of fraud is possible
only when there is a risk of collaboration between the billing and cash receipts staff,
so the control is needed only when the fraud risk is present.
FORMS AND REPORTS
Cash—Mailroom Remittance Receipt
In larger companies, all incoming checks are recorded in the mailroom, which summarizes
all receipts on a worksheet such as the one shown in Exhibit 2-3. This sheet can then be
matched against cash receipts recorded by the accounting department, thereby indicating if
any checks were fraudulently removed from the mail delivered by the mailroom staff. The
24 GAAP Implementation Guide
“City and State” column on the report is used to identify which branch of customer has sent
in a check, since payments may be received from multiple customer locations. For companies
with a smaller number of customers, this column can be omitted.
Exhibit 2-3: Mailroom Remittance Sheet
Source
Check If Not
Number Check Sender City and State Amount
1602 The Rush Airplane Company Scranton, PA $ 126.12
Cash Rental Air Service Stamford, CT $ 19.50
2402 Automatic Service Company Los Angeles, CA $ 316.00
1613 Voe Parts Dealer Toledo, OH $ 2.90
9865 Brush Electric Company Chicago, IL $ 25.50
2915 Ajax Manufacturing Company Cleveland, OH $ 1,002.60
8512 Apex Machine Tool Co. New York, NY $ 18.60
Total Receipts $ 1,511.22
Prepared by:
Date:
Company Name
Mailroom Remittance Sheet
Receipts of [Month/Day/Year]
SOURCE: Adapted with permission from p. 617 of Willson, et al., Controllership, 6E (John Wiley & Sons, Inc.,
Hoboken, NJ, 1999).
Cash—Bank Reconciliation
The bank reconciliation identifies the differences between a company’s record of cash
on hand and that of its bank. Preparing the report frequently results in the identification of
errors in recorded cash transactions, and can be used as a control to spot fraudulent activities.
It should be completed at least once a month, but can be done each day if online bank records
are available through the Internet. Many accounting computer systems include a partially
automated reconciliation module, along with a bank reconciliation report. If not, the format
in Exhibit 2-4 can be used as a model.
Chapter / 2 Cash, Receivables, and Prepaid Expenses 25
Exhibit 2-4: Bank Reconciliation Report
Balance Disburse- Balance
11/30/XX Receipts ments 12/31/XX
Per bank……………….. $ 126,312.50 $ 9 2,420.00 $ 8 5,119.00 $ 1 33,613.50
Add:
Deposits in transit
11/30 per book $ 5,600.00 $ (5,600.00)
12/31 per book $ 1 2,500.00 $ 1 2,500.00
Deduct:
Outstanding checks
November (see list) $ 4,320.00 $ (4,115.00) $ 2 05.00
December (see list) $ 6 ,110.00 $ 6 ,110.00
Other Items:
Bank charges not recorded -5.01 5.01
Per books…………………. $ 1 27,592.50 $ 9 9,320.00 $ 8 7,108.99 $ 1 39,803.51
Prepared by
Date
Company Name
Bank Reconciliation
Bank: __________________ Account No: ___________________
As of ________________________
SOURCE: Adapted with permission from p. 623 of Willson, et al., Controllership, 6E (John Wiley & Sons, Inc.,
Hoboken, NJ, 1999).
Cash—Cash Forecasting Model
The cash forecasting model is the most important report in the controller’s arsenal of
cash reports, because it gives a detailed forward-looking view of when excess cash can be
invested or when new cash inflows are required. A good working model is shown in Exhibit
2-5. The report shows weekly cash flows for each week of the next two months, which are
usually fairly predictable in most businesses. The model then switches to monthly forecasts
for the following three months, which tend to be increasingly inaccurate for the later months.
The first block of information is receipts from sales projections, which is drawn for the corporate
sales funnel report. The next block is uncollected invoices, listing larger invoices by
customer name and smaller ones at a summary level in a Cash, Minor Invoices category.
The collections staff can itemize the weeks in which individual collections are most likely to
arise, based on their experience with individual customers. The third block contains the most
common categories of expenses, such as payroll, rent, and capital purchases, with all other
expenses summarized under the Other Expenses category. By combining cash inflows from
the first two blocks with the cash outflows listed in the third block, one can obtain a reasonably
accurate picture of cash flows in the near term. These projections can be compared to
budgeted cash levels, which are noted at the bottom of the report, in order to gain some idea
of the accuracy of the budgeting process.
Exhibit 2-5: Cash Forecasting Model
Date Last Updated 3/9/2004
(partial)
3/9/2004 3/16/2004 3/23/2004 3/30/2004 4/6/2004 4/13/2004 4/20/2004 4/27/2004 5/4/2004 May-04 Jun-04 Jul-04
Beginning Cash Balance 1,037,191 $
1,034,369 $
968,336 $ 967,918 $ 918,082 $
932,850 $
918,747 $
829,959 $ 834,924 $
754,124 $
808,592 $ 798,554 $
Receipts from Sales Projections:
Coal Bed Drilling Corp. 16,937$ 174,525 $
Oil Patch Kids Corp. 12,965$ 48,521 $
28,775 $
Overfault & Sons Inc.2,500 $
129,000 $
Platte River Drillers 3,000 $
53,000 $
Powder River Supplies Inc. 8,700 $
18,500 $
14,500 $
Submersible Drillers Ltd. 2,500 $
16,250 $
16,250 $
Commercial, Various25,000$ 25,000 $
Uncollected Invoices:
Canadian Drillers Ltd. 9,975 $
Coastal Mudlogging Co.6,686 $
Dept. of the Interior1,823$ 11,629 $
2,897 $
18,510 $
Drill Tip Repair Corp. 5,575 $
Overfault & Sons Inc. 9,229 $
Submersible Drillers Ltd. 4,245 $
U.S. Forest Service 2,967 $
812 $
8,715 $
Cash, Minor Invoices 2,355 $
-
$
3,668 $
-
$
21,768 $
Total Cash In 4,178 $
2,967 $
30,370 $
30,164 $ 21,768 $
2,897 $
-
$
12,965 $
14,200 $
139,468 $
188,750 $ 259,050 $
Cash Out:
Payroll + Payroll Taxes 62,000 $
65,000 $
68,000 $
71,000 $
71,000 $
138,000 $ 138,000 $
Commissions 7,000 $
7,000 $
8,000 $
9,000 $
Rent10,788$ 10,788 $
10,788 $
10,788 $
Capital Purchases10,000$ 10,000 $
10,000 $
10,000 $
10,000 $
Other Expenses 7,000 $
7,000 $
10,000 $
8,000 $
7,000 $
7,000 $
10,000 $
8,000 $
7,000 $
14,000 $
32,000 $
32,000 $
Total Cash Out:7,000 $
69,000 $
30,788 $
80,000 $
7,000 $
17,000 $
88,788 $
8,000 $
95,000 $
85,000 $
198,788 $ 199,788 $
Net Change in Cash (
2,822) $
(
66,033) $
(
418) $
(
49,836) $
14,768 $
(
14,103) $
(
88,788) $
4,965 $
(
80,800) $ 54,468$ (10,038)$ 59,262 $
Ending Cash:1,034,369$ 968,336 $
967,918 $ 918,082 $ 932,850 $
918,747 $
829,959 $
834,924 $ 754,124 $
808,592 $
798,554 $ 857,816 $
Budgeted Cash Balance: 897,636 833,352 800,439 815,040 857,113
Cash Forecast
For the Week Beginning on
SOURCE: Adapted with permission from p. 445 of Bragg, Accounting Reference Desktop (John Wiley & Sons, Inc., Hoboken, NJ, 2002)
Chapter / 2 Cash, Receivables, and Prepaid Expenses 27
Receivables—Bad Debt Authorization Form
The bad debt authorization form is used to itemize the specific invoice to be written off
and the reason for doing so, and to obtain management permission for the write-off. Of considerable
importance from an operational perspective is the list of reasons used on the form
for writing off an invoice, since this information can be summarized and used to improve
company systems to ensure that write-offs are reduced in the future. For example, if there
are many incidents of “customer unable to pay,” then there is a probable need for more intensive
credit reviews prior to the acceptance of customer orders. Consequently, the form format
shown in Exhibit 2-6 can and should be modified to match the types of bad debt problems
being encountered by a business.
Exhibit 2-6: Bad Debt Authorization Form
Customer Name: ____________________ Invoice Number: ____________
Customer Code: ____________________ Invoice Amount: ____________
Reason for Write-Off
Customer unable to pay
Damaged goods
Incorrect pricing
Incorrect shipment quantity
Product quality not acceptable
Other nonstandard reasons for a write-off: ________________________
Requested Write-off Amount: _________________________
Name of Requesting Clerk:___________________________
Signature of Requesting Clerk: ________________________ Date: __________
Name of Approving Manager: ________________________
Signature of Approving Manager: ______________________ Date: __________
Company Name
Bad Debt Write-Off Approval Form
Receivables—Collection Actions Taken
Any reasonably organized collections staff should make notes about the status of their
collection activities with each customer account, including the dates of contact, representations
made by customers, and when the next collection contact is scheduled to be made. This
information may be just handwritten notes, in which case it is quite difficult to summarize
into a report. A better approach is to have the entire collections staff use a centralized collections
database, from which a variety of reports can be printed. With such a system, the
report shown in Exhibit 2-7 can be easily printed whenever necessary. It can be sorted by the
28 GAAP Implementation Guide
dollar amount of overdue balances to bring attention to the largest items, or by invoice date
in order to focus attention on the oldest collection problems, or by collection staff so that
problems with collection techniques can be highlighted.
Exhibit 2-7: Collection Actions Report
Collections
Contact Customer
Invoice
Number Amount
Next
Contact
Date Comments
Jones Alpha Labs 5418 $500.25 5/04 Waiting on controller approval
Jones Blue Moon 5009 250.00 5/09 Sent bill of lading
Jones White Ice 5200 375.15 5/03 Sent replacement part
Jones Zora Inc. 5302 1,005.00 5/12 Meeting in person to discuss
Smith Chai Tea 5400 2,709.15 5/01 Issued credit for price change
Smith Deal Time 5417 5,010.00 5/13 Sent claim to bankruptcy court
Smith Energy Ltd. 5304 128.45 5/08 Faxed new invoice copy
Smith Foo & Sons 5215 495.31 5/07 Waiting for call back
Smith Green Way 5450 95.97 5/05 Offered 25% discount to pay
Receivables—Aging Report
The single most used receivables report is the aging report, which divides outstanding
invoices into thirty-day time buckets. It is heavily used by the collections staff as their key
source of information about old unpaid invoices. The report is standard with all accounting
packages, and so would be constructed only if a manual accounting system were used. An
example is shown below in Exhibit 2-8. The main modification worth considering is shifting
the date range on the time buckets to match the terms of company invoices, plus a few days
to allow for mail float. For example, altering the current time bucket to contain all invoices
issued within the past thirty-five days instead of the usual thirty days would cover all
invoices issued under “net thirty” terms, as well as any invoices already paid by customers
but in transit to the company. This approach does not bring invoices to the attention of the
collections staff until collection activities are truly required.
Exhibit 2-8: Accounts Receivable Aging Report
Customer Invoice no. Current +30 Days +60 Days +90 Days
Alpha Labs 5418 $500.25
5603 $1,042.75
5916 $639.50
Chai Tea Inc. 5400 $2,709.15
5511 $25.19
5618 $842.68
5900 $100.00
Totals $739.50 $1,885.43 $525.44 $2,709.15
Receivables—Loan Collateralization Report
Receivables are the most common asset used as loan collateral, since they can be more
easily liquidated than other assets. Typically, a lender requires that a loan collateralization
report such as the one shown in Exhibit 2-9 be completed at the end of each month. The
agreement usually requires that old receivables be stripped from the reported balance to arrive
at a core set of receivables most likely to be collected by the lender in the event of default.
In addition, each category of assets used as collateral is multiplied by a reduction percentage
(shown in bold in the exhibit), reflecting the amount of cash the lender believes it
can collect if it were to sell each type of asset. The reduced amount of all asset types is then
summarized and compared to the outstanding loan balance; if the collateral amount has
Chapter / 2 Cash, Receivables, and Prepaid Expenses 29
dropped below the loan balance, then the company must pay back the difference. The report
is typically signed by a company officer.
Exhibit 2-9: Loan Collateralization Report
For the month ended: ____________
Accounts receivable balance $1,800,000
Less receivables > 90 days old -$42,500
Net accounts receivable $1,757,500
80% of net accounts receivable balance $1,406,000
Raw materials inventory balance $2,020,000
40% of raw materials inventory balance $1,010,000
Finished goods inventory balance $515,000
70% of finished goods inventory balance $360,500
Total collateral $2,776,500
Total loan balance $2,000,000
Total collateral available for use $776,500
CFO Signature: ______________________ Date: ___________
Company Name
Loan Collateralization Report
I assert that the above calculation is correct, and that all bad debts, work in process, and obsolete inventory have been
removed from the above balances.
FOOTNOTES
Cash—Restrictions on Use
Any restriction on a company’s use of its cash should be disclosed in a footnote. An example
follows:
Contributors to the organization have specified that their contributions be restricted to one of
three funds: conservation, trail maintenance, and mountain properties. As of year-end, approximately
$875,000 was restricted in the conservation fund, $520,000 in the trail maintenance fund,
and $1,209,000 in the mountain properties fund. This left approximately $2,041,000 in unrestricted
cash.
Cash—Restrictions Caused by Compensating Balance Agreements
If there are restrictions on a company’s cash balances caused by compensating balance
agreements, a footnote should detail the terms of the agreement as well as the amount of cash
restricted by the agreement. An example follows:
As part of the company’s loan arrangement with the Second National Bank of Boise, it must
maintain a compensating balance at the bank of no less than $200,000 at all times. The bank segregates
this amount and does not allow drawdowns from it unless the balance of the associated
line of credit is less than $500,000. Also, the bank requires an additional compensating balance of
30 GAAP Implementation Guide
10% of the loan balance; there is no restriction on use of this additional compensating balance, but
the company must pay an additional 2% interest on the loan balance whenever its average cash
balance drops below the required compensating balance. During the past year, this resulted in an
average 0.4% increase in the average interest rate paid on the line of credit.
Cash—Excessive Concentration in Uninsured Accounts
If there is a significant amount of credit risk resulting from the excessive concentration
of cash in bank accounts that exceeds federally insured limits, then the excess amounts
should be revealed in a footnote. An example follows:
The company concentrates the bulk of its cash at the Second National Bank of Boise for cash
management purposes. This typically results in cash investments exceeding Federal Deposit Insurance
Corporation (FDIC) insurance limits. As of the balance sheet date, $2,045,000 held as
cash reserves at this bank exceeded the FDIC insurance limits.
Receivables—Bad Debt Recognition
The method by which a company derives its bad debt reserves should be noted in a footnote,
including the amount of the reserve contained within the balance sheet, and its method
for recognizing bad debts. Also note any factors influencing the judgment of management in
calculating the reserves. An example follows:
The company calculates a bad debt reserve based on a rolling average of actual bad debt
losses over the past three months, divided by the average amount of accounts receivable outstanding
during that period. It calculates separate loss percentages for its government and commercial
receivables, since government receivables have a significantly lower loss rate. Given the
current recession, management has elected to increase this calculated reserve by an additional
1.5%. As of the balance sheet date, the loss reserve percentage for government receivables was
1.1%, while the reserve for commercial receivables was 2.9%. This resulted in a total loss reserve
of $329,000 on outstanding accounts receivable of $18,275,000. The company recognizes all receivables
as bad debts that have been unpaid for more than ninety days past their due dates, or
earlier upon the joint agreement of management and the collections staff, or immediately if a
customer declares bankruptcy.
Receivables—Separation of Types
Though different types of receivables may be clustered into a single line item on the balance
sheet, one should describe the different types of receivables in a footnote, describing
each general category of receivable and the approximate amount of each type. An example
follows:
The ABC Truck Company had approximately $12,525,000 in accounts receivable as of the
balance sheet date. Of this amount, $485,000 was a short-term note due from a distributor, while
$48,000 was for a cash advance to a company officer and $9,000 was for cash advances to nonkey
employees. The company expects all cash advances to be paid within ninety days, except for
the advance to the company officer, which will be paid back as a single balloon payment in six
months.
Receivables—Used as Collateral
When accounts receivable are pledged to a lender as collateral on a loan, the terms of the
agreement should be listed in the footnotes, as well as the carrying amount of the receivables.
An example follows:
The XYZ Scuba Supplies Company has entered into a loan agreement with the International
Credit Consortium. Under the terms of the agreement, XYZ has pledged the full amount of its
trade receivables as collateral on a revolving line of credit carrying a floating interest rate 2%
Chapter / 2 Cash, Receivables, and Prepaid Expenses 31
above the prime rate. The amount loaned cannot exceed 80% of all outstanding accounts receivable
billed within the past ninety days. As of the balance sheet date, the total amount of accounts
receivable subject to this agreement was $2,500,000.
JOURNAL ENTRIES
Cash
Bank reconciliation. To adjust the accounting records to reflect differences between
the book and bank records. The cash entry is listed as a credit, on the assumption that bankrelated
expenses outweigh the interest income.
Bank charges xxx
Credit card charges xxx
Interest income xxx
Cash xxx
Receivables
Accounts receivable, initial entry. To record the creation of a receivable at the point
when a sale is made. The entry includes the creation of a liability account for a sales tax.
The second entry records the elimination of the account receivable when cash is received
from the customer, while the third entry records the payment of sales taxes payable to the
relevant government authority.
Accounts receivable xxx
Sales xxx
Sales taxes payable xxx
Cash xxx
Accounts receivable xxx
Sales taxes payable xxx
Cash xxx
Accounts receivable, recording of long-term payment terms. To record any accounts
receivable not due for payment for at least one year. The receivable is discounted at no less
than the market rate of interest. The first journal entry shows the initial record of sale, while
the second entry shows the gradual recognition of interest income associated with the receivable.
Notes receivable xxx
Revenue xxx
Discount on notes receivable xxx
Discount on notes receivable xxx
Interest income xxx
Accounts receivable, sale of. To record the outright sale of an account receivable, including
the recognition of interest expense and any loss on the transaction due to the expected
incurrence of bad debt losses by the factor on the purchased receivables.
Cash xxx
Factoring expense xxx
Loss on sale of receivables xxx
Interest expense xxx
Accounts receivable xxx
Accounts receivable, payment due from factor. To record the outright sale of accounts
receivable to a factor, but without taking payment until the due date of the underlying
receivables, thereby avoiding interest expenses. The second entry records the eventual payment
by the factor for the transferred receivables.
32 GAAP Implementation Guide
Receivable due from factor xxx
Factoring expense xxx
Loss on sale of receivables xxx
Accounts receivable xxx
Cash xxx
Receivable due from factor xxx
Accounts receivable, establishment of recourse obligation. To record an obligation to
pay back a factor for any bad debts experienced as part of a receivable sale to the factor, for
which the company is liable under a factoring with recourse arrangement. The second entry
shows the recourse obligation being reduced as bad debts are incurred and the company pays
back the factor for the receivables written off as bad debts.
Allowance for bad debts xxx
Recourse obligation xxx
Recourse obligation xxx
Cash xxx
Accounts receivable, write off. To cancel an account receivable by offsetting it against
the reserve for bad debts located in the bad debt accrual account.
Bad debt accrual xxx
Accounts receivable xxx
Accrue bad debt expense. To accrue for projected bad debts, based on historical experience.
Bad debt expense xxx
Bad debt accrual xxx
Account for receipt of written-off receivable. To record the receipt of cash on a sale
that had previously been written off as uncollectible.
Cash xxx
Bad debt accrual xxx
Accrue for sales returns. To accrue for expected sales returns from sales made on approval,
based on historical experience.
Sales returns expense xxx
Reserve for sales returns xxx
Early payment discounts, record receipt of. To record the amount of early payment
discounts taken by customers as part of their payments for accounts receivable.
Cash xxx
Sales: Discounts taken xxx
Accounts receivable xxx
RECORDKEEPING
Detailed and well-organized cash records are needed by all external auditors. Accordingly,
all bank statements should be stored in a binder by account number, and by date within
each account number. In addition, a copy of the bank reconciliation for each month should
be stored alongside each bank statement. If canceled checks are returned by the bank, they
can be stored separately and labeled by month of receipt. If canceled checks are stored, one
should pay the bank a small additional amount to sort the checks by check number prior to
returning them to the company, which makes it much easier to locate checks in the archives.
Chapter / 2 Cash, Receivables, and Prepaid Expenses 33
Prepaid expenses should be reconciled as part of the month-end closing process, so there
is no risk of an item continuing to be carried on the books as an asset when it should really
have been written off as an expense. This is a common problem that can have serious ramifications
at the end of the reporting year if large amounts of prepaid items have been ignored,
resulting in large write-offs that drive profits below predicted levels. The best approach is to
list not only the detail in the prepaid expense account, but also the date by which it is to be
written off (if any) and the calculation method used to write it off over time. The spreadsheet
should be retained in the journal entry file for each month in which a balance is maintained
in the prepaid expense account. An example of such a reporting format is shown in Exhibit
2-10.
Exhibit 2-10: Itemization of Prepaid Expenses
Origination
date Payee Description
Termination
date
Remaining
amount
1/04 MESE LLC Employers’ council annual dues
(expense at 1/12 per month)
12/04
3,200
7/04 LifeConcepts Key man life insurance (expense
at 1/6 per month)
12/04
5,800.00
8/04 CSE Software Software maintenance fee (expense
at 1/12 per month)
7/05
29,500.00
10/04 Halley & Burns Annual audit fee (expense at 1/12
per month)
9/05
24,000.00
Total $62,500.00
Auditors reviewing a company’s accounts receivable balances are primarily interested in
an accounts receivable aging report that they can trace back to individual invoices and supporting
documents, showing evidence of product shipment or services rendered, such as
shipping logs, bills of lading, and employee time sheets showing evidence of time billed to
customer projects. Thus, recordkeeping for accounts receivable should include a complete
aging as of the fiscal year-end date, while invoices should be stored in order either by customer
name or invoice number, so they can be easily traced back from the receivables aging
document. The packet of information used to create each invoice, such as freight billing information,
time sheets, bills of lading, customers, or shipping logs, should be stapled to each
invoice, so that proof of delivery is easily accessible.
Accounts receivable information must also be stored for sales tax auditors. They will
want to determine which invoices were billed within their state, so it is useful to have access
to a report that sorts invoices by state, though a detailed sales journal is usually acceptable.
In addition, one can regularly archive a report listing customer addresses, which government
auditors can then use to trace back to the sales journal for those customers whose addresses
are in the state for which sales tax remittances are being investigated. These auditors will
trace back from the sales journal to individual invoices in order to test sales tax calculations,
so the same packets of invoice information described in the previous paragraph must be retained
for this purpose, too. Sales tax remittance forms must also be retained, since auditors
will want to compare them to the records in the sales tax payable account in the general
ledger to ensure that all liabilities are being properly paid to the applicable state sales tax
revenue department.
Completed bad debt write-off forms should be sorted by date and stored in a separate
binder in the archives. This information is particularly useful in situations where fraud by a
collections person is suspected, and evidence is needed detailing the amounts of write-offs
requested, the reasons given, and who approved the forms. Given the sensitive nature of this
information, the binder should be stored in a secure location.
3 SHORT-TERM INVESTMENTS AND
FINANCIAL INSTRUMENTS
Definitions of Terms 34
Concepts and Examples 34
Fair Value Hedges 34
Cash Flow Hedges 35
Foreign Currency Hedges 36
Policies 36
Hedges—General 36
Controls 37
Hedges—General 37
Fair Value Hedges 37
Cash Flow Hedges 37
Footnotes 38
Short-Term Investments 38
Restricted Short-Term Investments 38
Disclosure of Objectives for Derivative
Use 38
Valuation of Financial Instruments 39
Hedging of Foreign Operation Investment
39
Recordkeeping 39
DEFINITIONS OF TERMS
Cash flow hedge. The use of an offsetting cash flow from a hedging instrument to reduce
the uncertainty of future cash flows.
Derivative. A financial instrument whose fair value is based on changes in a benchmark.
It is frequently used as a hedging instrument to offset changes in the fair value of
hedged items. Examples of derivatives are interest rate caps and floors, option contracts,
letters of credit, swaps, and futures.
Fair value hedge. A hedge designed to protect the fair value of an asset.
Financial instrument. A contract to exchange cash or other financial instruments between
entities, or an ownership interest in another entity, or cash.
Forecasted transaction. An expected transaction that has not yet occurred, and for
which there is no final commitment.
Foreign currency hedge. A hedge designed to protect against future fluctuations in the
value of an investment denominated in a foreign currency.
Hedge. The act of protecting oneself against potentially unfavorable pricing changes,
usually by financing an asset with an offsetting liability having a similar maturity, or vice
versa.
CONCEPTS AND EXAMPLES
Fair Value Hedges
A hedging transaction qualifies as a fair value hedge only if both the hedging instrument
and the hedged item qualify under all of the following criteria:
• Documentation. At hedge inception, there is documentation of the relationship between
the hedging instrument and the hedged item, the risk management objectives of
the hedging transaction, how the hedge is to be undertaken, the method to be used for
gain or loss recognition, identification of the instrument used for the hedge, and how
the effectiveness calculation is measured.
• Effectiveness. There is a high level of expected effectiveness for the transaction to
regularly create offsetting fair value changes.
• Options. If using a written option, there must be as much potential for a gain as a loss
from fair value changes.
Chapter 3 / Short-Term Investments and Financial Instruments 35
A financial asset or liability is considered a hedged item to which a hedging instrument
can be matched only if it qualifies under all of the following criteria:
• It is not a held-to-maturity debt security, unless the hedged risk does not include
changes in the interest rate or foreign exchange rate.
• It is exposed to fair value changes that can impact earnings.
• The documented hedge risk is comprised of fair value changes in the market interest
rates, the total hedged item, foreign currency rates, or the obligor’s creditworthiness.
• It is not an equity method investment, minority interest, or firm commitment to acquire
or dispose of a business.
• It must be specifically associated with a fair value risk, which must be either changes
in the fair value of a total hedged item (or a percentage thereof), specific contractual
cash flows, the residual value of a lessor’s net investment in a direct financing or
sales-type lease, or a call, put, floor, or cap not qualifying as an embedded derivative.
Gains and losses on both the hedging instrument and hedged item are recognized in
earnings, while the book value of the hedged item is adjusted by the amount of any gains or
losses. The impact of any ineffective amounts or factors excluded from a hedging relationship
in its initial documentation is recognized in earnings. This accounting can continue
until such time as the criteria for the hedge are no longer met, the hedging designation is canceled,
or the derivative instruments used in the hedge are terminated. If any of these circumstances
arise, a new hedging relationship can be documented with a different derivative instrument.
The periodic determination of hedging effectiveness first requires the establishment of
the method to be used to assess hedge effectiveness, as well as the designation of what type
of fair value change in the derivative instrument will be used to assess the hedge effectiveness.
Hedge effectiveness must be evaluated at least quarterly, and must include an assessment
of both the retrospective and prospective ability of the hedging instrument. Both assessment
types can be accomplished through statistical analysis.
There are no quantitative GAAP guidelines for the determination of fair value hedging
effectiveness, so a company should create a policy defining the hedging range for different
types of hedges (see the Policies and Controls sections).
Cash Flow Hedges
A cash flow hedge is designed to offset uncertain future cash flows. To establish a valid
cash flow hedge, one must document the relationship between the hedging instrument and an
asset, liability, or forecasted transaction (including expected date of occurrence and amount).
The documentation must also describe the hedging strategy, risk management objectives, and
how the effectiveness of the transaction shall be measured.
In addition, the hedging relationship must be expected to be highly effective, and evaluated
at least quarterly to ensure that this is the case.
If one intends to match a forecasted transaction with a hedging instrument, this is allowable
only if the forecasted transaction is probable, is not a held-to-maturity debt security, is
specifically identified, could affect earnings, is with an external party, and does not involve a
business combination or any equity investment.
One must discontinue a cash flow hedge when the hedge criteria are no longer met, the
hedging designation is canceled, or the derivative instruments used in the hedge are terminated.
If any of these circumstances arise, a new hedging relationship can be documented
with a different derivative instrument.
When reporting derivative gains and losses for a cash flow hedge, the effective portion
of the gain or loss is reported in other comprehensive income, while any gains or losses at36
GAAP Implementation Guide
tributable to the ineffective portion of the hedge are reported in earnings. Any remaining
gain or loss on the hedging relationship is reported in earnings. Whenever one expects a net
loss from the hedging transaction, the amount not expected to be recovered must be shifted in
the current period from other comprehensive income to earnings. Also, if a hedging relationship
is established for a forecasted cash flow transaction and the transaction is deemed
unlikely to occur, any gain or loss thus far recorded in other comprehensive income must be
shifted to earnings in the current period.
There are no quantitative GAAP guidelines for the determination of fair value hedging
effectiveness, so a company should create a policy defining the hedging range for different
types of hedges (see the Policies and Controls sections).
Foreign Currency Hedges
In brief, the accounting for various types of foreign currency hedges is as follows:
• Available-for-sale security hedge. One can designate a derivative instrument as a
fair value hedge for an available-for-sale equity security only if all fair value hedge
criteria are met and payments to equity holders are denominated in the same currency
to be received upon sale of the security, and the security is not publicly traded in the
investor’s functional currency. These restrictions do not apply if the available-for-sale
security is a debt security.
• Debt-for-equity swaps. If a company’s foreign debt is legally required to be reinvested
in that country, one must first determine the difference between the US dollar
values of the debt and the equity in which it is invested. The difference must first be
used to reduce the basis of acquired long-term assets and then to reduce the basis of
existing long-term assets, with any remaining variance being reported as negative
goodwill.
• Forecasted transaction in foreign currency denomination. One can designate a derivative
instrument as a cash flow hedge of a forecasted transaction denominated in a
foreign currency. Cash flow hedge accounting can be used only if the transaction is
not denominated in the functional currency, all cash flow hedge criteria are met, foreign
currency inflows and outflows are not included in the same groups of transactions,
and one party to the transaction is an operating unit with foreign currency exposure.
• Net investment hedge. One can designate a derivative or financial instrument as a
foreign currency hedge for an investment in a foreign operation. Any effective gain or
loss is reported as a translation adjustment.
• Unrecognized firm commitment hedge. One can designate a derivative or financial
instrument as a fair value hedge of an unrecognized firm commitment in a foreign currency.
POLICIES
Hedges—General
• The determination of hedge effectiveness shall always use the same method for
similar types of hedges. GAAP allows one to use different assessment techniques in
determining whether a hedge is highly effective. However, changing methods, even
when justified, allows the accounting staff room to alter effectiveness designations,
which can yield variations in the level of reported earnings. Consequently, creating
and consistently using a standard assessment method for each type of hedge eliminates
the risk of assessment manipulation.
Chapter 3 / Short-Term Investments and Financial Instruments 37
• A hedge shall be considered highly effective if the fair values of the hedging instrument
and hedged item are at least ___% offset. GAAP does not quantitatively
specify what constitutes a highly effective hedge, so a company should create a policy
defining the number. A different hedging range can be used for different types of
hedges.
CONTROLS
Hedges—General
• Include in the hedging procedure a requirement for full documentation of each
hedge. Hedging transactions are allowed under GAAP only if they are fully documented
at the inception of the hedge. One can ensure compliance by including the
documentation requirement in an accounting procedure for creating hedges.
Fair Value Hedges
• Include in the closing procedure a requirement to review the effectiveness of any
fair value hedges. GAAP requires that hedging transactions be accounted for as fair
value hedges only if a hedging relationship regularly produces offsets to fair value
changes. Since this review must be conducted on at least a quarterly basis and every
time financial statements are issued, including the requirement in the closing procedure
is an effective way to ensure compliance with GAAP.
• Compare hedging effectiveness assessments to the corporate policy setting forth
effectiveness ranges. GAAP does not specify the exact amount by which hedging instruments
and hedged items must offset each other in order to be deemed highly effective,
so a corporate policy should be established (see the Policies section) to create
such a standard. This control is intended to ensure that the policy is followed when
making effectiveness assessments. Comparison to the corporate policy should be included
in the assessment procedure.
Cash Flow Hedges
• Include in the monthly financial statement procedure a review of the recoverability
of cash flow hedge losses. GAAP requires that a nonrecoverable cash flow hedge
loss be shifted in the current period from other comprehensive income to earnings.
Since this can result only in a reduced level of earnings, accounting personnel tend not
to conduct the review. Including the step in the monthly procedure is a good way to
ensure prompt loss recognition.
• Include in the monthly financial statement procedure a review of the likely occurrence
of forecasted cash flow transactions. GAAP requires that any accumulated
gain or loss recorded in other comprehensive income be shifted into earnings as
soon as it becomes probable that the forecasted cash flow transaction will not take
place. Including a standard periodic review of forecasted transactions in the monthly
procedure is a good way to ensure prompt inclusion of accumulated gains or losses in
earnings.
• Compare hedging effectiveness assessments to the corporate policy setting forth
effectiveness ranges. GAAP does not specify the exact amount by which hedging instruments
and hedged items must offset each other in order to be deemed highly effective,
so a corporate policy should be established (see the Policies section) to create
such a standard. This control is intended to ensure that the policy is followed when
making effectiveness assessments. Comparison to the corporate policy should be included
in the assessment procedure.
38 GAAP Implementation Guide
FOOTNOTES
Short-Term Investments
A company should disclose the types of investments it makes on a short-term basis, as
well as their usual term and how they are recorded in the financial records. An example
follows:
The company invests all excess cash over $1 million in marketable stocks and bonds. All
stocks held are required by company policy to be of companies listed on the New York Stock Exchange,
while all bonds must be of investment grade. Given the company’s high tax bracket, it
keeps at least 50% of all excess cash invested in investment-grade tax-free municipal bonds.
These investments are carried at cost, which approximates market pricing.
Restricted Short-Term Investments
If there is a restriction on the ability of a company to access its invested funds, this information
should be disclosed, along with the reason for the restriction, the amount restricted,
and the duration of the restriction period. An example follows:
The company is required by the terms of its building term loan with the Second National
Bank of Milwaukee to restrict all investments related to its loan for the construction of a new corporate
headquarters. Accordingly, the Second National Bank has custody over these funds, which
are invested in short-term US Treasury funds yielding approximately 3.25%. The restricted
amount is $4,525,000 as of the balance sheet date, and is expected to be eliminated as of year-end,
when the headquarters building will be completed and all contractors paid.
Disclosure of Objectives for Derivative Use
If a company is party to a derivative financial instrument, it should state its objective and
related strategies for using such an instrument and what specific risks are being hedged with
its use. The following additional disclosures are required for fair value and cash flow
hedges:
• Fair value hedge. One must disclose the net gain or loss recognized in earnings during
the period stemming from the ineffective portion of a fair value hedge, as well as
any derivative instrument’s gain or loss excluded from the assessment of hedge effectiveness.
If a hedged firm commitment no longer qualifies as a fair value hedge, then
disclosure must also include the resulting gain or loss shown in earnings.
• Cash flow hedge. One must disclose the net gain or loss recognized in earnings during
the period stemming from the ineffective portion of a cash flow hedge, as well as
any derivative instrument’s gain or loss excluded from the assessment of hedge effectiveness.
Also note the future events that will result in the reclassification of gains or
losses from other comprehensive income into earnings, as well as the net amount expected
to be reclassified in the next year.
Further, itemize the maximum time period over which the company hedges its
exposure to cash flows from forecasted transactions (if any). Finally, if forecasted
transactions are considered unlikely to occur, note the amount of gains or losses
shifted from other comprehensive income into earnings as a result of canceling the
hedge.
The first footnote sample is for a fair value hedge, while the second addresses a cash
flow hedge:
1. The Company designates certain futures contracts as fair value hedges of firm commitments
to purchase coal for electricity generation. Changes in the fair value of a derivative that is
highly effective and that is designated and qualifies as a fair value hedge, along with the loss
Chapter 3 / Short-Term Investments and Financial Instruments 39
or gain on the hedged asset or liability that is attributable to the hedged risk are recorded in
current period earnings. Ineffectiveness results when the change in the fair value of the
hedge instruments differs from the change in fair value of the hedged item. Ineffectiveness
recorded related to the Company’s fair value hedges was not significant during fiscal 2005.
2. If a derivative instrument used by the Company in a cash flow hedge is sold, terminated, or
exercised, the net gain or loss remains in accumulated other comprehensive income and is reclassified
into earnings in the same period when the hedged transaction affects earnings. Accordingly,
accumulated other comprehensive income at September 30, 2005, includes $6.5
million of the loss realized upon termination of derivative instruments that will be reclassified
into earnings over the original term of the derivative instruments, which extend through December
2009. As of September 30, 2005, the Company had entered into contracts for derivative
instruments, designated as cash flow hedges, covering 200,000 tons of coal with a floor
price of $58 per ton and a ceiling price of $69 per ton, resulting in other current assets of $0.7
million and $0.7 million of accumulated other comprehensive income representing the effective
portion of unrealized hedge gains associated with these derivative instruments.
Valuation of Financial Instruments
If a company has outstanding financial instruments, it must describe the method and assumptions
used to estimate their fair value. If it is impossible to determine fair value, then it
must disclose the carrying amount, effective interest rate, and maturity of the instruments, as
well as why it is not possible to determine their fair value.
The Company’s significant financial instruments include cash and cash equivalents, investments
and debt. In evaluating the fair value of significant financial instruments, the Company
generally uses quoted market prices of the same or similar instruments or calculates an estimated
fair value on a discounted cash flow basis using the rates available for instruments with the same
remaining maturities. As of December 31, 2005, the fair value of financial instruments held by the
Company approximated the recorded value except for long-term debt. Fair value of long-term
debt was $2.9 billion on December 31, 2005.
Hedging of Foreign Operation Investment
When a company hedges its investment in a foreign operation, it must disclose the net
gain or loss incorporated within the cumulative translation adjustment. This applies to any
derivative or hedging instruments that may cause foreign currency gains or losses. An example
follows:
The company has invested $40 million in a manufacturing facility in Dubai. It has entered
into certain foreign currency derivative instruments that are designed to hedge its investment in
this facility. The cumulative translation adjustment includes a net loss of $1,240,000 from these
derivative instruments.
RECORDKEEPING
At the inception of a fair value hedge, GAAP requires documentation of the relationship
between the hedging instrument and the hedged item, the risk management objectives of the
hedging transaction, how the hedge is to be undertaken, the method to be used for gain or
loss recognition, identification of the instrument used for the hedge, and how the effectiveness
calculation is measured. Since hedge accounting cannot be used unless this documentation
exists, it is important to store a complete set of documentation for each hedge for the
duration not only of the hedge, but also through the audit following the hedge termination. It
can then be included in the archives with accounting documentation for the year in which the
transaction terminated.
4 INVENTORY
Definitions of Terms 40
Concepts and Examples 41
Goods in Transit 41
Accounting for Inventories 42
Valuation of Inventories 43
Overhead costs allocable to inventory 43
Lower of cost or market rule 44
Specific identification inventory valuation
method 44
First-in, first-out (FIFO) inventory
valuation method 45
Last-in, first-out (LIFO) inventory
valuation method 46
Dollar-value LIFO inventory valuation
method 47
Weighted-average inventory valuation
method 50
Decision Trees 51
Policies 54
Goods in Transit 54
Accounting for Inventories 55
Valuation of Inventories 55
Procedures 56
Goods in Transit—Receiving
Procedure 56
Accounting for Inventories—Physical
Count Procedure for Periodic
Inventory 56
Accounting for Inventories—Cycle
Counting Procedure for Perpetual
Inventory 58
Accounting for Inventories—Part
Logging Procedure for Perpetual
Inventory 58
Accounting for Inventories—Inbound
Consignment Inventory 59
Accounting for Inventories—Obsolete
Inventory Review 59
Valuation of Inventories—Period-End
Inventory Valuation 59
Valuation of Inventories—Lower of
Cost or Market Calculation 60
Controls 60
Goods in Transit 60
Accounting for Inventories 61
Valuation of Inventories 62
Forms and Reports 64
Goods in Transit 64
Accounting for Inventories 64
Valuation of Inventories 66
Footnotes 68
Disclosure of Inventory 68
Journal Entries 68
Goods in Transit 68
Record received goods 68
Move inventory to work-in-process 68
Move inventory to finished goods 68
Sell inventory 69
Accounting for Inventories 69
Adjust inventory for obsolete items 69
Adjust inventory to lower of cost or
market 69
Adjust inventory to physical count 69
Write off abnormal scrap/spoilage 69
Valuation of Inventories 69
Record indirect expenses incurred 69
Record indirect wages incurred 69
Record receipt of supplies 70
Record normal scrap/spoilage 70
Allocate overhead costs to inventory 70
Recordkeeping 70
Goods in Transit 70
Accounting for Inventories 71
Valuation of Inventories 71
DEFINITIONS OF TERMS
Book inventory. The amount of money invested in inventory, as per a company’s accounting
records. It consists of the beginning inventory balance, plus the cost of any receipts,
less the cost of sold or scrapped inventory. It may be significantly different from the
actual on-hand inventory if the two are not periodically reconciled.
Chapter 4 / Inventory 41
Consignment inventory. Inventory that has been shifted to the location of a third party
by the owning entity in order to sell it. The inventory continues to be recorded on the books
of the owning entity until it has been sold.
Cycle counting. The ongoing incremental counting of perpetual inventory records, with
the intent of correcting record inaccuracies and determining the underlying causes of those
errors.
Finished goods. Completed manufactured goods that have not yet been sold.
First-in, first-out. A process costing methodology that assigns the earliest cost of production
and materials to units being sold, while the latest costs of production and materials
are assigned to units still retained in inventory.
Inventory. Tangible items held for sale, or that are being produced for this purpose, or
that will be used during the manufacturing process to create these items.
Last-in, first-out. An inventory costing methodology that bases the recognized cost of
sales on the most recent costs incurred, while the cost of ending inventory is based on the
earliest costs incurred. The underlying reasoning for this costing system is the assumption
that goods are sold in the reverse order of their manufacture.
Lower of cost or market. An accounting valuation rule used to reduce the reported
cost of inventory to its current resale value if that cost is lower than its original cost of acquisition
or manufacture.
Periodic inventory. An inventory tracking system that determines inventory levels only
at fixed points in time through the use of physical inventory counts.
Perpetual inventory. An inventory tracking system that determines inventory levels on
an ongoing basis by making incremental adjustments to inventory records based on individual
production transactions.
Raw materials. Materials kept on hand prior to their use in the manufacturing process.
Scrap. The excess unusable material left over after a product has been manufactured.
Spoilage, abnormal. Spoilage arising from the production process that exceeds the
normal or expected rate of spoilage. Since it is not a recurring or expected cost of ongoing
production, it is expensed to the current period.
Spoilage, normal. The amount of spoilage that naturally arises as part of a production
process, no matter how efficient the process may be.
Work in process. Inventory that is partway through the conversion process that will
transform it into finished goods.
CONCEPTS AND EXAMPLES
Goods in Transit
Inventory that is in transit to the buyer continues to be owned by the seller as long as
that entity is responsible for the transportation costs. If the seller is paying for transportation
only to a certain point, such as to a third-party shipper, then its ownership stops at that point
and is transferred to the buyer.
In reality, companies do not usually track goods in transit, preferring instead to not count
them if they either have already left the facility (in the case of the seller) or have not yet arrived
at the facility (in the case of the buyer). The reason for avoiding this task is the difficulty
in determining the amount of goods in transit that belong to the company, especially
when the accounting staff is trying to close the books very quickly and does not want to keep
the books open long enough to make a proper determination. This avoidance has minimal
impact on the receiving company’s recordkeeping, since a missing inventory item would
have required both a debit to an inventory account and a credit to a liability account, which
42 GAAP Implementation Guide
cancel each other out. This is more of an issue for the shipping firm, since it is probably recognizing
revenue at the point of shipment, rather than at some later point in transit, which
can potentially overstate revenue if this occurs near the end of the reporting period.
Examples of different types of transit scenarios
• If goods are shipped under a cost, insurance and freight (C&F) contract, the buyer is paying
for all delivery costs, and so acquires title to the goods as soon as they leave the seller’s
location.
• If goods are shipped Free Alongside (FAS), the seller is paying for delivery of the goods to
the side of the ship that will transport the goods to the buyer. If so, it retains ownership of
the goods until they are alongside the ship, at which point the buyer acquires title to the
goods.
• If goods are shipped Free on Board (FOB) destination, then transport costs are paid by the
seller, and ownership will not pass to the buyer until the carrier delivers the goods to the
buyer.
• As indicated by the name, an Ex-Ship delivery means that the seller pays for a delivery until
it has departed the ship, so it retains title to the goods until that point.
• If goods are shipped FOB shipping point, then transport costs are paid by the buyer, and
ownership passes to the buyer as soon as the carrier takes possession of the delivery from
the seller.
• If goods are shipped FOB a specific point, such as Nashville, then the seller retains title
until the goods reach Nashville, at which point ownership transfers to the buyer.
Accounting for Inventories
The type and quantity of items stored in inventory can be accounted for on a periodic
basis by using the periodic inventory system, which requires one to conduct a complete
count of the physical inventory in order to obtain a calculation of the inventory cost. A more
advanced method that does not require a complete inventory count is the perpetual inventory
system; under this approach, one incrementally adds or subtracts inventory transactions to or
from a beginning database of inventory records in order to maintain an ongoing balance of
inventory quantities. The accuracy of the inventory records under this latter approach will
likely degrade over time, so an ongoing cycle counting program is needed to maintain its
accuracy level.
The perpetual inventory system is highly recommended, because it avoids expensive
periodic inventory counts, which also tend not to yield accurate results. Also, it allows the
purchasing staff to have greater confidence in what inventory is on hand for purchasing planning
purposes. Further, accountants can complete period-end financial statements more
quickly, without having to guess at ending inventory levels.
Perpetual inventory example
A company wishes to install a perpetual inventory system, but it has not established tight
control over the warehouse area with fencing or gate control. Accordingly, production employees
are able to enter the warehouse and remove items from the shelf for use in the manufacturing
process. Because of this issue, inventory balances in the perpetual inventory system are chronically
higher than is the really the case, since removed items are not being logged out of the system.
The scenario changes to one where the company has not assigned responsibility for inventory
accuracy to anyone in the company, but still creates a perpetual inventory system. As a result, the
employees charged with entering inventory transactions into the computer system have no reason
to do so, and no one enforces high accuracy levels. In this case, inventory accuracy levels rapidly
worsen, especially for those items being used on a regular basis, since they are most subject to
transactional inaccuracies. Only the inventory of slow-moving items remains relatively accurate.
Chapter 4 / Inventory 43
The scenario changes to one where transactional procedures have not been clearly established,
and employees entering inventory transactions have not been properly trained. This results
in the worst accuracy levels of the three scenarios, since employees are not even certain if they
should be adding or subtracting quantities, what units of measure to enter, or what special transactions
call for what types of computer entries.
Consigned inventory is any inventory shipped by a company to a reseller, while retaining
ownership until the product is sold by the reseller. Until sold, the inventory remains
on the books of the originating company and is not on the books of the reseller. A common
cause of inventory valuation problems is the improper recording of consignment inventory
on the books of a reseller. Inventory that has been sold with a right of return receives
treatment similar to consignment inventory if the amount of future inventory returns cannot
be reasonably estimated. Until the probability of returns is unlikely, the inventory must remain
on the books of the selling company, even though legal title to the goods has passed to
the buyer.
Right of return example
A company has sold a large shipment of refrigerators to a new customer. Included in the
sales agreement is a provision allowing the customer to return one-third of the refrigerators within
the next ninety days. Since the company has no experience with this customer, it cannot record
the full amount of the sale. Instead, it records that portion of the sale associated with the refrigerators
for which there is no right of return, and waits ninety days until the right of return has
expired before recording the remainder of the sale.
Valuation of Inventories
Overhead costs allocable to inventory. All costs can be assigned to inventory that are
incurred to put goods in a salable condition. For raw materials, this is the purchase price,
inbound transportation costs, insurance, and handling costs. If inventory is in the work-inprocess
or finished goods stages, then an allocation of the overhead costs shown in Exhibit 4-
1 must be added:
Exhibit 4-1: Costs to Allocate to Overhead
Depreciation of factory equipment Quality control and inspection
Factory administration expenses Rent, facility and equipment
Indirect labor and production supervisory wages Repair expenses
Indirect materials and supplies Rework labor, scrap and spoilage
Maintenance, factory and production equipment Taxes related to production assets
Officer salaries related to production Uncapitalized tools and equipment
Production employees’ benefits Utilities
Allocation of overhead costs can be made by any reasonable measure, but must be consistently
applied across reporting periods. Common bases for overhead allocation are direct
labor hours or machine hours used during the production of a product.
Overhead allocation example
A company manufactures and sells Product A and Product B. Both require considerable machining
to complete, so it is appropriate to allocate overhead costs to them based on total hours of
standard machine time used. In March, Product A manufacturing required a total of 4,375 hours
of machine time. During the same month, all units of Product B manufactured required 2,615
hours of machine time. Thus, 63% of the overhead cost pool was allocated to Product A and 37%
to Product B. This example results in a reasonably accurate allocation of overhead to products,
especially if the bulk of expenses in the overhead pool relate to the machining equipment used to
complete the products. However, if a significant proportion of expenses in the overhead cost pool
could be reasonably assigned to some other allocation measure, then these costs could be stored in
a separate cost pool and allocated in a different manner. For example, if Product A was quite
bulky and required 90% of the storage space in the warehouse, as opposed to 10% for Product B,
then 90% of the warehouse-related overhead costs could be reasonably allocated to Product A.
44 GAAP Implementation Guide
Lower of cost or market rule. A company is required to recognize an additional expense
in its cost of goods sold in the current period for any of its inventory whose replacement
cost (subject to certain restrictions) has declined below its carrying cost. If the market
value of the inventory subsequently rises back to or above its original carrying cost, its recorded
value cannot be increased back to the original carrying amount.
More specifically, the lower of cost or market (LCM) calculation means that the cost of
inventory cannot be recorded higher than its replacement cost on the open market; the replacement
cost is bounded at the high end by its eventual selling price, less costs of disposal,
nor can it be recorded lower than that price, less a normal profit percentage. The concept is
best demonstrated with the four scenarios listed in the following example:
Item
Selling
price –
Completion/
selling
cost =
Upper
price
boundary –
Normal
profit =
Lower
price
boundary
Existing
inventory
cost
Replacement
cost 1
Market
value 2 LCM
A $15.00 $ 4.00 $ 11.00 $ 2.20 $ 8.80 $ 8.00 $ 12.50 $11.00 $ 8.00
B 40.15 6.00 34.15 5.75 28.40 35.00 34.50 34.15 34.15
C 20.00 6.50 13.50 3.00 10.50 17.00 12.00 12.00 12.00
D 10.50 2.35 8.15 2.25 5.90 8.00 5.25 5.90 5.90
1 The cost at which an inventory item could be purchased on the open market.
2 Replacement cost, bracketed by the upper and lower price boundaries.
In the example, the numbers in the first six columns are used to derive the upper and
lower boundaries of the market values that will be used for the lower of cost or market calculation.
By subtracting the completion and selling costs from each product’s selling price,
we establish the upper price boundary (in bold) of the market cost calculation. By then subtracting
the normal profit from the upper cost boundary of each product, we establish the
lower price boundary. Using this information, the LCM calculation for each of the listed
products is as follows:
• Product A, replacement cost higher than existing inventory cost. The market price
cannot be higher than the upper boundary of $11.00, which is still higher than the existing
inventory cost of $8.00. Thus, the LCM is the same as the existing inventory
cost.
• Product B, replacement cost lower than existing inventory cost, but higher than
upper price boundary. The replacement cost of $34.50 exceeds the upper price
boundary of $34.15, so the market value is designated at $34.15. This is lower than
the existing inventory cost, so the LCM becomes $34.15.
• Product C, replacement cost lower than existing inventory cost, and within price
boundaries. The replacement cost of $12.00 is within the upper and lower price
boundaries, and so is used as the market value. This is lower than the existing inventory
cost of $17.00, so the LCM becomes $12.00.
• Product D, replacement cost lower than existing inventory cost, but lower than
lower price boundary. The replacement cost of $5.25 is below the lower price
boundary of $5.90, so the market value is designated as $5.90. This is lower than the
existing inventory cost of $8.00, so the LCM becomes $5.90.
Specific identification inventory valuation method. When each individual item of inventory
can be clearly identified, it is possible to create inventory costing records for each
one, rather than summarizing costs by general inventory type. This approach is rarely used,
since the amount of paperwork and effort associated with developing unit costs is far greater
than under all other valuation techniques. It is most applicable in businesses such as home
Chapter 4 / Inventory 45
construction, where there are very few units of inventory to track, and where each item is
truly unique.
First-in, first-out (FIFO) inventory valuation method. A computer manufacturer
knows that the component parts it purchases are subject to extremely rapid rates of obsolescence,
sometimes rendering a part worthless in a month or two. Accordingly, it will be sure
to use up the oldest items in stock first, rather than running the risk of scrapping them a short
way into the future. For this type of environment, the first-in first-out (FIFO) method is the
ideal way to deal with the flow of costs. This method assumes that the oldest parts in stock
are always used first, which means that their associated old costs are used first, as well.
The concept is best illustrated with an example, which we show in Exhibit 4-2. In the first
row, we create a single layer of inventory that results in 50 units of inventory, at a per-unit
cost of $10.00. So far, the extended cost of the inventory is the same as we saw under the
LIFO, but that will change as we proceed to the second row of data. In this row, we have
monthly inventory usage of 350 units, which FIFO assumes will use the entire stock of 50
inventory units that were left over at the end of the preceding month, as well as 300 units that
were purchased in the current month. This wipes out the first layer of inventory, leaving us
with a single new layer that is composed of 700 units at a cost of $9.58 per unit. In the third
row, there is 400 units of usage, which again comes from the first inventory layer, shrinking
it down to just 300 units. However, since extra stock was purchased in the same period, we
now have an extra inventory layer that is comprised of 250 units, at a cost of $10.65 per unit.
The rest of the exhibit proceeds using the same FIFO layering assumptions.
Exhibit 4-2: FIFO Valuation Example
FIFO Costing
Part Number BK0043
Column 1 Column 2 Column 3 Column 4 Column 5 Column 6 Column 7 Column 8
Net Cost of Cost of Cost of
Date Quantity Cost per Monthly inventory 1st inventory 2nd inventory 3rd inventory
purchased purchased unit usage remaining layer layer layer
05/03/03 500 $10.00 450 50 (50 x $10.00) -- --
06/04/03 1,000 9.58 350 700 (700 x $9.58) -- --
07/11/03 250 10.65 400 550 (300 x $9.58) (250 x $10.65) --
08/01/03 475 10.25 350 675 (200 x $10.65) (475 x $10.25) --
08/30/03 375 10.40 400 650 (275 x $10.40) (375 x $10.40) --
09/09/03 850 9.50 700 800 (800 x $9.50) -- --
12/12/03 700 9.75 900 600 (600 x $9.75) -- --
02/08/04 650 9.85 800 450 (450 x $9.85) -- --
05/07/04 200 10.80 0 650 (450 x $9.85) (200 x $10.80) --
09/23/04 600 9.85 750 500 (500 x $9.85) -- -- 4,925
$ 500
6,706
5,537
6,999
6,760
7,600
5,850
4,433
6,593
Column 9
Extended
inventory
cost
There are several factors to consider before implementing a FIFO costing system.
• Fewer inventory layers. The FIFO system generally results in fewer layers of inventory
costs in the inventory database. For example, the LIFO model shown in Exhibit
4-3 contains four layers of costing data, whereas the FIFO model shown in Exhibit 4-
2, which used exactly the same data, resulted in no more than two inventory layers.
This conclusion generally holds true, because a LIFO system will leave some layers of
costs completely untouched for long time periods, if inventory levels do not drop,
whereas a FIFO system will continually clear out old layers of costs, so that multiple
costing layers do not have a chance to accumulate.
• Reduces taxes payable in periods of declining costs. Though it is very unusual to
see declining inventory costs, it sometimes occurs in industries where there is either
ferocious price competition among suppliers, or else extremely high rates of innovation
that in turn lead to cost reductions. In such cases, using the earliest costs first will
46 GAAP Implementation Guide
result in the immediate recognition of the highest possible expense, which reduces the
reported profit level, and therefore reduces taxes payable.
• Shows higher profits in periods of rising costs. Since it charges off the earliest
costs first, any very recent increase in costs will be stored in inventory, rather than
being immediately recognized. This will result in higher levels of reported profits,
though the attendant income tax liability will also be higher.
• Less risk of outdated costs in inventory. Because old costs are used first in a FIFO
system, there is no way for old and outdated costs to accumulate in inventory. This
prevents the management group from having to worry about the adverse impact of inventory
reductions on reported levels of profit, either with excessively high or low
charges to the cost of goods sold. This avoids the dilemma noted earlier for LIFO,
where just-in-time systems may not be implemented if the result will be a dramatically
different cost of goods sold.
In short, the FIFO cost layering system tends to result in the storage of the most recently
incurred costs in inventory and higher levels of reported profits. It is most useful for those
companies whose main concern is reporting high profits rather reducing income taxes.
Last-in, first-out (LIFO) inventory valuation method. In a supermarket, the shelves
are stocked several rows deep with products. A shopper will walk by and pick products from
the front row. If the stocking person is lazy, he will then add products to the front row locations
from which products were just taken, rather than shifting the oldest products to the front
row and putting new ones in the back. This concept of always taking the newest products
first is called last-in, first-out.
The following factors must be considered before implementing a LIFO system:
• Many layers. The LIFO cost flow approach can result in a large number of inventory
layers, as shown in the exhibit. Though this is not important when a computerized accounting
system is used that will automatically track a large number of such layers, it
can be burdensome if the cost layers are manually tracked.
• Alters the inventory valuation. If there are significant changes in product costs over
time, the earliest inventory layers may contain costs that are wildly different from
market conditions in the current period, which could result in the recognition of unusually
high or low costs if these cost layers are ever accessed. Also, LIFO costs can
never be reduced to the lower of cost or market (see the Lower of Cost or Market
Rule), thereby perpetuating any unusually high inventory values in the various inventory
layers.
• Reduces taxes payable in periods of rising costs. In an inflationary environment,
costs that are charged off to the cost of goods sold as soon as they are incurred will result
in a higher cost of goods sold and a lower level of profitability, which in turn results
in a lower tax liability. This is the principle reason why LIFO is used by most
companies.
• Requires consistent usage for all reporting. Under IRS rules, if a company uses
LIFO to value its inventory for tax reporting purposes, then it must do the same for its
external financial reports. The result of this rule is that a company cannot report lower
earnings for tax purposes and higher earnings for all other purposes by using an alternative
inventory valuation method. However, it is still possible to mention what profits
would have been if some other method had been used, but only in the form of a
footnote appended to the financial statements. If financial reports are only generated
for internal management consumption, then any valuation method may be used.
• Interferes with the implementation of just-in-time systems. As noted in the last
bullet point, clearing out the final cost layers of a LIFO system can result in unusual
Chapter 4 / Inventory 47
cost of goods sold figures. If these results will cause a significant skewing of reported
profitability, company management may be put in the unusual position of opposing
the implementation of advanced manufacturing concepts, such as just-in-time, that reduce
or eliminate inventory levels (with an attendant, and highly favorable, improvement
in the amount of working capital requirements).
In short, LIFO is used primarily for reducing a company’s income tax liability. This
single focus can cause problems, such as too many cost layers, an excessively low inventory
valuation, and a fear of inventory reductions due to the recognition of inventory cost layers
that may contain very low per-unit costs, which will result in high levels of recognized profit
and therefore a higher tax liability. Given these issues, one should carefully consider the
utility of tax avoidance before implementing a LIFO cost layering system.
LIFO inventory valuation example
The Magic Pen Company has made 10 purchases, which are itemized in Exhibit 4-3. In the
exhibit, the company has purchased 500 units of a product with part number BK0043 on May 3,
2003 (as noted in the first row of data), and uses 450 units during that month, leaving the company
with 50 units. These 50 units were all purchased at a cost of $10.00 each, so they are itemized in
column 6 as the first layer of inventory costs for this product. In the next row of data, an additional
1,000 units were bought on June 4, 2003, of which only 350 units were used. This leaves an
additional 650 units at a purchase price of $9.58, which are placed in the second inventory layer,
as noted in column 7. In the third row, there is a net decrease in the amount of inventory, so this
reduction comes out of the second (or last) inventory layer in column 7; the earliest layer, as described
in column 6, remains untouched, since it was the first layer of costs added, and will not be
used until all other inventory has been eliminated. The exhibit continues through seven more
transactions, at one point increasing to four layers of inventory costs.
Exhibit 4-3: LIFO Valuation Example
LIFO Costing
Part Number BK0043
Column 1 Column 2 Column 3 Column 4 Column 5 Column 6 Column 7 Column 8 Column 9 Column 10
Net Cost of Cost of Cost of Cost of Extended
Date Quantity Cost per Monthly inventory 1st inventory 2nd inventory 3rd inventory 4th inventory inventory
purchased purchased unit usage remaining layer layer layer layer cost
05/03/03 500 $10.00 450 50 (50 x $10.00) -- -- -- $ 500
06/04/03 1,000 9.58 350 700 (50 x $10.00) (650 x $9.58) -- -- 6,727
07/11/03 250 10.65 400 550 (50 x $10.00) (500 x $9.58) -- -- 5,290
08/01/03 475 10.25 350 675 (50 x $10.00) (500 x $9.58) (125 x $10.25) -- 6,571
08/30/03 375 10.40 400 650 (50 x $10.00) (500 x $9.58) (100 x $10.25) -- 6,315
09/09/03 850 9.50 700 800 (50 x $10.00) (500 x $9.58) (100 x $10.25) (150 x $9.50) 7,740
12/12/03 700 9.75 900 600 (50 x $10.00) (500 x $9.58) (50 x $9.58) -- 5,769
02/08/04 650 9.85 800 450 (50 x $10.00) (400 x $9.58) -- -- 4,332
05/07/04 200 10.80 0 650 (50 x $10.00) (400 x $9.58) (200 x $10.80) -- 6,492
09/23/04 600 9.85 750 500 (50 x $10.00) (400 x $9.58) (50 x $9.85) -- 4,825
Dollar-value LIFO inventory valuation method. This method computes a conversion
price index for the year-end inventory in comparison to the base year cost. This index is
computed separately for each company business unit. The conversion price index can be
computed with the double-extension method. Under this approach, the total extended cost
of the inventory at both base year prices and the most recent prices are calculated. Then the
total inventory cost at the most recent prices is divided by the total inventory cost at base
year prices, resulting in a conversion price percentage, or index. The index represents the
change in overall prices between the current year and the base year. This index must be
computed and retained for each year in which the LIFO method is used.
There are two problems with the double-extension method. First, it requires a massive
volume of calculations if there are many items in inventory. Second, tax regulations require
that any new item added to inventory, no matter how many years after the establishment of
the base year, have a base year cost included in the LIFO database for purposes of calculat48
GAAP Implementation Guide
ing the index. This base year cost is supposed to be the one in existence at the time of the
base year, which may require considerable research to determine or estimate. Only if it is
impossible to determine a base year cost can the current cost of a new inventory item be used
as the base year cost. For these reasons, the double-extension inventory valuation method is
not recommended in most cases.
Double-extension inventory valuation example
A company carries a single item of inventory in stock. It has retained the following year-end
information about the item for the past four years:
Year
Ending
unit quantity
Ending
current price
Extended at
current year-end price
1 3,500 $32.00 $112,000
2 7,000 34.50 241,500
3 5,500 36.00 198,000
4 7,250 37.50 271,875
The first year is the base year upon which the double-extension index will be based in later
years. In the second year, we extend the total year-end inventory by both the base year price and
the current year price, as follows:
Year-end
quantity Base-year cost
Extended at
base-year cost
Ending
current price
Extended at
ending current price
7,000 $32.00 $224,000 $34.50 $241,500
To arrive at the index between year 2 and the base year, we divide the extended ending current
price of $241,500 by the extended base year cost of $224,000, yielding an index of 107.8%.
The next step is to calculate the incremental amount of inventory added in year 2, determine
its cost using base year prices, and then multiply this extended amount by our index of 107.8% to
arrive at the cost of the incremental year 2 LIFO layer. The incremental amount of inventory
added is the year-end quantity of 7,000 units, less the beginning balance of 3,500 units, which is
3,500 units. When multiplied by the base year cost of $32.00, we arrive at an incremental increase
in inventory of $112,000. Finally, we multiply the $112,000 by the price index of 107.8% to determine
that the cost of the year 2 LIFO layer is $120,736.
Thus, at the end of year 2, the total double-extension LIFO inventory valuation is the base
year valuation of $112,000 plus the year 2 layer’s valuation of $120,736, totaling $232,736.
In year 3, the amount of ending inventory has declined from the previous year, so no new
layering calculation is required. Instead, we assume that the entire reduction of 1,500 units during
that year were taken from the year 2 inventory layer. To calculate the amount of this reduction,
we multiply the remaining amount of the year 2 layer (5,500 units less the base year amount of
3,500 units, or 2,000 units) times the ending base year price of $32.00 and the year 2 index of
107.8%. This calculation results in a new year 2 layer of $68,992.
Thus, at the end of year 3, the total double-extension LIFO inventory valuation is the base
layer of $112,000 plus the reduced year 2 layer of $68,992, totaling $180,992.
In year 4, there is an increase in inventory, so we can calculate the presence of a new layer
using the following table:
Year-end
quantity Base-year cost
Extended at
base-year cost
Ending
current price
Extended at ending
current price
7,250 $32.00 $232,000 $37.50 $271,875
Again, we divide the extended ending current price of $271,875 by the extended base year
cost of $232,000, yielding an index of 117.2%. To complete the calculation, we then multiply the
incremental increase in inventory over year 3 of 1,750 units, multiply it by the base year cost of
$32.00/unit, and then multiply the result by our new index of 117.2% to arrive at a year-4 LIFO
layer of $65,632.
Thus, after four years of inventory layering calculations, the double-extension LIFO valuation
consists of the following three layers:
Chapter 4 / Inventory 49
Layer type Layer valuation Layer index
Base layer $112,000 0.0%
Year 2 layer 68,992 107.8%
Year 4 layer 65,632 117.2%
Total $246,624 --
Another way to calculate the dollar-value LIFO inventory is to use the link-chain
method. This approach is designed to avoid the problem encountered during doubleextension
calculations, where one must determine the base year cost of each new item added
to inventory. However, tax regulations require that the link-chain method be used for tax reporting
purposes only if it can be clearly demonstrated that all other dollar-value LIFO calculation
methods are not applicable due to high rates of churn in the types of items included
in inventory.
The link-chain method creates inventory layers by comparing year-end prices to prices
at the beginning of each year, thereby avoiding the problems associated with comparisons to
a base year that may be many years in the past. This results in a rolling cumulative index
that is linked (hence the name) to the index derived in the preceding year. Tax regulations
allow one to create the index using a representative sample of the total inventory valuation
that must comprise at least one-half of the total inventory valuation. In brief, a link-chain
calculation is derived by extending the cost of inventory at both beginning-of-year and endof-
year prices to arrive at a pricing index within the current year; this index is then multiplied
by the ongoing cumulative index from the previous year to arrive at a new cumulative index
that is used to price out the new inventory layer for the most recent year.
Link-chain inventory valuation example
This example assumes the same inventory information just used for the double-extension example.
However, we have also noted the beginning inventory cost for each year and included the
extended beginning inventory cost for each year, which facilitates calculations under the linkchain
method.
Year
Ending
unit quantity
Beginning-ofyear
cost/each
End-of-year
cost/each
Extended at
beginning-of-year price
Extended at
end-of-year price
1 3,500 $ --- $32.00 $ --- $112,000
2 7,000 32.00 34.50 224,000 241,500
3 5,500 34.50 36.00 189,750 198,000
4 7,250 36.00 37.50 261,000 271,875
As was the case for the double-extension method, there is no index for year 1, which is the
base year. In year 2, the index will be the extended year-end price of $241,500 divided by the extended
beginning-of-year price of $224,000, or 107.8%. This is the same percentage calculated
for year 2 under the double-extension method, because the beginning-of-year price is the same as
the base price used under the double-extension method.
We then determine the value of the year 2 inventory layer by first dividing the extended yearend
price of $241,500 by the cumulative index of 107.8% to arrive at an inventory valuation restated
to the base year cost of $224,026. We then subtract the year-1 base layer of $112,000 from
the $224,026 to arrive at a new layer at the base year cost of $112,026, which we then multiply by
the cumulative index of 107.8% to bring it back to current year prices. This results in a year 2 inventory
layer of $120,764. At this point, the inventory layers are as follows:
Layer type Base-year valuation LIFO layer valuation Cumulative index
Base layer $112,000 $112,000 0.0%
Year 2 layer 112,026 120,764 107.8%
Total $224,026 $232,764 --
In year 3, the index will be the extended year-end price of $198,000 divided by the extended
beginning-of-year price of $189,750, or 104.3%. Since this is the first year in which the base year
was not used to compile beginning-of-year costs, we must first derive the cumulative index, which
is calculated by multiplying the preceding year’s cumulative index of 107.8% by the new year 3
50 GAAP Implementation Guide
index of 104.3%, resulting in a new cumulative index of 112.4%. By dividing year 3 extended
year-end inventory of $198,000 by this cumulative index, we arrive at inventory priced at base
year costs of $176,157.
This is less than the amount recorded in year 2, so there will be no inventory layer. Instead,
we must reduce the inventory layer recorded for year 2. To do so, we subtract the base year layer
of $112,000 from the $176,157 to arrive at a reduced year 2 layer of $64,157 at base year costs.
We then multiply the $64,157 by the cumulative index in year 2 of 107.8% to arrive at an inventory
valuation for the year 2 layer of $69,161. At this point, the inventory layers and associated
cumulative indexes are as follows:
Layer type Base-year valuation LIFO layer valuation Cumulative index
Base layer $112,000 $112,000 0.0%
Year 2 layer 64,157 69,161 107.8%
Year 3 layer -- -- 112.4%
Total $176,157 $181,161 --
In year 4, the index will be the extended year-end price of $271,875 divided by the extended
beginning-of-year price of $261,000, or 104.2%. We then derive the new cumulative index by
multiplying the preceding year’s cumulative index of 112.4% by the year 4 index of 104.2%, resulting
in a new cumulative index of 117.1%. By dividing year 4 extended year-end inventory of
$271,875 by this cumulative index, we arrive at inventory priced at base year costs of $232,173.
We then subtract the preexisting base year inventory valuation for all previous layers of $176,157
from this amount to arrive at the base year valuation of the year 4 inventory layer, which is
$56,016. Finally, we multiply the $56,016 by the cumulative index in year 4 of 117.1% to arrive
at an inventory valuation for the year 4 layer of $62,575. At this point, the inventory layers and
associated cumulative indexes are as follows:
Layer type Base-year valuation LIFO layer valuation Cumulative index
Base layer $112,000 $112,000 0.0%
Year 2 layer 64,157 69,161 107.8%
Year 3 layer -- -- 112.4%
Year 4 layer 56,016 62,575 117.1%
Total $232,173 $243,736 --
Compare the results of this calculation to those from the double-extension method. The
indexes are nearly identical, as are the final LIFO layer valuations. The primary differences
between the two methods is the avoidance of a base year cost determination for any new
items subsequently added to inventory, for which a current cost is used instead.
Weighted-average inventory valuation method. The weighted-average costing
method is calculated in exactly in accordance with its name—it is a weighted-average of the
costs in inventory. It has the singular advantage of not requiring a database that itemizes the
many potential layers of inventory at the different costs at which they were acquired. Instead,
the weighted-average of all units in stock is determined, at which point all of the units
in stock are accorded that weighted-average value. When parts are used from stock, they are
all issued at the same weighted-average cost. If new units are added to stock, then the cost of
the additions are added to the weighted-average of all existing items in stock, which will result
in a new, slightly modified weighted average for all of the parts in inventory (both the
old and new ones).
This system has no particular advantage in relation to income taxes, since it does not
skew the recognition of income based on trends in either increasing or declining costs. This
makes it a good choice for those organizations that do not want to deal with tax planning. It
is also useful for very small inventory valuations, where there would not be any significant
change in the reported level of income even if the LIFO or FIFO methods were to be used.
Weighted-average inventory valuation example
Exhibit 4-4 illustrates the weighted-average calculation for inventory valuations, using a series
of 10 purchases of inventory. There is a maximum of one purchase per month, with usage
Chapter 4 / Inventory 51
(reductions from stock) also occurring in most months. Each of the columns in the exhibit shows
how the average cost is calculated after each purchase and usage transaction.
Exhibit 4-4: Weighted-Average Costing Valuation Example
Average Costing
Part Number BK0043
Column 1 Column 2 Column 3 Column 4 Column 5 Column 6 Column 7 Column 8 Column 9
Net Net change Extended Extended Average
Date Quantity Cost per Monthly inventory in inventory cost of new inventory inventory
purchased purchased unit usage remaining during period inventory layer cost cost/unit
05/03/03 500 $10.00 450 50 50 $ 500 $ 500 $10.00
06/04/03 1000 9.58 350 700 650 6,227 6,727 9.61
07/11/03 250 10.65 400 550 (150) 0 5,286 9.61
08/01/03 475 10.25 350 675 125 1,281 6,567 9.73
08/30/03 375 10.40 400 650 (25) 0 6,324 9.73
09/09/03 850 9.50 700 800 150 1,425 7,749 9.69
12/12/03 700 9.75 900 600 (200) 0 5,811 9.69
02/08/04 650 9.85 800 450 (150) 0 4,359 9.69
05/07/04 200 10.80 0 650 200 2,160 6,519 10.03
09/23/04 600 9.85 750 500 (150) 0 5,014 10.03
We begin the illustration with the first row of calculations, which shows that we have purchased
500 units of item BK0043 on May 3, 2003. These units cost $10.00 per unit. During the
month in which the units were purchased, 450 units were sent to production, leaving 50 units in
stock. Since there has been only one purchase thus far, we can easily calculate, as shown in column
7, that the total inventory valuation is $500, by multiplying the unit cost of $10.00 (in column
3) by the number of units left in stock (in column 5). So far, we have a per-unit valuation of
$10.00.
Next we proceed to the second row of the exhibit, where we have purchased another 1,000
units of BK0043 on June 4, 2003. This purchase was less expensive, since the purchasing volume
was larger, so the per-unit cost for this purchase is only $9.58. Only 350 units are sent to production
during the month, so we now have 700 units in stock, of which 650 are added from the most
recent purchase. To determine the new weighted-average cost of the total inventory, we first determine
the extended cost of this newest addition to the inventory. As noted in column 7, we arrive
at $6,227 by multiplying the value in column 3 by the value in column 6. We then add this
amount to the existing total inventory valuation ($6,227 plus $500) to arrive at the new extended
inventory cost of $6,727, as noted in column 8. Finally, we divide this new extended cost in column
8 by the total number of units now in stock, as shown in column 5, to arrive at our new perunit
cost of $9.61.
The third row reveals an additional inventory purchase of 250 units on July 11, 2003, but
more units are sent to production during that month than were bought, so the total number of units
in inventory drops to 550 (column 5). This inventory reduction requires no review of inventory
layers, as was the case for the LIFO and FIFO calculations. Instead, we simply charge off the
150-unit reduction at the average per-unit cost of $9.61. As a result, the ending inventory valuation
drops to $5,286, with the same per-unit cost of $9.61. Thus, reductions in inventory quantities
under the average costing method require little calculation—just charge off the requisite number
of units at the current average cost.
The remaining rows of the exhibit repeat the concepts just noted, alternatively adding units to
and deleting them from stock. Though there are a number of columns noted in this exhibit that
one must examine, it is really a simple concept to understand and work with. The typical computerized
accounting system will perform all of these calculations automatically.
DECISION TREES
The decision tree in Exhibit 4-5 shows how to determine who owns inventory that is in
transit. The “ex-ship” transportation noted in the tree refers to the practice of the seller paying
for delivery up to the point when the product is removed from a ship on its way to the
buyer.
52 GAAP Implementation Guide
Exhibit 4-5: Decision Tree for Ownership of Inventory in Transit
Decision to Own
Inventory in Transit
to Buyer
Pay for
transport to
shipping point?
Pay for
transport exship?
Pay for
transport to
buyer?
Retain inventory
ownership through
point noted in
decision tree
Shift ownership to
buyer when leaves
point noted in
decision tree
Yes
Yes
Yes
No
No
No
The decision tree in Exhibit 4-6 assists in determining which inventory tracking system
to install, based on the presence of several items that are required to achieve an accurate
perpetual inventory system.
Chapter 4 / Inventory 53
Exhibit 4-6: Decision Tree for Type of Inventory Tracking System to Use
Decision to Install
Inventory Tracking
System
Install perpetual
inventory system
Install periodic
inventory system
Transactional
responsibility?
Inventory
transaction
procedures?
Restricted
access to
warehouse?
No
No
No
Yes
Yes
Yes
The decision tree in Exhibit 4-7 assists in determining which inventory valuation system
to use, based on the type of inventory, the type of business, and the preferences of management
in reporting financial information.
54 GAAP Implementation Guide
Exhibit 4-7: Decision Tree for Type of Inventory Valuation System to Use
Separately
identifiable
inventory
items?
Decision to Select
Inventory Valuation
Method
Retail
establishment?
Prefer higher
reported
earnings and
taxes?
Prefer lower
reported
earnings and
taxes?
Use Last-in, Firstout
Method
Use Specific
Identification
Method
Use Retail Method
Use First-in, Firstout
Method
Yes
Yes
Yes
Yes
No
No
No
No
POLICIES
This section lists the policies that should be used in relation to the handling, accounting
for, and valuation of inventory. Though some are mutually exclusive, most can be copied
directly into a company’s policy manual.
Goods in Transit
• Revenue shall be recognized on goods in transit based on the point when the company
no longer has title to the goods. This policy ensures that there is a consistent
cutoff at the point at which a company records revenue on shipments of finished
goods to customers.
• Incoming inventory shall be recorded after it has been received and inspected.
This policy ensures that the quantity and quality of incoming inventory has been veriChapter
4 / Inventory 55
fied prior to recording it in the inventory database, thereby avoiding later problems
with having incorrect usable quantities on hand.
• Goods received on consignment shall be identified and stored separately from
company-owned inventory. This policy keeps a company from artificially inflating
its inventory by the amount of incoming consignment inventory, which would otherwise
increase reported profits.
• Consignment inventory shipped to reseller locations shall be clearly identified as
such both in the shipping log and the inventory tracking system. This policy
keeps a company from inflating its sales through the recognition of shipments sent to
resellers that are actually still owned by the company.
Accounting for Inventories
• A complete physical inventory count shall be conducted at the end of each
reporting period. This policy ensures that an accurate record of the inventory is used
as the basis for a cost of goods sold calculation.
• The materials manager is responsible for inventory accuracy. This policy centralizes
control over inventory accuracy, thereby increasing the odds of it being kept at a
high level.
• Cycle counters shall continually review inventory accuracy and identify related
problems. This policy is intended for perpetual inventory systems, and results in a
much higher level of inventory accuracy and attention to the underlying problems that
cause inventory errors.
• No access to the inventory is allowed by unauthorized personnel. This policy
generally leads to the lockdown of the warehouse, yielding much greater control over
the accurate recording of inventory issuance transactions.
• No inventory transaction shall occur without being immediately recorded in the
perpetual inventory database. This policy keeps the inventory database accurate at
all times, preventing errors from arising when employees adjust the database on the
incorrect assumption that the current record is correct.
• Only designated personnel shall have access to the inventory database and item
master file. This policy not only ensures that only trained employees adjust inventory
records, but also that the responsibility for their accuracy can be traced to designated
people.
Valuation of Inventories
• Only designated personnel shall have access to the labor routing and bill of materials
databases. This policy ensures that untrained employees are kept away from
the critical computer files needed to value inventory quantities.
• Standard cost records shall be updated at least annually. This policy ensures that
standard costs used in inventory valuations do not stray too far from actual costs.
• Lower of cost or market calculations shall be conducted at least annually. This
policy ensures that excessively high inventory costs are stripped out of the inventory
before they can become an excessively large proportion of it. This policy may be
modified to require more frequent reviews, based on the variability of market rates for
various inventory items.
• Formal inventory obsolescence reviews shall be conducted at least annually. This
policy requires an inventory review team to periodically scan the inventory for obsolete
items, which not only removes the cost of such items from stock, but also gives
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management a chance to profitably dispose of older inventory items before they become
worthless.
• Management shall actively seek out, identify, and dispose of scrap as soon as
possible. This policy requires the production team to remove scrap from the manufacturing
process immediately, thereby keeping it from being recorded in the inventory
records and artificially inflating profits.
• Changes in production processes shall be immediately reflected in labor routings.
This policy ensures that the costs assigned to products through labor routings accurately
reflect the actual production process, equipment usage, and production staffing.
• Changes in product components shall be immediately reflected in the associated
bills of material. This policy ensures that the costs assigned to a product through a
bill of materials accurately reflect the current product configuration as designed by the
engineering staff.
PROCEDURES
Goods in Transit—Receiving Procedure
Take the following steps to ensure that received goods are properly inspected and recorded
in the accounting system:
1. When the shipper arrives, compare the shipment to the description on the bill of lading
and the authorizing purchase order. If there are significant discrepancies, reject
the shipment.
2. Sign a copy of the bill of lading to accept the delivery.
3. Access the authorizing purchase order on the corporate computer system and record
both the received quantity and the warehouse location in which they will be stored.
If portable bar code scanners are used, then record this transaction at the time the
warehouse move is made.
4. Store a copy of the bill of lading in an indexed file.
5. Forward a copy of the bill of lading to the accounting department or digitize the image
in a scanner and enter the document into the corporate accounting system.
NOTE: If items are received during a physical inventory count, clearly mark them as not being available
for counting and segregate them. Either wait to enter the transaction in the corporate accounting
system until after the count has been completed, or make the entry but list the received goods as being
unavailable for counting in the database.
Accounting for Inventories—Physical Count Procedure for Periodic Inventory
Take the following steps one week before the physical count:
1. Contact the printing company and order a sufficient number of sequentially numbered
count tags. The first tag number should always be “1000.” The tags should
include fields for the product number, description, quantity count, location, and the
counter’s signature.
2. Review the inventory and mark all items lacking a part number with a brightly colored
piece of paper. Inform the warehouse manager that these items must be
marked with a proper part number immediately.
3. Clearly mark the quantity on all sealed packages.
4. Count all partial packages, seal them, and mark the quantity on the tape.
5. Prepare “Do Not Inventory” tags and use them to mark all items that should not be
included in the physical inventory count.
Chapter 4 / Inventory 57
6. Issue a list of count team members, with a notice regarding where and when they
should appear for the inventory count.
Take the following steps one day before the physical count:
1. Remind all participants that they are expected to be counting the next day.
2. Notify the warehouse manager that all items received during the two days of physical
counts must be segregated and marked with “Do Not Inventory” tags.
3. Notify the manager that no shipments are allowed for the duration of the physical
count.
4. Notify the warehouse manager that all shipments for which the paperwork has not
been sent to accounting by that evening will be included in the inventory count on
the following day.
5. Notify the warehouse manager that all shipping and receiving documentation from
the day before the count must be forwarded to the accounting department that day,
for immediate data entry. Likewise, any pick information must be forwarded at the
same time.
6. Notify all outside storage locations to fax in their inventory counts.
Take the following steps on the morning of the physical count:
1. Enter all transactions from the previous day.
2. Assemble the count teams. Issue counting instructions to them, as well as blocks of
tags, for which they must sign. Give each team a map of the warehouse with a section
highlighted on it that they are responsible for counting. Those teams with
forklift experience will be assigned to count the top racks; those without this experience
will be assigned the lower racks.
3. Call all outside storage warehouses and ask them to fax in their counts of companyowned
inventory.
4. The count supervisor assigns additional count areas to those teams that finish counting
their areas first.
5. The tag coordinator assigns blocks of tags to those count teams that run out of tags,
tracks the receipt of tags, and follows up on missing tags. All tags should be accounted
for by the end of the day.
6. The data entry person enters the information on the tags into a spreadsheet, and then
summarizes the quantities for each item and pencils the totals into the cycle count
report that was run earlier in the day.
7. The count supervisor reviews any unusual variances with the count teams to ensure
that the correct amounts were entered.
8. Review the test count with an auditor, if necessary. Give the auditor a complete
printout of all tags, as well as the cycle counting spreadsheet, showing all variances.
The following job descriptions apply to the inventory counting procedure:
• The count supervisor is responsible for supervising the count, which includes assigning
count teams to specific areas and ensuring that all areas have been counted and
tagged. This person also waits until all count tags have been compared to the quantities
listed in the computer, and then checks the counts on any items that appear to be
incorrect.
• The tag coordinator is responsible for tracking the blocks of count tags that have
been issued, as well as for accounting for all tags that have been returned. When distributing
tags, mark down the beginning and ending numbers of each block of tags on
a tracking sheet, and obtain the signature of the person who receives the tags. When
58 GAAP Implementation Guide
the tags are returned, put them in numerical order and verify that all tags are accounted
for. Once the verification is complete, check off the tags on the tracking
sheet as having been received. Once returned tags have been properly accounted for,
forward them to the extension calculation clerk.
• The extension calculation clerk is responsible for summarizing the amounts on the
tags (if there are multiple quantities listed) to arrive at a total quantity count on each
tag. This person also compares the part numbers and descriptions on each tag to see
if there are any potential identification problems. This person forwards all completed
tags to the data entry person.
• The data entry person is responsible for entering the information on all count tags
into the computer spreadsheet. When doing so, enter all the information on each tag
into a spreadsheet. Once a group of tags has been entered, stamp them as having been
entered, clip them together, and store them separately. Once all tags are entered in the
spreadsheet, sort the data by part number. Print out the spreadsheet and summarize
the quantities by part number. Transfer the total quantities by part number to the cycle
count report. If there are any significant variances between the counted and cycle
count quantities, bring them to the attention of the count supervisor for review.
Accounting for Inventories—Cycle Counting Procedure for Perpetual Inventory
Take the following steps to ensure that a perpetual inventory database is properly cycle
counted:
1. Print a portion of the inventory report, sorted by location. Block out a portion of the
physical inventory locations shown on the report for cycle counting purposes.
2. Go to the first physical inventory location to be cycle counted and compare the
quantity, location, and part number of each inventory item to what is described for
that location in the inventory report. Mark on the report any discrepancies between
the on-hand quantity, location, and description for each item.
3. Also use the reverse process to ensure that the same information listed for all items
on the report matches the items physically appearing in the warehouse location.
Note any discrepancies on the report.
4. Verify that the noted discrepancies are not caused by recent inventory transactions
that have not yet been logged into the computer system.
5. Correct the inventory database for all remaining errors noted.
6. Calculate the inventory error rate and post it in the warehouse.
7. Call up a history of inventory transactions for each of the items for which errors
were noted, and try to determine the cause of the underlying problem. Investigate
each issue and recommend corrective action to the warehouse manager, so the
problems do not arise again.
Accounting for Inventories—Part Logging Procedure for Perpetual Inventory
Use this procedure to ensure that all transactions associated with the use of inventory are
properly logged into the inventory database, thereby ensuring the ongoing existence of accurate
perpetual inventory records.
1. The materials management department will issue a parts request form to the warehouse
for each new job to be produced. Upon receipt, the warehouse staff should
set up a pallet on which to store the requested items.
2. The warehouse staff collects the requested items from the warehouse, checking off
each completed part number on the list and noting the quantity removed and the location
from which they were removed.
Chapter 4 / Inventory 59
3. The warehouse staff accesses the inventory database record for each removed item
and logs out the quantities taken from the appropriate warehouse locations.
4. The warehouse staff delivers the filled pallet to the production floor.
5. If any parts remain after the production job is complete, the warehouse staff accepts
them at the warehouse gate, logs them back into the computer system, and notifies
the materials management department of the overage, so they can adjust the bill of
material for the products being produced.
6. If any parts are returned in a damaged condition, the warehouse staff logs them in
with a damaged code and stores them in the review area where the Materials Review
Board can easily access them. The warehouse staff periodically prints out a
report listing all items stored in this area, and forwards it to the Materials Review
Board, so they will be aware that items require their attention.
Accounting for Inventories—Inbound Consignment Inventory
Use this procedure to properly track consignment inventory owned by other parties but
stored in the company’s warehouse.
1. Upon receipt of consigned inventory, prominently label the inventory with a colored
tag, clearly denoting its status.
2. Record the inventory in the computer system using a unique part number to which
no valuation is assigned. If a consignment flag is available in the database, flag the
part number as being a consignment item.
3. Store the item in a part of the warehouse set aside for consigned inventory.
4. Include the consigned inventory in a review by the materials review board (see next
procedure), which should regularly determine the status of this inventory and arrange
for its return if there are no prospects for its use in the near future.
Accounting for Inventories—Obsolete Inventory Review
Use this procedure to periodically review the inventory for obsolete items and account
for items considered to be obsolete.
1. Schedule a meeting of the materials review board, to meet in the warehouse.
2. Prior to the meeting, print enough copies of the Inventory Obsolescence Review Report
(see the Forms and Reports section) for all members of the committee.
3. Personally review all items on the report for which there appear to be excessive
quantities on hand.
4. Determine the proper disposal of each item judged to be obsolete, including possible
returns to suppliers, donations, inclusion in existing products, or scrap.
5. Have the warehouse staff mark each item as obsolete in the inventory database.
6. Have the accounting staff write down the value of each obsolete item to its disposal
value.
7. Issue a memo to the materials review board, summarizing the results of its actions.
Valuation of Inventories—Period-End Inventory Valuation
Use this procedure to ensure that the inventory valuation created by a computerized accounting
system is accurate, as well as to update it with the latest overhead costs.
1. Following the end of the accounting period, print out and review the computer
change log for all bills of material and labor routings. Review them with the materials
manager and production engineer to ensure their accuracy. Revise any changes
made in error.
60 GAAP Implementation Guide
2. Go to the warehouse and manually compare the period-end counts recorded on the
inventory report for the most expensive items in the warehouse to what is in the
warehouse racks. If there are any variances, adjust them for any transactions that
occurred between the end of the period and the date of the review. If there are still
variances, adjust for them in the inventory database.
3. Print a report that sorts the inventory in declining extended dollar order and review
it for reasonableness. Be sure to review not only the most expensive items on the
list but also the least expensive, since this is where costing errors are most likely to
be found. Adjust for any issues found.
4. Review all entries in the general ledger during the reporting period for costs added
to the cost pool, verifying that only approved costs have been included. Also investigate
any unusually large overhead entries.
5. Verify that the overhead allocation calculation conforms to the standard allocation
used in previous reporting periods, or that it matches any changes approved by
management.
6. Verify that the journal entry for overhead allocation matches the standard journal
entry listed in the accounting procedures manual.
7. Print out the inventory valuation report and compare its results by major category to
those of the previous reporting period, both in terms of dollars and proportions. Investigate
any major differences.
Valuation of Inventories—Lower of Cost or Market Calculation
Use this procedure to periodically adjust the inventory valuation for those items whose
market value has dropped below their recorded cost.
1. Export the extended inventory valuation report to an electronic spreadsheet. Sort it
by declining extended dollar cost, and delete the 80% of inventory items that do not
comprise the top 20% of inventory valuation. Sort the remaining 20% of inventory
items by either part number or item description. Print the report.
2. Send a copy of the report to the materials manager, with instructions to compare
unit costs for each item on the list to market prices, and be sure to mutually agree on
a due date for completion of the review.
3. When the materials management staff has completed its review, meet with the materials
manager to go over its results and discuss any major adjustments. Have the
materials management staff write down the valuation of selected items in the inventory
database whose cost exceeds their market value.
4. Have the accounting staff expense the value of the write-down in the accounting
records.
5. Write a memo detailing the results of the lower of cost or market calculation. Attach
one copy to the journal entry used to write down the valuation, and issue another
copy to the materials manager.
CONTROLS
Goods in Transit
The following controls should be installed to ensure that goods in transit are properly
accounted for:
• Audit shipment terms. Certain types of shipment terms will require that a company
shipping goods must retain inventory on its books for some period of time after the
goods have physically left the company, or that a receiving company record inventory
on its books prior to its arrival at the receiving dock. Though in practice most compaChapter
4 / Inventory 61
nies will record inventory only when it is physically present, this is technically incorrect
under certain shipment terms. Consequently, a company should perform a periodic
audit of shipment terms used to see if there are any deliveries requiring different
inventory treatment. The simplest approach is to mandate no delivery terms under
which a company is financially responsible for transportation costs.
• Audit the receiving dock. A significant problem from a recordkeeping perspective is
that the receiving staff may not have time to enter a newly received delivery into the
corporate computer system, so the accounting and purchasing staffs have no idea that
the items have been received. Accordingly, one should regularly compare items sitting
in the receiving area to the inventory database to see if they have been recorded.
One can also compare supplier billings to the inventory database to see if items billed
by suppliers are not listed as having been received.
• Reject all purchases that are not preapproved. A major flaw in the purchasing systems
of many companies is that all supplier deliveries are accepted at the receiving
dock, irrespective of the presence of authorizing paperwork. Many of these deliveries
are verbally authorized orders from employees throughout the company, many of
whom are not authorized to make such purchases, or who are not aware that they are
buying items at high prices. This problem can be eliminated by enforcing a rule that
all items received must have a corresponding purchase order on file that has been authorized
by the purchasing department. By doing so, the purchasing staff can verify
that there is a need for each item requisitioned, and that it is bought at a reasonable
price from a certified supplier.
Accounting for Inventories
The following controls should be installed to ensure that inventories are properly accounted
for:
• Conduct inventory audits. If no one ever checks the accuracy of the inventory, it
will gradually vary from the book inventory, as an accumulation of errors builds up
over time. To counteract this problem, one can schedule either a complete recount of
the inventory from time to time, or else an ongoing cycle count of small portions of
the inventory each day. Whichever method is used, it is important to conduct research
in regard to why errors are occurring, and attempt to fix the underlying problems.
• Control access to bill of material and inventory records. The security levels assigned
to the files containing bill of material and inventory records should allow access
to only a very small number of well-trained employees. By doing so, the risk of
inadvertent or deliberate changes to these valuable records will be minimized. The
security system should also store the keystrokes and user access codes for anyone who
has accessed these records, in case evidence is needed to prove that fraudulent activities
have occurred.
• Keep bill of material accuracy levels at a minimum of 98%. The bills of material
are critical for determining the value of inventory as it moves through the work-inprocess
stages of production and eventually arrives in the finished goods area, since
they itemize every possible component that comprises each product. These records
should be regularly compared to actual product components to verify that they are correct,
and their accuracy should be tracked.
• Pick from stock based on bills of material. An excellent control over material costs
is to require the use of bills of material for each item manufactured, and then requiring
that parts be picked from the raw materials stock for the production of these items
based on the quantities listed in the bills of material. By doing so, a reviewer can
62 GAAP Implementation Guide
hone in on those warehouse issuances that were not authorized through a bill of material,
since there is no objective reason why these issuances should have taken place.
• Require approval to sign out inventory beyond amounts on pick list. If there is a
standard pick list used to take raw materials from the warehouse for production purposes,
then this should be the standard authorization for inventory removal. If the
production staff requires any additional inventory, they should go to the warehouse
gate and request it, and the resulting distribution should be logged out of the warehouse.
Furthermore, any inventory that is left over after production is completed
should be sent back to the warehouse and logged in. By using this approach, the cost
accountant can tell if there are errors in the bills of material that are used to create pick
lists, since any extra inventory requisitions or warehouse returns probably represent
errors in the bills.
• Require transaction forms for scrap and rework transactions. A startling amount
of materials and associated direct labor can be lost through the scrapping of production
or its occasional rework. This tends to be a difficult item to control, since scrap
and rework can occur at many points in the production process. Nonetheless, the
manufacturing staff should be well trained in the use of transaction forms that record
these actions, so that the inventory records will remain accurate.
• Restrict warehouse access to designated personnel. Without access restrictions, the
company warehouse is like a large store with no prices—just take all you want. This
does not necessarily mean that employees are taking items from stock for personal
use, but they may be removing excessive inventory quantities for production purposes,
which leads to a cluttered production floor. Also, this leaves the purchasing staff with
the almost impossible chore of trying
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