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Inventory or Materials Costs?

M. S.'s Profile

Hello, We are a service company that performs scientific/lab testing and our end deliverable is a report (no goods are delivered). To conduct the testing numerous gases and materials are used for calibration of machinery and as inputs into the testing process. The value of said materials an be valued between 5 - 7% of total assets. Some gases could have a shelf life of > 1 year but the actual value of the gas is negligible as percentage of total assets. I would like to bleed the current inventory balance off my balance sheet and would prefer to expense as incurred. Issues are: Not delivered to customer Can have long shelf life Arguably de minis as % of total assets End goal to is to argue to auditor as to why I do not have my balance sheet. Inventory or materials expense? Any thoughts are appreciated.

Answers

Topic Expert
Karoline Mello
Title: Director, FP&A
Company: Apollo Group
(Director, FP&A, Apollo Group) |

What happens to the chemicals once the analysis is complete? Or are they used for multiple projects during the shelf life and then replaced? Do you recoup any $ from disposal? I ask because I would argue, if there isn’t a gain on disposal, that the chemicals are not inventory and have no inherent value but rather are R&D expenses that should be expensed as incurred.

If there is a disposal value you need to keep them as assets.

Timothy Ogden
Title: President/CFO
Company: Joseph Elon, LLC
(President/CFO, Joseph Elon, LLC) |

R&D expenses? They are using them in the course of analysis projects that other firms have hired them to complete. These items are Cost of Sales to them--not expenses (initially). If they expire before they are used in the normal course of their trade and must be disposed of, then and only then are they expensed as capital losses <--Capitalized on the balance sheet first (please look at the accounting definition of capitalize).

As he said--they are a service company. Also, (myself having owned an environmental consulting firm in the past) the disposal of virtually any chemical or gas will cost them money (and usually quite a bit of it). Even if there was a gain on disposal (like used oil and filters), that would have no effect on what GL account they live under while they are actively listed on the BALANCE SHEET.

Let's assume they do have a positive disposal value: They are still used as Cost of Sales items in the normal course of their trade. In the event leftover chemicals are disposed of for a capital gain, the will affect a GL expense account--the same one they would affect if they cost money to dispose of. It's called a Capital Gain. You treat it the same way you'd treat depreciable assets that are disposed of for more or less than their book value (which can be zero).

Topic Expert
Bob Scarborough
Title: CEO
Company: Tensoft, Inc.
(CEO, Tensoft, Inc.) |

There are inventory management models other than purchase to stock and issue to job/order. A few examples of these are below – for discussions with your auditors. My suggested approach would be:

1) Add purchases to inventory on your balance sheet on purchase
2) For your services – when performed – do the equivalent of a “back flush” (consumption of a standard amount of material) on completion of the order. This will move expense to your P&L without having to issue/consume specific amounts of material.
3) Perform routine physical inventory to balance the stock value on the P&L. Your services team is really already doing this – given they must know when to re-order.

You do have something where an asset is purchased and consumed on the job – and it would not be that hard to use a method like the one above to get COGS matching to your services revenue. Additionally the effort to determine the standard amount of inventory consumed for each service will be useful information for pricing discussions in the future.

For other industry examples:
1) Floor stock is common in manufacturing. These are the required materials that are too small to value and issue independently. These are allocated to inventory like an overhead allocation – and are usually replenished in bulk.
2) Field inventory in a variety of fields. Everything from a Nurses Closet to a Tradesman’s truck are often treated like a petty cash account. You maintain a standard balance for the inventory at that location, do a physical count on a routine basis, and record the issue of new material to the inventory location as COGS.
3) Some outsourced manufacturing models include your company purchasing a component for the outsourcer to include in their production. However setting up work orders in your system to support the consumption of a low value component is a lot of additional busy work for what can be a low value item. People often handle this either by the back flush / physical inventory model or with a ‘buy/sell’ model where they ‘sell’ the consumed components to the outsourcer each month and ‘buy’ goods from them as well that include the value of the consumed part.

While the matching principle is useful and core to accounting there are numerous instances where business reality finds compromise approaches to how the matching is done. Consumption of low cost inventory in the process of delivering goods or services is one of those areas.

Bob Scarborough
www.tensoft.com

Len Green
Title: Performance Improvement Consultant and E..
Company: Haygarth Consulting LLC
LinkedIn Profile
(Performance Improvement Consultant and ERP Strategist, Haygarth Consulting LLC) |

I like what Bob suggests, it addresses the accounting principles of:
1-accrual, 2-matching, 3- consistency and 4-conservatism. The gas and materials seem to be similar to "consumables" and especially if there is a fairly standard consumption for each type of test, it looks like you could treat it as non -inventory.
Can you also adjust the timing of your purchases so as to receive most of the materials at the beginning of each accounting period, thus depleting most of it by the time you get to month/quarter end?

M. S.
Title: Accounting
Company: Environmental Co.
(Accounting, Environmental Co.) |

Bob, this is in essence what we are currently doing.

(1) All purchases to balance sheet. (2) We calculate actual job usage via weight of gas cylinder (in and out of shop). (3) Shop manager periodic inventory of gases for adjustment to COS.

Going to discuss with our auditor and I am predicting we will stay status quo.

I was curious as to other ideas.

Thanks for the constructive input.

Timothy Ogden
Title: President/CFO
Company: Joseph Elon, LLC
(President/CFO, Joseph Elon, LLC) |

I'm hesitant to offer you the correct answers and the methodology behind them. Many accountants (like myself) have worked hard for nearly the last 20 years and have encountered plenty of folks along the way who want to 'radically change the accounting game'. Your end goal is unreasonable and I feel you're looking for excuses to reduce your property tax burden to nothing.

As a former auditor, I assure you that you would LOSE the argument for not having your balance sheet if you sat down with me. I started a successful environmental consulting firm that is still thriving today--we didn't get it that way by what you're aiming to do. The fact that you've taken the title of Controller and you're asking these questions is very alarming. With all due respect--please consider another profession.

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