Manufacturers rarely carry inventory at actual cost. They carry it at standard cost and book the difference in variance accounts. Whether those variances end up in inventory or in cost of sales is where audit adjustments happen. This guide covers standard cost under ASC 330, the treatment of overhead at normal capacity, costs that are expensed as abnormal, losses on firm purchase commitments, and the audit work for each. For the cost flow methods and the write-down side, see FIFO, average cost, LIFO and NRV under ASC 330 and inventory write-downs and NRV entries.
Is standard cost acceptable under US GAAP?
Yes, when the standards reasonably approximate actual cost. CLA states that the use of standard costs is acceptable under US GAAP provided the standards reasonably approximate actual costs, and BPM says standard costing is acceptable under GAAP when standards are refreshed regularly. When standards are revised only periodically, a one-time catch-up adjustment to inventory and earnings can be material.
That makes the update cycle an audit item. A standard set 18 months ago on a product whose resin cost has moved is a standard that no longer approximates anything.
Where do the variances go?
Standard cost systems post purchase price, usage, rate, efficiency and overhead variances to separate accounts. BPM states that these accounts must be analyzed and properly disposed of during each accounting close, and that how variances are allocated can meaningfully change reported profit. CLA says companies must verify that variances between actual and standard cost are absorbed into inventory at the reporting date. The practical reading is that the part of a variance relating to goods still on hand belongs in inventory, and the part relating to goods sold belongs in cost of sales. The entity needs a written, consistently applied policy for the split.
Illustration only, with round numbers. At year end a manufacturer has a net unfavorable purchase price variance of $90,000. Of the materials bought, one-third remain in inventory at the balance sheet date.
| Account | Debit | Credit |
|---|---|---|
| Inventory (capitalized variance) | $30,000 | |
| Cost of goods sold | $60,000 | |
| Purchase price variance | $90,000 |
If the variance is small and applied consistently, a firm may accept leaving it in cost of sales. When the variance is large or systematic, the inventory balance is understated by the amount not capitalized.
Which costs are expensed, not inventoried?
Abnormal costs. FASB Statement No. 151 on inventory costs, effective for inventory costs incurred in fiscal years beginning after June 15, 2005, requires that abnormal amounts of idle facility expense, freight, handling costs and wasted materials be recognized as current-period charges. It also requires that fixed production overhead be allocated to inventory based on the normal capacity of the production facilities, as the Journal of Accountancy summarized in February 2005. That standard is now part of ASC 330.
Normal capacity is the production level the entity expects to achieve over a number of periods under normal circumstances. A low-volume quarter does not reset it.
Illustration only. Fixed overhead is $200,000 a year and normal capacity is 100,000 machine hours, so the absorption rate is $2.00 per hour. Actual output in the year uses 80,000 hours.
| Account | Debit | Credit |
|---|---|---|
| Work in process / finished goods | $160,000 | |
| Cost of goods sold (unabsorbed fixed overhead, abnormal idle capacity) | $40,000 | |
| Fixed overhead control | $200,000 |
Absorbing the full $200,000 into 80,000 hours would price inventory at $2.50 per hour and push $40,000 of idle-capacity cost onto the balance sheet. That is the misstatement the rule exists to prevent.
When is a loss recorded on a firm purchase commitment?
Net losses on firm purchase commitments are accrued under ASC 330-10-35-17, and ASC 330-10-50-5 requires that the amounts be disclosed separately in the income statement. An SEC staff comment letter response quotes that disclosure requirement: the amounts of net losses on firm purchase commitments "shall be disclosed separately in the income statement."
The loss is an accrued liability for a commitment the entity cannot avoid, so the first audit question is whether the commitment is truly firm. The illustration below uses a contract price above the year-end market price.
Illustration only. The entity committed to buy 10,000 units at $50. At year end the market price is $44.
| Account | Debit | Credit |
|---|---|---|
| Loss on firm purchase commitments (cost of sales) | $60,000 | |
| Accrued purchase commitment loss | $60,000 |
Audit angle
The auditor tests for four things in this area.
- Standards versus actuals. Compare standards to recent invoices, routings and labor reports. Quantify the gap and test whether the entity's update cycle keeps it small.
- Variance disposition. Obtain the variance roll-forward. Test the allocation between inventory and cost of sales, and recompute the capitalized portion for the units still on hand. Look for a policy that changed between years.
- Overhead absorption. Recompute the absorption rate on normal capacity. Check that idle capacity, scrap above normal and abnormal freight are expensed. Ask production for downtime logs.
- Commitments. Read the open purchase orders and supply contracts. Identify which are firm. Compare contract prices to year-end market prices using post-year-end invoices and quotes. Check that the loss is recorded and shown separately in the income statement.
Common misstatements: stale standards, variances left in the P&L, fixed overhead absorbed on actual rather than normal volume, abnormal waste inventoried, and commitment losses omitted because the contract is not on the balance sheet. See also cutoff testing for the purchases side.
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Sources
- CLA (CliftonLarsonAllen), What's the Difference Between Average and Standard Costing of Inventory?: https://www.claconnect.com/en/resources/blogs/manufacturing/whats-the-difference-between-average-and-standard-costing-of-inventory
- BPM, Standard Cost Accounting: What It Is and When It Makes Sense for Businesses: https://bpm.com/insights/standard-cost-accounting
- Journal of Accountancy, Accounting, February 2005 (FASB inventory costs standard): https://www.journalofaccountancy.com/issues/2005/feb/accounting-feb-2005
- SEC, correspondence filing quoting the ASC 330-10-50-5 disclosure requirement: https://www.sec.gov/Archives/edgar/data/1070235/000107023514000092/filename1.htm
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