Bailey, Karen

Bailey, Margaret L.

English

eGrove (Univ. of Mississippi)

Woman C.P.A. Volume 35 Issue 3 Article 5 7-1973 Theory and Practice: Current Studies and Concepts Margaret L. Bailey Karen Bailey Follow this and additional works at: https://egrove.olemiss.edu/wcpa  Part of the Accounting Commons, and the Women's Studies Commons Recommended Citation Bailey, Margaret L. and Bailey, Karen (1973) "Theory and Practice: Current Studies and Concepts," Woman C.P.A.: Vol. 35 : Iss. 3 , Article 5. Available at: https://egrove.olemiss.edu/wcpa/vol35/iss3/5 This Article is brought to you for free and open access by the Archival Digital Accounting Collection at eGrove. It has been accepted for inclusion in Woman C.P.A. by an authorized editor of eGrove. For more information, please contact egrove@olemiss.edu. THEORY AND PRACTICECurrent Studies and ConceptsMARGARET L. BAILEY, CPA, Special Editor Wheat Ridge, ColoradoGUEST WRITERThe column for this issue is the work of a guest writer that this editor is pleased to present. She is Karen Bailey, a junior member of the Denver Chapter of the American Society of Women Accountants. Karen has studied at Colorado State University at Fort Collins, Colorado, and at Community College of Denver.Inventory ValuationWe are all aware of the constant changes taking place in the methods and reports of the accounting profession. One new proposed regu­lation has such wide-reaching effects that we should make a concerted effort to understand it. It will have a direct effect on all companies engaged in manufacturing or production opera­tions. The proposed regulation would amend Regs 1.61-3, 1.446-1, 1.471-2, and 1.471-3, and add new Reg. 1.471-11, and would require usage of the full absorption method of inven­tory valuation.The full absorption method requires that all direct and indirect production costs be allo­cated to goods sold and goods in inventory at the end of the year. This means that instead of treating certain indirect costs as period costs and deducting them fully in the year incurred, at least a portion of these costs would be held in the inventory valuation until the next year. No longer would it be permissible for a manu­facturer to choose the inventory valuation that suits his fancy. At the present time no strict rules govern who shall use what method of valuation for inventories, except that the con­sistency principle is expected to be applied from year to year.One might think that this new proposed regulation, by requiring a specific group to use one method of inventory valuation, would sim­plify the accounting process and terminology of this perplexing area. Unfortunately, the pro­posed regulation is not so simple as it appears at first glance.Direct production costs must all be included in the inventoriable cost calculations. The pro­posed regulation sets up four categories to provide guidelines as to which indirect costs are to be included in the calculation of inven­toriable costs:Category 1 lists indirect costs which must be included in the calculation regardless of their treatment in the financial state­ments. Such items include repairs and maintenance, utilities, and rent.Category 2 includes indirect costs which needn’t be included in the calculations re­gardless of their treatment in financial reports. Such costs include interest, adver­tising and marketing, and distribution and selling expenses.Category 3 lists indirect costs which must or must not be included in inventory cal­culations, depending on their treatment in financial reports of the taxpayer, provided that treatment is in accordance with gen­erally accepted accounting principles. This category deals with costs associated with the processes or operations of pro­duction or manufacturing including de­preciation and depletion, officer’s salaries, and insurance expenses.Category 4 includes a list of costs which either must be or needn’t be included in the computation of the taxpayer’s financial accounting method is not comparable to his tax accounting method. Items which must be included under this category in­clude those costs associated with manufac­turing or production operations or pro­cesses such as overtime or vacation pay or taxes otherwise deductible under section 164. Costs which needn’t be included are research and experimental expenses and losses.Taxpayers who have been using other meth­ods of costing their inventories and would therefore be required to change under the pro­posed regulations may elect to change to full absorption during a transition period. This election would need to be made during the first 17180 days of any tax year beginning on or after the regulations become final and before 2 years after their finalization. Taxpayers who have elected to make the correction during the tran­sition period need not change to the full ab­sorption method for taxable years prior to the year of that election provided they have not received a deficiency notice for prior years with respect to an inventory costing issue. Taxpay­ers electing to change during the transition period will receive the benefits of transition rules which allow the taxpayer to make ap­propriate adjustments for the change over a ten-year period.The new proposed regulations provide for the use of the standard cost method as well as the manufacturing burden rate method which was allowed under the previously proposed regulations. If significant in amount, adjust­ments resulting from both methods must be reallocated to ending inventory if the tax­payer allocates them in his financial statements. The concept of practical capacity can be used in conjunction with either the manufacturing burden rate or the standard cost method of allocating indirect production costs to the cost of goods in ending inventories.Practical Capacity ConceptPractical capacity may be established by comparison with theoretical capacity after ad­justments for allowances for estimated inability to achieve maximum production for items such as machine breakdown, idle time, or other nor­mal work stoppages. Theoretical capacity is, of course, the level of production which could be reached if all machines and departments operated continuously at peak efficiency. Both theoretical capacity and practical capacity may be computed in terms of tons, yards, labor hours, machine hours or other units of produc­tion appropriate to the cost accounting sys­tem used by the company. An example is pro­vided which can be summarized as follows:XYZ Company operates a plant with a theoretical capacity of 50 units per hour. The plant actually operates 1960 hours per year (based on a 5-day week with 15 days shut­down for vacations and holidays). Down time can be reasonably estimated at 5%. Assuming no loss of production during starting up, clos­ing down, or employee work breaks, the XYZ Company computes a practical capacity as follows:Practical capacity before allowance for down time (based on theoretical capacity per hour- 1960 X 50)...................................98,000Less—5% reduction for Down time............................................... 4,900Practical Capacity 93,100Therefore 93,100 units would constitute the base for calculating fixed indirect production costs to be included in the computation of amount of inventoriable costs for the period. On this basis if only 76,000 units were pro­duced, the effect would be that 81.6% of the fixed indirect production costs would be in­cluded in the inventoriable costs during the year. Those not included (18.4%) would be deductible during that year. Assume further that 7,600 units were on hand at the end of the year (or 10% of the 76,000 actually pro­duced. Thus 10% of the fixed indirect produc­tion costs and 10% of the variable indirect production costs would be included in the cost of goods in ending inventory.SummaryVarious forms of absorption costing have been in use for several years where prime costs and predetermined fixed and variable costs are used to compute inventory costs. Modified full absorption, allowed in certain cases under the old regulations, allows the exclusion of costs under the full absorption method, if the inven­tory valuation method includes at least 35% of all fixed indirect production costs, and those costs are excluded from the taxpayer’s financial reports. The new proposed regulation liberal­izes this arbitrary percentage test by allowing costs to be excluded provided they are ex­cluded from the company’s financial reports and also provided those exclusions are in ac­cordance with generally accepted accounting principles.18

Theory and Practice: Current Studies and Concepts

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