Variances, Incentives, and SFAS 151

CPA Journal, The, Sep 2007 by Biggart, Timothy B, Carnes, Thomas A

While globalization continues to shrink the world by integrating its economies, one necessary outcome appears to be the convergence of accounting standards. Statement of Financial Accounting Standards (SFAS) 151, Inventory Costs, which went into effect in June 2005 and aims to clarify how corporations account for abnormal amounts of idle facility expense and spoilage (wasted material), is a recent example of this convergence. Many consider this a minor change, including FASB itself, and managerial accounting practice provides much of the information companies need to consider when applying tiie standard. SFAS 151 has the potential, however, to inject production-level concerns into external reporting decisions.

In October 2002, FASB and the International Accounting Standards Board (IASB) issued the Norwalk Agreement, pledging that the two groups would seek convergence in their accounting standards. The goal was "to improve the comparability of cross-border financial reporting by working . . . toward development of a single set of high-quality accounting standards."

FASB describes SFAS 151 as one example where the two boards see an opportunity to improve standards by eliminating certain narrow differences. In this case, FASB changed its standard [found in Accounting Research Bulletin (ARB) 43, No. 4] to adopt the language of the international standard. The adoption was uncontroversial; FASB received only 26 comment letters and did not hold a public hearing on the proposal.

'Abnormal' Inventory Costs

The change centers on the term "abnormal" as it applies to idle-facility expense, freight, handling costs, and wasted material. ARB 43 stated that "under some circumstances" such charges might be so abnormal that they should be treated as current-period expenses. If such circumstances were not met, or the charges were not "so abnormal," these charges typically would be included in fixed overhead and recognized as part of cost of goods sold when the related inventory is sold. Standards-setters were concerned that firms might apply the U.S. standard and the international standard inconsistently, even though both attempted to ensure the same outcome.

This concern led to SFAS 151. Required for all inventory costs incurred during fiscal years beginning after June 15, 2005, it states that "unallocated overheads are recognized as an expense in the period in which they are incurred," and that abnormal freight, handling costs, and wasted materials must be treated as "current period charges rather than as a portion of the inventory cost" The standard also requires that "the allocation of fixed production overheads to the costs of conversion is based on the normal capacity of the production facilities."

Neither ARB 43 nor SFAS 151 provides explicit guidance as to the form of the current period expense. Customary usage of "period cost" refers to those operating expenses recorded on the income statement below gross margin. Based on the use of that phrase, the unallocated overhead expense would be recorded with selling and administrative expenses. The cost principle of inventory valuation, however, explicitly identifies manufacturing overhead as an inventory cost. Thus, it could be argued that the unallocated overhead expense should be added to cost of goods sold, above gross margin. Of course, location of the expense within the income statement does not affect net income, but it does affect gross margin and gross margin percentage.

Although the issue of how to treat abnormal inventory costs and where they fit on the income statement existed before SFAS 151, the requirements of the new standard can help illuminate the complexities of tiiis issue. Closer examination is needed into what normal capacity should be, and the role played by variances and incentives.

Normal Capacity

One question the standard leads to is the definition of normal capacity. Businesses incur fixed manufacturing costs to acquire a certain throughput capacity. The acquisition of plant, equipment, and supervision enables a company to produce a certain level of output. In one sense, that normal capacity could be modeled as the practical physical output capacity of a facility. The definition of practical capacity usually is the maximum efficient output level, or around 85% of the absolute maximum output level. If a company used practical capacity as normal capacity, any time it produced at levels lower than full production, it would have to recognize its unallocated overhead expenses as current-period costs.

FASB recognized this potential problem and took steps to address it. SFAS 151 considers normal capacity as a range, not as a single point. It describes normal capacity as a range of production levels expected to be achieved over multiple periods or seasons, and it adds that variation in production levels across periods is expected and determines me range of normal capacity. It also states that business- and industryspecific factors will affect the range of normal capacity. On that basis, FASB is using a definition of normal capacity close to the definition used in standard normal costing, which considers budgeted (planned) production to be normal capacity and uses it as the denominator in the fixed manufacturing overhead allocation rate. Such a system allocates fixed overhead based on what a company plans to produce for the period. In this case, an existing flexible budgeting system variance, the fixed manufacturing overhead production volume variance (when unfavorable), would measure the unallocated overhead expenses SFAS 151 requires to be recognized as current-period costs.