What are Unicorns?
In our day-to-day life, we often use the term unicorn to refer to a mythical horse-like creature. In the year 2013, a venture capital investor named Aileen Lee borrowed the term to describe a particular kind of startup company. The unicorn term was used to describe the startup companies which were thought to be so […]
Fundamental Principles of Pension Fund Risk Management
Pension funds are amongst the most heavily supervised financial instruments in the world. This is because of the fact that these funds hold the retirement funds of a large number of people. This means that the risk management practices at a pension fund have to be top-notch. The inability to manage risks can cost the […]
The End of the Dollar Hegemony
The dollar today is the uncrowned king of the financial world. This means that the dollar does not face much of competition from other currencies as on date. However, that does not mean that the dollar is invincible. Economies all over the world today are tired of the United States imposing its military and financial […]
Pension Funds and Systemic Risks
Systemic risks received a lot of media attention after the 2008 financial crisis. The world realized that the failure of one financial institution may not remain restricted to the same financial institution. Instead, such a failure can potentially spiral out of control and impact the entire financial system. Up until now, the idea of systemic […]
Single Period Dividend Discount Model
To understand the dividend discount model, we need to start from the basics. The simplest way to understand the dividend discount model and its application is to first start with a single period and then later extend it on to more complex cases. Hence, the term single period dividend discount model. The objective of application […]
The relationship between when cash is spent and when it is recognized as an expense is fairly complex in job order costing. Costs flow through the inventory accounts and finally become an expense when the sale is complete. This relationship and the complexities that arise have been tracked in this article.
To understand this relationship better we have to take a back track to financial accounting. There, we defined the difference between an outlay and expenditure. An outlay is when resources are utilized whereas expenditure is defined as a loss of value. Hence, when a firm spends money to create inventory it is not an expense. It is an outlay of cash. Cash has changed form and is now another asset called inventory. There is no loss of value, instead there is only transfer of value.
Also, in the previous article, we defined the types of costs that are likely to be incurred in a job costing scenario. They were direct materials, direct labor, manufacturing and non-manufacturing overhead. We classified non-manufacturing overhead as period costs and all others as product costs.
When costs are incurred one of the two things happen depending upon the type of costs. If the cost is product related, we add it to the inventory. This cost is not recognized as an expense until the sale is complete and loss of value has occurred. On the other hand, when it comes to period costs, they are expensed immediately because they have no cause and effect relationship with production.
It is important because the treatment of two costs is very different. When direct materials are purchased, they are directly allocated to their respective jobs. Same is the case with manufacturing related overhead and direct labor. They can be seen immediately in the job cost sheet. On the financial statements, they are considered as inventory. Inventory shows up under assets and not under the expense column.
The problem does not end there. Firms have to carefully calculate the breakup of inventory. Inventory is a big account with 4 sub accounts viz. raw material, work in progress, cost of goods manufactured and cost of goods sold. Companies need to carefully check the manufacturing overheads to ensure that they are not overstating or understating the value of any of these assets.
Once again, companies follow subjective treatments while allocating costs to separate sub inventory accounts. The amount of manufacturing overhead that is actually spent on work in progress cannot be precisely known. Accountants make estimates stating that relative proportions that they think have been spent on work in progress.
From an examination point of view, calculating the values of WIP, raw materials and finished goods may not be such a hassle since the percentage allocations are already given. However, in reality, determining these percentage allocations is a tough task that needs a lot of expertise and experience.
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