How to Identify and Avoid Cash Flow Pitfalls

How Businesses Can Identify and Increase Efficiency with Managerial Accounting

Delving Into Forensic Accounting

Defining and Understanding Reproduction Costs

Different Ways to Value a Business

How Secure 2.0 Will Impact Employers’ Tax Situations

Defining an Impaired Asset

Understanding the Weighted Average Cost (WAC) Method for Inventory Valuation

tranche contributes to the overall valuation of its cost of goods sold (COGS) and inventory. Recognized by both GAAP and IFRS, it’s determined by taking the cost of goods available for sale and dividing it by the quantity of inventory ready to be sold. It’s important to note that while WAC is a generally accepted accounting principle, it’s not as precise as FIFO or LIFO; however, it is effective at assigning average cost of production to a given product.

It’s done primarily for types of inventories where parts are so intertwined that it makes it problematic to attribute clear-cut expenditures to a particular part. This often happens when stockpiles of parts are indistinguishable from each other. It also accounts for businesses offering their inventory for sale all at once. Here’s a visual representation of the formula: 

Weighted Average Cost (WAC) Method Formula

WAC per unit = Cost of goods available for sale / Units available for sale

Costs of goods available for sale is determined by adding new purchases of inventory to the value of what the business already had in its existing stock. Units available for sale is how many saleable items the company possesses. Its value is assessed per item and encompasses starting inventory and additional purchases.

When it comes to calculating WAC, there are two different types of inventory analysis systems: periodic and perpetual.

Periodic Inventory System

In this system, the business tallies its inventory at the end of the accounting period – be it a quarter, half or fiscal year – and analyzes how much the inventory costs. This then determines the value of the remaining inventory. The COGS is then calculated by adding how much starting, final, and additional inventory within the accounting period cost.

Perpetual Inventory System

This system puts a bigger emphasis on more real-time management of its stock levels. The trade-off for such real-time tracking of inventory requires more company financial resources. Looking at an example of how a company began its fiscal year with the following inventory can illustrate how it works.

At the beginning of the year, a company had 1,000 units, costing $50 per unit. It also made three additional inventory purchases going forward.

Jan 20: 75 units costing $100 = $7,500

Feb 17: 150 units costing $150 = $22,500

March 18: 300 units costing $200 = $60,000

During the fiscal year, the business sold:

235 units sold during the last week of February

325 units sold during the last week of March

Looking at the Periodic Inventory System, for the first three months of its fiscal year, the company can determine its COGS and the number of items ready to be sold over the first three months of its fiscal year.

WAC per item – ($50,000 + $7,500 + $22,500 + $60,000) / 1,525 = $91.80

Based on this method, the WAC per unit would be multiplied by the number of units sold during the accounting period, therefore:

560 units x $91.80 = $51,408 (inventory sold)

To calculate the final inventory value, we take the entire purchase cost and subtract the remaining inventory to arrive at the valuation:

$140,000 – $51,408 = $88,592

Perpetual Inventory System

Unlike the periodic inventory system, this looks at determining the mean prior to the transaction of items:

This would calculate the average before the 235 units were sold during the last week of February:

WAC for each item: ($50,000 + $7,500 + $22,500) / 1,225 = $65.31

Looking at the 235 units sold during the last week of February, it’s calculated as follows:

235 x $65.31 = $15,347.85 (inventory sold)

$80,000 – $15,347.85 = $64,652.15 (remaining inventory value)

Before calculating for the 325 units sold the last week of March, the unit valuation per WAC is: ($64,652.15 + $60,000) / (1225 – 235 + 300) = 1290 = $96.63

Looking at the 325 units sold during the last week of March is calculated as follows:

325 x $96.63 = $31,404.75 (inventory sold)

$124,652.15 – $31,404.75 = $93,247.40 (remaining inventory)

Based on these options, businesses have the choice, along with LIFO and FIFO, to decide how they want to vary it based on their own business needs.

Defining and Calculating Amortization

noticeable differences for each method, including how to salvage value is considered, whether accelerated expensing is allowed, and how each type is expressed on financial statements.

Amortization

Amortization is an accounting practice of spreading the cost of an intangible asset over its useful life. Examples of intangible assets, according to the Internal Revenue Service’s “Section 197 Intangibles,” include goodwill, intellectual property such as trademarks, patents, and government or agency-granted permits or licenses. These are all assets that must be amortized over 15 years.

Based on IRS regulations, when it comes to determining how an asset is expensed over its useful life, amortization is most similar to the straight-line basis method of depreciation. 

It’s important to note that the timeframe of amortization is subject to interpretation. Examples, according to the IRS, include a 36-month amortization timeline for computer software because it’s not categorized as an asset under the same IRS Section. Other examples not mandated to be amortized under a 15-year time frame include interests to land, business partnerships, financial contracts (such as interest rate swaps) or creation of media. 

Depreciation

One of the main differences when it comes to depreciation is that it focuses on tangible or fixed assets and requires a certain percentage of its useful life to be allocated each year. Examples of assets that can be expensed include trucks for service calls, computers, printers, equipment for production, etc. Another important difference is that the asset’s salvage value is deducted from the asset’s starting cost. The remaining balance (original cost – salvage cost) determines annual expensing amounts, which is divided by the asset’s years of useful life.

Along with the above method of depreciation, also called “Straight-Line Method,” there are other ways depreciation can determine how much is expensed annually and over the asset’s useful life. For example, Declining Balance or Double Declining Balance methods are alternate ways businesses can depreciate their assets – some frontload the amounts to take advantage of accounting/tax rules to reduce their tax liabilities. Another way is to depreciate via Units of Production. This method pro-rates the level of an asset’s expected use within a particular accounting period, on a per-unit basis, to determine how much the company can expense during a particular accounting timeframe.

When it comes to accounting for goodwill, according to a November 2020 electronic survey of CFA charter holders by the CFA Institute, respondents found that investors who see amortization used by companies still require investors’ due diligence. Sixty-one percent of respondents said there need to be alternate ways to figure out if management is effective or not, and 63 percent said that amortization “distorts financial metrics.”

When it comes to understanding and navigating the differences between amortization and depreciation, business owners and investors need to be well-versed in performing due diligence to ensure compliance.

Sources

https://www.irs.gov/pub/irs-pdf/p535.pdf

https://www.cfainstitute.org/en/research/survey-reports/goodwill-investor-perspectives

Auditing: What it is & Why It’s Done