General Ledger Re-Classification Will Not Determine Your Cost

Jul 31, 2014

A few weeks ago I was talking to a CEO who was having difficulty with his costing system and he was looking to make improvements. He mostly wanted to be able to use the system to make management decisions about the profitability of his products. Unfortunately, the cost system was so problematic that for the last several years he was being questioned from his outside auditors on the value of the inventory. Specifically, the outside auditors wanted to see how the products were being costed, and they expected to be able to use the cost system for that purpose.


The outside accountant discovered that the cost system was so inadequate that they even further called into question the value of the inventory and the effects that it would have on profitability. Consequently, in the first year the auditors determined too little cost was being assigned to the inventory and as a result, a large inventory adjustment was required. The CFO at the time was quite concerned with the problem and took action to try to solve the dilemma. First, he took a number of general ledger accounts that would normally be assigned to general and administrative (G&A) and reclassified them into factory overhead. Second, he dramatically increased the overhead application rate that was based on labor hours.

The result of these two changes left the year-end inventory being overvalued which, of course, required yet another adjustment by the outside accounting firm. Typically, with these adjustments, the bank involved has many questions which calls into question the credibility of the statements.. This CFO was no exception as he had questions from not only the bank but the company’s ownership and the outside auditors.

As will likely come as no surprise, the CFO is no longer employed with the company and the CEO is currently worried about regaining credibility and producing accurate costing information.

I thought about that entire process and the specific problems related to the accuracy of the cost system. I mostly was surprised by the unique solution that the CFO had struck upon reclassifying certain sales and G&A accounts into factory overhead. His goal of course was to increase the overhead to be applied, which thereby assured that the inventory would have a higher value. I am just not sure why he thought this would pass an audit testing that most likely would be proving out the net realizable value (NRV). I have seen and heard a lot over the years, but this was the first time I had ever heard of this as a potential solution. I would think such re-classifications would be quite obvious to the outside accountants, particularly if the accounts themselves retained their original titles. Furthermore, those kinds of adjustments are relatively easy to find in the overall inventory testing if the outside accounting firm is doing normal year-end procedures related to NRV of the inventory and other cost assurance testing that would be part of most year-end audits.

In this case, the CFO was not interested in figuring out what was actually going on in product costs but rather offer a quick solution to value inventory and thereby pass the audit testing. Luckily for the owners of the company, the CEO had a far broader view of product costing and was looking to create valid management information from his cost system.

Categories: Cost Accounting