Accruals are recorded separately from the purchase value of the spare parts, which is why a spare part purchased 10 years ago for $100 can still be valued in the inventory list today at $100. The accrual is recorded elsewhere.
A further explanation of accruals is beyond the scope of this book; however, it is important to understand that accounting principles require that the cost of inventory over time is recognized in a company’s accounts. This is one reason that accountants are often the people pressing companies to reduce their spare parts inventory.
1.10 Follow the Money-Accounting for Spare Parts
Expenses Versus Capital
Before explaining the accounting for spare parts, it is important to explain the differences between the type of capital and expenses. When a company spends money on spare parts, it is using its available cash (this includes funds made available through credit and other means, not just literally cash). How this expenditure is treated by accountants depends on why the purchase is made and when the utility of the expenditure is realized.
Utility is the term used to describe the benefit that a company gains from its purchases. For example, if a company buys a machine and expects that it will operate for 10 years, then the utility is realized over 10 years. The accountants take account of this by reducing the reported value of the machine by 10% each year. This is called depreciation. If the company buys some spare parts and they are used immediately, then the utility is realized and depreciation is not necessary.
Expenditures where the utility is realized during the current fiscal reporting period are generally referred to as expenses. Expenditures where the utility is realized in more than one fiscal reporting period are generally referred to as capital. Put another way, capital is the money that a company spends on items that it does not expect to sell or use in the current fiscal reporting period. This is why spare parts inventory is treated as capital. There are two types of capital:
1 Fixed capital. This includes buildings and plant and equipment. Essentially these are the physical items used over time.
2 Working capital. This is the money invested to operate a business to act as a buffer between payment terms for purchases and the revenue from sales.
While expenses and capital both require the use of cash, these expenditures are treated differently by accountants, and that is why there is a series of reports that the inventory manager must understand.
Four Key Financial Reports
The four key financial reports to understand are:
1. Balance sheet, as seen in Figure 1.3.
2. Profit and loss statement, as seen in Figure 1.4.
3. Cash flow statement, as seen in Figure 1.5.
4. Operating statement, as seen in Figure 1.6.
Each of these is explained and represented in the accompanying pictograms.
The balance sheet takes account of a company’s assets and liabilities to determine the net worth at a particular point in time.
Figure 1.3. The balance sheet
The profit and loss statement (P&L) is sometimes called the statement of financial performance and compares a company’s revenue to its expenses to determine if a profit was made. The P&L applies over a period of time such as a month, quarter, or year. The P&L does not include capital expenses.
Figure 1.4. The profit and loss
The cash flow statement reports on the cash that comes in and goes out, including both capital and expenses. The cash flow report includes every dollar into or out of a company, no matter the source or destination. The cash flow report applies over a period of time.
Figure 1.5. Cash flow
The operating statement (otherwise known as the budget) reports the actual expenditure versus expected or planned expenditure over a period of time.
Figure 1.6. Operating statement
Follow the Money
Figures 1.7 and 1.8 show how companies account for the value of spare parts.
As you can see in Figure 1.7, when a spare part is purchased as part of an inventory, the value is recorded as both an asset on the balance sheet and a cash-out expense on the cash flow statement. At this stage the value is not recorded on the profit and loss or the operating statement. This is why additions to inventory don’t impact maintenance budgets.
In Figure 1.8, you can see that when the spare part is removed from the inventory for use by maintenance or engineering, the value is shifted from the balance sheet to the expense section of the profit and loss. At this stage the value is also added to the operating statement as a measure of expenditure against the budget for the machine on which it is used or relevant department.
Figure 1.7. Financial allocation with purchase of a spare part
Figure 1.8. Financial allocation with use of a spare part
Accounting in this way uses the balance sheet as a kind of buffer for the accounting of inventory so that the inventory does not get counted as an expense until it is actually used. This helps to smooth out the reported operating cost for a company by only accounting for the cost of the spares in the reporting period in which they are used.
Recalling that one of the principles of accounting is to reflect the actual value of a company, this buffer-type impact of the balance sheet does just that because the inventoried parts do have a value and that value is reflected in the balance sheet. To do otherwise would result in massive swings in expenses as a company might spend up big on spare parts in one year (say, for new plant and equipment) but then spend very little as it uses up those parts over time.
Some companies don’t use this buffering approach; instead they expense all spare parts when they are purchased. We can let the accountants and auditors argue whether this practice is in accordance with accounting principles, but it is important to note that both the buffering and expensing approaches do have their pros and cons. These are shown in Table 1.1.
Table 1.1. The pros and cons of the balance sheet and expensing approaches
| Approach |