Accounting for and classification of special tools referred to as tooling
With the development and globalisation of the manufacturing industry, there has been an increase in the number of producers involved in supplying individual components to assemble a final product. The automotive industry may serve as an example with a chain of businesses engaged in the development, production and delivery of individual components for car manufacturing. The issue of tools, most frequently referred to as “tooling” today, is typical for the automotive sector. The term includes various moulds for injection, casting, pressing or shaping, tools, matrices, dies, special transport boxes/baskets/containers, etc.
Before starting its production, a car producer typically provides its sub-contractors with special tools at its expense or provides precise instructions according to which sub-contractors develop, produce or arrange for the production of the tooling. A car producer’s requirement flows through the entire supply chain so that components supplied by individual sub-contractors precisely meet the technical requirements for the whole, i.e. the car model that is produced. The production preparation is a demanding process in terms of time, quality, costs, effort and administration, including the certification required.
In practice, tooling accounting and reporting results in many questions and therefore, we will try and shed more light on this issue in this article.
Tooling in accounting regulations
Tooling accounting is based on the general guidance of Act no. 563/1991 Coll., on Accounting, as amended (the “Accounting Act”), Regulation no. 500/2002, providing implementation guidance on certain provisions of the Accounting Act, as amended (the “Regulation”), and Czech Accounting Standards for entities accounting under the Regulation (businesses), as amended (the “CAS”).
Provisions pertaining namely to tangible fixed assets, inventory and complex deferred expenses are applied to individual accounting procedures relating to tooling valuation, recording, depreciation, inventory taking, etc.
To make our illustration of possible accounting treatments clearer we will use three-digit account numbers although it is not required by the Regulation.
Tooling acquisition phase
We will consider two time periods simultaneously: a period before serial production is commenced (starting from the development and production or acquisition of the tools needed to produce serial components) and a period from the start of the serial production (production continues for several years depending on success of the produced model and its modifications). The start of serial production (following the tooling testing period) is usually a moment on which tooling is sold to a car producer (invoicing is confirmed) or, on the contrary, on which the tooling starts being depreciated by the sub-contractor.
Tooling development and acquisition (through own production or purchase) usually takes some time before the serial production is launched and an entity incurs costs relating to the tooling acquisition but no sales are generated in that period. Subsequently, during the serial production, a business generates sales of components for the production of which the tooling is used.
We will base appropriate reporting of expenses to acquire tooling and income from the use thereof on its primary classification and the accruals principle as the time aspect of expenses and income plays a significant role in the accounting for tooling.
There are three basic situations:
- A car producer (or another producer in the chain) arranges for the tooling at its own expense and, subsequently, it provides it to its sub-contractor. The tooling continues to the owned by the producer.
- A car producer provides technical parameters based on which a sub-contractor produces the tooling. The tooling continues to be owned by the sub-contractor who uses it to manufacture components ordered by the producer.
- A car producer provides technical parameters based on which a sub-contractor manufactures the tooling. The ownership of the manufactured tooling is transferred to the car producer while the sub-contractor uses it to produce components ordered by the producer.
The name “tooling” indicates that it should be treated as an asset. Specific classification (fixed assets or inventory) depends on who will remain to be the owner of the tooling under contractual documentation concluded between the sub-contractor and the producer, i.e. whether the tooling will be held by the sub-contractor over the entire serial production (refer to alternative 2 above) and its acquisition will be accounted for as fixed assets or whether it will be owned by the car producer (refer to alternatives 1 and 3 above) when the acquisition is recognised by the sub-contractor as inventory to be subsequently sold.
In practice, there is also a hybrid situation when the ownership of tooling is transferred to the producer but the expenses of tooling production or acquisition are paid to the sub-contractor gradually in the price of invoiced components (rather than based on one-off invoicing at the start of the serial production). In such a situation, tooling acquisition costs are recognised on an accruals basis by the sub-contractor through Complex deferred expenses.
As a matter of fact, acquisition of tooling often occurs hand in hand with other significant expenses relating to a future project (to which the tooling relates), such as expenses relating to the preparation for changes in the production process, in the set-up of tools and production lines, testing, searching for optimal internal logistics, collection of relevant insights and their reflection in the process documentation, irrespective of the fact who owns the tooling after it is finished. The expenses are also recognised and deferred typically through Complex deferred expenses but this is not the topic of this article.
Let us have a look at individual approaches to the accounting for tooling by a sub-contractor who needs the tooling to produce serial components for its customer, i.e. a car producer.
Tooling as an expense
This is a rare situation but it will make our overview complete: if tooling is acquired as part of a short-term project and does not qualify for capitalisation through assets, i.e. it does not exceed the useful life of one year, all expenses related to its production will be recognised and have an impact on profit or loss in the current period. In fact, it is an approach similar to low-value assets charged to consumed material.
Tooling as a tangible fixed asset
Tooling is classified as a tangible fixed asset if a sub-contractor develops, produces or purchases the tooling from an external supplier as instructed by a car producer and then it keeps its ownership. All expenses relating to tooling acquisition are accumulated in the value of fixed assets on the part of the sub-contractor on account 042 Intangible fixed assets under construction including possible capitalisation of own expenses through account group 58. This approach provides for the accumulation of all expenses, both internal and external, incurred by a company to acquire the tooling and meeting the definition of expenses to be included in the cost of assets under Section 47 of the Regulation before the serial production starts.
When the tooling is ready to be used, it is tested, or certified, by a car producer, meets all legal and technical requirements and usually after the serial production is commenced, it should be capitalised through account 022 Individual movable assets and depreciated through expense account 551 Depreciation of intangible and tangible fixed assets. The depreciation period goes hand in hand with the life of the project for which the tooling was produced and for which it is used. The profit or loss thus reflects the expenses through tooling depreciation and income is reflected subsequently as sales of serial components. Their price is naturally calculated to include all relevant expenses, including tooling expenses (tooling depreciation).
Tooling as inventory
If tooling ownership is transferred from a sub-contractor to a producer, it may be easily classified by the sub-contractor as inventory in group 12 if the tooling is produced in-house by the sub-contractor or in account 132 Goods if the sub-contractor purchases the tooling and resells it to the producer. Costs of tooling acquisition are again reflected in assets, in inventory this time, and the costs have an impact on profit or loss in the moment or period(s) in which the sub-contractor generates sales as a result of selling the tooling to the producer.
The moment in which tooling ownership is transferred to the producer is usually contracted; most frequently, it is the start of a serial production, i.e. when serial components of the appropriate quality start to be produced in series.
If tooling is classified as a product, expenses incurred for its production will be reflected if the product warehouse release is debited to account 583 Change in products / credited to account 123 Products and if its sales are debited to account 311 Trade receivables /credited to account 601 Sales of own products. Expenses for tooling classified as goods will be reflected by debiting goods warehouse release to account 504 Costs of goods sold / crediting to account 132 Goods and debiting sales of tooling to account 311 Trade receivables / crediting to account 604 Sales of goods.
In practice, gradual invoicing is often applied to tooling in long-term projects (advance payments are less frequent) when a producer requires from a tooling sub-contractor to issue invoices according to specified stages (milestones) in the course of tooling development and production or acquisition. In this case, income from invoicing is recognised on an accruals basis, i.e. a partial invoice issued by a sub-contractor is debited to account 311 Trade receivables / credited to account 384 Deferred income. Operating income will reflect the invoicing appropriately in the moment when the tooling is delivered to a customer through a debit on account 384 Deferred income / a credit on account 601 Sales of own products or 604 Sales of goods. In the same moment, profit or loss will reflect expenses of production or acquisition of the tooling as specified above.
Tooling as a complex deferred expense
Considerations on accounting for tooling through Complex deferred expenses is based on the accruals principle. In this situation, a producer (the tooling owner) pays for the expenses incurred by a sub-contractor to acquire the tooling gradually as part of the price of components delivered by the sub-contractor: the income gradually generated from the tooling should be matched with expenses – expressed by gradually depreciated (amortised) Complex deferred expenses. The sub-contractor is not the tooling owner and as such it cannot recognise tooling expenses in profit or loss through regular depreciation of fixed assets. At the same time, it is not a one-off sale with a payment schedule.
Complex deferred expenses include expenses of such a type that is not attributable to a single specific expense account, e.g. several expense types in the form of wages, external services, material consumption, purchase of supporting material used to develop the tooling.
The expenses incurred for this purpose are recognised in the relating period on accounts of operating expenses and the impact on profit or loss of the current period is eliminated by a debit on account 382 Complex deferred expenses / a credit on account 555 Charge and release of complex deferred expenses. The value of tooling is accumulated during the acquisition on balance sheet account 382 Complex deferred expenses from which it is gradually depreciated through a corresponding debit on account 555 Charge and release of complex deferred expenses / a credit on account 382 Complex deferred expenses over the period of settlement in the price of purchased components. It is an analogy with a situation when a sub-contractor owns the tooling and has it recognised in its assets whereby expenses for the tooling are settled through the price of supplied components.
Accounting estimates related to tooling accounting
The key estimated parameters relating to tooling include the length of the project (the model produced), the volume of production over the project period and recoverability of tooling valuation (the price parameter).
In practice there are occasions when the selling price of tooling does not cover the expenses incurred in its development and production. Sometimes, the tooling sub-contractor, who is also a sub-contractor of serial components, prefers a commitment of future contracts for another tooling and other components supplied.
There are also frequent situations when a contractual arrangement between a sub-contractor and a car producer stipulates compensation for a lower selling price of the tooling through an increase in the unit selling price of serial components. This situation requires monitoring of the risk that due to a lack of orders or production there will not be a sufficient amount of serial components to outbalance the loss of tooling through the increase in the selling price. However, it should be noted that the set-up of tooling selling price or the absorption of its production expenses in the unit price of a serial component always depends on an agreement between the sub-contractor and the car producer.
Car producers’ production plans respond to the market development and reflect it in their orders with a greater or smaller delay.
In any case, related estimates should be reflected in accounting through:
- Correct set-up of tooling depreciation period recognised in items of fixed assets and complex deferred expenses;
- Assessment of the need to create provisions for tooling (in fixed assets, complex expenses and inventory – in this case already in the period of tooling acquisition with reference to the requirement of a net realisable value as stipulated in Section 26 of the Accounting Act) due to impairment; and
- Recognition of a reserve for a loss-making project which was determined to make loss due to future expenses.
Impact of COVID-19
We cannot omit the fact that in the current period of the coronavirus pandemic causing COVID-19 it is appropriate to assess the use of tooling and recoverability of the funds invested to acquire the tooling. This relates to both finished and used tooling as well as tooling projects in progress.
If the situation affects the general course and funding of the project which is most likely not to generate profit according to management’s estimate the estimated loss should be recognised in accounting books through a provision and/or reserve for a loss-making project.
There are several options of accounting for tooling with any of them having its rules. Tooling classification depends on contractual arrangements between a sub-contractor supplying components and tooling and a car producer as a customer for serial components and on arrangements on tooling ownership. Apart from the ownership of tooling, the method in which a sub-contractor is paid for the tooling acquisition is critical.
Internal processes of sub-contractors and producers play a significant control task. For example, a physical inventory taking should result in the required records of tooling located in a business producing serial components if the tooling is owned by the car producer.
The challenges and difficulties include an entity’s options to keep detailed and complex records of tooling and a possibility to link them to the accounting system. It is appropriate for an entity to incorporate the selected method of tooling recognition including relevant arguments in its internal regulation allowing for sufficient understanding of the specifics and assessment of appropriateness of the approach selected by the entity.