In This Chapter
Realizing there’s more than one way home
Examining the effects of alternative accounting methods on profit and balance sheet
Taking a closer look at cost of goods sold and depreciation expenses Scanning the revenue and expense horizon
This chapter explains that when recording revenue, expenses, and other transactions of a business, the accountant generally must choose among different methods for capturing the economic reality of the transactions.
You might think that accountants are in unified agreement on the exact ways for recording business transactions, but I must tell you that this isn’t the case. An old joke is that when two economists get together there are three economic opinions. It’s not that different in accounting.
The financial statements reported by a business are just one version of its financial history and performance. A different accountant for the business undoubtedly would have presented a different version. The income
statement and balance sheet of a business depend on which particular accounting methods the accountant chooses. Moreover, on orders from management the financial statements could be tweaked to make them look better. I discuss how businesses can (and do!) put spin on their financial statements in Chapter 12.
It’s one thing to be generally aware that financial statements depend on the choice of accounting methods used to prepare the statements. It’s quite another to see the effects in action. In this chapter I present two opposing versions of the financial statements for a business. I explain the reasons for the differences in its revenue, expenses, assets, liabilities, and owners’
equity. And, I explain the main accounting alternatives for two major expenses of businesses that sell products — cost of goods sold and depreciation.
Accounting for the economic activity of a business can be compared to judging a beauty contest. There might be agreement among the judges that all the contestants are goodlooking, but ranking the contestants is sure to
vary from judge to judge. Beauty is in the eye of the beholder, as they say.
Setting the Stage
Let me get directly to the point. The dollar amounts reported in the financial statements of a business are not simply “facts” that depend only on good bookkeeping. Here’s why different accountants record transactions differently. The accountant:
Must make choices among different accounting methods for recording the amounts of revenue and expenses.
Can select between pessimistic or optimistic estimates and forecasts when recording certain revenue and expenses.
Has some wiggle room in implementing accounting methods, especially regarding the precise timing of when to record sales and expenses.
Can carry out certain tactics at year-end to put a more favorable spin on the financial statements, usually under the orders or tacit approval of top management. I discuss these manipulations in Chapter 12 on getting the financial report ready for release.
The popular notion is that accounting is an exact science and that the amounts reported in the financial statements are true and accurate down to the last dollar. When people see an amount reported to the last digit in a financial statement, they naturally get the impression of exactitude and precision. However, in the real world of business the accountant has to make many arbitrary choices between alternative ways for recording revenue and expenses, and for recording changes in their corresponding assets and liabilities. (In Chapter 4 I explain that revenue and expenses are coupled with assets and liabilities.)
I don’t discuss accounting errors in this chapter. It’s always possible that the accountant doesn’t fully understand the transaction being recorded, or relies on misleading information, with the result that the entry for the transaction is wrong. And, bookkeeping processing slip-ups happen. The term error generally refers to honest mistakes; there is no intention of manipulating the financial statements. Unfortunately, a business may not detect accounting mistakes, and therefore its financial statements end up being misleading to one degree or another. (I point out in Chapter 3 that a business should institute effective internal controls for preventing
accounting errors.)
Taking Financial Statements with a Grain of Salt
Suppose that you have the opportunity and the ready cash to buy a going business. The business I have in mind is the very one I use as the example in the previous three chapters in which I explain the income statement (Chapter 4), the balance sheet (Chapter 5), and the statement of cash flows (Chapter 6). Of course, you should consider many factors in deciding your offering price. The company’s most recent financial statements would be your main source of information in reaching a decision — not the only source, of course, but the most important source for financial information about the business.
I recommend that you employ an independent CPA who has a professional credential in business valuation. The CPA could also examine the company’s recordkeeping and accounting system, to determine whether the accounts of the business are complete, accurate, and in conformity with the applicable accounting standards. The CPA should also test for possible fraud and any accounting shenanigans in the financial statements. As the potential buyer of the business you can’t be too careful. You don’t want the seller of the business to play you for a sucker.
Only one set of financial statements is included in a business’s financial report: one income statement, one balance sheet, and one
statement of cash flows. A business does not provide a second, alternative set of financial statements that would have been generated if the business had used different accounting methods and if the business had not tweaked its financial statements. The financial statements would have been different if alternative accounting methods had been used to record sales revenue and expenses and if the business had not engaged in certain end-of-period
maneuvers to make its financial statements look better. (My late father-in- law, a successful businessman, called these tricks of the trade “fluffing the pillows.”)
Taking an alternative look at the company’s
financial statements
Everyone that has a financial stake in a business should understand and keep in mind the bias or tilt of the financial statements they’re reading.
Using a baseball analogy, the version of financial statements in your hands may be in left field, right field, or center field. All versions are in the
ballpark of general accounting standards, which define the playing field but don’t dictate that every business has to play straight down the middle. In their financial reports, businesses don’t comment on whether their financial statements as a whole are liberal, conservative, or somewhere in between.
However, a business does have to disclose in the footnotes to its statements its major accounting methods. (See Chapter 12 that discusses getting a financial report ready for release.)
As the potential buyer of a business, you have to decide on what the business is worth. Generally speaking, the two most important factors are the profit performance of the business (reported in its income statement) and the composition of assets, liabilities, and owners’ equity of the business (reported in its balance sheet). For instance, how much would you pay for a business that has never made a profit and whose liabilities are more than its assets? There’s no simple formula for calculating the market value for a business based on its profit performance and financial condition. But, quite clearly, the profit performance and financial condition of a business are dominant factors in setting its market value.
Figure 7-1 presents a comparison that you never see in real-life financial reporting. The Actual column in Figure 7-1 presents the income statement and balance sheet reported by the business. The Alternative column reveals an income statement for the year and the balance sheet at year-end that the business could have reported (but didn’t) if it had used alternative but acceptable accounting methods.
Assuming you read Chapters 4 and 5, the actual account balances in the income statement and balance sheet should be familiar — these are the same numbers from the financial statements I use in those chapters. The dollar amounts in the Alternative column are the amounts that would have been recorded using different accounting methods. We don’t particularly need the statement of cash flows here, because cash flow from profit (operating activities) is the same amount under both accounting scenarios and the cash flows from investing and financing activities are the same.
The business in our example adopted accounting methods that maximized
its recorded profit, which recognize profit as soon as possible. Some businesses go the opposite direction. They adopt conservative accounting methods for recording profit performance, and they wouldn’t think of tinkering with their financial statements at the end of the year, even when their profit performance falls short of expectations and their financial condition has some trouble spots. The Alternative column in Figure 7-1 reports the results of conservative accounting methods that could have been used by the business (but were not). As you see in Figure 7-1 using the alternative accounting methods results in less favorable measures of profit and financial condition.
Figure 7-1: Actual versus alternative income statement and balance sheet for a company.