Figure 7-1: Actual versus alternative income statement and balance sheet for a company.
example, say you want to make cost of goods sold expense lower. You could arbitrarily decrease the balance in this expense account. And you also have to increase the balance in the inventory account (or possibly some other asset account) and in the retained earnings account in order to keep the books in balance, so that total assets equal the total of liabilities and owners’ equity. Being a financial statements fraudster requires some accounting savvy to make the fraud-based numbers plausible.
Now, you may very well ask, “Where in the devil did you get the numbers for the alternative financial statements?” The dollar amounts in the
Alternative column are my best estimates of what conservative numbers would be for this business — a company that has been in business for several years, has made a profit most years, and has not gone through bankruptcy. Both the actual and the alternative financial statements are hypothetical but realistic and are not dishonest or deceitful. (See the sidebar
“Faking the financials.”)
Spotting significant differences
It’s a little jarring to see a second set of numbers for the bedrock financial statements, such as the income statement and balance sheet. You’re bound to raise your eyebrows when I say that both sets of accounting numbers are true and correct, yet different. Financial report users have been conditioned to accept one version for these two financial statements without thinking about what alternative financial statements would look like. Seeing an alternative scenario takes a little time to get used to, like learning how to drive on the left side of the road in Great Britain. There’s always an alternative set of numbers lurking in the shadows, even though you don’t get to see them.
The differences in revenue and expenses don’t look that big, until you get to the bottom line. Net income is $340,000 lower in the alternative scenario, which is 20 percent smaller. Suppose that in putting a market value on the business, you use the earnings multiple method. (For more information on the valuation of a small business, see Small Business
Financial Management Kit For Dummies, which I coauthored with my son, Tage C. Tracy [John Wiley & Sons]). Suppose you are willing to pay six times the most recent annual profit of the business. (I certainly don’t mean to suggest that six times earnings is a standard multiple for all small
businesses.) Using the actual financial statements, you would offer $10.74 million for the business ($1.69 million net income × 6 = $10.14 million). If the alternative accounting methods was used, you would offer only $8.1
million ($1.35 million net income × 6 = $8.1 million). If the business had used the more conservative accounting methods, you would offer $2.04 million less for the business!
The balance sheet differences look more sizable, and they are. Accounts receivable and inventory are significantly lower in the alternative scenario.
And, the book value of its fixed assets (original cost minus accumulated depreciation) is significantly smaller. In both scenarios the actual condition and usability of its fixed assets (space in its buildings, output of its
machinery and equipment, future miles of its trucks, and so on) are the same. In the alternative scenario these key assets of the business just have a much lower reported value.
And I’m sure you noticed that the company’s retained earnings balance is
$2,405,000 lower in the alternative scenario. Its retained earnings balance is 43 percent smaller! This much less profit would have been recorded over the years if the business had used the alternative accounting methods. Keep in mind that it took all the years of its existence to accumulate the
$2,405,000 difference. The net income difference for its latest year (2013) is responsible for only $340,000 of the cumulative, total difference in retained earnings.
Explaining the Differences
In the following discussion you need to refer to the Differences column in Figure 7-1. We start by checking the $2,405,000 difference in retained earnings. Recall that profit is recorded in this owners’ equity account.
Because retained earnings is $2,405,000 lower, the cumulative profit of the business would be $2,405,000 lower if it had used the conservative
accounting methods.
Remember the following about revenue and expenses:
Recording sales revenue increases an asset (or decreases a liability in some cases).
Recording an expense decreases an asset or increases a liability.
Therefore, assets are lower and/or liabilities are higher having used the alternative accounting methods, and collectively these differences should equal the difference in retained earnings. In Figure 7-1 total assets are
$2,340,000 lower in the alternative scenario. And liabilities are $65,000 higher ($102,000 higher Accrued Expenses Payable minus the $37,000 lower amount of Income Tax Payable = $65,000 higher liabilities).
Therefore, the difference in retained earnings checks out:
$2,340,000 smaller amount of assets + $65,000 higher amount of liabilities = $2,405,000 less net income recorded over the years
The following sections briefly explain each of the differences in Figure 7-1, except the retained earnings difference that I explain just above. I keep the explanations relatively brief and to the point. The idea is to give you a basic taste of some of the reasons for the differences.
Accounts receivable and sales revenue
Here are some common reasons why the balance of the accounts receivable asset is lower when conservative accounting methods are adopted:
A business waits a little longer to record sales made on credit, to be more certain that all aspects of delivering products and the acceptance by
customers are finalized, and there is little chance of the products being returned by the customers. This delay in recording sales causes its accounts receivable balance to be slightly lower, because at December 31, 2013 credit sales of $345,000 were not yet recorded that were still in the process of final acceptance by the customers. (Of course the cost of goods sold for these sales would not have been recorded either.)
If products are returnable and the deal between the seller and buyer does not satisfy normal conditions for a completed sale, the recording of sales revenue should be postponed until the return privilege no longer exists. For example, some products are sold on approval, which means the customer takes the product and tries it out for a few days or longer to see if the customer really wants it.
Businesses should be consistent from year to year regarding when they record sales. For some businesses, the timing of recording sales revenue is a major problem — especially when the final
acceptance by the customer depends on performance tests or other conditions that must be satisfied. Some businesses engage in channel stuffing by forcing their dealers or customers to take delivery of more products than they wanted to buy. A good rule to follow is to read the company’s footnote in its financial statements that explains its revenue recognition method, to see whether there is anything unusual. If the footnote is vague, be careful — be very careful!
A business may be quicker in writing off a customer’s past due balance as uncollectible. After it has made a reasonable effort to collect the debt but
a customer still hasn’t sent a check, a more conservative business writes off the balance as a bad debts expense. It decreases the past due accounts receivable balance to zero and records an expense of the same amount. In contrast, a business could wait much longer to write off a customer’s past due amount. Both accounting methods end up writing off a customer’s debt if it has been outstanding too long — but a company could wait until the last minute to make the write-off entry.
Inventory and cost of goods sold expense
The business in the example sells products mainly to other businesses. A business either manufactures the products its sells or purchases products for resale to customers. (Chapter 11 explains the determination of product costs for manufacturing businesses.) At this point it is not too important whether the business manufactures or purchases the products it sells. The costs of its products have drifted upward over time because of inflation and other
factors. The business increased its sales prices to keep up with the product cost increases. When product costs change a business must choose which accounting method it uses for recording cost of goods sold expense.
One accounting method takes product costs out of the inventory asset
account and records the costs to cost of goods sold expense in the sequence in which the costs were entered in the asset account. This scheme is called the first-in, first-out (FIFO) method. Instead, a business may choose to use the reverse method in which the latest product costs entered in the inventory asset account are selected for recording cost of goods sold expense, which leaves the oldest product costs in the asset account. This method is called the last-in, first-out (LIFO) method. I explain these two opposing methods in more detail later in the chapter (see Calculating Cost of Goods Sold Expense and Inventory Cost). FIFO is being used in the actual scenario and LIFO is what you see in the alternative scenario in Figure 7-1.
When product costs drift upward over time the FIFO method yields a lower cost of goods sold expense and a higher inventory asset balance compared with LIFO. In Figure 7-1 we see that inventory is $700,000 lower in the alternative accounting scenario and that cost of goods sold expense is
$280,000 higher. The $700,000 lower inventory balance is the cumulative effect of using LIFO, including the carry forward effects from previous years.
Some of the $700,000 inventory difference and some of the
$280,000 cost of goods expense difference for 2013 are due to differences in how rigorously the business applies the lower of cost or market (LCM) rule. Before being sold, products may suffer loss in value due to
deterioration, damage, theft, lower replacement costs, and diminished sales demand. A business tests regularly for such product losses and records the losses by decreasing its inventory balance and charging cost of goods sold expense. The LCM test can be applied loosely or tightly. It is applied more strictly in the alternative accounting scenario than in the actual scenario, which results in a larger amount of write-down of inventory (and higher expense).
Fixed assets and depreciation expense
All accountants agree that the costs of long-term operating assets that have limited useful lives to a business should be spread out over those predicted useful lives instead of being charged off entirely to expense in the year of acquisition. These long-lived operating assets are labeled property, plant and equipment in Figure 7-1, and less formally are called fixed assets. (The cost of land owned by a business is not depreciated because land is a
property right that has perpetual life.) The allocation of the cost of a fixed asset over its estimated useful economic life to a business is called
depreciation. The principle of depreciation is beyond criticism, but the devil is in the details.
The original costs of fixed assets should theoretically include
certain costs in addition to their purchase or construction costs. However, in actual practice these fringe costs are not always included in the original cost of fixed assets. For example, it is theoretically correct to include installation costs of putting into place and connecting electrical and other power
sources of heavy machinery and equipment. It is correct to include the cost of painting logos on the sides of delivery trucks. The cost of an older
building just bought by a business should include the preparatory cleanup costs and the safety inspection cost. But in practice a business may not include such additional costs in the original costs of its fixed assets.
In the actual accounting scenario the business does include these additional costs in the original costs of its fixed assets, which means that the cost
balances of its fixed assets are $225,000 higher compared with the
alternative, conservative scenario (see Figure 7-1). These additional costs are not expensed immediately but are included in the total amount to be depreciated over future years. Also, in the actual scenario the company uses straight-line depreciation (discussed later), which spreads out the cost of a fixed asset evenly over the years of its useful life.
In the alternative conservative scenario the business does not include any costs other than purchase or construction costs in its fixed asset accounts, which means the additional costs are charged to expense immediately. Also, and most importantly, the business uses accelerated depreciation (discussed later) for allocating the cost of its fixed assets to expense. Higher amounts are allocated to early years and smaller amounts to later years. The result is that the accumulated depreciation amount in the alternative scenario is
$1,020,000 higher, which signals that a lot more depreciation expense has been recorded over the years.
Accrued expenses payable, income tax payable, and expenses
A typical business at the end of the year has liabilities for certain costs that have accumulated but that will not be paid until sometime after the end of the year — costs that are an outgrowth of the current year’s operating activities. These delayed-payment expenses should be recorded and matched against the sales revenue for the year. For example, a business should accrue (calculate and record) the amount it owes to its employees for unused vacation and sick pay. A business may not have received its
property tax bill yet, but it should estimate the amount of tax to be assessed and record the proper portion of the annual property tax to the current year.
The accumulated interest on notes payable that hasn’t been paid yet at the end of the year should be recorded.
Here’s another example: Most products are sold with expressed or implied warranties and guarantees. Even if good quality controls are in place, some products sold by a business don’t perform up to promises, and the customers want the problems fixed. A business should estimate the cost of these future obligations and record this amount as an expense in the same period that the goods are sold (along with the cost of goods sold expense, of course). It should not wait until customers actually return products for
repair or replacement because if it waits to record the cost then some of the expense for the guarantee work would not be recorded until the following year. After being in business a few years, a company can forecast with reasonable accuracy the percent of products sold that will be returned for repair or replacement under the guarantees and warranties offered to its customers. On the other hand, brand new products that have no track record may be a serious problem in this regard.
In the actual scenario the business does not make the effort to estimate future product warranty and guaranty costs and certain other costs that should be accrued. It records these costs on a when-paid basis. It waits until it actually incurs these costs to record an expense. The company has
decided that although its liabilities are understated, the amount is not material. In the alternative scenario, on the other hand, the business takes the high road and goes to the trouble of estimating future costs that should be matched against sales revenue for the year. Therefore, its accrued
expenses payable liability account is $102,000 higher (see Figure 7-1).
In the alternative conservative scenario (see Figure 7-1) I assume that the business uses the same accounting methods for income tax, which gives a lower taxable income and income tax for the year. Accordingly, notice that the income tax expense for the year is $295,000 lower and the year-end balance of income tax payable is lower. A business makes installment
payments during the year on its estimated income tax for the year, so only a fraction of the annual income tax is still unpaid at the end of the year. (A business may use different accounting methods for income tax than it does for recording its transactions, which leads to complexities I don’t follow here.)
Wrapping things up
In the business example (Figure 7-1) the accounts payable liability is the same in both scenarios. These short-term operating liabilities are definite amounts for definite services or products that have been received by the business. There are no accounting alternatives in recording accounts payable. Also, cash has the same year-end balance in both scenarios
because these transactions are recorded when cash is received and paid out.
(Well, a business may do a little “window dressing” to bump up its reported cash balance, which I discuss in Chapter 12.) Finally, the accounts not
affected by recording revenue and expenses are the same in both accounting scenarios, which are notes payable and owners’ invested capital.
To be frank, my numbers for the alternative, conservative scenario are no more than educated guesses. Businesses keep only one set of books.
Even a business itself doesn’t know how different its financial statements would be if it had used different accounting methods. Financial report readers can read the footnotes to determine whether liberal or conservative accounting methods are being used. Footnotes are not easy to read. It is very difficult, if not impossible, to determine exactly how much profit would have been and how much different balance sheet amounts would be if alternative accounting methods had been used by a business.
If you own or manage a business, I strongly encourage you to get involved in deciding which accounting methods to use for measuring your profit and how these methods are actually implemented. Chapter 15
explains that a manager has to answer questions about his or her financial reports on many occasions, so you should know which accounting methods are used to prepare the financial statements. However, “get involved”
should not mean manipulating the amounts of sales revenue and expenses recorded in the year — to make profit look higher, to smooth fluctuations in profit from year to year, or to improve the amounts of assets and liabilities reported in your ending balance sheet. You shouldn’t even consider doing these things. (Of course these manipulations go on in the real world. Some people also drive under the influence, but that doesn’t mean you should.)
Calculating Cost of Goods Sold Expense and Inventory Cost
Companies that sell products must select which method to use for recording cost of goods sold expense, which is the sum of the costs of the products sold to customers during the period. You deduct cost of goods sold from sales revenue to determine gross margin — the first profit line on the income statement (refer to Figure 7-1). Cost of goods sold is a very
important figure; if gross margin is wrong, bottomline profit (net income) is wrong.
A business can choose between two opposite methods for recording its cost of goods sold and the cost balance that remains in its inventory asset
account:
The first-in, first-out (FIFO) cost sequence