7.2. Figuring Out Why Financial Statements Differ

Look at the third column on the right in Figure 7-1. These are the differences between the two financial statement versions. In the balance sheet the differences are concentrated in assets; only one liability is different. In total, assets are $1.55 million lower and liabilities are $65,000 higher. These differences are the results of recording slightly lower amounts of sales revenue and significantly higher amounts of expenses in the conservative Version C scenario.

Remember the following about revenue and expenses:

• Recording sales revenue increases an asset (or decreases a liability in some cases).

• Recording an expense either decreases an asset or increases a liability.

Most of the balance sheet differences in Figure 7-1 are caused by higher amounts of expenses in the Version C scenario. The cumulative amount of net income recorded over the years by the business in the Version C scenario is $1,615,000 less than in Version A:

$1,550,000 smaller amount of assets + $65,000
  higher amount of liabilities = $1,615,000
   less net income recorded over the years

At the end of each year, the amount of annual net income is recorded in the retained earnings owners' equity account. As you can see in Figure 7-1, the retained earnings balance in Version C is exactly $1,615,000 less than in Version A. This is a sizable amount, to be sure. But keep in mind that it took all the years of its existence to accumulate that $1,615,000 amount. The net income difference for its latest year (2009) is responsible for only part of the cumulative, total difference in retained earnings.

Sales revenue and every expense except interest are different between Versions A and C. Net income in Version C is $340,000 (about 20 percent) lower than in Version A.

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, written by myself and my son, Tage C. Tracy [Wiley]). 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.) In Version A, you would offer $10.74 million for the business ($1.69 million net income × 6 = $10.74 million). In Version C, you would offer only $8.1 million ($1.35 million net income × 6 = $8.1 million). If the business had used more conservative accounting methods, you would offer $2.64 million less for the business!

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 main reasons for the differences. Note: From here on, instead of referring to Version A and Version C, I will call the two different situations Company A and Company C. Remember that Company A uses aggressive accounting methods that boost recorded profit, and Company C uses conservative accounting methods that dampen recorded profit.

7.2.1. Cash balance

Company A engaged in what is called window dressing, which I discuss in Chapter 12. Company A held its books open for a few days after the close of the fiscal year in order to record additional cash collections from its accounts receivable. It's as if the cash had been received on December 31, 2009, even though the cash was not actually deposited in its checking account until the first week in January 2010. Isn't this cheating? Well, yes; it's like telling a small fib or a white lie.

The reason a business would do some window dressing is to improve the cash balance in its ending balance sheet. A business knows that when its creditors and shareowners read its ending balance sheet they pay particular attention to how its cash balance stacks up against its liabilities. Also, keeping the books open for a few days (only for cash collections of accounts receivable) makes the company's ending accounts receivable balance appear to be more under control because the balance is a smaller percent of total sales for the year. This gives the impression that the credit terms extended to customers are under good management, and the ending balance of accounts receivable is not too large (which would indicate that too many customers are late in paying their amounts owed the business).

7.2.2. Accounts receivable balance

One reason the ending balance of accounts receivable is lower is explained in the previous section: Company A did some window dressing. But there are two other reasons as well:

• Company C waits a little longer to record sales made on credit than Company A, 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, 2009 it had not yet recorded some credit sales that were still in the process of final acceptance by the customers.

  NOTE

  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 ordered. A good rule to follow is to read the company's footnote in its financial statements that explains its revenue recognition method, and see whether there is anything unusual about it. If the footnote is vague, be careful — be very careful!

  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.

  
  

• Company C is stricter about 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, Company C 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. Company A, in contrast, waits much longer to write off a customer's past due amount. In the long run Company A still has to write off a customer's debt if it has been outstanding too long — but it waits until the last minute to make the write-off entry.

7.2.3. 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. What is important is that the costs of its products have drifted upward over time because of inflation and other factors. Therefore, the business has had to increase its sales prices to keep up with the product cost increases.

There are two ways to deal with product cost inflation:

• Push the higher, most recent costs through to cost of goods sold expense as soon as possible.

• Follow the chronological order of acquisition and let the older product costs go out to cost of goods sold before the more recent product costs are charged out to expense.

I explain these two methods in the later section "Calculating Cost of Goods Sold and Cost of Inventory."

Company A uses the method that minimizes cost of goods sold expense and maximizes cost of ending inventory. Company C, in contrast, uses the method that maximizes cost of goods sold expense and minimizes cost of ending inventory. Note in Figure 7-1 that Company C's ending inventory is $700,000 lower and its cost of goods sold expense for the year is $280,000 higher. Over the years its cost of goods sold expense has been charged with $700,000 that Company A has not yet charged to the expense. Company C's cost of goods sold expense in 2009 is $280,000 higher than Company A; the remainder of the $700,000 cumulative difference in inventory cost is attributable to prior years.

Actually, not all of the cumulative $700,000 inventory difference and not all of the $280,000 cost of goods sold difference in 2009 is due to the different inventory and cost of goods sold expense methods used by the companies. Part of each difference is due to how each company applies, and puts into practice, the lower of cost or market (LCM) accounting rule. I explain this topic later in the chapter; see the section "Recording Inventory Losses under the Lower of Cost or Market (LCM) Rule." Company C is tougher and stricter in implementing the LCM procedure. It records higher amounts of inventory write-down at the end of the year, which increases its cost of goods sold expense (or some other expense account).

7.2.4. Cost of fixed assets, accumulated depreciation, 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.

Company A does include most of these additional costs in the original costs of its fixed assets, which means that the cost balances of its fixed assets are higher. These additional costs are not expensed immediately but are included in the total amount to be depreciated over future years. Also, Company A uses what is called straight-line depreciation, which spreads out the cost of a fixed asset evenly over the years of its useful life to the business.

In contrast, Company C does not include any costs other than purchase or construction costs in its fixed asset accounts, which means these additional costs are charged to expense immediately and are not delayed to future years. Also, and most importantly, Company C uses what is called accelerated depreciation for allocating the cost of its fixed assets to expense. Higher amounts are allocated to early years and smaller amounts to later years. Only the original cost is allocated to expense over time, but there is a front-end loading on the early years using accelerated depreciation.

I explain the straight-line and accelerated depreciation methods later in the chapter (see the section "Appreciating Depreciation Methods"). For now, note in Figure 7-1 that the original cost of Company C's property, plant, and equipment is $225,000 smaller than Company A's, and its accumulated depreciation balance is $425,000 higher. The company's depreciation expense is not disclosed as a separate expense in the income statement shown in Figure 7-1. We can't tell from the information in the income statement the amount of 2009 depreciation expense between the two companies. But Company C's depreciation expense for the year is higher because the business has been growing and increasing its investments in new fixed assets.

7.2.5. Accrued expenses payable liability balance

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. 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. However, brand new products that have no track record may be a serious problem in this regard.

Company A does not make the effort to estimate future product warranty and guaranty costs; 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 the understatement of its liabilities is not significant.

Company C, on the other hand, takes the high road and goes to the trouble to estimate the amount of future costs for the products it has already sold. Therefore, its accrued expenses payable liability account is $65,000 higher than Company A's. The difference of this particular expense for the year between the two versions is a bit tricky to determine. (I won't delve into details here.) Furthermore, the $65,000 higher amount of the liability includes accruals that a business records to recognize other unpaid expenses at the end of the year.

7.2.6. Wrapping things up

In Figure 7-1, you should note that the accounts payable liability is the same in both versions. These short-term operating liabilities are definite amounts that have definite due dates. There are no accounting choices or options in recording accounts payable. Also in Figure 7-1, I keep the income tax payable the same in both versions. If the business had used different accounting methods for determining its annual taxable income, its annual income tax expense would have been different, and the ending amount of its income tax payable liability might be a little different. This point is not that important to go into here.

So, why don't I include the statement of cash flows in the financial statements comparison in Figure 7-1? Generally speaking, this financial statement, which summarizes cash flows for the year, is the same no matter which accounting methods are used by a business. Cash flows are recorded when cash is actually received or disbursed; cash flow entries don't depend on which accrual-based accounting methods are used. However, a business may engage in window dressing at the end of the year (see the earlier section "Cash balance"). In this situation, the cash flow from operating activities is higher because the business has recorded cash flows that actually did not take place until after the end of its accounting year.

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 16 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" does 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.)