Accounting is Not Economic Reality1
This chapter describes the underlying nature of accounting and illustrates the necessary trade-offs that limit the ability of accounting to reflect a firm’s underlying economic reality.
There is a perception that accounting numbers present the truth. This probably stems from accounting’s mathematical basis. The Balance Sheet presents a firm’s assets (what it owns) and how it financed the assets (by borrowing-called liabilities or from the owners-called owners’ equity).
Why does a Balance Sheet have to balance? Ask this question to an accountant and you are likely to be told that the Balance Sheet is simply the mathematical equation:
Assets = Liabilities + Equity
If you press the accountant further, you will be told about the components of the Balance Sheet and how it is produced (with a high chance you will also be told all about the use of Debits, which means to the left, and Credits, which means to the right—more on this in Chapter 3). The accountant will say that if a Balance Sheet does not balance, it means a mistake has been made. While true, this view misses what the Balance Sheet is really about.
The Balance Sheet must balance because on one side it reflects the resources that a firm owns and controls and that will provide the firm with future cash flows (the Assets), and on the other side, how those resources are financed (the Liabilities and Equity). Each side is measured separately, and the two sides must balance. If they are not equal, it means a mistake has been made, which must then be found and corrected (if they are equal, however, it does not mean the Balance Sheet is free of mistakes). A Balance Sheet is seen in Exhibit 2.1 using a large T with the Assets on the left and the Liabilities and Equity on the right (again the details will be discussed in the coming chapters).
Thus, the Balance Sheet is an algebraic equation. However, the truth is that accounting is closer to an art, or a language (the language of business), than a science. The accounting numbers present one of many pictures of the underlying economics of a firm—but there is no single truth to present. Why? Because accounting rules and practices provide managers with discretion over how they present the economic reality of a firm.
Let us use an example to illustrate the many different accounting “truths.” Consider a simple business venture: selling T-shirts. For simplicity, the owner/investor puts in $36 (meaning both the firm’s cash and the owner’s equity account increased by $36). Over time, the owner purchases three identical T-shirts for $10, $12, and $14, meaning a total of $36 from cash is spent and T-shirt inventory increases by $36. Note, this example involves a change in purchase prices. It does not really matter why the price changes (inflation, market conditions, and so on). Since, as stated, the T-shirts are identical, a customer will not care which one he is given. Before anything has been sold, the Balance Sheet will balance with $36 in T-shirt inventory and $36 in owner’s equity as shown in Exhibit 2.2.
Now assume the business sells one T-shirt for $20. How much profit has the business made by selling one T-shirt? Write down your answer and then read the possible accounting choices below.
There are five possible methods to answer this question:
1. Inventory reported using the First-In First-Out method,
2. Inventory reported using the Average method,
3. Inventory reported using the Last-In First-Out method,
4. Cash accounting, or
5. Inventory valued at its market value.
The first three are traditional accounting methods based on how the firm decides to value “cost” the dollar amount of the one T-shirt sold, which is then subtracted from the selling price. If the firm chooses to do so in the same order they were purchased, then they would be costing the oldest unit first. This method is called “first-in first-out” (FIFO) and would result in the firm having a profit of $10 ($20 in revenue − $10 in cost). Note that this leaves the most recently purchased T-shirts (the last two T-shirts) on the Balance Sheet as assets with a value of $26 as shown in Exhibit 2.3.
It is also possible to report the inventory by computing an average cost for the three T-shirts ($36/3 = $12). This method is called “average” (AVG) and produces a profit of $8 ($20 in revenue − $12 in cost). Note that this will value the two remaining T-shirts at $12 each for a total of $24 in inventory as shown in Exhibit 2.4.
A third option is to cost the unit of inventory sold by using the most recent purchase price. This method is called “last-in first-out” (LIFO) and it produces a profit of $6 ($20 in revenue − $14 in cost). Note that this leaves the earliest purchased T-shirts (the first two) in the Balance Sheet as assets with a value of $22 (the first at $10, the second at $12) as shown in Exhibit 2.5.
Thus, three different methods (FIFO, AVG, and LIFO), all of which are correct, results in three different profit amounts and three different Balance Sheets.
An argument in favor of FIFO is that the two units of unsold inventory on the Balance Sheet would be valued at $26 ($12 + $14), which is probably closer to a replacement cost of $28 (assuming prices have increased to $14, replacing the two units would probably mean paying the last purchase price of $14 for each one). In contrast, the inventory value computed under LIFO is much lower than the potential replacement cost: LIFO would value the remaining inventory at $22 ($10 + $12). Thus, by using FIFO and using the value of (costing) the oldest unit first, the Balance Sheet is more reflective of the current underlying value (i.e., replacement cost) of inventory. The inventory number under FIFO is probably more relevant, in terms of the Balance Sheet, than the number under LIFO.
So why is FIFO not mandated for all financial statement disclosures? The reason lies in the fact that firms’ equity values are not based strictly on the numbers on a Balance Sheet. Most firms are valued based on their ability to generate profits in the future. A key objective in financial reporting is to provide outsiders with an ability to estimate the future cash flows of a firm, and this is done by starting with an examination of the accounting profits (we predict the future by starting with the past). For this, the outsiders use not only the Balance Sheet but also the Income Statement and the Statement of Cash Flows (all coming attractions).
Although FIFO may provide a more relevant valuation of inventory on the Balance Sheet, the profit generated using FIFO is $10 ($20 in revenue less $10 representing the FIFO cost of the T-shirt that was sold). The profit generated using LIFO is $6 ($20 in revenue less $14 representing the LIFO cost of the T-shirt that was sold). Which of these two profit numbers is a better predictor of future profits and cash flows? If the selling price remains at $20 and the purchase of new T-shirts stays at $14, then the $6 computed under LIFO is a better estimate of expected profits going forward. The $4 difference in profits ($10 − $6) will eventually be realized when the firm sells off its inventory. The extra profit on the first and second T-shirts, for which the firm paid $10 and $12 is not sustainable, and thus LIFO may provide a better estimate of future profits and cash flows.
The average method is a compromise between the two.
Why not simply number the three T-shirts and cost the one which is actually sold? This is a valid method called specific identification and is used in high-value products where customers choose the specific product sold (e.g., automobiles). However, in the example being given, the T-shirts are of low value and identical. Costing the actual T-shirt sold would allow management to choose the profit they will report by choosing which T-shirt they give the customer (the customer would not care, as they are identical). A key goal of accounting is to set up a process preventing management from simply choosing the profit it reports to outsiders.
It is true that by being able to choose the accounting method to use—FIFO, LIFO, and AVG—management can also alter a firm’s profit. However, because firms must disclose their accounting choice, an outsider can interpret the profit number accordingly (and/or adjust it to reflect an alternative choice).2
These three traditional accounting methods—FIFO, LIFO, and AVG—demonstrate the trade-off being made between focusing on a Balance Sheet and wanting those values closer to economic reality (i.e., what the assets are worth and how they were financed) or focusing on an Income Statement (the difference in selling price and costs, used to estimate future cash flows). But there are two other possible methods to compute the profit made by this simplified business venture.
Another approach is to focus on cash. As we will see later when we discuss cash flows, reality is cash (or alternatively “Cash is King”). How much cash came in, and how much cash went out? Using cash accounting, there is only one asset category: cash.3 Costs are incurred when cash is paid and revenue occurs when cash is received. Thus, if the only asset recorded is cash (which is what cash accounting does), then the firm will have a loss of $16 after the sale of one T-shirt (the initial $36 outlay plus the $20 from the first sale) as shown in Exhibit 2.6.
The benefit of the cash basis of accounting is that it reflects one element of reality: the actual flow of cash in and out of an organization. The limitation of this basis of accounting is that it fails to value the remaining inventory or provide any ability to predict future cash flows.
Finally, another option is an economic concept of accounting called fair value reporting. This approach values the remaining T-shirts not at their cost but at an estimate of their market value. The T-shirts would be valued at their market value, the price established by the last sale ($20 each).4 The firm’s profit is computed as the difference in value from the start to the end of the year as shown in Exhibit 2.7.
Thus, the firm began with an economic value of $36 (the cash invested by the owners) and ended with an economic value of $60 ($20 cash and T-shirt inventory valued at $40). The difference between the opening ($36) and closing firm value ($60) is the profit, real, and potential, of $24. Fair value accounting reflects the fact that if we were to sell our T-shirt business to someone else, with assets of $20 cash and two T-shirts worth $20 each, we would be looking for a price of $60.
Fair value accounting attempts to overcome an element not corrected by the other accounting methods: management’s discretion over the accounting process. One benefit of fair value accounting is that the value will be the same regardless of how many units are sold or in what order. The problem with fair value accounting is that it still provides management with discretion to influence the process by choosing how to value the unsold inventory. The true economic value of the inventory (or whatever is being valued) is the relevant (i.e., useful to outsiders) number. However, if there is no active liquid market for the item being valued, then a management-determined number, which may not be objective, must be used.5
Note: The choice of how to cost the inventory (FIFO, LIFO, AVG, and so on) or of whether to use cash accounting or fair value is not required if the accounting is only done after all three T-shirts are sold. If firms only did their accounting when the business was being liquidated, all these accounting choices would give the same results.6 Thus, it is only because we do accounting every year (or month or quarter) that we are required to make these choices.
The Bottom Line
These examples, from a simple business venture, demonstrate why there is no single truth in accounting. Accounting faces a trade-off between providing the best valuation of the assets vs. providing the best basis for estimating future cash flows. The manager decides based on the picture of the firm she wants to present to outsiders. As the business venture becomes more complex, so does the impact of these trade-offs. This is why there is no single way to determine the one “profit” number or “net value” in accounting. To understand the underlying economics of a business, the financial statements must be viewed in their totality as a starting point and not an end point and it is critical to know the accounting choices that were made.
The next chapter provides an explanation of how the accounting process works—the details of what accountants do behind the numbers. But first, Appendix 2A presents an important illustrative exposition on ethics in accounting.
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1This chapter is also an appendix in Asquith and Weiss, Lessons in Finance © 2016. Reprinted with permission.
2Firms are allowed to change their accounting choice. However, they must state the reason for the change and in the year of the change provide information using both the old and new accounting methods.
3Cash accounting (in contrast to the more commonly used accrual accounting) is often used by farmers, fishermen, and some small businesses. It is also sometimes used for tax purposes.
4Other profit numbers are possible. For example, using the last purchase price of $14 instead of the most recent selling price of $20 to value the two units of ending inventory, which would yield a final Balance Sheet of $48 ($20 cash and 2 × $14 = $28 in inventory) and a profit of $12 (a $36 starting value vs. $48 ending value).
5A liquid market is one where assets can be sold quickly at a fair price.
6Luca Pacioli, the Venetian monk who first wrote down our modern system of accounting, did so for Venetian merchants accounting for shipping expeditions. Goods were acquired, a boat and sailors were hired. The boat sailed away, goods were traded, the boat returned, the goods were sold. Then, the profits were distributed. Accounting for this type of expedition did not require the timing assumptions. Profits were not computed per quarter or per year. The profits were computed only at the end of the enterprise.