Chapter 7

Accounting Alternatives

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.

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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, bottom-line 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

The last-in, first-out (LIFO) cost sequence

Other methods are acceptable, but these two are the primary options.

Product costs are entered in the inventory asset account in the order the products are acquired, but they are not necessarily taken out of the inventory asset account in this order. The FIFO and LIFO terms refer to the order in which product costs are taken out of the inventory asset account. You may think that only one method is appropriate; however, accounting standards permit these two alternatives.

The choice between the FIFO and LIFO accounting methods does not depend on the actual physical flow of products. Generally speaking, products are delivered to customers in the order the business bought or manufactured the products — one reason being that a business does not want to keep products in inventory too long because the products might deteriorate or show their age. So, products generally move out of inventory in a first-in, first-out sequence. Nevertheless, a business may choose the last-in, first-out accounting method. Read on.

FIFO (first-in, first-out)

With the FIFO method, you charge out product costs to cost of goods sold expense in the chronological order in which you acquired the goods. The procedure is that simple. It’s like the first people in line to see a movie get in the theater first. The ticket-taker collects the tickets in the order in which they were bought.

Suppose that you acquire four units of a product during a period, one unit at a time, with unit costs as follows (in the order in which you acquire the items): $100, $102, $104, and $106, for a total of $412. By the end of the period, you have sold three of these units. Using FIFO, you calculate the cost of goods sold expense as follows:

$100 + $102 + $104 = $306

In short, you use the first three units to calculate cost of goods sold expense.

The cost of the ending inventory asset, then, is $106, which is the cost of the most recent acquisition. The $412 total cost of the four units is divided between $306 cost of goods sold expense for the three units sold and the $106 cost of the one unit in ending inventory. The total cost has been accounted for; nothing has fallen between the cracks.

FIFO has two things going for it:

Products generally move out of inventory in a first-in, first-out sequence: The earlier acquired products are delivered to customers before later acquired products are delivered, so the most recently purchased products are the ones still in ending inventory to be delivered in the future. Using FIFO, the inventory asset reported in the balance sheet at the end of the period reflects recent purchase (or manufacturing) costs, which means the balance in the asset is close to the current replacement costs of the products.

  When product costs are steadily increasing, many (but not all) businesses follow a first-in, first-out sales price strategy and hold off raising sales prices as long as possible. They delay raising sales prices until they have sold their lower-cost products. Only when they start selling from the next batch of products, acquired at a higher cost, do they raise sales prices. I favor the FIFO cost of goods sold expense method when a business follows this basic sales pricing policy, because both the expense and the sales revenue are better matched for determining gross margin. I realize that sales pricing is complex and may not follow such a simple process, but the main point is that many businesses use a FIFO-based sales pricing approach. If your business is one of them, I urge you to use the FIFO expense method to be consistent with your sales pricing.

LIFO (last-in, first-out)

Remember the movie ticket-taker I mentioned earlier? Think about that ticket-taker going to the back of the line of people waiting to get into the next showing and letting them in first. The later you bought your ticket, the sooner you get into the theater. This is what happens in the LIFO method, which stands for last-in, first-out. The people in the front of a movie line wouldn’t stand for it, of course, but the LIFO method is acceptable for determining the cost of goods sold expense for products sold during the period.

The main feature of the LIFO method is that it selects the last item you purchased, and then works backward until you have the total cost for the total number of units sold during the period. What about the ending inventory — the products you haven’t sold by the end of the year? Using the LIFO method, the earliest cost remains in the inventory asset account (unless all products are sold and the business has nothing in inventory).

Using the same example from the preceding section, assume that the business uses the LIFO method. The four units, in order of acquisition, had costs of $100, $102, $104, and $106. If you sell three units during the period, the LIFO method calculates the cost of goods sold expense as follows:

$106 + $104 + $102 = $312

The ending inventory cost of the one unit not sold is $100, which is the oldest cost. The $412 total cost of the four units acquired less the $312 cost of goods sold expense leaves $100 in the inventory asset account. Determining which units you actually delivered to customers is irrelevant; when you use the LIFO method, you always count backward from the most recent unit you acquired.

The two main arguments in favor of the LIFO method are these:

Assigning the most recent costs of products purchased to the cost of goods sold expense makes sense because you have to replace your products to stay in business, and the most recent costs are closest to the amount you will have to pay to replace your products. Ideally, you should base your sales prices not on original cost but on the cost of replacing the units sold.

During times of rising costs, the most recent purchase cost maximizes the cost of goods sold expense deduction for determining taxable income, and thus minimizes income tax. In fact, LIFO was invented for income tax purposes. True, the cost of inventory on the ending balance sheet is lower than recent acquisition costs, but the taxable income effect is more important than the balance sheet effect.

But here are the reasons why LIFO is problematic:

  Unless you are able to base sales prices on the most recent purchase costs or you raise sales prices as soon as replacement costs increase — and most businesses would have trouble doing this — using LIFO depresses your gross margin and, therefore, your bottom-line net income.

The LIFO method can result in an ending inventory cost value that’s seriously out of date, especially if the business sells products that have very long lives. For instance, for several years, Caterpillar’s LIFO-based inventory has been billions less than what it would have been under the FIFO method.

Unscrupulous managers can use the LIFO method to manipulate their profit figures if business isn’t going well. They deliberately let their inventory drop to abnormally low levels, with the result that old, lower product costs are taken out of inventory to record cost of goods sold expense. This gives a one-time boost to gross margin. These “LIFO liquidation gains” — if sizable in amount compared with the normal gross profit margin that would have been recorded using current costs — have to be disclosed in the footnotes to the company’s financial statements. (Dipping into old layers of LIFO-based inventory cost is necessary when a business phases out obsolete products; the business has no choice but to reach back into the earliest cost layers for these products. The sales prices of products being phased out usually are set low, to move the products out of inventory, so gross margin is not abnormally high for these products.)

If you sell products that have long lives and for which your product costs rise steadily over the years, using the LIFO method has a serious impact on the ending inventory cost value reported on the balance sheet and can cause the balance sheet to look misleading. Over time, the current cost of replacing products becomes further and further removed from the LIFO-based inventory costs. In our business example (Figure 7-1) the 2013 balance sheet may very well include products with 2003, 1997, or 1980 costs. As a matter of fact, the product costs reported for inventory could go back even further.

Note: A business must disclose in a footnote with its financial statements the difference between its LIFO-based inventory cost value and its inventory cost value according to FIFO. However, not many people outside of stock analysts and professional investment managers read footnotes very closely. Business managers get involved in reviewing footnotes in the final steps of getting annual financial reports ready for release (see Chapter 12). If your business uses FIFO, ending inventory is stated at recent acquisition costs, and you do not have to determine what the LIFO value would have been.

Many products and raw materials have very short lives; they’re regularly replaced by new models (you know, with those “New and Improved!” labels) because of the latest technology or marketing wisdom. These products aren’t around long enough to develop a wide gap between LIFO and FIFO, so the accounting choice between the two methods doesn’t make as much difference as with long-lived products.

Another serious problem with LIFO has emerged recently. I discuss in Chapter 2 that for several years there have been continuing and serious efforts towards developing one unified set of global accounting and financial reporting standards. How this will all turn out is anyone’s guess. More problems have arisen that anyone would have predicted. In any case, the international standards group does not approve LIFO. This position does not seem, at this time, open to negotiation. So, LIFO may become obsolete if international accounting standards are adopted.

One last note: FIFO and LIFO are not the only games in town. Businesses use other methods for cost of goods sold and inventory, including average cost methods, retail-price based methods, and so on. We don’t have the time here to go into these other methods. FIFO and LIFO dominate.

Recording Depreciation Expense

In theory, depreciation expense accounting is straightforward enough: You divide the cost of a fixed asset (except land) among the number of years that the business expects to use the asset. In other words, instead of having a huge lump-sum expense in the year that you make the purchase, you charge a fraction of the cost to expense for each year of the asset’s lifetime. Using this method is much easier on your bottom line in the year of purchase, of course.

Theories are rarely as simple in real life as they are on paper, and this one is no exception. Do you divide the cost evenly across the asset’s lifetime, or do you charge more to certain years than others? Furthermore, when it eventually comes time to dispose of fixed assets, the assets may have some disposable, or salvage, value. In theory, only cost minus the salvage value should be depreciated. But in actual practice most companies ignore salvage value and the total cost of a fixed asset is depreciated. Moreover, how do you estimate how long an asset will last in the first place? Do you consult an accountant psychic hot line?

As it turns out, the IRS runs its own little psychic business on the side, with a crystal ball known as the Internal Revenue Code. Okay, so the IRS can’t tell you that your truck is going to conk out in five years, seven months, and two days. The Internal Revenue Code doesn’t give you predictions of how long your fixed assets will last; it only tells you what kind of time line to use for income tax purposes, as well as how to divide the cost along that time line.

Hundreds of books have been written on depreciation, but the book that really counts is the Internal Revenue Code. Most businesses adopt the useful lives allowed by the income tax law for their financial statement accounting; they don’t go to the trouble of keeping a second depreciation schedule for financial reporting. Why complicate things if you don’t have to? Why keep one depreciation schedule for income tax and a second for preparing your financial statements?

The IRS rules offer two depreciation methods that can be used for particular classes of assets. Buildings must be depreciated just one way, but for other fixed assets you can take your pick:

Straight-line depreciation: With this method, you divide the cost evenly among the years of the asset’s estimated lifetime. Buildings have to be depreciated this way. Assume that a building purchased by a business costs $390,000, and its useful life — according to the tax law — is 39 years. The depreciation expense is $10,000 (1/39 of the cost) for each of the 39 years. You may choose to use the straight-line method for other types of assets. After you start using this method for a particular asset, you can’t change your mind and switch to another depreciation method later.

Accelerated depreciation: Actually, this term is a generic catchall for several different kinds of methods. What they all have in common is that they’re front-loading methods, meaning that you charge a larger amount of depreciation expense in the early years and a smaller amount in the later years. The term accelerated also refers to adopting useful lives that are shorter than realistic estimates. (Very few automobiles are useless after five years, for example, but they can be fully depreciated over five years for income tax purposes.)

The salvage value of fixed assets (the estimated disposal values when the assets are taken to the junkyard or sold off at the end of their useful lives) is ignored in the calculation of depreciation for income tax. Put another way, if a fixed asset is held to the end of its entire depreciation life, then its original cost will be fully depreciated, and the fixed asset from that time forward will have a zero book value. (Recall that book value is equal to original cost minus the balance in the accumulated depreciation account.)

Fully depreciated fixed assets are grouped with all other fixed assets in external balance sheets. All these long-term resources of a business are reported in one asset account called property, plant and equipment (instead of the term fixed assets). If all its fixed assets were fully depreciated, the balance sheet of a company would look rather peculiar — the cost of its fixed assets would be offset by its accumulated depreciation. Keep in mind that the cost of land (as opposed to the structures on the land) is not depreciated. The original cost of land stays on the books as long as the business owns the property.

The straight-line depreciation method has strong advantages: It’s easy to understand, and it stabilizes the depreciation expense from year to year. Nevertheless, many business managers and accountants favor an accelerated depreciation method in order to minimize the size of the checks they have to write to the IRS in the early years of using fixed assets. This lets the business keep the cash, for the time being, instead of paying more income tax. Keep in mind, however, that the depreciation expense in the annual income statement is higher in the early years when you use an accelerated depreciation method, and so bottom-line profit is lower. Many accountants and businesses like accelerated depreciation because it paints a more conservative picture of profit performance in the early years. Fixed assets may lose their economic usefulness to a business sooner than expected. If this happens, using the accelerated depreciation method would look very wise in hindsight.

Except for brand-new enterprises, a business typically has a mix of fixed assets — some in their early years of depreciation, some in their middle years, and some in their later years. There is a balancing-out effect among the different vintages of fixed assets being depreciated. Therefore, the overall depreciation expense for the year using accelerated depreciation may not be too different than what the straight-line depreciation amount would be. A business does not have to disclose in its external financial report what its depreciation expense would have been if it had been using an alternative method. Readers of the financial statements cannot tell how much difference the choice of accounting methods would have caused in depreciation expense that year.

Scanning Revenue and Expense Horizons

Recording sales revenue and other income can present some hairy accounting problems. As a matter of fact, the — accounting rule-making authorities — rank revenue recognition as a major problem area. A good part of the reason for putting revenue recognition high on the list of accounting problems is that many high profile financial accounting frauds have involved recording bogus sales revenue that had no economic reality. Sales revenue accounting presents challenging problems in some situations. But in my view, the accounting for many key expenses is equally important. Frankly, it’s damn difficult to measure expenses on a year-by-year basis.

I could write a book on expense accounting, which would have at least 20 or 30 major chapters. All I can do here is to call your attention to a few major expense accounting issues.

Asset impairment write-downs: Inventory shrinkage, bad debts, and depreciation by their very nature are asset write-downs. Other asset write-downs are required when an asset becomes impaired, which means that it has lost some or all of its economic utility to the business and has little or no disposable value. An asset write-down reduces the book (recorded) value of an asset (and at the same time records an expense or loss of the same amount).

Employee-defined benefits pension plans and other post-retirement benefits: The U.S. accounting rule on this expense is extremely complex. Several key estimates must be made by the business, including, for example, the expected rate of return on the investment portfolio set aside for these future obligations. This and other estimates affect the amount of expense recorded. In some cases, a business uses an unrealistically high rate of return in order to minimize the amount of this expense. Using unrealistically optimistic rates of investment return is a pernicious problem at the present time.

Certain discretionary operating expenses: Many operating expenses involve timing problems and/or serious estimation problems. Furthermore, some expenses are discretionary in nature, which means how much to spend during the year depends almost entirely on the discretion of managers. Managers can defer or accelerate these expenses in order to manipulate the amount of expense recorded in the period. For this reason, businesses filing financial reports with the SEC are required to disclose certain of these expenses, such as repairs and maintenance expense, and advertising expense. (To find examples, go to the Securities and Exchange Commission website at www.sec.gov.)

Income tax expense: A business can use different accounting methods for some of the expenses reported in its income statement than it uses for calculating its taxable income. Oh, boy! The hypothetical amount of taxable income, as if the accounting methods used in the income statement were used in the tax return, is calculated; then the income tax based on this hypothetical taxable income is figured. This is the income tax expense reported in the income statement. This amount is reconciled with the actual amount of income tax owed based on the accounting methods used for income tax purposes. A reconciliation of the two different income tax amounts is provided in a technical footnote schedule to the financial statements.

Management stock options: A stock option is a contract between an executive and the business that gives the executive the option to purchase a certain number of the corporation’s capital stock shares at a fixed price (called the exercise or strike price) after certain conditions are satisfied. Usually a stock option does not vest until the executive has been with the business for a certain number of years. The question is whether the granting of stock options should be recorded as an expense. This issue had been simmering for some time. The U.S. rule-making body finally issued a pronouncement that requires a value measure be put on stock options when they are issued and that this amount be recorded as an expense.

You could argue that management stock options are simply an arrangement between the stockholders and the privileged few executives of the business, by which the stockholders allow the executives to buy shares at bargain prices. The granting of stock options does not reduce the assets or increase the liabilities of the business, so you could argue that stock options are not a direct expense of the business; instead, the cost falls on the stockholders. Allowing executives to buy stock shares at below-market prices increases the number of shares over which profit has to be spread, thus decreasing earnings per share. Stockholders have to decide whether they are willing to do this; the granting of management stock options must be put to a vote by the stockholders.

Please don’t think that the short list above does justice to all the expense accounting problems of businesses. U.S. businesses — large and small, public and private — operate in a highly developed and very sophisticated economy. One result is that expense accounting has become very complicated and confusing.