Presenting an alternative income statement

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 (and one statement of changes in owners’ equity). A business doesn’t 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 hadn’t 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 hadn’t 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.”)

Figure 8-2 presents a comparison that you never see in real-life financial reporting. The Actual column presents the income statement reported by the business. The Alternative column reveals an income statement for the year that the business could have reported (but didn’t) if it had used alternative but acceptable accounting methods. The Difference column shows the impact on profit between the two methods. For example, sales revenue is less in the Alternative scenario, and thus profit is less, so you see a negative $225,000 difference. In the Alternative scenario, income tax expense is lower and thus profit is more, so you see a positive $295,000 difference in profit.

If you’ve read Chapter 5, the Actual account balances in the income statement should be familiar — these are the same numbers from the financial statements I use in that chapter. The dollar amounts in the Alternative column are the amounts that would have been recorded using different accounting methods. You don’t need the statement of cash flows here, because cash flow from profit (operating activities) is the same amount under both accounting scenarios and because the cash flows from investing and financing activities are the same. Keep in mind these important points.

The business in our example adopted accounting methods that maximized its recorded profit by recognizing 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 8-2 reports the results of conservative accounting methods. As you see, using alternative accounting methods results in a lower bottom line. Net income would have been $340,000 smaller, or 20 percent lower!

Now, you may very well ask, “Where in the devil did you get the numbers for the alternative financial statements?” The dollar amounts 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 income statements are hypothetical but realistic and are not dishonest or deceitful.

Spotting significant differences

It’s a little jarring to see a second set of numbers for the income statement. 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 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 information on the valuation of a small business, see Small Business Financial Management Kit For Dummies, which I coauthored with my son, Tage.) Suppose you’re willing to pay six times the most recent annual profit of the business. 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 were used, you’d 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!

I don’t show the balance sheet differences in Figure 8-2, but they’d be sizable in the Alternative scenario. Accounts receivable and inventory would be significantly lower in the Alternative scenario, and the book value of the business’s fixed assets (original cost minus accumulated depreciation) would be 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.

The company’s retained earnings balance would also be much lower in the Alternative scenario. 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 the business’s existence to accumulate the difference. The net income difference for its latest year (2017) is responsible for only $340,000 of the cumulative, total difference in retained earnings.

Accounts receivable and sales revenue

Here are some common reasons sales revenue and accounts receivable are 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 that there’s little chance the customers will return the products. This delay in recording sales causes its accounts receivable balance to be lower, because at December, some credit sales weren’t yet recorded because they were still in the process of final acceptance by the customers. (Of course, the cost of goods sold for these sales wouldn’t have been recorded.)

  If products are returnable and the deal between the seller and buyer doesn’t 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 whether 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’s 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’s 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 it sells or purchases products for resale to customers. (Chapter 13 explains the determination of product costs for manufacturing businesses.) For this discussion, it isn’t 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 to use for recording cost of goods sold expense.

One accounting method takes product costs out of the inventory asset account and records the costs to the 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. A business may instead choose to use the reverse method, in which the latest product costs entered in the inventory asset account are selected for recording the 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 opposing methods in more detail later in “Calculating Cost of Goods Sold Expense and Inventory Cost.” In Figure 8-2, FIFO is being used in the Actual scenario, and LIFO is what you see in the Alternative scenario.

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 8-2, you see that cost of goods sold expense is $280,000 higher. The inventory balance would be lower, which makes total current assets in the balance sheet lower. The lower balance sheet value due to LIFO is the cumulative effect, which includes the carry-forward effects from previous years.

Some of the $280,000 cost of goods expense difference for 2017 is 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’s applied more strictly in the Alternative accounting scenario than in the Actual scenario, resulting 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 and, less formally, are called fixed assets. (The cost of land owned by a business isn’t 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 detail.

The original costs of fixed assets should theoretically include certain costs in addition to their purchase or construction costs. However, in practice, these fringe costs aren’t always included in the original cost of fixed assets. For example, it’s theoretically correct to include the installation and connection costs of the power sources for heavy machinery and equipment. It’s 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. The business should be careful concerning IRS rules in this area of accounting. The IRS recently cracked down on the abusive expensing of such costs (and also asset improvement costs that were being charged to repair and maintenance expense).

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 higher compared with the Alternative, conservative scenario. These additional costs aren’t 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 conservative scenario, the business doesn’t 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 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 won’t be paid until sometime after the end of the year — costs that are an outgrowth of the current year’s operating activities. The amounts of 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 when 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 shouldn’t 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 won’t 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 doesn’t make the effort to estimate future product warranty and guarantee 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 higher.

In the Alternative, conservative scenario (see Figure 8-2), 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, 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

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 aren’t easy to read. It’s very difficult, if not impossible, to determine exactly how much profit would have been and how much different balance sheet amounts would be if a business had used other accounting methods.

If you own or manage a business, get involved in deciding which accounting methods to use for measuring your profit and how these methods are actually implemented. As Chapter 15 explains, a manager has to answer questions about his or her financial reports on many occasions. However, “get involved” shouldn’t 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.)

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 how 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:

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 the $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)

Imagine a movie ticket-taker goes to the back of a line of people waiting to get into the next showing and lets 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 for U.S. businesses, 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:

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’ll 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.

Here are the reasons LIFO is problematic:

• Unless you’re 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 the 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 isn’t 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 8-2), the 2017 balance sheet may very well include products with 2003, 1997, or 1980 costs. 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 9). If your business uses FIFO, ending inventory is stated at recent acquisition costs, and you don’t 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.

LIFO may become obsolete if international accounting standards are adopted in the U.S. As I discuss in Chapter 2, for several years, there have been serious efforts toward developing a unified set of global accounting and financial reporting standards. The international-standards group doesn’t approve LIFO, and this position doesn’t seem open to negotiation.

One last note: FIFO and LIFO aren’t 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. However, FIFO and LIFO dominate.