Accounting For Dummies, 4th edition

Chapter 7: Choosing Accounting Methods: Different Strokes for Different Folks 143

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).

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.

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.

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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.

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 clean-up costs and the safety inspection cost. But, as I say, in practice a business may not include such additional costs in the original costs of its fixed assets.

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

146 Part II: Figuring Out Financial Statements

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.

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.

A typical business at the end of the year has certain costs that will not be paid until sometime in the future — costs that are an outgrowth of the current year’s operating activities. For example, a business should accrue (calculate and record) the amount it owes to its employees for 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. One expense accrual is easy to calculate: the accumulated interest on notes payable that hasn’t been paid yet at the end of the year. Calculating this amount is straightforward because the amount borrowed and the interest rate are definite.

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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.

Figure 7-1 presents just one alternative scenario regarding how different accounting methods cause differences in the financial statements of a company. The differences in Figure 7-1 are not unrealistic in my opinion. But to be frank, my alternative numbers 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, but footnotes are not easy to read. Plus, they don’t allow you to determine what profit would have been and how the balance sheet amounts would be different if alternative accounting methods had been used.

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 accrualbased 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.)

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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 in and move out of inventory in a first-in, first-out sequence. Nevertheless, a business may choose the last-in, first-out accounting method.

The FIFO (first-in, first-out) method

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. 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 works well for two reasons:

Products generally move into and out of inventory in a first-in, first-out sequence: The earlier acquired products are delivered to customers before the 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.