Accounting For Dummies, 4th edition

150 Part II: Figuring Out Financial Statements

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 using 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 FIFObased 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.

The LIFO (last-in, first-out) method

Remember the movie ticket-taker I mentioned earlier? Think about that tickettaker 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 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 first, 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 instead of FIFO. 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 last unit you acquired.

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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 too 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 (refer to 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.

The average cost method

If you were to make an exhaustive survey of businesses, you would find out that some businesses use methods other than FIFO and LIFO to measure cost of goods sold expense and inventory cost. Furthermore, you would discover variations on how LIFO is implemented. I don’t have the space in this book to explain all the methods. Instead, I’ll quickly mention a third basic method: the average cost method.

Compared with the FIFO and LIFO methods, the average cost method seems to offer the best of both worlds. The costs of many things in the business world fluctuate, and business managers tend to focus on the average product cost over a time period. Also, the averaging of product costs over a period of time has a desirable smoothing effect that prevents cost of goods sold from being overly dependent on wild swings of one or two acquisitions.

However, to many businesses, the compromise aspect of the average cost accounting method is its worst feature. Businesses often want to go one way or the other and avoid the middle ground. If they want to minimize taxable income, LIFO gives the best effect during times of rising prices. Why go only halfway with the average cost method? If the business wants its ending inventory to be as near to current replacement costs as possible, FIFO is better than the average cost method. Plus, recalculating averages every time product costs change, even with computers, is a real pain in the posterior. But the average cost method is an acceptable method under GAAP and for income tax purposes.

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Determining current replacement cost values for every product in your inventory isn’t easy! When I worked for a CPA firm many years ago, we tested the ways clients applied the LCM method to their ending inventories. I was surprised by how hard it was to pin down current market values — vendors wouldn’t quote current prices or had gone out of business, prices bounced around from day to day, suppliers offered special promotions that confused matters, and on and on. Applying the LCM test leaves much room for interpretation.

Some shady characters abuse LCM to cheat on their income tax returns. They knock down their ending inventory cost value — decrease ending inventory cost more than can be justified by the LCM test — to increase the deductible expenses on their income tax returns and thus decrease taxable income. A product may have proper cost value of $100, for example, but a shady character may invent some reason to lower it to $75 and thus record a $25 inventory write-down expense in this period for each unit — which is not justified. But, even though the person can deduct more this year, he or she will have a lower inventory cost to deduct in the future. Also, if the person is selected for an IRS audit and the Feds discover an unjustified inventory knockdown, the person may end up with a felony conviction for income tax evasion.

Appreciating Depreciation Methods

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.

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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 (usually not “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 (a lower or more moderate) picture of profit performance in the early years. Who knows? 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. So, the overall depreciation expense for the year may not be that different than if the business had been using straight-line depreciation for all its depreciable fixed assets. 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 the Expense Horizon

Recording sales revenue and other income can present some hairy accounting problems. As a matter of fact, the Financial Accounting Standards Board (FASB) — the private sector authority that sets accounting and financial reporting standards in the United States — ranks 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

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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). A write-off reduces the asset’s book value to zero and removes it from the accounts, and the entire amount becomes an expense.

Employee-defined benefits pension plans and other post-retirement benefits: The GAAP 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.

Certain discretionary operating expenses: Many operating expenses involve timing problems and/or serious estimation problems. Furthermore, some expenses are very 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 EDGAR database of the Securities and Exchange Commission 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.

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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 Financial Accounting Standards Board (FASB) 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.

In any case, the main problem today concerns how to put a value on stock options at the time they are issued to executives. The FASB pronouncement opened the door to alternative methods for calculating the value of stock options. Guess what? More than one method is being used by public businesses to measure the expense of management stock options. This should not be a surprise to anyone. It will take some time for things to settle down on the preferred way to measure the cost of management stock options.

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.