Understanding Business Accounting For Dummies, 2nd Edition (95 page)

A View from the Top Regarding Costs

The CEO of a business gets paid to take the big picture point of view. Using the business example in the chapter (refer to Figure 12-2 again), a typical CEO would study the management profit and loss account and say something like the following:

Not a bad year. Total costs were just about 90 per cent of sales revenue. EBIT per unit was a little more than 10 per cent of sales price (£145 per unit ÷ £1,400 sales price). I was able to spread my fixed operating expenses over 110,000 units of sales, for an average of £195 per unit. Compared with the £340 contribution margin per unit, this yielded £145 EBIT per unit. I can live with this.

I'd like to improve our margins, of course, but even if we don't, we should be able to increase sales volume next year. In fact, I notice that we produced 10,000 units more than we sold this year. So, I'll put pressure on the sales manager to give me her plan for increasing sales volume next year.

I realise that cost numbers can be pushed around by my sharp-pencil accountants. They keep reminding me about cost classification problems between manufacturing and non-manufacturing costs - but, what the heck, it all comes out in the wash sooner or later. I watch the three major cost lines in my profit and loss account - cost of goods sold, variable operating expenses, and fixed operating expenses.

I realise that some costs can be classified in one or another of these groupings. So, I expect my accountants to be consistent period to period, and I have instructed them not to make any changes without my approval. Without consistency of accounting methods, I can't reliably compare my expense numbers from period to period. In my view, it's better to be arbitrary in the same way, period after period, rather than changing cost methods to keep up with the latest cost allocation fads.

Chapter 13
:
Choosing Accounting Methods

In This Chapter

Having a choice of accounting methods

Understanding the alternatives for calculating cost of goods sold expense and stock cost

Dealing with depreciation

Writing down stock and debtors

Keeping two sets of books

S
ome people put a great deal of faith in numbers: 2 + 2 = 4, and that's the end of the story. They see a number reported to the last digit on an accounting report, and they get the impression of exactitude. But accounting isn't just a matter of adding up numbers. It's not an exact science.

Accountants
do
have plenty of rules that they must follow. The official rule book of generally accepted accounting principles (GAAP) laid down by the Accounting Standards Board (and its predecessors) is more than 1,200 pages long and growing fast. In addition there are the rules and regulations issued by the various government regulatory agencies that govern financial reporting and accounting methods and those issued by publicly-owned companies such as the London Stock Exchange. Also, the Institute of Chartered Accountants and the other professional accountancy institutes also play a role in setting accounting standards.

Although we're still in the early stages, standards are going
international
- the goal being to establish worldwide accounting standards. With the advent of the European Union and the ever-increasing amount of international trade and investing, business and political leaders in many nations recognise the need to iron out differences in accounting methods and disclosure standards from country to country. You can keep alert about what's going on at the International Accounting Standards Committee Web site,
www.iasc.org.uk
.

Perhaps the most surprising thing - considering that formal rule-making activity has been going on since the 1930s - is that a business still has options for choosing among alternative accounting methods. Different methods lead to inconsistent profit measures from company to company. The often-repeated goal for standardising accounting methods is to make like things look alike and different things look different - but the accounting profession hasn't reached this stage of nirvana yet. In addition, accounting methods change over the years, as the business world changes. GAAP are, to one degree or another, in a state of flux.

Because the choice of accounting methods directly affects the profit figure for the year and the values reported in the ending balance sheet, business managers (and investors) need to know the difference between accounting methods. You don't need to probe into these accounting methods in excruciating, technical detail, but you should at least know whether one method versus another yields higher or lower profit measures and higher or lower asset values in financial statements. This chapter explains accounting choices for measuring cost of goods sold, depreciation, and other expenses. Get involved in making these important accounting decisions - it's your business, after all.

Decision-Making Behind the Scenes in Profit and Loss Accounts

Chapter 5 introduces the conventional format for presenting profit and loss accounts in
external
financial reports. (Also see Figure 9-1 for another example.) Figure 13-1 presents another profit and loss account for a business - with certain modifications that you won't see in actual external profit and loss accounts. For explaining the choices between alternative accounting methods, certain specific expenses are broken down under the company's sales, administrative, and general expenses (SA&G) category in Figure 13-1. Of these particular expenses, only depreciation is disclosed in external profit and loss accounts. Don't expect to find in external profit and loss accounts the other expenses shown under the SA&G category in Figure 13-1. Businesses are very reluctant to divulge such information to the outside world.

Here's a quick overview of the accounting matters and choices relating to each line in the profit and loss account shown in Figure 13-1, from the top line to the bottom line.

Sales revenue:
Timing the recording of sales is something to be aware of. Generally speaking, sales revenue timing is not a serious accounting problem, but businesses should be consistent from one year to the next. For some businesses, however, the timing of recording sales revenue is a major problem - such as software and other high-tech companies, and companies in their early start-up phases. A footnote to the company's financial statements should explain its revenue recognition method if there is anything unusual about it.

Note:
If products are returnable and the deal between the seller and buyer does not satisfy normal conditions for a completed sale, then recognition 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. This area is increasingly significant with the continuing rapid growth of the Internet as a medium for selling. In response, the UK introduced the Distance Selling Regulations in October 2001. These regulations give consumers additional rights to obtain full refunds on goods bought over the Internet and through mail order without having to give a reason for doing so.