Tracy John A. Accounting for Dummies
Подождите немного. Документ загружается.
Puffing Profit by Excessive Production
Whenever production output is higher than sales volume, be on guard.
Excessive production can puff up the profit figure. How? Until a product is sold,
the product cost goes in the inventory asset account rather than the cost of
goods sold expense account, meaning that the product cost is counted as a
positive number (an asset) rather than a negative number (an expense). Fixed
manufacturing overhead cost is included in product cost, which means that
this cost component goes into inventory and is held there until the products
are sold later. In short, when you overproduce, more of your total of fixed man-
ufacturing costs for the period is moved to the inventory asset account and
less is moved into cost of goods sold expense for the year.
You need to judge whether an inventory increase is justified. Be aware that
an unjustified increase may be evidence of profit manipulation or just good
old-fashioned management bungling. Either way, the day of reckoning will
come when the products are sold and the cost of inventory becomes cost of
goods sold expense — at which point the cost impacts the bottom line.
Shifting fixed manufacturing
costs to the future
The business represented in Figure 11-1 manufactured 10,000 more units than
it sold during the year. With variable manufacturing costs at $410 per unit,
the business expended $4.1 million more in variable manufacturing costs
than it would have if it had produced only the 110,000 units needed for its
sales volume. In other words, if the business had produced 10,000 fewer
units, its variable manufacturing costs would have been $4.1 million less —
that’s the nature of variable costs. In contrast, if the company had manufac-
tured 10,000 fewer units, its fixed manufacturing costs would not have been
any less — that’s the nature of fixed costs.
Of its $42 million total fixed manufacturing costs for the year, only $38.5 mil-
lion ended up in the cost of goods sold expense for the year ($350 burden
rate × 110,000 units sold). The other $3.5 million ended up in the inventory
asset account ($350 burden rate × 10,000 units inventory increase). The $3.5
million of fixed manufacturing costs that are absorbed by inventory is shifted
to the future. This amount will not be expensed (charged to cost of goods
sold expense) until the products are sold sometime in the future.
Shifting part of the fixed manufacturing cost for the year to the future may
seem to be accounting slight of hand. It has been argued that the entire
amount of fixed manufacturing costs should be expensed in the year that
240
Part III: Accounting in Managing a Business
17_246009 ch11.qxp 4/17/08 12:50 AM Page 240
these costs are recorded. (Only variable manufacturing costs would be
included in product cost for units going into the increase in inventory.)
Generally accepted accounting principles require that full product cost (variable
plus fixed manufacturing costs) be used for recording an increase in inventory.
However, as the example in Figure 11-1 shows, producing more than you sell
does boost profit.
Let me be very clear here: I’m not suggesting any hanky-panky in the example
shown in Figure 11-1. Producing 10,000 more units than sales volume during
the year looks — on the face of it — to be reasonable and not out of the ordi-
nary. Yet at the same time, it is naïve to ignore that the business did help its
pretax profit to the amount of $3.5 million by producing 10,000 more units than
it sold. If the business had produced only 110,000 units, equal to its sales volume
for the year, all its fixed manufacturing costs for the year would have gone into
cost of goods sold expense. The expense would have been $3.5 million higher,
and EBIT would have been that much lower.
Cranking up production output
Now let’s consider a more suspicious example. Suppose that the business
manufactured 150,000 units during the year and increased its inventory by
40,000 units. It may be a legitimate move if the business is anticipating a big
jump in sales next year. On the other hand, an inventory increase of 40,000
units in a year in which only 110,000 units were sold may be the result of a
serious overproduction mistake, and the larger inventory may not be needed
next year. In any case, Figure 11-2 shows what happens to production costs
and — more importantly — what happens to the profit lines at the higher
production output level.
The additional 30,000 units (over and above the 120,000 units manufactured
by the business in the original example) cost $410 per unit. (The precise cost
may be a little higher than $410 per unit because as you start crowding pro-
duction capacity, some variable costs per unit may increase a little.) The
business would need $12.3 million more for the additional 30,000 units of pro-
duction output:
$410 variable manufacturing cost per unit × 30,000
additional units produced = $12,300,000 additional
variable manufacturing costs invested in inventory
Again, its fixed manufacturing costs would not have increased, given the
nature of fixed costs. Fixed costs stay put until capacity is increased. Sales
volume, in this scenario, also remains the same.
241
Chapter 11: Cost Concepts and Conundrums
17_246009 ch11.qxp 4/17/08 12:50 AM Page 241
But check out the business’s EBIT in Figure 11-2: $23.65 million, compared with
$15.95 million in Figure 11-1 — a $7.7 million higher amount, even though sales
volume, sales prices, and operating costs all remain the same. Whoa! What’s
going on here? The simple answer is that the cost of goods sold expense is $7.7
million less than before. But how can cost of goods sold expense be less? The
business sells 110,000 units in both scenarios. And variable manufacturing
costs are $410 per unit in both cases.
Income Statement for Year
Sales volume 110,000 units
Totals
Sales revenue $1,400 $154,000,000
Cost of goods sold expense (690) (75,900,000)
Gross margin $710 $78,100,000
Variable operating expenses (300) (33,000,000)
Margin $410 $45,100,000
Fixed operating expenses (195) (21,450,000)
Earnings before interest and income tax (EBIT) $215 $23,650,000
Interest expense (2,750,000)
Earnings before income tax $20,900,000
Income tax expense (7,106,000)
Net income $13,794,000
Manufacturing Costs for Year
Production capacity 150,000 units
Actual output 150,000 units
Production Cost Components Per Unit
Per Unit
Totals
Raw materials $215 $32,250,000
Direct labor 125 18,750,000
Variable manufacturing overhead costs 70 10,500,000
Total variable manufacturing costs $410 $61,500,000
Fixed manufacturing overhead costs 280 42,000,000
Total manufacturing costs $690 $103,500,000
To 40,000 units inventory increase (27,600,000)
To 110,000 units sold $75,900,000
Figure 11-2:
Example in
which
production
output
greatly
exceeds
sales
volume for
the year,
thereby
boosting
profit for the
period.
242
Part III: Accounting in Managing a Business
17_246009 ch11.qxp 4/17/08 12:50 AM Page 242
The culprit is the burden rate component of product cost. In the Figure 11-1
example, total fixed manufacturing costs are spread over 120,000 units of
output, giving a $350 burden rate per unit. In the Figure 11-2 example, total
fixed manufacturing costs are spread over 150,000 units of output, giving a
much lower $280 burden rate, or $70 per unit less. The $70 lower burden rate
multiplied by the 110,000 units sold results in a $7.7 million lower cost of
goods sold expense for the period, a higher pretax profit of the same amount,
and a much improved bottom-line net income.
Being careful when production output
is out of kilter with sales volume
In the example shown in Figure 11-2, the business produced 150,000 units (full
capacity); therefore, its inventory asset absorbed $7.7 million of the company’s
fixed manufacturing costs for the year, and its cost of goods sold expense for
the year escaped this cost. But get this: Its inventory increased 40,000 units,
which is quite a large increase compared with the annual sales of 110,000 during
the year just ended. Who was responsible for the decision to go full blast and
produce up to production capacity? Do the managers really expect sales to jump
up enough next year to justify the much larger inventory level? If they prove to
be right, they’ll look brilliant. But if the output level was a mistake and sales do
not go up next year . . . they’ll have you-know-what to pay next year, even though
profit looks good this year. An experienced business manager knows to be on
guard when inventory takes such a big jump.
Summing up, the cost of goods sold expense of a manufacturer, and thus its
operating profit, is sensitive to a difference between its sales volume and pro-
duction output during the year. Manufacturing businesses do not generally
discuss or explain in their external financial reports to creditors and owners
why production output is different than sales volume for the year. Financial
report readers are pretty much on their own in interpreting the reasons for
and the effects of under- or over-producing products relative to actual sales
volume for the year. All I can tell you is to keep alert and keep in mind the
profit impact caused by a major disparity between a manufacturer’s produc-
tion output and sale levels for the year.
243
Chapter 11: Cost Concepts and Conundrums
17_246009 ch11.qxp 4/17/08 12:50 AM Page 243
244
Part III: Accounting in Managing a Business
17_246009 ch11.qxp 4/17/08 12:50 AM Page 244
Part IV
Preparing and
Using Financial
Reports
18_246009 pp04.qxp 4/17/08 12:03 AM Page 245
In this part . . .
F
inancial reports are like newspaper articles. A lot of
activity goes on behind the scenes that you may not
be aware of. In reading a financial report, you see only the
finished product. Chapter 12 gives the inside story of how
financial reports are put together.
Outside investors in a business — the owners who are not
on the inside managing the business — depend on its finan-
cial reports as their main source of information. Chapter 13
explains financial statement ratios that investors use for
interpreting profit performance and financial condition.
Serious investors must know these ratios.
The financial report is the end of the line for the outside
investors and lenders of a business. They can’t call the
business and ask for more information. But the financial
statements are just the starting point for the managers of
the business. Chapter 14 explains the more detailed and
highly confidential accounting information they need for
identifying problems and opportunities.
Chapter 15 explains the reasons for audits of financial
reports by independent CPAs. Investors and lenders defi-
nitely should read the auditor’s report, which is explained
in this chapter. The chapter also discusses the ugly topic
of accounting fraud. Unfortunately, some businesses resort
to accounting fraud, which is not only unethical but illegal.
18_246009 pp04.qxp 4/17/08 12:03 AM Page 246
Chapter 12
Getting a Financial Report
Ready for Release
In This Chapter
Keeping up-to-date on accounting and financial reporting standards
Assuring that disclosure is adequate
Nudging the numbers to make things look better
Comparing private and public businesses
Dealing with financial reports’ information overload
Looking at changes in owners’ equity
I
n Chapters 4, 5, and 6, I explain the three primary financial statements of a
business:
Income statement: Summarizes sales revenue and other income (if any)
and expenses and losses (if any) for the period. It ends with the bottom-
line profit for the period, which most commonly is called net income or
net earnings. (Inside a business this profit performance statement is
commonly called the Profit & Loss, or P&L, report.)
Balance sheet: Summarizes financial condition at the end of the period, con-
sisting of amounts for assets, liabilities, and owners’ equity at that instant in
time. (Its more formal name is the statement of financial condition.)
Statement of cash flows: Reports the cash increase or decrease during
the period from profit-making activities (revenue and expenses) and the
reasons this key figure is different than bottom-line net income. It also
summarizes other cash flows during the period from investing and
financing activities.
These three statements, plus the footnotes to the financials and other content,
are packaged into annual financial reports so a business’s investors, lenders,
and other interested parties can keep tabs on the business’s financial health. In
this chapter, I shine a light on the preparation process so you can recognize the
types of decisions that must be made before a financial report hits the streets.
19_246009 ch12.qxp 4/17/08 12:04 AM Page 247
Recognizing Management’s Role
Whether a business is a small private company or a large public corporation,
its annual financial report consists of
The three basic financial statements: income statement, balance sheet,
and statement of cash flows.
A statement of changes in owners’ equity (if needed). Although it’s
called a “statement,” this item is more properly described as a supple-
mentary schedule. It reports certain information regarding changes in
owners’ equity accounts during the year that is not included in its three
primary financial statements. (See “Statement of Changes in Owners’
Equity” later in the chapter.)
And more.
In deciding what “more” means, the business’s CEO and top lieutenants play
an essential role — which they (and outside investors and lenders) should
understand. The CEO does certain critical things before a financial report is
released to the outside world:
1. Confers with the company’s chief financial officer and controller
(chief accountant) to make sure that the latest accounting and finan-
cial reporting standards and requirements have been applied in its
financial report. (The president of a smaller private company may have
to consult with a CPA on these matters.) In recent years, we’ve seen a
high degree of flux in accounting and financial reporting standards and
requirements. The private sector Financial Accounting Standards Board
(FASB) and the governmental regulatory agency, the Securities and
Exchange Commission (SEC), have been very busy in recent years — to
say nothing of the federal Sarbanes-Oxley Act of 2002 and the creation of
the Public Company Accounting Oversight Board.
A business and its auditors cannot simply assume that the accounting
methods and financial reporting practices that have been used for many
years are still correct and adequate. A business must check carefully
whether it is in full compliance with current accounting standards and
financial reporting requirements.
2. Carefully reviews the disclosures in the financial report. The CEO and
financial officers of the business must make sure that the disclosures — all
information other than the financial statements — are adequate according
to financial reporting standards, and that all the disclosure elements are
truthful but, at the same time, not damaging to the business.
248
Part IV: Preparing and Using Financial Reports
19_246009 ch12.qxp 4/17/08 12:04 AM Page 248
This disclosure review can be compared with the notion of due diligence,
which is done to make certain that all relevant information is collected,
that the information is accurate and reliable, and that all relevant require-
ments and regulations are being complied with. This step is especially
important for public corporations whose securities (stock shares and
debt instruments) are traded on securities exchanges. Public businesses
fall under the jurisdiction of federal securities laws, which require very
technical and detailed filings with the SEC.
3. Considers whether the financial statement numbers need touching
up. The idea here is to smooth the jagged edges off the company’s year-
to-year profit gyrations or to improve the business’s short-term solvency
picture. Although this can be described as putting your thumb on the
scale, you can also argue that sometimes the scale is a little out of bal-
ance to begin with and the CEO should approve adjusting the financial
statements in order to make them jibe better with the normal circum-
stances of the business.
When I discuss the third step later in this chapter, I’m venturing into a gray area
that accountants don’t much like to talk about. Some topics are, shall I say,
rather delicate. The manager has to strike a balance between the interests of
the business on the one hand and the interests of the owners (investors) and
creditors of the business on the other. The best analogy I can think of is the
advertising done by a business. Advertising should be truthful, but, as I’m sure
you know, businesses have a lot of leeway regarding how to advertise their
products and have been known to engage in hyperbole. Managers exercise the
same freedoms in putting together their financial reports. Financial reports may
have some hype, and managers may put as much positive spin on bad news as
possible without making deceitful and deliberately misleading comments.
Keeping in Mind the Purpose
of Financial Reporting
Business managers, creditors, and investors read financial reports because these
reports provide information regarding how the business is doing and where it
stands financially. Indeed, these accounting reports are the only source of this
information! The top-level managers of a business, in reviewing the annual financial
report before releasing it outside the business, should keep in mind that a finan-
cial report is designed to answer certain basic financial questions:
Is the business making a profit or suffering a loss, and how much?
How do assets stack up against liabilities?
Where did the business get its capital, and is it making good use of the
money?
249
Chapter 12: Getting a Financial Report Ready for Release
19_246009 ch12.qxp 4/17/08 12:04 AM Page 249