I/EC
Costs
A Grain of Truth With a Grain of Salt
Handle
with care.
Comparison of
financial statements may ignore serious differences in accounting practice by James B. Weaver, Atlas Chemical Industries, Inc.
I HE SOUNDNESS of most engineering jobs can be tested by soundness of the resulting structure. Likewise, a doctor's skill is attested by the survival a n d healthy condition of his patients. Such j u d g m e n t s as to a d e q u a c y are not as easily reached when dealing with abstractions such as costs, profits, a n d return on investment. T h e r e is no real standard for comparison. T h e accountant is responsible for reporting " a c c u r a t e l y " the history of a firm, in dollar terms, to represent the financial operations of a company over each period a n d its financial status at any instant. A series of compromises has necessarily resulted a n d , before any standardization was attempted, m a n y different compromises were m a d e by different companies. Because accountants deal with figures with great precision, a considerable degree of accuracy m a y be erroneously inferred. T h e intent of this column is not to disparage the accounting profession; most accountants recognize a n d m a n y are trying to improve the situation to be described. It is rather to a c q u a i n t engineers with some of the deficiencies in the usual financial statements, so t h a t they will understand t h a t such statements cannot be accurate in the absolute sense of the word. T h e financial statement m a y still have certain useful purposes, but only for those familiar with the possible compromises which have been made. T h e relevant financial statements are the balance sheet a n d the profit
a n d loss statement. Most texts on engineering economics contain adeq u a t e discussions of all the elements of these statements. Certain parts of these two interrelated statements are discussed here, to point out some of the wide variations which different firms use u n d e r " a c c e p t a b l e accounting principles." These ambiguities are particularly misleading to novices in accounting because it is difficult to believe they could exist in official, approved, precise financial statements, in a standard format, a n d with a standard certification by an independent auditor. Inflation I n general, accounting practice has not been extended to reflect inflation, and therefore the basic dollar units of the usual financial statements are not truly c o m p a r a b l e from year to year. This distorts any historical comparisons a n d may actually result in indicated progress a n d growth where none would be indicated if constant dollars could be utilized. Inventories If materials are charged to current operations on a first-in, first-out basis, inventories showing on the balance sheet are usually fairly representative of current values. However, m a t e rials charged to current expense m a y often be at a lower value, because of price increases since their purchase, which distorts the current earnings statement.
It is equally acceptable, with certain restrictions, for a c o m p a n y to choose the last-in, first-out basis ( L I F O ) which keeps the earnings statement on a relatively current basis but understates asset value, as long as inflation continues.
Land, Buildings, and Equipment Cost at acquisition is the accepted basis of valuation for these items on the balance sheet and no recognition is given to any change in value due to inflation or to increase in real estate values. This means that the balance sheet can seldom be used as any approximation of the real value of such assets. Acceptable accounting practice does also permit revaluation of assets transferred from one corporate entity to another. If a management wishes, it m a y reflect some of such changes in asset value by transfer of assets a m o n g subsidiaries. T h e r e is n o requirement that this be done a n d the usual reason for such transactions is the convenience or advantage of the c o m p a n y m a n a g e m e n t , rather t h a n the better information available to those studying financial statements. Reserves for depreciation are usually deducted from the cost value shown on the left side of the balance sheet, to give a net book value of buildings and equipment. However, it is also acceptable to add this reserve to the right side of the balance sheet ! VOL. 53, NO. 11
·
NOVEMBER 1961
111
A
COSTS Depreciation 1*11.1*1 |»| \ \ 1 ΓΚ'ί
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Depreciation is a noncash expense reflecting capital expenditures by the corporation in previous years which are gradually being charged to cur rent expenses. Because depreciation expense does not reduce available funds, but does reduce taxes by in creasing reported expenses, it is al most universal practice to maximize the account for tax purposes. The amount of the reserves for deprecia tion on the balance sheet and the deduction for depreciation which de termines current earnings may there fore be distorted. Although this does reduce taxes, the variety of practices reduces comparability among financial statements. Many companies still use the famil iar straight-line depreciation both for tax purposes and for reporting to stockholders. Others continue to use straight-line depreciation in reporting to stockholders, although they have taken the additional tax deductions permitted by acceler ated depreciation. The use of accel erated depreciation also distorts his torical comparisons within a single company. Goodwill
is the only w a y There is no other way in which you can learn so much, so quickly about so many new developments than by visit ing the fact-filled Exposition of Chemical Industries. To actually SEE and compare the new cost-saving products of over 500 manufacturers in one location will pay big dividends in new ideas that can be applied in your plant. SEE what's new in process equipment, materials han dling, chemicals and raw materials, laboratory equipment and supplies, control instruments and automation. Keep informed—plan your visit now, and bring your associates with you. It will more than pay you for the modest investment in time. Write for free advance registration. @3oo,
28
th E X P O S I T I O N CHEMICAL
OF INDUSTRIES
Ν. Υ. Coliseum, Nov. 27—Dec. 1 , 1 9 6 1 MANAGEMENT; International Exposition Company, 480 Lexington Ave., Ν. Υ. 17, Ν. Y. Circle No. 6 on Readers' Service Card 112 A
INDUSTRIAL AND ENGINEERING CHEMISTRY
Goodwill is an appealing name for a simple adjustment factor which allows accountants to come out with the right answer in balancing assets and liabilities, according to the prac tice of double-entry bookkeeping, at the time of acquisition of certain types of assets. It usually repre sents the price paid for assets in ex cess of their previous balance sheet value (on someone else's books), which excess value is not recognized by the federal government as within a tax base. Such an "asset" may be amortized without recognition as an expense for tax purposes or held on the balance sheet indefinitely, largely at the company's discretion. Since such amortization reduces earnings reported to stockholders, comparisons among companies and among various years for the same company become more treacherous. The item of goodwill was intro duced on the balance sheet to try to approximate in dollar terms the know-how and other intangible values of the company not truly reflected in any other part of the balance sheet. (Continued
on page
114
A)
Circle No. 77 on Readers' Service Card
>
COSTS
PENNSALT ALKYL ALKANOL AMINES Semi-Commercial (Pilot Plant Quantities) N-ISOPROPYLETHANOLAMINE 2523 (CH 3 )2CHNHC 2 H 4 OH.Mol. W t . 103.2 Sp. Gr. @ 20°C
0.89-0.90
IBP 168°C
FBP 178°C.
N-ISOPROPYLDIETHANOLAMINE1338 (CH 3 )2CHN(C 2 H40H)2.Mol. W t . 147.2 Sp. Gr. © 20°C
0.98-0.99
IBP 255°C
FBP 270°C.
N-BUTYLETHANOLAMINE1097 C4H9NHC2H4OH
M o l . W t . 117.2
Sp. Gr. @ 20°C
0.88-0.90
IBP 192°C
FBP 210°C.
N-BUTYLDIETHANOLAMINE 1029 C 4 H 9 N(C2H40H)2
M o l . W t . 161.2
Sp. Gr. @ 20°C
ment in the corporation. However, stock is generally shown at a par or some stated value which, except by coincidence, has no relationship to current stock values and may actually have had little or no relationship to the actual market price of the stock (one instance of a stockholder's valuation) at any previous time.
Reserves
The Independent Auditor
A reserve is an account set up against some known or potential future company obligation for cash outlays. Earnings which have not yet been distributed to stockholders can be considered a basic company reserve—earned surplus. Reserves for pension funds and bad debts are tax deductible and certain types of contingency reserves may also be maintained. While good accounting practice requires some consistency by any one company, requirements are not rigorous and there is little comparability in such practice between companies. Any addition to reserves of this nature decreases directly the earnings shown for the current year, and therefore the earned surplus, whether the reserve is tax deductible or not. When the expected contingency does occur, it is charged to the reserve and does not reduce earnings in the year it occurs. This mechanism can be used to level out earnings, thereby distorting financial comparisons between companies or between years.
Because the auditor's certificates are so comparable from annual report to annual report, one might expect similar comparability in the financial statements which they certify. However, this is not the case, as indicated by examples above, because of the wide variations still encompassed by the phrase "in conformity with generally accepted accounting principles." These principles cover a wide range of accounting techniques, from which one set is chosen by the accountant and his management (not the auditor) to record the incomes and expenses of a business. The one requirement is that techniques be consistently applied from year to year. Furthermore, the auditor has no control over, or responsibility for, any supplemental statements by the management in the annual report.
0.96-0.97
IBP 265°C
FBP 287°C.
DIETHYLAMINOETHOXYETHANOL1480 (C 2 H 5 )2NC2H 4 OC2H40H Mol.Wt.161.2 Sp. Gr. @ 20°C
0.93-0.95
Distillation: 9 5 % between 215-228°C. Technical literature available
This sort of goodwill has generally been ruled out by closer government regulations, because it was misused by company management. However, the total valuation of the company as shown on the balance sheet can never really be meaningful unless some attempt is made to value such assets.
and samples
on request.
Market Development Dept. «Industrial Chemicals Division
PENNSALT CHEMICALS CORPORATION Three Penn Center · Philadelphia 2, Pa.
®
Pennsalt Chemicals ESTABLISHED 1850
Leasing
Loans are shown as a liability. Leases, essentially an alternative means of debt financing, are not generally indicated on the balance sheet although they represent a longterm committment of very similar nature. There has been some pressure within the accounting profession to correct this situation, and lenders commonly require a detailed reporting of such leases when additional debt financing is being arranged. Important leases are sometimes shown in footnotes to financial statements. Stock V a l u a t i o n
The lower right-hand side of the balance sheet is generally considered to represent the stockholders' invest-
Circle No. 64 an Readers' Service Card 114 A
INDUSTRIAL AND ENGINEERING CHEMISTRY
Conclusion
It is universal practice to compare closely the financial statements of companies throughout industry ; Chemical and Engineering
News, Sep-
tember 4, 1961, is a good example. Useful information can certainly be gained, but remember the compromises necessary to reach that profitafter-tax figure, and restrain your interpretation of the results shown. Most financial analysts subject the published statements to rigorous analysis, putting the obvious differences in company practice on a consistent basis before using them. But even experts may often be misled.
Our authors like to hear from readers. If you have questions or comments, or both, send them via The Editor, l/EC, 1155 16th Street N.W., Washington 6, D.C. Letters will be forwarded and answered promptly.
