:E/E C
I
Costs
A Grain of Truth With a. Grain of.Salt
Handl.e/····wifh care.
Comparison of
financial statements may ignore serious differencesiii" atcounting practice by James B. Weaver, Atlas Chemicallndusfries, Inc.
THE
SOUNDNESS of most engineering jobs can be tested by soundness of the resulting structure. Likewise, a doctor's skill is attested by the survival and healthy condition of his patients. Such judgments as to adequacy are not as easily reached when dealing with abstractions such as costs, profits, and return on investment. There is no real standard for comparison. The accountant is responsible for reporting "accurately" the history of a firm, in dollar terms, to represent the financial operations of a company over each period and its financial status at any· instant. A series of compromises has necessarily resulted and, before any standardization was ·attempted, many different compromises were made by different companies. Because accountants deal with figures with great prec£sion, a considerable degree of accuracy may be erroneously inferred. The intent of this column is not to disparage the accounting profession; most accountants recognize and many are trying to improve the situation to be described. It is rather to acquaint engineers with some of the deficiencies in the usual financial statements, so that they will understand that such statements cannot be accurate in the absolute sense of the word. The financial statement may still have certain useful purposes, but only for those familiar with the possible compromises which have been made. The relevant financial statements are the balance sheet and the profit
and loss statement. Most texts on engineering economics contain adequate 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".l1se-under"acccpta:bleaccount.. ing·. principles~" These ambiguities are particularly·misleading to novices inaccountingbeeauseit is· difficult to believ~ithey:·cgu;Jdexist,·· i n · official,
I l' is equally acceptable, with certain restrictions, for a company to choose the last-in, first-ou t . basis (LIFO) which keeps the earnings statement on a relatively current basis but understates asset value, as long. as inflation continues.
apPF:~ea~··· • ·p:fe~ise··Ainancial····'s'tate*
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 may reflect some of such changes in asset value by transfer of assets among subsidiaries. There is no requirement that this be done and the usual reason for such transactions is the convenience or advantage of the company management, rather than 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!
m:ents;:-iIl::a:standardfgrm.at,.• a.nd:with a standard certification by an independent. auditor. Inflation
In general, accounting practice has not been extended to· re~ect infIa tion, and therefore the basic dollar units of the usual financial statements are not truly comparable from year to year. This distorts any historicalcomparisons and may actually result in indicated progress and 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, materials charged.to current expense may often be at a lower value, .because of price increases since their purc·hase, which distorts the current earnings statement.
Land,. 'Buildings,andEquipment
VOL. 53, NO. 11
•
NOVEMBER 1961
111 A
C05T5
_
Depreciation Depreciation is a noncash expense reflecting capital expenditures by the corporation in previous years which are gradually being charged to current expenses. Because depreciation expense does not reduce available funds, but does reduce taxes by increasing reported expenses, it is almost universal practice to maximize the account for tax purposes. The amount of the reserves for depreciation on the balance sheet a nd the deduction for depreciation which determines current earnings may therefore be distorted. Although this does reduce taxes, the variety of practices reduces comparability among financial staten~ents. Many companies still use the familiar 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 perrritted by accelerated depreciation. The use of accelerated depreciation also distorts historical comparisons vvithin a sing~e company.
Goodwill
is the only way There is no other way in which you can learn so much, so quickly about so many new developments than by visiting 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 handling, 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. ® 300\
Goodwill is an appealing narpe for a simple adjustment factor which allows accountants to corre out \vith the right a ns\,\-er in bala ncing asset:-> and liabilities, according to the practice of double-entry bookkeeping, at the tin~e of acquisition of certain types of assets. I t usually represents the price pa id for assets in excess of their previous ba la nee sheet value (on sorr:eone else's books), which excess valee is not recognized by the federal governrrent as ","ithin a tax ba~~e. Such an "asset" may be amortized \Ivithout recognition as an expense for tax purposes or held on the balance sheet indefinitely, largely at the cOinpany's discretion. Since such amortization reduces earnings reported to stockholders, comparisons among companies and among various years for the same company beCOHJe more treacherous. The item of goodwill was introduced on the balance sheet to try to approximate in dollar terms the know-how and other intangible values of the COInpany not truly reflected in any other part of the balance sheet.
(Continued on page 114 ,,4) Circle NO.6 on Readers' Service Card
11 2 A
INDUSTRIAL AND ENGINEERING CHEMISTRY
Circle No. 77 on Readers' Service Card-+-
C0515,
assets.
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 Independenl Auditor
A reserve IS an accou n t 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 anyone 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 ac~ counting 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 fOf, any supplemental statements by the management in the annual report.
This sort of goodwill has generally been ruled oul 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
PENNSALT ALKYL ALKANOL AMINES Semi-Commercial (Pilot Plant Quantities)
N·ISDPRDPYLETHANDLAMINE 2523 (CH,),CHNHC,H,OH .Mol. WI. 103.2 Sp. Gr. @ 20·C IBP 168·C
0.89-0.90 F8P 178·C.
N-ISOPROPYLDIETHANDLAMINE 1338 (CH,),CHN(C,H,OH},.Mol. WI. 147.2 Sp. Gr. @ 20·c.. 0.98-0.99 IBP 255·c.. FBP 270·C.
N-BUTYLETHANDLAMINE 1097 C,H,NHC,H,OH
Mol. WI. 117.2
Sp. Gr. @ 20·C IBP 192·C
0.88-0.90 F8P 210·C.
N-BUTYLDIETHANOLAMINE 1029 C,H,N(C,H,OH), Sp. Gr. @ 20·C IBP 265·C
Mol. WI. 161.2 0.96-0.97 FBP 287·C.
D1ETHYLAMINOETHOXYETHANDl 1480 (C,H,},NC,H,OC,H,OH Mol. Wt.161.2 Sp. Gr. @ 20·C
0.93-0.95
Distillation: 95% between 215·228°C.
Technical literature and samples available on request. Market Development Dept-Industrial Chemicals Division
PENNSAlT CHEMICALS CORPORATION Three Penn Center· Philadelphia 2, PI.
;:; 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 Valuation The lower right-hand side of the balance sheet is generally considered to represent the stockholders' invcst~
Circle No. 64 on Readers' Strtice 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, September 4, 1961, is a good example. Useful information can certainly be gained, but remember the compro~ mises 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 di.ffer~ ences in company practice on a consistent basis before using them. But evt:n experts may often be misled.
Our authors like to hear from readers. n you have questions or comments, or both, send them via The Edijor, IfEC, 1155 16th Street N. W., Washington 6, O. C. leiters will be forwarded and answered promptly.
