Accounting Procedures
The second major cause of distortions in the picture presented by financial statements and ratio analysis of the items in the statements is the different accounting procedures that may be used in arriving at the figures presented in the income statement and balance sheet.
Although accountants apply generally accepted accounting principles, there is room for variation among different businesses (and among different accountants) in the application of GAAP.
Consistency generally is required within a particular business. However, different policies in different businesses can affect their reported results and distort the picture of where your business stands in relation to other businesses.
In this regard, consider that:
- The time at which sales show up on an income statement may differ from business to business. A more aggressive approach may accelerate income items by reporting them at the earliest possible moment, while a more conservative approach may postpone revenues.
- Depreciation charges for financial reporting purposes on essentially similar assets can differ from business to business, depending on accounting policies with regard to depreciation methods and useful lives.
- Inventory accounting policies may differ. A business using first-in, first-out (FIFO) accounting will show higher profits in a period of rising prices than will a business using last-in, first-out (LIFO) accounting.
- Policies may differ in regard to expensing. One business may charge an item to income immediately as an expense, while another business may capitalize the same item and report a higher profit.
- Different methods of treating the cost of developing a product will affect the cost of goods sold and affect the gross profit reported.
- Extraordinary or nonrecurring charges may or may not be reflected in operating income, depending on your accounting policies.
- The treatment of tax items may vary from one business to the next.
For all these reasons, when you're comparing your financial statements to industry standards or to those of another business, take the results with a grain of salt.
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