Financial statements are an invaluable measure of your business's fiscal health. With that in mind, you'll need to acknowledge that they may not always give a true picture of the condition of your business and how you stack up against other businesses. Various factors can distort the reality on paper.
The major causes of distortions in the income and performance pictures presented by the financial statements are:
- inflation
- different accounting treatment for the way in which items are reported
Unless the impact of these factors is considered, a false picture of the condition of the business may emerge.
Inflation's influence on financial statements
Inflation can take its biggest toll on the reported profits of businesses with sizable inventories. Consider the following example:
Example
Patrick's PC Shop reported sales of $100,000 last year. Its cost of goods sold was $75,000, which meant gross profits of $25,000.
Now, assume Patrick's PC Shop sells exactly the same number of units this year, but— because of inflation of 5 percent—raised its prices 5 percent. Also assume that its cost of goods rose 5 percent, but that half of its sales will be made from "old" inventory purchased last year, at last year's cost.
So, for the current year, Patrick's PC Shop reports sales of $105,000 and cost of goods sold of $76,875 ($75,000 + 5% [ 1/2 x $75,000]). Patrick's gross profits rose by $1,875—at least some of which will show up in net income—even though its level of business activity remained unchanged.
The increased profits of Patrick's PC Shop in the example above cannot be attributed to improved performance. They are merely "inflation profits."
Inflation also distorts reported income when the costs of fixed assets are charged to income through depreciation. The increased costs of replacing fixed assets are not reflected in the depreciation charge.
Inflation has an impact on how a business is valued by investors and prospective purchasers who do not value inflation profits highly. A business that fails to take this factor into account in its financial planning may see the value of the business decline, despite steady or modestly rising profits.
Considering accounting procedures
When financial statements and ratio analysis of the items in the statements differs from accounting procedures that may be used in arriving at the figures presented in the income statement and balance sheet, you'll also experience some dissonance between the data and the real world.
Although accountants apply generally accepted accounting principles (GAAP, there is room for variation among different businesses and among different accountants in the application of GAAP.
Consistency 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 upon 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.
