Understanding Business Accounting For Dummies, 2nd Edition (97 page)

Earnings before interest and tax (EBIT):
This profit measure equals sales revenue less all the expenses above this line; therefore, EBIT depends on the particular choices made for recording sales revenue and expenses. Having a choice of accounting methods means that an amount of wriggle is inherent in recording sales revenue and many expenses. How much wriggle effect do all these accounting choices have on the EBIT profit figure? This is a very difficult question to answer. The business itself may not know. We would guess (and it's no more than a conjecture on our part) that the EBIT for a period reported by most businesses could easily be 10-20 per cent lower or higher if different accounting choices had been made.

Interest expense:
Usually a cut-and-dried calculation, with no accounting problems. (Well, we can think of some really hairy interest accounting problems, but we won't go into them here.)

Corporation tax expense:
You can use different accounting methods for some of the expenses reported in your profit and loss account than you use for calculating taxable income. Oh, crikey! The hypothetical amount of taxable income, if the accounting methods used in the profit and loss account were used in the tax return, is calculated; then the corporation tax based on this hypothetical taxable income is figured. This is the corporation tax expense reported in the profit and loss account. This amount is reconciled with the actual amount of corporation tax owed based on the accounting methods used for tax purposes. A reconciliation of the two different tax amounts is provided in a rather technical footnote to the financial statements. See ‘Reconciling Corporation Tax' later in this chapter.

Net income:
Like EBIT, can vary considerably depending on which accounting methods you use for measuring expenses. (See also Chapter 8 on
profit smoothing
, which crosses the line from choosing acceptable accounting methods from the laundry list of GAAP into the grey area of ‘earnings management' through means of accounting manipulation.)

Whereas bad debts, post-sales expenses, and asset write-downs vary in importance from business to business, cost of goods sold and depreciation methods are so important that a business must disclose which methods it uses for these two expenses in the footnotes to its financial statements. (Chapter 8 explains footnotes to financial statements.) HM Revenue and Customs requires that a company actually record in its cost of goods sold expense and stock asset accounts the amounts determined by the accounting method they use to determine taxable income - a rare requirement in the company tax law.

Considering how important the bottom-line profit number is, and that different accounting methods can cause a major difference on this all-important number, you'd think that accountants would have developed clear-cut and definite rules so that only one accounting method would be correct for a given set of facts. No such luck. The final choice boils down to an arbitrary decision, made by top-level accountants in consultation with, and with consent of, managers. If you own a business or are a manager in a business, we strongly encourage you to get involved in choosing which accounting methods to use for measuring your profit and for presenting your balance sheet. Chapter 17 explains that a manager has to answer questions about his or her financial reports on many occasions, and so should know which accounting methods are used to prepare the financial statements.

Accounting methods vary from business to business more than you'd probably suspect, even though all of them stay within the boundaries of GAAP. The rest of this chapter expands on the methods available for measuring certain expenses. Sales revenue accounting can be a challenge as well, but profit accounting problems lie mostly on the expense side of the ledger.

Calculating Cost of Goods Sold and Cost of Stock

One main accounting problem of companies that sell products is how to measure their
cost of goods sold expense
, which is the sum of the costs of the products sold to customers during the period. You deduct cost of goods sold from sales revenue to determine
gross margin
- the first profit line on the profit and loss account (see Chapter 5 for more about profit and loss accounts, and Figure 9-1 for a typical profit and loss account). Cost of goods sold is therefore a very important figure, because if gross margin is wrong, bottom-line profit (net income) is wrong.

First a business acquires products, either by buying them (retailers) or by producing them (manufacturers). Chapter 12 explains how manufacturers determine product cost; for retailers product cost is simply the purchase cost. (Well, it's not entirely this simple, but you get the point.) Product cost is entered in the stock asset account and is held there until the products are sold. Then, but not before, product cost is taken out of stock and recorded in the cost of goods sold expense account. You must be absolutely clear on this point. Suppose that you clear £700 from your salary for the week and deposit this amount in your bank account. The money stays in there and is an asset until you spend it. You don't have an expense until you write a cheque.

Likewise, not until the business sells products does it have a cost of goods sold expense. When you write a cheque, you know how much it's for - you have no doubt about the amount of the expense. But when a business withdraws products from its stock and records cost of goods sold expense, the expense amount is in some doubt. The amount of expense depends on which accounting method the business selects.

The essence of this accounting issue is that you have to divide the total cost of your stock between the units sold (cost of goods sold expense, in the profit and loss account) and the unsold units that remain on hand waiting to be sold next period (stock asset, in the balance sheet).