Basic Accounting Decisions

Accounting managers have a degree of freedom in choosing how to account for certain items and transactions. This section discusses the most significant areas of discretion for each part of a company’s financial statements.

Accounts Receivable

Bad debts arise when customers fail to make payment on their accounts owed to the company. The company has previously recorded sales revenue and offsetting accounts receivable for these amounts. When it is determined that these accounts will not actually be collected, the company must reduce its accounts receivable and record an expense for the bad debt not to be collected. The determination of when to record a bad debt amount can be made using one of two methods.

Specific Write-Off Method

Under the specific write-off method, a company writes off its accounts receivable based on an individual account-by-account determination. Once the company has reason to believe that a specific customer’s account will not be honored, the company writes off that account. This method is normally used by companies with few or unusually large receivable accounts, for which it does not take an inordinate amount of effort to monitor each account individually.

Allowance Method

Using the allowance method, a company estimates the amount of accounts that it anticipates not collecting (based on empirical evidence, such as the company’s historical collection ratio). As opposed to the specific write-off method, which may take a significant amount of time to eventually write off a receivable, the allowance method creates a better match between income and expenses by recording anticipated bad debt expenses immediately upon booking the corresponding sales. At the end of each accounting year, the company reviews its collection history and determines whether an adjustment needs to be made to the allowance account and estimates. This method is best for larger companies with many credit accounts and the possibility of many smaller uncollectible accounts.

Fixed Assets

Depreciation is used in the accrual method of accounting to allocate the cost of a capital asset ratably over the period during which the company obtains a benefit from that asset. The rationale for this treatment is that, in order to match income most accurately with corresponding expenses, an asset that benefits multiple periods should not be charged entirely to the period in which it is purchased. Commonly depreciated assets include buildings, equipment, automobiles, and so on. The company should choose the depreciation method that it feels most closely reflects the contribution of the asset to the company’s performance.

Straight-Line Method

Straight-line depreciation is the most commonly used and least complex depreciation method. It expenses the cost of an asset equally over each year throughout the expected life of the asset.

Declining-Balance Method

Declining-balance depreciation is a form of accelerated depreciation in which the company’s cost basis in an asset is depreciated more quickly than under the straight-line method. In the double-declining-balance method, for example, the straight-line rate is doubled and then multiplied against the total book value.

Units-of-Production Method

If the useful life of the asset is based on physical wear, units-of-production depreciation may be preferable. In this method, the asset’s life is estimated based on the expected total production capability of the asset rather than on an expected number of years. The amount of depreciation to write off is then determined based on each respective year’s production, relative to the asset’s total expected production over its life.

Inventory

A company also has choices in how it accounts for its inventory.

Inventory Costing

Inventory value is based on the cost of merchandise purchased, increased by shipping costs, inventory overhead costs, and the costs of preparing the inventory for sale.

Inventory Tracking

A company may use one of two methods to count its inventory at the end of its accounting period:

• Perpetual method: Perpetual inventory records inventory transactions constantly, in real time. Every time an item is purchased or sold, the inventory ledger is immediately updated.
• Periodic method: Periodic inventory is measured at specific points in time, usually at the end of the accounting period. Inventory amounts are not specif-ically measured during the period. Then, at the end of the period, the inventory “taking” determines the amount and valuation of the inventory, with the cost of goods sold being the residual difference between the ending inventory and goods available for sale.

Inventory Valuation

A company can choose from four methods of inventory valuation, based on what it feels most appropriately reflects its business activity.

• Specific identification: This method does not involve any estimation; rather, it specifically tracks the value of each individual inventory item from the time it is purchased into inventory until the point that it is sold out of inventory. This method requires that it be possible to tell the difference between each inventory item. Specific identification is most useful for a com­pany with few, high-dollar inventory items, such as an auto dealer, a jewelry merchant, or a landowner.
• First-in, first-out (FIFO): This method assumes that the first goods acquired into inventory are the first to be sold. Therefore, the cost of the goods purchased earli­est is used to determine cost of goods sold. The FIFO method often results in higher accounting profit, as the first inventory items purchased are usually acquired at a lower price than those acquired in later years.
• Last-in, first-out (LIFO): This method assumes the last goods acquired into inventory are the first to be sold. Therefore, the cost of goods purchased most recently is used to determine the cost of goods sold. The LIFO method often results in lower accounting profit, as the last inventory items purchased are usually acquired at a higher price than those acquired in earlier years.
• Weighted average: This method calculates one cost for all items sold by dividing the total cost of all items to be sold by the total number of items to sell. This average cost, recalculated each time a new purchase is added to inventory, is applied to any sale to determine gross profit.

Accounting Period and Method

Finally, a company also must determine the accounting period and overall method that it wishes to use.

Calendar Year vs. Fiscal Year

A company must choose an accounting period in order to determine the appropriate cutoff for its annual revenues and expenses, as well as the measurement date for its assets and liabilities. Most companies base their accounting period on the calendar year. However, a company that can demonstrate a business purpose for deviating from the calendar year may choose an alternate fiscal year that corresponds more closely with its business cycle.

Accrual-Basis Accounting vs. Cash-Basis Accounting

Accrual-basis accounting allocates income and expense amounts to the period to which they relate, regardless of the period in which they are paid. Cash-basis accounting records income and expenses in the period in which they are actually paid or received. As a result, the accrual basis gives a more accurate representation of a company’s actual performance for a given year. Because the cash method tends to distort annual income, there are many restrictions on the types of companies that qualify to use it; as a result, most companies use the accrual method.