When many people think of small business accounting, they think “boring.” They picture an emotionless drone in a poorly lit room entering numbers into a dusty journal or perhaps an outdated computer. It is the antithesis of marketing and sales, which is considered the “sexy” part of business.
While accounting may not be the most exciting area of business, it is certainly far removed from the caricature that many portray. Accounting involves critical thinking and strategic decision-making and can have a tremendous impact on the current and future success of your business.
Generally Accepted Accounting Principles “GAAP”
Generally accepted Accounting Principles, known as “GAAP,” represent the policies, standards, conventions and rules used by accountants to record financial accounting transactions and to prepare financial statements. GAAP is extensive and covers many complex areas of accounting. The Securities and Exchange Commission (“SEC”) has the authority to establish GAAP in the United States. The SEC, however, usually delegates the establishment of GAAP to the private sector. Since 1973, the Financial Accounting Standards Board known as “FASB” has been granted this authority. Prior to FASB, The Accounting Principles Board (and before them the American Institute of CPAs) had this authority.
Conservative Versus Liberal Accounting Policies
For the record, this has nothing to do with politics! Whether a company tends to implement conservative or liberal accounting policies doesn’t provide a clue as to who the owners vote for in elections. The difference arises in the choices that businesses make when choosing between different GAAP alternatives. In many cases, there is more than one valid way to account for a financial transaction and still comply with GAAP. Conservative versus liberal in an accounting context refers to the impact that these choices between valid GAAP alternatives have on a company’s earnings.
Conservative accounting choices tend to result in lower current reported earnings. Liberal accounting choices tend to result in higher current reported earnings.
It’s in the Timing
The difference between conservative and liberal accounting choices comes down to timing – when do you recognize revenues and expenses.
With conservative accounting choices, revenues tend to be recognized later and expenses tend to be recognized sooner. This decreases your current revenues and increases your current expenses. This has the effect of lowering your current reported earnings.
With liberal accounting choices, revenues tend to be recognized sooner and expenses tend to be recognized later. This increases your current revenues and decreases your current expenses. This has the effect of increasing your current reported earnings.
Over the long-term, however, these differences tend to reverse. There is no free ride. If you use liberal accounting polices, this will boost your current earnings at the expense of future earnings. Conservative accounting policies provide higher earnings in the future, but you have to settle for lower earnings now.
Areas Where Small Businesses Make Accounting Choices
Below are five key areas where companies choose between conservative and liberal accounting policies. The selection of choices below is restricted based on the particulars of the transaction which goes beyond the scope of a single article. Each area will be addressed in detail in future articles. Keep this in mind.
Choice of Method for Revenue Recognition
There are different methods for recognizing revenues which impacts how soon the revenue is recognized. These methods in order of “more liberal to more conservative” are:
- Revenue recognition during production (also known as “percentage of completion”)
- Revenue recognition at completion of production (“completed contract”)
- Revenue recognition upon delivery to customer
- Revenue recognition at some specified time after delivery
- Revenue recognition as cash is collected
- Revenue recognition after cash is collected
Choice of Method for Uncollectable Accounts
There are two main ways to account for the fact that some customers are not going to pay what they owe you even if you comply with the terms of your agreement. The more “liberal” is the “direct write-off” method. With this method, the loss is recognized when the account in question is determined to be uncollectable and it is written off.
The more “conservative” option is to use an “allowance for uncollectable accounts” which assumes a specified percentage of revenues during the period will be uncollectable. It basically assumes that something bad will happen before hand, instead of only acknowledging it when it happens.
Choice of Method for Inventory Costing
This has to do with recording the cost of inventory which has a direct impact on your profitability for the period. Lower inventory costs yield higher earnings in the current period while higher inventory costs yield the opposite. The three main ways to address inventory costs are:
- FIFO or “First in First Out” assigns the costs of the first units available for sale to the cost of goods sold for the period. This tends to produce higher profits in the current period since costs tend to rise over time, so using the “older pricing” gives you lower cost of goods sold.
- Average cost – assigns to cost of goods sold the average cost of all goods available for sale during the period.
- LIFO or “Last in First Out” assigns the costs of the last units available for sale to the cost of goods sold for the period. This tends to produce lower profits in the current period since costs tend to rise over time, so the newest or most expensive units provide a higher cost of goods sold. This, however, is the most popular method used in the U.S. since it provides certain tax advantages under tax accounting and the law requires companies that use LIFO for tax purposes to also use it for financial accounting purposes (the “LIFO conformity” rule).
Choice of Method for Depreciation
An asset can be depreciated under straight-line or accelerated depreciation. Straight-line, the more liberal method, recognizes an equal amount of depreciation expense over the useful life of the asset. Accelerated depreciation recognizes a greater amount of depreciation in earlier periods and a smaller amount in later periods. Therefore, accelerated depreciation is considered more conservative because it recognizes more expense sooner and lowers earnings in the current period.
Choice of Method for Leases (From the “Lessee” Perspective)
There are two methods of accounting for leases: Operating leases and Capital leases. Accounting for a lease as an operating lease is considered the more liberal choice.
This is an overview of conservative versus liberal accounting methods. Before making any decisions based on the ideas presented in this article you should consult with your accountant and financial advisor.
Mike Periu is the founder of EcoFin Media, LLC an independent producer of financial, economic and entrepreneurial content for television, radio, print and the internet. Over the past ten years he has started three companies and advised over 50 companies on financial strategies including fundraising. Mike also hosts regular small business webinars on a range of topics relevant to business owners.