The Balance Sheet topic brings about a brief discussion on the
Financial Accounting and Standards Board – or FASB as it is commonly referred
to in business circles. The Financial
Accounting Standards Board is a private, non-profit organization whose primary
purpose is to establish and improve generally accepted accounting principles
within the United States in the public's interest. As auspicious as this may sound, they have
only been in business since 1973.
This entity is the
source for generally accepted accounting principles and their application. In essence, when an auditing firm is
confirming that the financial statements of a company are “in accordance with
generally accepted accounting principles” it is referring to at least some
adherence to the FASB rules.
This does not mean
that you can compare one company’s results directly to another’s without
looking at how the FASB rules were applied.
Let’s take one very quick example of how FASB rules can be applied in
two completely different ways.
Accounting for
inventory (an asset on the balance sheet) can be computed in several ways. Two of the most common methods are FIFO and
LIFO. These acronyms stand for
First-In-First-Out and Last-In-First-Out.
A critical component in the manufacturing of plastic containers is High
Density Polyethylene (HDPE – you’ve probably seen this stamped into your
containers). This raw material is
purchased by a plastic bottle manufacturing company from a supplier at some
price. Let’s suppose that in January the
plastic container company bought a million gallons of HDPE at $1.00 per gallon
(I have no idea what they pay for plastic, this is just an example so don’t
Google me into the ground over the price!).
As they use the material – let’s say half of it – so they are down to
500,000 gallons – they reorder additional HDPE from their supplier in
February. However, due to problems in
the Middle East, the price for the HDPE has risen to $1.50 per gallon. So they order 500,000 gallons at $1.50 per
gallon and it arrives to be pumped into the main holding tank that has 500,000
gallons of the cheaper $1.00 per gallon HDPE.
So what is the current investment in the inventory? You could easily determine that it is $1.25
per gallon (500k gallons at $1.00 per gallon + 500k gallons at $1.50 per gallon
/ 1,000k gallons = $1.25). But that
doesn’t work very long before you run into trouble. So in March, they have used 31% of the new
$1.25 per gallon raw material and have to order more HDPE at $1.15 per gallon –
what’s the inventory cost now? As you
can see this runs away quickly.
So FASB has stated
that you must determine how you calculate your inventory when compute your cost
of manufacturing plastic containers based on one of two ways – FIFO or
LIFO. This solves the issue of averaging
the cost of replenishing varying cost raw materials. Now, when the company produces plastic
containers, it is using either the FIFO or LIFO method until that inventory is
exhausted. So even though they new “mixed”
cost of the HDPE is $1.25 in February, the company using FIFO is still using
$1.00 as the cost of the HDPE until it is exhausted. At that time, they would switch to using
$1.50 until that supply was exhausted, followed by $1.15 per gallon, etc. The company using LIFO would instead be using
$1.50 per gallon in February until they have exhausted that supply, then
switching to the January price of $1.00 per gallon unless they hit the latest
shipment in which case they can use $1.15 per gallon.
As you can see, the
cost of the materials varies wildly form one method to the next. Most plastic container manufacturing
companies use one or the other methods to avoid this confusion to
investors. But sometimes they can
significantly alter their financial statements and results by choosing whatever
method is most favorable to their performance.
In that case they have to disclose their switching of methods and
recalculate past years performance based on that change – but that’s a little
bit like the lawyer retracting a outlandish accusation in front of the jury
only to have the objection upheld making him/her withdraw the question – but
the jury has already heard it and it may have influenced them! You can’t put toothpaste back into the
toothpaste tube once it is squeezed out!
So ends a long and
somewhat tedious discussion of the application of FASB. It also explains why we started this long
monologue – that Shareholders’ Equity is a plug figure and is not something
“real” like money in the bank, it is just an accounting convention.
