A somewhat tedious discussion on the complexity of accounting principles for Marketers.

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.