Why Financial Statements Differ for a Business
The accounting method that a business chooses has an impact on the bottom line for the business’s financial statements. For example, a company may use aggressive accounting methods that boost recorded profit or it may use conservative accounting methods that dampen recorded profit.
As an example, look at the last column on the right in the figure below. These are the differences between the two financial statement versions shown in the adjacent columns (Version A and Version C). Version A uses aggressive accounting methods that boost recorded profit, and Version C uses conservative accounting methods that dampen recorded profit.
In the balance sheet, the differences are concentrated in assets; only one liability is different. In total, assets are $1.55 million lower and liabilities are $65,000 higher. These differences are the results of recording slightly lower amounts of sales revenue and significantly higher amounts of expenses in the conservative Version C scenario.
Remember the following about revenue and expenses:
Recording sales revenue increases an asset (or decreases a liability in some cases).
Recording an expense either decreases an asset or increases a liability.
Most of the balance sheet differences in the figure above are caused by higher amounts of expenses in the Version C scenario. The cumulative amount of net income recorded over the years by the business in the Version C scenario is $1,615,000 less than in Version A:
$1,550,000 smaller amount of assets + $65,000 higher amount of liabilities
= $1,615,000 less net income recorded over the years
At the end of each year, the amount of annual net income is recorded in the retained earnings owners’ equity account. The retained earnings balance in Version C is exactly $1,615,000 less than in Version A. This is a sizable amount, but keep in mind that it took all the years of its existence to accumulate that $1,615,000 amount. The net income difference for its latest year is responsible for only part of the cumulative, total difference in retained earnings.
Sales revenue and every expense except interest are different between Versions A and C. Net income in Version C is $340,000 (about 20 percent) lower than in Version A.
Suppose that in putting a market value on the business, you use the earnings multiple method, and you are willing to pay six times the most recent annual profit. In Version A, you would offer $10.74 million for the business ($1.69 million net income × 6 = $10.74 million). In Version C, you would offer only $8.1 million ($1.35 million net income × 6 = $8.1 million). If the business had used more conservative accounting methods, you would offer $2.64 million less for the business!