5 Accounting Issues That Are Often Misunderstood

Accounting departments have access to dozens of reports and hundreds of financial ratios, and it may be difficult to understand all of the data. Staff turnover requires CFOs and controllers to train new employees, and the entire accounting team must understand what information is most important. Here are five accounting topics that are often misunderstood.

#1. Using a Multi-Step Income Statement

A simple income statement’s formula is (revenue less expenses equals net income), and this basic format does not show enough detail to make informed decisions. For this discussion, net income is also referred to as profit.

Every business should use a multi-step income statement, which provides detail on both operating income and non-operating income. Successful companies generate the vast majority for revenue and profits from day-to-day operations, and this data is reported in a multi-step income statement.

To illustrate, assume that Prestige Furniture manufactures and sells furniture. Here is the multi-step income statement for the year ended 12/31/21:

There are several line items that are valuable for financial statement analysis:

Computing gross profit

The formula for gross profit is (sales less cost of goods sold), and cost of goods sold includes materials, labor, and other costs that are directly related to the product produced. In this case, Prestige Furniture purchases wood as a raw material, and incurs labor costs to run machinery. Cost of goods sold also applies to service businesses

Evaluating operating expenses, operating income

Operating expenses are costs incurred that are not directly related to producing a product or delivering a service. This category includes overhead costs, including utility costs, insurance, and expenses related to the home office (HR, accounting, legal costs).

Gross profit less operating expenses equals operating income, or the income generated from a company’s primary product or service. Prestige Furniture manufactures and sells furniture, and that is the source of operating income.

Considering non-operating income (expenses)

It’s likely that your business generates income or expenses that are not related to day-to-day operations, which may include:

• Gain or loss on the sale of an asset
• Interest income earned on investments, or on a bank balance
• Loss due to an event (theft, natural disaster) that is not completely covered by insurance

Prestige has $10,000 in non-operating income, and no non-operating expenses. Operating income plus non-operating income equals net income (or profit). 

Managers have more data that can be used to make better decisions, including details that explain profitability and sales.

#2. Analyzing Profit Margin and Sales Mix

Businesses can use income statement detail to analyze profit margin and sales mix. Let’s define both terms:

• Profit margin: The formula is (net income divided by sales), or the amount of profit generated by each dollar of sales

• Sales mix: The percentage of total sales generated by each individual product or service sold

Your business may sell dozens or hundreds of products, and you need to assess both profit margin and sales mix to maximize total company profit.

Think about a hardware store, a business that typically sells hundreds of products. Each product has a different sale price and profit margin. Here are the details for two products:

As you can see, the lawn mower generates more revenue, but a lower profit margin. In addition, lawn mower inventory purchases require a much larger cash investment. The cost of sales for each mower is ($300 – $60), or $240, while each hose has a ($20 – $5), or $15 cost of sales. The sales mix percentages indicate that hoses represent 1% of total annual sales, and mowers produce 12% of annual sales.

Managers need to find a balance between profit margin and sales mix, in order to generate a sufficient amount of profit. The hardware store must generate a minimum level of revenue to cover costs, particularly fixed costs. Hoses generate a higher profit margin, but the sale price is much lower than lawn mowers. 

The goal is to shift marketing and advertising costs to promote higher profit margin items, while keeping an eye on total revenue. The store should promote hoses, and maintain a slightly smaller level of lawn mower sales.

Some owners don’t analyze the most useful data to monitor total company debt.

#3. Managing Company Debt

Generally speaking, businesses raise money by selling equity, or by issuing debt, and a firm’s balance sheet reports both equity and debt. Businesses that generate consistent earnings, such as utility companies, can carry a larger amount of debt and cash flow the interest payments and principal repayments.

The debt to equity ratio is a useful tool to assess leverage, which is the dollar of debt compared to equity. There are other ways to define leverage, but this ratio is often used. The ratio is calculated as (total debt) divided by (total equity), and managers can compare their firm’s ratio to other companies in the same industry. Some managers don’t monitor the debt to equity ratio, and issue too much debt.

Assume, for example, that businesses in your industry maintain an average debt to equity ratio of 2.5 to 1. You need to raise capital, and issue debt several times in an 18-month period. If your company’s ratio is higher than the industry average (say 3 to 1 or 4 to 1), you may be taking on too much debt. Debt increases your interest expense, and may limit your ability to make strategic decisions, such as buying a competitor or starting a new product line.

Planning for future purchases is often neglected by some managers.

#4. Planning for Asset Replacement

Businesses need assets to operate now, and in the future, and management needs a plan to replace aging assets. 

Think about a restaurant, for example. The business needs ovens, refrigerators, kitchen equipment, and freezers to prepare food, and these assets depreciate over time. Well-managed restaurants have a plan to finance asset purchases over time, and forecast the cost to repair and maintain assets. Review the fixed asset listing and determine when expensive assets are no longer useful.

Managers can lower costs, increase efficiently, and remain competitive when they embrace technology.

#5. Leveraging Technology to Support Growth

In a period of rising costs and slower economic growth, leveraging automation is your best tool to maintain profitability. One area that can benefit from automation is accounts payable.
Stampli’s end-to-end AP platform gives you full control and visibility over all your corporate spending, from cards to invoices to payments — all in one place. Take control over invoice and bill processing with smart, intuitive, and actionable AP Automation from Stampli.