Question

Suppose Hamilton Manufacturing Co. and Freeman Products, Ltd. have exactly the same reported net income for 2019. Would you be able to say confidently that their performance was identical in that year?

Briefly comment on how accounting practices affect the comparisons of performance between companies. In your answer, specifically comment on the accounting for uncollectible accounts, depreciation, and lower-of-cost-or-net-realizable-value valuation of inventory. (Hint: do judgment and estimation by accountants affect the amount of income that is reported in a given year? Explain.)

Answer 1

No. Based on net income of  Hamilton Manufacturing Co. and Freeman Products Ltd it would be wrong to say that there performance was identical in the year. Here we will try to explain this through various things in accounting like it could be posible that one of company was having different capital employed, different debts, different collectibles, different payables, different fixed asset expenditures, different Investments, different inventory valuation methods, etc. Comparing the two companies based on there net income is like comparing the two companies in isolation. Investors see different perspectives when they compare two companies for investment. Like liquidity, leverage, capital employed, customer base, future capital expenditure, accounting policies, etc of two companies.     

Now we try to explain above specifically through accounting for uncollectible accounts, depreciation, and valuation of inventory. Firstly taking uncollectible accounts, here two companies can have different position like one company is achieving higher sales by having lenient debtor collection policy resulting in more sales but at the same time more bad debts also. Whereas on the other hand other company having moderate debtor collection policy resulting in more sales but at the same time less bad debts. Secondly depreciation method of two companies will result in different profits. Like one company is using Straight line method of depreciation to increase book profits while on the other hand other company is using WDV method to show lesser profits in initial years of fixed asset purchases. Thirdly valuation of inventory can result in different profits. Like one company is using FIFO method of inventory valuation to increase book profits while on the other hand other company is using LIFO method to decrease profits in inflationary environment. So, If we want to compare two companies we need to firstly see the accounting practices of each of them to make comparison between the two & make adjustments for comparison.