When comparing various divisions within a company, describe what problems can arise from evaluating divisions that have different accounting methods, as described in Chapter 11 of your text. Cite three examples of accounting methods that could cause divisions’ profits to differ.
One issue that can happen when comparing divisions in a business is accuracy of the evaluation if differing accounting methods are used in each division. A second issue could be a standard or criteria set by upper management for all divisions subject to one standard not being doable and tantamount if some sections using different standard (Koenig & Nick 2004). Typically, there could be a master plan where profits seem extremely different (or identical) between divisions presently utilizing differing methods, but could be identical (or different) if examined using the same accounting method. A third issue is the financial worth of inventory, costs, or overhead could be under- or overstated in comparison between methods. According to Schneider (2012), the appraisal of an asset is difficult enough without considering various accounting methods being used (p.453). Hence, as Schneider (2012) further comments divisions being compared should have the same or akin accounting methods (p.453). The first cited example of accounting methods that could cause divisions’ profits to differ is one division using the FIFO (first-in first-out) inventory method and another division using the LIFO (last-in first out) method. FIFO and LIFO are, basically, adverse because FIFO is the inventory method where the first bought is the first used and LIFO is where the last bought is the first used leaving the previously purchased products. Therefore, with the prices changing all the time, one method will show more profitability than it’s opposite, leading administration to erroneously portray one department as better than another. Another example would be one division using the cash based accounting method, which records revenue when cash is received and expenses when they are paid in cash; and another division using the accrual accounting (the method where transactions are counted when they happen regardless of when the money is collected or paid). This example applies to a small business close to my home, in which the owner uses the cash basis for the café part of the business and accrual for the motel part of the business because most of the clients pay every three months at the motel. If the owner was not aware of the set up, errors such as the café having $50,000 in sales at year end, but only being paid for $45,000 and the motel having $50,000 sales. The difference in the café sales and actual collection would send up a flag if the situation was not known in advance. Lastly, would be an example in the depreciation method utilized. For instance, one division may use the straight line method for depreciation and another division use the unit of activity depreciation method. According to Accounting-Simplified (2010-2013), straight line depreciation is when the same amount of depreciation is charged over the entire useful life; and the units of activity is when the depreciation amount varies each period in proportion to the change in level of activity (para.2). Therefore, the variance effects net income because depreciation causes net income to lower. So, if one division uses one of the mentioned methods and another uses the other mentioned method, there will be an unfairness since the methods calculate depreciation differently.
Accounting-Simplified (2010-2013). Methods of depreciation. Retrieved July 20, 2016 http://accounting-simplified.com/financial/fixed-assets/dpereciation-methods/types.html
Inc. 5000 (2000). Cash vs. accrual accounting. Retrieved July 20, 2016 http://www.inc.com/articles/2000/04/19194.html
Koenig, K., & Nick, M. (2004). ROI selling: Increasing revenue, profit, and customer loyalty through the 360 sales cycle. Chicago, IL: Dearborn Trade, a Kaplan Professional Company.
Schneider A. (2012). Managerial accounting: Decision making for the service and manufacturing sectors. San Diego, CA: Bridgepoint Education.
Organizations should set an evaluation standard that works best and according to the times. The various divisions do not necessarily mean you have to evaluate them differently. What’s important is for top level management to discuss and analyze the differences and similarities of each division and create a standard that all divisions will be evaluated upon. Now the ROI is not a bad one to start off with, but I think there can be a one size fits all according to the organization, especially if leadership is thinking outside the box. “In the past, within the corporate practice majority of methods were concentrated to measure corporate performance refers to in particular the financial performance of the company, whereby a basic parameter was considered an indicator of profit. Performance measurement indicators oriented on profitability we consider as traditional” (Rajnoha, Lesníková & Korauš, 2016). I prefer the Division Controllable margin because it puts more responsibility in the hands of division managers. Now the problems that can arise in evaluating differences are the fact that some divisions will not be at the same operating level as others, some divisions may have more responsibility than another just as the example in our text on residual income. “A disadvantage with residual income arises when comparing the performance of divisions of different sizes. For example, a division with $50 million in assets should be expected to have a higher residual income than one with $2 million in assets.” (Schneider, 2017). A proper case made right under our nose. You cannot expect a division to be measured the same under certain conditions that those conditions would only apply to some if they do not apply to all. As another example, fixed overhead cost, variable operating cost may differ in division profits so weather you are using that evaluation as a division or division managers performance you will not get the same results between divisions. Now it makes sense as well as the text stated that top management can select different rates of return for each division because management recognizes different roles that each division has overall in the organization. Measuring performance by different standards is chaos. Another thing that would cause different divisions profits to differ would be for example a start up division which would require a little more attention than a mature one would but there has to be a minimum standard set regardless of how mature or not the division is. Measuring division, A with the denominator – investment measure and division B with ROI would not make sense because each method is completely different which would not be fitting for corporate to do. Top management should select one method then “select different minimum desired rates of return for each division to recognize the unique role each plays in the organization.” (Schneider, 2017).
Rajnoha, R., Lesníková, P., & Korauš, A. (2016). From Financial Measures to Strategic Performance Measurement System and Corporate Sustainability: Empirical Evidence from Slovakia, 9(4), 134–152. Retrieved from http://search.ebscohost.com.proxy-library.ashford.edu/login.aspx?direct=true&db=eoh&AN=EP120496031&site=eds-live&scope=site.
Schneider, A. (2017). Managerial Accounting: Decision making for the service and manufacturing sectors (2nd ed.) [Electronic version]. Retrieved from https://content.ashford.edu/.