Accounting is a useful tool for understanding how businesses work; after all, companies spend millions hiring financial consultants, banking groups, and auditors all for the purpose of financial reporting and strategy. In theory, the three basic financial statements (across time) — balance sheet, income statement, and cash flow statement – should give a very good picture of a company’s performance. The problem is the practice of accounting doesn’t always match up with that theoretical reality.
- Mystic mumbo-jumbo: Accounting has rules (and accompanying government regulations to make sure that accountants follow those rules) to reduce uncertainty. The problem is those rules aren’t necessarily simple or commonsense. While each rule has a specific purpose, when taken in combination, accounting statements and their terms and classifications can seem as arcane as the fine print at the bottom of legal papers (not to mention that almost every line item in a financial statement has an associated line of fine print). When is something an expense or an expenditure? Why aren’t “retained earnings” money that you just “retained”? What the heck are “non-current liabilities”? Anyone with the slightest of accounting background can answer these questions easily, but at the end of the day it’s just arbitrary jargon that is unnecessarily complex to the point where even diligent professionals might be confused. Case in point: some of my colleagues are working on a case with a tech company which has multiple groups of people tracking the same financial information — and yet the different groups have completely different results some of which differ by hundreds of millions of dollars!
- The market doesn’t always make sense: While not an accounting concept per se, the idea that markets have an underlying rationality to them is the underlying basis for a lot of finance (particularly on the valuation side). While markets certainly have some semblance of rationality (something economists call efficiency) to them, there are numerous cases where the market seems to make no sense whatsoever. The internet bubble, for instance, is an example of the market appraising companies which had essentially no real value as if they were as strong and profitable as big, successful companies like Coca-cola and Walmart. Why? Did accounting not exist just a few years ago? Of course it did. And of course it’s easy to look back and point out mistakes, but the point is market irrationality means that the book value of a company and its assets, debts, and anything else on that financial statement may mean absolutely nothing.
- Lies and the lying liars that lie them: Despite the rules behind accounting, it is notoriously easy to mislead with financial statements. Even a diligent and honest company has a great deal of legitimate discretion with which to classify and report financial activities. Do you have one underperforming division and one superstar? Just merge the two divisions in your financial statement and hide the fact that one of the CEO’s pet projects is a total dud. Do you want to pay lower taxes but report strong performance to your investors? Do some one-time write-offs so that they hit your taxable income but note them as one-time so your investors think the core of your business is doing well. And if you want to mislead people, just lie. It’s not that hard to do and very hard to verify. Remember Enron? Worldcom? Tyco?
Now at this point, those who don’t have an accounting background probably only have the slightest inclination that “goodwill” is an accounting concept. It is indeed one of the most nebulous concepts in accounting. In principle, it’s supposed to reflect that a company has worth beyond it’s immediate assets (which is a no-brainer). But, in practice it’s a concept where a lot of discretion is available in deciding just how much “goodwill” a company has. If it sounds silly, it’s because it is — it’s as if I were to let a random guy on the street decide how much he thinks he deserves over his base salary.
And of course, all stupid corporate examples can always be illustrated by Dilbert.
