Accounting

Luca Bartolomeo de Pacioli working it out with chalk

The dismal science Economics

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Accounting is the measurement, processing, and communication of financial information about economic entities and dates back to Italian mathematician Luca Pacioli in 1494. In theory, all accountants are to adhere to Generally Accepted Accounting Principles (GAAP) in the U.S., and International Financial Reporting Standards in other, less significant parts of the world. In practice, not all do, and thanks to the actions of these few, the profession as a whole gets a bad rap.

Misuse of terms

As with any profession, accounting has its own definitions for terms, and how these differ from lay use allows for nasty sleights-of-hand.

For example, a company says it made $1 million in revenue and people will falsely interpret this as the company making $1 million in profit. Profit in accounting means revenue minus expenses. So if the said company had expenses of $1.5 million, it actually lost $500,000 dollars. Moreover "gross margin" or "gross income" are sometimes called Gross Profit or Sales Profit. This again is not how much the company made (Net Profit), but the profit made on its sales; it doesn't figure in things like interest on bought goods, salaries and the like.

Depreciation

“”This thing all things devours: Birds, beasts, trees, and flowers. Gnaws iron, bites steel; Grinds hard stones to meal; Slays king, ruins town, And beats high mountain down.

—Gollum in The Hobbit

Few things last forever — enter depreciation. To oversimplify, depreciation represents the wear and tear of physical assets such as buildings or vehicles. The purpose of depreciation is twofold: it is meant to show assets' decline in value over time, and also to properly match the expense associated with the purchase of an asset to the revenue the asset helps produce over time. These goals can conflict, however, when assets (such as real estate) actually appreciate in value over time, despite providing huge depreciation write-offs to their owners.

Cooking the books

Cooking the books is near the bottom of the barrel in accounting circles. Keeping two sets of books (one for internal use and one for the outside world) is the bottom of the barrel. Cooking the books is basically manipulation of accounting records toward making the records appear better then they actually are. Enron and WorldCom have become poster children of what is informally called creative accounting, but other ways to cook the books aren't so obvious. Misrepresenting credit sales channel stuffing (sending a host of unordered goods at the end of the quarter and recording them as credit), recording nonrecurring expenses on a regular basis, and misuse of depreciation are all ways the books can be cooked.

The Master Chefs

However, there is creative accounting beyond even what Enron and WorldCom did; this little gem is known as Hollywood Accounting. One example of the type of insanity this produces is seen in Return of the Jedi; the film cost $32.5 million and made $475 million at the box office...yet according to Lucasfilm the film "has never gone into profit" Harry Potter and the Order of the Phoenix, is even worse as it is claimed it has a lost of $167 million despite taking in $938 million in revenue.

Things are so screwed up that what actually makes a profit and what doesn't is, many times, obscured to the point that no one really knows what the sam hill is going on.

Tools and users

Accounting's goal is to provide information which can be used to keeps a business profitable but in of itself it is a tool and like all tools it can be used or misused. Often accountants get the blame when a business does something for short term gains (laying a load of people off or raising a good's price for example) but in reality their reports are only as good as the information they are given. Furthermore how the business owner uses those reports is often outside of the accountant's control. Yes they can make recommendations but those recommendations are dependent on what the owner wants.

The Gold Standard

In the U.S., Generally Accepted Accounting Principles (GAAP) is the common set of accounting principles, standards, and procedures issued by the Financial Accounting Standards Board (FASB). GAAP's goal is to improve the clarity, consistency, and comparability of the communication of financial information. It has 10 general Principles:

• Principle of Regularity
• Principle of Consistency
• Principle of Sincerity
• Principle of Non-Compensation
• Principle of Prudence
• Principle of Continuity
• Principle of Periodicity
• Principle of Materiality / Good Faith
• Principle of Utmost Good Faith

Because of this GAAP compliant reports are required by the U.S. Securities and Exchange Commission (SEC) in order to remain publicly listed on the stock exchanges. For some insane reason non-GAAP reports are allowed alongside the GAAP compliant report, like to encourage investment by the clueless. Anyone who make an invest on a company based on non-GAAP reports might as well be playing slots in Vegas.

References

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