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by: Anthony Parent 2018-11-05
If you are confused when you review the books of your company or a company you are thinking of investing in, consider: perhaps someone wants you to be confused. That's the first lesson of accounting and financial analysis -- confusion can be used as weapon to get you uninterested in something you really should be interested in. In this article, I will share four other key insights that hopefully will make the financial statements, that is, Balance Sheets, Profit & Loss Statements, Statement of Cash Flows, make a lot more sense to you.
As a kid, finance always interested me. So when I was able to look at my grandfather’s trust and business documents I was beyond excited. But yet, afterwards, I felt demoralized. Why? Not because the trusts weren’t valuable — oh they were. But I didn’t understand something — I knew enough to know that a balance sheet was supposed to tell you what something was worth, but the trust balance sheets I looked at left me utterly confused. They were all sorts of wrong. In trust one, the properties were undervalued giving a phony owner's equity amount. And in trust two, the properties were over valued, which lead to another phony owner's equity amount.
The conclusion I reached is accounting is something you do to get the wrong number. What you did with the wrong number, I had no clue.
What I didn’t realize was that these were merely book or the acquisition values - which is a completely legitmate way to value assets. But completely unhelpful for what I was interested in. As a potential heir I was really interested in the value of something that might be coming my way!
But what should have been there was a footnote that took out the guess work --- there should have been an explanation why the assets were valued this way - in fact footnotes are often the first thing I look at when reviewing a company's financials.
Still confused, I hoped that some day my ignorance would be cured. So I looked forward to accounting classes required as a part of my Finance major in college. Yet, after a short while I became lost. Why? I remember the day -- in order to make double-entry accounting work sometimes you just have to invent out of thin air something called a “contra account." This baffled me. I knew accounting to is supposed to reflect reality yet now we are inventing complete fictions? This reminded me of learning imaginary numbers in Algebra II.
But here's a quick aside that I think could be an appropriate analogy. Like contra accounts which too are invented, imaginary numbers do have a purpose. My brother, David W. Parent, a professor of Electrical Engineering at San Jose State University explained to me that imaginary numbers are actually quite helpful -- they can provide a shortcut to the right answer in circuit and chip design.
And likewise imaginary numbers can provide a shortcut to make double-entry bookkeeping work. To me the best answer is that a contra account is a placeholder for breadcrumbs. In fact, double-entry bookkeeping is nothing but a series of breadcrumbs so that transactions can be tracked and traced back. to verify what happened is what is recorded.
But the answer if you research contra accounts? You'll get something like:
A contra account is a general ledger account which is intended to have its balance be the opposite of the normal balance for that account classification. For instance, a contra asset account is intended to have a credit balance instead of the debit balance normally found in an asset account.
Do you see how this make absolutely does not answer the question "why are we inventing fictious accounts?" Could it be that accounting classes love to talk in circles to create accountants that can talk in circles? I hope not!
My real education came much later. After close to two decades helping out thousands of businesses get their affairs in order, these are four things I think everyone who cares about their business or investments needs to know about accounting:
Bottom line: Your books should work for you, not the other way around. But sometimes a business owner needs help getting their books to work for them. For us, we’ve seen very little difference between a great accountant and a great lawyer and a great CFO. As a tax and business attorneys, we actually speak the same language as our accountants and our clients' CFOs. All of us work in concert to characterize and qualify things in order to better represent a narrative that suits our clients needs the best.