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Why accounting and financial analysis should never scare you

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.

 

 

A precocious young man gets confused


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.

 

The confusion gets deeper


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!

 

The other accounting and financial lessons

 

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:

 

  1. There are no black and white answers. Accounting is supposed to reflect reality. Yet reality is an awfully complicated sort of thing, isn’t it? And also, sometimes people want to show you a particular kind of story. For instance, can you ethically manipulate your books to show a high value so that you can obtain optimum financing? The answer is yes. It’s done all the time. And conversely, could you show lower profits, hence a lower value, to reduce your taxes? Yes, and this too, is done all the time.  In fact, both things are done so routinely, no one even mentions it. Yet there exists this idea that “numbers are the numbers” and “numbers don’t lie.”  What complete nonsense. Numbers can be the most effective lies The dirty secret about accounting is that everything is cooked.  But as long as you understand the underlying assumptions and the purpose of the books, and how they were “cooked” the books can still be both honest and helpful.  
  2. If you are more confused after speaking with either your attorney or accountant or CFO or whoever is helping you out, something is wrong. If you are able to start or run your own company, a good attorney, accountant, or CFO should be able to explain any concept to you in simple language.
  3. Trust your gut. No one should ever be more interested in your business than you. You probably know the right answer, you are just unable to express it in accounting terms. But just because you can’t express it, doesn’t mean that you’re not right.
  4. If you can measure something you can improve it. This is a critical function of accounting. This is why it is so important to understand the underlying assumptions that are “cooked” into the books — then you can make meaningful comparisons to see how you are improving and what still needs improving.  

 

 

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.

 


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