In the following chapter we’re going to plunge into the first of the three major financial statements. But before we do, we want to tell you a little more about that secret in accounting. We’ve already warned you that many of the numbers aren’t real in the same sense as your bank balance is real. Rather, they are based on estimates and assumptions—on the art of finance. In this chapter we want to help you understand what to look for.
If you’re like a lot of entrepreneurs, you may be a little mystified by the idea that finance is partly an art. Everything else in the business world—marketing, operations, managing people, and so on—is obviously subjective, a matter dependent on experience and judgment as well as data. But finance? Accounting? Surely, the numbers produced by the accountants are objective, black and white, indisputable. Surely, a company sold what it sold, spent what it spent, earned what it earned.
The best way to understand why this isn’t so is to look at specific examples.
One of the variables that is frequently estimated, for instance, is revenue or sales—that is, the value of what a company sold to its customers during a given period. You’d think revenue would be an easy matter to determine. But the question is when revenue should be recorded (or “recognized,” as accountants like to say). Here are some possibilities:
If you said, “When the product or service is delivered,” you’re correct, as long as you are using accrual accounting (more on this in chapter 3). As we’ll see in chapter 5, that’s the fundamental rule that determines when a sale should show up on the income statement. Still, the rule isn’t simple. Implementing it requires making a number of assumptions. In fact, the whole question of “when is a sale a sale?” was a hot topic in many of the fraud cases dating from the late 1990s.
Imagine, for instance, that you run a business that resells specialized telephone equipment to local customers. Most of your customers buy the equipment with a maintenance contract, and the whole thing is wrapped up in one financial package. Now, suppose you deliver the equipment in October, but the maintenance contract is good for the following twelve months. How much of the initial purchase price should be recorded on the books for October? After all, you haven’t yet delivered all the services that you are responsible for during the year. Your accountant can estimate the value of those services, of course, and adjust the revenue for October accordingly. But this requires a big judgment call.
This example isn’t purely hypothetical. Witness Xerox, which played a game with revenue recognition on such a massive scale that it was later found to have improperly recognized a whopping $6 billion of sales. The issue? Xerox was selling equipment on four-year contracts, including service and maintenance. So how much of the price covered the cost of the equipment, and how much was for the subsequent services? Fearful that the company’s sagging profits would cause its stock price to plummet, Xerox’s executives decided to book ever-increasing percentages of the anticipated revenues—along with the associated profits—up front. Before long, nearly all the revenue on these contracts was being recognized at the time of the sale.
Xerox had clearly lost its way and was trying to use accounting to cover up its business failings. But you can see the point here: there’s plenty of room, short of outright book-cooking, to make the numbers look one way or another.
Operating expenses are the costs that are required to keep a business going day to day. They include salaries, benefits, and insurance costs, among a host of other items. Operating expenses appear on the income statement.
A second example of the artful work of finance—and another one that played a huge role in the financial scandals that came to light in the late 1990s and 2000s—is determining whether a given cost is a capital expenditure or an operating expense. We’ll get to all the details later; for the moment, all you need to know is that an operating expense reduces profit immediately and that a capital expenditure spreads the hit over several accounting periods. You can see the temptation here. Wait. You mean if we take all those office supply purchases and call them capital expenditures, we can make ourselves look a lot more profitable? This is the kind of thinking that got WorldCom, for example, into trouble (more on WorldCom later in the book). To prevent such temptation, both the accounting profession and individual companies have rules about what must be classified where. But the rules leave a good deal up to individual judgment and discretion. Again, those judgments can affect a company’s profit dramatically. If it’s a public company, they’ll affect its stock price as well. If it’s a small business, judgments that are too close to the line may make the bankers nervous.
You need to know about such judgment calls because you use numbers to make decisions. No matter what your definition of success is—business excellence, professional achievement, personal satisfaction, financial rewards, or some combination—the numbers tell you what is going on in your business and where you need to focus your attention. You make decisions about budgets, capital expenditures, staffing, and a dozen other matters based on an assessment of your company’s financial situation. If you aren’t aware of the assumptions and estimates that underlie the numbers and how those assumptions and estimates affect the numbers in one direction or another, your decisions may be faulty.
A capital expenditure is the purchase of an item that’s considered a long-term investment, such as computer systems and equipment. Most companies follow the rule that any purchase over a certain dollar amount counts as a capital expenditure, while anything less is an operating expense. Operating expenses show up on the income statement and thus reduce profit. Capital expenditures show up on the balance sheet; only the depreciation of a piece of capital equipment appears on the income statement. More on this in chapters 3 and 9.
Financial intelligence in this context means understanding where the numbers are “hard” (that is, well supported and relatively uncontroversial) and where they are “soft” (that is, highly dependent on those judgment calls). What’s more, your investors, bankers, vendors, and maybe even your customers will be using your company’s numbers as a basis for their own decisions. If you don’t have a good working understanding of the financial statements and don’t know what those folks are looking at or why, you are at their mercy.
So let’s plunge a little deeper into this element of financial intelligence, understanding the artistic aspects of finance. We’ll look at two examples and ask where the assumptions and estimates are and what they might mean. The examples we’ll look at are depreciation and valuation. If these words sound like part of that strange language the financial folks speak, don’t worry. You’ll be surprised how quickly you can pick up enough to get around.
Depreciation allows accountants to spread the cost of equipment and other assets over more than one accounting period. Most capital expenditures are depreciated (land is an example of one that isn’t). Accountants attempt to depreciate the item over what they believe will be its useful life. There’s more about depreciation in parts 2 and 3.
The notion of depreciation isn’t complicated. Say your company buys a computer system or truck that it expects to use for several years. Accountants think about such an event like this: rather than subtract the entire cost from one month’s revenues—perhaps plunging the company into the red for that month—we should spread the cost out over the equipment’s useful life. If we think a truck will last three years, for instance, we can record (“depreciate”) one-third of the cost per year, or one-thirty-sixth per month, using a simple straight-line method of depreciation. That’s a better way of estimating the company’s true costs in any given month or year than if we recorded it all at once. Furthermore, it better matches the cost of the equipment to the revenue that it is used to generate—an important idea that we will explore at length in chapter 3.
The theory makes perfect sense. In practice, however, accountants have a good deal of discretion about exactly how a piece of equipment is depreciated. And that discretion can have a considerable impact. Take the airline industry. Some years back, airlines realized that their planes were lasting longer than anticipated. So the industry’s accountants changed their depreciation schedules to reflect that longer life. As a result, they subtracted less depreciation from revenue each month. And guess what? The industry’s profits rose significantly, reflecting the fact that the airlines wouldn’t have to be buying replacement planes as soon as they had thought. But note that the accountants had to assume that they could predict how long a plane would be useful. On that judgment—and a judgment it is—hung the resulting upward bias in the profit numbers. On that judgment, too, hung all the implications: investors deciding to buy more stock, airline executives figuring they could afford to give out better raises, and so on.
If your business owns any significant tangible assets, you should understand how your accountants depreciate them. The accountants’ practices will go far toward determining your company’s bottom line. You are using that bottom-line number to make decisions about what the business can and should do next. And you can bet your banker will want to know the details of depreciation if you ever apply for a loan.
Another example of the art of finance has to do with the valuation of a company—that is, figuring out how much a company is worth. Publicly traded companies, of course, are valued every day by the stock market. They are worth whatever their stock price is multiplied by the number of shares outstanding, a figure known as their market capitalization or just market cap. But even that doesn’t necessarily capture their value in certain circumstances. A competitor bent on a takeover, for instance, might decide to pay a premium for the company’s shares because the target company is worth more to that competitor than it is on the open market.
The millions of companies that are privately held, of course, aren’t valued at all on the market. When they are bought or sold, the buyers and sellers must rely on other methods of valuation. Talk about the art of finance: much of the art here lies in choosing the valuation method. Different methods produce different results—which, of course, injects a bias into the numbers.
Suppose, for example, you run a small chain of restaurants. How much is it worth?
Well, you could look at your company’s earnings (another word for profits) and then see how the stock market values large restaurant chains in relation to their earnings. (This is known as the price-to-earnings ratio method.) Or you could look at how much cash your restaurants generate each year and figure that a buyer, in effect, would be buying that stream of cash. Then you would use some interest rate to determine what that stream of future cash is worth today. (This is the discounted cash flow method.) Alternatively, you could simply look at your company’s assets—its real estate, equipment, inventory, and so on, along with intangibles such as its reputation and customer list—and make estimates about what those assets are worth (the asset valuation method).
Needless to say, each method entails a whole passel of assumptions and estimates. The price-to-earnings method, for example, assumes that the stock market is somehow rational and that the prices it sets are therefore accurate. (It also assumes that the prices are applicable to privately held companies.) But the stock market reflects many factors other than the outlook for any one business. If investors are bullish (optimistic) on the future, for example, the market will be high, and your company will be valued at more than it would be if investors were feeling bearish (pessimistic) and the market were low. And besides, that earnings number, as we’ll see in part 2, is itself an estimate.
So maybe, you might think, we should use the discounted cash flow method. The question with this method is, what is the right interest or discount rate to use when we’re calculating the value of that stream of cash (which is itself an estimate)? Depending on how we set the rate, the value of your business could vary enormously. And of course, the asset valuation method itself is merely a collection of guesses about what each asset might be worth.
As if these uncertainties weren’t enough, think back to that delightful, outrageous, nerve-racking period known as the dot-com boom, at the end of the twentieth century. Ambitious young Internet companies were springing up all over, fed and watered by a torrent of enthusiastic venture capital. But when investors such as venture capitalists (VCs) put their money into something, they like to know what their investment—and hence what the company—is worth. When a company is just starting up, that’s tough to know. Profits? Zero. Operating cash flow? Also zero. Assets? Negligible. In ordinary times, that’s one reason VCs shy away from early-stage investments. But in the dot-com era, they were throwing caution to the wind and so were relying on what we can only call unusual methods of valuation. They looked at the number of engineers on a company’s payroll. They counted the number of hits (“eyeballs”) a company got every month on its Web site. One energetic young CEO of our acquaintance raised millions of dollars based almost entirely on the fact that he had hired a large staff of software engineers. Unfortunately, we observed a “For Lease” sign in front of this company’s office less than a year later.
The dot-com methods of valuation look foolish now, even though they didn’t seem so bad back then, given how little we knew about what the future held. But the other methods described earlier are all reasonable. Trouble is, each has a bias that leads to different results. And the implications are far reaching. Companies like your own are bought and sold based on these valuations. They get loans based on them. The equity you hold in your company should reflect an appropriate valuation, and when the time comes to sell your business, the buyer will probably use some combination of these methods to determine what he or she offers. It seems reasonable to us that your financial intelligence should include an understanding of how those numbers are calculated.
So keep the art of finance in mind as we proceed through the rest of the book. As we’ll see, it crops up repeatedly.