SOME THINGS INVESTORS MAY NEED TO KNOW ABOUT COMPANY ACCOUNTING

Keep in the following in mind.  This section is written to augment your studies.  I write it because it supports my perspective on investing and helps support the approach taken by many fundamental investors.  You don’t have to read this section if you don’t want to.

Like it or not, as you delve into the world of investing, you’re going to learn a little bit about accounting.  When most people think of accounting, an image of bookkeeping probably pops into the head.  As you’ll discover—I hope—accounting is much, much more than bookkeeping.

The goal of accounting is to provide financial information so that people can make a decision.  Accountants attempt to provide accurate information about the health and operations of a business.  This activity is a little trickier than you might think.

A Company Asset 

An asset is defined as a probable future economic benefit obtained or controlled by a particular entity as a result of a past transaction or event.

Let’s say that you an importer of widgets—Garden Widgets Inc.  You import the widgets from SinoWid—a leading Chinese manufacturer.  You have exclusive rights to sell these products in the hot US widget market.  You start of with $1 million in cash, which you use to invest in a warehouse to store the widgets.  These things—cash, a warehouse, even the widgets—are assets.  An asset is something that is likely to have economic value some time in the future; the asset was purchase or otherwise obtained by the company as a result of something that happened in the past.

Depreciation and amortization

If you invest $500,000 to buy the warehouse, have you incurred a $500,000 expense.  Well, you might have exchanged an asset of a half million in cash for a different asset called a warehouse, but accountants would say it’s not really a one time expense.

If you think the useful life of that warehouse is 25 years, the presumably this asset would be used up—depreciated—over that time.  In fact, your half million dollar investment would be expensed over 25 years—perhaps at $20,000 per year

Depreciation is the consumption of a tangible asset—a physical asset, such as a car, a machine, a building, etc.  An intangible asset, on the other hand, is not physical.  Examples of intangible assets include things like trademarks, know-how, patents and so on.  Intangible assets are used up over time too—a patent has a life span.  Consumption of an intangible asset is called amortization.

Who decides how fast things depreciate, what an asset is and so on?  Well, accounting practices should adhere to a thing called generally accepted accounting principles or GAAP (pronounced just like the clothing store!)  GAAP is almost a dynamic tradition!  Accountants patrol one another to make sure that what they’re doing makes sense (and earns dollars—sorry!)  The industry is really self regulated—and that’s the way it should be.  The system works!  (Stepping off soap box!) When it comes to accounting for financial reporting purposes, another body is responsible for establishing GAAP: it’s the Financial Accounting Standards Board—FASB (pronounced FAZ-bee).  The SEC has delegated the authority to FASB to come up with rulings for interpreting GAAP.

Revenues and expenses

Let’s talk about revenues for a second.  A revenue item seems pretty self-explanatory.  We’ve talked about an asset already—it’s something of value a company owns.  A revenue is something that increases the size of an asset.  You’ve heard the term “revenue stream”; imagine a stream of revenue—let’s say cash.  As it flows into your company it increases your stockpile of cash—your stockpile is an asset.  However, there is a wrinkle when it comes to accounting.  Imagine the following events in the life of a widget order

1. You receive a purchase order from IBM for 1,000 widgets at $100 each
2. You get the widgets from your warehouse and package them
3. FedEx picks up the package and off the widgets go
4. You send an invoice for $100,000 to IBM in a separate FedEx shipment
5. FedEx confirms the arrival of the widgets
6. IBM sends a document acknowledging receipt and acceptance of the widgets
7. A check for $100,00 is received from IBM
8. You lodge the check into the company checking account
9. The check bounces! (just kidding—sorry IBM)

Here’s the question for you: in which of the nine events above can you recognize (record in the books) a revenue for $100,000.  The general rule in accounting is that revenues are recognized when they are earned and expenses are recognized as they are incurred.  This rule is called the accrual principle.  The accrual principle has a corollary called the “matching concept.”  In reporting the financial activities of a business entity, accountants try to associate all relevant expenses with the appropriate revenue.  You can almost picture this concept as a cause and effect relationship: effort and results are matched together.

So, in the example above, when does this revenue recognition occur?

Well, you have some latitude here.  Most people would agree that the revenue should be recognized at or before step 8—let’s not wait until the check clears.  No complaints received from GAAP.  Some might recognize the revenue at step 7—again, nothing wrong with that.  How about at step 5 or 6—that would work.  Step 4 anyone?  Well, some companies would recognize the revenue at step 3.  Garden Widgets would be well served to recognize the revenue at step 3—Note, cash has not changed hands at this point.  Revenue and expense recognition has nothing to do with transfer of cash.

Think of it this way, Garden Widgets is in the business of selling products to a customer.  They’re only going to sell to people whom they believe can pay their bills.  So once those widgets are shipped out the door, most of the work in the sale has been done.  It’s fine to recognize the revenue at that point.

A revenue is recognized then the business activity is essentially completed.  Once those widgets are shipped and not available for sale to anyone else, it’s time to recognize the revenue.  If a company decides to be super conservative in its revenue recognition, it might wait until some other point.  However, the key point is that when the widgets are shipped, revenues could be recognized at that point.  The revenues are realized when the cash is received—when the transaction (swapping one thing for another)—is completed.  The terms recognition and realization are related one to the other, but they do not mean the same thing.

In fact, mention of a company being super conservative leads me to another point.  A principle exists in accounting referred to as conservatism (sounds like the Tories are back!)  This conservative principle means that when accountants have two or more choices, they select the one that is less likely to overstate assets or earnings.  You often read in Business Week or the Wall Street Journal criticisms of accounting practices that are not conservative.  This principle might sometimes conflict with the historical principle.  On occasion, accountants will write-down (devalue) an asset, when it is believed that its value is overstated on the balance sheet.  Although this violates the historical principle, it preserves its overall intent.
When accountants report financial information, they are doing a balancing act with a series of accounting principles.  The information has to be accurate and meaningful yet conservative; it has to be useful for making decisions in the future yet adhere to an historical principle.  Accounting for financial reporting purposes is a tough job!

For various reasons, some customers just don’t pay, so Garden Widgets might create a special account called the “allowance for doubtful accounts.”  They could split the sale up: 98% as a revenue, 2% to the allowance for doubtful accounts.  As you read company financial, you will see that not all customers pay and that judgment is exercised in offsetting some of the revenue stream to cover these occurrences.

Expenses, which decrease assets or increase a liability, are recognized as they are incurred.  If you import a lot of product from SinoWid, none of that product would be expensed until it is sold.  The widgets in the warehouse would be recorded as an asset called inventory.  I’ll talk about inventory in a minute.  There’s one big exception to this rule: R&D expense.  R&D is expensed immediately.  So if a pharmaceutical company spends $500 million over ten years, those funds are expensed as they are incurred.  When we get to talk about a thing called ROE, return on equity, the consequences of this matter will be clear.  The key thing to keep in mind is that if a company buys some kind of an asset that has a useful life of over a year—that item will be depreciated.  Each reporting period (four times each year), you incur depreciation expense for that item.

Depreciation and financial reporting

Let me say a little more about depreciation.  You’re getting a belly-full here, but you can come back and read it later, if these topics crop up again.  To recap, depreciation is the “using up” of a tangible asset over time.  There are two things you have to decide when you depreciate something: over what period of time will you depreciate it and how much will you depreciate each period.  But, there’s more!  Depreciation for financial reporting and tax reporting purposes are not necessarily the same.  For example, let’s say you work for Pfizer and you buy a chemical reactor (a 4,000 gallon reaction vessel) to manufacture a pharmaceutical product.  You spend $2 million to buy and install the thing.  The IRS might have you depreciate this asset over seven years, even though the manufacturer says that it will last twenty years.  Further, they have a depreciation schedule that might have $500,000 in year one, $400,000 in year two, $300,000 in year three—a modified kind of depreciation schedule.  When you develop your books for the IRS, you follow their rules for depreciation.

When it comes to reporting for financial purposes (shareholders, Wall Street and so on), the depreciation differs.  You might have a nice linear schedule—an equal amount in each period—or some kind of non-linear schedule (of which there are many).  So, the chemical reactor that Pfizer bought would likely be depreciated over twenty years—its useful life.  The asset would be depreciated at a rate of $100,000 per year, or $25,000 in each quarter.

The bottom line is that when you look at an income statement prepared for the IRS and compare that to one prepared for shareholders, they would differ.  There’s nothing sinister or underhanded going on here—it’s all perfectly legal!  Again, you’ll have to wfait until later for a discussion on the consequences of this difference.

Inventory

Now for something else about inventory.  It all sounds pretty simple: you buy the widgets at $100 each and as you sell them, you incur an expense for one hundred bucks per widget.  However, what do you do if you buy widgets for different prices due to currency fluctuations?  You might think: you charge for the widgets you sell; however, for accounting purposes, you don’t have to do it that way—sometimes, you just can’t!  Here's a case for you to think about.

You work for Continental Airlines at the Newark hub.  You’re the Director of Fuel Management.  You have tanks that store 2,000,000 units of fuel: half the tanks are for overflow and are usually empty.  You really only need 1,000,000 units, so that’s all you keep in fuel inventory.  Fuel prices plummet to $1 per unit, so you decide to fill the empty overflow tanks.  So you buy 100,000 units a week.  The price spikes $1.10 by the first week, it’s $1.20 in week two.  By the tenth week, the price reaches $2.00!  So, then you start to use these extra 1,000,000 units, how much do you expense per gallon?  Tricky.  They’re all mixed up together in the overflow tanks.

Well, accountants have two methods to use up inventory, abbreviated as LIFO and FIFO.  They’re not dogs!  LIFO is last in, first out.  And, you guessed it, FIFO is first in, first out.  So, if you used LIFO and put 100,000 units into various aircraft, you expense this fuel at $2 per unit—the last fuel in cost $2 per unit.  With FIFO, you would expense $1.10/unit—the first fuel in storage cost $1.10 for each unit.  Once again, the consequences will be discussed later.  However, if you wanted to minimize your expenses, in this example, you’d prefer $1.10/unit.  When accounting for inventory, companies sometimes change from LIFO to FIFO and vice versa.  It can be used to “manage earnings”  If a company changes accounting practices for inventory, it will be noted in the financial statements.

I have talked over a lot of issues.  So, let’s get cracking on where the financial information originates—financial reports.