Monday, February 15, 2010

The 5 Most Important Things I learned in Financial Accounting Class

You think accounting is boring? Okay, you're right. It can be.

However, accounting is the language of business. It's important. And every once in a while, it's really interesting.

Last quarter, I took Financial Accounting at Chicago Booth. What follows are the five most important things I learned.

5) Accounting is not about giving an accurate picture of a business. It is about compliance with the law.

There is a perception amongst laypeople that financial reports are objective pictures of a company's financial situation. Not true.

There are a number of reasons that managers would want to misrepresent numbers. Their bonuses depend on meeting numerical targets. Investors show a bias toward investing in companies that have certain numerical patterns. Disadvantageous regulations can kick-in when numbers hit thresholds. Reasons for cheating abound.

But cheating is illegal. Hence, businesses do what they must do. They comply with the law - most of the time - even when they don't want to. 1

4) The numbers can tell (almost) any story you want them to tell.

"Creative" is not generally a word used to describe accountants. But after learning about the ways that accountants and bankers manipulate numbers, I started to notice their craftiness.

The truth is that no matter how smart regulators are, an army of accountants is smarter. They are capable of hiding big, big items for a long time. The financial crisis was partially fueled by a particular kind of creative hide-and-seek with the numbers, called off balance sheet financing.

Long story short . . . don't take the numbers at face-value.

3) Often, the most important information about a business is buried deep in the footnotes of hundred page reports.

General Electric's annual report is 144 pages long. In Note 12 on pages 92-94, they discuss loans worth $282.7 billion.

Read that again and actually picture the size of the number: $282,700,000,000. That's no small amount. It's enough to pay 10,096,428 people for one year at $28,000/year.

This note contains the details given about the loans which caused financial problems for banks and GE financial.

2) If you don't understand the business itself, the numbers are meaningless.

Looking at financial numbers without observing the operations of a business is like reading sheet music when you've never actually heard. You might understand the values of the musical notes, but they have no meaning.

Accounting numbers are a reflection of the actions of a business (albeit an imperfect one). They all have an underlying cause. They all come together in specific patterns when the business is making money, and different patterns when the business is losing money. You learn the underlying patterns by observing the business . . . not by observing the numbers.

1) Business people have their own language. They can maintain power partially because others don't understand it.

Business does not require extraordinary mental power. It does require a working knowledge of accounting language if you want to be a manger . . . or if you want to do anything that requires more than a hundred thousand dollars in investments to get going.

If you don't understand your company's revenue streams and basic cost structure, you probably are not ready to be a manager. If you don't know the difference between debt and equity financing, your business probably won't grow beyond the family.

If you don't understand what a "yield to maturity" is, you shouldn't be picking your own bonds. And if you don't understand what "capital gains," "dividend yield," "earnings per share," "common stock," "preferred stock," and "bonds" are, you probably shouldn't be purchasing any individual stocks.2

The point is that business has its own rich and descriptive language. It describes important phenomena that occur every day in the course of business. Those who understand the language are insiders. They are better prepared for success. Those who do not understand the language are outsiders. They are less prepared for success.

In ten weeks of class and 500+ pages of reading, these were the five best lessons that I learned. I hope this opened your eyes to things you didn't know.

This post is the first in a series of posts that I plan to write to share a variety of MBA knowledge that I think would be useful for laypeople. It's meant to help people without an MBA education to become aware of issues that may come up when making important decisions.

Please let me know if you thought this was useful. And if you like it, share it with a friend.


1 In fact, many companies' managers would prefer to abstain from external reporting if they had the choice - privately held companies generally do not create external reports.

2 If you can stand to lose the money that you are speculating, I guess you could, but I still wouldn't recommend it.