1.4 The Practice of Accounting

Welcome back to Finance for Non-Financial Professionals. And, we’re gonna talk now about the way that accounting is practiced. It gets confusing. It gets confusing because there are rules but more often then rules, there are guidelines. And where the rules come into play is enforcing the way you use the guidelines, all right. So you have a lot of leeway, and again as a non-financial professional you’re not doing accounting. But you have to understand when you sit down at the table, and the accountant’s pass out the financial statements, or the managers start pulling out the financial statements, en, and reading things off, it’s good to understand how these were put together, and why things are, reflected the way they are. And so, there’s, there’s, there’s different committees out there as we should say or different standards out there. They give guidelines to accountants on how they should prepare these statements. One of the very famous ones is U.S. GAAP, G, A, A,P, Generally accepted accounting principles. Another one is the FASB, the Financial Accounting Standards Board, ‘kay. And these people, these organizations put out guidelines and enforce the rule, or help enforce the rules of accounting and make sure that accountants are accounting the way they should be. Now there’s several principles, especially in, in GAAP, U.S. GAAP. And European GAAP doesn’t actually differ usually that much from U.S. GAAP. There are some distinctions. But if you know one it’s very int, it’s very easy to understand. And the other. And so there’s these principles of what we do when we’re accounting for something. And I’m just gonna go over a few of those principles. You can easily Google the list and, and, and see the entire list of principles and definitions et cetera, et cetera, but I’m going to talk about the most commonly referred to and the most commonly relevant principles. The first of those is Historical Cost. Okay. Now the Historical cost Principle says that we record the value of an item at the price for which we acquired it. Now this is important because as we all know, the value of things change. Right. If I go and buy a brand new car for $50,000, the moment I drive that car off the car lot, it’s not a brand new car anymore it’s a used car and now it’s just lost at least 10% of its value, it’s not worth more than 45,000 now. So I buy a car and I put that on the books at $50,000. Well, how about a year later? What’s it worth a year later? What’s it worth two years later? What’s it worth three years later? Well historical costs tells us it doesn’t matter. We’re going to record the car at $50,000. And as long as it’s on the books, the car is going to be worth $50,000. Now, there are exceptions to this, of course. There are other things that come into play here. One of these is well, the car is one of the items that we’re going to depreciate. So we’re going to depreciate the car over time. And therefore we’re going to have historical costs. And then we’re gonna have the cost net of depreciation. Right. So in the case of the car we actually are going to show the, the value of that car net of depreciation. So on things that get depreciated that does come into play. There’s also the issue of a stock. What if I buy a stock? I buy a stock in Coca Cola and I buy it today for $3 and tomorrow it’s worth $4 and next week it’s worth $2 and two weeks after that it’s worth $10. The stock’s going up and down all the time. Well guess what. In marketable securities, we’re actually allowed to record the market value of our purchase. So every time that market value changes we can update the, the value of that on our books. Well what’s the difference? How come I can do that with a stock or a marketable security, and I can’t do it with my car or with my building? To un, unlike my car, my building is probably worth more over time. So I bought a building for $100,000 back in the 1940s and now that buildings worth over $10,000,000 today. But on my balance sheet, my asset shows that building at $100,000. That’s not fair. I have more assets than that. Building’s worth 5 million. Well, the reason for this is, is because marketable securities, the value of them, is actually set by the market, and we can see that value in real time easily and instantly, right. Just go onto the, the, the financial center. Look at what that security or stock is trading for at that moment, and you know the actual market value. And, you can’t, it’s not contestable. That is the value of that security at that moment. It’s quick and easy to find, and it’s reliable. In th, the, in the case of my building, well, I can hire the, the evaluators, the appraisers to come over and appraise my building and say well, your building now, today, is worth about this much. But as we’re going to learn in the evaluation section of this, we’re going to learn if you call three evaluate, evaluators, three appraisers, you’re going to get three different values. So the value of the of the building is really more subjective in many ways. Also, it costs me a lot to do it’s time consuming and therefore, I record my building at historical cost. Whereas my stocks, my marketable securities, I can record those and not only can I record these, but I should record these at their current market value, okay. Now, again, an exception, if I bought this building for $100,000 in the 1940s and today it’s worth $5 million, $10 million, that’s a huge difference, and really that difference probably should be reflected. So, before it gets that far out of whack, I probably should call an appraiser. Spend the money and have a formal appraisal done and update my book value. And if I do that, then I can actually update my book value and I can record the actual the new value of my building as opposed to the past value. So, you’ve got this this principle of historical cost. We record things at the cost of which they were purchased. But then there’s exception number one, exception number two, and exception number three and this is accounting. And this is this is where it gets confusing, this is where it gets subjective, this is where many times, the market can lose confidence in businesses that are known for dubious accounting practices, which is why you want to keep your accounting consistent. Okay. Another principle, the revenue recognition principle. Basically says, that companies should re, record revenue when that revenue is earned. Okay so, as revenue is earned we record the revenue. This is the basis for what we call accrual accounting. So in accrual accounting, we don’t necessarily, we don’t account for things as they happen, which is called cash accounting, which is pretty much statement of, of cash flows, we don’t record them as they happen but as they accrue to the business. So when a sale is made, I put that sale on my books, even though I gave my customer 60 day terms or 90 day terms. So I make a sale in December I record that sale in December, okay. I may not be paid until January or February but the sale was made in December. This is accrued accounting. I also accrue costs as they are incurred, so a cost that maybe I pay in 60 or 90 days, I accrue that cost on my books as it is incurred, okay. So wh, that way we’re able to match the revenue and the costs, therefore the income of a business to the actual period in which it generated. That revenue and incurred those costs. And this gives us a more accurate picture of the business and how the business if performing. Then there’s the matching principle. The matching principle says that to the best of my ability, I need to try to match my expenses with my revenue. So as my revenue comes in, expenses that revenue incurred, I need to match my expenses to that revenue, okay. And this is in line with the accrual principle. So even though income might come in at one point and expenses might be paid at another, I’m gonna match these together to again show the benefit of a certain period of time or a certain series of actions in my business. Depreciation, as I mentioned before, when I buy a car and I depreciate that over time. That’s an example of this. I buy a car and that car is gonna be used for my business and I have, I figure that the usable life of that car is five years. So, I simply depreciate that car, I allocate the same amount of, of expenditure for that car to every month of my business for five years. Okay. So, I’m matching the expense of that car to the use of that car. Another way is when we do cost of goods sold. Again I have a, a retail business as I’ve mentioned before. So, I go and I buy stock and I, and because I import my own stock I buy it in bulk, and I oftentimes have to pay cash for it at the time that I buy it, because of where I bring it from. So I go out and I drop lots of money all at once. But, and although that money goes out and you’ll see that on my cashflow statement. It’s not expensed until someone comes into one of my shops, purchases that item and walks out the door. The moment they purchase the item, my cost of goods sold is accounted for, right. And therefore, it matches the cost with the actual transaction and of course with the time. As it were, we’re actually recording this in the month of December. It’s Christmas time. I’m gonna have lots of sales this month. I already have. Therefore, my costs of goods sold will be very high this month. But a lot of what I’m selling this month I bought in September. So if we weren’t matching cost of goods sold to sales, I would show huge expenses in September and huge incomes and profits in December. This wouldn’t accurately reflect what’s really going on in my company. Next principle is the full disclosure principle. Now this is a funny one. I like this one. This one tells us that the more time we spend, the more accurate we can get. But, that accuracy doesn’t always justify the amount of time it would take. So, we need to make a trade off. We need to be as accurate as possible, in as little time as we can to deliver the level of accuracy that we feel we should deliver. Now, eh, you’ve heard, it’s even hard to describe this one because you hear me going well, well how we feel, what we think, what we, it’s all subjective. There’s no rules here. Right. How accurate do you need to be? Well, how accurate do you wanna be? And, really, I guess in the end, the market’s gonna decide, if the market looks at your financial statements and says, well, these aren’t very accurate, well, that’s gonna tell you you should have spent more time on that. At the same time, you don’t wanna spend all the time and get down to the very, very nitty gritty. And the more and more I look at financial statements, or as the years progress, the less and less accurate, unfortunately, I see them becoming. And the more and more general they group everything in just the same little headings. Just a few little lines whereas you know, ten years ago they would’ve had 15 lines. Now they’ve got three to five, right. So they’re getting a little bit more general as they go. But we want to disclose what is required for a reasonable person to be able to make accurate decisions. There’s the materiality principle which means and this is the same kind of thing. The significance of an item should be considered when it’s reported. Okay. An item is considered significant when a reasonable person would want to know that piece of information to make their decision. What’s a reasonable pershon, person? What’s significant? You really, you, you have to use good judgement here and you can see that there is a lot of leeway. For people to be honest or corrupt in this process. And, and unfortunately we seen that in the business world over the last several years. This one is important, The Consistency principle. The Consistency principle says whatever kind of accounting you want to use. Okay, you gotta be consistent. You gotta keep doing that kind of accounting. Th, there’s different ways to account for things, as we’ll see. Just even when you look at stock. There’s what’s called the FIFO method the LIFO method, first in, first out is FIFO, last in, first out is is, is LIFO. Okay, because when you when you purchase items you don’t always purchase them at the same price. And so, when you cost, have a cost of goods sold, well I’ve got an item in my shop right now that comes from two different purchases, and because the size of those purchases varied, one of that item is at one price, and one of that item is another. So if you walked into my shop today, and you bought one of those items, well, which cost of goods sold do I associate. Do I associate the oldest one on the shelf, or the newest one on the shelf, or do I do something called average cost, the average cost of my shift, on my shelf. This is actually up to you, but you need to be consistent in it, okay. And any other accounting practice principal that you choose to do, you need to be consistent. And finally we have what’s called the the cons, conservatism principal, saying that a, the the, accounts, the financial statements,should be as conservative as possible, to not give an overly rosy view or an overly optimistic view of a business. We wanna be as conservative as possible. Again, whatever that means. So in the next module we’re gonna look at costing methods. We’re gonna look at how we cost our product, our service, and how that fits in to finance in general, and becomes part of our financial equation. So I’ll see you in the next lesson.