If you read the papers regularly, you have learned a good deal in recent years about all the wonderful ways people find to cook their companies’ books. They record phantom sales. They hide expenses. Some of the techniques are pleasantly simple, like the software company a few years back that boosted revenues by shipping its customers empty cartons just before the end of a quarter. (The customers sent the cartons back, of coursebut not until the following quarter.) Other techniques are complex to the point of near-incomprehensibility. (It took years for accountants and prosecutors to sort out all of Enron’s spurious transactions.) As long as there are liars and thieves on this earth, some of them will no doubt find ways to commit fraud and embezzlement.
But maybe you have also noticed something else about the arcane world of finance, namely that many companies find perfectly legal ways to make their books look better than they otherwise would. Granted, these legitimate tools aren’t quite as powerful as outright fraud: they can’t make a bankrupt company look like a profitable one, at least not for long. But it’s amazing what they can do. For example, a little technique called a one-time charge allows a company to take a whole bunch of bad news and cram it into one quarter’s financial results, so that future quarters will look better. Alternatively, some shuffling of expenses from one category into another can pretty up a company’s quarterly earnings picture and boost its stock price. While we were writing this book, the Wall Street Journal ran a front-page story on how companies fatten their bottom lines by reducing retirees’ benefit accrualseven though they may not spend a nickel less on those benefits.
Everybody who isn’t a financial professional is likely to greet such maneuvers with a certain amount of mystification. Everything else in businessmarketing, research and development, human resource management, strategy formulation, and so onis obviously subjective, a matter dependent on experience and judgment as well as data. But finance? Accounting? Surely, the numbers produced by these departments are objective, black and white, indisputable. Surely, a company sold what it sold, spent what it spent, earned what it earned. Even where fraud is concerned, unless a company really does ship empty boxes, how can its executives so easily make things look so different than they really are? And short of fraud, how can they so easily manipulate the business’s bottom line?
THE ART OF FINANCE
The fact is, accounting and finance, like all those other business disciplines, really are as much art as they are science. You might call this the CFO’s or the controller’s hidden secret, except that it isn’t really a secret, it’s a widely acknowledged truth that everyone in finance knows. Trouble is, the rest of us tend to forget it. We think that if a number shows up on the financial statements or the finance department’s reports to management, it must accurately represent reality.
In fact, of course, that can’t always be true, if only because even the numbers jockeys can’t know everything. They can’t know exactly what everyone in the company does every day, so they don’t know exactly how to allocate costs. They can’t know exactly how long a piece of equipment will last, so they don’t know how much of its original cost to record in any given year. The art of accounting and finance is the art of using limited data to come as close as possible to an accurate description of how well a company is performing. Accounting and finance are not reality, they are a reflection of reality, and the accuracy of that reflection depends on the ability of accountants and finance professionals to make reasonable assumptions and to calculate reasonable estimates. It’s a tough job. Sometimes they have to quantify what can’t easily be quantified. Sometimes they have to make difficult judgments about how to categorize a given item. None of these complications necessarily arises because they are trying to cook the books or because they are incompetent. The complications arise because accountants and financial folks must make educated guesses relating to the numbers side of the business all day long.
The result of these assumptions and estimates is, typically, a bias in the numbers. Please don’t get the idea that by using the word bias we are impugning anybody’s integrity. (Some of our best friends are accountantsno, reallyand one of us, Joe, actually carries the title CFO on his business card.) Where financial results are concerned, bias means only that the numbers might be skewed in one direction or another. It means only that accountants and finance professionals have used certain assumptions and estimates rather than others when they put their reports together. Enabling you to understand this bias, to correct for it where necessary, and even to use it to your own (and your company’s) advantage is one objective of this book. To understand it, you must know what questions to ask about these assumptions and estimates. Armed with that information, you can make well-considered, appropriate decisions.
For example, let’s look at one of the variables that is frequently estimatedone that you wouldn’t think needed to be estimated at all. Revenue or sales refers to the value of what a company sold to its customers during a given period. You’d think that would be an easy matter to determine. But the question is, when should revenue be recorded (or “recognized,” as accountants like to say)? Here are some possibilities:
- When a contract is signed
- When the product or service is delivered
- When the invoice is sent out
- When the bill is paid
If you said, “When the product or service is delivered,” you’re correct; as we’ll see in chapter 6, 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, and 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 a company sells a customer a copying machine, complete with a maintenance contract, all wrapped up in one financial package. Suppose the machine is delivered in October, but the maintenance contract is good for the following twelve months. Now: how much of the initial purchase price should be recorded on the books for October? After all, the company hasn’t yet delivered all the services that it is responsible for during the year. Accountants can make estimates of the value of those services, of course, and adjust the revenue accordingly. But this requires a big judgment call.
Nor is this example merely hypothetical. Witness Xerox, which played the revenue recognition game 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 leases, 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 revenuesalong with the associated profitsup 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.
A second example of the artful work of financeand another one that played a huge role in recent financial scandalsis 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 the bottom line immediately, and a capital expenditure spreads the hit out 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 increase our profit accordingly? This is the kind of thinking that got WorldCom into trouble. 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, and hence its stock price, dramatically.
Now, we are writing this book primarily for people in companies, not for investors. So why should these readers worry about any of this? The reason, of course, is that they use numbers to make decisions. You yourself make judgments about budgets, capital expenditures, staffing, and a dozen other mattersor your boss doesbased on an assessment of the company’s or your business unit’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. Financial intelligence means understanding where the numbers are “hard”well supported and relatively uncontroversialand where they are “soft”that is, highly dependent on judgment calls. What’s more, outside investors, bankers, vendors, customers, and others 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.
This is an excerpt from Financial Intelligence: A Manager’s Guide to Knowing What the Numbers Really Mean by Karen Berman, Joe Knight, and John Case, published by Harvard Business School Press, January 2006. Copyright 2006 Business Literacy Institute. All rights reserved.
In a familiar phrase generally attributed to Peter Drucker, profit is the sovereign criterion of the enterprise. The use of the word sovereign is right on the money. A profitable company charts its own course. Its managers can run it the way they wish to. When a company stops being profitable, other people begin to poke their noses into the business. Profitability is also how you as a manager are likely to be judged. Are you contributing to the company’s profitability or detracting from it? Are you figuring out ways to increase profitability every day, or are you just doing your job and hoping everything will work out? Another familiar saying, this one attributed to Laurence J. Peter of The Peter Principle, tells us that if we don’t know where we’re going we’ll probably end up somewhere else. If you don’t know how to contribute to profitability, you’re unlikely to do so effectively. In fact, too many people in business don’t understand what profit really is, let alone how it is calculated. Nor do they understand that a company’s profit in any given period reflects a whole host of estimates and assumptions. The art of finance might just as easily be termed the art of making a profitor, in some cases, the art of making profits look better than they really are.
We’ll see in this part of the book how companies can do this, both legally and illegally. Our experience is that most companies play it pretty straight, though there are always a few that end up pushing the limits. We’ll focus on the basics of understanding an income statement, because “profit” is no more and no less than what shows up there. Learn to decipher this document, and you will be able to understand and evaluate your company’s profitability. Learn to manage the lines on the income statement that you can affect, and you will know how to contribute to that profitability. Learn the art involved in determining profit, and you will definitely increase your financial intelligence. You might even get where you are going.
A (VERY) LITTLE ACCOUNTING
We told you early on that we wouldn’t teach you accounting, and so we won’t. There is one accounting idea, however, that we will explain to you in this chapter, because once you understand it, you will grasp exactly what the income statement is and what it is trying to tell you. First, though, we want to back up one step and make sure there isn’t a major misconception lurking in your mind.
You know that the income statement is supposed to show a company’s profit for a given periodusually a month, a quarter, or a year. It’s only a short leap of imagination to conclude that the income statement shows how much cash the company took in during that period, how much it spent, and how much was left over. That “left over” amount would then be the company’s profit, right?
Alas, no. Except for some very small businesses that do their accounting this wayit’s called cash-based accountingthat notion of an income statement and profit is based on a fundamental misconception. In fact, an income statement measures something quite different from cash in the door, cash out the door, and cash left over. It measures sales or revenues, costs or expenses, and profit or income.
Any income statement begins with sales. When a business delivers a product or a service to a customer, accountants say it has made a sale. Never mind if the customer hasn’t paid for the product or service yetthe business may count the amount of the sale on the top line of its income statement for the period in question. No money at all may have changed hands. Of course, for cash-based businesses such as retailers and restaurants, sales and cash coming in are pretty much the same. But most businesses have to wait thirty days or more to collect on their sales, and manufacturers of big products such as airplanes may have to wait many months. (You can see that managing a company such as Boeing would entail having a lot of cash on hand to cover payroll and operating costs until the company is paid for its work. But we’ll get to a concept known as working capital, which helps you assess such matters, later in the book.) And the “cost” lines of the income statement? Well, the costs and expenses a company reports are not necessarily the ones it wrote checks for during that period. The costs and expenses on the income statement are those it incurred in generating the sales recorded during that time period. Accountants call this the matching principlethe appropriate costs should be matched to all the sales for the period represented in the income statementand it’s the key to understanding how profit is determined.
The matching principle is the little bit of accounting you need to learn. For example:
- If an ink-and-toner company buys a truckload of cartridges in June to resell to customers over the next several months, it does not record the cost of all those cartridges in June. Rather, it records the cost of each cartridge when the cartridge is sold. The reason is the matching principle.
- And if a delivery company buys a truck in January that it plans to use over the next three years, the cost of the truck doesn’t show up on the income statement for January. Rather, the truck is depreciated over the whole three years, with one-thirty-sixth of the truck’s cost appearing as an expense on the income statement each month (assuming a simple straight-line method of depreciation). Why? The matching principle. The truck is one of the many costs associated with that month’s workthe work that shows up in January’s sales.
- The matching principle even extends to items like taxes. A company may pay its tax bill once a quarterbut every month the accountants will tuck into the income statement a figure reflecting the taxes owed on that month’s profits.
- The matching principle applies to service companies as well as product companies. A consulting firm, for example, sells billable hours, meaning the time each consultant is working with a client. Accountants still need to match all the expenses associated with the timemarketing costs, materials costs, research costs, and so onto the associated revenue.
You can see how far we are from cash in and cash out. Tracking the flow of cash in and out the door is the job of another financial document, namely the cash flow statement (part 4). You can also see how far we are from simple objective reality. Accountants can’t just tote up the flow of dollars; they have to decide which costs are associated with the sales. They have to make assumptions and come up with estimates. In the process, they may introduce bias into the numbers.
THE PURPOSE OF THE INCOME STATEMENT
In principle, the income statement tries to measure whether the products or services that a company provides are profitable when everything is added up. It’s the accountants’ best effort to show the sales the company generated during a given time period, the costs incurred in making those sales (including the costs of operating the business for that span of time), and the profit, if any, that is left over.
Possible bias aside, this is a critically important endeavor for nearly every manager in a business. A sales manager needs to know what kind of profits she and her team are generating so that she can make decisions about discounts, terms, which customers to pursue, and so on. A marketing manager needs to know which products are most profitable so that those can be emphasized in any marketing campaigns.
A human resources manager should know the profitability of products so that he knows where the company’s strategic priorities are likely to lie when he is recruiting new people. Over time, the income statement and the cash flow statement in a well-run company will track one another. Profit will be turned into cash. As we saw in chapter 3, however, just because a company is making a profit in any given time period doesn’t mean it will have the cash to pay its bills. Profit is always an estimateand you can’t spend estimates.
With that lesson under our belts, let’s turn to the business of decoding the income statement.