Accounting Shenanigans

Posted by PITHOCRATES - August 13th, 2012

Economics 101

Two Important Accounting Principles are the Realization Principle and the Matching Principle

Accounting isn’t exciting.  It’s dull.  And tedious.  Anyone who struggled to get a trial balance to balance knows this well.  But accounting is a necessary tedious.  Someone has to put those numbers into the proper accounts.  Correctly.  Down to the penny.  Because only then can you prepare financial statements that are useful to business owners.  As well as investors.

When we post these numbers correctly we can produce the income statement.  Or as some call it the profit and loss statement.  Or P&L.   Which tells you whether you made a profit or a loss for an accounting period.  And some of the most important accounts on the income statement are income accounts (or revenue accounts).  The money they get when they sell their goods or services.  And expense accounts.  But not all expense accounts.  They’re all important but some are particularly important.  The expenses used to specifically generate that revenue (the cost of sales).  Production labor.  Production material.  The labor and material that make the things a business sells.  These expenses are variable.  They go up and down with sales.  As opposed to fixed overhead.  Which remains the same regardless of sales.

We have to define the accounting period carefully.  It can be annually.  Quarterly.  Even monthly.  The smaller the period the more useful information for business owners.  Investors study a company’s quarterly statements.  As well as annual statements.  The shorter the accounting period, though, the more careful the posting to the accounts is.  Because of two accounting principles.  The Realization Principle.  And the Matching Principle.   Which places revenue into the accounting period it occurs.  And then matches the expenses to the revenue it created into the same accounting period.  So when you subtract expenses from revenue in that accounting period you get the gross profit for that accounting period.  Given a measure of how business was during that accounting period.  If business was good there is revenue remaining after subtracting all variable expenses and all fixed expenses.  If sales are down there may be a gross profit.  But there may not be enough left over to pay the fixed overhead costs.  Resulting in a business loss.  For that accounting period.

The Smaller the Accounting Period the Greater the Math required to apportion Revenues and Expenses

When businesses ‘cook’ their books they are making business results look differently from what they actually are.  Perhaps the most common way to ‘cook’ the books is to violate the Realization Principle and Matching Principle.  Such as moving revenue or expenses to other accounting periods instead of where they belong.  If a business needs better business results for investors they may realize revenue early.  Or push expenses out to a subsequent accounting period.  Thereby increasing profitability for the one period better than it actually is.  As revenue will be greater and expenses will be smaller.

As an example consider a now common summer business model.  Selling ice-cold water at traffic intersections.  You need some cases of bottled water.  Ice.  And a cooler.  If you buy all the water in July but sell some of it in August you have to split the expense of the water between these two months.  If you don’t your expenses will exceed your revenue in July because it includes water purchased for both July and August.  You would subtract two months of water expense from one month of water sales.  Making July business show an operating loss.  While August would subtract no water expense from August sales making August more profitable than it actually was.  However, if you combine the two months together there will be no misrepresentation of the accounting data.  As you would subtract two months of water expenses from two months of water revenue.

This is why larger accounting periods are easier to post.  As they get smaller you have to do a lot of math to apportion these revenues and expenses into the proper accounting periods.  And sometimes mistakes happen.  Honest mistakes.  A business could have felt they had a good month but their income statement shows a loss.  Or the month could be far better than you feel it should be.  If you look hard enough you can often find a timing error.  Revenues or expenses appearing in the wrong period.  Such as recording a down payment as revenue.  It’s not.  A down payment is a liability.  Because it is a prepayment for you something owe someone at a later date.  And it’s at that later date when you can realize that down payment as revenue.

As you Pull Revenue Up and Push Expenses Out each Subsequent Accounting Period Starts with a Larger Operating Loss

But some businesses cook their books.  And once they start it becomes more difficult with every accounting period.  Which is why most companies that do cook their books fail.  And they fail big.  Here’s why.  If you realize revenue early in this period instead of next period (where it belongs) the following accounting period will underreport revenue.  Worse, the expenses to produce that revenue are still in that period.  When you subtract the properly reported expenses from the underreported revenue it will result in an operating loss.  Unless they cook the books in the following period, too.  By pulling revenue into that period from another period.  Or pushing out expenses to a later period.

The problem is when you keep doing this it makes the following accounting period more difficult to ‘fix’.  For as you pull revenue up and push expenses out each subsequent accounting period starts with a larger operating loss.  And if a business is having problems (which they typically do when they start cooking their books) actual revenue for that period will be depressed as well.  So as they go through subsequent accounting periods beginning operating deficits grow larger in the face of falling revenues.  To keep the scam going they have to take it up a notch.  Taking things ‘off balance sheet’ (basically ignoring some bad financial information).  Creating a shell company to dump bad financial data on.  And other accounting shenanigans.  The bigger the scam, though, the harder the fall.  And there is always a fall.  Think Enron.  And WorldCom.

But it’s just not businesses that cook their books.  Government does, too.  Especially when they want to pass unpopular and costly programs.  They will send the financial data for a program to the Congressional Budget Office to score.  To determine the cost over a 10 year period.  But to make the program less expensive and more palatable to the taxpayers they will cook that data.  Their bill may include new taxes over the ten year period.  But benefits may kick in a few years after the new taxes start.  So you may have 10 years of taxes paying for only 8 years of benefits.  But everyone thinks it’s 10 years of benefits.  Making the program appear less costly than it actually is.  Of course when they get caught in their accounting shenanigans nothing happens.  They just say, “Oops.  We goofed.  Shucks.  Looks like we’ll have to raise taxes.”  Not quite the same thing that happens in the private sector.  Just ask those who were running Enron.  And WorldCom.

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Inventories

Posted by PITHOCRATES - July 23rd, 2012

Economics 101

Before a Business Earns any Sales Revenue they have to Spend Cash to Build an Inventory

To sell something a business needs to have it on hand first.  Because when it comes to manufactured goods we rarely custom manufacture things.  No.  When businesses sell something it’s something they already have in their inventories.  So how do they get things into inventory?  With cash.  Businesses buy goods and place them in their inventories.  They exchange some of their cash for the goods they hope to sell at a later date.  And the bigger the inventory they maintain the more cash it will take.  Cash they have to spend before they sell these goods.  Which requires financing.  Each large business, in fact, has a finance department.  That works to raise cash.  So the businesses can buy inventory (and pay their operating and overhead expenses) before they start selling anything.

This is how the retail stores work.  For manufacturers it’s a little different.  They make things.  Out of other things.  Things that go through various stages of production before becoming a finished good.  So to make these things requires different types of inventories.  Raw goods.  Work in process.  And finished goods.  When they pull raw goods out of inventory and begin working with them they become work in process inventory.  When finished goods come off the final production line they enter finished goods inventory.  The finance department secures the cash to buy the raw materials.  And for the equipment and labor used through the stages of production to produce a finished good.  Which enters finished goods inventory until they sell and ship these goods.

Before a business earns any sales revenue they have to spend huge amounts of cash first to move material through these inventories.  Cash they can’t use for anything else.  Like paying their overhead expenses.  Or servicing their debt.  So it’s a delicate balancing act.  You need inventory to produce revenue.  But if you run out of cash you can’t produce any inventory.  Or pay your bills.  A large inventory creates a large variety of things for customers to buy.  But if customers aren’t buying that large inventory will consume cash leaving a business struggling to pay its bills.  If they become so cash-strapped they will cut their prices to unload slow moving inventory.  Cut back on production rates.  Even cut back on expenses.  As in cost-cutting.  And lay-offs.

Good Inventory Management is Crucial for the Financial Health of a Business

A business doesn’t start generating cash until they start selling their finished goods.  Sales numbers may sound high but most sales revenue goes to pay for the costs of producing inventory.  A firm’s accounting department records these revenues.  And matches them to the cost of goods sold.  Which in a retailer is what they paid to bring those goods into inventory.  A manufacturer may use a term like cost of sales.  Which would include all the costs they incurred throughout the stages of production from bringing raw material into the plant.  To the labor to process that material.  To the energy consumed.  Etc.  Everything that was an input in the production process to place a finished good into inventory.  So from their sales revenue they subtract their costs of goods sold (or cost of sales).  The number they arrive at is gross profit.  Which has to pay for everything else.  Rent, utilities, marketing and advertising, non-production salaries and benefits, insurances, taxes, etc.  And, of course, interest on the cash their finance department borrowed to start everything off.

There is a unique relationship between inventories and sales.  There are countless things that happen in a business but what happens between inventories and sales receives particular attention.  A business’ greatest cost is the cost of goods sold.  Or cost of sales.  Everything that falls above gross profit on their income statement (the financial statement that shows a firm’s profitability).  This cost is a function of inventory.  The bigger the inventory the bigger the cost.  The smaller the inventory the smaller the cost.  This is a direct relationship.  You move one the other follows.  Whereas the relationship between sales and inventory is a little different.  The higher the sales revenue the bigger the inventory cost.  Because you have to have inventory to sell inventory.  However, there is no such corresponding relationship for falling sales.  As sales can fall for a variety of reasons.  And they can fall with a falling inventory level.  They can fall with a steady inventory level.  And they can fall with a rising inventory level.

In business sales are everything.  There are few problems healthy sales can’t solve.  It can even overcome some of the worst cost management.  So rising sales revenue is good.  While falling sales revenue is not.  There are many reasons why sales fall.  But the reason that most affects inventories is typically a bad economy.  When people scale back their purchases in response to a bad economy a firm’s sales fall.  And when their sales fall their inventories, of course, rise.  Until management scales back production to reflect the weaker demand.  Because there is no point building things when people aren’t buying.  Those who don’t scale back production will see their sales fall and their inventories rise.  Creating cash problems.  Because sales aren’t creating cash.  And a growing inventory consumes cash.  Making it difficult to meet their daily expenses.  Such as payroll and benefits.  As well as paying interest on their debt.  Which can lead to insolvency.  And bankruptcy.  So good inventory management is crucial for the financial health of a business.

If Retail Sales are Falling and Inventories are Rising Bad Times are Coming

Businesses target specific inventory levels.  During good economic times they increase inventory levels because people are buying more.  During bad economic times they decrease inventory levels because people are buying less.  And they monitor changes in the actual sales and inventory levels continuously.  Adjusting inventory levels to match changes in sales.  To balance the need to have an inventory flush with goods to sell.  While keeping the cost of that inventory to the lowest level possible.  All businesses do this.  And if you track the aggregate of the inventory levels of all businesses you can get a good idea about what’s happening in the economy.

John Maynard Keynes used inventory levels in his macroeconomics formulas.  The ‘big picture’ of the economy.  Looking at inventories tied right into jobs.  If sales are outpacing inventory levels then businesses hire new workers to increase inventory levels.  So sales growing at a greater rate than inventory levels suggest that businesses will be creating new jobs and hiring new workers.  A good thing.  If inventory levels are growing greater than sales it’s a sign of an economic slowdown.  Suggesting businesses will be reducing production and laying off workers.  Not a good thing.

Because of the stages of production changes in finished goods inventories can create or destroy a lot of jobs.  For if the major retailers are cutting back on inventory levels due to weak demand that will ripple all the way through the stages of production back to the extraction of raw materials out of the ground.  Which makes inventory levels a key economic indicator.  And when we combine it with sales you can pretty much learn everything you need to know about the economy.  For if retail sales are falling and inventories are rising bad times are coming.  And a lot of people will probably soon be losing their jobs.  As the economy falls into a recession.  Which won’t end until these economic indicators turn around.  And sales grow faster than inventories.  Which indicates a recovery.  And jobs.  As they ramp up production to increase inventory levels to meet the new growing demand.

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Capital and Capitalism

Posted by PITHOCRATES - May 7th, 2012

Economics 101

Entrepreneurs have an Insatiable Desire to Think and Create

It takes money to make money.  For it is money that buys the means of production.  The land, manufacturing plants, small shops, office space, machines, equipment and infrastructure that make things.  The trucks, barges, container ships, locomotives and rolling stock that transport raw material, work-in-progress and finished goods.  These physical assets are capital.  From assembly lines to inventory control systems to accounting software.  Things that let businesses conduct business.  And make profits.

This is the key to capitalism.  Profits.  It’s what allows businesses to make the things we need and enjoy.  Profits are what make an entrepreneur take a risk.  To spend their life savings.  To mortgage their home.  To borrow from a bank.  They do these things because they believe they will be able to earn enough profits to replenish their life savings.  To make their mortgage payments.  To repay their loans.  AND to earn a living in the process.  It is a risky endeavor.  And far more risky than working for someone and earning a steady paycheck.  But if entrepreneurs didn’t take these risks we wouldn’t have things like the iPhone or the automobile or the airplane.  All of which were brought to us because one person had an idea.  And then invested in the capital to bring that idea to market.

Some business ideas succeed.  Many more fail.  But people keep trying.  Because of that insatiable desire to think and create.  And the ability to earn profits to pay for their ideas.  To build on their ideas.  To expand their ideas.  From the first thoughts of it they kicked around in their head.  To the multinational corporations their ideas grew into.  All made possible by the profits they earned.  The more they earned the more they could do.  As they reinvested those earnings into their businesses.  To buy more capital.  That allowed them to build more things.  And use even more capital to bring these things to market.  Creating jobs all along the way.  Jobs that only came into being because of those profits that started as a single thought in someone’s head.

If you can’t Service your Debt your Creditors can and will Force you into Bankruptcy

This is where corporations come from.  From a single thought.  Profitable business operations grow that thought into the corporations they become.  For corporations are not the evil spawn of the damned.  Corporations come from people having a great idea.  Like Starbucks.  And Ben and Jerry’s.  Who are now everywhere so we can enjoy their products wherever we are.  All made possible by the profits of capitalism.

Who’s up for a little accounting?  You are?  Well, then, you came to the right place.  For we’re going to learn a little accounting.  Right here.  Right now.  Corporations determine their profits by closing their books at the end of an accounting period.  A series of accounting steps culminate in the trial balance.  Where the sum of all debits equal the sum of all credits.  Or eventually do after various adjusting entries.  Once they do the books are balanced.  And business at last can see if they were profitable.  By producing an income statement.  Which lists revenue at the top.  Then sums all costs (materials, production wages, payroll taxes & health insurance for that labor, etc.) that produced that revenue.  Subtracting these costs from revenue gives you gross profit.  Then comes overhead costs.  Fixed costs.  Like rent and utilities.  And overhead labor (corporate officers, management, accounting, human resources, etc.).  They sum these and subtract them from gross profit.  Which brings us to earnings before interest and taxes (EBIT).  A very important profitability number.  For if there is any money left by the time you reach EBIT your business operations were profitable.  Your business was able to pay all the due bills to produce your revenue.  Which leaves just two numbers.  Interest they owe on their loans.  And income taxes.

EBIT is a very important number.  For if it’s not large enough to service your debt everything above EBIT is for naught.  Because if you can’t service your debt your creditors can and will force you into bankruptcy.  Never a good thing.  And what follows is usually the opposite of growing your business.  Shrinking your business.  By seriously cutting costs (i.e., massive layoffs).  And eliminating unprofitable lines of revenue.  Downsizing and reorganizing as necessary so your cost structure can produce a profit at the given market price for your goods and/or services.  A price determined by your competition in the market.  If you cannot downsize and reorganize sufficiently to become profitable then you go out of business.  Or you sell the business to someone who can make a profit.  Because unless you can turn a profit your business will consume money.  And that money has to come from somewhere.  Typically it is the business owner until they run out of life savings and home to mortgage.  Because a bank can’t give you money to lose in your business.  For their depositors put their money into the bank to grow their savings.  Not to shrink them.  So a bank has to be profitable to please their depositors.  And if the bank is using their money to make bad loans they will remove their money.  As will other depositors.  Perhaps creating a run on the bank.  And causing the bank to fail.  So while operating at a loss will save employees jobs in the short term it will cause far greater harm in the long term.  Which isn’t good for anyone.

Capitalism works because with Risk there’s Reward

As you can see getting those accounting reports to fairly state the profitability of a business is crucial.  For it’s the only way a business knows if it can pay its bills.  And the way they pay their bills complicate matters.  Revenue and costs come in at different times.  To bring order to this chaos businesses use accrual accounting.  Which includes two very important rules.  To record accurately when revenue is revenue (for example, a down payment is not revenue.  It’s a liability a business owes the customer until the sale transaction is complete).  And to match costs to revenue.  Meaning that every cost a business incurred producing a sale is matched to that sale.  Even long-term fixed assets like buildings and machinery.  Which they depreciate over the life of the asset.  Charging a depreciation expense each accounting period until the asset is fully depreciated.

Because of these accounting reports that fairly state business operations a business knows if they are profitable.  That they can pay all of their bills.  Their suppliers AND their employees.  Their health insurance AND their payroll taxes.  The interest on their debt AND their income taxes.  They can pay all of these when they come due.  And not run out of money when other bills come due.  Which is why they can have confidence when they read their income statement.  Knowing that they paid all their costs due in that accounting period.  Including the interest on their debt.  And their income taxes.  Which takes them to the bottom line.  Net profit.  And if it’s positive they have money to reinvest into their business.  To expand operations.  To increase sales revenue.  Create more jobs.  And they can grow.  But not too much that they lose control.  So they can always pay their bills.  So they can keep doing what they love.  Thinking.  And bringing new ideas to market.

This is capitalism.  Where people take risks.  In hopes of making profits.  They invest in capital to make those profits.  And then use those profits to invest in capital.  It works because there is a direct relationship between risk and profits.  It’s why people take risks.  Create jobs.  And provide the things we need and enjoy.  Because with risk there’s reward.  And accounting reports that fairly state business operations give a business’ management the tools to be profitable.  By matching costs to revenue.  Telling them when they are not using their capital efficiently.  Helping them to stay profitable.  (Unlike anything the government runs.  Because there is no matching of costs to revenue.  Taxes come into the treasury and the treasury pays for a multitude of things.  With no way to know if they are using those taxes efficiently).  And this is capitalism.  Risk and reward.  And accountability.  For when you’re risking your money you become very accountable.  Which is why capitalism works .  And government-run entities don’t.

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