Sunday, February 8, 2009

Accounting Bitch #1

Occasionally, for the benefit of my non-business-educated readers, I will post on a specific element of business life that defies all logic, and thus creates endless frustration for me. For while at its root business, in all its creative and adaptive brilliance, is a beautiful phenomenon, there are parts of it that could drive an improperly equipped rational person insane. Naturally, most, if not all, of these stem from some kind of government influence, whether tax-, regulation-, or lawsuit-related. Needless to say, I doubt the well will ever run dry on this topic. So, without further ado...

Today's stupid business topic is accounting, and so is titled "Accounting Bitch #1." My first bitch with accounting is a general one. Accounting is "accrual-based" and not "cash-based." Allow me to explain. Most people think you record revenue when someone pays you for something and you record an expense when you pay someone for something. This might be true for some very small businesses, but any business that must report financial results must do so with an accrual-based method. The method is known as GAAP, or "Generally Accepted Accounting Principles." (This, of course, is a misnomer because GAAP consists more of rules than principles, and pretty much everyone hates them) These rules are enforced by the FASB, or Financial Accounting Standards Board, a "non-governmental" agency. I use quotes because once FASB has settled on standards, they are religiously enforced by a batallion of government bureaucrats.

GAAP has evolved over several decades, but today's bitch focuses on the fact that it uses "accrual-based" accounting, whereby revenues and expenses are recognized based on when they are earned, rather than on when cash is exchanged. In theory, there is not much wrong with this approach, and it makes sense in several industries. However, since the rules are enshrined in regulatory stone, all accrual-based accounting does is offer companies legal ways to obfuscate their results. Cash is cash, and it is impossible, without committing fraud, to be misleading about how much cash has come in or gone out, and how much sits in the company coffers. As an example of how accrual-based accounting can be misused, consider that Enron recorded millions of dollars in revenue on unsure projects that had not brought in a dime. Such a practice was completely legal, however, because they had secured the contract. That cash never came in, by the way.

Accounting is a necessary component of capitalism. It is the language of business, the common understanding that enables those with capital to find those with initiative and to create profitable ventures. The more the accounting system loses objectivity (it's been on a steady decline and has been accelerating recently) the more stagnant our economy will become because investors will not trust the numbers they are presented.

Ideally, accounting would be a privately designed system (or competing systems) for keeping track of assets, liabilities, revenues, and expenses. Short of privatization, the government should at least adopt a cash-based system and junk FASB's accrual-based nightmare. More on this in my next accounting bitch: Mark-to-Market rules


  1. It's fascinating to see just how irrational people are when it comes to, well, anything, but business in particular. Thank you for providing real life examples of how people majorly suck :)

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  3. - This comment is from Mitchell Blatt, just so you know. -

    Yeah, but accrual based accounting works better in some instances. For example, if I sell an ad for a year on my blog, I get paid all at once, but the revenue is really earned over a 12 year period.

    And as for accounting being a privately designed system... That would just make it be very inconsistent and manipulated. Every company could inflate their assets like Enron and there wouldn't be anything to stop them, then investors would get screwed.

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