One of the most basic principles in business is that it is important to be able to compare profitability and productivity for different products, different services, and different companies. This is true whether you are an accountant, a manager, or just a shareholder. You want to know whether your investments are paying off. You want to know which of your products or services are most profitable. And you want to know whether the company you work for is doing a good job.
A CEO was talking to his accountant. “How’s business?” he asked.
“Great,” said the accountant, “we’re making tons of money!”
“Great,” said the CEO, “what are you going to do with it?”
“I’m going to put it in a bank,” said the accountant.
“What for?” asked the CEO. “So they can lend it back to us at interest?
What kind of business is that?
Actually this story is not about banking but about information theory. In order to make good decisions about how to invest, a company needs to have good information about what its return on investment is likely to be. Banks are in a position to know how much each potential borrower can pay back; companies are in a similar position with regard to their own investments. But if a company has no idea what its return on investment is going to be, then any financial data it sees will just seem random, and it won’t have any way of making informed decisions.
Since we generally can’t get financial data from other companies, we have to get it from the companies themselves.
But even when they give it to us, we can’t tell how reliable it is. In fact, business data has been called “the greatest lie ever told.” That’s because the people who make the numbers aren’t telling us everything they know about them. And what they’re not telling us may be more important than what they are telling us. Here’s an example:
An accountant acquaintance of mine has an expression: “If you can’t follow the money, you don’t know what’s going on.” The point is that if you don’t know how money is flowing in a business, you can’t tell whether it’s working or failing. It’s not safe to use your own money to try something new if you can’t see how it affects other parts of your business. And it’s not safe to use other people’s money—investment capital—if you can’t see whether it makes sense for them either.
Usually, companies’ financial statements are prepared by accountants. Accountants are not always neutral parties. Depending on who hires them, they may be working for the company or for the shareholders. How can you tell?
For one thing, the job of an accountant is to produce reliable financial statements, which means that they have to follow certain rules that are designed to give you information about whether or not the company is successfully generating wealth. If the accountant has different priorities than producing reliable financial statements, you’ll know it.
A more subtle difference between an accountant hired by shareholders and one hired by management is that an accountant hired by shareholders will ask tougher questions than one hired by management. Management’s job is to maximize profits; if profits are rising, management doesn’t care whether profits would have risen higher if the CEO had been replaced with a monkey. But if profits are rising because someone is cooking the books, shareholders want to know about it.
Financial statements are supposed to give you information about whether or not managers are cooking the books. This isn’t easy; even when managers aren’t intentionally cooking the books, they can still do it inadvertently because they don’t understand what their organizations do well and what they do poorly. But accountants who work for shareholders have a stronger incentive
There’s a reason for this. The numbers are about the business, but the business is not just the numbers. The numbers are like a map; they tell you where you are, but not how to get where you want to go.
It’s like owning a car with no gas gauge, or one that can only read “F.” You know how much fuel you have, but only if you stop and look. And even then it’s hard to be sure; maybe there’s a leak somewhere, or maybe the needle is stuck.
And once you start driving, if you don’t know exactly how many miles per gallon your car gets, you might run out of gas without realizing it. Maybe your trip will take longer than you thought; maybe there’s traffic; maybe something else will come up. If running out of gas means getting stuck by the side of the road, or even crashing into something, it matters whether your car runs out at 60 miles or 70 miles or 80 miles per gallon. But if all you care about is getting from point A to point B as cheaply as possible, without factoring in time and other costs such as wear and tear on your car, then fuel efficiency doesn’t matter much.
I remember my family friend’s first job as a financial analyst at a publicly-owned company. He had been hired straight out of college and was excited to finally have access to the data he had only been able to see at my old employer, which was private.
His enthusiasm quickly turned to dismay. The financial statements looked nothing like the ones he had grown accustomed to seeing in the private sector. He soon verified that the company had been following a common but ill-advised practice of classifying all operating expenditures as assets or liabilities, regardless of whether they were intended to be used for more than one year. This allowed them to make their balance sheet look better, since they could record high revenues but low costs at the same time.
He was able to identify some of this misclassification using simple ratios, such as cash flow from operations versus total assets. But it took him many months to figure out how much of the rest of the bad accounting was due simply to a lack of information about important decisions made outside his department. He couldn’t tell if a new building was an operating expense or a capital expenditure, or if a large amount of inventory was being kept on hand because it might be sold soon or because there wasn’t enough room in the warehouse for new shipments.