Description
Please be reminded – this project is to be done as a regular paper, with a header page – PLEASE DO NOT USE MEMO FORMATIn this one, this assignment is analyzing the SECOND company you have chosen in the industry of choice. (Second company: Toyota Motor Credit Corp 10-k file attached)Prepare a three-page analysis (the header/title page and the references page are NOT included in the count of pages) where you describe the following for the FIRST company you have selected:1. Examine and describe how the company makes money and when revenue is recognized. Is it clear to you how the company makes money?2. Find one interesting thing that you did not know about the company that is related to a specific line item on the income statement or the balance sheet. Start by identifying something that you think is unusual on the income statement or balance sheet (maybe one line item has variations in balances from year to year, or you see in one year a balance that is much higher than in other years). Seek the answer to this anomaly in the SEC 10-K report. Assess what you researched, why you researched it, and what you found out
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m an agem ent
berman
knight
case
Praise for the first edition of Financial Intelligence
revised
edition
“It’s like The Elements of Style of finance.”
—CFO.com
founders of the Los Angeles–based Business
Literacy Institute. They train managers and
leaders at organizations such as Electronic
Arts, Goodrich, Gulfstream, and Visa. They
have been interviewed in a wide range of
media including the Wall Street Journal,
Inc. magazine, and businessweek.com.
To learn more, visit
financialintelligencebook.com
“[One of ] the best, clearest guides to the numbers that I know of.”
—Inc. magazine
“On any given subject, it’s safe to say that most people don’t know
what they’re talking about. That goes double for finance and accounting,
a subject that leaves many nonprofessionals trembling.
Take pity, and give them a copy of Financial Intelligence.”
—Accounting Today
“There is no shortage of books explaining the financial aspects of a company,
but I have not come across one as useful as this for support people.
Rather than simply presenting the usual basics of financial measurement—
the income statement, balance sheet, and cash flow statement—
as if they were science, the authors show why these are art as well.”
—The Times (South Africa)
“Authors Karen Berman and Joe Knight don’t want to turn
managers into accountants; they just want managers
at all levels to become financially literate.”
Financial Intelligence
karen berman and joseph knight are the
US $27.00 / CAN $30.00
revised
edition
harvard business review press
Financial
Intelligence
A Manager’s Guide to Knowing
What the Numbers Really Mean
Inc. magazine calls it one of “the best,
clearest guides to the numbers” on the
market. Since its original release,
Financial Intelligence has become a favorite
among leaders and managers who need a
guided tour through financial statements
and financial concepts and analysis—an
explanation not only of what it all really
means, but also why it matters.
This new updated edition brings the data
up to date and continues to teach the basics
of finance, and its art, to anyone who ever
wanted to “talk numbers” confidently with
their colleagues. It also addresses issues
that have become even more important in
recent years—including questions about
the financial crisis and those concerning
broader financial and accounting literacy.
Accessible, jargon-free, and filled with
entertaining stories of real companies,
Financial Intelligence gives nonfinancial
managers and leaders the confidence
to understand the nuance beyond the
numbers—and helps bring everyday
work to a new level.
You’ll learn about:
Who the financial players are in your
organization and what they do
—HR Magazine
The many peculiarities of the income
statement
The basics of balance sheets
The particulars of return on investment
and how to calculate it
jac k e t d e s ig n: s tephani finks
Stay informed. Join the discussion.
Visit hbr.org/books
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ISBN-13: 978-1-4221-4411-4
90000
hbr.org/books
9 781422 144114
karen berman + joe knight With john case
Financial
Intelligence
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REVISED
EDITION
Financial
Intelligence
A Manager’s Guide to Knowing
What the Numbers Really Mean
KAREN BERMAN
JOE KNIGHT
with JOHN CASE
HAR VARD BUSINESS REVIEW PRESS
BOSTON, MASSACHUSETTS
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Copyright 2013 Business Literacy Institute, Inc.
All rights reserved
Printed in the United States of America
10 9 8 7 6 5 4 3 2 1
The web addresses referenced in this book were live and correct at the time of the book’s
publication but may be subject to change.
No part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form, or by any means (electronic, mechanical, photocopying,
recording, or otherwise), without the prior permission of the publisher. Requests for permission should be directed to [email protected], or mailed to Permissions,
Harvard Business School Publishing, 60 Harvard Way, Boston, Massachusetts 02163.
Library of Congress Cataloging-in-Publication Data
Berman, Karen, 1962–
Financial intelligence : a manager’s guide to knowing what the numbers really mean /
Karen Berman and Joe Knight ; with John Case. — 2nd ed., rev. and expanded.
p. cm.
ISBN 978-1-4221-4411-4 (alk. paper)
1. Financial statements. 2. Cash management. 3. Corporations—Finance.
I. Knight, Joe, 1963– II. Case, John, 1944– III. Title.
HG4028.B2B422 2013
658.15′11—dc23
2012039043
The paper used in this publication meets the minimum requirements of the American
National Standard for Information Sciences—Permanence of Paper for Printed Library
Materials, ANSI Z39.48-1992.
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Karen dedicates this book to her husband, her daughter,
and her circle of family and friends.
Joe dedicates this book to his wife, Donielle, and to the
seven Js—Jacob, Jordan, Jewel, Jessica,
James, Jonah, and Joseph Christian (JC).
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CONTENTS
Preface: What Is Financial Intelligence?
xi
PART ONE
THE ART OF FINANCE (AND WHY IT MATTERS)
1. You Can’t Always Trust the Numbers
3
2. Spotting Assumptions, Estimates, and Biases
10
3. Why Increase Your Financial Intelligence?
17
4. The Rules Accountants Follow—and
Why You Don’t Always Have To
26
Part One Toolbox:
Getting What You Want; The Players and What
They Do; Reporting Obligations of Public Companies
36
PART TWO
THE (MANY) PECULIARITIES OF THE INCOME STATEMENT
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5. Profit Is an Estimate
43
6. Cracking the Code of the Income Statement
48
7. Revenue: The Issue Is Recognition
56
8. Costs and Expenses: No Hard-and-Fast Rules
63
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viii
Contents
9. The Many Forms of Profit
Part Two Toolbox:
Understanding Variance; Profit at Nonprofits;
A Quick Review: “Percent of ” and “Percent Change”
75
83
PART THREE
THE BALANCE SHEET REVEALS THE MOST
10. Understanding Balance Sheet Basics
89
11. Assets: More Estimates and Assumptions (Except for Cash)
95
12. On the Other Side: Liabilities and Equity
106
13. Why the Balance Sheet Balances
111
14. The Income Statement Affects the Balance Sheet
114
Part Three Toolbox:
Expense? Or Capital Expenditure?;
The Impact of Mark-to-Market Accounting
119
PART FOUR
CASH IS KING
15. Cash Is a Reality Check
125
16. Profit ≠ Cash (and You Need Both)
129
17. The Language of Cash Flow
135
18. How Cash Connects with Everything Else
139
19. Why Cash Matters
148
Part Four Toolbox:
Free Cash Flow; Even the Big Guys Can Run Out of Cash
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152
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ix
Contents
PART FIVE
RATIOS: LEARNING WHAT THE NUMBERS ARE REALLY TELLING YOU
20. The Power of Ratios
157
21. Profitability Ratios: The Higher the Better (Mostly)
164
22. Leverage Ratios: The Balancing Act
172
23. Liquidity Ratios: Can We Pay Our Bills?
176
24. Efficiency Ratios: Making the Most of Your Assets
179
25. The Investor’s Perspective: The “Big Five” Numbers
and Shareholder Value
185
Part Five Toolbox:
Which Ratios Are Most Important to Your Business?;
The Power of Percent of Sales; Ratio Relationships;
Different Companies, Different Calculations
191
PART SIX
HOW TO CALCULATE (AND REALLY UNDERSTAND) RETURN ON INVESTMENT
26. The Building Blocks of ROI
197
27. Figuring ROI: The Nitty-Gritty
203
Part Six Toolbox:
A Step-by-Step Guide to Analyzing Capital Expenditures;
Calculating the Cost of Capital; Economic Value Added
and Economic Profit—Putting It All Together
216
PART SEVEN
APPLIED FINANCIAL INTELLIGENCE: WORKING CAPITAL MANAGEMENT
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28. The Magic of Managing the Balance Sheet
225
29. Your Balance Sheet Levers
229
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x
Contents
30. Homing In on Cash Conversion
234
Part Seven Toolbox:
Accounts Receivable Aging
239
PART EIGHT
CREATING A FINANCIALLY INTELLIGENT COMPANY
31. Financial Literacy and Corporate Performance
243
32. Financial Literacy Strategies
249
33. Financial Transparency: Our Ultimate Goal
257
Part Eight Toolbox:
Understanding Sarbanes-Oxley
Appendix: Sample Financials
Notes
Acknowledgments
Index
About the Authors
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259
261
265
267
271
285
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P R E FA C E
WHAT IS FINANCIAL INTELLIGENCE?
We have worked with thousands of employees, managers, and leaders in
companies all over the world, teaching them about the financial side of
business. Our philosophy is that everyone in a company does better when
they understand how financial success is measured and how they have an
impact on the company’s performance. Our term for that understanding
is financial intelligence. Greater financial intelligence, we’ve learned, helps
people feel more committed and involved. They understand better what
they are a part of, what the organization is trying to achieve, and how they
affect results. Trust increases, turnover decreases, and financial results
improve.
We came to this philosophy by different routes. Karen took the academic path. Her PhD dissertation focused on the question of whether information sharing and financial understanding on the part of employees
and managers positively affects a company’s financial performance. (It
does.) Karen went on to become a financial trainer and started an organization, the Business Literacy Institute, devoted to helping others learn
about finance. Joe earned an MBA in finance, but most of his experience
with financial training in organizations has been on the practical side. After stints at Ford Motor Company and several small companies, he joined a
start-up business, Setpoint Systems and Setpoint Inc., which manufactures
roller coasters and factory-automation equipment. As chief financial officer (CFO) and owner of Setpoint, he learned firsthand the importance
of training engineers and other employees in how the business worked.
In 2003 Joe joined Karen as co-owner of the Business Literacy Institute
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Preface
and since then has worked with dozens of companies, facilitating financial
intelligence courses.
What do we mean by financial intelligence? It isn’t some innate ability that you either have or don’t have. Granted, some people are better at
numbers than others, and a few legendary folks seem to have an intuitive
grasp of finance that eludes the rest of us. But that’s not what we’re talking about here. For most businesspeople—ourselves included—financial
intelligence is no more than a set of skills that can be learned. People who
work in finance acquire these skills early on, and for the rest of their careers
are able to talk with one another in a specialized language that can sound
like Greek to the uninitiated. Most senior executives (not all) either come
out of finance or pick up the skills during their rise to the top, just because
it’s tough to run a business unless you know what the financial folks are
saying. Managers who don’t work in finance, however, too often have been
out of luck. They never picked up the skills, and so in some ways they’ve
been relegated to the sidelines.
Fundamentally, financial intelligence boils down to four distinct skill
sets, and when you finish the book, you should be competent in all of
them. They are:
• Understanding the foundation. Managers who are financially intelligent understand the basics of financial measurement. They can read
an income statement, a balance sheet, and a cash flow statement. They
know the difference between profit and cash. They understand why the
balance sheet balances. The numbers neither scare nor mystify them.
• Understanding the art. Finance and accounting are an art as well as
a science. The two disciplines must try to quantify what can’t always
be quantified, and so must rely on rules, estimates, and assumptions.
Financially intelligent managers are able to identify where the artful
aspects of finance have been applied to the numbers, and they know
how applying them differently might lead to different conclusions.
They thus are prepared to question and challenge the numbers when
appropriate.
• Understanding analysis. Once you have the foundation and an appreciation of the art of finance, you can use the information to analyze
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xiii
Preface
the numbers in greater depth. Financially intelligent managers don’t
shrink from ratios, return on investment (ROI) analysis, and the like.
They use these analyses to inform their decisions, and they make better decisions for doing so.
• Understanding the big picture. Finally, although we teach finance, and
although we think that everyone should understand the numbers side
of business, we are equally firm in our belief that numbers can’t and
don’t tell the whole story. A business’s financial results must always
be understood in context—that is, within the framework of the big
picture. Factors such as the economy, the competitive environment,
regulations, changing customer needs and expectations, and new
technologies all affect how you should interpret numbers and make
decisions.
But financial intelligence doesn’t stop with book learning. Like most
disciplines and skill sets, it must not only be learned, it must also be practiced and applied. On the practical side, we hope and expect the book will
prepare you to take actions such as the following:
• Speak the language. Finance is the language of business. Whether
you like it or not, the one thing every organization has in common
is numbers and how those numbers are tabulated, analyzed, and
reported. You need to use the language to be taken seriously and to
communicate effectively. As with any new language, you can’t expect
to speak it fluently at first. Never mind—jump in and try something.
You’ll gain confidence as you go.
• Ask questions. We want you to look at financial reports and analysis
with a questioning eye. It’s not that we think anything is necessarily
wrong with the numbers you see. We merely believe it is tremendously
important to understand the what, why, and how of the numbers
you are using to make decisions. Since every company is different,
sometimes the only way to figure out all those parameters is to ask
questions.
• Use the information in your job. After reading this book, you should
know a lot. So use it! Use it to improve cash flow. Use it to analyze the
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xiv
Preface
next big project. Use it to assess your company’s results. Your job will
be more fun, and your impact on the company’s performance will be
greater. From our vantage point, we love to see employees, managers,
and leaders who can see the link between financial results and their
job. Suddenly, they seem to have a better idea of why they are carrying
out a particular set of tasks.
Why This Second Edition?
Financial concepts don’t change much from one year to the next, or even
from one decade to the next. The fundamental concepts and ideas we discussed in the first edition of this book, published in 2006, are exactly the
same in the current edition. But there are good reasons for presenting you
with this revised and expanded version of the original text.
For one thing, the financial landscape has changed—and in a big way.
Since the first edition of Financial Intelligence appeared, the world underwent a major crisis directly related to our topic. Suddenly more people
than ever were talking about balance sheets, mark-to-market accounting,
and liquidity ratios. The crisis also changed what was discussed inside
companies: how the company was doing financially, how it could best be
evaluated, and what financial issues managers and employees as individuals needed to consider.
To help facilitate these conversations, we added many new subjects, including the following:
• A chapter on GAAP versus non-GAAP numbers. Today, many companies are reporting both GAAP and non-GAAP results. (You can find
out what GAAP and non-GAAP numbers are, and why they matter, in
chapter 4.)
• A chapter (chapter 25) that examines how the marketplace evaluates
companies. The financial crisis, like other bubbles and meltdowns,
provided new insights into which measures are most (and least) helpful in understanding a company’s financial performance.
• Lots of additional information about return on investment (ROI),
including a section on the profitability index, a discussion of cost of
capital, and an example of ROI analysis.
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xv
Preface
We also gathered up feedback from the thousands of people around the
world who read the book, and from our clients who used it in their training
classes. Thanks to that feedback, we have added several new concepts, such
as contribution margin, the impact of exchange rates on profitability, and
economic value added (EVA). We discuss bookings and backlog, deferred
revenue, and return on net assets, or RONA. We think you’ll find the book
more useful as a result.
Finally, we added additional information about how to increase financial intelligence throughout your company. In our training business, we
work with many companies, including dozens in the Fortune 500, who see
this as a necessary part of employee, manager, and leader education.
So this book will support the development of your financial intelligence.
We hope readers will find our experience and advice valuable. We hope it
will enable you to achieve greater success, both personally and professionally. We hope it helps your company be more successful as well. But most
of all, we think, after reading this book, you’ll be just a bit more motivated,
a bit more interested, and a bit more excited to understand a whole new
aspect of business.
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Part One
The Art of Finance
(and Why It Matters)
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1
You Can’t Always Trust
the Numbers
I
F Y O U R E A D T H E N EW S R EG U L A R LY, 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. They sequester
some of their properties and debts in a mysterious place known as off balance sheet. 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 course—but not until the following quarter.) Other techniques are complex to the point of near-incomprehensibility. (Remember
Enron? It took years for accountants and prosecutors to sort out all of that
ill-fated company’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
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4
THE ART OF FINANCE
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. A while ago, the Wall Street Journal ran a front-page story on how
companies fatten their bottom lines by reducing retirees’ benefit accruals—
even though they may not spend a nickel less on those benefits.
Anybody who isn’t a financial professional is likely to greet such maneuvers with a certain amount of mystification. Everything else in business—
marketing, research and development, human resource management,
strategy formulation, and so on—is 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
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5
You Can’t Always Trust the Numbers
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 means
that the accountants and financial folks are trying to cook the books or
that they are incompetent. The complications arise because they 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 accountants—
no, really—and 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, depending on the
background or experience of the people who compiled and interpreted
them. 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. Armed with the information you gather, you can
make informed, well-considered decisions.
Box Definitions
We want to make finance as easy as possible. Most finance books make us flip
back and forth between the page we’re on and the glossary to learn the definition
of a word we don’t know. By the time we find it and get back to our page, we’ve
lost our train of thought. So here, we are going to give you the definitions right
where you need them, next to the first time we use the word.
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THE ART OF FINANCE
JUDGMENT CALLS
For example, let’s look at one of the variables that is frequently estimated—
one 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 7, 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?” is a hot topic in many fraud cases.
According to a 2007 study by the Deloitte Forensic Center, 41 percent of
fraud cases pursued by the Securities and Exchange Commission between
2000 and 2006 involved revenue recognition.1
Income Statement
The income statement shows revenues, expenses, and profit for a period of time,
such as a month, quarter, or year. It’s also called a profit and loss statement,
P&L, statement of earnings, or statement of operations. Sometimes the word
consolidated is thrown in front of those phrases, but it’s still just an income
statement. The bottom line of the income statement is net profit, also known as
net income or net earnings.
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7
You Can’t Always Trust the Numbers
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 several
years ago 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 at the time decided to book ever-increasing percentages
of the anticipated revenues—along with the associated profits—up 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 finance—and another one that
often plays a role in financial scandals—is determining whether a given
Operating Expenses
Operating expenses are the costs required to keep the business going from day
to day. They include salaries, benefits, and insurance costs, among a host of
other items. Operating expenses are listed on the income statement and are
subtracted from revenue to determine profit.
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8
THE ART OF FINANCE
cost is a capital expenditure or an operating expense. (The Deloitte study
notes that this issue accounted for 11 percent of fraud cases between 2000
and 2006.) 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—
the big telecommunications company that went bankrupt in 2002—into so
much trouble (see the part 3 toolbox for details). 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
matters—or your boss does—based 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 uncontroversial—and
Capital Expenditures
A capital expenditure is the purchase of an item that’s considered a long-term
investment, such as computer systems and equipment. Most companies follow
the rule that any purchase over a certain dollar amount counts as a capital expenditure, while anything less is an operating expense. Operating expenses show
up on the income statement, and thus reduce profit. Capital expenditures show
up on the balance sheet; only the depreciation of a piece of capital equipment
appears on the income statement. More on this in chapters 5 and 11.
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9
You Can’t Always Trust the Numbers
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
know what they’re looking at or why, you are at their mercy.
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2
Spotting Assumptions,
Estimates, and Biases
S
O LET ’ S PL U N G E A L I T T L E D E E P E R into this element of financial intelli-
gence—understanding the “artistic” aspects of finance. Even though
you’re just at the beginning of the book, this will give you a valuable
perspective on the concepts and practices that you’ll learn later on. We’ll
look at three examples and ask some simple but critical questions:
• What were the assumptions in this number?
• Are there any estimates in the numbers?
• What is the bias those assumptions and estimates lead to?
• What are the implications?
The examples we’ll look at are accruals, depreciation, and valuation.
If these words sound like part of that strange language the financial folks
speak, don’t worry. You’ll be surprised how quickly you can pick up enough
to get around.
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11
Spotting Assumptions, Estimates, and Biases
ACCRUALS AND ALLOCATIONS:
LOTS OF ASSUMPTIONS AND ESTIMATES
At a certain time every month, you know that your company’s controller
is busy “closing the books.” Here, too, is a financial puzzle: Why on earth
does it take as long as it does? If you haven’t worked in finance, you might
think it could take a day to add up all the end-of-the-month figures. But
two or three weeks?
Well, one step that takes a lot of time is figuring out all the accruals
and allocations. There’s no need to understand the details now—we’ll get
to that in chapters 11 and 12. For the moment, read the definitions in the
boxes and focus on the fact that the accountants use accruals and allocations to try to create an accurate picture of the business for the month.
After all, it doesn’t help anybody if the financial reports don’t tell us how
much it cost us to produce the products and services we sold last month.
That is what the controller’s staff is trying so hard to do, and that is one
reason why it takes as long as it does.
Determining accruals and allocations nearly always entails making assumptions and estimates. Take your salary as an example. Say that you
worked in June on a new product line and that the new line was introduced in July. Now the accountant determining the allocations has to estimate how much of your salary should be matched to the product cost
(because you spent much of your time on those initial products) and how
much should be charged to development costs (because you also worked
on the original development of the product). She must also decide how
to acc
