How to Speak Accountant

Editor's Note: This article is the first installment in an ongoing series focusing on accounting and financial matters relevant to corporate counsel.

Corporate law is a team-oriented activity. Too often, a team of very talented lawyers, accountants, operations managers, and sales managers is assembled but doesn't gel. The reason is often that they misunderstand each other ' they come in with different underlying assumptions, different perspectives, and even different definitions of the same words or terms. Communication suffers and valuable information does not get adequately conveyed to all team members.

Adequate communication within the team is critical. Today's business cycle is short, unpredictable, and fierce. To survive, you must understand your business dynamics ' the key drivers, the relationships, the timing and flow, and the causes and effects.

Accounting is the score-keeping mechanism within your company. This is the first in a series of articles that will help you understand your business better by discussing how accounting information is prepared, how to determine the assumptions and biases underlying the numbers, how to determine what the numbers in front of you mean, and what to do with them once you have them.

Financial statements and other financial information are key pieces of data that fuel an overall thought process, the end result of which is to identify business strengths and problems, predict what may occur in regards to that business, make and execute decisions, and then begin evaluating again.

The Language of Accounting

Most professionals speak in their own language. Arguably the most frustrating language of all in the business tower of babble is that of the accountants and financial people. Nobody feels stupid asking a doctor to translate his diagnosis into English or a lawyer to describe the section of code she just referenced. Finance can be intimidating because it expresses thoughts numerically instead of in words.

Accountants present their numbers in the “generally accepted” format and mistakenly think that makes them generally understood. That attitude in turn often prevents others in the organization from asking the questions that need to be asked in order to understand what the numbers are communicating. It doesn't have to be that way. With a little bit of guidance, anybody with a basic understanding of business can understand financial statements and other financial information.

Numbers are a symbolic representation of thought, just as words and sentences are. Numbers in business share the following characteristics:

• Numbers are all driven by the activity in the business. The preparation of financial information is an iterative process ' the numbers on the financial statements are one way of measuring what is happening in a company (as are discussions with employees, surveying customers, physical measures, etc.). These measurements should be used to help influence further activity in the business, which will in turn influence future financial statements. Numbers cannot exist independently of the factors that are driving them, and are not an end in themselves.
• Financial information is presented in standard formats ' Balance Sheets, Income Statements, Statements of Cash Flow, etc. Usually there are notes and management discussions to further elaborate on important components of the statements.
• Numbers on the financial statements got there via an accounting system. Every accounting system has strengths and limitations that influence and determine the quality and usefulness of the information presented on the financial statements. The system of internal controls over the accounting system also influences the quality of the information presented, as well as the susceptibility to fraud or unintentional misstatements.
• There are many ways to analyze the numbers on financial statements, including ratio analysis, trend analysis, horizontal analysis, vertical analysis, variance analysis, common-size analysis, etc. These are all just shorthand for different patterns of thought. A good analysis will raise a lot of questions and indications of what to further investigate in terms of what is driving the numbers to be what they are.
• There are many different uses for the same sets of financial statements. These include making investment decisions, paying taxes, diagnosing and solving problems, settling legal disputes, finding fraud, raising capital, etc.

The Big Picture

It is important to understand both the basics about business cycles and how financial statements reflect a business cycle. A company starts by incurring costs and acquiring assets. From there it generates revenue and incurs the necessary expenses that need to be spent to realize those revenues. Revenues beget more assets and expenses beget liabilities. Ultimately the assets, the revenue-generating capability, the accumulated equity, etc. become value.

Before exploring financial statements in more detail, it is important to understand each of the terms in the diagram below.

Assets

An asset is an item or resource with economic value. It has value because it can ultimately be converted to cash. Assets can be tangible or intangible, and the value of a specific asset can be different based on different situations or uses (valuation issues will be discussed in future installments). Assets are also classified into current or long-term, depending on how soon they are likely to be converted to cash.

Costs

Costs are a measure of effort, material, resources, time, risks incurred, opportunity forgone, and other trade-offs made in order to get something. If the cost has measurable monetary value that satisfies accounting criteria, it will be classified as either an asset or an expense, depending on its useful life, its amount, and other factors. Some costs are very real and may ultimately produce value, but do not qualify for inclusion in financial statements ' an example would be the uncompensated time spent writing articles.

A business incurs costs before it can generate revenue. Before a lawyer can hang her shingle and begin taking money from clients, she has incurred the costs of her education which include her tuition, the forgone time that she could have spent earning money at another job, etc. The costs that are incurred will hopefully generate revenue.

Revenue

Revenue (also known as “sales”) is the dollar amount that a customer pays for goods or services provided as the result of a transaction. Inherited money, gifts, and money found on the sidewalk are all wonderful things but they are not revenue. “Revenue recognition” refers to the time when accountants determine that revenue has been earned.

Recognition depends not only on having a high likelihood of being paid, but also on when the goods have been delivered or the services have been provided. This not as straightforward as it seems. Some companies recognize revenue when their customer pays for the goods, some when the customer receives the goods, some when the goods are first shipped, some when the goods are merely moved from one part of the warehouse to another, and some when the customer simply signs a contract to buy the goods.

Expenses

Expenses are costs incurred in the effort to generate revenue. The effort doesn't have to be successful. Whether an expenditure qualifies as an expense of your business is dependent on the nature of the business. A new pair of skates is a business expense to a person in the business of selling hockey lessons, but not to a person in the business of printing signs. Every cost of doing business resulting in revenue-generating activities generates either an asset or an expense.

The difference between an asset and an expense is often a function of time (expected life) and amount (significant or not) ' an umbrella is an expense because the amount is small and the useful life is short, whereas a new roof is most likely an asset.

Liabilities

Liabilities are obligations to pay money, goods, or services to someone else. Examples include accounts payable, taxes, accrued expenses, and deposits being held. Liabilities can be contingent (e.g., one associated with a pending lawsuit) but they do not get put on financial statements unless they are the result of a transaction or past event and there is some certainty as to their amount. Liabilities most often are the result of costs that have been incurred but not yet paid for.

Equity

On a Statement of Profit and Loss, the difference between the revenues recognized and the expenses incurred in realizing those revenues is profit, or “net income.” On the Balance Sheet, the difference between assets and liabilities is equity. Equity can also be calculated independently of assets and liabilities by taking the net capital contributions of the owners and adding (subtracting) the cumulative net income (losses). Equity is where it all comes together.

In simpler times when the dollar was stable, assets were mostly tangible, transactions were straightforward, and the amounts of liabilities were easy to determine, Equity was also called “Book Value.” This was the first and often only place an investor or judge went when he wanted to know the value of a company.

In today's more complex world of intangible assets, volatile markets, political uncertainty, technological change, creative transaction structures, complicated tax and legal environment, etc. financial statements at best provide hints at the estimation of a company's performance, health, and value. To really know a company, you have to get into the guts of the assumptions and processes used to generate its financial statements.

The Pixels Within the Big Picture

According to Wikipedia, a “pixel” is the smallest addressable element in a digital picture. Other arrangements of pixels are also possible, with some sampling patterns even changing the shape of each pixel across the image”

Each of a business' many transactions or activities gets classified as one of those elements ' assets, revenues, expenses, liabilities, etc. Just like pixels, the same transaction can have very different looks depending on the context ' an expense in one company may be an asset in another, for example, or the exact same asset can be carried at very different values in two different companies. Just like a digital photograph needs rules on how to display the pixels, accounting has rules on how to handle the different transactions that occur. It is important to understand the concepts that provide the context for all financial statements.

Financial statements are usually prepared under Generally Accepted Accounting Principles, or GAAP. For non-public companies GAAP is not required if the basis of alternative presentation is disclosed. Some alternate basis of presentation is the Income Tax basis or the Cash Basis. Statements prepared under the Income Tax Basis use the accounting regulations determined by the IRS, while statements prepared under GAAP use the conceptual framework determined by the American financial community. Cash Basis statements are prepared like a giant bank ledger, tracking nothing but the cash that flowed in and the cash that flowed out. There can be very significant differences between each of these different basis of presentation.

The basic tenets of GAAP are:

Reporting Entity

Accounting and financial statements cannot be commingled across entities ' each financial statement has to purely represent a single entity. Financial statements of numerous related entities often get consolidated together, but at bedrock every economic entity has its own set of financial statements.

Reporting Period

Every financial statement is prepared for a defined reporting period, typically a month, quarter, or year. Balance Sheets have an “as of” date ' the date at which the assets and liabilities are tabulated. Income Statements represent profit and loss activities for a specified period of time, such as “the year ending 12/31/11.” This sounds simple, but there are actually different definitions of common terms such as “year” or “month”; some companies report their financial results based on a 52-week year rather than on a calendar year, or use a 4-5-4 quarterly calendar, where two of the months consist of four weeks each and the middle month of the quarter is a five-week “month.”

Going Concern

Financial statements assume that the entity will continue normal operations for at least another year. Remember, that one of the key differences between an asset and an expense is the useful remaining life of the expenditure ' if it will last less than a year it is an expense, if more than a year it is probably an asset. If the entire entity isn't likely to survive the year, all of its assets will probably end up in the liquidation heap for far less than they cost, so continuing to report them at the higher value would be misleading. This is why when companies are not in compliance on their loan agreements either the bank needs to waive the breach, or it needs to be resolved. Until the threat of foreclosure and liquidation passes, the company cannot be considered a going concern and the balance sheet will need to be revalued from its current state.

In order to measure something, you need a unit of measure. Units of measure must be objective and consistent in order for them to have any meaning. Unless we are in a period of severe inflation or currency upheaval, the dollar is generally considered to be an acceptable unit of measure.

Historical Cost

Historical cost is the amount of dollars that were actually paid for an item. A building bought for $1 million 20 years ago may have a liquidation (fire sale) value today of $700,000, a replacement cost (if you had to rebuild it) value of $3 million, and a market value (what you could receive in an unhurried arms-length transaction) of $2 million. The only truly objective measure of value is what you paid for the item ' in this case, $1 million (less the 20 years of accumulated depreciation). It doesn't matter that neither the amount you paid 20 years ago nor the rate at which you've been depreciating the building have any economic relation to anything going on today. Objectivity is what is important, and historical cost is considered the most objective standard.

There are exceptions to the Historical Cost principle. When the market value of an asset declines below its cost, the value should be written down to the Lower of Cost or Market. This is a one-way street ' if the value increases, it cannot be written back up on the statements. Some investment assets may be continually marked to market price, depending on the business reason for holding the asset and the type of business holding it. All deviations from historical cost must be disclosed in the notes or other disclosures required for GAAP financial statements.

Consistency

While different companies in the same industry may apply very different accounting methods, fit is essential that an individual entity applies the same accounting methods consistently in all of its similar transactions.

Matching

Under GAAP, revenue and all of its related costs must be reported in the same time period. For example, a company's employees are entitled to earn bonus and vacation time as they work. A company that is at its seasonal peak may not allow vacations to be taken during the period being reported on, but is required to accrue the cost of those vacations as they are earned. This is different from the Cash Basis of accounting, where no accruals are made and the entire expense of the vacations and bonus is realized when they are paid. Under the Income Tax Basis, you may end up with a third result, depending on whether the employees are owners or “highly compensated” and how soon after the close of the accounting year the obligations are paid.

The GAAP requirement to match related costs and revenues makes the Profit and Loss Statement more usable, but often leads to accrued liabilities, pre-paid expenses, deferred revenues, and other unnatural items on the entity's balance sheet. For example, if you pay your insurance policy once a year at the beginning of the year, this becomes a pre-paid expense that gets amortized each month until your insurance coverage expires.

Realization of Revenue

The realization of revenue principle is supposed to enforce consistency and objectivity, but is ripe for abuse. Under GAAP, revenue is not realized until an exchange has occurred and the earning process is virtually complete. At least some of the revenue is not allowed to be realized if there are significant contingencies, warranties, or other obligations still to be performed. Sometimes, special accounting rules such as the Percentage of Completion method may apply.

Many frauds, usually overstatement of revenue, are committed by tinkering with the definitions of the various terms that define Revenue Recognition. Some companies declare their product to be shipped when the product leaves the building, some when the shipping label is printed, and others when the product crosses a certain line in the warehouse. Determining what contingencies or what warranty obligations still exist can also be subjective. Understanding when revenue actually gets realized is an important element to understanding a company.

Other important concepts include: 1) Materiality ' defining how large an amount is to matter; 2) Objectivity ' two people looking at the same data would reach essentially the same result; 3) Conservatism ' when in doubt, choose the outcome least likely to overstate assets or income; and 4) Industry Practice ' it makes sense and is allowable for different industries to recognize those differences and have accounting practices that may be unique to them (but common among all companies in the industry).

Conclusion

Someone who has just read all of the above would be excused for thinking that accounting is objective, clear-cut, and simply a matter of following some rules that every accountant knows and agrees to. This is definitely not the case. Even simple precepts can become murky in their execution. Upcoming installments will delve into the financial statements to show how much subjectivity and leeway actually exists.

[IMGCAP(1)]

Michael Goldman, MBA, CPA, CVA, CFE, CFF, is principal of Michael Goldman and Associates, LLC in Deerfield, IL. He may be reached at [email protected].

Editor's Note: This article is the first installment in an ongoing series focusing on accounting and financial matters relevant to corporate counsel.

Corporate law is a team-oriented activity. Too often, a team of very talented lawyers, accountants, operations managers, and sales managers is assembled but doesn't gel. The reason is often that they misunderstand each other ' they come in with different underlying assumptions, different perspectives, and even different definitions of the same words or terms. Communication suffers and valuable information does not get adequately conveyed to all team members.

Adequate communication within the team is critical. Today's business cycle is short, unpredictable, and fierce. To survive, you must understand your business dynamics ' the key drivers, the relationships, the timing and flow, and the causes and effects.

Accounting is the score-keeping mechanism within your company. This is the first in a series of articles that will help you understand your business better by discussing how accounting information is prepared, how to determine the assumptions and biases underlying the numbers, how to determine what the numbers in front of you mean, and what to do with them once you have them.

Financial statements and other financial information are key pieces of data that fuel an overall thought process, the end result of which is to identify business strengths and problems, predict what may occur in regards to that business, make and execute decisions, and then begin evaluating again.

The Language of Accounting

Most professionals speak in their own language. Arguably the most frustrating language of all in the business tower of babble is that of the accountants and financial people. Nobody feels stupid asking a doctor to translate his diagnosis into English or a lawyer to describe the section of code she just referenced. Finance can be intimidating because it expresses thoughts numerically instead of in words.

Accountants present their numbers in the “generally accepted” format and mistakenly think that makes them generally understood. That attitude in turn often prevents others in the organization from asking the questions that need to be asked in order to understand what the numbers are communicating. It doesn't have to be that way. With a little bit of guidance, anybody with a basic understanding of business can understand financial statements and other financial information.

Numbers are a symbolic representation of thought, just as words and sentences are. Numbers in business share the following characteristics:

• Numbers are all driven by the activity in the business. The preparation of financial information is an iterative process ' the numbers on the financial statements are one way of measuring what is happening in a company (as are discussions with employees, surveying customers, physical measures, etc.). These measurements should be used to help influence further activity in the business, which will in turn influence future financial statements. Numbers cannot exist independently of the factors that are driving them, and are not an end in themselves.
• Financial information is presented in standard formats ' Balance Sheets, Income Statements, Statements of Cash Flow, etc. Usually there are notes and management discussions to further elaborate on important components of the statements.
• Numbers on the financial statements got there via an accounting system. Every accounting system has strengths and limitations that influence and determine the quality and usefulness of the information presented on the financial statements. The system of internal controls over the accounting system also influences the quality of the information presented, as well as the susceptibility to fraud or unintentional misstatements.
• There are many ways to analyze the numbers on financial statements, including ratio analysis, trend analysis, horizontal analysis, vertical analysis, variance analysis, common-size analysis, etc. These are all just shorthand for different patterns of thought. A good analysis will raise a lot of questions and indications of what to further investigate in terms of what is driving the numbers to be what they are.
• There are many different uses for the same sets of financial statements. These include making investment decisions, paying taxes, diagnosing and solving problems, settling legal disputes, finding fraud, raising capital, etc.

The Big Picture

It is important to understand both the basics about business cycles and how financial statements reflect a business cycle. A company starts by incurring costs and acquiring assets. From there it generates revenue and incurs the necessary expenses that need to be spent to realize those revenues. Revenues beget more assets and expenses beget liabilities. Ultimately the assets, the revenue-generating capability, the accumulated equity, etc. become value.

Before exploring financial statements in more detail, it is important to understand each of the terms in the diagram below.

Assets

An asset is an item or resource with economic value. It has value because it can ultimately be converted to cash. Assets can be tangible or intangible, and the value of a specific asset can be different based on different situations or uses (valuation issues will be discussed in future installments). Assets are also classified into current or long-term, depending on how soon they are likely to be converted to cash.

Costs

Costs are a measure of effort, material, resources, time, risks incurred, opportunity forgone, and other trade-offs made in order to get something. If the cost has measurable monetary value that satisfies accounting criteria, it will be classified as either an asset or an expense, depending on its useful life, its amount, and other factors. Some costs are very real and may ultimately produce value, but do not qualify for inclusion in financial statements ' an example would be the uncompensated time spent writing articles.

A business incurs costs before it can generate revenue. Before a lawyer can hang her shingle and begin taking money from clients, she has incurred the costs of her education which include her tuition, the forgone time that she could have spent earning money at another job, etc. The costs that are incurred will hopefully generate revenue.

Revenue

Revenue (also known as “sales”) is the dollar amount that a customer pays for goods or services provided as the result of a transaction. Inherited money, gifts, and money found on the sidewalk are all wonderful things but they are not revenue. “Revenue recognition” refers to the time when accountants determine that revenue has been earned.

Recognition depends not only on having a high likelihood of being paid, but also on when the goods have been delivered or the services have been provided. This not as straightforward as it seems. Some companies recognize revenue when their customer pays for the goods, some when the customer receives the goods, some when the goods are first shipped, some when the goods are merely moved from one part of the warehouse to another, and some when the customer simply signs a contract to buy the goods.

Expenses

Expenses are costs incurred in the effort to generate revenue. The effort doesn't have to be successful. Whether an expenditure qualifies as an expense of your business is dependent on the nature of the business. A new pair of skates is a business expense to a person in the business of selling hockey lessons, but not to a person in the business of printing signs. Every cost of doing business resulting in revenue-generating activities generates either an asset or an expense.

The difference between an asset and an expense is often a function of time (expected life) and amount (significant or not) ' an umbrella is an expense because the amount is small and the useful life is short, whereas a new roof is most likely an asset.

Liabilities

Liabilities are obligations to pay money, goods, or services to someone else. Examples include accounts payable, taxes, accrued expenses, and deposits being held. Liabilities can be contingent (e.g., one associated with a pending lawsuit) but they do not get put on financial statements unless they are the result of a transaction or past event and there is some certainty as to their amount. Liabilities most often are the result of costs that have been incurred but not yet paid for.

Equity

On a Statement of Profit and Loss, the difference between the revenues recognized and the expenses incurred in realizing those revenues is profit, or “net income.” On the Balance Sheet, the difference between assets and liabilities is equity. Equity can also be calculated independently of assets and liabilities by taking the net capital contributions of the owners and adding (subtracting) the cumulative net income (losses). Equity is where it all comes together.

In simpler times when the dollar was stable, assets were mostly tangible, transactions were straightforward, and the amounts of liabilities were easy to determine, Equity was also called “Book Value.” This was the first and often only place an investor or judge went when he wanted to know the value of a company.

In today's more complex world of intangible assets, volatile markets, political uncertainty, technological change, creative transaction structures, complicated tax and legal environment, etc. financial statements at best provide hints at the estimation of a company's performance, health, and value. To really know a company, you have to get into the guts of the assumptions and processes used to generate its financial statements.

The Pixels Within the Big Picture

According to Wikipedia, a “pixel” is the smallest addressable element in a digital picture. Other arrangements of pixels are also possible, with some sampling patterns even changing the shape of each pixel across the image”

Each of a business' many transactions or activities gets classified as one of those elements ' assets, revenues, expenses, liabilities, etc. Just like pixels, the same transaction can have very different looks depending on the context ' an expense in one company may be an asset in another, for example, or the exact same asset can be carried at very different values in two different companies. Just like a digital photograph needs rules on how to display the pixels, accounting has rules on how to handle the different transactions that occur. It is important to understand the concepts that provide the context for all financial statements.

Financial statements are usually prepared under Generally Accepted Accounting Principles, or GAAP. For non-public companies GAAP is not required if the basis of alternative presentation is disclosed. Some alternate basis of presentation is the Income Tax basis or the Cash Basis. Statements prepared under the Income Tax Basis use the accounting regulations determined by the IRS, while statements prepared under GAAP use the conceptual framework determined by the American financial community. Cash Basis statements are prepared like a giant bank ledger, tracking nothing but the cash that flowed in and the cash that flowed out. There can be very significant differences between each of these different basis of presentation.

The basic tenets of GAAP are:

Reporting Entity

Accounting and financial statements cannot be commingled across entities ' each financial statement has to purely represent a single entity. Financial statements of numerous related entities often get consolidated together, but at bedrock every economic entity has its own set of financial statements.

Reporting Period

Every financial statement is prepared for a defined reporting period, typically a month, quarter, or year. Balance Sheets have an “as of” date ' the date at which the assets and liabilities are tabulated. Income Statements represent profit and loss activities for a specified period of time, such as “the year ending 12/31/11.” This sounds simple, but there are actually different definitions of common terms such as “year” or “month”; some companies report their financial results based on a 52-week year rather than on a calendar year, or use a 4-5-4 quarterly calendar, where two of the months consist of four weeks each and the middle month of the quarter is a five-week “month.”

Going Concern

Financial statements assume that the entity will continue normal operations for at least another year. Remember, that one of the key differences between an asset and an expense is the useful remaining life of the expenditure ' if it will last less than a year it is an expense, if more than a year it is probably an asset. If the entire entity isn't likely to survive the year, all of its assets will probably end up in the liquidation heap for far less than they cost, so continuing to report them at the higher value would be misleading. This is why when companies are not in compliance on their loan agreements either the bank needs to waive the breach, or it needs to be resolved. Until the threat of foreclosure and liquidation passes, the company cannot be considered a going concern and the balance sheet will need to be revalued from its current state.

In order to measure something, you need a unit of measure. Units of measure must be objective and consistent in order for them to have any meaning. Unless we are in a period of severe inflation or currency upheaval, the dollar is generally considered to be an acceptable unit of measure.

Historical Cost

Historical cost is the amount of dollars that were actually paid for an item. A building bought for $1 million 20 years ago may have a liquidation (fire sale) value today of $700,000, a replacement cost (if you had to rebuild it) value of $3 million, and a market value (what you could receive in an unhurried arms-length transaction) of $2 million. The only truly objective measure of value is what you paid for the item ' in this case, $1 million (less the 20 years of accumulated depreciation). It doesn't matter that neither the amount you paid 20 years ago nor the rate at which you've been depreciating the building have any economic relation to anything going on today. Objectivity is what is important, and historical cost is considered the most objective standard.

There are exceptions to the Historical Cost principle. When the market value of an asset declines below its cost, the value should be written down to the Lower of Cost or Market. This is a one-way street ' if the value increases, it cannot be written back up on the statements. Some investment assets may be continually marked to market price, depending on the business reason for holding the asset and the type of business holding it. All deviations from historical cost must be disclosed in the notes or other disclosures required for GAAP financial statements.

Consistency

While different companies in the same industry may apply very different accounting methods, fit is essential that an individual entity applies the same accounting methods consistently in all of its similar transactions.

Matching

Under GAAP, revenue and all of its related costs must be reported in the same time period. For example, a company's employees are entitled to earn bonus and vacation time as they work. A company that is at its seasonal peak may not allow vacations to be taken during the period being reported on, but is required to accrue the cost of those vacations as they are earned. This is different from the Cash Basis of accounting, where no accruals are made and the entire expense of the vacations and bonus is realized when they are paid. Under the Income Tax Basis, you may end up with a third result, depending on whether the employees are owners or “highly compensated” and how soon after the close of the accounting year the obligations are paid.

The GAAP requirement to match related costs and revenues makes the Profit and Loss Statement more usable, but often leads to accrued liabilities, pre-paid expenses, deferred revenues, and other unnatural items on the entity's balance sheet. For example, if you pay your insurance policy once a year at the beginning of the year, this becomes a pre-paid expense that gets amortized each month until your insurance coverage expires.

Realization of Revenue

The realization of revenue principle is supposed to enforce consistency and objectivity, but is ripe for abuse. Under GAAP, revenue is not realized until an exchange has occurred and the earning process is virtually complete. At least some of the revenue is not allowed to be realized if there are significant contingencies, warranties, or other obligations still to be performed. Sometimes, special accounting rules such as the Percentage of Completion method may apply.

Many frauds, usually overstatement of revenue, are committed by tinkering with the definitions of the various terms that define Revenue Recognition. Some companies declare their product to be shipped when the product leaves the building, some when the shipping label is printed, and others when the product crosses a certain line in the warehouse. Determining what contingencies or what warranty obligations still exist can also be subjective. Understanding when revenue actually gets realized is an important element to understanding a company.

Other important concepts include: 1) Materiality ' defining how large an amount is to matter; 2) Objectivity ' two people looking at the same data would reach essentially the same result; 3) Conservatism ' when in doubt, choose the outcome least likely to overstate assets or income; and 4) Industry Practice ' it makes sense and is allowable for different industries to recognize those differences and have accounting practices that may be unique to them (but common among all companies in the industry).

Conclusion

Someone who has just read all of the above would be excused for thinking that accounting is objective, clear-cut, and simply a matter of following some rules that every accountant knows and agrees to. This is definitely not the case. Even simple precepts can become murky in their execution. Upcoming installments will delve into the financial statements to show how much subjectivity and leeway actually exists.

[IMGCAP(1)]

Michael Goldman, MBA, CPA, CVA, CFE, CFF, is principal of Michael Goldman and Associates, LLC in Deerfield, IL. He may be reached at [email protected].