Thursday, September 10, 2009

Accounting: The Fundamental Physics of Finance

In our Financial Accounting class, our professor refreshed the idea of balance sheets, assets, liabilities and equity (A = L + E) and debits and credits in T accounts.

In the same way that physics in engineering boasts a model to explain the universe in such a meticulous way such that energy cannot be created or destroyed, so too does accounting explain that value can move and change shape, but can not 'mysteriously' evapourate from a balance sheet without an income or cash flow transaction.

In each of the examples provided, it's shown how no matter the transaction, the balance (which can also be seen as an allocation of value to different accounts) is maintained in the above equation. No exceptions.

While accounting fraud is still possible, there is a valuable point to make based on a case we had read in a previous (our first) class. There is a fine line between what is illegal versus legal in accounting (misreporting revenues and expenses versus deferring revenue for the next reporting period respectively).

With accounting, the first action, misreporting revenues and expenses, is illegal and undetectable by reading financial statements (hence why accountants are often required to statistically sample and verify inventories, revenue recognition methods etc). Most illegal activities tend to be undetectable as off book transactions (Think Enron and it's 'sale' of three oil tankers to bankers which was recorded as a non-operating gain whereas it was a financing deal and deflated their debt and inflated their earnings).

However, the second action, legal earnings 'manipulation' can be detected and can be accounted for. As with my previous posts regarding valuation of companies based on financial statements and earnings, profit smoothing and managed earnings are criticized as being dishonest and misleading. But again, I would say that it is the responsibility of the analyst doing the valuation to do the proper homework to account for these factors. I had previously spoke about how some companies were reporting positive earnings in one of the greatest financial declines since the great depression of the 30's and it is absolutely necessary to understand the underlying reasons for the numbers.


Anonymous said...


in reality, the assets almost never exactly equal liabilities and stockholder's equity. The fact of the matter is that there's always a slight difference. Theoretically and conceptually, however, the accountants decided it would be easier to tell people


when in reality there's a small difference known as an "immaterial pass", meaning it's too small to bother with.

Joshua Wong said...

True, but if I can extend my physics analogy, when you take measurements in physics, there are also "immaterial" differences also.

As Roger Martin would say, no "model" is perfect. But understanding how each is useful and (conversely limited).

That's a very good attitude. To understand the shortcomings of systems which are taken "for granted". Thanks for the comment!