Accounting 101: Financial Accounting (College Prep)

Sample Lesson - Introduction

Lesson 1.01: GAAP

GAAP (Generally Accepted Accounting Principles) is not a long, complicated set of rules you need to commit to memory. GAAP is really just a single principle. It is a religion, shared among accountants, with one basic, unifying element:

When you can be conservative in the way you calculate profits, you should be.

What does that mean? Isn't there just one way to calculate profits? Like...isn't 5 minus 2 always 3?

Well, no. It is in the world of math, yes, but not necessarily in the world of accounting.

Silly example: Suppose someone signs up for $1 for the first month of Match.com. In the fine print, by paying that dollar, the buyer has just committed to pay for 1 year at $20 a month, or $240 for a year.

So, now you're the accountant at Match.com, trying to figure out how on earth you are supposed to recognize these revenues. Did your company just have revenues of a dollar? $20? $240?

The key ethos, or culture, shared by all accountants is conservatism. That is, whenever there is potential to overstate profits, GAAP instructs accountants to...not do so. Specifically, you'd have to figure out when the money-back guarantee expired, and then and only then would you begin to recognize revenues.

At this point in the course, you don't need to have any idea of the specifics or how you'd even begin to think about that revenue recognition. You just need to grok the basic concept that you hold off recognizing revenues for as long as is reasonable, such that the revenues don't just evaporate one day when a stampede of lonely Match.com subscribers decide that they don't, in fact, want to take the anti-loneliness pills.

Sample Lesson - Reading

Reading 1.1.01a: GAAP from the Horse's Mouth

GAAP is arguably the most important concept in accounting. So, you should at least be able to spell it. Why so important? Because skeezy accountants—being oh so clever—could easily fudge or fake numbers so that profits aren't really profits.

Isn't there more to GAAP than that? Well, in a word: yes. But rather than go too deep into the weeds at this point, we'll just leave it to the good folks at the Financial Accounting Foundation (the organization that largely oversees GAAP standards) to explain GAAP in more depth.

Sample Lesson - Reading

Reading 1.1.01b: Ways to Be Skeezy

So, how could one of those skeezy accountants run their scam?

Depreciation

Well, imagine that a drone-making company has to build a new $20M factory every four years to upgrade its processes and stay competitive. If the company produced $8M in cash profits in a given year but ignored the fact that they have to replace the factory every four years, then it would look like the company made $8M.

But by GAAP standards, the company should account for the fact that the $20M factory is depreciating in value. If their accountants applied straight line depreciation to that $20M cost, then they would take out $5M a year from the $8M of cash profit to account for the fact that all of that profit will be used up building a new factory.

Depreciation

The process of assigning the decline in value of a license or product over time.

You buy a computer for $3,600. The law says that you must depreciate it $100 a month for 36 months until, on your books, it is valued at zero. The thinking is that at the end of the period then you "know" you have to buy another computer. Many computers last more than 3 years, though, so the numbers get all messed up.

Straight Line Depreciation

Straight Line Depreciation is one method of depreciating an asset. In the land of SLD, accountants deduct the same value amount per year, each year, until the asset is fully and properly depreciated.

If you applied straight line depreciation to an espresso machine you bought for $800 and used it for 10 years to then sell it for scrap for $100, you'd depreciate straight line $700 of value for 10 years, or $70 each year.

$70
x 10 
$700

So, what's the right number for GAAP profit in the $20M factory example?

Yeah, it's just $3M—not nearly as profitable as the company made it seem at first. And this is a really big deal in a world where companies are valued at something like a 20 times their earnings or profits multiple.

So, 20 times the $8 million figure gives you a huge number, while 20 times the $3M gives you a lot less. With GAAP, everyone follows the same rules, so no company's numbers get wonky.

Reserving Expenses

Then there's door #3. The company you love so dearly just got sued for testing their dissolving agent on puppies. The company is only worth $300M, yet it's being sued for a billion. That is, the lawyers on the other side want the company to hand over the keys to the castle in its entirety and go away, in order to pay for the damage done.

What's the right number to reserve as an expense in this situation? In other words, what costs can you anticipate having to pay in the future, rather than just accounting for what you have to pay now?

If the company reserved a billion dollars, and they calculated that it would take a decade to pay it all off, they could then take a $100M a year deduction in their profits, such that the expected $100M a year of profits would become $0, and voila! The company would have no taxable profits. At least not for a very long time.

In fact, more likely a team of lawyers would give an educated guess as to the real amount of the damages, which might be a lot closer to $3M than a billion. To be conservative, the company might reserve an expected loss of $10M or $20M, payable over a few years, which would reflect how most lawsuits like this get settled in real life.

So, the basic idea is that GAAP accounting requires the company to be conservative, but not ridiculously so. Like Baby Bear, GAAP strives to get it...just right.

Matching

Another of the key precepts of GAAP accounting is the notion of matching. While not a dating service, angst and loneliness are, in fact, involved. The goal of matching is to try and present the best, clearest reflection of how the business is honestly doing, without trying to make it look better or worse than it actually is.

So, one core element of GAAP accounting is to match revenues and expenses such that they both will have occurred in the time period in which they occur.

A computer printer-making company orders 10,000 plastic form factors to house the ink, paper roller, input/output devices, etc. It sells only 8,000 units in that period in which it was obligated to pay for those form factors.

That is, a computer printer manufacturing company orders 10,000 plastic form factor "housings" to hold the ink, paper roller, input/ output devices, etc. in place. But it sells only 8,000 units in that period (call it a quarter), in which it was obligated to pay for those form factors.

So, what's the "matching rule" here?

Well, it had to pay for 10,000 of them. So, being conservative, you recognize the paying for them all up front as an expense, largely because the remaining 2,000 units are barely worth anything if you had to sell them on eBay. So, one way you can rationalize the matching here is to expense the inventory entirely up front, as if the minute you have bought it, it is essentially worthless, so you completely write it off as a "dead asset." In this way, you are taking the most conservative route in valuing the inventory you've just acquired.

You've done this believing that next quarter you'll sell that last 2,000, and your earnings will appear more profitable than they actually were because you were "overly conservative" in the previous quarter.

The other, more traditional way is to just match 8,000 sales with 8,000 form factors purchased, leaving 2,000 form factors held at whatever the printer-manufacturing company paid for them. Said another way, you note that the form factors you have purchased are only useful—have value—if and only if you sell them, composited with the drones that you're selling.

That is, you are bundling the form factor in with the propeller, guts, battery power, guidance systems, etc. of the drone. If you do not sell drones for whatever reason—competition, an asteroid from space—then the plastic housing around them is worth whatever it's worth when it's melted down, which is probably 1/100th the price you actually paid for it.

The key idea here is that not everything is obvious and that you need to conceive of consistent rationale in the way you manage the accounting for events in a given period. As long as you take the most reasonably conservative path in counting your beans, as Bob Marley sings, everything's gonna be alright.

Sample Lesson - Reading

Reading 1.1.01c: The Goal—Chapters 1-5

Read Chapters 1-10 of The Goal. It's the best book on accounting ever written. And yeah, that's a bit like talking about the finest golfer in Alaska.

You don't have to read absolutely everything—you can skim the stuff about the protagonist's personal life. The important elements to follow revolve around the manner in which the company uses careful resource allocation to produce their product in a way that is massively more efficient than the manner in which they made it in the past.

As we go along, we're going to be summarizing and analyzing the book to help you out. Providing you with clear comprehension is, uh, our goal.

Introduction

The introduction? Really? Can't we just skip that part and get to the meat?

Yeah, we really can't. Just think of it as an order of mozzarella sticks while you're waiting for your pizza. Speaking of which, remind us to talk to you about your dietary habits.

The reason we can't skip the introduction is that this is no ordinary book on business. You'll see why in a sec. Anyway, it's the introduction that gives us the most concise, most on-the-nose and in-your-face explanation of the author's message. So, if we can grok what he's trying to say here...the 40 chapters that follow should just be the gravy on the turkey.

Alright, so, what is he trying to say?

The Goal is about science and education. Yeah—that's the first sentence in its entirety, so...we can assume it's important. What about science and education specifically? In terms of science, Goldratt talks about what a shame it is that the word is almost exclusively used to refer to stuff you can either cram into a test tube or open up with surgical dissection tools. But he says that there's a science to business. How? It's all about making an assumption, testing that hypothesis, learning where you went wrong, and making the adjustment. So, that people can better understand industrial phenomena, rather than just natural phenomena.

As for education, Goldratt stresses the importance of us arriving at our conclusions by thinking, instead of just regurgitating information we're given. In other words, it's about learning and deduction, not about rote memorization or accepting everything you hear as undeniable fact. It's that whole "give a man a fish" vs. "teach a man to fish" argument. Or, if you're a first-year acting major, "teach a man to act like a fish." But that probably applies to very few of you, so we'll move on.

Long story short—if you want to excel in business, you've got to understand the principles on a deep level; i.e., actually read this book.

Chapter 1

The first thing we realize when we start reading this book is that it's not about soccer. Too bad. We were really excited about hearing that overly enthusiastic announcer scream "GOOOOOAAAAALLLL!!!" every five pages.

The second thing we notice is that there's dialogue. And there are characters. And like, a plot.

Yeah—the book is a novel. And yes, we realize you just had to read Wuthering Heights, Huck Finn, and The Great Gatsby in your lit course, but make room for one more. The good news? This thing is a super-easy read. And you'll be thankful for the dialogue, characters, and plot, because it makes subjects like business and accounting palatable.

So, in the first chapter we meet our protagonist, Mr. Rogo. He's dealing with an emergency at his factory: there's an urgent work order that hasn't gone out on time, and everyone's scrambling to fix the problem. To make matters even more fun, he's got Bill Peach, his supervisor, riding his derriere.

And we find out it isn't just this one work order. The manufacturing plant has been losing money. A lot of it. Peach gives Rogo three months to flip the switch and get the money moving in the right direction.

We don't get into the nitty-gritty of accounting just yet—this chapter more or less sets up a couple of the main characters and the scenario—so just make sure you give it a light read and have a grasp on the situation.

All right, so as novels go, maybe this thing is no Gatsby. But as books on business go, it's "the cat's pajamas." As Jay Gatsby might say.

Chapter 2

Right away we meet Julie, Rogo's wife. They squabble. But just before this thing turns into a book on the difficulties of marriage, Rogo heads to work.

He grew up in this town (Bearington), and can't stand to see all the businesses fail and close shop.

"The town has been losing major employers at the rate of about one a year ever since the mid-1970s. They fold completely, or they pull out and go elsewhere. There doesn't seem to be any end to it. And now it may be our turn."

So, yeah—he's desperate. And we get a sense that it's that desperation which is going to drive him to come up with some ingenious solution to get his own company back on the right track. Either that, or this novel might actually be more depressing than Wuthering Heights.

We get our first taste of accounting-speak on page 14, as Rogo considers the financial repercussions of the prior day's troubles:

"I don't know where we'll bury the expense, but we've got to get this order shipped tonight."

Hmm, burying expenses. Sounds shady. Is our hero considering doing something...not quite above board?

Then, on page 16, we get some insight into how much this setback is going to cost the company. It's not just the repair bill for the broken-down machine. It's also the talented machinist who quit. And the time lost while the machine was down.

Chapter 3

Peach is bringing the hammer down. Everyone in the factory is suddenly grasping the thin ice they happen to be skating on, as Peach gives the factory managers and supervisors the cold, hard truth about their dire situation.

Rogo tells us that the first quarter has just ended, and "it's been a terrible one everywhere." So, yeah—that three month deadline isn't arbitrary. They have exactly one quarter (divide the months in a year by four and you'll see that it checks out) to make things right.

Finally, as Rogo is zoning out in the meeting, we hear some snippets from the Peach speech:

"...first quarter sales down twenty-two percent compared to a year ago…" "total raw materials' costs increased…" "...direct labor ratios of hours applied to hours paid had a three-week high…" "...now if you look at numbers of hours applied to production versus standard, we're off by over twelve percent on those efficiencies…"

Sounds like a whole lot of gibberish now, but hopefully it will all make more sense as we progress through this course.

Chapter 4

In this chapter, we meet Jonah, and he's got a story to tell us. Hopefully, it's not a, uh, whale.

So, yeah—we learn that Jonah is a physicist Rogo used to know back when he was a student. What does a physicist have to do with accounting? Well, maybe it has something to do with the whole "science" thing from this book's introduction?

As the two get to chatting, Jonah is able to predict—with eerie accuracy—the difficulties Rogo is having at the factory.

"Check your numbers if you'd like," says Jonah. "But if your inventories haven't gone down…and your employee expense was not reduced…and if your company isn't selling more products—which obviously it can't, if you're not shipping more of them—then you can't tell me these robots increased your plant's productivity."

So, here we get our first inkling that these robots may not be our friends. They probably seemed like an absolute slam-dunk when they first arrived at the plant, but if the factory is still struggling long after the robots have started uh, roboting...are they really working positively to reap the company a net profit?

Jonah goes on to say that Rogo doesn't know what the goal is (hey, that's the name of the book!). Rather than flat out telling him what it is, he insists that Rogo can "find the answer with your own mind." Yet another callback to what was discussed in the introduction, this time in reference to the importance of learning rather than just memorizing or being told something.

And then Jonah vanishes, off to catch his plane. Like some ephemeral, jet-setting Yoda.

Chapter 5

With Jonah's words ringing in his ears, Rogo tries to make sense of it all, and figure out where exactly his company has gone wrong.

"One of the things a manufacturing organization must do is buy raw materials. We need these materials in order to manufacture, and we have to obtain them at the best cost, and so purchasing in a cost-effective manner is very important to us."

He's not just focusing on the robots, which is where Jonah insinuated the problem lies. He's trying to go through every step of the manufacturing process, starting with purchasing, trying to re-learn everything he's ever been taught about running a successful business. He notes that raw materials have to be obtained at the best possible cost. But what parts of the equation is he not addressing here? How many and what type of materials should a company be purchasing? i.e. should they just be buying for the present, or should they be building up their inventory? What about the quality of those materials. Is it just about being cost-effective?

Then Rogo starts to hypothesize about what this mysterious "goal" might be. Is it a combination of quality and efficiency? Couldn't you be efficiently creating quality products...and still have trouble keeping a plant going?

Eventually, he forms this conclusion:

"The goal of a manufacturing organization is to make money."

Maybe a little "duh." But time will tell if that's what Jonah was getting at.

Review Questions

As we make our way through the book, we'll be asking you to think about certain questions. No need to write down full-formed answers, but we strongly recommend getting those wheels turning.

1. Is it easier to learn about business concepts when they're communicated in the form of a story?
2. Why all the subplots about his marriage, personal life, etc.? Is that just background color to add depth, or is there some connection between it and "the goal"?
3. Why doesn't Jonah just come out and give Rogo the answers? Is it really that beneficial for him to arrive at them on his own?
4. Is Rogo on the right track—is "the goal" about making money?