An expense reduces our profit in recognition of some business cost. Simple enough. The tricky thing is what do we consider business costs?

Let’s take inventory for a moment. Is buying inventory a business cost? It does cost us some money (now, or later if we’ve purchased on credit). However, we still have the inventory once it’s been purchased, and it is listed as an asset on our Balance Sheet. Though we’ve converted money into inventory, we don’t consider it a cost because we still have the inventory. It becomes a cost when we actually use the inventory - it’s the Cost of Goods Sold expense. Similarly, when we buy a piece of equipment, we still have it. A year later, the equipment is (likely) still in operation. We don’t consider the purchase of the equipment to be a cost. We consider the actual usage of the equipment (or simply the fact that it has become a year older) to be the expense. More on this in a future article.

What if we pay for a multi-year service contract? Same concept applies - it becomes an expense when we actually use up the contract. When we buy the contract, its value becomes an asset on our Balance Sheet, which is then reduced as we use (and actually expense) the service.

Let’s go one step further. What if we’re paying employees (or contractors, etc) to build something for us. Perhaps it’s a building. Maybe it’s an improvement to an existing building. Or it may be software that we’ll be using for years to come. We’re paying people - sounds like a wage expense, right? But like the items above, we still have these assets after we’ve paid for them. And like the items above, they’ll become expenses as we use up their useful life. In the meantime, we capitalize these expenses; in other words, we treat them just like the purchase of any other assets, and they are listed on our Balance Sheet.

Soon we’ll discuss the sort of expenses these types of assets create, as well as the true nature of expenses. If you find these pointers to be useful, imagine the value you’ll get from taking one of our courses!

Now we’re not making any sense, right?  Liabilities and expenses are both things you have to pay for – why aren’t they the same, you might wonder. 

Recently we have been taking a look at expenses - what they are (costs of operating the business), how they may be used to…adjust…corporate earnings (by varying estimates and accounting choices), and how they relate to loan payments (paying down principal is NOT an expense, but interest is an expense).  So what about liabilities?

Liabilities are what we owe - to lenders and anyone who has sold us goods or services on credit - suppliers, professionals, etc. If we pay for our expenses when they come due, or in advance (we pay the rent when it’s due, we buy inventory for cash, we prepay for insurance), then those expenses never become liabilities.  If we’ve paid for them on credit, then those expenses generate liabilities because we still owe them, not simply because they are expenses.  And if we have a liability because we need to repay money we’ve borrowed, then as discussed in a recent article, those repayments are not expenses.

Looking at it another way, expenses are items that happen in time and liabilities are persistent.  An expense happens in a moment - the rent comes due, interest comes due, we use a service, or it’s payday.  We then add the expenses to our Income Statement (a/k/a P&L Statement, or Profit & Loss).  If we pay for them at the time, or prepaid for them, then that’s it – they never become liabilities.  If we haven’t paid for them yet, then they create liabilities related to those expenses – but those liabilities are not the expenses themselves.  Liabilities persist for a period of time – they’re created when the bill comes due, or we borrow money, and they go away once the bills are paid or the debt is repaid.

More confused than ever?  We hope not! It sounds a lot more complicated than it really is.  Stay tuned as we look further at Expenses vs. Capitalization and the true nature of expenses.  Better yet, sign up for one of our upcoming live, online, or on-demand courses for a more complete understanding!

Ever wonder why certain public companies meet or beat the earnings number predicted by Wall Street research analysts? GE, Microsoft, Apple are just a few of many corporate behemoths that tend to impress analysts and investors quarter after quarter. So how are they able to consistently able to beat these numbers, even in a slow economy? Two factors contribute to this:

1. Guidance
2. Profit Smoothing

As much as we would like to believe that the stars align for such companies, the reality is that managing earnings is more a product of skill than divine intervention.

When it comes to guidance, corporate managers tend to under-promise and hope to over-deliver. It works something like this: Company X just released its quarterly earnings report and beat the consensus earnings number. The consensus number is the average of analysts’ prediction for net earnings (also referred to as net income, net profit or the bottom line). Company X was pleased to report that due to aggressive cost cutting, they were able to beat the consensus number by one penny per share (total net earnings divided by total shares of stock outstanding). Beating the estimate is always a good thing and will often drive the stock price higher. While analysts and investors rejoice, the corporate management pats itself on the back for achieving strong results.

So how did they pull this off? At the conclusion of last quarter, Company X purposely issued very conservative earnings guidance even though there were several large sales likely to close before the end of the quarter. To play it safe, they sought to keep expectations low knowing they could easily surpass them and push the stock price higher.

As it turned out, several of the planned sales fell through. Time to bring in the heavy artillery. In this case, the heaviest of all is profit smoothing. Company X can adjust the assumptions on non-cash gains and expenses to make the earnings number beat expectations. Still too low? Why not lower the charge against a bad loan portfolio? How about changing the depreciation schedule to lower the expense taken in the near term? Through some combination of non-cash adjustments, Company X is able to generate the right earnings number. Unfortunately, once in a while no amount of profit smoothing will save a company from a bad earnings number which is what happened to GE a few quarters ago. And when that happens, look out below!

Recently we began a discussion about expenses: what are expenses - and what are they not, and talked about a few examples.  This time we’ll look at expenses related to financing.

There are two common issues that come up regarding finance-related expenses.  First let’s start with the debt-related one - some assume that our entire loan payments are expenses.  On the other hand, a common mistake is for an entire loan payment to be applied to paying down a loan.  Why is this so confusing?

Loan payments, of course, consist of both principal and interest – some of the payment reduces principal, and the rest of the payment covers the interest that we owe on the loan.  Think about what happens when we borrow the money in the first place - does it increase our profit?  Of course not.  It would be great - well, in the short term, anyway - if we could increase our profits simply by borrowing money, but of course this isn’t the case.  So when we pay back the principal, it also doesn’t decrease our profit - it’s not an expense.  But the interest is an expense - it is the cost that we incur for borrowing the money for this period of time.  So the whole loan payment doesn’t reduce what’s owed - only the principal portion does that, and neither is the whole loan payment an expense - only the portion that pays the interest.

In terms of Equity, we wonder why it’s not an expense when we distribute profits to owners (i.e. pay dividends).  The answer is subtle, but simple.  Dividends are a distribution of profits - they aren’t used to determine the profits themselves.  Profits for a given period are determined by subtracting expenses from revenue, and then those profits are either distributed to owners or they’re kept in the company as Retained Earnings (earnings is another name for profits, so Retained Earnings are simply profits kept in the company instead of being distributed).  So we don’t count dividends as an expense (though we wish we could, because expenses reduce our taxes).

Stay tuned in coming weeks as we build on these concepts and discuss Expenses vs. Liabilities, Expenses vs. Capitalization, and the true nature of expenses.  Better yet, sign up for one of our upcoming live, online, or on-demand courses for a more complete understanding!

Expenses are the items on the Income Statement (a/k/a P&L – Profit and Loss statement) that reduce profit during the period of time that Income Statement covers.  So, many would think that an expense is simply anything that costs money.  But, of course, it’s not that simple. In fact, many items that reduce our cash are not expenses, and many expenses may not cost us any cash at all - at least not at the time that we book the expense.  Uh oh - more accounting confusion!  Let’s see if we can make this clearer:

It’s somewhat better to think of expenses as “costs of operating the business.” This still isn’t exactly right, but it helps. Here are a few examples:

• Rent, utilities, salaries, etc: these are the most straightforward expenses. We probably pay them when they come due, so indeed our cash is reduced by the amount of the expense. 
• Cost of Goods Sold: typically, these are our inventory costs. Note that buying the inventory is not an expense. Cost of Goods Sold (COGS) is the expense that comes from actually using (selling) the inventory.
• Depreciation & Amortization: these are expenses that don’t reduce our cash at all. Why? Because they are simply a recognition that a portion of the life of the assets that we own (and paid for some other time) have been used up.

When we buy assets of any kind - inventory, property, plant, equipment, prepaid expenses, etc - the cost is not an expense. Instead, we incur an expense when we use up the assets.

Stay tuned in coming weeks as we build on these concepts and discuss Expenses and Financing, Expenses vs. Liabilities, and Expenses vs. Capitalization. Better yet, sign up for one of our upcoming live, online, or on-demand courses for a more complete understanding!

There are many misconceptions about the Balance Sheet and its purpose. For example, the moment that one learns that assets on the Balance Sheet are generally valued at “historical cost” (i.e. what we paid for them) rather than “fair market value” (the current market price) for many may be the moment that they begin to give up on accounting. “The Balance Sheet doesn’t have the actual asset values on it? Then how do I know what the business is worth?” is a common refrain. In fact, not only are asset values on the balance sheet typically not updated to fair market value, but the values of other items such as the company’s brand(s), their relationships with suppliers and customers, and other intangible assets are generally not included at all. The complaints are correct: the Balance Sheet is generally not used to determine the value of a company. There are instead a variety of other valuation tools available, which we discuss in our Valuation programs.

Then is the Balance Sheet some antiquated holdover from less sophisticated times, a necessary evil but one that provides little utility?

If you look no further than determining valuation, you’ll miss out on the compelling story that the Balance Sheet tells about a company. The most important thing to understand about the Balance Sheet, and Accounting in general, is that it’s about dollars. Dollars that have come in to the company (and from where), and where they are now. Actual dollars as well as potential dollars the company expects to receive, such as from customers who purchased on credit. Under Liabilities and Owners’ Equity we find the sources of the dollars in the company - some dollars came from Equity, including dollars invested and profits earned, and some came from Debt and buying on credit. And what did we do with these dollars? Some dollars are still cash, some were “loaned” to our customers (so they could buy our products and services - those same dollars we expect to collect), and some were used to buy assets such as inventory and property, plant, and equipment.

So the Balance Sheet tells us the company’s financial condition at a given moment in terms of dollars - how many have come in and from where, and where they are now; how many of those dollars the owners can claim and how many dollars are owed to creditors. This is just part of the story, of course - join us for one of our upcoming live and online programs for much more.

As the nation slips deeper into the depths of economic turmoil, virtually every media pundit and politician seems to have a theory as to why this happened and who is responsible. The newsrooms and congressional chambers are filled with banter about collateralized debt obligations, mark-to-market accounting and swap spreads. The problem is that invoking these terms in the context of such discussions is not the same as understanding them. As evidenced by recent congressional hearings, it is clear that our nation’s leaders have less than a basic understanding of finance and accounting. If they are truly committed to solving these problems, they will have to educate themselves as quickly as possible.

In the last several months, we have witnessed the former and current heads of the Federal Reserve Bank, US Treasury and some of the largest financial institutions testify before congress. In the standard questioning process, there seems to be a recurring theme. A question is asked by a member of congress that relates to some aspect of the financial crisis and as the response is offered, more confusion seems to arise. In a recent discussion between Fed Chairman Bernanke and a notable congressional leader, Mr. Bernanke was lambasted for injecting capital into several of our nation’s largest banks. The members of congress were irate over the fact that taxpayers are paying to bailout these institutions. Mr. Bernanke tried to explain that this was a capital injection and not an expenditure. Its intent was to solidify the company’s balance sheet and allow them to lend money. Exasperated by the puzzled looks from the congressional leaders, he sought to clarify the difference between capital injections and expenditures, something that fell on deaf ears. Former Fed chairman Greenspan also encountered widespread consternation recently when attempting to explain the complexities of derivative structures and their role in the crisis. Recognizing the daunting nature of this task, he too conceded limited understanding of these structures.

My professional experiences have taught me that even some of the most accomplished professionals have difficulty distinguishing between income and cash flow let alone recognizing derivative structures. Our leaders in Washington need to acknowledge their deficiencies in this area and do their best to correct them. Given the magnitude of the current crisis and the role our leaders play in maneuvering it, perhaps it is time we consider devoting a portion of the stimulus package to financial education for our leaders. We at Telestrat are prepared to heed the call.

Reuben Advani is a former investment banker, founder of Telestrat Education and author of The Wall Street MBA (McGraw-Hill). 

To explore these and related issues, join us for one of our in-person courses (in major U.S. cities) inAccounting and Financial Statements or Corporate Finance and Valuation, or one of our webinars inUnderstanding Financial Statements, Financial Analysis, Stocks, Bonds, Options Online - Securities Basics for Lawyer, or Valuation, or one of our On-Demand programs (available 24/7) including our Financial Markets Update, which explains what brought on our current market issues.

Question: How does an obscure accounting rule find its way to the top of a new president’s agenda?

Answer: By creating the worst financial crisis in over 70 years.

Indeed, folks, a topic previously discussed by CPA’s and CFO’s is making front page headlines. Why? Well, to put it mildly, the fate of our banking system may depend on a method of accounting known as mark-to-market accounting. Mark-to-market is used to assign value to an asset based on its current market price. The idea came about in the 19^th century when future traders used it in an effort to mark their positions to the current market price. In other words, futures as well as other derivative instruments, are often traded on and off exchanges. While they may simply serve as contracts to buy or sell something at some point in the future, they maintain some value during their life. With mark-to-market accounting in place, the changes in value of these instruments are recorded on a regular basis on the financial statements of the company holding them. In other words, they are marked-to-market rather than listed at cost (what was paid for them).

To illustrate the way mark-to-market accounting has been applied in recent history, imagine this: you purchased a home for $100,000 ten years ago. Three years ago, in the height of the real estate boom, your home’s value was assessed to be $200,000. If you were to use mark-to-market accounting, you would list this increase in value on your personal financial statements and specifically, show an increase in your non-cash income. Did you benefit from this increase? Not directly. It doesn’t impact your household income or available cash as you have not sold the home. However, it does help your net worth on paper which means that in theory, you might be able to borrow more. In fact, you could likely obtain a larger home equity loan or line of credit based on this increase in net worth. Having access to this capital appears to place you in a stronger financial position.

Let’s consider another scenario: the home you purchased ten years ago for $100,000 is worth $70,000 today due to a major collapse in the housing market. Using mark-to-market accounting, your non-cash income would be reduced based on the drop in market value and more importantly, your net worth has dropped as a result. Although your household income is not affected and this represents no significant change to your lifestyle, your ability to borrow could be diminished. This may present some problems should you be in need of a home equity loan or some other source of capital.

Fortunately, we have little need for mark-to-market accounting in personal finance but what happens when some of the largest corporations in the world use this technique? That is what happened in 2007 when financial institutions were required by the Financial Accounting Standards Board (FASB) to use this method in an effort to disclose the values of various financial instruments. Some of these instruments, such as mortgage backed securities, were quite complex in that they were based on massive bundles of other instruments such as home mortgages. Quantifying their values became increasingly difficult when such instruments were not actively traded. In other words, when such instruments are actively traded, assigning a mark-to-market value is relatively simple. It becomes the price that buyers and sellers agree on. But what happens when these instruments are no longer traded? Then you have the makings of a major financial crisis at hand. As the appetite for these instruments waned in late 2007, financial institutions found it difficult to sell them. Without a liquid market, these institutions were forced to use broad based estimates to determine their values. In essence, they moved from mark-to-market accounting to mark-to-model accounting. The results were ugly. As the housing market collapsed, the values determined by these financial models were shockingly lower than in past quarters. As a result, major banks around the world were writing down these assets at a rapid pace while lowering their profits and eroding investor confidence. As investors lost confidence based on these massive write-downs, stock prices fell to reflect this.

Where does this leave us today? The world is divided on mark-to-market account. There are those in favor of it as it increases transparency in financial disclosure. As the argument goes, if something loses value the financial statements should reflect that. The opposing argument is based on the idea that trying to estimate market values can do more harm than good and ultimately prove misleading, especially in illiquid markets. Perhaps this dilemma is best summarized by the greatest punk band ever (and prescient market forecasters), The Clash. To paraphrase:

Should it stay or should it go? If it goes there will be trouble, and if it stays it will be double. So come on and let me know, should it stay or should it go.

To explore these and related issues, join us for one of our in-person courses (in major U.S. cities) in Accounting and Financial Statements or Corporate Finance and Valuation, or one of our webinars in Understanding Financial Statements, Financial Analysis, Stocks, Bonds, Options Online - Securities Basics for Lawyer, or Valuation, or one of our On-Demand programs (available 24/7) including our Financial Markets Update, which explains what brought on our current market issues.

There is a great deal of discussion and speculation about the current stock market. “Where is it headed?” is the question most of us are asking. Well, don’t look to me for precise answers because if I knew, I wouldn’t be writing this entry or doing anything work related for that matter. In fact, the only thing I do know for certain is that no one can predict what will happen in the stock market at this point. Now, more than ever, this holds true.

In the last few years, analysts and investors were able to offer substantive predictions with relative ease. Why? Economic growth was strong, consistent and predictable. Based on macroeconomic data, companies could effectively predict demand increases for their products and services. And with solid demand forecasts, costs and expenses could be budgeted as well. Put them all together and what you have is a well defined profit forecast for the next year.

With credible profit projections, a company’s stock price generally adjusts to fall in line with the industry average PE multiple (price to earnings). The PE multiple for a company is its stock price divided by its earnings per share. PE multiples for an industry are based on an average of PE multiples for all companies in the industry. When a company offers a projected earnings number for the next year, the company’s stock price should adjust to align with the industry average multiple. So in theory, this allows one to not only predict where a company’s stock will be trading at in the future but where the entire market will be trading at. This is because the market is an aggregation of individual stocks. Consider the following example:

Company ABC projects its earnings for 2009 to be $2 per share. If the industry average PE multiple is 15, then ABC’s stock price should reach $30 by year end in order for it to be in line with the industry. So if the current stock price is $20, we can predict a 50 percent increase in stock price over the next year.

In 2009, stock market predictions will be as accurate as those pertaining to a Vegas craps table. There are two reasons for this. First, companies are having a difficult time projecting their earnings. Given that we will likely remain in the throes of the Great Recession, it will be difficult to determine how consumer and corporate spending patterns will react. This will make it challenging to forecast earnings and, consequently, stock prices. Second, investors large and small have been scared away by the recent market tumult and may very likely keep their cash tucked securely under the mattress. It’s unclear when their confidence will be restored and more specifically, when their funds will return to the market.

What we are facing is a paradigm unlike any we have seen in a very long time, if ever. Therefore my prediction for the stock market in 2009 is as follows: it may go up or it may go down.

To explore these and related issues, join us for one of our in-person courses (in major U.S. cities) in Accounting and Financial Statements or Corporate Finance and Valuation, or one of our webinars in Understanding Financial Statements, Financial Analysis, Stocks, Bonds, Options Online - Securities Basics for Lawyer, or Valuation, or one of our On-Demand programs (available 24/7) including our Financial Markets Update, which explains what brought on our current market issues. 

As I write this, stock markets around the world are teetering on the verge of major collapse. What only a few weeks ago was a topic of interest for Wall Street bankers and academics has become a global contagion affecting everyone. In previous blog postings, I discussed several topics including mark-to-market accounting and short selling, each of which has played a role in this crisis. But what is now at the forefront of both the diagnosis and treatment of this malady stems from simple human psychology: confidence. Few deny that the overriding lack of confidence in our financial system and leaders exacerbates the current economic crisis. But how has this lack of confidence brought us to where we are today?

Let’s recap what we know so far: banks loaned money to borrowers under very aggressive terms predicated on the notion that housing prices always go up. New home construction reached unprecedented levels causing an excess of inventory. As home values started to decline due to this buildup of inventory, home values started to decline. This created problems for home owners who financed their mortgages with nominal down payments. As interest rates started to rise, it became even more difficult to make the required mortgage payments. At this point, confidence started to erode in the housing market driving down home values in most markets.

What about the banks? With the banks buying and selling complex financial instruments that are based on home prices, concerns started to mount that perhaps the banks would soon feel the pressures of the housing market decline. Sure enough, thanks in part to an obscure accounting rule known as FAS 157, major financial institutions were forced to estimate the loss of value on these financial instruments and record any drop as a charge against earnings. This raised bigger questions: how were they determining these values and more importantly, were they underestimating them. This created a further crisis of confidence among the clients of these banks as well as the investors in these banks. As clients started to close accounts, investors started to sell shares of stock in these companies. These factors worked in tandem to literally collapse several major banks in a matter of days as they no longer had the ability to meet their required capital obligations.

With housing collapsing and the banks collapsing, equity investors grew fearful that businesses would no longer have access to capital. Furthermore, consumers would curb spending out of fear that their most valued tangible asset, their home, wasn’t worth what they thought it was. And more importantly, businesses in turn would curb spending out of fear that consumers would buy few products. Most of all, businesses would have difficulty gaining access to capital due to problems with the banks. All of this ultimately stems from a lack of confidence in the spending ability of institutions as well as individuals.

So here we are in the midst of one major crisis of confidence. How do we fix it? Simple, restore confidence. To do that, the government (Congress, the Treasury and the Fed) has:

1.) passed the $700 billion rescue package which will, among other things, allow financial institutions to sell their distressed mortgage-based instruments to the government and
2.) agreed to loan money directly to companies by purchasing their commercial paper.

Unfortunately, these steps have done little but further undermine confidence in our financial system and leaders. What happens next? Stay tuned. I have a feeling another blog entry will be posted sooner rather than later.

To explore these and related issues, join us for one of our in-person courses (in major U.S. cities) in Accounting and Financial Statements or Corporate Finance and Valuation, or one of our webinars in Understanding Financial Statements, Financial Analysis, Stocks, Bonds, Options Online - Securities Basics for Lawyer, or Valuation.