Jamesian Philosophy Refreshed

The other central document of accounting is an income statement.   This represents a period of time, rather than the moment-in-time of the balance sheet. If all is working properly, the income statement should give investors an idea of the underlying processes that have made the present condition of the company what it is.   We won’t spend a lot of time on the income statement, simply because much of what we might say about it we’ve already said. The issues that arise in compiling an income statement look familiar to anyone who understands the latest balance sheet.   For example, the expenses part of an income statement should indicate the costs of goods sold (COGS), that is, the costs directly attributable to such of the goods that have gone out the door in the hands of a customer over the past year or quarter, separately from all the other costs, especially the “general and administrative expenses.” The issues that arise when valuing COGS are the same is...

In a series of posts in this blog I've discussed the basics of accounting, going through the varous items on the balance sheet. Today I will complete the overview by looking much more concisely at the other critical document, the income statement. -------------------------------------------- The income statement, also known as the profit-and-loss statement, represents a period of time, rather than the moment-in-time of the balance sheet. If all is working properly, the income statement should give investors an idea of the underlying processes that have made the present condition of the company what it is. One is pasted below. We won’t spend a lot of time on the income statement, simply because much of what we might say about it we’ve already said. The issues that arise in compiling an income statement look familiar to anyone who understands the latest balance sheet.   For example, the expenses part of an income statement should indicate the costs of goods sold (COG...

  Our earlier discussions on this blog of accounting basics have focused on the assets side of a balance sheet. Now let’s move over to the right-hand side. This includes the two great subdivisions of liabilities and equity. For a simple business entity we might break down the liabilities section into just two parts itself: accounts payable and notes payable. Accounts payable is the obverse of the accounts receivable heading on the asset side. Payables are (typically non-interest bearing) debts that the firm must pay to its trade creditors, like the due bill to the electricity company for the juice that keeps that conveyor belt moving.   A bit of forensic accounting here: when a business is audited because fraud is suspected (either because the principals of the business are worried about a crooked employee or because investors/creditors worry about the potential crookedness of the principals), the payables are always an object of great scrutiny. The diversion of ...

An issue quite analogous to depreciation is depletion. For businesses that operate by extracting resources from the ground, surely one of their most important assets is the expected amount of oil, coal, diamonds, or whatever-it-might be that is still down there, yet to be extracted, on the land owned or leased by the company for this purpose. Over time, as oil [let us say] is removed, necessarily the remaining oil under there is depleted. The issue has often been politically contentious. Indeed, references to the oil depletion allowance in various stages of its development run like a Wagnerian motif through the various volumes of Robert Caro’s work on the life and times of Lyndon Johnson, who as both Representative and Senator from the oil-rich state of Texas was a stalwart defender of a very generous allowance for the tax accounting books, one which does not have to be duplicated in the financial accounting books. But let’s stick to the latter.   One way in which account...

  Continuing down the list of assets on a balance sheet (beyond those described in our last discussion of such a sheet), we come to a line for prepaid expenses. If our business has paid $1,800 for a year of insurance coverage, it will own something, a claim against the insurance company. This may not sound like an “asset” in a rough commonsensical sense of the world but … hey … the common sense cookie often crumbles. We have to recognize this as an asset in order to convey fairly the economic realities our books are designed to describe. We’ll move now to tools & equipment. Perhaps our business involves a conveyer belt, which we use to move a product from the back room to the front, where it is shown to the customers and, with luck, purchased. The conveyor belt is a fixed asset or, in less formal parlance, it’s part of our “overhead.”   When we bought the conveyor belt and had it installed (for, we will say, $500) we might have paid $100 cash, charging...

Entities large enough to hire accountants tend to keep a different set of books for each of three purposes: 1) Dealing with the tax authorities, 2) Communicating with their own investors and creditors, and 3) Allowing their managers to engage in informed internal deliberations about mergers, spin-offs, prices, wages, and so forth. That is to say, there are three sorts of accounting: tax, financial, managerial. The two sets of books that are designed for external communication, the tax and financial accounting books have a fascinating off-setting feature. The normal temptation in financial accounting will be to overstate revenue, and the normal temptation in tax accounting will be to understate it.   If you are a potential investor, and if you suspect the books they’re showing you are a bit too rosy, you’ll want to see the books they show the tax authorities. At any rate, in what follows we will chiefly discuss financial accounting. There is a good deal of drama ...

Thinking this through. What happens to the value of shares of public stock if the company buys some of the stock back in the marketplace? Think of it first as a simple accounting matter, and let's assume for simplicity's sake that the actual or potential buyers of the stock in the marketplace (who constitute the market demand) know and care about the book value on the balance sheet: that is, the equity as defined by the formula Assets - Liabilities = Equity . Suppose the company has 1,000 shares of stock outstanding, each selling for $50. Its market capitalization, then, is $50,000.  Now, it uses some of its own cash (an asset) to buy back some of the shares of stock. This decreases the amount of stock still available to a would-be buyer.  So if 100 shares are retired and 900 are left, as a first approximation -- assuming demand for the stock stays the same, we might well expect the value of those to increase to $55.55 per. BUT something else has taken place, ...

Continuing yesterday's thought under the appropriate visage of Hugo Chavez: Tom told me, "The preferred shares the government received did not represent an ownership position. Preferred shares are a type of debt instrument not equity." I was flabbergasted. The chief difference between preferred shares and common shares is that preferred shares don't vote. Preferred shareholders have to be bribed in certain ways for the denial of the franchise. The chief bribe is that, in the event of a bankruptcy/liquidation, the preferred shares are in a position just a notch better than the common shares. But both types of shares are at the bottom of the pile relative to anything else, relevant to any form of debt. The fundamental equation of accounting, after all, is this: Assets - Liabilities = Equity. Those are non-overlapping categories. If you sell a bond, you have incurred a liability. If you sell a share of stock, common or preferred, you have redistributed the...

Are accounting rules of any broader significance than just something for accountants to follow? do they themselves constitute data for the science of economics? or are they arbitrary, subject to erasure and thus re-writable at will? I've been thinking about this recently because of an argument I got into at a message-board site about the Bush adminsitration's bait-and-switch over the TARP legislation of 2008. As some of you will of course remember, the crisis-created coalition of Bush and Pelosi sold to the public and both houses of Congress a Troubled Assets Relief Program. The idea was that the government would buy up certain positions of the Wall Street banks, positions that typically involved both assets and liabilities, and that in the circumstances of the crisis involved way too much of the latter, too little of the former. But even as Congress was voting on TARP, on October 3, 2008 [a month before Obama's election, and less than a week after Congress had reje...

The year 1990 in business and finance. Big Picture: the two Germanies formally re-united, the Soviet Union tottered toward its end, Bush reached an agreement with Congress that raised taxes, despite his lip-reading pledge, and Secretary of the Treasury Nicholas Brady was still at work implementing an ambitious plan hatched the previous year to retire unpayable debts by undeveloped countries, i.e. the Brady Bonds plan. Little Pictures: The following items may all have seemed mere details, but it is my contention that each imply important stories, and these small-picture stories help us understand why we are where we are even today.  But I'll make no effort to explain the significance of each as mentioned. January: Time Inc. merges with Warner Communications to become Time Warner February: The US Supreme Court decides REVES v. ERNST & YOUNG, struggling with the question of what is a "security" for reg purposes. March: FASB issues a pronoucnement on the discl...