In the previous installment of my series on how cost accounting chokes business by making it more difficult to understand how you really make money, I discussed how inventory is evil, though, a necessary one. This time I'm going to discuss the whacky way that cost accounting handles capital investments when seen from an operational point of view.
ONCE WITH FEELING: I AM NOT DISSING ACCOUNTANTS
Financial reports have proven to be of great value since the GAAP was introduced in the 1930's. The problem from the point of view of running a business is that the Generally Accepted Accounting Principles are the only standards for reporting, so people have tried to manipulate them into working in an area that they were never intended or designed to work in: Operations. What works for knowing the value of an investment at any point in time, is of little use for knowing how to run a business better in the flow of time.
I believe the right place for capital investments in an operational report is in inventory, rather than in “assets." Like all inventory, they should be treated as liabilities. I owe a debt to Throughput Accounting for first introducing this idea to me. When I saw it, my years in the trenches held in bondage by misleading reporting flashed before my eyes, I snapped to attention and was reborn. Eureka! The emperor has no clothes!
Teenagers are the Best Marketers
When my son was 18 he was dying to buy a fancy looking sports car. His intuition, was that it would make him instantly popular with the girls. Like all adolescents, who are masters at marketing, he kept trying to convince me that buying a more expensive car was a good investment, because it “held its value over time.” I countered, as true today as it was then, the minute you drive a car off a lot, it has lost value.
Money is Money!
Last I checked money spent is money spent. Whether you spend it on raw materials, operational expenses, product inventory, or capital purchases, you still spend money. The definition of profit to me is when you make more money than you spent. I am a simple person.
Things that lose value are liabilities, not assets:
- If you have watch them closely,
- If you have to keep them maintained,
- If you have to try and stop thieves big and small,
- They are liabilities not assets, or worse, they freeze your money.
Money tied up in inventory is not available to you to use to buy raw material and convert it into sales, or pay people to create or deliver services It may be a necessary investment to provide the space and tools to be able to add value and sell it, but as long as your money is frozen it is a burden you have to carry. Seeing it that way, will help you make better business decisions.
Cost accounting gives us the impression that there is a difference between "operating profit" and return on your investment. Think about it! This is really weird! How can I have made a profit if I haven't paid myself back for all the money I put in? If you put up 100 bucks to start a business and you've only made 50 back in "operating" profit you are still 50 bucks in hole by my count.
Model what is REAL, not what you wish it to be
Cost accounting tries to get around this problem by creating a little white lie called ASSETS. The theory is that at the end of the day, when you sell your business, you get all that money back; it's all waiting patiently for you, in your assets. In practice, this doesn't happen.
First, companies can rarely sell their assets at the value they record them in the balance sheet. And worse, this little white lie encourages companies to play nasty with the books in order to get more funding, or keep lenders happy, or dress up the books for banks and investors.
Perhaps the most damaging manipulation of reality due to the misleading and inaccurate picture businesses get from cost accounting, is the focus it takes away from making a profit by producing goods and services: the nasty business of inflating “assets,” to create the illusion of short term profit.
Purchasing capital goods under the assumption that they hold their value is just plain wrong; overvaluing the already purchased to cover less than perfect results may be fraud, but many companies and many departments within those companies do it to keep bosses, regional managers, investors and banks off their backs, as if it has always been done that way, because they too are only looking through the distorted lens of cost accounting. Ask the wrong questions and you get the wrong answers.
Covering over problems is poor management.
Surfacing problems so they become obvious, and can be dealt with, is far better than pushing them out of sight behind accounting tricks, or passing them over under the false assurance that you are protected by overvalued “assets.”
Cost Accounting lends itself to this kind of shenanigans because it does not properly reflect what really goes on: hindering a company by making it more difficult to understand how it really operates.
Capital investments listed as assets invites fuzzy thinking, sometimes fraud. The factors generated by cost accounting may give a sense of control to those computing them, but they are far too inaccurate to operate from, and mask real problems that a better system, an operational accounting system, would bring to the surface and get solved.
Cost accounting also chokes your business by putting the focus on support, and not work flow. It needs to go, and be replaced by accounting that clarifies rather than confuses the true nature of a company as a money generating system, illustrated in the following diagram (with the emphasis on the upper flow): (in the case of a knowledge industry like consulting, the customer is the raw material and the output, the value you give them the value added.)
We All Have To Serve Somebody (Commentary)
Since some deluded fool coined the phrase, shareholder value, companies have been playing nasty with the facts in order to create and run companies only to be packaged and sold so the original investors can “cash out,” a dunderheaded strategy championed for years in Executive MBA programs; treating a company itself as just product, with only a 3 to 5 year lifecycle that must be dumped quickly by inflating its value. And it never seems to stop, as we careen through bubble after bubble, watching them rise then explode, always offering a get rich quick kind of flavor. Infantile myths are hard to manage.
The production of real goods is the foundation of true national wealth. The road of being a no manufacturing, “service” economy ago has led us to being an economic servant of the only ones left manufacturing anything.
The US owes China over 900 billion dollars, close to 3,000 dollars per man, woman and child in the US, and on which we are paying interest, and Brazil is heading down the same path. That is not trade deficit, that is hard dollars.
And when companies, individuals and even nations can no longer secure credit, as is happening today, how do they pay for debt? By printing money? Oops, I was joking when I wrote this, but then, the US. government up and did it to the tune of 85 billion dollars a month from 2008 to 2013, now they are only printing 60 billion or so a month.
The government has chosen that option, but how can a business whose capital assets are not worth what they have down on paper find the money to survive?
As intellectual property has no real value until consumed, how is a service provider with no real value to their listed assets?