# Accounting explained - part 2 ## Liabilities A liability involves anything an organization owes: - Current liabilities are due within the next year: - Principal and interest on loans in the next year - Lines of credit with suppliers - Wages owed - Taxes payable - Bank fees - Non-current liabilities are long-term: - Mortgage - Pension obligations - Principal and interest on loans beyond a year out - Bonds and long-term loans - Deferred tax liabilities - Lease payments that aren't due for more than a year - Contingent liabilities are things an organization *might* owe. One of the more frequent uses of accounting reports is to indicate assets a company can use to leverage/gear further financing. - A company can have deficits and a negative net worth many times, but fails the first time it runs out of money. Any money that needs to be put aside for a future liability is an encumbrance or provision. - Sometimes, the money can go into a sinking fund to repay a debt or replace a wasting asset. - The amount of unsecured debt a company owes if it's liquidated is its subordinated debt. A [loan](money-2_debt.md) can be compound or simple interest: - Simple interest loans charge periodic interest on the principal (e.g., an unpaid 3% on $100 is $103 on Month 1, $106 on Month 2, $109 on Month 3). - A compound interest loan charges interest on the principal *and* interest (e.g., an unpaid 3% on $100 is $103 on Month 1, $106.09 on Month 2, $109.27 on Month 3). - Compound interest is subtle, but over time it creates exponential (and [some would say extortionate](money-2_debt.md)) costs on unpaid debts. ### Accounts payable (A/P) Even if an organization stays *very* diligent to paying all its bills, an organization will always have some form of owed payments that are "payable" to other entities: - [Payroll](business.md) (the most common) - Alongside payroll, there's also withholding for tax and benefits (e.g., health [insurance](money-insurance.md)) - For convenient payroll calculations, 3 minutes is equal to 0.05 hours - Outstanding [loan](money-2_debt.md) principal or interest to be paid to other entities. - Subscriptions which expect payment *after* delivery. - Trade Payable, which is when a vendor has given goods or services but hasn't been paid yet. Often, not tracking liabilities can cause loans to go into default and further troubles for an organization. Sometimes, charges need to be reversed, usually for defective goods or poor service. - The [Visa/Mastercard](politics-monopolies.md) duopoly means many payments have guaranteed transaction fees. - A chargeback is reversing the payment, which may still incur transaction fees. - Rebates give a partial refund for services that were overpaid or partly used and then canceled. - Credit notes cancel a customer's debt. Debts can be secured (with some form of collateral) or unsecured (with a promise and wishful thinking). - Unsecured debt is essentially impossible for the lienholder to ensure it will be paid. - While most secured debt is against the object in question (e.g., an [automotive](autos.md) for an auto loan), it can be collateralized on essentially anything the lienholder will [agree to](people-6_contracts.md), typically with a refinancing agreement. ### Bonds While anyone can borrow money from a bank, sometimes a company does *not* want to use a bank, so they'll issue bonds instead. - A bond is a specific [debt instrument](money-2_debt.md) that allows large organizations like governments and corporations to borrow a *lot* of money from many people. In its most straightforward use, a bond's structure is relatively straightforward to understand: 1. An organization issues bonds with an interest rate and maturity, typically in $1,000 or $100 denominations (e.g., 10,000 bonds at a $1,000 face value). 2. Those bonds will have a certain number of years to maturity, with an interest rate (e.g., $1,000 face value, with a 4% yield to maturity in 3 years). 3. The bond price will be whatever the investor originally pays (e.g., a $1,000 bond with a 4% yield to maturity in 3 years is $889). 4. Before the bond matures, the investor can take back their money without interest. 5. At the bond's maturity, the investor can redeem that bond at any time, and the organization must make a balloon payment of the entire amount. This gets *much* more complex, though: - Some bonds are callable *before* the maturity date. In that situation, the yield-to-call will be lower than the yield-to-maturity (e.g., 1.7% instead of 4%). - Bonds can be sold at par, but also can be sold at a premium or discount. This can happen from [market conditions](economics.md) for the bond, as well as the [reputation](image.md) of the organization. - The organization can use a coupon rate, which is where the organization pays a set percentage of interest every year (e.g., a 4% coupon rate on $1,000 pays $40 a year). - If the coupon rate is the same as the yield rate, the organization will simply pay back the original amount when it's called. Like any other debt obligation, bonds can be secured or unsecured: - Secured bonds collateralize an asset. A mortgage-backed security (MBS), for example, will collateralize the title of the borrower's [home](home-buy.md). - Unsecured bonds by companies are called debentures. In the event of a liquidation, unsecured creditors will only get whatever assets are left over *after* the secured investors. Short-term bonds are 1-3 years' maturity, medium-term are typically 10 years, and long-term are over an even longer period of time. ## Equity Assets deals with things that "exist", and liabilities deals with things that are "owed", but equity is strictly conceptual. - Since [investors](money-investing.md) often make [decisions](people-decisions.md) from [optics](image.md) (or are taken in by [fashions](trends.md) they [don't understand](understanding.md)), there are *many* complex domains within equity that have very little practical explanation. - The only 2 ways to increase profits are to increase revenues or decrease expenses. There are a few forms a business can take. They are either taxed *before* the owner receives money, or it's pass-through to the owners: - A sole proprietorship is a person's individual business (pass-through). - A partnership is the shared business of several individuals (pass-through). - A Limited Liability Company or Limited Liability Partnership (LLC/LTD or LLP) is a legal (not accounting) demarcation to protect the business owners from [liability](legal-safety.md). - A corporation is a living, separate legal entity that's incorporated on a specific date, and comes in a few forms: - A C corporation can be publicly traded (*not* pass-through). - An S corporation has many more filing requirements and can't be publicly traded (pass-through). In a publicly traded company, the shares are owned by whoever is willing to pay for them, and the majority stakeholder typically has decision-making power over the company. A company can also perform a share repurchase, where it buys back the shareholders' shares of stock. ### Income A company that succeeds in an accounting period will have money left over, and it has several options: 1. Save it as Retained Earnings, typically by placing it in a reserve account (i.e., make a [self-insurance](money-insurance.md) policy). - It's taxable, but reinforces Operating activity. - A not-for-profit organization can't technically make a profit. 2. Reinvest the money into more assets (e.g., buy new equipment). - Often *not* taxable, and can be an Investing activity. 3. Pay down liabilities. - Not taxable, like a Financing activity, but boring to [executives](mgmt-1_why.md). 4. Use the money as [collateral](money-2_debt.md) to get *more* liabilities. - Not taxable, a direct Financing activity, but exposes more [risk](safety-riskmgmt.md) to the company. 5. Send the money out as Owner's Draw (to the owner) or Dividends (to the shareholder). - Taxable, and lowers the company's net worth, but is how people who own the company get paid. Calculating total earnings isn't always simple: - Gross income is the total earnings after subtracting loss from profit. - EBITDA: earnings before interest, tax, depreciation, and amortization. - EBITA: earnings before interest, tax, and amortization. - EBIT: earnings before interest and tax. - Net income comes *after* removing expenses, interest, tax, depreciation, and amortization from revenue. - The quality of earnings is *actual* earnings that come from higher sales or lower costs, and can't be attributed to accounting anomalies. ### Expenses Overhead is the cost of keeping the organization running that's *not* tied to production or sales. - The break-even point is the precise number of units that must be sold in an accounting period to return a profit. - Quantity to sell = total fixed costs / (selling price per unit - variable cost per unit). - An example helps the most to illustrate the concept: - It takes $10,000 to run the organization in a given month. - That same month, the company's product can sell for $100 and costs $50 to make. - If the company sold 100 units (making $10,000), it would cover the overhead, but not the per-unit price. - To make a profit of $0, they would need to sell 200 units (10,000 / [100 - 50]). Operating risk is when fixed operating expenses are high enough that they may interfere with profitability. ### Paying out If the organization isn't owned by a singular entity, the owners each own a percentage of the earnings. - The company's stock is a fractional "sharing" of that company. - Preferred stock is paid dividends first and has priority with company assets (e.g., with a liquidation), but the shareholders don't have voting rights. - Common stock is secondary on dividends and receiving assets, but shareholders have voting rights. - The rights to [manage the organization](mgmt-1_why.md) are often *not* evenly matched with the income they'd receive (e.g., board members can't own common stock). Often, the language of the corporate bylaws dictate how stakeholders can be paid. - Frequently, the leadership leaving can trigger a golden parachute, leaving that executive *very* wealthy even as they leave the organization. ### Equity games A stock split divides the shares evenly (e.g., 2:1 or 3:1). - This means every shareholder has twice or thrice the shares, at 1/2 or 1/3 the value. - Nothing technically "changes", but our [bias](mind-bias.md) means it can influence people to buy more stock. For various reasons that affect equity, a business can be carved out into different domains: - Some portions of a business are cost centers (often e.g., accounting, [IT](computers.md)) and others are profit centers (e.g., sales, [marketing](marketing.md)). - Segment reporting divides out various divisions of a business to create specialized reports. While a dividend is considered income that goes to the shareholders, a share repurchase/buyback is considered an expense. - Therefore, net income can be reduced by buying company shares back from shareholders. The nominal value of a share, when it's first issued, establishes its initial public offering (IPO). - That IPO value *will* move around (meaning its value isn't *that* utterly important), but it generally represents a dramatic shift in the way a company operates and indicates the first time the public can purchase it. - The listing requirements for IPOs are a [legal domain](glossary-legal.md) that falls *way* outside the range of accounting. ### Stock markets The complexity of stock markets comes through a proliferation of third parties. - Market makers are individuals or entities that arrange [two-sided transactions](people-6_contracts.md) to buy or sell securities and make a profit between the bid (buying) and ask (selling) price. - The National Best Bid and Offer (NBBO) represents the highest bid and lowest ask for a security, making it the tightest bid-ask spread. - Payment for Order Flow (PFOF) is a small commission the market makers make when ## Valuation Typically, valuations take more work than most standard accounting activities, so they're made annually at most, or when needed. - The measurement will be very specific when investors, governments, or equity-holders want to see it. [Estimations](imagination.md) and [reality](reality.md) don't always match, and variance is the difference between them. The book value is the lesser of the original cost paid for the asset (historical value) and its current value (fair market value). - Sometimes, a buyer can pay a premium on top of the advertised price. - Other times, the asset can be discounted. Cost-based pricing determines the price of the sold good on how much it costs to manufacture, *not* on [marketing](marketing.md). - Typically, a highly competitive market *requires* cost-based pricing, and increasing profits involves cutting costs while maintaining the product's quality. One of the most severe procedures associated with valuations is when it goes bankrupt (or insolvent if it's an LLC): 1. All secured debt is reconciled first, typically by those organizations claiming their assets. 2. Any remaining assets are liquidated to pay the rest, based on a specific order. The discrepancy between the appraised net worth and publicly interpreted value by a company is often different. - Gross margin is the difference between the cost of making/getting something and how much it's sold for. - Accountants only concern themselves with Fair Market Value (what its assets are worth, minus its liabilities) and Historical Value (what people originally paid for it), so they plug in Goodwill for the price will people *actually* pay for the company. ## Ratios There are *tons* of ratios, which take several numbers to create a third number. - Most of the ratios can be useful to determine the health of an organization, barring [Goodhart's Law](lawsaxioms.md). - Numerous ratios serve as key performance indicators, and new ones are constantly arising. Ratios which measure profitability: - Operating profit margin = operating profit / total sales - Net profit margin = net income / net sales Ratios that indicate how prepared a company is for short-term changes: - Current ratio (or working capital) = current assets - current liabilities - Quick ratio = (current assets - inventory - prepaid expenses) / current liabilities Ratios that indicate long-term financial strength relative to debt: - Debt ratio (or debt-to-total-assets) = total liabilities / total assets - Long-term debt ratio = long-term liabilities / total assets - Debt-to-capital ratio = total liabilities / (total liabilities + total equity) - Debt-to-equity ratio = total liabilities / shareholder equity - Fixed-charge coverage = EBIT / all interest and lease payments Ratios that can indicate investment performance and profitability: - Return on equity = net income / average shareholder equity - Gross margin = gross profit / net sales - Return on assets = net income / total assets Ratios for multiple owners' return on their investment: - Earnings per share = total profit / number of shares - Price to earnings (or P/E) = the market price of a share / earnings per share - Can use the previous 12 months (trailing P/E) or projected 12 months (forward P/E). - Price to book value = share's market price / (share's book value - intangible assets) - Price to sales = price per share / revenue per share - Dividend yield = annual dividend / share's market price ## Primary roles While [computers](computers.md) have completely automated every aspect of accounting, the two remaining domains that require humans for the role are in [taxes](money-accounting-taxes.md) and auditing. ## Auditing Audits are an extremely mind-numbing process of examining an organization's entire accounting system. There are 3 types of audits: - Internal audits - company employees examine issues with financial and business practices. - External audits - independent evaluators examine financial records to provide an objective opinion that affirms their financials are accurate and complete, or offers guidance to help them make more informed financial decisions. - Internal Revenue Service (IRS) audits - financial examinations conducted by the IRS to ensure tax was sufficiently paid. Irrespective of whom, the process is straightforward: 1. Start with the first accounting period to audit. 2. Start with the first account. 3. Grab a sample transaction from that account. 4. Thoroughly examine the sample transaction and all supporting evidence. 5. Ensure the transaction has material evidence and is accurate. 6. Repeat Step 3 a few more times. 7. Move to the next account and repeat Steps 3-6. 8. Repeat Step 7 until all accounts have been audited. 9. Move to the next accounting period. 10. Repeat Steps 2-8 for that accounting period. 11. Repeat Steps 9-10 until all accounting periods have been audited. Auditors are hunting for specific things that may represent worse problems: - Compensating errors - two mistakes that curiously canceled each other, since it may belie worse problems. - Creative accounting - clever methods that make accounts appear like the balance is higher or lower than they really are. Underneath all of it, auditors work to expose unethical or criminal activity: - Fraud - intentionally misusing a company's resources. - Money laundering - hiding illegally obtained money by merging it in with legal activities. - Negligence - disregarding the rules or failing to exercise proper care in keeping records. Auditors, like claims adjusters, do *not* believe in mere coincidences, and they will issue an opinion after their investigation: - Unqualified opinions indicate that the information is sound. - Qualified opinions indicate they have a "qualification" that demonstrates a problem with the information. There are also specific audits for [ESG](politics-leftism.md) and [cryptocurrency](computers-blockchain.md), but they're new enough [trends](trends.md) that there's not as much precedent as a standard audit. ## Mergers/acquisitions Generally, a company that isn't growing is dying, and they grow through several approaches: 1. Growing larger and expanding their operations, which will reflect somewhere on their financials. 2. Acquisitions of other companies, though they themselves may grow larger as a unit of a larger company acquiring *them*. When a company is purchased, the relationship between the entities gets complicated. - A merger combines the accounts together from two entities to form a singular, separate third entity. - An acquisition keeps the accounts separate, with a parent and subsidiary company. - A consolidation combines all of a subsidiary company's accounts into a parent company, and shares being exchanged in a stock-for-stock merger. - Consolidated financial statements track *all* activities of a parent company, along with its subsidiaries. Most of the issues tie into [conflicts](people-conflicts.md) about company valuations, along with the [rights and privileges](people-boundaries.md) that naturally emanate from the forms of the final business entities from the procedure. Beyond the value of an asset (which may have [sentimental value](mind-feelings.md) for some investors), there's a Total Cost of Ownership (TCO) that diminishes the simple value of something: - New software - Installation costs - Transition costs - Employee training - Security costs - [Disaster recovery planning](safety-riskmgmt.md) - Ongoing support costs - Necessary future upgrades ### Merger games An IPO is pricier and more complicated compared to a merger/acquisition, so a relatively new vehicle for companies is to create a special purpose acquisition company (SPAC): 1. Someone creates a corporation that's publicly traded, but with zero assets or liabilities. - Its $0 or negative IPO net worth is therefore tax-free. - People will trade that IPO on a market based on their understanding that the company *will* purchase other companies. 2. After the first accounting period or tax year, the company purchases other companies. - Those other companies were privately held, but are now part of a mega-merger with other companies. 3. After a few purchases of those other companies, the corporation operates like any other corporation. - The legitimate value of the SPAC is based on the performance of those other companies, give or take how well they were [managed](mgmt-1_why.md) during the entire time up to that point. - SPACs are particularly popular among industries that lean heavily into [intellectual property](legal-ip.md), such as [software](computers-software.md) or pharmaceuticals. ## Breakups A company can sometimes become too large. At that point, it may need to break up: - The company has too much [bad publicity](image.md) and needs a [new brand](marketing.md). - The leadership had a [difference of opinion](people-conflicts.md), and they agree to segment the company internally into several subsidiaries. - A government considers them too large as a [monopoly](politics-monopolies.md), and uses [laws](people-rules.md) to break them apart. However it happens, the accounting typically records the information as at least a partial liquidation of the original entity, then the formation of a new entity. ## Accounting fraud There are many ways to violate GAAP and lie on accounting reports. Money laundering involves moving money across multiple entities to make the accounting appear legitimate. - Income must be overstated (to move money in). - Expenses must be proportionately embellished (to move money out as well as avoid the risks of a tax audit). Losses that *should* be indicated as expenses can easily be obscured as future losses if the liabilities aren't closely tracked. Using shell companies offloads expenses or revenue onto subsidiary companies. - The concept is relatively simple: 1. Create a subsidiary organization. 2. Pass on all expenses to that organization. 3. The publicly traded entity will make obscene profit, creating an [investing](money-investing.md) boom (e.g., Enron). - This can also be reversed to avoid taxation, with shell companies in more tax-favored situations receiving the revenues. In [unregulated](people-rules.md) [cryptocurrency](computers-blockchain.md), traders can use wash trading (inspired by wash subscribing in [marketing](marketing.md)) to magnify the value of their assets: 1. Make a cryptocurrency that mines across at least a few servers. 2. Perform many, many trades (often with fees) with yourself, which makes it look wildly [popular](trends.md). 3. [Advertise](marketing.md) to as many people as possible that your cryptocurrency is wildly popular. 4. If you can acquire enough actual users, you've created a legitimately popular cryptocurrency and can sell your assets for actual cash.