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Accounting Allah shmoop ways to be Ski Z So if

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honest cold neutral UN emotional financial reporting is thie accountants

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flavor of the force then what are some ways in

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which the force gets cheated at least in the short

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run All right well let's consider an example here in

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the realm of depreciation your thinking of investing in a

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drone making company Blade Runner Nano Drone Ticker Brnd It

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has to build a new twenty million dollars factory every

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four years to upgrade its processes and stay calm petted

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with its arch rival the drones own If the company

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produced eight million dollars in cash profits in a given

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year but ignored the fact that they have to replace

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the factory every four years for a cool twenty million

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bucks there well then it would look like the company

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made eight million dollars that year Ski's alert Well yes

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you could in fact just talk about the fact that

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the company in the last twelve months produced eight million

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bucks in cash That would be a true statement But

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if it hits the wall every four years by not

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spending to build a new whiz bang factory it's sales

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then plummet and well then it's out of business three

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years later so it has to spend that money for

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upgrading the factory The statement of eight million dollars in

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cash profits is true but misleading Welcome to the teachings

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of the force of gap accounting Bye gap standards That

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company should account for the fact that the twenty million

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dollar factory is depreciating in value each year That is

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it's getting worth less and less every year If they're

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accountants applied straight line depreciation to that twenty million dollars

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in cost every four years Then they would take out

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five million a year from that eight million dollars of

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cash profit to account for the fact that twenty million

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dollars worth of that profit will be used up in

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building a new factory So what's the right number for

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Gap profit here A least notional profit Well yeah it's

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just three million dollars not nearly as profitable a company

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as that eight million dollars of cash generated might have

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made it seem to be at first And this is

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a re a really big deal in a world where

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companies are valued usually as a multiple of their profits

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not revenues not arm leavings by the CEO not units

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sold Not well pretty much anything else over time anyway

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Profits or earnings Riel earnings Not just one year's onetime

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cash production earnings are the primary driver for the method

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in which companies are valued when bought sold and or

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traded publically on Wall or Bond Street If it going

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multiple at which a stock trades is something like it

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twenty times their earnings or their profits well fudging profits

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can be a huge delta in the value or valuation

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of the company That is twenty times the eight million

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dollar figure here gives you a huge number one hundred

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sixty million dollars that you think you might value that

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drone company at while twenty times the three million gives

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you well a whole lot less one hundred million dollars

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less to be exact One tiny fact or gaff element

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omitted and glam o one hundred million dollars hit to

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the value of your company Will gap is the force

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It's the rules the law the Constitution It's the structure

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behind which every bean is counted and then fairly represented

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to investors to the company To the world The beauty

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of gap is that it sets all of those beans

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on a level playing field you know so they don't

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roll off the table What with Gap Everyone follows the

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same rules Sono cos numbers get you know uniquely wonky

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So this first example was about fairly allocating known costs

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for known events like the upgrading of a factory to

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produce drones But having already know numbers is a luxury

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in a lot of cases What happens when you have

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no idea what the newer new newest factory will then

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cost when you're ready to build it Or that it

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needs to be a nuclear powered or that it has

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to buy a land permit somewhere and it has no

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idea what that permit will cost Well when you don't

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really know what something will cost you'll want to reserve

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expenses for it in some form You go out and

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get blind folds from your fifty shades party gay game

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pack have your partner's spin you around three times and

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then you throw a dart and ooh that's gotta hurt

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Yeah you throw the dart and you just guess Well

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the idea simply being that you give yourself some reasonable

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wiggle room there which when you're trying to avoid dart

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is really important Picture this scenario The company you love

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so dearly just got sued for testing They're dissolving agent

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on puppies The company is only worth three hundred million

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dollars yet it's being sued for a billion That is

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the lawyers on the other side want the company to

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hand over the keys to the castle in its entirety

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and fully go away in order to pay for the

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damage done Well What's the right number two reserve as

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an expense in this situation Well in other words what

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costs can you anticipate having to pay in the future

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rather than just accounting for what you have to pay

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right now in the weekly retainer lawyer bills Well if

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company reserved a billion dollars and they calculated that it

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would take a decade to pay it all off well

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they could then take one hundred million dollars a year

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deduction in their profits at least notionally such that the

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expected one hundred million dollars a year of profits would

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become zero And voila The company would have no taxable

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profits at least not for very long In fact more

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likely a team of lawyers would give an educated guess

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as to the real amount of the damages which might

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be a lot closer to three million dollars than a

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billion To be conservative the company might reserve unexpected loss

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of ten million or even twenty million payable over a

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few years which would reflect how most lawsuits like this

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gets settled in real life So the basic idea is

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that Gap Accounting requires the company to be conservative but

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not ridiculously so Like Goldie Locks gaps Dr Tio not

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be too hot not too cold but you know get

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the porridge They're just right Okay Another Gap Force element

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beyond fair representation of profits and proper methods of reserving

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is about matching And it has nothing to do with

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a dating site angst and or bitter loneliness Matching in

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fact is the practice of cordoning off revenues with relevant

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expenses or assigning related elements in a business with each

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other So that if you had a global whoopee cushion

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distributor but the warlords in Somalia decide one year that

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those would now come their weapon of choice Well when

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the Somalian division had huge revenues those revenues would be

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held inside of Lionel say the African Division and not

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attributed to the sales of whoopee cushions in Switzerland where

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they're really not into no thinking would be specifically The

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goal of matching is to try and present the best

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clearest reflection of how the business is honestly doing without

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trying to make it look better or worse than it

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actually is So one core element of Gap accounting is

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toe match revenues and expenses such that they both will

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have occurred in the time period in which they occur

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Your computer printer manufacturing company orders ten thousand plastic form

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factor housings toe hold the ink paper roller input output

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devices etcetera You sell only eight thousand units during the

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quarter in which you were obligated to pay for those

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form factors Right See about ten thousand years sold only

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eight So what's the matching rule here How does it

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apply How do you properly match the sails and the

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expenses in the period Well you had to pay for

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ten thousand housings Always cash for them and it went

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out the door and recede of them came in the

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door to your storage warehouse which you pay cash to

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rent So there's some amount that you're paying to store

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those housings that goes beyond what you paid for the

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individual housing itself Inventory of storing It ain't free people

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anyway Being conservative you recognize paying for these plastic housings

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all upfront as an expense largely because the remaining two

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thousand units are barely worth anything If you had to

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go sell them quickly on eBay So one way you

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can rationalize the matching here is to expense the inventory

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entirely upfront As if the minute you bought it all

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of it became well essentially worthless So you completely write

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it off as a dead asset In this way you're

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taking the most conservative route in valuing the inventory you've

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just acquired You've done this believing that next quarter you'll

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sell that last two thousand and your earnings will appear

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more profitable than they are Actually we were because you

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were overly conservative in the previous quarter Bear rational reasonable

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gap compliant Well probably sure Maybe it is an insane

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that you would sell no more units ever but it's

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probably overly conservative here And well the more traditional way

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you track these set of beans that you're counting is

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to just match the eight thousand in sales with the

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eight thousand informed factors you bought leaving two thousand form

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factors held that book value or whatever the printer manufacturing

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company paid for them in the first place Yeah that's

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book value Alright set another way You note that the

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form factors you've purchased are only useful or have value

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If and only if you sell them composited with drones

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that you're selling that is your bundling the form factor

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in with the Peller guts battery powered guidance systems et

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cetera of the drone If you do not sell drones

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for whatever reason competition and asteroid from space wealth in

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the plastic housing around them is worth well whatever it's

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worth when it's melted down which is probably one hundredth

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of the price you actually wait for it The key

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idea here is that not everything is obvious and you

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need to have a consistent rationale for the way you

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manage your company's accounting in a given period You are

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in a way the guardian of truth justice and the

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accounting way It's almost a sacred thing to adhere to

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the financial force in being truly honestly neutral when presenting

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your numbers And likewise it's the duty of the auditor

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of an accountant's work toe sniff carefully for lies or

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leanings away from the cold neutral un emotional honest truth

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and well that happens to be our favorite brand of

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tea as well Run

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