Friday, September 23, 2011

Does Your Accountant Speak “Finance”?

I can’t begin to count how many times I saw a Vice-President of Finance role being advertised, got all excited, only to find that it was almost 100% accounting-related. Or a Director of Decision Support, only to find that it principally involved comparing actual accounting results to budgets.
[Disclaimer: I do not in any way mean to malign accountants by this post. I like accounting. I have taken enough accounting courses to qualify for an accounting degree. There are plenty of times in the course of a year when I use T-accounts to analyze transactions. Accountants should be a valued and esteemed part of any organization, performing numerous tasks that help it fulfill its mission.]
What seems to happen though is that accountants have a tendency to get caught up in GAAP and IFRS and things like that (disclaimer again: and at one level, rightly so). It is understandable, after all it is part of the profession and part of the certification.
However, sometimes the needs of the organization diverge from GAAP. Sometimes we need a finance view of things. Let’s be clear, Accounting and Finance are two very different animals.
A Potential Investment:
Assume that we have a cost of capital of 10% (which we have determined by some permutation of the capital asset pricing model), and we are contemplating an investment where, if we make it, will generate ²1 of cash per year for 10 years (the ² is a symbol for Treasury Café Monetary Units, or TCMU’s). We will be willing to pay approximately ²6.14 for this opportunity, utilizing the Net Present Value calculation (the formula for NPV can be found in an earlier post) below:
When valuing an asset - be it a machine, a business, a tractor - we pay attention to cash flows. Our investment above represents the most basic of investment archetypes, cash out in the beginning and cash coming in thereafter. A graph of this cash flow is:

Summarizing so far, we have dealt with items such as cash, cash flow throughout time, investment, and cost of capital - all important subject areas to a finance person. Also note that our endeavor so far has been future directed. We are valuing a projected stream of cash flows and determining their value.
A Tale of Two Returns
From the finance perspective, all free cash flow coming in is one of two things: a return on capital or a return of capital. If we put ²10 of our money into a bank CD for one year bearing 10%, then at the end of the year we get ²11. The ²1 is our return on capital, and the ²10 is a return of capital.
We can breakdown our ²6.14 investment into its return on and return of components for the entire investment horizon, as follows:
We can notice a couple of things here. Return On capital is higher in the beginning and lower later, and Return Of capital exhibits the opposite pattern. If we have a mortgage this is the same type of phenomenon - we pay a fixed amount every month, and in the beginning that payment almost entirely goes to interest (i.e. "return on") while near the end of the mortgage it almost all goes to principal (i.e. "return of").

We can also notice that return on capital, when it is divided by beginning asset value, is 10% for every period. It is not a coincidence that the cost of capital we used to value this asset is also 10%. From the above, we can verify that we have correctly valued the asset - if the return of capital is 10% every period and the ending asset value is 0 at the end, we know we started with the correct value.

Now, Enter the Accountants
In the accounting world, the matching principle requires that we attribute cash outflows into the period in which the benefits of those outflows are realized. One method used to do this is straight-line depreciation (other methods exist, double-declining balance, MACRS, etc.). Since our investment horizon is 10 years and we initially spent ²6.14 on the asset, using the straight line method under accounting rules we will depreciate 1/10 of the initial cost every year, or ²0.614.
The difference between the revenue of ²1 and the depreciation rate, assuming no other costs, is net income, and can be considered the return on capital (note that we are simply assuming that items not important to our example don’t exist, such as taxes, O&M, etc). The amount of depreciation is the return of capital.
Interestingly, this then is the pattern according to accounting of the above:
Notice, if we calculate return on capital (same as above, Return On / Beginning Asset Value) under this scenario, it varies from 6% to 62%!

Don’t Make a Bad Decision
This is a problem, especially if we are going to use past performance information to make decisions. Say we had two different investments, one that makes matchsticks and one that makes buggy whips, that both match our original payout profile (i.e. ²6.14 investment and ²1 cash flow for 10 years thereafter). Say our matchstick investment is now one year old and the buggy whip investment just finished its ninth year.
According to our accounting, we would have earned 6.27% on the matchstick business and 31.37% on the buggy whip business. What is the likely outcome of the decision to invest another ²6.14 in something? Most will naturally choose the higher returning investment.
Yet we know that there is no difference between the investments, they had the same payoff profile. The only difference was their length of operation.
What if we say that these two were separate businesses and we were investors? We might be tempted to overpay for stock in the almost 32% return business and underpay for stock in the almost 6% business. Overpaying and underpaying for two businesses that have the exact same economics?
The graph below illustrates over the 10-year investment period  the return using the economic value finance perspective and the return using the accounting methodology:

The Moral of the Story Is…
While we need to have accountants to produce required financial statements for investors and auditors in the accounting language, we need to make sure we have someone who speaks finance as well.
While we need to have accounting systems to correctly capture our organization's performance according to the established rules, we need those systems to provide us the flexibility to recast this data in ways that allow us to evaluate from a finance perspective as well.
Both accounting and finance are important in an organization, but let's be careful about confusing the two.
I would love to hear your thoughts about the language of finance or your stories on this topic if you have them.
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1 comment:

  1. Very good breakdown on the difference between finance and accounting. There is a large gap between the two. Having one and not the other in an organization could be costly. You wouldn't have an accountant pick your investments nor would you have your finance manager do the company taxes.