Accounting & Finance: It's Not Black and White 22 December, 2010

Everyone knows that finance and accounting deals with money. What they don't know is that these two subjects are not black and white. Assuming ethical behavior is taking place, there are three factors that make the numbers not so obvious, predictable, or in other words, black and white.

First, the interpretation of many measurements can vary because there is not a globally accepted way to calculate everything. Not only are there different accounting standards from country to country, the best way to calculate many financial ratios differs depending on who you talk to. There are also different algorithms to calculate items such as depreciation and inventory attributes. Knowing the general theory behind many financial ratios can lead to a more correct interpretation.

Second, assumptions are used to predict elements that are unknown. These assumptions are best guesses by individuals that themselves may not have all relevant information. Aside from discussions or critical thinking, assumptions can also come from a probability analysis based on best and worst case outcomes. A common simulation used to create these assumptions is the Monte Carlo method.

Third, the availability of inside information may not be widely known, but may contribute significantly to changes in the numbers. This factor can be hedged by having an understanding of annual and quarterly reports. One of the most important parts of annual and quarterly reports, besides the actual financial statements, is the Management Discussion and Analysis (MD&A). Management is required to divulge any important risks, benefits, or other factors that could affect the current state of the company or any official projections that have been made.