Chapter 2 - Spotting Assumptions, Estimates, and Biases Flashcards
Allocations
Allocations are apportionments of costs to different departments or activities within a company. For instance, overhead costs such as the CEO’s salary are often allocated to the company’s operating units.
Berman, Karen; Knight, Joe. Financial Intelligence, Revised Edition: A Manager’s Guide to Knowing What the Numbers Really Mean (p. 12). Harvard Business Review Press. Kindle Edition.
Accruals
An accrual is the portion of a revenue or expense item that is recorded in a particular time span. They are used to match costs to revenues in a given time period as accurately as possible
Depreciation
Depreciation is the method accountants use to allocate the cost of equipment and other assets to the total cost of products and services as shown on the income statement. It is based on the same idea as accruals: we want to match as closely as possible the costs of our products and services with what was sold. Most capital investments other than land are depreciated. Accountants attempt to spread the cost of the expenditure over the useful life of the item. There’s more about depreciation in parts 2 and 3.
Berman, Karen; Knight, Joe. Financial Intelligence, Revised Edition: A Manager’s Guide to Knowing What the Numbers Really Mean (p. 13). Harvard Business Review Press. Kindle Edition.
What are three key questions to ask when analyzing financial numbers?
What were the assumptions in this number? Are there any estimates in the numbers? What is the bias those assumptions and estimates lead to?
Why do accruals and allocations often involve assumptions and estimates?
Because accountants need to determine how to match costs with revenues in a specific period, and how to allocate costs across different parts of the company, and this often requires judgment. For example, they may need to estimate how much of an employee’s salary should be allocated to product cost versus development cost
How can decisions about accruals and allocations affect a company’s financial statements?
They can dramatically change the appearance of the income statement. For example, allocating more salary to development costs can make product costs seem lower, and vice versa
Why is depreciation considered an “artistic” aspect of finance?
Because accountants have discretion in how they depreciate an asset, meaning that the way they choose to do it can significantly impact a company’s financial results and reported profits
