Accounting is Descriptivist (and why you need to know that)
For the past month, this idea has been gently tapping on my head with a little squeaky hammer.
The pieces have come together, and I’d like to share them with you.
(With the caveat that I am sometimes wrong. When it comes to Accounting, maybe even often wrong.)
Prescriptivist vs. Descriptivist Mental Model
I first learned this idea from a friend and linguist, Olivia Rhinehart. She explained the two types of linguists, prescriptivists and descriptivists.
Prescriptivists try to prescribe (“write before”). They believe linguists make rules about language, and people should follow them.
Descriptivists try to describe (“write down”). They believe people make the language to suit them, and linguists try to learn and understand how that language works.
Example: Saying “Y’all” or “Bae” makes prescriptivists angry and descriptivists curious.
I found “Prescritivist vs. Descriptivist” a helpful general idea. It helped me understand how people think, the culture of organizations, and how some systems work.
Realizing “Accounting is Descriptivist” unlocked a few important insights for me:
Accounting lags in the short-term
Accounting lags in the long-term
Accounting responds to behavior, not forbids it.
We’ll expand on each, and show why you might care too.
Accounting lags in the Short-term
If accountants are bean-counters, they can only count the beans that are already on the move. They are describing how beans are moving, not predicting or measuring in real-time. There are always outstanding expenses, accounts receivable, and expected future income whose beans haven’t been counted yet.
The Map is not the territory, and the financial statements are not the business. More to the point, the statements at the end of Q3 do not show you every day of Q3. You can drown in a puddle, and you can run out of cash surrounded by cashflows.
Every business owner I know could list off a string of invisible asterisks around their financial statements.
“Yes, but we have a big order about to come in from them.”
“No, because they were an early customer.”
“They always pay late, but they always pay.”
“That’s an expense, but is really an investment.”
“That’s a meal expense, but will pay back in referrals.”
Why does it matter that accounting lags in the short-term?
Don’t drown in that puddle. It’s expensive to run out of money, and just because a business looks healthy on an end of quarter statement doesn’t mean it had oxygen (cash) for every day of those 3 months. Important to know as an operator or investor.
The data isn’t real-time. If all you know is what’s on the statement, you’re looking at a 30-day old picture, not today’s picture. Like light from a faraway star, you’re reading the past, not the present. Find a way to know the present (and ideally the future).
When making decisions perfect information is ideal, but the best you can get may be understanding the foibles of the information you have.
Accounting lags in the Long-term
Like laws, culture, and sloths in suits, accounting conventions change slllooowwwlllyyy.
Our accounting principles mostly come from the era focused primarily on assets with atoms -- property, plants, equipment.
(I should have low natural believability on claims like this, and did not do deep research to support this particular claim.)
Today, assets are often intangible (brand, software, team). Google’s competitive advantage shows up nowhere on the balance sheet (hard assets), but everywhere on the income statement (engineer salaries, marketing expense, perks, recruiting).
Yet the team, the software they produce, and the resulting brand IS the value of the company. It’s the moat, the value-creation, the competitive advantage. But on an accounting statement, it looks like an “Expense.”
A mistake that no entrepreneur would make creating a dashboard to observe their company:
Because Accounting is descriptivist, convention lags, and accurately reflecting changes to business models immediately is impossible. It may be another 30 years before accounting principles change to reflect the intangible value created in software companies -- or maybe they never will.
To explore this idea much more deeply, financial writing legend Michael Maubbousion has written a rather large paper with many words exploring how companies are changing the pattern of their investment, and how traditional accounting often miscategorizes as a result.
It’s full of detailed graphs like this one, which make me feel smart just to look at.
If a 24-page paper doesn’t fit into your schedule, you can just read these tweets from Michael Mauboussin instead:
1/ Just a quick reminder that negative free cash flow is not bad in and of itself. The key question is whether investments will pay off. To answer that you need to understanding the basic unit of economic analysis - i.e., how the company makes money.
2/ Walmart was consistently free cash flow negative in the decade+ after it went public. But the store economics were very attractive so investment > net operating profit after tax created a lot of value.
3/ This is more complicated now as investments are increasingly expensed on the income statement vs capitalized on the balance sheet. Separating operating costs from investment expenses is tricky but more relevant than ever. Then work to grasp the basic unit of economic analysis.
“Separating costs from investment expense” sounds like something accounting is naturally supposed to do, right? But accounting is descriptivist, and conventions lag reality in the long-run.
Why does it matter that accounting lags in the long-term?
Speak only the language of the past, and you will miss the present. Warren Buffett missed the past 20 years of high returns in software companies, despite being besties with Bill Gates. WB was so used to seeing value based on conventional financials he couldn’t see these were excellent companies -- because it didn’t show up in the accounting.
Good investing requires looking past basic accounting language. If you saw the assets and advantages that didn’t show up in the financials, you had a great last few decades. With change changing faster than ever, this skill is only going to get more valuable. Tokens will value differently than equity, and those who get comfortable making judgments outside the territory mapped by conventional accounting will be handsomely rewarded. Accounting was not designed to help you value a business by predicting future cashflows!
Good operating requires looking past accounting language. Blindly minimizing expenses could cut off a major source of earnings or competitive advantage. Focusing only on traditionally defined assets may lead you to miss opportunities to build huge value or new cash flows.
This leads us to…
Accounting responds to behavior, not forbids it.
“Biology enables, Culture forbids” is how Farnam Street summarized Yuval Noah Harari’s idea from Sapiens. Many things are physically possible (natural) that we culturally condemn or forbid.
To adapt this idea in our context: “Accounting describes, Law forbids”
Traditional accounting has a set of standards, but they are not The Law. They are designed to make it simple and obvious to follow The Law. (Laws are also somewhat descriptivist over the long-term, but that’s another post.)
The law is what prevents you from committing fraud, not accounting principles. (*cough cough* Enron)
Just because an accountant doesn’t know how to account for something, doesn’t mean it’s not a good idea. You can make a good investment that completely confounds your accountant… and they’ll figure it out. Accounting responds.
This doesn’t mean your accountant isn’t full of good advice. She might have a better idea, or might save you money executing your idea…
Only to say: don’t let your accountant talk you out of a good idea because it’s not obvious ahead of time how to account for it.
Perhaps a clarifying example:
Me: “Can I buy Ethereum with the cash on my balance sheet?”
Accountant: “Yes and no. Can you please not?”
Me: “I can’t not. I’m going to.”
Accountant: “Shit. Fine. We’ll figure it out.”
Why does it matter that Accounting responds, not forbids?
Trust yourself to make good decisions, categorization be damned. If you give me a Prime Rib French Dip from Houston’s, I don’t care if it’s breakfast, lunch, dinner, or the last supper. I’m eating it. If I can invest money in a way that brings me a bunch more money in the future, I don’t give a shit what an accountant calls it, I’m investing.
(This is even more true with high proximity to profits.)
Accountants, like people, do not like extra work. If you’re doing weird new cool stuff (you contrarian!) that makes you money (you correct, non-consensus genius!) all it means to your accountant is more work for no extra money. Tough sell. Do you want to make the money or not?
Eventually, value creation and value capture create cash. If a person is a subject, the oil painting is the accounting. The painting itself could be photorealistic, abstract, or just awful. It doesn’t make the subject ugly. If you deliver value to customers, profitably and consistently you’ll succeed, even if you look bad in your painting.