I knew they were talking English, but they might as well have been talking Martian. I was sitting in a meeting where the accountants were discussing the year-end accounts with my boss.
I heard the word ‘cost’, which I thought I understood, but then I heard ‘cost of sales’, ‘operating costs’ and ‘capital costs’, and wasn’t quite sure what the difference was.
‘Marginal cost’ and ‘opportunity cost’ came up next, and I started getting even more confused. What were all these different types of cost?
I kept my mouth firmly shut. When the conversation moved onto sales, I relaxed, as I thought I might now understand a little more of what was going on. But in a matter of seconds, I heard ‘PBIT’ and ‘ee-bit-dah’, and realised I was sinking even deeper into the murky world of accounting-speak.
The key words
At the first opportunity, I told Ronnie, my mentor and financial literacy teacher, about my confusion and embarrassment.
“Relax,” he said. “Of all the words in the English language, only about 3 400 or 2% are used in everyday communication. It’s the same with accounting-speak. While there might be some 4 000 words listed in the Oxford Dictionary of Accounting, you’ll only ever need to understand about 80 of them to have the accountants thinking you’re one of them!”
With this encouragement, and Ronnie at my shoulder, I set out to learn those 80 important words and what they meant.
The value of Intangible assets
As in all industries, accounting is littered with abbreviations designed to fool ordinary mortals, yet are often not that difficult to get one’s head around. PBIT, for example, is short for ‘profit before interest and tax’, or simply profit with interest and tax excluded.
‘Ee-bit-dah’ is ‘EBITDA’ – ‘earnings before interest, tax, depreciation and amortisation’. It’s almost the same as PBIT, but with ‘D’ and ‘A’ added for ‘depreciation’ and ‘amortisation’. In other words, earnings (‘profit’ by another name) with the costs of interest, tax, depreciation and amortisation excluded from the calculation.
‘Amortisation’ is similar to ‘depreciation’, but instead of being applied to tangible assets such as tractors and implements, which lose their value over time, and for which provision must be made to replace, it relates to intangible assets. These include trademarks, patents, goodwill and the like.
Ronnie told me that, more often than not, these intangible assets actually increase in value over time, unlike tractors and implements. However, accountants sometimes like to ‘amortise’ them, as this reduces tax, but let’s not plumb the depths of that mystery here.
Instead, let’s take a closer look at one of those intangible assets – goodwill. Think of all the time, effort and ingenuity that has gone into building a successful business, but which has never been calculated.
For example, consider the reputation value that a good business builds up with its clients over the years. This is ‘goodwill’, and while there is no doubt that it is very real, it is still intangible and its actual value is largely a matter of opinion.
Items such as goodwill, the accrual concept and several others we have not yet explored should be watched with an eagle eye, because they recognise cost or revenue without any cash actually flowing into or out of the business.
While the International Financial Reporting Standards Foundation has developed an excellent set of accounting standards, there remains room for interpretation.
This is why cash is the only fact you can depend on. As I have mentioned before, profit is an opinion, and, like all opinions, it can change.