Class Takeaways — Learning the Language of Business

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Ed deHaan: Hi, my name’s Ed deHaan. I’m the MBA Class of 1963 Professor of Management here at Stanford’s Graduate School of Business. I teach the Financial Accounting and Reporting class that all MBAs take, their first quarter here at the GSB. Today, I’m excited to share with you five takeaways from that course.

Now, my first takeaway is something you might’ve heard before. It is accounting is the language of business. Now, what do I mean by that? Imagine firms in different industries. We have a manufacturing company, a tech company, an oil and gas company. They have completely different products and completely different internal structures. Yet at the end of every quarter, they all produce a set of common financial reports. That commonality is what allows investors and other outsiders to analyze companies in different industries or even different countries on a comparable basis. Accounting is also the unifying language within organizations. Imagine a boardroom. We’ve got the CEO and the CFO. You also have the chief marketing officer, the chief technology officer, maybe the head of HR. Their jobs are very different. Yet in the boardroom, they can all talk in a common language of assets, liabilities, revenues, and expenses. This is why we call accounting the language of business.

The second key takeaway is that accounting numbers are not statements of fact. They’re instead often opinions. They’re based on accounting principles and rules. They’re based on assumptions. And at the end of the day, it’s a lot of managerial judgment. The problem is that everything has to be boiled down to a dollar value in order to be presented on an accounting statement, and those values are often highly uncertain. Take for example something as simple as a firm’s sales revenues. Revenues are not just a matter of adding up the cash receipts in the register. You also have to think about things like, well, how many products are going to be returned next quarter? That value has to be reduced from revenues. You also have to think, how many services or products did we deliver, but we haven’t yet billed for them? Well, that needs to be included in revenues. It can be hard, even for a small company to accurately estimate its revenues in a quarter, let alone for a multinational corporation selling thousands of different products and services all around the world.

Now, things get even harder when we’re trying to determine the value of intangible assets. Think about when Facebook bought WhatsApp back in 2014. They paid billions of dollars for it. And they had to value things like the trademark of WhatsApp or the value of how many users already had WhatsApp installed on their phones. It turns out that the value of those two things were two and a half billion dollars, but that’s a wild estimate. It might be much higher, it might be much lower. Because accounting numbers are often based on assumptions and judgments. There is plenty of room for someone to manipulate those numbers for their own gain. So being a informed user of financial reports requires that you carefully consider the incentives of who prepared the report, what is it that they would like you to believe, and where might they have massaged the books in their own favor?

Now, here’s an example using real data from the real world. This is a distribution of firms earning surprises at the end of the quarter, which is an accounting number that firms report. What we see here is a kink in the distribution. There’s too few small earnings misses, and there seems to be too many small positive earnings surprises. So what this data indicate for us is that something fishy is going on below the surface. Probably what’s happening is that managers get towards the end of the quarter, they realize they’re not going to hit their earnings target, so they somehow manipulate the books to squeak out that small earnings surprise. Now, to be clear, this behavior is unethical and very likely violates GAAP and the law. But we spend a lot of time in class thinking about how companies prepare their reports so that we can be skeptical and informed users of those reports.

No single number can tell the real story of a company. You instead have to consider the financial statements in their entirety, understand them holistically so you know which direction the stock price might go. Let’s take for example the tech companies all around Stanford at the moment. Many of them are reporting big declines in cash flows and big increases in expenses. And at first glance, that might seem like a really negative sign. But you look below the hood and what you see is those companies are spending big bucks on AI. And that investment now might produce big revenues in the future. So at first glance, these indicators look like the stock price should go down, but in reality, investors view it as a good thing.

No matter what role you want within a company, reaching the highest levels of management in that role will eventually require that you can speak the language of business. Think about the example of being a marketer. You might be the most brilliant artist. You can create content that engages people. And you might be a wonderful manager of the artists and designers on your team. But eventually, if you want to be in that boardroom speaking with the CEO and CFO, you have to be able to communicate those marketing plans in accounting terms. You’ll have to be able to understand things like expenses and asset capitalizations. You’ll have to be able to explain when your marketing campaign will impact future revenues.

Being fluent in the language of business, understanding financial accounting will help you accelerate your career from mid-manager to senior manager. It’ll help you bridge the gap between all the different departments in the organization you work for. And it’ll make you feel more confident and comfortable as you work through your career. My path to professorship happens the way many people’s careers do. It was a bunch of happy accidents and I sort of stumbled into it. I ruled out a few things that I didn’t like and eventually found one that I do like.

My path to professorship happens the way many people’s careers do. It was a bunch of happy accidents and I sort of stumbled into it. I ruled out a few things that I didn’t like and eventually found one that I do like.