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An excerpt from “A 30 Years’ War:” on the role of accounting

June 16th, 2014

Trouble is inevitable in a business. Management omissions, as opposed to commissions, do not cause it, but do increase its likelihood. Ordinary economic volatility—especially in tandem with a person’s overreaction—can cause a crisis. More broadly, crises are changes in the economy, driven by innovation, but often altered by the sometimes-fickle tastes of consumers.

Accounting cannot anticipate these changes. But if most trouble is caused by economic change, the trouble is made much more difficult by the failure of accounting. Trouble is impossible to overcome even with accounting, if its source is an adversary’s uninformed or misinformed reaction to economic events. Because of adversarial presumption, the next two chapters take up the problem of knowing and understanding the conditions outside the firm and the importance of forceful communication of the entrepreneurial idea.

An attorney, an associate of mine decades ago with 30 years’ experience in business bankruptcy, observed that trouble comes to all companies. At a break from chapter 11 proceedings, standing with him outside the courtroom, I asked him whether from his years he could summarize what he learned. He said that he had never seen a company in bankruptcy that had sound financial reporting. He said that the first thing that happens when things get tight is that companies quit looking at their financial reports, and the second is that they fire their accountants in order to save money. These two reactions are errors of commission for which there is little justification, and from which management has little possibility of redemption later on.

Despite its critical role, accounting is a poor predictor, because it is too slow and offers only symptomatic information. The gap, the delay between cause and effect, is too great. Accounting is symptomatic because it reports the effect, but it is scarcely able to detect the cause.

It is said that most business failures are failures due to sub-par management and insufficient capital. This is tautological causality. That is, since the business failed, it follows that the cause is poor management. Since it ran out of money, it therefore did not have enough capital. All that begs two questions: What is good enough management, and what is enough capital? (Note: not failing is not the same as succeeding.)

Two decades ago, driven by growing frustration, I began looking for answers. Incidental to a conference on management I was attending, and pondering the comments by the business bankruptcy specialist, I came to this:

Failing is caused by four things:

1) untimely, unreliable, and incomplete financials;

2) failure to read the financials;

3) excessive investment in inventories and receivables; and

4) doing things the same old way, because that is how we’ve always done them.

At the time, these four seemed a fairly reasonable and approachable answer to sound management and sufficient capital. Although negatively bent (how not to fail), I still relish them for their basic application to entrepreneurial credibility.

They have still another merit. It is based on the observation that many competitors will sooner or later fall short on more than one of them. It is survival by attrition. But like the German defensive strategy in WWI, entrepreneurial success is eventually lost on the home front. Not failing can be the means of buying time for an idea to succeed, but it is not by itself the means of success.