Opinions Wanted: The Usefulness of Financial Accounting

Ken Abbott

Managing Director
Quantitative finance is now about 35 years old* and some quants are assuming positions in senior management within banks and funds. (Example: my old boss at Barclays, with 3 degrees form MIT is now CEO.) I think that for practicing quants, knowledge of accounting has limited value. As one ascends up the management ladder, however, understanding exactly how P&L and more generally, "value" is measured, monitored, and reported becomes crucial.

How should quants be introduced to accounting concepts?

I'm "quant-lite" on a good day and I got my introduction by taking three semesters of accounting in the 1980s. Those courses gave me the background I needed to figure the rest out.

What are the key accounting concepts quants need to understand?

Most of accounting isn't rocket science, but I have found that understanding depreciation and amortization, credit loss accrual and posting, and the general flow of data from the P&L through the Income and Expense Summary and onto the balance sheet to be invaluable. Also, it's good to understand the concepts of hedge accounting revenue recognition and trading book/banking book distinctions.

I will be introducing some of this into my risk course in the Baruch MFE program as well a into some quant leadership material we are assembling.

*I usually assign the start date to 1987 or so because in 1985 the few practicing Wall Street quants were viewed as voodoo alchemists, but by 1989 people with quant skills were actively and systematically being sought on human resources people.
 
I really like the idea of slapping some traditional financial management to quant programs to provide a bit more wholistic education. Also, could not agree more with the increasing importance of financial accounting as one moves up the corporate ladder. Important to note the word "financial" in the nomenclature - to me, that means that one does not necessarily need to be able to put together all three major statements from scratch (that's what actual accountants are for), but rather be able to read them and understand them thoroughly.

I'll caveat that I might be thinking about this differently because I'm used to looking at my client's financials (in the Energy sector), not at my own team's / bank's. So if the goal is to have students look at their own team's P&L and then make decisions based on that, feel free to disregard the below if not useful. Put another way: I'm not thinking about teaching accounting solely from inside the bank's perspective, but from a more general standpoint.

How should quants be introduced to accounting concepts?
Given the nature of the MFE student pool, most people (in my experience) has had zero exposure to accounting. I took 5 accounting courses during my undergrad, but always thought the way the initial course introduced concepts was pretty intuitive and really laid down the basics - students were presented with an imaginary hot dog stand that we "owned" and used it as case study for how sales, discounts, costs, capex, D&A and financing decisions affected P&L. So throughout the course, we'd study different scenarios with different expansion opportunities that would require us to make investments into our stand and see how that flowed through each financial statement. We would also see different line items that became relevant as different scenarios required more accounting tools.

I think the above could develop a basic framework before introducing more advanced concepts like hedge accounting or bank-specific concepts like trading vs banking book or MTM. Also, it's generally more difficult to understand a bank's financials because a bank's balance sheet is so highly levered (good opportunity to introduce capital requirements and tie it to risk management?) and the duration mismatch between Assets & Liabilities. Also, a bank's balance sheet tends to appear "upside down" to people from the "loans are assets and investments are liabilities" perspective (not to mention interest income being substantial versus companies in other industries).

What are key accounting concepts needed to understand?
Again, I might be taking a different approach here, but I think it's paramount for people to understand how U.S. GAAP works and how it deviates from cash on the income statement and why (tax purposes mainly) - knowing how to follow actual cash is key for every manager. Obviously, the cash flow statement will show you cash flow form operations, but then again it generally starts from Net Income and will include non-recurring items (which is why people report Adjusted EBITDA even though it's not a U.S. GAAP measure).

Anyways, in terms of important concepts, I'd say (including the items you mentioned) are some of the most important to include:
  • Revenue (along with discounts and contra revenues)
  • Costs - although not the most glamorous task, understanding the business' cost structure will often dictate a manager's success
  • Interest*, D&A, NOLs / Credit Losses** (items - outside operating costs - that allow a company to lower taxes paid)
    • Maybe touch on how financing decisions affect Net Income (100% debt versus a mix of debt and equity)
  • Flow from a company's Income Statement to its Balance Sheet to its Cash Flow Statement
  • Profitability metrics - always important to understand
  • Leverage metrics (will affect financing capacity of your company as well as interest and profitability)
  • EV and valuation metrics
  • Defer to the experts on any banks-specific topics (RWA / capital requirements / risk-based capital ratios, marking to market, ....)


* Note that Trump's Tax Cuts and Jobs Act of 2017 (in effect as of 2018) actually limits interest deductibility to 30% of EBITDA until 2021 and 30% of EBIT thereafter. Interest used to be 100% deductible and I've seen people still treat it as such, which is a mistake
** Unlike NOLs, Credit losses would technically be an expense in the Income Statement corresponding to a move in a contra Accounts Receivable line item in the Balance Sheet
 
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