This chapter is about the various forms of accounting and their uses. The authors argue that accounting is the single most important tool in making sense of a business. It is the language of business, and investors who seek to understand companies must become fluent in it.
The distinctions between the following forms of accounting are discussed: cost accounting, tax accounting, and financial accounting. The authors argue that they each have their purpose, and noting the distinctions between them will help investors understand the limitations of financial accounting, which is the form of accounting used by investors.
For example, the authors argue that it is a misconception that the relative efficiencies of competing companies can be determined using financial accounting. There are too many assumptions that managements are free to make in financial accounting to allow for such direct comparison. To truly compare efficiencies between companies, one would have to have access to numerous internal (i.e. non-public) documents.
The authors also distinguish between financial accounting as used for corporate analysis and as used for market analysis. Market analysts focus on net income and earnings per share, on the expectation that changes to these numbers will lead to short-term changes to the stock price. Corporate analysts rely much more on financial position than current income numbers.
The authors also discuss circumstances where accounting describes the situation well, and where it doesn't. For example, financial statements are most useful when most profits are to come from the operations of a going-concern and there is heavy regulation limiting management leeway in the accounting assumptions. On the other hand, accounting is not so useful when a large portion of profits are to result from asset sales, imaginative financial techniques are employed, and managements throughout the industry make different accounting choices.