Friday, July 24, 2009

Munger on Accounting

Charlie Munger said the following in the Stanford Lawyer back in 2002:

"Proper accounting is like engineering. You need a margin of safety. Thank God we don't design bridges and airplanes the way we do accounting."

He also added the following during a talk at USC Business School in back in 1994:

"...you have to know accounting. It's the language of practical business life. It was a very useful thing to deliver to civilization. I've heard it came to civilization through Venice which of course was once the great commercial power in the Mediterranean. However, double-entry bookkeeping was a hell of an invention.

And it's not that hard to understand.

But you have to know enough about it to understand its limitations—because although accounting is the starting place, it's only a crude approximation. And it's not very hard to understand its limitations. For example, everyone can see that you have to more or less just guess at the useful life of a jet airplane or anything like that. Just because you express the depreciation rate in neat numbers doesn't make it anything you really know."

Financial statements provide an estimate, not some absolute truth about what's going on in a business. As a result, sound judgment on the impossible or hard to measure aspects of a business matters a bunch.

If you cannot measure something well it doesn't necessarily make the factor lose significance. Over-analyzing the easy to measure stuff while ignoring what's difficult to measure but important can prove rather costly for an investor.

Adam

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