Accounting is Not Economic Reality1

This chapter describes the underlying nature of accounting and illustrates the necessary trade-offs that limit the ability of accounting to reflect a firm’s underlying economic reality.

There is a perception that accounting numbers present the truth. This probably stems from accounting’s mathematical basis. The Balance Sheet presents a firm’s assets (what it owns) and how it financed the assets (by borrowing-called liabilities or from the owners-called owners’ equity).

Why does a Balance Sheet have to balance? Ask this question to an accountant and you are likely to be told that the Balance Sheet is simply the mathematical equation:

Assets = Liabilities + Equity

If you press the accountant further, ...

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