Accounting author Steven Bragg formulated the three laws of accounting, which focus on the concepts of cost management, financial reporting, and financial accuracy, and the underlying behaviors that impact each one. The laws are:
First Law of Accounting
Expenses will continue into the future unless acted upon by an outside force.
Commentary: The structure of the sentence was taken from Newton’s first law, which is sometimes called the law of inertia. And inertia works here, too. When a company starts to incur an expense, there is a natural inclination to keep on incurring it. So if you hire someone into a new position, there is a natural assumption that you need to keep incurring the cost of that position. But that doesn’t have to be the case. Instead, a good manager is always recasting how a company is structured, and so should always be questioning why we spend money. But that doesn’t happen very much – and the result is expenses that become very entrenched.
Second Law of Accounting
When the financials are stretched to make the numbers, future results always decline.
Commentary: Consider the situation in which you deplete a reserve, or perhaps let shipments at month-end go a little past midnight on the last day – just to make sure that you make the budgeted profit number. The reason for that stretch is probably that the company is topping out, and cannot quite muster the wherewithal to keep reporting growing profits. Right at that point, management steps in and lays on the pressure to deliver good financial results. If you comply, all that does is deplete the amount of revenue and profit for the next month, and precisely at the point when the company’s financial results are probably starting to decline, anyways.
This second law has a follow-up impact. If the subsequent decline is steep enough, and if the company is publicly held, it is quite possible that there will be shareholder lawsuits for misrepresenting financial results. So in this case, the second law of accounting speaks to the psychological pressure that the accounting department is under.
Third Law of Accounting
The quality of financial statements begins to degrade as soon as they are perfect.
Commentary: The third law sounds a little counterintuitive, but think it through. You obtain perfect financial statements by continually identifying errors in the financial statements and correcting the underlying causes. But once you don’t find any more errors, the resources of the accounting department are shifted elsewhere. So now, no one is watching over financial statement accuracy. And that is a big problem when the underlying systems that feed into the financial statements continue to evolve – which they will do every time you introduce a new product, or sell into a new market, or install new software, and so on.
So in this case, project management and the allocation of resources leads to the appearance of errors in the financial statements.