Notes on Statistics Done Wrong

Statistics Done Wrong
Alex Reinhart

https://www.statisticsdonewrong.com/


P Values

  • Measure of ‘surprise’. The smaller the p the larger the ‘surprise’. P values work by assuming that there is no difference between the 2 samples. If you want to show a drug works you counterintuitively show that “the data is inconsistent with the drug not working”
  • P values say nothing about the magnitude of the effect. A small p can reveal a massive effect or a tiny effect with great certainty (say if you collected massive data). Statistical significance does not mean practical significance! Similarly, statistical insignificance does not mean zero and is simply the best evidence-based on the trial data you studied.
  • Neyman-Pearson uses p-values in a conceptually different way. They estimate an acceptable false positive rate called ‘alpha’. Statistical significance allows us to reject the null hypothesis for the established alpha or false positive rate. This rate is informed by the experimenter’s understanding of the procedure.

Confidence Intervals

  • These are preferable to p-values since they provide a point estimate and a measure of uncertainty and if they can be supplied instead of just p-values they should.
  • They are less common in the literature perhaps b/c they can be very wide

Statistical Power

  • The probability that a study of a given amount of data is capable of showing statistical significance. For example, how many coin flips do you need to be 95% sure that your experiment can reveal a biased coin that is 60% weighted towards heads? Statistical power is a function of :
    • The size of the effect; a smaller effect requires more data
    • Sample size; more data means the study has higher statistical power
    • Measurement error; more subjective measurements have less power
  • Many studies are underpowered because there is not enough data. This often occurs because it is expensive/risky (ie drug studies) or unethical (studies on animals)
  • While an antidote for multiple comparison problems can be to require lower p values, the trade-off is that studies will become underpowered
  • The concept of power is often forgotten because it is not taught in intro stats and is not readily intuitive. Again, confidence intervals which are wide can reveal a lack of statistical power again supporting their use over p values.
  • Truth inflation or type M error (‘magnitude’) is the effect of there being many experimenters ‘competing’ to publish extreme results.
  • Small samples have more variance; be careful to draw conclusions from them since they are more likely to be underpowered
    • Rural states have counties with both the lowest AND highest kidney cancer rates; this is likely due to small populations, not a real effect. The same is true for test scores in smaller schools; we may interpret them to be ‘better’ based on test scores but this is because their average extremes are higher than the average extremes of bigger schools!
    • Remedies for this include shrinkage. Weighting the average from a small sample with a weighted average from a larger population (ie weighting a small county with a higher weighted national average). This will, unfortunately, bias truly abnormal cases too much towards normal. The best remedy is to try to find a larger sample (ie use congressional districts instead of counties). Shrinkage is a good technique in measuring average product reviews (products with few reviews are shrunk towards a generic version of the product).

Pseudoreplication

  • Using additional measurements that are highly dependent on highly correlated to previous data. This form of replication doesn’t allow you to generalize inferences.
  • If you cannot eliminate hidden sources of correlation between variables you must try to statistically adjust for confounding factors.

Base rate fallacy

  • A low p-value is often touted as evidence of significance but significance also depends on the base rate. Consider Bayesian examples like mammogram testing. If mammograms have a false positive rate of 5% and a 90% chance of accurately identifying cancer then if you test 1000 people and 50 of them test positive then it is still quite unlikely that most of those people have cancer. Why? Because the base rate is a mere 1%. Only 10 people in that sample have cancer and we expect 9 of them to be accurately identified but more than 50 will test positive! When testing for conditions with very low base rates false-positive rates will swamp true positive rates.
  • An extreme example of these false discovery rates you are looking for an effect which definitely does not exist, no matter how low you set your p threshold we know your so-called significant results are still false positives, and you are bound to record significance results with a large enough sample.
  • Combatting false discovery rates with multiple comparisons is challenging but important since you expect many false discoveries. Tips include:
    • Remember p < .05 doesn’t mean there’s a 5% chance your result is false
    • When making multiple comparisons using a procedure such as Bonferroni or Benjamin-Hochberg will make your required p values much more conservative by accounting for the number of tests
    • Be aware of stat techniques specific to your field for testing data
    • Have an idea of base rates to estimate how prevalent false positives are likely to be

Confounding variables

  1. Correlation is not causation
  • Because you do not know if there is a confounding variable. If you create a model that predicts heart attack rates based on weight, exercise, and diet it’s tempting to say that if you change one of them x% that the heart attack rate will change by y%. However, that is not what you tested. You didn’t change the variables in a real experiment and measure the outcomes. It is not clear that a confounding variable is actually influencing the heart attack rate.
  • Also, to say a variable changes all else equal is a fantasy. In reality, it is unusual for single variables to change in a vacuum.
  1. Simpsons Paradox
  • When a trend in the data disappears when the data is divided into natural groups. It tends to occur in observational studies with biased samples thus obscuring a confounding variable.
  • Examples:
    • Berkeley admission bias against women in 1973. In aggregate, women looked discriminated against but at the department level, the opposite was true. The bias occurred bc women applied in higher numbers to competitive, underfunded departments. The bias happened earlier in the process: women were systematically pushed towards these fields
    • Penicillin appeared to improve outcomes for meningitis cases in the UK. At a closer look, the sample was biased since it was only administered to children who were not rushed to the hospital so they were the milder cases. Isolating the sample to those who visited a general practitioner first we find that penicillin, in fact, seemed to correlate with worse outcomes (there are theories about the breakdown of the contagion causing shock but there aren’t experiments for testing if penicillin actually causes meningitis patients to die)
    • Looking at aggregate data United flights are delayed more frequently than Continental. But at individual airports, the trend reverses. The aggregate data doesn’t account for the fact that United flys out of more airports with bad weather.

Notes on How Not to Be Wrong: The Power of Mathematical Thinking

How Not to Be Wrong: The Power of Mathematical Thinking
by Jordan Ellenburg


  • Math gives you tools to extend your common sense of reasoning and logic. He uses the analogy of Ironman’s suit.
  • Competitions including war are often decided by small edges. Being 5% better at x or y can decide the outcome over a long enough game. (Similar to my experience with boardgames. A more efficient engine in a game of 7 Wonders or Settlers can save you actions; like reducing the cost of capturing winning victory points.)
  • Zooming in on points of a curve they look and can be approximated by lines. Trajectories are curves influenced by gravity but objects appear to move in straight lines. Using lines to approximate curves is the basis of calculus and even the derivation of pi as the area of a circle (Archimedes did this by iteratively computing the edges of a circumscribed circle as a polygon. Imagine an octagon, then a polygon with 64 sides, and so forth until it looks like a circle. You can then use trigonometry to compute the area of the triangles you keep creating until the sum of all the area approximates the area of the circle)
    • Critics of this method like Zeno highlighted the uncomfortable paradox of constantly halving something until you get nowhere. Comically, the skeptic Diogenes countered Zeno by simply walking across the room to make the point that motion is indeed possible!
  • The law of large numbers explains why South Dakota can have the highest rate of brain cancer and North Dakota the smallest. They both have small populations. Be careful when comparing quantities from 2 very different sample sizes. Small samples are more volatile. If you flip 10 coins, your odds of getting 8 heads is unlikely but real. But flip 1000 coins it’s nearly impossible to get 800 heads.

Data mining 

“The more chances you give yourself to be surprised the higher your threshold for surprise had better be.”

“A significance test is a scientific instrument and like any other instrument, it has a certain degree of precision. If you make the test more sensitive by increasing the size of the studies population, for example, you enable yourself to see ever-smaller effects. That’s the power of the method but also the danger”

  • An underpowered study has the opposite problem. You dismiss an effect that your method was too weak to see. A good example is the original 1985 hot hand studies. They rejected the idea of a hot hand but it turns out the methods they used rejected a hot hand even on data sets that were generated by simulations that deliberately baked in a hot hand! In fact, their methods failed to notice even the effects of good vs bad defenses which we know influences offensive shooting percentages.
    • The final verdict is there may be some hot hand effect but it is too difficult to detect because if it exists it is very small. In fact, players who think they are hot take harder shots and perform worse so it’s best for them to not believe in the effect since it will be more than offset by an unjustifiably confident shot selection.

The Bayesian examples in the book are great.

  • In a Bayesian framework how much you believe something after you see the evidence depends not just on what the evidence shows but much you believed it to begin with. Posterior probabilities still depend on the strength of your priors.
  • On conspiracy theories: “If you do happen to find yourself partially believing a crazy theory, don’t worry — probably the evidence you encounter will be inconsistent with it, driving down your degree of belief in the craziness until your beliefs come in line with everyone else’s. Unless, that is, the crazy theory is designed to survive the winnowing process. That’s how conspiracy theories work”.

Tradeoffs and cost of perfection

  • Stigler type arguments that optimal decisions often leave a margin for error. Getting to the airport early enough to have a 100% chance of making the flight is probably so conservative it’s wasteful (depends on your utility curve but almost certainly wasteful to be 100% certain vs say 95%). When you read a story about social security overpaying people bc they were actually dead, it turns out that mistake represents less than 1 basis point of payments. In other words, they do a great job not making this mistake and the cost of being 100% compliant may simply not be cost-effective to be worthwhile.

St Petersburg and the role of expected utility

  • Fran Lebowitz utility curve of money: she would drive a cab each month until she could eat and pay rent. Afterwards, she would write. In other words, she had a linear utility curve which flattened abruptly. If you raise her taxes she works more as opposed to someone with a logarithmic curve who is at the point of indifference between work and leisure
  • Ellsburg Paradox highlights the limitations of utility theories. It highlights the difference between what Rumsfeld called “known unknowns” or what mathematics refers to as risk vs “unkown unknowns” or uncertainty. Utility theory may help with uncertainty but formal math is less useful.

Regression to the mean explains many phenomena that are usually attributed to another reason.

  • Examples, best-performing companies (competition attribution), musician/writer sophomore slump, RB after signing a big contract, dietary fiber speeding or slowing digestion, Scared Straight juvenile detention program, diet effects when people are at their peak weights. When something is at an extreme we should expect reversion simply bc of math and therefore be very careful of attributing to an intervention.

Correlations between variables reduce the information content of the variable.

  • You try to identify criminals by foot and hand size you are choosing highly correlated variables.
  • Strong correlations lie behind how we compress images and music files. A green pixel is probably next to a green pixel.

Notes From Lessons of History

The Lessons of History
by Will and Ariel Durant


Geography

  • As technology evolves, the influence of geography is diminished
  • The prosperity of civilizations is closely tied to geography notably rivers and coasts
  • Ultimately, humans create culture, not the earth

Biological lessons of history

  • Life is competition
  • We rely on the protection of our tribes and may cooperate within its confines but this is adaptive behavior in service of a wider competitive landscape. Until a group is as large as a state it will “continue to act like individuals and families in the hunting stage”
  • Life is selection
  • Nature knows nothing of our egalitarian ideals or Bill of Rights. “Freedom and equality are sworn enemies”. If people are free, relative advantages will grow nearly geometrically. Inequality is inborn, we can only aspire to ideals such as equal access to education and justice.
  • Natural selection benefits from the diversity and range of natural ability as it is the basis of evolution.
  • Life must breed; birth rates shape history
  • Nature cares only about the species, not the individual. Diversity and large “litters” are the fertile grounds that natural selection needs as fuel. Nature’s check on overpopulation is famine, pestilence, war.
  • Higher birth rates can give rise to stronger tribal powers while progression into a higher standard of livings and industry appears to slow the birth rates as the tribe advances.
  • To track the future of ideas, it may be instructive to watch birth rates; weakened ties to ethnicity or tribalism can leave the incumbent group vulnerable (Caesar and Augustus were aware of this and sought to penalize birth control; Italy’s ethnicity diluted over time making the empire vulnerable to its neighbors)
  • On race: “A knowledge of history may teach us that civilization is a cooperative product, that nearly all peoples have contributed to it; it is it common heritage and debt; and the civilized soul will reveal itself in treating every man or woman, however lonely, as a representative of one of these creative and contributory groups.”

Government

  • Monarchy has been the historical norm while democracies have been ‘hectic interludes’
    • Roman democracy crumbled under class wars giving way to Pax Romana, a 200 year succession of benevolent dictators until the murder of Caesar. This period was followed by disgraceful monarchs including Caligula before giving way to the greatest succession of monarchs ever, the last being Marcus Aurelius. Some of these monarchs had no heirs and promoted by merit until Aurelius died. Afterward his son Commodus ruled when no heir was named.
    • Monarchy has a mixed record, typically at its worst is when it is determined by blood and accompanying incompetence
  • Most modern, complex governments  are oligarchies — ruled by a minority
    • Aristocracy by birth
    • Theocracy by religion
    • Democracy by wealth
  • Plato reduced the cycle to monarchy->aristocracy->democracy->dictatorship. Repeat. This was based on Greece and repeated with the Romans. Democracies are overthrown or conquered as envy amongst the majority tires of the ‘sham’ of having a vote and uses the state to seize wealth. Other oligarchies fall when they wield their great power to narrowly or incompetently.
  • The US democracy started from a wider base and in unity against British rule. Rural land-owning enhanced the sense and dedication to freedom, while geographic isolation created a national sense of freedom. These conditions have given way as land as sparse and cities have grown “Every advance in the complexity of the economy puts an added premium upon superior ability and intensifies the concentration of wealth and [power]”
  • Democracy is a difficult form of gov’t since effective mob rule requires widespread intelligence to avoid manipulation by ‘the forces that mold public opinion’.
  • Democracy, however, has done the most good and it can maintain its promise only if it affords equal opportunity for education [my own thought is this will always be uneven, and the unevenness grows with population size. For a small population, it is reasonable that the average access to education can be even]
  • “If a race or class war divides us into hostile camps, changing political argument into blind hate, one side…may overturn the hustings with the rule of the sword. If our economy of freedom fails to distribute wealth as ably as it has created it, the road to dictatorship will be open to any man who can persuasively promise security to all”

History and War

  • Competition via war is often for the same reasons as competition amongst individuals however while individuals are restrained by law and morals a state ‘acknowledges no substantial restraint either because it is strong enough to defy any interference…or because there is no superstate to offer its basic protection, and no international law or moral code wielding effective force’
  • Religious wars in the 16th century and the wars of the French Revolution were battles between aristocracies leaving the masses to maintain mutual respect for their foreign counterparts while wars of the 20th century in accordance with technology and ‘means of indoctrination’ made war all-consuming ‘struggles between people’ and completely destroying centuries of labor and property.
  • He presents the general case for the inevitability of war — competitive human nature, envy, beliefs so fundamentally different that cannot be settled by negotiation. Perhaps and only if we were united against aliens could we imagine our species not warring with each other. The opposing view is that the imperative to avoid large scale war because of the destructive power of current technology will prevail over any disagreements over ways to organize our lives and economies.

Progress

  • Are we the ‘same trousered apes’ merely armed with increased tech, locomotion, and knowledge but weighed down by the persistent features which moor us to our primitive ancestors? Progress is defined not by happiness or similar measure but to the degree in which we may control our environment. By this standard, as evidenced by our increased adaptability and lifespans we have made tremendous progress. While subject to lapses and regressions, the avergae human has been the beneficary of an accumulated history and knowledge which has been succeeds in being recorded and transmitted to subsequent generations so that they may continue to build on this heritage from its most advanced point.

Notes from The Rebel Allocator

The Rebel Allocator
by Jacob L. Taylor


Summary

Using a Socratic device, the author creates a Buffet/Munger composite doppelganger named Mr X to help guide Nick, a young left-leaning journalist turned investor. Nick is disillusioned by the business world from his seat at Big Rock, a cartoon of a private equity firm whose short-term, scorched earth practices give capitalism a bad name. Through his regular lessons, Nick learns the principles of sound capital allocation and sees them applied within billionaire Mr X’s nationwide burger chain. The book covers a broad array of ideas that underpin business and strategy, while its narrative structure makes the lessons more enjoyable and practical than the dry texts that typically teach these topics.

The Profit Constraint

Apply this: revenue – profit = expenses aka pay yourself first.

  • Yarak: “hungry but not weakened”
    • A bird in this state is the purest expression of its genetic capabilities.

3 Key qualities in employees

Integrity, intelligent, energy

  • 2 out of 3 will do so long as you have integrity!

A compass for what to focus on

4 hours a day spent on something that will make other things easier or unnecessary

Zero-based budgeting

Every year budget items are subject to a ‘delight’ test. If the expense doesn’t delight the customer it’s non-strategic and subject to trimming. Don’t paint the (unseen) fourth wall.

Effect of compounding improvement

365 days of 1% improvement is 37x return

Iron Law of Economic Survival

Cost, price, value triangle (straws model introduced in ch 19)

  1. Cost is true economic cost not accounting cost.
  2. Price can be based on lifetime revenue.
  3. Value is subjective,context dependent, and variable.
  • Trade-off between profit (price minus cost) and brand (value minus price).
  • By flying under the radar with lower profits you may be able to store brand in your customer’s mind.
    • Profit would alert competitors and regulators! Brand is poorly measured.
    • Me: Interesting to think of underpriced companies as those storing economic value in their brand which exists in the customer mind.
    • Net promoter score surveys compare the percent of people who are superfans vs those who are ambivalent or detractors

Customers don’t want a quarter-inch drill bit they want a quarter-inch hole

A business should consider its competition broadly with the criteria of who else fills the need. (ie Southwest airlines early on was competing with Greyhound for short trips).

Understand your edge

​Franchise model allows parent company to do what it does best: source ingredients, craft customer experience, marketing. The franchisee is really in the real estate business. (in the 4 seasons model this is same). Real estate unlevered returns are close to inflation while the fictional McDonald’s is closer to 12%

Effective capital allocation requires evaluating all options

Mr X looking at an empty plot poses the question, how many ways could we build a restaurant?

Student answers buy a plot, hire a construction crew and build one. But there are more strategies:

  1. Buy land and erect building later
  2. Buy land and wait
  3. Buy competitors store and convert
  4. Buy public stock
  5. Buyback your own stock
  6. Just waiting
  • Your next best option is your opportunity cost. Important to not define menu too narrowly
  • If you were trying to improve the experience of traveling across the country one option is to fly faster. This will cost substantial additional fuel and maintenance. Installing TVs on the planes may provide a better ratio of benefit to cost to the consumer.

2 kidneys for a reason

Tradeoff between efficiency and survival: virtue of cash and less leverage

Trees don’t grow to the sky

There are feedback loops which lead to mean reversion

The virtues of efficient capital allocation

“Good capital allocation means doing more with less to create happier customers. The pressure to continually deliver value is one of the wonders of the free market. Roll up all of those customers into society at large. When you are able to provide value for the least required cost, you free up resources that can go toward adding value somewhere else.

Imagine that inside you are all of these different locks. Each lock represents one of your wants or desires. You have a lock for food, a lock for shelter, a lock for water, a lock for the opposite sex. Now imagine that each capital allocation project creates one key. Ideally, the entrepreneur knows the lock their key will fit beforehand. A restaurant provides you food, a hotel gives you shelter, shoes protect your feet. The role of business is to use the least amount Of resources to create the key that fits a certain lock. Doing a proper job spares resources to create more keys for other locks. In this sense, profit should be celebrated as a signal that an entrepreneur provided value while consuming the least amount of resources to do so. When all of society’s businesses are properly allocating capital, more locks get keys, and we’re all better off.

That’s all technology really is: the means for us to turn more locks using fewer and cheaper keys.”

When simple models outperform experts

Simple models thrive when:

  • Problem is ill-structured and complex.
  • The information is incomplete, ambiguous, and changing.
  • The goals are ill-defined, shifting, or competing.
  • The stress is high, due to time constraints and/or high stakes.

Notes on Invisible Heart

Invisible Heart
by Russ Roberts


Thinking like an economist: Second Order

Price modulates supply/demand

Suppose the world has 531 billions of barrels of oil in reserve and on balance consumes 16.5 billion barrels a year. How long before we run out of oil?I’ll give you a hint. You don’t need any more information. If you know the answer it is because you reasoned like an economist. I never said it required more horsepower to think like an economist. It’s just a different lens. 

If you are stumped then consider Robert’s thought exercise.

I gave you a room full of pistachio nuts in the shell. It’s a big room, say the size of a classroom. The room is filled with pistachio nuts up to a height of five feet. There are millions of them. Welcome to the Nut Room. The nuts in this room are yours for the taking. Any time you want to come in here and help yourself, there is no charge. Bring your friends if you’d like. Just wade in and have a pistachio party.

“You’re happy because you love pistachio nuts. Outside the Nut Room, they’re expensive. Inside, they’re free. There’s only one rule in the Nut Room. As you eat the nuts, you’ve got to leave the shells in the room. You can’t take them out with you. At first, that’s no problem. For the first few days and maybe weeks and months, the pistachios are plentiful. But as the years go by, it takes longer and longer to find a pistachio. The shells start getting in the way. You come in with your friends and you spend hours wading through the shells of pistachios you’ve already eaten in order to find one containing a nut. Your friends say, we’ve got to stop meeting like this. ‘Why?’ you ask. ‘Don’t you like free pistachio nuts?’ And what do your friends say in response?”

The nuts aren’t free anymore” In other words, the price of finding the nuts has exceeded the price of just getting them at a store. The price rationed demand. 

So what about the oil?

“Remember the pistachios!”

You will never run out of oil. The price of finding the marginal barrel will become high enough that people will find cheaper sources of energy before they ever extract the final barrel. By thinking like a microeconomist you were able to see that the relative price of substitutes meant the supply of oil was not headed to zero with a slope of negative one. It’s a curved line that never approaches zero.

Being a nanny state

“Children don’t anticipate the future very well, so we treat children differently from adults. But when we start treating adults like children, we start taking away the essential human challenge of coping with uncertainty and making decisions”

  • A life without consequences and costs has no meaningful choices. A life without meaningful choices is the life of a “child, animal, or robot”
  • The connection between choices and rewards is the essence of responsibility

Chapter 13: The Rules of the Game

  • Thought experiment about designing the perfect law highlights the reality that every choice is a trade-off. If you had access to a “Dream Machine” a construct referenced from Nozick’s Anarchy, State, and Utopia then you would fast forward to the goals and prizes but the seeking, trials, failures and risks of the world would never be endured but remember without valleys, there are no peaks.
  • When people are laid off it sharpens our focus on them. What’s blurred is the competition which rose to combat the cost-cutting company. The employees of those competitors get to have jobs.
  • Maimonides thoughts on charity. The giver and receiver must be considered.

On an ascending level, they are as follows:

8. When donations are given grudgingly.

7. When one gives less than he should, but does so cheerfully.

6. When one gives directly to the poor upon being asked.

5. When one gives directly to the poor without being asked.

4. Donations when the recipient is aware of the donor’s identity, but the donor still doesn’t know the specific identity of the recipient.

3. Donations when the donor is aware to whom the charity is being given, but the recipient is unaware of the source.

2. Giving assistance in such a way that the giver and recipient are unknown to each other. Communal funds, administered by responsible people are also in this category.

1. The highest form of charity is to help sustain a person before they become impoverished by offering a substantial gift in a dignified manner, or by extending a suitable loan, or by helping them find employment or establish themselves in business so as to make it unnecessary for them to become dependent on others.

  • A key to the self-regulating property of economies is private property. Regulation can make far more sense when dealing with a common resource that nobody owns. How did Zimbabwe turn such a resource into a form of ownership, thwart poachers and increase elephant populations? Making the villages able to charge to hunt them. This gave villages an incentive to care for the elephant population since elephants were now a source of revenue. While some conservationists found it reprehensible others found it practical. If you care more about elephant populations it turned out to be an effective strategy.
  • “The human heart has its reasons that reason cannot know”. A divorce is complex and its cause is never as simple as one reason (ie infidelity). A divorce is the “product of a thousand misused moments”. The legal system is smart enough to recognize this and not try to determine whose fault it is. This is a good lesson when thinking about using courts to adjudicate discrimination. While some cases may be cut and dry most will not be and the ability of courts to intervene leads to changing incentives and potential for unintended consequences.

Notes on The Accounting Game

The Accounting Game: Basic Accounting Fresh from the Lemonade Stand
by Darrell Mullis and Judith Orloff


Balance sheet

Assets = Liabilities + Equity

Income statement

The movie that connects a period’s beginning and ending balance sheets which are snapshots.

Sales

-COGS
-Labor

________________

Gross Profit

-Expenses

________________

Net profit

Examples of expenses

bad debt, interest, insurance

An expense like insurance can be prepaid (ie a 10 year policy). So while you may pay cash for it upfront reducing your cash assets, you will expense only 1 year worth of its benefit while booking the remaining value as a “prepaid asset” on the balance sheet

For service businesses:

Sales

-Cost of services

_________________

Gross profits

-Expenses

_________________

Net profit

Cost of services are direct cost of providing service hours. Expenses include items like admin, sales & marketing including commission for leads, and R&D to develop materials, salaries including to owners.

  • Income taxes are deducted on the income statement to compute a net income after taxes.
  • If you sell an asset at a value higher/lower than book value you will register a gain/loss on the income statement

Inventory

  • The inventory from a beginning balance sheet will be part of the COGS in an income statement.
  • Inventory on balance sheet can be divided into raw materials and finished good. It takes cash (for example to pay labor) to turn a raw material to a finished good so there can be cash “locked” up in the balance sheet in the finished goods that can only be realized by making sales.

Valuing inventory

  • In an inflationary business where the cost of materials rises over time, LIFO accounting will value the inventory and COGS higher, in turn, reducing paper profits and taxes.
  • Most businesses start using FIFO which is operationally easier but switch to LIFO for tax reasons. In fact, LIFO records are expensive to maintain and usually only done by companies with large inventories.
  • The IRS must grant permission for your business to switch methods a second time and require any back taxes be paid.
  • Where it was possible to report cash balance sheets to the IRS and accrual ones for investors it is required to be consistent with method used to value inventory (LIFO or FIFO). So accounting statements will usually footnote whether the assets are being under or overstated based on the method used.
  • If it is easy to value the inventory individually (ie each item has a serial number) then some businesses will average the value of the inventory.

Accrual vs Cash Accounting

  • Accrual accounting is more accurate but leads to higher profits than cash accounting so it leads to higher taxes. Companies prefer cash method for IRS but accrual method for investors.
  • Service companies have the advantage of being able to use cash accounting but companies who have inventories as a significant portion of business are required to use the accrual method. Otherwise, they could easily shield profits by spending cash on hand to buy inventory and reduce reported earnings.

By allocating items, we can allocate items in a way that lends economic insight into the business and price services correctly.

Capitalizing an asset vs expensing it

Plants and buildings are fixed assets although costs to maintain them would be recorded on the income statement as expenses.

  • Equipment is also a fixed asset but usually separated from plants and buildings which are stationary.
  • Whether a purchase is treated as an asset or expense really depends on:
  1. duration of its use. If it is many years then capitalize it as an asset. If it’s treated as an expense it will reduce earnings in the current period.
  2. Its cost. You can set a dollar limit, and any item which exceeds it will be capitalized.

Cash Statement

Keeps track of cash flow which is necessary when doing accrual accounting. For example, if you made a sale on credit in a previous accounting period and the cash for that sale comes in we do not adjust the income statement since we already accounted for the sale. However we will update the cash statement.

Depreciation

Shows up as an expense on the income statement reducing earnings. The balance sheet will be kept in balance by reducing the value of the fixed assets by the same amount as the expense.

  • It is a rare Non-Cash Expense allowing us to reduce earnings without losing cash!
  • Buildings must use “straight line” depreciation while equipment can use “straight line” or “accelerated”. There are a few types of “accelerated” schedules and the IRS intermittently changes them. “Accelerated” depreciation uses the updated “base” (ie the asset’s value after the last depreciation period) to calculate the new depreciation amount. The resulting curve will allow you to save taxes near term by taking steeper depreciation expense.

Categorization of Assets

“Current Assets”: assets such as cash, receivables, inventory and prepaid expenses which are probably convertible to cash within 1 year.

“Net Fixed Assets” or “net book value of assets”: gross fixed assets (using purchase price) + accumulated depreciation

  • By breaking net fixed assets into gross + depreciation we can estimate how old the assets are.
  • Assets are typically listed on a balance sheet in descending order of liquidity (ie cash is first).

Understanding the difference between earnings and cash

When you are investing in a business you may find that it has little cash and even if the business is very profitable it is very possible to have high retained earnings but no cash. Retained earnings are not cash! It is not a sum just sitting in a bank. It reflects that the business has been profitable, and also your ownership but it is not spendable like cash. It can be tied up in assets.

  • On a daily basis, cash runs the business!

Refactoring Austin Kleon’s Steal Like An Artist

Get started

  • Nothing is original.
    • Original is usually what you call things when you don’t know what preceded it
    • Screw imposter syndrome. Fake it til you make it.
    • All the world’s a stage

Creativity Loop

  • Collect ideas
    • Thoroughly study the thinkers and artists that inspire you. Branch to their inspiration
    • “Build your own family tree”. “See yourself as part of a creative lineage”. Hang pictures of them in your studio. You are not alone.
    • Surround yourself by people more talented than you. You are the average of the 5 people you are closest with. “If you are the most talented person in a room, you need to find another room”.
  • Remix
    • We learn by copying. When copying you are seeking a glimpse into your hero’s mind.
    • In failing to faithfully copy you will find your own voice. That unique part is what you amplify.
    • Your remixed ideas will be blended in a unique way
    • This is a reason to not discard periphery interests. You cannot predict the interactions of your interests. “Don’t worry about unity”
  • Produce what you want to see exist
    • Don’t write what you know. Write what you like.
  • Share
    • Be grateful for obscurity when you have it. It’s a safe space to take risks. Use it.
    • There’s no penalty for revealing your secrets. You are not a magician.
    • The internet is not just a destination for your work but a place to iterate and develop your work.
    • Share your dots but don’t connect them.
    • Don’t look for validation. You can’t control how your work is received. Plus people may not come around to your work while you still care about it (or until you’re dead)

Tips for the journey

  • Bring your body into your work.
    • Move. Your nerves are not a one-way street.
    • Analog tools engage your senses.
    • The computer is great for editing but not creating. It edits ideas before they can blossom. Cartoonist Tom Gauld, “things are on an inevitable path to being finished. In my sketchbook, the possibilities are endless.”
    • 2 workstations if possible: a digital one and a purely analog one
    • Take time to be bored and let your mind wander
  • Routine
    • Day jobs that leave you time to work on your projects give you structure. They also surround you with people to learn from.
    • Work gets done in the time available. No holidays, no excuses. Don’t stop.
    • “Inertia is the death of creativity You have to stay in the groove”
    • “Get a calendar. Fill the boxes. Don’t break the chain”
  • Embrace constraint
    • Jack White advice — don’t wait until you have all the equipment or time
    • “Nothing is more paralyzing than the idea of limitless possibilities”
    • Green Eggs and Ham was the result of a bet that Seuss couldn’t write a book with under 50 words
    • Creativity is about what we choose to leave out as much as what we choose to include