Hi

Traditional accounts – sometimes called financial accounts – are drawn up using rules, devised largely by academics, which are wholly unsuitable for managing your business.

They are drawn up using what are called generally accepted accounting principles, and are meant for a very different purpose. No clued-up business owner would accept them, let alone pay for them, unless they want to be misled.

You should be aware of this trap with conventionally formatted accounts and change them as soon as you can to the safer and more accurately structured accounts that show what is really going on in your business.

Your accountant isn’t entirely to blame. He or she was taught these generally accepted accounting principles and had to pass exams to prove they knew them. They had thick books in their offices that explained the – sometimes weird – and most obtuse rules you can imagine.

The purpose financial accounts are meant for is to inform financial markets about the performance of large, often listed, companies. The safer and more accurately structured accounts – sometimes called management accounts - that show what is really going on in your business are for a totally different purpose: to help you take decisions to improve performance, profit and cash flow.

Here are some of the differences:

1. The treatment of fixed and variable costs

There are fundamentally two types of cost in a business: those that happen anyway and are a product of time like salaries, rent, rates, insurance, office costs etc., and only those that happen when something is sold like material costs, marketing and delivery costs.

The first type is called fixed costs and the second type is called variable costs because they vary in direct proportion to the activity (sales) in the business. The difference between sales and variable costs constitutes gross profit, which expressed as a percentage of sales is your gross margin.

Do not confuse this with the gross profit shown after cost of sales in the accounts prepared under generally accepted accounting principles where labour costs, which are more in the nature of fixed costs, are usually included and marketing costs are often excluded and shown as overheads.

Because your gross margin is such an important number – and is used for all sorts of decision making – you should calculate it accurately and not the way it is shown in your financial accounts.

2. The valuation of stock, work-in-progress and contracts

Generally accepted accounting principles make life unnecessarily complicated by including fixed salary costs and a proportion of overheads in work-in-progress and finished goods. This cannot in any way affect cash flow but does have a big impact on your numbers because

1. It can improve the apparent gross margin percentage;
2. It can lower your apparent overheads;
3. It can lower your break-even point, and therefore
4. Increase apparent profitability.

Remember the contractor Carillion that went bust owing money to thousands of smaller contractors? They actually included a proportion of the profit they expected to make in the valuation of their contracts. Bonkers.

3. Revenue recognition

Another distortion of reality created by generally accepted accounting principles is the concept of revenue recognition before it has been earned. This often occurs in large contracts (like the Carillion example) but is also prevalent in financial accounts where an attempt is being made to show the results of activity rather than performance.

Some banks for example show the income they will earn in the future on 0% credit cards (assuming that the customer will pay interest after the expiry of the interest free period) based on the argument that they should include some revenue to ‘match’ the cost of marketing the credit card in the first place.

4. Cash flow statement

Have a look at the most recent accounts your accountant has prepared for you. Do they include a cash flow statement? Do they show a reconciliation between profit and cash flow? I thought not.

The irony of the cash flow statement is that it is the most useful of the three financial statements (the profit and loss account and balance sheet being the other two) but is the only one that accountants rarely include in the accounts they prepare for their clients.

Its other distinguishing feature is that it is, also, the only one of the three statements that is based on fact, rather than estimates and assumptions.

Within your cash flow statement is the operating cash flow statement which records whether net cash has flowed into or out of a business over a period of time and determines whether the business is solvent and for how long it will remain so.

If operating cash flow is positive then the business will be accumulating cash for distribution to its owners or for future investment. The business is solvent and healthy. If operating cash flow is negative this represents a warning sign and if it remains negative for any length of time then the warning rises to critical. The business is running out of cash. A simple calculation to compare ‘cash burn’, the weekly or monthly negative operating cash flow, with cash reserves will tell you how soon cash will run out if the reserves are not topped up, but this calculation isn’t required by generally accepted accounting principles and so it is rarely included, if ever, in financial accounts.

I could go on and show you even more examples but I hope I have made my point.

The purpose of your monthly management figures is to provide an accurate picture of what is actually happening in your business and what needs to be done to rectify any deficiencies. Figures that are misleading, however unintentionally, will invariably lead to poor decision making.

Fortunately it is not difficult to get accurate monthly management accounts, particularly if you install a cloud accounting system such as Xero. You may even ask an accountant experienced in producing management accounts to help you structure the reports you require each month to tell you how you are really doing. One such report will be a cash flow statement which in current times will probably be the most useful of all.

Not surprisingly, at Guilford Accounting, we specialise in producing really useful management reports. Isn’t it time you had these in your business?

Stay safe

Noel Guilford