It sounds like a simple idea. Profit is profit, so are there any real options as to how to measure profit? The answer is decidedly yes and the way you measure profit can be all the difference in the world as to the way you run your business and the decisions you make. Now we are not talking to the Controller or even the CFO who are primarily concerned with accuracy, adhering to professional accounting standards (i.e. GAAP or FASB). We are instead talking the CEO, President or those with P&L responsibility and need to make decisions based on the real performance of the company. This is often called management accounting.
Let’s start with the big divide, which is choosing between a cash basis or an accrual accounting system. To determine the performance of business one usually uses an accrual system so that for example how one elects to pay their bills for instance does not distort the real performance of the company. For example, if one forgets to pay their rent in one month and profits are higher, that does not mean the company is doing better, conversely if one doubles up next month and pays last months rent as well as this months rent it does not mean that they are suddenly doing worse. Accrual accounts books rent as an accrued expense in the month it should have been paid anddoes not double count rent in the following month, but treats it as a prepaid liability. Similarly, if one has a big Christmas party in December for a reward for a great year they should accrue for that expense each month as 12th of the estimated cost. Otherwise December may look terrible when it really wasn’t. If one accrues for a $48,000 party and books $4,000 a month and the final bill comes in at $52,000 and we only have a $4,000 extra cost in December not $52,000. Not all costs can be anticipated but with a bit of planning a good many things can be anticipated and dealt with in this manner. Also owner’s compensation cost for small, private companies should be adjusted to reflect the fair market compensation and cost. Otherwise the owner can payout all of the profits in compensation cost and totally distort the true profitability of the company.
Other things that distort what a company is doing is not matching up revenue with expenses that are related to those revenues. For example if a sale is made in the first month and the commission or other compensation is not paid two months later, that expense should be accrued for in month 1 so we don’t overstate profit in month 1 and understate it in month 3.
There are many other such situations that arise, but I think this illustrates the choices one has. One can always revert from an accrual to a cash basis by registering changes in the balance sheet, so one can have both a management P&L which gives a more accurate picture of the company’s operating performance as well as a cash flow statement that reflects how much money is paid out and reflects a check book approach to accounting.
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