Tea Leaves and Financial Statements – Something in Common?

Author: Larry Chester

Financial reports contain the most important reading that a business owner looks at on a regular basis. And yet, for many business owners, reading financial statements can seem as helpful as reading tea leaves. Some of the issues that create confusion are the result of the way the reports are created. Look at these scenarios, and see if any sound familiar to you:

1. An internet sales company showed financial reports with huge profits for three straight months, and then suddenly, huge losses during the next few.
2. Very stable financial reporting gave confidence to the owner, but there were two times a year when labor costs caused his profits to shrink.
3. In spite of having significant amounts of inventory on the floor of the warehouse, the bank complained that the balance sheet showed no major assets.
4. A services-based company sent out annual invoices in January and February. In spite of growing sales, they showed increasing losses as the year progressed.
5. Profitability had always been stable, but there were a few months during the year when profits shrank unexpectedly.

Proper financial reporting is important to decision making, and even though business owners all know that reporting is important, not everyone really understands what they are looking at when they get their profit and loss statements.  Part of it is the way that financial statements are created.  It’s not unusual for companies to have their accountants produce financial statements at year-end in preparation for their income tax filings.  But there’s a difference between financial reporting for your taxes and financial reporting for you and your business.

We leave it up to our accountants to produce financials for tax purposes, and those may be done either on an accrual or cash basis.  Leave it up to your CPA to make those decisions.  But when it comes to understanding how your business is operating, there’s only one way of looking at your financials that makes sense, and that’s by accrual reporting.  What’s the difference, and why is it so important?  Here are the basics:

Cash basis reporting is following the money through your bank.  If you collected more money than you spent, then you made a profit.  If you spent more money than you collected, then you had a loss.  It’s that simple.  It makes no difference if you sold something for less than you paid for it.  If you collected more from your customers than you spent buying materials, then on a cash basis, you made money, because you had more money in your bank at the end of the month than you had at the start.

Accrual basis reporting aligns expenses with the time period that they belong to.  The cost of an item hits the financial reports at the same time as the revenue.  The expense for insurance or any long-term expense is aligned with the period that it covers.  So, annual insurance expenses are spread monthly over an entire year.

It’s always interesting to hear what business owners say when we point this issue out to them.  Sometimes they really don’t understand the differences.  Sometimes they are just trying to follow their accountant’s advice and feel that if they are doing cash basis for tax reporting, they need to do the same for operational monthly reports.  They don’t.  Sometimes they say that they have a “hybrid” system, so they are doing both cash and accrual basis reporting, depending on the GL account they’re working with.  That’s just not right.  You can’t be a little of both.  Proper accounting guidelines demand that you do your reporting either one way or the other.  But in reality, only by using Accrued Accounting will you be able to really understand your companies’ profitability.

Let’s take a look at the five examples at the top of this article.

1. An internet sales company showed financial reports with huge profits for three straight months, and then suddenly, huge losses during the next few.

Since their company was operating on a cash basis, following the money provided the answer.  Since all of their online sales were credit card-based, they collected their cash in 48 hours.  But they were on net 60-day terms with their suppliers and tended to pay them late.  Since they had increasing sales and pushed off their vendor payments, they showed very strong profits except for the few months that they decided to pay their bills, then their cash outlay far exceeded their cash receipts, and their financials showed a heavy loss.

2. Very stable financial reporting gave confidence to the owner, but there were two times a year when labor costs caused his profits to shrink.

The company only posted its payroll expense when it ran payroll.  So, depending on when the payroll hit the bank, that’s the only labor costs that are posted to their financials.  Since they paid their staff every other week, there were two months that had three payrolls.  This dramatically affected their profits.  If they had accrued their month-end payroll expenses, their payroll costs would only vary by a day or two every month, rather than having an increase of 50% in their payroll costs in those two months when they ran three payrolls.

3. In spite of having significant amounts of inventory on the floor of the warehouse, the bank complained that the balance sheet showed no major assets.

The company expensed all of its inventory when it purchased it.  This skewed their profitability, because the items they sold varied monthly, as did their inventory purchases, but the two never aligned.  The value of the company was based on its reported balance sheet assets.  Since they expensed all of their inventory purchases, there was no inventory on the balance sheet, and the income statement didn’t accurately reflect their profitability.  The bank lacked proper information on the company’s value, which affected the company’s ability to borrow, and ownership had no way of understanding the company’s profitability.

4. A services-based company sent out annual invoices in January and February. In spite of growing sales, they showed increasing losses as the year progressed.

Instead of recognizing and therefore posting their revenue monthly, the company posted their sales and their cash all at once.  This pushed all their sales into the first few months of the year, even though their expenses were a year-long process.  So, as the year wore on, their profitability sagged, because they had already collected and posted their “sales” months earlier.

5. Profitability had always been stable, but there were a few months during the year that profits shrank.

Most of the company’s expenses came in monthly, but there were some significant invoices that arrived only once a year.  Invoices for all of their commercial insurance policies, which were significant, arrived and were all paid at once.  Since the company was on a cash basis, that entire expense hit the bottom line all at once, skewing the company’s profitability for the month.

If you’re using your financial reports to see how your company did last month, as you should, then it’s important that they accurately reflect your company’s results.  This isn’t just a matter of making sure that expenses and revenues are posted to the correct accounts.  As the examples above have shown, using the wrong reporting methods can make a profitable company look like they’re losing money, and conceal the losses that a company is really facing.  Changing your reporting from Cash Basis to Accrual can usually be done easily.  But it probably also means changing the way some of your expenses are posted.  If you don’t understand what your financial statements are telling you, reach out for some help.  Otherwise, you won’t be able to:

Make Changes Today That Affect Profitability Tomorrow.