Accrual Accounting and Cashflow


Before the end of World War 1 most managers kept track of cash out and cash in. many senior citizen owner-managers still do today. There is an inherent problem in keeping the records that way, however, if the business offers and receives much credit. Doing business on credit displaces the time of the exchange of cash from the exchange of goods and services. Sometimes very little cash comes in during a particular month and very much cash comes in during other months. The same is true of cash out.

Keeping in track of what you pay or get paid for credit transactions causes the monthly reports describing the operations to fluctuate from month to month even though the goods and services flowing in and out of the business may be very much the same. About 1920 the accounting profession began placing emphasis on the accrual method of accounting to overcome this difficulty.

The accrual method portrays the smoothed-out profit as if all the transactions had been for cash and as if the business had purchased only exactly what was needed to make the sale. It is not an accurate portrayal of everything going on in the business, but it is a good approximation of the net effect of those things that affect profit. The problem is that so much emphasis has been placed on the accrual method income statement and balance sheet that the importance of cash has been regulated to virtual obscurity.

Even this result is satisfactory when the reports are describing large businesses with access to external financing through the stock market, commercial paper, and bank loans at the prime interest rate. But companies that do not have access to these external sources of financing have a different problem. For them, the flow of cash through the business means life or death, whether the accrual based profit is great or terrible. When new or small businesses need cash they must turn to the bank, the banker will look to the personal savings and assets of the owner-manager for collateral.

Accountants have not forgotten nor overlooked the importance of cash. They recognize the need for cash in sufficient quantity to keep the business operating. For their purposes, however, they often infer the cash available to the business from the income statements and describe future cash availability with the balance sheets. They, and others, frequently describe it as: cash flow equals net profit after taxes plus depreciation and other noncash expenses, such as amortization.

This statement is incorrect except under some very stringent preconditions that rarely exist in practice for a small business. This statement is an approximation that is valid for large and stable businesses in which changes from year to year are small and the statements from which the cash flow is inferred are annual reports. For a small and new business looking at monthly financial reports this approximation is inadequate. In a small, growing business the net cash flow to the firm’s bank account does not equal the net profit plus depreciation. Profit is not cash nor is it cash flow.

Although this pronouncement may be unconventional, entrepreneurs are realistic. Successful entrepreneurs ask how it really works and then get on with building their business. In the conventional approach the analysts, having inferred cash flow from profit, depreciation, and amortization, stop there, allowing their readers to assume that the resulting cash is in the bank wiating to be spent.

My Consultancy–Asif J. Mir – Management Consultant–transforms organizations where people have the freedom to be creative, a place that brings out the best in everybody–an open, fair place where people have a sense that what they do matters. For details please visit www.asifjmir.com, Line of Sight

Good Management


Good planning and good management are probably the best protection against most of the other risks. Price fluctuations of any normal retail inventory may be upward or downward. Good management will keep itself informed of price trends. Study of population trends and business activity will warn merchants early if their location is losing its value. Good accounting records and study of operations against a budget will warn of any developing adverse trends.

 To handle the risks of dishonest employees, good management will provide devices such as internal security guards and signal systems for detecting pilferers. A reputation for prosecuting pilferers and training all employees to be alert to the problem will help to reduce pilferage. Tags in merchandise which act of alarms at the entrance unless removed by the sales person are now common. These methods are often expensive but necessary. Personnel policies will provide means of checking employees whose honesty is questioned. Inspection of employees of checkout time is being used by manufacturing firms, some airlines, and other type of firms. It is recommended for wholsalers and retailers when losses in this area are deemed a high risk. Fidelty bonds may be purchased to protect the firm from losses by dishonest employees.

 The risk of financial hardship can best be coped with by proper financial planning and financial management. This common risk has caused the downfall of many firms which otherwise had a most profitable future. Over and above good planning along the lines, watching the key financial ratios in the financial statements, the cash adequacy rule, and investment in receivables, and having a cash flow statement are devices to protect against this risk. Having a good performance record for honesty and fair dealing will help the business secure financial help when it is needed.

 My Consultancy–Asif J. Mir – Management Consultant–transforms organizations where people have the freedom to be creative, a place that brings out the best in everybody–an open, fair place where people have a sense that what they do matters. For details please visit www.asifjmir.com, Line of Sight