My undergraduate and masters degrees are in Mathematics, Computer Science, and Computer Engineering, but I spent almost a decade teaching at a business school, and in the first lesson always pointed out to those MBA candidates that I’ve yet to ever actually take a class in business, finance, or accounting.
Nonetheless, I’ve operated at least twenty corporate entities (a mix of companies, funds, my family office, and a nonprofit) and I’ve personally been the accountant for most of these organizations.
What I’ve learned, and what I continue to teach entrepreneurs is the benefits that come from good bookkeeping practices, standard accounting reports, and corporate financial management. Few entrepreneurs have any hands-on experience with any of these activities and don’t understand how much easier it is to operate a business if these are done well.
That said, what seems to go unsaid by the accountants and auditors and CFOs is that those standard accounting reports are not the real truth. They are at best a truth, but not the truth.
For example, what were the revenues last month? The income statement is supposed to answer this question. But it reports the amount of sales, ignoring the fact that many customers pay 30 or 45 or more days after the sale. So, the amount of revenues booked and the amount of cash that arrived from customers don’t match up day to day, week or week, month to month, or quarter to quarter.
Similarly, what were the fixed costs last month? Again, there is the total of the bills that arrived and the total payables that were actually paid. And there are vendors where the bill is due 30 days after the invoice arrives, so some payables are supposed to be paid next month.
Then there is depreciation. I understand why that line item shows up on the income statement, but I can’t pay those payables with depreciation. Which means in any income statement with depreciation (which is nearly all of them) the “bottom line” doesn’t tell me how much more cash should be in the bank this month, even in a “cash business” where customers pay in cash and expenses are paid immediately.
All of these variences from the actual flow of cash to/from the bank doesn’t create confidence in accountant reports to first-time entrepreneurs. They want the truth, and the standard accountant reports are not that truth.
Cash accounting doesn’t help, as then no report explains the booked revenues or yet-to-be-paid expenses. Accrual accounting doesn’t help, given the depreciation and other accounting adjustments.
Does anyone have a third way? A pro forma that they use in their business that is closer to the truth? I have a one-page format I teach for forward-looking financial models, but it ignores the timing issue in receivables and payables.
P.S. most of the readers receive this as an email and most of the comments have been arriving as replies rather than comments. Unless it is personal, please leave the comments in the comments as substack doesn’t automatically do that from email replies.
I have always assumed that the Statement of Cash Flows was designed to overcome some of the discrepancies that an accrual-based Income Statement will not show you. But that document is only a partial truth as well.
Philosopher of Accounting Paolo Quattrone teaches us to see accounts as mirrors that reflect back to us, so we can see them, the values that we actually value. The numbers don’t lie.
But they do reflect the values that we value.
Accrual accounting, as you describe, values the collateral value or selling price of an enterprise, because that is the value that lenders and securities trading markets value.
Impact investors and values aligned business organizers who value the velocity of cash flow will see their own values more clearly reflected in accounts maintained on a cash basis, where receivables are reported as financing for custom and payables as financing from custom. Depreciation becomes savings for future replacement of worn-out artifacts of business operations: buildings, furnishings, machinery etc.