Saturday, December 22, 2007

Accounting as Simple as it Gets

Many people look at accounting and say, "Accounting doesn't make a lot of sense." Well I hate to be bold but there is no better way to say, "Hey I'm a moron, I shouldn't be running a business." Accounting is the story of your business and you should know not only how to read that story but how to tell the story. There are a lot of complex accounting issues, that can be a nightmare. The chances are that you will never deal with them. Don't worry about the complex stuff, focus on the basic principles of accounting. You should be able to understand ninety-nine percent of all accounting issues with just a basic understanding of the principles and constraints.

Accounting is an ongoing story, the financial statements are a snapshot in time of the continuous action taking place.  The fundamentals of accounting are based on Relevancy, Reliability, Comparability, and Consistency. To test the relevancy principle just make sure that the information can be used by outside users to analyze your business. Reliable information is unbiased and not a crock of b.s. you cooked up. If you can't fight temptation get a third party accountant/auditor who is unbiased to your business to actually make or confirm entries to the accounting system. If you report in a comparable manner you report in a way that is typical of other businesses in your industry. This is to ensure nobody is comparing your apple company to someone else's orange company. I always get confused when I compare apples to oranges. Consistency involves simply staying in line with the current accounting practices and using the same principles from year to year. You can't just simply switch accounting methods mid-stream (without fixing historical information) to make numbers look better. Your financial statements should follow the same logic/method over time.

When developing accounting information there are two important constraints to keep in mind conservatism and materiality. Conservatism is simply saying hey I can represent a loss here buy reporting this way or a gain if I report another way; I am gong to choose to take a loss. This can change with tax reporting. When it comes to taxes the conservative approach would be to report a gain. The government likes that money and they don't get to tax you on losses. That is what AMT (Alternative Minimum Tax) is all about.

By now you may be asking yourself what this accrual garbage about. Well if you just bought inventory, prepaid rent or you owe your employees a bonus at the end of the year how do you want to represent that. You want a way of keeping track of your inventory, how long you have the rights to a building and what those costs are over time, and you should want to know what you are going to owe your employees so you can anticipate what you'll need to pay. Well this is where accruals come in handy.  More importantly they tie expenses to revenue by accruing those expenses when the revenue occurs from incurring those expenses.

With cash accounting you recognize inventory expenses upon the purchase of goods. With accrual accounting you say I've got a benefit/asset here I want to represent this benefit to outside users. You do this by reporting it as an asset and expense the cost of inventory when the product is sold (Cost of Goods Sold). This helps you tell the story of a business by telling all the parts not just bits and pieces at a time when cash transactions are made. The same thing goes on with prepaid rent and other assets paid in advance of when delivery is made.

Now, for accruing liabilities. Well you tell your employees that you are going to pay them a bonus based on performance at the end of the year. Hopefully, you plan on paying this bonus, because you don't want to face the dreaded everybody quits on you all at once type of turnover.  STRIKE!!!! Well if you are keeping track of your companies performance you can keep track of what you owe them each month and record the liability and expense.  Basically, you promised employees 1% of net income at the end of the year. Simply, multiply 1% times your profit(loss) and make the appropriate entry. Tie your expense and liability to the month in which the profit was realized. Doing this will give you a better idea of the cash outlay you'll need to make at the end of year. Accounting is full of good ideas and methods to keep track of what is occurring in your business.  Now if there comes a point when you realize you will not owe employees a bonus you would have to true the account to zero because you employees won't be paying you for the losses of the business.

At the end of the day tell the full story of what is going on in your company, through accrual accounting. Don't embellish the story, keep a conservative outlook. Don't change your logic without letting everybody know through restatement of prior year financials. Put out information that doesn't waste the time of internal or external users. Last but not least don't be an accounting moron by excepting that you just don't understand accounting.


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