I am told that accounting issues are not considered the most exciting blogging topics. They are, however, the focus of much of my thinking at present, which is why they will be addressed here. Accountancy does, in my opinion, have the power to change understanding. That, for me, is its importance.
I addressed this point in an article on AccountingWEB yesterday. One of the most common questions asked of an accountant is ‘did we make any money?'. The profit and loss account, or income statement, does not provide a mechanism to answer that question because what it reports is whether or not a reporting entity is bigger or smaller as a result of the activities of a period, and not whether the resulting growth delivered more cash to the business, which doe snot necessarily follow.
Nor does a balance sheet answer this question because it is static data, determined at a point in time.
To address this issue a statement reconciling these two primary accounting reports is required. A true cash flow could do it, but they are very hard and costly to prepare, and not necessarily very helpful. I suggest that a Statement of Source and Application of Funds, last a compulsory retirement in U.K. accounting in 1990, would provide most of the information a cash flow statement can provide and can answer this fundamental question if ‘did we make money?' They are also quick and ready quite easy to prepare, based on my own experience. As such the inclusion of one in any set of accounts would considerably add to user understanding, most especially when the much harder to comprehend cash flow statement required by current accounting standards is probably disclosed in less than one per cent of all U.K. accounts at present, despite the enormous significance of the issue.
My AccountingWEB piece is here. This need for better accounting standards, and similar ideas to enhance the presentation of smaller business accounts so that users might understand them, is going to be a recurring part of my work this year.
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“The profit and loss account, or income statement, does not provide a mechanism to answer that question because what it reports is whether or not a reporting entity is bigger or smaller as a result of the activities of a period”
This echo a blog you wrote in December; however it is possible for an entity to make a profit and shrink – if distributions exceed profit.
Wow, do you really want me to have to always spell out the bleedin’ obvious?
Why?
Am I not allowed to assume some intelligence
And have you not noticed that dividends are not a P&L charge, or wondered why?
One of the things I was often being asked as an accountant when presenting the annual P&L was “if we made all that money where is it?” Most small business owners I dealt with were unable to understand balance sheets so it was hard to explain. Also, I often had to provide cash-flow statements to clients’ banks for lending support and I agree it’s tricky to do – software such as Sage claims to do it but doesn’t. In one case I used to prepare two sets of accounts, one on an accrual basis for HMRC and one on a cash basis for the company’s bankers. I haven’t read your AccountingWeb piece yet but will do so with great interest.
Now try asking “did the government make (or lose) any money?” MMT shows us that the question is irrelevant and that the annual deficit or surplus is only of interest for purposes of statistical analysis. The government does not have any money and never has any money, nor does it make or lose any because it issues it as allocated by Parliament. What we should look at is whether it has improved the well being of its citizens by way of its social provisions, national infrastructure and security.
Thanks Nigel
Excellent post Richard: it goes to the heart of understanding what’s going on in a company’s finances. I spent a lot of my career doing corporate turnaround work and the old mantra of “Turnover is vanity, profit is sanity, but cash is reality” still rings true.
In many turnarounds I found that much of management thinking and strategy revolved around pushing turnover without properly considering the cash flow implications of the deals struck by the sales team. The Statement of Source and Application of Funds was a key document in demonstrating where cash flow problems originated, although it was by necessity retrospective. I thought it just as important to understand the future value of deals being struck now, and insisted on Discounted Cash Flow calculations being produced before any proposed sales deal could be approved and contracts issued. This restricted salesmen from offering extended payment terms or ‘mates rates’ which might adversely affect cash flow in future years and in large-scale engineering contracts spanning more than one financial year it proved very helpful.
On another (but recurring) topic, GERS figures might be very revealing if a Statement of Source and Application of Funds were appended.
But Ken, Scotland does not have a balance sheet
And that’s another reason why GERS is nonsense: there is no capital maintenance concept within it
I only observe that cash flow statements are indeed complex, unintuitive and tough to produce – initially. Took me years to get to grips with them professionally. However fiendish they are to set up they are the most important of the financial reports and it is incumbent on accountants to ensure lay users bridge the gap in understanding, for their benefit.
I have long argued that as a profession we do our clients a disservice by only being required to produce two of the three main financial statements and missing out the most important one. I think both a Source and Application and funds and cash flow statement would be a helpful way of looking at this most important metric and still produce the former from time to time.
You cite the complexity of preparing cash flow statements; in many ways modern software has made the task a lot more straightforward particularly for small businesses and it is a lot easier to calculate ‘net operating cash flow’ – the most important metric a business owner should know each month to assess the health of a business – as the software does the heavy lifting .
Point accepted
My software does it
My concern is do most accountants understand what they rely on software to prepare?
And the format is clunky
In the example you quote in AccountingWeb, I note that there are 3 columns headed only as “£’000” and that the leftmost column seems to have no entries – what is it for?
Can you point me to a reference that details what should appear under the main headings of the table, and explains how to source the various entries?
The layout in AccountingWEB is not good…
It is based on SSAp 10 but has not worked well
Two columns can do
The aim is that the various entires should all either logically be in the accounts already (the ideal) or readily available from them
Having studied bookkeeping during high school, I have some understanding of what income statements and balance sheets are. However, the concept of “cash flow statement” did not exist at that time. Can someone say why a cash flow statement is inherently complex to prepare (even if mitigated by computerization)?
In essence it should not be, but as it has been defined it can (and I stress the ‘can’ require additional data to be prepared from the accounts, which is an obstacle
The SSAF is effectively a reconciliation of data already in the accounts and so simpler to prepare, explain and understand
Anything that encourages business owners to make more use of the accounts is to be welcomed. Taking a bit of time to walk through results is often a springboard to a greater understanding of what is happening now.