It sounds like a simple idea. Profit is profit, so are there any real options as to how to measure profit? The answer is decidedly yes.
The way you measure profit can make all the difference in the world as to the way you run your business and the decisions you make. And I’m not talking to the controller or even the CFO; they are primarily concerned with accuracy, adhering to professional accounting standards (i.e. GAAP or FASB). I am instead talking the CEO, president or those with P&L responsibility who need to make decisions based on the real performance of the company. This is often called “management accounting.”
Let’s start with the big divide, which is choosing between a cash basis or an accrual accounting system. To determine the performance of business one usually uses an accrual system so that, for example, the way bills are paid does not distort the real performance of the company. For instance, if one forgets to pay their rent in one month and profits are higher, that does not mean the company is doing better; conversely if one doubles up next month and pays last month’s rent as well as this month’s rent it, does not mean that they are suddenly doing worse.
PREMIUM CONTENT: North America Staffing Company Survey 2017: Management priorities
Accrual accounts book rent as an accrued expense in the month it should have been paid and does not double count rent in the following month, but treats it as a prepaid liability. Similarly, if one has a big Christmas party in December as a reward for a great year, they should accrue for that expense each month as one-twelfth of the estimated cost. Otherwise, December may look terrible when it really wasn’t. Not all costs can be anticipated, but with a bit of planning, a good many things can be anticipated and dealt with in this manner.
Additionally, owner’s compensation cost for small, private companies should be adjusted to reflect the fair market compensation and cost. Otherwise the owner can pay out all of the profits in compensation cost and totally distort the true profitability of the company.
Other things that distort a company’s activity include not matching up revenue with expenses that are related to those revenues. For example, if a sale is made in the first month and the commission or other compensation is not paid two months later, that expense should be accrued for in month one so we don’t overstate profit in that first month and understate it in the third month.
There are many other similar situations that arise, but I think this illustrates the available choices. One can always revert from an accrual to a cash basis by registering changes in the balance sheet, providing both a management P&L — which gives a more accurate picture of the company’s operating performance — as well as a cash flow statement that reflects how much money is paid out and reflects a check book approach to accounting.
MORE: Transitioning To Professional Management
