The 30 Day MBA (5 page)

Clearly, the level of ‘materiality' is not the same for all businesses. A multinational might not keep meticulous records of every item of machinery under £1,000. For a small business this may represent all the machinery it has.

Consistency

Even with the help of those concepts and conventions, there is a fair degree of latitude in how you can record and interpret financial information. You should choose the methods that give the fairest picture of how the firm is performing and stick with them. It is very difficult to keep track of events in a business that is always changing its accounting methods. This does not mean that you are stuck with one method forever. Any change, however, is an important step.

The rule makers

The accounting professional bodies, with a little prodding from govern-ments, are responsible for ensuring that accounting reports conform to what are known as Generally Accepted Accounting Practices (GAAP). A new entrant, International Accounting Standards, is challenging that term as GAAP rules have been interpreted differently on different continents and indeed largely ignored on others.

The rule book has to be adapted to accommodate changes in the way business is done. For example, international business across frontiers is now the norm, so rules on handling currency and reporting taxable profits in different countries have to be accommodated within a company's accounts in a consistent manner.

Although an MBA isn't usually expected to know all the rules, you should be able to get up to date before any meetings where the subject is likely to come up. You can keep track of changes in company reporting rules on the websites of the American Institute of CPAs (
www.aicpa.org
> Publications > Financial Management & Reporting), the Institute of Chartered Accountants (
www.icaew.com
> Technical resources > Financial reporting > UK GAAP) and the International Financial Reporting Standards (
www.ifrs.org
> Stay informed).

Protecting investors

When confidence in US businesses was rocked badly with a series of high-profile financial frauds, Enron and Worldcom for example, the US government introduced the Sarbanes–Oxley Act, known less commonly but better understood as ‘The Public Company Accounting Reforms and Investor Protection Act – 2002'. The Act's purpose is to close the loopholes opened up by creative accountants, who are always devising ways to overstate profits and understate liabilities, and so make it easier for shareholders to see how profitable a business really is. The act doesn't just apply to US companies; any businesses with shares listed on a US stock market that does business in the United States is swept into the net. Check out
www.sarbanes-oxley.com
for the low-down on that Act.

The UK version is The Companies (Audit, Investigations and Community Enterprise) Act. You can read up on the UK rules at
legislation.gov.uk
(
www.legislation.gov.uk/ukpga/2004/27/contents
).

Auditors – the gatekeepers

All public companies, that is, those listed on a stock exchange, are required to have an annual audit by a qualified accountant appointed by the directors and approved of by the shareholders. Any company with outside shareholders and indeed all but the smallest private companies are required by law to be audited. The auditors' job is to examine the accounts, ensure that they conform with the prevailing accounting rules and give an opinion about the financial statements. Though the auditors' report may be 50 pages long, with a score or more footnotes, the findings are summarized in a single sentence: ‘The financial statements give a true and fair view of the state of affairs of the company at (a certain date) and the financial statements have been properly prepared in accordance with the Companies Act 2006.'

The Companies Act 2006, the longest Act ever introduced, has brought in some tough rules on how auditors, among others, should report on company accounts. MBAs, unless they are also accountants, don't get involved in doing audits. But they are expected to know who's who in the auditing world.
Accountancy Age
(
www.accountancyage.com/static/top50-this-year
) will keep you informed as to who's who in the auditing world.

Bookkeeping – the way transactions are recorded

Until Luca Pacioli wrote what was in essence the world's first accounting book, over 500 years ago, accounting records were maintained in single-entry format; one event merited one record. This meant that errors could be prevented only by a major duplication of effort, for example by having different people making and counting up parallel records. Pacioli, a mathematician who worked for the Doge of Venice, came up with a system of double-entry bookkeeping that required two entries for each transaction and so provides built-in checks and balances to ensure accuracy. Each transaction requires an entry as a debit and as a credit.

To give an example, selling goods in a double-entry system might result in two separate journal entries – a debit reducing the stock by $/£/€250 and a corresponding credit of $/£/€250 of new cash in – a double entry (see
Table 1.3
). The debits in a double-entry system must always equal the credits. If they don't, you know there is an error somewhere. So, double entry allows you to balance your books, which you can't do with the single-entry method.

TABLE 1.3
  
An example of a double-entry ledger

Pacioli's genius lay in seeing that the ultimate balancing number in a company's accounts was the profit or loss for the owners of that enterprise. In fact he required at least two entries or as many as are required to balance the books. Let us take the above example to its logical conclusion. On the not unreasonable assumption that the business plans to make a profit from selling goods, the figures will look rather different. To keep the numbers simple, let's suppose the goods they sold cost them $/£/€125 (a 50 per cent margin); then the entries would be as follows. Goods in stock go down by $/£/€125, while cash goes up by $/£/€250. That net change of $/£/€125 is balanced by an increase in profits of $/£/€125, so the assets and liabilities are kept in balance.

In this example, had the goods sold for less than was paid there would have been a loss, which would have reduced the value of the owner's stake in the business by a corresponding amount.

This is all an MBA student needs to know about bookkeeping; the main part of the knowledge they require is how to interpret the figures once recorded.

Cash flow

There is a saying in business that profit is vanity and cash flow is sanity. Both are necessary, but in the short term, and often that is all that matters in a business as it struggles to get a foothold in the shifting sands of trading, cash flow is life or death. The rules on what constitutes cash are very simple – it has to be just that, or negotiable securities designated as being as good as cash. Cash flow is looked at in two distinct and important ways: as a projection of future expected cash flows; and as an analysis of where cash came from and went to in an accounting period and the resultant increase or decrease in cash available.

Cash-flow forecasts

The future is impossible to predict with great accuracy but it is possible to anticipate likely outcomes and be prepared to deal with events by building in a margin of safety. The starting point for making a projection is to make some assumptions about what you want to achieve and test those for reasonableness.

Take the situation of High Note, a business being established to sell sheet music, small instruments and CDs to schools and colleges, which will expect trade credit, and members of the public who will pay cash. The owner plans to invest $/£/€10,000 and to borrow $/£/€10,000 from a bank on a long-term basis. The business will require $/£/€11,500 for fixtures and fittings. A further $/£/€1,000 will be needed for a computer, software and a printer. That should leave around $/£/€7,500 to meet immediate trading expenses such as buying in stock and spending $/£/€1,500 on initial advertising. Hopefully customers' payments will start to come in quickly to cover other expenses, such as some wages for bookkeeping, administration and fulfilling orders. Sales in the first six months are expected to be $/£/€60,000 based on negotiations already in hand, plus some cash sales that always seem to turn up. The rule of thumb in the industry seems to be that stock is marked up by 100 per cent, so $/£/€30,000 of bought-in goods sell on for $/£/€60,000.

On the basis of the above assumptions it is possible to make the cash-flow forecast set out in
Table 1.4
. It has been simplified and some elements such as VAT and tax have been omitted for ease of understanding.

TABLE 1.4
  
High Note six-month cash-flow forecast (
£
/$/
€)

The maths in the table is straightforward; the cash receipts from various sources are totalled, as are the payments. Taking one from the other leaves a cash surplus or deficit for the month in question. The bottom row shows the cumulative position. So, for example, while the business had $/£/€2,450 cash left at the end of April, taking the cash deficit of $/£/€1,500 in May into account, by the end of May only $/£/€950 ($/£/€2,450– $/£/€1,500) cash remains.

Overtrading

In the example above, the business looks like having insufficient cash, based on the assumptions made. An outsider, a banker perhaps, would look at the figures in August and see that the faster sales grew the greater the cash-flow deficit became. We know, using our crystal ball, the position will improve from September and that if we can only hang on in there for a few more months we should eliminate our cash deficit and perhaps even have a surplus. Had we made the cash-flow projection at the outset and raised more money, perhaps by way of an overdraft, spent less on fixtures and fittings, or set a more modest sales goal, hence needing less stock and advertising, we would have had a sound business. The figures indicate a business that is trading beyond its financial resources, a condition known as overtrading, anathema to bankers the world over.

Cash-flow spreadsheet

You can do a number of ‘what if' projections to fine-tune cash-flow projections using a spreadsheet: Entrepreneur (
www.entrepreneur.com/formnet/form/483
) has a spreadsheet you can download.

Statement of cash flows for the year

A cash-flow statement summarizes exactly where cash came from and how it was spent during the year. At first glance it seems to draw on a mixture of transactions included in the profit and loss account and balance sheet for the same period end, but this is not the whole story. Because there is a time lag on many cash transactions, for example tax and dividend payments, the statement is a mixture of some previous year and some current year transactions; the remaining current year transactions go into the following year's cash-flow statement, during which the cash actually changes hands. Similarly, the realization and accrual conventions relating to sales and purchases respectively result in cash transactions having a different timing to when they were entered in the profit and loss account.