Finance Insider: Accounting methods may mask performance

By Tracey D. Jeffers Cash and accrual methods each have their pluses and minuses. Editor’s note: This is the second of a two-part series. In her first article (The Zweig Letter, Feb. 21, issue 899) Tracey Jeffers wrote about how successful banking relationships require having a good understanding of financial statements. Business owners who are using an income statement to track financial performance may be misleading themselves when it comes to actual cash available. More than once I have heard from business owners bewildered by the fact that their income statement says they are making a profit but they never have any cash in the bank. It may be due to the accounting election chosen. With accrual-based accounting, the income is recorded upon the generation of an invoice to a client as an indication that the revenue has been earned, even though the payment may not be received for several weeks to months. The same is said for expenses. If you enter a bill into your accounting system that is due mid-month, accrual based accounting records the expense at that time, even though you may not pay the bill until the first of the following month. Cash basis accounting does not record the revenue until the check or cash is actually received by the business and expenses are not recorded until checks have been cut to pay the bills. Cash in, cash out. Pretty simple, right? Maybe. Cash basis accounting provides an owner much less of a full-blown financial picture than accrual based accounting. If you are showing a profit on your cash basis income statement, that may be because you have a pile of bills to be paid and haven’t paid them yet. A pile of bills netted against that income statement may result in a much different financial picture, so be careful. Lastly, it is easy to get confused about what shows up on the various financial statements. So, here is a brief list of some items that are all related and appear on the various statements. Just remember that each statement has its own purpose and they should be read in total to have a good understanding of firm performance. * Loans. Balances of loans will show up on your balance sheet and each time you make a payment, the principal portion is reduced by that amount. The principal portion of a loan payment will not show up on your income statement, but the interest portion is deductible and will be reported on the income statement. The cash flow statement will show both the principal and interest payments together. * Assets. If you purchase a new asset for your firm and it is going to be depreciated over time, the cost of the asset will not appear on the income statement at the time of purchase. The cost of the asset will be recorded on the income statement in increments known as depreciation. The new asset will appear on the balance sheet at its cost and any depreciation is recorded against the original cost. Any cash that you might have expended to purchase a new asset will appear on your cash flow statement. * Depreciation. Depreciation is a non-cash expense that is deductible for tax purposes. It will show up on your income statement and reduce taxable net income. It also shows up on the balance sheet, reducing the value of company assets on an incremental basis using life expectancy of the asset. So, remember that the net income on your income statement does include depreciation. If you have a sizeable amount of depreciation, it can have a big impact on the bottom line. Having financial statements to provide to your lender at their request is important to fostering a good banking relationship. Likely one of the most important things to remember about your statements is that good, clean statements make lending decisions go much smoother. Jumbled, messy statements are more difficult to read and analyze. Your financial statements are not only the measure of your firm’s performance; the appearance of those statements is a representation of your firm. If you are trying to forge a new banking relationship, in particular, be sure your financial house is in order in all aspects before the first meeting occurs. TRACEY JEFFERS, MBA, CBA, CMEA, is a principal in ZweigWhite’s Financial Advisory Services Group, where she oversees valuation services. Contact her at tjeffers@zweigwhite.com.