Cash vs Profit – Part 2
Last month, we looked at why cash and profits differ. Part of the reason is due to timing differences between when invoices are posted onto the Profit and Loss account and when cash is received or paid.
This month, we’ll be examining a second key reason for the difference between cash and profit which is the paper adjustments posted to the profit and loss account as part of the month end process. These paper adjustments are not cash, they are to help us understand and run the business better.
Two common examples are accruals and prepayments as follows:
As part of the month-end process, accountants accrue various costs in the P&L. Accruing simply means the best estimate of costs that have been incurred but the invoice has not yet been received. A typical example would be a salesperson who has expenses for all their travel in the month visiting potential clients. If they had not submitted their expenses claim by the end of the month, the accountant would ‘accrue’ their best estimate of the costs incurred. They may do this by asking the salesperson directly or by making sensible assumptions based on previous months.
A prepayment is the exact opposite of an accrual. A prepayment means something has been prepaid. For example, annual membership subscriptions for a professional trade body are paid for the year in January. The cash has therefore gone out of the business already. However, in the P&L account, 1/12th of this cost will be shown in each month. If we take myself as an example – I need to pay my annual subs to the ACCA, my accounting body, at the start of each year. I am just as much of an accountant in October as I am in January. In the accounting world, I am therefore deemed to be ‘using’ that cost in each month of the year.
How do accruals and prepayments help us understand the business better?
If we look at the two tables below, we can see that if we used a cash-based system, the business would show a profit of £10k per month for the first 3 months but would then plummet to a loss of £15k in month 4.
The accruals-based table shows as close to the true picture of the business as possible. This company knows it has used the telephone for the first 3 months of the year and therefore estimates (accrues) the cost of this until the bill comes in. The profits are ‘smoothed’ and better represent the actual business, therefore facilitating better decision making.