I MADE THE POINT in my article last month writes Adrian Goodman (pictured), managing director of PPX Consulting that the correct calculation of profit is vital for decision-making within a business. I discussed the different ways to classify costs and why this is so important.
To expand on this theme, this month I’ll be looking at the accounting concepts used to ensure accuracy, which, in my opinion, all business owners should know.
- The Accounting Equation
- Double Entry Accounting
- The Accrual Accounting Convention
The Accounting Equation states that Assets – Liabilities = Equity. In other words, if you add up all the assets owned by the business and then deduct the liabilities owed by the business, the amount left over should match the accumulated profit (equity) retained in thebusiness. This is represented by the Balance Sheet, where you can clearly see assets, liabilities and equity and the relationship between them.
Double Entry Accounting is the accounting system used by most businesses globally. It dictates that for every debit, there must be a credit and this is why the Accounting Equation works.
These two concepts are relatively well known and, if they are adhered to, the numerical accuracy of your numbers is guaranteed.
The third concept, The Accrual Accounting Convention, is less to do with numerical accuracy and more about timing. This adds another angle to my assertion that calculating your profit correctly is vital. It is not just important to get the numbers right – it is alsoessential that they appear in the correct period.
The Accrual Accounting Convention stipulates that any costs incurred in generating revenue must be recognised in the same period asthe revenue generated. For example, if you buy stock in one period but sell it in a later period, the cost should not be recognised until the stock is sold.
The reasons for this are relatively obvious. If you receive a massive shipment of stock the day before your financial year ends, it is unlikely you will sell any of that stock in the same year as you receive it. Unless you defer this invoice, it will result in a significant cost being added to your accounts in one year and a large sale the following year. Profit – and therefore tax – in the earlier period would be very low while profit in the later period would be artificially high since all the cost relating to those sales would have already been accounted for in a different period.
But why does this matter? After all. the profit would be made and tax paid at some point and it would all ‘come out in the wash’. Right?
Apart from the fact that it would be very difficult to measure the performance of your business internally, consider the sharp increase in the corporation tax rate earlier this year. Any profits made prior to April 2023 would have been taxed at a lower rate, which may seemlike good news. But if this is achieved by manipulating the recognition of cost, you may well end up with penalties from HM Revenue & Customs.
When it comes to performance evaluation, as with many things in life, timing is important.
Find out more at www.ppxconsulting.co.uk, email or call 01536 856740.
Adrian Goodman is Managing Director of PPX Consulting and author of Achieving Profitable Growth, a guide to establishing financial control in business.