The accounting industry hasn’t always had the best reputation for providing financial transparency, but its origins are based on providing consistency to company reporting. Given the millions of businesses that exist, imposing the same universally stringent accounting practice on every company would not however help in this endeavour. Modern day accounting standards therefore allow companies scope to ‘express’ the underlying economic realities of their business in a given year, and when used properly, can be very useful.
Company A builds a factory in a year for £1 million. It expects this factory will last ten years and produce a consistent economic output each year. Under an accounting practice called depreciation, rather than recognising the entire cost on its profit and loss statement on the year of construction, it evenly recognises a cost of £100k each year for the next ten years. Now this makes perfect sense, as the cost is spread across the economic life of the factory, but depreciation is one of the many accounting practices which is open to manipulation. Rather than stating its factory will be used over a ten year period, Company A could say that it will be used over twenty years. This would mean that only £50k of costs are recognised each year and would result in net profits being artificially boasted. Net profit is therefore an accounting construct of profitability which can be manipulated.
Fortunately we have the cash flow statement, which is a lot harder to game as it only accounts for the cash which has come in and out of the business in a given period, the purest measure of profitability. Although cash flow can be lumpy – think large cash outflow on year of a factory purchase – by analysing it over a period of time we can determine whether a business is making more money or not. So the phrase “cash is King” is pretty apt. Bear this is mind next time you read about soaring net profits, but fails to mention cash flow.