GAAP accounting assumes and insists that there exists within the firm a realistic matching of revenue and expense. This notion makes sense, particularly if someone is looking at the firm’s financial statements and wants to understand the firm’s revenues or expenses during a specific period of time, say for a month, or a quarter or a year. Investors and lenders are especially interested.
Subsequent to this notion, GAAP includes all sorts of accounting rules about inventory valuation methods, that is, FIFO or LIFO, etc. This matching concept likewise affects the inventory movement valuation which becomes part of the cost of sales line item, as a firm must sell inventory on hand in order to have recognized sales.
Let me wax more specific. One client of mine spent $60,000 out-of-pocket to manufacture 15,000 units of an item the firm then sold at a rate of 1,500 to 2,000 units a month at a retail price many times the cost. If the entire $60,000 were recognized as cost of sales expense immediately, then we might have an operating statement loss in the month the $60,000 is spent to buy inventory and a gain in every future month that those items are sold. Instead, this product is inventoried and appropriately parceled out, therefore appropriately matching revenues and expenses per GAAP rules.
The GAAP matching rule helps negate these kinds of distortions. We might wonder though, is there a trade-off? There are also GAAP accounting rules to follow regarding recognizing depreciation expenses in a specific accounting period, because depreciation expenses definitely affect the operating profit or operating loss for a specific period, whether we use straight-line depreciation or some accelerated depreciation method.
Likewise, according to GAAP, payroll expenses paid on a weekly and/or bi-weekly and/or bi-monthly basis, must be matched with accrued vacation, etc. That means payroll expenses, including accrued vacation, must be spread across accounting periods, appropriately, because of the same necessity of matching revenues and expenses to avoid distorting financial statements. There are other cross-period expenses incurred as well.
However, closely following GAAP accounting rules does not necessarily mean that the long-term sustainability and profitability of the firm is enhanced. In fact, somewhat the opposite may happen, especially if the accounting tail is inappropriately wagging the dog. One answer to the trade-off question asked above may be less critical focus on cash flow.
One small business firm client actually reduced their total accounting expenses from 3% of total revenue to less than 2% of total revenue, while overall revenue shrank, becoming more profitable and not missing a beat. This increase in profit is attributed to more than the simplification of accounting software, of course.
The benefit accrued mostly by paying careful attention to actual cash flow together with forecasted cash flow, instead of harboring concern whether there were sufficient accounting personnel on hand to carefully match revenues and expenses according to GAAP.
This is not to denigrate GAAP accounting, but in today’s world where financial institutions in America (2009 – 2011) are typically not lending to small business, why spend money on prettifying the financial statements when a loan from a financial institution may not be forthcoming anyway?
I am not suggesting ignoring GAAP accounting rules at all, nor saying a firm ought not to use a CPA firm to file Tax Form 1120 (or whatever form is appropriate) with the IRS annually, but instead proposing that as most successful business owners know, it is focusing on cash flow that will make or break their firms, not anything else.
If you closely analyze your cash flow forecast and know during which weeks you will likely be light on cash and which weeks you will be more likely to be flush with cash, then a business owner can speak to their vendors with conviction and accuracy, improving his credibility. The same applies to staging and staggering one’s major purchases of inventory.
Purchasing nine to twelve months of inventory at one time requires intimate familiarity with your cash flow. Can you the business owner afford not to know where your cash flow likely will be each week for one month or two months into the future?
Instead of only using accounting personnel to massage past transactions, spending non-essential hours daily complying with GAAP accounting rules, why not re-task these same accounting people to help to create a future of the business owner’s choosing?