The accounts of a business must reflect all transactions, whether physical or cash, that take place during the accounting period. If they don’t, beware, especially if someone assures you the company is profitable!
Be on your guard when you hear someone use the word ‘profit’. It’s a slippery word, changing its meaning according to the situation, sometimes being used as a verb, sometimes as an adjective, and most often as a noun, referring to the financial state of a business.
In farming circles, it’s likely to occur in the context of business. But are we talking about gross or net profit? Is it pre- or post-tax? Is it ‘headline earnings’, with the figure adjusted for one-off major abnormal expenses or revenue items, or is it perhaps one of those weird profit concepts, EBIT (earnings before interest and tax) or EBITDA (earnings before interest tax, depreciation and amortisation)?
The Lehman disaster
Do you remember the saga of the Lehman Brothers, the collapse of which triggered the 2008 global financial crisis?
The original brothers started trading cotton in Alabama in 1844, moved into other commodities and brokerage, and helped found the New York Cotton Exchange in 1870.
They had their ups and downs, but over time built a huge enterprise.
In 1984, after 140 years as a family-led business, personality clashes and hostilities among the firm’s bankers and traders came to a head, and the firm was sold. Under new owners, Lehman prospered and in 2007 generated about US$3,1 billion (R45 billion) in revenue and almost US$800 million (nearly R12 billion) in pre-tax income.
On 9 September 2008, in his report to shareholders, the chairperson reported: “We have produced another year of record revenues, net profit, and earnings per share, and successfully managed through the difficult market environment.”
Just six days later, Lehman Brothers filed for bankruptcy.
Here you had a company trading under the tightly regulated rules of the New York Stock Exchange, employing highly qualified chartered accountants, and audited by a leading international company. Yet it ran out of cash. ‘Highly profitable,’ said the chairperson, but it couldn’t pay its bills!
The perversions in the accounting were due mainly to the creative manner in which the non-cash transactions were reported. It was all due to manipulation of the ‘accrual’ concept.
Let me explain.
Take the example of a purchase of fertiliser in September on 90 days’ credit. Payment is due only in December, but we need to ‘recognise’ that a purchase occurred in September, and it must be included in the September accounts.
We can’t pretend that because we don’t have to pay until December we don’t have the goods.
But what if the supplier didn’t send an invoice with the goods? Does it mean we can pretend the fertiliser never arrived? A goods received note should have been completed, and this provides the docket that ‘recognises’ the transaction and brings it into the accounts.
The same can happen with revenue. Consider the fixed price sale and dispatch of an export consignment of citrus in June.
If we choose to ‘recognise’ or accrue the revenue that will arise from the sale on the day of dispatch, despite the fact that we will receive the cash only in August, the accounts for June will show a nice ‘profit’.
Of course, it’s never prudent to ‘recognise’ a transaction until the cash is in the bank, but the accrual concept opens up much room for error in judgement or sheer dishonest manipulation.
Ignore the talk about profit – get the full picture
If you hear someone refer to a ‘profit’ figure that seems too good to be true, dig for the details about the non-cash transactions, and how the accruals were handled.
In plain English, the accounts must reflect all transactions that took place during the accounting period, without waiting for the resultant cash side of things to catch up.
‘Accrual’ is a concept that cannot be trusted, so remember the cliché: ‘Cash is a fact, profit is an opinion!’
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