Small Business Accountants since 1991

How Accounting Software Distorts Your Profits

falling profits strangling businessmanSo you want a set of management accounts. You’d like to know how much profit you made last month, to help you price future quotes and check whether you’re on track for an annual profit.  So off you go to your accounting software to print off an instant report.

Most accounting packages can produce such monthly and quarterly reports, and very handy it is to be able to have “management accounts” roll off at the push of a button. According to Small Business Accountants Taxsmiths®, these vary in quality from one accounting package to another. Most depend heavily upon the skill and knowledge of the end-user who configures them. At the very least, those reports should be set up in accordance with basic accounting concepts and conventions, so as to eliminate anomalies and distortions. Otherwise you could be left wondering why your profits fluctuate wildly from one month to another, or even be fooled into believing you’ve made an abnormally small profit or large loss.

management accounts statement 1

Figure 1

Of course, configuring management reports is beyond the comfort zone of many DIY accounting package users. Most rely on the standard push-button reports which come with an accounting package. To illustrate the flaws in that, let’s use a hypothetical start-up business – say Stubbs the Builder:

Let’s suppose that in his first month of trading, Stubbs invoices £3,000 of work to his customers, having purchased £1,000 of materials. He also incurs some other expenses for his van, telephone, and for the rent of a lock-up unit.

So at the end of his first month’s trading, the push-button management accounts that Stubbs extracts from his accounting package make depressing reading – he’s made a loss of £180 (figure 1) and must feel like packing it in already.

 

Let’s take a look at how an accountant might adjust those figures to get a ‘truer’ picture.

management accounts statement 2

figure 2

Firstly, the matching concept, a cornerstone of accounting convention, dictates that income should be matched against expenses for the correct period. Let’s suppose the £480 invoice for van insurance is an annual premium, so that only one twelfth (£40) should be charged to a single month’s accounts.

Let’s also suppose that the £1,200 paid for rent includes a £500 bond, refundable at the end of the rental, so that the rent consumed for the month is just £700.

So, after those two adjustments, Stubbs now has a profit of £760 (figure 2) for the month.

 

Let’s look next at Revenue Recognition and stocks.

management accounts statement 3

figure 3

Suppose on closer inspection we discover that, as well as invoicing £3,000 for work completed to an agreed stage, Stubbs has also carried out a further £500 of work that has yet to be invoiced. That additional £500 of Work in Progress needs to be added to Sales.

Let’s also suppose that of the £1,000 paid for materials, £400 is still unused stock – so only £600 of stock has been used for the £3,000 of sales and £500 of Work in Progress.

So, after work in progress and stock adjustments, the month’s net profit increases to £1,660 (figure 3).

 

Finally, let’s adjust for depreciation and for the accruals concept.

management accounts statement 4

figure 4

Let’s suppose that Stubbs’ van depreciates at the rate of £100 per month. The depreciation charge simply reflects the wear and tear, and loss of value, consumed in one month.

Let’s also suppose that the Accountants’ annual bill for preparing accounts will be £600. So one month’s accrual will amount to £50 (one twelfth). That represents the amount of accountancy services apportioned to one month’s management accounts.

Following those adjustments, the final management accounts profits for the month should amount to £1,510 (figure 4). That’s a far cry from the £180 loss churned out by Mr Stubbs’ accounting software. His business isn’t so bad.

 

This simplified example serves to illustrate some of the common distortions to bottom-line profit in push-button management accounts. Business owners may well be confused by their apparently fluctuating profits – scratching their heads as to why profits often fall below expectations; and on occasion being fooled into believing they are making super-profits when they are not. Of course, if Stubbs the Builder wasn’t a start-up business then profits would be subject to such distortions not only at the end of the management accounts period, but at the beginning as well – meaning double trouble for the unwary!

All blindingly obvious? Well, you’d think so; and yet you’d be surprised just how many business owners – and for that matter their bank managers – place blind faith in the unadjusted management accounts that roll off from their accounting software. Many important decisions, ranging from quoting for work to hiring or firing staff, from taking a bank loan to purchasing equipment, or from managing cash-flow to awarding oneself dividends, are often based on such distorted accounts. Next time you need management accounts, do make sure your accountant or bookkeeper doesn’t palm you off with an accounting software printout.

© Taxsmiths® 2014

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