Business is Best When Accountants Don't Get Creative

By Ben Scott
Entrepreneur

There is an old joke that goes like this: the CEO walks into work one fine Monday morning and says “good morning” to the admin crew, the first people he meets is he walks into the office and asks “what’s one plus one?” And they respond, “Two, of course.” Then he walks off to the factory, says “good morning team,” bumps into his production manager and asks “What’s one plus one?” The production manager looks a bit confused and says “Well, it’s two, sir.” The CEO replies, “Thank you very much.” And off he goes to see the accountant, and he says, “Good morning, what’s one plus one?” And the accountant just looks at the CEO, smiles and says, “What would you like it to be?”

Now, as we all know, there’s never a truer word said in jest. And throughout modern history, there are plenty of examples of scandals and problems caused by people dabbling in financial engineering. Whether that was Enron, WorldCom, Nortel, or obviously the most famous of them all, the 2008 financial crisis. And whether the games were played with junk bonds or home loans, it’s all the same. You could dress it up any way you wanted to, but it was still fraud. Bent people taking advantage of those who don’t think things through or are too trusting.

From a reporting point of view, accounting is at the heart of any business. Many people, especially company leadership and investors, must know and understand the financial health of their business at a given point in time.

For most of us, when we start a business we work on a cash accounting basis. This is quite simple and intuitive — how much cash did I put in the bank, what am I spending and what has come in. This works as it focuses us on cash flow, which keeps us fed and clothed.

As businesses grow we generally move to the more accepted, accrual-based accounting. This allows us to be more precise, take into account things like inventory, inventory movements, things we have paid for but not used and investments in machines. From there, both the profit and loss statement and balance sheet can be formed. This then precipitates the need to begin recruiting more qualified people.

At first, an accounting service or firm will be enough. That is usually replaced by recruiting an in-house bookkeeper which is then upgraded to a full accounting service and full-time accountant. As a company continues to get larger, you must have an accountant on the board of directors. I have always stretched my available resources to build and structure the business in order that it functions correctly and key stakeholders, like the bank, have comfort and confidence. However, this is where having the right people on the bus is critical.

For an accountant, the company’s balance sheet takes precedence over the profit and loss statement, but what takes precedence over everything is cash — you can be profitable and insolvent at the same time. It matters not how much profit you think you might be making if you can’t make payroll.

One of the things that often happens in the accounting department is the so-called “innovations” in finance. Financial engineering was en vogue pre-financial crisis. This always made me laugh as it is bullshit and eight-tenths fraud. Earnings manipulation is real and has been with us since the dawn of trade. The oldest error detection tool is double entry bookkeeping. This has been with us since the 11th century and in daily use since the 15th century. Wherever there are people and money, controls are needed.

The incentives on management to dress things up can lead people to get distracted, to try and show that they’re making more money than they really are. Certain treatments of accruals, pre-payments, CAPEX, depreciation, inventory, income, or warranty claims can all manipulate the image of how well the business is doing. Any leader or accountant can dress these numbers up any way they like, but in the end, good business is good business.

Cash is cash. If cash isn’t coming in, or cash is going out too fast, you’re screwed.

Manipulating the balance sheet is so easy, and hard for many to avoid the temptation and seduction of monkeying with the numbers. However, if more people applied Benford, Beneish or irrational number tests (preferably a combination of all) to balance sheets, fewer frauds would go undetected as these tools see right through the veneer of numbers and structures that are the function of a human mind rather than a function of operations and activity. Numbers just don’t lie, people do.

No matter what you do, these tricks are only short-run solutions. The message here, really, is don’t get distracted by the numbers and don’t think that somehow, something new is better than good old fashioned business and good old fashioned accounting and cash management. That is, paying customers and cash in the till, all day, every day. It’s a simple matter of honesty and integrity.

Your business needs cash; cash is everything and when you’ve got profits and you’ve got cash in the bank, you’re in good shape. That’s a simple measure for success (the other is paying taxes). If you’re trying to play games because you don’t have that cash, then no matter what you do, the cash won’t magically appear. One of my first customers used to say that to have a business you do not need an office, you do not need a factory, or a desk, a name or logo. You need a customer. When you have a customer, you have a business. Good business is very simple — it has a purpose and purpose transcends money.

Even if you’re not currently making an accounting profit, but you’re generating cash, you’re in good shape. The key is to keep your mind focused on paying customers, making sure they are sticky and you are creating new ones. As Peter Drucker said, our only purpose [in business] is to create a customer.