In a perfect world without taxes and bad debt, your cash flow and your P&l would be the same. However, the reality is these two start to diverge quickly as your business develops.
This is an introduction to accounting theory, so do not worry too much about perfecting depreciation! Instead, use this to familiarise yourself with some concepts which I hope helps explain why cash flow is very different to your businesses P&L.
So why the difference?
Now for the theory! There are a few principles/concepts that need to be understood to appreciate why there is a difference. However, before I go into these, a quick point about accounting periods.
Depending on when you started your business, your accounting period runs 12 months from the first month-end of trading, so if you started trading (sole trader) or incorporated on the 17th of October 2016, your first year-end/period-end will be 31st October 2017.
Which bring me nicely to the first concept of accounting ‘Matching’. In a nutshell, income and expenses should belong to the period in which they are incurred or when the economic benefit is derived. However, many startups go wrong, by looking at income on a bank account and assuming it belongs to that financial year.
If someone gives you money in advance for a product/service, in theory, you should only account for that income when the service/product is delivered. Therefore, while you have a positive cash flow, you have not actually earned any income and more than likely have not incurred any expenses to deliver that product/service. So the tax implications should be obvious here.
Accounting too soon:
Less no expenses
Tax liability £10,000
Account in the correct accounting year
Tax liability £6,000
So if you do get money in advance, for a future accounting year, please treat as deferring income. Which will sit on your balance sheet as follows:
Bank DR £10,000
Deferred Income CR £10,000
To realise in the following year:
Profit & Loss
Credit Revenue Cr £10,000
Deferred Income DR £10,000
A step further with matching is the accruals concept. Now, this causes hours of confusion for trainee accountants, so you are not alone here. Think of an accrual, firstly, as a way of recording a transaction you know is going to happen, but you have yet to receive the paperwork.
Secondly, when you know you have these expenses, they should be spread out over the year. Why? You do not take out annual insurance for the benefit of March, do you?
To account for an accrual, set up an asset in the balance sheet, for the quoted or approximate amount. Then charge a monthly portion of the P&L, E.G.:
Electric bill estimated £1,000 - /12 = 83.33 per month
Similar in concept is prepayments. You may pay upfront at the beginning of the year, yet the benefit is for the full year not just the month of the expense E.G.:
Insurance paid £1,000
What you may have noticed that irrespective of where the accrual and prepayment are placed on the balance sheet, both are treated as expenses in the P&L.
Now you might be wondering- 1) what’s the point of accruals and prepayments? 2) Should you treat every expense like this? Well, to answer the second question, no. A pencil might last you 3 months, but no one expects you to create accounting entries for £.50p!
This comes down to another concept- Materiality. If something makes a substantial difference to your monthly P&L, then you need to treat it appropriately.This is the point of the first question. As a business owner- you need to spot real trends in your books.
If you standardise and account for all the expected costs and incomes, you have a better chance of spotting a serious issue or trend and budgeting more appropriately. If your P&L is jumping around, unexpected trends will not pop out and maintaining your margins, will be a nightmare. So, it's important to capture expenses you know will happen for the year.
The next area that diverges cash flows from accounting profit and loss, is depreciation.
When you buy a printer, you would hope to get at least 5 years out of it, yeah I know not a chance, but let’s use it as an example, for now, bear with me!
Looking back to the matching concept, isn’t the economic benefit 5 years? This is where depreciation fits in. It is a way of spreading the costs over a number of years but recognising the remaining value of this item on the balance sheet. So, yes a large amount of money may leave your bank account, but from an accounting point of view, the value of this will last for a number of years.
If you were to sell your business, you would want to make sure the value of all your equipment makes up part of the asking price, therefore it’s important to record, asset values.
To calculate, there are a few methods. For small businesses, I would keep it simple and use the straight line method- which is dividing the asset cost by the number of expected years and charging that portion to the P&L over 5 years:
Laser Printer cost £5,000/
Number of year 5 = £1, 000 per year Depreciation charge to the P&L
As your business grows in complexity and the types of assets you purchase lose their value far sooner in their life-cycle, e.g. cars, you can use the reducing balance method by setting a factor:
Number of year 8 Weighted factor 40%. Each year apply the factor to the remaining value to work out the depreciation amount.
For this example, this would continue until year 8 as the remaining amount would be a few hundred pounds. Any residual balance would be expensed and removed from the balance sheet.
The last term I'm going to cover is amortization. This is very similar to depreciation in terms of calculation however, amortization is for assets that are more long-term and of a higher value, e.g. buildings.
Amortization – the flexible asset
As a small business grows you may invest in buildings, workshops etc, in these cases you will need to consider how you value these assets annually.
You may have a building purchased for £100k but could be worth £150 in year 3. This increase in value will never hit your P&L until you sell the asset. It is what is termed, ‘unrealised’.
Instead, within your balance sheet, Capital section, there is a category called ‘revaluation reserves’. This will go up and down as your business grows but should form part of your businesses value but not its profit.…until realised through selling.
There are a few more complicated items around pensions and leases, but what I hope you can appreciate is that a cash flow is very different to a P&L. A cash-flow records the money flowing through your business and your P&L the economic value of your activities.