“Accounting is the language of business.” Warren Buffett
Profit and Loss account shows the profit a business earns. But this could be illusionary if the entrepreneur is not aware of the accounting.
Usually, companies play with the profit to satisfy the bankers and to evade taxes. This is a fine balance. For bank projected profit is important and for tax purpose deflated profit dishonest entrepreneurs aspire for.
There was a time when two sets of books of accounts were maintained. One for the bank and one for the tax department. Now with the integration/sharing of the data across the Govt departments, this practice has reduced substantially if not stopped completely.
Yet financial frauds like Satyam, Enron, ILFS, and Toshiba are about accounting jugglery and not declaring the true financial picture. Public companies fool investors by wrong disclosures. Most of the large corporate accounting frauds are about overstated profit, sales, and revenue.
“If lies are more comforting to you than facts, you need to get out of your comfort zone.”
As mentioned above, all private companies and small businesses also play with the accounting data to evade tax and to justify their limits with the banks.
handpicked related post: Dear Entrepreneurs, Cashflow Is Not Your Money
Two data which are usually manipulated and remain manipulated are:
- Sundry Debtors
Inflated inventory helps in higher working capital drawing power. It also helps in higher profit data.
Bank’s working capital cash credit limit is arrived by adding account receivable and inventories and subtracting accounts payable.
Inventory valuation also impacts the profit figure. Therefore, there is a tendency to inflate inventory and continuing bad debts in sundry debtors’ figure.
Higher profit is many times necessary to manage ratios and projections given to the banks. Lower profit and relevant affected ratios affect the credit rating of the company.
Writing off bad debts reduces debtors and profit figure. Higher debtor’s data helps the company to maintain the working capital drawing power.
There are some sales which just book entries. With the introduction of GST the practice of fake sales might have reduced. But the profit component of these sales is also book entries. This practice also tends to show more than actual book profits.
This allows the company to keep higher drawing powers (DP), but if an entrepreneur does not understand the data and assume the profit shown in Profit and Loss account as the real profit, there is a serious issue.
Imagine the data:
Turnover Rs. 250 mn,
Net Profit of Rs. 20 mn.
The bad debt of Rs.5.00 mn (2% of sales) and
Carrying a dead/very slow-moving stock of Rs. 4.00 mn (2% of Purchase).
In the above case, the real profit is Rs.11.00 mn and not Rs.20.00 mn
Net Profit Rs.20.00 mn
Minus Bad Debts Rs. 5.00 mn
Minus Dead Stock Rs.4.00 mn
Real Profit Rs. 11.00 mn
Every year the balance sheet is inflated by about 50% profit. This inflated data is represented by Capital on the liability side and Inventories, and Debtors on the asset side.
If you do not write off bad debts and dead stock periodically, the balance sheet becomes unreliable. Your bankers may be happy and you are also happy with higher drawing power, but your working capital is financing your dead investments, not your working investments.
Though bankers are now cautious about financing overdue debtors, your reliance on wrong data could prove a costly mistake.
Every business which goes out of business for manipulating the data, affect the lenders and creditors but the highest casualty is for the entrepreneur himself.
The entrepreneur goes out of business; no lenders or creditors would lend him. It becomes difficult to build a business after a failure.
The solution is knowing your data well. Understand the implications of data manipulation, and keep the record straight. Do not get swayed by short-term benefits. Correct books of accounts will help you incorrect analysis of the data. Manipulated data will fool the system first but in the end, it eats away the business itself.
“Managers thinking about accounting issues should never forget one of Abraham Lincoln’s favorite riddles: How many legs does a dog have if you call a tail a leg? The answer: Four, because calling a tail a leg doesn’t make it a leg.” Warren Buffett
Do not be happy with your bottom-line figure. Adjust it for the real profit. Your wrong belief is not going to increase the real profit. The real profit is the profit which really is.
You may also like to read: Why do Entrepreneurs Need to Save for Personal Obligations?