Accrual accounting

I do not know how the accounting system we currently follow came into being. At some level, the accounting system is an elaborate exercise in trying to prove a tautological premise. Let's say you have two dogs: Debit and Credit. You give each dog a set of bags. The number of bags given to either dog need not be the same. You then take an even number of beads and start distributing one bead each to either dog asking the dog to put the beads into one of the bags based on some complicated rule.

You keep doing this: pick up two beads, give one to Debit and the other to Credit. Do this for a year. And at the end of the year ask either dog to list the total number of beads against each of its bags. After a lot of fretting, the totals match. You are happy and someone responsible signs off the paper certifying that the totals match. Everyone is happy, Debit and Credit wag their tails, the beads for the new year start coming in.

I could never understand double entry book-keeping in B school. There was just too much pressure which prevented me from making a fundamental assessment of what was going on. It was only recently did I really understand the gist of it all. The difficulty lie in the rules that apply to determine which bead should go into which bag and the exacting exercise of choosing a few bags from either dogs and putting down the bead-count details of those.

Now that I understand accounting in the simple bead, dog, bag model, it is important to understand what constitutes the beads and the bags.

Statutory accounting is done on an accrual basis as against a cash basis. This I'm assuming was a decision taken after a lot of deliberation. Accounting on an accrual basis is more elegant, better for analysis and structurally easier to monitor/maintain. But at the end of the day cash is king, queen and most wanted. Cash accounting is reality. Cash accounting helps you sleep in peace.

Interpreting cash movement from accrual accounting detail can be a harrowing exercise. The problem is that accrual accountants (ergo all certified professional accountants) overdo the elegance bit, mostly at the cost of obfuscating reality.

Lets take a simple example: you own a company that sells soda ash. Your chief executive tells you that he's manufactured and sold 100,000 tonnes of soda ash to Charles Taylor in Sub Saharan Africa. You congratulate him on the sale and tell yourself that you're company is doing well. You order a glass of wine, eat an expensive dinner and go to bed imagining yourself in the new Armani.

A couple of months later your bank calls you and tells you that a 1,000 Rupee check drawn on the bank by the soda ash company is about to bounce. You flip. You ask your accountant to check on what's amiss. He tells you "Sir, yes we're overdrawn".

You look at the company profit & loss statement. It has been a great year; the super-large order from Africa had been the buzz. Your company had made windfall profits thanks to Charles Taylor. What could have gone wrong?

Cash. And the bloody lack of it. The problem is sales, margin, EBITDA, profit are all accrual measures. What really matters is cash. Your profit tells you nothing about whether Charles Taylor paid you for the soda ash. It is designed not to tell you. Charles Taylor's payment or non-payment is hidden in the receivables. The beauty is that you could have gone around town claiming that your company made large profits and yet end up getting caught in a 138 offence on a piddly little check.

This illustration might be simplistic and anyone even remotely familiar with business will be able to spot the miss. But the point I emphasize is that financial reality is often hidden in the accounting statements and takes some finding out.

Accountants are strange people who seem to belong to some secret brotherhood. They seem to have designed things in a way to ensure their necessity is always felt.