We are all accountants by nature, keeping track of things mentally, instinctively. In buying a new car we ask: Will this be an asset or a liability…convenience and pleasure versus garaging costs, insurance, maintenance? Will it add value? When we meet a new person, we ask: Asset or liability? Pros and cons? Will the relationship add value?
In answering those questions, we can be a cash accountant or an accrual accountant.
A limousine driver buys a car with a bank loan, paying only $5000 up front, seeing this as a much better proposition than paying the full price of $80,000 for the car. He does not think of the monthly payments in the future and their relation to his monthly cash income from driving clients. In accrual accounting terms, he does not mentally book the liability for future payments on the financing loan. He is a cash accountant facing potential surprises as time evolves. The accrual accountant sees an asset in terms of the expected income from the car and a liability to service the loan.
A limousine driver sees monthly net cash receipts…cash revenue from clients less cash paid for fuel and insurance…of $3,500 or $42,000 a year and declares to his family: I am making good money that we can spend! He is a cash accountant. Yet, for his business he requires a car costing $80,000 that requires replacement after four years due to its intensive use. That is depreciation of $20,000 per year, so the accrual accountant says he makes only $22,000 per year. The cash accountant is in the hole: His family has spent the $42,000 cash each year. He has no funds to replace the car to provide for his family.
Worse, the driver spends the $42,000 without recognizing that he must pay income taxes on it. The accrual accountant books a (mental) liability for those taxes. In technical terms, the amounts the driver takes out of the business for his family are dividends which are in excess of the accrual income from the business. He is effectively liquidating the business.
The limousine business is a simple protype of any business which just becomes more complicated with expenses incurred on credit rather than cash and with customers given credit rather than paying with cash. With these complications, the business keeps a formal accounting book rather than trusting mental accounting.
One might belittle the elementary thinking of the limousine driver. But it’s common thinking even among supposedly accomplished investment analysts. They bandy about a measure of earnings called EBITDA: Earnings before Depreciation, Amortization, Interest, and Taxes. Well, just as with the limousine driver, firms must account for depreciation, taxes, and interest to be paid on debt. EBITDA is bad accrual accounting.