In an increasingly integrated world it seems reasonable to have a standard such as IGAAP that allows international investors to examine the accounts of any company anywhere in the world and know they were calculated with the same rules. Law dictates that companies create accounts according to generally accepted accounting principles (GAAP). That’s one way to view a company’s financial performance and current position. It serves investors and the market purpose and because of that it’s a view shared by the senior executives and board members. In between this view of a company and the reality inside it, things tend to get muddled. Really, the operational and financial view inside a company should be quite different to the outside view of investors.

Here’s Bill Waddell talking about Lean Accounting:

Abstraction is useful because it’s often applied to make things easier to understand. But with too much abstraction we can lose touch with reality and suffer abstraction fatigue. When abstraction goes so far it can create a whole new universe more complicated than reality, then we should be worried. When that universe is perceived to be reality, then alarm bells should be ringing.

When an asset isn’t an asset

Traditional accounting practices see inventory as something of value to the business and it’s therefore treated as an asset. That means that software still being worked on or completed software not yet released is treated as an asset. I find it hard to accept that holding equity in something that’s not generating revenue is actually an asset. If you’re living in a house and paying a mortgage on it, that house is more like an expense? If that same house were being rented out at a profit then I’d consider it to be an asset. I prefer to deal in what’s real. Cash is real. It’s not the accounting definition of an asset but I like the idea of an asset being something that creates positive cash flow and drives a profitable service.

Inventory is a high-risk investment

Building inventory is a high-risk investment because it assumes that demand will exist for whatever is being built when it is finished. What if demand dries up? What if the wrong thing is being built?

The world of software is dominated by the Big Project funded by a Big Budget and scheduled for a Big Bang release. That’s a mighty big bet with big pile of cash on getting it right first time. Don’t worry, it’s a corporate asset, right? And with the added benefit of tax relief on the capital expenditure for research and development. Splendid! All looking good on the balance sheet. No. It’s inventory, and as Waddell says, “inventory is a great big pile of cash that’s being drained from the company on a regular basis.”

Shorter cycles and smaller bets

Lean principles are about reducing the time between being asked for something and delivering it. Two-week iterations are popular. If software is released every week instead of every fortnight inventory is reduced. Continuous delivery where each feature is released upon completion reduces inventory even further. Less money is spent more slowly. That can only be a good thing for cash flow.

In terms of risk, making small investments to continuously validate features with customers has proved an effective way to deal with uncertainty. Releasing early and often presents repeating opportunities to drive revenue, keep sunk costs to a minimum, and ultimately achieve profitability sooner. Or to find out earlier that we should stop investing.

Cash basis accounting

Over two years, starting back in 2008, I experimented with Throughput Accounting applied to the portfolio management and governance of software product streams. It felt clumsy and the model didn’t really fit so I moved to Lean Accounting. Eventually I settled on plain old cash basis accounting – money in, money out. This has proved a more meaningful way of accounting that helps visualize software economics and facilitate more informed decision-making. Real, unequivocal profit comes from having more cash coming in than going out and not by making accounting allocations and assignments. Waddell’s analogy of the family budget is spot on. When you sit down at the end of each month there’s no ambiguity – you know exactly whether it was a good month or a bad month.

Keep it real

The increasing popularity of Lean Accounting, albeit very slow, and Beyond Budgeting of course, suggests there is some recognition that operational decisions would be better informed by something other than the abstracted accounting numbers we find in traditional company accounts. Why not run simple cash books in parallel with the GAAP accounts? Move more accountants to the front line, closer to customers, and where their financial insights can add real value.

Further reading:

  1. Throughput Accounting
  2. Throughput Accounting: A Guide to Constraint Management
  3. Practical Lean Accounting: A Proven System for Measuring and Managing the Lean Enterprise
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