In the 1994 movie Stargate starring James Spader and Kurt Russell, some fictitious freak of nature had opened up a strange luminous gate between two dimensions. On one side of it was the world as we know it. On the other side, a strange, alien world, like nothing we’d ever seen.
Today is another stargate, the place where two dimensions meet. And in this case, it’s not science fiction, it’s as real as business itself. One of these dimensions is accounting. The other is planning. They meet at today.
Basically, it goes like this: Accounting ends today and goes backward into the past. Planning starts today and goes forward into the future.
If that strikes you as theoretical or conceptual, perhaps a bit impractical, think again. This is important. It can save you needless headache and stress. It helps keep you in the right dimension, understanding that the financial projections in your business plan are not meant to be built in excruciating detail.
A Simple Example
Take the balance sheet here, a sample taken from Wikipedia. The so-called balance sheet is a standard financial report, listing the assets and liabilities and capital of a business at the end of some specific day, month, year, or whatever. Assets are good, things you own like cash and land, or money owed to you like accounts receivable. Liabilities are debts, money you owe, which is why you see things that are “payable” – meaning you’re going to have to pay them – as liabilities. Capital is what’s left over. It’s called a balance sheet because it’s magic, the magic of double-entry bookkeeping, the assets are always exactly equal to the liabilities and the capital.
Is this as accounting report or a projection in a business plan? You can’t tell. It looks exactly the same, either way. However, in truth, they are different dimensions.
Accounting Collects Records of Transactions
Accounting goes backward from today into the past in ever increasing detail
If it’s accounting, then every number shown there is actually a summary report of a database full of transactions. The cash balance is like your checkbook balance, it’s the result of adding up all the deposits and subtracting all the checks. What they call accounts receivable is the sum of all the amounts of money owed by all the different customers, a report of hundreds, maybe thousands of different transactions. You make a sale, leave an invoice, wait to get paid, then finally get paid, record the transaction, debit cash and credit accounts receivable, and so on, through a collection of specific transactions. The $52,000 reported as land value might be what you paid for land, but it might be the resolution of dozens of land transactions, selling some, buying others, and that’s the balance.
Liability balances, like assets, are built from bottom up in accounting by keeping track of all the transactions and summarizing the end result. Notes payable might be dozens of small trade bills sitting on a spike somewhere, or a loan from the bank, in which case it’s related to the starting loan amount less the total of all the principal payments.
I hope you get the idea: accounting is a huge collection of summarized past transactions. Focus on any number in an accounting statement and you should be able to zoom in on more detail, down to each individual transaction.
Planning Makes Reasonable Educated Guesses
Planning goes forward from today into the future in ever increasing summary and aggregation.
Now consider, if you will, that same illustration as part of a business plan, making an estimated guess of what the balance will be two or three years from now. Don’t even try, not for a second, to think that you’re going to estimate cash by estimating the details of thousands of transactions and adding them up. You’re not going to estimate assets by guessing what you’re going to buy, and when (not to mention depreciation, so pretend I didn’t). You’re not going to estimate debts by guessing when you took out each loan, exactly what you purchased, and when. No, that’s impossible, and silly. You’re going to find some way to guess your cash, you assets, your liabilities, based on larger educated guesses tied logically into the major flows, like sales.
We’ll be working together later on how you can make reasonable estimates, but for the sake of illustration, I have some of examples to explain the difference in dimensions:
- Accounts receivable means money owed to you by customers. You make the sale but you deliver an invoice, and wait to get paid; that’s the way it goes in business-to-business sales. So you need to guess how much money will be sitting there, at important points in the future, waiting to get paid. Every dollar in accounts receivable is a dollar less cash, because it was booked as sales but you don’t have the money. You don’t however, try to guess all the specific sales transactions with all the specific customers and add them all up and figure out where the total will be two or three years from now. Instead, you guess what percent of sales involve invoices and waiting, and then you guess how many days on average you have to wait, and you can do some numbers tricks to make an educated guess.
- You don’t guess what you’re going to owe by adding up all the imagined bills from some guessed-at future purchases. Instead, you estimate how much you’re paying out in expenses as a matter of percentages of sales and payroll or something, then estimate about a month’s worth of that as payables.
I’m not going to belabor the examples because I think that’s already enough to make the point. You have to make some logical guesses.
Why Does This Matter?
Top Down vs. Bottom Up
Every so often I encounter somebody trying to manage the minute detail of projected interest expense to allow for several different loans with differing rates and terms as part of a business plan. Or there’s somebody trying to guess assets by guessing the detailed purchase dates and values. And then there are people trying to project future accounts receivable by customer, guessing each customer’s future sales and payment patterns.
The problem, of course, is that is really hard to do. You can spend a lifetime calculating details and never get as close as you would with a good estimate.
Compare the levels of certainty: let’s say interest is normally a percent or two of total expenses, and expenses are normally something like two-thirds of sales. If your sales estimate for future years is within 5% either way, you’re doing way better than most. How wrong can you go with a simple estimated interest rate, and how much does that affect your projections? Aren’t we talking about tiny percentages of expense, in a system that has to estimate other elements that have hundreds of times more uncertainty?
Here’s an example with numbers: a company plans to sell $1 million and has interest expense of $10,000. The range between plus or minus 5% in sales is $100,000, from $950,000 on the low end to $1,050,000 on the high. So if you miss the projected interest by $2,000? Or maybe $5,000? Your projection depends on estimating sales, cost of sales, all expenses, plus flow of assets and liabilities. There is a lot of uncertainty in this system, necessarily, that’s part of the process. Eventually you will manage the uncertainty by tracking your results every month and checking the difference between what you planned and what actually happened,
I suggest we think about this for just a second. Does it make sense that business planning is about projecting the future so exactly that using a simple average estimated interest rate applied to your projected liabilities isn’t good enough? Do you really have time to be modeling the detailed impact of multiple hypothetical interest rates on multiple hypothetical loans as part of a projection that depends on an estimated sales forecast?
Planning is for making decisions, setting priorities, and management. Accounting is also for information and management, of course, but there are legal obligations related to taxes. Accounting must necessarily go very deep into detail. Planning requires a balance between detail and concept, because there are times when too much detail is not productive.
Good News: It Makes Things Easier
This is really good news for business planning. What it means is that you don’t have to paint a picture of your financial future by detailing every brick in every building. You can do it with a broad brush. That doesn’t make it less realistic, in fact it will usually make it more realistic, at least that’s what I’ve seen while working with thousands of people on thousands of business plans.
We’re human. We work better at imagining the future in scale than at building it brick by brick in our mind.
Accounting can never be wrong. Business plans are always wrong (not that they aren’t useful — it’s like walking or steering, the value is in the correction and the management of where and why they’re wrong, but that’s a different chapter.)
A Final Word of Warning
The difference between planning and accounting is particularly hard for well-trained accountants to handle. They learned to build reports from the bottom up, from the detail, and it can drive them crazy when you make estimates using percentages and algebra and plain common sense for something they’ve learned to build up from painstaking detail.
More important than driving them crazy, unfortunately, is that sometimes this dimensional discomfort can make the accountants so unhappy that they’ll say your estimates are wrong. In these cases, they are often misunderstanding what it means to be projecting the future in summary instead of counting the detail in the past. Forgive them, they mean well; but don’t let them drive you crazy either. Stick to the planning.