on account of market microstructure frictions, transaction prices may deviate from the equilibrium price, generating transaction costs. As we have noted, the bid–ask spread is a frequently used indicator of market liquidity. This differential is an important component of trading costs, often referred to as implicit transaction costs to distinguish them from explicit costs such as brokerage fees and taxes. We will offer different measures of the spread, each one focusing on a different interpretation.

The quoted spread, or the difference between the best ask and best bid prices offered by liquidity suppliers, is an estimate of the costs that a generic investor incurs for a round-trip transaction, i.e. a purchase followed by a sale. On the other hand, the realized spread is an estimate of the gain a market-maker can expect to make from two consecutive transactions. We show that the two definitions coincide when transaction costs consist solely in order-processing costs. We will also show that the difference between the quoted and the realized spread, which is always positive or at least zero, is a positive function of adverse selection and inventory costs. This difference can also be affected by the number of transactions at prices within the spread, as well as by order fragmentation. Furthermore, we will provide a definition of the effective spread, which is twice the difference between the transaction price and the midpoint of the quoted bid–ask spread and is therefore a better proxy of transaction costs when quoted prices are not binding.

Henry David Thoreau wasn’t an accountant when he said, “Simplify! Simplify!” but he captured the essence of balance sheet management. Keep it simple at first. Your accounting system will grow as your business grows.

Accrual accounting is used by all businesses of any size because it allows for better cash management, providing a better match between expenses and revenues, whether transactions are for cash or on credit. Without an accrual system, in fact, there’s no need for more complex accounting functions. It’s a way to better match revenues with the means for producing those revenues and gives a clearer picture of the actual profits your company makes.

In cash-based accounting, on the other hand, you record nothing until actual cash has traded hands. Whether you’re purchasing raw materials for manufacture from a vendor or selling finished goods to a distributor, nothing is entered in the ledger without a money transaction attached to it.

In applying the ARTS formula identified earlier—Accurate, Relevant, Timely, and Simple—the accounting function can be a major source of information vital to the success of a business. The discipline of the balance sheet, although it may seem foreign to some, gives it the strength and application to help you master all accounting steps within your business cycle.

One more distinction to understand is the difference between cash basis and accrual basis. The choice depends on the type of business, and we don’t need to enter into the reasons here. What you do need to know is how the basis used by your company affects how financial transactions are handled.

The difference focuses to some degree on the question of cash flow. Accrual accounting, popular with large businesses, records transactions when they are made—regardless of whether any money has changed hands. The company is accruing sales revenue that will be deposited at a future date. The difference is that it is immediately posted to the general ledger. The actual cash is incidental to the accounting procedure under accrual accounting.