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3 Things Every Business Owner Needs to Know about Accounting

By May 3, 2015 No Comments

Small businesses are failing at an alarmingly high rate and new business creation is at a 40 year low.  Our nation depends on new business creation for jobs, and the disruption a failing business creates for the community and the families it employed is worse than one that wasn’t started.  We need to turn this around, and accounting is going t be our small business savior.

Increasingly, small business owners are coming to the realization that accounting (and more specifically excellent accounting) that allows business owners to manage the business by the numbers, is not the most important thing…it is the only thing that separates a failing business from a successful business.

Are your numbers perfect?

If so, you are in the minority.  Only 1 out of 20 small businesses have perfect accounting, but those businesses perform at 7x the national average for revenue growth, 14x the national average for profit growth, and fail an astonishingly .5% of the time.

If you want to be a part of those statistics, here are the 3 things that every business owner needs to know about accounting:

  1. Accrual accounting is the only type of true accounting.  The basic principle behind accounting is the concept of “matching.”  Amazingly, this concept has not changed in over 500 years, and it is still as important as it was then.  Here is the way it works.  Every expense needs to be recorded and accounted for in the same period of time when it was actually incurred.  Here is a story to illustrate the point:

 

  1. A few years ago, a business owner told me that January was always a terrible month for him.  “Orders a little slow after the holidays?”  I asked.  “No” he replied, “in fact, we get a ton of orders in January.  We just have to put a deposit down with our supplier to process our orders.  Also, we have to pay all of our insurance expense every January for the whole year.”  “Does it affect your pricing?”  I asked.  “Oh, yes.” he said, “I give people a 10% discount in January if they give me a 20% refundable deposit.  I need the cash so that I can make a profit in January.”

 

I stopped him at that point and we ran through his numbers.  Incorrectly, he was recording these transactions on a “cash basis.”  That led him to expense all of his insurance expense in January (making January expenses unusually large).  Additionally, he was recording a sale for the deposit that his customers were sending in (making it look like a sale when really it was an amount he owed to his customers), and he was recording an expense for the deposit he was sending to his suppliers (making it look like his gross margins were much lower than they should have been).

 

All of this led him to believe that he needed to give a 20% discount to make a profit in January.  In fact, due to his reduced margins (on the 20% discount he gave to customers), all of his January orders lost him money.  Worse, he had to work all of February, March, and April to make-up for the lost profits.

 

Accrual accounting would have shown him clearly that he could not give the 20% discount (that, in fact, anything over am 8% discount was unprofitable).  Further, proper accrual accounting would have shown him that January was not that bad – he didn’t need to give the discount in the first place.

  1. Accounting needs to be done by more than one person.  There are four simple reasons why your accounting needs to be done by more than one person:
    1. Fraud – Fraud happens in 37% of small businesses and the average size of the theft is $114,000 per occurrence.  You must separate the person who enters the check from the person who reconciles the account.  The person who runs payroll must not be the person who reconciles the payroll account.
    2. Efficiency – If it takes you until the end of the month to get the numbers from last month, they are getting very old.  Getting accurate numbers quickly is a competitive advantage and a sign of a well-run organization.  Demand that your accounting team close the books by the 15th of the following month, and don’t let them tell you that your business is unique and it can’t be done.  That is just not true.  You need timely numbers to make good decisions.
    3. Accuracy – One person, no matter how smart, is still a human, and, like anything else in life, humans make mistakes.  Having more than one person (trained in accounting) to review your accounting numbers increases the likelihood of perfect numbers.  Without perfect numbers, you might as well not look at the numbers at all.  Making decisions on bad information is worse than making decisions on no information.
    4. Redundancy – It is estimated that the average accountant graduating college today will have more than 9 jobs before he or she retires.  Your people are no exception, and, when your accountant leaves, you will need to replace him/her with someone immediately.  Having an extra person in the accounting department insures redundancy and retains the integrity of your numbers.

 

  1. Accounting for small businesses is black and white.  99.9% of the small business transactions have one right answer and all other answers are wrong.  This is not the case in large public companies where arguments are made over esoteric revenue recognition issues.  If you are a small business owner, your accounting is pretty basic (in accounting terms), but it must be done correctly.  Any accountant who tells you that 98% of the accounting is correct and that 98% is close enough, should be fired.  If you are ok with a 2% annual variance in your numbers, be prepared to fail.  That 2% compounded on itself will create a 16% loss in profitability over a 3 year period.  I don’t know many businesses that can withstand that sort of slow death.

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