3 High-Level Accounting Blunders of Startups and Growth Companies
A CFO’s guide to fixing them
The average new business has a fantastic website, a great network of contacts, a beautiful product line…and a very limited plan for accounting. In fact, most entrepreneurs would openly admit their accounting lacks.
I think if I asked an average startup team what they think their specific accounting weaknesses are, the list would look this:
- It’s June, and the last time we caught up the books was February.
- The line of credit on the balance sheet doesn’t look right.
- For that matter, most of the balances on the balance sheet don’t look right.
- The accounts receivable report shows 6 customers with balances due, but 4 of them paid in full a long time ago.
All of those problems are transaction-related and can be fixed with a good bookkeeper and a little hard work.
The 3 High-Level Accounting Blunders are foundational problems most entrepreneurs don’t even know they have. Thankfully, in the right hands, these high-level blunders typically take less time to fix than the transactional issues in the list above.
The 3 High-Level Accounting Blunders
Blunder 1. Basing internal financial statements on the tax return.
Most businesses start out with simple accounting software to track income and expenses for tax purposes. Accordingly, the financial reports in Xero or QuickBooks match the tax return. While that may be fine for a small startup, as the business scales, it should abandon tax accounting in favor of management accounting for internal financial reports.
An example of a major difference between management and tax accounting is depreciation. The IRS currently allows most small and mid-sized companies to fully expense say a $150,000 Mack dump truck in the year of purchase.
While this may make sense for tax reasons, from an internal management perspective it does not make sense to write off a $150,000 dump truck the year you buy it. You’ll want to expense it slowly (depreciate it) over its useful life, which could be 5 or 10 years.
Another common difference is cash basis vs. accrual basis accounting. The IRS allows many small and medium-sized businesses to calculate their taxable income based on cash received from customers and cash paid to vendors. Again, that may be fine for tax, but for internal financials it can be very distorting.
Blunder 2. Basing internal financial statements on Generally Accepted Accounting Principles (GAAP).
Wait, woah! I can hear my accounting colleagues coming up for air. If the company is using GAAP, they are already way ahead of everyone else. Please don’t discourage them!
Many companies move from tax-basis to GAAP-basis financials as they mature. GAAP is basically required for financial statements that go out to lenders and investors.
Just like tax-basis financials, GAAP financials are structured to please people outside the company. GAAP does a better job of producing useful financial reports for an entrepreneur, but often not a good-enough job.
For internal purposes, you are free to arrange your financials just as you please. As an example, GAAP requires factory equipment depreciation to be included in cost of goods sold (COGS). COGS is subtracted from sales to determine gross margin. For a manufacturer, gross margin percentage is one of the most important metrics to watch.
Here’s the problem: depreciation is generally a fixed cost every month. Let’s say it’s $10,000 per month. If sales are $200,000, depreciation expense is 5% of sales. If sales drop to $100,000, depreciation will now be 10% of sales. Gross margin will fall by 5% simply because sales are down.
The 5% drop isn’t from price discounts or inefficient shop employees. It is simple math that happens when you have a fixed cost like depreciation included in the gross margin formula. To help smooth margins, you can take depreciation out of COGS and move it down to the fixed overhead section of your internal financial statements.
Or, don’t move it. That is the beauty of tailoring your financials to generate the metrics you need to run your business. Don’t be afraid to be creative!
Blunder 3. Running with a poorly developed chart of accounts.
The chart of accounts is the (often-overlooked) foundation of financial statements. The meaningfulness of your financial reports is directly proportional to the care you put into developing your chart of accounts.
Simply put, the chart of accounts is the list of buckets you code financial transactions to. For example, you can have one big expense account called “Cost of Goods Sold” that all materials, labor, and production overhead go into (not recommended). Or, you can have 1,000 accounts in your Cost of Goods Sold section (also not recommended, unless you are Ford Motor Company).
Refining your chart of accounts is possibly the single most effective step you can take to quickly improve financial clarity and accuracy. Here is a separate practical how-to guide for this point. If you don’t have the time or patience to do it yourself, a chart of accounts project is also easy to outsource.
Well-run companies and organizations almost universally invest in good accounting practices. That investment pays long-term dividends in the form of highly useful reports for making strategic decisions.
I listed 3 different blunders, but fixing all 3 of them really boils down to one point: Reboot your chart of accounts to fit your company. If you do that correctly, the foundation is in place for robust accounting that could make all the difference in the future of your startup.
Author’s note: Thank you for reading today. If you have questions or comments, feel free to write them in the box below. I’ll try to respond promptly.
If you happen to be with a mid-sized company (10 to 100 employees) and would like to discuss a one-time project to take your accounting to the next level, feel free to reach out to me at firstname.lastname@example.org or through toptal.com.