Ledger Nightmares: Entries only an accountant should make
One of my favorite holiday traditions is watching "The Nightmare Before Christmas". For those of you unfamiliar with the movie, here is the basic plot synopsis: The leader of Halloween Town takes an accidental visit to the land of Christmas and is so enchanted by all of it that he decides to give Santa the "year off" and take over in his place. The residents of Halloween Town are, needless to say, ill-suited for this task, and the results are hilarious and horrifying.
The problem is, they see just enough of Christmas to think they know how to emulate it, but they misunderstand the core concepts.
This is a frequent issue when non-accountants take on bookkeeping duties. Recording sales and expenses is one thing, but there are certain entries which really should be left to the professionals.
This week we're looking at the most frequently-confused accounting principles and discussing why it is better to not attempt these yourself.
Setting Up Chart of Accounts & Opening Balances
Though you would think bookkeeping would be simple with a clean slate, getting your company started can be one of the most complicated times, accounting-wise. (Okay, everything about starting a company is complicated.) There are legal and professional expenses, you must determine book value of any assets which you already have, and entering equity amounts can be difficult. (In particular, how you record money the owner contribues, whether as paid-in capital or a loan from the owner, can affect tax liability.)
When these issues are compounded by extra demands on the owner's time and focus (not to mention the learning curve associated with self-training on accounting software), you have a recipe for inaccuracies.
While you are setting up your business, get someone with experience to jump-start the accounting side of it.
Capital Expenditures
Expanding your business is an exciting time, particularly when you're investing in new locations. Whenever you are spending funds or assuming liability to obtain a physical asset which will be used for productive purposes for at least one year, that is a capital expenditure. Capital expenditures can be land, buildings, machinery, or even software upgrades (generally provided they meet a certain cost threshold).
For an amateur bookkeeper, capital expenditures might appear deceptively easy. Buying some land for a new plant site? Debit Land, credit Notes Payable, and expense whatever incidentals come up along the way, right?
Of course not! If it was that easy, everyone would do their own books.
If you record a capital expenditure like that, your book value will be off and when you calculate depreciation it will be inaccurate. (We'll get to depreciation and other contra-accounts later.)
Rather, when capital expenditures are recorded, you are also to include in the book value the net cost of getting the property ready for use. If the ground needed to be levelled, that cost would be included. Likewise, if there were salvageable materials present which were then sold, that gain would be used to reduce the book value. Certain legal and professional fees surrounding the sale may be included as well. It's all very interesting (but also very complicated for a layperson).
Referring to our example, what about that Note Payable? Assuming it's accruing interest, at year-end you'll need to make...
Adjusting Entries
Month-end and year-end adjusting entries are both necessary and a pain in the neck. There are several types of adjusting entries, such as adjustments for goods or services clients prepaid you for (Unearned Revenue), expensing those things for which you prepaid, recording accrued interest, etc.
One of the biggest dangers at year-end is recording adjustments to inventory. Even with consistent inventory tracking throughout the year, there are generally still adjustments to be made at year-end. Mistakes in inventory recording can result in over or understated COGS (Cost of Goods Sold) and inaccurate tax liability calculations. For reasons such as this, it's usually a good idea to have an accountant look at your year-end statements before preparing taxes. (Remember that many CPAs will simply prepare your taxes based on the statements you give them. For that reason, be sure you are hiring someone who will actually look for issues in the accounts themselves.)
Even if it's not a special occassion, such as making a major purchase or at year-end, there are still transactions that require bookkeeping assistance. Notably, any of those involving...
Contra Accounts
A contra account is one which is intended to have an opposite normal balance for that account classification. For instance, a sales discount is a contra revenue account, so it has a normal debit balance (whereas most revenue accounts have a normal credit balance).
Contra account entries have the potential to be very tricky, and the greatest offender for this is depreciation. Recording depreciation is essential for accurately estimating the current value of assets, but calculating it is a complicated process. First, life expectancy of the asset and salvage value must be computed. After that, straight-line depreciation is the simplest, but nowhere near as accurate as usage-based or the double-declining balance method. Finally, when the asset is finally sold or scrapped, the gain or loss must be calculated and recorded based on the present value. Of course, any errors can then negatively affect tax liability.
Long story short, any time you feel like you're getting in over your head, ask a professional. Trying to D-I-Y complicated accounting entries can turn your General Ledger into a horror story.
Stop Eating Frogs
Mark Twain famously said, “Eat a live frog first thing in the morning and nothing worse will happen to you the rest of the day.” In recent years this has become a particularly popular sentiment amongst entrepreneurs, used as a reminder to not procrastinate in completing disliked chores. Small business owners typically have to manage so many different aspects of their company, it's inevitable that there will be some tasks they dread.
For many, their "frog" is accounting.
But, here's the secret...for some people, frog is a delicacy.
We may be in the minority, but, at The Bookkeeper, accounting and finance aren't just something that pays the bills. We actually find a lot of it fun.
Here are a few of our services which, though business owners typically find distasteful, we really enjoy.
Developing Business ProceduresYou know the only thing more fun than reading a collections procedure manual? Writing a collections procedure manual. It combines several of the things we love, like research, technical writing, and custom-tailoring business practices to an individual company. What's not to love?
Of course, we've heard some people refer to research as "boring" or technical writing as "tedious". But we feel the same way about SEO optimization and, apparently, some people enjoy that.
Budgeting
Budgeting seems to have a negative connotation for a lot of people. A budget is seen as something constraining. But we think budgeting is awesome. You get to look at all your revenues and expenses, and figure out where you can save or earn more money. Who doesn't like having more money? A budget lets you make plans and take steps to achieve your goals. Not knowing your budget is like driving blindfolded. Maybe exciting for some, but too risky for us.
Debt Repayment Plans
A lot of people who are in a great deal of debt don't like to think about how much debt they're in. Of course, ignoring a problem doesn't make it go away.
For business owners overwhelmed by debt, figuring out a way to repay it all is too big a frog to eat. Much easier to just make the minimum payments and try not to think too hard about those rising balances. Fortunately, we love writing debt repayment plans.
Like so many problem, debt seems a lot bigger when you're in the middle of it. That's why we enjoy taking an objective, mathematical look at the problem, and coming up with a tangible, step-by-step solution to eliminating it. And it is so exciting to show someone how they can, often without even spending additional money, be debt-free and have savings built up in, frequently, as little as five years.
Profitability Analysis & Pricing Strategies
Some people may be put off from some aspects of accounting because of the math involved, particularly when it comes to things like calculating gross profit margins. We at The Bookkeeper are huge fans of math, perhaps because of its consistency and objectivity or, perhaps, as the great philosopher Cady Heron stated, "Because it's the same in every country." (Yes, both Mark Twain and "Mean Girls" quotes in one article. Small business accounting can be very culturally relevant.)
Math is especially useful when it comes to looking at which products or services provide higher revenues or greater returns, and where prices can be raised to improve profitability. Using a little bit of math and research to make more money, without having to sell more or perform more work? That's fun.
These are just a few of the services we provide for our clients, not just because our clients find them difficult or loathe doing them, but because we actually do find them interesting. Where the client sees a live frog, we see a perfectly seared filet mignon.
If there's some chore in your business which you simply despise completing on a daily basis, whether it's finance-related or something else, consider whether it's worth it to you to pay someone else to eat that frog.
You're in business for yourself, so why do something you hate?
Managing Accounts Receivable: Because sales are meaningless when clients don't pay you.
In order to stay competitive, many business owners find it necessary to extend credit to customers. However, if you offer later payment options, it is crucial that you have a well-developed and communicated accounts receivable system.
Here we have listed a few elements of a successful A/R management plan, and how to implement them in your business.
Communication. It's said to be the key to a good relationship, and that can apply to business relationships as well as personal ones. Communicating well is key to managing receivables accounts. Let's look at the who, what, when, and how, of A/R communications.
Who? This seems obvious, enough...the customer, right? But, in reality, it's not just the customer with whom you are communicating. Assuming you're not a 1-person operation, you need to be in good communication with your employees or co-workers regarding what promises and agreements have been made with the customer. If you contact a customer on Tuesday afternoon regarding a past due invoice, and they just told your partner that morning that the check is in the mail, your entire company looks disorganized and unprofessional.
What? When alerting a customer to a past due payment, simply informing them of the amount owed is not the best option. Providing a detailed statement, possibly with an itemized duplicate of the referenced invoice, is far more helpful. Important information to include is the amount owed, days past due, what services were rendered, options for remitting payment, and contact information for questions regarding the account.
When? Generally, you would expect to increase contact as balances get further past due. A gentle reminder the day after the due date if payment has not yet been received is appropriate, with missives gradually becoming more frequent and insistent as the invoice gets to 15 days past due, 30 days past due, etc. (However, it would be best to avoid multiple communications a day, as that could constitute harassment.)
How? "The medium is the message". For an account that is just barely overdue, a mailed or emailed statement (as described above) might be enough of a reminder. If more time passes without payment or a response from the customer, a more direct phone call is in order. This leads us to our next element of a successful accounts receivable management system...
Delegation. To maintain a good working relationship with the customer, it is ideal if you can separate the less pleasant side of that relationship, collections, from the more positive side, which is the work and value you provide to the client.
Delineating separate avenues of communication between the service and payment sides of your business can help you achieve your A/R management goals without damaging the rapport you have built with your client. Large companies have entire Accounts Receivable departments, but small businesses rarely have that option.
However, if you have more than one employee, someone other than the client's primary contact could act as the accounts receivable delegate. If you're the sole employee, you can even do something as simple as set up a separate email. (For instance, if your email is "[email protected]", you could set up an email called "[email protected]".)
The key is to avoid marring interactions with the customer which could lead to continued or future work by derailing the conversation into payment discussion.
Documentation. Good documentation can prevent so many problems in every area of business, but especially in accounts receivable. Before a single customer is invoiced, your A/R plan should be formulated and written down so everyone in your business knows exactly what the payment terms are, who is responsible for contacting customers, what to do in case of a dispute, etc.
Payment terms should be made clear to the customer before services are rendered, and should then be reiterated on the invoice. If a balance does become overdue, remind customers of the payment terms, and document every communication with the customer regarding the overdue balance. Reference previous conversations about the account in new discussions about them. Established fact is far more effective in encouraging remittance than strong emotions or harsh words.
What should you do with a customer who isn't paying?
If the customer hasn't gone ghost on you (in other words, if they are still maintaining some form of contact with you), and would like to continue purchasing goods or services from you, do not cut them off. Cutting them off completely is a great way to ensure that they will do no further business from you, and will not pay you the money already owed.
However, do not provide any further service on credit. Request pre-payment for any further work you perform, then apply that payment to their outstanding balance. This allows you to maintain a working relationship with the customer and recoup the money you are owed.
5 Signs You're Ready to Hire an Accountant
Of course, assuming all goes well, most businesses reach a place where they do need to hire an accountant. The trick lies in knowing when you have gotten to that point.
We have identified five simple signs that your business is at that point. If you see yourself anywhere in the following list, it might be time for you to start searching for an accountant.
1. When you're presenting your business. This is an easy one. Everybody knows that you need pristine books whenever you're opening your business to inspection. Whether you are applying for a loan, interviewing a potential partner, or looking to sell, you want to showcase your business in the best possible light. Preparing your financial statements for close investigation entails a lot more than running a few reports. If accounting is not your area of expertise, this is really a time when you want to "leave it to the professionals".
2. Before you're in over your head. Like most other varieties of disaster, bookkeeping disasters are much easier to prevent than they are to fix.* If you're falling behind on your reconciliations, or guessing at balancing entries, you're probably already in worse shape than you realize. Don't kid yourself that you're going to figure it out as you go along, or do some extra studying in your spare time. You're a business owner - "spare time" is a myth. (You do still require sleep and social interaction, after all.)
*This is not to say we aren't willing to work with you to fix disasters after they happen; we just greatly prefer identifying problems before they become disasters.
3. When something seems..."off". There's an old joke (you may have heard it) that, "The definition of an accountant is, 'Someone who solves problems you didn't know you had in ways you don't understand.'" This somewhat feeds into entry #2 in that, by the time a bookkeeping layperson realizes something is wrong, it's probably very wrong.
If your cash flows don't seem to be accurately reflecting your revenue, or if your expenses are running unexpectedly high, it's good to get a second set of (highly-trained) eyes on your books, to identifying current and potential problems. In addition to the fact that identifying and correcting problems is core to an accountant's job description, it's also good to have an outsider who can take an objective look at your financials and identify issues you may have overlooked.
4. When it's taking time away from other things. Maybe you just need to hire a bookkeeper because your business is doing so well that your attention is required elsewhere. If accounting is not your forte, and doing it yourself is sucking time and energy away from areas of your business which better suit your skillset, outsource it. There is no logic in toiling away at something you dread when you could focus on growing your business. When your business needs you marketing, or training employees, or meeting with clients, and you can't because you're mucking through bookkeeping, hire an accountant.
5. When you're sick of it. Chances are, you didn't start your own business to work hard doing something you hate. If you loathe doing your bookkeeping, you are going to have a very hard time doing a good job at it. Distaste for a task compels the doer to procrastinate, or rush through it. In accounting, this can very quickly lead to huge errors (particularly if it's already not a subject of familiarity for you). If keeping your own books is making you miserable, then delegate it. After all, you're the boss for a reason.
The Financial Reasons Small Businesses Fail
Almost every entrepreneur has heard the statistic: 80% of small businesses fail. There are many reasons this happens, and can include everything from market slumps to lazy owners. To enumerate every way a business can go under would be an endless, impossible task.
However, there are a few financial characteristics frequently found in struggling businesses. Here are the most common financial reasons small businesses fail.
There's no plan. It's not uncommon to meet new small business owners who have a brilliant product idea, a well-developed marketing plan, a slick website, and not one thought given to their budget. We've already written on the tough financial questions to answer before starting your own business, but the importance of a solid financial bedrock cannot be overemphasized. A well-researched budget and fixed goals is the key to surviving that crucial first year in which most businesses go under. Great customer service and spot-on marketing are not enough to balance out shaky financials.
Speaking of customer service...
Poor credit management and pricing strategies are bad for everyone. No one craves popularity like an entrepreneur and, when your business's success is entwined with how well-liked you are, the urge to avoid offending anyone becomes even stronger. In the early days of a business, when there are only a few customers, there is a common impulse to let clients slide on late payments, or to offer frequent "friends and family" discounts. It's easy to justify this with the logic with the idea that you need to establish customer loyalty, and you can tighten the reins a bit when you have a solid customer base. There are a few reasons this doesn't work:
- Clients who don't pay on time aren't going to appreciate the slack you've given them in the past; they are going to resent the restrictions you enforce in the future.
- Likewise, your patrons who are just coming to you for the lowest price will quickly go elsewhere when your rates rise.
Lenient accounts receivable and cheap pricing might gain you a quick boost in early sales, but they are not a sustainable model. Delivering a product you can be proud of, at a price that is worth your hard work and can keep your business afloat (and actually requiring customers pay you that fair price) ensures that your customers the pleasure of patronizing your business for years to come. Because you have to remember...
Cash is king. Yes, it's a cliche, but that doesn't make it any less true. A great business model matters little if you run out of money before you can implement it. Managing cash flow is key to not just the health but the continued existence of your business. Here are a few of the most common cash pitfalls small businesses face:
1.) Insufficient capital. In all likelihood, your business will not be immediately profitable. So not only do you need enough cash to get your business started, but you need enough to allow yourself to operate at a loss for a while.
2.) Not having a large enough cash cushion. Think "Princess & the Pea" levels of padding. Regardless of how well you plan, the economy is unpredictable. Look to history for examples. No one expected the Boston Molasses flood which, in addition to the damage caused and lives lost, resulted in a nearly $11M settlement (in today's money) for the responsible company.
3.) Over-investing in fixed assets. It's great to plan for the long-term but, if you don't plan for the short-term as well, your business will not get a long-term. Sacrificing too much of your cash for something like manufacturing equipment (even if you're getting a great deal) can hurt you, as that is not a liquid asset and will be of no help to you in the event of an emergency (i.e. your factory flooding a major metropolis with 2.3M gallons of molasses). Think of it like a game of Monopoly; if you start building hotels too soon and suddenly need cash, you're stuck selling all your buildings back to the bank for half-price, and you know bankruptcy is right around the corner. Only, in real business, instead of losing yet another game to your annoying brother-in-law, you've lost your entire livelihood.
Expanding your business is the ultimate goal, but maintaining cash flow gives you the solid foundation you need to build upon.
80% of new businesses fail, but that means 20% succeed. To be that 1 out of 5, have a plan, know your value, and remain patient. Better to start small and grow something big than to start too big and dwindle away.
Resolutions for Your Books
The clock has struck midnight, and rung in a new year. And you only have 105 days to get in shape.
Your books, that is. April 15th is coming up fast, and you want your books to be looking goodwhen the big day rolls around. Fortunately, there are many ways in which getting your books healthy is a lot like getting yourself healthy. So, to help you keep a resolution for good accounting in the new year, we'll be comparing it to the most consistently popular New Year's resolution.
How to Clean Up Your Books in the New Year
1. Make a plan. A common first step to those seeking to lose weight is to get a gym membership. Likewise, those who are serious about cleaning up their books should invest in some good accounting software. It is also imperative that, if you haven't yet, you set up a chart of accounts and have separate bank accounts and credit cards for your personal and business finances.
2.
Smaller, frequent efforts are more beneficial than larger, infrequent efforts. Going to the gym once a week for four hours isn't going to help you as much as going three times a week for one hour. In fact, you're expending more energy for less results. Bank reconciliations are similar. Doing your reconciliations on a monthly basis is a huge, exhausting chore. Doing reconciliations weekly or even daily is an easy, manageable routine which keeps your books in better shape.
3. Follow your document "diet". Yes, we'll go ahead and admit this point is a bit of a stretch. (Extended metaphors are hard, guys.) Would it help to say that receipts are the organic granola of accounting? Anyway, just like a lot of people track their calories while attempting to lose or maintain weight, you should be tracking your purchases as well. When tax-time arrives, those documents are a great asset for itemizing deductions.
4. If it's too much to do alone, get help. Personal trainers make their living showing people how to work out, but they still can't do the exercise for them. That's just one (of many) ways in which accountants are cooler than personal trainers. A good accountant can do project work and help you get your books in order. However, many business owners prefer to avoid the work entirely, entrusting an expert with keeping their books long-term.
Imagine how easy it would be to get in shape if you could just pay a trainer to go work out for you. Just shows how much easier it is to take care of your financials.
Tough Financial Questions to Answer Before Starting Your Own Business
Almost everyone, at some point in their lives, entertains the idea of starting their own business. For most it's a purely speculative exercise, a fun "What if...?" daydream. But for those who start seriously contemplating entrepreneurship, there are a lot of tough questions to consider.
Now, there are hundreds of articles out there with titles like "Do you have the mind of an entrepreneur?" and "Is starting your own business right for you?" This isn't like that. There's no personality quiz here, nor checklist of character traits. This is because...
A.) Those articles frequently aren't very realistic. Personality quizzes don't work because not all businesses require the same personality. Checklists don't work because everyone thinks they are "reliable" or "able to think outside the box".
B.) We're numbers people. Numbers don't lie, and neither do we. So we're going to skip the fluff and go straight to the tough financial questions you need answered before you start your own business.
What is your break-even point?
Of course, there are lots of accounting questions regarding business entities, expenses, profit-margins, etc., but this is really the big one. How much do you need in sales before you are making money instead of losing it?
You'd be surprised at how many people we meet who do not have this question answered, though almost everything hinges on it. It really is necessary to know your break-even point because it ties your financials together and paints a clear goal. Because, isolated from each other, numbers can be deceiving. For instance, $100,000 in sales may look like a great success, until you compare it against $150,000 in expenses. Likewise, even if you keep expenses low, if your sales are lower, you are still operating at a loss. Knowing your break-even point lets you know exactly what your target is.
How l
ong can you run in the red?
In a perfect world, every business would be instantly profitable. Obviously, we don't live in a perfect world. And, in our imperfect world, most new businesses take some time to hit their stride.
Early failure is, in some ways, a natural part of a new business. When you're the new leader of a new company, it's a bit like going from playing a sport to coaching it. Even if you're a professional, the strategies that worked for you as an individual might not work on a larger scale, and you have additional responsibilities piled on you as well. Initial setbacks are to be expected.
"The most important thing for entrepreneurs is not to be put off by failure." - Sir Richard Branson (Source.)
That's not to say everything is doom and gloom, however. Many new businesses do go on to long-term success. However, new businesses owners have to be realistic and be prepared to deal with and mitigate some degree of failure early on.
This is why it is so very important to know how long your company can run at a loss. Too many new business owners, clouded by the dream of their assured success, expand too aggressively and wake up one day to find their capital is gone. Knowing in advance, "I can operate at x loss for y months," can help you set goals, know when to cut back and, in general, prepare for the unexpected. (And with a new business, the unexpected is inevitable.)
What
's your exit strategy?
In fact, according to data strategist Thomas Thurston, somewhere between 70%-80% new small businesses fail within their first 10 years. (Source.) That leaves, at best, a long-term success rate of less than a third. And, according to the SBA (Small Business Administration), 552,600 new businesses opened in 2009, but, that same year, 660,900 closed. (Source.)
Obviously, losing a business is hard, but not being prepared can make it even harder. For example, something as seemingly simple as how you register your business entity can affect whether your personal assets are at risk in the event of a closure.
Now, hang on, because we're getting to the bright side. Maybe you're going to leave your business because it's so successful. You want to cash-in, leave behind the stress of running the show, and go retire to an island. Well, you still need an exit strategy for that. How you set your business up in the early days can affect how much reward you get for the years of work and risk you invested in it.
In fact, we frequently advise our clients to always, regardless of their long-term plans, keep their books as clean as though they were planning on selling the company. As we mentioned in the previous point, life, inevitably, happens, but the unexpected is much easier to weather with pristine financials.