How To Get Hit by a Freight Train -
And Not See It Coming
Here is a true story that happens over and over with successful small businesses. The names have been changed to protect the guilty.
I have a client who has built a very successful small business that now has a national reputation, and has won many awards for creative design.
The business reached $1,000,000 in gross revenues in its fifth year of operation, which is a fine achievement. As a general rule, if a million dollars comes into the business, another million goes right back out, one way or another.
So the accounting challenge in terms of just tracking the cash flow in and out is $2,000,000. But not all of this cash doesn't necessarily appear in the Income Statement. Some of it moves in and out of the Balance Sheet, so the total accounting challenge is closer to $2,500,000.
This level of accounting is really more bookkeeping - it's all about accurately and consistently classifying various transactions so the business has a complete and accurate record of its economic performance. And hopefully meaningful management reports are produced and reviewed on a timely basis so that good decisions can be made.
And herein lies my tale of woe.
The owner properly wants to run a lean operation and to spend as little on overhead as possible. Thus he chose to keep his financial records in QuickBooks, which is fine.
This story is not a QuickBooks bash - I have used QuickBooks in my own practice since 1997, and have taught maybe 70 QuickBooks courses for various colleges in the area. QuickBooks is a fine product, but this story is about the way small business owners neglect their own accounting.
I received the datafile on April 10. As you might imagine, April 10 is a busy time for us, so I told him that we would review the data in May.
When we looked at the datafile, we found that the bank statements had not been reconciled. Uh-oh. We knew that no oversight or review had taken place, and that the financial statements could not be proven. Nor would they stand up to an IRS audit.
So we told him that we could not begin the return until a full year's worth of bank statements had been reconciled. The bookkeeper who had kept the books had just left, so we agreed to work with the new bookkeeper who would perform the reconciliation in addition to her other duties.
That task took a couple of months, which meant that our first analysis of the financial statements took place in June. After completing our usual reviews and tests, I called my friend and happily reported that the Company had made a fine profit of about $150,000 on sales of $1,000,000.
Total silence on the other end of the line. He finally said, Bill, how can that be? I don't have that kind of money. Where did it all go?
My response was, That's a terrible question for you to have to ask, 6 months after the close of the tax year.
The answer is that the money leaked out through the balance sheet in a variety of ways, and for different reasons. I must talk only in general terms about this part, but here's a classic mistake QuickBooks users typically make.
They write a check each month to pay off part of a loan. The loan may be for a building, a rental property, a truck, a credit card, or some collection of all these liabilities.
The payment really has two parts - an interest payment which is deductible, and a principal payment which is not deductible. The good part about the principal repayment is that while it's not deductible, it does reduce the overall liability.
The accounting term for this transaction is split - the payment is split between two components, only one of which is deductible.
Classically, many QuickBooks users don't split the payment; they assign it to a deductible account, and therefore overstate their expenses and understate their profits.
But that's not the only problem here. The owner, who is busy building the business and collecting national awards, has never looked at the reports his financial system is generating. He's working from two things, and two things only. One thing is the level of the checking account, which is enough to operate, but only barely.
The other thing is his feel for the health of the business. He's very capable, so his feel is accurate. The business is very healthy.
There are three lessons owners can learn from this story. Ignore these lessons at your peril:
- Reconcile the bank and credit card statements. You catch many mistakes that way.
- Faithfully review the reports periodically. The accounting system is just a machine that makes reports.
- And get (Pay) someone to look over your accounting to make sure it is telling you the truth.
That freight train he didnt see coming? He owes some $40,000 in taxes. Overdue. No withholding, and no Estimated Payments. And no $40,000 in the bank.
Freight train. True story.
Author: Bill Belchee
Copyright 2010 Bill Belchee All rights reserved
Printed here by permission of Bill Belchee