The question: ‘How is your business doing?’ gets some interesting responses at times — especially when you compare the verbal answer with the situation later revealed by the accounts. Business owners sometimes tell me they’re doing really well, and proudly direct me to the bottom line on their profit and loss statements which features a nice, fat figure indicative of a profit well above the benchmark for that type of business. What could be possibly wrong with that?
Single entry bookkeeping
Well, over the years I’ve been in the consulting business, I’ve come to understand that accounting can be a fairly flexible and somewhat arbitrary process, especially when the business is using what we call single entry bookkeeping. Without going into a rather boring treatise on accounting, this simply means that when the business actually pays out money it shows on the accounts as a debit. Most of the small business sector in this country work this way.
This kind of accounting is used because it is easy, simple and reasonably cheap to administer; but it does have one rather major flaw — it does not give a true picture of the financial performance of the business, and this can cause quite a problem when the owner decides to sell the business and believes there is a pot of gold due to them.
The flaw with single entry bookkeeping
The flaw with this kind of bookkeeping is that it does not account for predictable liabilities that will cost the business large lumps of money at irregular intervals. Take refurbishment and renovation for instance — you know that your environment will need cosmetic work every couple of years and major renovation every seven to ten years. This work will cost you a large amount of money, and is quite predictable.
In a single entry bookkeeping system there will be no allowance made, or money put aside (in accounting jargon: an accrual) to pay for renovation when it is due. Come the time, the hapless business owner will probably have to borrow money to pay for the work required. In the meantime they have been taking money out of the business, thinking it is profit, when in reality a substantial portion of it is money that should have been put aside for refurbishing.
Single entry bookkeeping may give you a reasonably accurate annual profit and loss, but it won’t give you an accurate picture each month. You need to spot a problem trend much quicker than once a year.
When you come to sell your business
Come the time when they want to sell the business, we often find a healthy looking set of books, but the environment is run down, out-of-date and badly in need of major expenditure. We would then have to deduct the expenditure required to bring the business up to scratch from the sale price normally asked for a business with these figures. This can seriously downgrade the value of the business.
Handling predictable, cyclical expenses
This kind of accounting handles lots of other expenses the same way. Take holiday pay, for instance; in a single entry bookkeeping system holiday pay is shown when it is paid out to the staff, even though the liability for it may have been built up over quite a period of time. In a small business the payment of holiday pay often causes a severe dent in the profit for the month in which the money is paid out.
The accounts then don’t show a true representation of the month’s business because the accounts are showing an expense that, in reality, occurred progressively over the last year or so.
Another example of predictable liability is long service leave. We’ve seen a few examples of business sales where a serious purchaser has walked away because the process of due diligence (the fact finding process that a purchaser goes through when they are seriously interested in purchasing a business) reveals that there is a substantial liability owed to existing staff, and there has been no money put aside to pay for this.
Consider the handling of bills that don’t correspond to your accounting month as yet another example. Your telephone and energy bills might only appear quarterly, but when they do appear they represent three months consumption. Putting all this expense into the month in which you received the bill further distorts the picture your monthly profit and loss is giving you.
Double entry bookkeeping
The alternative to this system, and the one that will give you a true picture of how your business is travelling, is the installation of a double entry bookkeeping, or, as it is simply known, an accrual bookkeeping system. This is an accounting system in which an allowance is made in the monthly accounts for any liabilities that are actually incurred (but not necessarily paid) in that accounting month. For example, holiday pay is accrued as a percentage of wages earned that month, rather than shown as an expense as it is paid out at a later date.
A double entry system is more complicated and more expensive to set-up and maintain, but absolutely necessary if your business is turning over more than, say, $1.5 million per year. Those business owners who go to the time, expense and trouble of converting to this kind of bookkeeping will be rewarded with profit and loss information that is accurate and represents a true picture of the financial performance of their business, every month — not some arbitrary figure that gives a false sense of security.
More importantly, when they come to sell their businesses there should be no nasty surprises for either party in the transaction and the business (excluding any real estate involved) should be worth a straight multiple of it’s average net profit for the past three years or so.