One of the more difficult aspects of writing is avoiding cliches. Cliches are cliches for a reason: because somebody wrote it once, and then it clicked for a lot of people. It’s a quick and easy way to find common ground for everybody, like playing a Beatles song. I’ve spent about 15 minutes trying to figure out how to start this post without saying “People always tell me…” and come up with something original instead, but they DO always tell me... so here goes:
Founders often tell me: “Greg - I worry about my accounting. I feel like it’s wrong, but I don’t know how to tell”. Most startups have one of two initial setups when it comes to accounting in the early days:
Setup 1: The accounting is performed by a founder or non-finance team member with a passing familiarity with accounting concepts
Setup 2: The accounting is outsourced to an offsite bookkeeping firm
Regardless of which setup you have, if you don’t have a high-level review process, it’s very possible that you have some accounting issues with your books.
Here are some things to look for that may point to accounting errors or bad process in order from most basic to most complicated:
Assets = Liabilities + Equity. This formula is why your Balance Sheet is called a Balance Sheet. With a quick bit of algebra you can get to a much more intuitive Equity = Assets - Liabilities formula, if that’s an easier way to think about it. This is one of the most basic of accounting concepts. So if you ever find yourself looking at a balance sheet that doesn’t balance, which can’t be explained away by rounding or a simple typo, it’s probably time to find a new accounting solution.
Retained Earnings Rollforward. Retained earnings is a line that you will see towards the bottom of your balance sheet, in the Equity section. It represents the sum of all of the earnings (aka net income/loss) of the entity from inception up to the balance sheet date. As such, it serves as the link between your Income Statement and your Balance Sheet. To make sure that Retained Earnings is calculating properly, perform the following check:
Period 2 Retained Earnings - Period 1 Retained Earning = Period 2 Net Income
Intercompany Balances eliminate in consolidation. If you have more than one business entity in your company (for example, a US corporation and an international corporation), you should be maintaining separate sets of books for each entity. When Entity A sends money to Entity B, this creates an asset and a liability on their respective books. But when considering the consolidated financials of Company X (the parent company), these particular assets and liabilities should cancel each other out. If you are seeing intercompany balances on your consolidated financials, something is amiss.
Rent expense consistency. You can perform this check on any expense account really, but I pick out rent because it should basically be the same amount every month. Sometimes, rent gets paid a day early, or a day late. If the timing works out just so, and your accountants aren’t paying attention, you could end up looking at an income statement that has three months of rent recorded in one month. This would indicate that your accounting team isn’t being particularly vigilant about accrual-based accounting.
Gross Margin consistency. This one is a little bit trickier, but is really important. Some companies may have their gross margin vary wildly from month to month, if they have a lot of fixed costs in their COGS and a lot of volatility in their revenue. However, I’d say that most companies aren’t built this way, and you should know roughly what your gross margin will look like before you even look at an income statement. If you see your gross margin bouncing around like a pinball from month to month, and you don’t think that should be the case, it might mean you have a timing issue, whereby revenue from one month is being reported over COGS from another month, and vice versa. It could also indicate a classification issue, where items which should be included in COGS are being reported in operating expenses, or vice versa. It could mean a lot of things, and you should get to the bottom of it.
Startup accounting is tricky. There’s no history to follow, no auditors to grade the books, and usually no CFO to provide a layer of review and mentor junior staff. Not to mention the possibility that the accounting rules haven’t even been written yet for some of the most cutting edge companies. So while the above items are by no means a comprehensive list of all of the accounting landmines that a team might step on, these are the issues I see most often. If you can tick these items off your list with confidence, then there’s a good chance your books are in decent shape.
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