Our accountant sent out a report without verifying it

We got the monthly accounts from Quickbooks and it showed a much larger profit than we had expected.  We estimates profit and cash weekly, so this was a real surprise - a pleasant one I had to admit. I didn’t really give the matter much more thought because the variance was positive. If it has been negative, I would have been all over it.

Then, driving home I began to wonder how we could have made so much profit. The next morning I went in early and started looking at the reports. Sales looked right, but the margins were way too high. We normally have around 40% gross margin but these accounts showed it a 56%. I kept looking. Most of the expenses seemed to be normal with the exception of the sales discounts, which looked really low. They were below the normal 15% level. Suddenly it dawned on me: somehow the discount had been added the to gross margin.

I called in the accountant and asked what was going on. He looked at the accounts and said they were wrong. I was right there was a misposting. I asked why he hadn’t checked the accounts and he said he didn’t feel well and had gone home. When I asked who he sent them to, he answered the bank, board, and all our investors. I told him we needed to recall them ASAP and make sure this never happens again. I told him next time he goes home without signing off on the accounts at the end of the month, he needs to tell me.

Our balance sheet is off by $18K and we have no idea why

What happens when the balance sheet doesn’t balance? My background is in agriculture and I don’t know much about finance. I can understand the profit and loss account, but I could never understand or read a balance sheet.

I asked our accountant what it meant. She said she wasn’t quite sure, it could be a number of things: it could be a bookkeeping error, it could be that some cash was missing, or there could be something wrong with our depreciation schedules.

She told me there was over $18K difference, which is a lot for a small company like us. I asked her how long it’s been a problem and why we didn’t know about this sooner? She said she didn’t know and that she doesn’t look at the balance sheet or do a reconciliation every month.

Our new admin assistant was paying invoices to a fake company

During the first three years of operation, I signed every check and reviewed every bill. The volume increased beyond what I could handle so we hired a full-time administrative assistant. She was a friend of one of our employees and came from a large company located in the city. I was so glad to get rid of this task.

We got our accounts within 10 days of the end of the month. Everything looked OK. One day I was in our bank and ran into the local bank manager who asked how things were going. I told him things were good and we were profitable and growing. I told him we had a new admin assistant who had come from XYZ company. He asked her name and when I told him, he was very concerned.

He asked if we had asked for references. I told him we had and he advised that I start looking at all the invoices and making sure I knew how we were paying. I wasn’t sure why he said this, but it sounded like good advice with no downside.

I spoke to the admin assistant when I got back from the bank and asked to see the invoices from the last month. Right away, I noticed several new names and that one new supplier had sent in four invoices that month. I got suspicious when I asked our operations people about the company and they had never heard of it.

When I went to the admin assistant, she said she just paid the bills managers signed. I took three invoices to the responsible managers. They knew nothing about them. When I confronted the admin assistant, she denied anything was wrong. I called phone number on the invoice and it went to voicemail. The voice on the message was the admin assistant’s.

Is cash or profit more important for my business?

I don’t know which is more important, cash or profit, for my early stage business. I know I need to reduce stock levels and this will increase cash flow, but it will also have a negative impact on my margins. I know I need new computers, but this will increase cash outflow and the depreciation will negatively impact my earnings.

I talked with a serial entrepreneur and she said that the only reality in business is cash, that accounting and profit are an art form. She told me you need cash to pay bills and salaries and that profit and cash were not the same thing. She said not to worry about depreciation, it was a non-cash item. She said get what you really need and can afford and don’t worry about depreciation.

We got into a real mess because we didn't keep accounts from the beginning

I have a photographic memory. I keep all the details of the business in my head. I do have a notebook where I record invoices and orders and once every couple of months I do a profit and loss.

In the first quarter, our business had $18K in sales. Now we have $87K and I think we’ll reach $150K by the middle on next year. I still keep everything in my head but I have to admit some things are slipping through the cracks.

Finally, I gave in and we hired someone to do the accounts. He slaved away and after two months had things somewhat under control. He found over $12K in unpaid bills including demands for the local and federal tax offices. Together these came to over $30K; we don’t have that kind of cash on hand.

Two days later we saw the first set of accounts since we started the business. We had lost over $90K, were selling at least half our products at a loss, and had not paid state sales tax for three months.

I was astonished. I priced all my products myself and thought we were making good profit since we had cash in the bank. I was also sure I had paid the tax bills.

I didn't realize taking spending money out of the company would cause tax issues

Every month I took $2000 out of my business for my own expenses. This was in addition to my salary. I used credit cards and cash and thought this was my company so it was my money.

When we filed our tax returns we did not declare this as income for me. There were only five of us, so no one was really looking. We paid taxes on all the income we declared. Over the next three years the business grew and I started taking $3000 per month. No one said anything.

One day we got a notice that there would be a sales tax audit by the local government officials. I didn’t see any problems with this as we paid all the tax that was due. We passed the audit but I began to think what would happened if they audit our federal returns? I had taken more than $100K over the years. Even if I wanted to declare it, I could not afford to pay the tax and penalties. I was stuck

We needed to get a bridge loan from the bank to finance a new machine in the factory. When they examined our accounts they immediately said there was something wrong. The financial accounts and the bank statements did not balance. I told them I would look into it but knew the difference was the money I had used for my expenses

How did I get into this mess? How do I get out of it?

How do we account for bribes to the customs agent?

We have to bribe the customs agent every time we ship something out of the country. How do we report this in our accounts? Does this go into the cost of goods?

Should I use cash or accrual accounting?

I don’t have an accounting background, but I do keep the accounts for our startup using Quickbooks. When I first started using it, it asked if wanted to use cash or accrual accounting. I didn’t understand the significance of the question.

My fundamental desire with numbers and finance is simplicity. I want to be able to see how things fit together. I want the bank account, my accounts, and the checkbook to balance.

Unfortunately, I chose “accrual accounting” with Quickbooks. At the end of the first month, the cash balances and the accounts were very very different. Once I started to think about this, I realized that when I sent out an invoice, I recorded a sale but didn’t have the cash. I also realized that when I recorded an expense, I had not actually paid the bill. Then I found that if I made a mistake on the invoice or the check, nothing balanced. I was totally confused.

Luckily, I identified this confusion early on. It was then easy for me to change to “cash accounting” and things began to make more sense. It’s not prefect, but it makes sense.

Commitment accounting for stronger financial control

It was SO amazing to finally see a decent amount of money in the bank. The transfer of funds had just arrived from our first institutional investors and I was excited to no longer worry about where every penny was going.

My personal advocate had a different point of view. He said this was a dangerous time and that I needed to pay even more attention to the bank account. He suggested I sign every check and every bill and move to “commitment accounting.” This meant opening  a commitment document for every planned expenditure; it would show what we were spending, why, to whom, and the estimated cost. The document would be closed when the bill was finally paid. This would show if expenditures were more or less than planned.

My PA also suggested that every check over $2500 should be signed by two people. He said this was necessary to build discipline in the company and to exercise strong financial control as we grow.