How Much Does Poor Accounting Play a Role in Business Failure?

By Daryl Ching, CFA | Managing Partner Vistance Capital Advisory When an entrepreneur sets out to start a business, they often have a vision to launch a product or service that will change the world. Entrepreneurs are often either innovative inventors or masterful marketers, and in some rare cases, both. However, very rarely are entrepreneurs strong in accounting and finance, yet it is precisely accounting and finance that provide the lifeline required for a business to survive. It is an unfortunate reality that entrepreneurs must learn to deal with financial data and cash flow. The majority of small businesses at an early stage are set up with a part-time bookkeeper and a CPA firm that shows up once a year at year-end to generate annual financial statements and file taxes. Most business owners opt for the most cost-effective engagement called a “Compilation Engagement” (previously known as Notice to Reader), where the accountant is not required to undergo tests or provide any assurance that the financials are accurate. While this often results in a total spend of no more than $15,000-20,000 in accounting for the entire year, the end result is that the business owner has a set of financial statements that are very inaccurate. They may be good enough for tax purposes, but they are certainly not “investor ready”. Based on this state: · Business owners often know their annual top-line revenue and net profit, but not much detail in between on their profit and loss statement. · Business owners often do not know on a month-to-month basis how profitable they are and therefore lack understanding of what expenses they can afford to take on. Many early-stage business owners view accounting as a cost center and cannot fathom investing money into resources that do not directly generate revenue. There is money in the bank, the company is meeting its obligations, revenue is growing, and the CRA isn’t bothering them, so why does this matter? What really are the consequences of kicking this can down the road? 1. Being rejected for a loan or equity investment because the financial statements are inaccurate and do not match the business plan. The cleanup process may take months and cost thousands of dollars. 2. Being rejected for subsidies and grants from the government because the financial statements are inaccurate. 3. Running out of cash unexpectedly and having to tell employees and vendors they need to wait an extra month for their payment. 4. Losing money month to month and not fully understanding if it is the gross profit margin isn’t high enough on products and services or if fixed costs are too high. 5. Getting called for an audit by the CRA and being asked to produce invoices and banking transactions going back three years. These are the common drivers that force business owners to invest more in their accounting. They may not drive a company into insolvency, but they certainly are setbacks that are stressful, distracting, and can deviate the trajectory of a company’s success. So the question is, should an entrepreneur wait until something like this happens before they become proactive on accounting? According to data from the Bureau of Labor Statistics, approximately 70% of small businesses fail within 10 years of startup. The most common reason for this failure is because they run out of cash. This is not to say that this is entirely a finance and accounting problem. It’s possible the company just couldn’t generate sales, the idea wasn’t strong enough, or they had a poor management team and couldn’t execute. However, it is also likely that a large number of them failed because they couldn’t raise the capital they needed, could not manage their expenses and cash flow, or weren’t charging enough for their products because they didn’t fully understand their gross margins. It is our opinion that an investment in accounting and finance at an early stage significantly increases the chances of business survival and will pay for itself because it can help business owners achieve their goals faster than trying to fly blind.