Accounting isn’t meant to be done backward. Yes, you can retroactively clean up past accounting mistakes and inaccuracies — but it’s costly from multiple perspectives.
First, there’s the price of fixing these mistakes — which are typically much more expensive to correct than if you had proactively addressed them at the onset.
Second, there are business costs. Bad accounting can lead to slow or misguided decisions, money leakages, the inability to adapt quickly, and a lack of reliable historical performance. For example, if your emerging growth venture has three years of financials but only one year of good accounting, you can’t use all three years to illustrate your progress.
We see a lot of emerging growth ventures face these costs. When we discuss these issues with young companies, they usually ask us the following question:
Why do we have to fix these problems now instead of just moving forward with clean accounting?
Here’s what we tell them.
Clean accounting from this point forward doesn’t erase the past. Bad accounting is cumulative.
If you have two years of bad accounting, your accumulated profits, losses, or individual accounts will carry mistakes forward. While a specific, isolated period could be accurate, you’re not fixing the core issue — you’re extending the problem.
In other words, bad accounting infects your books. It stays bad until you fix it.
Bad accounting is inconsistent, incomplete, unreconciled, or negligent practices that lead to inaccuracies. We’ve outlined a few common mistakes:
Mistakes happen from time to time, but we usually see emerging growth companies unwittingly make mistakes because they adopted a rudimentary cash-based accounting model: simply, a bookkeeper tracks historical performance by reconciling bank accounts. Net cash accounting isn’t implicitly bad; it’s often appropriate for smaller organizations. However, it’s not the best model for venture-backed growth firms — accrual accounting is far more accommodating.
But making this switch can cause problems for your company if you don’t have the guidance of a financial professional.
Bad accounting isn’t uncommon — even established companies have slip-ups now and then. But what causes bad accounting for early-stage growth companies? Here are the four main catalysts.
Timing is a crucial differentiator between cash accounting and accrual accounting. These methods recognize revenue and expenses very differently. So, when you switch from one to the other, the results of previous time periods will change — this often leads to mistakes when an expert doesn’t handle the process.
Let’s assume your historical financials are organized on a cash basis. Under this method, you could have a single journal entry in one time period. Now let’s assume you transition to accrual accounting; that single journal entry could turn into six entries in six different time periods.
Imagine you had a 12-month revenue contract. In cash accounting, this contract was booked and recognized as revenue in one month. In accrual accounting, it’s recognized over the entire 12 month period. Now you have to unwind and rebook that single entry as 12 entries and create a new account (deferred revenue).
And that’s just a small sliver of the transactional pie. Emerging growth companies that have expanding operations with multiple distributors will have even more contracts to reassess, unwind, and rebook.
Along the same lines as above, unwinding and rebooking singular entries as multiple entries under different accounts often leads to accounting mistakes.
Cash-basis accounting is typically simpler from a bookkeeping standpoint, which is because (a) transactions only require one entry and (b) those entries are easy to track (i.e., when money changes hands).
With accrual accounting, your transactions will have at least two entries, which will either be debits or credit. On top of that, you have more balance sheet items and accounts in play. Naturally, the process is more complex, so companies are more likely to make recurring mistakes -- such as crediting the wrong account (i.e., an error of principle).
But, when appropriately implemented, accrual accounting is worthwhile because it’s more accurate and insightful. You can leverage your financial data to make informed business decisions.
A lot of the emerging growth companies we work with lack support for their transactions. Their books don’t include roll forwards or reconciliations, which convolutes the big picture. We ask them, “What was this entry for?” And they have no idea.
As a result, we have to do forensic accounting — we have to investigate to see what happened, which includes a host of time-consuming questions:
Peeling back the layers behind historical accounting entries takes a lot of time — and money. That’s why we emphasize the importance of reconciliations. As your business scales, make sure you have reconciliations at every level. The first level includes bank accounts and credit cards. The second addresses inventory and physical counts. The final level covers the rest of your balance sheet.
As an emerging growth company scales, its chart of accounts changes drastically. Two factors drive this radical transformation. First, the typical early-stage growth company isn’t using an industry-standard chart of accounts; in turn, we have to convert it to the standard and break apart historical transactions.
For example, let’s look at how a consumer packaged goods or eCommerce business may unintentionally mishandle the recognition of freight shipping costs. There are three different types of expenses: freight-in (buying goods and paying to receive them), freight-out (paying to ship out goods), and freight revenue (collecting revenue from the client when they pay for the shipping of goods). Yet, we see clients that consolidate these costs into a single account called “freight.”
They have the ins and outs of all different shapes and sizes, but we can’t analyze that data because everything is lumped into one bucket. This inaccessible data represents a business cost of bad accounting since management can’t make informed shipping decisions.
In this situation, we would help this company unpack this one account and segment it into three, which is the industry standard for freight.
Let’s walk through another example for a growing SaaS company. We often see marketing and sales costs merged into one account — but, like freight, that leads to business costs. By separating customer acquisition costs, you can measure the costs and compare them to industry-standard KPIs. In turn, management gains tangible benchmarks — and potential investors can accurately assess your KPIs.
We often see new companies adopt a bootstrapping mentality to minimize costs while capital is tight, but this mindset can actually create obstacles (like fixing bad accounting) and inhibit growth.
Bad accounting not only leads to clean-up costs down the road — which can be 2-3x the cost of putting the right pieces in place upfront — but can drive business costs and strategic limitations. By taking a proactive approach with your company’s finance and accounting functions, you can spend a little more now to save a significant amount later on.
AVL helps companies avoid the repercussions of bad accounting by guiding them through the process early on — connect with us to learn more.