As you’re studying your monthly financials and preparing for year-end reporting, and you find that your financials are not depicting the business narrative you know to be true, it could be a sign of bad accounting. Here are some best practices for reviewing your P&L and determining if there is an opportunity to enhance the accounting practices:
• Revenue – if you’re having a great month and selling a ton of services or inventory, but revenue is not telling the same story, it’s likely revenue is not recorded in the proper period on your financials. For service revenue, the best practice is to record revenue in the period the service is provided, not when invoiced (which invoicing usually occurs well after the service is provided). For revenue from goods sold, the best practice is to record revenue once the item has shipped or good is exchanged. There are other factors that may change the timing of revenue recognition, but in general these principals should be applied and will help your financials mirror what is happening in your operations.
• Cost of services – just like service revenue, the cost of services should be recognized in the period the services are provided, not when the services are paid for. Matching the timing of revenue with the cost of providing that revenue will result in margins that reflect the actual business operations and could lead to better decision making.
• Cost of goods sold – For companies that sell inventory, we often find the main driver for swings in gross margin period over period is due to inaccurate inventory accounting. Best practice is to capitalize all costs incurred to directly obtain and get inventory ready to be sold. For a lot of companies, there are costs that are expensed each period like direct labor or inbound freight that should be sitting in inventory on the balance sheet and expensed when the inventory is sold. Examples of costs that should be capitalized to inventory include direct labor costs, inbound freight and tariff cost, direct materials cost, indirect labor costs, storage costs and manufacturing overhead.
• Payroll – payroll should always be recorded in the period the hours were incurred. If the payroll cycle is every 2 weeks, this will result in a few months of the year having three payroll runs. This can greatly distort the financials and margins if payroll is not properly accrued. Three payroll runs in one month should not define a bad month.
• Insurance costs – if the timing of your premium payments is anything other than monthly, these costs should be capitalized as prepaid expense and amortized over the policy period. Depending on the size of the premium, this could be a significant expense in one period and could distort profit margins in one period over another.
• Subscription costs – if you have any other subscription costs that are paid annually, these should also be capitalized as prepaid and amortized over the policy period.
• Balance Sheet – review your balance sheet and determine if there are any deferred revenues or costs that should be recognized on the P&L.
Another powerful visual that could help you understand your monthly and annual operating performance is looking at your financials or key drivers (like revenue, gross margin, and profit margin) each month on a trailing twelve-month basis. Using this viewpoint will eliminate seasonality in sales or costs and could convey insights around growth and performance on an annual basis.
Being able to decipher financials and knowing whether the results are indicative of a good or bad period or just bad accounting can be a powerful tool. Being able to decipher financials and correct bad accounting practices will help the business owners align their financial story with their business narrative.