We are going to tell you a secret about your financials. Most of them are designed only for the purpose of creating a tax return. Don’t believe us? Look at the default accounts in popular accounting software programs, like QuickBooks. Only one sales account, one cost of goods sold account, and a dozen or so expense accounts!
How many entrepreneurs only have one product or service they sell? None that we know. Eureka, a tax return only has one line for sales, one line for cost of goods sold, and thirteen lines for expenses.
Think about it; tax preparers are crunched for time. So why would they spend time coaching their clients to create financials that don’t line up with the number one product they sell? Therefore, you probably need to ditch your current financials and re-engineer your financials to tell a story about your company. So, let’s dive into the information your financials should tell you.
Table of Contents:
Five questions you should consider when re-designing your financials:
What services or products are most profitable?
What are your recurring revenues and expenses?
What metrics are you trying to measure?
Who are my top customers and vendors?
Is the overall business profitable?
What is the Chart of Accounts?
First, let’s go back to the basics. We need to understand the makeup of the financials before diving into the story-telling aspect. Each account is assigned a category, which in accounting terms is called the "chart of accounts." Think of this like sections in a library (fiction, non-fiction, periodicals, etc.) that help you find books. Each account is assigned a category, so you know where to find it on the financials.
One thing to note before going over these categories is that there are no right or wrong answers here. We don’t care what the accounting textbooks tell you unless your bank requires some fancy "GAAP" (we will leave it up to someone else to explain paint drying) financials. The financials should be designed for the company's leadership team, so if the categories make sense to the leadership team, that is all that matters.
Understanding the Income Statement Chart of Accounts
The income statement has four main categories: sales, cost of goods sold, operating expenses, and other income and expenses.
Income - This is money brought in by the company for selling products and services. Some companies will include discounts, refunds, and other items that are paid out or reduce income, but we don’t have time to go into the specifics. Again, the leadership team should agree on what makes sense for the company.
Cost of Goods Sold ("COGS") – This is probably the most botched category we see on
financials. Cost of goods sold is anything that goes into producing a product or service. We see a lot of financials neglect to properly account for direct labor. Usually, direct labor is included in a one-line item called "payroll" in the operating expense category.
We get it, in most small businesses, Frank does five different tasks for the company, one of which is producing the product or service. Allocating time can be complex and cumbersome. Plus, most payroll software suck at splitting out people into different payroll accounts (Gusto is our go-to payroll provider that excels at splitting out payroll).
We will have some suggestions on direct labor allocations later. At the end of the day, you need to know how much money you are making on your product or service, known in accounting as "gross profit." To calculate gross profit (= Income - COGS), you need to include all of the costs it takes to produce that product or service.
Operating Expenses ("OPEX") – These are essentially any expenses not included in either COGS or other expenses. These are the costs behind the scenes that it takes to run your business. For example, admin staff, software, rent, utilities, etc.
Other Income and Expenses – These are one-off items that do not directly relate to the company's primary operations. For example, interest expense, interest income, deprecation, etc.
Re-Engineer the Chart of Accounts to Tell a Story
Now that you have a basic understanding of the components of the income statement, we can dive into how to make your financials tell a story. We’ll start with question #1 from earlier, "What services/products are most profitable?.” Let's use the following as an example:
Total revenue for rolling twelve months = $1,500,000
Revenue
The revenue piece is easy. There would be three income accounts: Service #1 income, Service #2 income, & Service #3 income, and there would be two decisions:
Is service #0.25 worth tracking separately? If so, create a separate account. If not, create a generic account called "other operating income" that would include other small services in the future.
Is there a customer or client that should be tracked separately? For example, Unicorn Client, Inc. makes up 50% of service #1; therefore, management should decide whether to create a separate account or sub-account for Unicorn Client, Inc.
Cost of Goods Sold ("COGS")
Next is COGS, direct materials ("DM"), subcontractors, and software, which should be straightforward. Each service line in most cases should have a separate COGS account. One thing to consider would be whether to split out a large vendor like Unicorn Client, Inc. in the revenue section. The difficult part is allocating direct labor.
COGS - Direct Labor ("DL")
In an ideal world, each employee would have an electronic timesheet that has a task code for each service line and admin tasks, but this rarely happens. Plus, employees hate tracking their time, and you are better off value pricing than trading time for dollars.
Creating allocation percentages by employee is a simpler solution to the timesheet. To do allocations successfully, you need to determine two things:
Know how much to allocate for overhead per employee. These are things like payroll taxes, insurance, 401(k) match, phone, tools, etc. Again, keep it simple. In most cases, it should be around 20% to 35% of payroll.
Chart of Accounts Example
You might be asking yourself, why does re-engineering the chart of accounts matter? Well, let's look at the following example.
Before restructuring the chart of accounts:
Sales = $1,500,000
COGS = $600,000
GP = $900,000
GP % = 60%
Payroll = $500,000
Other OPEX = $100,000
In the above example, it’s unclear what service line you should focus on or cut. Plus, gross profit looks solid.
After restructuring the chart of accounts:
Service #1
Sales = $500,000
COGS – DL = $200,000
GP = $300,000
GP % = 60%
Service #2
Sales = $250,000
COGS – DL = $150,000
COGS – DM = $90,000
GP = $240,000
GP % = 4%
Service #3
Sales = $700,000
COGS – DM = $200,000
COGS – Subs = $300,000
GP = $200,000
GP % = 29%
Service #0.25
Sales = $50,000
COGS – Subs = $5,000
COGS – Software = $5,000
GP = $40,000
GP % = 80%
Payroll = $150,000
Other OPEX = $100,000
In the above example, Service #2 is not profitable, so the leadership teams need to justify whether to keep the service. They also should discuss:
How do they expand Service #0.25?
Next Steps on Re-Engineer the Chart of Accounts
Here is what we at a2advisers.com recommend as the next steps:
Have the leadership team read the above article
Send each person on the leadership team a copy of the financials
Set up a meeting to go over the financials to discuss what makes sense and what does not make sense
Start making changes to the chart of accounts
Meet at least quarterly to go over the financials as a leadership team
Update the chart of accounts as needed