Why Your Business Needs a Clear Basis of Accounting

If you own or lead a private business, you probably rely on your financial statements to answer some fairly practical questions. Are we making enough money? Are margins improving? Which areas of the business are performing well? Can we afford to hire? Should we buy that piece of equipment? Why is revenue growing but cash still tight?

Before relying too heavily on the answers, there is another question worth asking: are the financial statements prepared consistently from one month to the next?

This is where the concept of a basis of accounting becomes important.

It sounds technical, but for a business owner it is quite practical. Your basis of accounting is the set of rules that translate what happens in your business into financial results. It determines when revenue is recorded, when costs are recognized, what appears on the balance sheet, how inventory or work in progress is treated, and ultimately what shows up as profit.

Without a consistent basis, your financial statements can still look professional and add up correctly, yet give management a misleading picture of what is actually happening.

What Does “Basis of Accounting” Mean?

Most business owners are familiar with the general idea of cash versus accrual accounting. Cash accounting records activity largely when money changes hands, while accrual accounting recognizes revenue when it is earned and expenses when they relate to the business activity generating that revenue.

For a growing private business, however, the issue usually goes beyond simply choosing between cash and accrual.

A useful basis of accounting establishes how the business will consistently handle matters such as revenue recognition, inventory, work in progress, customer deposits, prepaid expenses, accrued costs, capital assets, bad debts, and related-party transactions. Depending on the business, it may also establish how overhead gets allocated between divisions, how foreign exchange is handled or how costs are assigned to individual projects.

Many Canadian private companies prepare annual financial statements in accordance with the Accounting Standards for Private Enterprises (ASPE). The day-to-day management issue is more basic: are the accounting practices used throughout the year sufficiently consistent for management to rely on the monthly results?

Consider a business that reports $175,000 of profit in April and $62,000 in May. On the surface, April looks excellent, and May looks disappointing. An owner might reasonably start asking what changed.

Perhaps not very much changed operationally.

A large customer deposit might have been recorded as revenue in April even though the work had not been completed. Several supplier invoices relating to April may not have arrived until May. Payroll might cross reporting periods. Work completed but not yet invoiced may be treated differently from one month to another.

The apparent swing in profitability may therefore have less to do with how the business performed and more to do with how transactions were recorded.

That makes it very difficult to manage from the financial statements.

What This Can Look Like in an Ontario Manufacturing Business

Imagine a growing manufacturer in Kitchener. Revenue is increasing, production is busy, and management reviews gross margin every month. One month, gross margin is 37%. The next month it is 25%. A month later it is back above 30%.

For an owner, those swings raise important questions. Have material costs increased? Is overtime becoming a problem? Are certain products underpriced? Is scrap increasing? Has the customer mix changed?

Before answering any of those questions, the finance team needs to know whether the margin itself has been calculated consistently.

Manufacturing creates several accounting challenges because costs move through raw materials, work in progress, and finished goods before the related product is sold. Labour, freight, production overhead, scrap and inventory adjustments can also materially affect reported margins.

If material purchases are largely expensed when purchased in one month but properly reflected in inventory in another, gross margin will move. If labour related to work in progress is captured inconsistently, the gross margin will shift. If inventory adjustments are made periodically rather than maintained accurately throughout the year, gross margin can fluctuate again.

The owner may spend a significant amount of time investigating operations when part of the volatility is coming from accounting.

Once those accounting practices are consistent, management has a much stronger starting point for asking the questions that really matter: which products make money, which customers are worth growing, where costs are increasing and whether pricing needs to change.

What About a Construction Company in Belleville?

Construction and project-based businesses have their own version of the same challenge.

Imagine a contractor in Belleville with several large jobs underway. One project is almost complete, another has just started, and a third customer has paid a substantial deposit before much of the work has been performed. Materials have been purchased for upcoming work, subcontractor invoices are arriving several weeks after the work occurred, and there are approved change orders that have not yet been billed.

Looking only at invoices sent, cash collected, and bills received will not necessarily tell the owner how profitable those jobs actually are.

A large deposit can make cash and even revenue appear strong, depending on how it is recorded, while future costs remain outstanding. On another project, the company may have completed substantial work that has not yet been invoiced. Subcontractor costs relating to that work may also be missing from the accounting system.

If revenue recognition, work-in-progress, unbilled revenue, deposits and project costs are not handled consistently, job profitability can move dramatically between reporting periods.

That becomes a problem when the owner is trying to answer one of the most important questions in construction: are we actually making enough money on the work we are quoting?

Historical project results should help improve estimating and pricing. They cannot do that very well if the costs and revenues associated with those projects shift between periods due to inconsistent accounting.

A Growing Durham Region Business Can Be Profitable and Still Run Short of Cash

Another common example is a growing distributor, wholesaler or equipment business in Durham Region.

Revenue may be up 20% or 30%. The income statement is showing a profit. Sales are strong. Yet the owner feels like the business constantly needs more cash.

There may be nothing contradictory about that.

Growth can require the company to carry more inventory. Larger customers may take longer to pay. Suppliers may require payment well before customers pay the company. Slow-moving inventory can accumulate. Equipment may have been purchased. Receivables and work-in-progress can absorb substantial amounts of cash.

In this situation, the balance sheet becomes just as important as the income statement.

A consistent basis of accounting allows the finance team to show where the money is going and separate profitability from working-capital requirements. The owner can then see whether cash is being absorbed by healthy growth, poor collections, excessive inventory, declining margins or some combination of the three.

If the underlying accounting is weak, these issues can easily get mixed together.

Why Problems Often Appear as the Company Grows

Many successful private businesses operate for years without formal accounting policies.

That isn’t necessarily surprising. When a company is smaller, the owner may know almost every customer, employee and supplier. A long-time bookkeeper understands how everything works. There may only be a handful of accounts or a relatively straightforward business model.

The weaknesses in the financial infrastructure often become visible as complexity increases.

The company adds a second location. It begins carrying more inventory. It starts undertaking larger projects. A new division is opened. The business acquires another company. More managers become responsible for financial decisions. Debt increases. The founder begins transitioning responsibilities to the next generation.

At that point, accounting practices that used to live in the heads of the owner, bookkeeper or controller need to become more deliberate.

The management team should not need one particular person in the room to explain whether the financial statements are comparable with last month.

What Happens When You Don’t Have a Consistent Basis?

One of the first signs is usually a lack of confidence in the monthly financial statements.

You begin hearing comments like, “The accountant will fix that at year-end,” or “Ignore that account for now,” or “The margins aren’t quite right this month.”

Any one of those comments can be perfectly reasonable. Accounting involves estimates and adjustments. The concern is when they become a normal part of every management discussion.

Over time, inconsistent accounting affects much more than the finance department.

Management may make pricing decisions using unreliable margins. Budgets and forecasts may be built from historical numbers that were never truly comparable. A profitable business line may appear unprofitable because costs were allocated incorrectly, while another division may look healthier than it really is.

It can also complicate conversations with banks and lenders. Financial statements may support operating lines, covenant calculations, equipment financing and other credit decisions. Large unexplained adjustments or significant differences between internal reporting and year-end statements naturally create questions.

Eventually, year-end accounting can become a major cleanup exercise.

Your external accountant may be able to correct many of the issues when preparing annual financial statements, but there is an important limitation to that process: the business decisions have already been made.

If you discover after year-end that gross margin was actually 27% rather than the 34% management believed, the financial statements can be corrected. The company cannot go back and change the prices it quoted customers during the previous twelve months.

Isn’t This What My Year-End Accountant Is For?

Your external accountant plays an important role in helping ensure your annual financial statements are appropriately prepared.

Management reporting serves a different purpose.

Owners and leadership teams need information throughout the year because they are making decisions throughout the year. Pricing, hiring, purchasing, capital investment, financing and growth decisions cannot all wait for year-end.

A strong internal accounting process means that the annual financial statements should confirm and refine management’s understanding of the business, rather than reveal a substantially different version of what happened.

That does not mean every monthly financial statement has to be perfect. In most private businesses, perfection would be expensive and unnecessary.

The information, however, needs to be reliable enough to support the decisions made based on it.

How Much Accounting Structure Does a Private Business Actually Need?

The answer depends on the business.

A $5 million professional services company does not need the same accounting infrastructure as a $75 million manufacturer with inventory, multiple plants and cross-border sales.

The purpose of establishing a basis of accounting is not to create policy for the sake of policy.

The finance team should identify the areas that can materially affect management’s understanding of performance and ensure a consistent approach to handling them.

For one company, that may mean improving revenue recognition and month-end accruals. For another, the priority may be inventory and product costing. A construction company may need to focus on WIP and project profitability. A multi-location organization may need a better approach to allocating shared overhead. A family business may need to clean up how transactions among shareholders, holding companies, and operating companies are recorded.

As the company grows, these practices should also be documented so that they do not disappear when someone leaves the organization.

A Useful Question for Business Owners

When reviewing your next set of monthly financial statements, consider how confident you would be in making an important decision based on them.

Could you increase prices based on the reported gross margin?

Could you decide which product line to expand?

Could you determine which jobs are most profitable?

Could you explain why cash decreased despite reporting a profit?

Could you compare this quarter to the same period last year without wondering whether something was accounted for differently?

Could another member of your finance team explain how the important numbers were calculated?

If the answers are uncertain, improving the reporting package alone may not solve the problem. The company may need to look more closely at the financial statements to see how the accounting is being handled.

Good Financial Reporting Starts Below the Financial Statements

At Part Time CFO Services, we work with private and family-owned businesses across Ontario whose complexity has begun to outstrip the financial processes that support them.

The situation looks different in every organization. It may be a manufacturer in Kitchener trying to understand product margins, a contractor in Belleville improving job costing, an aerospace supplier in Peterborough preparing for growth or a family business in Durham Region preparing for succession.

In each case, good financial management starts with being able to rely on the underlying information.

Once that foundation is in place, management can spend less time questioning whether the financial statements are right and more time using them to decide what the business should do next.

Part Time CFO Services provides businesses with access to an entire finance department, including a CFO, Controller, Financial Analyst, and accounting support capabilities, scaled to the organization’s needs. We help businesses strengthen the accounting foundation underlying their reporting, so owners and management teams have better information to make the decisions they need to make.