CPA at Centaur Digital Corp, helping busy business owners decrease the amount of time and energy needed to manage their accounting system.
As the tax year came to a close for her business, Elvina contacted her accountant to discuss filing tax returns. Elvina’s small business, which provides counseling services, allowed her to finally pay down her business credit card debt from prior years. Her accountant informed her that she had a profit of $50,000 and thus owed about $8,000 in tax. Elvina was shocked. “How can I have this much profit when I used all that money to pay the business credit card?” To address the problem in more depth, they decided to do a thorough financial review.
Elvina’s example illustrates a common issue I see. When you start a business, it’s usually because you have a marketable skill or idea. Most small-business owners don’t start with accounting knowledge, so this tends to be a skill they pick up on the fly. Thus, it’s important to have an accountant who can not only ensure your company is in compliance but who can translate the data for you, too. This way, as the business owner, you have a clearer picture of what is happening in your business.
While an accountant who can translate the data for you is great, it’s also important that you understand some basic accounting concepts so you have a fruitful conversation. There are a lot of accounting terms that get incorrectly interchanged, while others that might be synonyms, such as net income and profit, get assigned different definitions. Consider discussing these four ideas to get more out of your conversations with your accountant.
Idea One: Profit Vs. Cash Flow
It’s important to understand that cash flow is not always equal to profit. There are certain types of transactions such as loans and owner distributions that will impact cash flow but not profit. Accounting software will provide a report called the statement of cash flows, which is one of the three main financial reports along with the balance sheet and income statement, sometimes called a profit and loss statement. The statement of cash flows will explain why your profit is different from the change in cash in your bank account. An in-depth knowledge of accounting is needed to interpret this statement, so make sure you get your accountant to help.
Idea Two: Balance Sheet Vs. Income Statement
To understand your business better, you have to understand the difference between a balance sheet and an income statement. The balance sheet shows your business’s net worth at a single point in time, while the income statement shows how much profit you made over a period of time. There are many intricacies to these statements that get exacerbated if your bookkeeping is not tidy. Keep in mind that there should be a logical story behind each line on the statements when you review these with your accountant.
Idea Three: Estimated Taxes Vs. Cash
For small businesses, the company’s accountant typically doubles as its tax preparer, and thus, a discussion of estimated taxes will help ensure compliance. Most businesses in the U.S. have to pay taxes quarterly, but even this time frame might be too long for some businesses. If your cash flow is tight, or you reinvest heavily in your business, you must ensure enough cash is left to pay taxes.
Idea Four: Historical Analysis Vs. Intuition
As you run your small business, you will have a general intuitive inkling if your business is profitable or not. Typically, this will be reflected in the amount of cash in your bank, but not always. When you use many credit cards and loans, it can be hard to intuit exactly how much money you’ve made. It’s always a good idea to validate your intuition with a historical analysis. This will help you determine if your intuition aligns with reality.
After a thorough financial review and an accounting crash course, Elvina had a better understanding of her business’s financial statements. “So the charges on the business credit card were deducted last year when they occurred, which is why I paid so little tax last year. And this year when I paid it off, it didn’t affect profit,” Elvina summarized. “Exactly,” her accountant said. “This year, you used those profits to pay it off. But that is a balance sheet transaction, so it does not impact your income statement.”
Running a small business can feel overwhelming with the number of hats the owner must wear. However, some of that burden can be shared by having good contractors and employees who not only get the job done but also help the owner understand the business’s overall picture and its finances. These four ideas should help facilitate a productive conversation between owners and their accountants.