About Me

I am A Chartered Certified Accountant who does a bit of gardening.
The Pictures of the flowering and non-flowering plants, fruits, vegetables, culinary & aromatic herbs
in this blog are of my garden.
Most of my garden collections are driven by the Fs: They either Flower, have a Fragrance, provide Flavor, bring Fruit, Food or are air Freshening.

Friday, 17 October 2014

A Small Business Challenge: False profits due to hidden costs in

Research indicates that 9 out of 10 businesses do not celebrate their 1st anniversary. One of the key factors that contribute to this high mortality rate is lack of systems and founder syndrome. Many small and medium enterprises are setup with founders who have no holistic business management skills.
It is reported that the typical owner or managers of small businesses develop their own approach to management, through a process of trial and error. As a result their management style is likely to be more intuitive than analytical, more concerned with day-to-day operations than long-term issues, and more opportunistic than strategic in its concept. One of the areas of challenges I have seen is in Accounting and Financial Management. I do business mentoring for a number of MSMEs in Uganda and so I decided to start writing a series about some of these challenges and among them is False profits due to hidden expenses in MSMEs. 

Are you paying yourself a salary or drawing down your capital?

“Why don’t you pay yourself a salary?” I asked. “This business cannot afford to pay me a salary!” was the response I received from this client. Interestingly I have this response from many MSMEs. From analyzing his accounts, he could actually afford a salary because his average drawings were Ugx1.5M a month.

This client had engaged me to set up the accounting structure for him to help him track his finances because he needed to know where all the money he was making was disappearing to. After installing QuickBooks and setting up the account codes, I guided the Book keeper on how to do the data entry. When it came to the Cashbook and Petty cash book, all the monies that went out of the business had to be posted into the respective financial accounts.

This process revealed that the business owner was frequently but haphazardly getting money from his business for his family running and personal upkeep. As individual transactions (e.g. Ugx20k or Ugx50k) they looked little but when aggregated the sums were sizable comparative to the size of the business. Now in Accounting, all the monies that a business owner gets out of the business for personal use which is not a salary are ideally categorized as drawings.

Drawings go to reduce the owner’s capital or equity in the business balance sheet (statement of financial position). Whereas salary would be a business expense and would be reflected in the profit and loss or income statement (statement of comprehensive income). The latter will reduce the business profits, which is not only a tax advantage, but is also very useful information on the true cost of running the operations.
The question a business owner should ask: If you were not playing the role you are playing in your business at the moment, how much would you remunerate someone to do it for? If this cost of doing business is not reflected in your accounts, it means that the profits or loss declared for that period are not true.

Have you considered rent expense for your business?
As many an MSME would have it, we started out our first business in one of the bedrooms in our house. We made it a complete office, with office furniture, computer, printer and all the basics of functional office. From the onset, we were determined to professionalize the business. We registered the business name with the registrar of companies, applied for a TIN number with URA etc. We even applied for a VAT (this was before the e-tax era so there was a difference between the TIN number and the VAT number. I remember the URA officials had to come to visit the business premises to verify existence.

Being an Accountant, I was keen to record on record keeping and accounting. I had set up the accounting structure and all the expenses that I deemed relevant to the type of business. When reviewing the initial financial report I noticed that the office rent expense had a zero amount. We therefore had to come up with a way of attaching value to the space the business was occupying and charge the business ‘rent’.
Since the rent is not being charged directly to the business because it is housed in a business owner’s home or premises, this expense item tend to be forgotten by many start-up businesses. If your business is occupying a space somewhere and it is not paying rent, do you realize that the full cost of running that business is not reflected in your income and expenditure statement? This means that your profits or losses are not giving the true performance of the business?

I have come across a similar scenarios to the clients that I have mentored and there businesses are being incubated by institutions that provide for them both the factory and office space. These businesses tend to give impression that they are profitable but once the incubation period (ranging 2-3 years depending on the institution) is over, they realize that they cannot afford rent. In our case, as the business grew, it was easy to move out to an office in town, we had a good starting point to set a range of the rental space the business could afford and went office-space-hunting within that range.

Have you considered depreciation in your business?
When I set up a business or a company’s accounting and financial management system, I also advise them on best practice or point out some of the issues they need to put into consideration. What I discover is that there are some expenses that are ‘hidden’ because cash does not flow out from the business and therefore easily forgotten.

I computerized the accounting system for a client and in the process I advised the accounting personnel that they have to include depreciation on the fixed assets as an expense in their accounts. At the end of the exercise, the income and expenditure statement indicated that the business had made a loss. The Boss/Owner insisted that the business could not have made a loss because the sales had gone up than the prior year.

When we went through the report in detail, we came across depreciation as the one that tilted the scales. She had made a profit of Ugx20 million before depreciation. However, based on the fixed assets the depreciation charge for the year was Ugx25 million which meant a loss of Ugx5 million.

They had made a new purchase of a motor vehicle of Ugx80M to be used for distribution of their products. This was not in their fixed assets register in the previous year but it resulted to an additional Ugx16M depreciation expense charge in the financial year.

Depreciation is a method of allocating the cost of a tangible (fixed) asset over its useful life. For accounting purposes, depreciation indicates how much of an asset's value has been used up. The are various methods:
1) Depreciation methods based on time
Straight line method
Declining balance method
Sum-of-the-years'-digits method

2) Depreciation based on use (activity)

Depreciation is used in accounting to try to match the expense of an asset to the income that the asset helps the company earn. For example, if a company buys a piece of equipment for Ugx10 million and expects it to have a useful life of 10 years, it will be depreciated over 10 years. Every accounting year, the company will expense Ugx1M (assuming straight-line depreciation), which will be matched with the money that the equipment helps to make each year.

The learning point is that the higher the value of your fixed assets the higher the annual depreciation charge over its useful life.

For example using straight line depreciation: If Business A buys a Motor Vehicle at Ugx80M which they anticipate to use over 5 years, the annual depreciation charge will be Ugx16M. If Business B buys a Motor Vehicle at Ugx40M which they anticipate to use over 5 years, the annual depreciation charge will be Ugx8M

What do you do when you use your personal car to make deliveries or go buy stock or provide a service?
At start-up or when a business is still small, it may not afford a business vehicle. Therefore many a times we drive our own cars to make deliveries of either the product or provide a service. This is usually done while also running other that are not business related errands.

This presents two potential challenges:
1) Expenses being overstated. I have seen some business owners buying fuel for their personal cars and charging the entire fuel on the business whereas they also use the same car for other non-business related errands. The same case applies to servicing and repair of personal vehicles
2) Expenses being understated. Some business owners do not remember to include the transport element in their business when they use their personal cars for business related errands such as marketing or distribution.

In the spirit of professionalizing your business and also avoiding challenges with the tax man for un-allowable business expenses, among the options to consider are:

1) If the business cannot afford business car, you could maintain a mileage log for the business related use of private/personal car. The mileage log sheet would indicate the distance covered from point A to B and the purpose for the trip. A mileage rate is then applied to the distance covered to give you the transport expense incurred. This option means that the business will not incur fuel, servicing, repairs and maintenance expenses but only the mileage.
2) If the business can afford a business car, then by all means buy one and the business can fuel the car, repair and maintain it and even have it insured. In this case then you may only need to track your private use of the car or come up with some method of apportioning it.

How have you managed these aspects in your business?

Image Credit:The word Profits on a green

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