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?
You can see comments to this post on LinkedIn as well, http://www.linkedin.com/today/post/article/20141017092820-70681999-false-profits-due-to-hidden-costs-in-msmes
Image Credit:The word Profits on a green
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