Statistics from the U.S. Small Business Administration reveal that about half of all new small businesses launched in the U.S. will fail within the first five years. What is the chief cause of small business failure? Poor financial management.
Sound financial management starts with an understanding of some basic rules of business bookkeeping, so here are 10 of the most common accounting and bookkeeping errors made by small businesses — and how you can avoid making them.
1. Using the Wrong Accounting Method
There are two main business accounting methods: cash and accrual. Cash accounting is the simpler method because it’s based on the actual flow of cash in and out of a business. The cash method is used primarily by sole proprietors and businesses with no inventory. On the flip side, accrual accounting records income and expenses as they occur, whether cash has actually changed hands or not. As they grow and become more complex, most small businesses should switch to accrual accounting, because this makes it easier to accurately match revenue to expenses.
2. Combining Personal and Business Finances
It’s critical that personal and business finances be kept separate at all times, regardless of a company’s size. That’s why one of the first things new business owners should do is open a business checking account and deposit all business income into this account. The next step is to work with an accountant to devise an earnings management strategy dictating how cash is removed from the business to meet personal expenses and savings goals.
3. Misclassifying Workers
In the eyes of the IRS, there are several different categories of workers: full-time, part-time, and temporary employees, as well as independent contractors, such as freelancers and consultants. Classifying your workers in the wrong categories can be extremely costly. The employee categories are often used to determine who is eligible for employee benefits. Full-time employees are generally eligible for all benefits offered by an employer, while part-time employees may be eligible for a pro rata share of benefits. Temps and independent contractors generally receive no benefits, and independent contractors are not covered by minimum wage, overtime, payroll tax, workers’ compensation, or unemployment compensation laws.
4. Not Performing Basic Account Reconciliation
Reconciling your business’s books with your business bank statement every month is one of your most fundamental accounting duties.
5. Being Too Nonchalant About Petty Cash
Many businesses keep an informal stash of “petty cash” that can be used by employees to cover small and incidental business expenses, such as postage stamps, snacks from vending machines, and office supplies. But just because the amounts are small doesn’t mean that petty cash shouldn’t be accounted for properly.
6. Not Knowing the Difference Between Profits and Cash Flow
A business can have positive cash flow in the short term but still be unprofitable; conversely, it can have negative short-term cash flow but still be profitable in the long term. The first scenario is common among small businesses because they often have to pay suppliers before they get paid by their customers. The second scenario is common among point-of-sale and cash-based businesses, such as retailers and restaurants, that pay their vendors on terms.
7. Using the DIY Method of Bookkeeping
Many small business owners pride themselves on their ability to wear a many different business hats, including the accounting and bookkeeping hat. However, this is one area where small business owners are usually much better off hiring a specialist rather than trying to do it themselves. Accounting and bookkeeping can get very technical and complex. The money spent to hire a trained bookkeeper or accountant, even on a part-time or contract basis, will usually come back to the owner many times over given the time savings and all the mistakes that will be avoided.
8. Not Saving Receipts for Small Purchases
The IRS requires that expenses for business travel, meals, and entertainment that are greater than or equal to $75 be substantiated with a receipt in order to be deductible. So many business owners don’t bother saving receipts for expenses less than $75.
9. Not Implementing Adequate Internal Controls
If proper checks and balances aren’t implemented in a business’s accounting system, bookkeepers may have opportunities to commit fraud and embezzlement. Losses from internal fraud can significantly cripple a small business, or even lead to bankruptcy. The best way to guard against embezzlement by a bookkeeper is to implement solid internal financial controls.
10. Relying Too Heavily on a Paperless Work Environment
To reduce expenses and be better stewards of the environment, many companies today are trying to go paperless. In the realm of bookkeeping and accounting, however, there’s simply no substitute for paper documentation and a paper trail, when needed. There are many instances in which paper documentation of financial records will come in handy or be required. An IRS audit is one example. Bookkeeping isn’t an area where you should skimp on the paper.