How Does a Small Business Fail With Lack of a Proper Accounting System?

Without proper accounting systems, profitable businesses can still fail, and failing businesses might seem profitable. Poor financial reporting can give business owners a false sense of security that leads to emergencies a company doesn’t have time to fix. Using a variety of basic accounting practices, you can decrease the chances of miscalculating your financial position and help you spot problems before they become fatal.

Businesses that don’t budget properly can’t manage their costs, set prices that help the company make a profit, identify areas for cost containment during times of slow sales and track cash flow. In addition to an annual master budget, proper accounting requires profit-and-loss statements, balance sheets, cash flow statements, overhead, manufacturing and general and administrative expense breakouts. Management that isn’t aware of the financial performance of a business on a regular basis can’t prevent financial crises. Effective accounting systems include budget variance analyses to determine if a business is meeting its projections or if it must take steps to head off problems.

Many small businesses fail to understand and track cash flow, which can lead even profitable companies to miss debt payments and experience the ensuing problems this causes. Cash flow projections and statements let you know exactly when your money is coming in and when you have bills to pay. This might seem like an obvious fact every business owner would know, but budgets are often created by placing income in the month sales are made, rather than when the money will be received. This can lead to offering customers 60-day terms on orders they buy, even though you must pay your suppliers in 30 days for materials you purchased to make the orders. Even if you have large receivables, if a supplier cuts you off, you might not be able to fill orders, yyour customer might defect and by the time you arrange for credit or get your receivables in, you might be out of business. Proper management of receivables and payables is critical to managing cash flow.

If you run your business using credit cards or rely on short-term bank loans, failing to keep track of your debt situation can lead to your demise. Accounting systems that don’t properly track debt and interest amounts lead to surprises with serious consequences. For example, rising debt can reduce your credit score, leading to higher interest rates on future loans or prevent you from getting credit during emergency situations. Failure to add interest payments to budgets can lead you to believe you have set spending levels that will make you profitable by the end of the year when you’re not. Credit card interest, for example, can sneak up on you because you don’t make separate interest payments each month; the card company simply increases your account balance. If you have $30,000 on business credit cards at 20 percent interest, you will have an additional $6,000 in interest expense by the end of the year. This can max out your available credit during the year, lower your credit score and prevent you from getting new loans or credit.

Effective accounting systems include procedures for preventing errors and fraud or reducing their impact. Simple monthly bank statement reconciliations let you spot errors, fraudulent transactions and uncashed checks. In addition to this type of internal audit, external audits help you maintain accurate records and reduce fraud by having an independent third party review your records. Your accounting system should include internal controls that minimize fraud and errors. For example, you might set a policy that requires checks for more than a certain amount to have two signatures or that mandates that travel expenses must be approved in advance and reimbursement requests must include receipts.

Proper accounting helps you keep track of your tax obligations, make required payments on time and avoid large payments, fines or liens when you don’t have enough money to pay your taxes. In addition to your annual income tax, you might have quarterly payroll taxes and monthly or quarterly sales tax. If you’re an independent contractor, you might have quarterly income tax payments. In addition to paying what you owe in a timely fashion, your accounting department can help you plan tax strategies that reduce your tax burden. For example, depreciating assets such as office furniture, computers and machinery can help you increase your reportable expenses, reduce your reportable income and decrease your income taxes.