Don’t Confuse Business Models, Financial Reporting, and Accounting

Peachtree Accounting

January 22, 2013.  Hello entrepreneurs, board members, and investors – here’s a topic that comes into play once your fledgling startup has a product released “into the wild” and has actual results to measure.  Almost any good student who has had a finance course can create an Excel model that forecasts in detail the revenue and expenses of a new venture.  Almost any investor recognizes that only the expense side of this has any hope of being accurate; the revenue side is where all the guesswork comes into play, and you can miss by a mile either high or low.  If nothing else, the model should prove that if certain assumptions are valid then there is a scenario where the business can make money on $X investment.  As soon as $X is in hand, however, assumptions are quickly trumped by reality.

Then comes the need to reduce to paper the numbers that describe the performance of the venture.  This is part of basic corporate governance, but its primary value is to guide management as to what in the original model is working and what is not.  And, it should shed light on how best to deploy funds going forward.  Here’s a type of statement I saw recently for one company, with numbers rounded for simplicity and to protect the innocent.

Expenses

Contractors   $100,000

Marketing       $25,000

Travel              $5,000

Operations     $10,000

Technology    $10,000

Total             $150,000

The underlying books in this case are accurate.  And, as material to use for a tax return, this may be acceptable.  However, it really says very little about what the company has been doing.

Suppose it were presented thusly:

Product Design                      $20,000

Product Engineering              $60,000

Business Development           $15,000

Fixed Overhead                      $15,000

Variable Marketing                 $40,000

Total                                     $150,000

A list with the same total dollars now means something, and it should bear some resemblance to the original model.  It gives management, board members, and advisors a better basis for making informed decisions as to next steps.

Whether you use a software tool like Peachtree or QuickBooks, or even if you’re keeping track of expenses on Excel, or you just have your checking account records, the results can still be characterized in a way that conveys meaning to an observer.  Like a fine dinner, presentation matters.

Accounting, on the other hand, has different goals.  Your CPA wants you to start with a chart of accounts and provide information in a format that can be audited if necessary and easily used for compiling a tax return.  Accounting principles are not necessarily consistent with providing management information.  For example, after selling Peachtree Software, I was pretty flush, used a completely “unlean” startup canvas, and build a new office building for my next venture.  I personally owned the building and leased it to the company.  In that era there were many tax advantages to that arrangement, and there were very attractive financing deals called Industrial Revenue Bonds.  Arthur Andersen (R.I.P.) was always my auditor of choice because they audited the Masters and provided their clients both a badge and a ride on their King Air shuttle service from PDK in Atlanta to Augusta. (Tears) They hit me with a then-new rule calling my deal a “capitalized lease” where the building was shown as a company asset and the lease obligation as a liability.  There was no net effect on the balance sheet, but it distorted it relative to the early stage of the company.

A few years later I sold that corporate entity to Rupert Murdoch’s News Corp., and a while after I got a call from their accountant:  “Don’t we own that building.”  “Well, no.”  It was ultimately immaterial to them, but even they were confused.  To put things in perspective, their VP once invited a number of us to lunch in Atlanta, and we chose our favorite local meat & 3 called Mary Mac’s.  When the check came, he reneged on paying.  He said his accounting clerk would never approve such a small tab for a lunch with 12 people; it would just look too suspicious.  He probably could, however, have bought the building and expensed that.

Finally, there are the entrepreneurial businesses I see where funding was on an idea and books and/or financial reporting have never distracted management from the exciting parts of the business.  You can get away with that for a while, but the tax man cometh.  I had to make a personal appearance last fall before a hearing at the Travis County Central Appraisal District to get my TechDrawl assets (zero for income tax reporting) valued somewhat near actual.  They wanted to assess me for UT surplus furniture in my office at the ATI, even though it is not owned by me, and they presumed that because I had acquired and fully depreciated some assets about 5 years ago that I must have something lying around.   The tax in question was reduced from about $98 to $21, but I’ve learned never to let these matters get started with a high base from which to escalate in future years.  And, I had to produce all manner of tax returns and financial reports to back up this puny case.

And, suffice to say that if things go really well for you and you have an exit opportunity, the magnitude of that will ultimately hinge on your financial records.  HP got the hots for Autonomy and didn’t look very closely at those records, much to their current chagrin, but I trust that no TechDrawl reader would actually resort to cooking the books as was the case there.