This article is part of a two-part series on accounting for startups article. In this article, I will explain the basic accounting foundation that the entrepreneur must adopt from day one to prevent or mitigate any potential problems in the future. Founders, “ideators”, and inventors, understandably spend most of their time concerning themselves with perfecting their value propositions, and at the same time neglect establishing a solid accounting foundation for the business. Like many people, the financial know-how, accounting mechanics, and analysis are founders and co-founders Achilles heels. During the startup phase, economic activities are taking place, and they must be properly documented to measure success and track the progress of the business. Proper and timely accounting records form the basis of a successful exit strategy, whether it is to list on a stock exchange, to sell to a third party, or merge with another entity. Also, let us not forget that the startup will have to comply with regulatory requirements (tax filings), and those of other third parties (investors, lenders). The satisfaction of these requirements is only possible by adopting a formal process of capturing, recording, and analyzing the results of the economic activities.
What is Accounting?
A quick google search gifted me with a good dose of potent entrepreneurial medicine. According to Accountingverse.com, accounting is known as the language of business. It is a means through which information about a business entity is communicated. It is through the financial statements, the end-product reports in accounting, that information is delivered to different users. Where there is business, there is accounting.
The American Institute of Certified Public Accountants (AICPA) defines accounting as:
"the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and, events which are, in part at least of financial character, and interpreting the results thereof."
Though the entrepreneur may not have that many muscles in finance and accounting, it is incumbent upon him to understand the purpose and role of accounting as there is no business without proper accounting. The entrepreneur must understand that:
Now that we have a further understanding of the accounting discipline, we can now appreciate the need for an accountant/bookkeeper, the accounting basics that must be adopted, and the potential pitfalls of not properly accounting for a startup.
Common accounting pitfalls for startups
If a company neglects proper accounting practices, this can result in strangulating impacts on the success of the venture. A point to note is that a business is almost as good as its accounting. Some major pitfalls of not employing proper accounting practices include:
What are the accounting basics?
Because this article is specifically geared towards the founder, co-founders, and the entrepreneurially enthusiastic, I will assume that there is no background in accounting, which is fine. To not get too technical with the accounting discipline, I will try to make it quite simple for the non-accountant. Remember, the main aim of the accounting aspects of the business is to capture and summarize all the business-related economic events so that they are presented in a way (final financial statements) to aid in making informed decisions. Here, I will list some important basics in getting accounting for a startup in order and prevent challenges in the future.
Business bank account
Once the startup is registered, there should be a bank account/s opened in the name of the business. This will ensure that there is a separation of business and personal activities. A true and fair picture of the startup over any period includes only those economic activities relating to the startup.
Whilst some entrepreneurs may have the time to keep track of the startup's economic activities, a bookkeeper should be hired whether in-house or this function be outsourced so that the core activities/objectives of the startup are tended to.
Not all bookkeepers are accountants, but almost all accountants are bookkeepers. Most people confuse the two, but there is a marked difference. An accountant is a trained specialist in the science and art of accounting. He/she interprets the financial records to ensure accuracy and reliability. He/she would have satisfied the basic educational training, and have sat and passed all the requisite professional licensing examinations (CPA, CGA, ACCA, CMA), licensed by a professional body, and continuously engage in professional educational development, which is a requirement to maintain his/her licensure.
The bookkeeper on the other hand usually has the knowledge, training, and experience in the recording of the startup’s business transactions but may not be proficient in the advanced areas of accounting and taxes.
So, depending on the nature, stage, and need of the startup, the founder/s can decide whether a bookkeeper or an accountant should be hired. In any case, at some point, a tax accountant, or a chartered accountant must be hired to file the taxes and interpret the accounting pronouncements and their application based on the type/nature of business activities.
Chart of Accounts
To make it simple for the non-accountant, I will liken this to the blueprint that an architect uses to build a house. In accounting, a solid chart of accounts (accounting listing), usually unique codes representing business activities. This helps the bookkeeper/accountant in identifying, coding, and classifying the various types of business activities (income, expenses, liabilities, assets, etc.).
Simply put, there should be a solid chart of accounts.
Basis of Accounting
Dear entrepreneur, like choosing the type of business entity you wish to operate (sole trader, partnership, corporation), there is also choosing an accounting method that will shape your system of accounting. So, depending on where you are in the startup, the type of business, the intentions in terms of an exit strategy, and the jurisdiction in which you operate, the available basis are:
Cash basis: this is recording the transactions only when cash is received or spent. Most startups will start at this level. Note, however, that if you intend to grow, attract investors, and obtain financing, this is not the most appropriate basis of accounting to employ.
Accrual basis: This is the industry standard used by most accountants globally as stipulated by Generally Accepted Accounting Principles (GAAP), and International Financial Reporting Standards (IFRS). With this method, revenue and expenses are recorded when they occur and not when collected.
You may choose whichever method you prefer, provided you satisfy certain parameters within certain jurisdictions. You can speak to your accountant on the tax implications of each method.
Once a method is chosen, you must remain consistent. However, you would not commit an accounting sin if you were to change the basis once it is explicable and reasonable.
Accounting is a different discipline all by itself and whilst the non-accounting entrepreneur/entrepreneurial enthusiast may not necessarily need to be baptized with all the details. Aside from concerning yourself with the value proposition and bringing an idea to fruition, basic accounting knowledge is necessary to avoid the accounting pitfalls of what could be a successful venture. Additionally, handling all the accounting by yourself or internally can be daunting, so if needs be, it is better to outsource so that a better picture can be had to make more informed decisions, attract the right investors, source adequate funding, and stay within the ambits of the tax regulatory framework. Remember, there is no great business without a solid accounting architecture.