That's exactly what Anne and Elizabeth did, but when I spoke with them again several months later, I realized they had neglected a critical step. They hadn't made sure that The Event Studio submitted bills to their respective companies for the work done. They hadn't thought of it, of course, because they were the ones doing the work, just as if they had simply continued to partner. Billing their old companies felt like sending invoices to themselves. Problem was, the customers' contracts were with the old companies, and those were the entities that received the payments. Unless the old companies, in turn, received -- and paid -- bills from The Event Studio, it would appear that Anne and Elizabeth had taken the money and invested it in the new business.
So, you ask, what's wrong with that? Nothing, in principle. It wouldn't become a concern for them until they had their accountants figure out their respective tax liabilities for the year. At that point, they would discover they owed a lot more than they expected. Why? Because each of their old companies would have revenue with no expenses to put against it. The expenses would have been incurred by The Event Studio. The money that the old companies received from their customers for the work done by The Event Studio would look like pure profit, on which they would be taxed accordingly. Fortunately, we caught the oversight in time.
To be sure, they didn't necessarily need my help to avoid this particular pitfall. A good accountant might well have discovered what had happened before Anne and Elizabeth were forced to pay taxes they didn't really owe. Then again, many outside accountants don't ask all the questions they should about the numbers they're given. They're too busy. They have dozens of clients and only so much time to spend on each one. That's why it's dangerous for entrepreneurs to rely on an outside accountant to oversee their finances. Like it or not, you need to understand the numbers of your business, and that requires knowing something about accounting.
And if there's one aspect you need to know, it's the difference between cash- based and accrual-based accounting. Otherwise, you won't really know whether you're making or losing money. Here's the (somewhat oversimplified) difference in a nutshell: With cash-based accounting, you record sales and expenses only when money changes hands. That is, you don't recognize a sale until you get paid for it or an expense until you hand over the cash. With accrual-based accounting, you record sales and expenses when you do the work involved in creating and delivering the product or service a customer has agreed to purchase.
All individuals and most small businesses use cash-based accounting to figure out what taxes they owe, and it's fine for that purpose. But cash-based accounting doesn't tell you how you're really doing as a business, and as a result it can lead you astray. I'll give you a hypothetical example. Suppose The Event Studio books two new events in December. One is a large conference that will take place the following spring, for which the company receives a deposit of $10,000 but on which it does no work in December. The other is a sales meeting scheduled for February. Let's say the total fee for that one is $6,000, and the company operates at a 50 percent gross margin, meaning its direct costs will be $3,000. It will be paid half of its total fee for the sales meeting in the middle of January. Nevertheless, it completes a third of the work in December and pays a third of the costs, or $1,000.
On a cash basis, the women made $9,000 ($10,000 of cash received minus $1,000 of expenses paid) during the month. If they had no other sales or expenses during the year, that's the amount on which they would pay taxes. But to understand how the business really did in December, they need to look at sales and expenses on an accrual basis. They can't include the $10,000 deposit in their sales figure, because they did no work on the conference during the month. On the other hand, since they've done a third of the work on the sales meeting, they can record a third of the total fee, or $2,000, as well as the $1,000 they incurred to cover the cost of that work. So their profit for the month was really $1,000, not $9,000. (For the purposes of this example, we're ignoring overhead expenses.)
Now, all that may seem obvious to you, but it doesn't seem so obvious if you aren't used to working with the numbers of a business. When I asked The Event Studio women for their 2008 income statement, they had no idea whether to include the deposits in their sales totals. Similarly, they didn't know whether to include expenses they'd been billed for but hadn't yet paid. Predictably, what they produced was a mishmash, and not because they're stupid. On the contrary, all three are extremely bright. But if you've never taken the time to learn the basics of accounting, even experienced entrepreneurs can get tripped up.
On the other hand, when you do learn the basics of accounting, you realize that the numbers aren't as complicated as you feared and that you're finally developing the knowledge you need to be in control of your company. As we went through their income statement, I had the sense that Elizabeth, Beckie, and Anne felt a fog lifting. It was a small step on the road to building their business, but it was a crucial one. We'll be looking at the next steps in the months ahead.
Norm Brodsky is a veteran entrepreneur. His co-author is editor-at-large Bo Burlingham. Their book, The Knack, was published by Portfolio in October.
