3 Elusive Accounting Concepts

In my 21 year career as a CPA, I have met scores of entrepreneurs….start-ups, established business owners, and those about to jump into the arena of comfortable retirement. To be successful, you have to understand accounting concepts. But there are some areas that are just elusive….too nebulous for anyone to understand. Enter the reinforcements…the trusted advisor….the CPA.

Retained Earnings:  “Um, what is that number down at the bottom…retained earnings?”  I get this one all the time. I remember having a tough time wrapping my college-aged head around this. I have taken to using the penny jar analogy, and it goes like this:

Imagine that all of your profits from Day 1 have been deposited into this penny jar.  Imagine also that every year that you lose money, pennies are withdrawn from the jar.  And lastly, if you take distributions of profit from the company, pennies are also withdrawn.  What’s left over is your Retained Earnings figure.”  50% of the time, I get an enlightened nod.  50% of the time, I get a hesitant nod, meaning “I don’t quite get it, but let’s move on.”

Dividends/Owner Draws:  Entrepreneurs are a lot like my 10-year old daughter when it comes to profits.  When my daughter receives money for doing things around the house, she wants to spend it right away. Same goes for entrepreneurs who start to see blank ink where their net profit figure resides. So, they remove the profit from the company in the form of dividends.  Trouble is, you can’t do this forever because you will come to a point where those profits have been exhausted. And telling the trusting entrepreneur who has looked to me for advice and guidance that she can’t keep taking dividends quickly turns her into my 10-year old. The look of incredulity is scary. So, I won’t attempt to explain dividends and draws here, but suffice it to say that I will spend hours explaining this concept in Start-Up School…it’s not an easy one to understand.

Accrual Basis Accounting vs. Cash Basis Accounting: My therapist probably makes money off me due to the stress that this conversation causes with my entrepreneurial clients. There’s a reason “accrual” has the word “cruel” in it.I should just place a bull’s eye on my face and give them a hammer.  So, I've tried to use this example:

Accrual basis accounting records income and expense when incurred…you send an invoice to your customer, it counts are revenue. You receive your utility bill that is due in 28 days, it counts as an expense. Cash basis accounting records ONLY record things when cash is received or spent. But, there is one exception….credit card expenses….

And then I lose them. Insert bull’s eye and get your hammer.

I get it, this stuff comes easy to those of us that do it every day. But, as I have said, I don’t change my tires because the guy at the tire shop does it all the time and it takes him 30 minutes. Entrepreneurs like to be “do-everything” people, but sometimes you gotta call in reinforcements to explain retained earnings and why it’s important.  That way, you can get back to filling that penny jar.