February 11, 2008: When to turn to ‘chainsaw accounting’ and how to avoid it
February 11, 2008
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Call it bonehead accounting. Call it accounting 101. Call it whatever you want, but if your financial statements are a mess, you need to read this.
I was recently at a dealership that had not looked at their balance sheet for 10 years. The outside CPA finally said, “Get this fixed or don’t come back!” So I showed up to see what I could do for them, and here is what I found.
The balance sheet was a mess. It was a small shop, but customer deposits were more than $1 million. Inventories were negative, the bank balance was upside down and clearing accounts were overflowing with unresolved items. Accounts receivable and accounts payable were bogus, and the parts inventory had 10 pages of negative on-hands, and another six pages of parts where cost was greater than the selling price.
The profit and loss statement (P&L) wasn’t much better. They had been double posting the cost of labor for 10 years and didn’t even know it. The Work In Progress Inventory for labor and sublet each showed an impossible credit balance. Looking back through the history, I could see that this had been true year after year.
These owners did not know what to do about their dilemma. All they knew was that it wasn’t right; nobody believed it, and they didn’t know how it got that way.
So I dug in. Accountants have a solution that works every time.When the books are so bad they just can’t be fixed, you simply count what you see in front of you, use those numbers and recalculate the value of the business. So that’s what I did. Around here, we call this “chainsaw accounting.” It works. And it works well. When you are through, you have the truth in front of you, no matter what the books had said. The proper accounting term that your CPA will understand is to “reconcile the balance sheet.” They know that if the balance sheet is correct, the P&L must be correct.
So I tore up the balance sheet. Every number was tested and confirmed against independent third party confirmation. Every amount was proven with detail reports that had been purged of all values that were questionable, such as accounts receivable that would never be received, accounts payable that would never be paid and major units that had been stolen years ago but were still carried on the books because nobody knew how to get them off. When we had that, we adjusted the balance sheet to agree with the detail and then locked them both together.
Over and over again, for each balance sheet account.
And when we got through, we had the truth. There was a significant correction that reduced the owner’s equity in the business, but we all knew that was the way it was. There were simply no more assets to be found, and no more liabilities to book.
The lesson here is no matter how bad your mess is, it can be fixed. The truth always lies in the real world. All you have to do is find it, count it and record it.
But when you finally have good numbers in front of you, how do you read this thing? Assets, liabilities, expenses, profit — what does it all mean? And how does it fit together?
Here’s the 101 part.
You have two reports: The balance sheet and the profit and loss statement (The P&L). Bottom line here is the balance sheet shows things that you have, and the P&L shows things that you did.
How much cash and inventory do I have? You look on the balance sheet.
What were my sales, my margin and my expenses? You look on the P&L.
Structure? From 40,000 feet, it’s pretty simple.
The balance sheet only has three kinds of accounts on it: assets, liabilities and equity, and the total of all assets is equal to the total of the liabilities plus the equity. That’s why they call it a balance sheet.
The P&L starts with sales, shows the cost of the merchandise (cost of sales), and the subtotal at that point is called gross margin.
From gross margin I subtract my expenses, and the end result is net profit, which appears both on the P&L as the bottom line and on the balance sheet as current earnings. This is the link between the two reports.
Don’t be afraid of your financials. Don’t just turn to the P&L, drop your eyes to the bottom line and just sigh. Scan that balance sheet every month and ask about “funny numbers.” An inventory cannot be negative (what’s it made out of? Antimatter?), and each account should be where your good sense tells you it ought to be. If month after month your accounting person cannot explain a number, get a new accounting person.
Your financials are you. The whole world — from the IRS to the banks and the OEMs — judges you by what your financials say. If you’re in a mess, get out the chainsaw, rip them up, tie them to hard proven facts, gain confidence in them — and even if it is terrible, you will finally know the truth. Then, knowing this, you can either rest easy, or get to work and do what you have to do. Until then, you are just kidding yourself.
Hal Ethington has been associated with the powersports industry for more than 30 years. Ethington is a senior analyst at ADP Lightspeed. He can be reached at Hal_ethington@adp.com.