The glasses were at the end of her nose as she reviewed my financial records. This gave me a very distinct impression I was in trouble. It didn’t help that she reminded me of my 2nd-grade teacher, Ms. Provisor who was a stickler for details and tolerated not an ouch of nonsense. Though I was probably less terrified of Ms. Provisor than I was of the IRS auditor sitting in front of me going through my records in my home office that afternoon asking me about my travel and very large meals and entertainment expenses.
“Tell me about that ‘business trip’ to Brazil,” she asked.
It turns out visiting a real estate office while on vacation in Brazil doesn’t make for a write-off.
“Can I see some notes from your ‘business meal’ meetings, looks like you had a lot of them,” she inquired.
Insert my quick introduction to the 50% rule – only 50% of real business meal expenses are deductible, and you better have some notes from the meeting to substantiate it was a business meeting.
It went like this for several days as she examined nearly every business expense. In the end I was assessed an additional $30,000 in taxes, penalties, and interest which was my brutal introduction to my messy Profit and Loss Statement – business finance 101 via an in-person IRS audit 5 years into my real estate business. I was frustrated, scared this could all happen again, and confused about what I needed to do to get a handle on things.
Luckily I’ve learned a lot since then.
15 years later, I wonder what that auditor would think of me now as I advise small business owners on how to organize, manage, and analyze their finances. Actually scratch that. I hope I never see her again!
In all seriousness, I’m honored to be in a place now where I can teach, advise, and provide services to entrepreneurs to manage their own back end finances profitably. Without this experience, I would never have realized the importance of having my books in order and my financial processes in place. I’m not a CPA, attorney, or a licensed financial advisor, though I am a “learn the hard way” on the ground entrepreneur and am producing webinars, consulting, and virtual CFO services to help my fellow business owners advance their profit goals.
In that work, I’ve noticed three danger signs to look out for that might be an indication you need some help.
You’re mixing business and personal expenses
This is incredibly common, and not the end of the world – though it does have the effect of distorting the business performance. Yes, there are tax implications too, such as too many or too few deductions.
The practical matter is unless you’ve isolated business revenue and expenses in an honest and accurate way, you won’t actually know how well the business you’re operating is actually working. For example, many of the meal purchases I had booked in my business P&L were actually personal meals, though because it was all booked in the same category, over time it became impossible to know which was a business expense and which was not. As a result, I was penalized in the audit for not being able to distinguish (she threw them all out) and ended up with a smaller deduction than I could have had. Not to mention I wasn’t able to accurately measure how much my business was spending on wining and dining clients.
The lack of transparency around your own true business financial numbers using a P&L also makes it nearly impossible to make good decisions about investing and growing. The common argument I hear is I have some expenses I want to deduct so I “throw them in there”. I understand, and there are ways to accommodate expenses that are a blend of personal and business, though that’s no excuse for not fully understanding how much it actually costs to run your business.
This is important because in addition to tracking all expenses you need to measure expenses as a percentage of revenue to determine if you’re spending efficiently. For example, for most service businesses business development expenses should not exceed 10% of revenue. If you’re not accurate with what is in that category you can’t hold your expenses accountable to a result.
Mixing business and personal expenses doesn’t do you any favors in the long run.
Your CPA created the P&L for you and it doesn’t make much sense from a practical point of view
First of all, your CPA is just doing his or her job by helping you do this and does need some degree of organization to file your taxes. Though the other side of the perspective is that while the P&L is important and quite helpful come tax time, it’s not the only function of the report. The majority of the year, the P&L needs to guide your decision making and the only way it can do that is if it is reflective of what actually happens in your business – in a way you can understand it. The organization of the P&L (called the chart of accounts) must be agreed to and understood by the entrepreneur primarily. You get that right and the P&L will be on its way to be more of a strategic tool and not just a static report.
At a high level, the most important thing to understand about your P&L is the relationship between revenue, cost of sale, expenses, and net profitability. Meaning at the end of the day, what percentage of your revenue is actually making it to the bottom line profit and what is happening to it while it moves through various expenses. This calculation is referred to as a profit margin which is a strong indication of how effective you are as a business owner. If you don’t understand the making of your profit margin, you might very well be in danger of growing the business without growing your profit. Over time you’ll be working harder and harder for less profit.
You genuinely don’t know where all the money is going
Sound familiar? If you’re in business chances are, like me, you know how to make money. Knowing how to make a profit though is an entirely different exercise. For years it felt to me like the money was just slipping through my fingers and the IRS came knocking more often than I care to admit. It seemed awfully expensive to run my business and I couldn’t imagine what all of those transactions were actually for.
It was too overwhelming to look at them so I ignored the issue, hoping it would get better as my income increased. Guess what. It doesn’t. More income just makes the problem worse. Not to mention when you’re in this state it’s impossible to know how much to pay in taxes and it’s a mystery as to when you can actually afford to make an investment in your business by hiring someone.
The only way to get a handle on this is to fully label the data and ensure it is accurate and organized so you can see where the money is actually going.
What do you do next?
If this sounds like you then what do you do? First, don’t underestimate the time necessary to fix your issues. If you’ve been creating bad habits for several years it could take a while to create new habits and build the systems and resources around you to get a handle on everything.
That’s where I come in. I help business owners clean up this process so they never have to go through what I went through with the IRS or have the anxiety of not knowing how to smoothly operate their business or know-how to impact the profit. It’s pretty straightforward to set up something for the current year to give you an immediate view on the state of your business and some insight on some fast decisions to maximize profit now. Then we can deal with any previous issues.
Remember, all of this is an investment in the long term success and viability of your business. For most of us the health of our business is directly tied to the health of our life. Could the stakes be any higher to taking concrete steps to get a handle on this right now?
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