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  • Writer's pictureJoe Minich, CPA

False Profit - A Common Pitfall of Small Biz Financials


Joe Minich, CPA





"Joe, I'm making 25% net profit, it says it right here on my P&L statement. I'm doing better than anyone else in my coaching group. Why isn't my bank account growing? How come every slow season I just squeak by?"


That was a question from a business owner I was recently onboarding It's a version of similar conversations I've encountered many times over.


"Well, Mr. Business Owner, you have 5 technicians in the field, right? "


"Right"


"And you are one of them, correct?"


"Right"


"And where is your pay on the income statement?"


"Well, I pay myself through owner draws."


"Well then, your owner draws aren't on the P&L, they are equity draws on the balance sheet."


There it is. The false profit. Just one example of a misleading P&L.


Roughly 20% of the labor costs were not reflected on his bottom line. His 25% profit is truly around 5% if you adjust for his labor. Not such a great place to be.


The P&L (also known as the income statement) is but one of the three main financial accounting reports. Another is the balance sheet. Owner draws, distributions, and guaranteed payments are all on the equity section of the balance sheet, and unless they are otherwise adjusted, are not reflected in the net profit on the P&L. The statement of cash flows is the third common report, and essentially reconciles the P&L to the balance sheet.


That is a stark example, but there are many more situations where the bottom line on the P&L is not a good indicator of the health of a business. Cash flow can be a better measure, but can also be misleading as a proxy for "true profit" due to period-over-period variances in receivables, payables, credit cards, and loans.


Even better, is an adjustment to the income statement to get an adjusted profit or "true profit". Understanding this requires a quick primer in the differences between financial and managerial accounting.


Financial accounting is governed by strict accounting standards called GAAP (Generally Accepted Accounting Principles). Think public company reporting to the SEC. In the above case of the false profit, it was indeed correct by GAAP. But as we saw, this is generally not the best measure to run a business by.


Managerial accounting is not governed by the same degree of standards and can be tailored to assist management decision-making. Our adjustment to the books shifts the owner draws over to an adjusted P&L, and we can see a better measure of profits for Mr. Business Owner.


Few accountants and bookkeepers are willing to make these adjustments and take the extra time to build customized reporting beyond what Quickbooks spits out. I've seen some accountants short-circuit at the mention of making such adjustments because they are wired to adhere to the GAAP standards and keep the books clean for taxes. But we do make these adjustments in our advisory practice because we think managerial accounting is better for business owners. We want people to have a clear picture of their true profitability.


Contact Joe today to discuss






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