Here it goes: The GAAP has it all wrong. Now, before you click the little X at the top of the screen to close out of this article or look for the comments button to sound off, hear me out on this. As an entrepreneur, you may just find the new accounting method that I propose (read on for that) to be enlightening and helpful.
Sure, the Generally Accepted Accounting Principles that have been pounded into your head have an important function. Those include preparing financial statements that are used to report to investors or even those given to the IRS for the sake of mergers. They do have their place in the business world. But if you want to grow a profitable business, and I’m assuming you do, using the GAAP as your main accounting method is absolutely not the way to go.
Now, I must warn you that replacing the GAAP method in order to track your cash-flow management and track spending, and even to assess your company health, is going put you “out there.” People will think you are off your rocker, headed in the wrong direction, or are just plain wrong. They will warn against it, and they may even sound like they make some sense. But just because it goes against the grain doesn’t mean that it’s wrong. Not by a long shot!
Let me explain the problem with using the GAAP method. Like that of other entrepreneurs, your salary likely comes from your net income. Meaning that everything else came out first, including general expenses, sales support, etc. What you consider to be your profit are those few pennies that are left over. Yet the key to financial success is to always pay yourself first. This is in direct conflict with the GAAP, which tells us to pay ourselves after paying everything else.
If you follow that GAAP advice, you will be left trying to eek your salary out of the leftovers, that is, if there is anything left after you pay for everything. Do this for a while and you may be so unhappy with your salary that you find yourself looking at the classified ads. This brings me to that new accounting method that I'd like to propose, which is called Profit First Accounting.
The difference with PFA is that you are going to first deduct your profit. On the income statement generated using this method, revenue will be your first line item, then you will have a deduction for profit, followed by your salary, then finally a line for the cost of goods and all the other expenses.
While you may have the same final number, this route will show you when you are losing money, and it will motivate you to backtrack and figure out a new direction. And the bottom line here becomes your expense, rather than your salary or the profit of the company. This route comes with benefits you didn’t have before, like being able to track growth and having control of all of your costs, which will likely make you become more frugal.
To determine the amount of profit to deduct, see what others in your industry are doing. The amount they are deducting will likely be between 5 and 15 percent. When you have that amount, use it as your “profit first” setting. Then add that amount into your interest-bearing PFA account each time you make a deposit.
This PFA method is the one that I have used for a long time. I have also helped my clients use it. The results are always the same: more control over company expenses and higher profits. It is a simple change that will help you reach new goals and, most important, always pay yourself first!