The Top 5 Accounting Risks for Startups and SMEs
There are some accounting risks every startup founder and owner operator should be aware of. These risks can not only impact the ongoing viability of a business but also have a detrimental effect at major events such as investment rounds or exit processes. Robust management accounting is fundamental to the enterprise value of a company and will help mitigate accounting surprises such as those outlined below on an ongoing basis or within due diligence.
1. Intercompany Accounts
In some cases, businesses will have associated companies, whom they either own, or are owned by. In this instance, it is crucial to ensure that expenditure is paid for in the right entity. Where this is not done, an intercompany account must be set up and these transactions accounted for in both entities. It is crucial to be aware that money moved between limited companies, even if they have identical shareholders, will appear on the balance sheet of both companies, and will need to be accounted for in a company valuation.
This could become particularly relevant for owner operated businesses approaching an exit where historically, funds may have been moved between companies with little thought.
2. Tax Liabilities
Corporation Tax is due 9 months after the final year end. In too many cases, businesses don't budget for this annual, large payment. As such, when it falls due, there is not enough cash in the company to cover the cost. Late payment comes with significant penalties, and associated interest on late payment.
Companies can avoid this danger by putting aside a percentage of their profit each month to pay for the impending tax liability and this should be standard practice in your accounting procedures. Appropriate professional advice will also ensure you apply the appropriate VAT treatment to the products and services you sell, especially if you have customers in multiple jurisdictions.
3. Dividends
Legally, a company can only pay dividends from the distributable reserves they have available. As such, there is a risk that a business owner pays themselves a dividend based on the cash balance of the company, not their true financial position (often known as cash-based accounting.) Where this is done, they run the risk of receiving an unexpected personal tax bill for having wrongly extracted dividends which the company was not able to pay.
It is also unwise to take out too much too soon, as it may leave the company with cash flow issues down the line. Unless robust management accounts are being produced periodically, it will be difficult to know the true financial health of the business to make an informed decision about appropriate dividend payments.
4. Cash Flow
Most startups that fail do so because of cash flow. Their concept may be profitable, but poor cash management can mean the business runs out of cash before it has time to flourish. As such, cash levels must be regularly monitored, not as an indicator of the success of the business, but because without cash, the business will quickly die.
Much of this can be done using the management accounting principles, particularly surrounding understanding the seasonality of the business’ income and expenditure. Knowing when potential pressure points fall in the year will enable the company to plan for these and ensure that they never run out of cash to pay their staff, suppliers, and other creditors.
5. Reserves
It is crucial for companies to build up some level of cash reserves, whether through investment or not spending all their income. The generally accepted rule of thumb is 3-6 months of total company expenditure. However, a professional would be better placed to advise on a more nuanced figure based on the specifics of the company.
All the accounting risks mentioned above can be mitigated by producing accurate and regular management accounts. There is often a cost associated with this, whether by engaging a professional advisor or through a part time or permanent hire, that small companies would prefer not to take on. However, as we’ve outlined, there is too much risk associated with not understanding the true financial health of a company when making investment decisions, paying dividends or entering due diligence processes.
If you would like to discuss the management accounting needs of your business, please get in touch with our small business, SME and startup accountants as we'd love to discuss some simple, practical and cost-effective steps you could take to better understand the financial health of your business.
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