Do you like to sleep at night? Do you like knowing that your finances are in order, and everything is under control? If so, I have a story for you that will make you lose sleep. I'm talking about accounting horror stories. Stories of businesses who have faced financial ruin because they didn't keep their books in order. Today, I want to share with you the first accounting horror story. This is a story of a business who faced bankruptcy because of bad accounting practice. Are you ready for it? Buckle up, it's a scary one!
Once upon a time...
There was an entrepreneur that built a half a billion-dollar construction company from the ground up. He was a great salesman, and his business was in a hot market niche. His company was doing well, his business was in operations in multiple different states, and had large contracts with some of the biggest names in the business. The company's billing was timely and their accounts payable looked healthy, it has not ballooned in the last year of activity, which is an excellent sign for any business! Furthermore, the company took advantage of financing options to bridge its collections to payables: credit cards, supply chain finance and factoring receivables, a process in which the business sells its invoices for a discount in order to receive cash up front. Although on paper the company was profitable, the company continued to struggle with cash flow issues. The company had to use multiple loans just to keep his business afloat and pay his employees, additionally the entrepreneur had to dip into his personal savings. As the company continued to struggle to pay its bills, the vendors and lenders became irritated, their desperation they forced the entrepreneur towards bankruptcy.
It was profitable, how could this happen?
One thing to understand is that unless a profitable company is purchasing large assets, cash problems are primarily driven by timing gap in between collections and payables, which can be solved by borrowing money. But since the company continued to struggle with cash-flow issues even after taking advantage of many financing options, it became apparent that the company was not actually profitable.
How did the company report positive financial performance?
The company billed ahead of time recording revenues before the work was actually completed. Basic accounting principles explains that revenues should be recognized when earned. Revenues must be earned, not when billed, and to earn the money you must do the work first. Not following this rule made it very difficult to analyze operating performance month-over-month as each period can fluctuate from highly profitable to terribly hopeless. The company's payables also came out underreported as it did not match the balance due on the vendor's monthly billing statements.
Why did the accounting do such a terrible job?
Although the company CFO had a strong finance background in the field of investment banking, the company did not have anyone with strong accounting skills controlling the financial reporting. Coincidentally, the CFO was also responsible for Accounts Payable and Accounts Receivable. The staff was not trained well enough to identify these issues. They were not able to give the company the attention it needed and vice versa, which attributed to very high turnover.
What can we learn from this story?
This story is a great reminder that just because a company is profitable on paper, it does not mean that the company is actually doing well. It is important to look at the cash flow statement to get a true picture of the company's financial health. The cash flow statement shows how much cash is coming in and going out of the business. If a company is not generating enough cash to cover its expenses, it will eventually run into financial trouble.
This story is also reminder of the importance of following basic accounting principles. Revenues should be recognized when earned, not when billed. Furthermore, all expenses should be properly recorded and matched to the corresponding invoices. This ensures that the financial statements accurately reflect the company's true operating performance.
The scariest part
Apart from the business going through bankruptcy, the entrepreneur in this story also filed for personal bankruptcy losing his home and his livelihood.
Conclusion
Even if a company appears to be profitable, it’s important to look more closely at its finances. In some cases, a company may be profitable due to creative accounting practices, not because it is actually making money. Unfortunately, this seems to be the case with the company in this story. According to recent reports, the company did not follow proper revenue recognition procedures, which led to an inaccurate portrayal of its financial health. Additionally, the company failed to take care of its accounting department, which eventually led to its bankruptcy. If you are looking for a reliable and experienced accounting partner, contact GFT today. We can help your business thrive by ensuring that your finances are in order and accurate.