Now, one entrepreneur says you're wrong to use GAAP to manage your business. Here's why: Mike Michalowicz, author of The Toilet Paper Entrepreneur, says GAAP has a problem when it comes to growing your business into a smash success: GAAP pays you last.
While knowing how to state your finances in GAAP is important for many uses -- if you're a public company for reporting to the Securities and Exchange Commission, for instance, or if you're a fast-growing startup hoping to get investors or go public in the future. But when it comes to running your business day-to-day and making decisions, Michalowicz argues that entrepreneurs need to break out of this mentality and pay themselves first instead.
He advocates putting your income way up high in the statement as a fixed cost. Then, you'll be forced to be more creative in how you manage the business, finding ways to cut other costs.
He calls it Profit First Accounting. By putting your income and a profit deduction up top, the expenses come down below, leaving them to be cut to make the books balance. With traditional GAAP, your salary and profit is at the bottom, and we all know what happens there -- if you have a bad month, your income disappears.
The idea is to enforce a frugal mentality, which is good for helping your business thrive in any case. Michalowicz suggests benchmarking your company against successful businesses in your industry to determine an appropriate profit margin. For some industries, it might be 4 percent, others 15 percent. Once you know that benchmark, plug it into your financial statement right below revenue.
As someone who's read a lot of company financial statements, I can say GAAP definitely forces many companies into contortions as they try to show how their business is progressing. The companies end up offering supplemental accounting sheets that explain how free cash flow is growing, or pretax earnings. Also, GAAP definitely does put expenses first, over profit. There may be a psychology to that, where profit doesn't figure big enough in entrepreneurs' thinking that way.
Certainly, all entrepreneurs want to make money from their business, and all too often, profit vanishes in a sea of expenses, and there isn't enough focus on keeping expenses down. Putting that profit first may be a way of getting those priorities straight.
Do you use GAAP, or do you pay yourself first? Leave a comment and let us know how you think about your business's finances.