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Trust but verify (aka how to spot check a Profit & Loss report)

by | Feb 19, 2022

Profit & Loss reports are one of the most common small business financial reports. They are relatively easy to understand, can be generated with a few clicks in your accounting software, and are the starting point for your financial decisions, tax returns, bank loans, and budgets. They’re incredibly important. They’re also frequently full of hidden errors. And, mistakes on your Profit & Loss can lead to incorrect decisions, paying too much tax, increased audit exposure, being denied for loans, and ineffective budgets. While you should trust your accounting team (whether they’re in-house, outsourced, or it’s just you DIYing it), you should also do your own due diligence and double-check their work before making decisions or sending your Profit & Loss to a third party (aka your tax accountant or banker).

Reviewing your Profit & Loss may sound intimidating, but it’s relatively simple. You don’t need to review every single underlying transaction or run a full-fledged financial audit on your books just to make a decision. You just need to check a few problem areas and review easily verifiable numbers. If you don’t find any issues (or they’re relatively minor), great. You can make those decisions. If you dooo find issues, point them out to your accounting team, ask for clarification, and circle back to your decision-making next week.

(Note: Profit & Loss reports are surprisingly nuanced for just a bunch of revenue and expenses. If you find a potential issue, ask for clarification before jumping down your accountant’s throat. You may’ve stumbled on some weird accounting nuances. And, if you hit them with a “some accountant on the internet says you’re dumb”, my math friends won’t talk to me anymore 😓)

 

Check numbers against other reports :

Every line on your Profit & Loss report is a summary of all the revenue or expenses in that category (eg, ‘Software Expense’ is a summary of allll your software expenses). Depending on the category, there could be dozens of transactions with no easy source document to quickly check them against (unless you reallyyy like going thru receipts). Then, there’s other categories that could be easily double-checked in less than 30 seconds by verifying them in another system. For example, if you collect all your client payments thru a Stripe integration, then the total amount collected thru Stripe and your total revenue on the Profit & Loss shoulddd match. If they don’t, something is missing. Take 2 minutes to check a few of these easily verifiable categories for potentially missing info.

Examples:

  • Revenue can be quickly checked against your merchant processor revenue report (plus cash and checks)
  • Gross payroll plus employer payroll taxes can be checked against your payroll software’s total payroll cost
    • If you pay contractors thru your payroll software, you can also check your P&L contractor expense against the payroll software’s
  • Phone expenses can be checked against your phone bill summary
  • Rent expense can be checked against your rent (yes, this one is especially easy, but that’s kinda the point. This doesn’t have to be difficult. Review those super easy numbers.)

 

The ‘does this make sense?’ test:

You work in your business every single day. You make the sales, approve the expenses, and manage the work. While you might not have an accounting background or know every single little transaction off the top of your head, you should have a pretty good gut feeling for your business. Take a look at your Profit & Loss and ask yourself “does this make sense based on what I know about my business?” For example, if you run a marketing agency, I’d expect a significant amount of Payroll Expense, Contractor Expense, Software Expense, and Rent with a healthy profit. As opposed to an e-commerce business, where I’d expect a lottt of Cost of Goods Sold.

 

The twelve test:

Just about everything is a recurring expense nowadays. Landlords, utilities, bank loans, software, and, now, some service providers all bill you monthly. And, while it doesn’t make sense to individually verify each software expense during a quick review, you can quickly check how many transactions there were. If you’ve been subscribed to a service all year, there should either be 12 transactions (for monthly billing) or 1 huge transaction (for annual billing). Check your rent expense, interest expense, and expensive software for 12 monthly transactions.

(Note: I wouldn’t try this test with payroll because one or two off-cycle payrolls for new employees or bonuses will throw off your count.)

 

Check the junk drawer :

Every household has a junk drawer. It’s full of spare batteries, take-out menus, and all that other junk you didn’t know how to organize so you decided to ‘out of sight, out of mind’ it. Your accounting software also has a junk drawer. It’s either Miscellaneous Expenses, Office Expenses, or Supplies. That’s where everyone shoves things instead of figuring out what to do with them. Quickly review the transactions in each of these categories for anything important that shouldn’t be there. If you find some important, move it by editing the category. And, if you find literally everything in there with no rhyme or reason, ask your accountant about it (or, if you’re DIYing it, maybe it’s time to outsource).

 

Significance and relevance (aka materiality):

In life (and accounting), there’s a line where things just aren’t a big enough deal to worry about. In accounting, we call this materiality with items being either material (important, relevant, significant) or immaterial (the opposite of all that). When you’re spot-checking your Profit & Loss, let those minor and immaterial items go. For example, it doesn’t matter if your Zoom expenses are in Software Expense or Office Expense. They’re functionally the same categories and the $15/mo you’re spending isn’t gonna make or break any decision-making. Or, maybe you found a $10 mistake. That should be fixed before sending your Profit & Loss to your accountant or banker, but probably doesn’t matter when making internal decisions. On the other hand, if you notice an entire month’s worth of Payroll Expenses are missing, that’s a material issue that needs to be fixed.

(Note: where the line is between material and immaterial is up to personal preference and what you’re using the report for. If you don’t know where to start, let’s just say that no individual transaction should be off by more than $25 and no Profit & Loss line should be off by more than 0.5% of revenue. If you have $1,000,000 revenue, that means each line shouldn’t have more than $5,000 of mistakes (for internal decisions, you should totally fix that for taxes))

 

Action Item:

 

It’s tax season, so review your Profit & Loss before sending it to your accountant.

(By the way, if you’re a client, I’ve already reviewed it for you 👍)

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