Why The GAAP Principle Will Destroy Your Business
The GAAP is wrong.
Before you hit the "comments" section, let me clarify. I do believe following the GAAP (Generally Accepted Accounting Principles) is important so that when the time comes, you are prepared to submit financial statements for investors, mergers or the IRS. However, using the GAAP as your primary accounting method is the wrong way to grow a hugely profitable business.
Just because something appears to be true and "everyone" goes along with it, doesn't mean it makes sense—and it doesn't make it true.
Take a look at your latest income statement. At the top you have revenue, then costs of good sold, then other expenses such as sales support, general expenses and administrative costs. If you are like most entrepreneurs, you take your salary from the net income. And if you still have a few pennies left over afterward (which rarely happens), that is your profit—way down there at the bottom of the page.
Yet if you consult any financial expert, you'll hear that the secret to financial success is to pay yourself first. This is sound advice because most of us expand our expenditures to fit our disposable income. We spend more when business is good. No matter how much we earn, we seem to find a good reason to spend every single dime.
The GAAP actually directs us to spend first, then pay ourselves, and call the leftovers profit. How are you going to grow a successful business and accumulate wealth using that method? Generate more revenue, you say? Well, sure. Except that you're going to spend it. So you're right back where you started—working with the leftovers, if you have any.
I propose a new type of accounting: Profit First Accounting (PFA). The difference between GAAP and PFA is simple: Deduct profit first, from the top down. On a PFA income statement, the first line item is revenue, followed by a profit deduction, then your salary, followed by cost of goods and all other expenses.
Now, before you say, "But the end number is still the same," hear me out. When you change to using the PFA model, and your new profit-and-loss statement shows that you are losing money, you will focus on how to get back to black. But this time, the bottom line isn't your salary or your company's profit—it's the expenses.
There are many benefits to PFA, such as the ability to track growth in a consistent, proven pattern, which will appeal to investors and potential buyers should you decide to sell. But the best part is you will be in control of your costs from the get-go. Since your revenue will first go toward profit and then your salary, there will be less to spend on expenses. Many small-business owners determine how much they can spend based on the cash they have in the bank. The PFA method automatically forces frugality, since your profit is deducted every time cash comes in the doors.
So how do you know how much profit to deduct? Review the income statements of financially healthy public companies in your industry to find out how much they throw to the bottom line. Is it 5%, 10% or even 15%? Whatever it is, set that percentage as your "profit first." Then every time you make a deposit, take that percentage and put it into your interest-bearing PFA account.
I've been following this PFA method in my own business for years, and I have helped my clients implement this method in their businesses. The results have consistently been more profit and tighter control over expenses. The PFA is a simple adjustment that forces you to follow what you suspected all along: Pay yourself first. Galileo would be so proud.