Many founders are surprised at the total cost of accounting and tax preparation.
While there are a lot of reasons, the biggest cost contributors are related to two things:
- The differences between personal and business tax code.Most people are familiar with personal income tax preparation. At the end of the year, you add up all your income (salaries, income from investments, 1099s, etc.) minus a few potential deductions, and you can easily calculate your tax burden.
- Business income taxes are much more complex. Although they are based on existing information within your accounting system such as revenue and expenses, there are nuanced rules around what expenses are deductible and the timing of when they are deductible, mostly depending upon when the services were performed, rather than when money changed hands. Furthermore, there are additional tax filings for franchise taxes, issuance of 1099s to contractors, and so on. This requires more time, effort, and detailed tracking compared to a personal income tax return.
- Investor expectations.Venture investors expect formal financial reporting (often, accrual financial statements), and common investor request often require additional metrics and customer data needed to value a private company.
For both of the situations mentioned above, preparing accrual financial statements and sharing metrics that investors will trust requires significant additional effort from accounting personnel.
So what goes into preparing financial statements and metrics for a company?
- The cost of the software (fixed)This is the direct software cost of a system like Puzzle, Quickbooks or Xero. The cost scales with company size and additional features.
- The cost of bookkeeping (fixed + variable)This is the hourly rate of a bookkeeper ($) * # of hours of work. Most independent bookkeepers charge $80-$125/hour or more, controllers $125-$175/hour, and CFOs $200-$400/hour and some new startup bookkeeping firms even charge a percent of expenses.
- The cost of tax preparation (fixed + variable)This is partially based on how much you invest upfront for setup.
There is also an underestimated hidden cost: the time and effort required for a founder or business operations leader to coordinate and compile all the necessary information if there are shortcomings in the information included in the software.
The biggest contributor to how many hours it takes is the complexity of the business and the decision to prepare cash vs. accrual financial statements. A cash accounting basis recognizes money when it is received, while accrual accounting recognizes revenue when it is earned. Since it is expensive to go back and prepare accruals later, startups that plan to generate meaningful revenue or raise capital from day one often choose to do accrual financials.
The bulk of bookkeeping hours relates to calculating the adjustments required to prepare accrual financials. As one example of the type of adjustments that are required, consider the accrual accounting process for revenue. For illustration, assume a customer pays you $1,200 upfront for an annual plan at a price of $100 per month. In accrual accounting, you can only recognize $100 of revenue per month for delivering the service. Initially, this would be considered “deferred revenue” (on the balance sheet), and each month you have to add $100 of revenue, and subtract $100 from the deferred revenue balance. Most companies track various accrual schedules in Excel because current SMB accounting software does not natively support accruals.
Accounting Costs Example
Fundamentally, the purpose of accounting is to answer two questions:
(1) are all of the transactions in the system (i.e. are financials complete)? Accounting systems and personnel accomplish this through a series of reviews and reconciliations.
(2) are all of the transactions categorized the right way (i.e. are financials accurate)? Accounting systems and personnel accomplish this through creating a robust chart of accounts (i.e. the relevant categories for accounting purposes) and making sure all the transactions are properly categorized and tagged.
Let’s look at a hypothetical but realistic scenario to illustrate how the considerations above translate into the total cost of accounting. A founder and four employees just raised a seed round. They are building a product and not yet generating revenue. They rent space at a WeWork and have some monthly expenses such as lunches and software. They use industry best practices for startups to select a business bank account such as Mercury or SVB, a payroll provider such as Gusto or Rippling, and a dedicated company card such as Brex or Ramp.
- Revenue = $0
- Expenses = $55,000 per month
- Salaries and Benefits = $100,000 * 5 employees * 20% benefits simplification / 12 months = $50,000 per month
- Office Space = 5 employees * $500/month = $2,500 per month
- General Operational Expenses = $2,500 per month between software (AWS, G Suite, Slack, etc), office food, computers, etc
While this can vary, it typically takes about 5-10 hours per month once everything is set up to complete the bookkeeping process. At an hourly rate of $80 (which is low for some bookkeepers), that means about $400 to $800 per month for non-revenue generating, simple startups with no additional questions or support needed. You can see some pricing here for well known startup bookkeepers here and here.
So, if we assume a bookkeeping expense of $650 per month, that is $7,800 annually plus an estimated $2,000 for simple federal tax preparation (don’t forget state or local taxes and filings), for a total of about $10,000 per year. The cost can get even higher as you prepare aging reports for accounts payable, accounts receivable (typical fee of $125-$170/hr), revenue recognition (typical fee of $150-$200/hr), and financial modeling (typical fee of $400/hr). In our next post, we’ll look at ways to minimize the cost of accounting while still remaining compliant.