How important is first year accounting?
Photo by Katie Harp on Unsplash
One of the most common questions we receive from new founders is: Do I need accounting for a brand new startup (company) only in its first year?
For new startups, it is highly likely that you may not see any revenue or sales in the first year. Even on the expenses side, there may only be one or two costs accrued per month. So, how important exactly is this first year accounting?
The short answer:
Important enough that you should do it.
The more detailed answer in three points:
There is more to accounting than just revenue, costs, and profit.
Company assets and capital are relevant from the date that the company is established officially, and these numbers are tracked on an ongoing basis in a financial document called the “Balance Sheet.” These numbers carry over from year to year, and so you can imagine that starting in the later years could be quite a large task, as you try to trace the numbers from the very beginning.Net losses can be carried forward to reduce tax liability in the future.
As most of us already know, all KKs (the most common form of startups) are required to pay a minimum of ¥70,000 in corporate tax, even when filing a year with net losses.However, net losses can be carried forward to offset later years with positive profit.
Loss carryforward works in the following way:
Losses carried forward can offset up to 50% of taxable income for a given year
Newly established companies that do not belong to a large-sized company group (usually the case for independent startups that are not subsidiaries) can offset 100% of taxable income for the first 7 years
Losses can also be carried forward for 10 years
To highlight how significant this can be, let us look at an example. Say you established a startup in 2022 and book net losses for the first two fiscal years of 2022 and 2023. Then from 2024 and on, you start booking positive profit, leading to taxable income.
For the loss booked in 2022, this can be carried forward to deduct up to 100% of taxable income per year starting with your first positive year of 2024 until 2029 (first 7 years of incorporation), and then deduct up to 50% taxable income per year for the remaining years up to 2032, until the entire loss ‘credit’ is used up.
The loss booked in 2023 can also deduct up to 100% of taxable income per year for the period within the first 7 years of establishment, and then deduct up to 50% taxable income per year for the remaining years up to 2033, until the entire loss is used up.
As you can see, properly tracked expenses — and therefore losses — can help reduce your tax liability greatly when you finally enter the positive profit part of the typical startup J-curve. This in itself should be an incentive to practice proper accounting right from the start.
Future investors and/or key shareholders want to know your financials at all times.
If investors or shareholders ask you “What’s your current burn rate?”, you should be able to answer with an accurate number. There should be no guessing involved. Especially for those who are invested into your company, they want to check-in frequently to see what costs you might be incurring and — usually in the case of VCs — help direct or redirect you based on current financial status. By keeping track right from the beginning, you can see for yourself how your production, development, and operations are trending and make adjustments wherever necessary. At the same time, investors can use these trends to predict future development costs and make investment decisions. If your goal is to convince investors that your startup is a worthwhile investment, it starts with presenting clean financials and good tracking.
With that out of the way, let’s address some other questions that you may have.
I know nothing about accounting. Do I need to spend money to hire an accountant right from the beginning?
No, you do not!
Accountants can aid your company in two ways:
As a retainer — this is the case where you pay your accountant a monthly “subscription” fee so that they can oversee and manage all of your accounting for you. They will categorize your expenses for you, and keep track of all incoming and outgoing money.
As a tax filer — this is where you pay for the accountant once a year to gather all of your transactions for the year, organize it, and file the tax return on your behalf.
Depending on what you can afford and what you are going for, some new founders go only the second route of getting an accountant to help them file once a year. A retainer relationship with an accountant may not be needed until you scale further and have many more revenue channels and expenses to keep track of. The key here is that you do not have to hire an accountant right off the bat, but you can choose to do so.
If I don’t hire an accountant and I know nothing about accounting, then how can I start “practicing proper accounting” myself?
By starting with tracking your own expenses diligently. Especially for new startups, your expenses will most likely start off very minimally, with only a few transactions per month. There is an abundance of free to affordable software that can help you do this yourself. To name a few,
Moneytree — an English interface is available
freee — fully Japanese interface, works decently with in-browser Google Translate, can prepare tax return documents
MoneyForward — fully Japanese interface, can prepare tax return documents
Many of these software have built-in tax return preparation capabilities. A common myth is that a corporate tax return must be filed by a licensed accountant. This is not true — you are well within your rights to file your own corporate tax return.
Another alternative is to use something as simple as Google Sheets or Microsoft Excel to track your own receipts and expenses. It matters less about what you are currently using, and more about the fact that you are actually doing it. If you are more of a spreadsheet type of person, Startup Work also offers a downloadable expense tracking template on the free resources page.
What’s the point of tracking my own expenses if I have to file taxes anyway, and therefore I can just pay an accountant once a year to do it for me?
This is true. If you pay an accountant to file for you once a year, they can definitely handle all of your transactions and expenses at that time. But that’s the keyword — once a year. Going for a full year without knowing or tracking your expenses is a long time. Even if you are keeping a close eye on your bank account and remaining capital, when time comes to cut back costs or reevaluate your spending rate, you may find yourself taking out extra time to go through all of your past spending. If everything is tracked as you progress, you can reference the data at any time and make adjustments as you go.
Also, if we recall back to point 3 above when we discussed the importance of accounting, having this information ready when talking to investors and shareholders is much preferable than having to wait an entire year to get the information from your accountant.
The last point to make is that the accountant’s cost categorizations and deductions, while correct from a tax standpoint, may not be sufficient from an internal company cost analysis standpoint. For example, say that the largest tax category of your expenses is “Consumables” based on the documents prepared by the accountant. If you need to cut back costs, you have now identified that “Consumables” is the one you want to cut, but you do not know any further details without spending time and digging further. However, if you have been tracking your own expenses and categories, you may easily see that you have been spending a lot on expensive coffee for your team under the “Consumables” category, and should probably switch to cheaper coffee or cut down on coffee intake. This is also one (of many) reasons why some companies may run two sets of financial statements. One is prepared by the accountant for tax filing and uses very generalized deduction categories, and one tracked internally to keep full transparency and detail on exactly what each cost is and where it is being spent.
Accounting seems like a tedious task, and as new startup founders, we have a hundred and one things to do every single day. It is very easy to write off accounting as something that is not “worth our time” when so many other arguably more important things need to be done.
However, it is good to remember that accounting is not just for filing tax according to the law. New startups usually look to investors, and if investors are involved, then obviously so is money — and by extension, the earning and spending of money. Good accounting practice can start simply with tracking expenses, which might only take as much as 30 minutes of your time in a single week. The rewards of doing so outstrips the effort involved, and we highly recommend any new founders to start by tracking expenses if they have not already.
