Accounting

What is accounting?

Accounting (German: Rechnungswesen) is the umbrella term for all procedures by which a company records, prepares, evaluates and plans its business transactions in figures. By addressees and rules, it is divided into two areas. External accounting (financial accounting) informs third parties about assets, liabilities and results. Internal accounting (management accounting) provides the management with a basis for decisions. The external part resembles a report card issued for outsiders under fixed rules. The internal part is more like a training log that the management itself works with.

Business administration classically distinguishes four sub-areas: bookkeeping and annual financial statements, cost and performance accounting, ratio and comparative analysis, and planning. Controlling uses these sets of figures to set targets, identify deviations and support steering. In funding rounds and company sales, both areas come together. The annual financial statements evidence the past; contribution margins (revenue less variable costs), metrics and planning justify the valuation.

External accounting

External accounting includes bookkeeping, the annual financial statements under the HGB and the determination of profit for tax purposes. Corporations generally extend the balance sheet and income statement by notes to the financial statements, and medium-sized and large ones additionally prepare a management report (Section 264(1) of the German Commercial Code, Handelsgesetzbuch, HGB). Through the principle of authoritative linkage (Maßgeblichkeit) (Section 5(1) of the German Income Tax Act, Einkommensteuergesetz, EStG), the commercial balance sheet is the starting point of the tax balance sheet. Addressees are shareholders, creditors, banks, the tax authorities and, through publication (Section 325 HGB), also the public.

Content and form are regulated by law and designed for prudence. Profits may be reported only when they are realised on the balance sheet date. Foreseeable risks and losses that arose up to the balance sheet date, by contrast, are already taken into account (Section 252(1) no. 4 HGB). This serves creditor protection and capital maintenance but makes the annual financial statements a limited steering instrument. The international accounting standards IFRS (International Financial Reporting Standards) are mandatory in Germany mainly for the consolidated financial statements of capital-market-oriented companies (EU law, supplemented by Section 315e HGB). For most growth companies, the HGB continues to apply.

Internal accounting: cost accounting and controlling

The form of internal accounting is not prescribed by law and follows the management's need for information. Its core is cost and performance accounting. Cost type accounting asks which costs have arisen, cost centre accounting where they arose and cost unit accounting what for: for which product, which customer or which project. Overheads that cannot be assigned directly to a product are classically distributed to the cost centres by cost centre accounting using the cost centre accounting sheet (Betriebsabrechnungsbogen, BAB), from which mark-ups for the calculation are determined.

Expenses and costs

Costs are not the same as expenses. Non-operating, out-of-period and extraordinary expenses are left out of cost accounting. Conversely, it applies imputed costs that do not appear as such in the annual financial statements, for example depreciation based on replacement values over the actual useful life or interest on the equity employed. A fully depreciated but still used asset no longer causes any expense under commercial law but continues to cause costs in the calculation.

Contribution margin accounting and controlling

Marginal costing first deducts the variable costs from revenue. The remaining contribution margin shows what a product, a customer or a project contributes to covering fixed costs. This is the basis of unit economics, that is, the profitability per customer or contract, which investors examine for recurring business models. Controlling links the actual figures with planning and budgeting, explains deviations and condenses the result into a few metrics. For a GmbH (German limited liability company), Section 1 of the German Corporate Stabilisation and Restructuring Act (Unternehmensstabilisierungs- und -restrukturierungsgesetz, StaRUG) requires the management to monitor continuously developments that could endanger the company's continued existence. Without internal accounting, this duty can hardly be met.

Worked example: contribution margin accounting in internal accounting

A software company generates revenue of EUR 4.5 million, of which EUR 3.0 million from subscriptions and EUR 1.5 million from implementation projects. The income statement shows an operating result of EUR 0.3 million. A two-stage contribution margin accounting shows where it comes from. Contribution margin I deducts the variable costs from revenue. Contribution margin II additionally deducts the fixed costs that can be assigned directly to a product line (product-specific fixed costs). What remains after that bears the company's common costs (company-wide fixed costs).

• Subscriptions: EUR 3.0 million revenue minus EUR 0.6 million variable costs for hosting, payment processing and support = contribution margin I of EUR 2.4 million (80%)
• Projects: EUR 1.5 million revenue minus EUR 1.2 million variable costs for project hours and freelancers = contribution margin I of EUR 0.3 million (20%)
• Subscriptions after product-specific fixed costs of product development of EUR 1.1 million: contribution margin II of EUR 1.3 million
• Projects after product-specific fixed costs for project management and tools of EUR 0.4 million: contribution margin II of minus EUR 0.1 million
• Sum of contribution margins II: 1.3 minus 0.1 = EUR 1.2 million
• Operating result after company-wide fixed costs for sales, administration and management of EUR 0.9 million: 1.2 minus 0.9 = EUR 0.3 million

The result comes entirely from the subscription business; the project business does not cover its own fixed costs. It does not necessarily follow that the projects should be discontinued: implementations are often the prerequisite for new subscriptions, and part of their fixed costs would not fall away immediately. For valuation, the split matters nevertheless, because investors and buyers generally weight recurring revenue higher than project revenue.

Accounting in funding rounds and sales

In financial due diligence, the reviewers combine both areas. The starting point is the figures of external accounting, which they break down by products, customers and cost centres using internal analyses. This produces the analysis of earnings quality (quality of earnings). It usually leads to the adjusted EBITDA, earnings before interest, taxes, depreciation and amortisation without one-off effects. The planning in the financial model is measured by whether it demonstrably builds on these actual values.

Investors and buyers recognise quality by a written definition of each metric, by cost centres that have been cut in the same way for years and by a monthly report with a budget vs actual comparison. They examine the reconciliation particularly closely: revenue and result in the management report must be traceable to the business management evaluation and the annual financial statements. As the company grows, this task shifts from the tax adviser to a dedicated finance function, the CFO (Chief Financial Officer).

Distinctions: accounting, bookkeeping and controlling

• Bookkeeping: the documenting part of external accounting. Accounting additionally comprises closing, cost accounting, comparative analysis and planning.
• Controlling: a management support function that uses the data of accounting for planning, steering and control. Accounting supplies the figures, controlling their interpretation and the proposals for measures.
• Financial model: the part of planning that links income, balance sheet and liquidity planning over several years. It calculates forwards, whereas bookkeeping and annual financial statements depict what has happened.
• Business management evaluation: an intra-year condensation of financial bookkeeping. It belongs to the external data stock and does not replace cost accounting.

Common mistakes

• Calculating only externally. Anyone who evaluates only the annual financial statements recognises losses of individual product lines only with a long delay.
• Balance sheet values as the basis of calculation. Depreciation based on commercial or tax useful lives often does not reflect actual consumption of value and leads to prices that do not cover costs.
• Flat overhead mark-ups. A uniform percentage on all products hides which service carries the result and which burdens it.
• Inconsistently defined metrics. If recurring revenue or the churn rate is delimited differently from quarter to quarter, time series lose their informative value.
• Missing reconciliation. If the management report and annual financial statements cannot be reconciled with each other, reviewers doubt both.

Frequently asked questions

What are the tasks of accounting?

It fulfils four tasks: documentation, accountability, control and planning. In concrete terms, it records all business transactions without gaps, accounts to shareholders, creditors and the tax office, monitors profitability and solvency and supplies the figures for decisions. The first two tasks are borne mainly by external accounting, the other two by internal accounting.

Is internal accounting required by law?

Not in a particular form. Indirectly, however, the annual financial statements also need data from cost accounting, for example to value self-created assets at their production costs (Section 255(2) HGB). In addition there is the duty of early crisis detection under Section 1 StaRUG.

When does a dedicated cost accounting pay off?

As soon as the company has several products, customer groups or locations. At the start, a contribution margin per product group derived monthly from the bookkeeping suffices.

Must growth companies report under IFRS?

As a rule, no; the HGB is decisive. IFRS become relevant if an IPO is planned or if an investor or acquirer demands reconciliations for its own consolidated accounts.

Who is responsible for accounting?

Legally, the management. In practice, the tax adviser often takes over bookkeeping and closing, while planning, cost accounting and reporting lie with an internal finance function or an interim finance manager.

The Roemer Capital view

In investor conversations, the annual financial statements are rarely enough. Questions are asked about contribution margins per product line, customer acquisition costs and the value of a customer over the entire contract term. Such figures arise only in internal accounting. For Roemer Capital, KPIs and unit economics are among the four pillars that show whether a company is investor-ready. A ratio of customer value to customer acquisition costs of at least 3 to 1 can be evidenced only with data at customer level.

If this view is missing, Roemer Capital builds it as part of its fractional CFO services: planning, monthly reporting and a reconciliation to the figures of the tax adviser. External accounting stays with the tax adviser. The task of Roemer Capital is that both views fit together before an investor places them side by side.