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How are assets classified in accounting?

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In my previous post, I introduced assets. Now let’s see how assets are classified in accounting.

There are two major asset classifications 1) non-current and current, 2) tangible and intangible. Let’s have a brief look at each.

Non-current versus current assets

A non-current assets is one which typically cannot be converted into cash within one year. The classic example of a non-current asset is plant, property and equipment. Current assets normally convert into cash within one year e.g. receivables from customers, inventories. This non-current and current classification is used in the financial statements of most organisations.

Tangible versus intangible assets

This one is a little more tricky to understand, and it is something not normally seen on financial statements. As you might guess, a tangible asset is one which you can see and touch i.e it physically exists. Typically examples are again, plant, property and equipment, but also inventories are a tangible asset. Money due from customers is also arguably a tangible asset, as it does exist as money albeit somewhere outside the business. Intangible assets are those which do not physically exist, but yet have a value. This value may arise from intellectual or legal rights. For example, trademarks, patents, in-house software or knowledge built up through research and development are intangible assets. The accounting standard which governs intangible assets is IAS 38, and it gives some examples:

  • computer software
  • patents
  • copyrights
  • motion picture films
  • customer lists
  • mortgage servicing rights
  • licenses
  • import quotas
  • franchises
  • customer and supplier relationships
  • marketing rights.

 

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What is an asset?

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The next few posts will provide some basic accounting terms and definitions – concentrating mainly on assets.

So what is an asset? If I look at a dictionary, I might see something like “a useful thing” or a “desirable quality”. This may be correct in a general sense, but in accounting we need to get a bit more specific. But before we do that, would you regard something which is useful or desirable as having some value to you? I’ d hope you say yes. Now keep that in mind.

If I look to some accounting rules such as the IASB Framework I get the following:

” An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity”

Let’s break that down:

  • It is controlled –  does this mean you must own an asset. Simply, no, as you can control something, but not legally own it
  • It as a result of past events – this means you bought it or somehow acquired it or rights to use it in the past
  • Future economic benefits  will flow – this means it will be something which directly or indirectly allows the business to make money. For example, an office building does not sell anything (usually) or deliver goods, but without on the business cannot carry on its work to bring in those economic benefits i.e. cash and profits.

So, going back to the general idea I introduced at the start, if you want a very basic tip to identify an asset, think of it as something of value to a business – a truck, a machine, a building, customers you owe money etc,

 

Expense tracking – there’s an app for that

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To keep track of the many things I do, I have to take notes.  For example, all the posts on this blog are noted somewhere first and then I write about them when I get time. I use a product called Evernote, which is just brilliant. I can do anything I want in this app in terms of taking notes. And, like all apps there tends to be adverts for related products from time to time.  One I found interesting (but don’t use) is Expensify.  This app seems to be very useful for track this annoying expenses. You can see more here on the app’s features. One thing it might be really useful for is those annoying fuel receipts small businesses have. For example, a sole trader might have 2 or 3 receipts for diesel each week, which are probably paid for in cash. These receipts frequently get lost and are a pain to store too. So it might be useful to use a product like Expensify to take a snap shot of these and store them. You can also use the app to track mileage, so this might be useful for small companies whose employees may get paid mileage.

Is double entry accounting here forever?

Some time ago, I read a blog post on the Zoho website about double entry accounting. Zoho provide a number of business related applications. The essence of the Zoho blog post is conveyed in the title of this post. Double entry accounting has been around for the last six centuries and has been embedded in the most simple and most complex accounting software. And there are no signs of it disappearing. The have been some proposed alternatives, such as the Resources, Events, Agents model (which is sometimes used in teaching). But like the DVORAK keyboard, even if some alternatives may be an improvement on the double entry system, they are likely never to catch on. Why you might ask?  Well, in my institutional theory thinking the answer is probably because the practices around double-entry accounting have been repeated so many times by so many people, that they have become the accepted way of doing things in business. In other words, the double entry system of accounting is a routine. And, not only that, there are also rules about double entry. I regard rules as written, and there are plenty of written rules of the double entry system – in text books, in software for example. If a practice has both been repeatedly performed for 600 years or so, and it has been written as a rule, the as the Zoho blog post says ” the traditional double-entry model was deeply ingrained in the business person’s and accountant’s psyches, and it was never going to be easily changed”. And it will probably remain so.

What is a ledger account?

Sometimes we often forget the basics of accounting. It’s so easy nowadays to forget what’s behind the transactions and journal entries we make in accounting software. So, today I’ll got back to basics and describe a ledger account. Ledger accounts can be used in financial and management accounting to accumulate things like costs, revenues, the value of assets etc.

It’s probably easiest to describe what a traditional manually written ledger account looks like. The term T account (see left) is often used to describe a ledger account as this is what an account looks like in a handwritten ledger (a ledger is just a type of notebook). The left side of the account is called the Debit side, the right hand the Credit side. The details of every business transaction can be recorded in a ledger account. There are rules (called rules of double entry accounting) which tell us what to do. What we do depends on the type of transaction. If we wish to record an increase in an asset or expense , then we record the details (date, amount, some narrative) on the debit side of the account. If we wish to record in increase in an income, liability or capital account, then we record the details on the credit side. For example, if I make a sale for cash of €1,000, I would record this on the debit side of the bank account and the credit side of the sales account. There are always at least two ledger entries for every transaction – this is the double entry system of accounting, which you can read more on in this post. If I were to enter this cash sale in some accounting software, while I might not see a ledger account, the principles are there in the background. For example, some software might show debit entries as a plus, credits as minus. No matter what the software, be it simple like Quickbooks or complex like SAP, the same process as a manual ledger account occurs.

Single entry accounting

Elsewhere on my blog, I have written a post of the basics of the double entry accounting system. I had a comment on this post asking for some more information on single entry accounting – so here it is.

The basic idea of the double entry accounting system is that information is recorded twice. The system allows any business or organisation to get a picture of its incomes, expenditures, assets, liabilities and capital at any point in time. The double entry system is encoded into all accounting software and is the basis of all financial reports of businesses.

In the double entry system, any transaction is recorded from its source all the way through to the financial statements. For example, if a supplier is paid the following happens:

  • the cheque is recorded in a “day book” – normally a cash/cheque payments book
  • the suppliers balance is updated – in a personal ledger account
  • the bank balance is updated
  • by virtue of the previous two items, the assets (bank) and liabilities (trade payables) are updated
  • the financial statements (income statement and balance sheet) are updated.

In a single entry system, some of the above is not done. The best way to explain this is by an example. When I worked in small accounting firm some years ago, most sole traders kept what were single entry records. At that time (the early 1990’s) most small sole traders kept records in a manual form –  most had no computer anyway. The records would typically comprise  a book where all purchases/expenses were recorded, a book where all payment in and out of the bank were recorded and a book where all sales were recorded. Records of things like assets – how much was owed by customers or records of vehicles for example – and liabilities – how much was owed to suppliers for example – were not kept. Using these books, it is only possible to prepare an income statement. Thus, as the double entry system is not applied in full, i.e. transactions are not recorded through ledgers in this example, then the single entry system applies.

It is not possible to say that the single entry system means that only certain specific records are kept. It’s probably better to think of the single entry system of accounting as one which does not fully use the principles of double entry, but does allow profit to be calculated. In the example above, what we did was to build up a list of the assets and liabilities, as well as the capital of the business, to allow us to prepare an income statement (profit and loss account) and statement of financial position (balance sheet).

Three acounting mistakes made by entrepreneurs

I read an article on entrepreneur.com a few months ago. It recounted the experiences of some entrepreneurs in terms of the common accounting mistakes made. The 3 top mistakes/misconceptions according to this article are:

1.  Treating sales as revenue before the product is delivered or service provided. A common mistake actually. For example, if you have agreed to sell goods in March, you cannot record the sale until then. There are some exceptions, but let’s keep it simple.

2. Capital expenditure is not reflected in the accounts immediately. If you buy a new asset, you part with some cash. But in accounting, the cash amount spent is recorded against profits over several years.  Sometimes the cash outflow may be too much, so you need to consider the cash situation of the business.

3. Proftit and cash flows are confused. The best way to explain this is to think of selling on credit. If you sell on credit, the sale is recorded, but you don’t get the cash for some time later. So, you could be profitable but have no cash – a bad scenario.

The article gives some real examples, so have a read.

The right accountant for my business?

I’ll a bit lazy today, so here’s a useful recent blog post from smallbusinesscan.com  The right accountant for my business?. It’s a good check-list if you’ve just started out in business.

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Top 10 Book-keeping mistakes made by small business

Still on holidays, so a shorter piece again. I found this post on all allbusiness.com. It is US orientated, but you’ll be able to change VAT for sales tax and dollars for euro/pounds. The post gives some good tips, whether you’re looking after your own book-keeping or getting someone to do it for you.

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Performance indicators in small businesd

Measuring performance of any kind means a target, plan or standard must be in place to measure against. Any business, large or small needs some kind of a plan. In the accounting world plans equals budgets – yes those annoying things! A budget is plan expressed in money terms. Usually budgets for incomes and expenditures are set for a year and each month the business performance is measured against the budget. This is common practice in many businesses but how useful the comparison of results versus budget is depends on how good the budget was in the first place. Should a business complement measuring against budgets with other types of performance indicators? Yes is the answer. Larger businesses use many indicators of performance other than comparing to budgets or profits. For example, a key performance indicator for an airline is”bums on seats”. This is something that can be measured by flight, day etc and related to the costs of running the airline. Could a small business do something similar? Sure it can. Here’s an example for a business I know. This business automates entrances gates for residential and business customers. It offers both installation and maintenance services. As a small business, the owner does not have the time (or staff) to do detailed plans and compare these to actual performance. But, he does know the costs of running the business. So he equates costs to a number of service calls or installations needed per week. For example he knows he needs to do 5 service call to cover wages. One installation and 5 service calls covers all costs and makes a profit.This is a little easier to track and relates the work done to performance in terms of covering costs. It might not be 100% accurate, but it’s a good guide. So what performance indicator would you use for your business?

Can I employ myself and treat this as an expense?

If you have just become self-employed, you’ve got a million things on your mind and book-keeping and accounting is not usually top of the list.  But there are some important things you need to do in terms of getting registered for various taxes.  What I say below, and the title of this entry, was inspired by a conversation I had last night with someone who was looking for some help with book-keeping.

Let’s assume you become self-employed i.e. you are a sole trader. In any of my books, the early chapters explain the format a business can have (sole trader, partnership or company) and also a fundamental accounting concept – the entity concept. This concept means that the person is separate from the business. So here’s an outline of what happened to this guy I met last night. He lost his job and set up his own business as a sole-trader.  He got some bad advice telling him to register as an employer with the tax authorities and pay himself a wage i.e. he was both the employer and the employee. Under the entity concept this could not happen. Why? When a sole trader makes a profit, a portion of this profit (usually called drawings) can be withdrawn for personal use. Or in accounting  jargon, the business entity gives a portion of the profits to the person behind the business.  Wages are an expense in the accounting world, being deducted from revenues to calculate profits.  And, wages are paid to employees you must by definition be a different person or entity from the employer. If this business was a company however, the story would be different. A limited company is a separate legal and accounting entity, so the guy I was advising could set up a company, be a director of that company and pay himself a wage. So, in summary if you are a self employed sole trader, you cannot pay yourself a wage as if your were an employee; instead you withdraw some portion of the profits to live on.

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Outsourced accounting?

Brian Skelly wrote recently on outsourcing the work of accounting practices in Irish monthly journal BusinessPlus (www.bizplus.ie). The piece detailed an Irish firm Online Web Accounting (OWA), who are a small accounting practice based in County Meath.  OWA  provides normal accounting services, but also provides value-added services such as monthly management accounts  – all at minimal cost. In fact, Nigel McAuley OWA founder, says he can deliver such services “without being substantially more expensive than an annual service”.  How can OWA do this?  Well, the firm have reduced costs by outsourcing back office task like book-keeping to their office in Sri Lanka. Here, salary costs of accountants and book-keepers are approximately 25% of Irish levels. Is this a trend to watch out for? For smaller and growing businesses, this might be just what is needed to provide improved management accounting information, without a corresponding increase in cost.

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Choosing the right accountant for your business

I read a piece on inc.com recently about how to choose the right accountant for your business.  I’ll summarise it  here and add my own few thoughts. By the way, the picture on the left pops up in a google image search for “accountants”. Not the typical image we have of an accountant perhaps!

The piece on inc.com starts off with great question and answer.

Q: What’s the definition of an accountant?
A: Someone who solves a problem you didn’t know you had in a way you don’t understand.

This Q&A is of course a bit of a joke, but it is often the case that the problems with many smaller businesses is that the owners don’t have the knowledge or time to work with the numbers. Or buying some accounting software is just not top priority. hence the need to hire an accountant.  Assuming you need to hire an accountant, here are some things to think about:

1 .  What do you need the accountant to do?

If your business needs regular information of an accounting nature, then it might be worthwhile actually employing an accountant. This might be the case in larger businesses. The alternative is to engage the services of an accountant as needed e.g. at year end.

2. What qualifications and experience should the accountant have?

Unfortunately, in Ireland the word “accountant” can be used by anyone. Therefore, be sure you engage someone who is a member of one of the recognised professional bodies.  If  it’s a book-keeper you need, ask for references from other clients. If your business is a start-up or small one, you might be better off avoiding larger accounting firms as these tend to be able to give you less time.

3. There is no substitute for a personal recommendation. Ask someone else in business questions like “Are you happy with your accountant?”, ” Does your accountant help your business”?. If you are hiring an accountant as an employee, check their references and ensure they have a professional qualification.

4. Going back to the Q&A at the start, can you talk to your accountant? Or ask this another way, can your accountant talk to you? You need someone you can understand your business and problems if has, and be able to communicate to you in simple terms. Go and meet any prospective accountant and you’ll get a feel for what I call their social skills.

5. Can your business and your accountant grow together?  Most smaller businesses will start off with an accountant doing accounts and tax returns at year end. But as your business grows (hopefully) can your accountant offer more services. This might be something as simple as working with you on expansion plans, but it is worth asking any prospective accounting firm what skills are within the firm.

To conclude, when you get to the point of needing an accountant, take your time to choose the right one.  Remember, the accountant is a key person in your business, both now, and in the future.

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A simple way to bill customers – software you can use for free!

I read this article in Business & Finance (Ireland) recently and thought, whoa, this is too good to be true! A new website called billfaster.com offers small business owners the ability to create good looking invoices for free – yes free! I had a quick look at the software, and it is free to start off with. You can, according to the website, add more features at a charge but the basic invoicing function is free. You can easily (3 clicks they claim) create and invoice and print it or email it to your customer.

To be fair, the 3 click is probably right if you have all your products and customers set-up. The invoices created are quite professional and all is in simple layman’s terms. The whole idea is wonderful for a start-up business in two ways 1) it’s free and 2) it helps you get off to a good start in terms of accounting – a point I keep on making in my books. As the system is web-based, this means your accountant can hop in every so often to see if you doing okay and also you don’t need to worry about things like computers failing or needing backups. A big drawback though is that although invoices can be done, that’s as far as it goes it seems on the free version. You cannot for example get any reports on how much each customer owes you etc.

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The basics of double-entry accounting.

The double-entry system of accounting is used to records business transactions. No matter how simple or complex the transaction, it is recorded in ledger accounts with a debit and credit entry. The rules are double-entry accounting are incorporated into all accounting software, even if you don’t see them!

The double-entry accountin system ensures the integrity of business transactions and their financial values. It does this by ensuring that each individual transaction is recorded in at least two different ledger accounts and so implementing a double checking system for every transaction. It does this by first identifying values as either a Debit or a Credit value. A Debit value will always be recorded on the debit side (left hand side) of a ledger account and the credit value will be recorded on the credit side (right hand side) of a ledger account. A ledger has both a Debit (left) side and a Credit (right) side. If the values on the debit side are greater than the value of the credit side of the nominal ledger then that nominal ledger is said to have a debit balance and vice versa.

Luca Pacioli, an Italian monk, was the first to document the system in a mathematics textbook of 1494. Pacioli is often called the “father of accounting” because he was the first to publish a detailed description of the double-entry system, thus enabling others to study and use it

Click on this link for a brief animated tutorial I have put together to explain the workings of double-entry.

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