Comparing profits and other figures from accounts
One thing really annoys me about how the media reports company performance – they only ever give % increases or decreases in sales or profit typically.
If you have ever studied accounting you probably learned about ratios analysis, and how just looking at absolute numbers ( like sales or profit ) can give a false picture. Here’s a recent example from the Irish Times to illustrate what I mean.
According to the Irish Times (see here :
“Irish-owned book and stationery retailer Eason & Son has recorded a net profit after tax of €2.3 million in its financial year to January 2014, compared with €2.6 million the previous year. Eason Group revenues, however, were down 7.1 per cent to €227.4 million, in what the company called a “challenging year”.”
All the above is true, but if we do a quick calculation, profit as a % of sales ( profit margin ) is pretty much the same from one year to another. So despite a 7% drop in sales, costs must also have been well managed to maintain a stable profit margin. I appreciate the media try to keep these reports simple for the general public, but a little more depth would be very useful.
Incomplete records
Sometimes a business does not keep (or have) proper records. Most countries require a business to keep accounting records by law, so in my experience the only time a business does not have records is when there is something like a fire, or records are lost or destroyed. When this happens, there are several techniques which can be used to help “build” a set of accounts. Here is a nice article from CPA Ireland which details some of these.
More accounting tricks – Hollywood accounting
My last post noted some “tricks” used to make a budget balance. Here’s another story on how accounting tricks can be used to make something with huge revenues into a loss maker – it’s Hollywood accounting.
An interesting view on assets and income…
Here is a good post from worthytoshare.com which looks at a lady seeking a partner from an interesting view. It is worth a read, trust me
Accounting and public services
Accounting and accounting information is used for many purposes. Even the public sector immune to accounting information, and accounting-based controls. Recently (March 4th, 2014), BBC Radio 4 broadcast a very interesting programme (The Accountant Kings) on accounting in the provision of public services in the United Kingdom. Here is a link to the series website http://www.bbc.co.uk/podcasts/series/fileon4, and the podcast itself can be found at http://downloads.bbc.co.uk/podcasts/radio4/fileon4/fileon4_20140304-2050c.mp3.
A lively accountant’s website…
Have a look at this post from Accountancy Age. There is a link within to the website of a firm called Wood & Disney. It’s a well designed website, but with a touch of humour.
Overhead accounting error
Image from wikipedia
As I have written in a previous post, when error are discovered in financial statements, these errors should be corrected at the next available opportunity. This can mean re-stating published accounts. What to do is governed by IAS 8 — Accounting Policies, Changes in Accounting Estimates and Errors.
Finding examples of errors in published accounts for example or teaching purposes is not always that easy. In March 2014, Bloomberg reported an error in the financial statements of SolarCity, a large US solar energy company. The company made an error in how overhead costs were allocated between cost of sales and other expenses it seems. While overall profits/costs were not affected, the cost of sales figure increased by about $20m per annum for 2012 and 2013. You can read the full article here.
Building a better income statement – according to McKinsey
McKinsey have a nice web article which highlights the problems with GAAP reporting versus the needs of investors and analysts. The kernel of their article is that financial statements, with some small adjustments, could save investors a lot of re-working of figures. They provide the following example:
Image copyright McKinsey
Two things come to my mind. First, in my first real management accounting job almost 20 years ago now, we prepared an income statement which was not too far away from the one on the right above. And, most management accounting courses would teach students to draw up some kind so similar profit statement – at least separating direct and indirect costs.
Second, the articles does not mention XBRL at all. With tagged data from GAAP financial statements, XBRL could re-draw financial statements in any format. I am not saying all XBRL tags are there to do what McKinsey suggest, but it is certainly possible technically.
You can read the full article at the link below. It is worth a read.
Anyone can call themselves an accountant
Accountant upstairs ↑ (Photo credit: jah~)
Yes it’s true, anyone – in Ireland at least – anyone can call themselves an accountant. And, this has been the case for as long as I have been an accountant. I was reminded of this recently by an article in the Irish Times. To quote from the article:
“Don’t fret, because no qualifications are necessary to trade as an accountant. Anybody can open up a practice, no matter how innumerate they may be – there are no absolutely restrictions on the use of the term “accountant”. Remarkable, isn’t it?”
I guess it is remarkable. Yes, there are professional accounting bodies whose members must pass examinations and keep their training up to date. And yes, to be an auditor you must generally be a member of such bodies. But after that anyone can claim to be an accountant. As noted in the Irish Times, even an upcoming review and consolidation of Irish company law has failed (as yet) to include a provision of who can use the term accountant.
Related articles
- So, you think you are an accountant? (irishtimes.com)
Cash accounting – an alternative to accruals accounting? And what about accounting software?
English: Accounting machine from UK manufacturer Powers-Samas. (Norwegian Technology Museum, Oslo.) (Photo credit: Wikipedia)
In Ireland and the United Kingdom (and maybe come other countries) it has always been possible for smaller business to pay VAT based on cash received rather than on an accruals basis. You probably know what the accruals concept is, but if not click here. When I teach accounting or prepare accounts, the accruals concept is used almost without exception. The profit & loss account (income statement) and balance sheet (statement of financial position) will definitely use the accruals concept. In fact, these financial statement often take a different name and format when prepared for a cash-based business. For example, when I teach how to prepare the financial statement of not-for-profit organisations such as clubs, we often refer to a “Receipts and Payments Account” and a “Statement of Affairs”. The former is like an income statement, but is based on cash records; the latter is a list of assets and liabilities and will normally draw on the accruals concept.
From April 1st 2013, the UK tax authorities permits smaller unincorporated businesses to use a cash based accounting scheme where the turnover is less than £77,000 (see here for more detail). I’m not a UK tax expert, but from my reading about the topic on the web, the “income” of a small business will be the cash received, and the “expenses” will be cash paid for business expenses. This sounds like a reasonable effort to simplify the tax system for the smallest of businesses. The accruals concept may not be that relevant to many of these businesses as, for example, they may have few assets (to depreciate) and receive payment for most work as soon as it is done. So all fine? Well apparently, many accountants protested this new scheme, and that’s not surprising given how the accruals concept is engrained not only in the teaching of accounting, but also in accounting regulations. As a management accountant, I would always encourage the smallest of businesses to think in cash terms – it is easier for business owners with little accounting skills to understand. But I do see one big problem with this scheme in the UK. It centres around what happens when turnover exceeds £77,000. Once this happens, the business must revert to accruals accounting. This would cause much confusion if a business is using accounting software. Normally, accounting software incorporates accruals accounting, but some also support cash accounting in the way described here. I’m not 100% sure, but I would imagine if you set up software to work in one method, it may not be that easy to switch. So even though this cash scheme is easier and optional for small UK business, if they use accounting software (and more and more do) then it is probably best to stick to accruals accounting.
What is depreciation?
Okay, the last two posts were about assets, and now I’d like to give a brief introduction to depreciation. As you may know the accruals concept (also known as the matching concept) sets out how revenues and expenditures should be matched against each other – when cash is paid/received is nots relevant. When a business buys a non-current asset, the accruals concept kicks-in. The asset itself is typically used by the business for several years, and thus generates revenue. So applying the accruals/matching concept, the cost of an asset needs to be matched against revenue over several years. How do we do this? Well, we depreciate the asset. This means the cost of the asset is spread over several years.
This raise two questions 1) how much per year and 2) over how many years? This is where certain assumptions are made. First, an estimated useful life of an asset is determined, for example from previous experience of a similar asset. Second, then business will attempt to assume whether the assets contributes to revenue earned equally over time, or more in earlier years for example. In the former case, the business might use what is termed the straight-line method – which charges an equal amount each year. For example, is an asset cost €10,000 and it’s useful life is 5 years, then the depreciation expense in the income statement each year is €2,000. On the statement of financial position, the asset value falls by €2,000 each year. If an asset is assumed to earn more revenue in earlier years, for example a motor van or truck, then the reducing balance method can be used. This method charges more depreciation in the earlier years. For example, if we assume an asset costs €10,000 and is depreciated at 10% reducing balance, here is what will happen:
Cost €10,000
Year 1 (1,000) x 10%
Balance 9,000
Year 2 (900) x 10%
and so on…
Thus, using the reducing balance method, the asset will still have a value in the accounts for many years, but the depreciation charge will be smaller each year. If you think about the total costs of owning a car/van/truck, the repairs tend to get higher as it gets older, so the reducing balance method reflect this too.
How are assets classified in accounting?
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.
What is an asset?
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,
FRS102 – a great reference guide
As you may know, non-listed UK and Irish companies are not subject to International Financial Reporting Standards (IFRS). Instead, local standards are applied to financial reporting in such entities. Recently, the FRC in the UK has issues FRS102, which is applicable to all non-listed UK/Irish companies from January 1st 2015. This standard replaces all previous local accounting standards.
Financial reporting is not my speciality, so if you want to read more about FRS 102, Prof Robert Kirk has authored an excellent reference guide for CPA Ireland. You can find the guide at this link: A new era for Irish & UK GAAP – A quick reference guide to FRS102 – CPA Ireland and a hard copy of the book is also available to purchase here.
Accounting – in the eyes of an 8 year old
A few weeks ago, my daughter asked me what exactly is it I do in work. My reply- I teach accounting. Now as, any of you with kids will know it never ends with a single question. So the next question: “What’s accounting?” And I think, damn. Ok, deep breath – how do I explain it. My reply: it’s about finding out how much money you make. Am I out of jail? Of course not. The next question was: how do you make money? Can you not just print more?. So, I ignore the second question as I don’t teach economics. My reply: you make money by selling something for more money that you bought it for. So the next question came back – can you always do that and make money? My reply: no. Next came a rhetorical question: well why do you need accounting then? If you don’t always make money, you don’t need accounting as you said accounting only tells you how much money you make.
Young minds – the clarity they have sometimes!
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