A financial dashboard for entrepreneurs?
I read a post on the “Your the boss” blog on the NYTimes recently [see here] which gave some details about some software called inDinero. It’s one of a number of software solutions out in “the cloud” at the moment. The company got off to a really good start, recently receiving $1m in funding which is not bad for a start-up founded by a 20-year old graduate.
I read a little about the software on the website and was surprised by one of its logos “no more accounting”. I suppose this true to an extent in that inDinero does away with the drudgery of enterjng transactions like sale invoices and so on. How you ask? Well it concentrates on the key thing in any business – cash. The software connects with the business bank accounts and credit card accounts online [US banks only at present it seems] and automatically updates all cash inflows and outflows. So, for an entrepreneur, reports are available daily on the cash situation of a business. Any cash flow issues can be seen pretty quick and managed.
I don’t think it’s true to say that inDinero equals no accounting, as financial accounting is of course still needed for tax authorities and so on. It can export data to MS Excel and common accounting applications like Quickbooks, so this can help with the dull but necessary accounting. But, where the real advantage lies is the simplicity with which information on the cash flows of a business is gathered and reported – and this is just what entrepreneurs need. Remember, CASH IS KING. Let’s hope this or similar products make their way this side of the globe too.
Reading a cash flow statement
A cash flow statement is a financial statement that describes the sources of cash in a business and how that cash was spent. It does not include non-cash items seen in other financial statements such as depreciation. This makes it useful for determining the short-term viability of a company, particularly liquidity and solvency.
The cash flow statement is similar to the income statement in that it records a company’s performance over a specified period of time – normally a year. A difference is that the income statement also takes into account some non-cash accounting items such as depreciation, accrued expenses and provisions for bad debts. The cash flow statement excludes all non-cash items and shows exactly how much actual cash the a business has generated. Cash flow statements show how companies have performed in managing inflows and outflows of cash. It provides a sharper picture of a company’s ability to pay creditors, and finance growth.
It is possible for a company that is profitable to fail if there isn’t enough cash on hand to pay bills. Comparing the amount of cash generated to outstanding debt, known as the “operating cash flow ratio,” illustrates the company’s ability to service its loans and interest payments.
Unlike the varying treatments on some transactions in accounting , there is little a company can do to manipulate its cash flow. Analysts will look closely at the cash flow statement of any company in order to understand its overall health.
The cash flow statement
Cash flow statements classify cash receipts and payments according to whether they are operating, investing, or financing cash flows. A cash flow statement is divided into sections by these same three functional areas within the business:
• Cash from Operations – this is cash generated from day-to-day business operations.
• Cash from Investing – cash used for investing in assets, as well as the proceeds from the sale of other businesses, equipment, or other non-current assets.
• Cash from Financing – cash paid or received from issuing and borrowing of funds. This section also includes dividends paid – although dividends can be listed under cash from operations.)
• Net Increase or Decrease in Cash – increases in cash from previous year will be written normally, and decreases in cash are typically written in (brackets). The net movement in cash should be the differences between the opening and closing balances on the bank account (as per the balance sheet).
There are two ways to prepare a cash flow statement according to International Accounting Standard (IAS7) – the direct method and the indirect methods. The direct methods means looking at the cash records of the business and classifying according to the headings above (operations, finance and investing, which are specified by IAS7). While the direct methods seems practical, most of the time the indirect method is used. This is because IAS7 only requires a cash flow statement to be produced annually (this does not mean internal cash flow forecasts won’t be needed). The indirect method uses the income statement and balance sheet to extract cash flows. While this takes a bit of work, the information is easily available.
Reading a balance sheet
A balance sheet (or statement of financial position) is an accounting report that provides a snapshot of a business’s position at a given point in time, including its assets, its liabilities and its total or net worth (assets less liabilities). “A balance sheet does not aim to depict ongoing company activities,” wrote Joseph Simini in Balance Sheet Basics for Nonfinancial Managers. “It is not a movie but a freeze-frame. Its purpose is to depict the dollar value of various components of a business at a moment in time.”
Balance sheets are typically presented in a vertical report form. Asset accounts are listed first, with the liability and owners’ equity accounts listed in sequential order directly below the assets. The term “balance sheet” originates from the the fact that the balance sheet is a representation of the accounting equation (assets=liabilities + capital), thus the two totals should balance.
Contents of a balance sheet
Most of the contents of a business’s balance sheet are classified under one of three categories: assets, liabilities, and (owners) equity.
Assets
Assets are items owned by the business, whether fully paid for or not. These items can range from cash to inventories, equipment, patents, and deposits held by other businesses. Assets are further categorized into current assets and non-current assets.
Current assets include cash, accounts receivable, inventories, prepaid expenses, and any other item that could be converted to cash in the normal course of business within one year.
Non-current assets include property,equipment (from office equipment to heavy operating machinery), vehicles, fixtures, and other assets that can reasonably be assumed to have a life expectancy of several years. In practice most non-current assets—excluding land—will lose value over time. This is reflected in accounts through a a process called depreciation. Non-current assets are reported net of depreciation in the balance sheet.
Non-current assets also include intangibles like the value of trademarks, copyrights, and a difficult category known as “goodwill.” When someone buys a company and pays more for it than the worth of its assets, the difference is written into the books of the acquired entity as “goodwill.”
Liabilities
Liabilities are the business’s obligations to other entities as a result of past transactions. Liabilities may be due to employees (salaries), investors ( for loans) or to other companies (who have supplied goods or services). Liabilities are typically divided into two categories: current liabilities and non-current liabilities.
Current Liabilities are due to be paid within a year. These include payments to suppliers, payable taxes and accrued expenses (like wages and salaries). Current liabilities also include the “current” portion of long-term debt payable within the coming year. Non-current liabilities are amounts owed to lenders, mortgage holders, and other creditors payable over more than one year
Equity
Once a business has determined its assets and liabilities, it can then determine (owners’) equity i.e. the book value of the business. Owners’ equity, Or shareholders equity in the case of a limited company, is in essence the company’s net worth.
A balance sheet, if studied closely, can tell the any business owner much about the enterprise’s health. In Balance Sheet for Nonfinancial Managers, for instance, Simini points out that “in a well-run company current assets should be approximately double current liabilities.” He goes on: “By analyzing a succession of balance sheets and income statements, managers and owners can spot both problems and opportunities. Could the company make more profitable use of its assets? Does inventory turnover indicate the most efficient possible use of inventory in sales? How does the company’s administrative expense compare to that of its competition? For the experienced and well-informed reader, then, the balance sheet can be an immensely useful aid in an analysis of the company’s overall financial picture.”
(Some of the material in this post has been adapted from inc.com, the original post can be found here http://www.inc.com/guides/2010/06/how-to-read-a-balance-sheet.html)
Reading an income statement
This is the first of three posts which give you a quick guide to reading the three key financial statements – the income statement, balance sheet and statement of cash flows. This post deals with the income statement, with the other two coming over the next few weeks.
The Income Statement
An income statement presents the results of a company’s operations for a given period—usually a year. The income statement presents a summary of the revenues, expenses, profit or loss of an entity for the period. This statement is similar to a moving picture of the entity’s operations during the time period specified. Along with the balance sheet and the statement of cash flows, the income statement is one of the primary means of reporting financial performance. The key item listed on the income statement is the profit or loss.
Within the income statement there’s a good bit of information. If you’re knowledgeable about reading financial statements, in a company’s income statement you’ll find information about return on investment, risk, financial flexibility, and operating capabilities.
The current view of the income statement (in line with International Financial Reporting Standards (IFRS)) is that income should reflect all items of profit and loss recognised during the accounting period. The following summary income statement illustrates the format under IAS 1 – Presentation of Financial Statements (image from http://www.accaglobal.com):
This example above is fairly typical of the income statement of a large public company. I’ll explain some items below.
Some terms on the income statement explained
Revenue
According to the IASB’s IAS 18, revenue is defined as “the gross inflow of economic benefits (cash, receivables, other assets) arising from the ordinary operating activities of an entity (such as sales of goods, sales of services, interest, royalties, and dividends)”. This means that revenue is typically the figure for sales of goods or provision of services for the period of the income statement.
Cost of sales.
The cost of sales figure includes all expenses incurred in buying to making the product or service which generates revenue.
Other Income
This is income from sources like interest or investment income.
Expenses
Expenses are classified as either distribution cost, administrative expenses, other expenses or finance costs. No further detail is needed.
Share of profit of associates
This figure is the share of the profits made in an associate company – one where 20-49% is owned by the company (or group of companies) the income statement is prepared for.
The final item in the example above represents a loss made in a section of a business which is discontinued. This separate disclosure is required by accounting standards. Additionally, IAS1 also requires a short statement of comprehensive income, which shows unrealised gains (like unrealised asset revaluations, or currency gains/loses on translation). I don’t include it here, but it is usually no more than a few lines.
Investors call for clearer business reporting
CIMA commented recently (see here) on an IFAC report which suggests that financial reports have become too complex with the result that the underlying financial performance of a business is hidden. Add to this the increasingly complex nature of businesses and you get some idea if the problems in compiling clear concise and meaningful reports. The IFAC report quotes Tanya Branwhite, executive director of strategy research at Macquarie Securities in Australia: ‘If financial accounts are not prepared with the users in mind, then we risk a whole area of unaudited “shadow reporting” being provided directly to investors that doesn’t go through the rigorous financial accounting process,’ she warns.
I remember from my early accounting lectures that a ‘knowledgeable’ investor in seen as the defining user of accounting reports. If you are prepared to stick your money where your mouth is, you’ll want to know all the detail. But the problem is that financial statements just can’t provide this, or as the IFAC report highlights, are too complex. According to the IFAC report, business reporting suffers from a number of significant issues at present: information overload, fair value accounting, operational performance, convergence of accounting standards, real time reporting, management commentary and sustainability reporting. The big questions is how can financial reporting help solve these? One simple answer suggested is that investors might become more actively involved in the standard setting process (i.e. IFRS) and discussions about the presentation and content of financial reports.
The changing face of corporate reporting
Are companies using social media to publish financial results. The answer is yes. Here’s a link to a recent post on Nick Topazio’s blog on CIMA’s website.
Audit exemption for Irish companies
If your business is a limited company, one of the most difficult tasks is dealing with the annual audit of the company and its financial statements. However, most small Irish companies can avoid an audit by availing of an Audit Exemption under Irish company law.
What’s an audit?
An audit is a comprehensive examination of a company’s accounts and financial statements/records by an external auditor. It involves a detailed examination of the company books and records, a review of the estimates, policies, and judgements used in preparing the accounts. The output of an audit is a formal ‘audit report’ setting out the findings. In recent years, audits have become more stringent. Auditing standards apply equally to small and large companies. As a result, owners of small companies can find the audit to be a bit of a nightmare.
Does my company qualify for an Audit Exemption?
A limited company can enjoy an exemption from an annual audit if:
- Turnover is below €7.3 million
- The total value of Non-Current and Current Assets on its balance sheet is less than €3.65 million
- The average number of its staff in a year is 50 or less
- The company’s Companies Office filing record is fully up to date
- The company is any of:
- a company “limited by guarantee”, nor
- a holding or subsidiary company, nor
- a bank, insurance, management or investment company.
All these conditions must be met, both for the current financial year and the previous year.
For eligible companies, annual accounts must still be prepared and filed with the Companies Office, Revenue Commissioners etc. However these accounts need not be subjected to a formal audit – although they might be if banks or lenders require audited accounts.
Can the Exemption be lost?
Yes, if any of the above conditions are broken.
Even with an exemption, directors of audit-exempt companies must still comply with company law, including the keeping of proper books and records, and the preparation of annual accounts that comply with accounting standards and the requirements of the Companies Acts.
So what is the accountant’s role?
Although audit-exempt companies no longer need an auditor, most such companies still choose to have their accounts and annual returns prepared by a firm of practising accountants. This ensures all is keep in full compliance with accounting standards and relevant company law. If your company meets the conditions as set-out above, you might at least be able to reduce your annual accounting fee as a full audit is not required. However, I’d recommend that if you’re in doubt about anything to ask your accountant.
Proposals to improve the financial reporting of leases
The IASB and the FASB (respective International and US accounting standard setters) have recently published proposals
(see here) to change the way leases are reporting in financial statements, i.e. the income statement and balance sheet. A lease is a contract for the use of an asset, and in accounting terms a lease can be either an operating lease or a finance lease. Without going into detail, a finance lease is capitalised in the balance sheet, meaning the asset subject to the lease is included as a business asset, with a corresponding liability for the amount owed to the lease company or bank. An operating lease on the other hand does not appear on the balance sheet, with any lease payments going through the income statement as an expense. The new proposals are suggesting that all leases must be accounted for as assets of a business, with a liability shown for the amounts owed on the lease. The argument from the standard setters is that a balance would show the true future liabilities of the business. How would this affect a business? Well, it might not affect the business at all if it had no operating leases, but some firms use operating leases quite a lot. If these leases suddenly were capitalised to the balance sheet, an immediate increase in long-term debt occurs. This might put businesses beyond the capacity to raise more debt. Airlines typically lease aircraft, which are normally treated as an operating lease. For example, Aer Lingus (an Irish airline) has about a €50m operating lease charge on their balance sheet annually. Let’s assume this is a 10 year lease, so if this were to be capitalised to the balance sheet, an increase in debt of €500m happens overnight. On a smaller scale, many retailers in capital cities might have expensive 21 year leases on prime retailer sites. Putting these leases on the balance sheet might cripple the borrowing capacity of smaller companies. It looks like a debate on this proposal will be quite heated.
Accounting for long term contracts
Construction type companies are subject to a special accounting standard called IAS 11 (see http://www.ifrs.org). This standard specifies how construction companies deal with revenues and costs associated with contracts in their published accounts. What’s the problem you might ask? Why a special standard? The problem is that construction or similar contracts often span multiple accounting periods. If too much revenue is recorded early, profits might be inflated incorrectly. And, if costs are recorded too early, profits might look much lower than they should be. So, IAS 11 says what is allowed and not allowed. In a nutshell, losses must be included in accounts immediately; profits should be reported only when certain and in proportion to the completion of a contract. A recent news article in the Telegraph highlights one UK company (Connaught Group) that may be incorrectly applying the standard – you can read it here – to long term social housing maintenance contracts.
In fact, IAS 11 applies two basic accounting concepts. First is applies the prudence concept, as losses are to be recognised straight away and profits only when reliable estimates are possible. It also applies the accruals concept, which means that revenues and costs should be matched against each other as evenly as possible over time.
The use of the word ‘fair’; some thoughts for accountants
In accounting we use the word ‘fair’ a bit. ‘Fair value’ and ‘true and fair view’ are two key concepts that come to mind. But what is fair, and what is unfair. What might be fair to you, is unfair to me and so on. And then, what if we try to translate ‘fair’ into other languages. Does it retain it’s meaning. I don’t know to be honest as I’m not a linguist. But as an accountant, I’m sort of programmed to think logically and look for a definite answer. But maybe there isn’t one. To get you thinking, have a read of this piece from economist.com. It’s a bit a bit of fun on the use of the word ‘fair’ around the recent emergency budget in the UK.
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.
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.
Some good YouTube videos on basic accounting
If you struggling with basic accounting concepts, here’s a great collection of videos from Susan Crossan which cover the basic accounting topics. The audio quality if not great on some (and some of the terms are more US than Europe) but she gets the topics across well. This link ( FA YouTube Videos ) will bring you to a summary page, where you can then click on the topic of interest to you.
Creativity in business – ideas from a creative writer.
I read Creativity Now! by Jurgen Wolff a short while ago. Jurgen is a great writer and he offers regular courses on creative writing in London (see www.timetowrite.com). This book is a wonderful summary of things you can do to be creative. Given the poor business and economic environment we’re in, a little spot of creativity might do us no harm. I’ll give you two examples from Jurgen’s book of how creativity in business has helped increase profits. For more, go on, buy the book.
Adding unusual value to a routine service
Jurgen cites a story about a couple owning a B&B in Connecticut. The husband is an accountant and what has made their B&B successful is a “Tax and Relax” package. Customers can relax and have a night away, with breakfast, while their tax returns are being done. Oh this, is a little different than having a 50″ plasma in the room, but the business is thriving.
Follow your heart, and the money comes too (sometimes)
In this piece, Jurgen recounts the experience of an interior designer who visited a hospice. She was appalled by the sombre surroundings. Using her interior design skills, this lady now makes a good living making the surroundings in healthcare facilities look a little brighter.
Creativity Now! has lots of tips on how to bring out your creative side – this might be just what business people need at the moment.
How to track the “Critical Numbers” in your business
I read an article recently from Inc Magazine -“How to Track Your Company’s Critical Numbers” – which a useful piece on how to watch the key numbers in your business. The article emphasises the need to achieve a balance between having a good accountant, and not being too reliant on them at the same time. You don’t need to be an accountant yourself to keep a track on key figures and ratios in your business.
Martin's accounting blog 