Fooling accounting
Jennifer Hughes writes an interesting piece in the Financial Times (London) which reminds us of one of the basic concepts of the accounting world – “true and fair view”. The recent investigation into Lehman Brothers revealed how $49billion had been “moved off” the balance sheet in 2008, a move which was supported by the now defunct banks’s directors. And we don’t have to look as far away as the US – what about Anglo Irish Bank moving (was it) €6billion in to and out of its deposits at year end to make things look nice. And, as Hughes says, this kind of thing has happened before – she cites the case of London & County Securities back in 1973, who were up to the same sort of shenannigans as Anglo Irish.
Can we stop this kind of tom-foolery in accounting? Maybe not completely, but as Hughes says, a global set of accounting standards might help. Let’s wait and see.
Accountants as translators
I had a guest speaker at one of my lectures recently. The talk was about accounting software, but during her presentation the speaker mentioned that accountants should be translators for their clients – especially to new small business clients who may not have much knowledge of accounting terms. This made me think about the role a good accountant should work link a language translator with clients. One of the key functions of accounting is to communicate information. But what happens when the language used to communicate is too complex to be understood without translation? Personally, I can speak both English and German quite well. While learning and using German I know that some things just don’t readily translate. On top of this, my German is not fully fluent, so I sometimes need to ask the speaker to slow down or use simpler words. Now think about what a small business owner or up-and-coming entrepreneur knows about the language of accounting. Let’s assume nothing, but they know things like how much money comes from sales, they have a pile of receipts in a drawer somewhere, they have an office computer, owe some suppliers and have invested a lump-sum in the business. To accountants these are:
| Business owner’s term | Accountant’s term |
| Money from sales | Turnover/Revenue |
| Receipts in a drawer | Expenditure |
| Computer in office | Non-current (fixed) asset |
| Money owed to suppliers | Liability -trade payables |
| Lump sum put in business | Capital/Equity |
So some advice to the accountant’s out there – be a translator if you need to be. Translate your jargon into understandable language for the business owner – especially new business ventures. Over time, both accountant and business owner will start to understand each others language.
A very interesting piece on BBC Radio 4 – history of double entry accounting
BBC Radio 4 are this week (Mar 8th, 2010) and next broadcasting a short history of the double entry system of accounting. Here’s a link. There are 10 episodes, each day Monday to Friday, at 15:45.
IFRS for SMEs
I have written previously about the FRSSE, which is a summarised set of accounting rules used by some private companies in the UK and Ireland. Since 2005, all public companies throughout Europe use what are called International Financial Reporting Standards (IFRS). These standards are complex and the bound volume runs to a few thousand pages. Not the sort of thing a smaller private company might find all that useful when preparing its financial statements. In the UK, a body called the Accounting Standards Board (ASB) is responsible for implementing all accounting standards. In August 2009, the ASB decided to adopt the IFRS for Small and Medium-sized Entreprises (IFRSSME) with effect from January 1, 2012. According to accounting firm Deloitte (see this link), this means that approximately 50,000 larger private companies will have to adopt the IFRSSME, while about 2 million others can continue to use the FRSSE. Unlike its big cousins, the IFRSSME is small and compact, at around 230 pages of rules. The International Accounting Standards Board (IASB) hope that the IFRSSME will meet the needs of SMEs, who typically account for 90-95% of businesses in any country. Unlike the full IFRS, the IFRSSME is not compulsory in the UK or any other EU nation, but watch this space.
The IFRSSME can be downloaded free at this link.
Global IFRS adoption
While the minute detail of the many accounting standards is not one of the topics I like to write about, it occured to me recently ” how international are the International Financial Reporting Standards (IFRS)?”. A key advantage of one set of reporting standards is ease of comparison and understanding of financial statements. Since 2005, all EU listed companies are required to use IFRS and some member states allow smaller companies to use it. On a global scale, approximately 120 countries have adopted IFRS, with about 90 of these making adoption mandatory for all listed companies. Most of the G20 countries have either adopted IFRS or set dates for adoption (see http://is.gd/jMVJw). The US Federal Accounting Standards Board and the International Accounting Standards Board (the body who issue IFRS) have agreed a date of June 2011 for convergence of US and International standards. Also, some countries are planning to adopt the IFRS for SME, which is a cut down version of the full IFRS set. This will not only extent IFRS principles to SME but possibly to developing economies also. So the spread of IFRS is pretty wide, and by about the middle of this decade, the standards will be quite international in nature and name.
Are you afraid of numbers?
Numerophobia is the fear of numbers. We all know that some numbers might be “unlucky”, like 13 or 666. As a trained accountant I’d be in serious bother if I had such a phobia. Thankfully, I don’t and I have actually stayed in a room number 666 in a hotel in Cologne, Germany some years ago and had an enjoyable stay. I often hear people saying they hate accounting and tax because there are too many numbers. Is this a phobia or just putting things on the long finger? Well, the latter might be the more common reason, particularly when the numbers look bad. In a NY Times article (21/11/2009), Jacob Soll says that anxiety about accounting and taxation often increases to the point of denial. He quotes a 2005 study by Lloyds TSB (UK) which reported that accounting anxiety has led to “balance denial syndrome,” in which bank customers so fear being in the red that they systematically ignore their bank statements. Not really a good idea! Let’s think back to what accounting is about. Its purpose is collect, collate and communicate information (usually of a financial nature). As an example, let’s assume a small business keeps poor records or worse, none at all. In such a case, a bank statement might be the only indicator of how a business is performing. So to ignore it is to cut-off the only source of communicated accounting information a business has. In practice, letting records fall behind is more common than none at all. And, we may let things fall behind because we can’t face the bad story the records tell – especially in the current economic climate. However, this is big mistake. Having the courage to face the books and realise they don’t tell a good story is the first step to solving the problem. As Soll says, “It might be that the first step to balancing the books is finding the courage to face keeping them”. So hands up, admit it and get down to solving your problems. If you’re too busy putting out other fires, call your accountant and ask them to help.
Accounting rules in smaller companies
Limited companies must prepare financial statement in accordance with accounting standards and Company Law. As you can imagine, complicated rules and laws are often way too much for a small company to deal with. Most to the time, directors of small companies leave the work of preparing financial statement up to practicing accountants. In fact, in the UK and Ireland, small companies are also exempt from the requirement to have their financial statements audited provided they meet certain conditions.
In June 2008, the UK’s Accounting Standards Board (ASB) issue an accounting standard specifically designed to cater for and simplify the accounting rule for small companies. What constitutes a small company is specified by Company Law. In the UK, any company with turnover of not more than £5.6m, a balance sheet total of not more than £2.8m and has less than 50 employees is a small company. If a business meets these criteria, it can then adopt the ASB’s Financial Reporting Standard for Small Entities (FRRSE). This standard is very useful in that it incorporates all requirements relating to financial statements as set out in Company Law. Thus, by following this standard in the preparation of its accounts, a company is also fully compliant with the law. The FRRSE covers many areas of financial statements- for example: the profit and loss account, fixed assets, current assets, the Directors Report and much more. It also exempts smaller companies from some more complex requirements of other accounting standards. If your business is a small company, it might be worth while asking your accountant if the FRRSE is suitable for you. It might simplify their work, and as a result save you some fees.
Here is a link to the ASB’s website, where you can download the FRRSE for free;
http://www.frc.org.uk/documents/pagemanager/asb/FRSSE/FRSSE%20Web%20optimized%20FINAL.pdf
The profit and loss account (income statement)
This brief post covers the basics of the profit and loss account. The profit and loss accounts lists all income and expenditure, with the difference being they profit or loss made by the business. The profit and loss account has two parts, albeit in the same statement. The first part account calculates the profit earned from buying and selling goods. This is called the Trading account.
Here’s an example of the layout.
Trading account for Red Books for year ended 31/12/2009
|
€/£ |
€/£ |
|
| Sales |
|
250,000 |
| LESS COST OF SALES |
|
|
| Opening stock |
20,000 |
|
| Purchases |
150,000 |
|
|
170,000 |
|
|
| Less closing stock |
30,000 |
|
| Cost of sales |
|
140,000 |
| Gross profit |
|
110,000 |
Here’s a brief explanation of each of the some of the items and terms above. First, there is the title of the account. It informs the user of the name of the statement (what), the name of the business (who) and the time period involved (when).
Sales: The amount of money earned by the business selling books in the past year i.e. Income. Sales returns/returns in may have to be subtracted to get this figure.
LESS COST OF SALES: this is a heading, which indicates that this calculation is going to be completed. This calculation will work out the cost of all the books that were sold in the year. It is calculated as follows
Cost of sales = opening stock + purchases – closing stock.
Opening stock: This is the value of stock left over from the previous year. This stock will be the first to be sold in the this year, thus it is a cost for this year (c.f. the accruals concept)
Purchases: This is the cost of all the new books bought during the year. (Additional costs like carriage in and import duty might be added to the purchase cost). Purchase returns/returns out may have to be subtracted.
Closing stock: This is the value of all the books left at the end of the year. It is subtracted from opening stock and purchases, as it does not form part of the goods sold during this year (c.f. accruals concept).
Cost of sales: This is the answer to the calculation of the cost of sales.
Gross profit: This measures the profit the business makes by buying and selling books. It is calculated as follows:
Gross profit = Sales – Cost of Sales
The second part, the profit and loss account calculates the profit the business has earned after allowing for all the expenses incurred in running the business. Here’s an example following on from the trading account above
Profit and loss account for Red Books for year ended 31/12/2009
| €/£ | €/£ | |
| Gross Profit | 110,000 | |
| LESS EXPENSES | ||
| Wages and salaries | 40,000 | |
| Depreciation | 20,000 | |
| Light, heat and telephone | 10,000 | 70,000 |
| Net Profit | 40,000 |
As you can see, the profit and loss account starts with the Gross Profit and deducts expenses to arrive at Net Profit. Net profit is the profit that is owed to the owner(s) of the business. In the case of a sole trader, this forms part of the capital of the business, whereas with a company the shareholders may be paid a dividend from available profits.
All other elements from the Trial Balance i.e. assets, liabilities and capital do not appear on the Profit and Loss account, but the balance sheet.
Accounting and HR
In the July 2009 (July 30th) edition of People Management, the journal of the Chartered Institute of Personnel and Development (CIPD), Claire Warren provides an example of the importance of accounting information to HR professionals. The article touts the often cited expression ‘people are our greatest asset’, but questions how many HR professionals appreciate the full costs of people in an organisation.
According to Vanessa Robinson of the CIPD, HR professions shouldn’t ‘merely say “people are our greatest asset”, but look at the profit and loss account and see what they cost!’ The problem is that many HR professionals may not have sufficient basic accounting knowledge to understand basic accounting principles. They need to be familiar with the basic financial statements – the profit and loss account (income statement), balance sheet and cash flow statement. What this article tells us is something we as accountants already know – that accounting is a communication medium, a language indeed, that not everyone understands. Having said that, while HR professionals may not think they require fluency in accounting, they do need to make business decisions which are underpinned by sound financial information. Having an understanding of accounting information (rather than just accepting it from the accountants) will benefit HR and other professionals in an organisation. The article in People Management is a great start for anyone who wants to know the basics, so take a few minutes to read it.
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.
Measuring monetary value in accounting
You would imagine that in the world of accounting, putting a monetary value on an asset is simple. All that is needed is a unit of measurement i.e. a Pound, Dollar or Euro. Measuring things in the natural sciences is easy as units of measurement have been defined and are totally static e.g. a mile, a metre or a kilogram. When is comes to measuring using money values though, things can get messy. A article in The Economist (July 18, 2009) provides a useful example, which is receiving a lot of attention as a result of the recent financial and economic downturn.
Financial institutions like banks and insurance firms have always had problems valuing items like loans, securities and other financial assets. The debate is hot divided between those who want to ‘mark-to-market’ value and those who want to use the historical cost of such assets. The latter is the easy solution as the value can be readily determined. Using mark-to-market is problematic in that first, a market value can be difficult to determine, and second can cause huge swings in the balance sheet figures. Large changes in the balance sheets are not looked on well by shareholders as comparisons with prior years become difficult. To make matters worse, some firms have used a mixture of both mark-to-market and historic cost to value assets making comparisons even more difficult. Finally, some commentators argue that mark-to-market values actually add to the woes of financial institutions as falling values drives shareholders away.
The International Accounting Standards Board (IASB) is trying to come up with a solution. The IASB sets accounting rules for Europe and most of Asia and is likely to have authority in the USA in the future. There task is not easy. They need to balance maintain comparability between accounts of financial institutions, but also prevent accounting for exacerbating any economic downturn. This may help investors place more trust in accounts in the future.
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