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 parntership? How does it change financial statements prepared?
In business, a partnership refers to the coming together of two or more persons to conduct a business. Normally, there is a maximum number of partners with exceptions made in cases like accounting practices and legal practices. A partnership is usually formed to take advantage of the combining of skills and resources. The objective is normally to make a profit, and this profit is shared out in some agreed way among partners. Losses too are borne by the partners.
As essential element in the formation of a partnership is the Partnership Agreement. This is a legal agreement (which ideally should be written) which contains items such as the following:
- the capital to be contributed by each partner
- how profits are to be divided
- any interest to be paid on capital contributions
- any interest to be paid by the partners on monies withdrawn
- salaries to be paid to partners
- arrangements for admission of new partners
- arrangements to dissolve the partnership, and procedures on the retirement/death of a partner.
In the absence of a partnership agreement, in the UK and Ireland, the Partnership Act 1890 applies (see here).
In terms of preparing financial statements, there are some differences. First, any adjustments to profit are made in a profit and loss appropriation account – which is in effect an addendum to the income statement/profit and loss a/c. For example, any interest due to or to be paid by partners, salaries etc are made here. The resulting adjusted profit is then shared among the partners as agreed. In the statement of financial position (balance sheet), each partner will have their own separate capital account. Some partnerships used a combination of capital and current accounts. The former shows only the fixed capital contributions, the latter shows profits, drawings, interest, salaries etc. This approach is probably better as the any negative balances on the current account will signify that perhaps a partner is taking out more from the business than they should.
John Teeling, founder of Cooley Distillery talks about his business
John Teeling founded Cooley Distillery in 1987. In January this year, he signed off on a deal to sell the business to global spirits firm Beam (see here) US firm to buy Cooley Distillery – The Irish Times – Fri, Dec 16, 2011. On January 14th 2012, Dr Teeling gave a very useful radio interview on his life is business. Have a listen to the podcast here (January 14th, 2012). There are a few things of interest. For example he tells the story of why Irish whiskey sales declined from 60% to 2% of the world market in the past. And how in 1960, he was one a few people in Ireland you could do Discounted Cash Flows – something we take for granted nowadays.
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.
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 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 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 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
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)
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.
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.
No Accounting for startups?
While having a regular look on inc.com, I found this interesting blog post from Steve Blank’s blog. He writes that financial statements are not the best thing to use to monitor a start-up business. Sometimes banks or venture capitalists insist on things like regular income statements and balance sheets. While I don’t think it’s right to say “no accounting”, there is a point in the pieces in that a start-up might be much better served concentrating on more important performance indicators. Have a read and see for yourself.
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.
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.
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.
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.