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Financial Accounting Financial statements

Accounting for Leases – IFRS 16

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Some of the key points IFRS 16 requires:

Application:

IFRS 16 “Leases” is effective from 1 January 2019 with earlier adoption permitted. The standard primarily provides accounting treatment on leases for lessees. The impact on lessors is almost nil.

Long term leases:

IFRS 16 classifies leases into two main types. First is the short term lease, these are the leases which are for a period of 1 year or less than that. The second type of leases is long term lease; these are the leases whose duration is more than 1 year. IFRS 16 is applicable on long term leases.

Right of Use assets:

A right of use asset is an asset which is been leased by a lessee on a long-term lease i.e., the lease period is of more than 1-year duration. The right of use means the lessee has effectively rights of use of assets almost similar to that of an owner.

Capitalization of right of use assets:

IFRS 16 requires lessee to recognize a right of use asset in its balance sheet, as non-current asset, for the long-term leases where certain conditions are met. The capitalization of right of use asset shall be done at the present value of lease payments to be made over the life of the lease.

Lease liability:

IFRS 16 requires recognition of lease liability as a corresponding credit entry to recognition of right of use assets. Thus, a lease liability will be booked at present value of lease payments over the life of the lease. The initial recording of asset and liability will be at the same value and the accounting entry for right of use of asset and lease liability will be as follows:

Debit: Right of use asset                                                               $5,000

Credit: Lease Liability                                                                     $5,000

 

Depreciation of right of use assets:

Once a right of use asset has been capitalized, its useful life shall be assessed. This useful life will become the basis of calculation of depreciation on right of use asset. Thus, although these assets are not legally owned by the lessee, depreciation will be charged on right of use assets, recognized as per requirements of IFRS 16.

Rent Expense:

IFRS 16 does requires that rent expense shall not be reported or recognized in the profit and loss statement (or in the books of accounts). This is because, IFRS 16 is treating this item effectively as an owned asset (i.e., right of use asset). So, there cannot be a rent expense booked for the assets which has been classified as right of use assets. But depreciation on these assets will be booked and presented in P&L, as discussed above.

Unwinding of discount (or interest expense):

After the initial liability is recognized (as stated above) on the implementation of IFRS 16 (or on booking of a new right of use asset), we need to calculate and incorporate interest expense from time to time. This interest expense is for the time period for which the liability remains outstanding. Let’s say that if we recognized a liability of 1 January 2019, we need to book interest expense on this liability once we reach the month end closing on 31 January 2019. The accounting entry for the interest expense will be as follows:

Debit: Interest expense ($5,000 X 5% X 31/365)                 $ 21.23

Credit: Lease Liability                                                                $ 21.23

The above entry would keep increase the liability amount.

Payment of lease liability:

Once the lease liability is paid, the liability will be debited and the bank account will be credited. This is as per normal accounting practices.

Accounting for short term leases:

There will be no recognition of a right of use asset or a lease liability once a lessee enters into a leasing arrangement. Therefore, there is no depreciation charge and no interest charge as well.

Accounting for Lessor:

The lessor shall identify whether it is an operating lease or a finance lease and then will account for it accordingly. A finance lease is a lease which substantially transfers risks and rewards associated with the asset. All other leases are operating leases.

While accounting for a finance lease, lessor shall recognize a lease receivable amounting to net investment in the lease.

 

Key features of IFRS 16:

  • IFRS 16 does not provide options. It instructs to follow a single model. If the lease period is more than 1 year, the lessee MUST recognize right of use assets and corresponding long term lease liability. There is no option or choice available. This enhances consistency of financial statement presentation and enhances investors’ confidence on financial reporting.
  • Materiality, as a basic accounting feature, is still an important factor. If the lease amount is not material then lessee is not burdened with unnecessary recognition of right of use assets and lease liabilities.
  • Lessor’s are allowed to continue to adopt the same approach of operating lease or a finance lease as it was available under IAS 17 – Leases.
  • First time adoption of IFRS 16 allows the adoption to be prospective or retrospective. Propsective application is simplified method of IFRS 16 adoption, under which you don’t need to restate the figures of comparative period. In full adoption method, the figures of comparative period of 2018 have also to be complied as if IFRS 16 was in effect from 1 January 2018.
  • Assets shall be subsequently measured at cost model (or revaluation model if that asset comes under a class which is measured at revaluation model by lessee) or at fair value model if it is an investment property (if the policy of the lessee is to use fair value for investment properties).

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Categories
Financial Management

WORKING CAPITAL MANAGEMENT

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What is capital

Capital refers to total investment in a business. This capital has usually two components, one is the equity and second is the debt. The equity is owner’s own money invested in the business and debt is the amount of money borrowed by the business (in terms of long term debt or bank loans or bonds or debentures etc).

 

What is working capital

Now, it is important to understand that working capital is the money taken from the capital and then invested in certain items. Working capital is actually the allocation of the capital in specific assets.

So, the amount of the capital invested in inventories and receivables (netted off by the payables) is called working capital. It is referred to as working capital because this part of the capital would be continuously in the working (or rotating) cycle. The inventories will be sold to customers and customers will pay, this money will be used to pay to creditors and new inventories will be purchased. Thus a cycle of work will continue. The ‘work’ in this scenario refers to core functions of the business i.e., buying goods on credit from suppliers, holding the inventory till it is sold to the customers and then collecting the money from customers against sales. This is the core work of a business. Thus, an investment on this core cycle of the business is referred to as investment in working capital.

 

Definition of Working Capital

Working capital can be defined as: ‘Working capital is the money which a business has invested in its core operational activity mainly the inventory items which it sells, the receivables which it finances less the payables which are financing the company’.

Thus, by this definition, we understand that there are 3 core components of working capital. First is inventories, second is receivables and third is payables. Inventories and receivables add up to the investment in the working capital and the payables decrease the investment in the working capital. Thus, higher the payables amounts and days, the lower will be the working capital amount and days. Working capital is also referred to as Net Working Capital (NWC).

 

Formula for calculation of working capital

In order to calculate working capital amount of a business at any given time, we need to add receivables amount and inventory amounts subtracting creditor amount. This formula will give us the answer of working capital amount at any given date.

If we want to calculate average working capital of a business during a year then we need to take sum of average inventory and inventory receivables and subtracting average payables amount. This will provide us the answer of how much was the average working capital during the year for the business in amount.

Inventory + Receivables – Payables = Working Capital

The interesting thing about working capital formula is that it can be applied in two ways. One is that we can use all values in amounts and we’ll get the working capital answer in amounts ($ etc.). The other way is to use all values in number of days and then we will get the answer of working capital in number of days.

For example, if the inventory holding period is 15 days, receivables credit period is 30 days and payables credit period is 20 days, then the average working capital is 25 days.

 

Example of working capital cycle

Working capital cycle can be better understood in a business dealing in goods (as opposed to a business dealing in services). However, both types of business do have a working capital cycle and an amount invested in their working capital.

Let’s take example of a retail computer shop which purchases different laptops from wholesalers and then sale these units to individual customers. The Elegant Computers (Pvt.) Ltd, a fictitious name, purchases from laptops and then stores them in the shop for display to the customers. The money paid to purchase these inventories is investment on working capital.

Let’s say that at any one given date, the net position of the business is such that total inventories are $5,000, total receivables are $7,000 and total payables are $4,000. If we apply the formula of working capital calculation, adding receivables and inventory and subtracting payables, we’ll arrive at net investment figure of $1,200 for the business (i.e., $5,000 + $7,000 – $4,000).

 

 

Why we need to calculate Working Capital

Working capital management is a topic of ‘resource allocation’ or ‘budgeting’. Every company would need to understand its different classifications of expenditures. Studying each class of expenditures helps in correct analysis and allocation of resources. Some famous classifications of expenditures are capital expenditures (a.k.a CAPEX), operating expenditure (a.k.a OPEX) and working capital.

There are multiple reasons of calculating and analyzing working capital, as mentioned below:

  1. Working capital investment requires financing and this financing comes at a cost. We need to analyze our working capital to assess if we are maintaining an optimal level of inventories and receivables.
  2. Financing cost of working capital can be significant sometimes. We need to make decisions on how much credit period to be offered and what is the impact of this credit period on our financing cost and sales. We need to make right decision and therefore, we need to know our investment in working capital and the cost of this investment.
  3. Analysis of working capital can provide key insights into a business. For example, if the inventory number of days is unusually longer than the industry average number of days, then this might suggest some red flats (e.g., that we have either some obsolete inventory or our sales performance is lower than average.
  4. Management would be keen to negotiate best terms with suppliers and thus would need to understanding how much financing is coming from payables for working capital.
  5. It is important for us to understand how much money we need to invest and for how many days. Because, that money (working capital) will be blocked for that period. Similarly, we need to know, how much money will be received and after how many days.

 

 

Calculation of Debtors Days, Creditors Days and Inventory Days

In order to calculate working capital in days, we need to add inventory days and receivables days and subtract payables days. The formulas for the inventory days, receivables days and payables days are given below.

In order to calculate average inventory, we can add opening and closing inventory in a year and then divide it by two. Alternatively, we can use closing inventory figure if average inventory figure is not available.

Receivables days can be calculated by dividing average receivables with annual sales. Average receivables are calculated by adding opening receivables figures and closing receivables figure and then dividing it by two.

Payables day can be calculated by dividing average payables in a year with cost of sales. Average payables are calculated by taking average of opening and closing payables for the year. If average payables figure is not available, then closing payables figure can be used in the formula of payables days.

Here we have used 365 days in the formula but in practice, some companies may use 360 days (keeping fix 30 days for 12 months).

 

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Categories
Financial Management

ROCE – Return on Capital Employed

[vc_row][vc_column][vc_column_text]ROCE is one of the tools in the tool box of a financial analyst. This is a useful ratio which would calculate the performance of a particular investment or can be applied on different investments. It can be used for one period as well as for multiple periods.

 

Return on Capital Employed (ROCE)     =   Profit Before Interest and Tax (PBIT)

 

Capital Employed

Capital employed means total assets minus current liabilities. From an investor’s perspective, a higher ratio is better. An investor can compare two ROCE on two investments and find out which one performed better.

The formula is quite simple and interesting, all you have to do is to divide the profit on your capital employed, phew, you’ll get your ROCE (Return on Capital Employed).

So, take a basic example first, let’s say that you commenced a trading business with your life-long saving of $50,000. This business earned you a PBIT (Profit before interest and tax) of $10,000. So, how was much was your return on capital employed.

ROCE = $10,000 / $50,000 * 100 = 20%

Thus, Return on Capital Employed is 20% for one year. Now, question is, if you run the same business for 5 years, and you earn $20,000 each year, how much will be your ROCE and how to calculate it.

If we need to calculate 5 year’s ROCE, then we need to calculate as follows:

 

Year Return ($) in present value ROCE (on investment of $50,00)
1 10,000 20%
2 12,000 24%
3 8,000 16%
4 15,000 30%
5 8,000 16%
Total 53,000 106%

 

In the above table, we can see that ROCE ratio has been calculated for each of the 5 years. However, if we want to calculate average Return on Capital Employed in the five years, we can take an average by dividing 106% by 5 resulting in answer of 21.2% average annual Return on Capital Employed (ROCE).

 

 

Key features of ROCE ratio:

  1. The formula for ROCE is simple to understand and calculate. You don’t need to be a CFA charterholder in order to calculate ROCE. An investor can easily calculate this ratio.
  2. ROCE is easy to understand and explain. An investor can himself identify a better investment by calculating ROCE of two investments. For example, if Return on Capital Employed of company A is 20% and the ROCE for company B is 15%, then the company A is a wise investment choice.
  3. ROCE can be used across different sectors and industries and even across different geographies. This measure work in almost all organization types. You don’t need to make changes for making two investments comparable.
  4. It is a good performance measurement tool and performance of different products, divisions, companies and countries can be calculated and compared easily. Therefore, the ROCE ratio is used for multiple purposes.
  5. Minimum data input is required for calculation of Return on Capital Employed. The profit figure is mostly available from the annual report or published condensed financial statements of companies.

 

 

Draw backs of ROCE ratio:

  1. ROCE does not itself take into account time value of money. However, an analyst needs to first calculate present value of the returns before using them in the formula of Return on Capital Employed. For this purpose, cash flows need to be discounted using Net Present Value (NPV) method.
  2. ROCE would not indicate how long is the payback period of a particular investment. For that, payback period method will have to be used. Does not depict what is the payable period.
  3. Accounting policies may be different for different companies and industries. This may lead to distorted comparison of ROCE. For example, a company may be using revaluation method for its fixed assets while another company may be using cost method. Different methodologies will result in different figures for profit and assets.
  4. ROCE ratio does not take into account various non-cash factors like depreciation, provisions, amortization etc. More meaningful comparison may be made by calculating EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization) ratio.

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Categories
Financial Accounting

Implementation of IFRS 17 – Insurance Contracts

[vc_row][vc_column][vc_column_text]IFRS 17 is a major transformation in the way insurance companies are currently accounting. This standard will bring many changes in the insurance industry. The items which are significantly going to be affected are the provisioning for the receivables, booking of earned premium, recognition of claims, estimating reserves, actuarial estimates, provisioning for IBNR, reinsurance claims and reinsurance premium.

Implementation of IFRS 17 cannot be done single handedly or by a single person. It would require a collaborative effort of experts of different disciplines. Management needs to understand and decide on strategic nature issues of the transformation process. Actuaries will provide guidance on changes to the reserving methodologies. I.T teams need to assess the capability of existing infrastructure and its compatibility with the requirement of IFRS 17. Finance needs to ensure correct transition at the time of system upgrade and ensure correct accounting rules application.

 

The implementation date is 1 January 2022 and it is two years away from now. Many organizations have not yet taken concrete steps in the implementation of IFRS 17. Some are in the process of negotiating with a implementation partner while others are still having intermittent internal discussion. Some of the organizations are quite fast and they have already signed agreements and things are set in place to start working on the designing and implementation of IFRS 17.

Regulators of insurance sector, all around the world, are also taking special interest in the implementation journey of IFRS 17. Since, the new standard is going to significantly impact the insurance industry and regulators have to ensure that the interest of the policy holders are protected appropriately, they need to monitor the compliance with IFRS and its impact on financial stability and solvency of the insurance companies.

A change in the existing accounting systems is a must in order to meet with the requirements of new standard. There are several functionalities which are required but not available in the legacy systems of insurance companies. The changes to the systems, their testing and the final implementation is going to cost significantly in terms of money, time and effort.

 

All these challenges are bringing lots of opportunities as well, especially in the job market, many new positions are about to be created. Organizations would need project managers, implementation partners, consultants, IFRS experts, actuaries, database administrators, data anlysts, financial analysts and investment advisors. IFRS 17 implementation would require a handful expertise from different disciplines. This is the right time to acquire these skills and pitch for these positions in the insurance sector.

How will the shareholders of insurance companies be affected by the implementation of IFRS 17. This is a big question mark and there are different aspects which can lead to different directors. For example, the increased cost of the compliance would initially result in higher expenses and thus will decrease the profits. Increased requirements for solvency, strict criteria for booking provision and recognition of the provisions for receivables at the early stage of policy booking would all lead to lower net profits. However, on the other side, the new standard would enhance investors’ confidence on the financial reporting. It would also provide additional opportunities of financing and funding insurance companies and thus trading would boost.[/vc_column_text][/vc_column][/vc_row]

Categories
Financial Accounting Financial statements

Cash and trade discounts explained intelligently

[vc_row][vc_column][vc_column_text]A discount is kind of a concession or waiver from the original obligation.

For example, if a prisoner is jailed for four years but is released after four years, he has got a discount of one year. Now, this example is not in business context, but to explain the discount.

In a business context, if a company had to pay $100 to a supplier and the supplier offered to make payment of $95 only against full settlement, it means that the supplier has given a discount of $5.

 

Trade Discount (or bulk discount)

A trade discount is a discount which is given at the time of trading (i.e., the discount given at the time of making the deal).

For example, you get a quotation from a car dealer for annual maintenance contract of the car at a price of $500. Now, you want them to lower their price as if you feel that it is high. If they agree to bring it down to, say, $450, it means that you have been given a trade discount.

Normally trade discount is offered when a bulk purchase is made. For example, if standard price of a watch is $100 and you want to purchase ten such watches, you might be offered a bulk purchase discount of 10% on total price. In this case, you will have to pay only $900 (instead of $1,000) for ten watches.

Another reason of offering a trade discount is the long term relation between customer and supplier. If there is a longstanding customer, the supplier may be willing to sale products at a discounted price than standard rate.

Some suppliers who are relatively new in business would consider offering trade discounts to new customers as well in order to make long term relations with them.

 

 

Accounting entries for trade discounts:

The general ledger entries done by bookkeepers for trade discounts or bulk discounts is usually, not recorded in the books of accounts of the company. This is because sales value has to be booked as per the contractual terms agreed between customer and seller.

For example, if a company sells a trolley bag at a price of $45 whose standard price is $50, it means that the company has offered a trade discount of $5 to its customer. Now, the deal is done at $45 and therefore, applicable accounting standards would require sales amount to be booked at the value of the consideration agreed between parties. The accounting entry for this sale will be as follows:

Debit: Customer account                              $45

Credit: Sales Account                                      $45

As you can see above, there is no space available for the discount to be recorded as account double entry is of equal amounts on debit and credit sides.

 

Needs for recording trade discounts:

However, from a management reporting point of view, financial analysts would want to know how much trade discount was offered to the customers during a particular month or a year. Similarly, to which customers trade discount was offered and by how much. From an internal and external audit point of view, auditors would want to check if the approvals for trade discounts were properly obtained. From an internal controls point of view, management would be keen to ensure that no unauthorized approvals are given for the trade discounts.

All of above requirements (management information system, audits, internal controls, performance measurement, sales performance etc.) require that trade discounts should be recorded and reported appropriately.

 

Recording trade discounts:

Although we cannot record trade discounts in our accounting books as this is prohibited by GAAP. But we can incorporate this in our management information system (MIS). A good MIS would have standard price of each product in the system. Any trade discount offered by sales team (after due approvals) would be entered in system and system would keep the record of trade discount offered. Later on, a report can be extracted from system for performing various types of analysis on discounts offered. However, this discount will not be reported in the company’s income statement.

 

 

Cash discount or Settlement Discount

Cash discount (or settlement discount) is an incentive offered to the customer for making early payment.

For example, if a customer has a credit period of 30 days for payment of $1,000, you can offer them an early settlement discount (or cash discount) of 2% if they make the payment within 10 days of the sale.

It is important to understand that cash discount does not necessarily require a ‘cash’ payment. The real objective of cash discount is to incentivize early settlement of the outstanding amount. Payment can be made using any mode like cash, cheque, bank transfer or credit card etc. As long as payment is made within the required time period, the customer will be eligible for the discount. Therefore, the cash discount may also be referred to as cheque discount, bank transfer discount, credit card discount, paypal discount etc. However, these terms are not common.

 

 

Accounting for Cash discount:

The cash discount shall be recorded in the books of accounts of the company as an expense. The cash discount will be booked as debit entry in the cash discount expense account and the respective credit will be provided to client’s account.

Cash discount is an expect for the company and thus will be classified in P&L as discount expense. In profit and loss account gross sales shall be reported as a top line. The discount given shall be then subtracted to arrive at net sales revenue figure.

Comprehensive example for cash discount:

Let’s say that Company A purchases 50 units of leather jackets at a credit period of 30 days, from an online retailer of leather jackets (i.e., www.smartleatherjackets.com). The standard price of these jackets is $100 per jacket. The supplier agrees to provide a 10% trade discount and additionally offers to provide 5% of settlement discount if payment is made within 5 days. Assuming that Company A makes payment within 5 days and avails cash discount. The accounting entries shall be recorded as follows in the books of supplier.

 

 

Deciding when to provide cash discount

When a company would want to offer cash discount is not an easy question. Financial analysts have to make carefully opportunity cost analysis to find out whether it is worthwhile offering cash discount or not. A cash discount offered will help in faster collection of receivables and thus interest cost of financing working capital (receivables) can be lowered. On the other hand, the amount of discount offered will be expense for the company. So, a cost benefit analysis has to be done. If the company is spending significantly on working capital investment and the early collection benefit is higher than the amount of discount offered, then offering discount is worthwhile. On the other hand, if the company is not incurring significant cost of financing working capital and there is no hurry to collect money from the customer, then offering discount will be expensive for the company. These decisions require significant study and analysis.

 

Practices of discounts in different industries

Retail or FMCG Sector

In retail sector, trade discount is most common. As an ordinary customer, if you enter a retail store, you might find some products on discount. Often in a sales promotion, you might get upto 50% off or 75% off etc. All this is practical example of trade discount.

There is no cash/settlement discount, usually, in retail sector for retail customers. However, corporate customers may still obtain a cash/settlement discount, in addition to trade discount.

 

 

Real estate sector

Cash discount/ settlement discount is quite common when it comes to buying a property. Many project plans offer 10% off or 5% off on full settlement of property price. This is a good practical example of cash/settlement discount in real estate sector.

Financial / banking sector

Often banks offer a settlement discount if you choose to close your mortgage by making a full payment of the total outstanding liability. This is an example of cash/settlement discount. However, this policy varies from place to place. Some banks charge a penalty for early settlement as well.

 

 

Electronics industry

If you are ordering bulk quantities of electronics equipement (say mobiles, headsets, chargers, powerbanks etc.) from China, you are likely to receive good trade discount. This means that you’ll get, say, 20% or 30% off on the standard product retail price. Trade discount is common across industries when it comes to buying in bulk quantities.

 

Conclusion

Understanding trade and cash discounts is relatively a simple topic. By now, you would be aware of nature of discounts, accounting entries and application of discounts in different industries. Providing discounts is an important economic phenome and it there are psychological implications of discounts as well. We will cover further details about discounts in more articles.[/vc_column_text][/vc_column][/vc_row]

Categories
Cost Accounting Cost types

Direct Cost, Variable Cost, Fixed Cost, Indirect Cost

[vc_row][vc_column][vc_column_text]Do you find it confusing on how to classify costs among direct cost, variable cost, fixed cost and indirect cost? Well, this article is written for you and this will bring an end to the confusion about these classifications of costs.

 

Executive summary

Before we go on to explore the definitions and examples of direct cost, the variable cost, fixed cost and indirect cost, let’s understand first that the sum of direct costs and indirect costs is equal to total costs.

All Direct Cost + All Indirect Costs = Total Costs

Similarly, the sum of all variable costs and all fixed costs also equals to Total Costs.

All Variable costs + All Fixed Costs = Total Costs

Total costs mean all and every kind of expenses which a company may incur. So, there are two ways of calculating total costs. Now, the critical point is, the total costs would always be the same, whether we calculate by the first formula or by  second formula. The answer should be the same and not different.

Another critical point is that Direct costs can be classified into further two types, i.e., Direct Variable cost and Direct Fixed cost. Similarly, indirect costs may be classified into two types, i.e., Indirect Variable Cost and Indirect Fixed Cost.

On the same lines, variables costs can be classified as Direct Variable costs and Indirect Variable Cost. Further, Fixed costs may be classified as Direct Fixed cost or Indirect Fixed cost.

Even if you didn’t understand the concepts till now, don’t worry, let’s start and explore all these types of costs one by one.

 

Businance.com Fixed Costs Variable Costs Total
Direct Costs
  • Rent of production factory
  • Security charges of production department
  • Utilities fixed charges of plant
  • Crew salaries
  • Salaries of bus drivers for a tour operator company
  • Direct material
  • Direct Labor
  • Direct supervision
  • Electricity consumption charges of manufacturing unit
  • Food served on a plane
  • Fuel used by a taxi company
  • Construction workers daily wages
  • Hourly teaching rate of visiting faculty
 Fixed Direct costs + Variable Direct Costs = Total Direct Costs
Indirect Costs
  • Direct material
  • Rent of admin office
  • Salaries of finance staff
  • Staff medical insurance cost
  • Utilities fixed charges of administration
  • Annual license fee
  • Indirect material
  • Indirect labor and supervision
  • Sales commission
  • Additional packaging cost
  • Utilities variable charges of administration
  • Income tax
 Total Indirect Costs
Total Total Fixed Costs Total Variable Costs Total Costs

 

Direct Costs and its types (definition, examples and explanation)

 

Direct Cost definition: “A direct cost related to a product or a service is a cost which is incurred directly as a result of producing that product or providing that service.”

In short, any cost related to manufacturing / producing a product is a direct cost. Below are some of the examples of direct costs:

  1. Cost of wood and steel used in manufacturing a chair (furniture industry)
  2. Cost of labour which produced hand-made jackets (manufacturing sector)
  3. Cost of utility bills (electricity, water) of the production plant (
  4. Cost of food served in an aeroplane to the passengers (airline sector)
  5. Salaries of bus driver and crew for a tour operator (tourism sector)
  6. Commission of real estate agent for each unit of an apartment sold (real estate sector)

 

All of the above-mentioned costs are directly related to the manufacturing of goods or providing services. There is no chance of these goods manufactured or services offered without incurring these costs. Therefore such costs are termed as direct costs as they incur directly as a result of making a product or delivering a service.

As a general rule of thumb, any expenses which are incurred in the production plant will be considered as direct expenses (or direct cost).

Now, let’s discuss what are the two types of direct costs, as mentioned earlier, the two types of direct costs are as below:

  1. Direct Variable cost (also called Variable Direct cost)
  2. Direct Fixed cost (also called Fixed Direct cost)

 

 

Direct variable cost

A direct variable cost is that type of direct cost, which is proportional to the activity level, i.e., this cost will increase if more units are products and this cost will decrease if fewer units are produced.

Example 1

For example, the cost of material is a direct variable cost. The more leather jackets a company will manufacture, the more will be the total cost of raw material for that company. The fewer jackets it produces, the less expenditure the company will have to incur on raw material for leather jackets.

Example 2

Another example is the cost of direct labour, i.e., the worker or staff who worked directly on manufacturing that product or delivering that service will be considered as a direct variable cost. Let’s take one example of the construction sector, where construction labour is paid daily for construction work. The number of days the labour will work, the more will be the cost of labour. Thus, it is a variable direct cost.

Example 3

Another example would be the fuel cost of a transport company. The more trips a bus will make, the higher will be the fuel cost. Fuel cost is directly related to the provision of service (pick and drop, city tour, transportation etc.), and it would vary depending upon the level of activity is done in a day. Therefore, fuel cost would be classified under direct variable cost for a transportation company, logistics company, tour operator company, cargo service, airline, bus and railway network etc.

However, it is important to differentiate that same fuel cost will not be a direct cost for some other sectors like an I.T company, a furniture manufacturer or a towel manufacturer as this fuel is not used directly on the production of goods or delivery of services.

Example 4

For a software development company, the salaries of developers can be classified as a direct variable cost. A time record sheet can be kept to track how many hours of each developer are spent on a particular software/project. Then, the salary of that developer will be directly allocated for those number of hours to that particular software/project. The more time a developer will spend coding a particular program, the higher will be salary recharge to that project. Thus, salaries of software developers become a direct variable cost for that service.

Example 5

Electricity consumption charge of a factory where surgical equipment is produced would increase with the increase in the activity level. If more medical products are manufactured, the higher will be the electricity consumption charge. Thus, electricity consumption charge of the manufacturing facility is a direct variable cost as it is being incurred directly on the production process, and it varies as per the activity level. (Please note that we are not referring to fixed-line rent of the electricity meter here, as it would remain fixed regardless of activity level).

 

 

Direct fixed Costs

A direct fixed cost is the second type of direct costs (the first being direct variable cost). A direct fixed cost is a cost which is directly related to the production process or service delivery but does not vary as per activity level. This cost would remain the same even if more or fewer units are produced.

It is essential to understand that direct fixed cost is incurred on the core product or the service which is being provided to the customer, and this cost should not increase if the activity level is increased or decreased.

Example 1

Let’s take an example of a manufacturing unit which produces textiles in a rented building. The rent of the building where manufacturing is being done is directly related to the production because production is happening here. However, the lease amount will not increase if the textile unit produces 1,000 shirts or 1,200 shirts in a month. Similarly, rent will not decrease if that textile unit produces 800 shirts. Rent will remain the same. Thus, rent expense of the production facility is considered as a direct fixed cost.

Example 2

Let’s take an example of a university whose core service is to provide education and lectures to the students. The full-time lecturers who are employed at a monthly salary provide this core service to the customers (i.e., students). The salaries of these full-time lecturers remain the same regardless of the number of lectures delivered in a day. This is an example of a direct fixed cost in an educational institution. Please note that if a lecturer is on visiting faculty and charges university at an hourly rate, then, the remuneration of that visiting lecturer would be considered as a direct variable cost.

Example 3

In the healthcare segment, where doctors are employed at a fixed monthly salary, the salaries of such doctors will be considered as a direct fixed cost. The salary is a direct cost because doctors are directly involved in providing the service (i.e., treatment) to the customer (i.e., patient). Since the salary is fixed (regardless of the number of patients treated), it would be considered as a direct fixed cost.

Example 4

If a company registers a patent of a particular formula or a product, the cost of that registration of copyright would be considered as a direct fixed cost. For example, let’s take an example of a manufacturing company which invented a new medicine for the treatment of cough. Now, this medicine and its formula are patented by the company by paying registration and patent fees. Under this patent, the company can manufacture unlimited units of this product, and no other company can use the same formula. The registration cost of this patent is directly related to the manufacturing of this medicine. Because, without having registered this patent, the company could not produce this medicine. But the cost of the patent would remain fixed and will not vary based on the number of units produced. Thus, the cost of registration of patent of a new formula or design or a model for a pharmaceutical company or an automobile company would be considered as Direct Fixed cost.

Example 5

Depreciation expense of the plant, machinery and the manufacturing equipment is a fixed direct cost. The cost is fixed as the rate of depreciation would remain the same (unless there is some situation where depreciation is accelerated based on the usage of the machinery). Similarly, depreciation of the building where manufacturing is carried out will be considered as a direct fixed cost. Similarly, in case of a telecom company, depreciation expenses of the telecom equipment (towers) installed in different areas would be considered as a direct fixed cost. This cost is direct because it is directly related to the provision of telecommunication services, and it remains fixed on a monthly or yearly basis.

 

Indirect Costs and its types (definition, examples and explanation)

 

Definition of indirect cost: “An indirect cost is a cost which is not directly related to manufacturing of a product or creating a service”.

So, instead of being the core activity of the business, these are the additional or support functions which facilitate the core activity of the business.

Examples of Indirect Costs are as below:

  1. Salaries of human resource department, finance department, I.T department, administration department etc.
  2. Traveling charges, printing charges, postage charges incurred by support functions (i.e., finance department, HR department, IT department, procurement department etc.)
  3. Rent expense of the support departments
  4. Utility charges incurred by support departments
  5. Depreciation, amortization and impairment of the assets not related to production

There are two categories of indirect expenses:

  1. Variable indirect expenses
  2. Fixed indirect expenses

 

Variable indirect expenses

Variable indirect expenses are costs incurred in an organization which are not directly related to the manufacturing of a product or providing of service but which vary with the activity level of the company. i.e., if more goods are sold, these expenses will be increased, and if fewer products are sold, these expenses will decrease. Similarly, if more services are provided, these expenses will increase, and if fewer services are provided, these expenses will decrease.

Example 1

The first example of an indirect variable cost we will take is of the ‘indirect material’. An indirect material is a material which is not used in the manufacturing process, but it is used as part of the sales. For example, let’s take the case of a factory outlet which sales shoes. Now, the box in which shoes are handed over to the customer is not a direct cost related to the production of shoes. But still, the cost of a box is a variable cost as it would increase with the increase in the number of sales.

Alternatively, take an example of a retail store which is in the trading business, i.e., it would buy products and then sale ahead without any modification. The direct cost for the retail industry is the cost of the purchase of those products. However, once any product is sold, it is usually handed over to the customer in a polythene bag. This polythene bag is not part of the product cost, which is purchased, so it is not a direct cost, but it is an indirect cost. The cost of polythene would increase with each level of activity, i.e., sales; thus, it would be considered as an indirect variable cost.

Example 2

Let’s take the example of a football stadium which conducts football matches and tickets are sold online through a ticketing partner. This ticketing partner will charge a commission on each ticket sold. Now, the commission of the ticketing partner on the sale of the tickets is not a direct cost for the football stadium because the direct costs are related to the providing of sports facility to the player. However, this cost would increase with each ticket sold through the ticketing partner, and thus will be classified as an indirect variable cost.

Example 3

Let’s say that you are the owner of a restaurant and provide meals to the customers. As part of your business strategy, you also offer free home delivery at the same rate as of dine-in. Now, if a customer places an order to deliver a meal to his doorstep, you need to send this meal to the customer. This has been outsourced to a third party company. This third party would charge say $2 for each delivery of your meal. Now, this cost is another example of an indirect variable cost. This cost is not directly related to the preparation of the meal. However, it would increase with each new level of activity.

 

 

Fixed indirect expenses

Fixed indirect expenses are those expenses which are not directly related to the activity level or production level or service providing. Further, these are fixed in a given period and do not change with a change in activity level.

This means that fixed indirect expenses will not increase if more customers buy your product or service.

Example 1

If you are an online retailer and your I.T team is inhouse who handles all IT related issues. The salaries of this IT team would not increase due to the higher number of orders in a month than another. The same applies to the salaries of Finance team, HR team, procurement team and administration team.

Example 2

Another ubiquitous example of indirect fixed cost is the rental expense of office blocks (not of the production block). The building in which all support functions are operating, the rent of those buildings or units would be considered as indirect fixed costs. The rents would not increase or decrease from one month to another if there are a higher or lower number of orders between these two months.

Example 3

All routine office expenses like printing and stationery, courier, postage, electricity, water, pantry expenses and routine repair and maintenance incurred in the support function departments like HR, IT, Finance, Procurement, Administration, Security etc. would be considered as indirect fixed costs. These expenses are not directly related to production or service delivery. These expenses would also not be varying with a change in activity level.

Final Remarks

Correct classification of expenses may seem easy in simple situations. However, it might get extremely complex is today’s dynamic and fast-changing environment. With significant growth in industrialization, it might be challenging to find out what is the correct classification of a particular cost. Correct classification sometimes requires judgment, and there might not be one right answer always. Classification of costs varies industry to industry, requires sharp observation and understanding of the cost nature.

Classification of expenses is a complex task, it varies from industry to industry, and there is significant involvement of judgment. Some theorists have defined classification in a different way than what is outlined here. For example, some theorists would classify the electricity cost of the production department as an indirect variable cost. However, in our approach, we have taken all expenses related to production as direct expenses. It depends on which methodology you use, but you need to be consistent in your methods.[/vc_column_text][/vc_column][/vc_row]

Categories
Finance basics Investment Management

Share capital, definitions and types

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Shares:

The term shares frequently refer to ‘share capital’. The word ‘shares’ is used as a short form of ‘share capital’.

Capital:

Capital usually refers to investment in a business. It is money for starting or investing in a company. Sometimes, the word ‘capital’ is also used as a short form of ‘share capital’. However, the word ‘capital’ includes both shares and long term borrowings.

Share capital:

Share capital refers to the money which is attributable to the owners of the company: This includes common stock and preferred stock (but does not include borrowings and debts).

Ordinary share capital (or common stock):

Ordinary share capital or common stock refers to primary shares of the company. This type of shares of the company contains ownership rights, and this is the most common type of shares. These shareholders have the rights to appoint the company’s directors at the election of shareholders.

These shareholders have the residual interest in the company, i.e., in the case of winding up of the company, whatever remaining assets will remain after payment of all other liabilities, loans, preference dividend, taxes etc. that residual assets will be distributed among ordinary shareholders.

Preference share capital:

Preference share capital is the second type of share capital where preference shareholders are entitled to a predetermined preference dividend. The dividend amount is fixed at the time of issuance of these shares. These shareholders usually do not have voting rights at the annual general meetings of the company. These shares do not have an expiry or maturity date, similar to ordinary share capital.

 

Authorized share capital:

Every company is run under defined regulations contained in the memorandum of association and the articles of association of the company. These regulations specify an authorized amount of the share capital of the company. The authorized share capital of the company is the maximum amount of share capital which a company can issue. For example, a company’s regulations may state that the authorized share capital is $10,000,000. This clause means that the company can issue a maximum of $10,000,000.

The nominal value of shares:

Nominal value of the stock is the value of the share stated on its share certificate. The nominal value of the share is the par value of one share of the company. Usually, the nominal value of the shares is $1. However, these shares may be traded on a stock market at a value significantly higher than the nominal value, e.g., $5 or $20.

The market value of the shares:

The market value of the shares is the value of the share at which a transaction is carried out in the market. The market value of the shares may be significantly higher (or lower) than the nominal value of the shares.

 

 

Issued Share Capital:

Issued share capital means the amount of share capital which has been issued by the company out of its total authorized share capital. Let’s say that if the company’s authorized share capital is $10 M, the company may issue only $2 M out of it at one instance. Later on, the company may issue further shares of $1 M. Thus; company’s issued share capital is always less than or equal to its authorized share capital. It is important to note that the value of the issued shares of the company in the company’s balance sheet will always be represented at the nominal value of the shares. For example, the $2 M issue which we talked about here, is the nominal value of the shares and not the market value.

Let’s say that if the nominal price of a company’s share is $1 per share, and it issues 1 million shares at a market value of $2 per share. In this case, the company’s issued share capital shall be considered as $1 M only. This is because issued share capital is booked at the nominal value of the shares of the company.

Issuance of share capital:

Issuance of share capital means that the company collects share price from the investors and award them shares of the company (in the form of written certificates). Once investors purchase these share certificates, those investors become shareholders of the company.

Share certificates:

Share certificates are the written pieces of paper which contain the number of shares and the name of the shareholder duly authorized by the company. For a shareholder, a share certificate is proof of the share ownership.

 

 

Subscribed share capital:

Subscribed share capital is the amount of the share capital, which has been purchased by the shareholders. This is usually equal to the issued share capital. For the sake of understanding, consider the below press release from a company, “We had announced to issued $ 2M share capital, and all of that got subscribed within a week.” This statement means that when the company announced to issue share capital and invited investor to invest money, the investors subscribed (submitted application forms along with fees, etc.) all share capital.

Paid-up Share capital:

Share capital of the company for which the shareholders have made payment to the company. Shareholders are liable to make the payment for the shares after they subscribe to the shares within a particular time. Sometimes, a shareholder may subscribe the share capital by submitting application forms, but later on, does not complete the payment. However, usually, paid-up share capital is equal to the subscribed share capital of the company, which in turn is equal to the issued share capital of the company.

Called up share capital:

This is the part of the share capital for which the subscribers have not made payment of the share capital, i.e., shareholders. For these shares, the company has requested the payment, but payment is not yet made. Called up share capital is a contrast to paid-up share capital. Once the payment for the called up share capital is made, it will be converted into paid-up share capital.

Callable share capital:

This is the part of the share capital for which payment has not yet been requested by the issuer of the capital. The company has the right to call up (i.e., raise demand for the payment against these shares) against this share capital.

Share premium:

Payment made by the shareholders to the issuer company for the purchase of shares in excess of the nominal share price of the company. This means that if the company’s nominal value of shares is $1,000 (i.e., 1,000 shares for $1 each) and the company issued these shares at a price of $1.5 each, i.e., for $1,500 then the additional amount of $500 ($1,500 minus $1,000) will be share premium. Share premium is kept as a capital reserve in the books of the company.

Issuer company:

A company which is issuing its shares to the investors/shareholders is called issuer company.

Capital reserve:

A capital reserve on the balance sheet of the company is a reserve which is not created through routing profit from profit and loss account. This means that this reserve is not created from the profits of the company. Instead, this reserve is directly created from contributions from some other sources. For example, the share premium payment made by shareholders above the nominal price of the share is reserved in the share premium account. This share premium account is an example of capital reserves. Another example of the capital reserve is an asset revaluation reserve which is created as a result of an upward revaluation of property, plant and equipment. A capital reserve cannot be used to pay dividends to the shareholders.

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Categories
Audit in general Auditing & Tax

Ten misconceptions about Role of External Auditors

[vc_row][vc_column][vc_column_text]In today’s complex corporate governance requirements, the role of external auditors is quite important and significant. They act as a third party check and provide an independent opinion about the financial statements of the company.

However, there are some general misconceptions about the role of external auditors. It is essential to understand the limitation of an external audit. In the below points, we have listed ten misconceptions about the role of an external auditor and the respective reality.

 

Misconception 1: External auditors are responsible for the detection and prevention of frauds and errors:

Reality: External auditors are not responsible for the detection and prevention of frauds and errors. However, they may (or may not) come to know about any fraud in the organization. Once they know or suspect that there is a fraud, they have to get further details about it. However, depending upon the quantum of the fraud, they may still not report the same in their audit report. Further, it is the management of the company who is still responsible for the detection and prevention of fraud in an organization.

Misconception 2: External auditors are checking and reviewing all the transactions of a company

Reality: The external audit is carried out in a short period with a limited number of team. It is not practically possible to test and verify every transaction of the company. External auditors only validate a sample of the transactions. This sample of transactions is selected using statistical techniques or based on the past assessment of the auditor or the materiality (high amount or nature) of the transactions. It is still likely that a significant portion of the suspicious transactions remains unchecked.

 

 

Misconception 3: External auditors report all errors found in their audit report

Reality: External auditors work as partners of the companies. They do not intend to report errors in their audit reports. Instead, if external auditors find any mistake in the financial statements, they help the organization by suggesting to correct these errors. Often, both auditors and company’s management finalize the financial statements together, reducing the mistakes and miscalculations in the financial statements. Only in the case of a material and pervasive disagreement between auditors and the company’s management, the auditor would report such disagreement in their audit report.

Misconception 4: External auditors ensure that financial statements are free from errors and are accurate

Reality: Based on the limited time, selected sampling and limited staff, an external auditor can’t detect all the errors in the financial statements and make the financial statements accurate and free of errors. External auditors cannot ‘ensure’ that financial statements are free from errors. Instead, they provide their opinion about financial statements which they formulate by performing audit procedures.

Misconception 5: External audit is a guarantee that there is no financial fraud happening in the company

Reality: A well-carpeted scam may still go undetected even if well-reputed external auditors regularly audit the company. Techniques of collusion, window dressing, under-provisioning, overestimating revenues, undercharging depreciation, misleading interpretation, misuse of assets, weak internal controls, politics, reporting selected ratios in annual reports, may still not be detected and reported by external auditors.

 

 

Misconception 6: External audit is a confirmation that the operations of a company are being conducted most efficiently and effectively.

Reality: An external audit is not an efficiency check on the operations of the company. A statutory external audit is about providing an opinion on the financial statements. There are separate categories of operational audits which are available to assess operational efficiency. For example, how much material is being wasted during production? How much time is extra being consumed during the hiring process? What are the critical elements missed out in a strategy formulation? Which contracts were awarded to close relatives? Etc. Such instances are not usually reported in a statutory external audit report. A specific operational or fraud investigation audit may be used for such conditions.

Misconception 7: A good external audit report indicates a good management strategy of the organization

Reality: An external audit is not usually about checking the strategic direction of the organization. Did the organization select the best product mix? How successful was the innovation process during the year? What improvements are brought in the customer service? Has hiring and retaining employees improved? How well the company competed in the market? These items are usually not on the agenda of the external auditor.

Misconception 8: A clean audit report means that the company’s chances of success and future profits are high

Reality: Many companies go bankrupt or liquidated even after having a clean audit report. Does it mean that their auditors were not competent? Or they did not perform their responsibilities with honesty? No, it doesn’t say that. It’s because it’s not on the auditor’s part to ensure that a company remains successful and profitable.

Misconception 9: A clear external audit report from external auditors means that the company is paying its taxes correctly

Reality: Statutory audits are not detailed testing of the tax calculation of the company. Instead, external auditors would make a quick analytical assessment of the taxes and whether they seem to be correctly reported. It is not a detailed, line-by-line checking of the tax returns ensuring that all the items are correctly calculated and reported and that the tax laws have been correctly and fully interpreted in the preparation and submission of tax returns.

Misconception 10: External auditors claim that their report is a guarantee of accurate financial reporting.

Reality: External auditors never claim that their report on the financial statement is a guarantee that the financial affairs of the company have been correctly and accurately reported. In fact, they mention in their description that it is the responsibility of the management to prepare and present financial statements correctly. External auditors only provide an opinion about the financial statements, whether, in their opinion, the financial statements of the company are presenting a true or fair view or not.

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Categories
Assets Financial Accounting

Prepayments, concepts and accounting

[vc_row][vc_column][vc_column_text]So today’s question is, how to handle prepaid transactions in accounting & bookkeeping. There are below important points in handling prepayments:

First of all, you need to ‘identify’ a prepaid transaction. A prepaid transaction occurs when you have made the payment, but you have not received goods and services in consideration of that payment. Alternatively, you’ll be delivered those goods or services over a while and not instantly upon payment.

A prepaid expense is represented under current assets in the balance sheet. Once the prepaid cost is utilized, it is presented as an expense in the income statement.

 

 

General examples of prepaid expenses

Following are some generic examples of prepaid expenses:

Rent paid in advance:

Usually, office and building rentals are paid by businesses in advance for three months or six months or sometimes for one year. So, let’s say if you have spent six months’ rent on 1 January for the period from 1 January to 30 June, you need to record this transaction as a prepaid expense on 1 January. Then, at the end of each month, you need to classify one month’s rent as an expense and reduce your prepaid rent gradually. Thus you’ll be passing debit rent expense and credit prepaid rent account entry at the end of every month.

Medical Insurance paid in advance:

Medical insurance for the employees and their dependents are usually paid for one year in advance (or at the beginning of the insurance period). Therefore, at the beginning of the insurance period, the insurance premium paid should be recorded as a prepaid expense and then it should be amortized subsequently at the end of each month as an expense. Same is true for any property or liability insurance.

Subscriptions paid:

If your organization is a member of any trade association or an activity group and you pay annual subscription of that association in advance at the beginning of each year, then, this annual subscription would be considered as a prepayment for one year when paid at the beginning of the year. You need to amortize this payment every month into expenses and gradually reduce the prepayment account.

Prepayments for goods or services:

If a supplier requires to make a prepayment (or advance) for before they can deliver products or services to you, then, this payment of advance to the supplier would be classified as prepayment until goods or services are provided.

Training program:

If a training program of six months is purchased and payment is made in advance, then this advance payment should be booked as a prepaid expense in the balance sheet. This prepayment will be expensed out every month in profit and loss.

Software fee:

If you have purchased a license for a software for one year (or less), then you can book this amount as a prepaid and charge it out to P&L every month.

Trade license:

In certain countries, a trade license is issued at a high cost for a year. This trade license cost should be recorded as prepaid and then monthly expensed out.

 

 

One comprehensive example of prepayment

For example, if you have to place an order for delivery of 500,000 blocks for your next construction project and the supplier of construction material provider has asked for an advance payment of 25% of the value of the order before he can accept the order. Now, let’s say today is 28th of the month, and you place this order with advance payment of (say) $1,000. You make the payment, and now you want to record this transaction. The delivery of the blocks will come after 15 days, i.e., in the next month and you need to close your books of accounts, and you also need to record this transaction of payment of $1,000.

Above is an example of prepayment transaction where you have made the payment but you didn’t receive any item regarding the payment, yet. So, you’ll record the transaction as follows:

Debit: Advances to suppliers account (a type of prepaid accounts) $1,000

Credit: Bank account $1,000

The ‘advances to suppliers’ account is a general account for any supplier to whom advance is given. This account is one example of prepaid accounts. If you don’t have an advances to suppliers account, you can use a general ‘prepaid expenses account’ also. However, the important thing is, this payment should be classified as a debit amount in the month-end financial statements.

Now, when the construction blocks are received in the next month, you need to record the transaction of receiving blocks. The accounting entry would be as follows:

Debit: Construction material account $1,000

Credit: Supplier payable account $1,000

Now, with the above entry, the receiving of the material is recorded. However, currently, we have a payable to supplier account and a receivable from supplier account (in advances to supplier account). Now, we need to knock-off these two accounting entries to clear the prepayment.

Now, we’ll pass below entry:

Debit: Supplier payable account $1,000

Credit: Advances to supplier account $1,000

This above accounting entry will nullify our prepayment, and thus we’ll have nil balance in our prepayment account.

A short way could have been to credit advances to supplier account debiting material account directly. However, in that case, we would not find any entry in the supplier’s account if we needed to check at a later stage whether we had any transaction or payment to this supplier.

The above was a comprehensive example of one prepayment.

 

Further important points

It is essential to understand why we have to book payments are prepayments and then reverse these payments later at the time of delivery of goods and services. This accounting treatment is to ensure that we present our financial assets and liabilities correctly in our financial statements. If we have only made the payment and have not received the service, then this payment is an advance and should be classified as a current asset in our balance sheet. However, if we have received requested goods and services, then those payments are expenses (or sometimes assets) and therefore, should be correctly classified.

Sometimes, people get confused about advances and prepayments. All advances are not prepayments. For example, advances paid to staff for their personal needs are not prepayments. So, the rule is, if advance paid will be returned to the business, then it is a simple advance and not a prepayment. However, if the advance paid will not be refunded, instead, some goods will be delivered, or service will be performed, then that advance is a prepayment.

It is essential to differentiate prepayments from securities and deposits. Securities are payments made as a guarantee or collateral; it is a safety for the other party ensuring compliance with the contractual obligations. Deposits are money kept with suppliers’ accounts which are usually returned at the end of the contract period or after a fixed period. We do not amortize securities and deposits, as we do with the prepayments.

Accounting for prepayments can be complicated sometimes. You need to prepare a prepayment schedule to keep a record of all the prepayments. Sometimes, annual payments are made in the middle of the year such that payment partially relates to past and future months.  In such cases, ideally, you might have accrued expenses for which payment is made in the middle of the year. Please read our articles on preparing prepayments schedule and accruals accounting for details on handling such complex scenarios.[/vc_column_text][/vc_column][/vc_row]

Categories
Business Strategy Introduction to business

Planning and Control

[vc_row][vc_column][vc_column_text]Planning and Control are two words often used together, mostly in the corporate world, usually in the context of performance management or strategy formulation. The objective of planning and Control is to ensure that an organization achieves its goals and avoid any unforeseen adverse circumstances.

We can define planning as “a pathway outlining a series of steps which should are ought to be taken to achieve a goal or an objective”.

So, for example, if you plan to visit the nearest lake on the weekend, you’ll list out the steps to be taken to achieve this goal, which would include allocating a time slot, arranging travel to the place, purchasing or renting items for using on the picnic day etc.

So, in the corporate context, a plan to achieve the objective of profit maximization may include identification of profitable products, purchase or production of those products and then selling such products to customers to achieve the aim of profit.

Some of the examples of planning are as follows:

  1. Identification of market gap and drafting a suitable line of action to enter the market.
  2. Preparing a sales plan (budget) for the first three months of the business.
  3. Allocation of limited resources on different activities for optimum output, for example, how to utilize a limited quantity of material on the production of various products.
  4. Preparing a schedule of activities at the beginning of the day to be done during the day.
  5. Identification of resources to achieve a particular objective, like plan to use social media to recruit talented staff.
  6. During a war, planning is assessing your environment and then coming up with a thoughtful response.

 

Control is ensuring that plan works out in the planned way. If things are going out of the plan, Control will help things bring back to the track. Controls would handle many risks and uncertainties including laziness, fraud, unprofessionalism, delays, competition, regulatory compliance etc.

For example, keeping a record of all products entering and exiting the warehouse is an example of Control. This Control ensures that there is no misappropriation of goods from the warehouse.

There can be various examples of controls; some of these are listed below:

  1. Setting salaries for the employees to avoid any conflict in future.
  2. Maintaining daily attendance to ensure that everyone comes to work.
  3. Setting credit limits for the customers to avoid significant bad debts.
  4. Keeping limited signatories of bank accounts to ensure the safety of cash at bank.
  5. A compliance team to be assigned responsibilities for ensuring regulatory compliance.
  6. Setting budgets and targets for different expenses and revenue items for cost control and business development, respectively.

 

 

The word ‘planning and control’ is often used together, often as a synonym. Some activities can be classified as both as a plan and as a control. For example, a budget is both a plan and Control. A budget is a plan to achieve the desired level of revenue or costs. However, if the budget is not being achieved, an intimation alerts higher management, and thus management takes suitable corrective measures. Thus budget acts as a control mechanism also to report and suggest improvements.

Planning and Controlling is a vital skill in today’s career market. It is one of the desired skills mentioned in most of the job advertisements. Organizations are looking for candidates who can plan in a dynamic ever-changing environment and can control various factors to help an organization achieve its objective.

Planning and control activity is primarily designed at the strategic level of the organization. Board of directors and top management would be entrusted mainly with planning the resources of the organization, controlling the risks and uncertainties and keeping organization progressive and profitable. It is a tool of performance management as well as performance measurement.

 

 

Many middle-level managers and operational level staff would also be planning and Control in their daily routines jobs. For example, a machine operator worker has to plan and control the quantity of the raw material being inserted in the production machine and control the flow. A driver has to plan all endeavours and control the vehicle as per the surroundings.

An adequate level of planning and Control can help an organization achieve its objectives; any major draw-back in the planning and Control may lead the organization into astray.[/vc_column_text][/vc_column][/vc_row]

Categories
Audit in general Auditing & Tax

Performing audit procedures on trade receivable (debtors) balances

[vc_row][vc_column][vc_column_text]Trade receivables are one of the risky areas in an audit assignment, and it should be tackled professionally and tactfully. There might be a high risk for the overstatement of trade receivables to enhance current assets and the corresponding growth in sales.

As an auditor, first, you need to identify what are the audit risks in trade receivables (debtors) balances and then devise suitable audit procedures to handle these audit risks.

 

Identification of audit risks on trade receivables

Let’s list out possible audit risks in trade receivables as follows, remember to use ‘what could go wrong’ (WCGW) methodology and generate as many risks as possible in the given circumstances:

  1. Trade receivables stated in the balance sheet may be fictitious and non-existent in reality.
  2. Trade receivables balance provided by the management may be artificially increased to show higher current assets and higher revenue.
  3. Party-wise break-up of receivables might not be available.
  4. Sum of closing balances of individual accounts might not be reconciled with the debtors’ control account total.
  5. The ageing of the trade receivables may not be provided at all.
  6. Ageing of trade receivables figures may not be calculated correctly or maybe deliberately distorted.
  7. Other receivables and prepayments might have been wrongly classified as trade receivables.
  8. Some expenses might have been incorrectly classified as trade receivables instead of booking in profit & loss.
  9. Opening balances in the current year may not be matching with the closing balance of the previous accounting period.
  10. A payment made to a creditor’s account might not have been correctly booked in the creditor’s account; rather, it might have been booked as a receivable debit balance.
  11. The receivable balances might be outstanding for long, and thus provision is required.
  12. A receivable related to the next accounting period may be booked in the current accounting period or a receivable pertaining to the current accounting period may be booked in the next accounting period.
  13. Provision for doubtful and bad debts might not be correctly calculated and booked.
  14. There is a risk that the amount received from receivables is not recorded in the company’s books and the accounts receivables still show outstanding balances.
  15. A consistent methodology is not used for calculation of the provision for bad and doubtful debts.
  16. Certain long outstanding old receivables might have been netted off against trade payables.
  17. Proper segregation of duties may not exist. For example, if the same person is performing any two or more of following responsibilities, i.e., receipting money, preparing bank reconciliation statement, issuing invoices to the customer, depositing money in the bank accounts etc.
  18. There might be some logical error in the system, and the ageing report is not correctly generated.
  19. Receivables might have been booked before conditions of revenue recognition are met in compliance with applicable accounting standard (like IFRS 15 or IFRS 17).

 

 

Audit procedures on trade receivables

Well, once you have identified what could go wrong, i.e., audit risks on trade and accounts receivables, it would be relatively easy to devise suitable audit procedures to tackle these risks. Audit procedures should be designed to target audit risks. Each audit procedure should help in catering one or more audit risks, partially or fully.

Below are possible audit procedures for auditing trade receivables:

  1. Obtain a list of trade receivables, party-wise balances and their respective ageing.
  2. Obtain a schedule of provision for bad and doubtful debts, broken down into party-wise provisions.
  3. Review the increasing or decreasing trend of the receivables with previous accounting periods and assess if it is in line with the general economic environment and the company’s financial performance.
  4. Perform substantive analytical procedures to understand the trends and critical movements in the balances of trade receivables.
  5. Inquire with the management on the significant variances (if any) in the movement of trade receivables.
  6. Send balance confirmation letters to a selected sample of receivables.
  7. Check subsequent positioning of the receivables, i.e., check the movement in the balance after the reporting date but before audit report issuance.
  8. Keep a sharp eye on any reversals passed after the reporting period.
  9. Check for any dishonoured cheques of material amounts subsequent to closing period.
  10. Propose adjustment entries in the receivables balance to the management of the company.
  11. Critically analyze the assumptions used for the calculation of the provision for doubtful receivables. Use the historical trends, industry practice and subsequent collection details in your assessment.
  12. Perform cut-off procedures to ensure that receivables are reported in the correct accounting period.
  13. Critically inquire the reasoning of the change of the provisioning policy, ensuring that the management duly approved the policy.
  14. Carefully review the movement of any long outstanding balances ensuring that the collection is made and the balance is not just netted off against any payable balance.
  15. Perform a system check on the ageing report generated from the system, take help of I.T team if required to ensure that the system is calculating ageing correctly.
  16. Check if receipts are daily reconciled with the amounts collected in cash and bank.
  17. Check if the cash collection option is limited to authorized individuals only, and a proper reconciliation is prepared.
  18. Inquire if a receipt is issued against each collection ensuring that no collection remains unaccounted in the books of the accounts of the company.
  19. Check that opening balances of receivables and provision for doubtful debts are correctly brought forward in the current accounting period.
  20. Match the balances of the trade receivables break-up and the provision break-up with the financial statements and the notes to the financial statements.

 

Ageing of receivables

Ageing of trade receivables is the break-up of balances by the number of days with which it is outstanding. For example, if a customer purchased goods worth $1,000 one year ago, and then he purchased another goods of $500 three months ago and did not pay both of these amounts as at the closing date, in that case the ageing of this receivable would $1,000 above 365 days and $500 above 90 days and the total outstanding would be $1,500.

 

 

Audit documents related to trade receivables

Below is the list of documents which are usually standard in the process of auditing trade receivables:

  1. Process document detailed understanding of the receivables cycle
  2. Management’s policy document containing policy for receivables collections and provisioning
  3. Confirmation letters for debtors
  4. Post-dated cheques received from customers
  5. Bank reconciliation statements and bank statements
  6. General ledgers of receivables and bank accounts
  7. Cut-off testing document

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Categories
Uncategorized

Introduction to the closing of books of accounts

[vc_row][vc_column][vc_column_text]Have you ever wondered why accountants are more busy at the end of the months? Well, please don’t expect a joke here. This month-end closing is a serious topic. Accountants perform a particular task at each month-end, which is referred to as ‘closing of books’.

This term has multiple names and may be referred to as ‘closing of books of accounts’ or ‘monthly closing’ or ‘yearly closing’ or ‘quarterly closing’ etc.

So what they do when they ‘close the books’? Does this mean that they close the books and stop working? If this was the case, then accountants should have been relaxed. But this is not the case. Closing of books means that you are ensuring that you have recorded all accounting transactions correctly, which should be recorded in that month or in that accounting period. Once you are sure that you have booked all the accounting entries, then you can close that accounting period or month and start the next accounting period.

Once an accounting period is closed, no further accounting entry can be passed (usually) in that month. Therefore, before closing the books of accounts, the accounting and finance team need to make sure that they have recorded all the transactions, and nothing is missed out. This monitoring includes ensuring that all prepayments, accruals, bank reconciliation entries, depreciation entries, system-generated entries have been correctly recorded.

Below are the usual items for which closing journal entries are passed at the time of closing of books of accounts:

  1. Prepayments made and charging out of prepayments to P&L for that period
  2. Accruals booking and ensuring the reversal of previous month’s accrual
  3. Monthly Depreciation and amortization charges
  4. Inter-branch reconciling items
  5. System generated accounting entries for balancing books of accounts
  6. Control account reconciliation accounting entries
  7. Bank reconciliation entries like interest payments and receipts
  8. Dividends, drawings, preference shares or any equity-related adjustments
  9. The material in transit or goods received near to the closing date
  10. Goods delivered or final sales made before closing
  11. Acquisition entries, investment entries and goodwill
  12. Impairment assessment and booking of tangible and intangible assets
  13. Deduction of monthly advances
  14. Monthly payroll entries
  15. Recording of various provisions including bonus provision (employees love bonus provision)

 

 

Closing books of accounts is usually a system driven setup. Once there is a confirmation to close the books of accounts, you can give the command in the accounting software to close the books of accounts. The accounting system will then lock that accounting period and a new accounting period will be opened.

Usually, all good companies close their monthly accounts as early at 5th of the following month. For example, the accounting books for the accounting month of January 1950 will be closed by 5 February 1950. Similarly, the accounting period for the month ended 28 February 1950 will be closed by 5 March 1950. (Please don’t be carried away by the year 1950, this is just given as an example, the article is not that much old).

 

 

Many companies prepare quarterly financial statements, and thus they close their quarterly accounts almost similar to their month-end closing deadline. Annual closing of books of accounts usually takes a more extended period than monthly or quarterly closing. This delay is because annual results are typically subject to a full-fledge audit, and these financial statements are presented to various stakeholders. Nevertheless, yearly closing would also be done maximum by 10th of the following month. For example, the closing of books of accounts for the year ended 31 December 1950 will be done maximum by 10 January 1951.

Once books are closed, any accounting entry shall be passed in the next accounting period only. Some companies may close their books of accounting for a month before the actual month-end closing date, e.g., some companies may close their books on 25th or 28th of the current month. This closing date is usually referred to as the cutoff date. This practice is used to ensure that financial reporting timelines to group and regulators are met on time. Early closing of books of accounts would provide sufficient time to the companies to complete the closing process and generate the financial results.

Closing of books of accounts is crucial from an owner’s or investor’s point of view. Because only after the closing of the books, a business will be able to determine how much profit it earned or what is the financial position and performance of the company. So, if you are an owner of a small business, please insist on monthly closing and monthly preparation of financial statements so that you are aware of the latest economic situation of the company.

The outcome of the closing of books of accounts is the final list of closing balances of all the accounts (also called trial balance). Once the trial balance is finalized, that is the final stage of the closing process. After the closing, the next step is the preparation of financial statements. Please read our article on the preparation of financial statements here.[/vc_column_text][/vc_column][/vc_row]

Categories
Basics of financial accounting Financial Accounting

Meaning of ‘Account’

[vc_row][vc_column][vc_column_text]The word ‘account’ has multiple meanings in different contexts, so you need to check the background before drawing meaning out of the word ‘account’.

If the speaker of the word ‘account’ is an ‘accountant’, then you can relate this word pretty quickly. There are multiple definitions, as stated in this article. An accountant is a person who takes care of different accounts, i.e., he makes sure that all accounting entries are correctly recorded in appropriate accounts. For example, a credit sale made to Mr A is recorded in the account of Mr A and not in the account of Mr B.

Recording of entries in the correct accounts is of utmost importance in accounting. However, today’s topic is more about discussing the term ‘account’.

Consider an account as an exclusive box. The box (or account) is for a specific title/person. Any transaction with that title shall be recorded in that box (or account). Let me give you an example from the old days. Let’s say that a vendor keeps a box for each of its credit customers. Whenever goods are sold to that credit customer on credit, the vendor adds stones in the box designated for that customer. Each stone indicates the sale of a particular weight/value. So, at any time, the vendor can count the number of rocks in that person’s box to calculate the total amount of the credit sale made to that person.

Similarly, after the writing was developed, an account (or a box) was created for each customer. Any transaction with that customer is recorded in that account (exclusive box) and kept it there. So that at any time, accounting can be done for that particular customer that how much is outstanding.

 

 

In today’s modern world, a bank account is an example of ‘account’. This bank account is an exclusive recording of transactions dealt with a particular party. Finally, an account statement is a listing of all those transactions. Keeping an account for each party ensures that transactions don’t get mixed. Let’s say that if Mr Jonathan deposits the money, then it should belong to Mr Jonathan only (and not to Mrs Jonathan).

In accounting, there are five broad categories of accounts in accounting, i.e., Assets, Liabilities, Income, Expenses and Capital. These accounts are kept not only for persons and parties but also for non-living items. For example, there will be a separate account for furniture, a different account for cars and a distinct account for electrical equipment.

Not only this, for each different kind of expense, there is a different account. For example, there is an account for ‘utility’ expenses, another account for ‘travel expenses’ and another account for ‘marketing expenses’. There might be hundreds of accounts for different costs in large multinational companies.

A listing of all accounts along with their closing balances is called a trial balance. Some large multinational companies may have hundreds or even thousands of line items on their trial balance. This bigness might be primarily due to multiple accounts for the same nature of item but different locations. For example, there would be one account for taxi expenses for California branch and same account for Texas branch. Thus, this would lead to an increased number of accounts for different locations, although the nature of expense is the same.

It is of utmost importance to make sure that you record transactions in the correct account only, i.e., a transaction for cash sale should be recorded in cash account (as a debit) and sales account (as credit). The recording of transaction in a relevant account is of utmost importance to maintain correct books of accounts. Then only any financial statements prepared would be of right presentation.

Please ensure that you find out the correct classification always, for example, do not book repair expenses in the account of rent expenses. This classification is incorrect and would lead to an inappropriate presentation of financial statements.

 

 

Sometimes, it is not so easy to identify the correct account for recording a transaction. For example, if you paid professional fees of your employees, is it your cost of ‘professional subscription’, or ‘staff benefits’ or ‘training & development’?

Similarly, if there is a door repair incurred in the office, should this be accounted for under ‘office expenses’ or ‘repair & maintenance expenses’ or ‘ad-hoc expenses’?

Well, sometimes there is a judgmental call, and sometimes it is industry practice on how to classify a particular asset. For example, a box of tissue purchased for the pantry would be usually classified as ‘pantry expenses’ along with other consumables like tea, coffee, milk etc. However, the same box of tissues, if used in the office area or reception area, would be considered as ‘general office expenses’.

That’s a lot about expenses; however, about customers and suppliers also, at least one account is opened for each party. Imagine about a company which has thousands of customers. So, in this case, control accounts are used to control a significant number of accounts of the same nature. A control account ensures that a consolidated recording is made in the control account as well as individual entries in the individual designated accounts of the company. You can read about control accounts in our article on control accounts in more detail.

Companies often use variance analysis techniques to find out key trends and identify areas which need attention. For example, if a utility account is showing an increase of 30% in the utility cost as compared to last period, then, management needs to investigate further that what is the cause of this increase. By this way, organizations control cost and keep an eye on the hikes. However, it is important that only correct and relevant transactions are recorded in each account. It is possible that on investigation it is revealed that some of the cleaning cost was also included in the utility expense account. So, variance analysis can highlight not only risky areas but also errors in the bookkeeping and expense recording.[/vc_column_text][/vc_column][/vc_row]

Categories
Uncategorized

20 Factors to consider while selecting the right MBA program

[vc_row][vc_column][vc_column_text]Many professionals, at one stage of their life, feel stuck in their current role and industry. They want to move further but are not able to find suitable opportunities. This situation usually happens between the time of 7 to 15 years of experience. At this time, some professionals are on the lookout to advance their careers or start their businesses. One of the options which come to their mind is a Master of Business Administration (MBA) degree.

These professionals who consider pursuing an MBA degree can be from any background and field. They may be doctors, engineers, finance professionals, lawyers or even entrepreneurs. So, If you are also one of such persons who is considering pursuing an MBA program then in this article, we’ll discuss briefly the factors which a person should consider while deciding to pursue MBA and from which institute, if at all.

This article will answer questions like:

How to select the right MBA program?

How to find the right MBA program?

Which MBA program is best?

Which university is best to do MBA?

What factors to consider for an MBA?

Should I be doing an MBA or not?

 

There are mainly two broad categories of MBAs, i.e., full-time MBA and part-time MBA (which is usually referred to as executive MBA). There are different brands under part-time MBA like Executive MBA, Global MBA, International MBA, Online MBA, Global Executive MBA, Exec. MBA in Strategy & management etc. However, more or less, the programs are the same.

A full-time MBA is usually for the candidates who either have recently completed their graduation or who are at a very early stage of their career, i.e., 2-3 years of experience only. If you are a recent graduate, then a full-time MBA is for you. To study a full-time MBA, you need to be present at the campus and attend classes usually on weekdays and in day timing. Thus, you have to sacrifice your day-job and study full-time.

 

 

Full-time MBA is usually of lesser duration (say one year) as compared to executive MBA. The annual fee of full-time MBA is higher than the yearly charges of executive MBA. However, the total cost of the program of Executive MBA may be higher (or sometimes lower) than full-time MBA. There are many online MBA options available now, which are usually cheaper than the on-campus MBA. If you are finding an affordable MBA program, try checking on online MOOC websites like coursera.com and edx.com.

An executive MBA is usually of double the duration than full-time MBA. However, this is not always the case. Some universities are offering one year executive MBA as well (although such universities are rare). Most of the executive MBA programs run for around two years (as opposed to 1 to 1.5 months full-time MBA programs).

An executive MBA is usually challenging considering that the candidates at this program are mostly married, having children and handling full-time job or business. So, juggling responsibilities of work and family, they have to accommodate studies as well. Completing an executive MBA program is no fun, you have to do a lot of research work, study significantly, read journals, attend lectures, visit university, appear in exam and complete the capstone project.

 

 

It is essential to realize that an MBA is a generic management qualification. It does not teach you any particular technical skill like engineering, science or IT. Therefore, an MBA can be most beneficial if you already possess the technical expertise, and you are proficient enough in that specialized field. MBA would add a significant advantage to your profile, and you’ll be best able to reap the benefits of the program. However, if you are only a management professional (like BBA or bachelors of management, etc.) then, your MBA would be comparatively less beneficial to you. In this case, it would be more advisable to you to do some short courses on the technical side of your interest.

 

Well, there is no one single best MBA. Rather, there are different factors with different weightage. You need to evaluate these factors and then make a decision. Choosing the right MBA is one of the most important decisions of your life. You need to consider the following factors carefully:

  1. Cost of the program: MBA programs range from $10,000 to $200,000. These fees fall in a vast range, and you need to make sure that you can meet the costs of the program.
  2. Duration of the program: The length of MBA programs usually ranges from 1 to 2 years. So, there is a time commitment involved. For this period, you’ll not be able to have any other significant time commitments.
  3. MBA Objective: Some people enrol in an MBA for better career prospects, while some do to start or enhance their business. So, thoroughly consider your objective for start MBA. Do you want to start your own business or you want to change your industry, or you want to get promoted in your existing company? Choose your right MBA program based on the analysis of your objective and the matching content of the MBA program. Some MBAs focus on entrepreneurship and some on specific industries.
  4. Classes schedule: What options are available to attend classes, is it day time, evening or weekend?
  5. Online lectures availability: Is it possible to complete the program and attend lectures online?
  6. Ranking of the university: University’s ranking is one of the most critical factors which you might consider in choosing the right school. When checking the ranking, ensure that ranking being checked is correct. There are several rankings criteria, and you need to find an accurate and reliable listing.
  7. Ranking of MBA program: In addition to checking the ranking of the university, you also need to check the ranking of the MBA program. It is possible that the university’s ranking is high, but it’s MBA program’s ranking is low. Similarly, the same university may have multiple MBA programs, so you need to check the ranking of that particular MBA program which you are considering.
  8. Time and budget commitment: Will you be able to devote time and the budget for the specified duration of the program.
  9. Program content: There are hundreds of MBA programs out there and all of them are not same. There is a difference in the curriculum. Please spend some time thoroughly going through the subjects and the full content of the program. Make sure that the curriculum is matching with your interests, and this is the kind of knowledge you want to spend your energy and time on.
  10. Country of stay: Prefer university in the country where you want to stay in future. For example, if you are planning to live in the UK after completing MBA, then prefer a UK university. Similarly, if you want to live in the US after completing MBA, then prefer a US university.
  11. Title of degree: Better ask for a sample of the certificate which is awarded to successful candidates. See if look, feel and title of the program motivates you. Read out the title carefully and assess its impact on your resume or your sense of achievement. Usually, the titles are ‘MBA’, ‘Master in Business Administration’, ‘Global Master in Business Administration’, ‘Online MBA’, ‘Online Global MBA’, ‘Executive MBA’, ‘Executive Master in Business Administration’. Etc.
  12. Funding options: Don’t be scared of high university fees and cancel the plan to get an MBA. There are many scholarships and funding options available for MBA programs. Each university lists out the details of funding options on their website.
  13. Lost salary: If you are committing yourself full time to an MBA program, then, you’ll not be able to do your day job. You will have to put a resign or take unpaid leaves for 1 or 2 years. The loss of income for the study period is an additional cost of your MBA (in addition to fees and other expenses).
  14. Senior’s Advice: Take advice from someone who has already studied at a business school. This first-hand advice would be significantly helpful for you to choose the right school and the right time to commence MBA journey.
  15. LinkedIn profile analysis: Check the LinkedIn profiles of the alumni of that business school. Study and analyze their career journey. If you believe that they got significant benefit from their MBA and were able to achieve good positions, then that is a positive motivator for you to consider that MBA program.
  16. Political factors: Consider the political factors in the country where you are planning to apply for MBA. A politically unstable country or any expected political upturn may create negative impacts on your institute and your MBA.
  17. Social factors: If you have to travel to another country for an MBA, consider the social behaviour of that country and the linguistic barriers which you may face.
  18. Commuting: If you are working and have to attend classes as well, make sure that your commute should not be killing. You need to have a manageable lifestyle and ensure to keep your routine comfortable.
  19. Health issues: If you are going through any particular health-related problems, it is advisable first to take care of these matters. MBA studies are challenging and would require significant energy. You’ll undergo a large amount of stress and pressure while trying to catch up with the requirements of the program.
  20. Campus Life: When you visited the campus, did you feel that the environment is enriching, bright, social, happy and thrilling? Did you feel like you want to spend time here and quench your thirst of learning management? You may be spending a significant and precious time of your life on the campus, so be sure to have a pleasant one. It is needless to say that you should have wifi access in the campus.

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Categories
Assets Financial Accounting

Significance of Intangible Assets and their Accounting treatment

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Introduction and examples of intangible assets

Intangible assets are those assets which cannot be physically touched. This ‘intangibleness’ is because they do not have a physical presence. Instead, most of the intangible assets have a virtual presence, either in the form of software or something in the understanding of people’s mind.

For example, a movie recorded by a film producer is an intangible asset stored in the soft form in the camera. You may not touch that film physically, but that movie is produced after spending millions of dollars and may have a significant market value.

There are many other examples of intangible assets like:

  1. Registered trademark and logo: You would have seen many companies having a small ‘®’ in their trade name or their slogan. This sign represents a registered trademark. That company have spent money on designing, composing and registering this trademark. No other company can use the same trademark. This trademark is an asset which distinguishes this company’s products from other companies’. Therefore, this is an asset for this company and
  2. Examples of trademarks and logos are four circles in a row for Audi, five rings (three up and two down) for Olympics, the ‘just do it’ slogan for Nike, slightly eaten apple for Apple and the picture of the founder of KFC for KFC.
  3. A brand recognition A book: Yes, it seems that a book has a physical presence, but the value of the book written by a great author doesn’t lie in the physical appearance of the book. The value is in the story or script of that book, that is the intangible part of that asset. The actual price of the book may be a few dollars, but the copyright of publishing that book or the intellectual property of that book may have the value in millions.
  4. A software: A software doesn’t have a physical presence, although we can see it on computer screens, and we may purchase software for a few dollars as a retail customer, but having the right to sale that software is an intangible asset worth millions. Similarly, the person who produced that code for the creation of software possesses a significant value as an intangible asset in the form of programming of that software.
  5. A chemical formula: let’s say that a company devised a specific chemical formula which is helpful in producing any substance or medicine or product, then that chemical formula is also an intangible asset, i.e., the knowledge of that chemical formula is an intangible asset which can be capitalized (if conditions are met). For example, the recipe to prepare Coke drink is secret and is an intangible asset of Coca-Cola.
  6. A photograph taken from an ordinary mobile or camera may also be classified as an intangible asset if that photograph is hugely appreciated and liked. Now, the picture would be saved in the computer; thus, it is intangible, but due to its high likeness, it may be sold with copyrights. Many photographs are being sold on shutterstock.com and similar websites. This is the trading of intangible assets.

 

 

Recognition of intangible assets

Question:

Can all intangible assets be recorded as assets in the balance sheet of a company?

Answer:

No, both as per US GAAP and IFRS, there are certain conditions which need to be met for recognition of intangible assets. Once these conditions are met, then only an intangible asset can be recognized on the balance sheet of a company.

 

Conditions under IFRS are:

The first condition is that the cost of the asset should be measured reliably; this means that the cost incurred to create or prepare that intangible asset should be measured reliably. If it is not clear that which costs have incurred or if no expenses have incurred, the intangible asset cannot be recognized.

It is essential to reiterate the point that any internally generate asset can only be recognized at the cost. For example, if an asset is manufactured/designed/prepared for $1,000 then the asset would be recognized at the cost of $1,000 only. We cannot recognize an asset at a value higher than it’s original cost.

The cost would include direct labor and direct material etc. less any disposal value. For example, if in making a movie, actors were paid amount X and some furniture was purchased for amount Y, and this furniture was later sold at amount Z then in this case, the amount capitalized as an intangible asset would X + Y – Z.

The second condition is that it is probable that future economic benefits will flow to the entity. Now, the future economic benefits will flow to the entity only if that asset is technically feasible and commercially viable. This means that the asset should have technical feasibility, i.e., the product or item on which you are working to build, it should be technically feasible. You should not be investing in something which is not possible. IFRS doesn’t allow the recognition of such intangible assets. For example, if you are trying to build a formula to convert sand into gold and you are spending money on it, and you can measure the cost incurred, but this is something which is not technically feasible. So the investment on formula of converting sand into gold cannot be recognized as an intangible asset.

Further, as stated above, the product should be commercially viable. This means that there should be a market demand for this asset and it should be sold at a value which would be beneficial for the company. For example, customers should be willing to purchase this intangible asset (or any product made using this intangible asset) at a price which is beneficial for the company.

However, in exceptional circumstances, if the technical feasibility is established and there are successful results, then that formula can be recognized as an intangible asset.

Other than the regulations and rules, let’s talk about some practices about intangible assets. Do companies always want to recognize intangible assets? No, not necessarily. Especially if the amounts are small, companies and management would prefer to charge out this expenditure in profit and loss account. This accounting approach is adopted because recognition would lead to further requirements such as calculation of amortization in small amounts every year.

All intangible assets (other than goodwill) need to be amortized over their useful life. Amortization is simply another name for depreciation. However, the depreciation is for tangible assets, while amortization is for intangible assets. This is the difference between amortization and depreciation.

If it has been established that accounting entries need to be passed and asset needs to be recognized, then initial recognition of intangible assets should be recorded as Debit: intangible asset and Credit: Bank (for the amount spent on intangible asset).

Goodwill is the most famous example of intangible assets. However, it is a unique kind of intangible asset. Goodwill is the market value of the name of a brand. Let’s say that you purchase an iPhone just because of the goodwill of Apple. This is something other than all other tangible and intangible assets. Please read our detailed article on goodwill to understand it’s nature, calculation, impairment etc.

It is important to note that financial assets (stocks, shares, debentures, loans, receivables, etc.) are not generally classified as intangible assets. They are separately dealt with as financial assets and have their separate accounting treatments.[/vc_column_text][/vc_column][/vc_row]

Categories
Business & Finance

What is an accounting transaction and an accounting event?

[vc_row][vc_column][vc_column_text]The word ‘transaction’ is commonly used in business and finance circles. We hear sentences like “how many transactions you did today”, “how much are your monthly transactions”, “What is the value of this transaction” and “I have not done any transaction recently” etc.

If we try to put a formal definition of a transaction, it would be something like this:

“a transaction is a performance of a deal between two or more parties having a financial impact which can be measured reliably.”

An easy example would be: Company Dokia purchases one laptop from Walmart for $500 on cash.

Now, we need to dig down deep into this definition to understand it’s components:

 

First of all, it is a ‘performance of a deal’. So, it is not merely entering into a deal or doing an agreement or a contract. Instead, the transaction is an ‘actual performance’ of that agreement or arrangement. Just entering into a contract would not be considered as a transaction.

The second important point is that it has to be between two parties, at least. One person cannot do a transaction on its own. Let’s say that if sales department borrows a car from the HR department for three months, this cannot be recorded as a transaction in books of accounts of the company, because both departments are under the same organization.

Thirdly, there should be a financial impact. In the above-given example of purchase of laptop from Walmart, there is a financial impact on Company Dokia. However, if there is a deal performed between two entities without any economic impact, then this is not an accounting transaction. For example, Company Dokia makes a deal with Walmart to invite each other’s CEOs at their respective premises and show them around their offices. So, in this deal, there is no (apparent) financial impact. So, this deal of visiting CEOs will not be recorded and considered as an accounting transaction.

 

 

It is essential to understand the difference between an accounting transaction and an accounting event. Sometimes, an event may happen, which has a financial impact. So, this event shall also be recorded in the books of accounts of the organization. However, this cannot be termed as a financial transaction. For example, if an employee of company Dokia accidentally drops the laptop purchased from Walmart, this will be considered as an accounting event and will not be considered as an accounting transaction.[/vc_column_text][/vc_column][/vc_row]

Categories
Business Strategy Retail sector

Value Creation in a Retail Business

[vc_row][vc_column][vc_column_text]In this article, we’ll be discussing different routes of value creation for a retail business.

Every organization aims to create value for its owners and customers. Most of the retail businesses are set up to generate profits for their shareholders. So, we’ll be discussing mainly the ways of enhancing profitability for the shareholders. Other than that we’ll also discuss value creation for the customers. The value for the customers is something which makes their experience friendlier, convenient and cost-saving.

Now, there is a conflict of interest when it comes to value creation for customers and value creation for shareholders. For example, if we put a 50% off on everything, then it will be significant value creation for the customers. However, owners might be at a loss as it would likely result in substantial losses. Therefore, we need to establish the best trade-off where value is created for both shareholders and customers.

Below are some of the basic as well as advanced ways for the creation of value in a retail business:

 

1. Wise Usage of Floor area

Floor area is an expensive resource for a retail store; we have to utilize the space wisely. The better we can use floor area, the more revenue can be generated. So, what is the meaning of better usage of the floor area? This means that we need to arrange and place the items in such a way that we can display a maximum amount of items in a presentable format. In the modern world, we have racks which contain multiple shelves, and thus, in one particular area, we can display various items in the stands. Further, goods are classified in horizontal lines so that customers can view the items in a specific row.

2. Accessibility to the items

The items should be easily reachable for the customer. The articles should not be placed so high that the customer is unable to access them. Further, the items should not be so deep in the cabin that his/her hand is not easily reachable. Accessibility to the goods should be open; in some retail shops, they keep items locked. This inaccessibility creates frustration for the customer and results in loss of a potential sale.

3. Easiness in finding required items

The structure of the store should be designed in such a way that it should be convenient for the visitor to find what he/she needs. There should be guidelines for the customers for them to see the relevant section. All rows should be given a heading/title at the top of the frames. So that customer understands what items to expect in that row before entering it. Goods which are used more frequently should be kept at the beginning, and the things which are relatively less required or not part of the everyday routine can be kept at back racks.

4. Price reader machine

A price reader machine should be installed at different locations in the retail store. Many times a customer would not be sure about the price of the item and may cancel the plan to purchase it because of not being sure about the price. A price reader confirms the cost and thus results in enhanced sales. Enhanced sales would be result in increased value for the business as well as improved confidence for the customer.

 

 

5. Helping staff for the guidance

Many times we need to ask a question in the supermarket, but there is no one around who can help. We only see other customers who also need help. This creates confusion and reluctance, and thus customers quit without making the purchase (or leaving out those items about which they need help). Placing suitable helpful staff might result in enhancing customer’s confidence and would add value in terms of increased sales.

6. Training of the store helpers

I have been to such stores where there are many helpers available in the store. But they are not focusing on helping customers. Instead, they are busy chatting among themselves or busy on their mobiles. They are even trying to escape customers who ask questions. These helpers also try to pass on queries to other helpers. A proper training program for the store helpers can increase their motivation to help customers. The passion of sales staff to guide customer enhances customer satisfaction and thus creates significant value for the customer as well as for the company.

7. Physical safety at the store

A retail store should be a safe place for customers. However, there have been accidents in stores which caused physical harm to the customers. These include falling due to a slippery floor, getting knocked with some hooks or bars, being stuck in a narrow space and getting a head injury due to dropping items. Any physical injury at a store may bring many adverse consequences for the business. These include legal claims for damages, erasure of brand reputation and damage to retail stock.

8. Internal controls to avoid misappropriation of assets

A retail store is a high-risk business when it comes to the risk of misappropriation of assets. There are many inherent risks of fraud, stealing and theft in a retail store. Customers might hide items and pass through gates without paying for these goods. All the value created by the business through other hard work may drain out if proper controls are not kept to safeguard assets of the company. Management should devise a comprehensive system of internal controls and ensure that it is correctly and accurately implemented.

9. Cash control

A retail business involves a lot of movement of cash. Cash handling is inherently a risk area. Risk of fraud and errors would increase with the increased involvement of money. Therefore, it is pragmatic to ensure that there are sufficient controls built in to ensure safe custody of cash. All the cash transactions should be promptly recorded, and receipt should be provided to the customers. The cash register should be maintained, and cashier should be held accountable for any shortage of the cash. The value created by operating a successful business shall only benefit to the owners of the company if there are proper cash controls in place.

10. Offering options to the customers

Everyone likes to have options, so does the customer. The more options you provide to them, the higher will they value you. Now when it comes to offering options to the customers at the time of payment, you can provide an option to pay by cash or by credit card or by loyalty points or even by cheque (for corporate customers).

11. Lower interest rates to credit card companies

A significant number of customers in the retail business are preferring to pay by credit card. Customers enjoy reward points from credit card companies for using the card. However, this results in a financial loss to the retail business. CC companies would charge a percentage of sales amount as interest for each sale; this interest rate is typically around 2%. A retail store should negotiate with banks and obtain the lowest possible interest rates for credit card transactions. This would ensure that the financing cost for the company is kept more economical, and the maximum value is created for the shareholders.

12. Encouraging their own card or cash transactions

Another way to curtail on bank charges is to discourage credit card transactions. Either offering discount on cash transactions can do this or issuing retail company’s credit card. Although running a financing solution business (like a credit card provider) is a separate business altogether and poses its own risks, still it might be a good idea to synergize both activities and yield maximum value for the customers as well as for the retail business.

 

 

13. CCTV monitoring and security

It is true that CCTV cameras are expensive, but not deploying a vigilant monitoring system may prove even more costly. We have covered this point above as well that retail business is inherently risky when it comes to misappropriation of assets and cash. However, a particular consideration in deploying CCTVs is that these cameras should be covering each view of the shop space. If CCTV does not cover a specific area or corner, there is a high risk that that area might be used for misappropriation of inventory. Many employees and regular customers can find out such a gap in security and may try to take advantage of that.

14. Availability of maximum items

No one likes to visit multiple stores for purchasing a few items. Nowadays, customers are lazier and want to have it all under one roof. This is especially true when husbands are sent for grocery. They would not bother to scan three shops to find the best in quality. Therefore, as a customer-friendly retail store, we need to ensure that we provide maximum range of products in our stores. The higher the product range of a store is, the increased will be the number of visitors in the shop.

15. Wise spending on working capital

An investment in the working capital is one of the significant investments for a retail business. The higher is the amount of inventory in the store; the increased will be the cost of working capital. It would be a nightmare for the store manager to buy the items which are not being sold or whose moving pace is slower than a snail’s pace. All inventory of a retail business would not have the same inventory turnover ratio. However, the investment in the working capital should be justified with higher margins.

16. Analysis of maintaining appropriate inventory items

It requires extreme skill to decide which goods or products should be available in a large retail store. There might be millions of products out there with the suppliers, but we have limited space. We need to ensure that we are maintaining a reasonable level of inventory mix. A retail store would contain sports goods, but it would not provide as much variety as a sports retail should. Similarly, a retail store might have electronics items, but not as much of specialization as an electronics store will have. Therefore, it is crucial to maintain the right mix of different kinds of inventory items so that the basics of all fields are covered.

17. Loyalty points

In today’s era of inflation, everyone is interested in fetching the maximum value from their buying power. Introduction of loyal points for return customers can create good value for the customers. These value points, once accumulated to a certain level, should be convertible into cash or credit against purchases. Customers would prefer to look for the same store if these points reward them. This is good value creation for the customers as well as for the retail business.

 

 

18. The freshness of the food and perishable items

Introduction of loyal points doesn’t mean that customers would be willing to buy rotten eggs and spoiled milk. We still need to provide fresh items when it comes to daily consumable like fruits, vegetables, milk and yoghurt. A customer will get a fantastic feeling as they find fresh produce in the shop. This sensation is of significant value for which customers will be willing to pay a premium. A strict quality control check on the validity of the products will ensure the customer’s happiness.

19. Ensuring child safety

We have discussed the point of customer safety above, but child safety requires additional measures. Young kids are more exposed to physical injuries as they run fast, are careless and are not aware of potential risks. They may also be fascinated by electrical wires and want to insert hands or small items in plugs. Children are also more likely to damage the goods in the store. Some kids like to throw things out of shelves and during this process they may get physical injuries.

20. Defined Sections for related items

Can we randomly put the inventory in the stock at different places? For example, keep the chocolates and insect killers together? Of course, not. We cannot also keep socks along with rice. We need to define sections as per the nature of the products and then keep related items together. For example, we should place rice and flour in the same row. We can keep washing powders, and cloth softeners close by. All the sections should be divided into categories and adequately labelled.

21. Wheelchairs or movable cars inside the stores

Today’s supermarkets are expanded to vast areas. A person may have to spend several hours and walk several kilometers inside the store to complete purchasing. An average person would become exhausted in this exercise and would want to seek assistance. If we provide wheelchairs inside the store which can be used by anyone to roam around, it would add significant value. Further, there might be small capacity cars which have a defined route inside the supermarket. Customers can hop on and hop off at any place. This would add significant value to the customers in a retail shop.

22. Offer Best prices

For many customers, the product’s price is the deal-breaker. Customers prefer to purchase from a retail brand which offers the right quality products at economical rates. Product profitability margins are tight in retail sectors, and a slight variation in the pricing can create significant impact. Best pricing can be achieved by controlling costs, negotiation better rates with suppliers and correct mechanism of product pricing.

23. Best price guarantees

Some retail business uses best price guarantees as a marketing tool. The idea behind this concept is that you need to provide an assurance to the customer that they are not being looted. Instead, the price being offered by our brand is the best price for the given level of product quality and service. These marketing tactics play a pivotal role in assuring clients. Thus, they will not keep looking around for better rates.

24. Cleanliness and Hygiene

There are many brands which are famous for the environment and cleanliness they offer. You feel a difference in the air. The level of freshness, shine, sanitation and hygiene exerts a significant impact on the customers and their buying patterns. If the place is messy, untidy and dusty, then people would not want to stay there for the long. The critical success factor for a retail business is the time which spends visitors in the store. The more time they spend in the store, the more shopping they’ll be doing. The place should be so well organized that they don’t feel like going away from it. A neat place is a significant value addition for the customers as well as the organization.

25. Product profitability analysis

A retail business can fetch maximum value by analyzing the profitability of its products. The more profitable products should be placed closer to the entrance of the store. The products with less margin may be kept at a distance which requires more walking. When performing a product profitability analysis, we need to consider both the product’s margins and the units sold. Some products may be less profitable by a margin, but they are the fast-moving and total number of units sold may be significantly higher. We need to consider both factors.

26. Rates negotiation with suppliers

Rates should be negotiated with suppliers availing the maximum benefit of the purchasing power of the supermarket. As per Porter’s model of competitive forces, bargaining power of suppliers is also a type of competition in the business. Therefore, we need to ensure that we agree on the best rates and terms with our suppliers. Many suppliers would agree to a sale on credit and extended credit terms with a supermarket. Supermarkets need to maintain good relations with the suppliers to ensure that

27. Renting of shelf spaces

Additional revenue can be generating by renting premium shelf spaces. The suppliers who want their items to be placed at prime locations in the store need to pay extra for that. This premium shelf space is usually at the beginning of the store where a customer would have their glaze at the time of entrance or the beginning. This renting of space creates significant value for the suppliers as they get the opportunity to promote their products to a broader audience. This additional revenue is an opportunity for value creation for the business.

28. Advertisements inside the stores

Certain areas in the store can be used as a to let space for placing advertisements. Different companies would be interested in displaying their ads to this segment of the audience which visits supermarkets for purchasing grocery, electronics and fashion products. The areas suitable for generating advertising revenue may include sides of racks, trolleys and walls of the supermarket. It will create additional synergy if the items advertised are available in the supermarket for purchasing for the customers.

29. Customized services solutions

Often customers need a customized product or a customized service. But there are standard items in the store. The customer would not find what they want and will leave the store empty-handed. A loss of value for the customer and the business. If there can be customization available for the customers in different products and services, it would add significant value for everyone. For example, if there is a dress but the customer wants alteration to be done on it. Another example would be the same product in a different colour. If specialized staff is available to help the customer there and then or at a later date, it will be a win-win.

30. Pre-ordering facility

Many people know what they have to purchase at the grocery, but still, they need to spend significant precious time at the store. If a facility to place an order online is available, and those items are ready for the pick-up of the customer, it would save precious time for the customer. This will be an excellent value service for the customer. Additionally, the time which is saved by the customer might be spent by exploring additional items and products and may lead to an increase in sales for the business. This facility is a significant value creator both for the retail industry as well as the customer.

31. Cash depositing and working capital management

Cash collected during the sales should be promptly deposited in the bank account to utilize this cash in the business. There might be multiple intervals in a 24 hours’ time slot to ensure prompt depositing of money in the bank statements. For example, cash of the overnight sales should be deposited early morning at 8 A.M. Similarly, another slot of cash deposit should be performed at 1 P.M. and the next deposit should happen before bank closure i.e., 4:30 P.M. This would ensure that maximum cash is added to the company’s account balance on the same day. Similarly, the cash of the evening sale can be deposited through cash deposit machine at 11 P.M. The cash collected from the daily sales, if deposited on a timely basis as mentioned above, would generate opportunities for interest income and will help in managing working capital.

32. Corporate customers accounts

Although a significant portion of the customers is the retail side, but a retail store might have corporate customers as well. The needs and requirements of these customers would be different from the retail customers and therefore, should be tackled accordingly. The value creation for these customers can happen by providing them with corporate services. These services include corporate credit account, bulk-purchasing discounts, delivery at different locations and option for ordering online by various staff for their respective office locations.

33. Customer recognition

If the sales staff and cashiers can recognize customers through loyalty cards, it would be an excellent opportunity to provide personalized interaction with the customers. If the cashier and sales staff greets the customers with their name, the customer would feel flying in the sky. The self-esteem need will be fulfilled for the customer, and this would be a significant value creation for the customer. The customer would become a loyal customer forever, and this would be the ultimate value creation for the retail operator.

34. Applying Artificial Intelligence on buying behavior

Artificial intelligence (AI) can be applied to analyze customers buying patterns and behaviors. These analytics can help boost sales and identify customers’ demands. If we use on an overall basis, it will provide useful insight on the preference of the customers. Helpful information can be extracted on what is customers’ choice, what factors influence buying decisions, and which marketing campaigns are generating returns. AI can also be applied on an individual level for each customer. At the checkout counter, AI can make a quick comparison of what customer purchased this time and what was purchased last time, it can suggest the items which customer forgot to buy or which can be a useful combination with the existing purchases. This would not only be a significant value creation for the customer, but it will also result in increased value creation for the business as it would drive an increase in sales.

 

 

35. Home delivery after purchase

Every visitor to the supermarket does not own a car. Some shoppers have to wait for the buses and metro to take things back home. The increased size of their shopping bags is a matter of concern for them, and they would prefer to buy less just because they don’t want to take the burden to carry these items through public transport. If a service is provided to the customers for free home delivery of the items purchased by them, it may increase the revenue. Even some customers who have a may not have sufficient space in the car or may not want to walk a lot in the mall along with big shopping bags. Therefore, this service of home delivery of purchased items would add a load of value for the customer as well as for the shareholders of the company in terms of increased sales.

36. Online purchasing

More and more people are finding it difficult to leave their couch and bother to walk hundreds of meters in a retail shop, all thanks to today’s sedentary lifestyle choices. But as a business point of view, the value can be created for these customers by offering them the facility to purchase the same items from the home of their homes. These customers may even be offered a discount as these products would not be necessarily coming from the expensive rented shops. These items can be directly shipped from the warehouse of the company. Online shopping is fun, easy, fast and secure.

37. Direct top-up without customer ordering

Let’s go one step further from online shopping. This is the level of the service, which might surprise customers. Based on the customers buying pattern and the purchasing behavior, the system will assess the need for daily use items for the customer. Even if a customer forgot to place an order, an order should be automatically placed to top-up necessary things like milk, yogurt, grocery etc. The customer will receive the notification for the direct top-up of grocery items, giving them the option to cancel it if required. If no response is received, the order shall be completed. This service would be surely loved by the customers and will lead to increased value for the retail business.

38. Ensuring a smooth supply chain

Supply chain function of a retail business is of utmost significance in the success of a retail business. Ensuring a smooth supply of thousands of products requires out of this world skills. The supply chain has to ensure that products are available in the store on a steady basis; there should not be any shortage of any products. Similarly, there should not be any excess of any items as well. Smooth supply chain requires a right balance between these two.

39. Finding new products

Man’s desires will never come to an end (the same is true for a woman). Every person wants to have new and modern products and services. Same is true for the customers of a retail store. Customers are looking for products which are unique, trendy and were not seen before. Therefore, the supply chain department of the retail business should always be on a lookout for new products and services. The more competitive, advanced and trendy products you can stuff your store with, the increased will be the value of your business for the customer. The increased will be value for the shareholders, ultimately.

40. Multiple branches

A successful retail business operates well when there are multiple stores of the same brand. Investing resources to form a chain of stores would increase brand reputation for a retail company. While opening new branches, there are various factors which needs to be considered including location, customer preferences, competition in the area and availability of the stocks. It is essential to provide a similar level of service quality at all outlets. This will give value to the customers as a customer would know that he/she can expect the same level of products and prices from any outlet of this retail organization.

 

 

41. Brand Value and recognition

Brand management is a subject in itself, and there are many books written on it. A retail store should create a brand, protect it, develop it and make it recognized. The higher the value of a brand of a retail company, the higher will be the sales growth for that company. The company’s brand and slogan should be eye-catching, easy to remember and protected by copyrights. A retail organization need to continuously invest in its brand reputation to ensure that maximum value is generated for the business.

42. A similar level of service at all outlets

Branding is valued because of the consistency of the products and services. You can buy a Coke and would get the same taste no matter from which retail shop you purchased it, throughout the country. Similarly, a sandwich of Burger King would be the same in taste regardless of the branch from which it is purchased. Likewise, a retail chain needs to ensure that it’s services and products are consistent across all its outlets. The structure of the product’s alignment and display should be consistent. For example, if fish is available near the vegetables in one store, this practice should be the same across all stores.

43. Differentiation focus

A retail store may not offer a differentiation focus, generally. But this is a type of business strategy which may be pursued by a retail business to provide value to its customers. The objective of differentiation focus is to offer high-quality service at a premium price. The number of customers might be less, but the margins will be high. This can be applied in a retail store by offering a personalized assistant to accompany throughout the shopping experience. The guide shall not only handle the items purchased but will provide useful information about product features and will make a comparison to help make wise shopping decisions.

44. Cost focus

A cost focus strategy is to compete based on cost, i.e., you have to offer the lowest price for the same product which is being sold at a higher price by other retailers. A cost focus strategy is a common line of action for most of the retail sector companies. This is achieved by keeping the costs at minimum and thus being able to offer the products at a lower price. A cost focus strategy would be successful when the sales volume is high so that overall profitability will be higher despite lower margin at a unit level. For example, if a pack of biscuits generates a gross profit of $0.1, selling 100,000 units of such packages would result in a profit of $10,000.

45. Financial planning and analysis

Effective financial planning and analysis are of pivotal significance when it comes to the creation of value and success of a retail business. This heading includes a range of activities including preparation of budgets, analysis of financial performance, product profitability analysis, identification and measurement of key performance indicators, expense analysis and reasoning of significant variances, tracing leakages and wastage, highlighting internal control deficiencies, identification of opportunities of value creation in the business, preparing feasibility studies for opening new outlets, assessing performance of existing outlets, identification of key business trends, presentation to management on essential findings etc. All these activities, when performed vigilantly, would create fantastic value for the shareholders of the company.

46. Own products

A retail store usually acts as a distributor of products of other companies. But many retail businesses have started to manufacture their products and market them through their stores. The target of such manufacturing should be those products which don’t require massive manufacturing setup and these products should be generating at a good margin than average. For example, facial tissues, detergents and handwashing liquids etc.  This is a type of related diversification and can be classified as backward diversification. A significant synergy value can be created for the business by introducing the company’s products.

47. Inventory analysis

The inventory analysis would comprise of understanding the type of inventory kept, the days for which it is outstanding, the inventory turnover ratio and the movement pattern. The objective of inventory analysis would be to identify loss-making or non-moving inventories. Such inventory shall be stopped as demand is low or nil. Those inventory items which are high moving can be considered for a price change (e.g., increase in price for enhancing margin on that product OR decrease in the price to further boost sales).

48. Supplier analysis

Just as all customers are not, all suppliers are not the same as well. Some suppliers might be more demanding (or problematic) than others. Some suppliers might be charging higher margins than others. The quality of some suppliers’ products may be lower than others. A comprehensive supplier analysis on all these factors can help a retail store to obtain a similar level of service from all suppliers. Once we identify which suppliers are taking more lead time to deliver the items, we can discuss our concerns with them and get the deliveries faster. Similarly, once we identify the suppliers who are charging higher margins, we can prepare our strategy to bring down their prices. Thus, a supplier’s analysis can create value for the business.

49. Section suggestions

Sometimes we visit a particular sector, say, bed-sheets section, and we don’t find what we are searching. We want to write a suggestion related to that section only. There should be an LCD fixed in each section which provides information about that section and which includes an option where customer can submit his/her input and suggestions. For example, if I don’t like the size of the comforters available in the section, I can write it, and I can request them to arrange the required size by x date.

50. Replacement Trolley

Many times a customer wants to buy further, but their trolley is already full, and there is no capacity to keep additional items. In such cases, the customer might not have the strength to go back to the entrance point and fetch another trolley. He would lose interest, and the business will lose potential sales. If we can introduce a built-in call button in a shopping cart which indicates to staff that this customer’s trolley is full and he/she needs an empty one, it would be a tremendous value-adding service. The team shall pick an empty cart, handover it to the customer, take the full trolley and put it near the exit queue. The customer can continue shopping with a fresh trolley mind.

51. Total trolley bill

Many people are researching reinventing shopping trolley, and many features and options are being advised in this regard. However, if we can add a straightforward function of price checking on each cart and the customer checks-in every item while keeping that in the trolley, by this way, not only that customer will know the price of each product being purchased but will also be aware of total value of the purchases made long before reaching the checkout counter. This will help the customer to plan their purchasing and would add value for the business and the customer both.

52. Analyzing new stores opening opportunities

One way of adding overall business value is to expand the business. The more you grow your business, the more likely you are to achieve success in the industry. For a retail company, management should be keen on expansion opportunities. The expansion would bring economies of scale for the company, enhanced reputation among customers, increased brand awareness, growth in the negotiation power with the suppliers, synergies of centralized operations and effective utilization of funding options. The investment

53. Acquisition of competitor stores

Expansion of business does not come only by opening new stores from scratch. Setting up a new outlet from scratch would require significant effort, time and investment. One good alternative is to acquire stores of a competitor. If an organization keeps a close eye on its competitors, it would be able to identify suitable value-adding opportunities. If one of the stores of a competitor is not operating profitably and they are interested in sale or close it down, you can avail this opportunity. This would not only provide you quick access to the customers of that store but would also provide an up and running business in no time. It is also likely that you negotiate a good deal on account of the poor performance of the store.

54. Selling to your competitors.

Sometimes in life, you need to take a step back so that you can jump forward multiple steps. The same is right in the business world. Selling one of your loss-making stores may seem a backward step in the business world, but it might open new opportunities for you to be successful in your retail business. Once you sale out your loss-making outlets to your competitors or an entrepreneur, you would be able to better focus on your profitable segments. The funding which you were doing to continue the loss-making business would be no longer required. Your profitability will increase, and this will be significant value addition and success for the company.

55. Quick exit spots

These are dedicated exit checkout counters for the customers who have purchased a few items only. They don’t want to wait helplessly behind a person having two full trolleys. Dedicated quick exit spots will provide an opportunity for the people to get a faster check out from the stores. The presence of these counters is value-adding for these customers and the business as well. Otherwise, these customers would leave the items behind and would not purchase as they don’t want to wait for a long time in the checkout queue.

56. No purchase exit spots

These are the exit spots dedicated to the people who entered the store intending to buy something but later on changed their mind. Dedicating a place through no purchase exit spot would help these people to move out of the shop quickly. This is a value addition for the customers as they will not have to wait at check-out counters. Further, it is value creation for the business as well as it will help reduce the number of people at the queues. Also, analytics may be deployed to observe the number of people quitting without purchasing anytime. These analytics may be used to identify customer behavior and find out the reasons for not making any purchase.

57. Deposit your luggage spots

If your retail outlet is in a shopping mall, there are good chances that the visitors would have some luggage. It would be either shopping items purchased from other businesses or general luggage. If the retail shop provides a dedicated spot where any shopper can deposit their luggage and then freely roam around in the retail shop that would be a great value addition for the customer as their both hands will be free to purchase as many goods as they want. This is a perfect value proposition for the owners of the retail business as well.

58. Warranty claims

Many electronics items are sold with warranty features at retail shops. Once the warranty claim is received, it should be serviced at the retail shop from where the item was purchased. This is because the customer purchased that electronic item from the retail store and thus expect the warranty claim to be serviced from the same retail unit. If the customer is asked to go to some other place, it would be displeasure for the client. The success of the retail business lies in the premise that warranty claims are settled at the retail shop itself.

59. Variety of products availability

Selection of suitable items for display at the retail center is a cumbersome job. You need to take care of multiple factors. For example, you don’t want to stack everything of one manufacturer or one particular brand. This is because different users would have a preference for various brands. Similarly, you should offer the products which contain varied features. All products providing the same features would not be meaningful for the customers. The retail business will be successful if the customer feels valued. The customer will feel valued if they get a tasty variety of products available at the shop.

60. Expert production information staff

When it comes to electronic items like hairdryer, laptops, LCDs, washing machines, the features of the product are of extreme significance. The helping staff at these products should be well aware of the product features and should be able to explain it to them. Many times a customer would hesitate to purchase a product because of doubt. The sales staff may clear this doubt if the team is well aware of the product’s features and characteristics. It is important to note that there is no problem or issue with the product itself. It is just the information about the product which is creating reluctance in making the buying decision. An expert staff having good communication skill can add significant value to the retail company and for the customer. The customer will feel more confident is he/she is properly explained about the functionalities and qualities of the product.

61. Competitor analysis

In today’s fast-paced environment, you need to keep one eye on your customers’ requirements and the other eye on the moves of the competitors. If your competitors are offering something additional than you, it would be quite difficult for you to survive in such a competitive market. For example, if your competitor provides 1-month cash back guarantee on certain products (e.g., fridge or washing machine), then, you’ll also have to come up with the same or a better plan.

62. Compliance with laws and regulations

Last, but not the least, aspect of creating value to run a successful retail business is to ensure that you are complying with all the relevant laws and regulations applicable in the jurisdictions in which you operate. Some of the possible laws which might be applicable on a retail company are labour laws, public safety laws, consumer rights laws, general sales tax laws, value-added tax laws, income tax laws, local companies’ laws, local municipality laws, regulations of trade assocations etc. A successful retail business is always a law-abiding business.

 

 

Final Words

Starting, running and managing a retail business is not simple. It requires a significant amount of determination, teamwork, investment and continuous endeavors to make it successful in the long term. There are many ways to create value and run a successful retail business which we have studied above.

It is also right that many of the value-adding suggestions conflict with each other. For example, having a maximum product range would conflict with lowering investment in working capital. Providing an increased product range would require a greater floor area and thus increased rentals. Ensuring physical safety might require additional workforce and equipment. An objective of faster checkout would require an increase in the number of cashiers.

With all the conflicts mentioned above, a trade-off needs to be obtained between the benefits and the costs involved. There is no one standard set of value-adding suggestions which fits all retail business. Each organization have to evaluate these suggestions as per their circumstances, strategy and funds availability.[/vc_column_text][/vc_column][/vc_row]

Categories
Career advice Finance careers

How to join an audit firm

[vc_row][vc_column][vc_column_text]If you are inspired to choose auditing as a career, then, as a next step, you need to find out how to join an audit firm or how to get enrolled in a Big 4 audit firm or what is the best audit firm for your career.

To become an auditor, you need to choose an audit firm. An audit firm is mandated and has a license to perform external audits of different companies for regulatory and other purposes. An audit firm would have a typical structure of some audit staff, audit managers and audit partners.

To join an external audit firm, ideally, you should be a university graduate with majors in accounting, finance or economics. There are many audit firms which hire engineers, scientists, IT professionals, architects and graduates of other disciplines. This diversity is because an audit firm will have a variety of clients and a variety of engagements. They will have clients in healthcare, engineering firms, construction, technology and financial sector. So having a workforce from a variety of backgrounds help an audit firm understand their clients closely and to assess audit risks in a better way.

 

Many audit firms also require professional accountancy qualifications like CPA, CIA, ACA and ACCA etc. They don’t expect you to have completed the studies fully, but if you have progressed somewhat towards these qualifications, it will put a good impression on the hiring manager.

Now, a vital step for you to identify the best audit firms around you and prepare a suitable strategy to approach a position in that firm. Most of the times, Big 4 audit firms are desired by aspiring auditors and accounting professionals; these include Pricewaterhouse Coopers (PwC), KPMG, Deloitte & Touche Tohmatsu and Ernst & Young. Big 4 audit firms are top four auditing and consultancy firms in the field of accounting and auditing.

 

Once you have selected which audit firm to aim for, you need to perform the following steps:

  1. Prepare your resume: Your resume should be highlighting your passion for the auditing profession. The more you express you’re interested in the field of auditing, the more likely you are to be taken seriously.
  2. The resume should also highlight advanced auditing skills which you might have learnt during your college or professional studies, including the ability to identify audit risk, business risks, control risk and inherent risks.
  3. Review job ads at LinkedIn (or other career websites) for different auditing positions and carefully go through job descriptions. Try to gain maximum understand and include some of those keywords in your resume as skills obtained as part of your studies (wherever applicable).
  4. Approach key management people of your target audit firm in your area through LinkedIn and send them personalized connection requests highlighting your potential and interest to join auditing as a career with their audit firm.
  5. Make a personal visit (and multiple, if possible) to the audit firm and try to meet with HR or audit partners or audit managers. Try to obtain their career advice on how to join a right audit firm like theirs. The more you engage them, the longer you are likely to remain on their mind. Usually, audit firms hire trainees after specific intervals. Obtain details of the next hiring cycle.
  6. Once you obtain an interview call for the position of audit associate, it’s your time to prove your best so that you can get into your dream audit firm. You may not have experience of interviews before, but try to stay calm and composed and be honest always. You do not have to try to impress them by faking or by telling lies. They will know it instantly, although they may not express it upfront.

 

 

If you get an employment offer from the audit firm, take your time to make your decision. Joining an audit firm is one of the most important decisions of your career and your life as well.  You are going to spend all of the daylight time of your life with these guys. You should be comfortable enough to take that decision.[/vc_column_text][/vc_column][/vc_row]

Categories
Business Strategy Entrepreneurship

How to generate new business ideas

[vc_row][vc_column][vc_column_text]As an aspiring entrepreneur, you would be tempted to commence a business. However, to initiate a business, you need to have a good business idea. A good business idea is the one which is technically possible, financially feasible and practically possible to implement. However, how to get a business idea which fits the above criteria.

Below we’ll discuss some ideas of generating new business ideas:

1. Review your skillset:

Every person in this world possess some skillset, make a list of your skills and then choose at which you are best. If you are good at gardening, you may choose this as a business idea to provide gardening services, same goes for cooking, hairdressing, plumbing, graphic designing, financial modelling, software development, news reporting, marketing, training, counselling, etc. You can utilize these skills and create your startup, providing any of these services.

2. Your family business:

Please don’t underestimate the organization run by your father (or anyone in your family). Try to join hands with them if possible. There will be fast growth of your career in a family business plus bright chances of becoming a shareholder soon. A family business is a fantastic ‘ready to eat’ entrepreneurship opportunity. The family business which you’ll continue would be transferred to your offspring’s as a legacy. You may join, however, any other job for a short time for learning and developing your business skills.

 

 

3. Meet with people:

Meet your friends, relatives, neighbours and acquaintances and find out what they are doing. Understand their financial situation and the business in which they are operating. Be open and ask for the advice for commencing similar business and express your desire to be a businessman. Ask someone to help you with some new business ideas. A bold entrepreneur is never afraid of holding the hands of aspiring ones. Further, it is better to avoid learning from a person who is not courageous enough.

4. Networking events:

You already know that attending networking events would help you to identify business opportunities as well as strengthening your network. However, what most people don’t know is, how to make the best use of networking events. My advice is, if you are attending a networking event to enhance your network and find out business opportunities, then, do not sit idle in the corner of the meeting hall. Please kill your hesitation and meet every stranger, extend your arm and say, “Hi, how are you, sir, my name is Vuznyaki Parasychi, I am working in Thermal Drums Pvt. Ltd., may I know your name please?”. I have used a fictitious name here, but you, please use your real name.

5. Travel in the city:

Be open-minded and look around. Just take a ride on a local bus and start filming around the town (make sure it’s not against local laws). Film or keep looking at all the streets, shops, roads and people. Look what they are doing. Then reach back home and see the movie filmed (on camera or in your mind). Make a list of what people were doing. You’ll notice a long list containing names such as laundry business, tyre trading business, petrol pumps business, furniture business, glass factories business, computer shops business, carpet trading business, import and export business, imports from china business, clothes trading business, fashion products business, FMCG, retail business, repair and maintenance of cars business, general repair and maintenance business, building maintenance business, electronics trading business, software development business, cleaning services business etc. This observation will help you to generate ideas about new business ventures.

 

 

6. Make Money Online:

You can find out many business ideas on the internet as well. Search for “new business ideas” or “best business ideas” or “online business ideas” on Google, and you’ll come across many options. There are billions and trillions of dollars being earned by people working online. If you are considering making money online, then there are many ways which you can utilize your skills in making money online. You may create Facebook videos or write a blog and then earn from the advertisements placed on our content. You may provide online freelancing services on a project basis — many websites like freelancer.com and upwork.com providing such platforms. But you need to be cautious of fraudulent activities and scams which are very common online. To avoid deception, do a background check on the reputation of the company by typing “scam company name” on google.

7. Full-time job:

Is it surprising that a full-time job can help you in generating new business ideas? No, it’s not. A full-time job in any industry would help you understand the business dynamics of that particular industry and will train you to launch your entrepreneurship journey. Let’s say if you work in a manufacturing unit as an engineer or as a machine operator or even as an accountant, you’ll get a chance to look at how things are happening practically. Once you see the whole process of purchasing, manufacturing and selling, this will help you a lot in launching your manufacturing unit. There are different options for raising finance for your business which you can read in our article on how to arrange finance for business.

8. Read books on business ideas:

There are many good books on successful and failed business ideas. Reading these books will help you evaluate different business models and enhance your understanding of various industries and sectors. Some of the books which you can consider reading are “The $100 startup”, “Start With Why”, and “The Founder’s Dilemma”.

9. Think of the Gap:

Sometimes, we wonder why a particular service or product is not available. For example, why there is no quick machine available where we can enter in one part of the world and pop-out immediately in another part of the world? Why can we not take things out of the internet and bring in our real world? Well, these are some extreme examples. But you may consider some small missing products or services which may not be present in your area or anywhere in the world. For example, why we have to go and pick the grocery ourselves, why there can’t be an App linked with nearest grocery stores etc. Why do we need to call someone to find out where is he or she. Why there is no product available which would clean the home out of its own? So, think of the gap which you are missing, and then you can utilize that idea as a business.

10. Innovation:

Innovation in any existing product or service can dramatically increase market demand for that product or service. A little add-on or a change in the method of delivery can result in significant value addition. Try to innovate any existing product or service and then launch that product with that innovative style. For example, a restaurant may offer its customers a custom made food where customers can select ingredients and quantities to be added and also participate in the cooking process and oversee it live.

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Categories
Career advice Finance careers

How to become a Finance Manager

[vc_row][vc_column][vc_column_text]If you are an accounting & finance student or at the early career stages of accounting & finance, then this is the right article for you. You need to read the below guidance to reach the position of Finance Manager.

Companies hire candidates mainly because of what they have done in the past. So, do proper research on the job descriptions (JDs) of Finance Managers and see what the ordinary functions of finance managers are. Once you go through some of the JDs of Finance managers, you’ll see a long list of tasks and responsibilities. However, all of them are not equal in importance. I can summarize these responsibilities in below 4 points:

  • Financial management of the organization, i.e., where to invest excess cash and how to arrange for the funding wherever required
  • Preparation of forecasts, budgets and financial models
  • Preparation of financial statements as per applicable accounting standards
  • Routine accounting functions like handling payments, collections from receivables etc.

 

 

Now, the first two points are critical. These are the points where usually candidates lack. The first point of financial management is related to the treasury side of the role. As a finance manager, you need to manage the flow of money. Money for an organization is like blood for a living body. A good finance manager knows how to manage the flow of the money and find out the ways wherever there is an issue.

Financial analysis and planning is another desired skill from Finance managers. If you can prepare financial models, prepare budgets and do business planning activities, then you are a star for your next employer. These are the skills which guide the organization on how to proceed ahead and take the right business decisions.

Another important role is related to financial reporting and consolidation; this is mainly an area of Financial Accounting but may be valuable for the position of Finance manager too. You need to learn the latest consolidation rules and master the art of group consolidation.

 

 

Now, if you don’t have good skills in investment management, treasury management, financial management, financial modelling, financial planning & analysis, budgeting, IFRS, consolidation, group reporting etc. then you need to learn these skills and apply in your current role. Once you learn these skills and use in your current position, then you’ll be able to showcase these skills of a good finance manager to prospective employers.

You can learn these skills through online courses available on various MOOC platforms (Massive Online Open Courses) like coursera.com, edx.com, khanacademy.com etc. These courses are available at quite low rates, and you can complete them at your own pace without worrying about attending formal classes.

Once you get these courses and certificates, and you apply the same in your current role, you are all set to reach the actual Finance manager position.[/vc_column_text][/vc_column][/vc_row]

Categories
Uncategorized

LET ME INTRODUCE YOU TO FINANCIAL STATEMENTS

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What are the financial statements?

How to obtain financial statements?

What information financial statements provide?

How and why financial statements are useful?

Who prepares financial statements and how often?

Why do investors want to have a look at the financials?

 

If any of these questions keep you anxious and restless, then, I am sure you’ll find comforting answers here, plus you’ll learn a lot additional.

Accounting & finance professional often use the word of financial statements in their life. Similarly, investors, bankers and auditors use this term frequently as well. This term is also used as a short ‘financials’ only, like “where are the financials of 2010” etc. Here the word ‘financials’ refer to ‘financial statements’. If you are new to this field or want to know more details about the type of financial statements and what are their contents, you have come at the right spot.

The term ‘financial statements’ refers to a set of documents or reports which provide financial information about a business or a person. These financial statements are prepared to provide information about the financial situation of the company to external parties. Therefore, sometimes, these are also referred to as ‘external financial statements’ but usually referred to as ‘financial statements’ only (or sometimes as ‘financials’ only).

Financial statements serve below purposes for different readers:

For Shareholders: Shareholders are considered to be primary users of financial statements, they are the owners of the company, and they need to know how is their business performing. So, shareholders use these financial statements to make suitable business decisions or investment decisions.

Potential investors:

Financial statement provide information about profitability, financial strength and liquidity of the company, and potential investors can utilize financials to perform analysis and make suitable investment decisions.

Regulators and tax authorities:

Regulators and tax authorities utilize these financial statements to regulate industries and cross-check tax calculations

Competitors and Industry analysts:

Competitors and industry analysts use financial statements to understand the strategy and performance of the company.

Listed companies and other regulated companies are required to publish their audited financial statements. This the financial information of such companies become public and different stakeholders can obtain these financial statements. However, for private companies, usually the financial statements are not disclosed publicly, and only authorized parties get access to it. These authorized parties may include shareholders, bankers, tax authorities and, of course, auditors.

Financial statements usually contain the following documents (or reports):

  1. Statement of Financial Position (or Balance Sheet)
  2. Income Statement (or Profit and Loss Account)
  3. Statement of Cash Flows (or Cash Flow Statement)
  4. Statement of Changes in Equity

 

 

Statement of Financial Position (or Balance Sheet)

A balance sheet is one of the primary financial statements. This document is typically the first one in the set of financial statements. The term balance sheet is used for this document as this statement contains two sides: one is the assets side, and the other is liabilities and equity side. Both sides of the balance sheet should be equal in value and thus, balanced. Therefore, we use the term balance sheet as both sides of this statement are equal in value. All debits and credits are matching in total amounts. If a balance sheet is out of balance, then it means that it is not a balance sheet J.

This statement is also referred to as a statement of financial position as it displays information about the financial situation of the company; it provides information about the financial strength (or weakness of the company). It states how much assets a company owns and how many liabilities it owes. A balance sheet is a beautiful snapshot and an excellent presentation of the company’s assets, liabilities and equity on a single page. (Usually on a single page, though you may expect two pages also).

We can use a company’s balance sheet for calculation of various key and important ratios like current ratio, quick ratio, debt-equity ratio etc. We can use these ratios for multiple financial analysis purposes.

It is pivotal to understand that the balance sheet is a company’s snapshot of its financial strengths (or weaknesses) at a given date only. This one day’s view means that balance sheet provides the situation as of on a particular date, it is not for a specific period etc. Let’s understand that if a balance sheet is prepared as on 31 December 2010, then all the items on balance sheet would provide details of assets, liabilities and equity which are existing as on 31 December 2010. It would not include any elements which have ceased to exist on or before 31 December 2010. It will also not add any item acquired after this date.

For example, if a building is purchased by the company on 25 December 2010, then this building will appear on the balance sheet of the company as on 31 December 2010. However, if the same building were purchased on 5 January 2011, then this building would not appear on the balance sheet of the company dated 31 December 2010.

It is also good to realize that balance sheet numbers are ‘cumulative’ numbers, i.e., these balances are closing figures as at balance sheet date of all the transactions which happened from the inception of the business till the balance sheet date.

If you are planning to invest in a company (whether in it’s bonds or shares) then a balance sheet is an essential source of information which can provide critical information which will help take a right decision. For example, whether the company is highly geared or not, how many liabilities it already owe, what are it’s highest assets and how much cash the company already has, all these information are available from the balance sheet (or statement of financial position) of the company.

 

Income statement

Income Statement is one of the essential items in the financial statements. It provides a significant source of information when a company needs to explain it’s financial performance or when a competitor needs to know the sales of a company. The income statement is also essential when an investor wants to know how much is the profit for the company or when a shareholder wants to know EPS (earning per share). Similarly, when a lender wants to see the finance cost of the company, he can utilize the income statement.

The income statement is also referred to as ‘profit and loss account’ (not ‘profit or loss account’, please). The correct term is ‘profit and loss account’ (and not ‘profit or loss account’). The general structure is that the statement usually starts with the revenue figure, then deducts the cost of sales. After that, there are general and admin expenses, sales and marketing expenses and other expenses. The outcome after deduction of taxes and interest is net profit (also referred to as net profit after tax).

The income statement is also referred to as ‘statement of comprehensive income’ if it includes ‘other comprehensive income’. (As per revised IAS 1)

The income statement is usually prepared for a period, i.e., let’s say for one year. So, if the income statement is prepared for the year ended 31 December 2010, this means that the income statement is a summary of all income and expenses related transactions which happened for the period from 1 January 2010 to 31 December 2010. This periodicity is in contrast to a balance sheet which is representative of one particular day’s reflection of assets, liabilities and equity of the company, while income statement is representative of all the transactions which happened in that period (a year or quarter etc.)

 

 

Statement of Cash Flows (or cash flow statement)

The title of ‘cash flow statement’ was changed to ‘Statement of Cash Flows’ in 2007 under the amendments to IAS 1. As both names depict, the statement describes the movement of cash for a business for a given period. This statement is a useful tool to understand how much money (cash) is generated or consumed by different activities of the company. These business activities are broadly classified as ‘operating’ activities, ‘investing’ activities and ‘financing’ activities.

The statement of cash flows is usually presented at the third spot (after balance sheet and income statement) in the financial statements. The usability of this report is quite limited as compared to the first two statements.

Please read our detailed article on the statement of cash flows here.

 

Statement of Changes in Equity

This report is the fourth and last statement in the set of financial statements. After this, there are usually notes, disclosures and break-ups of different items of financial statements. Statement of Changes in Equity (SOCE) is a shareholder specific statement. It would provide information on whether there has been any change in the equity, i.e., any movement in the shareholders’ equity.

E.g., a dividend is reflected in SOCE as an addition in the dividend reserve and a decrease in retained earnings. Similarly, if new shares are issued, they will be revealed as an addition to the shareholders’ equity of the company. SOCE is especially for shareholders and provides essential information about the movement in the equity, although this statement may not be of great interest to other readers of financial statements.

 

 

General Points related to Financial Statements

Usually, a company’s financial statements are prepared by its accounts team. Depending upon the structure of the department, it is often accounts manager or financial reporting manager who is responsible for the preparation of the financial statements.

Financial statements are usually prepared for the current date (or period) as well as a comparative date (or period). For example, if a company is producing a balance sheet as at 31 December 2010, it’ll also provide figures for last year, i.e., balance sheet as at 31 December 2009. These comparative figures are provided because a comparison of the numbers can be made between two years. Thus a reader of the financial statements will be able to

In large complex organizations, it is usually the CFO who is ultimately responsible for ensuring correct preparation and presentation of financial statements. Although multiple managers and specialists support him.

In small companies, either the financial statements are prepared by the company’s accounts staff itself, or sometimes the external auditors will also provide this service to compile financial reports on behalf of the company. The preparation of financial statements is a service provided in addition to the audit of the financial statements.

As a person having an interest in accounting & finance, I would invite you to download the financial statements of multiple companies and go through their annual reports. These yearly reports would contain financial statements of the company along with other information. Many companies (usually public and listed companies) provide their financial accounts on their websites free of cost, either as a regulatory requirement or to attract more investments from shareholders). A review of these set of financial statements would significantly enhance your knowledge and quench your thirst for reviewing financial statements.

As a reader possessing an interest in accounting & finance, I would invite you to download financial statements of multiple companies and go through their annual reports. These yearly reports would contain financial statements of the company along with other information. Many companies (particularly public and listed companies) provide their financial statements on their websites free of cost, either as a regulatory requirement or to attract more investments from shareholders). A review of these set of financial statements would significantly enhance your knowledge and quench your thirst for reviewing financial statements.

 

Management Accounts

Another important concept when discussing financial statements is that whatever we read above is related to external financial statements. However, companies prepare their internal financial statements also which are referred to as ‘management accounts’. The components of management accounts are usually same i.e., income statement, balance sheet and cash flow statement etc. However, there might be some additional statements like daily cash position, flash report or product-wise profitability report etc.

These management accounts are prepared for the use of management to make the right business decisions. These management accounts are not shared with anyone outside the organization. This area of accounting is governed more by cost accounting or management accounting, while the external financial statements are dealt more under financial accounting. Our article titled Management Reporting would provide you detailed knowledge on this topic.[/vc_column_text][/vc_column][/vc_row]

Categories
Audit in general Auditing & Tax

External Auditing as a Career

[vc_row][vc_column][vc_column_text]Auditing is a vast subject, has a massive impact on our society and plays a pivotal role in regulating the economy. It is a broad field, and some people in the profession of accounting & finance spend their entire life performing audits — others who don’t still spend plenty of time for auditing or related items. Auditing is so popular that even non-finance people also come across this subject from time to time, during their work.

Mastering the art of auditing would require years of experience, deep learning passion, and spending numerous hours concentrating on the audits. You need to stay away of all distractions and always keep thinking about “what could go wrong” or “what is the audit risk” or “what is the control risk” related to this assignment. If you are choosing the auditing as a profession, you have to question every item and assess that item’s impact on financial statements.

 

 

An auditor would assess the impact of transactions on the underlying financial statements. He/she will do it by trying to link a transaction with the financial statements. For example, how sales impact financial statements? What will be the impact of renovation going on the office on the financial statements? What is the audit risk in the new car purchased by the CEO? What is the control risk in selecting a supplier for awarding construction of new office building? What is the inherent risk in the outsourcing of call center?

The mind of an active and ambitious auditor would always seek clarifications. He would question every transaction, every process, every deal, every event and every system, all with scepticism. He would link all these items with the financial statements of the organization and vice versa. Does he see the building of the audit client on the balance sheet of the company? Can he trace back the rental income in the profit and loss account? Can he link the increase in the staff with the increase in the payroll cost during the year?

Many people enjoy auditing as it would provide the opportunity to visit different companies. An audit manager would be handling around 30-40 clients in a year, depending upon the size of the firm and the economy in which he operates. Visiting different companies, meeting with a variety of people, reviewing multiple accounting systems and assessing business risks of different sectors is a fascinating, challenging and skillful job. Auditing will expose you to various industries like real estate, retail, FMCG, manufacturing, oil & gas etc. This variety is quite fantastic and exciting.

 

 

To commence the career as an auditor, you usually need to join as an audit trainee or audit associate in an audit firm. Mostly audit firm provides three years or five years of training programs. You can also continue your studies during this training period.  The hierarchy in an audit firm would be something like audit associate, semi senior associate (or associate 2) and senior associate (or associate 3), audit supervisor, audit manager, senior manager, audit director and then audit partner.

Many external auditors prefer to stay in the audit firm for an extended period and seek to become audit partners in the audit firm. Usually, an audit partner is the highest rank in the field of external auditing. Some partners are further promoted later to the level of the senior partner or managing partner. Many people choose to move out of an audit firm during different stages of their audit career. The move is usually into some company. If a person moves from audit practice to join a company in their accounts/finance team, they call it a ‘career in the industry’.

Auditing as a career is quite promising; it provides a career ladder, a stable job and a continuous learning curve. General public considers auditors as people of high integrity and excellent ethical standards. A career as an external auditor would lead to respect in society and would strengthen your network.[/vc_column_text][/vc_column][/vc_row]

Categories
Investment Management Ratio analysis

Earnings Per Share (EPS)

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Earnings per share = Net Profit After Interest, Tax and Preference Dividends / Number of Shares

 

Earnings Per Share or EPS is a measure of the financial performance of an organization. The ratio of EPS informs shareholders of the amount of profit attributable to each share of the company. EPS is the amount of profit earned per share of the company. The result of the ratio is in absolute amount, and a higher amount represents better performance.

Let’s say that if a company’s net profit after interest and tax is $50,000 and there are a total of 5,000 issued shares of the company. In this case, the earning per share of the company will be $5 per share.

 

 

In the EPS calculation formula, take the number of shares in the denominator as the weighted average number of ordinary shares outstanding at the date for which you are calculating EPS.

It is essential to understand that EPS is a very indicator of a company’s financial performance. It is even a better indicator than profit for the year.

Let’s take the example in the below table containing some fictitious companies’ data. We can note that Zakoota LLC has earned a profit of $900,000, much higher than the profit of the other two companies, but it has a lower EPS of $36 than the other two companies.

 

 

The earning per share (EPS) is simple to understand ratio and an ordinary investor or shareholder can interpret it easily. The higher the per-share earnings is, the better the company’s performance is. If the answer of the ratio goes into a negative figure, then it means there has occurred a loss per share equivalent to the amount of the ratio.

Earning per share is also referred to as basic earnings per share or simple earning per share. All that we have read above is about basic earnings per share or simple earning per share. One variation of the EPS is to calculate primary Earning Per Share (PEPS). Primary earning per share excludes preference dividends from the formula of EPS.

 

 

Diluted Earnings Per Share

Let’s assume that if a company issues additional shares, then the existing income will be divided among more number of shares. This increase in the number of shares will decrease (dilute) earnings per share.

Diluted earning per share takes into account of all convertible share options. If all convertible share options get converted into ordinary shares, then the total number of shares will increase and earning per share will decrease.

So, to understand, what will happen if lenders exercise all the conversion options, we can calculate diluted earnings per share.

Convertible options mostly comprise of staff share options, directors share options, convertible preference shares, convertible bonds etc.

The formula for calculation of diluted earning per share is below:

 

Diluted EPS = Profit after interest, tax and preference dividend / (Weighted average shares outstanding + Convertible shares)

 

To calculate weighted average shares for basic or diluted EPS, let’s take an example. If a company, Zakoota LLC, had outstanding shares at the beginning of the year (1 January) of 10,000 until mid of the year, i.e., 30 June. Then, the company issued additional 15,000 shares and at the end of the year (31 December) there were a total of 25,000 shares outstanding. Now, how to calculate weighted average shares for EPS calculation?

 

Weighted Average shares = (10,000 * 6 / 12) + (25000 * 6 / 12) = 17,500

 

Final words

EPS is widely used in financial analysis and for investment decision purposes. It is easy to understand, easy to calculate and easy to comprehend. We can also compare EPS across different companies as well as various industries. It is especially relevant for the prospective shareholders as it is directly related to the earning of the shareholders. However, it is essential to understand that directors may not distribute all earnings of the company among shareholders immediately. Therefore, an investor should not expect to receive calculated EPS as a dividend. It depends upon the directors of the company how much dividend they want to distribute among shareholders.[/vc_column_text][/vc_column][/vc_row]

Categories
Investment Management Ratio analysis

Dividend Per Share

[vc_row][vc_column][vc_column_text]Dividend per share is a measure for the company’s financial performance. Corporate world widely uses this ratio for financial analysis purposes. It directly affects shareholders, and therefore it is a common question among shareholders and in their minds. How much is the dividend per share in my company? Or How much is the dividend per share in a prospective company?

Let’s first look at the simple formula of dividend per share:

 

Dividend per share = Dividend for the common stockholders / Number of shares outstanding

 

Let’s say that if the company announced a total dividend of $25,000 and the total number of common stock shares is 5,000 shares, then it means that for each share there is a dividend of $5 ($ 25,000 / 5,000 shares).

Shareholders prefer to receive a higher dividend payout. However, a higher dividend payout ratio is not a good indicator to measure the financial performance of a company. Sometimes, directors of a company may announce a higher dividend to keep shareholders happy and to conceal poor performance of the company. Better measures of the company’s performance are earnings per share and price-earnings ratio.

In contrast, sometimes, directors want to utilize the earnings of the company for future projects. In such cases, they would announce a lower dividend per share. This approach may not be welcomed by shareholders of the company, but it might be better for the company’s future as well as shareholders’ future. The more money kept in the company’s reserves and utilized wisely in future; the better would be the financial performance and financial position of the company.[/vc_column_text][/vc_column][/vc_row]

Categories
Audit opinions Auditing & Tax

Disclaimer of audit opinion

[vc_row][vc_column][vc_column_text]The external auditor of the company will issue a report of the disclaimer if he is not able to form an opinion about the ‘true and fair’ view of the financial statements of the company.

The reason why he is not able to form an opinion is that he could not obtain sufficient and appropriate audit evidence to support an audit opinion. This lack of ‘sufficient and appropriate’ audit evidence may be related to any one of the significant areas of the financial statements or multiple areas.

 

This extreme case of disclaimer of audit opinion would arise when the auditor concludes that possible effects of undetected misstatements could be both material and pervasive. There might be different examples of the cases when a disclaimer of opinion is appropriate.

These examples are listed below:

  1. When auditor required certain documents, but management refused to provide these documents to auditors on account of confidentiality or any other reason. These documents may include payroll slips, ownership documents or related party transactions etc.
  2. The finance team is not able to provide specific accounting records due to circumstances beyond its control, for example, a virus that deleted accounting records or a natural disaster.
  3. The management did not perform a particular evaluation or assessment, e.g., an impairment evaluation is required, but the management does not believe so. Similarly, the management did not carry out a required provisioning exercise for bad debts.
  4. Impact assessment for a specific contingency might be difficult at the time of issuance of the audit report. For example, a legal case decided against the company imposing hefty fines and restrictions and the company has filed an appeal. The court shall require a significant time to decide on this petition.
  5. Where going concern assumption cannot be substantiated with reasonable certainty.
  6. Where the company appointed its auditor at such a time (or due to some other reason), that auditor was not able to attend annual inventory count. Another case is, the company refuses to send balance confirmation letters to its receivables and banks.
  7. Where the company replaced its accounting system with a new system, and there had been multiple issues in the implementing like incorrect data transfer, lost data, duplication of entries, and lost connectivity time etc.

 

 

In the case of a disclaimer of opinion, the external auditor would prepare audit report mentioning that they are not able to form an audit opinion on the financial statements of the company indicating the reasons of the same.[/vc_column_text][/vc_column][/vc_row]

Categories
Business & Finance

The Debt-Equity (D/E) Ratio (Gearing / Leverage)

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Usage and Application

Usage of the debt-equity ratio is essential in the following cases:

  1. Investments decisions: When a potential investor is considering to buy shares of a company (called prospect), that investor has to analyze what is the current debt-equity ratio (gearing) of the company. Similarly, when an investor is considering purchasing bonds of a company, they need to understand the significance of the existing debt burden of the prospect. It might be unsafe to invest further in a highly geared company.
  2. Financial Management: A company’s management would need to keep an eye on it’s reported figures. Finance managers have to comply with the lenders’ covenants restricting specific ratios within defined ranges.
  3. Let’s say that a company is required to maintain a debt-equity ratio (gearing) of 2:1. Then the management would keep calculating this ratio on periodic intervals and at the time of critical decisions making to ensure that gearing ratio is under the limits.
  4. Credit Risk Management: Many banks and other lenders need to keep track of the financial strengths and weaknesses of their borrowers. This monitoring is a part of the credit control process to avoid the risk of bad debts or to book the provisions of bad debts (if required). Bank’s would calculate the debt-equity ratio of their clients firstly at the time of considering loan request or requests for other banking facilities (like an overdraft, letter of credit, letter of guarantee etc.)
  5. Regulators, brokers and stock markets: Many analysts are working as information house, and they need to calculate different ratios to update their clients. They advise about different investment options and provide industry figures. Such analysts and brokers estimate debt-equity ratio (gearing) to update their clients. Similarly, many regulators and stock markets also keep an eye on critical ratios of entities regulated by them.
  6. In Studies and exams: In many studies and assignments of accounting, finance and economics, students need to calculate debt-equity ratios for the analysis and exam purposes.

Definition, example and formula

So, considering the widespread use of the gearing ratio, let’s first see the definition and formula of debt-equity ratio:

A debt-equity ratio calculates debt as a proportion of the equity of the company. Its formula is as below:

Debt equity ratio (or gearing) = Total Liabilities / Equity of the company

Generally speaking, the wording of ‘debt-equity ratio’ or ‘gearing ratio’ or ‘gearing’ or ‘gearing level’ or ‘financial leverage’ are used interchangeably and refer to the same ratio (or with some slight variations).

Example: Let’s say that if a company has total liabilities of $100,000 and its share capital and reserves sum up to $150,000, then the debt-equity ratio will be calculated as follows:

$ 100,000 / $150,000 = 0.667 or 66.7%

 

 

Interpretation of debt-equity ratio (or gearing)

So now, let’s understand how to interpret this ratio, what is the underlying message, is this a comfortable level of gearing? If not, then what to do when the debt-equity ratio goes high? Or what is the importance of debt-equity ratio in investment decision making? Or Let’s discuss below.

The above calculated debt-equity ratio of 66.7% denotes that the total liabilities on the company is 66.7% of the equity of the company.

This ratio indicates that lenders’ investment in the company is equal to 66.7% of the investment of the shareholders in the company.

Generally speaking, as a lender, a debt-equity ratio of below 1 (or below 100%) would sigh relief to the lenders that the shareholders have invested their own money more than what lender have invested in the company. This proportion is comforting for lenders as shareholders have a more significant stake in the company than lenders. Now, if the company would go bankrupt, lenders will not be the only one who will be at a loss. It is one of the psychological impacts of debt-equity ratio on the lenders.

It is easily understandable that a zero debt-equity ratio means that there is no loan on the company and that owner’s contributions fully fund the company.

A 100% geared company means that the amount of debt on the company is equivalent to the shareholder’s funds. So it means that both lenders and shareholders are equally financing capital of the company.

 

An acceptable or ideal level of gearing

Now the question is, what is the general or acceptable or ideal ratio of gearing. What is an optimal level of gearing. Well, the answer is, “it depends”. It depends on a lot of factors, including company size, industry, regulations, macro and microeconomics environment, business strategy, future projects and of course, competition. In some companies, it is reasonable to be highly geared. These are those industries which require a high setup cost, involving high investment in plant and machinery. Examples include the airline industry, construction industry, real estate, manufacturing and maritime etc. As such, a gearing level of above 100% to 200% would not be considered alarming in these industries.

While in some industries where initial business setup costs are low and in those industries, the gearing level of companies is generally low. These industries would include retail, trading, service sectors, technological and software companies. As such, a gearing level of 0 to 30% would be considered normal in these sectors.

It is essential to understand that the gearing ratio (leverage level) would not remain the same over the years; it is a ratio which keeps moving with the business. The ratio is changing because of the payment of a portion of loans every year. Similarly, the profits of the company keep adding to the owner’s equity (if not fully drawn). So, the general nature of the gearing ratio is that you may observe a declining trend in the debt-equity ratio over several years. This decrease is on the assumption that the company will not avail new loans or will not reschedule its liabilities.

 

 

Controlling the gearing ratio

If you are handling the finances of the company, and you need to control the debt-equity ratio of the company, you may evaluate one or more of the following options:

  1. Avoid distribution of profits or keeping it to a minimum possible level.
  2. Say no to new borrowings and issuing bonds
  3. Negotiate with lenders for better (low cost) interest rates
  4. Fund any new projects with new investment from owners
  5. Utilize short term funding sources like money markets for short term requirements
  6. Issue bonds with convertible features (i.e., a bond which will be convertible into shares after a defined period)
  7. Early payment of loans to reduce the debt burden

 

Variations of debt-equity ratio

One variation of the debt-equity ratio is to utilize only long-term liabilities (instead of total liabilities) and dividing them with equity. The formula will be as follows:

Debt equity ratio = Long Term Debt / equity * 100

Using this formula means that we have to consider only long-term debts when calculating the debit-equity ratio. This formula is another meaningful variation as it ignores current liabilities. The argument is not to double-weight current liabilities in both the current ratio and the debt-equity ratio.

Therefore, the debt-equity ratio should compare only long term liabilities with the equity of the company.

Both ways of calculation of debt-equity ratio are acceptable in general. However, we need to use a consistent formula when comparing gearing of two different companies or when comparing across different accounting periods. When different companies use different methods, then the results of these ratios will not be comparable.

 

Taking benefit of high gearing ratio

Usually, it is considered risky to invest in a highly geared company. Therefore, for a highly geared company, it is typically difficult to obtain further financing, both in terms of debt or equity. A low-risk averse investor can take a significant benefit of such financial situation of the company. A company who is finding it difficult for its upcoming promising projects would be willing to pay a higher premium (i.e., a higher interest rate or lower share price) for the funding needed. If the investor is confident of the company’s prospects, they can take the benefit by investing in the company.

 

 

Final remarks

As an investor, you usually have two ways of investing in a company. Either you can invest in the equity of the company, or you can lend the money to the company. Lending may be either by purchasing bonds or through a loan agreement. However, whether you are a prospective shareholder or a potential lender, you need to keep track of the debt-equity ratio. Investing in a highly geared company is riskier, regardless of the mode of investment.

The debt-equity ratio is one of the most important ratios in the financial analysis of a company and evaluation of investments. The ratio, coupled with other ratios and other analysis, can prove useful in making the right investment decision.[/vc_column_text][/vc_column][/vc_row]

Categories
Business & Finance

A brief comparison of Internal Audits and External Audits

[vc_row][vc_column][vc_column_text]You might be wondering which audit is better, internal audit or external audit. Which audit is more efficient, effective and cost-effective? Or Which audit is more productive for the owner and the company?

Well, there is no one right answer here. Both internal audit and external audit are unique and do not compete with each other. Both complement each other, and both of the audit types serve their own purposes.

In the below table, we’ll have a comparison of internal audit and external audit and evaluate their respective strengths and unique features.

 

External Audit Internal Audit
Purpose The purpose of an external audit is to provide an opinion on the financial statements of the company. Purpose of internal audit is to have an independent check on different internal controls of the organization, identification of control weaknesses and suggesting improvements.
Who performs it Third-party auditors, known as external auditors, perform an external audit.

An external audit cannot be done by the company, or by its employees.

 Most of the times, companies have a separate department where it employs internal auditors. So, internal auditors are the employees of the company, but these employees are not involved in the operations.

Sometimes, internal audit function can be outsourced as well to some audit firm, however, not to the same audit firm, which is the external auditor of the company.
Deliverable Once an external audit is complete, the external auditors of the company will issue an external audit report. The title of this report is ‘independent auditors’ report on financial statements’. Depending upon the nature of the assignment, there are different kinds of reports issued by the internal audit team. Mostly, the title of these reports is “internal auditor report on [subject]”.
Frequency The external audit is usually performed once a year. Once annual financial statements are prepared, the annual audit is conducted by external auditors.

However, some companies prepare and publish quarterly summarized financial statements as well. In such cases, a quarterly review of the financial statements is also performed by external auditors. However, a review is not as detailed as a full-fledge annual audit.

 Internal audit team keeps working throughout the year in the company. They work on different account heads from time to time. Usually, the annual internal audit plan will define a schedule of which areas will be testing during a particular year.

For example, in year 1, the internal audit team may review internal controls systems of revenue, receivables, cash and bank. In year 2, they may decide to review operations of accounts payables, inventories and production etc.
Independence The external auditor is always a third party. Therefore, the opinion of the external auditor is considered an independent view, free of bias. Internal auditors are not involved in the routine operations of the company. They are not engaged in sales, production or accounting operations of the organization. Therefore, internal auditors are also independent up to a reasonable extent.
Appointment and Removal The owners of the company appoint external auditors. Owners select external auditors to review financial statements of the company which are prepared by the management of the company. If owners and management are same, then auditors are appointed either for regulatory purposes or for submission of financial statements to third parties like banks etc.

Since external auditor is appointed by shareholders only, the removal of the auditor or the change of external auditor is also done by shareholders only.

 Board of Directors of the company appoint internal auditors. As part of good corporate governance practices, head of internal audit (or chief internal auditor) is supposed to report directly to the board of directors.

Board of the Director (or top management) of the company can change internal audit staff or the outsourced internal auditor.
Time-line External auditors usually have a tight timeline to provide their report after the closing period. This timeline varies but typically ranges from 1 month to 4 months.

Deadline for the review reports of quarterly financial statements is usually less at 15 to 45 days.

 Internal auditor’s timeline is governed based on the nature of the assignment on which they are working. Further, since they are working throughout the year on the same company’s audit, they will have rolling deadlines.
Requirement/ Regulation Conducting an external audit is usually a statutory requirement for many registered companies, depending upon local legislation. Most of the times, all public companies, listed companies, regulated companies and private companies above a certain limit of revenue are compulsorily required to have it’s annual accounts audited from an external auditor. Internal audit is mostly a voluntary activity. However, in certain jurisdictions, corporate governance rules require an internal audit to be mandatory for listed companies and public companies. Many private companies have also started to build and enhance their internal audit teams as an additional check.
US GAAP / IFRS and IAS External auditors have to check compliance of financial statements with US GAAP or IFRS. Further, external auditors are required to perform their audit procedures as per International Accounting Standards. Internal auditors have to work under IIA’s International Standards for the Professional Practice of Internal Auditing (Standards).
Objective The objective of an external audit is to enhance reliance by introducing a third party check, on the financial statements of the company. The objectives of internal audit may include identification of control weaknesses, finding instances of internal controls violations, reducing operational losses, introducing efficiencies, finding fraud, detailed investigation, ensuring correct recording of accounting entries and true and fair view of the financial statements.
Scope The scope of external audit is limited to providing an opinion on the financial statements of the company.

The scope of the work of an external audit is usually defined in the statutory laws or company laws of the respective jurisdiction.

 The scope of internal audit is much bigger and may include various additional items such as detailed investigation, finding fraud, identifying weaknesses, suggesting improvements etc.
Conflict of interest External auditors have to be necessarily independent of the organization’s performance and profitability. Therefore, they cannot work on any business assignment or investment advisory function, in addition to being the external auditor. The internal auditor (whether employed in-house or outsourced) can provide additional business services like investment advisory, mergers & acquisitions, business development, business setup, deal negotiation etc.
Fee External auditors charge a fee in consideration of their audit services. If the internal auditor is in-house, they are paid salaries. In the case of outsourcing, the company will pay an agreed fee to the third party to whom internal audit is outsourced.
Qualifications The signing partner of the audit report has to be a qualified member of an IFAC member body. Usually, partners of external audit firms are Certified Public Accountants or Chartered Accountants. In some jurisdictions, it is now mandatory for the head of internal auditor to be a Certified Internal Auditor.
Cooperation External auditor usually takes input from internal audit reports issued by the internal auditor of the company. Based on these reports, the external auditor may enhance or decrease the extent of its audit procedures. Internal auditors may take note of the points raised by external auditors in their management letter.
Report format The external auditors’ reports are highly regulated and are in a particular format. There is minimal scope available to the external auditor to amend it’s report. The reports of the internal auditor may vary in length, size and structure, depending significantly upon the nature of the assignment being reported.
Users External auditor’s reports are mostly for external users. This report is shared usually with regulators, banks, stock exchanges, potential investors, fund managers, tax authorities etc. Internal audit reports are usually confidential and are not shared externally.

However, external auditors may require to review reports issued by internal auditors.
Terminologies The external audit is also referred to as ‘statutory audit’ or ‘annual audit’ or ‘regulatory audit’ or just ‘audit’.

 

 Internal audit is referred as ‘internal audit’.
Assurance level External audit provides a moderate level of assurance in their audit report. The internal auditor may provide a high, medium or low level of assurance, depending upon the extent of the work done by the internal auditor.

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Categories
Business & Finance

Markup Vs. Margin (or Gross Profit margin)

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$ Businance.com
Cost amount 12
Profit 3
Sales price 15
Markup 25.00% Profit divided by cost
GP margin 20.00% Profit divided by sales

 

A markup is a profit as a percentage of the cost. (markup = profit divided by cost of sales)

A gross profit margin is a profit as a percentage of the sales price. (margin = profit divided by sales)

Markup is also known as cost markup or only Markup.

A gross profit margin is also known as GP margin, margin.

 

Let’s take an example of a company called Mokia Telecom LLC, which produces a product Nobile 111 and then sales it. The cost of sales for the company per product is $12 and the company sales this product by adding a profit of $3, for $15.

Now, how much is the Markup for this product, and how much is the gross profit margin?

We calculate Markup by dividing profit with the cost. So the profit of $3 is divided by the cost of $12 and by multiplying with 100 we will reach a markup of 25%.

For calculating GP margin, we divided the profit of $3 with the sales price of $15 and then we reach a gross profit margin of 20%.

 

 

Another example

Let’s say that Botania Pvt. Ltd made sales of $1,000,000 in a year. The company incurred a cost of sales of $650,000. Can you calculate Markup and margin for this company, before scrolling down further?

Ok, the answer is:

In this case, profit of the company is $350,000 ($1,000,000 minus $650,000). To calculate Markup, we will divide profit with cost, i.e., $350,000 divided by $650,000 will give us an answer for Markup of 53.85%.

For calculating margin the gross profit of $350,000 will be divided with sales amount of $1,000,000, giving us an answer of 35%.

 

 

Some complex examples

In some exams and assignments, you’ll find questions like below:

  1. A company has a profit margin of 25%, and its gross profit is $2,000. Calculate the sales amount.
  2. If a company’s sales are $50,000, what will be the Markup if GP margin is 20%?
  3. If a company want to achieve 20% GP margin, how much profit it will have to add to its cost of $100,000.
  4. Assuming that a company adds Markup of 30% to its cost, how much it needs to make sales to achieve a profit of $1,000,000.

 

Now, here, the trick is, you need to understand how to calculate markup and profit margin quickly. Always bear in mind that Markup is a percentage of cost, and GP margin (or gross profit margin or margin) is a percentage of sales amount.

Below formulas are given for answering the above questions (or any similar question). You can use that formula for which you have the maximum number of inputs available in the question.

 

Gross profit margin formula

Sales – gross profit = Cost

If you are using GP margin formula, please note that sales

will always be taken as 100%.

Mark up Formula

Cost + Markup = Sales

 

 

 

Given below are answers of above four questions:

If you are using Markup formula, please note that “Cost of Sales” will always be taken as 100%.

  1. The answer is $ 8,000: Calculated by dividing $2,000 with 25%.
  2. The answer is 25%: This is calculated by first determining profit amount using gross margin formula and then applying that profit amount using mark up formula.
  3. Answer is $25,000: This is calculated by dividing $100,000 by 80% and then subtracting $ 125,000 from $100,000.
  4. The answer is $4,333,000: This is calculated by applying the markup formula to determine the amount of cost of sales.

 

 

General points

It is important to note that for both GP margin and Markup, we use only cost of sales and not the total cost. The cost of sales would include direct material, direct labour and direct overhead expenses absorbed.

Cost markup and profit margin are used in various industries and for multiple purposes, including pricing decisions and budgeting and planning. In financial sector mostly, the bank charge a markup, i.e., a profit on the value of the loan. So, if a banker says that bank will charge you a markup of 5%, this means that on the amount of the loan, an interest rate of 5% is applicable. Many financial analysts use GP margin for financial analysis in numerous sectors. Financial Analysts compare GP margin of companies to assess the financial performance of the company.[/vc_column_text][/vc_column][/vc_row]

Categories
Accounting concepts Financial Accounting

Bookkeeping and Accounting

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What is Bookkeeping?

What is Accounting?

 

Bookkeeping vs Accounting

What is the difference between bookkeeping and accounting?

What is the difference between a bookkeeper and an accountant?

Above are some of the questions addressed in this article, and a little bit more information.

 

 

Bookkeeping

Bookkeeping, by its pure definition, is: “a process of recording transactions of a business”.
This definition explains that the job or bookkeeping is limited to the recording of the transactions only. A bookkeeper would record the accounting transactions in the accounting system of the organization. Be it a manual accounting system or a computerized accounting system, whatever.

These accounting transactions may be receipts of payments. So, when a customer makes a payment, a bookkeeper would record this transaction in books of accounts of the company by debiting cash or bank account and crediting customer account. The bookkeeper (or the cashier) would issue a receipt to the customer for the payment received.

A bookkeeper is a person who keeps the books of the accounts of the company, i.e., he makes sure that the books of the accounts of the company are appropriately maintained, transactions are recorded correctly and updated as and when required.

The bookkeeper may not necessarily have to select debit and credit accounts in the system. Nowadays, many accounting systems are capable enough to create double entries. For example, the bookkeeper would only select ‘issue receipt’ option in the accounts software, and the system would automatically debit and credit respective accounts.

 

 

Accounting

Accounting: “is an art of recording, summarizing and presenting financial information in a manner which is easy to understand and reliable”.

Now, you can see that accounting includes bookkeeping. In addition to bookkeeping, there are some additional roles covered by accountants. They not only record accounting transactions, but they also do some further work. Once bookkeepers record all the transactions for a period, they’ll summarize these accounting transactions and then present them in the form of financial statements. These financial statements include balance sheet (statement of financial position), profit and loss account (income statement, statement of changes in equity (SOCE) and statement of cash flows (or cash flow statement, as previously called).

So in accounting and bookkeeping, the following tasks will be done:

  1. Identification of a financial transaction
  2. Recording of the identified transaction
  3. Summarizing the accounting transactions (at a given period end)
  4. Preparing the financial statements
  5. Presenting the financial statements

The first two points in the above list are in the domain of bookkeeping, while the remaining three are in accounting only. Thus, we can say that an accountant is a person who not only records the accounting transactions but also summarizes these transactions and prepares financial statements for presentation to the owners and other readers of financial statements.

 

Some additional points

While we are trying to differentiate accounting and bookkeeping, please note that many employers require the persons who can do both. Many job ads specify the words ‘accounting and bookkeeping’ or ‘bookkeeping and accounting’. Nowadays, you may find very fewer jobs, specifically for bookkeeper only. Although, still many people are working in corporate worlds whose role is solely to record the transactions like payments made, receipts collected, prepaid accounting entries, accruals accounting entries, PDCs recording etc. Even in some MNCs, there might be one dedicated person for recording collections only.

Modern accounting systems have automated most of the bookkeeping tasks, and are successfully handling the function of a bookkeeper. For example, if you go to a retail shop and purchase an item. The shopkeeper would tag the item in point of sale system (POS). This POS system is linked with the accounting system of the retail business. POS would automatically record the accounting entry for this transaction in the accounting system. Thus, there is no need to recruit a bookkeeper to record sales transactions in the retail business.

Roles of accountants have been increased significantly with the enhancements in the financial reporting standards. Accountants (Accounting managers, chartered accountants, chief accountants, etc.) are required to comply with applicable accounting standards like US GAAP and IFRS. With the increase in the regulations and new accounting standards being issued and changes being made to the existing standards, there is an increased demand for the professionals who understand and can apply these accounting standards in real life and complex scenarios.

The role of accountants is evolving in line with the increase in advancement of technologies, complexities of organizations, the globalization of businesses and the invent of new technologies and products. Accountants are required to ensure that they correctly assess, classify, record and present the transactions in the relevant accounting period in a complex business environment. Correct presentation of the financial statements would enhance reliability on the financial statements. This feature is of pivotal significant as many investors and shareholders make investment decisions using these financial statements. Please read our article on financial statements here.[/vc_column_text][/vc_column][/vc_row]

Categories
Career selection Finance careers

Big 4 firms or Non-Big 4? A comparison

[vc_row][vc_column][vc_column_text]There are four audit firms in the world which are categorized as ‘Big 4’, their names are listed below:

  • KPMG
  • Ernst & Young (EY)
  • Deloitte Touche & Tohmatsu (DTT)
  • Pricewaterhouse Coopers (PwC)

These professional services firms provide different services including auditing, business advisory, taxation and related services. The rankings of these Big 4 four firms varies from year to year and depends on various measures. For example, one of these may be number one based on the highest amount of revenue, and the other may be number one based on the higher number of employees etc. But these four firms are significantly larger than the rest of the audit firms in the world.

All other firms, other than Big 4 audit firms, are non-big 4 firms. We can classify them under top 10 or top 20 or top 50 (depending upon their respective category). So, if an audit firm is in ranking from number 5 to 10, that firm will be referred to as top 10 audit firm. Although Big 4 audit firms are also among top 10 audit firms, they are not usually referred to as top 10, as they have their distinctive ranking of Big 4 firms.

Below are the audit firms in considered in top 10 generally:

  • RSM
  • Crowe Horwath
  • BDO
  • Grant Thornton
  • Baker Tilly
  • Moss Adams

 

 

If you refer to most of the job advertisements in the field of auditing, accounting and finance, you’ll notice that a significant number of ads require Big Four candidates. Job posts contain wordings like “preference will be given to Big 4 candidates”, “candidate should have Big 4 background”, “A strong preference is for the Big 4 trained”, “Experience form Big 4 audit firms is mandatory”, and “Big 4 experience will be highly valued” etc.

This kind of sentences you’ll often find in jobs, and this conveys a message, i.e., most of the large companies prefer candidates who have good experience from Big 4 audit firms.

This preference is because of the following reasons:

  1. Big 4 candidates usually have worked on large scale assignments and projects like auditing of a listed or a multinational company or a large group. Such exposure rarely happens with candidates from small audit firms. This is because small audit firms usually have small and medium enterprises as their clientele.
  2. Big 4 audit firms provide rigorous training programs to their staff regularly. These training programs widely range from the use of software(s), ethical training, IFRS updates and interpersonal skills training. Such learning and development opportunities are not usually available to the staff of small audit firms because of budget and resource constraints.
  3. Big 4 audit firms are a preferred choice of candidates. Therefore, top graduates and high performing candidates prefer to choose Big 4. These candidates deliver better in audit firms and after that in the industry as well. The class of candidates left for small audit firms is usually not of impressive profile (however, exceptions always exist).
  4. Better branding and recognition of Big 4 exerts a significant impression on clients and the overall industry. This general perception means that any company would already be impressed with the profile of the candidate even before he or she enters the interview room. While on the other hand, candidates from small audit firms have to fight to obtain their credibility and significance.
  5. Cross-border secondments and assignments is another pie of the cake available mostly to the Big 4 candidates only. Many Big 4 audit firms send their staff to their international locations for different audit and advisory assignments. This arrangement provides candidates with an excellent opportunity to witness multiple work cultures, and it enhances the personal and professional growth of the candidates. However, such opportunities are rarely available to non-big four candidates.

 

 

However, it is not always the Big 4 audit firms and their candidates who are winners all the times. There are some points which are in favor of small and medium audit firms as well.

These are listed below:

  1. The career ladder is usually shorter in small audit firms. There would not be many hierarchy levels to reach the top level. In a small audit firm, a candidate may progress to Partner level in 5 to 7 years, while in a Big 4 audit firm, it may take around 20 years on average.
  2. Learning is, for sure, faster in small audit firms as compared to their large counterparts. This difference is because usually, an individual is handling all work of a short audit assignment. This single-handed-job provides an exceptional opportunity to learn all the items of an audit process, including preparation of financial statements, drafting and present management letter and performing audit procedures. While in the case of Big 4 audit firms, you may be given limited responsibility initially.
  3. Some company prefer candidates from audit firms as they are not demanding like the candidates from Big 4 audit firms. Some companies complain that Big 4 candidates change their jobs quickly as they get multiple offers, so they are not reliable or loyal. While candidates form non-Big 4 background are likely to stay in their roles for a relatively long period.
  4. Hiring a candidate from Big 4 audit firms require more money, so here comes the factor of cost. A company which prefers to save cost would evaluate a candidate from a small audit firm, and if they find him suitable, they would prefer this candidate over someone form Big 4, due to the apparent reason of cost-saving.
  5. Some candidates prefer small audit firms because they feel valued and important there. If the same candidate was in a Big 4 audit firm, he may not be able to grab that attention and significance, considering that there would be many other similar or better team members.

 

On an overall basis, we can conclude that there is no one best fit for everything. We cannot term clearly a Big 4 candidate better than a non-big 4 candidates. It depends a lot on one’s preference, option, context and personal capabilities. Each candidate should be evaluated at his own skill set and qualifications.[/vc_column_text][/vc_column][/vc_row]

Categories
Expenses Financial Accounting

Bad Debts (and how bad they can be)

[vc_row][vc_column][vc_column_text]From the term ‘bad debts’ a bad image comes to mind. Something very bad or disgusting.

Does it mean that the debts which you have taken were terrible? Was a ‘bad’ decision to take those debts? OR, are those debts so bad that they keep haunting you in dreams? No, no, nothing like this, all this is not the meaning of bad debts.

In accounting & finance, bad debts mean those customers who purchased from you on credit terms and now are not paying to you. They are not paying even after reminders and emails, and they are not attending your calls also. The terminology is given as ‘bad’ because now the chances of recovery of such debts are meager or nil.

There are two main categories in this regard; one is ‘bad debts’, and the other is ‘provision for bad debts’. The provision for bad debts is also referred to as provision for doubtful debts.

Now we’ll discuss what are the implications if a customer does not pay you even after the due date of the payment, how it affects the company, it’s cash-flows, it’s financial statements and what are the roles of auditors in this regard.

In different industries, there is a different practice of the credit period offered to the customers. In retail, typically, there is no credit period. Most of the sales are on cash. Like if you go to a grocery store, you’ll have to pay (by cash or card), and in any case, the store will get the money quickly.
However, the store will not be paying it’s suppliers daily or at the time of purchase. These suppliers who supply their products to the store provide a credit period of, typically, one month or two months (or even three months) to the retail store.

 

 

Credit terms are not very common for retail customers in any industry. Whether you are buying a car or milk, as a retail customer, you’re likely to pay immediately. You’ll either pay the full amount in cash or arrange a loan through a bank or a credit card company. But in any case, the vendor will get the money instantly (or max in one or two days).
However, credit terms are more common when it comes to Business-2-Business (B2B) transactions.

External auditors are interested in making sure that the receivables presented on the balance sheet of the entity are good enough, i.e., this money will be received to the company, i.e., they are not ‘bad’.  So, this is one of the areas auditors pay particular attention. It is a very judgmental topic, as well. How can someone tell if a specific customer will pay at the due date or not?
The term ‘bad debts’ refers to the receivables which are believed to be non-recoverable. Such debtors are declared as bad debts and then removed from the company’s receivables listing. The accounting entry for this would be to debit: bad debt expenses and credit: accounts receivables.

However, this rarely happens in practice. Usually, companies never credit their accounts receivables except in exceptional circumstances.
On the other hand, when the recover-ability of any debtor becomes suspicious or questionable, a provision is created in the books of accounts, ensuring correct accounting treatment. This provision is referred to as ‘provision for doubtful debts’ or ‘allowance for doubtful debts’. The accounting entry for this provision is debit: doubtful debts expense account and credit: allowance for doubtful debts.

The term of doubtful debts and bad debts is sometimes used interchangeably in practice.

 

 

The difference is that the receivables are not credited; instead, another account is created to reduce the balance of receivables. This is similar to provision for depreciation account.

It is important to note that the provision for doubtful debts and provision for depreciation expenses do not actually fall under the definition of ‘provisions’ as per IAS 37 Provisions, Accounting Policies & Accounting Estimates. However, the word ‘provision’ is used for these two items as a practice.
Creating a provision for doubtful/bad debts is a pain for the management of the company. As you understand now, that creating or increasing the provisions for doubtful debts results in increased expenses (and thus less profit) and decrease in the assets (lower receivables) in the balance sheet. It’s a double sword and management is keen to avoid this.

Most of the times, management would make assumptions and would try to convince it’s external auditors that a provision is not required. It would establish by different means that receivables are healthy and the company is going to collect this money.

It is important to note that the accounting standards do not provide any time frame for booking bad debt expenses or recording provisions. Accounting standards don’t specify that time duration, e.g., if a customer has not paid three months after the due date, then that customer is a bad/doubtful debt. No, there is no such time frame defined in the accounting standards. Instead, it is a judgmental call and varies from industry to industry.

Usually, in the construction industry, credit periods are more extended, and customers take significant time even after the due date to make the payment. So, this doesn’t necessarily mean that the customer is bad now. Especially when dealing with government clients or when dealing with contractors dealing with government clients, payments are usually slower than usual.

On the other hand, it is still possible that a customer is virtually certain as bad debt even before the due date of the payment. For example, if a customer goes bankrupt, then, there is a reasonable certainty that a provision is required to show the correct value of the receivable.

An essential concept in the provisioning of the bad debts is the aging of receivables. An aging of receivables is listing of time frame by which receivables are outstanding. For examples, how many (and which) receivables are outstanding for more than 30 days, more than 60 days and more than 90 days etc. There are separate columns prepared to represent aging of receivables. The longer a receivable is outstanding, the more doubtful is the recovery of that receivable (generally speaking). Below is a snapshot of how receivables aging looks like:

 

G.L Code Party name Less than 30 days Between 30-60 days Between 61-90 days More than 90 days Total
1000001 Yamazaki 500 100 – 900 1,500
1000002 Ping Poi 1,000 500 – – 1,500
1000003 Nakamura – – – 500 500
1000004 Yamloga 100 800 600 – 1,500
1000005 Keema 2,000 – – – 2,000
Total 3,600 1,400 600 1,400 7,000

 

All figures are in US$.
Based on the above table, it can be seen that there is a total of $ 1,400 outstanding for more than 90 days. Now, how to calculate the provision for bad/doubtful debts. Calculation of provision for doubtful debts depends on a lot, as stated earlier, on the industry as well as on the company’s policy. There are no defined regulations in accounting standards (IFRS / US GAAP) for calculation of the provision for doubtful/bad debts.

Now, based on the company’s past practice and experience, it can choose to fully provide (100% provision) for balances outstanding for more than 90 days, or it may provide less provision. Company may also check further provisioning brackets like balances outstanding for more than 180 days or even more than 365 days and then calculate provision in those brackets.[/vc_column_text][/vc_column][/vc_row]

Categories
Business & Finance

AUDIT RISKS AND AUDIT PROCEDURES FOR CASH AND BANK ACCOUNTS

[vc_row][vc_column][vc_column_text]Hello, welcome to your new role. In this role as an external auditor of company ABC (i.e., as a member of the external audit team), you have to ‘audit’ bank balances of the company as well as cash in hand. The term ‘audit’ would mean that you need to apply auditing procedures on cash and bank accounts of the company.

 

 

Identifying audit risks in cash and bank balances

Now, before we devise and apply audit procedures for testing cash and bank balances of the company, let’s firstly understand what the possible business and audit risks in the bank accounts of the company are.

Below are some of the examples of audit risks in cash and bank balances:

  • There might not be proper authorization procedures defined for opening a bank account.
  • Bank accounts may be opened or closed without due internal authorization process of the company.
  • There might not be any adequate segregation of duties, i.e., the person who is preparing the cheque may be signing it as well as an authorized signatory.
  • Bank accounts of the company may be overstated in the financial statements or understated or not disclosed in the financial statements at all
  • The balances in the bank accounts may be misappropriated, stolen, misused for personal purposes
  • Money laundering activities might be carried out through bank accounts.
  • There is a risk that the balances available in the bank accounts are not available for the company for withdrawal either due to some restrictions or some other reason
  • Some bank accounts which are owners or employees personal accounts may be reported as the company’s accounts.
  • Bank may wrongly debit or credit company’s account for the transactions which are not carried.
  • Bank may charge excessive bank charges not agreed with the company beforehand.
  • Some fake cheques may be presented by any party in the bank to withdraw money from the company’s bank account.
  • Authorization limits may be breached by staff by preparing multiple cheques of smaller amounts in the name of the same supplier.
  • Payments may be processed in the names of third parties without due purchase orders and receiving goods or services.
  • Fictitious transactions may be designed only to show economic activity on the bank statements. Such movement may be within the company’s bank accounts or in collision with some supplier or customer.
  • Fictitious transactions may be passed temporarily to increase or decrease a particular bank account balance, and such transactions may be reversed after the closing date.
  • There is a risk that the bank accounts which are being reported do not exist at all, or even in a worst-case scenario, the bank itself doesn’t exist in which accounts are being reported.
  • The company reported balances which are outdated and do not exist on the reporting date.
  • Bank reconciliation statements may not be prepared and reviewed at regular intervals.
  • There might be a significant number of pending items in bank reconciliation statements.
  • Cash-in-hand may be used for personal purposes and later reimbursed (or not reimbursed).
  • Cash-in-hand maybe misappropriated by making unauthorized transactions.
  • Cash in hand amount may be short of what it should be.
  • Accountant may not correctly record petty cash expenses in the correct expense code.
  • Expenses which should be paid through the bank only might be paid through petty cash.
  • There might be no defined petty cash limit and the designated person for handling petty cash.
  • The policy and procedure for obtaining petty cash may not be well defined (or not defined at all).

It is vital to consider WCGW (What Could Go Wrong) when identifying audit risks and devising audit procedures for cash and bank accounts, as well as any other account type. The higher the number of audit risks you can generate, the better. Because we’ll be devising our audit procedures to tackle these audit risks, if we couldn’t identify an audit risk, we might not want to formulate an audit procedure to assess that particular risk.

 

 

Identifying audit procedures to be performed on cash and bank balances

Once we have identified audit risks related to cash and bank, we need to perform audit procedures. Please note that we may not need to perform all audit procedures. The results of some of the audit procedures would guide us on our further action. So, some audit procedures are dependent upon the results of some other audit procedures.

Let’s review, what could be all (or maximum) possible audit procedures which may be performed on cash and bank balances of an audit client.

  • Inquire with the management about their cash handling policy as well as bank accounts policy.
  • Obtain the policy manual related to cash and banks (if available).
  • Obtain a list of bank accounts along with the closing balances and locations of the banks.
  • Understand if there has been any change in the payment process and what is the reason for the same.
  • Match the balances as per the lists provided with the trial balance and inquire if there is any difference.
  • Review the policies related to cash and bank and identify if there is any weakness in the designing of internal controls.
  • Inquire if historically there has been any instance of fraud or misappropriation in the cash and bank balances.
  • Send out bank balance confirmation letters to the bank accounts to verify the balances as well as any loans.
  • Obtain signed bank reconciliation statements for all bank accounts as at the reporting date as well as at any previous periods on a sample basis.
  • Review bank reconciliation statements carefully matching the balances as per general ledger and balances as per bank statement.
  • Inquire about unreconciled items on the bank reconciliation statements and understand the impact of these items.
  • Perform subsequent positioning test of the unreconciled items on the bank reconciliation statement.
  • Review bank ledgers subsequent to the closing date and check if there is any reversal of material transactions in the following accounting period.
  • Propose adjustment entries to rectify any errors found and to account for any pending items in the bank reconciliation statements.
  • Match the confirmations letters replied by banks with the bank balances in the bank reconciliation statements.
  • Obtain proforma samples of signatures of authorized signatories and assess the risk of copying these signatures by any party.
  • Ensure that the company’s cheque books are kept in a secure place with proper accountability of a specific person(s).
  • Perform a walk-through of the process explained by the management by reviewing one transaction each for cash and bank balances.
  • Select a sample of transactions to for detailed testing. Perform thorough testing for all sampled transactions and identify the non-compliance with the standard procedure.
  • Inquire about new bank accounts opened during the year and understand the need for opening these banks. Assess if this is in line with the requirement of the business. Discuss any suspicion with the management as well with your team.
  • Obtain a list of petty cash handlers, the amount authorized, and the current balance in hand.
  • Perform physical cash count as on the reporting date. Alternatively, Obtain a certificate of cash in hand as on the closing date.
  • Review cash replenishment requests on a sample basis and verify source documents.
  • Requester and approver should appropriately sign all cash disbursement requests.
  • Obtain a list of bank accounts closed during the year and understand the reason for closing these accounts.
  • Check that the balance in the accounts closed was successfully moved and accounted in the active bank accounts of the company.
  • Obtain a list of dormant bank accounts of the company and understand the reason of not closing these accounts or ask for the management’s plan regarding these accounts, whether these accounts will be used in future or will be closed.
  • Inquire with the management if there has been any instance or attempt of money laundering.
  • Obtain a list of authorized signatories, assess whether they are at a suitable level of responsibility.
  • Inquire if there has been additions or deletions in the list of authorized signatories. Check if all the deletions and additions have been timely informed to the bank.
  • Perform analytical testing on the bank account balances; let’s see how much bank balances have been increased or decreased. Observe the movements in the closing balances of bank accounts. Inquire with the management of any significant variance or unusual trends.
  • Wherever there is no satisfactory response from the management on the significant variations, perform further detailed procedures and obtain new audit evidence to validate the points raised during analytical testing.
  • All performed audit procedures have to be appropriately documented. This includes writing down the audit procedure performed, the result obtained and the conclusion drawn. All audit documents have to be dated with proper authorization by the preparer and reviewer of the material.

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Categories
Accounting concepts Financial Accounting

Accruals and Provisions

[vc_row][vc_column][vc_column_text]In accounting, the term accruals refer to those obligations for which a formal demand of payment (i.e., invoice) has not yet been received. This means that you owe someone a payment which you have to pay but that other party has not yet asked for the payment (meaning that invoice has not yet been issued by the vendor).

Or by another definition, this is the expense which has been occurred, but the supplier has not yet raised the invoice. For example, you are consuming electricity every day. But you’ll not receive the electricity bill every day. Let’s assume that you receive the electricity bill on 20th of every month which contains electricity charges up to 15th of that month. Now, this invoice we can book as a liability (debiting electricity expense and crediting utility services provider).

 

 

However, for the remaining 15 days of the same month, we will not receive an invoice in the current month or even early next month. Therefore, once we are closing our books of accounts for this month-end, we know that we have consumed electricity for the second half of the month, but we have not yet received the invoice. The invoice will come after 20 days, but this is our expense related to the current month, and therefore we should record this expense and book our liability (as an accrual).

A prudent company would book its expenses of a month (and corresponding payable) by the end of each month-end. This booking will be done even though an invoice is not yet received. A prudent company would assess and estimate its accruals and then make provision for them accordingly.

Following are the general types of transactions for which accruals are recorded:

  1. Utility bills (electricity, water, telephone, company mobiles etc.)
  2. Interest expense
  3. Rental expenses
  4. Municipality charges
  5. Audit fees
  6. Cleaning services

 

Here it would be a good idea to compare prepayments and accruals. In a prepayment, you make the payment, but that expense has not been incurred and thus payable has also not been recorded. In case of an accrued expense, the expense has been incurred, but payment has not been made, and that payable has not yet been created (because that supplier has not yet sent the invoice).

In most of the organizations, the source document for booking a payable is the supplier’s invoice. A payable is booked once an invoice is received in the payables department (after due approvals, of course).

A provision is a liability of uncertain timing and amount. Accruals are recorded where amounts and timing are certain (or near certain). However, in the case of provisions, the amount and timing are not certain. Timing of the obligation may be one month or up to 1 year delayed, depending upon circumstances outside the control of the organization.

However, the accounting impact of booking provisions and accruals is the same. In both cases, we debit profit & loss account for the expense and create a payable account on the balance sheet. Provisions are usually created for either a legal obligation or a constructive obligation. We’ll discuss provisions in more detail in our article about IAS 37 Provisions, Contingent Liabilities and Contingent Assets.[/vc_column_text][/vc_column][/vc_row]

Categories
Basics of financial accounting Financial Accounting

Assets and their types

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Definition

An asset by definition is a “resource in the control of the entity from which economic benefits are expected to be flown towards the entity“.

Now if we bifurcate above definition of asset, there are few keywords which are of extreme important, these words are following:

Resource:

It should be something of value, from which some benefit may be derived for the business. For example, a building is a resource which can be used to conduct business and sale goods/services. If it is something which is valueless, it cannot be booked as the asset.

 

 

Control

Entity should have control over the resource. So that the entity can control the asset as per its business needs. If entity doesn’t have control on the asset, it cannot book it as it’s asset in its accounting records.

For example, ‘sun’ is a resource but no entity has the control over it. So a business cannot record it as its asset.

Flow of economic benefits:

There should be a likelihood that the entity shall get some economic rewards by using that asset in appropriate way. These economic rewards may be either in terms of inflow of money or reduction in outflow of expenses.

For example, if a company possess a bus which it uses for the transport of its staff, then this bus is providing economic benefit to the entity in terms of reduction in cost of outsourcing staff transportation.

Classification of assets

Broadly speaking there are 3 types of assets i.e., current assets, non-current assets and intangible assets. Below we’ll discuss these and some other types of assets which can be classified within these 3 types of assets.

 

 

Current assets

Current assets are those assets which have a short-term life (usually a year or less than that). These are assets which are likely to be consumed/replenished/sold/utilized in a year or less than that. For example, receivables, trading stock, cash and bank balance etc.

Non-current assets

Non-current assets, also referred to asset fixed assets, are those assets which usually have a useful life of more than 1 year. For example, if a company purchases furniture for its office, this furniture is likely to last for more than 1 year and thus it will be classified as non-current (or fixed) asset. Other examples are buildings, motor vehicles, electrical equipment, computer software and machineries.

Intangible assets

Intangible assets are those which cannot be touched and felt physically. They don’t have a physical existence. These assets may or may not be visible. These are the assets which exist normally in electronic format like computer software, movie, design, key ideas etc. Another good example of intangible assets is goodwill.

Tangible assets

Tangible assets are those which can be touched and felt physically like computers, mobiles, telephones, cars, buildings etc.

 

 

Financial assets

Financial assets are those assets which would be settled in transfer of money in the favor of the asset holder. For example, accounts receivables, cash and cash equivalents, short term deposits with banks or other financial institutions.

Liquid asset

Liquid asset This term refers to the assets which easily gets converted to cash or already is cash. Cash is the most liquid form of the assets. Other easily cash convertible assets are debtors and stock.

Illiquid assets

Illiquid assets are those assets which may require significant time to convert into cash. This time may be a 6 months or more than that. For example, it may take significant time to sale a building than to sale a product on a retail shop.

 

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Categories
Accounting concepts Financial Accounting

A comprehensive overview of Depreciation

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Why there is a need for a depreciation charge?

A good accounting system records all income and expenses and then provides the net profit/loss result at the end of the accounting period. Some expenses are easy to record like an electricity bill or rental expense. It is convenient to charge them to the relevant expense account in that accounting period.

However, some significant expenses like the purchase of buildings or machinery cannot be charged merely to P&L. These expenses (or call them fixed assets) would be useful for the company for several years. Therefore, it is not appropriate to charge the full cost of that building in any 1 accounting year. So there was a requirement to devise a method to apportion the cost of fixed assets across the years where these assets shall be used. This method has been termed as `depreciation`.

 

 

Depreciation by definition:

“Depreciation is a systematic way to charge the cost of fixed assets in profit & loss statement over the useful life of the asset.”

 

Simplest example:

Let’s say that a manufacturing machine is purchased at the cost of $60,000 and this machine has a useful life of 3 years. Now, this $60,000 cannot be booked fully as an expense in profit and loss account. Instead, this amount of $60,000 may be divided into 3 equal portions of $20,000. This $20,000 shall be booked as an expense in all 3 years. This expense shall be termed as depreciation expense.

Key Features of depreciation:

Following features will help you understand and grasp the concept:

  • Depreciation is an unavoidable instance, and it happens gradually with the passage of time for every tangible non-current asset
  • Wear & tear of the asset with the passage of time is NOT depreciation.
  • The total value of depreciation over the life of the asset should be matching with the total cost of the asset. Let’s say an asset has a cost of $100,000 and has a useful life of 5 years, the total depreciation over the life of the asset should be same as $100,000 (i.e., $20,000 per year in case of a straight line depreciation)
  • Repair & maintenance expenses incurred on the asset are NOT depreciation.
  • Depreciation is a term which should be used strictly for fixed (or non-current) tangible assets.For intangible assets, the alternative word for depreciation is `amortization` Amortization has the same features as depreciation, except for the fact that the word amortization is used for intangible assets.

Impairment and depreciation are the two different accounting concepts. However, sometimes the words are used as synonyms, which is not correct. It is imperative to understand the difference between the two and use the right words for the right situation. To understand the impairment and its key features, read our article on impairment of assets.

 

 

Accounting treatment:

Depreciation cost is booked as an expense on the debit side, and the credit goes to a reserve of depreciation account. It is important to realize that there is no credit entry in the asset account for the depreciation charge. This is because depreciation is something invisible, which happens with the passage of time and there is no physical reduction in asset’s quantity or volume.

Therefore, the expense is debited in `depreciation expense` account and credit entry is booked in a reserve account specifically created to accumulate the depreciation expense. This account is usually referred to as `accumulated depreciation account` or `provision for depreciation account`.

Let’s pass entry for an asset which cost $60,000 and has a depreciation charge of $20,000 for 3 years.

Below are the accounting entries to be passed:

 

Reducing balance depreciation method sketch

The accumulated depreciation account offsets the asset account in the balance sheet. In the above example, the balance sheet value in the first year shall appear as $ 40,000 (instead of $60,000 as available in the asset account). The reason is that asset account of $60,000 shall be netted-off against $20,000 of accumulated depreciation account, resulting in a net figure of $40,000 on the face of the statement of financial position (balance sheet).

The more appropriate word for the depreciation reserve account is `accumulated depreciation a/c.` However, some people also use the term `provision for depreciation a/c`. It is worth mentioning that `provision for depreciation a/c` is not a `provision` as defined under accounting standards. Provisions are separately discussed under IAS 37, “Provisions, Contingent Assets, and Contingent Liabilities.”

Standard rates of depreciation of different types of assets:

For example, if a fixed asset (say a motor vehicle) is purchased at a price of $1,000 and it has a useful life of 5 years, then the annual depreciation will be $200 (using straight-line depreciation method).

So what should be the rate of depreciation of a particular asset? Should it be 10% or 20% or 50% in a year? It all depends upon the useful life of the asset. An asset should be depreciated over its useful life in a manner which depicts the usability of the asset. Let’s say that a non-current asset has a useful life of 5 years, the applicable rate of depreciation will be 20%. Below table provides standard rates for depreciation for the different type of assets. However, it is up to the company’s management to decide the useful life of the asset.

 

Type of assets Estimated useful life Depreciation rate (per annum)
Land Infinite N/A
Building 25 years 4%
Machines 10 years 10%
Furniture & fixtures 5 years 20%
Motor vehicles 4 years 25%
Computers and mobiles 3 years 33%

 

The useful life of an asset can be assessed by one or more of the following techniques:

  1. Product description and warranty period as provided by the supplier
  2. Experience of the useful life of similar assets
  3. Expert advice related to that specific machinery (e.g., An engineer can advise how long a particular machine be used)
  4. Other companies’ financial statements having similar fixed assets

 

 

Calculation of depreciation: There are two most popular methods for calculating depreciation of fixed assets.

Straight line method of depreciation:

In this method, the same amount of depreciation is charged in each year of the useful life of the asset. Let’s say that a machine has cost $ 100,000 and shall be used for the production of 1,000 units of a product over its useful life of 5 years. The machine shall be disposed-off after 5 years.

As the production of units remains consistent over 5 years and there is no decrease or increase in the usability of the machine with the passage of time. Therefore, it is suitable to charge the same amount of depreciation expense, i.e., $20,000 every year in all 5 years.

Reducing balance method of depreciation:

Let’s take an example of an asset that is used for 5 years but is most productive during the initial years andits usability would decrease in subsequent years. In this case, the depreciation charge should be higher in the initial years and should decrease gradually in subsequent years. This example fits for car rental business. New cars can be rented out at higher premiums while old cars would not attract many customers. Therefore, the most suitable methods in this scenarios would be a reducing balance depreciation method.

 

Depreciation accounting entries sketch

 

However, it is worth analyzing that although depreciation charge decreased gradually over the years, the depreciation charge was highest in the final year of the asset’s life. This is because full net book value of last year has been charged as depreciation expense considering Nil residual value.

Let’s take the example of the same asset assuming that it has a residual value of $10,000 at the end of its useful life. In this case, the full cost of the asset ($100,000) shall not be depreciation over its useful life. Instead cost minus residual value shall be depreciated over it’s useful life i.e., $90,000 ($100,000 minus $10,000). In this case, depreciation rates and amounts shall remain in first four years. In 5th year, the depreciation charge shall be $21,641 ($31,641 minus $10,000). The asset shall remain at a closing value of $10,000 until it is eventually disposed-off at its residual value.

Tax treatment of depreciation expense

In most of the tax jurisdictions, depreciation will be treated as inadmissible expenses because it is a non-cash expense. Further, it is based on several assumptions and may be subject to revision from time to time (i.e., in case of revaluation of assets). Therefore, most of the tax regimes provide their own `tax depreciation schedule` which replace accounting amounts of depreciation.

Investors / Business Analysis point of view

If you are an investor reading financial statements of a company where you have invested in, you don’t need to worry much about the high depreciation expense. This is not an `expense` in the sense that it is consuming resources of the entity. Rather, it is an asset which is contributing towards the entity’s business performance. It is a non-cash expense (not in the first year of the asset’s life, though). Most importantly, there is no control which management can exercise to reduce this expense (once an asset has been purchased). So, do not blame your CEO/management that they are unable to control depreciation expense and it is eating up the profits. It is an expense which will be charged over time.

The only way management can control depreciation expense is that it decides not to invest in the company’s fixed assets anymore. This way may or may not be beneficial for the entity. It will lead to the debate about whether owning a building is better or renting a building is better? Although renting a building will save depreciation expense but owning a building will save rental expense.

 

Conclusion

Depreciation is a fundamental accounting concept which is often misunderstood as wear & tear of the assets. It is imperative to comprehend the concept and understand it’s logic. Further, it is a judgmental item and may affect the profitability of a company in the short term. The overall impact, however, remains Nil.`

 

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Categories
Basics of financial accounting Financial Accounting

Basics of Double Entry Accounting System

[vc_row][vc_column][vc_column_text]Let me clarify one thing guys, double-entry accounting is not doubling of accounting. There is no risk that a transaction will be recorded twice or that you have to do double work. So don’t worry about the concerns which may arise on listening the term first time. It is a beautiful system which properly takes care of accounting entries, read below.

 

Background

If you are new to learn accounting then this would probably be the first article you should read after knowing definitions of assets, liabilities, income, expenses and capital here. This article shall lay foundation of your accounting concepts regarding double entry accounting system.

If you are a professional then this article would help in revising basic concepts of double entry and would erase your doubts, if there is any. If you are an accounting teacher or a mentor, then feel free to utilize explanations and definitions given in this article and share the link of this article with your students for their better understanding.

Before we talk about the double entry book keeping system, I would like to mention that a company’s accountant will have to open `accounts` for each of the items of assets, liabilities, income and expenses etc. Every item for which a transaction needs to be recorded, an account of that particular head has to be opened, so that debit and credit transactions can be recorded there. For example, an account for `cash in hand` has to be opened. If you are not aware of basic definitions of `assets`, `liabilities`, `books of accounts` or `account` etc. I would strongly recommend you to first read our article on definition of accounting terms.

 

What is Debit and what is Credit

Now what is a debit and what is a credit. We’ll not go on their literal English meanings. We’ll just treat these as two sides of the book where we are recording our transactions. Left-hand side is the debit side and right hand side is the credit side. Both debit and credit are opposite to each other and they negate each other. For example, if there are debit entries of $100 in one account and there are credit entries of $80 in the same account, then the net balance of that particular account shall be $20 ($100 minus $80).

We cannot say that a debit is a good thing or a bad thing. Similarly, a credit is a good thing or a bad thing. We also cannot say that a debit is an increase or a decrease. Similarly, we also cannot say that a credit is an increase or a decrease. IT ALL DEPENDS. So have to see differential scenarios. In some cases, debit indicates an increase and in some cases debit indicates a decrease. In some cases, debits are good while in some cases debits may not be liked by the management.

If you see “Dr.” in any accounting document, please note that it is not `doctor`. In accounting, “Dr.” normally refers to Debit and “Cr.” Refers to Credit.

 

Principles of debits and credits

There are 5 main classes of types of accounts in accounting. All of the accounting entries are booked under any of these classes. These 5 main classes are i) Assets, ii) Liabilities, iii) Income, iv) Expenses and v) Capital.

Below, we have provided a brief detail of the rule of debit and credit for each type of the account. When you have debit an account and when you have to credit an account. Ready these rules below first carefully and absorb them as much as possible. Then refer to the detailed examples given in the next section to enhance your understanding.

Assets:

Whenever company’s purchases a new asset (i.e, increase in assets) then in the asset account a debit entry should be recorded. Whenever there is a decrease in assets (i.e., any asset is sold) a credit entry should be passed in an asset’s account. Please remember that this is just 1 side of the double entry. (Refer example 1 below)

Liabilities:

When a company borrow’s money (or incurs any other liability), it should record a credit entry in that liability’s account. The principle is that liabilities are recorded as credit entries once they increase. Similarly, liabilities are recorded as debit entries once they decrease. (Refer example 5 below)

Income:

Sales shall be recorded on the credit side of the sales account. A sales return/return (i.e., decrease in sales) shall be booked as debit entry in the sales account. (Refer example 2 below)

Expenses:

Whenever a company shall incur an expense, that expense shall be recorded in the debit side of the expense account. So increase is expenses is always debited. Similarly, if there is any decrease in expense it will be recorded on the credit side of the account. However, decrease in expense is a rare scenario. (Refer example 3 below)

Capital:

When capital increases, it is recorded on the `credit` side of the capital account. When the capital decreases, it is booked as a debit entry in the books of accounts of the company. (Refer example 4 below)

Below tables shall be a key basic tool for you to understand debit and credit principles. Same principle has been explained in two different tables using different presentation style. Read both tables separately or together, they refer to same accounting principle.

 

Principles of debits and credits
 

Principles of double entry bookkeeping

Double entry book keeping system is based on the premise that every financial transaction has two aspects. One is referred to as `debit` and the other is referred to as `credit`. These two terms (debit and credit) are very important to understand if you really want to have clear concept of double entry book keeping system. This will be base of your whole accounting knowledge.

The key concept here is “Every financial transaction has two aspects. One being debit and other being credit”.

This means that whatever financial transaction is performed, it will result in production of one debit entry and one credit entry, in the books of accounts of the company. That transaction may be sale of goods to customers, purchase of inventory from suppliers, paying of rental bills or consumption of electricity in the company’s office. Every financial transaction shall be recorded in two lines, one will be a debit line and other will be a credit line.

 

 

Examples of double entry

Now, we’ll look at detailed examples and utilize the above principles of double entry. Let’s try to create double entry for these transactions.

Purchase of furniture worth $500 against paying cash.

Now, there are two sides of this transaction. First is the increase in company’s assets (i.e., by purchase of furniture) and second is the decrease cash (as cash is paid to the furniture seller). This example contains the cases where an asset (furniture) has increase while the other asset (cash) has decreased.

It will be recorded as follows:

Account title Debit Credit
Furniture account $500
Cash account $500

 

Sale of $100 to a customer for cash.

Now, apparently, this seems 1 transaction i.e., goods sold for $100 and collected cash. But from an accounting perspective, it has two implications (remember? Every transaction will have 2 entries i.e., 1 will be debit and 1 will be credit), the first implication is the increase in sales by $100 and second implication is increase in cash by same amount.

If we refer to above tables, increase in sales shall be entered as credit entry and increase in cash (asset) will be recorded as debit entry.

So the double entry for the above transaction shall be recorded as follows:

 

Account title Debit Credit
Cash account $100
Sales account $100

 

Let’s say that a cleaner was hired to clean the new office and he charged $30 to do the work.

This transaction has two aspects (one debit and one credit ). The debit aspect is that an expense has been incurred by the company (i.e, cleaning expense). This will be referred to as `increase in expenses` and will be booked as a debit entry. The credit aspect of this transaction is that cash has been paid to the cleaner thus resulting in decrease of cash (decrease of asset). This decrease of asset shall be recorded as a credit entry.

 

Account title Debit Credit
Cleaning expense account $30
Cash account $30

 

Capital entry of the businessman’s contribution to start the business.

Let’s say that Mr. Yamazaki commenced a business with an amount of $100,000. He deposited this money in the bank account of his enterprise. This will be an introduction of capital by the owner. This transaction has two aspects in the books of accounts of the business. Firstly, assets of the business has increased by a bank balance of $100,000. Secondly, owner’s capital has also increased by the same amount.

This increase in the bank balance shall be booked as a debit entry in `cash at bank account` because this is an increase in the assets of the enterprise. Secondly, a credit entry shall be booked as increase in capital in the capital account of the owner.

 

Account title Debit Credit
Cash at bank account $100,000
Capital account $100,000

 

If a company borrows money from a bank. This would result in increase in liabilities of the company because now it has an obligation to repay this loan to the entity. Therefore, this increase in liabilities shall be booked as a credit amount. Similarly, company’s own cash at bank will be increased because bank will transfer money in the company’s bank account. This second aspect of the transaction shall be booked as a debit.

 

Account title Debit Credit
Cash at bank account $xxxxx
Loan from bank account $xxxxx

 

In some cases, more than two accounts are also affected but total of all debits and credits should always be equal. Let’s take example of Mr. Sampochi. He purchased items worth of $3,000 but paid cash only $1,000 and promised to pay the rest of the amount after 2 months. Now, the accounting entry by the business will be as follows:

 

Account title Debit Credit
Cash in hand account $1,000
Receivables from Mr. Sampochi $2,000
Sales account $3,000

Total of all debits and all credits in any double-entry should always be same.

 

Characteristics of double-entry

Double entry book keeping system has been in place for more than 600 years in the accounting history. This was a great invention and is still in place. There doesn’t seem to be any alternative of this in the near future as well. Below are some key properties of double entry accounting system:

  1. It ensures that every transaction is recorded with its both aspects i.e., debit and credit.
  2. This leads to ensuring that a balance trial balance is generated so that a balanced statement of financial position can be prepared easily.
  3. This helps in identifying missing transactions in case the accounting records are lost or burnt etc.
  4. In an entry where multiple accounts are involved, any shortage in debit or credit shall be alerted by system and would lead to instant identification of missing amounts while posting the entry. Thus, it helps in reduction of errors.

 

 

Single-entry accounting

Double entry can be contrasted with single-entry accounting system. Single-entry accounting system is very limited and in no way can compete with the double-entry accounting system. Therefore, single entry system is used in a very limited manner. Please refer to our detailed article on single-entry accounting for more information.[/vc_column_text][/vc_column][/vc_row]

Categories
Assets Financial Accounting

Impairment of Assets

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Impairment by definition:

“Impairment is a factor which hampers the ability of an asset to yield future economic benefits.”

Didn’t get it? Ok, let me simplify it for you. Impairment makes assets less usable. This means, after the impairment, the asset will not be as useful as it was before the impairment happened.

For example, if a car gets damaged in an accident, it’s market value may decrease. Also, its ability to generate future cash flows may also decrease. Both these factors result in a decrease in the ability of the car to generate economic benefits and is thus impairment of the car.

In accounting terms, an asset is impaired if its net book value exceeds the present value of its future cash flows. (this will be explained further in the calculation of impairment)

 

Key Features of Impairment:

  • Impairment is not a necessary happening with every asset. Some assets may complete their useful life without any impairment.
  • Impairment is a very subjective term and would require special examination or detailed analysis to find out the value of impairment. Different experts may determine a different amount of impairment depending on what assumptions have been keyed in the analysis.
  • Impairment may result either in a loss in the market value of the assets OR the reduction in the flow of economic benefits from that asset OR both.
  • There may be different causes of impairment like physical damage or decrease in the market value or decision of the management or loss of reputation or some regulatory or government directives.
  • Both tangible and intangible non-current assets may get affected by impairment
  • Charging impairment (where appropriate) ensures that assets are not overstated in the statement of financial position of the entity.
  • What’s best about an asset whose net book value is zero? There won’t be any impairment on it

 

Accounting treatment

Impairment is an expense which results in a credit entry in the asset’s account and debit in the impairment expense account. This area is dealt in detail with IAS 37 “Impairment of Assets.”

Debit: Impairment expense account (P&L)

Credit: Asset cost account (B/S)

This accounting treatment is in contrast to the depreciation where there is no accounting entry passed in the asset account directly.

 

 

Indicators of impairment

Sometimes the impairment may be quite visible, i.e., physical damage to the asset due to some accident or natural calamity. However, in some cases, impairment is not entirely visible. Below are some of the indicators which may suggest that an impairment has occurred.

  1. In-house or external development of an alternative process/machine
  2. A decrease in the market demand of the product(s) produced by the asset
  3. A release of an updated model of the product by the vendor
  4. Decrease in the useful life of the asset due to an external factor
  5. A partial or full ban by regulators on the products manufactured through the asset
  6. Physical damage to the asset
  7. Leakage of the secret product formula which created a competitive edge
  8. Attack of infectious viruses which lead to malfunctioning of the software
  9. Obsolescence of the technology which was used to develop the asset
  10. Development of a better software by the vendor or the competitor
  11. Theft of the base code by hackers

Last 4 points in the above list are related to software/intangible assets.

 

Calculation of impairment

In order to calculate impairment, first, check if the net book value of the asset is higher than its recoverable value. The recoverable value is calculated by taking higher of

  1. the value in use, and;
  2. fair value less cost of disposal.

Calculation of value in use of the asset may not be simple always and may require several complex calculations.

On a general note, adopt the following step-wise-approach:

  1. Estimate future cash flows specifically attributable to the asset/CGU (Cash Generating Unit)
  2. Use appropriate discount rate to calculate the net present value of the asset/CGU
  3. Ensure that all irrelevant and non-incremental costs/revenues are not included in this calculation

Fair value less cost of disposal is rather easy to calculate in the sense that a market rate of the similar asset/similar deal is taken and any selling expenses (i.e., commission, advertisement, necessary repair, loading/unloading, etc.) are deducted from the sale proceeds.

Let’s take the following example to understand the above concepts:

A company has purchased a machine for $100,000 which has a useful life of 4 years. The company uses straight-line depreciation method. At the beginning of year 4, this machine started malfunctioning due to electric shock, and now it is estimated that its production ability is reduced to half.

If the machine is used in business, it’ll generate an annual profit of $20,000 in the fourth year with nil residual value. If the machine is sold immediately, it will be purchased by a scrapyard for $16,000 after paying a commission of $500.

What will be the impairment charge at the beginning of year 4?

Let’s take a step-wise approach:
Steps 1: Calculate net book value of the asset: i.e., After 3 years of depreciation $75,000 ($25,000 x 3 years) the net book value will be $25,000 ($100,000 – $75,000) at the beginning of year 4.

Step 2: Calculate recoverable value which is higher of:

  1. The value in use: Value in use, in this case, is $20,000
  2. Immediate disposal proceeds less cost to sell: in this case is $15,500 ($16,000 – $500)

Thus the recoverable value of the machine is $20,000.

Step 3: Compare answers to step 1 and 2 and see if net book value is higher or low than the value in use. As net book value is $25,000 and the recoverable value is $20,000, there is an impairment charge of $5,000.

 

 

Reversal of impairment

It some rare cases, it is allowed to reverse the impairment charged on an asset/CGU. Reversal of impairment may result due to any of the following factors:

  1. Revised estimates of the remaining useful life of the asset indicating improved useful life
  2. Improvement in the production capacity of the asset due to better operations or maintenance
  3. Increase in the market value of the product which is being produced/manufacturing using the asset under review
  4. Other factors which may logically depict reversal of the impairment

It is worth mentioning that the reversal of the impairment can be up to a maximum extent of the impairment charged earlier. Let’s say if impairment was charged on an asset of $5,000, then the maximum reversal of this entry can be only up to $5,000 and not more than that (however, less than $5,000 reversal of impairment is allowed).

 

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Categories
Basic concepts of management accounting Cost Accounting

Management Reporting

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Background

How does a CEO decide that the company should launch a new product?

How would the Board of Directors approve opening a new branch of the company?

How would the Marketing Director determine that we should now launch a new campaign?

What is the basis of all major decisions taken by the management of the entity?

Yes, you may have guessed it by now. It is the management reports which provide the basis for all these decisions. Based on the management reports, management would use their judgment, do the required discussion and would take the right business decision.

 

 

What is management reporting

Management reporting means the preparation of reports (mainly financial reports) and presenting them to the management. These reports contain essential information about income, expenses, assets and cash flow, etc. of the business. These reports help management to take the right business decisions.

For example, management reports will inform the management about how much profit is earned in last month or how much balance is available in the company’s bank account at a particular date. Management would use this information to prepare an action plan for the future.

 

Importance of management reporting

Management reporting is a vast area which plays a pivotal role in the performance management of the organization. It is one of the critical functions of a Finance Department where you can help top management to make the right decisions in the right direction.

Finance department usually has data and insights for the key performance indicators (KPIs) for fundamental processes. A carefully prepared financial analysis which briefly summarizes followings items would do a great job:

  • Current business results (comparison of different periods)
  • Key ratios and key performance indicators
  • Key areas which require improvement
  • Management commentary for the whole analysis

However, it is not only the finance department which is preparing management reports. Other departments also prepare and provide management reports. For example, a manufacturing department would prepare and produce reports about the manufacturing statistics. However, it depends how functions have been distributed in the organization.

 

Examples of some standard management reports

Management reports vary from industry to industry, company to company and management to management and person to person. However, there are some necessary reports which we can summarize below which would apply to most of the entities. Please note that the format, content, and extent of each of these reports would depend upon the size and scale of the organization and how management wants to view the information. Below descriptions are prepared from a general point of view.

Daily bank balance:

Usually this report is the first report which some executives want to see on their table at the start of the day. They can assess the fund flow situation and make important decisions regarding payments and collections.

This report would be a table containing Sr #, Name of bank account, account number, opening balance, debits, credits and closing bank balance of previous day or even today.

 

 

Monthly MIS:

This is a useful tool which primarily informs management on the income and expenses (sales and purchases) for a month. It might be a somewhat detailed report spanning 2-3 pages containing product-wise sales figure for the last month and cumulative figures for the year. This kind of MIS is more like an income statement but provides additional details.

Product-wise profitability report:

This report, in its most straightforward format, would show a table of different products. For each product, critical financial figures like sales, cost, and profit shall be included in the table.

This report is usually suitable for manufacturing companies which are producing 5-10 products in their portfolio. You can imagine that in a large retail superstore, where the number of products is in thousands, this report may not be presentable on a product-level.

Customer-wise/project-wise profitability report:

This report would mention customer-wise/project-wise profitability report. Both are different reports, but here we are explaining them as same as the concept is the same. The report would contain income and expenses related to each customer/project.

This report is quite a helpful report for the management to identify profitable customers/projects and decide future business terms for these customer/projects. For example, if a project is profitable, management will know that they have a reasonable margin for the price reduction (if a customer is insisting for that). However, for a customer who is already resulting in a loss to the company, reducing prices further for that customer may not be an ideal strategy.

 

 

 

Expense reporting:

This is a crucial report when management is concerned about cost-cutting and budgetary control. This report would only contain details of the expenses under different heads for example printing cost, travel cost, legal expenses, utility expenses, etc.

This is a tool where management keeps track of the expenses incurred and compare them with the past period and the budgets. Wherever there is a significant variation, management would inquire the reason for the variation and would take rectifying measures to control the cost.

Flash report:

A flash report is a flash (or a snapshot) of critical financial data for a particular date or a period. For example, it will contain sales, cash collected, expenses incurred, payments made on a particular date.

Management accounts:

These are financial statements which are prepared for the company’s internal use only. These usually contain profit & loss account and balance sheet (among other data). However, there is no fixed/strict format for this (as it is for audited financial statements). Every entity decides the format and content of management accounts according to their needs.

Management accounts usually provide more details regarding specific products, services, and expenses. They may not cover all aspects of the financial reporting.

These can be contrasted with external Financial Statements which are shared with banks, regulators, shareholders, etc. and are prepared under IFRS/GAAP.

 

marine-harvest-asa-annual-report-2017
Source:http://marineharvest.com/about/news-and-media/news_new2/marine-harvest-asa-annual-report-2017/

 

Importance of industry knowledge in management reporting

The main problems with accountants preparing management reports is that they may not be aware of the insights of the industry or that particular sector. A good management report CANNOT be prepared merely with proper accounting and report writing concepts. It is pivotal to have a business and commercial acumen of that particular industry to assist management in taking right decisions.

Therefore, it is strongly suggested to all accounting & finance professionals to pay a focus on the business development and business understanding side of their respective company/sector. The better industry knowledge you have, the better you will be in management reporting.

 

Key Challenges in Management Report

  1. Businesses are continuously evolving, and the external environment is rapidly changing. It is imperative to keep yourself update with the changes in the environment so that you are aware of all risk factors.
  2. Management reports should cover all relevant factors which will affect the net results of the decisions. If any relevant factors have not been taken into account in the analysis, then the management report is insufficient and would not lead to the best decision.
  3. Critical assumptions used in preparing the reports should be well explained either in annexure or remarks so that management is aware of the limitations of the report.
  4. Management reports should be presented in a way understandable to management highlighted vital information in bright and bold fonts or charts.
  5. Sources from where data is taken should be reliable and accurate.

 

Structure of a management Report

If you are preparing a management report in a powerpoint presentation, we will guide you on the structure of the report. The structure of a good management report would depend on the nature of the industry and the geography of the company, however, following sequence may be adopted in a management report in general:

  1. Heading slide: This would include the title of the report, the period to which it relates and the preparer’s name and department.
  2. Key highlights: Ideally this should be some graph or chart of crucial ratios on one slide only where the key and most important results are provided in a tabular or graphical format.
  3. Executive Summary: This is a part which is often missed in financial management reports but it a pivotal role where Finance can give their input and play a core role in the company’s success. An executive summary should be a one (or max) two paged slides where the background of the situation, current analysis, and critical recommendations are provided.
  4. Detailed analysis: This would be a significant portion of the presentation and may span over several slides. The information on the detailed analysis should be in a structured format which is easy to read for the management, and it contains key
  5. Conclusion: The key actions which are being recommended to the management to tackle the situation
  6. Footer Slide: This would typically include a closing thank you note slide.

 

Financial Reporting Vs. Management Reporting

financial-reporting-vs-management-reporting

 

Conclusion

Management reports are not limited to Finance / Accounting function only. Almost every department in the organization would be preparing and presenting management reports in their fashion. These management reports are prepared usually by mid-level professionals and are presented to Directors or top management. Top management would make critical business decisions taking inputs from the management reports.

 

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Categories
Career knowledge Finance careers

Responsibilities of a Busy Finance Manager

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What are the responsibilities of a Finance Manager? What do they keep doing the whole day? What will be your life like once you become a Finance Manager? What can you improve in your current role as Finance Manager? What makes them come home late every night? If you have any of the above questions in your mind, then this article is written for you. Stop all the distractions around you and start reading it below carefully.
By Finance Manager, we mean someone who is at a mid-career level of Accounting & Finance Profession. He/she may have a different designation that Finance Manager. This article applies to the similar titles like accounting manager, accounts manager, Finance & administration manager, financial Controller, Assistant finance manager, Treasury manager or even Senior Accountant, etc.
Firstly, it is important to realize that the life of all finance managers is NOT the same. There may be significant differences in the work routine of Finance managers depending on various factors like size of the organization, organization structure, sector/industry in which they work in, current business situation, management plans, capability and functionality of current I.T systems and many other things. However, we’ll true to cover the responsibilities of a super busy finance manager who is trying to juggle all responsibilities simultaneously:

 

Financial Reporting

This area mainly comprises the preparation of financial reports and getting them audited in coordination with external auditors. Some company may have an annual requirement for audited financials, and some may have to report quarterly results with a review report from external auditors. Financial Reporting is a crucial function and requires significant devotion and time. Preparation of financial statements and resolving auditors’ queries is an essential job and may require several late sittings during audit days. This task requires a full understanding of the accounting system and IAS/IFRS.

 

 

Management Reporting

Management reporting or internal reporting is usually a monthly job, and it may be even less than that, i.e., on a weekly or even daily basis. If you have set templates for monthly reporting, you may need to update the figures from the latest trial balance. However, a comprehensive management reporting with management commentary is also a vital task and requires significant devotion. Read our detailed article on management reporting here.

 

Regulatory compliance

For the companies which are listed on a stock exchange, then there would be regulatory reporting requirements from the stock market. For the companies in a specific industry say like, Insurance, the company will have to provide specific reports to Insurance Regulator. If the company is a member of a particular trade association, then it will have to report figures to the trade association. Similarly, a central bank is a main regulatory body for financial institutions. So, depending on the industry, regulatory reporting would affect the responsibilities of the finance manager.

 

Budgeting & Forecasting

How much money will be spent in the next year or next month on different kind of expenditures? What will be our maximum spend in the pantry? What amount can we maximum afford in the advertisement expense? Well, it is the Finance Manager who answers all these questions. Because it is usually the Finance team, who is responsible for preparing budgets and forecasts for the entity. These budgets and forecasts are prepared usually on a monthly or yearly basis to ensure financial control over the expenditures of the entity. However, we cannot ignore the input of other departments and managers in preparing budgets. We can say that the Finance manager will prepare the budget in coordination with input from other departments.

 

System changes

With the fast changing technology, all systems are becoming obsolete much faster than the original anticipation. With increased demands from the business and the management, there is a requirement of several new reports which existing systems may not be able to provide. With increased competition and for better costing mechanism, there is a requirement for more smart systems. Whenever there is a change in the system, the Finance manager has to play a pivotal role in the successful implementation of the new systems. They have to be involved in all stages of software change/upgrade like planning, expectation setting, data flow designs, implementation, testing and review after implementation.

 

 

Receivables Management

When the customers have purchased goods/services on credit, and they are not paying themselves. It is usually the Finance team who has to run after them. This chasing and following up to collect the money is a daunting task. In order to achieve this task, Finance Manager will also be looking after all the queries from customers like provision of proper invoices, generating a statement of account, reconciliations, receipts issuance, and allocations.

 

Payables Management

You may be an ethical finance manager who calls your debtors once in a week to remind them of the outstanding amount due. However, your creditors may not be preferring the same approach. A finance manager may receive calls on a daily basis from the same vendor for the outstanding payment. Payables Management may be one of the hard-hitting areas of the finance managers’ duties where he/she may have to listen or respond to unpleasant calls and emails. For all the conflicts for the account balances and the booked/un-booked invoices, finance manager has to play a critical role to sort out the issues.

 

Banking & Financial Management

Financial management is an area which exactly coincides with the word ‘Finance Manager.’ Therefore, the importance of this functionality is self-evident. In brief, in this functionality, the finance manager ensures that the finances of the company are well managed. Financial management means that money is appropriately rotated, the bank account is adequately funded, expenses are well controlled, misappropriation of the money is prohibited, revenues are timely collected, payables are suitably managed, and investments are wisely selected.

 

Product Costing

Do you know how a company decides that what should be the price of their products? Checking the price of a product in a retail market is very easy. However, calculating that price from a company’s perspective is an intricate matter. Do you want to meet the guy who plays a pivotal role in product costing (and thus in product pricing)? Yes, you guessed it right, it is the Finance Manager who is to ensure that proper methods of costing techniques are applied to reach out at the correct pricing for the product.

 

 

General ledger maintenance

This section would cover all the accounting entries being passed promptly, in the correct accounts, with correct amounts and correct descriptions. These tasks are usually done by the team under the Finance Manager. However, the Finance Manager has to ensure that the general ledger is being maintained appropriately. Whenever there is missing account code or a new account code to be created, FM has to ensure that it is created in an appropriate category and sub-category. The users of the G.L should have appropriate access rights only.

 

Team management

A finance manager may be managing a team ranging from a couple of staff to more than 50 persons, depending upon the size of the organization. Team management and people management is one of the critical success factors for a finance manager. If the responsibilities are appropriately allocated, and the resources are effectively utilized, it would be easy for the manager to fulfill its responsibilities successfully. However, if the team is not well balanced, not adequately trained or if there are unresolved conflicts among the team, it would significantly hamper the productivity and performance of the finance manager and the whole finance team.

 

Conclusion

Some organizations may split these responsibilities among different designations like credit controller, costing manager, accounting and reporting manager and finance manager (of course). However, it depends upon the organization’s structure (as stated earlier).

If you are planning to pursue a career as a Finance professional, then the above would give you a hint of how life would be in this career. I can say that a career in Finance is exciting and you’ll have some power being a financial controller of the entity.

If you have already joined the profession and are in an initial stage, the above responsibilities would help you to advance your vision and career. Try to get those responsibilities which are not in your domain yet. The more responsibilities you have, the more valuable you’ll become for the entity.

If you are an owner of an SME business and you are wondering how to hire right finance manager, then don’t base your decision on the right color matching of the tie and the shirt. Instead, try to obtain understanding from the candidates based on the above headings. Let’s know their experience in each of these areas, and this will help you choose the right candidate for the Finance Manager position. The more confident and experienced the candidate is, the better he deserves this position.

 

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Categories
Financial Accounting Revenue

Revenue recognition in Insurance Sector

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Revenue recognition in the insurance sector is little daunting at first sight. However, you can grasp the concept easily if you ponder on the below content. There are 3 key items to understand in this article. These are GWP, UPR and EP. Details are below.

 

Gross Written Premium (GWP)

GWP is the amount which has been charged to the customer for issuance of a policy (but not necessarily recognized as a revenue). GWP is booked once an insurance company issues insurance policy (or in more technical words, when an underwriter underwrites the policy).

In most of the cases, the insurance policies are issued for 1 year. GWP is full policy premium and is booked at full insurance premium for the policy. For example, if a health insurance policy is issued worth $ 1,000.00, the insurance company shall pass following accounting entry.

Debit: Gross Written Premium

Credit: Customer account


It is worth noting that GWP account will not be considered as revenue for the entity. Rather the revenue is determined/considered GWP net off UPR (read below).

 

Gross Unearned Premium Reserve (GUPR)

Gross UPR refers to the portion of the GWP which has not yet been recognized as income in the statement of comprehensive income. Therefore, it is referred to as ‘unearned premium’ or UPR.

You will appreciate the fact that insurance premium is recognized as income with the passage of time. As the time passes/days pass, premium is transferred from GWP to EP. Because insurance premium relates to a particular period (normally 1 year). So the full premium cannot be recognized as income/earned premium upon receipt. It is similar to rental income. Rental income is also recognized as earned income with the passage of time.

Debit: Unearned Premium account (P&L)

Credit: Unearned Premium Reserve account (Balance sheet)

 

Gross Earned Premium (GEP)

This is the amount of the premium which has been recognized as a revenue in the books of the accounts of the insurer.

There are two ways to calculate net earned premium.

  1. Earned premium is calculated by subtracting Unearned Premium Reserve (UPR) from GWP. In it’s simplest terms, subtract any GWP which is not yet earned from total GWP to reach at the earned premium.

  2. Second way is to calculate proportionate GWP on a timely basis to reach at EP. Let’s say that a policy is booked on 1 January amounting to $1,000. Now, with the passage of every month, 1 month GWP would be recognized as earned premium. So gradually, UPR shall keep decreasing and EP would keep increasing, with the passage of time. By the end of the year i.e., 31 December, full $1,000 would be recognized as earned income/earned premium.

 

Whatever the approach you follow to reach at earned premium, the amount of answer should be same. These are just two different approaches to arrive at the same figure.

 

Comprehensive Example

Now, let’s take a look at a detailed example of how figures are recognized over a period of 1 year in insurance income. The company’s financial year runs from 1 January till 31 December. Let’s take the example of an insurance policy which is issued on first day of the company’s financial year i.e., 1 January for a gross premium of $1,000.

1 January

On the first day, GWP amount would be booked as $1,000 and this amount will remain same throughout the year in this account. GWP amount will not change at any time during the year. This amount once booked, would remain same for this policy (unless there is any addition, deletion or other adjustment which we are not discussion in this article).

So, the accounting entry on morning of 1 January will be:

 

Debit: Client account (B/S) $1,000

Credit: Gross Written Premium (GWP) account (P&L) $1,000

 

However, at this point of time, full premium amount is unearned. Therefore, a reserve of the same amount shall be created as follows:

 

Debit: Unearned Premium account (in P&L) $1,000

Credit: Unearned Premium Reserve account (in B/S) $1,000

 

However, on the end of first day, 1 day’s premium shall be recognized as income because 1 day has passed and now insurer is entitled to reverse 1 day’s premium from its UPR reserve. This will lead to recognition of 1 day’s income as earned premium. The amount of 1 day’s premium is $2.74 ($1,000 / 365 * 1).

 

Debit: Unearned Premium Reserve (B/S) $2.74

Credit: Unearned Premium (P&L) $2.74

 

On the end of the day of 1 January, UPR reserve amount in the balance sheet will be $997.26 ($1,000 minus 2.74).

1 April

After 3 months, on 1 April, a total of 91 days premium would be recognized as income. These days is calculated as this: 31 days January + 28 days February + 31 days March + 1 day April = 91 days.

The accounting entry will be debit:

1 October

On 1 October, company recognize premium of 274 days out of 365 days of the premium. These are calculated as follows: 31 days January + 28 days February + 31 days March + 30 days April + 31 days May + 30 days June + 31 days July + 31 days August + 30 days September + 1 days October = 274 days.

31 December

At the end of the year, on the evening of 31 December, full policy premium of $1,000 would be recognized as earned premium. There would not remain any amount in the unearned premium for this policy.

 

 

Reinsurance Ceded Premium

Ceding literally means giving up, leaving it out or surrendering something. From the term ‘ceded premium’ it seems that this premium has been just given to someone else. This is not fully wrong. This was the premium which was an insurance company’s collection from the policy holder but the insurance company rendered it to someone else.

Ceded premium is the premium which an insurance company to another insurance company (a reinsurance company, more appropriately) to share the risk of an insurance contract. This means that a part of the insurance risk has been transferred to another insurance company (a reinsurer) in return for the ceded premium.

Let’s take a simple example of reinsurance ceded premium:

Let’s say that an insurer Conservative Insurance Company underwrites a policy for a Big Fat LLC client. Total policy premium is $1,000 and sum insured is $50,000. Now, Conservative Insurance Company feels that this is a big risky policy and they want to transfer some of the risk to Helper Insurance Company by transferred them 25% of the premium and 25% of the risk.

So, in this case, reinsurance ceded premium will be $2500 (25% of $100,000). The accounting entry to record RI GWP will be as follows:

 

Debit: RI GWP account (P&L) $250

Credit: Reinsurer’s account (B/S) $250

 

If you think that Reinsurance Ceded Premium has only 1 name, then think again please because it is also referred to as “Reinsurance Premium” or “ceded premium” or “R.I premium” or “reinsurer’s share of premium” or “Reinsurer’s Share of Gross Written Premium” or simply “RI GWP”. All these terms are used interchangeably for the same thing.

The more an insurance company cedes premium to its reinsurers, the less risky it’s business becomes. However, it also loses money in the sense that it has to share the premium with someone else (with reinsurer). But reinsurance is very common in insurance sector and it may not be wise to retain all the risks of every policy with you.

 

 

Net Written Premium

Gross Written Premium minus Reinsurance ceded premium is equal to net written premium.

 

Reinsurer’s Share of Unexpired Risks (RI UPR)

Reinsurer’s Share of Unexpired Risks or RI UPR refers to the portion of the premium which is paid/to be paid to the reinsurer but which has not yet been recognized as expense in the insurer’s books of accounts.

At the time of policy issuance, a reserve shall be created for RI UPR for the full amount of RI GWP. Let’s continue the above example of $1,000 policy and 25% reinsurer’s share. On 1 January, below entry shall be passed for RI UPR immediately upon policy issuance which will be equivalent to RI GWP:

 

Debit: RI UPR account (B/S) $250

Credit: RI UPR account (P&L) $250

 

The above entry shall ensure that on policy issuance, RI GWP and RI UPR are equal and there is no expense on this arrangement. However, as first day will pass, 1 day’s RI UPR shall be reversed leading to recognition of 1 day’s RI GWP as incurred expense.

Debit: RI UPR account (P&L) $0.685

Credit: RI UPR account (B/S) $0.685

 

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Categories
Business Strategy Theories in business

SWOT ANALYSIS IN BUSINESS MANAGEMENT

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SWOT is an abbreviation of four letters which are:

  • Strength
  • Weakness
  • Opportunity
  • Threat.

A SWOT analysis is a simple but effective tool in business management as it leads to portray of an overall strategic position of an entity in a simple one-page look. It is useful for both small and large organizations in most of the circumstances. However, SMEs are more likely to benefit from SWOT analysis because their business environment is not as much complex as MNCs or large corporates. A SWOT analysis can be used by individuals as well, but mainly it is studied/performed from an organization’s perspective. In this article, we’ll talk about SWOT analysis primarily for entities/corporates/businesses.

The primary purpose of SWOT analysis is to:

  • Analyze how to utilize your strengths to avail opportunities
  • Evaluate and tackle the threats which are being faced due to weaknesses

A SWOT analysis is an excellent planning tool as it persuades to study the elements in both the external and internal environment of the organization and then summarizes and presents them in a simple format for brainstorming and problem-solving.

 

 

Strengths

An organization’s strengths can be referred to as critical resources which it owns/ has. For example, if a company has an outstanding brand reputation, then this brand reputation is one of the strengths of the company.

A strength is something which is positive about the company, and the company already owns that positive feature. This strength is mainly an internal factor to the organization.

Other Examples of strengths: An organization may have the following strengths

  • The excellent reputation of the brand
  • Skills and strength of the workforce
  • Availability of reserves/profits
  • Secure network with suppliers, customers, and other stakeholders
  • Secret recipes of the products
  • Patented rights of different products, processes or formulas
  • Installed property, plant and equipment/manufacturing facilities or other assets

From an individual’s perspective examples of strengths are: having good physical health, possession of useful skills and knowledge, ability to communicate effectively, access to key contacts and having some political influence.

No strength of an organization is forever. Strengths may fade over time or may deplete into weakness. Any competitive advantage may diffuse once your competitor achieves the same level of strength.

 

Weaknesses

An organization’s weakness is a lack of necessary resources in tools in its basket. For example, if a company doesn’t have a serious and smart management team, it is one of the weaknesses of the organization.

A weakness is more of an internal feature than external. It is something terrible within the organization itself. It doesn’t come from outside the company.
A weakness can be mitigated either through internal management or external help.

 

 

Other examples of weaknesses are:

  • Strategy not well defined or no strategy at all
  • Lack of sufficient contacts/network with customers, suppliers and other stakeholders
  • Unhealthy policies and unprogressive attitude of the management
  • Policies, procedures, and systems not well defined
  • Lack of wise and visionary leadership
  • Lack of availability of funding from the company’s owner
  • Geographical boundaries and limitations

 

Opportunities

An opportunity is something which you have not owned/accessed, but you want to have it because of its potential benefits.
For example, if a person is hungry and a hotel is providing free (or even paid) food, then the food being offered is an opportunity for that person to kill his hunger.
From an organization’s perspective, if a new customer walk-in and inquires about the company’s products or services, this customer (or the potential sale) is an opportunity for the company.

Features of opportunity:

  • It is something which is NOT owned/possessed by the company/entity right now
  • It is something which is likely to be of benefit for the business
  • It is something which will be obtained by exercising company’s strength in the right manner

Other examples of opportunities are:

  •  Special occasions (like a new year, religious festivals, national holidays) are opportunities for many businesses to boost their sales.
  • Opportunity to acquire a competitor or merger. If your competitor is facing difficulty in running the business and wants to sell it, you can acquire your competitor if you have sufficient financing.
  • Detailed exercise to redesign the products or introduce new model is an opportunity for the business to introduce a better item and increase its profits
  • Government’s announcement to commence a particular project (it may be a construction of a new road, a new bridge or a new building). Once the government starts to spend in a particular industry, it is an opportunity for that industry’s players to obtain the contracts and work for the government and make money.
  • A new development in science and technology is an opportunity for the commercial organizations to utilize that new technology in their products/services on an industrial scale. For example, if a new medicine is invented which stops the aging process, it would be an excellent opportunity for pharmaceutical companies to develop that product and sell it on a commercial level.

It is important to realize that one has to wait for some of the opportunities and they arise from external sources like government’s announcement to start a new bridge/road/dam/building. is an opportunity which is not always available. However, certain opportunities are the ones which can be created by the entity. For example, the exercise to redesign s products OR evaluate its internal processes OR restructuring of the business units. These internal opportunities and have to be identified and exploited by the management.

 

 

Threats

A threat is something which is approaching and will impact the organization in an adverse manner, if realized (or not taken care of).
Simply, you are crossing a road, and a reckless driver is speeding towards you. This is a threat and if you don’t take appropriate action (i.e., step out of the way quickly) timely, this threat may actually become a reality and will impact you adversely.

The example from an organization’s perspective is: An entity has incurred significant losses, and it is short of funding now. If additional capital is not injected or a loan is not secured, there is a threat that the company may fail and go into liquidation.

Threats need to be managed by utilizing your resources (read strengths) effectively. For example, the risk of a regulatory fine for non-compliance of regulations should be avoided by spending money on complying with the statute.

Alternatively, calculated level of threats can also be accepted, if they are not manageable. For example, the threat of entry of new competitors may not be manageable always and have to be disregarded.

Other Examples of threats from a SWOT analysis perspective of an organization are:

  • Risk of business failure, i.e., going into liquidation or incurring losses
  • A possibility of theft of assets of the company
  • A danger of cancellation of license or imposing of fines by the government or other regulators
  • Endangerment of the losing agency status/sole distribution rights of the manufacturer
  • Likelihood of a strike call from the labor union
  • Risk of the cancellation of the company’s trade license or ban on any of the products

SWOT Analysis of British Airlines Incorporation

Now, to understand the concepts of SWOT analysis, we’ll perform a simple SWOT analysis of any one organization. Let’s take the example of British Airlines. If we present a simple SWOT analysis of British Airlines, in its simplest form, it will look like as below:

Strength:

  • Licenses to operate and fly in different regions, parking license at different airports of the world
  • Governmental backing concerning financial and logistics support
  • Huge Fleet of modern air crafts
  • Experienced management, loyal workforce
  • Existing agreements with other airlines as partnerships

Weaknesses

  • Internal politics among management and staff
  • More bureaucratic processes and organizational structure
  • Expensive transformation in systems and I.T due to the complexity of operations
  • Less scope for cost reduction due to extensive size 

Opportunities

  •  Opportunity to expand in other markets and regions (subject to regulations)
  • Opportunity to join hands with other airlines to extend its area of coverage
  • Opportunity to diversify in similar activities (like operating airport hotels and car rentals)
  • Acquisition of failing competitors to capture market share

Threats

  •  A threat of competitors’ increasing market share
  • A threat of accidents and mishaps
  • Risk of any Regulatory and compliance regulated regulatory
  • Severe weather conditions and the possible loss of revenue due to such conditions

This article was of an introductory level on the topic of SWOT analysis (Strengths, Weaknesses, Opportunities & Threats) including a comprehensive example of the airline industry. There were many smaller examples provided for other industries/sectors.

 

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Categories
Business & Finance

Statement of Cash Flows

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A Statement of Cash Flows (or as formally called cash flow statement) provides an explanation in the movement of the actual cash inflow and outflow from different activities of the entity. There are three broad classifications under which cash flows are categories. We have provided brief explanation of each with abstracts of some of companies for the relevant sections.

  • Operating activities
  • Investing activities
  • Financing activities

 

Consolidated cash flow statement
source: https://www.kingfisher.com/files/reports/annual_report_2018/files/pdf/annual_report_2018.pdf

Cash flows from operating activities:

Refer to the operating aspects of the cash flows. This includes collection and payments to and from trade receivables and trade payables and even other payables and other receivables. Everything which is related to the main trading activity of the entity.

In order to calculate cash flows from operating activities under indirect method, the beginning figure is profit for the year. So, first put profit/(loss) for the year and then make following adjustments to it:

  • Add back all non-cash expenses (like depreciation, amortization etc.)
  • Exclude interest income and other income (these will be separately calculated on actual cash flow basis)
  • Add all decreases in working capital and substract all increases in working capital (stocks, receivables and payables)

 

consolidated statement of cash flow
Source: https://www.ibm.com/annualreport/2017/assets/downloads/IBM_Annual_Report_2017.pdf

A positive figure of ‘net cash flows from operating activities’ indicate that the company has collected more than the cash it paid out, related to the operational activities of the entity. A positive figure generally is considered as good because it shows that company’s operations are cash sufficient. It will not need to arrange cash from financing or investing activities to support its operations.

However, a negative cash flow from operating activities cannot be blindly termed as something bad. We need to do a more in-depth analysis to find out the movement of items of cash flow statement and along with other business factors, it needs to be evaluated to find out whether a negative cash flow is actually bad or not for the entity. For example, a negative net cash from operating activities may have arisen to due increase in inventories (resulting in negative cash flows). These inventories may have been purchased to support expanding sales and market demand.

Direct method and Indirect method: These are 2 methods to prepare statement of cash flows. There is no difference in ‘investing activities’ and ‘financing activities’ under these 2 methods. The difference is only in the presentation of figures under ‘operating activities’.

Indirect method is more common and the begins the operating cash flows with ‘profit for the period’ however, in the direct method the beginning point is revenue from sales to customers. Then deduct all expenses like cost of goods sold and admin expenses. After that deduct increase and add decrease in working capital. Remove all non-cash items (like depreciation and amortization) and it will reach to the ‘net cash flows from operating activities’ using direct method.

So, how do you decide whether a cash flow is related to operating activity or an investing activity or a financing activity? So, the key deciding factor is like this, firstly check whether the cash flow is related to a financing activity or not? If it is a financing activity, then straight away classify it under financing activities. Secondly, check if it is an investing activity or not. If it is an investing activity then straight away classify it as investing activity. However, if a cash flow is neither an investing activity nor a financing activity, then as a residual bucket, put that cash flow under operating activity.

 

 

Cash flows from Investing Activities

Cash flow from investing activities usually includes capitation expenditure and doesn’t include cash flows of operational/routine nature. Unlike operating activities, these cash flows are not related to the operational running of the entity. This provides an idea to the investor that how much cash flow is invested or divested from the investment activities of the company.


This segment of cash flow focuses on the items which are related to long term investments of the entity like:

  • Purchase or sales of property, plant & equipment
  • Investments or divestment in subsidiaries or associates
  • Purchasing of shares and debentures of other entities
  • Receipt of dividends and interest generated the investments made

In order to prepare this section all investments/purchases in investing activities should be entered as negative value, because these are cash outflows. All collection of money under this section should be added as positive values e.g., proceeds from disposal of fixed assets.

The sum of all amounts under this category is called ‘net cash flows from investing activities’ (whether the net is positive or negative). But if net amount is negative then it may be labelled as ‘net cash flows utilized in investing activities’. If the net amount is positive, then it may be termed as ‘net cash flows generating from investing activities’.

 

Source: https://www.vodafone.com/content/annualreport/annual_report18/downloads/Vodafone-full-annual-report-2018.pdf

 

Cash flows from Financing Activities

This section provides information about how cash flow movement in the financing activities of the company. Like how much loan is obtained by the entity or how much is repaid? Are there any new shares issued? Or how much dividend is paid. This section is about transactions (and their cash flow impact) of matters related to company’s own funding and financing. Has the company borrowed money? If so, then how much? Has it issued more shares? Has it repaid its loans? The details about all these transactions will be available in this section of the statement of cash flows. Therefore, this is an important section from investor’s point of view. A good risk assessment can be made from the company’s cash flow of financing activities whether this is a good choice for investment or not.

 

Source: https://cdn.exxonmobil.com/~/media/global/files/summary-annual-report/2017-summary-annual-report.pdf

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