Category: Financial Accounting

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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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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]

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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]

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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]

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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]

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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
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
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
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
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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