Category: Accounting concepts

[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 20^th of every month which contains electricity charges up to 15^th 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]

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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]

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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:

 

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.

 

 

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 5^th 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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