Welcome To Businance

Statement of Cash Flows

Statement of Cash Flows

A Statement of Cash Flows (or as formally called cash flow statement) provides an explanation in the movement of the actual cash inflow and outflow from different activities of the entity. There are three broad classifications under which cash flows are categories. We have provided brief explanation of each with abstracts of some of companies for the relevant sections.

  1. Operating activities
  2. Investing activities
  3. Financing activities


source: https://www.kingfisher.com/files/reports/annual_report_2018/files/pdf/annual_report_2018.pdf

Cash flows from operating activities: Refer to the operating aspects of the cash flows. This includes collection and payments to and from trade receivables and trade payables and even other payables and other receivables. Everything which is related to the main trading activity of the entity.

In order to calculate cash flows from operating activities under indirect method, the beginning figure is profit for the year. So, first put profit/(loss) for the year and then make following adjustments to it:

  1. Add back all non-cash expenses (like depreciation, amortization etc.)
  2. Exclude interest income and other income (these will be separately calculated on actual cash flow basis)
  3. Add all decreases in working capital and substract all increases in working capital (stocks, receivables and payables)


Source: https://www.ibm.com/annualreport/2017/assets/downloads/IBM_Annual_Report_2017.pdf

A positive figure of ‘net cash flows from operating activities’ indicate that the company has collected more than the cash it paid out, related to the operational activities of the entity. A positive figure generally is considered as good because it shows that company’s operations are cash sufficient. It will not need to arrange cash from financing or investing activities to support its operations.

However, a negative cash flow from operating activities cannot be blindly termed as something bad. We need to do a more in-depth analysis to find out the movement of items of cash flow statement and along with other business factors, it needs to be evaluated to find out whether a negative cash flow is actually bad or not for the entity. For example, a negative net cash from operating activities may have arisen to due increase in inventories (resulting in negative cash flows). These inventories may have been purchased to support expanding sales and market demand.

Direct method and Indirect method: These are 2 methods to prepare statement of cash flows. There is no difference in ‘investing activities’ and ‘financing activities’ under these 2 methods. The difference is only in the presentation of figures under ‘operating activities’.

Indirect method is more common and the begins the operating cash flows with ‘profit for the period’ however, in the direct method the beginning point is revenue from sales to customers. Then deduct all expenses like cost of goods sold and admin expenses. After that deduct increase and add decrease in working capital. Remove all non-cash items (like depreciation and amortization) and it will reach to the ‘net cash flows from operating activities’ using direct method.

So, how do you decide whether a cash flow is related to operating activity or an investing activity or a financing activity? So, the key deciding factor is like this, firstly check whether the cash flow is related to a financing activity or not? If it is a financing activity, then straight away classify it under financing activities. Secondly, check if it is an investing activity or not. If it is an investing activity then straight away classify it as investing activity. However, if a cash flow is neither an investing activity nor a financing activity, then as a residual bucket, put that cash flow under operating activity.



Cash flows from Investing Activities

Cash flow from investing activities usually includes capitation expenditure and doesn’t include cash flows of operational/routine nature. Unlike operating activities, these cash flows are not related to the operational running of the entity. This provides an idea to the investor that how much cash flow is invested or divested from the investment activities of the company.

This segment of cash flow focuses on the items which are related to long term investments of the entity like:

  1. Purchase or sales of property, plant & equipment
  2. Investments or divestment in subsidiaries or associates
  3. Purchasing of shares and debentures of other entities
  4. Receipt of dividends and interest generated the investments made

In order to prepare this section all investments/purchases in investing activities should be entered as negative value, because these are cash outflows. All collection of money under this section should be added as positive values e.g., proceeds from disposal of fixed assets.

The sum of all amounts under this category is called ‘net cash flows from investing activities’ (whether the net is positive or negative). But if net amount is negative then it may be labelled as ‘net cash flows utilized in investing activities’. If the net amount is positive, then it may be termed as ‘net cash flows generating from investing activities’.


Source: https://www.vodafone.com/content/annualreport/annual_report18/downloads/Vodafone-full-annual-report-2018.pdf

Cash flows from Financing Activities

This section provides information about how cash flow movement in the financing activities of the company. Like how much loan is obtained by the entity or how much is repaid? Are there any new shares issued? Or how much dividend is paid. This section is about transactions (and their cash flow impact) of matters related to company’s own funding and financing. Has the company borrowed money? If so, then how much? Has it issued more shares? Has it repaid its loans? The details about all these transactions will be available in this section of the statement of cash flows. Therefore, this is an important section from investor’s point of view. A good risk assessment can be made from the company’s cash flow of financing activities whether this is a good choice for investment or not.


Source: https://cdn.exxonmobil.com/~/media/global/files/summary-annual-report/2017-summary-annual-report.pdf

SWOT ANALYSIS IN BUSINESS MANAGEMENT

SWOT ANALYSIS IN BUSINESS MANAGEMENT

Swot-analysis-in-business-management

SWOT is an abbreviation of four letters which are:

  1. Strength
  2. Weakness
  3. Opportunity
  4. Threat.

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

The primary purpose of SWOT analysis is to:

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

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

  1. Strengths

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

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

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

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

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

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

  1. Weaknesses

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

A weakness is more of an internal feature than external. It is something terrible within the organization itself. It doesn’t come from outside the company.

A weakness can be mitigated either through internal management or external help.

Other examples of weaknesses are:

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

An opportunity is something which you have not owned/accessed, but you want to have it because of its potential benefits.

For example, if a person is hungry and a hotel is providing free (or even paid) food, then the food being offered is an opportunity for that person to kill his hunger.

From an organization’s perspective, if a new customer walk-in and inquires about the company’s products or services, this customer (or the potential sale) is an opportunity for the company.

Features of opportunity:

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

Other examples of opportunities are:

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

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

  1. Threats

A threat is something which is approaching and will impact the organization in an adverse manner, if realized (or not taken care of).

Simply, you are crossing a road, and a reckless driver is speeding towards you. This is a threat and if you don’t take appropriate action (i.e., step out of the way quickly) timely, this threat may actually become a reality and will impact you adversely.

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

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

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

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

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

SWOT Analysis of British Airlines Incorporation

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

Strength:

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

Weaknesses

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

Opportunities

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

Threats

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

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

Revenue recognition in Insurance Sector

Revenue recognition in Insurance Sector

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.

Comprehensive-Example

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

Responsibilities of a Busy Finance Manager

Responsibilities of a Busy Finance Manager

What are the responsibilities of a Finance Manager? What do they keep doing the whole day? What will be your life like once you become a Finance Manager? What can you improve in your current role as Finance Manager? What makes them come home late every night? If you have any of the above questions in your mind, then this article is written for you. Stop all the distractions around you and start reading it below carefully.

By Finance Manager, we mean someone who is at a mid-career level of Accounting & Finance Profession. He/she may have a different designation that Finance Manager. This article applies to the similar titles like accounting manager, accounts manager, Finance & administration manager, financial Controller, Assistant finance manager, Treasury manager or even Senior Accountant, etc.

Firstly, it is important to realize that the life of all finance managers is NOT the same. There may be significant differences in the work routine of Finance managers depending on various factors like size of the organization, organization structure, sector/industry in which they work in, current business situation, management plans, capability and functionality of current I.T systems and many other things. However, we’ll true to cover the responsibilities of a super busy finance manager who is trying to juggle all responsibilities simultaneously:

  1. Financial Reporting

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

  1. Management Reporting

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

  1. Regulatory compliance

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

  1. Budgeting & Forecasting

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

  1. System changes

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

  1. Receivables Management

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

  1. Payables Management

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

  1. Banking & Financial Management

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

  1. Product Costing

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

  1. General ledger maintenance

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

  1. Team management

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

Conclusion

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

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

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

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

A comprehensive overview of Depreciation

A comprehensive overview of Depreciation

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.

  1. 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.

  1. 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.`

Management Reporting

Management Reporting

Background

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

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

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

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

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

What is management reporting

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

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

Importance of management reporting

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

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

  • Current business results (comparison of different periods)

  • Key ratios and key performance indicators
  • Key areas which require improvement
  • Management commentary for the whole analysis

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

Examples of some standard management reports

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

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

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

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

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

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

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

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

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

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

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

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

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

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



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


Importance of industry knowledge in management reporting

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

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

Key Challenges in Management Report

  1. Businesses are continuously evolving, and the external environment is rapidly changing. It is imperative to keep yourself update with the changes in the environment so that you are aware of all risk factors.

  2. Management reports should cover all relevant factors which will affect the net results of the decisions. If any relevant factors have not been taken into account in the analysis, then the management report is insufficient and would not lead to the best decision.

  3. Critical assumptions used in preparing the reports should be well explained either in annexure or remarks so that management is aware of the limitations of the report.

  4. Management reports should be presented in a way understandable to management highlighted vital information in bright and bold fonts or charts.

  5. Sources from where data is taken should be reliable and accurate.

Structure of a management Report

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

  1. Heading slide: This would include the title of the report, the period to which it relates and the preparers’ name and department.

  2. Key highlights: Ideally this should be some graph or chart of crucial ratios on one slide only where the key and most important results are provided in a tabular or graphical format.

  3. Executive Summary: This is a part which is often missed in financial management reports but it a pivotal role where Finance can give their input and play a core role in the company’s success. An executive summary should be a one (or max) two paged slides where the background of the situation, current analysis, and critical recommendations are provided.

  4. Detailed analysis: This would be a significant portion of the presentation and may span over several slides. The information on the detailed analysis should be in a structured format which is easy to read for the management, and it contains key

  5. Conclusion: The key actions which are being recommended to the management to tackle the situation
  6. Footer Slide: This would typically include a closing thank you note slide.

Financial Reporting Vs. Management Reporting

financial-reporting-vs-management-reporting

Conclusion

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

Impairment of Assets

Impairment of Assets

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).

Basics of double entry accounting system

Basics of Double Entry Accounting System

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.

  1. 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

  1. 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

  1. 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

  1. 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

  1. 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.

Comprehensive overview of Depreciation

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

Key Features of depreciation:

Following features will help you understand and grasp the concept:

  • Depreciation is an unavoidable instance and it happens gradually with passage of time for every tangible non-current asset

  • Wear & tear of the asset with passage of time is NOT depreciation.

  • The total value of depreciation over the life of the asset should be matching with 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 exactly same features as depreciation, except 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 very important to understand the
difference between two and use right words for the right situation. To understand the impairment and its key features, read our article on impairment of assets.

Accounting treatment:

This area is dealt by IFRS in IAS 16 “Property, Plant & Equipment” and also in IAS 40, “Investment Property”. 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 asset account for the depreciation charge. This is because depreciation is an
invisible concept which happens with the passage of time and there is no physical reduction in asset’s quantity or volume.

Therefore, expense is debited in the ‘depreciation expense’ account and credit entry is booked in a reserve 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 costed $ 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). This is because asset account of $60,000 shall be netted-off against $20,000 of accumulated depreciation account, resulting in net figure of
$40,000 on the face of statement of financial position (balance sheet).

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? It should 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 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 different type of assets, however, it is upto 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%

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

i)     Product description and warranty period as provided by the supplier

ii)     Past experience of the useful life of similar assets

iii)     Expert advice related to that specific machinery (e.g., An engineer can advise how long a particular machine be used)

iv)     Other companies’ financial statements having similar fixed assets

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

i)     Straight line method of depreciation:

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

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

ii)     Reducing balance method of depreciation:

Let’s take an example of an asset that is used for 5 years but is most productive during initial years andits usability would decrease in subsequent years.In this case, 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 much customers. Therefore, the most suitable methods in this scenarios would be a reducing balance depreciation method.

Tax treatment of depreciation expense In most of the tax jurisdictions, depreciation will be treated as inadmissible expenses because it is a non-cash expenses. 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 is replaced with accounting amounts of depreciation.

ConclusionDepreciation is a key accounting concept which is often misunderstood towards 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 short term. Overall impact, however, remains Nil.

Accounting & Finance Terms

In this article we’ll talk about some basic accounting & finance terms which are used in a routine by accounting and finance professionals. We’ll explain here in brief and simplicity that what is the meaning of these term and how they are used in different context.

Account
An account is opened for each type of assets, liabilities, income, expenses or capital. So that relevant accounting entries can be booked in that account.

Accounting Period
The timeline for which accounts of the entity are prepared is referred to as accounting period.For examples, if an entity prepares its financial statements for 3 months of its operations from 1 Jan to 31 March, then the accounting period would the 3 months ended 31 March 2018.

Accounting system/system
The accounting system is a comprehensive term and sometimes refer to the accounting software used by the company. Accounting system is also referred to as only ‘system’. For example, if you ask a company which accounting system do you have, they may reply with the name of their accounting software like Oracle, PeachTree, QuickBooks, SAP, etc.
However, accounting system is comprehensive term which also refers collectively to books of accounts, ledgers, trial balance, the way entries are posted and approved.

Accrual booking
Recording of expenses in the books for that transactions where supplier has not sent the invoice but expense has been incurred. For example, the accrual is booked for utility payments based on previous months’ bill.

Asset
An asset is a property or item owned by a company. For example, the furniture in the office of a company is its asset (unless it is rented from some other company). Other examples include owned buildings, motor vehicles, computers, machines etc.

Books of Accounts
Nowadays, there are no physical books where accounting transactions are recorded. Almost all the businesses are usually (at least in partially, if not full) 

Capital
Capital is the amount invested by the owner in the business. This amount may be from his own funds (equity) or borrowed from someone (debt). So, capital is equity + debt.

Crediting an account
Crediting an account means that a payable has been recorded in the books. Usually this transaction happens when an invoice or a credit note is received.

Cumulative figures
“The cumulative revenue for March is xxxx…”. Here, in this sentence the cumulative means the revenue from the beginning the of the year till the end of the March.

Debiting an account
Debiting an accounting means that a receivable from that party/account has been recorded in the books.

When Business A sends an invoice to Business B, this means that Business A has debited account of Business B in books of Business A. Similarly, sending a debit note also means that account of the receiver of debit note has been debited.

External financial statements
External financial statements refer to the financial statements which are prepared primarily for external parties like banks, regulators, tax authorities, stock exchange etc. These financial statements are prepared and are usually audited by an external auditor.

Figures
This refers to financial figures or numbers. It’s a broad term in accountancy and may be used to refer any amount, revenue, expense, collection, accrual etc.
The term ‘cumulative’ is contracted with ‘for the month’. For example, “The amount of sales made for the month of March are xxx…”.

Financial performance
Refer toprofitability reported of the entity. Let’s say that a company reported a profit of $ 1 M in a year, then this is the financial performance of that entity.

Financial period
If a company is preparing its financial statements for a period which is less than 12 months, then that period is referred to as financial period. For example, if a company prepares its financial statements for the period from 1 July to 31 December, then this is the financial period of company. However, a financial year may also be referred to as financial period.

Financial Position
A new term has recently replaced ‘balance sheet’ with ‘statement of financial position’. Financial position refers to assets, liabilities and capital of the organization.

Financial results
Refer to income statement and other financial statements of the entity. But the term is more used for the profit of the company, earning per share, dividend per share etc. So disclosing financial results of the entity means that company has made public what was the outcome of the financial year in terms of profitability/loss and where does the company stand in terms of its financial position.

Financial Statements
Refer to a set of the documents containing financial results of the entity. These documents include profit & loss statement, statement of financial position (or balance sheet), statement of cashflows and statement of changes in equity.

Financial Year
A financial year is a twelve-month period for which a company prepares its financial statements and products its financial results. This usually runs from 1 January to 31 December or from 1 July to 30 June. On a rarer level some companies run their financial year from 1 April to 31 March.

Internal financial statements/management accounts
Internal financial statements/management accounts is also a set of financial statements which would usually contain profit & loss account and balance sheet etc. However, these accounts are not shared with external parties. These are prepared for entity’s own use and usually for management reporting. There is no practice of these internal accounts being audited by external auditors.

Liability
A liability is an obligation of an entity to pay money or settle otherwise to someone. For example, if a company has borrowed money from a bank then this bank loan is a liability for the company. Because company has to repay this bank loan.

Monthly closing and Quarterly Closing
Closingof the books of accounts for that month or quarter so that no further entries can be postedin that month or quarter. For example, monthly closing will be done at the end of every month. For example, January’s books will be closed by 31 January. All transactions carried out during January shall be recorded in January’s month. Once January month is closed in accounting software, February month will be opened. From 1 Feb, all transactions shall be recorded in February.
Normally monthly closing is done either last day of the month or in first few days of the next month. For example, January’s books might be closed by second or third of February. This delay is to ensure that all transactions are properly recorded for January and no entry is missed out.

Nominal Accounts
All accounts related toprofit and lossstatement are called nominal accounts i.e., revenue account, material expense account, labour cost account, general expense account, finance cost account etc.

Passing an entry
Whena transaction is recorded in the books of a company, this is done by passing an entry. For example, if a transaction of sale has happened in the entity where 10 units of company’s products are sold for a total consideration of $100. Then an accounting entry shall be passed in the accounting system of the company to record this transaction. The entry is passed by debiting and crediting relevant ledger accounts in the accounting software (assuming that accounting is done in softwares).

Statement of account or account statement
Refers to history of transactions with a particular party. This contains details of all invoices, payments received and the net balance due for a particular period.
This is an important tool for credit control department and for reconciliation of balances between two parties. When Business A wants to know which accounting entries have been passed in books of Business B in the account of Business A, Business A would request Business B to send them a statement of account. This statement of Account which will be generated from the accounting system of Business B and would contain all debits and credits passed in that account.

Year-end closing
When the books of accounts are closed after the accounting year, so that annual financial statements can be prepared and reported, this is called year-end closing. Once year has been closed, it means that no further accounting entry can be passed in that year’s books of accounts.
For example, if a company has an accounting year of 1 Jan to 31 Dec. The year-end closing shall be done usually in early days of January of next year. All the transactions shall be booked in December (or in respective months of that year) and the year shall be closed.