Accounting standards are essential to ensure that financial information is presented as being true, fair and accurate to the users of financial statements. Do I hear you ask “What is the accounting standard that is used today?”
The answer simply is there are a few standards we accountants pay attention to. Don’t despair as most of these standards follow in the footsteps of each other meaning they have the same goal of reporting accurate accounts. However it would be good practice to understand the different accounting standards.
There are two different views to accounting standards. One view is that standards should be based on a principle view and the other view is it should be a rule based standard. This rule based system is used in the USA. While a more principle based system is used in Europe.
Users of financial statements need these standards to compare figures from year to year.
The Conceptual Framework
The conceptual framework forms a reference point for financial reporting which relies on generally accepted theoretical principles. With the framework to guide accountants, tackling difficult events such as how to treat a peculiar asset or other dealings can be referred to the framework.
One advantage to this framework is that in some countries tackle issues by dealing with them as they occur rather than having principles to guide them. With having no framework there tends to be contradictions if using a fire fighting policy.
Check out this video link to learn more about the conceptual framework:
Lesson FA-10-010 - Clip 01 - The Conceptual Framework of Accounting (13:04)
Generally Accepted Accounting Principles. GAAP indicates all the rules from whatever source that preside over accounting. GAAP requires a continuous examination of its principles due to the changing business environment. For instance if there was a brand new accounting treatment for a particular asset or liability, would this new treatment go under the term “generally accepted”?.
However to not take the actual title of GAAP too literally. Look at the title as accounting techniques that are allowed and used in today’s world.
To find out about the future of Irish GAAP check out this link:
The International Accounting Standard Board. This is an independent accountant standard setter. It has the responsibility for setting a benchmark for accounting standards.
Their objective is to produce high quality accounting standards that are seen to be in the public interest. The IASB also promote the use of these standards.
The IASB is made up of 15 members whose backgrounds include being auditors, accountants and users of financial statements.
Financial Accounting Standard Board. This standard is used in the USA. This standard is different to those above as this relies on using a rule based system rather than a principle based system. It is made up of seven accounting professionals. FASB sets up standards of financial reports and accounting practises that are in the public interest. There objective is to also promote the accounting standards and produce high quality financial statements. FASB tries to improve the understanding of financial reports.
We move on to the concept of
depreciation. “What is that?” I hear you ask. To put it simply it is certain
amount of value that is deducted of a particular asset over a period of time.
There are various ways of
depreciation depending on the type of asset, company policy or which shows the
true value of the asset.
Whichever method is chosen it is
best to stick to one type of method rather than changing from year to year. If
this was done the assets would not be shown as their true value and it could be
seen as a company messing with its books.
Depreciation of an asset is recorded
as an expense in the income statement. It is also known as a misusing of an asset. It will also be seen in the
capital assets section of a balance sheet where it is taken away from the
original value of the asset. This will accumulate over a period of time.
This is known as accumulated deprecation.
Depreciation is
used to show the true and fair value of an asset as it is used over a period of
time. For instance a car that was bought in 2011 won’t have the same value in
2012 due to the car been used. It is not the same worth because it is not new
not worn and cleaner.
Straight line Depreciation
This method works by talking an equal amount of an asset over its useful economic life and charging it in the income statement as an expense. It is also the most used type of deprecation method. This states that the same value will be taken of the assets every year. This is calculated by dividing the asset by its useful economic life.
Let's see an example to understand how it works.
A company called Dall decides to by a new lorry. It cost €60,000 and had an expected useful life of 20 years. The company decides to use straight line deprecation for the lorry. The depreciation is calculated by dividing €60,000 by 20 years. This means the company will take €3000 of value of the lorry. Next year the starting value of the lorry will be valued at €57,000.
The accumulated depreciation will be €6000 in the balance sheet at the end of year 2. This will be done again and again until the end of the assets useful life.
With certain assets there will be a residue value at the end of its useful life. The asset will either be sold for this value or kept on after its useful life.
Check out this link to learn more about straight line deprecation:
The reducing balance depreciation is also a popular method but not as used as straight line depreciation. This is also known as the diminishing balance method. It works by a certain percentage of the book value of the assets is written off. This will mean that in the income statement will have a larger figure for depreciation for year 1 but will get progressively smaller each year.
So let's see an example of this method.
The company Fonta, decides to buy a new company car that is expected to
last for 15 years in 2012. They use the reducing balance method which will
deprecate the car’s value by 15% depreciation each year. 15% of €15,000 is €2750. The
company will take this away from €15,000 and the car’s value is €12750 for
2013.
Check out this link to learn more about the reducing balance method:
This method is not as popular as the methods above. It calculates
deprecation by adding up all its expected useful years and whatever years it
has left it is multiplied by the value of the asset by the year over the total expected
useful years. This seems a tad confusing. Let’s see an example which will help
make it clearer.
The company 7ap buy a car for €12,000. They decide to use the sum of
digits method for its depreciation. The car has an expected life of 10 years. So
we add the individual years as so. 10 + 9 + 8 + 7..... + 1. The answer is 55.
So for the first years of deprecation it works as follows:
€12000 X 10 years = €2818.81
55
€12,000 X 9
years = €1963.63
55
And so on until the company gets to year 1. To do it manually it is time consuming and is one reason why it is not a popular form of deprecation.
To learn more about this method of depreciation check out this video:
I see you starting to ask yourself “What is the meaning of Assets, Liabilities, Debtors, Creditors andCapital, I don’t know any of these!?”
Yes these terms to the unfamiliar eye can look daunting but do not worry they are relatively simple to understand.
The picture above gives a good example of assets and the liabilities they accrue.
What is an Asset?
An asset is something that is controlled by an entity where the entity expects to receive resources such as financial benefits in the future. There are two types of assets fixed and current assets.
Fixed assets are also known as non-current-assets. They cannot be easily be converted into cash. They are usually held for long term purposes of greater than 5 years. Examples of fixed assets include Machinery, Inventories, Motor Vehicles, Land or Buildings.
Current assets are held for a short period of time. They are used to pay of small debts or liabilities of the company. They can also be easily be converted into cash. Examples include cash, prepaid expenses and stock. These examples are the main type of assets, as you continue your study of accounting you will see many more types of assets.
§Assets can be found in the Statement of Financial Position i.e. The Balance Sheet. Assets are something the entity has at the end of the accounting period.
§They are not found in the Income Statement.
§ Assets are also on the debit side of the accounts.
§Can you name other types of assets?
To learn more about assets in accounting check out this link:
A liability is a debt where an entity has to pay for. These liabilities arise from past events. There are also two types of liabilities fixed and current liabilities.
Current liabilities are debts that must be aid within a year usually. Examples of current liabilities include Bank Overdraft, unpaid phone bill and loans.
Fixed liabilities are debts that a company owns that are greater than one year. Examples of fixed liabilities include debentures, mortgages and long term loans. They are also known as long term liabilities.
§Liabilities are something the entity has at the end of the accounting period.
§As well as assets, liabilities can be found in The Balance Sheet and not in the Income Statement.
§Liabilities are also on the credit side of the accounts.
§Can you name other types of liabilities?
To learn more about liabilities in accounting check out this link:
A debtor is an entity who owes economic resources to the firm or a person for goods or services.
So for example a Furniture company OKEA Ltd. Has sold goods of €1000 to a customer and you give them 30 days credit. This means OKEA might not get paid for 30 days. This customer will be known a debtor or trade debtor.
Check out this link to understand more about debtors and creditors:
A creditor is where you or your company owe money for goods or services.
We can use the example furniture firm of OKEA Ltd. OKEA has electrical bills of €2000 for the month. Their electric company says they can pay the bill in a 30 days’ time. OKEA will be known a s a creditor or a trade creditor.
For a further explanation of creditiors check out this website:
When running a business
it is best to know how the business is performing from year to year. For
example, is profit up from last year? Can the firm support the interest from
loans? Or does the company have enough cash?
To analyse the
performance of the business we accountants must interpret accounts. This is
extremely useful to understand financial statements of a business.
“So how do we analyse
the business?”
A very good question!
We do this by looking at the businesses accounts through 4 aspects. They are as
follows:
Liquidity: This
highlights if the company has enough liquid resources or in other words cash to
pay off bills creditors etc.
Profitability:
Highlights the earnings or profit compared to expenses over a certain period of
time i.e. usually a year.
Efficiency: Highlights how well a company can perform in
regards to use of assets.
Liquidity
Current Ratio: Current
Assets: Current Liabilities
This ratio determines
if a firm can pay its liabilities. A ratio of 2:1 is an average for most
industries. This shows that a company has twice as many assets as to
liabilities. For example, Mazon Ltd. has current assets worth €1000. They also
have current liabilities of €800. If we use the current ratio asset we get.
1000: 800
1.25:1
While it is not the
preferred ratio of 2:1, the company still has more assets than liabilities and
is in relatively good health.
Quick (Acid Test) Ratio
Current Assets
(-Inventory): Current Liabilities
This ratio determines
if a firm can pay its liabilities without the inventory within the other
current assets. As stated above an average of 2:1 is highly desired however it
will be very difficult to achieve without inventories within the current
assets. Lets’ use the example again of Mazon Ltd. They have current assets of
€1000 inventories worth €100 and current liabilities of €800. This is what
would happen if used the acid test ratio.
1000 (-100): 800
900:800
1.125:1
While the company does
not have liquidity, it is perilously close to having some problems. The company
might have to look at ways to improve this ratio quickly.
Days Receivables
Outstanding Receivables X 365
Sales
This ratio deals with
the number of days that a business takes to gather revenue after the sale has
been completed. If a company has a high number of days to collect its income it
might mean it is giving too much credit to its customers. While if a company
has a low number of days to collect its income meaning they collect their
income faster. We use the number 365 for the amount of days in one year.
For example our friends
at Mazon Ltd have sales of €5000 for year. The company has receivables of
€1000.
1000 X
365 = 73 days
5000
This means that the
company will collect its receivables in 73 days. This might be seen as been too high for some
industries where the industry average is 30 days. The answer here might be due
to poor management of funds or with a recession on it is more difficult to
collect the revenue of customers.
Days
Payables Outstanding Payables
X 365
Purchases
This ratio deals with
the number of days that a business takes to pay its creditors after the
purchases has been completed. If a company has a high number of days to pay its
creditors this might mean the company have problems with liquidity or poor
management of funds. While if the company has a low number of days to pay its
creditors the company has enough resources and management of funds is very
efficient.
For example our friends
at Mazon Ltd have purchases of €4000 for year. The company has payables of
€2000.
2000
X 365 = 182.5 days = 183 days
4000
This means that the
company pays its creditors on average 183 days. This might be seen as been very
high for some industries where the industry average is 30 days. The answer here
might be due to poor management of funds again or with a recession on it is
more difficult to pay the bill of creditors.
Days
Holding of Inventory Inventory
X 365
Cost of Goods Sold
This
ratio deals with the number of days it takes to convert inventory into sales.
If the number is high it might mean there is a slowdown in trading. Or that the
company is holding onto too much inventory.
For
example Mazon Ltd. has sales for the year of €5000. The company also has
inventory worth €800.
800 X 365 = 58.4 days = 58
days.
5000
From this example we see that the company holds onto stock for 58 days. The average will depend on what industry the company is in and its competitors average as well.
To learn more about liquidity ratios check out this video:
Operating Profit
Percentage Operating
Profit X 100
Sales
This ratio calculates
the amount of sales that end up as operating profit. The ratio shows how
efficient the company converts sales into operating profit.
For example Bbay Ltd.
had sales for the year were €15,000. The operating profit was €3000. (The
operating profit is before interest and taxes).
3000
X 100 = 20%
15000 1
We see the company has
a 20% operating profit percentage. The higher the percentage highlights that
the company is controlling costs. This can also highlight that the company is
making higher sales faster than its costs. Generally the higher the percentage
the better the position the company is in.
Gross Profit Percentage Gross
Profit X 100
Sales
This ratio calculates
the amount of sales that end up as gross profit. The ratio shows how efficient
the company converts sales into gross profit.
For example Bbay Ltd.
had sales for the year were €15,000. The gross profit was €8000.
8000
X 100 = 53.33%
15000 1
The gross profit
percentage is 53.33%. Generally the higher gross profit percentage the better.
As we see the company has a high gross profit percentage which indicates that
it is converting sales into gross profit very effectively.
Mark Up Gross
Profit X 100
Cost of Sales
This ratio is the gross
profit i.e. mark-up divided the total cost i.e. cost of sales. It is the total
amount added to the cost to determine the sales price.
For example Asons Ltd.
costs of sales were €10000 and gross profit was €5000. Calculate the mark up.
5000 X 100 = 50%
10000 1
Thus he makes an 50%
mark up on their cost of goods sold. This type of formula is frequently used in
retail industry.
To see more examples of profitability check out this video:
For starters, working
capital is the money that is used for the day to day running of the company. It
is calculated by current assets less current liabilities. This ratio measures
how well working capital is used to generate sales for the company.
For example, Woods plc
have current liabilities of €10,000, current assets of € 12,000. Sales for the
company were €20,000 for the year. Working capital is €2,000. (Remember the
formula for calculating working capital).
20,000 = 10
times
2000
This means that the
company uses €2,000 of working capital to generate sales of €20,000 10 times
over. Generally the higher the working capital turnover the better because it
means the company generates a lot of sales relative to its working capital.
Usage of Non Current
Assets Sales
Non Current Assets
This ratio determines
how a company generates sales from its non-current assets i.e. fixed assets.
Examples of fixed assets include plant, machinery, equipment, etc.
Let’s take an example.
Boods plc has €50,000 worth of fixed assets. Sales for the year were €20,000.
80000 = 1.6
times
50000
As we see here the
company usage of non-current assets has a turnover of 1.6 times. This means
that the company has the ability to generate sales for fixed assets by 1.6 times.
As stated from the previous formula the higher the turnover the better.
Usage
of Assets
Sales
Total Capital Employed
This
is a measure of how much sales are generate from total amount of assets
employed by the business. Total capital employed is total assets minus total
liabilities.
For
instance Goods ltd has sales of €40,000 for the year and total capital employed
is €20,000. Now for the formula
40,000 = 2
times
20,000
Thus for every 1 euro
the company has of total capital employed it generates 2 times of that worth of
sales. The higher turnover figures the better.
Inventory
Turnover Cost of Goods Sold
Inventory
This
ratio deals with what is the relationship of money tied up in stock. Is it too
much or too little? In other words how effective can a company convert
inventory into sales.
For
example Doods Ltd. cost of goods sold for the year was €20,000. Inventory was
worth € 12,000.
20,000
= 1.67 times
12,000
This turnover
figure here is the number of times that inventory that has been sold for the
year. A low turnover means that there are bad sales and there is too much
inventory. While a high turnover means that the there could be strong sales or
poor management of buying.
