Finance Tips

Financial and Tax Accounting

It is a common misnomer that and organization needs to use the same method of accounting depreciation for financial reporting and tax purposes. An organization must decide if it is cost effective to use more than one depreciation method and furthermore which method or combination of methods to use. Each method carries with it a distinct list of benefits and draw backs and can be customized to fit a company’s unique situation.

There are three main types of depreciation techniques.

Straight-Line – Simplest deprecation technique. A company estimates the salvage value of the item and the usable life. It then subtracts the scrap value from the original cost and divides by the life span in years to get the annual depreciation expense. The largest benefit of this method is that it is very simple to understand and easy to use. A major drawback to this technique is that it does not acquire all the possible tax benefit early in the life cycle, effectively leaving those tax dollars on the table longer.

Double-Declining Balance – This technique factors in the fact that an item is more useful near the time of purchase as opposed to near the end of its life. The organization records a larger expense of depreciation in the first few years and it continues to decline until the scrap value is reached. A major benefit to this method being largely front loaded; where most of the depreciation is taken at the beginning of the life cycle is in reducing the taxable income quickly. This method is more complicated and requires involvement of the technical staff to accurately estimate an items life expectancy. Continue reading ‘Financial And Tax Accounting’ »

The Flaw of Accounts Receivable in Financial Accounting to Non-accountants

In my previous publication, The Unresolved Flaws in Financial Accounting I addressed some of the complex flaws in financial accounting that add to the confusion and frustration non-accountants face in trying to decipher financial reports. This time, I look at accounts receivable.

Accounts receivable is an asset account in a balance sheet. It allows a company to hold revenues and expenses within the period they occur which is a generally accepted accounting principle. This recognizes transactions irrespective of when actual payments take place. What this means is that when a firm sells on account, it considers future payments for its goods and/or services as assets thus increasing revenue.

To a non-accountant investor or stockholder, this recording appears easy to understand on a newly released balance sheet. The truth is that there are other entries that derive from the accounts receivable recording. The net realizable value of this account is the actually amount that the firm expects it will actually receive in payments. Off the back, that means that the amount recorded in accounts receivable though making assets look good will not be actualized. This amount is however an estimate based on previous experiences, trends, and ratios.

The net realizable value creates another account, the allowance for bad debt expense. This account holds the difference between what that actual accounts receivable and the net realizable value. Most firms use an aging method, usually in 30-day blocks to make adjustments to the value of their assets on the balance sheet. These uncollectible payments are described as “contra assets” because they reduce the vale of previously declared assets.

Most non-accountants do not understand the forward and backward entries and adjustments to pages and pages of detail reporting regardless of how many pages of accompanying notes there are. The question becomes, why not subtract the estimated bad debt from the account receivable entry? The problem is that though the firm knows or rightfully estimates that some payments will not be received, it cannot write-off an account unless it specifically knows which accounts will be in default.

The danger with this estimated is that if the allowance for bad debt is under estimates, then accounts receivable and net income will be overstated and returns on investments and equity (ROI and ROE) will be inaccurate. This usually is the case when an entity wants to appear conservative in its estimates of uncollectible debts. Continue reading ‘The Flaw of Accounts Receivable in Financial Accounting to Non-accountants’ »

Congratulations, you just bought a new truck for your landscaping business. You will now be more efficient because you no longer have to travel back and forth to get your tools to the job site. This new asset will take your business to the next level and you can now compete for those large jobs the competition gets every day. The question is, “how do you account for this large expense in your financial statements to your investors and your tax returns?” Depreciation is the accounting tool that allows you to account for the cost of this new asset.

Depreciation is an application of the matching principle. The purchase or buildings and equipment are recorded at their original cost. In our example, the new landscaping truck costs $30K, but the financial benefit from this new vehicle will not be realized until future jobs are earned. Therefore it is necessary to come up with some correlation between this expensive asset and the future economic benefit it brings to the company. Depreciation is that correlation. At face value, some think depreciation is just a recalculation of the new market value of an asset. This is not the case; depreciation applies a portion of that initial expense to the revenue earned for a given period of time. We will explore this relationship and how they are applied through straight-line depreciation and accelerated depreciation.

Straight-line depreciation takes the total cost of an asset, in our case $30K for the new truck, and divides it by the years of life for that asset. The straight-line depreciation method is most often used for reporting to stockholders because in early years it accounts for lower depreciation expense and therefore maximizes the revenue for that period. In our example, the trucks useful life is 10 years so we would take $30K and divide by 10 years to come up with yearly depreciation of $3K. During every fiscal year $3K would be applied to the income statement as an expense and reduce net income by $3K. Continue reading ‘Appreciation for Depreciation’ »

Depreciation and Your Business

Depreciation is the systematic deduction of the worth of assets that are used in production. The assets are the capital investments a company makes to enable production of goods or services. They include equipments and machinery, vehicles, and buildings among others. They are not recorded as expenses. Because these are resources, they are assigned a useful life span. Based on an estimate of the life of an asset minus the salvage value, entities are allowed to distribute the worth of the asset over the period of use of the asset measured in years in most cases. What this means is that at the end of each year, the worth of the asset is deducted because it is no longer expected to as productive as it was at the beginning of the year. There are different methods of depreciation.

Straight-line Depreciation:

The straight-line depreciation method allows entities to calculate the worth of an asset and distribute an even deduction of the amount on a yearly basis over the life of the asset. In this case the cost of the asset minus the estimated salvage value divided by the estimated useful life of the asset. The salvage value is what the asset is expected to fetch when sold at the end of its useful life.

Straight-line depreciation can also be measured in units-of production. In this case, the cost of each unit is calculated and that cost is multiplied by the number of units produced in every given year and that amount is deducted as the depreciated value of the asset. In this case, the cost minus the estimated salvage value divided by the estimated total units to be made.

Accelerated Depreciation:

In the accelerated depreciation method the basic premise consists of depreciating a greater part of the value of the asset in the earlier life of the asset which would be reflected as a greater cost and less income in the financial statement. In this case, either the sum-of-the–years’ digits or the double-declining method is used. In this method, the annual depreciation expense is the cost minus the estimated salvage value and that is multiplied by the remaining life in years divided by the sum-of-the-years’ digits. Continue reading ‘Depreciation and Your Business’ »