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Accounting for Depreciation

Depreciation is really important yet few bother to do it. Why? because it seems so hard to do.

But the reality is that it is really very simple.

But first we need to look at what it is, and why we need to do it.

The Value Of Assets

Everything you buy to use for your business is an asset. However, over time your assets generally lose value. A computer becomes obsolete, your vehicle’s mileage gets higher and higher and requires more and more spare parts. Something that you bought today, may be cheaper to buy a year from now.

There are many reasons of course. So why do we need to record the change in value to our assets? It is because we must always reflect a true picture of our business.

We may need to do that in order to get a loan, or to show our investors the value of the business as it stands today, or to value the business properly if we are going to sell it.

Depreciation and Tax Liability

There is one more important thing about depreciation. It is a book value item. That is, it has NOTHING whatsoever to do with tax and limiting your liability for it. This is a common misconception.

Inland Revenue services around the world deal with asset depreciation and claiming that depreciation against tax in different ways, but the most common is by giving business owners an allowance.

When you record depreciation, you are doing so only in your books. Never ever think of depreciation as some form of allowance or tax mitigating transaction. You are simply recording what you (or some valuer) really believes the loss (or gain) in value of an asset really is.

This is a good thing. You want your books to reflect reality. In fact you are legally obliged to do so. Before we get into the transactions, here’s one last reason why you must see depreciation and allowances as different things.

In many countries, if a business makes a loss, they can put off an allowance and carry it forward to a future year. So you can get the case where a business has bought, say, a computer for 500 and values it at the end of the year at 300 (if you bought a brand new computer today, how much could you sell it for tomorrow?).

The depreciation on that computer is 40% and that is what you must record in your books (don’t worry the actual transactions are coming shortly). However, your Inland Revenue (IR) service may only let your claim a 25% allowance, so you can see that the balances will already be skewed. But that is how it should be.

A worse case is where you make a loss and decide not to claim that year. In your books the computer will be worth 300 but your IR service will still have it valued at 500. The following year you will depreciate it down to, say, 200 and because you make a profit you will want to claim your 25% allowance of… 500! which is 125.

So now your book value is 200 and the IR have it as 375. The bottom line is, unless you are a tax specialist or you are submitting your own tax returns, you need not be concerned with the IR valuation. You are only concerned with recording a true and fair picture of the value of your business.

Depreciation Transactions

Your chart of accounts should be set up with a group called ‘Fixed Assets’. This is where you add accounts to hold the balance of assets you have bought. Each asset account should have a depreciation account associated with it. This will hold the accumulated depreciation of assets over the years (it is often called ‘Accumulated Depreciation’ for this reason).

To see the value of your assets, subtract the accumulated depreciation from the asset balance.

The reason for keeping both balances is so that you can see at a glance what your assets originally cost you (in case you need to replace them so you get a better idea of the investment needed).

There is one thing missing from this though. Where do we record the other side of the Accumulated Depreciation amount?

The answer is in the Profit and Loss account. You can set up a new group in there specially for it. Let’s call the account This Year’s Depreciation (or even P&L Depreciation to make it clear where it is going).

So make a journal Debiting This Year’s Depreciation and Crediting Accumulated Depreciation.

That’s it. That’s all there is to it.

Using the technique taught in the Accounting for Everyone course, you are simple transferring an amount From Accumulated Depreciation To P&L Depreciation.

If you want to try this out, download the trial of Business Accountz available on Accountz.com and give it a go. Use the Green books (‘transfers’) to do this or use the traditional journal. Remember you can flip between From/To and Credit/Debit in the menu option Tools > Language (choose English – Accountant for the latter).

And if you haven’t done so already, sign up below to start the Accounting for Everyone Online Certified Bookkeeping Course. We go into depreciation in greater detail on the course, including standard ways to depreciate such as straight line depreciation and reducing balance.

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2012 And All That

Another year is upon us and at a time of world recession, you can not do better than being a bookkeeper. The number of new startup businesses is increasing globally because of redundancies and people unwilling to work for others.

The one thing they all have in common is that they don’t want to learn or do bookkeeping. How do I know? Simple, I have trained tens of thousands of people since I first published ‘Accounting For Everyone’ in 1998, and this site is now in the top ten of bookkeeping tuition sites. yet out of a global population approaching 7 billion, only a very very small fraction are interested in the subject.

One of my missions has been to teach people how to make their businesses more successful through understanding accounting and I know from the feedback that it is greatly appreciated, but I also know that most businesses would prefer to pay someone for doing this task. And that is where you come in.

Now, how do you take advantage of this?

The simple answer is to understand marketing. I know from the many business owners I have talked to over the past 32 years that most spend less than 20% of their resources on marketing. And yet, statistics show that the most successful businesses spend upwards of 50%.

So the answer must be to either devote more time or spend more of your resources on marketing. The great thing about bookkeeping though is that once you have a full roster of clients (ie. enough to give you a full time business) then your marketing spend can come down considerably (unless of course your plans are to expand and take on additional bookkeepers).

This is great news for bookkeepers. But it means at the start you must get a grip on how to sell your business and yourself.

So let me introduce you to my other blog at QuentinPain.com. Everything I have ever learnt about running a business is being added to that site. Take a look and leave a comment if you can. I would love your feedback.

Advanced Balance Sheet Theory

If you are not familiar with balance sheets you should take my bookkeeping course first as I don’t want to put anyone off with this article. OK, with the warning out of the way, let’s press on…

With most accounting systems, things like balance sheets are considered as reports. That is, something you need to compile on such and such a date. The same convention also applies to the profit and loss account etc. What very few people realise is that they can all be expressed as accounts. Radical thinking eh!

Balance Sheet as an Account

A balance sheet usually consists of three items:

  1. Assets
  2. Liabilities
  3. Equity

It represents the accounting equation: Assets = Liabilities + Equity (or ALE to help you remember – imagine yourself drinking an ice cold beer on a hot summer’s day whilst entering a journal or two).

The system of double-entry is based (at its simplest level) on two things:

  • Debits
  • Credits

Your debits must equal your credits for everything to balance, hence the name balance sheet. But wait a minute, we are looking at three things on most balance sheets (ALE). How does that work?

  • Assets = Debits
  • Liabilities = Credits
  • Equity = Credits

Hence the accounting equation shown above. This is also why a horizontal balance sheet only shows two sides (you wont see this pattern in a vertically oriented balance sheet).

Profit and Loss as an Account

Let’s take a look at an extended Profit and Loss report:

  • Sales
  • Costs of Sales
  • Expenses
  • Depreciation
  • Taxes

It contains a whole bunch of account groups. But each group consists of accounts with either a debit or a credit balance. When you consolidate those accounts in each group you end up with either a debit or credit balance. Here we go:

  • Sales = Credit
  • Costs of Sales = Debit
  • Expenses = Debit
  • Depreciation = Debit
  • Taxes = Debit

The final balance of the Profit and Loss ‘account’ will be placed in the Equity section of the balance sheet. All your individual liability accounts will be summarised and placed into the Liability section, and all your assets (Bank, Cash, Debtors, Stock etc.) end up being summarised or consolidated into the Assets section.

The pattern is very simple and clear. Whether an account is some individual thing (like Stationery or Bank) or consists of a group of accounts (like Cost of Goods) you can look at them all as examples of ‘accounts’. Go that one step further and consolidate their balances into balance sheet ‘categories’ and you can see the same pattern.

So the result is quite simply that a balance sheet and a profit and loss report is at its core just another account. That is why I talk about the first rule of accounting as ‘everything is an account, and there are  no special cases’. It is wonderfully elegant.

On Journals And Ledgers

It’s been an incredibly busy month here on Accounting for Everyone, with many wonderful new comments on the various weeks course material.

It took me many years to really understand double-entry. I did it by reading all the books I could get my hands on, and talking to thousands of business owners, oh, and the odd accountant here and there 😉

There are so many idiosyncrasies in the jargon of double-entry bookkeeping, and of course different countries are bound to use slightly different terms for the same thing. Let’s take a look at a couple of those.

The Journal

This is a great one. Journal = book = diary = log. I.e. a place to write something down. That’s all. But it used most commonly to describe a specific type of transaction. That is where the confusion comes in. There are no ‘special’ transactions. In just the same way there are no special accounts. All a transaction does is move money around. Period. So a transaction consists of a number of ‘entries’. Each entry affects one account. If an accountant or trained bookkeeper needs to make some correction, they say ‘just journal it’ (or something similar). This raises the ‘journal’ on a pedestal to some new height, but it is not like that. In short, you can ‘journalise’ everything and anything.

It is really understanding terms like this that will make you confident in bookkeeping, and that of course is where my bookkeeping course really hits the target (according to all the comments).

Nominal Ledger

Another great one. In the UK we call it the ‘nominal’ ledger. Everywhere else it is called the ‘general’ ledger. What does it mean? Nothing. A ledger is where you place your accounts. That is all any ledger is. If you group all your customer accounts into one place, then you could name it your ‘Sales  Ledger’. If you are in the US you may want to call it ‘Accounts Receivable’. Whatever you want to label it, they are all the same. A place to store accounts and look up their balances.

There are of course a number of different alternative names used around the world, but the most fundamental are covered in the course. What is important is that whatever something may be called, it does not differ in terms of how it is used in accounting and bookkeeping.

Thank You For Subscribing

I just had to write a thank you note to all my loyal subscribers. Thank you so much for subscribing to Accounting for Everyone. Your comments have been fantastic, and the Facebook recommendations have also been overwhelming. Please do continue to recommend this course as I know it is helping a lot of people understand something that is core to the success of any business.

As global communication and information increases, so it empowers people to take action. This in turn not only drives economies, but gives people the responsibility needed to ensure their lives are, at the very least, interesting. By that I mean, running your own business or taking control of a particular area of a business. Of course, running a business does not necessarily make you immediately happy, but what it does do is give you the tools (and money) to achieve that end more easily.

I would like to find out what proportion of subscribers and visitors to this site are in business already, thinking of starting a business, wanting to help a friend, improving their career prospects, or are simply fascinated by double-entry. So please add your vote to the poll on the right (you can pick more than one answer if it applies). You can also see the results for yourself too.

Thanks again.

Quentin Pain

Happy New Year 2011

We are on the last day of 2010 and for me this year has gone way too fast. I don’t know whether it is simply because I am older – and everyone I know is also a year older! but they all say the same thing. Fast, fast fast!

Luckily in terms of bookkeeping, nothing has changed at all, apart from the fact that ‘modern’ double-entry bookkeeping is now one year older of course. But looked at in the perspective of around 600 years, that is very little indeed.

The recession continues, and pretty much everywhere in the world we are all in the so called ‘austerity’ era! For the poor, it has never gone away. For the rich, it means one less mince pie. For the rest of us, if we have a job, there is not much change really. So my advice for all those weary of the 9-5 working lifestyle… change it starting in 2011.

Start your own business. You will be working much longer hours, but the big difference is that you will be doing it because you want to do it. Once you start you will find it difficult to stop. Be warned about that. As soon as you taste the freedom of running your own business, it becomes an obsession. And that is a good thing.

One vitally important thing you must do is to ensure you surround yourself with enthusiastic and optimistic people. As Tim Smit, the founder of the Eden project in the UK says, get rid of anyone who tells you what you are doing is a waste of time (actually he encourages you to do something much worse with them!). What you are doing is you are doing something for yourself. It is by far the best way to do things. If you get it right, others will follow you. You wont be able to stop them. But you must stay focused. And you must take action.

I have read a number of great books this year. The two I absolutely recommend to anyone are:

1. Dale Carnegie: How to Win Friends and Influence People. If everyone followed his advice, we would all be so much happier with our lives.

2. Drew Whitman: Ca$hvertising. As Lord Sugar said once on The Apprentice: “I have written many books on advertising – most of them cheque books.”. This book explodes the myth of advertising. If you ever need the answer to whether advertising is any good, read this book. Did you know that the only place worth paying a premium for in print advertising is the inside front cover? Forget right hand facing, near content, inside back cover, back cover, they are all pretty much of a muchness. The front inside cover however shows an average 30% increase in response rates. And even that is not great when you think about how much extra you have to pay. As the book says, if what you are selling is not of interest to the audience, you are wasting your money.

So, Market, Media, Message. That is all you need to know. Of all the multiple letter abbreviations (the 7 p’s, the 3 R’s the 101 Z’s etc), this is the only one that really matters.

And finally, for the message itself. Read Dan S Kennedy’s book: The Ultimate Sales Letter.

Good luck and Happy New Year.

Quentin Pain FIAB

Online Filing in the UK

There is a lot of FUD spread by (many) software companies about filing online and that you must have some kind of (ie. their) special software. They are using the oldest marketing trick in the book, fear.

Here’s the reality. There is no law that says you must use software. Until there is, neither HMRC or any other Inland Revenue service can force you to use software to file (or even do) your accounts using a computer. In the UK the majority of accounts are still done on a spreadsheet (last time we did a survey it was around 50%, but as software gets easier that figure will be declining). So, will Microsoft (et al) suddenly release a UK specific HMRC uploader for Excel? Not anytime this side of the next millenium!

When HMRC and other Revenue services say you MUST file online by such and such a date, all they are saying is that you need a computer (your library has one if you don’t) to log in and enter your data via a computer by hand. What they are stopping is the paper format, that is all.

Does anyone remember when HMRC said you could have a tax refund if you filed your PAYE online a few years ago? What happened, some software companies started claiming that if you bought their software you would get a massive rebate (as though it was courtesy of them). They pushed the same FUD that you needed special software to file online too! What a cheek.

Maybe I am cynical, but if there is one thing I have learnt about corporates it is that their marketing departments are kept as far away as possible from development (and reality).