Accounting, Financial, Taxation

Accounting extends into virtually every walk of life. You’re doing accounting when you make entries in your checkbook and when you fill out your income tax return. When you sign a mortgage on your home, you should understand the accounting method the lender uses to calculate the interest amount charged on your loan each period. Individual investors need to understand accounting basics in order to figure their return on invested capital. And it goes without saying that every organization, profit-motivated or not, needs to know how it stands financially.

Here’s a quick sweep to give you an idea of the range of accounting:

1. Accounting for organizations and accounting for individuals
2. Accounting for profit-motivated businesses and accounting for nonprofit organizations (such as hospitals, homeowners’ associations, churches, credit unions, and colleges)
3. Income tax accounting while you’re living and estate tax accounting when you die
4. Accounting for farmers who grow their products, accounting for miners who extract their products from the earth, accounting for producers who manufacture products, and accounting for retailers who sell products that others make
5. Accounting for businesses and professional firms that sell services rather than products, such as the entertainment, transportation, and healthcare industries
6. Past-historical-based accounting and future-forecast-oriented accounting (budgeting and financial planning)
7. Accounting where periodic financial statements are legally mandated (public companies are the primary example) and accounting where such formal accounting reports are not legally required
8. Accounting that adheres to historical cost mainly (businesses) and accounting that records changes in market value (mutual funds, for example)
9. Accounting in the private sector of the economy and accounting in the public (government) sector
10. Accounting for going-concern businesses that will be around for some time and accounting for businesses in bankruptcy that may not be around tomorrow.
11. What else?

Accounting is necessary in a free-market, capitalist economic system. It’s equally necessary in a centralized, government-controlled, socialist economic system. All economic activity requires information. The more developed the economic system, the more the system depends on information. Much of the information comes from the accounting systems used by the businesses, institutions, individuals, and other players in the economic system.

Some of the earliest records of history are the accounts of wealth and trading activity. The need for accounting information was a main incentive in the development of the numbering system we use today. The history of accounting is quite interesting (but beyond the scope of this book). Taking a Peek into the Back Office. Every business and not-for-profit entity needs a reliable bookkeeping system.

Keep in mind that accounting is a much broader term than bookkeeping:

Accounting encompasses the problems in measuring the financial effects of economic activity. Furthermore, accounting includes the function of financial reporting of values and performance measures to those that need the information. Business managers and investors, and many other people, depend on financial reports for information about the performance and condition of the entity.

Bookkeeping refers to the process of accumulating, organizing, storing, and accessing the financial information base of an entity, which is needed for two basic purposes:

1. Facilitating the day-to-day operations of the entity
2. Preparing financial statements, tax returns, and internal reports to managers

Bookkeeping (also called recordkeeping) can be thought of as the financial information infrastructure of an entity. Of course the financial information base should be complete, accurate, and timely. Every recordkeeping system needs quality controls built into it, which are called internal controls or internal accounting controls.

Accountants design the internal controls for the bookkeeping system, which serve to minimize errors in recording the large number of activities that an entity engages in over the period. The internal controls that accountants design are also relied on to detect and deter theft, embezzlement, fraud, and dishonest behavior of all kinds. In accounting, internal controls are the ounce of prevention that is worth a pound of cure.

I have discussed about internal control (financial and operation) a lot. Here (in this post), I want to stress the importance of the bookkeeping system in operating a business or any other entity. These back-office functions are essential for keeping operations running smoothly, efficiently, and without delays and errors. This is a tall order, to say the least.

Most people don’t realize the importance of the accounting department in keeping a business operating without hitches and delays. That’s probably because accountants oversee many of the back-office functions in a business—as opposed to sales, for example, which is front-line activity, out in the open and in the line of fire. Go into any retail store, and you’re in the thick of sales activities. But have you ever seen a company’s accounting department in action?

Folks may not think much about these back-office activities, but they would sure notice if those activities didn’t get done. On payday, a business had better not tell its employees, “Sorry, but the accounting department is running a little late this month; you’ll get your checks later.” And when a customer insists on up-to-date information about how much he or she owes to the business, the accounting department can’t very well say, “Oh, don’t worry, just wait a week or so and we’ll get the information to you then”.

Typically, the accounting department is responsible for the following 5 (five) main areas:

Payroll

The total wages and salaries earned by every employee every pay period, which are called gross wages or gross earnings, have to be calculated. Based on detailed private information in personnel files and earnings-to-date information, the correct amounts of income tax, social security tax, and several other deductions from gross wages have to be determined. Stubs, which report various information to employees each pay period, have to be attached to payroll checks. The total amounts of withheld income tax and social security taxes, plus the employment taxes imposed on the employer, have to be paid to provincial (state) and the national (federal) government agencies on time. Retirement, vacation, sick pay, and other benefits earned by the employees have to be updated every pay period. In short, payroll is a complex and critical function that the accounting department performs. Many businesses outsource payroll functions to companies that specialize in this area.

Cash Collections

All cash received from sales and from all other sources has to be carefully identified and recorded, not only in the cash account but also in the appropriate account for the source of the cash received. The accounting department makes sure that the cash is deposited in the appropriate checking accounts of the business and that an adequate amount of coin and currency is kept on hand for making change for customers. Accountants balance the checkbook of the business and control who has access to incoming cash receipts. (In larger organizations, the treasurer may be responsible for some of these cash flow and cash handling functions).

Cash Payments (disbursements)

In addition to payroll checks, a business writes many other checks during the course of a year — to pay for a wide variety of purchases, to pay property taxes, to pay on loans, and to distribute some of its profit to the owners of the business, for example. The accounting department prepares all these checks for the signatures of the business officers who are authorized to sign checks. The accounting department keeps all the supporting business documents and files to know when the checks should be paid, makes sure that the amount to be paid is correct, and forwards the checks for signature.

Procurement and Inventory

Accounting departments usually are responsible for keeping track of all purchase orders that have been placed for inventory (products to be sold by the business) and all other assets and services that the business buys — from postage stamps to forklifts. A typical business makes many purchases during the course of a year, many of them on credit, which means that the items bought are received today but paid for later. So this area of responsibility includes keeping files on all liabilities that arise from purchases on credit so that cash payments can be processed on time. The accounting department also keeps detailed records on all products held for sale by the business and, when the products are sold, records the cost of the goods sold.

Property Accounting

A typical business owns many different substantial long-term assets called property, plant, and equipment — including office furniture and equipment, retail display cabinets, computers, machinery and tools, vehicles (autos and trucks), buildings, and land. Except for relatively small-cost items, such as screwdrivers and pencil sharpeners, a business maintains detailed records of its property, both for controlling the use of the assets and for determining personal property and real estate taxes. The accounting department keeps these property records.

The accounting department may be assigned other functions as well, but this list gives you a pretty clear idea of the back-office functions that the accounting department performs. Quite literally, a business could not operate if the accounting department did not do these functions efficiently and on time. And to repeat one point: To do these back-office functions well the accounting department must design a good bookkeeping system and make sure that it is accurate, complete, and timely.

This post lists set of ratios and formulas that can be derived primarily from the income statement. There are several that require additional information from the balance sheet, as well as internal information, such as employee headcount, that may not be readily discernible from published financial statements.

The general intent of the analysis tools presented here is to show a company’s ability to sustain its sales, the level of asset and expense usage required to do so, and the sustainability of its current sales and expense levels. There are also specialized ratios that deal with such issues as sales returns, repairs and maintenance, fringe benefits, interest expense, and overhead rates.

Each of the following sections describes the uses of a ratio or formula, explains the proper method of calculation, and gives an example. Each section also discusses how each ratio or formula can be misused, skewed, or incorrectly applied.

The ratios and formulas presented in this post are:

1. Sales to Working Capital Ratio Discretionary Cost Ratio
2. Sales to Fixed Assets Ratio Interest Expense to Debt Ratio
3. Sales to Administrative Expenses Ratio Foreign Exchange Ratios
4. Sales to Equity Ratio Overhead Rate
5. Sales per Person Goodwill to Assets Ratio
6. Sales Backlog Ratio Overhead to Cost of Sales Ratio
7. Sales Returns to Gross Sales Ratio Investment Turnover
8. Repairs and Maintenance Expense to Break-Even Point
9. Fixed Assets Ratio
10. Accumulated Depreciation to Fixed Margin of Safety Assets Ratio
11. Fringe Benefits to Wages and Salaries Tax Rate Percentage Expense
12. Sales Expenses to Sales Ratio

And here is the ratio formulas list:

More measurement ratio formula you may want to know as well:

Operating Performance Measurements (Ratios)

Cash Flow Measurements (Ratios)

Liquidity Measurements (Ratio)

Capital Structure and Solvency Measurements (Ratios)

Return on Investment Measurements (Ratios)

Market Performance Measurements (Ratios)

Measurements and Ratios For Financial and Accounting Department

Measurements and Ratios For Engineering Department

Measurements and Ratios For Logistics Department

Measurements and Ratios For Production Department

Measurements and Ratios For Sales Departments

As real estate projects often span long time periods until their completion, it is of critical importance to evaluate at the outset of a real estate project whether — for cost allocation purposes — a project should be divided into two or more phases. For example: a real estate development company may purchase a large tract of land to be developed over several years; portions of the land will be developed and sold before the project as a whole is completed. If that real estate development project is not divided into phases, the appropriate allocation and monitoring of costs is diffi cult, and project costs relating to the earlier stages of the development may inappropriately be allocated to a later stage, thereby overstating profits in the earlier years. Certain project costs may benefit one individual unit (such as a lot, home, or condominium unit) or a group of units within one phase; other costs may benefit one or more phases of a project or more than one project, such as utilities or access roads. As such, the allocation of costs to individual units, between different phases of one project, or to different projects generally involves several cost pools and multiple steps.

When allocating project costs, one needs to consider costs already incurred, as well as costs to be incurred in current and future periods. For example: in a master - planned community, individual homes are often sold before amenities (for example, golf courses, swimming pools, or parks) have been completed. To appropriately reflect the cost of sales that relates to one individual home sold, a portion of the costs expected to be incurred in future periods for the construction of the amenities must be allocated to that home.

Selecting an appropriate cost allocation method requires judgment. As a general rule, costs should be allocated to the portions of a project that benefit from the costs. The intent is to achieve a constant gross margin on sales for the project, irrespective of the point in time sales occur. FASB Statement No. 67 outlines three different ways to allocate costs:

1. Specific identification method
2. Relative value method
3. Area methods or other value methods

Specific Identification Method

Where practicable, the costs of a real estate project are assigned to individual components of a project based on specific identification. The specific identification method is most frequently used for “the allocation of acquisition costs and direct construction costs in small projects“. For example: costs charged by a contractor to install a staircase in a new home directly relate to that home. The amount invoiced by the contractor should be included in the cost basis of that home.

Relative Value Method

If specific identification is not feasible or is impracticable, as is the case for indirect costs or common costs, costs should be allocated based on the relative value of the components, if possible. Under this method, costs are allocated based on the relative fair values of the individual components of a project, based on either “Allocation Based on Relative Fair Value before Construction“. Land costs and all other common costs incurred before construction occurs (including the costs of any amenities) are allocated to the land parcels benefited, with cost allocation based on the relative fair value before construction. For example: a developer that purchases a tract of land on which to build a master planned community, a shopping center, and an office building would allocate the cost of the land based on estimates of the relative fair value of the land parcels of (1) the master - planned community, (2) the shopping center, and (3) the office building, prior to the construction of the structures. A cost allocation based on the size of the parcels would not reflect any differences in values and is generally not considered appropriate. Unusable land and land that is donated to municipalities or other governmental agencies that will benefit the project are allocated as common costs of the project.

Allocation Based on the Relative Sales Value of the Units. Under the relative value method, construction costs for a project, such as a condominium complex, are allocated to the individual units (for example, homes, condominium units) based on the relative sales value of the units. 56 When allocating costs based on the relative value method, the sales values of the units must be comparable. This is achieved by assuming that all of the units will be completed and ready for sale at the same point in time; any expected price increases for units that will be completed in future periods are not taken into consideration.

The relative sales value method results in allocating greater costs to more valuable components of a project. In practice, the relative value method is often implemented through the application of a “gross profit method“. Under the gross profit method, a cost - of - sales percentage is calculated by dividing the sum of capitalized project costs and project costs to be incurred in the current and future periods by the estimated sales value of the unsold units. When a unit is sold, the cost - of - sales amount attributable to that sale is determined by multiplying the sales value of that unit by the cost - of - sales percentage.

Area Methods Or Other Value Methods

If the relative value method cannot be applied, as would be the case if a real estate development company has not determined the ultimate use of the land, another method for cost allocation has to be used. FASB Statement No. 67 suggests the use of the area method, such as the allocation of costs to parcels based on square footage, or “another reasonable value method”.

Under the area method, costs are allocated based on lot sizes, the square footage of a structure, or the number of units in a development. The use of the area method is appropriate only if the allocation is not materially different from an allocation that is based on relative value methods, or if the application of the relative value method is impracticable.

Cost Allocation Case Example

Developers C purchases land for $10 million, which it intends to divide into three parcels. On Parcel 1, which is along the highway, it plans to construct a shopping center. On Parcel 2, which is behind the shopping center, C plans on building a row of 40 townhouses. Parcel 3 will be developed into a master-planned community. The fair value of the land before construction has been determined to be $4 million, $1 million and $5 million for parcels 1, 2, and 3, respectively. The sales prices for the shopping center, the town houses, and the master-planned community are estimated to amount to $40 million, $12 million, and $100 million. How much land cost should be allocated to Townhouse Unit 1, which has an estimated sales price of $500,000?

The first step is to allocate the cost of the land to the individual parcels based on the relative fair value before construction; accordingly, an amount of $1 million is allocated to Parcel 2. The land value allocated to the parcel on which townhouses are to be constructed then becomes part of the common cost pool for the townhouse, which is allocated to each townhouse based on its relative sales value. As such, Townhouse Unit 1 will be allocated land costs of $41,667. That amount is calculated as follows:

The sales value of Townhouse Unit 1 divided by the sales value of all Townhouses, multiplied by the cost of land allocated to the townhouse development: $0.5 million/$12 million multiplied by $1 million.

The allocation of costs needs to be reviewed every reporting period to ensure that changes in circumstances, such as a change in estimate of project costs or sales prices or in the design of the project, are taken into consideration. Cost reallocations within or between phases of a project are not uncommon, as the design of a project may evolve.