There can be lots of things that happen in your business. All of this action feeds into your accounting system. When the time comes, the reports you get from that system need to be useful. This is true both for you and for others that will use these reports. In order for these reports to be useful, you will need to classify your business activity. If classification is done poorly, then your financial reports may actually mislead you. You could also make incorrect statements to tax authorities.
Proper classification will help you at reporting time. If you need to prepare accounts publicly, then accounting standards impose minimum classification requirements. Your tax forms will also require you to break out specific items in your reporting.
At a basic level, things can be classified into five broad groups: assets, liabilities, equity, income and expenses. Within these broad groups, you will need to consider further classification.
Assets are things of durable value. Accounting standards consider assets to be controlled resources that have future economic benefit. This can include lots of different types of things. Cash is an obvious example. This is because you can spend it in the future. This is true also for buildings. They are not as liquid as cash, but there is still future economic benefit. A further example is service prepayments, such as insurance. You are still to receive the benefit of insurance over time, therefore there is a future economic benefit.
Accounting standards and tax authorities generally require you to report current assets. You are likely to need to file/lodge tax returns, therefore you’ll need to know what makes an asset a current asset.
What is a current asset? It is an asset that is or will be liquid (or realized) in the next 12 months. This also includes assets that are going to be “used up” in the next 12 months.
Typical current assets include:
- cash (or cash like)
- trade debtors (accounts receivable)
- other trading assets
Non current assets
Non current assets are any assets that are not current assets. Typical non current assets include:
- investments such as shares and bonds, but not those expiring within 12 months or held for trade
- buildings and leasehold improvements
- office equipment
- motor vehicles
Accounting standards classifications
If you need to make public accounts, there is a minimum level of detail that your classifications must include in addition to current and non-current asset classification. This includes:
- property, plant and equipment: long term assets used in your business
- investment property
- “equity method” investments – examples of this are holding 25% of the shares of a private company
- trade and other receivables
- cash and cash like assets
- other financial assets
- biological assets
- any assets held for sale
US GAAP has a broadly similar list to the above.
Liabilities are obligations or things you owe. They are obligations that involve future economic benefit that you will provide to someone else. Like assets, liabilities also need to be grouped as current liabilities and non-current liabilities. This grouping is based on whether the liability will be payable or “crystallized” in the next 12 months.
Typical current liabilities include:
- trade creditors (accounts payable)
- other payables such as payroll taxes, pension contributions (superannuation), sales taxes or GST/VAT payable
- bank overdrafts: For internal statements, these are often presented as a negative balance on a bank account. When applying accounting principles strictly, they are a current liability, not a negative current asset
- long term loans payable within 12 months
Current liabilities are critical to understand what demands will be placed on business cash flow in the short to medium term. If your business has fewer current assets than current liabilities, or otherwise the current radio is below 1, then you may need to more actively plan how your business will meet its commitments.
Non-current liabilities are any other liabilities after accounting for current liabilities. They include long term loans, notes or bonds. Long term employee liabilities can also be classified this way. Keep in mind if an employee is entitled to leave now, that liability needs to be classified current.
Accounting standards classifications
Again, if you report publicly, there are minimum classifications that apply:
- trade and other payables
- other financial liabilities
- tax liabilities
- long term tax effects (deferred tax assets and liabilities)
In Accounting, equity is what is left over if liabilities are deducted from assets. Essentially, it a “balancing” item. It is what makes a statement of position or assets, liabilities and equity a “balance sheet”. The effect of this is that equity is a representation of the value of the business to the owners of the business.
Equity can be broken down into:
- contributed capital: what has been paid or contributed by the owners of the business
- reserves: equity that has been set aside for various purposes
- revaluations: in some accounting standards, changes in values of certain assets and liabilities are presented here
- retained earnings, or surplus for a not-for-profit. Retained earnings is the accumulation of profit over the life of the business. Any dividends are taken from retained earnings. Retained earnings can be negative if the business loses money. In some jurisdictions, a dividend can only be paid to shareholders if there are sufficient retained earnings
- current year (period) earnings: What the business has made (or lost) in the current year. This is effectively all income for the current year less all current year expenses.
Income is economic gain of your business. In simple terms, consider them cash receipts. However, Accrual accounting gives you a clearer picture of income. This is because it is more focused on economic gain as it occurs, rather than when you receive the money.
Income can be broken down into:
- ordinary sales revenues: revenue received as you go about your business
- gains on disposal of long term assets
- other income: including grants and rebates
Some receipts you receive now for services performed in the future might not be income at all. It is instead “unearned income” which is a type of liability. You can learn more about “unearned income” here.
Expenses are costs to your business. They can be broken down into cost of sales, other variable expenses and fixed expenses.
Cost of sales
A cost of sale is any direct cost associated with selling. If you are selling physical products, then the cost for you buying these products, or manufacturing them is a cost of goods sold. Cost of sales can also incorporate other direct costs, like freight.
Variable expenses are costs, other than cost of sales, that scale with your business. An example is hourly contractors who you use to provide web services to web clients. If you don’t have any work for them, you don’t pay them. The more work you have, the more you pay them. Another example is cloud services. You pay for only what you use. The key point is that you are not committed to variable costs. They scale with your business.
Fixed expenses are costs that you incur, no matter how well your business trades. An example is office leasing expenses. You commit to the lease payments, regardless of what business revenue you receive. A business needs to be well aware of fixed costs. This is because they represent business risk. Lots of fixed expenses with little revenue can send you broke.
If you understand your “contribution” margin: Revenue minus cost of sales and variable expenses, then you will understand how much you need to cover the fixed costs of your business. Revenue minus cost of sales and variable expenses makes a “contribution” to your fixed costs, and any residual after that is your business profit.
Operating a business means you require financial reports. At an absolute minimum you need them to report to tax authorities. In addition, they can be very useful in giving you insight into your business.
In order for you to have useful reports so you do understand your business, and report correctly, you need to be able to correctly classify business activity in your accounts. This requires understanding five broad classification groups: assets, liabilities, equity, income and expenses. Within these broad groups, you will need to consider sub types.