When it comes to my financial statements, what is “real”?

This question came from the Executive Director of a small organization – and she asked it repeatedly, with a great deal of very genuine concern! The issue, it seems – and this is a common concern for non-financial folks – was understanding the nature of accrual accounting.

“Real,” in her terms, meant that money had changed hands. Even in the days of electronic transfers, cash in the bank still feels indisputably legit and tangible! However, non-cash transactions can be just as “real” as those involving money. For example, they may record agreements or management estimates that provide the basis for measuring financial results.

Accounts receivable and grants receivable are amounts owed to you by clients/customers and funders. A state of obligation exists when you have delivered work, and the promised payment is due. This state of obligation felt real to the Executive Director, because she was well aware of the costs her organization had incurred, and the urgency of collecting the receivable amounts.

By the same token, accounts payable were not questioned: the state of obligation between the organization and its suppliers was evident, because the organization had received goods or services for which it hadn’t yet paid, and the invoices were sitting in the “bills to be paid” file.

Prepaid expenses and deferred revenues posed a challenge. In both of these cases, money actually has changed hands – but those transactions are not recorded on the income statement as expenses and revenues; rather, they are recorded on the balance sheet as assets and liabilities (respectively). Eventually, when the obligations are satisfied, these items will be recognized as expenses and revenues. Read on…

A prepaid expense item is an asset – something you own. It arises when you have paid for goods or services ahead of time. A classic example would be a rent deposit. Often, when a lease is signed, the lessee must pay “first and last.” Obviously, you receive the first month of your tenancy right away. However, you have paid up-front for the last month on your lease, and you won’t receive that service for a period of years. You own the right to receive it, because you have prepaid it… and the landlord is effectively in your debt for that month of occupancy.

When the last month rolls around, the landlord provides the month of occupancy. At that point, the organization no longer has an asset, because it has collected on the obligation. In the accounting records, the asset must be removed – and the rent expense can be officially recognized. Note that the last month’s rent eventually does appear as an expense, but not until it’s being used. In that last month, it’s a non-cash expense item; the cash changed hands back when the lease was signed.

A deferred revenue item is a liability – something you owe. It arises when someone else has prepaid you for goods or services that you have not yet delivered. A classic example from the performing arts is a subscription. Many organizations run intensive campaigns during the spring and summer to sell subscription packages for the next fall/winter series of shows. At the point when the subscriber pays, they have a promise from the organization, but they won’t enjoy the concerts or plays for months down the road. The organization owes the subscriber those shows.

When the organization delivers its performances, it discharges its liability. In the accounting records, the liability must be removed – and the ticket sales revenue can be officially recognized. Thus, eventually those subscription packages do turn into revenue, but as a non-cash revenue item; the cash changed hands back when the subscriber made the purchase.

The depreciation of capital assets can also cause confusion. A capital asset is an item of significant value that an organization will own for a period longer than a year, and use in carrying out its operations. Depreciation (or amortization) is the process by which the cost of that asset is spread over the years of ownership. Please look to these further questions and answers that present the process in detail:

For our purposes here, the important thing to understand is that the asset (usually) must be paid for when it is bought. Each year’s depreciation is a non-cash expense item, representing that year’s estimated share of the cost.

One of the purposes of accounting is to measure the expenses and revenues associated with each year of operations, regardless of when money changes hands. As you can see, items may be paid for either before delivery or afterwards. The exchange of cash does not create the revenue or expense: rather, the usage of the goods or services in the course of operations. Balance sheet accounts are used to “park” or accrue items so that they can be properly recognized in the correct operating year. Non-cash revenues and expenses can be just as real as those paid “cash on the barrel head.”

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I received a grant to help with my capital asset purchases. My bookkeeper says this is a liability. How does this make sense?

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Your bookkeeper is correct. But, before you try to come to grips with the treatment of the capital grant, it will help if you review the depreciation of capital assets, explained in this FAQ.

Donations to a capital campaign (e.g. from individuals and businesses) are treated in the same way as grants (e.g. from foundations and governments).

Your funders and donors have provided money that is intended to benefit your organization over the life of the capital purchases. In the same way that the cost of a capital asset is spread over the years of ownership, the benefits of a capital grant must be spread over the same years, using the same technique.

A typical name for this item is “Deferred Contributions for Capital Assets,” and it appears with other deferred revenues in the liability section of the balance sheet.

You should discuss your organization’s capital policies with your accountant, to make sure they are appropriate to your particular situation.

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Does an audit mean that my statements are correct?

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Auditors are engaged to express an opinion on the quality of your financial statements. A typical positive audit opinion will say that your statements present your financial position “fairly, in all material respects.”

This isn’t the same as being free from error!

Straight from the CICA Handbook (Canadian Institute of Chartered Accountants): “An item of information, or an aggregate of items, is material if it is probable that its omission or misstatement would influence or change a decision.”

As part of their audit, your accountant makes a determination on what amount is material for your organization. They assess any errors they identify relative to this materiality threshold. Thus, they may pass small errors without making corrections.

This would be a good point to discuss with your auditor, so that you understand their process around addressing any bookkeeping errors they find.

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How can I know for sure what’s in the bank? The bank statement isn’t the same as my books…

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It’s typical for the bank statement to show a different month-end balance from your general ledger.

Now that online access to banking records is so prevalent, it’s easier to keep track of the differences. However, they still exist, and you need to understand why.

For one thing, you need to pick up bank charges and any interest earned. For another, there may be errors to deal with – yours or the bank’s – which must be identified and corrected by comparing the two sets of records. Finally – and most significantly – there are timing differences between when you initiate a transaction and when the bank sees it.

Your books record payments and deposits in the order in which you issue them. The bank’s records will also contain these amounts – but in the order in which they were presented at the bank. That might be quite a different thing!

Let’s say you issued a batch of cheques dated on the 25th of the month. Getting them signed and into the mail took a couple of days. Some payees may have received and banked their cheques before the 30th, but others won’t cash them till the new month. As far as your books are concerned, these cheques are all current month items – but from the bank’s point of view, some belong to this month and some to next.

Therefore, at the end of this month, the bank will have a higher balance than your books, because the bank doesn’t know what cheques may be in transit.

As this example demonstrates, it’s very important for you to keep your bookkeeping up to date, and use your balance rather than the bank’s. Once you’ve issued a payment, you need to assume the money is gone, even if it hasn’t cleared from your account. You don’t want to try spending the same money twice!

The same problem can happen with other transactions. The deposit you made at the ATM on Friday may not be processed by the bank until Monday. The online purchase you made, or the online donation that a supporter made from their home may be logged on your system today, but may not arrive in the bank’s records until tomorrow.

The tool that you need to understand is the bank reconciliation. It is the document that proves your bookkeeper has compared your general ledger to the bank statement, and identified all problems and timing differences to the penny. If you put your general ledger at your right hand, the bank statement at your left hand, and the bank rec document in the middle, you should be able to see your balance, the bank’s balance, and an itemized explanation of any differences.

How can I tell whether my accounting reports are correct?

This can be a perplexing question when you’re relying on the services of bookkeepers and accountants, but you don’t entirely understand what they do.

Here are a few ideas that may help:

Revenue and expense allocations are pretty much up to you, the manager. Do you want a single expense account for Salaries? That’s entirely correct. Would you prefer to have a separate expense account for each salaried position? That’s also correct. Do you want one account for Office Overhead? Not a problem. Would you prefer to have a series of accounts to distinguish amongst various supplies, phone, insurance, etc.? Also entirely acceptable.

Management (perhaps with input as appropriate from your Treasurer, Board, accountant, bookkeeper, staff) needs to decide what level of detail works best for your organization’s situation. Once you’ve established a set of revenue and expense accounts, it’s important to confirm on a regular basis that transactions are being allocated to the right place. Many accounting software packages provide detailed reports that allow you quite easily to scan the contents of these accounts for misplaced items.

Your cash resources – contained in your bank and investment accounts – are the lifeblood of your organization. It’s important to know how much money is readily available to your day to day operations. See our FAQ on how to tell for sure what’s in the bank.

Knowing who owes you money, how much, and since when, is very important. Most accounting software will produce a “customer aging” report that contains this information. (See the glossary for a definition.)

In the same way, you need to be able to review your list of payables, itemizing the suppliers to whom you owe money, how much and since when. On most software, a “vendor aging” report provides this detail.

Beyond that, if your bookkeeper is on their game, they will be able to provide an explanation of the contents of each account, and to pull out documentation from the files that substantiates the amounts. If your organization is audited, your chartered accountant will also be able to provide these explanations, as at your fiscal year-end. If these folks can’t provide a satisfying explanation, you need to challenge them! They should be able to help you understand your accounts, and justify that each balance is properly stated.

I discarded my capital asset before it was fully depreciated. Now what?

When you purchase a capital asset, you need to estimate what its useful life will be. The key word, here, is estimate. You don’t know at the outset what will happen… what will turn out to be a lemon, what will break, or what will (amazingly) last years longer than you anticipated. You also don’t know what advances will come along, that may make it more economical to replace something early than to use it ‘till it wears out.

If you discard something earlier than expected, then the year of disposal must take all remaining undepreciated cost.

This makes sense: the mechanism of depreciation is intended to spread the cost of an asset fairly over the years of ownership. If you dispose of an item early, then your accounting records must show that the asset is gone. The only way to do this is to take the expense.

Managing the journal entries around discarding capital assets is a good topic of discussion with your accountant. You need to follow your organization’s accounting policies, and make sure you’re recognizing the expense correctly.