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.

I’m still using a capital asset that has been fully depreciated. Is this ok?

That’s good news!

Capitalizing and depreciating (or amortizing) major purchases allows you to spread out expense over estimated useful life. When you buy a new asset, you have no way of knowing how it will perform. You might find yourself discarding some purchases early – and you might own others for longer than you had expected.

If you wind up using your asset after it has been fully depreciated, then those extra years of useful life get a “free ride,” from the viewpoint of expense.

Remember, the function of depreciation is to spread the purchase price over an estimated time span. Once the original cost has been fully expensed, that’s it!

It’s important to make sure that you are depreciating your capital assets over a reasonable time frame. Be sure to discuss capitalization and depreciation policies with your accountant, to confirm that you’re following methods that work for your organization and its belongings.

I know that my capital assets are worth more (or less) than my financial statements show. What’s with that?

Accounting does not attempt to reflect the market value of your assets. Your accounting statements reflect the cost of purchase.

The process of capitalizing and depreciating (or amortizing) major purchases allows the cost to be shared over the years of useful life. You can see other FAQs on aspects of this process:

It’s also true that the capital assets on your balance sheet indicate the investment your organization has made into significant purchases that support and enable your operations. It’s important to declare that you’ve purchased sufficient equipment to allow staff to carry out their work, and that you own a building, or have invested in renovations to improve the property that you lease.

Indeed, in the commercial world (not so much in the not-for-profit) companies calculate “return on assets” as a measurement of their productivity and success.

However, consider how hard it would be to show market (or resale) value.

You may just have bought a nice, state of the art computer for $1500 – but the moment you take it out of the box, it’s used equipment. You may not even have plugged it in – but you couldn’t expect to get $1500 if you tried to resell it. After you’ve used it for a year, how much would it be worth as a second-hand machine? And yet, as far as your organization is concerned, it’s still a useful and functional item in the office.

If that’s the case with equipment, which wears out and becomes obsolete, you can imagine that dealing with real estate – where market values can float up and down over time – would be much more complex.

To create meaningful financial statements, it’s essential to have a constant unit of measurement. Generally Accepted Accounting Principles (GAAP) recognize this through the Stable Dollar Concept, which assumes that the purchasing power of a dollar remains unchanged over time. This allows us to make reasonable comparisons between fiscal years.

That said, there are circumstances where it is permissible to “write up” or “write down” an asset to reflect a permanent change in its value. Your accountant can advise whether this pertains to your organization.

I just bought a computer. Why doesn’t it show up as an expense?

Of course, major purchases such as equipment most definitely are major costs to your organization! The short story is that it does show up as an expense. The longer story involves explaining how that happens.

Accounting makes a distinction between day-to-day operational costs – treated as expenses – and major purchases – treated as capital assets.

Anything treated as an expense is of minor value, and is generally consumed within a year. By contrast, capital assets (also known as fixed assets) cost a significant amount of money, last longer than a year, and are instrumental in carrying out your daily operations.

Buildings and equipment are the most typical examples. Major renovations (as opposed to maintenance work) are also treated as capital assets. Computer software and websites may also be capitalized, depending on their scope.

When an item is capitalized, the purchase cost is recorded in the assets section of the balance sheet. It moves gradually into the expense stream over a period of years, through the mechanism of depreciation (also known as amortization).

A key aspect of managing capital assets is estimating their useful life. Computers and other office equipment are often estimated to last five years. Vehicles are often depreciated over five years, office furniture and fixtures over seven years, and buildings over 40 years. These may be common periods, but you and your accountant need to discuss what makes sense for your organization and its belongings.

Once you’ve estimated useful life, you and your accountant need to select a method of depreciation. The simplest – and one that is commonly used in the not-for-profit sector – is straight-line depreciation.

If you estimate that you’re going to get five years out of your computer before you need to replace it, you divide the purchase cost by five. This year, you will see one-fifth of the cost of the computer in your expenses – and the same over the next four years.

Why is it done this way? An intuitive way to grab hold of the accounting theory might be to imagine it as a question of fairness. It wouldn’t be fair to charge this year’s bottom line with the full burden of a five-year purchase. Nor would it be fair to give the next four years a “free ride” in terms of computer cost. Depreciation allows the price of the computer to be spread fairly over the years of ownership.

I bought my capital asset part-way through the year. Should I take a full year of depreciation?

Policy around managing capital assets is a good topic for discussion with your accountant. You need to make sure that your processes are designed to work for your organization and its belongings.

The short answer on this one is that, no, for the sake of accuracy, you probably should not charge a full year of depreciation when you owned the asset for only part of the year.

A good question is, how accurate should you be?

To be right on the nose, of course you would count how many days you used the asset in the year of purchase, and allocate depreciation expense accordingly. Thus, if my organization uses a calendar year for its fiscal year (i.e. January to December), and I bought a new computer on May 22, I owned the computer for 223 days out of 365.

Now, remember, useful life is an estimate: you don’t know how long you will actually own your new purchase. So, it’s generally not considered necessary to be quite that particular about measuring depreciation expense.

One common method would be to go by the month of purchase. So, if I bought the computer during May, I would take 8 months of depreciation expense – that is, 8/12 of the full year’s depreciation cost.

Another common method is the “half-year rule.” Under this method, for every asset you buy, you take 6 months of depreciation in the year of purchase. The thinking is that if you do this consistently over a period of years, your total depreciation cost will more or less even itself out. You may under-depreciate some purchases, but you’ll over-depreciate others, and at the end of the day your depreciation expense for any given year will be within the zone of reasonable – plus there’s less finicky bookkeeping to do.

Remember, the last year of depreciation must make up the compensating time period. So, if I’m depreciating a computer over five years and I take eight months of depreciation expense in the year of purchase, I need a four-month period at the tail-end to make a full five years. Thus, six fiscal years would be affected:

  • Year 1 – 8 months’ depreciation expense
  • Year 2 – a full year of depreciation expense
  • Year 3 – ditto
  • Year 4 – ditto
  • Year 5 – ditto
  • Year 6 – 4 months’ depreciation expense