Are you one of the business owners making these 5 major mistakes?
If yes, then read on and save your business from potential fines and a risk of making wrong decisions.
1. Recording assets as expenses
Are you a business owner, presumably NOT a PC store owner, who has bought a laptop for business use? And naturally, you have recorded this purchase within expenses in your accounting software…Wrong.
Well, the laptop you’ve just purchased will contribute to increased revenues of your business, you’ll get more done in less time, therefore it will contribute to your increased effectiveness, efficiency and increased earnings. That is why it will be treated as an asset and recorded in the balance sheet and not in the income statement as an expense.
In fact, any asset whether in a physical (like equipment or machinery) or intangible form (like trademarks, licenses or any other intellectual property) that would contribute to earning additional business revenues should be recorded as assets on the balance sheet (for all the accountants out there, please bear in mind that I am simplifying this for the purpose of easy understanding of concepts).
So, if you are making a purchase and thinking about recording it as an expense, think it through and consider if it will give you additional earnings, technically speaking, if it will result in a flow of future economic benefits to your business, then record it accordingly either as an asset on the balance sheet or as an expense in the income statement.
2. Treating dividends as an expense
So you want to pay yourself dividends…where do you start?
The basic thing to know is: you can only pay out dividends out of your company’s PROFITS. And how do you get there?
Here is a very simplified scenario:
Turnover £100 less Costs £40 = Profits £60, then you can pay yourself dividends providing that you have enough set aside to cover the applicable taxes like for instance corporation tax, now payable at the rate of 19% on the profits, and naturally, you cannot make a dividend payment if you make a loss.
Therefore, following this logic, if your company generated a profit of £60, you would have £11.4 to pay in tax, and the remaining amount of £48.60 you could consider as available profits for paying your dividends.
P.S. Just watch that your dividend payment meets all other criteria set out by the Companies Act 2006 s.830 before you make the payment so that it doesn’t make the dividend illegal and make you face the potential consequences (but that’s another topic).P.S.Watch that your dividend payment meets all the criteria set out by the Companies Act 2006 s.830 before you make a payment so that it doesn't make your dividend illegal and make you face potential consequences. Click To Tweet
3. Mistaking profits for cash
So your company has made a significant profit for the year, but where is all that cash? The company’s bank account is in overdraft, so what’s going on?
So to start, profit is an accounting concept and is subject to judgment and accounting adjustments. Cash is what it is, money either spent or received.
So why would you see the profit when there is no money in the company’s bank account?
- You may be selling on credit but buying for cash, leaving you the timing gap in your working capital funding.
- You may have bought new computers for your employees as the old ones were too slow and inefficient, and this capital expenditure would not be shown in the profit and loss (what you would see would be just a small proportion of its usage labelled as ‘depreciation’ of computers).
- It may be that you prepaid for the telephone and internet, and possibly electricity as it was cheaper to pay in advance for the next 12 months.But these expenses would not yet be deducted from your revenues as they apply to the future periods. And the true and fair view of accounts manifests itself yet again.
The cash has been spent but for the future period usage, hence the balance of cash decreased but revenues and subsequently profits for the year have not changed.
That is why your company’s cash balance would greatly differ from your profit and that’s why cash flow assessment is vital for every business so that it would arrange the credit line when one is required before the company becomes illiquid and goes out of business.Cash flow assessment is vital for every business so that it would arrange the credit line when one is required before the company becomes illiquid and goes out of business. Click To Tweet
4. Mistaking accrual basis with cash basis
If you are a sole trader and have opted for a cash basis – you can skip this section, otherwise, please read on.
What does it even mean, cash basis or accrual basis? Accounting on a cash basis is when you record expenses in your accounts at the time when you hand money over to the supplier and receive money from the customers for your products or services.
Accrual basis, not only looks at when the money was received but also considers when the goods and services were actually received and used. The UK accounting standard has a very technical explanation of this method “items are recognised as assets, liabilities, equity, income or expenses when they satisfy the definitions and recognition criteria for those items”.
So, for instance, you bought stationery for your business in May and you would need to pay for it in 60 days time. Great. You have time. Money doesn’t leave your company until July.
BUT, and here is the difference between cash basis and accrual basis, you do make use of the stationery within your business so you should recognise it in your accounts. You record it as an expense (accrued expense to be precise) in the income statement and as an accrued amount (money still owed to your supplier) on the balance sheet.
Once you make the payment in July, then you ‘release the accrual’. It may sound a bit technical but, in short, it’s simply recognising the events in accounts as they happen.
Equally the accrual basis applies to the revenue earned by your company. So if you’ve been working on the project that was paid in advance, you wouldn’t take all that revenue into account at once, you would apportion it accordingly to the amount of work completed in the period for which accounts are being prepared.
And if you’ve been paid well after the work had been completed, you would have recognised it in the period when the work was completed and not when you finally got paid.
And to top things, the accrual basis also refers to prepayments. So if you paid in advance for your website development for instance, then you would NOT record it as your expense until there has been some progress on the project and let’s say a landing page (which is about one third of your planned website) ready, then you would recognise one third of this expense in the income statement. However, all this time you would record the amount of prepaid cost as a debit balance in your balance sheet (kind of like a debtor).
5. Forgetting about depreciation
Yes, equipment deteriorates and needs to be replaced with time, so why would you forget to take this important aspect of running the business into account?
There are different methods of depreciating assets and the most well know are a straight line and a reducing balance. The straight line method is the simplest, you simply estimate how long this piece of equipment will last and divide the cost of this equipment by the number of years (please note that this is a very simplified approach as there are different methods of assets valuation).
How to calculate depreciation:
You bought laptop for £400 in January 2018
You estimate that it will last 4 years, then it will get outdated and you will need to purchase a new one, so the number of years is 4
You divide £400 by 4 = £100 is the depreciation that you will need to take into account in each year in your income statement
Most of the time depreciation needs to be recorded in the software by the means of a manual journal (debit, in other words, expense depreciation in the year and credit accumulated depreciation, that is the wear and tear of the equipment accumulated over the years). Some software providers include it as an option for business owners but in most manual entries are required.
Feeling more confident now?
Just try and avoid these basics mistakes: don’t pay yourself dividends when the company has not made profits or has just enough to pay taxes, don’t expense the income generating assets, don’t mistake profit for cash, plug that depreciation into the accounts and plan for things early so that to avoid costly after effects.
And if you’re still not sure, you can always contact us or your accountant for help.