Understanding Business Accounting For Dummies, 2nd Edition (103 page)

Collecting or Writing Off Bad Debts

A business that allows its customers to pay on credit granted by the business is always subject to
bad debts
- debts that some customers never pay off. You are allowed, provided that you demonstrate serious efforts to recover the money owed, to write the loss in value off against your tax bill. You may also recover any VAT paid in respect of the invoice concerned. Don't forget in your role as an unpaid tax collector you will have charged your defaulting customer Value-Added Tax, paid that over to HM Revenue and Customs as required, but failed to recover the loot from the said customer, along with the rest of the boodle owed.

Reconciling Corporation Tax

Corporation tax is a heavy influence on a business's choice of accounting methods. Many a business decides to minimise its current taxable income by recording the maximum amount of deductible expenses. Thus, taxable income is lower, corporation tax paid to the Treasury is lower, and the business's cash balance is higher. Using these expense maximisation methods to prepare the profit and loss account of the business has the obvious effect of minimising the profit that's reported to the owners of the business. So, you may ask whether you can use one accounting method for corporation tax but an alternative method for preparing your financial statements. Can a business eat its cake (minimise corporation tax), and have it too (report more profit in its profit and loss account)?

The answer is yes, you can. You may decide, however, that using two different accounting methods is not worth the time and effort. In other areas of accounting for profit, businesses use one method for income tax and an alternative method in the financial statements (but we don't want to go into the details here).

When recording an expense, either an asset is decreased or a liability is increased. In this example, a special type of liability is increased to record the full amount of corporation tax expense: deferred tax payable. This unique liability account recognises the special contingency hanging over the head of the business to anticipate the time in the future when the business exhausts the higher depreciation amounts deducted in the early years by accelerated depreciation, and moves into the later years when annual depreciation amounts are less than amounts by the straight-line depreciation method. This liability account does not bear interest. Be warned that the accounting for this liability can get very complicated. The business provides information about this liability in a footnote to its financial statements, as well as reconciling the amount of corporation tax expense reported in its profit and loss account with the tax owed the government based on its tax return for the year. These footnotes are a joy to read - just kidding.

Two Final Issues to Consider

We think that you have been assuming all along that
all
its expenses should be recorded by a business. Of course, you're correct on this score. Many accountants argue that two expenses, in fact, are not recorded by businesses, but should be. A good deal of controversy surrounds both items. Many think one or both expenses should be recognised in measuring profit and in presenting the financial statements of a business:

Share options:
As part of their compensation packages, many public companies award their high-level executives share options, which give them the right to buy a certain number of shares at fixed prices after certain conditions are satisfied (years of service and the like). If the market price of the company's shares in the future rises above the exercise (purchase) prices of the share options - assuming the other conditions of these contracts are satisfied - the executives use their share options to buy shares below the going market price of the shares.

Should the difference between the going market price of the shares and the exercise prices paid for the shares by the executives be recognised as an expense? Generally accepted accounting principles (GAAP) do not require that such an expense be recorded (unless the exercise price was below the market price at the time of granting the share option). However, the business must present a footnote disclosing the number of shares and exercise prices of its stock options, the theoretical cost of the share options to the business, and the dilution effect on earnings per share that exercising the share options will have. But, this is a far cry from recording an expense in the profit and loss account. Many persons, including Warren Buffett, who is Chair of Berkshire Hathaway, Inc., are strongly opposed to share options - thinking that the better alternative is to pay the executives in cash and avoid diluting earnings per share, which depresses the market value of the shares.

In brief, the cost to shareholders of share options is off the books. The dilution in the market value of the shares of the corporation caused by its share options is suffered by the shareholders, but does not flow through the profit and loss account of the business.

Purchasing power of pound loss caused by inflation:
Due to inflation, the purchasing power of one pound today is less than it was one year ago, two years ago, and so on back in time. Yet, accountants treat all pounds the same, regardless of when the pound amounts were recorded on the books. The cost balance in a fixed asset account (a building, for instance) may have been recorded 10 or 20 years ago; in contrast, the cost balance in a current asset account (stock, for instance) may have been recorded only one or two months ago (assuming the business uses the FIFO method). So, depreciation expense is based on very old pounds that had more purchasing power back then, and cost of goods sold expense is based on current pounds that have less purchasing power than in earlier years.

Stay tuned for what might develop in the future regarding these two expenses. If we had to hazard a prediction, we would say that the pressure for recording the expense of share options will continue and might conceivably succeed - although we would add that powerful interests oppose recording share options expense. On the other hand, the loss of purchasing power of the pound caused by inflation has become less important in an era signified by low inflation rates around the world. However, an enormous increase in the rate of inflation would resurrect this argument, and with rates of 5 per cent and more prevailing in some parts of ‘new' Europe, 7 per cent in India, 10 per cent in Russia, and 11 per cent in Turkey, the beast is not quite as dead as economists would like us to believe.