IT Financials Glossary

Accruals

Posted in Accounting by mgentle on August 26, 2010

Accruals: enable revenue or expenses to be recognized before payment occurs.

If you’ve heard the term accruals before, it was probably associated with the year-end close, when all departments have to ensure that their unpaid invoices are booked to the financial year about to end. But accruals can also be used during the financial year to track costs with respect to budget, as we shall now see.

There are two types of accruals:

  • Accrued revenue: revenue is recognized when it is earned, which most of the time is before payment is received.
  • Accrued expenses: expenses are recognized when they are incurred, which is usually before the invoice is paid.

This form of accounting is called accrual accounting (the norm in any large company), as opposed to cash accounting (often used in small businesses), which only recognizes revenue and expenses when cash changes hands. Understanding cash accounting helps to appreciate the usefulness of accruals.

Cash accounting

In the following example, Fig. 6.2a  (NB click on the image to get a full-screen view) shows how cost management with cash accounting results in an incorrect situation with respect to budget. Because the invoice for work incurred in January will only be paid in February (assuming payment terms of one month), the snapshot for the end of January shows zero costs. Of course, this is incorrect, because, to take an extreme example, if the project were cancelled at the end of January, the vendor would still have to be paid. Continuing with this cash-based approach, by the time we get to March, the YTD costs give the impression that only $220k has been spent (ie, 150+70), whereas in reality it is $470k (ie, 150+70+250).

Accrual accounting

Fig. 6.2b (NB click on the image to get a full-screen view) shows how accruals capture the true cost situation with respect to budget. January work is accrued at the end of January, thereby recognizing the expense the month it was incurred, regardless of when the invoice is eventually paid. By the time we get to March, the YTD costs are correctly shown as $470k (ie 150+70+250).

Accruals can be thought of as “pre-booked actuals” pending payment, thus enabling more meaningful financial reporting. They are reversed once payment has occurred.

In accounting software systems, accruals can be generated after the corresponding goods or services have been received.

In this simple example, invoices are submitted quickly and paid one month later; in the real world, they could be submitted late and paid late. Without accruals, therefore, your financial reporting would not only be inaccurate, but it could also become unpredictable because it is based on when vendors submit their invoices (surprisingly, not always on time) and when these invoices are eventually paid (dependent on payment terms and on process inefficiencies).

Accruals vs commitments

The alternative to using accruals to track uninvoiced work is to use commitments instead, which is simply uninvoiced work recorded in the management accounting system. An accrual goes one step further and records the commitment in the financial accounting system.

The big advantage of an accrual is that once it is recorded, it is “on the books”, and relieves you of the burden of tracking the commitment through to when the invoice is eventually paid – with the attendant risk of double-counting, ie recording both the commitment and the paid invoice against your budget.

FURTHER READING: for an accounting view of accruals – which is both understandable and entertaining – check out the following article by Michael Sack Elmaleh.

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Actuals

Posted in Accounting by mgentle on August 26, 2010

Actuals: short for actual costs incurred, as opposed to planned or budgeted costs.

Amortization

Posted in Accounting by mgentle on August 26, 2010

Amortization: the technical term for the depreciation of non-material or intangible assets like patents, trademarks or brands.

Asset

Posted in Accounting by mgentle on August 26, 2010

Asset: tangible or intangible things that are directly or indirectly able to generate revenue over several years, thus allowing a company to produce goods or services. An asset therefore has a monetary value and can be sold if required. Tangible assets are usually called fixed assets, and include things like plant, property or equipment. Examples of intangible assets include things like patents and brands.

FURTHER READING: for an accounting view of fixed assets check out the following article by Michael Sack Elmaleh.

Balance sheet

Posted in Accounting by mgentle on August 26, 2010

Balance sheet: A snapshot of a company’s value at a specific point in time. It contains two parts, assets (cash, accounts receivable, equipment…) and liabilities (accounts payable and other debt). The difference between the two is the company’s net worth (also known as owner’s equity or shareholder’s equity).

Because IT is so capital-intensive (up to 50% of a company’s capital expenditure), it can form a significant part of the balance sheet.

An analogy would be one’s personal balance sheet, which would list one’s assets (car, savings, wife’s house and jewellery…) and liabilities (loans, dubious investment schemes, alimony payments to first wife …).

Note that the balance sheet does not tell us how the company is performing in terms of revenue and expenses each month – that is the role of the Income Statement or P&L (of which the analogy would be your monthly salary and living expenses).

Books

Posted in Accounting by mgentle on August 26, 2010

Depreciation

Posted in Accounting by mgentle on August 26, 2010

Depreciation: the reduction in value of an asset over its useful life (usually several years) through usage or obsolescence.

There are several methods of depreciation, the simplest of which is the linear or straight-line method, which divides the cost equally across the lifetime of the asset. So a $90k server with a useful life of 3 years will have an annual depreciation of $30k.

The financial impact on IT costs of mixing up capex and opex should hopefully be clear. If the server is correctly capitalized, the IT department will incur no costs this year against the IT budget; instead it will be charged $30k per year for 3 years starting next year. If, however, the PO incorrectly assigns the purchase to an opex account, then the $90k would figure as a current-year cost and hit the IT budget.

Or, to use a less obvious example, if a development team inadvertently enters $90k worth of time entry against functional design (opex) instead of technical design (capex), then instead of being depreciated as part of a software asset from next year on, the $90k would figure as a current-year cost.

Very important: depreciation is not a cost in terms of money out of the bank! The cost is what the company paid to acquire the asset (in cash or through borrowing). Depreciation is an accounting exercise that allocates a portion of the asset’s cost to the current financial year. The term expense in “depreciation expense” does not refer to a cost, but to operating expense, or opex. (Confused? Don’t worry, so was I not too long ago!).

FURTHER READING: for an accounting view of fixed assets and depreciation check out the following article by Michael Sack Elmaleh.

Equity

Posted in Accounting by mgentle on August 26, 2010

Equity: the difference between assets and liabilities. Equity can be owner’s equity or shareholder’s equity. Also known as net worth.

FURTHER READING: for an accounting view of equity, assets and liabilities, check out the following article by Michael Sack Elmaleh.

Financial year (FY)

Posted in Accounting by mgentle on August 26, 2010

Financial year (FY): the annual 12-month period over which a company does business, which may or may not coincide with the calendar year of January to December. The financial year is divided into 12 fiscal periods and 4 quarters.

At the end of each quarter, publicly traded companies publish their quarterly results, and at the end of the financial year close their books and declare their financial results.

Fiscal period

Posted in Accounting by mgentle on August 26, 2010

Fiscal period: see Financial Year.