Posted on Mar 25, 2014
Financial Statements Made Simple
Balance Sheets 101
Part 2 of 3
If you recall from Part I in this series, the Balance Sheet is made up of 3 major categories, Assets Liabilities, and Equity.
What is your most valuable asset?
Do you know what assets are?
Assets are things you own or use to generate income in your business.
They are also the first major category of accounts listed on your Balance Sheet.
Each of the 3 major categories will be split into sub-categories. The asset section will have categories titled current (aka short-term) assets, fixed assets (aka property, plant, and equipment or PP&E), and long-term assets.
A current asset is an asset that will be used up or converted to cash within a year. Cash in your bank account, the money customers owe your business (Accounts Receivable), and inventory that is expected to sell within one year would fall into this category.
Assets that won’t be consumed or converted to cash within a year are considered long-term assets. An investment in a bond with a term greater than one year and fixed assets are examples of accounts in this section.
Because Fixed Assets (office furniture, plant equipment, computer s, or vehicles to name a few) are used for terms greater than one year they eventually wear out or become obsolete. So, there needs to be a way to capture this deterioration or obsolescence.
It is for this reason the government (Canada Revenue Agency…aka…CRA…aka The Tax Man) allows you to depreciate or lower the value of these assets over time. Another reason….they want to encourage companies to invest in new equipment.
Did you catch the phrase “lower the value over time”?
CRA’s rule says you can’t deduct the cost of a fixed asset all at once (in other words, you can’t expense 100% of the cost). However, the rules will allow you to spread the cost of the asset over the number of years you plan on using it.
Here’s how it works:
Let’s say you purchase a machine with a 5 year useful life for $20,000. You would take the total cost of $20,000 and divide it by the 5 years you’ll be using it.
$20,000 / 5 years = $4,000
This means you’ll able to depreciate (write off) the value of the machine at a rate of $4,000 each year for 5 years.
So, you will reduce the value of the asset on your Balance Sheet by $4,000 and record an offsetting expense (reduce income) for $4,000. At the end of year 5 you will have completely written off the value of the machine.
By doing so, you will have matched the cost of using the machine to the income it helped produce, in accounting; this is called the matching principle.
It wouldn’t be too bad if the explanation ended here….unfortunately, it doesn’t!
See the government won’t just let you deduct depreciation willy-nilly…..if they did they’d be dealing with different companies depreciating like assets at different rates.
That won’t do!!
So, to keep things “fair”, all businesses must use CRA’s version of depreciation when they file their tax returns. That’s where Capital Cost Allowance (CCA) comes in.
Capital Cost Allowance is the government approved rate at which you can depreciate an asset.
What CRA has done is assign all depreciable assets to a category or class. In turn, each class has been given a CCA rate. This way everybody is depreciating the same asset the same way. The end result, all is “fair” in Tax Land! Yippee!!
Do you have to use the same rate as CRA to depreciate your assets?
Nope! You can if you want….but you don’t have to.
Here’s the deal….at the end of the year, your accountant will present you with a set of Financial Statements that you can use to run your business. A slightly modified version of those statements will be remitted to CRA when your taxes are filed. One of the modifications made will relate to the amount of depreciation reported. So, in a nutshell, your accountant will make sure you are compliant with CRA’s approved rate.
Let’s wrap things up with the last category of long-term assets; Intangible Assets. These are assets that can’t be physically touched or seen. Some examples of these types of assets would be Goodwill (the value of a business over and above its assets), patents, trademarks, a customer list, or trade secrets….like Grandma’s secret recipe!
So that wraps up the Asset section. Let’s move onto the Liability and Equity sections next.
A Balanced Boss = A HappyBoss