9 - Business Accounts

Question 1

Why is it important for solicitors to understand financial accounts in practice?

Answer 1

Understanding business transactions: Most business transactions have a financial motivation and impact the accounts, so a solicitor’s knowledge of accounts helps in understanding a client’s concerns.

Participation in negotiations: Solicitors need to understand financial statements to follow discussions in negotiation meetings with accountants and financial advisors.

Acquisitions: Knowledge of accounts is crucial when working on acquisitions and understanding the value of a business.

Litigation decisions: Reviewing accounts can help decide whether it is financially worth pursuing legal action, such as when deciding whether to bring a claim against the owner of a business.

General business knowledge: Understanding how financial statements are structured allows solicitors to interpret them more easily. Solicitors themselves are also in business and require accounts for their own practice, just like any other business.

Question 2

What are financial statements, and what do they include for a business?

Answer 2

Financial statements are prepared for each accounting period, usually a full year, although businesses can choose their own accounting period, often matching the calendar year or tax year.

The key financial statements are:
- Profit and loss account
- Balance sheet

These statements are part of a formal system of accounts that records all the financial transactions of the business throughout the year, which are used to prepare the year-end financial statements.

Businesses are considered separate from their owners, meaning if an owner contributes capital to the business, it is recorded as a liability of the business (the business ‘owes’ the owner the capital).

Question 3

What is book-keeping, and how are financial transactions recorded in a business?

Answer 3

Book-keeping is the process of recording the financial transactions of a business.
- On a daily basis, various transactions occur, such as the sale of stock or payment of wages. These need to be recorded logically and usefully.
- Nominal ledgers are used to group similar transactions together (e.g., payments for rent and electricity bills), creating a single record for that type of expense (e.g., nominal expense ledger).
- Different types of ledgers (also called accounts) are used to record various transactions, and all ledgers/accounts together are collectively referred to as the business’s books.

Question 4

What is the principle of double entry book-keeping and how does it work?

Answer 4

Double entry book-keeping is based on the principle that every financial transaction a business undertakes has a dual effect on its accounts.

For example, if a sole trader purchases an asset for £5,000:
-There will be a reduction of £5,000 in the cash account.
There will be an increase of £5,000 in the assets of the business.

Once the accounts affected are identified, and whether the transaction causes an increase or reduction, the transaction will be recorded in two places:
- One entry as a debit.
- The other entry as a credit.

The system ensures that the total value of all debits will equal the total value of all credits for a given accounting period.

Question 5

What is an accounting period and why is it important for a business?

Answer 5

An accounting period is usually a full year, though businesses are free to choose their own period.
- At the end of each accounting period, the ledgers/accounts of a business are ‘ruled off’ so the balances can be reviewed.
- This process helps to compare the financial performance of the business year-on-year.
- Many businesses also prepare interim accounts during the year for various reasons, providing additional insights into financial performance at different points.
- The end of the accounting period provides a snapshot of the business’s financial status for analysis and decision-making.

Question 6

What is a trial balance and how is it used in accounting?

Answer 6

A trial balance is a list of all the balances on a business’s ledgers/accounts as at the end of an accounting period.
- It includes debit balances in one column and credit balances in another column.
- The total of the debit column should equal the total of the credit column, ensuring that the accounts are in balance.
- The trial balance serves as the basis for preparing the business’s financial statements, including the profit and loss account and balance sheet.
- This process is vital for ensuring accuracy and completeness in the business’s financial reporting.

Question 7

What are the five main classifications of ledgers/accounts in accounting?

Answer 7

The five main classifications of ledgers/accounts are:

Asset: Something a business owns. A business will have a separate account for each category of asset (e.g., motor vehicles, cash at bank).

Liability: Something a business owes. A business will have an account for each different type of liability (e.g., loans, trade debts).

Capital: Usually identifiable as an injection of value from an owner or investor rather than money generated by the business.

Income: Money earned by the business, usually from a regular source. Each main income source of the business will have a separate account (e.g., a theatre might record income from ticket sales and venue hire in separate accounts).

Expense: Money spent by the business. Each different type of expense is recorded in a separate account (e.g., heating and lighting).

Question 8

Why is it important to classify accounts into Asset, Liability, Capital, Income, and Expense (ALCIE) categories?

Answer 8

Proper classification is essential for understanding the preparation of financial statements, such as the balance sheet.
- Classifying accounts as asset, liability, capital, income, or expense helps organise financial data for accurate reporting.
- Each type of account needs to be tracked separately for clarity, ensuring financial accuracy when preparing year-end statements.
- For example, a business will have separate accounts for motor vehicles and cash at bank (assets), or for loans and trade debts (liabilities).
- Recognising the importance of these classifications aids in preparing a clear financial picture of the business’s performance.

Question 9

What is a fixed asset and what are the key characteristics?

Answer 9

A fixed asset is any asset, tangible or intangible, owned by a business that will enable it to make profit.
- To be defined as a fixed asset, it must be held by the company for over a year and provide some long-lasting benefit to the company.
- Tangible fixed assets are physical assets (e.g., buildings, machinery).
- Intangible fixed assets do not have a physical existence (e.g., trademarks, patents, goodwill).
- Fixed assets may also be called ‘non-current assets’.

Question 10

What are current assets and what distinguishes them from fixed assets?

Answer 10

Current assets include cash and items owned by the business (or owed to the business) which can quickly be turned into cash, usually within one year.

These assets are continually flowing through the business and therefore have a short-term nature.

Examples of current assets include:
- Stock (inventory): Goods for use or resale.
- Debtors: People or entities that owe money to the business, most commonly ‘trade debtors’ who are customers that have bought on credit and have not yet paid.
- Cash: Includes cash the business has in its bank accounts and ‘cash in hand’ or petty cash. When looking at the accounts of companies, these types of cash are combined into a ‘cash and cash equivalents’ entry in the balance sheet.

Current assets differ from fixed assets in that they are short-term and expected to be converted into cash within a year.

Question 11

What is a liability and how is it classified?

Answer 11

A liability is an amount owed by the business to somebody else.

Liabilities are categorised as:
- Current liabilities: Amounts due to be paid within a year (e.g., bank overdrafts, trade creditors).
- Long-term liabilities (also known as non-current liabilities): Amounts due after more than one year (e.g., term loans).

Examples of current liabilities:
- Bank overdraft: Repayable on demand.
- Trade creditors: Suppliers of raw materials, the mirror image of trade debtors.

Question 12

What is capital in a sole trader business, and how is it treated for accounting purposes?

Answer 12

For a sole trader, the assets of the business are the sole trader’s property since the business has no separate legal personality.
- For accounting purposes, the business and its owner are seen as two separate entities.
- The sole trader may invest a lump sum of personal money into the business when setting it up. This, along with any retained profits, forms the capital account.
- The sole trader pays themselves via drawings, which represents the money taken out of the business, recorded in the capital account.
- The drawings account in the trial balance represents transactions between the business and its owner.
- The nature of the relationship between the business and its owner varies based on whether the business is a sole trader, partnership, or company, affecting the accounting treatment of capital accounts.

Question 13

What is the role of income and expense accounts in a business’s financial records?

Answer 13

Expense accounts record day-to-day spending, which is also known as revenue expenditure or income expenditure.
- These expenses do not include spending on long-term assets (e.g., a car or a building), which are sometimes confusingly referred to as capital expenditure.
- Example: If a business buys items or services it will quickly use up, such as bread, it treats this purchase as an expense.
- Analogy: Just like in everyday life, buying bread is a living expense, while buying a car or television is seen as acquiring an asset.

Income accounts record sums received by the business, such as payments from customers for sales of goods or services made by the business.

Question 14

What are year-end adjustments, and why are they needed in preparing financial statements?

Answer 14

Year-end adjustments are necessary to ensure that income and expenditure shown in the final financial statements relate to the correct accounting period.

These adjustments are needed to correct any imbalances when payments cover more than one accounting period, ensuring figures are accurate for the period they apply to.
- Example: If a business pays a year’s rent in advance on 1 July, only half of the payment corresponds to the current accounting period (1 June – 31 Dec.), while the other half (1 Jan – 30 June) relates to the subsequent accounting period.
- Without these adjustments, it would appear that the business has spent double the amount on rent in the current period, which is inaccurate. The adjustments correct this imbalance, ensuring accuracy.

Question 15

Provide a summary of double entry book-keeping, ledgers, and the trial balance.

Answer 15

Book keeping ledgers → Trial balance → ALCIE classification and year end adjustments → Profit and loss account and balance sheet

• Each transaction will be recorded in two places in the books of the business. One aspect will be recorded as a ‘debit’ entry and the other as a ‘credit’ entry.
• If we take all the balances on all of a business’s ledgers as at the end of an accounting period and list them in a trial balance, showing debit balances in one column and credit balances in another column, the total of each of the two columns should be the same.
• Every entry on the trial balance will relate to a ledger, which could be characterised as an asset, liability, capital, income or expense account.
• Before the trial balance can be used to prepare the financial statements, year-end adjustments will need to be made to some of the figures to ensure they are accurate for the relevant accounting period.

Question 16

What is a profit and loss account?

Answer 16

Accountants use the entries from the trial balance to construct the year-end financial statements of a business:
- The profit and loss account, and
- The balance sheet.

The profit and loss account essentially records the income of a business throughout an accounting period minus expenses incurred in that period, to arrive at a profit (or a loss) figure for the period.

Question 17

What is the purpose of a profit and loss account and how is it structured?

Answer 17

The profit and loss account records the income of a business throughout an accounting period, minus the expenses incurred during that period, in order to calculate the profit (or loss) for the period.

It provides a summary of the financial performance of the business over a specific period of time.

The accounting period is clearly stated in the heading, using phrases such as:
- “For the period ending on [last day of the period]”
- “For the year ended [last day of the period]”

Only the income and expense entries from the trial balance are transferred into the profit and loss account, reflecting the operations for that period.

Question 18

What types of accounts are included in the profit and loss account, and which are excluded?

Answer 18

Income accounts from the trial balance, such as sales, are included and appear at the top of the profit and loss account as income entries.

Expense accounts, such as telephone and postage, are included and appear in the expenses section of the profit and loss account.

Asset accounts, such as cash at bank, are excluded from the profit and loss account.
These types of accounts are not included because they relate to the financial position of the business, rather than the income and expenditure during the accounting period.

Question 19

What is the standard format of a profit and loss account for UK businesses?

Answer 19

UK businesses follow a standard format for presenting the layout of a profit and loss account, ensuring consistency across accounts.

A profit and loss account may also be referred to as an “income statement” in accounts prepared according to international accounting standards.

Format:
* All income entries from the trial balance are put at the top of the profit and loss account.

• The ‘cost of sales’ figure in the profit and loss account is calculated using figures for ‘opening stock’ and ‘closing stock’. These are both asset accounts, so these two accounts are exceptions to the general rule that a profit and loss account shows only income and expense accounts.]
• In order to calculate the ‘cost of sales’ figure on a profit and loss account, the accountants of the business will carry out the following formula: Opening stock + purchases – closing stock = cost of sales​
• The ‘gross profit’ calculation represents all the income of the business less the ‘cost of sales’.
• Towards the end of the profit and loss account, all of the expenses of the business excluding purchases are deducted from the ‘gross profit’.
• At the end of the profit and loss account is the ‘net profit’.

Question 20

Provide a summary of profit and loss accounts.

Answer 20

• The profit and loss account essentially records the income of a business throughout an accounting period minus expenses incurred in that period, to arrive at a profit (or a loss) figure for the period.
• All income entries from the trial balance are put at the top of the profit and loss account.
• The ‘cost of sales’ figure in the profit and loss account is calculated using figures for ‘opening stock’ and ‘closing stock’. These are both asset accounts, so these two accounts are exceptions to the general rule that a profit and loss account shows only income and expense accounts.
• The ‘gross profit’ calculation represents all the income of the business less the ‘cost of sales’.
• Towards the end of the profit and loss account, all of the expenses of the business excluding purchases are deducted from the ‘gross profit’.
• At the end of the profit and loss account is the ‘net profit’.

Question 21

What is the purpose of a balance sheet in a business’s financial statements?

Answer 21

A balance sheet is one of the year-end financial statements prepared by a business, alongside the profit and loss account.
- While a profit and loss account records only income and expense accounts, providing an incomplete picture, the balance sheet offers a comprehensive view of a business’s financial position.
- It records the position of a business in relation to its assets, liabilities, and capital accounts as listed in the trial balance, making it a snapshot of the business’s financial standing.

Question 22

How does the date on a balance sheet relate to its purpose, and how does it differ from the profit and loss account?

Answer 22

• A balance sheet differs from a profit and loss account because it serves as a snapshot of financial status on a specific date, rather than over a period (e.g., a year).
• The date at the top of a balance sheet reflects the last day of the accounting period it pertains to, and includes the words “as at [date].”
• This date indicates the value of assets held by the business on that day. This value could change the following day, for instance, if an asset were sold and the proceeds were used to pay bills, affecting the balance sheet.

Question 23

What are the main components of a balance sheet, and how is the structure organised to maintain balance?

Answer 23

The balance sheet shows two primary details:

• Net worth or net asset value (NAV) of the business:
  The top half of the balance sheet records the value of assets the business has, minus the liabilities it owes.
  The net current assets figure on the balance sheet gives an indication of how much cash the business could make available at short notice.
• Capital invested to achieve that net worth:
  The bottom half of the balance sheet records the capital invested by the owners in the business.

These two halves of the balance sheet must always balance, as the top half demonstrates how the invested capital shown in the bottom half has been used in the business.

Typically, asset, liability, and capital entries from the trial balance are transferred into the balance sheet.

For instance:
- “Debtors/receivables” in the trial balance is an asset entry and appears in the top half of the balance sheet.
- “Capital at the start of the year” is a capital entry and appears in the bottom half of the balance sheet.

Question 24

What types of items might appear on a balance sheet, and how are they organised?

Answer 24

A balance sheet includes key sections to show the financial position of a business as at a specific date.

These sections are:

Fixed Assets: Items such as land and buildings, plant, and motor vehicles are listed here, with details showing their original cost, accumulated depreciation, and net book value (cost minus depreciation).
Fixed assets (net book value) + net current assets – long term/non current liabilities = NAV.

Current Assets: This section covers assets expected to be used within the year, such as stock, receivables, prepayments, and cash in bank or on hand. Some items, like receivables, may include provisions (e.g., for doubtful debts).
The net current assets of a business = current assets - current liabilities.

Current Liabilities: These are short-term obligations like payables, accruals, and prepaid income. Net current assets are calculated by subtracting total current liabilities from total current assets.

Long-term Liabilities: These include debts like a bank loan, which are due over a longer period. Long-term liabilities reduce the total net assets of the business.

Capital: This section reflects the capital structure, showing starting capital, profit for the year, and any drawings (withdrawals by the owner). The balance sheet concludes with retained profits and total capital, which should balance with the total net assets.

Question 25

Provide a summary of the Balance Sheet.

Answer 25

• Asset, liability and capital entries from the trial balance are transferred into the balance sheet. The balance sheet is a snapshot relevant only on the given date.
• The net asset value (NAV) of the business is recorded in the top part of the balance sheet.
• Assets are categorised as either fixed assets or current assets on the balance sheet.
• The net book value takes into account the depreciation of fixed/non current assets over time.
• The liabilities of the business are categorised as either current or long term/non-current.
• The net current assets of a business = current assets - current liabilities.
• Fixed assets (net book value) + net current assets – long term/non current liabilities = NAV.
• The amount of capital invested in the business is recorded in the bottom part of the balance sheet.
• The NAV and total capital figures must always be the same in order for the balance sheet to effectively balance and demonstrate how the capital invested in the business has been used.

Question 26

What are year-end adjustments?

Answer 26

Year-end adjustments are transactions or modifications to the account entries on the trial balance. They are needed in order to apply the accruals/matching concept to the preparation of financial statements.

This concept requires that:
- All income and expenditure must be ‘matched’ to the relevant accounting period; and
- All current obligations must be anticipated as liabilities and all asset values must be assessed to make sure they can be recovered through future profits in conditions of uncertainty.

Question 27

What are the five types of year-end adjustments?

Answer 27

There are five year-end adjustments:
- Depreciation
- Accruals
- Prepayments
- Bad debts
- Doubtful debts.

Question 28

What is depreciation?

Answer 28

Depreciation is an accounting mechanism used to manage the decline in value of a fixed asset (or ‘non-current asset’) that has a useful life of several years and may have little or no value at the end of its life.

It is crucial for several reasons:
- Depreciation spreads the cost of the asset over its useful life, ensuring that the financial accounts provide a true reflection of the business’s position.
- Without depreciation, assets would remain recorded at their original cost, which may over time be much higher than their actual value.
- Depreciation must be carried out systematically, or regularly, and the chosen method should closely match how the asset’s value decreases over the relevant accounting periods.

Question 29

What are the two main methods of depreciation, and when might each be used?

Answer 29

The two primary methods of depreciation are:

Straight-line method: This method is used when an asset loses value at a consistent rate over its lifespan and generates a consistent income. For example, shelving would use the straight-line method, as it wears down steadily and produces stable revenue.

Reducing balance method: This method is suitable for assets that generate more revenue in their early years and lose a larger portion of their value early on. For instance, a van would use the reducing balance method due to its higher revenue generation and depreciation in its initial years. The amount allocated each year is referred to as the “charge to depreciation” or “depreciation charge.”

The straight-line method is the most common and straightforward method, which is why it is generally the primary focus.

Question 30

What is the straight-line method of depreciation, and how is it applied with an example?

Answer 30

The straight-line method of depreciation:
- Spreads the depreciation charge evenly over the asset’s useful life.
- Results in the same charge for depreciation each year.
- Is the most common and straightforward method.
- Used when the service provided by the asset is consistent throughout its useful economic life, as with shelving.

Example:
Marleys Department Store buys shelving for its warehouse costing £6,000. The shelving is expected to last for 5 years.
- Using the straight-line method:
- The depreciation charge is spread evenly over 5 years, giving an annual charge of £1,200 (£6,000 ÷ 5).
- This £1,200 charge will appear each year on the Profit and Loss Account as an expense.

Each year’s depreciation ‘accumulates’ over time:
- Year 1: £1,200
- Year 2: £2,400
- Year 3: £3,600, etc.

The accumulated depreciation is shown on the Balance Sheet in an accumulated depreciation account (liability account), which reduces the net book value of the shelving. By Year 3, the accumulated depreciation would total £3,600.

Question 31

What is the reducing balance method of depreciation, and how is it applied with an example?

Answer 31

The reducing balance method of depreciation:
- Charges depreciation each year as a percentage (e.g., 20%) of the asset’s reducing balance (the net book value at the start of each accounting period).
- This means more depreciation is charged in the early years and less in the later years as the asset’s value reduces.
- Is less common and slightly more complicated.
- Suitable for assets likely to lose a larger portion of value early on, such as motor vehicles.

Example:
First Response Plumbers purchases a van for £12,000, to be depreciated at a rate of 20% of the reducing balance each year:

Year 1: Depreciation charge = £2,400 (20% of £12,000). This amount is shown as an expense on the Profit and Loss Account for Year 1 and appears on the Balance Sheet as a liability.

Year 2: Depreciation charge is based on the reduced balance after deducting previous accumulated depreciation (£12,000 - £2,400 = £9,600). The charge for Year 2 is £1,920 (20% of £9,600). The accumulated depreciation by the end of Year 2 totals £4,320 (£2,400 + £1,920).

Year 3: Reduced balance is now £7,680 (£12,000 - £4,320). The depreciation charge is £1,536 (20% of £7,680). At the end of Year 3, accumulated depreciation is £5,856.

Each year’s depreciation charge is shown as an expense on the Profit and Loss Account, while the accumulated depreciation appears on the Balance Sheet as a liability.

Example:
- Vehicles, at cost - £50,000
- Provision for depreciation, vehicles - £8,000

The sole trader has decided that the vehicles should be depreciated at 20% per annum using the reducing balance method.
What would the depreciation charge for the year be?

Since the reducing balance method is used, the provision of £8,000 for depreciation needs to be deducted from the cost figure of £50,000 to give £42,000 as the written down value for the start of the year.

The depreciation charge of 20% should then be applied to the £42,000 to give a charge for depreciation for the year of £8,400.

Question 32

How is the Net Book Value of an asset calculated, and what does it represent on the Balance Sheet?

Answer 32

The Net Book Value (NBV) represents the estimated current value of a fixed (non-current) asset to the business, after accounting for its loss in value due to depreciation.

This value is shown on the Balance Sheet as follows:
- The asset’s original cost is recorded.
- Accumulated depreciation (the total depreciation charge to date) is subtracted from the cost.

The formula for calculating Net Book Value is:
COST – ACCUMULATED DEPRECIATION = NET BOOK VALUE

This calculation reflects the asset’s current worth to the business after depreciation has been applied.

Question 33

The following is an extract of the trial balance of a sole trader:

Equipment, at cost - £100,000

Provision for depreciation, equipment - £14,000

The sole trader has decided that the equipment should be depreciated at 10% per annum using the straight-line method.

What would the accumulated depreciation at the end of the year be?

Answer 33

£24,000

Question 34

Provide a summary of depreciation as a year-end adjustment.

Answer 34

• Year-end adjustments are transactions or modifications to the account entries on the trial balance.
• They are needed in order to apply theaccruals concept to the preparation of financial statements.

Depreciation is a year end adjustment and can be calculated using two methods:
* Straight line, or
* Reducing balance

• Depreciation is a mechanism used in the accounts to deal with this decline in value and to spread the cost of the asset over its useful life.
• The depreciation charge for the year will appear in the profit & loss account as an expense.
• The depreciation charge for the year will be added to the (accumulated) provision for depreciation (liability) account, which will appear in the balance sheet.

Question 35

What is an accrual, and why is it necessary in financial statements?

Answer 35

An accrual arises when an expense has been incurred and should be charged against profit in the current year, but the expense has not been included in the trial balance by the time the accounts are drawn up – for example, because the business has not received an invoice.
- An accrual adjustment is required when a business has benefited from something in one accounting period but will not pay for it until the next.
- This adjustment aligns with the accruals/matching concept, ensuring expenses are matched to the period they relate to.
- Without an accrual adjustment, the accounts will not give a true reflection of the business’s financial position, as they will show an artificially high profit for the year if the expense is not accounted for in that period.

Example:
Panache Beauty Salon (‘Panache’) has used its solicitors’ services multiple times in the past year. The preliminary trial balance shows £27,000 in the Legal Fees account, but Panache has not yet received a bill of £5,000 for recent legal work. An accrual adjustment is needed:
- The total legal fees used in the year are £32,000 (£27,000 + £5,000), so the Legal Fees account should reflect this amount in the Profit and Loss Account.
- The unpaid £5,000 must also be recorded as an Accrual in a current liability account on the Balance Sheet, accurately showing the liability and ensuring the accounts reflect the business’s true financial position for the year.

Question 36

What is a prepayment, and why is it necessary to adjust for it in financial statements?

Answer 36

A prepayment arises when an expense is paid for in the current year, but all or part of the cost should be charged as an expense in the following year.
- This occurs when a business has paid for something in advance during one accounting period but will not receive the benefit of the payment until the next period.
- A prepayment adjustment is necessary to comply with the accruals concept, ensuring expenses are matched to the period they relate to.
- Without a prepayment adjustment, the accounts will not accurately reflect the business’s financial position, as the profit would be shown as artificially low for that period.

Question 37

How is a prepayment adjustment applied in practice?

Answer 37

For example, Flitwick Carpentry (‘Flitwick’) paid £30,000 in rent for its premises on 1 October for 12 months in advance, with a year-end of 31 December.
- The trial balance shows the full £30,000 rent payment within the accounting year.
- However, only £7,500 of rent (covering October to December) should be recorded for this period, with the remaining £22,500 to be accounted for in the next period.

As a result of the adjustment:
- The Rent expense account on the Profit and Loss Account will show the correct amount of £7,500.
- The £22,500 prepayment will be shown in a Prepayment current asset account on the Balance Sheet, representing the future benefit of rent that has already been paid.

Question 38

Provide a summary of Accruals and Prepayments as year-end adjustments.

Answer 38

· Year-end adjustments are transactions or modifications to the account entries on the trial balance.

· They are needed in order to apply the accruals/matching concept to the preparation of financial statements.

· Accruals occur when a business has had the benefit of something in one accounting period but will not pay for it until the next.

· Accruals will appear on the Profit and Loss account as an expense in the appropriate account (eg legal expenses) and it will appear on the balance sheet as a current liability.

· Prepayments occur when a business has paid for something in advance during one accounting period but does not get the benefit of all or some of what it has paid for until the next.

· Prepayments will appear in the Profit and Loss account as a reduction in the appropriate expense account (eg rent) and it will appear on the balance sheet as a current asset.

Question 39

What are bad debts, and how should they be handled in financial statements?

Answer 39

A bad debt occurs when a business knows with certainty that it will not be able to collect the money owed to it by a debtor.
- The ‘Receivables’ account represents money owed to the business and is shown as an asset because it is expected to be received.
- However, not all debts are paid, and when a debt is confirmed as uncollectible, it is classified as a ‘bad debt.’

Bad debts may arise when a debtor goes bankrupt or when it becomes clear that the debt will never be paid.
- When a debt is written off, it is removed from the ‘Receivables’ entry in the accounts, as the business gives up any prospect of receiving the payment.
- If bad debts are written off during the year, a bad debts expense account will already be present in the trial balance. If no bad debts are written off, this account will not appear.
- Failing to adjust for bad debts will distort the accounts, as it will overstate the amount of money the business expects to receive, leading to a misleading financial position.

Question 40

How is the bad debt adjustment applied with an example?

Answer 40

At the end of its accounting period, Woburn Hardware Store (‘Woburn’) discovers that one of its trade customers has gone bankrupt, leaving £360 of its £7,000 receivables uncollectible.
- The trial balance initially shows £7,000 in the ‘Receivables’ account, but after discovering the bankruptcy, it becomes clear that £360 will never be paid.
- The receivables account must be reduced by the amount of the bad debt, so the updated balance is £6,640 (£7,000 - £360).
- The £360 that will not be paid is shown as part of a ‘bad and doubtful debts’ expense account, reflecting the financial loss to the business.

In company accounts, this expense account is referred to as ‘Impairments’. This ensures that the accounts reflect the true financial position by removing the uncollectible amount from the receivables balance.

Question 41

What are doubtful debts, and how are they classified into specific and general provisions?

Answer 41

Doubtful debts occur when a business provides for the possibility that some debts may not be paid, but they are not yet written off as bad debts.

A doubtful debt differs from a bad debt in that the business is not giving up on the debt completely, but is simply recognising that it may not collect the full amount owed.

There are two types of doubtful debts:
Specific doubtful debts: These are debts where the business has knowledge that a particular debtor is in financial trouble or is disputing the debt. The debtor may not have entered insolvency, but the business still wants to acknowledge the possibility that the debt might not be paid in full.

General doubtful debts: These are debts where the business does not have specific information on any individual debtor, but it is aware of general economic conditions or market trends that suggest a certain percentage of receivables may not be paid. For example, a business may estimate that 5% of its receivables could become uncollectible.

The business will make a provision to account for these doubtful debts, which is reflected in the balance sheet and adjusted at each year-end. This is called an impairment.

Question 42

How are specific and general provisions for bad debts managed?

Answer 42

Provision for Doubtful Debts: This amount is recorded in an account titled “Provision for Doubtful Debts” and is adjusted at the year-end, either increasing, decreasing, or remaining the same compared to the previous year’s provision.

Provision account nature: It is treated as a liability account, reducing the assets available to the business, and is used to ‘ring-fence’ part of its net asset value to cover potential future losses from doubtful debts.

Example:
At the end of Year 1, Nightingales’ receivables total £101,000. It creates:
- A specific provision of £1,000 for Contact Retail Ltd, which is facing financial difficulties.
- A general provision of £1,500 (1.5% of £100,000 which is the remaining receivables from the client) based on economic conditions.
- The total Provision for Doubtful Debts at Year 1 is £2,500.

Question 43

How are doubtful debts treated in the Profit and Loss Account?

Answer 43

Doubtful debts are recorded in the same expense account as bad debts in the Profit and Loss Account, under the “Bad and Doubtful Debts” category.
- Bad debts: These are actual costs to the business and are treated as an expense.
- Doubtful debts: These represent potential future costs that may or may not materialise.
- Increase in provision: Any increase in the provision for doubtful debts compared to the previous year’s provision is treated as an expense.
- Decrease in provision: A decrease in the provision reduces the expense.

Example:
Year 1: Nightingales creates a provision of £2,500 (an increase from £0), which is fully treated as an expense in the Bad and Doubtful Debts account.

Year 2: Nightingales increases the provision to £3,000, an increase of £500. The £500 increase is treated as an expense in the Bad and Doubtful Debts account for Year 2.

Year 3: The provision is reduced to £2,000, a decrease of £1,000. The £1,000 reduction is treated as a reduction in the Bad and Doubtful Debts expense for Year 3.

Question 44

How is the Provision for Doubtful Debts presented on the Balance Sheet?

Answer 44

The Provision for Doubtful Debts is treated as a liability on the Balance Sheet. It is presented separately from other liabilities and is matched directly to the receivables asset account it most affects.
- Nature of the provision: The provision reflects the possibility that some debts may not be collected, and it is used to prudently adjust the value of receivables.
- Presentation: It reduces the value of the receivables on the Balance Sheet, giving a more accurate representation of the business’s financial position.

Example:
In the Balance Sheet of Nightingales for Year 1, the Provision for Doubtful Debts is shown as:
- Receivables: £101,000
- Less Provision for Doubtful Debts: £2,500
- Net Receivables: £98,500

This presentation allows the business to show the full value of its receivables while also highlighting the amount that is unlikely to be collected.

Question 45

Provide a summary of Bad and Doubtful Debts as year-end adjustments.

Answer 45

• A bad debt is a debt which a business knows with certainty that it is never going to receive.
• Bad debts can be written off during the financial year or at the end of the financial year.
• A provision for doubtful debts occurs when a business is providing for the possibility that a debt or debts may not be paid.
• A provision for doubtful debts can be specific or general.
• Bad debts will appear on the balance sheet by a reduction in the Receivables account and in the P&L account as an expense.
• The increase/decrease in the provision for doubtful debts will be shown in the P&L account and they will appear on the balance sheet as a liability (matched to the asset that they reduce ie the receivables).

Question 46

How are the accounts of a partnership structured, and what is the role of a profit appropriation statement?

Answer 46

The accounts of a partnership are generally similar to those of a sole trader, with the main differences appearing in the bottom half of the Balance Sheet due to the ownership of the business by at least two partners.

Year-end adjustments: The year-end adjustments in a partnership’s accounts are the same as those of a sole trader.

LLPs and limited partnerships: The accounts of Limited Liability Partnerships (LLPs) and limited partnerships are prepared in a similar way to those of ordinary partnerships.

Capital section on the Balance Sheet: In a partnership, the capital section of the Balance Sheet differs from a sole trader because the business is owned by at least two people.

Profit appropriation statement: This statement is an additional, intermediate step used to show how the profits for the relevant accounting period are divided between the partners, enabling the capital of the partnership to be shown correctly on the Balance Sheet.

Question 47

What are the separate accounts for each partner in a partnership, and how do they function?

Answer 47

In a partnership, each partner has their own set of accounts, typically consisting of two separate accounts:

Capital account:
- This account records the partner’s original investment in the partnership, as well as any subsequent investments made by the partner.
- The capital in this account cannot be withdrawn under normal circumstances.

Current account:
- This account tracks the partner’s share of the ongoing business profits.
- It also records any drawings (withdrawals) that the partner takes from the business throughout the year.
- Drawings: These are usually based on an estimate of the partner’s share of the expected profits. If a partner withdraws too much, they may be liable to contribute a balancing payment back to the partnership, depending on the terms of the partnership agreement.

Question 48

How is the profit of a partnership appropriated after the Profit and Loss Account has been drawn up?

Answer 48

After the profit for the business as a whole has been calculated, it is divided amongst the partners in the following way:
- Interest on capital or salaries: Sums are allocated to individual partners corresponding to any ‘interest’ on their capital or ‘salaries’ due to them under the partnership agreement.
- Remaining profit: The remaining profit is distributed among the partners according to an agreed profit share ratio.

Question 49

What are notional ‘interest’ on capital and notional ‘salary’ in a partnership, and how are they treated in the accounts?

Answer 49

Notional ‘interest’ on capital: This is a payment representing interest on the capital in the partner’s long-term capital account. The rate of interest is specified in the partnership agreement. Although it is called ‘interest’, it should not be treated as an expense item in the Profit and Loss Account. It is, in fact, an appropriation of profit under a different name.

Notional ‘salary’: One or more partners may receive a notional salary, also specified in the partnership agreement. This is treated as an appropriation of profits, not an expense in the Profit and Loss Account. Salaries for partners are generally treated as drawings.

Question 50

Provide a summary of Partnership Accounts.

Answer 50

• Within a partnership, each partner will have their own accounts – commonly both a capital account and a current account.
• These are capital accounts.
• Partners in a partnership will take ‘drawings’ – ie a share of the profits of the partnership.

Surplus profits are distributed to partners in the following order:
- ‘Interest’ on their capital
- ‘Salaries’
Remaining profit will be distributed according to an agreed profit share ratio.

The Profit Appropriation Statement must be completed before the Balance Sheet can be drawn up.

The top half of a partnership Balance Sheet is similar to that of a sole trader. The bottom half, which shows capital, follows a different format.

Question 51

Why do companies prepare accounts, and what requirements must these accounts meet?

Answer 51

Companies are obliged to prepare accounts by statute. These accounts must meet specific requirements:
- True and fair view: The accounts must present a true and fair view of the company’s profits, assets, and liabilities.
- Specific format: The accounts must take on a particular appearance and format as required by statute.
- Provide key information: The accounts must present certain key information to the reader, such as shareholders, potential investors, or individuals investigating an allegation of fraud.
- Consistency: The information must be presented in the same way each year to ensure that the accounts tell an accurate and fair story.

Year-end adjustments such as accruals, prepayments, depreciation and bad and doubtful debts apply equally to companies as they do to sole traders and partnerships.

Question 52

How are accounts interpreted in practice, and why is this important?

Answer 52

Accounts are used by a wide range of people for various purposes, and understanding how to interpret them is crucial for making informed decisions.

Users of Accounts:
- Management uses accounts to assess business performance.
- Potential investors rely on accounts to evaluate investment opportunities.
- HMRC uses them for taxation calculations.

Solicitors’ Role: Solicitors must interpret business accounts to provide comprehensive advice, understanding how events will affect their client’s accounts and identifying potential issues the accounts may not reveal.

Financial Ratios: A common method for analysing accounts is the calculation of financial ratios (e.g., gearing). These ratios help provide context and meaning to the figures in the Profit and Loss Account and Balance Sheet, making them more significant than they might initially appear.

Question 53

What is an accounting reference date (ARD) and its significance for a company?

Answer 53

The Accounting Reference Date (ARD) is the date that marks the end of a company’s accounting reference period. Key points about the ARD include:
- Freedom of Choice: A company can choose its own accounting reference period, subject to the Companies Act 2006.
- ARD Definition: The ARD is the last day of the month in which the anniversary of the company’s incorporation falls (as per s 391(4) CA 2006).
- Changing the ARD: A company can change its ARD, provided the provisions under s 392 CA 2006 are followed.

Filing Deadlines:
Private companies must file accounts with Companies House within nine months after the end of the relevant accounting reference period (s 442(2)(a) CA 2006).

Public companies must file accounts within six months after the end of the relevant accounting reference period (s 442(2)(b) CA 2006).

Upcoming Changes: The Economic and Corporate Crime and Transparency Act 2023 will introduce changes to which companies must file annual accounts, though these provisions are not yet in force.

Question 54

What is the treatment of capital accounts in company financial statements?

Answer 54

In company accounts, the capital of the company is shown in the bottom half of the Balance Sheet.

The capital comprises:
- Share capital
- Reserves
- Retained earnings

This differs from the accounts of sole traders and partnerships, where the capital represents the individual owners’ investments rather than share capital or reserves.

This distinction is due to the separate legal personality of a company.

Question 55

How is tax accounted for in company financial statements?

Answer 55

Companies, due to their separate legal personality, are required to pay corporation tax on their profits.

The corporation tax amount is included in the company’s Profit and Loss Account, and it directly affects the company’s profitability.

Unlike sole traders and partnerships, which do not have separate legal status and instead pay tax through personal tax returns, a company’s accounts must reflect the tax it owes on its profits.

Question 56

How are dividends treated in company financial statements?

Answer 56

Dividends are the return on investment for the company’s shareholders and are an appropriation of profits (after tax). They are not considered an expense for the business.

Dividends are typically recorded in the Statement of Changes in Equity (SoCiE), which reflects:
- Profits brought forward from the previous period
- Profits added from the current period
- Any deductions for dividends
- The resulting Retained earnings showing the total profits carried forward to the next accounting period.

Dividends affect the company’s retained earnings on the Balance Sheet, but do not appear in the Profit and Loss Account.

Question 57

What are consolidated accounts and when are they required for a company?

Answer 57

Consolidated accounts are required for companies that have one or more subsidiaries.
- Under s 399 CA 2006, companies must publish accounts for the group of companies as a whole in addition to their own annual accounts.
- This requirement ensures that shareholders of the parent company have access to information regarding the subsidiary companies.
- While each subsidiary in the group should prepare its own individual accounts, there are widely available exemptions.
- Therefore, it is rare in practice for subsidiaries to prepare their own accounts.
- Relevant exemptions are found in ss 394A and 479A CA 2006.

Question 58

Provide a summary of company accounts.

Answer 58

• Companies prepare accounts because they are obliged to do so by statute.
• Companies are required to make up their accounts by their Accounting Reference Date. Companies are permitted to change their ARD.
• Year-end adjustments such as accruals, prepayments, depreciation and bad and doubtful debts apply equally to companies as they do to sole traders and partnerships.

There are three main differences in the financial statements for companies:
* Format;
* Tax
* Dividends.

• The bottom portion of the Balance Sheet, shows what is referred to as ‘Total Equity’ or ‘Equity and Reserves’.
• Companies can make an adjustment to the financial statements to reflect the fact that their assets have decreased in value.

Question 59

What are some key entries in the bottom half of a company’s balance sheet and what do they represent?

Answer 59

The bottom half of a company’s balance sheet shows equity and balances with the top half (Net Asset Value).

Key entries typically include:
- Called up share capital: The total value of shares that have been issued and paid for by shareholders.
- Share Premium Account: The amount received by a company above the nominal value of its shares when those shares are issued.
- Revaluation Reserve: Represents the increase in value of assets that have been revalued, reflecting unrealised gains.

A Capital Redemption Reserve (CRR) may also appear, but it is created only from certain transactions between the company and its shareholders, under specific provisions of the Companies Act 2006.

CRRs are uncommon and are not typically part of everyday business activities, so they are not further explored .

Question 60

What is called-up share capital, and how is it reflected on a company’s balance sheet?

Answer 60

Called-up share capital refers to the aggregate amount that the company has required its shareholders to pay on each class of issued shares, excluding any premium.

This called-up value may differ from the nominal value of the issued shares, particularly when shares are not fully paid.

It is relatively rare for shares to be partly paid.

Example:
- A newly-incorporated company issues 200,000 ordinary shares of £1 with 75p called up per share.
- The called-up share capital reflected in the company’s Balance Sheet will therefore be £150,000 (200,000 shares x 75p).
- This represents the amount shareholders are required to pay, not the nominal value of the shares.

Question 61

What are reserves, and how are they classified on a company’s balance sheet?

Answer 61

Reserves are the capital of the company that exceeds the called-up value of the issued share capital.

Reserves are classified into two categories:
- Capital reserves, which include items like the share premium account, revaluation reserve, and capital redemption reserve.
- Revenue reserves, such as retained earnings.

Capital reserves cannot be distributed as dividends or any other payment to shareholders.

Revenue reserves, however, are distributable reserves, meaning they can be distributed to shareholders, typically in the form of dividends.

Question 62

What is a share premium account and how is it reflected in a company’s accounts?

Answer 62

The share premium account represents the difference between the nominal value of the shares and the amount that shareholders actually paid for the shares, i.e., the subscription price (if greater).

Note: The market price of the shares, once issued, has no bearing on the company’s accounts, meaning that even if the market price goes up or down, the share premium account remains unaltered.

The share premium account is classified as a capital reserve.

As a capital reserve, the assets representing the share premium cannot be distributed to shareholders, except in exceptional circumstances such as a bonus issue.

Question 63

What is a revaluation reserve and how does it affect a company’s balance sheet?

Answer 63

A revaluation reserve is created when a company’s directors, as part of their accounting policy, wish to show more up-to-date values of non-current assets in the accounts.
- For example, if the value of the company’s real property portfolio has increased, the company may re-value the assets to their current value.

The increase in the asset’s value causes the figure for Net Assets to rise, which increases the top half of the Balance Sheet (the assets).

To balance this, a corresponding increase is made to the bottom half of the Balance Sheet by creating or increasing the existing revaluation reserve by the same value.

The revaluation reserve represents a notional profit to the company from the rise in value of the asset.

However, this profit is unrealised until the asset is sold, making it a capital reserve.
- Therefore, the revaluation reserve cannot be distributed as a dividend until the company sells the asset and realises the profit (s 830(2) CA 2006).

Any subsequent reduction in the value of a re-valued asset can be set off against the revaluation reserve.

Question 64

Provide a summary of Share Capital and Reserves.

Answer 64

• The bottom half of a company’s balance sheet shows the equity and will balance with the top half of the balance sheet (the Net Asset Value).
• There are different entries to consider on the bottom half of a company’s balance sheet.
• The called-up share capital is the amount of the nominal value of its shares that the company has required its shareholders to pay.

There are different kinds of reserves, ie:
* Capital
* Revenue

The share premium account represents the difference between the nominal value of the shares and the amount that the shareholders actually paid for the shares.

A revaluation reserve is created when a company’s directors, as a matter of accounting policy, wish to show more up to date values of non-current assets in the accounts.

Question 65

What is the relationship between shareholders and dividends in a company?

Answer 65

• The owners of companies are shareholders.
• Shareholders’ return on their investment is the dividend they may receive.
• A dividend is an appropriation of profits (after tax), similar to how a sole trader may take drawings from their business.
• Dividends are not an expense of the business; they are a distribution of profits to shareholders.

Question 66

How are dividends shown in a company’s financial statements?

Answer 66

In practice, dividends usually appear in a financial statement called the ‘statement of equity’ (or ‘statement of changes in equity’).

Dividends are considered transactions between the company and its shareholders.

For the purposes of the Statement of Changes in Equity (SoCiE):
- It shows profits brought forward and adds current year profits, subject to any deductions for dividends.

The resulting ‘Retained Earnings’ will appear on the bottom half of the Balance Sheet, showing the total profits carried forward to the next accounting period.

Question 67

What are retained earnings and how do they accumulate in a company?

Answer 67

Retained earnings is the reserve account for retained profits.
- Retained earnings represent profits after tax that the company has earned over its history and has not been distributed by way of dividend or appropriated to another reserve.
- Retained earnings generally increase year on year, as most companies do not distribute all of their profits, meaning the amount typically grows over time.

Question 68

What is the Statement of Changes in Equity (SoCiE) and how is it structured?

Answer 68

The Statement of Changes in Equity (SoCiE) is a separate calculation where profit for the year is carried over and not directly from the Profit and Loss Account to the bottom half of the Balance Sheet.

The SoCiE is appended to the bottom of a company’s Balance Sheet, showing the movement in retained earnings, which includes adjustments for profit and dividends.

The structure of the Statement of Changes in Equity is as follows:
Retained Earnings:
- Brought forward: the retained earnings brought forward from the previous period.
- Profit for the year: the profit earned during the current year added to retained earnings.
- Dividends paid: any dividends distributed to shareholders during the year are deducted.
- Retained earnings: the resulting retained earnings figure after accounting for the profit and dividends.

Question 69

How are dividends accounted for and what is their treatment in financial statements?

Answer 69

Dividends are paid or payable out of profits generated in the current or previous accounting periods.

A company can only make a distribution, such as a dividend, if it has ‘profits available for the purpose’ (s 830(1) CA 2006).

After the financial statements are completed, the profits for the period are determined, and dividends are recorded in a capital account as they are transactions between the company and its owner(s).

Dividends do not belong on the Profit and Loss account but are instead recorded in the Statement of Changes in Equity (SoCiE).

Question 70

What are the two types of dividends that can be paid on ordinary shares, and what is the difference between them?

Answer 70

There are two types of dividends that can be paid on ordinary shares:
- Final dividend
- Interim dividend

Both dividends are calculated in the same way, with the only difference being:
- Final dividend: Declared after the year-end and paid at a later date.
- Interim dividend: Paid during the current accounting period and in respect of that period.

Question 71

What is the process and accounting treatment for a final dividend, and how is it reflected in the accounts?

Answer 71

The final dividend is declared by the company’s directors in the Directors’ Report and must be approved by the shareholders through an ordinary resolution, usually passed at the Annual General Meeting (AGM).

Paid at the end of the financial year.

If the directors recommend a final dividend but it has not yet been approved by shareholders, it is called a proposed dividend.
- A proposed dividend is not enforceable as a debt until it is approved.
- A proposed dividend does not appear in the accounts of the relevant accounting period.

Example:
If a company has an accounting period ending on 31 December 2024 and intends to pay a final dividend, the directors will propose it for approval at a general meeting in April 2025.

If the dividend is approved at the meeting, it will be accounted for in the period ending 31 December 2025.

Once the final dividend is approved by shareholders, it is called a declared dividend.
- A declared dividend constitutes a debt enforceable by shareholders.
- It will appear in the Statement of Changes in Equity (SoCiE) as a deduction from Retained Earnings.

If the declared dividend has not been paid by the year-end, it will be listed in the Balance Sheet under current liabilities.

If the dividend has been paid before the year-end, it will only appear in the SoCiE.

Question 72

How is an interim dividend treated in the accounts, and how does it differ from a final dividend?

Answer 72

Interim dividends are usually paid under the authority of the company’s directors, as outlined in the articles of the company (e.g., Model Article 30).
- They do not require an ordinary resolution from shareholders.
- A board resolution to pay an interim dividend can be rescinded before the dividend is paid, so an unpaid interim dividend is not considered a debt that shareholders can enforce.
- They are paid during the financial year.

The accounting treatment for interim dividends differs from that of final dividends:
- Interim dividends will only be reflected in the accounts if they have actually been paid.
- Once paid, the interim dividend is deducted from the company’s assets (cash and cash equivalents) and shown as an item on the trial balance.
- As dividends are an allocation of profit (not an expense), they do not appear in the Profit and Loss Account.
- The interim dividend will be recorded in the Statement of Changes in Equity (SoCiE), similar to the treatment of declared and paid dividends.

Any profits after tax that are not distributed as dividends are retained in the company.

Example:
Lennon Limited’s accounting period ends on 31 March 2024. The directors propose a final dividend of £10,000, which is declared by shareholders at a general meeting in June 2024 and paid in September 2024.
- In the accounting period ending 31 March 2024, the final dividend does not appear in the financial statements, as it was not declared during this period.
- In the accounting period ending 31 March 2025, the final dividend will not appear in the Balance Sheet under current liabilities as it was paid in September 2024, but it will affect the Retained Earnings in the bottom half of the Balance Sheet as reflected in the SoCiE.

Question 73

Provide a summary of Dividends.

Answer 73

• Shareholders’ return on their investment is the dividend that they may receive.
• Dividends are paid or payable out of profits generated in the current or previous accounting periods.
• Dividends do not belong on a Profit and Loss account; when a company declares a dividend, it will show up in the SoCiE.
• Dividends can be interim or final.
• Some shares will pay a preference dividend.
• A company may decide to convert some of its reserves into share capital by issuing fully paid shares to existing shareholders on a pro rata basis.