Business Accounts Flashcards
Book-keeping ledgers
The process by which businesses record money transactions is called ‘book-keeping’.
Each day there will be a number of financial transactions that take place within a business eg sale of stock or payment of employees’ wages. These need to be recorded in a logical and useful way. As such, transactions of a similar type (eg the payment of rent and electricity bills by the business) are grouped together and recorded in a single place referred to as a ‘nominal ledger’ (eg a nominal expense ledger).
There are several different types of ledgers (also referred to in a general sense as ‘accounts’). The collective name for all of the different ledgers/accounts used by the business is ‘books’.
Double entry book-keeping
The principle of this system of book-keeping is that every money transaction that a business undertakes will have a dual effect in its accounts. For example, if a sole trader purchases an asset for £5,000, there will be a reduction of £5,000 in the record of its cash and an increase of £5,000 in the record of the assets of the business.
Having identified, in respect of a particular transaction, the types of account affected and whether there is an increase or reduction, the next step is that the 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.
As the value of every individual debit will be equal to the matching credit when all the debits/credits for all transactions are added together, the sum of the business’s debits should be equal to the sum of all its credits over the relevant accounting period.
The accounting period and trial balance
To make sense of the financial performance of a given business, it is helpful to be able to compare the position year-on-year. Periodically, therefore, the ledgers/accounts of a business will be ‘ruled off’ so that the balances on the various accounts can all be looked at together. This is done at the end of each accounting period/financial year. Many businesses also prepare ‘interim accounts’ during the course of a financial year for various reasons and at different points during the year.
Due to double entry book-keeping, if we take all the balances on all of a business’s ledgers/accounts as at the end of an accounting period and list them, showing debit balances in one column and credit balances in another column, the total of each of the two columns should be the same. This list is called a trial balance.
A trial balance is usually put together by a business or its accountants and forms the basis of information from which the financial statements, principally the profit and loss account and balance sheet are then compiled.
Trial balance
What is a trial balance?
A trial balance is a list of all the balances on all of a business’s ledgers/accounts as at the end of an accounting period.
The trial balance shows debit balances in one column and credit balances in another column. The total of each of the two columns should be the same (and thus balance).
The classification of ledgers/accounts
Every entry on the trial balance will relate to a ledger, which could be characterised as an asset, liability, capital, income or expense (ALCIE) account. You need to be able to recognise and classify the different types of account for the purpose of understanding the preparation of the financial statements.
Asset: something a business owns. A business will have a separate account for each category of asset (eg motor vehicles, cash at bank).
Liability: something a business owes. A business will have an account for each different type of liability (eg 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 (eg a theatre might record income from ticket sales and from venue hire in separate accounts).
Expense: money spent by the business. Each different type of expense is recorded in a separate account (eg heating and lighting).
Assets – Fixed Assets
A fixed asset is any asset, tangible (such as a building) or intangible (such as a trade mark), 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.
A tangible fixed asset is a physicalasset.
An intangible fixed asset does not have a physical existence, for example, a trade mark, patent or goodwill.
Fixed assets may also be called ‘non-current assets’.
Assets – Current Assets
Current assets include cash and items owned by the business (or owed to the business) which can quickly be turned into cash (as a rule of thumb, within one year).
These assets are current as they are continually flowing through the business and therefore have a shorter-term nature; for example:
- stock (goods for use or resale), also known as ‘inventory’;
- debtors, which are people who owe money to the business (most commonly ‘trade debtors’, who are customers who have bought on credit and have not yet paid);
- cash, including cash that the business has in its bank account(s) and ‘cash in hand’/’petty cash’. When looking at the accounts of companies, the various types of cash are combined into a ‘cash and cash equivalents’ entry in the Balance Sheet.
Liabilities
A liability is an amount owedby the business tosomebody else. These are categorised as current liabilities (broadly, those due to be paid within a year) and long-term liabilities (falling due after one year) (also known as ‘non-current liabilities’).
Examples of current liabilities include a bank overdraft (repayable on demand) and trade creditors(such as suppliers of raw materials). A trade creditor is the mirror image of a trade debtor.
A common example of a long-term liability (or non-current liability) (falling due after more than one year) is a term loan.
Capital
Where a business is owned by a sole trader, the assets of the business are the sole trader’s property since the business has no separate legal personality and cannot own property on its own account. However, for accounting purposes, the business and its owner are seen as two separate entities. A sole trader may invest a lump sum of his own money in the business when setting it up. As well as any such original capital contribution, a sole trader’s capital account will include the profits the business has retained over the years.
A sole trader will hope to earn a living from the profits of his business. Since the business is not a separate person, it cannot employ its owner and pay him a salary. Instead, the owner pays himself by means of drawings out of the profits of the business. The account labelled ‘drawings’ in the trial balance is a capital account because it represents transactions between the business and its owner.
Income and expense accounts
Expense accounts record day-to-day spending such as the examples in the previous summary, known as ‘revenue’ or ‘income’ expenditure. ‘Expenses’ for these purposes do not include spending on long-term assets (eg a car or a building) which are sometimes, confusingly, referred to as ‘capital expenditure’.
When a business pays for services or buys items that it will not hold for very long before it uses them up, it treats the purchase as an expense. By analogy to your everyday life, if you buy some bread from the supermarket you will think of this as a day-to-day living expense. However, if you buy a car or a television, you will think of this as acquiring an asset.
Income accounts record sums received by the business such as payments from customers in relation to sales of goods or services made by the business.
Year-end adjustments
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. The purpose of the year-end adjustments is to ensure that all income and expenditure shown on the final financial statements relate only to the relevant accounting period.
For example, if a business’s accounting period matches the calendar year and it pays a year’s rent in advance on 1 July, only half of this payment will correspond to the current accounting period (1 June – 31 Dec.). The remaining half (1 Jan – 30 June) will relate to the subsequent accounting period. According to the unadjusted trial balance, it will seem that the business has spent twice as much on rent for the current accounting period than it really has. The adjustments made effectively ‘correct’ this imbalance and you will see how this is done in a later element.
The contents of a profit and loss account
As you have seen, the profit and loss account 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. A profit and loss account is therefore a summary of the fortunes of a business over a passage of time. It is always vital to note the period to which a profit and loss account relates in order to understand it. The accounting period to which it relates is recorded in the heading for the account, always with the words ‘for the period ending on [last day of the period]’ or ‘for the year ended [last day of the period]’.
As a general rule, only the income and expense entries from the trial balance are transferred into the profit and loss account.
For example, ‘sales’ in the trial balance is an income account and this appears at the top of the profit and loss account. In contrast, ‘telephone’, ‘postage’ is a business expense and appears in the expenses section of the profit and loss account.
‘Cash at bank’, on the other hand, is an example of an asset account and so does not appear on the profit and loss account.
What is a balance sheet?
On its own, a profit and loss account (covered in a previous element) is an incomplete record of a business’s financial position as it only records two categories of account (income and expenses accounts). For this reason, a balance sheet will record the position of a business in respect of its asset, liability and capital accounts from the trial balance.
The date of a balance sheet
The balance sheet of a business differs from a profit and loss account as it is a snapshot relevant on a given date (unlike the profit and loss account which relates to a period, which in most cases is a year).
The date at the top of a balance sheet is the last day of the accounting period to which it relates. The heading of a balance sheet always contains the words ‘as at’ a specified date. For example, it will record the value of the total assets held by the business at that date.
That balance could be different the very next day, for example, if an asset were sold and the proceeds used to pay bills.
The contents of a balance sheet
The balance sheet principally tells the reader two key things:
- The net worth or net asset value (NAV) of the particular business (ie the value of the assets it has, less the liabilities it owes). This is recorded in the top half of the balance sheet.
- The capital invested in the business to achieve that net worth. This is recorded in the bottom half of the balance sheet.
These two figures (one in each half of the balance sheet) will always be the same, unless something has gone wrong. The two halves of the balance sheet must always balance. This balancing effect is because the top half of the balance sheet demonstrates how the money invested by the owners of the business (shown in the bottom half of the balance sheet) has been used.
As a general rule, asset, liability and capital entries from the trial balance are transferred into the balance sheet. For example, ‘debtors/receivables’ in a trial balance is an asset entry and this appears in the top half of the balance sheet. However, ‘capital at the start of the year’ is a capital entry and appears in the bottom half of the balance sheet.
There are standard formats for presenting this information on a balance sheet. The example balance sheet which follows explains the basics of how a balance sheet is put together. You do not need to worry about understanding each individual of a balance sheet, instead, you should focus on the fact that there are three different sections and briefly note what they consist of.
What are year-end adjustments?
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.
Year end adjustments
There are five year-end adjustments:
Depreciation
Accruals
Prepayments
Bad debts
Doubtful debts.
Depreciation
A fixed asset (which for a company may be referred to as a ‘non-current asset’) may have a useful life of several years, after which it may be of little or no value.
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.
If depreciation were not used, the accounts would not give a true reflection of the position of the business. The assets would be stated at their cost value, which may, over time, be well above their actual value.
Depreciation must be carried out in a systematic (ie regular) way but the method used should mirror as closely as possible how the asset loses value over the relevant accounting periods
Depreciation methods
There are two methods of depreciation:
the straight-line method, and
the reducing balance method.
The method that is chosen will depend not only on how the asset loses value but how it produces revenue for the business on an ongoing basis.
An asset such as shelving will use the straight-line method because the asset is being used up consistently over its lifespan and is generating a consistent amount of income.
An asset such as a van, however, will produce much more revenue for the business in its earlier years of use and will tend to lose a larger part of its value at this time and hence the reducing balance method will be more relevant. This amount is known as the ‘charge to depreciation’ or ‘depreciation charge’.
The straight-line method the most common and straightforward method, so we will focus on it.
Straight-line method
- spreads the depreciation charge evenly over the life of the asset; and
- gives rise to the same charge for depreciation each year.
This is the most common and straightforward method.
The straight-line method is used where the service provided by the asset continues throughout its useful economic life on a consistent basis (eg the shelving unit mentioned earlier).
If plotted on a graph, the depreciation of the asset would form a straight line.
Reducing balance method
- The depreciation charge each year is expressed as a percentage (x %) of the reducing balance (ie the net book value of the asset at the start of the relevant accounting period).
- More depreciation is thus charged in earlier years than in later years since the net book value of the asset reduces year on year.
This method is less common and slightly more complicated.
The reducing balance would be used where an asset is likely to lose a large part of its value in the first few years of ownership eg motor vehicles.
If plotted on a graph the depreciation of the asset would form a curved line.
Net Book Value
As you have seen, the fixed (or non-current) assets are recorded at the top of the Balance Sheet.
The original cost of the asset is shown, as is the accumulated depreciation relating to that asset. A calculation is then performed to show the current value of the asset after taking into account its loss of value due to depreciation.
COST – ACCUMULATED DEPRECIATION = NET BOOK VALUE
The Net Book Value of an asset is an estimate of the current value of the asset to the business.