Business - Accounts

Question 1

What are business accounts?

Answer 1

Summaries of financial information of a business.

In order to calculate their profits, they need to know how much income they have received in an accounting period, what expenses they have incurred, know assets, liabilities so they ascertain what the business is worth.

Question 2

What are the accounting standards?

Answer 2

UK Financial Reporting Council has produced the Financial Reporting Standards - accounting methods which should be applied to all financial accounts,

• Aim is to give a true, fair view of the business finances
• Not legally binding but failure to adhere to them can lead to disciplinary action by the governing body of the professional in question

There is also an international accounting standards board.

Question 3

What information do accounts provide?

Answer 3

Income - what the business earns from trading or offering its services - e.g. money received for sale of furniture in a furniture shop or money paid for legal services in a law firm

Expenses - items the business has paid for, and which it will benefit for a short time. E.g. gas, electricity, petrol, stock bought for resale - need to incur these for the business to operate

Assets - what the business owns, or has the right to own. E.g. premises, machinery, vehicles, cash and debtors (right to the money owed to it by its debtors and in theory it will receive this money where the debtor pays)

Liabilities - what the business owes. Outstanding bank loan, money owed to creditors.

Question 4

What method of accounting do businesses use?

Answer 4

Double entry book-keeping.

Whereby every business transaction has two aspects - debit and credit.

They begin with trial balance which involves obtaining all the credit and debit balances from the various accounts ledgers. The figures are then used to prepare the final accounts of the profit and loss account and the balance sheet.

Question 5

How often do book-keepers check the accuracy of the books?

Answer 5

At regular interval, daily or monthly, or sometimes weekly.

They will also check the end of the books at the end of the accounting period (usually one year). They will add all the DR balances and all the CR balances on the accounts. If there are no errors in the books, the two figures should be the same ‘Trial Balance’

Question 6

What is the purpose of final accounts?

Answer 6

To know how their business is performing financially and what it is worth.

The final account comprise the profit and loss account and the balance sheet gives them this information.

Question 7

What does the profit and loss account show?

Answer 7

Net Profit = Income - Expenses

Income is turnover, i.e. money brought in before considering expenses (sales for trading business, profit costs for services e.g. law firms, interest and rent received)

Expenses - sums spent on things where the benefit is used up quickly, e.g. advertising, marketing, stationery, wages, utility paid, travel

Question 8

When has a company made a profit?

Answer 8

When the income EXCEEDS expenses = Profit :)

Question 9

When has a company made a loss?

Answer 9

When the expenses exceed income = Loss :(

Question 10

What doesn’t the Profit and Loss Account show?

Answer 10

The profit and loss account does not show assets and liabilities.

Assets - Things a business has which is worth money i.g. they bring a long-term benefit to the business (this is different to how much money has been brought in this year from sales etc)
Example : Premises, Plant and Machinery, Computers, Creditor

Liabilities - Shows where the business owes money. This is distinct from expenditure made in the year.

Question 11

What are the two ways of increasing profits?

Answer 11

1) Reducing expenses or increasing income

E.g. by selling more and creating different or better products or marketing them better or by increasing their prices.

Businesses can decrease expenses by - buying cheaper stock or raw materials, reducing the number of employees, renting cheaper premises.

Question 12

What are trading accounts?

Answer 12

Businesses which buy and sell goods have a preliminary account called a trading account, in addition to their profit and loss account.
- Trading account shows gross profit by subtracting cost of sales (cost of buying trading stock) from the income received from sales. The gross profit is then transferred to the profit and loss account.
- Any other income, and other expenses such as utility bills, will also be added to the profit and loss account and factored into the calculation of net profit.
- Having a trading account as well as a profit and loss account means that the businesses can see where the problem lies if they are not satisfied with their net profits. The trading account will enable them to assess whether their business is buying stock at too high a price or whether is its other expenses, shown on the profit and loss account, which are reducing its net profit by so much.

Businesses engaged in the provision of professional services - e.g. law firms do not need a trading account.

Question 13

What is a balance sheet?

Answer 13

A balance sheet is not just a snapshot. It lists the assets and liabilities of the business on the last day of the accounting period. Thus it will only be accurate for that day.

Question 14

What is the calculation of the net worth of a company?

Answer 14

Assets minus liabilities = Net Worth of the Business
- If all of the assets of the business are added together and all of the liabilities are deducted, this shows the net worth of the business.

Question 15

What are the two sections of the balance sheet?

Answer 15

‘Employment of Capital or Assets’ - shows the worth of the business to third parties

‘Capital Employed or Financed by’ - shows the worth of the business to the proprietor.
i.e. how much would the proprietor get in the event that the business is wound up.

These two amounts should THE SAME
i.e. balance sheet should BALANCE, i.e. Net Assets = Capital

Question 16

What are the two types of asset categories that a business is split into? How are these shown on the balance sheet

Answer 16

1) Fixed Assets - these are assets which are not bought for re-sale but for providing long-term benefit to the business.
E.g. machinery and premises

2) Current Assets - i.e. short term assets, e.g. cash and debtors

Assets are listed in the balance sheet in decreasing order of performance (increasing order of liquidity)

Fixed Assets
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Current Assets

Question 17

What are the types of liabilities on the balance sheet?

Answer 17

Similar to assets, there are two forms of liability that a company may owe:

1) Current liabilities - e.g. liabilities repayable in 12 months or less from the date of the balance sheet
2) Long Term liabilities - liabilities repayable more than 12 months from the date of the balance sheet.

Question 18

How do you calculate the Net Current Assets and what does the figure indicate?

Answer 18

Net current asset = Current assets - Current Liabilities
- If this figure is negative - indicates that the business is in trouble
- It does not have available liquid assets to meet its liabilities within the next 12 months

Question 19

What are Net Assets? And what should the figure be?

Answer 19

Net Assets = Total Assets (Fixed + Net Current Assets) MINUS Total Liabilities (Long Term + Short Liabilities)

Net Assets should always equal the amount owning the proprietor as capital at the end of the year.
- This is because the Net Assets figure shows how much the proprietor can expect to get if the business were to be wound up
- i.e. They will get what is left of the total assets after total liabilities of the term have been paid to creditors
- This should be the same as their capital contribution

Question 20

What does the capital employed section shows?

Answer 20

The Net Profit from the profit and loss account (the turnover of the business MINUS its expenses) owed to the owner

Opening Balance = the amount contributed by the owner on opening the businesses. This is also amount owed to the owner.

Sometimes the business owner will have withdrawn money over the year, and this will be shown on the drawings account. The balance on drawings account is deducted from the other figure in the Capital Employed Section.

Question 21

What are adjustments in accounts?

Answer 21

Accounts often need to be adjusted to ensure the figures accurately reflect expenditure and income for the accounting period and asset value and liabilities are recorded accurately.

Question 22

What is the pre-payments adjusments?

effect on the Profit/Loss account?

Answer 22

Payments in advance reflect work that will be done in the next accounting period and therefore should not be included in this year’s income figure.

Pre-payments are also current assets, i.e. it is money owed in the next 12 months and so will be reflected on the balance sheet.

Effect on Profit/Loss
- Increase income in the current accounting year

Effect on Balance Sheet
- Increase current assets

Question 23

What is closing work in progress adjustment? WIP

effect on the Profit/Loss account?

Answer 23

I.e. work finished but not yet billed.
- As no bill has been delivered, no entries will be made on the accounts; yet the work has been done this year and therefore this years profit figure should reflect this.
- Also any WIP properly attributable to the previous year should also be deducted from this years profit and loss account

Effect on Profit/Loss:
- Work finished this year, but not billed will increase Income in the current Accounting Year.
- Work finished last year, but not billed until this year will reduce this year’s income figure.

Question 24

What is the closing stock adjustment?

effect on the Profit/Loss account?

Answer 24

How much stuff does the business have left at the end of the year which it can sell next year.

Closing stock is an asset of the business and therefore should appear on the balance sheet as a current asset, which shows that the business will start the following year with stock having already been purchased.

Effect on profit/loss
- N/A

Effect on balance sheet
- Increase current assets

Question 25

What are the bad and doubtful debts adjustments?

effect on the Profit/Loss account?

Answer 25

Where there is doubt over the recoverability of debts, the business should write down the amount of debts that it is owed to reflect this. E.g. if a debtor is in financial difficulty

This will result in a reduction in value of the debtors figure in the balance sheet.
- Doubtful debts are also an expense of the business as the business has incurred a cost for which it will now never receive payment

Effect on profit/loss
- Increase expenses

Effect on balance sheet
-Reduce current assets (debtors)

Question 26

What is the depreciation and revaluation adjustment?

effect on the Profit/Loss account?

Answer 26

The value of assets on the balance sheet should be reduced to reflect the fact they depreciate.
- It is an expense of the business and will thus reduce net profit
- It will also reduce the value of assets on the balance sheet

Effect on profit/loss
- Increase expense

Effect on balance sheet
- reduce the value or fixed / current assets (depending on what the asset is)

Question 27

What is the disposal of fixed assets adjustment?

effect on the Profit/Loss account?

Answer 27

• If an asset is sold for more than its book value, the excess will be a profit on the sale.
• Therefore, the profit will be added to the company’s profit and loss account
• If an asset is sold for less, it should be recorded as a loss
• The balance sheet will reflect the transformation of the fixed asset to cash

Effect of profit/loss
- Increase income where assets sell for more than book value
- Increase expenses where asset is sold for less than its book value

Effect on balance sheet
- reduce fixed assets (as the asset has become cash)

Question 28

What are the steps of analysing accounts?

Answer 28

1. Checking the date of the balance sheet
   - is it up to date, and showing an up-to-date financial position. Has it been distorted by a recent seasonal boost in sales, resulting in a high cash balance and lots of debtors?
2. Look at the business accounts from previous years
   - will help show if the business is growing and becoming more profitable, or in decline
3. Check how valuations have been carried out and how recently
   - e.g. value of freehold property, as it may be worth more.
   - value of fixed assets such as machinery
   - trading business - check how stock is valued, of if the stock is damaged/obsolete
4. Analyse debt figures
   - Debtors are classed as assets, because when they pay the outstanding debt to the business, the business will have more cash, sometimes debtors do not pay
5. Is there a bank overdraft?
   - Classed as a current liability, because it is repayable on demand. Will reduce current assets figure and make it look as if the business may have difficulty paying its debts in the short-term. Reality - banks will not demand repayment of an overdraft unless the business is in financial difficulties. Therefore, an overdraft isn’t really a problem.
6. Look for exceptional items, which may distort the accounts for that year - e.g. the business has made a major invesstment in machinery, which will increase profits in the long run, which has not happened yet.

Question 29

How to know whether a business can pay debts?

Answer 29

The balance sheet shows whether a business can pay its debts.

• Liquidity is the availability of liquid assets to a business.
• A liquid asset is an asset that can easily be converted into cash in a short amount of time
• In a balance sheet this is ‘current assets’

For example, an extremely valuable factory and office premises are of no use to a business if it needs cash within the next fortnight - it cannot sell a factory and office premises in 2 weeks, so owning these valuable assets will not help to pay its debts as they fall due.

Question 30

What assets are liquid?

Answer 30

1. Cash is the most liquid current asset - it can be directly used to pay a debt.
2. Debts are also liquid, as they are likely paid in cash. Businesses can sell debts on to a debt factor, whose business is to purchase other people’s debts from them for less than the amount of debt. The debt factor then collects debts when they are due and makes a profit because they can collect the full amount of the debt although they only paid a percentage of the amount of the debt to the seller

Note. Stock is not as liquid as cash or debts, because it might be difficult to sell the stock quickly, or for a good price or it may be seasonal, damaged or obselete stock.

Question 31

How are partnership accounts set up?

Answer 31

Partnership capital is contributed by partners and the firm’s profit is owed to these partners.

Partnership will need to
- Keep separate records for each partner
- Show how much capital they contributed
- How much profit is owed to them and how much they have withdrawn during the year
- Each partner will also have an account in their own name, called a capital account, which shoes the amount contributed by each partner

Question 32

How to partners share profits and losses?

Answer 32

• Partners will share profits and losses in accordance with their partnership agreement.
• If there is no agreement, in equal shares according to the Partnership Act 1980.
• Sometimes one or more partners may receive a salary to reflect the fact that they carry out more work for the business, or they may receive interest on capital contributions. Any remaining profit will then be divided between the partners in proportions set out in the PA 1980.
• It is important to remember that salary and interest in the context are not separate from profit, partners are not employees and so ‘salary’ in this context just means that some partners are entitled to a certain amount of the profits before the profits are divided up between the partners, and awarding interest is just a way of awarding a greater share of the profit to those have contributed more capital.

Question 33

What is the appropriation account (Partnerships and LLP)?

Answer 33

Partnership and LLP profit and loss accounts are prepared in the same way as the profit and
loss accounts of sole traders, but there will also be an appropriation account showing how net profit is divided between the partners.

Example: Marianne and Lindsey are in partnership. When the partnership was set up, Marianne
contributed £20,000 and Lindsey contributed £10,000. The firm’s net profit for the year is
£33,000. Under the partnership agreement, both partners receive interest on their capital
contributions, of 8% per annum. Marianne also receives a salary of £5,000 per annum. The
remaining profits are split equally between Marianne and Lindsey.

Question 34

What is the current account? (Partnerships)

Answer 34

• The net profit is owed to the proprietors of the business
• Where there is only one proprietor the profit is usually credited directly to the capital accounts
• In the case of partnership, it is usual to have a separate current account for each partner to which the appropriation of net profit (including salary and interest) is added and from which drawings are deducted
• The reason for separating capital and current accounts is because the partners are often entitled to interest on capital contributed. It is therefore desirable to keep the original capital contribution of each partner readily identifiable and unaffected by subsequent appropriation of profits and drawings.

Question 35

What is the balance sheet like for Partnerships?

Answer 35

-The capital and current account balances of each partner are shown separately on the balance sheet in the capital employed section
- Usually an appendix is provided to show movements on current accounts, and just the balance of the current accounts is inserted on the balance sheet

Question 36

What happens to the accounts when a partner leaves?

Answer 36

If a partner leaves or joins part-way through an accounting period.

The net profit for that year will be apportioned between the period before and the period after the change.

Two appropriation accounts will be prepared.
First- will show the allocation of profit earned before the change in membership, in accordance with the partnership agreement before the change.
Second - will show the allocation of profit earned after the change, in accordance with the shares set out in the partnership agreement in force after the change in membership

Question 37

How does taxation work in partnerships?

Answer 37

Partners submit their own tax returns, claiming their own personal allowances.

Question 38

What impact does issuing shares have on a company account?

Answer 38

The section of the balance sheet which shows how much the shareholders have contributed is often headed ‘capital and reserved’ or ‘financed by or equity’

Shares are either issued at par value - for example a shareholder will pay £1 for an ordinary £1 shares - or the shareholder will pay a premium to reflect the fact that the company is profitable and its shares are now worth more than £1 nominal value.

• The premium will be shown separately in the share premium account.
• Companies may have more than one type of share, for example, ordinary and preference shares and they will be shown separately on the balance sheet.

Question 39

What is a company’s net profit used for?

Answer 39

It is mainly used for
- Taxation
- Dividends
- Retention of Profits

Question 40

When can a company pay dividends?

Answer 40

A company is only permitted to pay dividends from profits (although they could be paid from previous years’s accumulated profits rather than the current year).

However, companies are unlikely to distribute all of their net profit
- this is because they need to pay expenses and run the business
- as some profit is actually debt cash so this will be factored into the profit and loss account.

Question 41

What is retained profit?

Answer 41

The balance of net profit, after tax and dividends is retained in the business.

These retained profits are generally known as the profit and loss reserve. Because the profit and loss reserve consists of profit the business has made while trading, it does not form part of the capital of the company.

This means that it can be distributed to shareholders if the directors decide to recommend a dividend. Contrast this with share capital, which forms part of the capital of the company because it derives from the money the shareholders have paid for shares. It is not usually available to shareholders because of the principle of maintenance of capital.

Question 43

What is the ‘outstanding expenses’ (accruals) adjustments?

effect on the Profit/Loss account?

Answer 43

Essentially, Bills the firm has received but not yet paid.

The expenses figure on the profit and loss account should be adjusted to show this
- The reason for this is that the expense was incurred in the current accounting period and through the firm will not actually pay it until the next one, it reflect expenditure from this years accounts.
- Accruals should be labelled on the balance sheet as Current Liability as it an amount due to a third party creditor

Effect on Profit / Loss
- Increase expenses in the current accounting year

Effect on Balance sheet
- Increase current liabilities

Question 44

What is available cash?

Answer 44

Just because a business made profit, does not mean the business has the net profit figure readily available in cash.

The business turnover figure will be made up of bills that have been sent out, however, these may not all be paid by the end of the year.

Although assets are not categorised on the profit/loss account - money will still have had to have been spent on purchasing assets, e.g. a computer.

It is prudent for businesses to leave certain amount of cash in the bank as a float to meet any upcoming bills: the profit/loss account should be adjusted to reflect these as expenditure incurred in the current year.