Chapter 1: Introduction to Accounting Flashcards
1.1 Introduction
Financial statements are defined as the financial records of an organisation, the financial statements primarily comprise a profit and loss account and a balance sheet. Accounting is the techniques involved in recording the transactions of a business on a regular basis to summarise the information on financial aspects, such as profitability or indebtedness to assist the owners, management or employees of the business. Bookkeeping is the process of recording financial transactions.
1.2 The Purpose of an Accounting System
Accounting should be able to determine if a business is operating at a profit and if the business is able to meet its liabilities.
The relevance of this from a tax point of view – the records or financial statements of the business is the starting point for calculating the amount of tax that needs to be paid. Tax legislation will dictate that adjustments are made to the accounting figures produced from these records; the adjustments known as adjustments to profit. The starting point for the adjustments is the net profit or loss as calculated for the financial statements, which as prepared following accounting standards.
Accounting standards require that accounts are prepared on an accrual’s basis. However eligible businesses are allowed to use the cash basis for tax purposes, whereas others use the accruals basis. This means income is accounted for when it is actually received, and allowable expenses are deducted when the cash is paid. Businesses can use the cash basis if they are unincorporated (sole trader or partnership), with income no less than £150,000 (that threshold can change). Limited liability partnerships are ineligible to use the cash basis, as are partnerships where one or more of the partners is a company.
1.3 The forms of business mediums
Sole trader – the business and personal affairs of the sole trader are not distinguished. If they incur a liability in their business dealings and the earnings of that business are not adequate to pay the liability, then the creditor can require payment of the trader’s non-business property (their house).
Partnership – two or more persons associated for the purpose of a business or profession. Their business and personal affairs are not separate. A partner’s non-business assets and income may be used to pay the liabilities of the partnership business (in Scotland however a partnership is regarded as a separate legal entity).
Company – distinct legal person created in order to separate responsibility for the affairs of a business from the person affairs of the individuals who own the business. Consequently, the company’s liabilities are those of the company and not those of its owners. Normally the shareholders will not be required to contribute further towards the liabilities of the company and have limited liability.
Limited Liability Partnerships – they have characteristics of a company and of a partnership. Like a company they have a legal personality as a body corporate, the liability of members to contribute to the LLP’s debts is limited to its assets. The LLP will be governed internally by an agreement between members which will perform the function of a partnership agreement.
1.3 The forms of business mediums - the accounting treatment of each business, the balance sheet
Accounting treatment for each business –
For accounting purposes, the individual business is regarded as an entity in its own right (separate from its owner). This is easy in the case of an LLP and a company. With a sole trader and a partnership, the business element must keep separate records as distinct from the traders or partners private and personal affairs.
The balance sheet – summarises the assets, liabilities and capital of a business at a particular date. Capital is the sum that is owed by the business to the owner/proprietor.
Fixed assets – used within the business on a long-term basis and used within the businesses trade. For example, land and buildings, plant and machinery, fixtures and fittings and motor vehicles.
Current assets – more volatile, they increase/decrease daily and in theory are easy to convert to cash. There are three types. Stock for goods for resale, debtors (people who owe the business money) and bank and cash balances. You show current assets in the order starting with the least liquid.
Creditors – someone who the business owes money to. The creditor total is split between amounts due within one year and amounts due more than a year from the balance sheet date. You deduct the creditors due in one year from the current assets to get the net current assets. You then deduct long term creditors from net current assets and fixed assets to get net assets.
Proprietor’s funds – consists of the capital at the start of the trading period plus any profits in that accounting period, less any amounts which have been withdraw by the owners (drawings). The total of proprietor’s funds shows how the business was able to afford its net assets and this figure should always equal net assets. The proprietor’s funds represent the amount which is owed by the business back to the owners.
The profit and loss account – summarise all income and expenditure in the trading period. It starts with the sales for the period, then deduct the cost of sales, to get the gross profit. The day to day running expenses of the business (rent, heating etc) are then deducted from the gross profit to get the net profit. These expenses in the profit and loss account will not necessarily be deductible for tax purposes.
