WS8 - Business Accounts Flashcards
Double Entry Bookkeeeping, ledgers and trial balance - a) Accounts/Solicitors in practice: Why is it important for us as solicitors to understand financial statements of business?
- Most business transactions have financial motivation and have an effect of accounts so having this knowledge will help solicitors understand client concerns.
- A solicitor needs to be able to follow discussions in negotiations and meetings with financial proffessionals.
- An understanding of accounts is important when working on acquisitions and understanding value of business
- Reviewing accounts can be important in a litigation business (decicing if to take action against owner of a business)
Double Entry Bookkeeeping, ledgers and trial balance - b) Accounts and Business - Financial statements: When are financial statements prepared?
- Each accounting period of a business which is usually a full year and every business free to choose its own period.
Double Entry Bookkeeeping, ledgers and trial balance - b) Accounts and Business - Financial statements: What are the statements prepared?
- Profit and Loss acccount
Double Entry Bookkeeeping, ledgers and trial balance - c) Bookkeeping Ledges: What does bookkeeping meaning?
This is the process by which business record money transactions.
Double Entry Bookkeeeping, ledgers and trial balance - c) Bookkeeping Ledges: What is a ledger?
Transactions of a similar type such as payment of rent and electricity bills need to be grouped together in a single place and referred to as a nominal ledger, e.g a nominal expense ledger for these examples.
Double Entry Bookkeeeping, ledgers and trial balance - c) Bookkeeping Ledges: What is the collective name for all ledgers?
“Books”
Double Entry Bookkeeeping, ledgers and trial balance - d) Double Entry Bookkeeping: What is the principle of the double entry system?
Every money transaciton that a business undertakes will have a dual effect in its accounts.
E.G: Sole trader purchases an asset, there will be reducition of £5k in cash and increase of £5k in record of assets of business.
Double Entry Bookkeeeping, ledgers and trial balance - d) Double Entry Bookkeeping: What must be done once identified the accounts affected and if increase or reduction?
- Next step is that transaction will be recorded in two place in the books.
- One aspect will be recorded as a debit entry and the other as a credit entry.
Double Entry Bookkeeeping, ledgers and trial balance - d) Double Entry Bookkeeping: What should be equal if added up?
As there should be matching credit and debit, when all these are added tgether, sum of business debts should equal to sum of all credits over accounting period.
Double Entry Bookkeeeping, ledgers and trial balance - e) Accounting period and trial balance: How is financial performance measured?
- HElpful to compare the position year on year.
- Therefore, periodically, ledgers/accounts of a business will be “ruled off” so that the balances on the various accounts can be looked at together.
- This is done at the end of each accounting period/financial year but some may also prepare interim accounts at different points of the year.
Double Entry Bookkeeeping, ledgers and trial balance - e) Accounting period and trial balance: What is the trial balance?
As mentioned, if all balance on a business ledgers/accounts are listed at the end of an accounting period, showing debt balances in one column and credit balances in another, total of each column should be the same, known as the trial balance.
Double Entry Bookkeeeping, ledgers and trial balance - e) Accounting period and trial balance: What is compiled using trial balance?
Forms the basis from which financial statements, principally the profit and loss account and balance sheet are then created.
See P181 for example
Double Entry Bookkeeeping, ledgers and trial balance - f) Classification of ledgers/accounts: What will every entry on trial baalnce relate to?
It will relate to a ledger which could be characterised as an asset, liaiblity, income or expense (ALCIE) account and you will need to be able to recognise the different types of account to understand preparation of financial statements.
Double Entry Bookkeeeping, ledgers and trial balance - f) Classification of ledgers/accounts: What is the definition for each account with ALCIE?
- Asset: This is something a business owns in which business will have seperate account for each type of asset (motor vehicles, cash at bank, etc.)
- Liability: This is something a business owes in which it will have account for each type of liability such as loans, trade debts owed, etc)
- Capital: Usually identifiable as an injection of value from an owner or investor rather than money generated by business.
- Income: Money earned by the busines, usually from regular source and each main income source will have seperate account.
- Expense: Money spent by the vusiness with each type having its own account such as heating and lighting,w ages paid to employees, etc.
See P182 for example
Double Entry Bookkeeeping, ledgers and trial balance - g) Assets - Fixed Assets: What is a fixed asset?
- Any asset which is tangible (physical) such as a building or intangible (No physical existence) such as a trade mark owned by a business that enable it to make profit.
- Note - May also be called “Non-Current Assets”
Thia follows on from balance sheet example which showed fixed assets/current assets when providing example of ALCIE and now we look at definitions
Double Entry Bookkeeeping, ledgers and trial balance - g) Assets - Fixed Assets: What is the time requirement to be defined as fixed asset?
To be a fixed asset, must be held by the company for over a year and provide some long lasting benefit to company.
Double Entry Bookkeeeping, ledgers and trial balance - h) Assets - Current Assets: What is a current asset?
This includes cash and items owned by business (or owed to them) which can quickly be turned into cash (as a rule of thumb, within 1 year)
Double Entry Bookkeeeping, ledgers and trial balance - h) Assets - Current Assets: What is the nature of these assets?
Continually flowing through the business and therfore have shorter term nature, such as:
* Stock (goods for use or resale) known as inventory
* Debtors also known as receivables who are people who owe money to the business (most commonly trade debtors, which are customers not yet paid.)
* Cash including that in bank accounts and cash in hand (petty cash) and often within accounts, it will be combined into “cash and cash equivalents” entty in the balance sheet.
Double Entry Bookkeeeping, ledgers and trial balance - i) Liabilities: What is a liaiblity within accounts?
An amount owed by the business to somebody else.
Double Entry Bookkeeeping, ledgers and trial balance - i) Liabilities: How are they categories?
- Current liabilities (Broadly, those due within a year) and example would be a bank overdraft which si repayable on demand and trade creditors such as suppliers.
- Long-term liabilities which fall due after one year and also known as “Non-current” liabilities such as a term loan from a bank.
Double Entry Bookkeeeping, ledgers and trial balance - j) Year End Adjustments: What must be done before trial balacne can be used to prepare financial statements?
Year end ajustments will need to be amde to some of the fugres and purpose is to ensure all income and expenditure shown on final financial statements relate only to the relevant accounting period.
E.G: If business accounting period matches calender year, and it pays one yea rrent in advance on 1 July then only half payment will correspondence to current account period 1 July to 31 December, remaining half 1Jan to 30 jun will relate to subsequent accounting period.
Double Entry Bookkeeeping, ledgers and trial balance: What is the overview of process from Bookkeeping ledgers to creation of profit and loss account/balance sheet?
Business prepares finacial statement at its financial year end, the profit and loss account and balance sheet and in order to do this, they use the trial balance enteries.
The profit and loss account - a) Intro: How do accountants prepare the profit and loss account/balacne sheet?
As mentioned above, they use the trial balance to construct these year end financial statements.
This section will focus on profit and loss account.
The profit and loss account - a) Intro: What is the definition of the profit and loss account?
This account essentially records the income of a business throughout an accounting period minus expenses incurred for that period in order to arrive at a profit (or loss) figure for that period.
The profit and loss account - b) Contents of a P/L Account: What summary does this account provide?
It is a summary of the fortunes of a business over a passage of time.
The profit and loss account - b) Contents of a P/L Account: What is it vital to understand when looking at a P/L Account?
The period for which the account relates to and this should be recorded in the heading for the account.
The profit and loss account - b) Contents of a P/L Account: What is the general rule for what entries are used from trial balance?
Only income and expense entries from trial balance are transferred into P/L account, E.G:
- Sales in trial balance is an income account and this appears at top of P/L account whereas transport costs or postage is a business expense and will appear in expenses section.
The profit and loss account - c) Format of a P/L Account: What is the format for these accounts?
- There are standard formats for presneting the layout of profit and loss account and all these accounts for UK businesses follow similar structure.
- Also note, you may see them referred to as an income statement in account prepared for international accounting standards.
See P186 for example for a P/L account
The balance sheet - a) Introduction: What is the definition of the balance sheet?
This records the position of a business in respect of its asset, liability and capital accounts at a particular date.
The balance sheet - a) Introduction: How does this contrast with P/L account?
- In its own, P/L is an incomplete record of business financial position as only covers income and expenses.
- For this reason, balance sheet will record position of business in respect of its asset, liability and capital accounts from trial balance.
Potential question to know which each covers
The balance sheet - b) Date of a balance sheet: How does balance sheet differ from P/L account?
- Balance sheet differs as it is a snapshot relevant on a given date, unlike P/L account which relates to the accounting period, which in most cases is a year.
- Date on top of balance sheet is last day of the accounting period to which it relates and always contains words “as at”, so balance could be different the very next day if asset were sold.
The balance sheet - c) Content of a balance sheet - NAV and capital: What are the two key things shwon by balance sheet?
- Net worth or net asset value (NAV) of the business (so the value of the assets it has and liabilities it owes) which is recorded in top half; and
- Capital invested in business to acheive that net worth which is recorded in bottom half.
The balance sheet - c) Content of a balance sheet - NAV and capital: How should the two figures above look?
- They will always be the same unless something gone wrong.
- The two halves of the balance must always balance and this is because top half shows how money invested by owners of the business (shown in the bottom half) has been used.
See P188 for example
Year-End Adjustments: Where are these adjustements made and why?
Transactions or modification to account entries on the trial balance and it is required because:
* All income and expenditure must be matches to relevant accounting period
* All current obligations must be anticipated as liabiltiies and all asset values must be assesed to make sure they can be recovered through future profits in conditions of uncertainty.
Year-End Adjustments: What are the five year end adjustements?
- Depreciation
- Accurals
- Pre-payments
- Bad debts
- Doubtful debts
Year-End Adjustments - a) Depreciation: What is depreciation?
- Fixed assets (non-current) may have useful life for several years, after which it may be little or no value.
- So, 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. but it must be carried out in systematic way but method used, should mirror as closely as possible how the asset loses value over relavant accounting periods.
Year-End Adjustments - a) Depreciation - i) Methods: What are the two methods?
- Straight line method and
- Reducing balance method
Year-End Adjustments - a) Depreciation - i) Methods: What will the chosen method depend on?
Not only how the asset loses value but how it procces revnuye on an ongoing basis.
Year-End Adjustments - a) Depreciation - i) Methods: How does the straight line method work?
- This spreads depreciation charge evenly over the life of the asset and gives rise to the same charge for depreciation each year.
- It will be used where service provided by the asset continues throughout its econimic life on consistent basis and if plotted ona graph, the asset would form a straight line.
- An asset such as shelving will use this method as the asset is used consistently over its lifespan and generates consistent amount of income.
Potentila question to identify which method should be used
See P190 for example
Year-End Adjustments - a) Depreciation - i) Methods: How does the reducing balance method work?
- Depreciation charge each year is expressed as % of reducing balance (i.e net book value of asset at start of relevant accounting period.
- More depreciation is charged in the earlier years than later years since net book value of asset reduces year on year.
- Less common but used where asset likely to lose large part of value in first few years of ownership such as motor vehicles and if on graph, it would have curved line.
Year-End Adjustments - a) Depreciation - ii) NBV: What is the net book value?
Costs of asset - accumlated depcreciation = NBV
Year-End Adjustments - b) Accruals: What is an accrual?
Accrual arises when expense has been icnurred and should be charged against profgit in the current year, but for some reason (e.g business ahs not received invoice for item) by the time accounts drawn up, that expense has not been included in trial balance.
Year-End Adjustments - b) Accruals: When will accural occur?
When business has had benefit of somehting in one accounting period but will not pay until the next.
Year-End Adjustments - c) Pre-Payments: What is a pre-payment?
- Prepayment arises when an expense ia paid for in the current year but all or part of the cost should be charged as an expense for next year.
- So, occurs if busines pays for something in advance during one accounting period but does not get benefit of all or some of what it has paid until the next, so opposite of accural.
Potential Question to know difference between accrual in which benefit received in account period but not yet paid, where as prepayment is paid but will not receive benefit until next accounting period.
Year-End Adjustments - d) Bad Debts: When may bad debts be written off?
- May be during the accounting year, if this is the case, there will be a bads debts expense account in the trial balance (if not, then this account will not exist)
- If business decided to write off further at year end, but year end adjustement not made, the accounts will nto give true reflection as it will seem business expecting more money than it will be actually paid.
Year-End Adjustments - d) Doubtful Debts - ii) Provision for doubtful debts on the balance sheet: How are doubtful debts treated on balance sheet?
- Provision for doubtful debts is treated as a liability on the balance sheet in which it is shown differently to other liaiblities and matched with the asset it most directly affects, the receiveables asset account.
- It will show the actual value of receivables account but also demonstrate it is providing for possibility of doubtful debts.
Share capital and reserves - b) Called up share capital: What does the share capital account tell?
- The aggregate amount that has been called up (nominal value of shares company ha srequired SH’s to pay)
- This called up value may or may not be the same as aggregate of the nominal value of issued shares, for example, if they are not fully paid and relatively rate to encounter shares not fully paid up.
Revenue reserves and dividends - c) Statement of changes in equity What happens for profit for the year?
- It is not carried over directly from the profit and loss account to bottom half of balance sheet.
- Instead, it is carried over into a seperate calaculation which is the statement of changes in equity.
Revenue reserves and dividends - e) Ordinary shares (ordinary dividend) - i) Final: What is the position if directors recommended final dividend but SH’s not approved?
- This is known as a proposed dividend.
- They do not consistute a debt enforceable by relevant SH’s until it is approved (i.e declared by ordinary resolution) so any final divdend which is proposed but not approved will not appear in accounts of that period.
Potential question to identify that a final dividend is proposed but not yet approved and therfore will not appear in accounts and not enforceable as debt. But once declared, it can be enforced by relevant SH’s.
