Business Accounting Unit 7. This unit will explain What is meant by ‘accounts’ Why businesses need to keep accounting records and use financial documents.

Business Accounting Unit 7

This unit will explain

• What is meant by ‘accounts’

• Why businesses need to keep accounting records and use financial documents

• Who uses these accounting records

• What the final accounts of a company contain- the profit and loss account and the balance sheet

• How the published accounts can be used to analyze the performance of a business.

What are accounts and why are they necessary?

• Accounts are financial records of a firm's transactions that is kept up to date by the accountants, who are qualified professionals responsible for keeping accurate accounts and producing the final accounts.

• Every end of the year, a final accounts must be produced which gives details of:

• Profits and losses made.

• Current value of the business.

• Other financial results.

• Limited companies are bound by law to publish these accounts, but not other businesses.

Financial documents involved in buying and selling.

• Accountants use various documents that are used for buying and selling over the year for their final accounts. These documents will be used by accountants to:

• keep records of what the firm bought and from which supplier.

• keep records of what the firm sold and to which customer.

• Provide the data needed to create the final accounts,


• Purchase orders: requests for buying products. It contains the quantity, type and total cost of goods. Here is an example


• Delivery notes: These are sent by the firm when it has received its goods. It must be signed when the goods are delivered.

• Invoices: These are sent by the supplier to request for payment from the firm.

• Credit notes: Only issued if a mistake has been made. It states what kind of mistake has been made.


• Statements of account: Issued by the supplier to its customers which contains the value of deliveries made each month, value of any credit notes issued and any payments made by the customer. Here is an example


• Remittance advice slips: usually sent with the statement of accounts. It indicates which invoices the firm is paying for so that the supplier will not make a mistake about payments.

• Receipts: Issued after an invoice has been paid. It is proof that the firm has paid for their goods.

Methods of making payment

• There are several ways goods can be paid for:

• Cash:• Traditional method – widely used for most small amounts

• Issues with security

• When used a petty cash voucher is written out


• Cheque: • It is an instruction to the bank to transfer money from a bank

account to a named person.

• Less security risk than cash

• Common form of payment between businesses

• Suppliers run the risk that customer don’t have the cash to pay

• Unless supported by cheque guarantee card, saying that they have enough money in their account to support this payment.


• Credit card: • Lets the consumer obtain their goods now and pay later.

• If the payment is delayed over a set period then the consumer will have to pay interest.

• Debit card: • Transfers money directly from user's account to that of the

seller’s.

• Recording accounting transactions• Businesses usually use computers to store their transactions so that

they can be easily accessed, calculated and printed quickly.

Who uses the final accounts of a business?

• Only accounts of limited companies that have to be published. The following groups have an interest in a limited company’s accounting records.

• Shareholders: They will want to know about the profit or losses made during the year and whether the business is worth more at the end of the year or not.

• Creditors: They want to see whether the company can afford to pay their loans back.

Who uses the final accounts of a business?

• Government: Again, they want to check to see if correct taxes are paid. They also want to see how well the business is doing so that it can keep employing people.

• Other companies: Other companies want to compare their performance with a business or see if it is a good idea to take it over

What do final accounts contain?

• The trading account: shows how the gross profit of a business

Gross profit = Sales revenue – cost of goods sold

• Gross profit does not include overhead cost or expenses

• Cost of goods sold (COGS) is not necessarily the same as the total value of goods bought by the business

Example

• Cost per unit

• Revenue per unit

• Opening stocks

• Purchases

• Closing stocks

1. How many cans did the business sell during the year?

2. What was the COGS?

3. What was the gross profit?

1. Goods sold= opening stocks + purchases – closing stocks

Profit and loss account

• The profit and loss account is a financial statement which represents the revenue that the business has received over a given period of time, and the corresponding expenses which have been paid.• The profit and loss account of

a business shows how net profit is calculated

Net Profit = Gross profit – overhead costs


• The profit and loss account begins with the gross profit calculated from the trading account.

• All other expenses and overheads of the business are subtracted. Any income from non-trading activities of the business is added on.


• Expenses

• Expenses are expired costs (i.e. costs from which all benefits have been extracted during an accounting period). Examples include wages, raw materials, and utility bills -often known as revenue expenditure.

Profit and loss account• 3. Expenses

• These are all the ongoing expenses associated with running your business that you can deduct from your

• “gross profit” figure on your profit and loss account to calculate a figure of “profit before taxation”.

• Legitimate business expenses for accounting purposes are:• - Employee costs - Premises costs

• - Repairs - General administration

• - Motor expenses - Travel

• - Advertising - Interest

• - Bad debts - Legal/professional costs

• - Other finance charges - Depreciation or loss - profit - on sales of equipment

• - any other expenses

• Note that some elements of these expenses are not allowed for tax purposes and are added back before

• your taxable profit is calculated.


• Depreciation: the fall in value of a fixed asset over time. This is included as an annual expense of the business.

Gross profit $32000

Non-trading income$5000

$37000

Less expenses:

Wages and salaries$12000

Electricity$6000

Rent$3000

Depreciation $5000

Selling and Advertising expenses$5000

$31000

Net Profit$6000

£000 £000

Sales Revenue 1,000

Cost of Sales:

Materials 300

Direct labour 200

Production overheads 100

(600)

Gross profit 400

Less selling expenses 100

Less administrative expenses

120

(220)

Trading [Operating] Profit

180

Add non-operating income

(10)

Profit before interest and tax

190

Less interest expense (30)

Profit before tax [Net Profit]

160

Less taxation (60)

Profit after tax 100Less dividends (20)

Retained Profit 80

• Profit and loss accounts for limited companies• Corporation tax paid on company profits will

be shown• The final section of the profit and loss

account is called APPROPRIATION ACCOUNT- it shows what the company has done with the profits

• Results from the previous year are also included

• Retained Profit is the net profit reinvested back into a company , after deducting tax and payments to owners, such as dividends.

Activity 7.3

Balance Sheet

• A balance sheet is a statement of a firm's assets, liabilities and owners' equity at a specific date (i.e. it is a "snapshot" of the financial strength of a business at a particular moment in time).

• It summarizes the financial state of the business at that date. When added together, the liabilities and owners' equity represent the sources of capital.

• The two sides of the account must always balance, since every penny raised as capital must have been used for some purpose and must be accounted for.

Balance Sheet

• Assets

• An asset is an item that will give present or future monetary benefits to a business as a result of economic events. Therefore, an asset is basically an item or money that the business owns.

• There are two main types of classification of assets - fixed assets and current assets.

• a) A fixed asset

• b) A current asset

Balance Sheet

• Fixed Assets

• A fixed asset is acquired for the purpose of use in the business and is likely to be used by the business for a considerable period of time (more than 12 months).

• There are three categories of fixed assets:

• a) Tangible fixed assets (physical items such as land, buildings, machinery, and vehicles, the purchase of which is known as 'capital expenditure').

• b) Intangible fixed assets (non-physical items, which are very difficult to place a value on, such as brand names, goodwill and patents).

• c) Financial fixed assets (investments that the business has, such as shares and debentures in other companies).

Balance Sheet

• Current Assets• A current asset is either part of the operating cycle of the

enterprise or is likely to be realized in the form of cash within 12 months.

• There are five categories of current assets:

• a) Cash in the bank.

• b) Cash on the premises ("petty cash").

• c) Debtors (customers who have purchased goods on credit, and have not yet paid).

• d) Stock (raw materials, work-in-progress and unsold finished goods).

• e) Prepayments (where the business has paid in advance for the use of an item, rent for example).

Balance Sheet

• Liabilities• A liability is the amount outstanding at the balance sheet date,

which the business is under obligation to pay. Therefore, a liability is basically an item or money that the business owes to a third party.

• There are two main types of classification of liabilities:

• a) long-term liabilities

• b) current liabilities

Balance Sheet

• Long-term liabilities• A long-term liability is a source of long-term borrowing and will

exist on the balance sheet for more than 12 months. There are three categories of long-term liability:

• a) Bank loans.

• b) Mortgages (essentially a long-term loan to purchase land and buildings).

• c) Debentures.

Balance Sheet

• Current Liabilities• A current liability can be simply defined as amounts of money

owing to third parties which will be settled within 12 months. They arise mainly through the process of day-to-day trading and there are five categories.

• a) Bank overdraft.

• b) Creditors (suppliers who the business has not yet paid).

• c) Accruals (debts for which a bill has not yet been received).

• d) Corporation tax (owed to the Government).

• e) Dividends payable.

Balance Sheet

• Shareholders funds

• There are several other items that appear on a Balance Sheet - most notably shareholders' funds (also called‘ owners equity') and reserves.

• These items show us where the business got its original capital from (i.e. the money it used to start-up), how much money the shareholders have a claim on within the business and what the business has done with any retained profits over the years.

• It also shows us the effect of a rise in value (an appreciation) of any of the assets owned by the business.

Balance Sheet

• Shareholders funds

• In a sense, owners' equity is a liability of the business, in as much as it is a claim on the assets. However, it differs from other liabilities in that it does not have a definite date by which it is to be repaid and it is not a fixed amount.

• The owners' equity is usually left in the business as long as it is required and it can fluctuate in value. Owners' equity is a residual claim on the business after all the other liabilities have been settled.

Balance Sheet

• Using simple algebra, we can see that:

• If Assets = liabilities + owners' equity

• Then Owners' equity = assets - liabilities

• Therefore, the owners of the business own the assets of the business less what the business owes to other bodies.

Balance Sheet for Big’s Hand Toilets December 31,2012

$(000) $(000)

Fixed Assets 500

Current Assets:

Cash 100

Debtors 150

Stock 50

Total Current Assets 300

Less Current Liabilities:

Overdraft 20

Creditors 140

Total Current Liabilities 160

Net Current Assets [=Working Capital] 140 [300-160]

Net Assets [=Assets Employed]

640 [500+140]

Represented by:

Long-Term Liabilities 200

Share Capital 250

Reserves 190

Capital Employed 640 [200 + 250 + 190]

Balance Sheet : Explanation

• Working Capital• Also known as net current assets

• It is used to pay short-term debt

• Net Assets

• Shows the net value of all assets owned by the company. These assets must be paid for or finance by shareholders' funds or long term liabilities

Balance Sheet : Explanation

• Shareholders’ funds:• The total sum invested into the business by its owners. This money

is invested in two ways:• Share capital: Money from newly issued shares.• Profit and loss reserves: Profits from current and previous years.

• Capital Employed

• Total long-term and permanent capital of the business which has been used to pay for the net assets of the business. Therefore

Balance Sheet

• ASSETS EMPLOYED = CAPITAL EMPLOYED: the two parts MUST always balance.

• Remember, a balance sheet shows what a company owns (assets), what it owes (liabilities) and where the company got its money (capital) from at a specific point in time.

Analysis of published accounts

• Without analysis, financial accounts tell us next to nothing about the performance and financial strength of a company. In order to do this we need to compare two figures with each other. This is called ratio analysis.

• The most common ratios used are for comparing the performance and liquidity of a business.

Ratio analysis of accounts

• Performance Ratios• Three common performance ratios are:

• Return on capital employed: This result should now be compared with other companies to see if the managers are running the business more efficiently or not.

Ratio analyses of accounts

• For example, if a business had a net profit of £2.2m and a capital employed of £7.6m, then the Return on Capital Employed figure would be:

• This means that for every £1 of capital invested in the business, the annual return would be 28.9 pence. Capital employed is equal to shareholders' funds plus long-term liabilities, and it is the final line in the balance sheet (remember that it is the same value as 'assets employed').

Ratio analysis of accounts

• Performance Ratios

• Gross Profit margin

If this percentage increases next year it would suggest that:

- Price have been put up by more than cost have risen

- costs of goods bought in have been reduced. Possibly a new supplier is being used or managers have negotiated lower cost prices


• For example, if a business has gross profit of £4 million and sales revenue of £6 million, then the gross profit margin would be:

• This means that for every £1 of sales revenue, £0.67 remains after all direct expenses have been deducted. This money then contributes towards covering the other expenses of the business.


• Performance Ratios

• Net profit margin

The higher this result, the more successful the managers are in making net profit from sales.


• For example, if a business has gross profit of £1 million and sales revenue of £6 million, then the net profit margin would be:

• This means that for every £1 of sales revenue, 16.7 pence remains after all direct and indirect expenses have been deducted. This money then contributes towards covering the corporation tax that must be paid on profits to the Inland Revenue and, if the business is a 'company', covering the dividend payments to shareholders.


• Liquidity Ratios• These measure the ability of a business to pay back its

short-term debts

• Current Ratio

• This ratio assumes that all current assets could be converted into cash quickly, but this is not always true since stock/inventory may take longer to sell. Generally, a result of 1.5 to 2 would be preferable.

• A result less than 1 would mean that the business could have a real cash flow problems.


• For example, if a business has current assets of £250,000 and current liabilities of £180,000, then the current ratio would be:

• This means that for every £1 of current liabilities, the business has £1.39 of current assets available. Ideally, the answer should be between 1.5 and 2. A figure less than 1.5 indicates that the business may experience difficulties in meeting its short-term debts (i.e. a liquidity crisis). An answer of more than 2 indicates that the business may be holding cash in an unproductive and unprofitable form, and it may be better used elsewhere.


• Liquidity Ratios

• Acid test or liquid ratio

• A result of 1 would mean that the company could just pay off its short-term debts from its most liquid assets.


• For example, if a business has current assets less stock of £150,000 and current liabilities of £180,000, then the current ratio would be:

• This means that for every £1 of current liabilities, the business has £0.83 of cash available at short-notice. Ideally, the answer should be between 1 and 1.2. A figure less than 1 indicates that the business may experience difficulties in meeting its short-term debts (i.e. a liquidity crisis). An answer of more than 1.2 indicates that the business may be holding cash in an unproductive and unprofitable form, and it may be better used elsewhere.


• Ratio are very useful as a quick way of comparing a firm’s performance and liquidity. Ratios can be used to:

• Compare with other years.

• Compare with other businesses.

• It is important to compare accounting ratios in these ways. One ratio on its own means very little.


• Consider the example:

• Hurtwood Trading Co Return to Capital employed 2006=12%

Hurtwood Trading Co Return to Capital employed 2005=8%

Westbay Return to Capital employed 2006=20%

Managers of Hurtwood can make realistic comparisons. Their company is performing more effectively than in the previous year BUT it still needs to improve further to equal the performance and profitability of one of the company’s closet rivals

Disadvantages of ratio analysis

• However, there are still some disadvantages of ratio analysis:

• Only shows past results, does not show anything about the future.

• Comparisons between years may be misleading because of inflation.

• Comparisons between businesses could be difficult since each has its own accounting methods.

Business Accounting Unit 7. This unit will explain What is meant by ‘accounts’ Why businesses need to keep accounting records and use financial documents.

Documents

final accounts

example financial documents

accurate accounts

published accounts

statement of accounts

financial documentswho

financial transactions

financial results