A STANDARD APPROACH TO ACCOUNTS

Before we leave the subject of the annual accounts there are three other matters to look at. These are the accounting concepts, the historical cost convention, and depreciation of fixed assets.

Accounting concepts

There are four accounting concepts in business today:

The going concern concept

This concept states that you should treat your business as if it will go on trading, unless there is some very clear pointer to say that it will not. The importance of this is that some of your assets may have a value in a continuing business, but very little value to anyone else.

Let’s take the case of a business taking up a five-year non-transferable lease on some premises; in addition to the annual rental let’s suppose it has to pay an initial premium of £5,000. As we assume that the business will continue, we don’t need to write off the whole cost of the premium in the profit and loss account in the year that it is expended. Instead we would write it off at £1,000 per annum over the period of the lease. Thus after two years there will still be an asset of £3,000 representing the balance of the lease premium: although it may have no resaleable value, it does have a value to the business as a going concern.

Accruals

To ‘accrue’ means to charge an amount in the accounts for the period to which it relates which may not actually be when it is due to be paid. Take the case of a business which pays rent of £1,200 pa for its premises, six monthly in arrears on 31 March and 30 September. If the business makes up its accounts to 31 December it will have to make an accrual of £300, being three months’ rent (October-December) which has not yet actually become due for payment, though the business has had the use of the premises.

The consistency concept

This means that matters within the accounts should be treated consistently from one year to the next. Suppose, for example, you decide to depreciate (write off) the cost of a machine over five years by equal instalments: unless there is some big change in the business to justify altering this treatment, this depreciation should be consistently applied over the five-year period.

The prudence concept

Don’t assume a profit until it is actually earned! Always be prudent and err on the side of caution. For example, it may be acceptable to state the profit on a sale, even though the debt has not yet been settled, but if there is any doubt over the debt being paid the profit should not be anticipated. Indeed, if there is a potential bad debt the potential loss must be provided for in the profit and loss account.

Historical cost convention

One potential weakness of a balance sheet prepared in the way outlined is that the value of the assets is based on their actual historical cost. In times of low inflation this may not matter much but when inflation rises it can lead to their real value being understated in the balance sheet.

Suppose a business purchased a freehold workshop in 1967 for £12,500, and those same premises are worth £80,000 today. Unless the accounts are adjusted for inflation the balance sheet would still only show the original (historical) cost of £12,500.

In times of high inflation annual accounts will include some adjustment, so that the current (true) value is shown. Such a system is termed current cost accounting. Whilst inflation is at its current low rate, current cost accounting is not thought necessary for most businesses.

Often, however, a statement or note will be included to remind the reader that an historical cost basis of accounting has been used and that the valuation of certain assets, in particular freehold property, may be in need of some review.

Depreciation of fixed assets

We have seen that fixed assets are items purchased which will benefit the business over several years. If a business buys a van to deliver its goods it may expect to go on using it for three or four years before replacing it. But if the van originally cost, say, £4,000, the business would hardly expect to receive £4,000 when it sold the van four years later. Suppose instead it receives £1,200 when the van is sold: if this is put into accountancy terms the motor vehicle account might look like this:

	Dr		Cr
	£		£
Yr.l:Bank – Purchase of Van	4,000	Yr.4:Bank – Sale of Van	1,200
		Yr.4: P & L a/c Loss on sale of Van	2,800
	_____		_____
	4,000		4,000
	_____		_____

We have had to transfer the balance on the account (£2,800) to the profit and loss account; there we will write it off with the other expenses of the business. However, the above example charges the whole of the loss of value of the van in the year that it was sold even though it was actually losing value throughout the whole of the period of ownership.

To overcome this problem it is normal to depreciate assets over their useful lives; that is to say, to write off part of their value to the profit and loss account in each year so as to reflect the reduction in value that has taken place in the year. It’s not normally practical (or necessary) to get valuations of such assets each year. The proprietor of the business will himself have a good idea of their value and their expected life.

There are two main methods of working out depreciation:

• the straight line method
• the reducing balance method.

Either can be used but once started you should not change from one system to the other (consistency - see above).

Straight line depreciation

This method writes off the cost of the asset, less its expected residual

value, by equal instalments over its estimated useful life. Using the

example above, the van would be depreciated by £700 in each of the

four years of ownership. This would mean that there would be an

equal charge for the use of the van in the accounts for each of the four

years.

Reducing balance method

Under this system a fixed rate per cent on the diminishing value of the asset is written off to the profit and loss account each year. The rate should be such that the depreciation is roughly equal to the loss in the value of the asset over the period of use. For example:

	£
Van cost	4,000
Yr. 1: Depreciation 25%× £4,000 =	1,000
	_____
Reduced value at end of year 1	3,000
Yr.2: Depreciation 25%× £3,000 =	750
	_____
Reduced value at end of year 2 c/fwd	2,250
Reduced value at end of year 2 b/fwd	2,250
Yr.3: Depreciation 25%× £2,250 =	562
	_____
Reduced value at end of year 3	1,688
Yr.4: Depreciation 25%× £1,688 =	422
	_____
Reduced value at end of year 4	1,266
	_____
	_____

THE RIGHT ACCOUNTS FOR THE BUSINESS

All this can only give a broad outline of how to prepare annual accounts, and in practice you may well be bringing in your accountant to do them for you. But it should be mentioned that different businesses need different things from their accounts. We have already seen that in some cases, where a product is being bought for resale, it will be right to show a figure for gross profit in the accounts. In other cases, particularly if the trade is providing a service, showing a gross profit will be inappropriate. In the same way, if the business is manufacturing goods for sale it can sometimes be appropriate to include a manufacturing account such as that shown below.

As you can see, all the expenses relating to the manufacturing process have been charged in the account, to arrive at the works cost of goods produced. This figure is then carried into the trading account which states the gross profit realised on the goods sold.

One further point which can cause confusion on annual accounts arises on the exchange of assets; for example, in the part exchange of motor vehicles. The simple and correct way of viewing the transaction is not to try to adjust figures using only the net sum that has been paid, but to deal with the purchase and the sale as two distinct transactions. Clearly the consideration for the sale of the old asset is part of the purchase price of the new asset but, apart from this, if the transaction is thought of as two separate deals it should prove much easier to record it all correctly.

	Manufacturing Account
	£	£
Opening stock of raw materials		2,615
Purchases		16,834
		______
		19,449
Less closing stock of raw materials		1,780
		______
Cost of materials consumed		17,669
Productive wages		10,350
		_____
		28,019
Opening work in progress		835
		______
		28,854
Less closing work in progress		870
		______
Prime cost of goods produced		27,984
Add works indirect expenses
Factory – Power	2,356
– Rent and rates	780
- Insurance	305
General factory expenses	115
Plant repairs	392
Plant depreciation	800
	______	4,748
		______
Works cost of goods produced		32,732
		______

To summarise

• The balance sheet is a ‘snapshot’ of the assets and liabilities of a business at a point in time.
• A profit and loss account shows how the change in the net worth of the business has occurred since the last accounts were prepared.
• There are the four accounting concepts to keep in mind during the preparation of the accounts: going concern, accruals, consistency and prudence.
• Some fixed assets will have lost value during the year as their useful life is slowly used up. Such assets need to be depreciated.
• Accounts are normally prepared using the historical cost basis.
• The way in which accounts are presented will depend partly on the nature of the business.