WHAT THE ANNUAL ACCOUNTS SHOW

One purpose of keeping records is to prepare the accounts at the end of the financial year, so that you can see how the business is doing. An example of the year end accounts is shown in Figures 35 and 36.

As you can see, these accounts consist of two main pages (plus a further page of notes which give more details; Figure 37). There are many different ways of setting out year end accounts but the example shows one of the commonest layouts.

Balance sheet

The first page, the balance sheet, is a ‘snapshot’ of the assets and liabilities of the business at a certain point in time. At the year end, in this example, the business owned the assets and owed the liabilities as shown on the balance sheet. You can tell a lot from the balance sheet. In this one, what has happened to the £6,622 on deposit from last year? Has the business spent it on bigger stocks?

Profit and loss account

The second page, the profit and loss account, is a summary of trading income and expenditure for the period. Is the gross profit margin bigger, or smaller, as a percentage of its sales? Why is the net profit less when sales seem to be up? Are the overheads under control?

Two types of expenditure

There is an important distinction to be made at this stage:

Capital expenditure

Capital expenditure relates to the purchase of fixed assets used by the

business and having a lasting effect over several years.

Revenue expenditure

Revenue expenditure on the other hand only contributes once to the

earning of profits; except for what may remain as stock, it is wholly used up in the period the expenditure is incurred. For example, expenditure on a new piece of equipment or a new building would be capital: it should benefit the business for many years. Expenditure on raw materials or motor expenses will have no long-term benefit so it is regarded as revenue expenditure.

In the same way income can be classified as revenue or capital. If a factory, or piece of equipment, is sold at a profit – that is a capital profit. On the other hand, if stocks are sold, that is revenue income.

Example

Figure 38 shows the trial balance used on page 84, this time showing which of the nominal ledger accounts are profit and loss account items and which are balance sheet items. This broadly follows the distinction between revenue and capital. There may be some confusion with regard to revenue items such as stock and debtors: although these items are not of a capital nature, the values are included on the balance sheet as they represent assets held at the end of the accounting period. (Stock also appears on the profit and loss account but in this case it is to reflect the change in the level of stock during the year – opening stock less closing stock.)

If you look at the totals on each side of the trial balance you will see that they are equal: the trial balance does in fact balance. But, if you just take the profit and loss items (Accounts 1 to 100) then the totals of these codes on their own do not balance. The debits total £121,961.02 and the credits total £140,253.56. The difference by which the credits exceed the debits is £18,292.54, which is in fact the amount of the profit for the year. Conversely if you look at the balance sheet items the debits exceed the credits by the same amount. This excess of debits reflects the increase in assets resulting from the year’s trading profit.

THE BALANCE SHEET

As we have seen the balance sheet sets out the assets and liabilities of a business at a fixed point in time. However, it does more than just list them. It arranges them into a suitable order so that the financial position of the business can be clearly seen.

Except for companies, there is no ‘legal’ order for the entry of the items on the balance sheet. However, it is usual to bring out certain figures to highlight the strengths or weaknesses of the business. In particular:

Total fixed assets

These are items such as property, motor vehicles, fixtures and fittings. More details about the treatment of fixed assets are given on page 125.

Total current assets

These are items which are either cash, or which can be turned into cash quite quickly. They include the balances of revenue expenditure not used up at the date of the balance sheet. For example, if raw materials have been purchased but not used, they appear in stock at the balance sheet date. These items are usually listed in the reverse order of liquidity: that is to say you start with the item that is most difficult to turn into cash and finish with the item that is easiest, i.e. cash itself.

Total current liabilities

This includes amounts owed to suppliers and can also include short-term loans, such as overdrafts, which are usually repayable on demand.

Net current assets

This is the difference between total current assets and total current liabilities. It’s also sometimes referred to as working capital. It shows the amount of ‘ready money’ available to the business for its day-to-day business activities.

Net assets

The net total of fixed plus current assets minus liabilities is referred to as the net assets of the business. This shows the net worth of the business (subject to a few matters discussed below).

Proprietor’s investment

The net assets are matched by an equal and opposite figure – the proprietor’s investments in the business. This is the amount owed by the business to its owner. It may include money actually invested into the business, and profits of the business left in to accumulate.

Comparison with previous period

As well as showing the figures relating to the current date it is also normal to show the figures at the previous balance sheet date. This allows the user to review the business, to assess its financial strength (or weakness), and see how it has changed during the last financial year.

THE PROFIT AND LOSS ACCOUNT

The profit and loss account summarises the revenue income and expenditure for the year. After allowing for timing differences (debtors, creditors and stock) it shows the profits and losses of the business. At the end of the accounting period the various balances on the nominal ledger revenue account (sales, purchases and overheads, e.g. wages, motor expenses) are transferred from their respective accounts to the year end profit and loss account summary. Figure 38 shows where the nominal ledger account balances go into the profit and loss account.

Modern financial accounts present the details in a vertical column form (see Figure 36). It’s usual to dispense with pence and just to show ‘round pound’ figures. Often, comparative figures for the previous year are shown alongside the figure for the current year. The layout for the profit and loss account may vary slightly according to the type of business. The example in Figure 36 would apply where a product is being bought and resold (for example as in a shop business). You will see that it is split into three sections:

• The top section is the trading account and this gives the figure of gross profit.
• The middle section is the overheads.
• The final section deals with incidental non-trading income.

Gross profit

The gross profit is the figure of profit directly from the purchase and sale of the goods. For example, suppose you run a shop and purchase an article for £10 and sell it for £15; you will have made a gross profit of £5 on the transaction. This would represent a gross profit margin of 33 per cent on sales.

Where the business is just carrying out a service – for example, an opticians or surveyor – it may be inappropriate to calculate a gross profit. In such a case it would be normal just to state ‘Income less expenditure’ to show the profit (see Figure 39).

Gross profit and trading account

It is often useful to compare your gross profit rate either from one year to another year, or with another business in the same trade. The easiest way to do this is to work out your gross profit as a percentage. This can be related either to the cost of the goods or to the selling price. Thus:

The expression ‘cost of sales’ has been used, rather than ‘purchases’. This is because some of the goods which have been purchased may still be in stock. They have not yet earned any profit and we have to allow for this when working out the gross profit. Take the following example:

Example

John starts up in business running a shoe shop. He buys 120 pairs of shoes at £10 per pair. During the financial year he sells 83 pairs of shoes at £15 per pair and still has 37 pairs in the shop year end. His trading account would look like this:

His gross profit ratio would then be:

415/1,245 % of sales = 33%

Overheads and net trading profit

By contrast, any revenue expenditure apart from the purchase of goods is referred to as overheads. Overheads include:

• administration costs (office wages, telephone, stationery, etc.)
• establishment costs (heating and lighting, property repairs, rent and rates)
• financial costs (bank interest and charges, HP charges, etc.)
• other overheads including depreciation (see page 125).

Certain payments of wages may be included as a direct cost of the business, and thus affect the gross profit. Whether they should be included will again depend on the type of business. Where goods are simply bought and resold, then wages will not form part of the cost of the goods resold and should therefore be included as an overhead. On the other hand, where a process is carried out on the goods before they are sold (e.g. manufacture or assembly) then the value of the goods has been enhanced before they are sold. In such circumstances these productive wages should be included with the purchase of the goods in the trading account.

After deducting overheads from the gross profit you arrive at the net trading profit. This is the amount that the business has earned from its trade during the year after paying all its expenses.

Non-trading income and net profit

Non-trading income is that which arises from activities incidental to the main trade. The most common sources of non-trading income are interest earned from bank deposit accounts, and the rental income from surplus property owned by the business.

After adjusting for non-trading income you finally arrive at the net profit of the business for the year. In many cases there will be no non-trading income; if so you don’t have to state both the net trading profit and the net profit, since the figure would be the same.

NOTES TO THE ACCOUNTS

We have dealt with the balance sheet and with the profit and loss accounts but some of the figures (particularly on the balance sheet) have been summarised and shown as one figure for clarity. The ‘Notes to the Accounts’ give extra detail to explain the summarised figures. Let’s look again at Figures 35 and 37. The fixed assets (equipment and property having a long-term benefit to the business) have been shown as a single figure on the balance sheet. The details of how this is made up are shown in a note. From the note you can see that the fixed assets include freehold property, motor vehicles, and fixtures and fittings of the shop. The note also shows how these figures have changed from a year ago.

The notes also describe the movement on the capital account for the year. The capital account shows the proprietor’s investment in the business. When the business makes a profit this is credited to the capital account and increases the balance on that account (the business now owes more to the proprietor). On the other hand, throughout the year the proprietor will withdraw money from the business (drawings) and this reduces the sum that the business owes to him. The drawings are debited to the capital account, so reducing its balance.