HOW YOUR ACCOUNTS WILL HELP YOU

Bookkeeping can sometimes seem a chore – especially if you feel like getting on with other things such as production or sales; but it’s worth remembering that there are several reasons (and advantages) for keeping good business records, and many of them are a real advantage to you:

• to show you where you stand financially
• to help you make important financial decisions
• to help you agree (and perhaps reduce) your tax liabilities
• to control VAT – collecting it in and paying it out
• to help your audit in certain cases, and keep the auditing costs down
• to discuss your financial position with other people.

Let’s consider them in turn.

Knowing where you stand financially

Without proper business records you will never know what your real financial position is. Not all businessmen and women, particularly when running small businesses, want to produce detailed financial statements every month, but it is very useful to be able to work out:

• how much money you have at the bank
• how much is owed to you by your customers
• how much you owe to your suppliers.

If you know that the money owed to you is enough to pay off your creditors and the bank, then you should certainly be able to sleep at night. (Do you know your current financial position?)

Suppose you suddenly find yourself short of £540 to pay a pressing supplier. You decide to telephone your bank manager to see if he will grant you some temporary help to tide you over.

Business manager. ‘Hello Alan, I wonder if you can help me? I urgently need to find £540 to pay off a supplier who’s threatened to stop an important delivery of new materials unless I pay. Can you help?’

Bank manager. ‘Yes, I should think so. What’s your overdraft at the moment?’

Business manager. ‘It’s only about £1300 . . .’

Bank manager (checking statement). ‘Yes, but hold on -1 see some cheques still haven’t cleared. I make it £1819.89 – and didn’t we agree a limit of £1500?’

Business manager. ‘Eighteen hundred quid? Good heavens, are you sure? I’d no idea.’

Bank manager. ‘Well, you should have! How much is owed to you by your customers? If it’s a lot, we may be able to sort something out.’

Business manager. ‘I don’t think we’ve got an exact figure – it must be a thousand or two. The papers are all over the place at the moment.’

Bank manager. ‘Look, why don’t you get your accountant in, and get the exact figures, then we can meet and see what can be done.’

Business manager (groaning). ‘That’s going to take ages and cost money – isn’t there anything else we can do?’

Bank manager. ‘Well, we’ve got to have the facts first. . .’

The business manager needs help, and the bank manager wants to give it – but not just on a wing and a prayer. What would you think of your bank manager if he was sloppy with key figures?

Could you answer the above questions about your own business?

Broadly speaking, if ‘what we’ve got’ is more than ‘what we owe’ the business is solvent. If not, it is insolvent and probably should not go on trading. However, it should be kept in mind that some of the assets (’what we’ve got’) are not in a form that can be used to pay the bills. The vehicles and equipment, etc. (collectively called fixed assets) are for the long-term benefit of the business and are not readily turned into cash. You should therefore also consider the situation without taking account of these items.

But these are basic questions, and are only the beginning of gaining a real understanding of your business as a financial entity. If you can’t find the answers to these questions fairly quickly and accurately, you will certainly need this book.

Making financial decisions

Armed with an up-to-date statement of your financial position and recent trading you can start to make real financial decisions. Can you afford to replace the delivery van? Is it worth taking on an extra salesman? Do you need a partner? Without business records to provide you with the necessary facts you will not be in a position to make such decisions.

Let’s take some examples:

Decision	Information needed	Business records
1 Buy a new van?	Exact cash position? General liquidity position?	Cash book Sales and purchase ledgers; cash flow forecast
	Enough profit to cover?	Management accounts
2 Take on new staff?	Wages and NI costs? Afford?	PAYE records Profit forecast Cash flow forecast
3 Extra credit to big customer?	Can I finance it?	Cash book Cash flow forecast Profit forecast (interest)

‘We got a great new account – lots of new business – but had no idea what giving them so much credit would mean. If only we knew what our trading margins had been, and had had a proper cash flow.’ Director of insolvent engineering company.

‘I desperately needed a partner to help the business and put in more cash, but I just couldn’t prove to him that we’re getting a good return on our money.’ Proprietor of a catering firm.

‘Our customer had several different invoices from us. He paid part of the third one, none of the first two and queried part of the seventh. We completely lost track of the account, and ended up having to write it off.’ Housewife running a wholesale crafts business.

Agreeing your tax liability

If the business seems to be ‘running itself you may not feel you need information to make financial decisions (although you could probably run the business even better if you did). But you will still need to keep records in order to agree your exact liability with the Inland Revenue. Under Self Assessment you are required by law to maintain proper accounting records and you can be fined up to £3,000 if you fail to do so. If you don’t keep on top of the situation you could soon lose out in several ways:

• fines imposed by the Inland Revenue
• loss of tax allowances you might be entitled to
• much wasted expense in getting your accountant in to sort out the details
• wasted time that could have been better spent on production or sales
• annoyed customers through mix-ups on their accounts, causing loss of business
• aggravation, spoiled plans and sleepless nights.

‘We seemed to spend the whole of November and December trying to sort out the wretched problem – and when the accountant sent in his bill it was more than double last year’s and I think the Revenue have made me a marked man.’

Rate yourself

I know:	Exactly	Roughly	No idea
What allowances I can claim	2	1	0
How much tax is due	2	1	0
When it is due	2	1	0
When my Self Assessment form is due with the Inland Revenue	2	1	0
How much my accountant charges per hour for tax work	2	1	0

Score

10	You’ve got the message.
7-9	You can identify the information you need
4-6	Time to give yourself a serious talking to.
1-3	You have been warned!

Accounting for VAT

Except in certain cases (see page 41) your business will have to register for VAT. You will have to keep proper records so that you can account for the correct amount of VAT to the Customs & Excise. You will usually need to charge 17.5 per cent VAT to your customers and pay 17.5 per cent VAT to your suppliers. There is no way round this (unless you run a crooked business) and you need to keep right on top of it each month or quarter – as the Customs & Excise most certainly will. If you get behind, they’ll soon be after you with final warnings and penalties. But since you collect VAT, it can actually be a benefit to your cash flow. VAT is dealt with more fully in Chapter 3.

Auditing your business

If your business is a limited company its accounts may have to be audited (checked) each year by an independent qualified auditor. The auditor, usually a chartered accountant or certified accountant, has to go right through your records and satisfy himself that your accounts give a ‘true and fair’ view of the company’s financial situation and of its profit or loss for the period. He must then give a report (which is appended to the accounts) to say that he has examined the records and to state his findings. This is required under company law. If the auditor is not happy about the accounts he may qualify his report (include a note of warning or caution). A company has to file its audited accounts each year at Companies House, where they are open to public inspection for a small fee.

In addition various other legislative and professional requirements have made an audit necessary for certain classes of business. For example, solicitors’ accounts need to have a specific report submitted to the Law Society and the Financial Services and Markets Act 2000 requires an audit of businesses that do investment advisory work.

Without proper business records the auditor won’t be able to do his work and the business won’t be able to meet the requirements of an audit. What then?

• you will have to pay an accountant possibly large fees to sort out your books
• you may ultimately be prosecuted under company law.

However, once you do have the audited accounts, you should have an accurate picture of the financial position of your business. Indeed, you’ll probably be chasing your accountant to get them out as soon as possible, so that you know exactly where you stand.

Discussing your financial position with other people

From time to time you may need to give other people an up-to-date financial picture of your business. In particular if you are relying on bank finance then the bank may ask you to provide regular information about your debtors (customers owing you money) and creditors (money owed by you to your suppliers) so that they can monitor the healthy progress of the business. And you may need facts and figures to discuss with:

• any co-directors, partners or senior staff
• a possible outside investor or partner in your business
• a major supplier (for example, if you are hoping to get extended credit)
• any major creditor who is unhappy about the way your business is going, and the risk he is taking.

Some horror stories

Some typical comments from bankruptcy proceedings:

‘The company was flying by the seat of its pants. It simply had no idea whether it was trading at a profit or loss each month.’

‘None of the partners knew what bills the other partners were running up. There were no proper records, and none of them seemed to appreciate that each was individually liable for all the debts of the partnership.’

‘Didn’t you ever sit down and do a cash flow forecast?’

‘You left it all to your accountant? Are you saying he was actually a director of the company?’

‘They never bothered to do a bank reconciliation statement and didn’t seem to realise their cheques would bounce. No wonder the bank foreclosed. They had been pretty patient.’

‘They didn’t know what all that gear was really costing them – not just the repayments, but interest charges, service costs, let alone depreciation which seemed to take them by surprise.’

‘The receiver couldn’t collect any money from customers, to speak of. The firm didn’t even issue statements, let alone keep a sales ledger.’

‘They seemed to think they’d never actually have to send in a PAYE return.’

Hard to believe? Yet the failure to keep proper business records is given time and time again as the main reason why an otherwise promising venture eventually failed.

WHAT RECORDS WILL I NEED?

The type of records you will need will depend on several factors. For example:

• Is the business large or small?
• How much bookkeeping work does the proprietor want to do?
• What kind of business is it – sole trader, partnership or limited company?
• What type of trade is conducted by the business?

Let’s consider each in turn.

The size of the business

There can be no hard and fast categories for size of a business. But obviously a national chain store such as Marks & Spencer will have a more sophisticated accounting system than a local trader with a market stall. The point at which you need more complicated records will also depend partly on the type of trade. However, here are some guidelines to get you started:

• If you are owed money by more than about 15 customers then you should consider starting a sales ledger system with the appropriate sales day book. (For the explanation of these terms see Chapter 4.)
• If you have more than about 30 purchase invoices a month you should consider starting a purchase ledger and purchase day book {see Chapter 4).
• If you have more than about 5 cash payments a week you should think about starting a cash record system independent of your bank records.

How much work does the proprietor wish to undertake?

There is no point in becoming a slave to bookkeeping. Unless you are going to use the information from a comprehensive bookkeeping system there is little point in doing more than the minimum in writing up your records. Clearly you will need enough records to run the business but there is normally no need to keep a full set of double entry records. You might, however, be forced to keep a sales and/or purchase ledger to administer the business and, for example, to help control your cash flow.

The type of entity conducting the business

There are three types of entity commonly found running a business. These are:

Sole traders

One person owning the business which he is running in his own right, e.g. Joe Bloggs trading as Uttoxeter Window Cleaners. Since the person is trading in his own right he is personally responsible for any debts his business incurs. Even if he uses a trading name the customers and suppliers are still trading with him as an individual.

Partnerships

A group of people owning and running the business, e.g. Taylor & Woodward, Estate Agents – a business run by Mr Taylor and Miss Woodward. As with the sole trader, it is the individuals in the partnership who are responsible for the partnership debts. Solicitors, accountants and other professionals often trade as partnerships, but in general anyone can do so.

Limited companies

A business which is owned by at least two people who may or may not also be involved in the day-to-day running of the business. The owners (or shareholders as they are better known) have a limited personal liability for the debts incurred by the company which is itself a separate legal ‘person’ or entity. The day-to-day running of a limited company is entrusted to its directors. The directors of a company may also be the shareholders. Note: in theory the shareholders’ liability is limited to the amount (if any) outstanding by way of payment for their shares. In practice a bank will often ask the major shareholders to personally guarantee the company’s overdraft; that is, to repay the overdraft if the company is unable to do so, and to use their own assets as security.

Limited Liability Partnerships

Limited Liability Partnerships (LLPs) have been available since 6 April 2001. They are a cross between the ordinary partnership as outlined above and a limited company. The LLP has the organisational flexibility of a partnership and is taxed in the same way as a partnership but in other ways it is similar to a limited company. It is a separate legal entity like a company and enjoys the limited liability status. It must also file its accounts with the Registrar of Companies and if the turnover is large enough it must have its accounts audited.

If you are starting a business, it is wise to discuss with your accountant which approach will suit you best.

Type of trade

Some types of trade need more records than others. For example, a small engineering company may well need a sales ledger system to keep track of its credit sales to customers. On the other hand, a clothes shop which does not allow credit to customers will only need a simple record to keep track of its takings.

Choosing what records to keep

Unless the owners decide otherwise, there is no legal need for an annual audit of the records of a sole trader or a partnership. There is, however, a legal obligation for an annual audit of the accounts of most limited companies. An audit is a formal check of all the accounting records; the modern auditor has to certify that they have examined a company’s records and that the balance sheet gives a ‘true and fair’ view of the state of affairs of the business, and that the profit and loss account accurately reflects the profit.

But the auditor can only audit the accounts if there are proper records for them to check. A company has a legal obligation to keep proper records and if it doesn’t the auditor must say so in their report. A copy of their report has to be filed with the Registrar of Companies, where it is on public record. If you’re not sure what records to keep, discuss things with the company’s auditor.

Unless you have a limited company it’s best to keep your records as simple as possible. You’ll save yourself unnecessary work which will make bookkeeping a chore and even lead to inaccuracy and other problems.

Distinction between a business and its owner

Before writing up any business records you need to understand the distinction between the business and its owner. This may seem odd, particularly as we said that the owner of a sole trader business or partnership is himself legally responsible for the debts of the business. Whilst this is true, there is no need for the business records to contain all the personal expenditure of the individual, assuming it has no bearing on the business. For example, the records of Taylor & Woodward, Estate Agents, should not record how much Mr Taylor has paid to his milkman for his daily pinta at home. It’s of no concern to the business.

Recording business expenses

There will be some expenses which are partly for business and partly for private purposes. For example, when Miss Woodward buys petrol for her car it is partly a business expense and partly a private expense. The car will be used on business, such as when she visits clients’ houses in connection with her estate agency business. But if she takes her friends out for pleasure the car is being used for private motoring. In such cases, you should:

• record the whole of the cost of the expense
• disallow par for taxation purposes (see Chapter 10).

Drawings

A subject which can cause problems is that of drawings taken from a business. From time to time the owner may want to draw money out of the business for his own private use. As this expenditure will in some way affect the business it must be recorded in the records. If Mr Taylor draws £500 from the partnership bank account for his own use then this must be recorded by the business, otherwise the bank account would not agree with the bank statement. But it’s of no concern to the business how Mr Taylor spends the money: all it has to record is ‘Mr Taylor – drawings – £500’.

The situation differs in the case of a limited company. This is because the company is a separate legal entity and whenever it makes a payment to its directors it must operate PAYE. The directors of small businesses quite often have loan accounts with their company (because the directors have lent money to the business). If at the end of the year the company has made a good profit it may want to grant a bonus to its directors. However, it might want to keep the cash inside the company to help its liquidity. If so, the company has to operate PAYE in the normal way on the bonus payment; but instead of paying out all the cash, the net amount of the bonus is placed to the credit of the director’s loan account. The director can then withdraw from the loan account as he needs to.

A company must not, however, lend money to its directors (except in very special cases) and so the directors must never ‘overdraw’ their loan accounts. They must always stay in credit.

Profits and drawings are not the same

There is often confusion between ‘profit’ and ‘drawings’ for sole traders or partnerships. Many people believe that they will be taxed on the amount that they actually withdraw from the business, and that if the money is left within the business they will not pay tax. This is not the case.

There is no direct connection between the ‘paper’ profits and actual drawings for a small business. If the business makes more profit than the proprietor withdraws then there is more money in the business bank account. If the business does not make enough profit to cover the drawings it will eventually go bust! This is the only ultimate connection.

When the business has made a profit, the profit is credited to the proprietor’s capital account. This could be likened to an employee paying his salary cheque into his bank account. When he makes withdrawals these are debited to his capital account rather as an employee might write cheques for housekeeping or to pay the mortgage. There is no direct link between the amounts that the employee receives and pays out (except of course that his bank manager will write to him if he becomes overdrawn, or his bank balance will increase if his expenditure is less than his earnings). The same applies to the proprietor of a small business.

We’ve already seen that a small business is just the ‘business side’ of the owner’s personal financial affairs. If the business side earns a profit it doesn’t matter whether the proprietor takes the profit out of the business bank account or not. Since in one way or another it is all his money, it is still his profit available for him to spend even if it is still within the business.

Outline of records

The records that you will need are described more fully in Chapters 2 to 7. However, in outline you will need:

• a cash book to record the banking transactions of the business
• copy sales invoices (of what you sell) and some way of filing them
• original purchase invoices (of what you buy) and some way of filing them.

Depending on your business you may also need:

• a cash book to record the cash transactions of the business
• a wages book
• a day book and ledger system for your sales
• a day book and ledger system for your purchases
• a nominal ledger for miscellaneous items.

We’ll see how to operate these later on.

Warning

Many people starting in business are tempted to rush out and buy a computer to ‘do the bookkeeping’. They are under the false impression that the computer will sort out their bookkeeping worries. There are more details about how to choose and use computer software in Chapter 7, but before you skip to that chapter, a note of caution. Experience shows that unless the person knows what they’re doing, computerised records often end up as an unbelievable mess. This is no reflection on the computer software (indeed there is some very good software available) – it’s the human factor. The software only does as it is told and where matters fall down is in the non-accountant’s idea of what is needed.

Often the ‘run of the mill’ work (e.g. invoicing) can be handled with a fair degree of success, but problems arise over one-off transactions. On

a manual system the bookkeeper can handle such transactions by just noting sufficient details to balance the books and leaving the rest to the accountant to sort out at the end of the year. They can also write notes in the margin of the book to say what has happened and what they have done. On the computer system this is not possible. You’ll run into problems if you’re not yet familiar with double entry bookkeeping and the preparation of accounts. You also need to know the way in which your particular software treats each item.

You should therefore work through the rest of this book to obtain at least a basic understanding of bookkeeping before you computerise your accounting records. When you understand what is needed, perhaps it will not seem so difficult after all, and remember a small business can still work wonders with a pocket calculator!

SUMMARY

• You will need to keep proper business records in order to operate efficiently and to fulfil your legal obligations.
• Larger businesses will generally need more complex records than smaller ones.
• There are differences between sole traders, partnerships and limited companies, and between the records they need to keep.
• The requirement that accounting records must be kept is laid down by law.
• Your accounts should show all expenses, even if part of a particular item was for personal use. This part should then be disallowed for tax purposes.
• All money drawn from the business by sole traders and partners must be shown in the accounts.