INTRODUCTION TO ACCOUNTS AND HOW TO INTERPRET THEM
WHAT ARE ACCOUNTS?
Accounts are summaries of a business’s detailed records.
•
Accounts usually refers to formal profit and loss account and balance sheet together with
accompanying notes
•
Published accounts also include the Directors Report and the Auditors Report.
BASIC PRINCIPLES – COSTINGS
Every business needs to have some kind of costing system. - although many smaller businesses
do not! Without one, management can have no idea of whether an individual product is making a
profit or a loss. When dealing with claims we find wide variety of costing systems, however the
basic principles are always there.
Accountants categorise costs incurred by a business as variable or Fixed
Variable: Cost varies directly with the number of units produced.
manufactured, the cost increases proportionally.
If one more unit is
Fixed: Cost remains the same irrespective of the number of units produced, assuming the
business continues.
Consider, as an example, the manufacture of motor vehicle sub assemblies which requires the raw
materials which are machined by the workshop staff to form a manufactured part which is then
assembled with a purchased part prior to incorporation into the vehicle. The machining process
uses power and needs consumables such as lubricants. Workshop staff are paid for a 40-hour
week irrespective of the number of parts produced.
In this example variable costs are those which vary directly with the number of sub assemblies
manufactured. In the example, raw materials, purchased parts, and power and consumables
associated with machining are all variable costs - if the Insured manufactures one more subassembly, then the value of these costs will all increase. In this example, labour is not variable, it
is fixed at least in the short term as the wages bill for the workshop will be the same whether 20
or 40 units are produced. We would, however, say that labour is semi-variable if overtime can be
worked to meet production over 40 units, or variable in the long term if additional staff are
recruited to meet demand. We would expect the cost of the workshop’s supervision, power for
light and heating, and general routine repairs to be fixed in the short term.
Example
Consider the Chinese takeaway restaurant again and identify which of the following costs are
variable or fixed:
Costs
Variable or Fixed
Meat and vegetables
Chef’s wages
Packaging materials
Gas and electricity
Counter staff wages
Telephone
Rent and rates
Variable
Fixed
Variable
Semi-variable
Fixed
Fixed
Fixed
BASIC PRINCIPLES – PROFIT AND LOSS ACCOUNT
The profit and loss account summarises sales and costs incurred during the financial year and
arrives at a net profit figure for the year.
We can summarise the profit and loss account as:
Turnover
Cost of Sales
Gross Profit
Overheads
Net Profit
A
(B)
C
(D)
E
A Turnover – sales achieved during the year, net of VAT
B Cost of Sales – just as it says, the variable cost of making or buying the goods that have been
sold.
Retail – simply the cost of buying goods from the supplier
Manufacturer – cost of raw materials, power and other variable costs
When calculating cost of sales e need to take into account opening and closing stock. Typically
cost of sales could be:
Opening Stock
Purchases
Labour
Power
Less Closing Stock
Cost of Sales
X
X
X
X
X
(X)
B
C Gross Profit – the difference between sales and cost of sales or the profit deducting only
variable costs or contribution to fixed overheads and net profit
D Overheads – all of the other costs of running the business. For example salaries, rent, rates,
cars, computers etc.
E Net Profit – The profit ‘left’ for the owner or shareholder
BASIC PRINCIPLES – THE BALANCE SHEET
The balance sheet is a ‘snapshot’ of the assets and liabilities of the business at a particular
moment – usually the year end.
Assets – things that belong to the business or amounts that are owed to it
Liabilities – Amounts that the business owes to someone else.
The balance sheet can be summarised as:
Fixed Assets
Current Assets
Current Liabilities
Net Current Assets
T
U
(V)
Long Term Liabilities
Net Assets
W
X
(Y)
Z
T Fixed Assets – land and buildings, plant and machinery, vehicles, intangible (eg brand names)
U Current Assets – Assets that can readily be converted to cash to pay debts as they fall due:
Cash
Debtors ( amounts customers owe us )
Stock
V Current Liabilities – Amounts the business owes that fall due within 12 months
Overdraft
Creditors ( amounts we owe suppliers )
W Net Current Assets – this is a balance between current assets and liabilities. It is traditionally
said that a ‘healthy’ business operates with net current assets although nowadays some businesses
operate well financed by creditors. Be aware that net current liabilities could be a warning sign.
Y Long Term Liabilities – amounts that fall due in more than 12 months time eg long term bank
loan or a mortgage.
Z Net Assets – a measure of the ‘worth’ of the business – if the business has net liabilities then it
is probably trading while insolvent.
Example Accounts – Advance Plastics
BASIC PRINCIPLES - ANALYSIS
Consider:
Year on year comparisons
Increase in Turnover (%) = This Year – Last Year x 100%
Last Year
Profitability Ratios
Rate of Gross Profit (%) = Gross Profit x 100%
Turnover
Liquidity
Current Assets
Current Liabilities
Ideally should be more than 1
Stock
Compare this year with last year.
TYPES OF BUSINESS
We commonly come across the following business entities. Each is required to keep different
records and prepare different documents for various purposes. We will consider
Sole Trader / Partnership
Limited Company
PLC (Public Limited Company)
SOLE TRADER / PARTNERSHIP
•
Not a Company – usually individual(s) ‘trading as’.
The business is owned by the proprietors who retain the profits.
Liability is not limited.
•
Only requirement for accounts is to have records to comply with VAT and Income Tax rules.
In effect business keeps cashbook / bank statements / pile of invoices and accountant prepares
accounts at the end of the year.
•
No requirement for the accounts to be audited. The accountants report usually says accounts
have been prepared based upon ‘information and explanations provided by the client’ – the
figures have not necessarily been verified or ‘certified’
•
As the business is not a limited company there is no requirement to submit accounts and
annual returns to Companies House and we cannot therefore carry out a Company Search.
•
We need to treat these accounts with caution – interpret them in the context of the business
•
We can obtain some comfort by reconciling accounts with quarterly VAT returns if the
business is registered – of course the business may be misdeclaring VAT too.
•
If the accounts do not give a true picture then it is most likely that turnover will be
understated and expenses overstated in the accounts to reduce VAT and Income Tax payable.
Both work in Insurers favour in a claims situation.
Example Accounts – A B Jones trading as Rags to Riches
Not audited
No particular format required by legislation
In this example there is no balance sheet
All expenses listed in detail
LIMITED COMPANY
•
Name of business is followed by ‘Limited’
The business is owned by the shareholders who receive dividends. Shares are not quoted
– usually owned by family or the directors.
Liability is Limited
•
Records and accounts etc are governed by The Companies Act(s) – this protects shareholders
as those running the business (directors) are not necessarily those who ‘own’ the business
(shareholders). Companies Act requires (detailed later)
Proper records must be kept
Proper accounts to be drawn up and audited – and filed with annual return at Companies
House (records available to the public – we can do a Company Search)
•
Accounts are audited and we can place more reliance on the records of the business and the
accounts
Example Accounts – Britannia Hotels Limited
Audited
Directors Report
These are ‘Group Accounts’ – see later
Less detail in Profit and loss account – detailed profit and loss acount not included – we need to
ask the Insured
Balance sheet
PLC (PUBLIC LIMITED COMPANY)
•
Name of business is followed by ‘PLC’
The business is owned by the shareholders who receive dividends. Shares are quoted on
the stock exchange – usually owned by many different people.
Liability is Limited
•
Records and accounts etc governed by The Companies Act(s) – this protects shareholders as
those running the business (directors) are not necessarily those who ‘own’ the business
(shareholders). Companies Act requires (detailed later)
Proper records to be kept
Proper accounts to be drawn up and audited – and filed with annual return at Companies
House (records available to the public – we can do a Company Search)
Accounts are audited and we can place more reliance on the records of the business and the
accounts – published accounts may only show an overview and be of little help to us in a claims
situation.
Example Accounts – Marks & Spencer PLC
Glossy format intended to impress shareholders and future investors
Business is generally on a large scale – it is difficult to identify the level of detail we may need.
COMPANIES ACT – ACCOUNTS AND RECORDS
Duties of Companies Regarding Accounting Records (s221)
•
Every company must keep records that are sufficient to show and explain the company’s
transactions and also to disclose, with reasonable accuracy, the financial position of the
company at any time.
•
Officers who knowingly or willfully permit or authorize inadequate records commit an
offence.
Private company
Public company
•
Keep records for 3 years
Keep records for 6 years
Records must contain:
Day book or journal (records sales, purchases and cash transactions)
Record of assets and liabilities (fixed assets, creditors, debtors)
If dealing in goods
•
Statement of stock held at the year end
Stock records
Record of all goods sold other than in normal course of trade
It is the Directors responsibility to maintain records.
Annual Accounts for Shareholders
Profit and Loss Account and Balance Sheet
Detailed formats set out in legislation
Directors Report
Review of development of the business during the year
Directors recommendation for dividend
Details of changes in fixed assets
Political and charitable donations over £500
Details of the directors
Details of trading in own shares
Auditors Report
Defines auditors responsibilities
It is the Auditors duty to gives an opinion as to whether the accounts ‘give a true and fair
view’ of the business and are ‘materially’ correct. Also that they have been prepared n
accordance with recognised standards. They do not ‘certify’ that they are totally correct.
Accountants can debate the questions of what is ‘true and fair’ or ‘material’ in a
particular case for hours!
Read the report – it may say that the records are such that they cannot form an opinion
or that their opinion is that the accounts are not materially correct – we need to know
this!
Annual Accounts
•
Directors must lay copies of Balance Sheet, Profit and Loss Account, Directors Report and
Auditors Report before the members at the AGM each year. Each member must be sent a
copy 21 days before the meeting.
•
Accounts to be filed at Companies House:
Limited Company
10 months from year end
PLC
7 months from year end
Abbreviated Accounts
•
Full accounts must be prepared but ‘small’ and ‘medium’ sized companies are permitted to
deliver only an abbreviated version to Companies House.
Reason – unfair to insist a small company discloses all of the detail.
For the year concerned must satisfy at least 2 of:
Small
Medium
Turnover less than
£1,400,000
£5,750,000
Balance sheet total less than
£700,000
£2,800,000
Number of employees
50
250
•
The rules are complex but generally such companies do not have to file a balance sheet and
only need to file a summary profit and loss account
Group Accounts
•
A Group is a holding company and its subsidiary companies.
•
Subsidiary means that the majority of the shares are held by the holding company.
•
Companies that have common directors or shareholders do not necessarily make a Group.
•
S229 – If at the end of the year a company has a subsidiary and is not itself a subsidiary then
it must include in its accounts group accounts dealing with the affairs of itself and its
subsidiaries as a single unit.
•
This is to give a truer picture of the real transactions of the business.
ANNUAL RETURN
Filed with accounts at Companies House
Provides us with useful information:
•
Names and addresses of current directors and those who have resigned
•
Other directorships the directors hold
•
List of all shareholders at that time
•
List of subsidiary and associated companies
•
Mortgages and Charges over assets of the business
Heather Parkinson B Eng FCA FCILA FUEDI ELAE
Parkinson Consulting
BASIC PRINCIPLES - ANALYSIS
Year on year comparisons
Increase in Turnover (%) = This Year – Last Year x 100%
Last Year
Profitability Ratios
Rate of Gross Profit (%) = Gross Profit x 100%
Turnover
Liquidity
Current Assets
Current Liabilities
Ideally should be more than 1
Stock
Compare this year with last year.
A B JONES Trading as “Rags to Riches”
Annual Accounts 1997
R T Smith & Co
Chartered Accountants
27 Old Oak Road
London SW4
Accountants Report
We have prepared the attached accounts based upon records and explanations provided by our
client and can confirm that the accounts reflect the information provided to us.
We have not performed an audit and have relied upon information provided.
R T Smith & Co
Chartered Accountants
27 Old Oak Road
London SW4
31 May 1998
A B Jones Trading as “Rags to Riches”
Trading Profit and Loss Account
for Year Ended 31st December 1997
Sales
Opening Stock
Purchases
Less Closing Stock
1996
1997
£
£
320,000
340,000
50,000
70,000
192,000
195,000
242,000
265,000
(70,000)
(80,000)
Gross Profit
172,000
185,000
148,000
155,000
Overheads
Staff salaries and NI
78,000
90,000
Rent and Rates
12,500
15,000
Light, Heat and Power
3,000
4,000
Telephone
1,500
2,000
Repairs and Renewals
6,000
1,400
Printing, Stationery and Postage
1,500
1,200
Advertising
4,800
2,600
800
1,000
Motor and Travel Expenses
1,800
2,000
Bank Charges and Interest
5,000
6,000
Credit Card Commission
4,800
5,100
Sundry Expenses
2,500
2,000
Discounts Payable
1,900
2,000
Accountancy
Depreciation
Total
Net Profit
550
500
124,650
134,800
23,350
20,200