1. Business Accounting
Unit 7

2. 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.

3. 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.
Imagine what would happen if a sole trader failed to keep a written record of all financial transactions, such as purchases and sales.
Lose track of people that owe you money
Order too much or too little raw material
Pay debt or bills when you don’t have enough money in the bank account
Is your business profitable? Should you continue? Opportunity cost
The government must be able to check your finance to see how much taxes you owe.

4. 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,

5. Financial documents involved in buying and selling.
Purchase orders: requests for buying products. It contains the quantity, type and total cost of goods. Here is an example

6. Financial documents involved in buying and selling.
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.

7. Financial documents involved in buying and selling.
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

8. Financial documents involved in buying and selling.
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.

9. 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
The traditional payment method. However, many businesses do not prefer to use cash for a number of security reasons. When cash is used, a petty cash voucher is issued by the person in charge of the firm's money. This person also signs the voucher to authorize the payment. The person making the purchase signs it the voucher as well to show that the money has been received.

10. Methods of making payment
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.
It is an instruction to the bank to transfer money from a bank account to a named person. In order to do this the bank needs a cheque guarantee card, saying that they have enough money in their account to support this payment.
Cheque guarantee card : saying that they have enough money in their account to support this payment.

11. Methods of making 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.

12. 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.

13. 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

14. 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

15. Example Cost per unit Revenue per unit Opening stocks Purchases
Closing stocks
How many cans did the business sell during the year?
What was the COGS?
What was the gross profit?
Goods sold= opening stocks + purchases – closing stocks
The city Café buys cans of drink from a wholesaler for $1 each. It sells them for $2 each.
City Café started the year 200 cans in stock (opening stocks).
It bought 1500 cans. – at the end of the year it had 300 left (closing stocks)

16. 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

17. Profit and loss account
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.
Such as rent from an apartment about your store. Income not made from normal activities
Income – not included in the trading account.

18. Profit and loss account
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.

19. 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.

20. Profit and loss account
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
It must be remembered that expenses are not necessarily the same as costs.
For example, if a business purchases a new fixed asset (such as a machine) then it will clearly incur the monetary cost of purchasing the machine (say $50,000).
However, this $50,000 will not be written-off as an expense, since the benefits from the machine will last for more than a single accounting period (i.e. for more than 12 months). Instead of writing-off the total cost of the machine, a portion of the $50,000 will be written-off as an expense each year over the useful life of the machine -this is known as a 'depreciation charge'.

21. Profit and loss accounts for limited companies
£000
Sales Revenue
1,000
Cost of Sales:
Materials
300
Direct labour
200
Production overheads
100
(600)
Gross profit
400
Less selling expenses
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
Less 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.

22. Activity 7.3

23. 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.
(i.e. it tells us where the money came from) and the assets represent the uses of the capital (i.e. it tells us how the money was spent).

24. 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

25. 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).

26. 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).

27. 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

28. Balance Sheet Long-term liabilities a) Bank loans.
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.

29. Balance Sheet Current Liabilities a) Bank overdraft.
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.

30. 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.

31. 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.

32. 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.

33. Balance Sheet for Big’s Hand Toilets December 31,2012
$(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 [ ]
Net Assets [=Assets Employed]
640 [ ]
Represented by:
Long-Term Liabilities
200
Share Capital
250
Reserves
190
Capital Employed
640 [ ]

34. Balance Sheet : Explanation
Working Capital
Also known as net current assets
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙=𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠−𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
It is used to pay short-term debt
Net Assets
𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠+ 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠−𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑜𝑟
𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑒𝑡𝑠+𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
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
One of the most important parts of a balance sheet is the 'net current assets' section. This is the day-to-day finance that is needed for running a business.
It is also referred to as 'working capital' and it is calculated by deducting current liabilities from current assets. Working capital is used to pay for expenses such as wages, raw materials and utility bills.
Working capital – if these debts cannot be paid because the business does not have enough working capital , the creditors could force the business to stop trading
If a business does not have sufficient working capital then it can face problems when paying its short-term debts (current liabilities). It may be the case that the business suffers a liquidity crisis and has to sell off some fixed assets, for example, in order to raise the necessary cash to meet its debts.
It is vital, therefore, that close control is kept over working capital, and the business must ensure that it does all that it can to keep enough cash available to pay its current liabilities.
On the other hand, if the business has too much cash tied-up in working capital, then it can be argued that this cash is not being used productively to help the business grow and diversify into new products and markets.

35. 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
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑=𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 𝑠 ′ 𝑓𝑢𝑛𝑑+𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Total long-term and permanent capital of the business which has been used to pay for the net assets of the business. Therefore
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑=𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
Profit and loss reserves: This profit is owned by shareholders but has not been paid out to them in the form of dividends.

36. 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.

37. 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.

38. 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.
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 % = 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 ×100

39. 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:
2.2 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 7.6𝑚𝑖𝑙𝑙𝑖𝑜𝑛 ×100=28.9%
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').
Clearly an investor would like to receive as high a R.O.C.E. as possible, although the figure would need to be compared to last year's return, to competitors' returns and to the returns on other investments.

40. Ratio analysis of accounts
Performance Ratios
Gross Profit margin
𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 % = 𝑔𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 ×100
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

41. Ratio analyses of accounts
For example, if a business has gross profit of £4 million and sales revenue of £6 million, then the gross profit margin would be:
4 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 6 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 ×100=66.7%
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.
The business would want this margin to be as high as possible, since a high margin will leave more profit for covering the remaining expenses and, if the business is a 'company', for covering the dividend payments to shareholders.

42. Ratio analyses of accounts
Performance Ratios
Net profit margin
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 % = 𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥 𝑠𝑎𝑙𝑒𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 ×100
The higher this result, the more successful the managers are in making net profit from sales.

43. Ratio analyses of accounts
For example, if a business has gross profit of £1 million and sales revenue of £6 million, then the net profit margin would be:
1 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 6 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 ×100=16.7%
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.
Any profit which remains is kept in the business for re-investment and is called 'retained profit'. Again, the business would want this margin to be as high as possible, allowing both large dividend payments to shareholders and a significant amount of profit to be retained for growth.

44. Ratio analyses of accounts
Liquidity Ratios
These measure the ability of a business to pay back its short-term debts
Current Ratio
𝑐𝑢𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜= 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
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.

45. Ratio analyses of accounts
For example, if a business has current assets of £250,000 and current liabilities of £180,000, then the current ratio would be:
250, ,000 =1.39
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.

46. Ratio analyses of accounts
Liquidity Ratios
Acid test or liquid ratio
𝑎𝑐𝑖𝑑 𝑡𝑒𝑠𝑡 𝑟𝑎𝑡𝑖𝑜= 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡−𝑠𝑡𝑜𝑐𝑘𝑠 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
A result of 1 would mean that the company could just pay off its short-term debts from its most liquid assets.
A result lower would worried the management and seeps may have to be taken to improve the working capital of the business

47. Ratio analyses of accounts
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:
150, ,000 =0.83
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.

48. Ratio analyses of accounts
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.

49. Ratio analyses of accounts
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

50. 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.