Amanda Profit & Loss Account for 12 months ended December 31 2004
£ £
Sales 480,000
Less: cost of sales 384,000
Gross margin 96,000
Warehouse rent 6,000
Wages 10,800
National insurance 1,200
Stock losses 239 18,239
Gross profit 77,761
Samples 2,000
Debtor insurances 10,000
Legal costs 5,000
Rent (office) 10,000
Delivery costs 16,500
Stationery 600
General insurances 1,500
Bank charges 15,300
Depreciation 6,250
Accounting and audit expenses 1,200 68,350
Profit before exceptional 9,411
items and interest
Setting up costs 12,000
Goodwill impairment 15,000 27,000
Loss before interest (17,589)
Interest 20,000
Net loss (37,589)
Figure 1.3 Case study – Amanda Profit and Loss Account
Before the introduction of UK GAAP, the Balance Sheet was prepared horizon- tally with assets on the right and liabilities on the left. For Amanda, this is shown as Figure 1.4(a).
The problem with Balance Sheets prepared this way is that they were very con- fusing and could easily be used to fool the numerically challenged. A common trick, when selling a business at that time, was to suggest that the business was worth its asset value. A finance specialist given the job of selling Amanda’s business might suggest that a selling price of £250 000 was an absolute unbeat- able bargain, given that the business had assets of £293 200, as certified by an auditor. Of course, this finance specialist would not tell the unsuspecting buyer that Amanda’s Profit and Loss Account was on the debit (asset) side;
this meant that she had made cumulative losses. The Profit and Loss Account should always be on the credit (liability) side of the Balance Sheet, as this is where it will be found if a profit has been made. It is a liability as it indicates what the business owes to its owner. In order to present the Balance Sheet in a more meaningful way, it was revised to look as in Figure 1.4(b).
Intangible assets are shown net of amortisation to date, or impairment as is currently the case, and tangible assets are shown net of depreciation. The sum of intangible assets and tangible assets are ‘net fixed assets’, but will often be shown in accounts in the abbreviated form as ‘fixed assets’. Next comes current asset, and from current assets, current liabilities are deducted. The difference between current assets and current liabilities is known as ‘working capital’. This is shown in accounts as ‘net current assets’, where current assets
Amanda Balance Sheet as at December 31 2004
Liabilities Assets
£ £
Capital
Long term loans Creditors and accruals
50,000 200,000 43,200
Intangible assets Tangible assets Stock
Debtors and prepaymemts Other debtors
Cash at bank
Profit and Loss Account
25,000 13,750 95,761 118,500 2,380 220 37,589
Total liabilities 293,200 Total assets 293,200
Figure 1.4(a) Case study – Amanda – Balance Sheet (prior to UK GAAP)
Amanda Balance Sheet at December 31 2004
£ £
Intangible assets Tangible assets
25,000 13,750 38,750 Stock
Debtors and Prepayments VAT
Cash at bank
Total current assets Creditors and accruals
Net current assets
Total assets less current liabilities Less: long term liabilities – loan
Total net assets
95,761 118,500 2,380 220 216,861 43,200
173,661 212,411 200,000 12,411 Capital
Less: loss in year Closing capital
50,000 (37,589)
12,411 Figure 1.4(b) Case study – Amanda – Balance Sheet
are higher than current liabilities, and as ‘net current liabilities’, where current liabilities are higher than current assets. Working capital is added to net fixed assets to give ‘total assets less current liabilities’ and this represents the total capital employed in the business. Long-term liabilities, such as long-term loans, are deducted from total capital employed to give ‘net assets’, and this ‘net assets’ figure is the true (assuming the accounts are accurate) asset value of the business. As can be seen from Figure 1.4(b), the true asset value of Amanda’s business at 31 December 2004 is £12 411, and this is a long way from the
£293 200 as it would have been shown in the old format.
The bottom block of a Balance Sheet will be different for a sole trader, partner- ship and Limited Company. Take three scenarios.
Sole trader
A sole trader starts with a capital of £120 000 and in the first year makes a net profit of £89 000. In the year he takes £50 000 out of the business and the business pays his tax bill of £28 000. The bottom block of the sole trader’s Balance Sheet at the end of his first year would be:
£
Net assets 131 000
Capital 131 000
Capital would be calculated: £
Opening capital 120 000
Add: net profit 89 000
209 000
Less: Drawings 78 000
131 000 Partnership
A, B and C start a partnership, bringing in a capital of £20 000, £40 000 and
£60 000, respectively. The partnership makes a profit of £89 000, and the profit is divided up as shown in the example on previous pages. In the first year of trading, A has received £30 000 and B has received £20 000 from the partner- ship. Also, the partnership had paid a tax bill of £13 000 for A, £7000 for B and
£8000 for C.
Now the Balance Sheet would look like:
£
Net Assets 131 000
Capital Accounts £
A 20 000
B 40 000
60 000 120 000 C
Current Accounts
A 3000
B 6000
C 2000
11 000
Total Partnership capital 131 000
The partners’ current accounts would be calculated as follows:
£ Current account – A
Opening Balance Add: share of profits
0 46 000 46 000
Less: Drawings 43 000
3000 Current account – B
Opening Balance Add: share of profits
0 33 000 33 000
Less: Drawings 27 000
6000 Current account – C
Opening Balance Add: share of profits
0 10 000 10 000
Less: Drawings 8000
2000
Limited company
If A, B and C had decided to set up a limited company, rather than a partner- ship, then they would have to divide up the net profit after tax, called ‘earnings’
in proportion to the capital they put in. However, those being employed in the company as well as providing capital would be paid a salary and they would be taxed on the amount of their salary and not on the profits the com- pany made. However, in addition to the personal tax borne by the sharehold- ers, the company would pay corporation tax on profits after the deduction of salaries.
Had A, B and C formed a company, with a view to achieving a similar share of the profits that they would have received had they been in a partnership, then they might have structured the company as below:
Issued share capital – 120 000 ordinary shares of 25 pence, purchased for £1 each.
A buys 20 000 ordinary shares, B buys 40 000 ordinary shares and C buys 60 000 ordinary shares.
A is to be paid a salary of £27 000 per annum and B is to be paid an annual salary of £17 000.
Now the bottom part of the Profit and Loss Account might read:
ABC Limited – Profit and Loss Account for the year ended ………...
£ £
Profit before salaries, national insurance and pension costs 89 000 Less:
Salaries 44 000
National insurance and pension costs 6729 50 729
Profit before tax 38 271
Corporation tax 7271
Earnings 31 000
Dividends 20 000
Retained Earnings 11 000
ABC Limited – Balance Sheet at………
£
Net assets 131 000
£ Share capital: 120 000 Ordinary shares of 25 pence 30 000
Share premium account 90 000
Profit and Loss Account 11 000
Equity shareholders’ funds 131 000
The Balance Sheet for limited companies will be dealt with more fully in later chapters, but with regard to the above Balance Sheet:
(1) The share premium account shows the difference between what shares were sold for and their par value. A share’s par value is the value shown on the share certificate.
(2) Share capital and share premium are capital reserves, while the Profit and Loss Account is a revenue reserve.
(3) Dividends can only be paid out of revenue reserves.
(4) The word ‘equity’ means ordinary shares, as against preference shares.
Now that Amanda’s Profit and Loss Account and Balance Sheet for the year ended 31 December 2004 are complete, her nominal ledger would be adjusted in preparation for the new financial year. Firstly, all items in the Trial Balance that were designated to be Profit and Loss Account items would be written down to zero and replaced by one line reading ‘Profit and Loss Account’. This is shown in Figure 1.5. Secondly, entries would be made in the nominal ledger to reverse all the reversible entries from the previous year. This is shown in Figure 1.6.
Trial Balance at December 31 2004
Debit (£) Credit (£)
Capital 50,000
Cash at bank 220
Goodwill 25,000
Samples 0
Loan 200,000
Debtor insurance 0
Setting-up costs 0
VAT 2,380
Legal costs 0
Stock 95,761
Trade creditors 40,000
Sales 0
Trade debtors 102,500
Cost of sales 0
Rent (office) 0
Fixtures and fittings 3,750
Van 10,000
Warehouse rent 0
Delivery costs 0
Stationery 0
General insurances 0
Wages 0
National insurance 0
Interest 0
Bank charges 0
Stock losses 0
Goodwill impairment 0
Depreciation 0
Accruals 3,200
Prepayments 16,000
Accounting and audit expenses 0
Profit and Loss Account 37,589
293,200 293,200
Figure 1.5 Case study – Amanda – Trial Balance (after completion of 2004 accounts)
Reversing double entries after year end close Accurals
Number Debit £ Number Credit £
Opening balance 3,200
23R 2,000
23R 1,200
Prepayments
Number Debit £ Number Credit £
16,000 Opening balance
16,000 24R
Wages
Number Debit £ Number Credit £
1,800 23R
National insurance
Number Debit £ Number Credit £
200 23R
Accounting and audit expenses
Number Debit £ Number Credit £
1,200 23R
Rent (office)
Number Debit £ Number Credit £
10,000 24R
Warehouse Rent
6,000 24R
Number Debit £ Number Credit £
Case study – Amanda
Her accountant came straight to the point. Her accounts were awful. Sales volumes were not high enough to justify her contract with Zehin Foods plc and her gross margin percentage at 20% was too low. Then, she had 91 days of stock at her year end and could not control this by reducing her orders as she was committed to buying minimum quantities from her supplier. Debtor days stood at 78 days and while there was not a bad debt risk because her debtors were insured, this indicated a complete lack of control.
Why, the accountant asked, were the debtors insured anyway when her sales were to large supermarkets that were very unlikely to go bust? Amanda explained that debtor insurance was a condition for getting the bank loan, but this did not satisfy her accountant. Why were her bank charges, being over 3% of turnover, so high? Amanda’s accountant believed that she could have negotiated with the bank for a better deal.
It was explained to her that the accounts demonstrated that her business was being run badly, to the effect that she had lost £37 589 of her original £50 000 capital, leaving her with only £12 411. The accountant explained that if she had difficulty selling any of her stock, the bank might get nervous and demand their money back. That would put her out of business; the only saving grace being that as they would have to write off some of their debt, they would not rush into such action.
The accountant suggested that Amanda needed to understand the meaning of