Double-entry book-keeping
Accountants have developed the technique of double-entry book-keeping for the preparation of financial statements. As the name implies, this requires that for every transaction there are two entries: a debit entry and a credit entry. In accounting, the
transactions of interest relate to sales, costs or capital expenditure. This is best illustrated with an example.
A business purchases a machine and pays a cash sum of $5,000. The transaction can be recorded in ledger or t-accounts. They are called t-accounts because their shape makes the letter T. Debit entries are always placed on the left and credit entries on the right. For the purchase of the machine:
debit: fixed assets account with $5,000 credit: cash account with $5,000
Suppose that the business in the example also made a sale to a customer for cash. For the sale of goods:
debit: cash account with $10,000 credit: sales account with $10,000
Cash account
Debit $
Sale of goods 10,000
10,000
Credit $
Purchase of machine 5,000
Balancing figure 5,000
10,000
Sales account
Debit $ Credit $
Sales for cash 10,000
Fixed assets account
Debit $
Machine 5,000
Credit $
Cash account
Debit $ Credit $
Purchase of machine 5,000
The financial statements 151
When all the ledger accounts have been completed, all the debits and all the credits within each account are totalled, and the difference between the totals is calculated to yield a debit or credit balance for the account. If the total debits are greater than the total credits, the account is said to have a debit balance; if credits exceed debits, the account has a credit balance. In the case of the cash account, a balancing figure has been computed
representing a debit balance of $5,000.
At the end of an accounting period a trial balance can be prepared. This combines all the ledger accounts that have been completed during the period and represents a list of all the debit and credit entries. In reality there would be many more ledger accounts, but for this simple example the trial balance would appear as follows.
Chart 15.1 Trial balance
Debit ($) Credit ($)
Cash 5,000
Fixed assets 5,000
Sales 10,000
Total 10,000 10,000
As a result of double-entry book-keeping, the sum of all the debits and credits must be equal. This is a useful check to ensure that the accounts have been completed accurately. If a difference arises, the entries in the ledger should be reviewed for errors of omission or incorrectly posting errors to the wrong side. To help ensure entries are posted to the appropriate side in the case of a cash transaction, it is useful to start with the cash account.
Cash moves through the cash ledger account from left to right: cash received is always a debit entry and cash paid out is always a credit entry. This may appear counter-intuitive to some people, who compare company accounts with their own personal accounts where a credit entry represents a cash inflow into their account. Once the cash side of a transaction has been posted, there is less chance of making an error with the other side.
If double-entry book-keeping is used for all transactions that take place during the year, all the ledger accounts will contain enough information with which to prepare the financial statements.
What are they and what do they look like?
The following three sections comprise a review of the layout and content of the financial statements followed by an examination of the individual transactions that make up the actual content of the statements. Initially, the financial statements will be examined at a high level. Some of the ideas may be difficult to grasp at this stage, but they will become clearer as you progress through the worked examples. Note that the figures are for
illustration only and do not represent a legitimate set of accounts. This means you will not be able to reconcile the accounts completely.
The profit and loss account or income statement
The profit and loss account (p&laccount) or income statement captures, for a specific
period, all the sales and the costs associated with achieving either a profit or a loss for the period, even if the associated cash flows did not take place during that time. The p&l account meets the fundamental accounting principle of matching. Chart 15.2 shows the format for a typical profit and loss account.
Chart 15.2 Profit and loss account for the 12 months ended March 31st
$
Sales revenue 236,000
Cost of sales (60,000)
Gross profit 176,000
Staff salaries (45,000)
Rent, light and heat (7,000)
Advertising (15,000)
General administration (26,000)
Total operating costs (93,000)
Operating profit 83,000
Depreciation (22,000)
Amortisation (13,000)
Interest income 2,250
Interest charges (9,500)
Profit before tax 40,750
Tax (12,250)
Profit after tax 28,500
Dividends (19,950)
Retained profit for the year 8,550
Calculating gross profit
Sales revenue is recorded net of any sales tax, such as value-added tax in the UK, and relates to all the sales achieved in a specific accounting period, which could be a year, a quarter, a month or even a week. The costs of sales are the direct costs associated with achieving the sales revenue. A direct cost is one that is directly related to the volume of sales, such that, if an additional unit of a product is sold, the cost of sales increases by the cost of that additional unit. Sales revenue, less the cost of sales, gives the gross profit for the business. The business must generate sufficient gross profit to cover all the other indirect costs associated with achieving the sales.
Calculating operating profit
If the cost of sales relates only to direct costs that vary directly with sales volume, operating costs such as salaries, premises rentals and advertising expenditure are indirect costs. The levels of these cost items do not vary with the level of sales. They are
interchangeably referred to as indirect, fixed or overhead costs. The difference between gross profit and total operating costs gives the operating profit for the business. This is the profit generated from normal operating activities. However, there are additional costs and potential revenues that must be accounted for.
The financial statements 153
Depreciation and amortisation
Many businesses are required to buy capital items, such as plant or machinery, which they use for a number of years. The principle of matching requires that these costs be matched against the revenues to which they have contributed. If the full cost of a machine, which is used for three years, is charged as an operating cost in year one, the business may well appear to make a significant loss in the first year followed by two years of large profits. To ensure that the profitability of a business in any year is representative, the business must spread the cost of the machine over the period during which it contributes to sales. In the case of a machine that is used for three years, one-third of the cost of the machine would be charged in the profit and loss account each year. The spreading of the cost of a capital item is called depreciation, which is dealt with in more detail later in this chapter.
Depreciation charges relate to the spreading of the cost of physical capital items. Non- tangible items, such as licences and patents that exist for a number of years, are treated exactly the same way but the charge to the p&laccount is described as amortisation.
Interest income and charges
To finance its operations a business may have borrowed money from the bank. As a result, the interest charges relating to the debts of the business must also be included in the p&l account. The interest charges reflect the cost of financing the assets necessary to support the generation of the revenues. A successful business will generate cash and build up cash reserves at a bank, on which it will earn interest income. This non-operating income must also be included in the p&laccount.
Calculating profit before tax
The profit before tax (pbt) figure is calculated by deducting non-operating costs, such as depreciation, amortisation, interest, foreign exchange losses and others, from operating profits and adding non-operating income.
Corporation tax, profit after tax and dividends
Businesses that generate profits are required to pay corporation tax on their profits, so a taxation charge is deducted from profits before tax to give profit after tax. Because profit after tax has been calculated after paying interest on loans from providers of debt finance, any profit remaining is available to be paid to shareholders as dividends or to be retained in the business. The amount retained within the business is added to the profit and loss reserve recorded in the balance sheet.
Balance sheet
The p&laccount examines a specific accounting period. The balance sheet represents a
snapshot of the business’s position at a particular point in time – the end of the accounting period covered by the p&laccount so far as the published annual accounts are concerned – but reflects transactions that have taken place throughout the history of the business. It lists all the business’s assets and liabilities as well as the shareholders’ funds. Assets are the things owned by the business that support the transactions recorded in the p&laccount, as well as all the money owed to the business by its debtors. Liabilities represent all the money owed to others by the business. Shareholders’ funds represent the equity share
capital placed in the business and any profits, or losses, retained by the business. Chart 15.3 shows the format of a typical balance sheet.
Chart 15.3 Balance sheet as at March 31st
$
Tangible fixed assets 51,500
Intangible fixed assets 9,000
Total fixed assets 60,500
Debtors 500
Stock 750
Cash at bank 50
Total current assets 1,300
Creditors (8,000)
Overdraft (6,000)
Total current liabilities (14,000)
Net current assets (12,700)
Total assets less current liabilities 47,800
Equity 30,000
Retained profits 12,000
Debt 5,800
Total capital employed 47,800
Fixed assets
Tangible fixed assets represent the total cost of all physical assets such as machinery, vehicles and buildings that have been purchased to support the business, less the total depreciation that has ever been charged in the p&laccount. However, the cost of any assets that have been sold and the corresponding depreciation that was charged are eliminated from this total. The tangible fixed asset figure therefore represents the cost of all physical assets that have been bought by the business but have not yet been charged as depreciation to the p&laccount. The difference between the total cost of the assets and the total depreciation is the net book value of the assets. Capital items are said to be presented in the balance sheet at their net book value. Intangible fixed assets are directly comparable to tangible fixed assets, the only difference being that they do not reflect physical assets. A brand is an example of an intangible asset. Tangible and intangible fixed assets combined represent the total fixed assets of the business.
Current assets
Sales to customers may be paid for in cash, but many customers are given credit, for example 30 days. The value of the goods received but not yet paid for is the debtors’ figure in the balance sheet. As debts are money owed to the business, they are treated as an asset.
A business that manufactures and sells a product will, at any point in time, have items of stock that it has not yet sold. Their value will appear as an asset in the balance sheet entitled “stock”. As stocks can be sold to generate sales, they are also treated as an asset.
The financial statements 155
If the business has performed well, or has just received a loan from the bank, it may have positive cash balances at the bank. As these can be used to purchase stock or to pay salaries that support sales activity, cash balances are defined as an asset.
Debtors, stock and cash combined are described as the total current assets of the business.
They are called “current” because they are assets that are currently being used by the business.
Current liabilities and working capital
Creditors are the opposite of debtors, representing those to whom the business owes money. These are described as liabilities: items that represent a future cash outflow for the business. An overdraft at the bank also represents a liability, as it must be repaid at some stage in the future. The difference between total current assets and total liabilities is called the net current assets or liabilities, sometimes referred to as working capital.
Total net assets
If the business’s net current assets or liabilities are combined with the total fixed assets, they represent the total net assets of the business. This is the net financial value of the components that make up the business and support the sales activity. The total assets less current liabilities of the business must be financed through different sources of capital, which are described in the bottom half of the balance sheet.
Shareholders’ funds
Equity is the money that shareholders have provided to the business in return for shares that entitle them to a future dividend stream from the business. If the business decides not to pay out all the profits generated in the year they are retained in the business, but the shareholders still retain the right to those profits. They are described as retained profits or shareholders’ reserves. Dividends cannot be paid until the business has eliminated all previous retained losses.
Debt
Debt represents the funding of the assets of the business that has come from banks and the holders of bonds.
Fundamental accounting identity
In accounting, there is a fundamental accounting identity or relationship that states that the total assets of the business must equal the total liabilities. This relationship must always hold true because of the equal and opposite entries of double-entry book-keeping. This also ensures that the balance sheet balances.
Cash flow statement
The cash flow statement examines the actual cash flows that take place during an accounting period and underlie the p&laccount and the balance sheet. The p&laccount
can suggest that the business is making strong profits, but the cash flow statement provides a view of the harsh realities. Profits can be flattered by careful accounting treatments, but the cash flow statement demonstrates whether the business is generating more cash than it is spending, which is the ultimate test of its success. As a result, the cash flow statement is one of the most important of all the financial statements. Chart 15.4 shows a typical cash flow statement. Note that this example does not relate to the earlier examples.
Chart 15.4 Cash flow statement for the year ending March 31st
$
Operating profit/(loss) 94,000
Movement in working capital (30,000)
Cash flow from operating activities 64,000
Capital expenditure (56,000)
Tax paid (15,000)
Cash flow before financial cash flows (7,000)
Interest paid (2,000)
Interest received 0
Cash flow before financing (9,000)
Equity issued 5,500
Debt raised 4,000
Cash flow after financing 500
Dividends paid 0
Cash flow for the period 500
Cash flow from operating activities
The starting point for the cash flow statement is the operating profit or loss. This figure represents the sales and associated supporting costs for the accounting period but does not take into account when the monies were actually received or paid. Before proceeding, it is necessary to convert the operating profit or loss into a corresponding cash flow. This is achieved by adjusting the profit or loss from operating activities to take account of the movement in working capital or net current assets. This idea is best demonstrated by a simple example.
A business makes two sales for $100 each, giving total sales of $200, and the total cost of sales is $100. The profit from operating activities is therefore $100.
Sales $200
Less: cost of sales ($100)
Profit from operating activities $100
One of the sales was for cash and the other on credit. As a result of the sale, debtors have increased by $100 and cash has increased by $100.
The cost of the materials was $50 each and three items of stock were purchased. The first two purchases were for cash and the remaining purchase was on credit with the supplier.
As a result, the cash balance has fallen by $100; creditors have increased by $50 and stocks
The financial statements 157
have increased by $50, as only two items of stock were sold. Intuitively, it is apparent that the combination of the sale ($100 increase in cash) and the purchase ($100 fall in cash) has resulted in a zero net movement in cash. The same result can be obtained by adjusting operating profits to take account of movements in working capital.
Movements in working capital
An increase in debtors represents money that has not yet been received by the business despite the sale, so it should be deducted from operating profits to calculate the actual cash flows. An increase in creditors represents money that has not yet left the business despite a purchase being recorded in the p&laccount, so an increase in creditors should be added to operating profits. An increase in stock represents money that has left the business but does not support a transaction that featured in the profit or loss of the business for that period, so an increase in stock should be deducted from operating profits. The combination of these three calculations represents the movement in working capital for the period.
$
Operating profit 100
Less: increase in debtors (100)
Less: increase in stock (50)
Add: increase in creditors 50
Cash flow from operating activities 0
Despite a profit of $100 reported in the p&laccount, the business has not generated any actual cash. This is consistent with the intuitive result obtained above.
Cash flow before financing activities
Once the cash flow from operating activities has been computed, the actual amount of money spent on capital items is deducted as well as any actual tax paid. With all these transactions the emphasis is on the flow of actual cash.
Cash flows associated with financing activities
With all the operational cash flows accounted for, the statement examines the cash flows associated with financing activities. Any interest paid or received is included to give a cash flow for the period. If the business actually consumes more cash than it generates, there will be a financing requirement. The inflow of cash from shareholders or lenders is then included to give a cash flow after financing. Lastly, if any dividends have been paid, the amount is deducted to give the final movement in cash or cash equivalents during the period. In the example above, there is cash inflow of $500 for the period which will be reflected as an increase in the business’s cash balances at the bank.
Interaction of the financial statements
All three financial statements are closely interlinked. For example, the retained profits for the year in the p&laccount are added to profit and loss reserves in the balance sheet, and the tax paid in the cash flow statement reduces the tax creditor in the balance sheet.