So far in our example the money spent on ‘capital’ items such as the £/$/€12,500 spent on a computer and on converting the garage to suit business purposes has been ignored, as has the £/$/€9,108 worth of sheet music etc remaining in stock waiting to be sold and the £/$/€12,000 of money owed by customers who have yet to pay up. An assumption has to be made about where the cash deficit will be made up, and the most logical short-term source is a bank overdraft. The balance sheet is the accounting report that shows at any moment of time the financial position taking all these longer-term factors into account.
For High Note, the example we have been using in the other finance chapters, at the end of September the balance sheet is set out in Table 21.1.
Table 21.1 High Note balance sheet at 30 September
|
£/$/€ |
£/$/€ |
|
|
Assets |
||
|
Fixed Assets |
||
|
Garage conversion etc |
11,500 |
|
|
Computer |
1,000 |
|
|
Total Fixed Assets |
12,500 |
|
|
Working Capital |
||
|
Current Assets (CA) |
||
|
Stock |
9,108 |
|
|
Debtors |
12,000 |
|
|
Cash |
0 |
|
|
21,108 |
||
|
Less Current Liabilities (CL) |
||
|
Overdraft |
4,908 |
|
|
Creditors |
0 |
|
|
4,908 |
||
|
Working Capital (CA–CL) |
16,200 |
|
|
Total Assets |
28,700 |
|
|
Liabilities |
||
|
Owners’ capital introduced |
10,000 |
|
|
Long-term loan |
10,000 |
|
|
Profit retained (from P&L account) |
8,700 |
|
|
Total Liabilities |
28,700 |
There are a number of other items not shown in this balance sheet that should appear, such as liability for tax and VAT that have not yet been paid and should appear as current liability. You will find a spreadsheet template to help you construct your own balance sheets at Business Accounting Basics (www.businessaccountingbasics.co.uk/balance-sheet-template.html).
The terms used in financial statements often seem familiar but they are often used in a very particular and potentially confusing way. For example look at the balance sheet below and you will see the terms ‘assets’ and ‘liabilities’. You may think that the money put in by the owner and the profit retained from the years trading are anything but liabilities, but in accounting ‘liability’ is the term used to show where money has come from. Correspondingly ‘asset’ means, in the language of accounting, what has been done with that money.
You will also have noticed that the assets and liabilities have been jumbled together in the middle to net off the current assets and current liabilities and so end up with a figure for the working capital. ‘Current’ in accounting means within the trading cycle, usually taken to be one year. Stock will be used up and debtors will pay up within the year, and an overdraft, being repayable on demand, also appears as a short-term liability.
Assets are ‘valuable resources owned by a business’. You can see that there are two key points in the definition:
These are the claims by people outside the business. In this example only creditors, overdraft and tax are shown, but they could include such items as accruals and deferred income. The ‘financed by’ section of our example balance sheet is also considered in part as liabilities.
This is the term used with both assets and liabilities to show that they will be converted into cash, or have a short life (under one year).
Now let’s go through the main elements of the balance sheet.
This is the ‘what have we done with the money?’ section. A business can only do three things with funds:
This section of the balance sheet shows where the money came from. It usually has at least two subheadings, although larger companies can have many more.
The profit or loss for each year is added to or subtracted from the shareholders’ investment. Eventually, once the business is profitable, it will have some money left each year to plough back into reserves. This term conjures up pictures of sums of cash stored away for a rainy day. It is important to remember that this is not necessarily so. The only cash in a business is that shown under that heading in the current assets. The reserves, like all the other funds, are used to finance a business and are tied up in the fixed assets and working capital.
These ground rules are generally observed by accountants when preparing a balance sheet.
In accounting, a record is kept only of the facts that can be expressed in money terms. For example, the state of your health, or the fact that your main competitor is opening up right opposite in a more attractive outlet, are important business facts. No accounting record of them is made, however, and they do not show up on the balance sheet, simply because no objective monetary value can be assigned to these facts.
Expressing business facts in money terms has the great advantage of providing a common denominator. Just imagine trying to add laptops and motor cars, together with a 4,000 square foot workshop, and arrive at a total. You need a common term to be able to carry out the basic arithmetical functions, and to compare one set of accounts with another.
The accounts are kept for the business itself, rather than for the owner(s), workers, or anyone else associated with the firm. If an owner puts a short-term cash injection into his or her business, it will appear as a loan under current liabilities in the business account. In his or her personal account it will appear as an asset – money he or she is owed by someone else. So depending on which point of view you take, the same sum of money can be an asset or a liability. And as in this example the owner and the business are substantially the same person, the possibilities of confusion are considerable.
This source of possible confusion must be cleared up and the business entity concept does just that. The concept states that assets and liabilities are always defined from the business’s viewpoint.
Assets are usually entered into the accounts at cost. For a variety of reasons, the real ‘worth’ of an asset will probably change over time. The worth, or value, of an asset is a subjective estimate on which no two people are likely to agree. This is made even more complex and artificial because the assets themselves are usually not for sale. So, in the search for objectivity, the accountants have settled for cost as the figure to record. It means that a balance sheet does not show the current worth, or value, of a business.
Fixed assets are usually depreciated over their working life rather than taken as one hit on the profit and loss account. There are accounting rules on the appropriate period to depreciate different assets over, usually somewhere between 3 and 20 years. If we believe the computer has a useful life of four years and the rules allow it, we take £250 a year of cost, by way of depreciation, as an expense item in the profit and loss account for the year in question. Depreciation, though vital for your management accounts, is not an allowable expense for tax purposes. The tax authorities allow a ‘writing down’ allowance say of 25 per cent of the cost of an asset each year which can be set as an expense for tax purposes. There are periods when the government of the day wants to stimulate businesses to invest, say in computers, and it will boost the writing-down allowance accordingly. This figure will almost certainly not correspond to your estimate of depreciation, so you need a profit for tax purposes and a profit for management purposes. You can see the effect of deprecation on the accounts in Table 21.2. Fixed assets reduce by £/$/€125 of depreciation and there is a corresponding reduction in profit retained for the year, thus ensuring the balance sheet balances.
Table 21.2 The changes to High Note’s balance sheet to account for depreciation
|
Balance sheet |
£/$/€ |
|
Asset changes |
|
|
Fixed assets at cost |
12,500 |
|
Less depreciation for six months |
125 |
|
Net book assets |
12,375 |
|
Liability changes |
|
|
Profit from P&L account reduced by £/$/€125 to |
8,575 |
One of the books you will keep will be a Capital Register, keeping track of the cost and depreciation of all fixed assets. Another accounting rule, that of ‘materiality’, comes into force here. Technically a pocket calculator costing £/$/€5 is a fixed asset in that it has been bought to use rather than sell and it has a life of over one year. But it is treated as an expense as the sum involved is too small to be material. There are no clear rules on the point at which a cost becomes material. For a big organization it may be for items costing a few thousand pounds. For a small business £/$/€100 may be the appropriate level.
Other assets, such as freehold land and buildings, will be revalued from time to time, and stock will be entered at cost, or market value, whichever is the lower.
The QuickBooks website offers a downloadable Excel spreadsheet that enables you to tailor a balance sheet to your own needs, You can find the spreadsheet by scrolling through the Resource Center until you reach the Free Balance Sheet Template, Example and Guide.
Accounting reports always assume that a business will continue trading indefinitely into the future, unless there is good evidence to the contrary. This means that the assets of the business are looked at simply as profit generators and not as being available for sale.
For example, a motor car might be recorded in the accounts at £3,000 having been depreciated down from its purchase cost. If we knew that the business was to close down in a few weeks, then we would be more interested in the car’s resale value than its ‘book’ value; the car might fetch only £2,000, which is a quite different figure.
Once a business stops trading, we cannot realistically look at the assets in the same way. They are no longer being used in the business to help to generate sales and profits. The most objective figure is what they might realize in the marketplace. Anyone who has been to a sale of machinery will know the difference between book and market value!
To keep a complete record of any business transaction we need to know both where money came from, and what has been done with it. It is not enough simply to say, for example, that someone has put £/$/€1,000 into their business. We have to show how that money has been used to buy fixtures, stock in trade, etc.