Debt finance and business accounts

What is the sequence from bookkeeping records to financial statements?

Bookkeeping ledgers → trial balance → financial statements (profit and loss account and balance sheet).

What are ledgers collectively referred to as?

The books.

What must be identified when recording a business transaction?

Which types of accounts or ledgers the transaction affects.

How many entries must be recorded for each transaction?

At least one debit entry and one corresponding credit entry.

What does ALCIE stand for when classifying ledger accounts?

Assets, Liabilities, Capital, Income and Expenses.

What is an asset?

Something owned by the business.

How should asset accounts be organised?

Separate accounts should be maintained for each category of asset, such as vehicles or cash at bank.

What are fixed (non-current) assets?

Assets that enable the business to make a profit and provide a long-lasting benefit, generally being held for more than one year.

What are examples of tangible fixed assets?

Buildings and other physical assets.

What are examples of intangible fixed assets?

Trade marks.

What are current assets?

Cash and items that can be quickly converted into cash, generally within one year.

What are examples of current assets?

Stock/inventory, debtors and cash.

What is stock/inventory?

Goods held by the business for use or resale.

Who are trade debtors?

Customers who have bought goods or services on credit but have not yet paid.

What is a liability?

Something owed by the business.

How should liability accounts be organised?

Separate accounts should be maintained for each type of liability, such as loans and trade debts.

What are current liabilities?

Liabilities due within one year, such as a bank overdraft or trade creditors.

What are examples of current liabilities?

A bank overdraft, which is payable on demand, and amounts owed to suppliers of raw materials.

What are long-term (non-current) liabilities?

Liabilities due after one year, such as a term loan.

Does a long-term liability automatically become a current liability when it enters its final year?

No. Under the notes, a liability classified as non-current does not automatically become current simply because it becomes due within one year after several years.

What is capital in accounting?

Value injected into the business by its owner or investors, rather than generated by the business itself.

How is a sole trader treated for accounting purposes?

The sole trader is treated as separate from the business.

What does a sole trader’s capital account include?

The original capital contribution and profits retained over the years.

How are transactions between a sole trader and their business recorded?

As drawings in the trial balance, including any 'salary' the owner pays themselves.

What is income in accounting?

Money earned by the business.

How should income accounts be organised?

Separate accounts should be maintained for each main source of income, such as ticket sales or venue hire.

What is an expense in accounting?

Money spent on the day-to-day running of the business.

How should expense accounts be organised?

Separate accounts should be maintained for each type of expense, such as heating and lighting.

What is excluded from expenses?

Capital expenditure.

What types of purchases are generally treated as expenses?

Purchases of items that the business will use up relatively quickly.

Why are year-end adjustments made before preparing financial statements?

To ensure income and expenditure relate only to the relevant accounting period.

How can rent paid a year in advance be treated through a year-end adjustment?

The rent expense is adjusted so that only the amount relating to the relevant accounting period is charged in that period.

What are the five types of year-end adjustment?

Depreciation, accruals, prepayments, bad debts and doubtful debts.

What is the purpose of depreciation?

To account for the fact that an asset may no longer be worth its original cost and to reflect the asset's consumption in generating revenue.

How is accumulated depreciation reflected on the balance sheet?

The original cost of the asset remains unchanged, but accumulated depreciation is deducted from it to calculate net book value.

What are the two main methods of depreciation?

The straight-line method and the reducing balance method.

When is the straight-line method of depreciation particularly useful?

Where an asset generates a relatively consistent amount of income over time.

How does the straight-line method calculate depreciation?

It spreads the depreciation charge evenly over the asset's useful life, producing the same charge each year.

How is the annual straight-line depreciation charge treated in the accounts?

As an expense in the profit and loss account.

Where is accumulated straight-line depreciation recorded?

In an accumulated depreciation account, shown on the balance sheet as a deduction from the asset's cost.

When is the reducing balance method particularly useful?

Where an asset generates more revenue earlier in its life and loses more value earlier, such as a motor vehicle.

How does the reducing balance method calculate depreciation?

It applies a percentage to the asset's reducing balance (its net book value at the start of the accounting period).

Why is the depreciation charge higher in earlier years under the reducing balance method?

The percentage is applied to a higher net book value at the start of the asset's life.

How is the annual reducing balance depreciation charge treated in the accounts?

It is shown as an expense in the profit and loss account.

How is accumulated reducing balance depreciation reflected on the balance sheet?

It is shown as a deduction from the asset's original purchase cost.

What is the difference between the annual depreciation expense and accumulated depreciation?

The expense is only the charge for the current year; accumulated depreciation is the total of all depreciation charges to date.

How is the reducing balance for the next year's depreciation calculated?

The previous year's depreciation charge is deducted from the asset's cost to establish the reduced balance on which the next year's percentage is calculated.

How is net book value calculated?

Original cost minus accumulated depreciation.

What is an accrual?

An expense that has been incurred in the accounting period but has not yet been included in the trial balance, for example because the invoice has not arrived.

Why must an accrued expense be recognised in the relevant accounting period?

The business has received the benefit during that period, even though payment will not be made until later.

How is an accrual treated in the financial statements?

It is recognised as an expense in the profit and loss account and as a current liability on the balance sheet.

Why are accruals necessary when calculating profit?

They prevent profits being artificially overstated by excluding expenses incurred during the period.

What is a prepayment?

An expense paid in advance where some of the benefit relates to a future accounting period.

How should a prepayment be treated in the profit and loss account?

Only the expense relating to the current accounting period should be charged.

How should a prepayment be treated on the balance sheet?

The amount relating to the following accounting period is shown as a current asset.

What is a bad debt?

A debt that the business knows it will never receive, for example because the debtor is insolvent.

What happens to a bad debt in the receivables account?

The debt is removed from the receivables account.

How is a bad debt recorded as an expense?

It is added to the bad and doubtful debts expense account, also known as impairments.

What is a doubtful debt?

A debt that may or may not be paid.

What is a specific doubtful debt?

A debt owed by an identifiable debtor who is in financial difficulty or disputing liability.

What is a general doubtful debt?

An estimated proportion of receivables that may not be paid because of wider market conditions, for example an estimate that 5% of receivables will be irrecoverable.

How are specific and general doubtful debts accounted for?

They can be shown in a provision account.

What is the purpose of a doubtful debts provision?

It provides a cushion by ring-fencing part of the net asset value to reflect the risk that receivables will not be collected.

How is a doubtful debts provision treated on the balance sheet?

As a liability account, matched against the receivables asset account it affects.

Where are bad and doubtful debts recorded in the profit and loss account?

In a joint bad and doubtful debts expense account.

Is the entire doubtful debts provision treated as an expense each year?

No. Only the increase in the provision compared with the previous year is treated as an expense.

What is a trial balance?

A statement of the total debit and credit entries at the end of an accounting period, which should be equal.

What is the purpose of a trial balance?

It forms the basis for preparing the financial statements.

What does it mean to 'rule off' ledger entries?

To draw a line underneath entries to mark the end of an accounting period and calculate the closing balance.

Why are ledger accounts ruled off?

To establish closing balances and help compare the business's position from year to year.

Can a business prepare accounts during an accounting period?

Yes. It can prepare interim accounts.

What are financial statements prepared for?

A relevant accounting period, usually one year.

Where must company financial statements be filed?

At Companies House.

What does the profit and loss account record?

Income minus expenses over an accounting period, resulting in a profit or loss figure.

What is another name for the profit and loss account?

The income statement.

How is gross profit calculated?

Total income minus cost of sales.

How is cost of sales calculated?

Opening stock + purchases − closing stock.

Where are income entries from the trial balance recorded in the profit and loss account?

At the top of the profit and loss account.

What does the balance sheet record?

The business's assets, liabilities and capital at a particular date.

How does the balance sheet differ from the profit and loss account?

The profit and loss account covers a period; the balance sheet is a snapshot of the business's position at a particular date.

What date is shown at the top of a balance sheet?

The final day of the accounting period to which it relates.

What does the top half of the balance sheet show?

The net worth or net asset value (NAV) of the business.

How is net current assets calculated?

Current assets minus current liabilities.

How is net asset value calculated under the notes?

Fixed assets (at net book value) + net current assets − long-term liabilities.

What does the bottom half of the balance sheet show?

The capital invested to achieve the business's net worth.

What is the bottom half of a company's balance sheet called?

Equity.

What relationship should exist between the top and bottom halves of the balance sheet?

They should always be equal.

How are transactions between partners and the partnership recorded?

As drawings in the trial balance, as with a sole trader.

What might partnership drawings include?

Amounts partners pay themselves as a 'salary'.

How are partnership drawings usually determined?

They are usually based on an estimate of the partner's share of profits.

What may happen if a partner draws more than their entitlement?

They may have to repay the excess, depending on the partnership agreement.

What capital accounts does each partner have?

An individual capital account and an individual current account.

What does a partner's capital account represent?

Their original investment and any subsequent investments, which cannot normally be withdrawn.

What does a partner's current account represent?

Their share of ongoing profits and any drawings taken out; this capital can be withdrawn at the partner's discretion.

What must partnership accounts include on the bottom half of the balance sheet?

A profit appropriation statement showing how profits are divided between the partners.

When is the partnership profit appropriation statement prepared?

After the overall profit and loss account has been drawn up.

How are profits initially allocated between partners in the profit appropriation statement?

Amounts due to individual partners for notional interest on capital or notional salaries are allocated first.

What is notional interest on capital in a partnership?

An allocation of profit to a partner based on their long-term capital account.

Why is notional interest on capital not treated as an expense in the profit and loss account?

It is an appropriation of profit, rather than a business expense.

How is a partner's notional salary treated in the accounts?

As an appropriation of profit and as drawings, not as an expense in the profit and loss account.