1 November 2018
Demystifying Company Accounts
Businesses have to keep records of all the transactions they carry out. For business owners and managers, they will need the information to work out how successful the business is. However, the drive for more detailed record-keeping derives from tax law so as to give the tax authorities some assurance that the tax on the trading profits is supportable. For companies, these requirements to keep records and to prepare accounts are enshrined in the company law. Companies would have to keep good records so that they can report, through their annual accounts, to shareholders and to others through public filing with the Companies House.
Record keeping
Accounting records are effectively lists of financial transactions, for example sales to customers or purchases from suppliers, each supported by documents (such as invoices) that legally validate the transactions. The details of the documents are then entered into the business’ accounting ledgers through a double entry system. Double entry bookkeeping is a fundamental method of recording transactions and adjustments to the financial records that aids the production of the accounts.
Trial Balance
The annual accounts that a company produces from its the accounting ledgers can be thought of as an aggregation exercise. All the transactions are added up, reflecting all the activities the company has undertaken in the year and the financial position at the end of the year. The aggregated information is presented in a high-level, summary format. However, a trial balance is normally required in order to get there. Essentially, a trial balance is a list of closing balances of all the ledgers. The trial balance is subject to review and final adjustments to deal with certain rules or correct errors before the final accounts are prepared.
Components of a Set of Accounts
A full set of accounts would usually consists of the following components:
Statement of Financial Position (Balance Sheet)
Statement of Income and Expense (Profit and Loss Account)
Statement of Cash-flows
Statement of Changes in Equity
Notes to the accounts
Statement of financial position
The Statement of Financial Position provides a “snapshot” of the business’ financial position, i.e. what it owns and owes, at a particular point in time. However, in accounting terms, not all things of value are recorded, nor are they recorded at current market value. Accordingly, some care must be exercised when reading this part of the accounts.
Generally, assets will include things like buildings, office furniture, IT equipment, cash, investments, money owed by your customers as well as your trading stock. However, in accordance with the financial reporting standards, internally generated goodwill cannot be included. This means that things like company’s brand, the know-how, the customer relationships and employee skills, cannot be capitalised.
Contractual obligations to pay for something, in cash or otherwise, are generally considered as liabilities. Liabilities will generally include things like loans, outstanding payments and things that has been consumed but yet to be billed for. Some will relate to asset purchases (for example, a mortgage over the property). In accounting terms, connected assets and liabilities are not net off and must be shown gross.
It is important to remember that the accounts are prepared as a snapshot and are backward-looking. Most of the time, subsequent events after the cut off date are ignored for accounting purposes.
Once all the assets and liabilities are accounted for, net equity can be calculated by deducting the total liabilities from the total assets. Equity is the proportion of the value of the business assets that is attributable to the company shareholders.
> Download Illustrative Statement of Financial Position
Statement of income and expense
Generally, the statement of financial position will change from year to year as a result of the company’s profit (or loss) over the relevant period. The statement of income and expense is prepared to provide insights of how the profit (or loss) was made over the accounting year at a summary level.
Income and expenses are normally accounted for on an accruals basis, i.e. when income is earned or expenses incurred, not when the cash is received or paid. For example, if your electricity is paid in arrears, you will still record the usage (based on estimates) even though you have not yet received any invoice.
> Download Illustrative Statement of Income and Expense
Statement of cash-flows
Whilst the accruals concept seems logical for matching income and expenditure to the period in which they arise, it does not mean cash flows are unimportant. In fact for most businesses, it is true to say that “turnover is vanity, profit is sanity and cash is reality” as without enough cash, companies could become insolvent. Most companies include a statement of cash flows that shows the cash received and paid out during the relevant period under various headings. It is reconciled to the movement in cash over the period shown in the statement of financial position. Statements of cash flows are required by accounting standards rather than law.
> Download Illustrative Statement of Cash Flows
Statement of changes in equity
The statement of income and expense shows a summary of transactions between the company and third parties. However, a company also deals with the equity owners, i.e. company shareholders, which will include transactions such as:
receiving capital as contributions in the form of ordinary share capital;
paying dividends;
buying back ordinary shares.
These are accounted for in the equity reserves of the company (the bottom part of the statement of financial position). They are usually summarised in a statement of changes in equity or as notes to the accounts if the transactions are straightforward.
For accounting purposes, preference shares are considered as liabilities, not equity. This is an example of substance over form. The dividend payable will be treated as interest in the statement of income and expense, not a transaction with equity owners. However, in legal terms, they are still shares and the payment is legally a dividend.
Notes to the accounts
Given that the above financial statements are prepared at high level aggregation, readers could find it difficult to make informed decisions based on them. The notes are therefore used to break down these highly aggregated numbers in a way that the users would find helpful. For example, the notes can contain disclosure information, including details of any transactions between related parties. These may indicate the amounts recorded for the transactions that were not a an arms’ length value because the contracting parties had reasons for setting a different price.
Complexities
Modern business has become increasingly complex and a more sophisticated approach to financial reporting is therefore required. Under the Companies Act 2006, directors must not sign off a set of accounts unless they show a true and fair view, meaning that the accounts must be free from bias and should not include false information.
Nonetheless, this true and fair requirement does not mean the numbers would be exact. One of the issues that may be difficult to understand is the number of estimates and unfinished transactions in a set of accounts. The accounting rules set a broad principle in that the extent to which something may be misstated depends on materiality, and that depends on what would change the view of a well-informed and diligent reader of the accounts. Often this is set in money terms by reference to one or more of the company’s matrix (for example 5% of the company’s after-tax profit). The objective is to strike a balance between cost of accounts preparation and relevance of the information. Materiality therefore allows a company to take a pragmatic but principled approach to the problem of uncertainty about uncompleted transactions or events.
Accounts Users
Accounts are produced primarily to provide information to shareholders as the suppliers of capital. They are also there to protect creditors (through public filing of company accounts) and are also used by potential investors and tax authority. This can lead to a tension between what to tell shareholders (profits are high) versus what to tell the tax authority (profits are low). Because the accounts preparation is a dynamic process involving choices that can lead to equally valid but different answers, directors have a legal duty to ensure that the accounts give true and fair view of the company’s affairs. Case law suggests that a court will consider that a true and fair view is given when accounts apply the generally accepted accounting practice (GAAP) as demonstrated by accounting standards and company law. The whole essence is to provide for recognition, measurement, presentation and disclosure for specific aspects of financial reporting in a way that reflects economic reality and hence provides a true and fair view.
The above information is intended merely to highlight issues and not to be comprehensive, nor to provide advice. Should you have any questions on issues reported here or on other areas, please contact one of your regular contacts, or alternatively please contact enquiries@mytaxadviser.co.uk.
