What are accounts?
‘Accounts’ is actually a misleading word, because there is no such thing as one set of accounts for a business. The fact is that different types of accounts can be prepared from the same information for different purposes.
So for example the following are all ‘accounts’ that can be prepared from your ‘books’:
- Receipts and payments accounts: these are just a summary of receipts into and payments from your bank accounts;
- Income and expenditure accounts: these take the receipts and payments accounts one step further and include debtors and creditors;
- Full (accrual) accounts: these take the income and expenditure accounts one stage further and include accruals, prepayments, provisions, taxes and any other adjustments. Although they are rarely called accrual accounts in practice. If your business is relatively straightforward there is no reason why you cannot prepare these yourself.
So, how do you know which is which, when you are presented with a set of accounts? The answer is you don’t unless the person who prepared them has been kind enough to tell you!
“But there must be” one client once said to me” because my previous accountant did my VAT return from my accounts”.
“So which VAT basis are you on?” I asked “Because there are several, and it depends which basis you are on which set of accounts he used”
Even more confused, I explained that:
- If he is on the cash accounting basis then all he needed was the receipts and payments accounts;
- If he is on the accruals basis he only needs the income and expenditure accounts; and
- If he is on a flat rate scheme he doesn’t need either – just his sales figure.
- He actually didn’t need the full accounts to prepare his VAT return at all!
This is why finance and accounting seems to be complex when it really isn’t, and why your accountant may well confuse you with jargon when he doesn’t (or shouldn’t) mean to.
So, what are statutory accounts?
These are the annual full accounts of a company that are prepared for statutory purposes as required by the Companies Act. They comprise the full accrual accounts plus various notes and other information required by the Act. These accounts must be filed annually at Companies House (https://www.gov.uk/annual-accounts)
If the company has sales of more than £10.2m and net assets of more than £5.1m then it will require an audit of its statutory accounts by a Registered Auditor. Guilford Accounting is not a Registered Auditor but can advise on what is required if you fall into this category of company.
There are a couple more things you need to know about accounts (and, when we use that term, from now on, we will be referring to the full accounts, which include the accruals, prepayments, provisions and taxes).
Accountants use estimates and assumptions
Accounting is not an exact science; in fact it is more of an art than a science because the accounting records only get you so far. In fact, we like to say that they don’t show the whole picture. Like all good artists, however, we want to show the clearest picture we can, so we add bits here and there to do just that. These bits are estimates and assumptions about what the accounts would look like if the accounting records had all the information at the time we needed it. But this is rarely the case.
So what you see and read isn’t all fact, and where the accounting people have made estimates and assumptions they may have done so without asking, or telling, you. This doesn’t matter so much now that you know that there are estimates (and can ask what they are), but it may be that you could have a better estimate than the accounting people, particularly if it relates to your area of expertise. The message is: don’t assume the accountants get it right just because their reports look like they should be right.
Accounting rules and regulations
By now, you may be wondering what the accountants get up to all day adding all those bits and making estimates and assumptions, or you may be thinking I am being critical of accountants. Far from it. As I said accounting is more of an art than a science, and the accountants are trying their best to get it right by painting as clear a picture as possible.
To help them accounting does have some rules; these are known as concepts and pervasive principles, but like most things in accounting, accountants’ rules are not quite like other people’s rules. Let me explain. If you drive a car, you are used to the rule that on some roads there is a speed limit and a sign which tells you how fast you can drive: 30mph for example. In accounting, that rule would just tell you not to drive too fast without being specific about how fast that is!
There are several of these rules, but the overriding ‘rule’ is the one stating that ‘the objective of financial statements is to provide information about the financial position, performance and cash flows of an entity that is useful for economic decision making by a broad range of users.’
To achieve this accountants employ two principles: prudence and matching. It is useful to understand that accountants are required to make judgments and in doing so they need to be cautious and prudent. Prudence is a key accounting principle which makes sure that assets and income of a business are not overstated and liabilities and expenses are not understated.
The matching principle requires that income and any related costs and expenses be recognised together in the same accounting period. Thus, if there is a cause-and-effect relationship between income and the costs, they should be recorded at the same time and in the same accounting period. This is one of the most essential concepts in accounting, since it mandates that the entire effect of a transaction be recorded within the same accounting period.
Despite these principles being quite easy to state, there remains a great deal of judgement required – and debate amongst accountants – as to their precise application in given circumstances.
In recent years accounting rules have become more prescriptive, particularly in relation to a company’s statutory accounts. This has meant that statutory accounts have become more rule based and rely less on the judgement of professional accounts, even to the extent that the prudence and matching principles can sometimes be ignored.
The financial position of an entity is shown in its balance sheet (sometimes called the statement of financial position) and is the relationship of its assets, liabilities and equity at a specific date.
- An asset is something owned by the entity as a result of past events, and from which an economic benefit is expected to flow.
- A liability is an obligation owed by the entity, the settlement of which will give rise to an outflow of resources, usually cash.
- Equity is the residual interest in the assets after deducting its liabilities.
So Assets minus liabilities = Equity
or Assets = Equity + liabilities
Hence the name balance sheet; the amount an entity owns (its assets) must equal the amount it owes (its liabilities plus equity). The reason equity is an amount it owes is because it owes this amount to its owners.
The reason the statement is drawn up to a specific date is because it is changing all the time; in a vibrant, ongoing trading business assets and liabilities are being generated, and settled, respectively, and equity (the amount the entity owes to its owners) is, hopefully, increasing, as the business makes a profit.
Financial performance is the relationship of the income and expenses of an entity during a period of time; put more simply, the difference between income and expenses is either the profit or loss made during a period of time (such as a week, month quarter or year). The profit or loss either increases or decreases the equity in the business. The reason is (and let’s assume that income exceeds expenses and the entity earns a profit) that the profit must belong to someone. That person is the owner and we have already seen that equity is the amount owed to the owner of the business. So if, over a period, the business earns a profit then equity must go up.
We can now add to the balance sheet equation:
Previously Assets = Equity + liabilities
Later on Assets = (Equity + profit) + liabilities
Can also be expressed as Assets = (Equity + income – expenses) + liabilities
The final statement is the statement of cash flow; fortunately this one is the easiest to understand because it does what it says. It states the cash that has flowed into, and out of, a business during a period of time.
If this seems confusing, don’t worry. It is not essential for the understanding of your business numbers, but it is fairly simple, and logical, and about as complicated as accounting gets. Often when I explain this to people they look at me and say “Is that it? We thought accounting was complex: why do accountants surround something that straightforward in mystery?”