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by Michael Kealy 03 Jan 2000 Diploma in Financial Management Relevant to Paper D1

One important dilemma faced by Certified Diploma students attempting Paper 1 is, as the title suggests, how to get started. Many students who are studying accountancy for the first time find the amount of detail included in financial accounting textbooks confusing, even if they are supposed to be of a basic nature. Once students cross this hurdle, the subject matter often becomes clearer, but how to get started can cause considerable concern.

One way of getting started with financial accounting is to build a basic understanding of the primary financial statements - what they are trying to achieve, the information contained in each statement, and so on. By doing this, students can familiarise themselves with the fundamental issues surrounding financial statements, before becoming involved with the more technical problems.

If students are studying in a group, it may be a good idea to set up a small fictitious business to which they all subscribe. The business can be involved in various simple transactions, from which the two basic financial statements - the balance sheet and the profit and loss account - can be built.

For example, in a class beginning in October 1999, we may decide to source a product designed to celebrate the arrival of the new century for sale in January 2000 and onwards. To begin, we need to contribute an initial sum of money (in theory, remember) of say £1,000 each to become a subscriber to the new business. We then open a business bank account under our new company name and lodge £40,000 (assuming 40 students) to it and receive our shares in the company.

The Balance Sheet
Before we discuss how we record this transaction, we need to become clear about the dual aspect of each accounting transaction - or, to use accounting terminology, debits and credits. For every transaction, two aspects are entered into the financial statements, namely, (a) where the resource came from and (b) what we did with it. So, in balance sheet terms, we record the bank balance of £40,000 as an asset of the business and its source, the owners/subscribers called up share capital, as business capital. This introduces the convention that the business has a separate existence and identity from its owners. Where the business is incorporated as a limited company, the legal position is that it is a separate legal entity. At this point, our balance sheet equation could be summed up as Assets (A) = Capital (C), both being the sum of £40,000.

As this sum may not be sufficient for our purposes, let us borrow, say £60,000, to ensure we are sufficiently funded. This causes our bank balance to increase to £100,000 and introduces a liability - a requirement on the business to repay the loan under the terms of the borrowing agreement, say repayable within twelve months. Our initial balance sheet equation can now be expanded to A - L = C, or laid out in the standard balance sheet format as:

To get down to business during November, we buy a delivery van for £12,500 and stock for £20,000, paying cash from our bank account for each purchase. At the month end, the balance sheet now appears as:

Some Accounting Terms
As can be seen, the capital remains the same but its uses have been changed by our use of cash. We have also introduced some new terms: Fixed Assets are those assets retained for long term use by the business and are not for re-sale in the normal course of trading. Current Assets are those assets held for the short term, either for re-sale or to be consumed by the business during the financial year. Creditors are amounts due for payment during the financial year and include short-term borrowings, sums due to suppliers (trade creditors), taxation liabilities and proposed dividends to shareholders.

During December, we sell a portion of the stock (cost price £15,000) for £27,500 on credit, that is the buyer receives the goods from us and commits to pay us £27,500 on an agreed future date. Money owed in this way for goods or services provided by the business is recorded as a debtor within the current assets category. Our balance sheet position will now be:

Balance Sheet as at 31 December 1999

The profit of £12,500 (the excess of the £27,500 sales price over the £15,000 cost of stock) is shown as a source of funds. It is essential to understand that this £12,500 profit is not cash - remember we still await payment for this sale! Upon receipt, our bank balance will rise by £27,500 and our debtors, now discharged, will disappear. As can be seen, this will leave us with a bank balance of £95,000. The remainder of the balance sheet is unchanged.

Before considering the profit and loss account, we will review one further set of transactions:

The Trading and Profit and Loss Account
To see the full financial implications of these transactions and to consider whether we have made a profit or loss during the trading period, we review the Trading and Profit and Loss Account (or p&l for short). This account matches the trading revenues with their related costs and other expenses for a specified period, usually one year. Our period is shorter, just as in business, where ongoing monthly or quarterly reviews are carried out.

Some Accounting Theory
The matching of revenues and costs is one of four fundamental accounting concepts, the accruals or matching concept, first enunciated in SSAP 2. These revenues and cost figures are taken into account, not as the business pays or receives sums of money, but as they are earned or incurred. However, following another fundamental accounting concept of SSAP 2, the prudence concept, we do not anticipate revenues and profits. However, we are required to include all anticipated expenses and losses, even though we may have to estimate the related figures.

Additionally, in accounting for expenditure, the distinction between capital and revenue expenditure has to be clear. Capital expenditure provides long term value to the business usually being the acquisition of a fixed asset. Examples are purchases of plant and machinery, buildings and motor vehicles. As we saw above, this expenditure will be recorded in the balance sheet. Revenue expenditure relates to the ongoing short-term trading and business costs. Examples are wages, insurance, rent and rates, bank interest, light and heat. This revenue expenditure is recorded in the profit and loss account.

Now, let us summarise our trading position in the profit and loss account for the trading period.

Profit and Loss account for the period ended 29 February 2000

The excess of our sales figures over the cost of those goods sold gives us our gross profit. Having also charged our expenses, whether paid or as yet unpaid, we get our operating profit, also referred to as PBIT (profit before interest and tax). These differing profit figures will all be critical later in the course when analysing the performance of a more formal business.

More Advanced Points
To finalise our accounts for the period, let us consider other anticipated outflows. These usually are taxation and dividends. We will estimate a tax liability of £3,000 and we will propose to pay dividends in the sum of £8,000 in total to ourselves, the shareholders. Under the accruals or matching convention referred to above, we must accrue, that is, include these figures in our accounts. As taxation and dividends relate to and are being charged to this period, we will include these amounts in the profit and loss account. However, since they are owed by the business to the tax authorities and to the shareholders and are unpaid at the end of the period, that is, at the balance sheet date, the dual aspect of accounting requires these accruals to be also recorded as liabilities under creditors due within one year in the balance sheet.

Our finalised profit and loss account and balance sheet will now be:

Conclusion
We can now see, I hope, that the profit and loss account shows the financial performance for the period. By contrast, the balance sheet is a listing of those assets and liabilities recognised by accounting rules at a particular date and time. It excludes, for example, important assets or qualities of a business such as talented staff or product excellence as these cannot be accurately measured in financial amounts. Thus the market value of our little venture will differ greatly, we optimistically expect, from the £46,000 net book value of its assets.

From this simple starting point, it is possible to introduce more complex transactions as your knowledge grows. By remembering to follow the simple rule that each transaction will have a debit entry and a credit entry in the books of the business, your books will always balance. Even when transactions become more complex, this rule continues to hold, therefore by having a good understanding of the basic concepts, financial accounting should hopefully cause you less problems. Good luck!

Suggested initial reading:
(1). Dyson J R "Accounting for Non-Accounting Students", Pitman Publishing
(2). Reid W & Myddleton D R "The meaning of company accounts", Gower

and later, for the really enthusiastic, try dipping into:

(3). Alexander D & Britton A "Financial Reporting" International Thomson Business Press

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