Small Business Accounting
Why is Small Business Accounting Important? - all small businesses require reliable management information systems to make decisions in order to make effective management decisions as well as demonstrate accountability to third parties for regulatory purposes. In particular, limited companies are required under the Companies Act 1985 need to maintain adequate records to explain the transactions of the company. In order to obtain management information, owners need simple and easy to manage bookkeeping and accounting processes. This does not necessarily mean that expensive and difficult to understand accounting software is required during the company formation stage. For most entrepreneurs, accounting and bookkeeping is dull, boring, tedious and time-consuming. Yet the information that can be gleaned from day-to-day receipts, invoices, bank statements and so on, is critical in summarising current and future business performance.
Cash is King - in the context of small businesses, cash is king. Calculating and predicting the cash inflows and outflows to and from a business is a necessity for business owners. Most cash is usually tied up in unpaid invoices, (where credit has been extended to attract or retain customers). This cash-flow problem is becoming an increasingly serious problem for UK business people, dealing with larger, more powerful suppliers. Cash is also typically tied up in the purchase of stock. By calculating the amount of cash available at any one point in time, and is taking action accordingly, some entrepreneurs may avoid running into cashflow problems that may lead to consolidating business debts or applying for expensive overdrafts from their bank.
Bookkeeping - to thrive and survive and prevent business failure, entrepreneurs need to be capable of translating financial records into an accounting profit or loss. These records include bank statements, invoices paid and outstanding, cash receipts, bills paid, credit notes, loan repayments and so on. Never throw away any paper-based records associated with the business. It is almost impossible to keep accurate records without records. To keep track of all of these business transactions that create movements in cash flow, businesses need some form of bookkeeping system. A well organised bookkeeping system will help the business owner to understand which aspects of the business are successful which are not. Accurate bookkeeping also helps to overall business planning, sales forecasting and budgeting. In addition, without accurate management information business financiers, such as bank managers or investors, will not be able to have a clear understanding of the current and future financial status of the company.
By helping investors understand the financial picture, they are more likely to approve business loans, overdrafts or offer to invest in the company in return for a equity stake. Having an accurate bookkeeping system also helps to reduce some of the costs of employing third-party accountants to produce accounts and undertake audits. Without accurate bookkeeping, a calculation of corporation tax, VAT, PAYE and company profits or losses cannot be produced. Lastly, tax inspectors will not accept the excuse of poor bookkeeping and may fine the company accordingly. Even worse a tax inspection may mean the company repaying unnecessary tax, if it cannot prove that business transactions such as 'allowable expenses' or 'income received', relates to sales efforts of the the enterprise. For small businesses, a simple single entry ledger (see example below), will assist the accountant to produce the end of year accounts. A single entry bookkeeping system means the business owner must write down the inflow of any monies taken (gross receipts), as well as any monies paid out (disbursements). A single entry bookkeeping system does not provide information regarding unpaid sales invoices (creditors) or unpaid purchases (debtors). These must be reconciled with the companies bank statements, in order to produce a profit and loss account and the balance sheet. However, a single entry ledger system should include a basic written record, to explain what all the items on the bank statement actually relate to.
Alternatively, a double entry bookkeeping system relies on the accounting principle that each transaction has two entries in the accounts, a debit and a credit. For instance, the purchase of stock would have the effect of increasing stock and reducing cash by equal amounts. A double entry bookkeeping system is generally managed using a professional accounting software package...
Accounting Software - there are many low-cost accounting software packages on the market, such as QuickBooks Intuit and Sage. These are relatively low-cost and poplar software packages, used by many small businesses across the UK. The main advantage of using an accounting software package, (as opposed to doing it by hand), is that human arithmetic error is eliminated. However, failure to enter the correct information in the first place will produce pretty looking accounts, but will be completely inaccurate - a computer is only as good as the data entered into it by the user. As well as human error being reduced, accounting packages are fantastic at ensuring double entry bookkeeping principles are reconciled, stock control is put in place, tax, payroll and VAT is accurately produced on time.
Accountancy Services - most accountants are likely to be able to provide bookkeeping services and will have accounting software in place to do these tasks. The most popular of these type of services is payroll processing, where PAYE (pay as you earn), is calculated and paid, and a formal payslip is produced for the employee's) of the company. Businesses must submit a PAYE and National Insurance return by 6th April every year, via the P14, P60 and P35 tax forms. These detail the amounts of PAYE and National Insurance deducted from your employees' wages by the company. In addition, chartered accountants will be able to give professional advice to organisations on a wide range of business, tax and finance issues. Accountants can assist you in registering your company for VAT and PAYE.
They can also provide valuable help with budgeting and forecasting, as well as setting up the day-to-day monitoring processes to collect information and interpret it. A long-term relationship with a trusted and qualified accountant can provide a valuable source of information when the inevitable accounting related questions arise. As your business grows, having a long-term relationship will benefit you as your accountant will have a first hand knowledge of the historical entries in the accounts. This is really useful when trying to remember what happened last year. Finding a good and local accountant can be achieved by asking friendly suppliers, your banking business manager or solicitor. Alternatively you could contact a 'fellow' of the Institute of Chartered Accountants (England & Wales) or the Institute of the Accountants, Scotland.
Company Accounts and Statutory Forms - directors of limited companies must ensure that proper accounting records and bookkeeping matters are implemented. They must also ensure that the accounts of the company are prepared according to statutory guidelines and that these accounts are presented to the company shareholders, no later than 10 months after the end of the last financial year. In addition, these accounts must be publicly filed at Companies House, where anyone can purchase and download a copy of them to review. In practice, the accountants of the company will be prepared by the company accountant. The Director must sign these and guarantee their accuracy. Even if a company is not actively trading, the annual accounts must be submitted to companies house. Any changes to the status of directors or shareholders must be noted and is submitted to companies house as and when they occur. A summary of these details must be completed every year on Company Return Form 363.
Understanding Company Accounts - typically the accountant will produce a statutory set off company accounts on behalf of the company, including a profit and loss account and a balance sheet. It is important that you are able to interpret these documents, so they can understand the true business performance. During the year, entrepreneurs may feel the business is going very well on the sales side and yet be ignorant of the problems that may impact end of year profit. For instance, unpaid debts from suppliers or unexpected expenses (that were not originally budgeted for), may have a big impact on company accounts (hence the attractiveness and future invest-ability of a company). Company accounts must be prepared in a structured way according to regulatory standard of the International Accounting Standard, which has been adopted by the European Union. This is also referred to as the International Financial Reporting Standards (IFRS) or "IAS". Since, the Finance Act 2004 and 2005, companies have had to adopt the (IAS) in the production of company accounts. It is similar to the use of UK GAAP (UK Generally Accepted Accounting Practice). Properly formatted company accounts will help the business owner understand how much cash is tied up in the business and how profitable it is. The main elements within the company accounts for companies with limited liability, that are required for annual submission, are as follows...
- Directors Report - the directors report outlines the timeframe of the submitted accounts. It states the principal activities and trading review of future developments. It summarises any dividends or appropriations paid as well as the shareholders of the company. It also outlines the directors responsibilities in terms of the preparation of financial statements and makes a declaration that provides that they are a 'true and fair view of the state of affairs of the company'. This page confirms whether or not the company has been audited. It must be signed by the Directors and will also provide details of the company secretary.
- Profit and Loss Account - in the context small-business accounting, cash or money coming in does not always equal accounting profit. The inflow of money is sometimes referred to as 'turnover', revenue or sales income. The outlay to manufacture and sell products and services is normally referred to as 'expenses'. Expenses include rent, staffing costs, phone bills and so on. In simple terms, profit is calculated by deducting expenses from turnover. To help understand and breakdown profitability, the conventional layout and format of the profit and loss account identifies a number of factors. The first is 'gross profit', which is a measurement of the difference between the cost of the raw materials to produce products and services sold, and the sales income received. The cost of the raw materials is calculated by deducting the closing stock balance from the opening stock balance, to identify the cumulative raw materials used to date. Lastly, the costs of labour and manufacturing overheads are also deducted, to arrive at gross profit. After all 'allowable expenses' are deducted from gross profit you end up with 'operating profit'. Operating profit is the key measure used to value most businesses. After deducting the cost of any financing (such as interest payments), from operating profit, you're left with 'profit before tax'.
- Balance Sheet - in simple terms, the balance sheet shows the assets and liabilities of the company. Assets are items such as cash, stock, capital items (such as buildings) and debtors i.e. outstanding invoices, To be classed as an 'asset' the item in question must be legally owned by the company and have some inherent value (such as a building or piece of machinery), which can easily be valued in monetary terms. The main exception to this rule are customer goodwill, intellectual property, brand awareness, customer loyalty etc. These are 'intangible assets' and have a real value, based on what a buyer is prepared to pay for them. There are two types of assets ('fixed assets' such as buildings and 'current assets'. On the other hand, 'liabilities' are items such as business loans from purchases, overdrafts, credit cards balances and so on.
Gross Profit Margin =
Gross Profit
x 100 The higher the %, the greater the business value is being added to sales turnover. Turnover
Net Profit Margin =
Net Profit
x 100 The higher the %, the greater the business value is being added to profitability. Turnover
Return on Capital Employed (ROCE) =
Operating Profit
x 100 The higher the %, the greater the business value is being added to financed assets. Fixed Assets + Working Capital
Gearing =
Debt (longer term borrowings)
x 100 It shows the % of money used by the business from debt, relative to shareholders funds. The credit crunch was caused by a global banking and corporate ethos of gearing (borrowing heavily) to create short term profits. Small firms with high gearing are more likely to fail due to inability to repay business debts. Debt + Shareholders Funds