10. Accounting - Cost Allocation Answers - v1.0 2017
COST ALLOCATION ANSWERS
In this document we have provided suggested answers to the cost allocation exercise about the imaginary social enterprise ‘XYZ Limited’. However it is important to note that cost allocation is subjective and there is no single right answer.OFFICE COSTS:
We suggest that the office costs for XYZ Limited are allocated on a ‘headcount’ basis. This means that they are allocated in proportion to the number of staff working on each project. This is complicated by the fact that Project B has 3 part-time team members. We have decided to allocate costs based on the number full-time equivalent (FTE) employees working on each project. As such Project A has 4 full-time employees and Project B has an equivalent of 4.5 full-time employees (3 full-time and 3 half-time). As such XYZ Limited has a total of 8.5 FTE employees. This is a cost of £4,000 per FTE employee (£34,000 / 8.5) per year. On this basis the office cost allocation for Project A is £16,000 (£4,000 x 4 FTE employees). The office costs allocation for Project B is £18,000 (£4,000 x 4.5 FTE employees). However one could argue that office costs should be allocated based on the total number of employees working on a project regardless of whether or not they are full-time. An office with 10 employees will need a bigger office and more resources (e.g. desks, computers) than one with 7 employees – even if 3 of those people only work part-time. If office costs were allocated based only on the number of employees working on each project then the cost per employee would be £3,400 (£34,000 / 10). On this basis the office cost allocation for Project A would be £13,600. The office cost allocation for Project B would be £20,400.GOVERNANCE COSTS:
We suggest that the governance costs for XYZ Limited are allocated on an expenditure basis. This means they are allocated in proportion to the amount of funding each project receives. Project A will receive £115,000 per year. Project B will receive £170,000 per year. This is a total of £285,000 per year. Project A represents 40% of XYZ Limited’s expenditure (£115,000 / £285,000 x 100). On this basis its allocation of governance costs will be £2,000. Project B represents 60% of XYZ Limited’s expenditure (£170,000 / £285,000 x 100). On this basis its allocation of governance costs will be £3,000. This is a reasonable basis for allocating governance costs but with additional information about XYZ Limited we might be able to find a superior basis for allocating costs. For example if one project requires more trustee oversight due to higher levels of risk we might find a basis for allocating cost based on the amount of time trustees spend on the governance for each project.2. Accounting - Facilitator Guide - v1.0 2017
Accounting A workshop for social entrepreneurs A Guide for UnLtd Workshop Facilitators November 2016 Introduction This workshop is designed to provide new UnLtd Award Winners with an introduction to financial and management accounting. The goal of the workshop is to help Award Winners to:- Understand what accounting is and why it is important
- Understand the differences between financial and management accounting
- Understand and apply the accounting equation
- Recognise the adjust the three major financial statements for a limited company
- Understand and apply the matching principle
- Be able to distinguish fixed and current assets/liabilities
- Allocate costs to specific projects Rationale The design of this workshop is based on the following rationale;
- It is planned as a half-day workshop,
- All participants have started their social ventures,
- It is primarily aimed at first-time entrepreneurs with early-stage ventures,
- It aims to develop a basic understanding of financial and management accounting
- It is interactive – the workshop is structured as a conversation between participants and the facilitator, punctuated by ‘hands-on’ exercises
- It is formed of 9 key questions which are stand-alone elements so you may pick and mix activities, to the suit the context and to suit your own facilitation style,
- There is a 127-slide PowerPoint presentation to accompany this workshop. Facilitation This workshop is designed to be facilitated by Award Managers. Facilitators should have a good understanding of the content, and can also draw on relevant examples from their own experiences. However ideally the workshop will be delivered as a conversation. Much of the workshop material is structured around questions and there are also a number of practical exercises that will be followed by group discussion. Please note that for simplicity some accounting concepts and terms have been ‘simplified’. This is an introductory workshop and is not designed to be comprehensive. Financial statements are presented in a format that will make them easy to understand and may not reflect the appearance of ‘real’ financial statements in some instances.
- Understand what accounting is and why it is important
- Understand the difference between financial and management accounting
- Be able to recognise three major financial statements
- Apply the matching principle to adjust simple examples of financial statements
- Understand how to distinguish fixed and current assets/liabilities
- Be able to devise a reasonable means of allocating costs to specific projects Outcomes By the end of the workshop participants will have had the opportunity to:
- Discuss the role of financial and management accounting
- Apply the accounting equation
- Create and adjust some simple financial statements
- Apply the matching principle to financial statements
- Devise a means of allocating costs for an example social enterprise Who would benefit from this workshop?
- Do-it Award Winners who are in start-up phase and need an introduction to accounting concepts
- Grow-it Award Winners who want to develop a better understanding of their financial statements Who is less likely benefit from this workshop?
- Social entrepreneurs who have previous experience of creating and interpreting financial statements
- Social entrepreneurs who have already created management accounting systems for their enterprises
- There are two main objectives of accounting
- The first objective is to provide useful financial information about a business
- For example accounting can tell us whether a business is making or losing money
- Accounting can also help us identify opportunities to improve the performance of a business
- The second objective is to provide this information to a range of different users
- Different groups will require access to different information
- For example the government/HMRC requires businesses to create financial statements in order to calculate the amount of tax that a business owes
- This information is important but only provides a high level overview and is not sufficient for some users
- For example the managers of a business need much more detailed information in order to make decisions about the future of the business
- There are two distinct elements of accounting
- The first is recording financial transactions as they occur
- This activity is sometimes referred to as ‘bookkeeping’
- The second element of accounting is summarising transactions in order to provide useful information to various different groups
- The process of summarising transactions is what we will focus on during this workshop Note: You may want to mention that there is a separate workshop that focuses on bookkeeping, particularly if participants will have the opportunity to attend that workshop in the near future.
- There are two types of accounting, ‘financial accounting’ and ‘management accounting’
- Is anyone aware the differences between the two types of accounting? It is possible that none of the participants will be able to make a distinction between the two types of accounting. If that is the case we suggest proceeding fairly quickly to the next slide. In any case you should allow only a short period for discussion of the question – there is plenty of other material to get through! .
- The first difference between financial and management accounting is the type of information that is prepared and the different users of that information
- Financial accounting involves the preparation of ‘summary statements’ that provide a general overview of the financial activities of a business
- These are primarily for external users such as HMRC, the Charity Commission (for charities), the CIC Regulator (for CICs) and other third-parties
- By contrast management accounting involves the preparation of detailed reports that are primarily for internal users such as the managers of a business
- The second difference between financial and management accounting is the frequency with which documents are produced
- Through financial accounting, summary statements are usually produced only on an annual basis at the end of each trading year or ‘accounting period’
- By contrast management accounting documents are produced much more frequently and typically on a monthly basis
- The frequency of production for producing management accounting documents will be determined by the needs of users – in some industries (such as high-tech manufacturing) it is not uncommon for management accounting reports to be produced on a daily basis Note: Certain businesses, such as publicly traded companies, have to produce financial statements on a quarterly basis. However the vast majority of businesses will produce statements on an annual basis.
- The third difference between financial and management accounting is that only one of them is a voluntary activity
- Financial accounting is generally required by law and so it is something that all businesses must undertake
- The extent of financial accounting activity will depend on the nature and size of a business
- In general financial accounting requirements increase as a business grows larger
- By contrast management accounting is entirely voluntary and there is no obligation to undertake management accounting at all
- However the great majority of businesses will benefit from undertaking some kind of management accounting activity on a regular basis
- The fourth difference between financial and management accounting is the time frames that they are concerned with
- Financial accounting reflects past performance and the current financial position of a business
- For the most part the summary financial statements produced for external users, such as HMRC, do not address the future of the business
- By contrast management accounting usually includes future forecasts (though of course as management accounting is voluntary it is up to the managers of an individual business whether or not they want to create forecasts) Note: In a narrow sense financial statements do address the future, in that they refer to long-term assets/liabilities owned by a business. However they only state the extent of these assets/liabilities based on the current position of a business. They do not reflect on how these assets or liabilities might change.
- The fifth and final difference between financial and management accounting is the basis for preparing accounts
- Financial accounting activity must be undertaken in accordance with the ‘International Accounting Standards’ (IAS)
- By contrast management accounting can be undertaken based solely on internal requirements
- Although there are common formats and practices, a business is free to prepare management accounts on any basis its managers choose
- Briefly recap each of the four key features of financial accounting
- Ask participants to name some of the ‘external users’ of financial statements, answer include:
- HMRC
- Other regulators (Companies House, Charity Commission, CIC Regulator etc.)
- Investors (though they would probably also want to see management accounts)
- Suppliers (to check if you are a credit risk)
- Other third-parties (e.g. trade unions)
- You may want to explain that in the UK the financial accounts of all limited companies are a matter of public record
- Anyone can download the financial accounts of any company from Companies House, free of charge
- However for small businesses the publicly available information is very limited in scope Note: If time is short then you may wish to omit the discussion of external users.
- The outputs of financial accounting are referred to as ‘financial statements’
- These are documents that summarise the financial performance of a business
- There are three main financial statements that we will consider during this workshop
- The first is called the ‘Income Statement’:
- This is a also known as a ‘Statement of Profit or Loss’ or ‘Profit and Loss Account’
- It reflects the performance of a business (i.e. profit or loss) over a period of time
- The second statement is called a ‘Balance Sheet’:
- This is also known as a ‘Statement of Financial Position’
- It reflects the position (i.e. assets and liabilities) of a business at a given point in time
- It is generally considered to be the most ‘scary’ financial statement
- However it relatively simple when you understand how it relates to the other statements
- The third document is called the ‘Cash Flow Statement’:
- It is also known as the ‘Statement of Cash Flow’ (which is essentially the same name..!)
- It summarises the movement of cash in and out of a business over a period of time
- We will be looking at the financial statements in greater detail later on in the workshop
- There are several different ways of performing financial accounting
- The most basic of these is known as ‘cash accounting’
- Under this system a business records income when it receives payment for goods and services
- Expenditure is calculated when a business makes payment for goods and services
- As such to the profit (or loss) a basis makes is total income minus total expenditure
- Under this system there is only one financial statement – which is a combination of a cash flow statement and income statement
- This is generally referred to as a ‘cash book’
- This is a simple example of a cash book
- For each transaction we record the date, a short description and the amount of income or expenditure
- It is also good practice to give each transaction a reference based on the type of transaction that has taken place
- For example the letter ‘P’ refers to purchases and so transaction ‘P1’ is the first purchase in the accounts
- We can perform some basic verification of the accounts by checking whether the difference in the opening and closing balance is equal to the profit or loss
- Here we see that the business made a £25 profit and that the closing balance of £525 is £25 higher than the opening balance of £500
- This can give us some (though not complete) confidence that the accounts have been prepared correctly
- Given the simplicity of cash accounting, you may be wondering why all businesses don’t choose to utilise it for their financial accounting activity
- However the simplicity of cash accounting also means that it has some significant limitations
- For example let’s imagine that we were going to open a new hotel, there are three important financial events that happen in our first year of operation
- First we spend £2 million in order to build our hotel
- Then we generate £1 million in sales of hotel rooms, restaurant meals and so on to our customers
- However in the process of making these sales we incur £0.5 million of costs; paying our staff, buying ingredients for restaurant meals and so on
- How would these three events be recognised on a cash accounting basis?
- We can plot the finances of our imaginary hotel into a cash book
- We can see that the business generated income of £1 million but had combined expenditure of £2.5 million
- Remember that under cash accounting we calculate profit or loss as income minus expenditure
- On this basis our imaginary hotel lost £1.5 million in its first year of operation
- However does that really seem accurate? Did the hotel really lose £1.5 million?
- Although in cash terms, we as the owners of the hotel have £1.5 million less than at the start of the year, we have not really lost that money (click to Slide 19)
- This is because the money we spent to build the hotel was not merely spent, it was invested
- Even if were not being used as a hotel, it is likely that the new building alone would in fact be worth more than £1.5 million
- However if we only think in terms of cash it is impossible to recognise the intrinsic value of the hotel
- If we have a large and complex business we need a more sophisticated means of accounting Note: This is a very important concept but may be initially be confusing to some participants. Spend as much time as is needed to ensure that all participants understand why cash accounting is too simple to provide an effective means of financial accounting in most business.
- There is no doubt that cash is very important to the survival of any business
- This is why the cash flow statement is one of the three main financial statements
- However a business is significantly more than its cash flows
- For example as we have just seen a business can own valuable assets, such as a hotel
- For a very simple business cash accounting can be effective
- However for large and complex businesses cash accounting is simply inadequate
- As such we use ‘accruals accounting’ to create a more sophisticated picture a business’s finances
- This is what we will focus on in the next section of the workshop Note: You may wish to mention that currently only sole traders or partnerships with a turnover lower than the VAT threshold (currently £82,000) are allowed to use cash accounting. Limited companies (and most other legal structures) must use accruals accounting.
- Now we will move on to examine how financial accounting is performed in greater detail
- First we will begin by looking at something called the ‘accounting equation’
- This is a simple formula that underpins all of financial accounting
- When you understanding the accounting equation it will be much easier to understand the purpose of different financial statements and how they are constructed
- The accounting equation describes the balance that must exist in the finances of any business
- The equation defines all of the financial affairs of a business in terms of three categories:
- Assets
- Liabilities
- Capital
- Assets are the things that a business owns, for example buildings, equipment, stock or cash
- Liabilities are things that a business owes to others, for example money owed to suppliers or an outstanding bank loan
- Capital is what the shareholders of a business own / what they are owed, typically this is the total of the money invested into a business and the profits or losses of the business Note: Social enterprises are unusual and in many cases they will not have shareholders. Where this is the case, capital reflects what is owed to an organisation’s social mission. In a more conventional business, the shareholders are entitled (via dividends) to the profits of a business. In a ‘mission-locked’ social enterprise these profits are owed to the specific cause that is defined in an organisation’s governing documents.
- The accounting equation states that the value of the assets of a business, less the value of its liabilities must be equal to the value of its capital
- At first this can seem confusing but do not worry we are going to work through an example that will make things clearer
- However first I want to give some examples of assets, liabilities and capital in order to provide more context
- Assets are things such as buildings, equipment, cash, stock and unpaid customer bills
- Liabilities are things like outstanding bank loans, unpaid bills from suppliers and taxes owed to the government
- Capital is anything that changes the total of money invested into the business or the amount of profit or loss the business generates
- This includes the revenue a business generates, because more revenue will (all other things being equal) increase the amount of profit a business makes
- But expenditure that is not on assets (for example paying rent) is also included in the capital category because (all other things being equal) more expenses will reduce profit At this stage do not worry too much if participants seem a little confused by the accounting equation, it will be much easier to understand once it is explained using an example. At this stage your main concern should be that participants understand the distinction between the three categories. Note: Some participants may ask why an unpaid customer bill is an asset. This is because the business would expect that bill to turn into cash in the future. Remember that under accruals accounting we record income when a customer is sent an invoice (or other bill). As such an unpaid bill is income that has not yet been received and is therefore an asset.
- Now you are going to complete an exercise that will test your understanding of the asset, liability and capital categories
- We have provided you with a list of various items that might appear in the accounts of a business
- We need you classify each item as an asset, liability or capital
- You should work in pairs to review the list and discuss why you think each item is an asset, liability of capital Give participants 5-10 minutes to complete the exercise and then briefly review the answers from the front of the room. If there are some items that participants found confusing you may wish to briefly elaborate on why they fit into a particular category. Note: The answers that participants are most likely to find tricky are those that fall into the ‘capital’ category. The key point here is that expenditure on things other than assets (e.g. a building) will reduce the amount of profit (or increase the loss) that a business makes. As such paying wages sits in the capital category – the more wages a business pays the less profit it makes and so the less capital it has. You could also present it this way: when a business spends money on a building it is* invested* by contrast when a business spends money on wages it is *used-up *and cannot be used again. This is explained in the answer sheet for the exercise, which you may also want to give to participants once they have completed the exercise.
- To demonstrate how the accounting equation works we are going to return to the example of building and running a hotel
- In this example there are four distinct financial ‘events’ over a one year period: raising investment, building the hotel, generating income from the hotel and paying its running costs
- We will see that the accounting equation balances after each of these events
- However first we will review the numbers associated with each of those events:
- The founders of the hotel raise £2 million in investment; they issue £1 million of shares and also secure a £1 million loan
- Then the founders spend all of this £2 million in order to build the hotel
- Once the hotel is open it generates £1 million of revenue during the rest of the year
- However the hotel also has running costs of £0.5 million over the same period
- Now we are going to feed the numbers from each of these events into the accounting equation to show you how it works
- We will start by looking at the accounting equation for the hotel before any financial activity has occurred
- As we know the accounting equation states that Assets – Liabilities = Capital
- Clearly before the business starts its assets, liabilities and capital are all zero
- As a result the accounting equation balances because zero minus zero is zero!
- However now we are going to show you how the accounting continues to balance after each financial event
- The first financial event for our hotel is generating investment
- This has two parts; issuing shares and securing a loan
- As we said earlier the founders of the business manage to raise £1 million pounds of equity investment and so issue shares to that value
- Money invested into a business is capital and so that column increases by £1 million
- This investment is received as cash, which is an asset, so we also increase the asset column by £1 million
- This introduces an important principle of accounting which is called the ‘double-entry principle’
- In order for the accounting equation to balance, an entry in any of the three columns must be offset by a second entry of the same value (or multiple entries adding up to the same value) Note: At this point it is likely that some participants will be wearing expressions that suggest a blend of confusion and sheer terror! We strongly recommend that you ask people to hold their questions and continue to work through the example. Most people need to see several iterations of the accounting equation before they ‘get it’ and at this point they are usually better off seeing more examples than hearing further theoretical explanation.
- As we know the business also secured a £1 million loan
- A loan is a liability so we add £1 million to the liability column
- We know that this must be matched by a second entry and because this loan is received as cash we also add £1 million to the asset column
- Now that we have processed all of the transactions relating to the investment event we can see how the accounting equation balances
- We will check the accounting equation by adding up the entries in each of the three columns
- In the asset column we have two entries for £1 million, reflecting the fact that payment for shares and the bank loan were received in cash
- As such the business has total assets of £2 million
- In the liability column we have one entry for the £1 million bank loan, this is a liability because it I something that the business owes to a third party
- In the capital column we have one entry for the £1 million issue of shares, this is capital because it is money invested into the business that belongs to the shareholders
- The accounting equation states that Assets – Liabilities = Capital
- Here our assets of £2 million less the £1 million of liabilities are equal to the £1 million of capital, as such the accounting equation balances
- Next we are going to look at how the accounting equation changes to reflect the activity of building the new hotel
- As we know it cost £2 million to build the hotel and so we reduce the asset column by £2 million to reflect the cash that is spent
- However because of the double-entry principle we know that this entry must be balanced by a second entry of equal size
- In fact the hotel is an asset in its own right so we make a second entry in the asset column, increasing it by £2 million to reflect the value of the building
- It is perfectly acceptable and in fact quite common to match an entry in one category with a second entry in the same category
- After our entries for the building of the hotel we can see that the business still has assets of £2 million and that when we deduct the liabilities of £1 million, we are left with £1 million of capital Note: Some participants might ask why a hotel building that cost £2 million to construct would not be given a greater valuation as an asset. In practice a building that cost £2 million to construct is very likely to have a market value significantly higher than £2 million. However the re-valuation of assets is a complex subject and is certainly outside the scope of this workshop. As such if a participant asks this question we recommend that you answer that £2 million is a conservative valuation and that in practice it may be possible to assign a higher value but this will not be covered during the workshop.
- Next we are going to look at how the accounting equation changes to reflect the revenue that is generated from running the hotel
- As we know the hotel generates £1 million of sales over a one year period
- Therefore we make an entry to increase the capital column by £1 million
- Remember that revenue is a form of capital because it increases what is owed to the shareholders of a business (who are entitled to the profits of a business)
- The entry in the capital column must be offset by a second entry, because the sales revenue is received as cash we make an entry in the asset column for £1 million
- Now the business has £3 million assets, £1 million liabilities and £2 million capital
- Because 3 -1 = 2, the accounting equation continues to balance Note: By this point participants should be feeling more confident with the accounting equation. If you want to challenge them you could ask them to predict the two entries that are required to reflect the income generated by the hotel before you show them this slide.
- Finally we are going to look at how the accounting equation changes to reflect the expenses that are incurred from running the hotel
- We know that the hotel had running costs of £0.5m
- As such we make an entry to reduce the capital column by £0.5m
- These expenses are a form of capital because they reduce the profits of the business and so reduce what is owed to the shareholders
- This entry is matched with a £0.5m reduction in assets, to reflect the cash that is used to pay for these expenses
- The business now has assets of £2.5 million, liabilities of £1 million and capital of £1.5 million
- As such the accounting equation for the business continues to balance
- The most important point to grasp from this example is that every entry in the accounting equation must be offset by another entry of equal size (or several entries adding up to the same size) Note: At this point you should answer any questions that participants have and ensure that all of them understand the mechanics of the accounting equation. If they do not understand the accounting equation they will find it very difficult to follow the rest of the workshop.
- Now that you understand the accounting equation we are going to move on and look at how financial statements are constructed
- As you will see, once you understand the mechanics of the accounting equation it is actually straightforward to extract the data and create financial statements
- We are going to use the accounting equation for the hotel business to construct a profit and loss statement (income statement), balance sheet (statement of financial position) and cash flow statement (statement of cash flows)
- Here we can see the accounting equation for the hotel business at different stages of its first year of operation
- The information that you see here is sufficient to construct all three of the main financial statements for the business
- First we are going to construct a Profit & Loss Account, which is also known as an income statement
- As the name suggests, this financial statement records the income and expenditure of a business
- The information that needs to be recorded in the profit and loss account in highlighted in orange
- As you can see all that needs to be included is the £1 million sales and the £0.5 million running costs
- Remember that the money spent on constructing the hotel is investment not expenditure Note: For this and all other slides in this key question, you should encourage participants to ‘follow along’ by referring to the relevant page of the ‘Accounting Equation’ hand-out. This will allow participants to see all of the relevant information at the same time and should make it easier for them to understand how financial statements are constructed.
- Now we’re going to take the income and expenditure data about the hotel business and use it to construct a profit and loss account
- First we want to show you how a profit and loss account is typically set out
- As you can see this profit and loss account is ‘for the year ended 31st December 20XX’
- A profit and loss account is usually prepared to cover a one year period
- This is known as a ‘trading year’ or ‘financial period’ and does not have to end on December 31st
- However a financial period will always end on the last day of a month – usually the last day of the month in which you incorporate a limited company
- For example if you incorporate a company on May 7th, its first trading year will be from May 7th of that year to May 31st of the following year
- All subsequent trading years will be from June 1st to May 31st of the subsequent year
- Our imaginary hotel business has a trading year that runs for January 1st to December 31st
- You can also see that we have a column headed 20XX, this indicates the year that figures relate to
- This is important because when a business has run for two or more years, financial statements will compare the figures for the current financial period with the one before it
- Finally the ‘£000’ is a way of saying that the figures will be written in thousands of pounds, rather than just pounds
- This means we can write ‘1,000’ rather than ‘1,000,000’
- A profit and loss statement starts by stating how much the business generated in sales and then deducts various costs to determine whether a business made a profit or loss
- The hotel business had sales of £1m so the top line of our profit and loss account simply states that – remember that ‘1,000’ means £1m because of the ‘£000’ heading
- Next we deduct expenses, the hotel had running costs of £0.5m and this is the second line of the profit and loss account
- You will notice that the £0.5m is in brackets, this is how a negative value is denoted in financial statements
- Now that we stated the income and expenses of the business we can calculate whether it made a profit or a loss
- To do this we deduct the expenses from income and if we deduct £0.5m from £1m we can see that the business made an operating profit of £0.5m
- Operating profit is the amount of money that a business made or lost before accounting for interest payments and taxation
- In this workshop we are going to ignore interest payments – we will assume that the £1 million loan the business secured is interest free
- As such in this case operating profit will be the same as profit before taxation
- Now we have calculated the profit or loss that a business has made before taxation
- Normally if a business had made a profit before taxation it would pay corporation tax on this amount
- For simplicity in this workshop we are going to ignore corporation tax but it is important that all social enterprises, except charities, are required to pay corporation tax
- Normally you will have nine months after the end of a trading year to calculate and pay corporation tax Note: It is possible that participants will have lots of follow-up questions about corporation tax. We strongly encourage you to politely deflect these questions and advise participants to see the link in the further learning guide that accompanies this workshop. We suggest you explain that there is a lot of accounting material to cover during the workshop and that unfortunately there is not enough time to talk about taxation in detail.
- Now we have completed the profit and loss account we are going to return to the accounting equation and look at the data we need to create a balance sheet
- The balance sheet is probably the financial statement that people are most ‘afraid of’ but it is actually quite straightforward
- It is called a balance sheet because it reflects the balance that must exist between the two sides of the accounting equation
- As such we construct the balance sheet by taking the total assets, liabilities and capital from the accounting equation at the end of a financial period
- Then we summarise what makes up the final total in each of the three columns
- Now we are going to take the data from the accounting equation and build a balance sheet for the hotel business
- The headings for a balance sheet are very similar to those used on a profit and loss account
- However there is a key difference: a profit and loss account reflects income and expenditure over an entire accounting period
- By contrast a balance sheet shows the assets, liabilities and capital of a business on the last day of a accounting period
- Where the profit and loss account is a document that covers a one year period, the balance sheet is a ‘snapshot’ of a business at a moment in time
- The hotel business has an accounting period that runs from January 1st to December 31st
- As such the balance sheet is a summary of the asset, liabilities and capital of the business at that moment in time
- As with the profit and loss account, if a business had been trading for more than one year, we would compare this year’s balance sheet with the one from the previous year
- The first thing that we record on the balance sheets are the assets of the business
- If you look at the accounting equation, you can see that at the end of the year the hotel business has assets worth £2.5m
- This is made up of two things: first the hotel itself, which is worth £2m
- Second the business has £0.5m of cash
- All we are doing with the balance sheet is recording the totals from the accounting equation and then providing a simple breakdown of that total
- The next thing we record on the balance sheet is the liabilities of the hotel business
- If you look at the accounting equation you can see that the hotel has liabilities of £1m
- This is just the £1m bank loan that the business secured
- As such on the balance sheet we just record the total liabilities and state that the liability arises from the bank loan
- Again all we are doing with a balance sheet is recording the total liabilities of a business and providing a simple breakdown of that total
- Now that we have calculated assets and liabilities we can calculate ‘net assets’
- Net assets is calculated by deducting liabilities from assets
- In other words ‘net assets’ is just the left hand side of the accounting equation
- Remember that in financial statements, a number in brackets represents a negative value
- As such we deduct £1m from £2.5m and we are left with £1.5m net assets
- We have now completed the ‘top half’ of the balance sheet
- Now we are going to create the bottom half of the balance sheet, which refers to the right-hand side of the accounting equation
- This is the capital that the hotel business has at the end of the year
- From the accounting equation we know that the hotel has £1.5m capital
- This is made up of the £1m of shares issued at the start of the year and the £0.5 million profit that was made from running the hotel
- So you can see that the value from the profit and loss account is transferred into the balance sheet
- This is why we need to prepare the profit and loss account before we create the balance sheet
- The total capital of a business is referred to as the ‘shareholders funds’
- You can see that net assets are equal to the shareholders funds
- In other words the assets of the business, less its liabilities are equal to its capital
- The finances of the business are in balance – hence ‘balance sheet’
- Now we have completed the balance sheet we are going to return to the accounting equation and look at the data we need to create a cash flow statement
- The cash flow statement is a summary of the amounts of cash that were paid and received by the business over a one year period
- We construct the cash flow statement by aggregating all of the transactions and then reconciling them with the other financial statements
- Now we are going to take the data from the accounting equation and build a cash flow statement for the hotel business
- The headings for a cash flow statement are very similar to those used on a profit & loss account and balance sheet
- Like the profit and loss account, the cash flow statement summarises transactions over a one year period
- As for a profit & loss account or balance sheet, if a business had been trading for more than one year, the cash flow figures for the most recent year would be presented alongside the figures for the year before
- The cash flow statement provides a net cash flow figure for three different areas:
- Operating activities (cash flow from running the business)
- Investing activities (cash flow from investing in/disposing of assets)
- Financing activities (cash flow from payments to/received from investors)
- We will now look at how the data for each of these three activities is presented Note: There are various ways of preparing a cash flow statement. Notably there are the ‘direct’ and ‘indirect’ methods of preparation but the distinction between the two is far beyond the scope of this workshop. If a participant has a question about the preparation method for their cash flow statement, please advise them to speak to an accountant.
- First we are going to examine how cash flows from what are called ‘Operating Activities’ are presented on the cash flow statement
- The term operating activities refers to the income and expenses from the day-to-day running of a business
- In our example this is the cash flows that arise from running the hotel
- We start by taking the operating profit figure from the profit and loss account
- As such our initial profit/loss figure on the cash flow statement is £0.5m
- We only need to amend this if net cash flow from operations is not equal to operating profit
- As it happens in this case the operating profit is equal to net cash flow from operations (£1 cash received as income - £0.5m cash paid out for expenses = £0.5m net cash flow)
- In later examples we will show how this number needs to be adjusted where net cash flow from operations and operating profit have different values
- Next we will examine how cash flows from ‘Investing Activities’ are presented on the cash flow statement
- The term investing activities refers to the income and expenditure from the purchase and disposal of various assets
- In our example this is cash spent in order to build the hotel, which is referred to as ‘capital investment’
- The hotel cost £2m to build and so we add this figure to the cash flow statement
- As this was the only investing activity in the year, the total cash flow from investing is negative £2m
- Now we will examine how cash flows from ‘Financing Activities’ are presented on the cash flow statement
- The term financing activities refers to the money paid to and received from various investors
- In our example this is the money received from shareholders and from the bank loan
- The business issued £1m of shares and received a £1m bank loan so the total cash flow from investing is £2m
- As this was the only investing activity in the year, the total cash flow from investing is negative £2m
- Finally we need to calculate what is called ‘Net Cash Flow’ which is the total cash flow from each of the three activities
- We calculate net cash flow by adding together the total cash flows from each activity, which gives us a total of £0.5m (CFO £0.5 – CFI £2m + CFA £2m)
- Now we have a complete cash flow statement for the hotel business and as you can see it is not difficult to create
- All we have to do is categorise cash flows into different activities and aggregate the money paid out and received by the business
- Now that we have looked in more detail at three main financial statements we will briefly review which of these your business will need to produce
- All limited companies must produce a balance sheet for submission to Companies House
- Small companies do not need to submit a profit and loss account to Companies House though will need to prepare one in order to complete a Corporation Tax return
- Only large companies need to produce a cash flow statement
- However some grant funders may ask you to submit a cash flow statement or provide some other proof of your cash flow
- In short if your business is a limited company you will need to produce a balance sheet and a cash flow statement to fulfil various legal obligations
- By contrast until your business becomes very large it will not have a legal obligation to produce a cash flow statement but it is possible that a third-party will ask you to produce one
- Now that we have introduced the financial statements we are going to look at something called the matching principle
- As we discussed earlier on, cash accounting is limited because it cannot adequately describe the financial affairs of a business with significant assets and liabilities
- The matching principle is a more sophisticated way of creating financial accounts for a business
- As we discussed earlier on, under cash accounting we recognise income and expenses when cash is paid or received
- By contrast under accruals accounting we record transactions in the period that they relate to
- This alternative means of recording transactions is referred to as the ‘matching principle’
- Under the matching principle we record income when it is earned
- In general this means that we will record income on the date we send the customer a bill (typically an invoice) for the products and services provided to them
- We do not wait to record income until a customer pays their bill
- In some businesses a customer may receive a bill and pay on the same date (e.g. shops, restaurants and other ‘retail’ businesses)
- However for many businesses (particularly those that sell to other businesses) a bill will not be paid for some time after a customer receives it
- To help you understand this we will look at an example in our imaginary hotel business
- We’re going to look at an example involving our hotel business but in this example we will imagine that they only have one customer in the entire first year
- This is a Corporate Customer so they will not pay each time a guest checks-out of the hotel
- Instead at the end of each month the hotel will send the corporate customer an invoice for the total cost of all the services they have used in the same month
- When the customer receives the invoice they have 30 days to pay the bill
- On December 30th we send our only customer an invoice for £1,000 for rooms they occupied earlier on in December
- In this example this is the only invoice the business sends in the first accounting period – there are no other customers or income
- The hotel’s first accounting period ends on December 31st and at this time the corporate customer has not paid the invoice
- The customer only pays the invoice on January 10th once the hotel is in its second accounting period
- How much income did the business generate in the trading year?
- The amount of income that the hotel generates depends on the type of accounting that we decide to use in order to record transactions
- Under cash accounting the hotel business has not made any income because it was not paid by the customer until the start of its second accounting period
- However on an accruals basis using the matching principle, the hotel generated £1,000 of income
- This is because even though the hotel did not receive payment from customers it had still earned the income during its first year by providing the customer with a service and sending them the bill
- As such we ‘match’ the income to the hotel’s first year of trading
- Now we are going to expand this example to look at how treating income using the matching principle affects the financial statements for a business
- We will return to the numbers from our original example and say that in its first accounting period the hotel business generated £1m of income
- In the original example all of this £1m had been received as cash by the end of the accounting period
- However this time we will work on the basis that the hotel has some corporate customers who do not pay each time they use a hotel room
- Instead these corporate customers receive an invoice once per month for the total value of all the services they have used in that month
- When the corporate customers receive these invoices they have 30 days to pay them
- At the end of December we issue invoices to corporate customers for a total value of £100,000
- The accounting period for the business ends on December 31st and so although the invoices were issued in the first accounting period for the business they will not be paid until the second period
- This business has still generated £1m of income in the year but at the end of the year it has only received £900k in cash
- Let’s look at how this will affect the accounting equation for the business
- As before our hotel has generated £1m of income in its first year
- Even though there are £100k of unpaid invoices at the end of the year they are still recognised as income because hotel earned that money during its first year
- However because these invoices are unpaid, in this version of the example the hotel only received £900k of cash from customers in its first year
- Therefore the unpaid invoices must be recognised as an asset in their own right in order for the accounting equation to balance
- Recognising the unpaid invoices as an asset is reasonable because we expect them to be paid in the near future
- Now we will look at how this change has an impact on each of the three financial statements Note: During this example you may want to encourage participants to refer to the ‘Accounting Equation’ hand-out from the previous example.
- First let’s look at the profit and loss account, how do you think it will be affected by recognising the unpaid invoices as an asset?
- In fact the profit and loss statement does not change at all
- Under the matching principle the business still earned £1m of income – just the same as it had done before
- Because the profit and loss account does not reflect when income is received there is no need to adjust it to reflect the unpaid invoices Note: If participants are finding it challenging to grasp the accruals principle, you may prefer to tell them that there is no impact on the profit and loss rather than asking the question. However this is a good opportunity for participants to demonstrate their grasp of the accruals concept.
- Unlike the profit and loss account, the balance sheet is affected by the unpaid invoices
- You will remember that the balance shows provides a summary of the assets, liabilities and capital of a business
- Previously the assets consisted of the £2m hotel building and £0.5m cash
- However this time the business has £100k that it has not received as cash at the end of year
- As such we need to reduce the amount of cash the business has on the balance sheet by £100k, from £500k to £400k
- The £100k of cash is replaced with £100k of unpaid invoices
- These unpaid invoices are referred to as ‘debtors’, these are people who owe money to a business at a particular point in time
- The total assets, liabilities and capital of the business are unchanged
- As before we are just using the balance sheet to summarise the assets, liabilities and capital of the business Note: This is a very important concept and some participants may find this difficult to understand. Do not be afraid to spend lots explaining this slide and answering any questions.
- The cash flow statement is also affected by recognising the unpaid invoices
- Can anyone guess how the cash flow statement will need to be altered?
- It is the cash flow from operations that we will need to adjust
- The profit / loss for the year remains the same – you will recall that we simply took this figure from the profit and loss account, which has not changed
- However this figure is then adjusted to reflect income that appears in the profit and loss statement but has not been received as cash
- The debtors of £100k is deducted from the profit / loss figure to give a new total cash flow from operations of £400k
- As a result the net cash flow for the business also falls from £500k to £400k
- Now we will consider how the matching principle affects the recording of expenses and the financial statements
- Under the matching principle we record expenses when they are incurred, meaning we record expenses in the account period they relate to
- This means that we often record expenses in an accounting period, even though they may not have been paid for in a particular accounting period
- Under accruals accounting we record expenses when they are incurred, generally this means that we record expenses based on when we receive a bill for something not when we actually pay the bill
- As we know the hotel had £0.5m running costs (i.e. expenditure) in its first year
- However now we want to recognise that some of those suppliers actually charge the hotel via invoice
- The suppliers send the hotel an invoice at the end of each month for products and services used in the same month
- At the end of December the hotel received invoices for £50k for products and services used during that month
- These invoices were unpaid at the end of the accounting period and so this will have an affect on the financial statements for the business
- We would like you to work in pairs to adjust the financial statements for the business At this point you should ensure that all participants have a copy of the ‘Matching Expenses Exercise’ hand-out. You should then allow the participants 15-20 minutes to complete the exercise. Note: The hand-out for this exercise provides some additional instructions. The revised accounting equation for the hotel business is provided and participants are told that the profit and loss account will not need to be adjusted. However if the participants are struggling with the material you may wish to walk them through the accounting equation (on the next slide) in order to prepare them for the exercise.
- The accounting equation needs to change in order to recognise the unpaid expenses at the end of the hotel’s first trading year
- Because the unpaid expenses were still incurred in the hotel’s first year of business, total expenditure remains unchanged at £0.5m
- However because £50k of invoices are unpaid at the end of the year, cash spent is reduced to £450k and we record the unpaid invoices of £50k as a liability
- Now we will examine how this change affects the financial statements for the business
- As when we were accounting for income that had not been received from customers, the unpaid expenses do not affect the profit and loss account
- The expenses were incurred in the hotel’s first year of trading and so they appear in the profit and loss account even though suppliers are yet to be paid
- There are two changes we need to make to the balance sheet in order to reflect the unpaid expenses
- In the previous version of the balance sheet, the business had cash at bank and in hand of £400k
- However this was based on the businesses having total expenses of £500k, all of which were paid by the end of the year
- In this exercise £50k of expenses are unpaid at the end of the year and so we need to increase cash in bank and at hand to £450k
- To balance this we also need to recognise the £50k of unpaid expenses as a liability
- The £50k of unpaid expenses are referred to as creditors, which is the term for individuals and organisations that a business owes money to at a given point in time
- When we recalculate total assets and liabilities we can see that the two adjustments cancel each other out and net assets are the same as they were before Note: It is likely that some participants will have arrived at the wrong answer to this part of the exercise so be prepared to help them work through the numbers and ensure they understand their mistakes.
- The cash flow from operating activities needs to be adjusted to reflect the unpaid expenses
- The profit/loss for the year of £500k is based on income of £1m and expenses of £500k
- However this figure is taken from the profit and loss account and does not reflect that £50k of expenses are unpaid
- As such in the same way we adjusted for income that has not been received, we adjust for expenses that have not been paid
- The £50k unpaid expenses are added to the cash flow from operations
- The new total cash flow from operations is £450k
- As a result the new net cash flow for the business is also £450k Note: This is the last slide relating to the matching expenses exercise. You may also want to take a moment to review the key lessons from the exercise and ensure that all participants understand how the matching principle affects the recording of expenditure on the financial statements.
- Under the matching principle expenditure if only recorded on the profit and loss account if it relates to that accounting period period
- However sometimes a business will pay for something in one accounting period that we will not use until the next accounting period
- Money spent on something that will not be used until the next accounting period is an example of something called a ‘current asset’, we will talk about these in more detail later on
- More specifically this is known as a ‘prepayment’
- To help you understand this concept we will look at an example Note: There are a few new terms here that participants may find confusing. However we recommend that you ask participants to hold any questions and proceed to the example on the next slide, which should help to clarify the meaning of the new terms.
- As we know the accounting period for our imaginary hotel runs from January 1st to December 31st of each year
- One of the things that the hotel business will need is an insurance policy to cover damage to the building, the contents and our liability for any injury or harm caused to guests
- We will imagine that this insurance policy costs £10,000 for the year and that this is included in our £500k of running costs for the first year
- Let’s say that because we were building the hotel for the first six months of the year, we did not buy our insurance policy until construction was completed on July 1st
- At that time we paid £10,000 for an insurance policy that will last for 12 months
- This means that on December 31st, at the end of the accounting period we will have six months of insurance cover that has already been ‘pre-paid’
- Because six months of the insurance policy has been used up, we record £5,000 of expense on the profit and loss account
- However the six months that has been ‘pre-paid’ appears on the balance sheet as a current asset that will be used up in the next accounting period
- Let’s look at how this affects each of the three financial statements
- As we said only half of the £10,000 insurance policy appears on the profit and loss account
- As such expenditure during the account period need to be reduced from £500k to £495k
- As a result profit for the year increases to £505k
- There are a number of changes that need to be made to the balance sheet in order to reflect the pre-paid insurance policy
- First because the balance of the profit and loss account for the year has increased, we need to reflect this in the capital section of the balance sheet
- As a result the value of the shareholders funds increases and so we know that the top half of the balance sheet also needs to change
- As such the £5,000 of pre-paid insurance is added to the top of the balance sheet as an asset
- This increases the net assets of the business and the balance sheet is ‘in balance’ once again Note: These adjustments to the balance sheet can be confusing for participants so be prepared to spend time answering questions and ensure that all participants understand the new figures.
- The cash flow statement also needs to be adjusted to reflect the pre-paid insurance
- Based on the other adjustments we have seen, can anyone explain how the cash flow statement will need to be adjusted in order to reflect the prepayment?
- First the profit/loss for the year needs to be increased to £505k, to reflect the increased profit made during the hotel’s first trading year
- Second the prepayment needs to be deducted from the profit/loss because that cash has already been spent
- Notice that the cash flow from operations and overall net cash flow for the business are unchanged
- This makes sense because there has been no change in how much money was spent
- Instead we are only changing how that expenditure is recognised
- The opposite of a prepayment is an accrual, this is an expense which is incurred in a particular accounting period but is not paid for until after the end of that period
- This should not be confused with the broader concept of ‘accruals accounting’
- In the most simple terms an accrued expense is the opposite of a prepayment
- Accruals are recorded as additional expenses on the profit and loss account
- They are also recorded as a liability on the balance sheet Note: As when introducing the concept of prepayments, there are a few new terms here that participants may find confusing. However we recommend that you ask participants to hold any questions and proceed to the exercise on the next slide.
- At the end of each accounting period the hotel will pay an accountant to prepare annual accounts and a corporation tax return
- The accountant charges fees of £2,000 for providing this service
- By definition it is impossible for the accountant to prepare those accounts until after the end of the first accounting period and so the fees are not paid until the second accounting period
- However the accountant’s fees are still recognised as an expense in the first accounting period
- This is because even though they have not been paid for in the first accounting period the accounting fees relate to business activity in the first period
- This is another example of the matching principle in action
- Now we would like you to work in pairs to determine how this will affect the financial statements for the business
- Remember that the accounting fees need to be added to the profit and loss account as an expense and to the balance sheet as a liability At this point you should ensure that all participants have a copy of the ‘Accrued Expenses Exercise’ hand-out. This document contains further instructions for completing the exercise and reiterates the key concepts and numbers participants will need to know. Allow 10-15 minutes for participants to complete the exercise.
- As we said earlier on the accounting fees need to be added to the profit and loss account as an expense in the accounting period
- As such when we add the £2k fees, expenses increase from £495k to £497k
- As a result operating profit, profit before tax and profit for the year all fall from £505k to £503k
- Next we will look at how the accrued accounting fees affect the balance sheet for the business
- As in our prepayments example, accounting for accrued expenses has affected the amount of profit for the year and so we need to revise the profit and loss figure for the balance sheet, reducing it from £505k to £503k
- There is no change to the assets section of the balance sheet
- The accrued expenses are reflected as a current liability because the business will have to pay for them in the next accounting period
- This increases the total liabilities for the business so that the top and bottom halves of the balance sheet are equal
- As with earlier examples we need to adjust the cash flow statement to reflect the accrued accounting expenses
- First we need to include the new figure for profit/loss for the year, which as we know has fallen from £505k to £503k
- Then we need to add the £2k liability from the balance sheet to offset this
- These two adjustments balance each other out so that cash flow from operations and net cash flow for the business as a whole are unchanged
- This makes sense because there has been no change in the amount of cash that has been spent – we are just reconciling the change in the profit and loss account with the unpaid accounting fees
- Note: This is the final slide of this exercise and of this key question. You may wish to make a few closing remarks before moving on and offer participants the opportunity to ask any questions they may have.
- Now we are going to look more carefully at how expenses should be categorised on the profit and loss statement
- Specifically we are going to examine the difference between cost of sales and overheads
- Cost of sales (also known as ‘cost of goods sold’ or ‘direct costs’) are the direct costs of producing and selling products and services
- For example imagine that we decided to open a cupcake shop
- The cost of the flour, sugar, eggs, butter, flour and other ingredients are examples of cost of sales
- By contrast overhead costs are the indirect costs of running a business
- In our cupcake shop the overhead costs would include rent, rates and utilities
- Now I would like you to work in pairs to create two lists
- One list should be the various ‘cost of sales’ that the hotel business will incur
- Remember that these are the direct costs of providing a product or service
- As such these will be the direct costs of renting out a hotel room for a night
- The second list should be of the overhead costs that the hotel business will incur
- These are the indirect costs of providing a product or service
- As such these should be the general running costs for the hotel After you have provided your explanation you should give the participants about 5 minutes to create two lists. If time is short you may prefer to run this exercise from the front of the room. Below is a list of some possible answers to the exercise: Note: In general the distinction between cost of sales and overheads is fairly clear. However there can be some confusion about when staff costs are cost of sales and when they are overheads. Staff costs will only be part of cost of sales where their labour is consumed in the production of a product or service. For example in a hotel the labour of the cleaning staff is arguably a cost of sales. However staff costs that do not directly relate to the cost of providing the guest with their room (e.g. front-desk, marketing) will be an overhead cost. This is an area of accounting where there is a lot of scope of for interpretation and there is no need to go into great detail. Your goal should be to ensure that participants understand the broad distinction between cost of sales and overheads – the details are not important for this workshop.
- So far when creating a profit and loss account for the hotel business, we have deducted all of the expenses the hotel incurs from turnover at the same time
- However cost of sales and overhead costs are presented separately on the profit and loss account
- Cost of sales is the first thing to be deducted from turnover (sales)
- Turnover less cost of sales produces a figure known as ‘gross profit’ (or loss)
- Overheads are then deducted from gross profit
- This gives us a figure known as ‘operating profit’
- This is an example of what the profit and loss account for the hotel might look like if we were to separate cost of sales and overheads
- It is important to note that we have just made up the numbers for overheads and cost of sales
- As before the number at the top of the profit and loss account is turnover
- Then we deduct cost of sales, this gives us our gross profit figure
- Next we deduct overhead costs from gross profit and this gives us our operating profit figure
- As before we are still ignoring taxes but you should be aware that if a business makes profit during an accounting period then it may have to pay Corporation Tax Note: The reason we say ‘may’ have to pay Corporation Tax is that businesses can offset profits against losses from earlier accounting periods. A detailed discussion of this point is beyond the scope of this workshop. If participants have questions about offsetting the losses in their business you should advise them to speak to their accountant.
- Next we are going to look at the different ways you can categorise assets and liabilities
- Specifically we want to make a distinction between ‘current’ and ‘non-current’ assets/liabilities
- Current assets or liabilities are those that have a lifespan of less than one year
- This means that they will either be used-up, settled or turned-over within the next accounting period
- By contrast non-current assets or liabilities are those with a lifespan of more than one year
- This means that some of their value will still remain at the end of the next accounting period
- Examples of current assets include:
- Cash
- Trade debtors (unpaid customers invoices)
- Prepayments (e.g. insurance policies)
- Stock
- Within one year we would expect unpaid invoices to be paid and turn into cash
- In the same way we know that prepaid expenses will have been used up
- Our stock and cash will be ‘turned over’ – we will probably still have stock and cash at the end of the next accounting period but it will be different stock and cash from the date of the balance sheet
- Can any of you suggest an example of a current liability?
- Possible answers include:
- Trade creditors (e.g. unpaid supplier invoices)
- Unpaid corporation tax (companies have nine months after each period to pay tax owed)
- Short-term loans (e.g. a bank overdraft)
- Examples of non-current assets include:
- Land
- Buildings
- Equipment
- Machinery
- At the end of the next accounting period we would still expect all of these items to retain some of their value unless we plan to dispose of them in some way
- However the value of non-current assets may decline from one year to the next, this is known as ‘depreciation’ and we will talk about this in greater detail in a few minutes time
- Can and of you suggest an example of a non-current liability?
- Possible answers include:
- Long-term loans
- Pension liabilities
- Deferred taxes Note: For most small businesses long-term loans are the most likely example of a non-current liability. Most other long-term liabilities are relatively rare and/or are only likely to apply to larger businesses.
- This is an example of a balance sheet that separates current and non-current, assets and liabilities
- The balance sheet does not look materially different but there is explicit separation of the different types of asset and liability
- As we mentioned a few moments ago the cost of a fixed asset is spread over its expected lifespan
- For example imagine that a business buys a computer costing £1,000
- We expect that the computer will have a useful life of 5 years
- After those 5 years we believe the computer will have a value of £0
- In other words the computer has a cost of £200 per year (£1,000 / 5 years)
- The computer is initially recognised as a fixed asset on the balance sheet
- However each year we reduce the balance sheet by value by £200
- At the same time we add £200 of cost to the profit and loss account to reflect the decline in value of the asset
- There are various different methods for calculating depreciation
- For example some assets will consistently decline in value over a period of time
- By contrast other assets will initially depreciate very rapidly and then more slowly over time
- You can use different methods of calculating depreciation in order to reflect this
- Not all assets with a life of more than one year need to be depreciated, only those that have a ‘material’ value
- This means that inexpensive assets with a long lifespan do not need to be depreciated
- Land and buildings generally do not depreciate
- If you own any fixed assets you should discuss your situation with an accountant in order to determine the appropriate course of action
- Now we are going to return to the subject of management accounting
- We spoke about this briefly at the start of the workshop but would like to remind you of some key points
- Management accounting involves the preparation of detailed financial information
- Generally these reports are for internal use and are not shown to external stakeholders
- They may relate to past, present or future performance of the business
- They are not legally required and so they can be prepared (or not prepared) at intervals to suit a particular business
- They can also be prepared in any format and on any basis that is deemed appropriate by the management of a particular business
- It is important for businesses to be able to compare expected and actual performance
- This can enable them to identify strengths and weaknesses in the business
- It is also useful for a business to create forecasts of future performance
- Information about past performance combined with future forecasts empower management to make more informed decisions
- Furthermore management accounting can help businesses to allocate costs appropriately across different divisions/teams/products/services
- The allocation of costs through management accounting is what we will look at now
- We are going to consider how a business should allocate it costs to different products, services and teams
- This is useful for internal accounting purposes but may also be important when submitting applications for grants that allow for some level of cost recovery
- The cost of providing a product or service has two parts
- First there is cost of sales, as we know these are the direct costs of producing a product or service
- Then there are overheads, these are the indirect costs of running a business
- We already know how (or can easily calculate) cost of sales for a particular product or service
- However the true cost (i.e. including overheads) of a product or service is not as easy to understand
- Different products and services are likely to consume overheads at different rates
- In many cases there will be no objective basis for allocating these costs
- As such we will need to decide on a reasonable and appropriate basis for allocating costs
- Unless we can appropriately allocate overhead costs it is difficult to determine whether a particular product or service is actually ‘profitable’
- Even though a product may be sold for more than its cost of sales, it may not be truly profitable once an appropriate proportion of overheads is absorbed
- As such unless we have a reasonable basis for allocating costs it is impossible to set prices appropriately
- Individuals or teams within a business may be assessed based on their ability to generate profit for the business, as such it is important that there is a reasonable basis for calculating profit
- Some external stakeholders (notably grant funders) may allow a business to recover a proportion of overhead costs within a grant application, provided that there is a reasonable basis for allocating those costs
- We allocate overhead costs by identifying ‘cost drivers’
- These are a reasonable basis for absorbing overhead costs to a particular product, service or team
- Imagine that a business has two products: ‘A’ and ‘B’
- The business has a finance manager who is paid a salary of £30,000
- How should we allocate the finance managers salary across the two products? Note: At this point you can ask participants to make suggestions for allocating the finance manager’s salary or just ask the question rhetorically. A suggestion for allocating the cost is provided on the next slide.
- One of the finance manager’s main jobs is to raise invoices and then chase customers to pay them
- Because this is an activity that takes up a large amount of the finance manager’s time it may be sensible to allocate his salary across the two products based on the relative number of invoices raised for each product
- Let’s imagine that the finance manager raises 100 invoices in a year
- This is a cost of £300 per invoice (£30,000 / 100 invoices)
- The finance manager raises 70 invoices for Product A and 30 invoices for Product B
- On this basis we would allocate £21,000 of his salary to Product A (£300 per invoice x 70 invoices)
- The remaining £9,000 of his salary would be allocated to Product B (£300 per invoice x 30 invoices)
- This is not necessarily a ‘perfect’ basis for allocating cost but it is transparent and straightforward
- Although we want cost allocation to be accurate it also needs to be easy to understand and perform
- We would like you to practice allocating the costs for an imaginary social enterprise
- The social enterprise has two projects and needs to determine how to allocate different overhead costs to each project
- Work in pairs to determine an appropriate basis for allocating the overhead costs
- We have provided some information about the social enterprise to help you make the decision
- Be aware that not all of the information will be useful – you will need to think carefully about what matters in order to allocate costs appropriately At this point you should ensure that all participants have a copy of the ‘Cost Allocation Exercise’ hand-out. You should allow participants 10-15 minutes to complete the exercise.
- There are various ways that you could answer this exercise and there is no single right answer
- However we have provided some suggested answers based on our best judgement
- We would allocated the office costs by Full-Time Equivalent (FTE) headcount
- Given that some staff work part-time it seems unreasonable to allocate costs based solely on the number of employees working on each project
- On this basis Project A has office costs of £16,000 and Project B has office costs of £18,000
- However there is a counter-argument that even if a person works part-time, the office still needs to be bigger in order to accommodate them (to ensure everyone would have space if all part-time and full-time staff are working in the office at the same time)
- This is a great example of why management accounting requires careful thought and may even cause internal conflict if not handled appropriately
- We would allocate governance costs by expenditure
- Our rationale is that the more expensive a project is, the more governance it is likely to require
- On this basis Project A has office costs of £2,000 and Project B has office costs of £3,000
- Again this may not be a fair basis for allocating cost – a project with a lower value could require far more governance if it is more complex than a project with a higher value Note: Our suggested answers are discussed in greater detail in the ‘Cost Allocation Answers’ hand-out. You may wish to give each participants a copy of this hand-out and if you have time you may also wish to engage in a discussion about the limitation of each approach to cost allocation
- Refreshments (tea, coffee, bottled water etc.)
- Toiletries (little bottles of shampoo etc.)
- Food/drink
- Some staff costs (e.g. cleaning hotel rooms) | Overheads:
- Most staff costs
- Maintenance
- Laundry
- Marketing
- Furniture/furnishings | | --- | --- |
Bookkeeping & Accounts support tips
Bookkeeping and accounts: **Sources of support: **General A great source of support in this area are the regional LEPs. LEP’s – learning and enterprise partnerships - work between the commercial, voluntary and social enterprise space and support regional business development. Each areas do operate a little differently so I can’t advocate for the particular level of support on offer but recommend taking a look at:- The Brighton and Hove local authority has a helpful page here which includes info about the Coast to Capital Growth Hub and the Business and IP Centre Sussex. The includes lots of information, including obligations for CICs. **Accountancy and Bookkeeping firms to consider when looking for your **provider Over the years I have compiled the below accountancy and/or bookkeeping firms who are either social enterprises themselves, or provide specifically for social businesses. These have mostly come recommended by other award winners we have worked with. As with any providers, we recommend you reach out to at least three providers on your search so you have ample comparables in terms of both services offer, and cost.
- Social Enterprise UK offer support services from management accounting, financial director type support as well as general bookkeeping, accounting and management accounts. They offer a free one hour consultation also.
- Green Accountancy have also come recommended previously and I believe also offer a free one hour consultancy offer (although they don’t promote it, I believe you can access just book via their website)
- Social Enterprise Accounts CIC are a smaller, Plymouth based outfit and may be worth reaching out to for those of you nearby who are keen to explore a local partner.
- For those of you in Scotland, Sheila Fazal from Social Enterprise Accountancy Scotland CIC has come well recommended from prior award winners: [email protected]
- Others on my radar include Accounting for Good CIC and Harris Accountancy.
- If you haven’t maintained business accounts before, this template could be helpful - provided free by the Start Up Loans company. The Cash Flow Forecast supports financial forecasting, and it comes with a complimentary user guide. Note the Personal Survival Budget tab, which can help you explore what salary you need to pay yourself to comfortably live on.
- Microsoft Office is a common standard go to for keeping finances in Excel. However, if you have an online Outlook/Hotmail, you may not need to buy a Microsoft software suite. A version of Excel comes free in the cloud-based OneDrive account. Gmail has the same thing via their online cloud. Their version is called Sheets (also free).
- If you are looking for the next stage in your financial reporting, there are lots of online accounting services (monthly subscription fees usually apply - but most have a free trial period so you can try before you buy and commit to a service). Xero is a popular choice, as is Quickbooks. If you would prefer to delegate this work from the off (and can budget for it), you can bring on a chartered accountant or a bookkeeper.
- Chartered Accountants are registered with a professional body (the Association of Chartered Accountants), have undertaken a minimum of three years of training and passed financial management exams.
- Bookkeepers are trained professionals who specialise in recording financial transactions in an accounting package. Qualified bookkeepers can be found at the International Association of Bookkeepers and the Institute of Certified Bookkeepers. You’ll still need an accountant at year-end to prepare and file your statutory accounts, but option for a bookkeeper may reduce set up costs and mid-year record keeping. Accountants:
- Check the accountant is suitably qualified and belongs to a professional body approved by the Financial Reporting Council. Look for the letters ACA or FCA after a chartered accountant’s name (CA in Scotland), ACCA or FCCA in the case of a chartered certified accountant, or ACMA or FCMA for a chartered management accountant.
- An accountant who is not a member of an approved professional body may offer cheaper rates, but they could cost a business more in the long run if the quality of their work or advice is poor. Members of leading accountancy bodies must also ensure that their technical knowledge is kept up to date by attending regular courses and seminars, as well as following a programme of continuing professional development throughout their careers.
- When considering an accountant/bookkeeper, it’s worth looking for one that works in or has experience in a similar industry to your social enterprise and/or working with startups.
- It is advisable to contact and meet more than one account/ accountancy firm and have face-to-face meetings before making a decision about who to choose. Ideally finding someone that has the necessery appropriate qualifications and experience - but is also empathetic. Some accountancy firms waive the fee for an initial meeting unless specific advice is given at that meeting. Check in advance whether the first consultation will be free. Quick reminders:
- If you’ve set up as a sole trader, you’ll need to register for self-assessment with HMRC. If this is your chosen legal structure then it’s important to set up a separate business bank account to separate your business spending from your personal account(s). Any tax payable will be due when the self-assessment deadline comes around.
- If you’ve registered as a limited company in the UK, you must file annual accounts with Companies House. If you’ve set up your social enterprise as a company, you’ll also need to file a tax return with HMRC, to find out how much, if any, corporation tax you are liable for.
- If you’re intent on filing your tax returns yourself, allow plenty of time. Forms can be long but the UK govt website will guide you through.
- Remember for the future that, depending on the type of services or products you’re offering, and if the turnover of the company exceeds £85,000, you could be required to register for Value Added Tax (VAT).
Bookkeeping_Accounts_support tips_2324
Bookkeeping and accounts: **Sources of support: **General A great source of support in this area are the regional LEPs. LEP’s – learning and enterprise partnerships - work between the commercial, voluntary and social enterprise space and support regional business development. Each areas do operate a little differently so I can’t advocate for the particular level of support on offer but recommend taking a look at your online, and also at your local CVS (or GMCVO – for those of you based in Greater Manchester) for support. The includes lots of information, including obligations for CICs. Accountancy and Bookkeeping firms to consider when looking for your provider Over the years I have compiled the below accountancy and/or bookkeeping firms who are either social enterprises themselves, or provide specifically for social businesses. These have mostly come recommended by other award winners we have worked with. As with any providers, we recommend you reach out to at least three providers on your search so you have ample comparables in terms of both services offer, and cost.- Social Enterprise UK offer support services from management accounting, financial director type support as well as general bookkeeping, accounting and management accounts. They offer a free one hour consultation also.
- Green Accountancy have also come recommended previously and I believe also offer a free one hour consultancy offer (although they don’t promote it, I believe you can access just book via their website)
- Social Enterprise Accounts CIC are a smaller, Plymouth based outfit and may be worth reaching out to for those of you nearby who are keen to explore a local partner.
- For those of you in Scotland, Sheila Fazal from Social Enterprise Accountancy Scotland CIC has come well recommended from prior award winners: [email protected]
- Others on my radar include Accounting for Good CIC and Harris Accountancy.
- If you haven’t maintained business accounts before, this template could be helpful - provided free by the Start Up Loans company. The Cash Flow Forecast supports financial forecasting, and it comes with a complimentary user guide. Note the Personal Survival Budget tab, which can help you explore what salary you need to pay yourself to comfortably live on.
- Microsoft Office is a common standard go to for keeping finances in Excel. However, if you have an online Outlook/Hotmail, you may not need to buy a Microsoft software suite. A version of Excel comes free in the cloud-based OneDrive account. Gmail has the same thing via their online cloud. Their version is called Sheets (also free).
- If you are looking for the next stage in your financial reporting, there are lots of online accounting services (monthly subscription fees usually apply - but most have a free trial period so you can try before you buy and commit to a service). Xero is a popular choice, as is Quickbooks. If you would prefer to delegate this work from the off (and can budget for it), you can bring on a chartered accountant or a bookkeeper.
- Chartered Accountants are registered with a professional body (the Association of Chartered Accountants), have undertaken a minimum of three years of training and passed financial management exams.
- Bookkeepers are trained professionals who specialise in recording financial transactions in an accounting package. Qualified bookkeepers can be found at the International Association of Bookkeepers and the Institute of Certified Bookkeepers. You’ll still need an accountant at year-end to prepare and file your statutory accounts, but option for a bookkeeper may reduce set up costs and mid-year record keeping. Accountants:
- Check the accountant is suitably qualified and belongs to a professional body approved by the Financial Reporting Council. Look for the letters ACA or FCA after a chartered accountant’s name (CA in Scotland), ACCA or FCCA in the case of a chartered certified accountant, or ACMA or FCMA for a chartered management accountant.
- An accountant who is not a member of an approved professional body may offer cheaper rates, but they could cost a business more in the long run if the quality of their work or advice is poor. Members of leading accountancy bodies must also ensure that their technical knowledge is kept up to date by attending regular courses and seminars, as well as following a programme of continuing professional development throughout their careers.
- When considering an accountant/bookkeeper, it’s worth looking for one that works in or has experience in a similar industry to your social enterprise and/or working with startups.
- It is advisable to contact and meet more than one account/ accountancy firm and have face-to-face meetings before making a decision about who to choose. Ideally finding someone that has the necessery appropriate qualifications and experience - but is also empathetic. Some accountancy firms waive the fee for an initial meeting unless specific advice is given at that meeting. Check in advance whether the first consultation will be free. Quick reminders:
- If you’ve set up as a sole trader, you’ll need to register for self-assessment with HMRC. If this is your chosen legal structure then it’s important to set up a separate business bank account to separate your business spending from your personal account(s). Any tax payable will be due when the self-assessment deadline comes around.
- If you’ve registered as a limited company in the UK, you must file annual accounts with Companies House. If you’ve set up your social enterprise as a company, you’ll also need to file a tax return with HMRC, to find out how much, if any, corporation tax you are liable for.
- If you’re intent on filing your tax returns yourself, allow plenty of time. Forms can be long but the UK govt website will guide you through.
- Remember for the future that, depending on the type of services or products you’re offering, and if the turnover of the company exceeds £85,000, you could be required to register for Value Added Tax (VAT).
Downloadable Resources
- [1. Accounting Slides v1.0 2017](/finance/assets/1. Accounting - Slides - v1.0 2017.pptx)
PowerPoint - [3. Accounting Accounting Equation v1.0 2017](/finance/assets/3. Accounting - Accounting Equation - v1.0 2017.doc)
Word - [4. Accounting Further Learning v1.0 2017](/finance/assets/4. Accounting - Further Learning - v1.0 2017.doc)
Word - [5. Accounting Asset, Liability or Capital v1.0 2017](/finance/assets/5. Accounting - Asset, Liability or Capital - v1.0 2017.doc)
Word - [6. Accounting Asset, Liability or Capital Answers v1.0 2017](/finance/assets/6. Accounting - Asset, Liability or Capital Answers - v1.0 2017.doc)
Word - [7. Accounting Matching Expenses Exercise v1.0 2017](/finance/assets/7. Accounting - Matching Expenses Exercise - v1.0 2017.doc)
Word - [8. Accounting Accruals Exercise v1.0 2017](/finance/assets/8. Accounting - Accruals Exercise - v1.0 2017.doc)
Word - [9. Accounting Cost Allocation Exercise v1.0 2017](/finance/assets/9. Accounting - Cost Allocation Exercise - v1.0 2017.doc)
Word - [A Guide to VAT](/finance/assets/A Guide to VAT.pdf)
PDF - [Action Planning Template 2024 2027 v3](/finance/assets/Action Planning Template 2024-2027 v3.xlsx)
Excel - [Charging and Accounting for VAT](/finance/assets/Charging and Accounting for VAT.pdf)
PDF - [Choosing and Using an Accountant](/finance/assets/Choosing and Using an Accountant.pdf)
PDF - G Managers checklist
Word - [Government Support for Research and Development in the UK](/finance/assets/Government Support for Research and Development in the UK.pdf)
PDF - Guide to Tax for a New Business 2
PDF - [Registering for VAT](/finance/assets/Registering for VAT.pdf)
PDF - [UnLtd Financial Management Checklist Draft 1](/finance/assets/UnLtd Financial Management Checklist - Draft 1.xlsx)
Excel - [UnLtd Financial Management Checklist Final](/finance/assets/UnLtd Financial Management Checklist Final.xlsx)
Excel - [invoicing 101](/finance/assets/invoicing 101.pdf)
PDF