TRADING, PROFIT, LOSS ACCOUNT-BALANCE SHEET 1

The effects upon the Balance Sheet of the various adjustments have been shown during the progress of this chapter, and consequently it will be only necessary to deal with one other important matter, namely, the sequence of the items.

Sequence. The Balance Sheet lends itself much more readily than does the Profit and Loss Account to a natural sequence of presentation of items. No two Balance Sheets will follow precisely the same order, but it is usual to set out assets and liabilities either:

TRADING, PROFIT, LOSS ACCOUNT-BALANCE SHEET 1

(a) In order of permanence, or

(b) In order of liquidity.

TRADING, PROFIT, LOSS ACCOUNT-BALANCE SHEET

Generally speaking. (a) is most commonly used by industrial and commercial businesses, (b) by banks and concerns of a similar nature. In order to comprehend the rule, a clear conception of the various terms applied to assets and liabilities is necessary.

Assets are designated under the following headings:

1. Fixed.

2. Floating or Current.

3. Fictitious,

Fixed Assets may be regarded as those assets of a business which are of a permanent nature, and are definitely held for the purpose of earning, and not with a view to resale, e.g. Plant and Machinery. Buildings. Assets of a wasting nature are sometimes included under a separate heading, but this distinction is hardly necessary, as they are really Fixed Assets, which by their nature depreciate rapidly in value or content. Assets may be further sub-divided into Tangible and Intangible, but it must be borne in mind that the latter are not necessarily fictitious. Goodwill, for example, provided it is represented by actual value, is definitely a fixed asset, notwithstanding its intangibility.

Floating or Current Assets may be regarded as those assets which are måde or acquired and merely held for a short period of time, with a view to sale at a profit in the ordinary course of business; that is to say, they are easily convertible into cash, e.g. Cash, Debtors, Stock, Bills Receivable.

Fictitious Assets are merely debit balances not written off; that is, items of expenditure or losses of an unusual character which are not recoupable: Preliminary Expenses of a Limited Company, property lost through confiscation and not yet written off. Removal Expenses carried forward etc.

The modern practice is to dispense with the general headings of 'assets" and liabilities' and to arrange the assets and liabilities in groups with appropriate headings and with sub-totals to show the amount of (a) fixed assets, (b) current assets, (c) current liabilities, (d) long-term liabilities, and (e) proprietor's interest. By making use of these arrangements the comparison of assets and liabilities is facilitated.

Where the order of permanence is chosen, the Fixed Assets will come first, usually commencing with Land and Buildings, Plant and Machinery, and so on (Goodwill, however, is often placed first), followed by the Current Assets in order of realizability ending with Cash. In the liquidity order, on the other hand, the reverse is followed, the most liquid (ie. Cash) being taken first, the remainder following in descending order of liquidity. Fictitious Assets, which are obviously not assets at all but merely debit balances not yet written off, will in either case appear at the bottom of the list.

Liabilities should as far as possible be placed in the same order as the assets. Thus, where the permanence order is chosen, Capital. Reserves

and undistributed profits-comprising the proprietor's interest-will come first, followed by Long-term Liabilities (Mortgages, Debentures, etc.) and Current Liabilities and Provisions.

0580

15.000

Capital Current Account

Loan on Mortgage Current Liabilities- Sundry Creditors

3,350

ACCOUNTANCY

BALANCE SHEET AS AT...

Fixed Assets-

Land and Buildings (1) Freehold

2,000

18.350

(2) Leasehold

3.000

6.000

Plant and Machinery

Less Depreciation at 10%

2.500

5,000

250

1.950

Bills Payable

1.800

Accruals: Rent etc.

750

Furniture and Fittings

Less Depreciation at 5%

1.500

2,250

Bank Overdraft

2,000

Mortgage Interest accrued

150

6,650

Goodwill

2.000

1.425

Secret Processes

Patents and Trade Marks

2.000

1.000

Investments:

5,000

Quoted

2,750

Not quoted

1,000

Current Assets-

Stock:

3,750

Raw Materials

£2,250

17,425

Finished Goods

1,400

.Work in Progress

725

Goods on Consignment

500

Stationery

125

5,000

Sundry Debtors

£2,750

Less Bad Debts Provision

450

2.300

Less Discounts Provision

100

2.200

Bills Receivable

575

£31,000

Insurance Rates

Cash in hand Cash at Bank: Deposit Current

Fictitious Assets

Property in X land confiscated

but not written off

The principles outlined on pp. 0578-9 relate to ordinary concerns and do not apply to certain companies whose Balance Sheets are required by law to conform with a set layout; in the case of limited companies, certain requirements are laid down by the Companies Acts 1948 to 1976 relating to the Balance Sheet, not so much in relation to sequence as to disclosure of specific details. These requirements are dealt with in Chapter 23. It will be realized that no such form is laid down for partnerships and sole traders, but it is considered that, as far as possible, their accounts should follow the same principles. Set out above is an illustration of a two-sided Balance Sheet constructed on the 'Permanence" principle, but it should always be borne in mind that there are considerable variations and modifications according to the nature of the business, the particular purpose of the Balance Sheet, and the wishes of the proprietor.

'See notes on p. 0581.

2 Comprising the Companies Acts 1948, 1967 and 1976.

Prepayments:

Advertising

£ 180

108

300

£ 15

2,500

485

3.000

1,075

2,500

£31,000

TRADING, PROFIT, LOSS ACCOUNT-BALANCE SHEET

Notes

1. The question as to whether investments are fixed or current assets is sometimes difficult to determine, but, generally speaking, investments in affiliated companies are classified as fixed assets. Short-term investments can be considered current assets since they essentially act as a cash substitute.

2. In the case of stock the basis of valuation should be clearly indicated; that is, whether it is taken at say the lower of cost and net realizable value.

3. Where prepaid expenses represent payment for services to be performed in the future. they may be treated as current assets.

4. It is usual to subdivide investments into those quoted on the Stock Exchange and those not quoted, the former being more easily realizable than the latter.

5. It will be noticed that whereas ordinary liabilities such as loans, creditors, etc., appear on the left-hand side of the Balance Sheet, certain credit balances in the nature of reserves or provisions, e.g. Bad Debts, are often deducted from the particular asset to which they refer.

6. Instead of deducting depreciation for the year from the fixed assets balance brought forward and carrying forward the new balance, as is done in this illustration, the fixed assets may be shown at cost (or valuation) less the aggregate of the provisions for depreciation to date (vide Chapter 23 for the requirements of the Companies Acts 1948 to 1976, in this respect.)

There are many alternative methods of presentation. In one method the proprietor's interest is shown on the left-hand side and the net assets, sub-divided, on the right-hand side. This method lends itself particularly to presentation in columnar form, as shown in the following abbreviated example:

BALANCE SHEET AS AT...

Current Assets

Less Current Liabilities.

Add Fixed Assets.

Less Long-term Liabilities

7,000

3,100

3,900

3,100

7,000

2,200

£4,800

Representing:

Issued Share Capital

£4,000

Reserves and undistributed profits

800

£4,800

General Survey. From the aspect of examination work the following matters are worthy of the most careful attention:

1. The Nature of the business; e.g. if an extractive business like a quarry, attention will be directed to depletion; if an exporter, to the question of foreign exchange.

2. The Period covered by the accounts. The matters most usually affected by the period are Depreciation, Loan Interest, Partners' Salaries and Interest on Capital, Investment Income; on the other hand, the Provision for Bad Debts will not be affected thereby as it depends upon the amount of Debtors at a particular date.

ACCOUNTANCY

3. Provision should be made for expenses and charges accrued and accruing where possible. Should no information be disclosed in the question, a footnote should be made. On the other hand, appropriations of profit and 'prudent' (as distinct from compulsory) reserves should not be made, but the matters relegated to a footnote. For instance, Loan Interest paid for six months only in a twelve month period (or indeed any the accounts for interest accrued or accruing; or in the less frequent period longer than six months) will indicate the necessity for provision in instance an adjustment in respect of a payment in advance. Care must be taken to note any change in the amount of the Loan or in the rate of interest in respect of the period not covered exactly by the payment, e by a repayment of principal. Depreciation will be provided for if the rate of depreciation is given, but not otherwise.

4. If an item paid in advance or accruing appears in the Trial Balance, that is if it is a BALANCE, the Double Entry will already have been made. Frequently the wording of the question will serve as a guide; thus 'Rest paid and outstanding' clearly indicates that the provision for Rent accruing has been made so that the latter item is a balance. Likewise Depreciation may be a balance if the Asset to which it relates is 'NET, after Deprecia.tion'.

Otherwise adjustment items are not part of the Trial Balance or if inserted must appear twice, once as a debit and once as a credit. Stock on hand (if closing) will, by the same rule, be (a) either a balance (after the Trading Account has been closed off), in which case the Trading Account balance-usually credit-will appear in the Trial Balance; or (b) an adjustment item requiring crediting to Trading Account and insertion in the Balance Sheet as an Asset. In this case the Opening Stock, Purchases, Sales and other Trading items will all appear in the Trial Balance as the Trading Account will not have been closed off.

5. Items which may properly appear either as a debit or as a credit must be carefully scrutinized, particularly as there may, notwithstanding errors, be agreement of the Trial Balance-Bank Interest, Discounts, Bank, Profit and Loss balance forward are typical.

On the other hand, certain items inevitably indicate incorrectness of accounting, e.g. credit balance on Cash Account, credit balance on Short Workings in Royalties (as will be noticed in Chapter 15). But a credit balance on an Investment (Asset) Account or a debit balance on a Bad Debts Provision Account indicates not so much incorrectness as incom- pleteness of the accounting, the former involving a profit on sale of investment and a consequential transfer; the latter an incurring of bad debts of an amount larger than the existing provision. A transfer to Bad Debts Account (usually after creating the new Bad Debts Provision) is required, but the fact of there being a debit balance on the old account I will not necessarily mean that the provision was inadequate, because the account may include bad debts incurred since the date of the provision.

6. Goods acquired in connection with expenses-and similarly stock on hand-must be dealt with in the appropriate account, and not in the Trading Account, which deals with goods bought for resale.

7. Goods withdrawn for private purposes are not SALES. The latter account should include goods sold at SELLING prices. When the proprietor takes goods for private use he reduces his BUSINESS purchases, so that the credit is to PURCHASES, not sales. Logically, any cash discount, if identifi- able, is not a business profit, and a transfer should be made to the credit of drawings.

8. Where 'no profit' sales take place they should be separately shown or deducted in an inset column from general purchases.

9. Particular care is required in 'placing' debits of a 'Profit and Loss' nature. It is of vital importance to distinguish between the CHARGE against, as distinct from APPROPRIATIONS of profit.

As to depreciation, where a Manufacturing Account is required there appears to be unanimity as to depreciation of machinery being charged in that account, but otherwise there appears to be a divergence of view as to whether depreciation should be charged in the Trading section or the Profit and Loss section. The proper course to adopt is to insert the charge in the latter account and state the alternative in a footnote.

10. Where ambiguities occur or essential dates are lacking any reasona- ble assumption (supported by reasons) may be made, e.g. if Interest on a Loan has to be charged, the Loan may be assumed to have been in existence at the commencement of the period; where interest on drawings has to be charged, the drawings may be assumed to have been made uniformly over the period.

11. Frequently an adjustment will require a consequential entry, eg, if goods sent out on sale or return have been incorrectly treated as sales, in addition to the reduction of Sales and Debtors there will be an increase of Stock at cost or say, net realizable value in respect of the goods in hands of customers. In addition, such adjustment may affect the amount of Bad Debts Provision, because as a result of the correction the amount of debts is diminished. Again, if the question requires the writing off of a loss on sale of an asset, part of the debit balance on the account may be in effect depreciation.

12. In regard to the Balance Sheet, the important matters are:

(a) Sequence and grouping of Assets and Liabilities.

(b) Deduction of provisions from the appropriate assets.

(c) A Bad Debts Provision is computed upon the book debts less contra accounts of customers, whilst the provision for discounts on debtors is based on the book debts less the Bad Debts Provision. (d) Contingent Liabilities should be dealt with at the foot of the Balance Sheet in a note.

ACCOUNTANCY

13. Finally, mere arithmetic balancing will not gain full marks, nor will failure to balance necessarily cause serious loss of marks, so long as the PRINCIPLES involved-always present in the mind of the examiner-be adequately and intelligently dealt with. Hence, supporting schedules and computations should be attached to the answer.

So far as balancing is concerned the most frequent sources of trouble are (a) that the Trial Balance is not in agreement; (b) errors in dealing with the adjustments either by reason of omission of the double entry or by making them both debits or both credits; (c) overlooking the carry out of inset items into the main column.

The Use of Percentages in the Trading and Profit and Loss Account, Much valuable information can often be gained by comparing the accounts of one year with those of another on a percentage basis, since comparisons are more easily made on this basis than between actual money values. Unless due care is exercised, however, particularly in regard to the basis on which the percentages are made, the results may be very misleading. Thus, the usual basis from which the percentages are worked is Sales (i.e. Sales are taken as 100 per cent) but it is obvious that there can be little interest in the percentage on Sales of Purchases alone, the real figure to be taken being the cost of the goods sold, that is, opening stock plus purchases, less closing stock. Similarly, wages should be related to output, carriage inwards to purchases, and so on.

A distinction must also be made between those items which may be expected to vary with Sales and those which may be expected to remain constant. Thus, whereas the percentage of Gross Profit will normally be related to Sales, standing charges generally bear no relation to them, so that the former will normally be variable in amount but constant in ratio, whilst the latter tend to be fixed in amount but variable in ratio. For this reason the use of percentages is often confined to the Trading Account. The term 'standing charges is, of course, only relative, e.g. there may be rising costs, etc., but even so some will remain the same, such as Rent on a long lease.

A business will seek to earn the marginal gross profit needed to cover its fixed charges, so that gross profit beyond that amount will, broadly speaking, be net profit, e.g. if standing charges are £400 per annum and the rate of gross profit 20 per cent, then the minimum net annual sales should be £2,000. Hence, if the net annual sales (assuming the same rate of gross profit) are increased to £6,000, there will be an increase of gross profit of £800 and a corresponding increase, subject to additional selling and distribution expenses, in net profit. Actually there will be included in the Profit and Loss Account some items which do vary with sales, c.. carriage out, and, where there are credit sales, discounts allowed and bad debts, so that for this purpose these items should be brought into account in arriving at gross profit, leaving only the fixed charges to be debited against it. Naturally these fixed or standing charges may themselves vary over a period-increases in salaries, rates etc.-but these increases are not caused by, nor have any relationship to sales.

TRADING. PROFIT. LOSS ACCOUNT-BALANCE SHEET

Illustration 30

X intends to purchase a retail shop and has the choice of two similar ones. the comparative figures of which are:

Annual Sales.

Fixed Charges

A Shop B Shop

40,000

120,000

2.500

4,000

The percentage of Gross Profit is 15 per cent in both cases. Both shops are run by their owners but X intends to install a manager at £3,500 per

annum for A or £3,750 for B.

Assuming that conditions remain the same and the fixed charges contain proprietorship items, the comparative position is:

Gross Profit: 15% of 40.000

6,000

Fixed Charges: £2,500+£3,500

6,000

15% of £120,000 £4,000+3.750

18,000

7,750

Nil

£10,250

The marginal gross profit (i.e. sufficient only to cover fixed charges) of A is £6,000 and of B £7,750. Regard will be had to the price of goodwill, stock to be carried, and working capital required. If X has insufficient funds to cover these he will have to resort to borrowing and the cost thereof will increase the fixed charges and convert A into a losing proposition. The charge for borrowing in connection with the goodwill would be a fixed charge, whereas that in connection with stock and working capital would be a variable and should be first deducted in arriving at the marginal gross profit.

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