Firms need financial accounts, because they use money and, often, other people's money.
The tax authorities want to see that they have not been cheated. Shareholders want to be sure that the directors have done a good job for them. Potential investors want to see how well the firm is doing. However, the most fundamental reason why incorporated businesses prepare them is because Company Law in most countries states that they have to, and as a result, the accounts are public property in most countries.
Accounts tell a story in numbers. The story is complex and often shrouded in intrigue and illusion. Company accountants are paid very well to make the accounts look good. In this section you will be introduced to some of the language of financial accounts. You will also become familiar with important accounting concepts and techniques, which will help unravel the figures, remove the shrouds and allow us to look at the real story behind the numbers.
Companies spend money so that they can make their product or service and then sell it later. They get revenue when it is sold and actually receive the payment.
Already you can see the two sides of accounting - expenditure and income. The order is important; usually expenditure comes before income. A firm usually has to make something and supply it before it will be paid for it.
All payments and receipts have to be accounted for, to both the owners of the business and the government. This is done through a formal set of financial accounts that consist of:
- The balance sheet
- The profit and loss account (P&L Account)
These will be accompanied by a set of notes, which explain entries in the accounts and also give a mass of interesting information. These accounts are what are called 'historic' meaning they report what has happened in the past. They tell the reader what a firm has done, but not what it will do. Accounts are probably 3 to 6 months out of date when they are published.
What follows are some descriptions and definitions:
The balance sheet is a financial statement of a business that lists the assets, debts, and owners' investment as of a specific date - usually the last date of an accounting period. Assets are ordered according to how soon they will be converted into cash, and debts according to how soon they must be paid. Balance sheets do not list items at their current monetary value, so may greatly overstate or understate the real value of certain corporate assets and liabilities.
The balance sheet is often referred to as a 'snapshot' of the firm on a particular date - as if the auditor had visited the firm on a single day and taken photographs of all the various components that make up the business. It can only be constructed on one date, and not over a period of time, as the values for assets and liabilities change constantly. Single balance sheets just show how things are on a particular date. Balance sheets reveal the most information when they are compared with previous balance sheets, as that process shows the extent to which the business has changed; whether it has grown or contracted and how one part has grown or declined relative to another. This is rather like looking at photographs of yourself over a number of years - it tells a narrative about how you have changed. However, there is always a story behind those changes and this is what financial analysis, such as the use of ratios, attempts to establish and explain.
The balance sheet is split into two parts:
- A statement of fixed assets, current assets and the liabilities (sometimes referred to as "Net Assets")
- A statement showing how the net assets have been financed, for example through share capital and retained profits.
The law requires a balance sheet to be included in the published accounts of all limited companies. In reality, all organisations that use other people's money need to prepare accounts for external users, since it is an important to provide stakeholders with feedback about the financial affairs of the organisation.
However, a balance sheet does not necessarily provide a true value of a business, because assets and liabilities are shown are historic, and some intangible but valuable assets, such as brands, quality of management and goodwill are not included.
A balance sheet has the following title which shows it is a 'snapshot' at a particular time; this is usually the last date of the firm's financial year:
|Balance sheet for|
|as at 'a date'|
Profit and loss account
A profit and loss account is a statement recording all of a firm's revenues, costs and net income within a past trading period. The account shows gross and net profit or loss on trading.
The Profit and Loss account:
|Profit and loss account|
|for the year ended 'date'|
So balance sheets act as 'bookends' to a profit and loss account and cash flow statement.
It is conventional to give the last years accounts alongside the new ones. This enables comparisons to be made right from the start. A balance sheet will be headed like this:
|As at 1st January 2011|
Look at the data section of this unit where you will find a set of accounts for a fictitious company. These will be used later, but look at their format now, if you like (Click on the right arrow at the top or bottom of the page to see them).