Understanding Business Accounting For Dummies, 2nd Edition (18 page)

If HM Revenue and Customs comes in for a field audit of your business, you'd better have good audit trails to substantiate all your expense deductions and sales revenue for the year. Rules exist about saving source documents for a reasonable period of time (usually at least five years) and having a well-defined process for making bookkeeping entries and keeping accounts. Think twice before throwing away source documents. Also, ask your accountant to demonstrate, and lay out for your inspection, the audit trails for key transactions - such as cash collections, sales, cash disbursements, stock purchases, and so on. Even in computer-based accounting systems, the importance of audit trails is recognised. Well-designed computer programs provide the ability to backtrack through the sequence of steps in the recording of specific transactions. The HM Revenue and Customs Web site (go to
www.hmrc.gov.uk
and click on ‘Businesses and corporations') gives you the lowdown on which books to keep and for how long. You can search for info about any unlisted topics by using the search panel at the top of the homepage.

Look out for unusual events and developments

Business managers should encourage their accountants to be alert to anything out of the ordinary that may require attention. Suppose that the debtor balance for a particular customer is rapidly increasing - that is, the customer is buying more and more from your company on credit but isn't paying for these purchases quickly. Maybe the customer has switched more of his or her company's purchases to your business and is buying more from you only because he or she is buying less from other businesses. But maybe the customer is planning to stuff your business and take off without paying his or her debts. Or maybe the customer is secretly planning to go into bankruptcy soon and is stockpiling products before the company's credit rating heads south. To some extent, accountants have to act as the eyes and ears of the business. Of course, that's one of your main functions as business manager, but your accounting staff can play an important role as well.

Design truly useful accounting reports for managers

We have to be careful in this section; we have strong opinions on this matter. We have seen too many hit-and-miss accounting reports to managers - difficult to decipher and not very useful or relevant to the manager's decision-making needs and control functions.

Part of the problem lies with the managers themselves. As a business manager, have you told your accounting staff what you need to know, when you need it, and how to present it in the most efficient manner? Probably not. When you stepped into your position you probably didn't hesitate to rearrange your office and maybe even insisted on hiring your own support staff. Yet you most likely lay down like a lapdog regarding your accounting reports. Maybe you've assumed that the reports have to be done a certain way and that arguing for change is no use.

On the other hand, accountants bear a good share of the blame for the poor reports. Accountants should proactively study the manager's decision-making responsibilities and provide the information that is most useful, presented in the most easily digestible manner.

In designing the chart of accounts, the accountant should also keep in mind the type of information needed for management reports. To exercise control, managers need much more detail than what's reported on tax returns and external financial statements. And, as Chapter 9 explains, expenses should be regrouped into different categories for management decision-making analysis. A good chart of accounts looks to both the external and the internal (management) needs for information.

So what's the answer for a manager who receives poorly formatted reports? Demand a report format that suits your needs! See Chapter 9 for a useful profit analysis model (and make sure that your accountant reads that chapter as well).

Double-Entry Accounting for Non-Accountants

A business is a
two-sided
entity. It accumulates assets on one side - by borrowing money, persuading investors to put money in the business as owners, purchasing assets on credit, and making profit. Profit (net income) is essentially an increase in assets, not from increasing liabilities and not from additional capital infusion from owners, but rather as the net result of sales revenue less expenses. Assets don't fall on a business like manna from heaven. Assets have
sources
, and these sources are
claims
of one sort or another on the assets of a business. He asked the class, ‘Shouldn't a business keep track of the sources of assets, according to the type of claim each source has against the assets?' We all said ‘yes,' of course. He then told us that this is precisely the reason for and nature of
double-entry accounting.

The two-sided nature of a business entity and its activities

In a nutshell, double-entry accounting means
two-sided
accounting. Both the assets of a business and the sources of and claims on its assets are accounted for. Suppose that a business reports £10 million in total assets. That means the total sources of and claims on its assets are also reported at a total of £10 million. Each asset source has a different type of claim. Some liabilities charge interest and some don't; some have to be paid soon, and other loans to the business may not come due for five or ten years. Owners' equity may be mainly from capital invested by the owners and very little from retained earnings (profit not distributed to the owners). Or the mix of owners' equity sources may be just the reverse.

The sources of and claims on the assets of a business fall into two broad categories:
liabilities
and
owners' equity.
With a few technical exceptions that we won't go into, the amount of liabilities that the business reports are the amounts that will be paid to the creditors at the maturity dates of the liabilities. In other words, the amounts of liabilities are definite amounts to be paid at certain future dates.

In contrast, the amounts reported for owners' equity are
historical
amounts, based on how much capital the owners invested in the business in the past and how much profit the business has recorded. Owners' equity, unlike the liabilities of a business, has no maturity date at which time the money has to be returned to the owners. When looking at the amount of owners' equity reported in a balance sheet, don't think that this amount could be taken out of the business. Owners' equity is tied up in the business indefinitely.

So one reason for double-entry accounting is the two-sided nature of a business entity - assets are on one side and the sources of and claims on assets are on the other side. The second reason for double-entry accounting is the
economic exchange
nature of business activities, referring to the give-and-receive nature of the transactions that a business engages in to pursue its financial objectives. Consider a few typical transactions:

A business borrows £10 million. It receives money, so the company's cash increases. In exchange, the business promises to return the £10 million to the lender at some future date so the company's debt increases. Interest on the loan is paid in exchange for the use of the money over time.

The business buys products that it will later resell to its customers: It gives money for the products (the company's cash decreases) and receives the products (the company's stock increases).

The business sells products: It receives cash or promises of cash to come later (the company's debtors increase), and it gives the products to the customer (the company's stock decreases). Of course, the business should sell the products for more than cost. The excess of the amount received over product cost is called
gross profit
, from which many other expenses have to be deducted. (Chapter 5 explains the profit-making transactions leading to bottom-line profit or loss.)

Recording transactions using debits and credits