Understanding Business Accounting For Dummies, 2nd Edition (45 page)

For most businesses, a small part of their total annual interest is unpaid at year-end; the unpaid part is recorded to bring the expense up to the correct total amount for the year. In Figure 6-2, the accrued amount of interest is included in the more inclusive accrued expenses payable liability account. You seldom see accrued interest payable reported on a separate line in a balance sheet unless it happens to be a rather large amount or if the business is seriously behind in paying interest on its debt.

Income tax expense

In Figure 6-2, earnings before income tax - after deducting interest and all other expenses from sales revenue - is £2,400,000. (The actual taxable income of the business for the year probably would be somewhat more or less than this amount because of the many complexities in the income tax law, which are beyond the scope of this book.) In the example we use a tax rate of one-third for convenience, so the income tax expense is £800,000 of the pre-tax income of £2,400,000. Most of the income tax for the year must be paid over to HM Revenue and Customs before the end of the year. But a small part is usually still owed at the end of the year. The unpaid part is recorded in the
income tax payable
liability account - as you see in Figure 6-2. In the example, the unpaid part is £80,000 of the total £800,000 income tax for the year - but we don't mean to suggest that this ratio is typical. Generally, the unpaid income tax at the end of the year is fairly small, but just how small depends on several technical factors. You may want to check with your tax professional to make sure you have paid over enough of the annual income tax by the end of the year to avoid a penalty for late payment.

The bottom line: net profit (net income) and cash dividends (if any)

A business may have other sources of income during the year, such as interest income on investments. In this example, however, the business has only sales revenue, which is gross income from the sale of products and services. All expenses, starting with cost of goods sold, down to, and including, income tax, are deducted from sales revenue to arrive at the last, or bottom-line, of the profit and loss account. The preferred term for bottom-line profit is
net income
, as you see in Figure 6-2.

The £1,600,000 net income for the year increases
retained earnings
by the same amount, hence the line of connection from net income and retained earnings in Figure 6-2. The £1,600,000 profit (here we go again using the term profit instead of net income) either stays in the business, or some of it is paid out and divided among the owners of the business. If the business paid out cash dividends from profit during the year, these cash payments to its owners (shareholders) are deducted from retained earnings. You can't tell from the profit and loss account or the balance sheet whether any cash dividends were paid. You have to look in the cash flow statement for this information - which is explained in Chapter 7.

Financing a Business: Owners' Equity and Debt

You may have noticed in Figure 6-2 that there are two balance sheet accounts that have no lines of connection from the profit and loss account - loans and owners' invested capital. Revenue and expenses do not affect these two key balance sheet accounts (nor the fixed assets account for that matter, which is explained in Chapter 7). But, both debt and owners' invested capital are extremely important for making profit.

To run a business you need financial backing, otherwise known as
capital.
Capital is all incoming funds that are not derived from sales revenue (or from selling off assets). A business raises capital by borrowing money, getting owners to invest money in the business, and making profit that is retained in the business. Borrowed money is known as
debt
;
invested money and retained profits are the two sources of
owners' equity
. Those two sources need to be kept separate according to the rules of accounting. See Chapters 5 and 9 for more about profit.

How much capital does the business shown in Figure 6-2 have? Its total assets are £14,080,000, but this is not quite the answer. The company's profit-making activities generated three operating liabilities - creditors, accrued expenses payable, and income tax payable - and in total these three liabilities provided £2,080,000 of the total assets of the business. So, deducting this amount from total assets gives the answer: the business has £12 million in capital. Where did this capital come from? Debt provided £5 million and the two sources of owners' equity provided the other £7 million (see Figure 6-1 or 6-2 to check these numbers).

Creditors, accrued expenses payable, and income tax payable are short-term, non-interest-bearing liabilities that are sometimes called
current liabilities
because they arise directly from a business's expense activities - they aren't the result of borrowing money but rather are the result of buying things on credit or delaying payment of certain expenses.

This particular business has decided to finance itself through debt and equity in the following mix:

Debt £5,000,000

Owners' equity
7,000,000

Total sources of capital £12,000,000

Deciding how to divide your sources of capital can be tricky. In a very real sense, the debt-versus-equity question never has a final answer; it's always under review and reconsideration by most businesses. Some companies, just like some individuals, are strongly anti-debt, but even they may find that they need to take on debt eventually to keep up with changing times.

Debt is both good and bad, and in extreme situations it can get very ugly. The advantages of debt are:

Most businesses can't raise all the capital they need from owners' equity and debt offers another source of capital (though, of course, many lenders may provide only half or less of the capital that a business needs).

Interest rates charged by lenders are lower than rates of return expected by owners. Owners expect a higher rate of return because they're taking a greater risk with their money - the business is not required to pay them back the same way that it's required to pay back a lender. For example, a business may pay 8 per cent interest on its debt and have to earn a 13 per cent rate of return on its owners' equity. (See Chapter 14 for more on earning profit for owners.)

The disadvantages of debt are:

A business must pay the fixed rate of interest for the period even if it suffers a loss for the period.

A business must be ready to pay back the debt on the specified due date, which can cause some pressure on the business to come up with the money on time. (Of course, a business may be able to
roll over
its debt, meaning that it replaces its old debt with an equivalent amount of new debt, but the lender has the right to demand that the old debt be paid and not rolled over.)