How to account for End of Year
This is the final installment on our series on the dummies guide to Debits and Credits and we have made it through our first year of trading. We have looked at:
- Why we need to record sales and purchases to keep track of the timing differences between when the invoices are raised and when they are paid.
- To add insult to injury we have looked out how we journal for VAT and PAYE/NIC payments to HMRC.
In the last of the series we look at how to journal for the end of a financial year.
Cash Capital Investment
When we began all that time ago, we had our budding business owner who stumped up the cash to start their own business. The initial deposit into the bank account was not a sale and had to be classified as “Capital”. So in essence this is an asset, in this case cash, that the business owner had available to “invest” in the business. Our business owner took a punt that their business idea would be successful and make more of a return than any other investment opportunity available at that time. So they have made an assumption that profit generated would be greater than if they had received interest from a bank account, stocks and shares or increasing their pension pot.
This may seem a different point of view than what most business owners take. Entrepreneurs tend to simply start with an idea and either through sheer luck, or force of will get it to work, or not as the case may be. People start off in business for a variety of reasons, either a desire for independence, an inventive aspiration or simply an ego as stubborn as a mule, but from a financial point of view they are taking a chance that their idea can make them more money than any other financial vehicle available. It is an investment decision. How many business owners do you know thought about starting a business in that light, let alone be able to say what was the comparable interest rate of return would be in 12 month’s time.
Measuring the Success or failure
So, as with any other investment, there comes a point in time where one measures the success or failure of the venture. In most cases (Companies and Sole Traders) this is done on annual basis. In the UK if you are self-employed the end of trade is the 5th of April every year, for Companies it is determined by your “Accounting Reference Date” as determined by Companies House and is usually 12 months after the company was formed. At that time you calculate your total amount of sales, minus the cost of bringing those goods to market (materials, subcontractors) and then deduct your overheads (everything else you have to pay regardless of making a sale, such as rent or telephone).
If the figure is positive then you are in profit, if negative, a loss. Simple enough, but in relation to the “capital” input, it gives a percentage return on the business owners original investment. If in Profit then the owner has made a gain on his capital. If in loss, the capital input has been reduced.
If it is a positive amount then it is “Credited” into a capital” account and debited against the profit and loss accounts.
Starting position from our 1st article:
| Debit | Clic | ||
| Debtor | Credit | 0 | |
| Expense | 50 | Liability | |
| Asett | 150 | Income | 100 |
| Debit | Capital | 100 |
Proposed End of year journal: Income and expenses zeroed out and result declared in the profit and loss account.
| Debit | Credit | ||
| Income | 100 | ||
| Expense | 50 | ||
| Debit | P&L Account 50 | 50 |
Result at End of Year:
| Debit | Clic | ||
| Debtor | Credit | ||
| Expense | Liability | ||
| Asett | 150 | Income | |
| Debit | Capital | 100 | |
| P&L Account | 50 |
There are now 2 lines in the capital accounts, one for the original amount of £100 inputted the other the gain in profit of £50. This is represented by the £150 in the bank account. Notice that when the profit and loss is declared, all of the income and expense accounts are set back to zero, ready for transactions in the next financial year. This is now the balance sheet position, what the business owes and owns after the 1st years trading. So, in this case, our business owner has put £100.00 pounds in at the start of the year and after one year’s trade he has made £50.00 profit or a 50%.return on their investment. Of course this is not the full story as any profits are then taxed and this what your accountant will use as a basis for preparing your tax return. Profit is not always a good thing.
If in loss it’s “debited”, or reduced the capital account which means our original investor has lost money from their original input. With this information they can make a decision on whether they can make this back in future years or cut and run.
Declaring profit or loss
The process of declaring your profit and loss forces a business to look at their progress over a set time line and the financial records need to accurately reflect the company’s position at that point. The journals above are the principles for how these transactions are posted and figures understood.
These basic principles of accounting, that we have looked at in this series, should not only help keep track of accounts but also provide useful tools to help you run your business. It was said at the funeral of original CEO of General Electric that when looking over the consolidated accounts of this large multi-national organisation he could tell if the petty cash account was out. He had still kept the original financial disciplines in place from running a small enterprise to becoming a world recognised brand. This financial language is the building blocks of becoming better informed on how to run a successful business. It is hoped that in this series we have take some of the “dryness” out of the subject and shown how these principles become useful in everyday business life.
Malcolm Ford: has worked for the past five years within Systems Implementation upgrading business’s from Accounting Packages to Enterprise Level. He has had 25 years’ experience of business experience in a wide variety of sectors on two continents. He also runs training courses on how to run business’s more efficiently.
