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Accounting and Business
Valuation Methods
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Accounting and Business
Valuation Methods
Malcolm K. Howard




AMSTERDAM • BOSTON • HEIDELBERG • LONDON
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Contents

List of Figures ix

Acknowledgements xi

Introduction: How to interpret IFRS Accounts xiii

1 Telling the story 1
Basic principles of accounting 3
Case study “ Amanda 7
Value added tax 10
Amanda™s transactions 13
Amanda™s reconciliations 21
The Trial Balance 24
The Profit and Loss Account 29
The Balance Sheet 34
Case study “ Amanda 43
The working capital cycle 43
Negotiating with banks 45
Asset management 50
Amanda™s meetings 60
Discussion Questions 62

2 Capital structure and basic tools of analysis 65
Case study “ Amanda™s lawyer introduces her to a
financial adviser 67
Capital structures “ venture capital (private equity) 68
The Enterprise Investment Scheme 71
Investment rules 75
Venture capital trusts 76
The Alternative Investment Market 77
Capital structures 78
Gearing 87
The weighted cost of capital 88
Case Study “ Amanda™s meeting her solicitor and his
recommended financial adviser 89
The financial planning process 90

v
Contents

Case study “ Amanda “ the deal structure 103
Capital structure summary and exit strategies 118
Basic tools of analysis 119
The key ratios 128
Case study “ Amanda™ completion meeting 132
Discussion Questions 133

3 Financial reporting and IFRS 137
Accounting is a series of judgements 139
The Auditors™ Report and their responsibilities 143
The limitations of the Independent Auditors™ Report 144
What happens when directors and auditors cannot agree 146
International Financial Reporting Standards 147
Revenue recognition 156
Research and development (notes 1 and 9) 157
Share-based payments (notes 2 and 8) 157
Intangible assets (notes 1 and 3) 165
Investment property and investment property under
development (Case Study: UNITE Group plc) 167
Dividends (note 4) 171
Salary-related pension schemes (note 5) 172
Financial derivatives (note 11) 175
Leases 178
Minor adjustments 179
IFRS vs. UK GAAP summary 179
Corporate governance 181
The Report of the Directors 184
The Directors™ Remuneration Report 185
Optional (non-statutory) reports 185
Annual Report “ Summary 186
The Sarbanes-Oxley Act 187
Shareholders™ power 190
Discussion Questions 191

4 Assessing risk and valuing companies 193
Amanda “ Case Study “ The acquisition of her company 195
Choice of investments 196
Risk 196
Portfolio theory 198

vi
Contents

The experiment 203
Risks associated with taking on unique risk 207
Assessing company performance 209
Basic checks 218
Valuation techniques 222
The BVCA Code of Conduct 222
Final Review 234
Why the market sometimes gets it painfully wrong 239
Restructuring “ a strategy to move the share price upwards 240
Profit Warnings 241
Takeover bids 243
Case study “ Amanda “ the conclusion 244
Discussion Questions 245

Case studies 247

Solutions to discussion questions 275

References 283

Index 289




vii
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List of Figures

Figure 1.1 Case study “ Amanda “ transactions (double entry) 14
Figure 1.2 Case study “ Amanda “ Trial Balance 25
Figure 1.3 Case study “ Amanda “ Profit and Loss Account 34
Figure 1.4(a)
Case study “ Amanda “ Balance Sheet (prior to UK
GAAP) 35
Figure 1.4(b) Case study “ Amanda “ Balance Sheet 36
Figure 1.5 Case study “ Amanda “ Trial Balance (after completion
of 2004 accounts) 41
Figure 1.6 Case study “ Amanda “ reversible entries 42
Figure 2.1 Case study “ Amanda “ 5-year plan “ base estimates 91
Figure 2.2 Case study “ Amanda “ 5-year plan “ Earnings Statement
(prior to equity investment) 95
Figure 2.3 Case study “ Amanda “ 5-year plan “ Balance Sheet
(prior to equity investment) 97
Figure 2.4 Case study “ Amanda “ 5-year plan “ calculation of loans
and interest (prior to equity investment) 102
Figure 2.5 Case study “ Amanda “ 5-year plan “ Earnings Statement 108
Figure 2.6 Case study “ Amanda “ 5-year plan “ Balance Sheet 109
Figure 2.7 Case study “ Amanda “ 5-year plan “ calculation of loans
and interest 111
Figure 2.8 Case study “ Amanda “ 5-year plan “ Cash Flow
Statement 114
Figure 2.9 A Food Manufacturing Co. “ Profit and Loss Account and
Balance Sheet 120
Figure 2.10 A Food Manufacturing Co. “ Cash Flow Statement 131
Figure 3.1 A Food Manufacturing Co. “ Profit and Loss Account
(IFRS vs. UK GAAP) 151
Figure 3.2 A Food Manufacturing Co. “ Balance Sheet (IFRS vs.
UK GAAP) 152
Figure 3.3 A Food Manufacturing Co. “ Cash Flow Statement (IFRS
vs. UK GAAP) 153
Figure 3.4 UNITE Group plc “ Income Statement for 2004 to 2006 168
Figure 3.5 UNITE Group plc “ Balance Sheet for 2004 to 2006 169
Figure 4.1 Con Glomerate plc “ Income Statement for year ended
31 December 2006 210
Figure 4.2 Con Glomerate plc “ Balance Sheet at 31 December 2006 211

ix
List of Figures

Figure 4.3 Con Glomerate plc “ Part Cash Flow Statement for the
year 31 December 2006 212
Figure 4.4 Con Glomerate plc “ revised Earnings Statement (revised
Figure 4.1) 214
Figure 4.5 Con Glomerate plc “ revised Part Cash Flow Statement
(revised Figure 4.3) 217
Figure 4.6 Formula to calculate discount factors 219
Figure 4.7 Discounted cash flow for Con Glomerate plc 220
Figure 4.8 Con Glomerate plc “ growth factor required to achieve
a 15% return 221
Figure 4.9 Formula to calculate growth built into share price 228
Figure 4.10 Formula to calculate price needed to achieve IRR with
forecast growth 229
Figure 4.11 Formula to calculate growth built into share price “
Con Glomerate plc 230
Figure 4.12 Formula to calculate Con Glomerate™s share price to
achieve IRR 231




x
Acknowledgements

The author would like to thank the following individuals:

Michael Glover for suggesting this book should be written in the first place and
for his editing of the HgCapital Trust plc case study.

Dr Dermot Golden, Paddy Power plc™s Head of Risk, for the help in writing that
company™s case study.

His son, Philip Howard, a mathematics graduate from Pembroke College,
Oxford, for providing and explaining the Black-Scholes formula.

Geoffrey Pickerill, a lawyer specialising in mergers and acquisitions, for his
valuable advice.

The author would also like to thank the following organisations:

The British Venture Capital Association for granting permission to reproduce
their Code of Conduct and extracts from their ˜International Private Equity And
Venture Capital Valuation Guidelines™.

Oxford University Press for granting permission to reproduce extracts from
˜3i “ Fifty Years Investing in Industry™.

In addition, the author would like to thank the directors of the following
companies for granting permission to reproduce their company™s accounts:

HgCapital Trust plc
Morrison (Wm) Supermarkets plc
Paddy Power plc
Topps Tiles plc
UNITE Group plc




xi
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Introduction: How to interpret IFRS Accounts

This book explains the methods used in accounting and business valuations
by using the fictional story of a new start-up business, from original concept to
eventual acquisition. Enamoured with entrepreneurial spirit, a business woman
buys her family™s secret salad dressing recipe from her brother and sets up a
business. Chapter 1 illustrates double entry bookkeeping and how to prepare
a Trial Balance, Profit and Loss Account and Balance Sheet and also discusses
the working capital cycle, asset management and how to negotiate with banks.
At the forefront of this chapter is how the combination of inexperience and
insufficient funds can lead to near disaster, which is clearly illustrated via the
fictional story.

Chapter 2 shows how to produce a 5-year plan and discusses capital structures
and the importance of getting gearing right. The fictional business woman,
Amanda, raises equity through a wealthy business angel who operates as if he
were a venture capital firm. This chapter discusses the basic tools of analysis
to enable Amanda to assess her business and which ratios are of utmost impor-
tance in certain circumstances. Finally, Amanda is made aware that controlling
cash is a key requirement in any business and why the Cash Flow Statement is
probably the most important statement in a set of accounts. The reader learns
the possible exit strategies for a small business in this position.

Chapter 3 covers financial reporting and the International Financial Reporting
Standards (IFRS) used by quoted companies that replaced UK GAAP (generally
accepted accounting principles). We see that the Profit and Loss Account is
replaced by an Income Statement and that the Balance Sheet and Cash Flow
Statement use different terminology and have a different format than before.
We discuss the essential changes from UK GAAP to IFRS being the move
away from historical cost accounting to fair value accounting and how the new
system is less prudent than the old.

In Chapter 4, Amanda receives a telephone call that leads to the sale of her
business and a new company is set up by her acquirer. She becomes a director
of the new company: after all taxes are paid she has over £1 million in the bank
and considers building an external portfolio. This chapter illustrates how IFRS
accounts might be interpreted and how such evaluations can sometimes give
the assessor a small advantage in the market place. Different methods used

xiii
Introduction: How to interpret IFRS Accounts

to value companies are illustrated. Four case studies featuring real events and
real company accounts illustrate the points made in this chapter.

Accounting students are often faced with a series of bland exercises, none of
which relates to each other; accordingly, to many the subject is uninteresting.
But accounts often tell an interesting story, in numbers rather than in words.
The fictional story of Amanda was chosen to illustrate this, but in addition it is
designed to help readers with entrepreneurial spirit to understand the financial
challenges they will face when they start a business and how they might make
profitable investments after they have been successful.




xiv
1
Telling the story
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Telling the story

Chapter 1 explains that accounts tell a story, but in numbers rather than words.
The story in this chapter is about Amanda and how, armed with an inherited
secret recipe, she started a business selling salad dressing. She had a traumatic
time in her first year nearly losing her business, but was determined to learn
from her mistakes to put herself on the road to recovery. This chapter describes
the process from the first transaction through to producing a Profit and Loss
Account and Balance Sheet and the steps that need to be taken to have a
financially sound business.
The topics covered are the following:


• Basic principles of accounting
• Primary and secondary books of account
• Accounting conventions
• Double entry bookkeeping
• How to account for value added tax (VAT)
• How to reconcile accounts with externally provided information
• How to prepare and examine the Trial Balance
• How to prepare the Profit and Loss Account and Balance Sheet
• Post year-end entries
• The working capital cycle
• How to negotiate with banks
• Asset management




Basic principles of accounting
Accounting has been around for thousands of years and yet, perhaps like an
elephant, it is easier to recognise than to define, but a useful (and much
quoted) assessment of what it is has been defined by the American Accounting
Association:

the process of identifying, measuring and communicating economic informa-
tion to permit informed judgements and decisions by the users of the information

(Source: Accounting Manual, originally devised by Alex Noble for the School of
Management for the Service Sector, University of Surrey.)

The word ˜judgements™ is shown in italics for, as this book discusses, this is a
key word and its significance needs to be taken on board straight away.

3
Accounting and Business Valuation Methods

There are many potential users of published accounts, including shareholders
and potential investors, bankers and other lenders, suppliers, customers, com-
petitors and those responsible for collecting taxes.

Accounts can be prepared for a sole trader, partnership or limited company.
Limited companies fall into two categories: private limited companies, where
the shares are owned by the owners of the business and not available to
the general public, and public limited companies (plc™s), where the shares
are available to the general public and can be bought on a recognised stock
exchange. In the case of published accounts for a limited company (private
or plc), the accounts will relate to the company and such company will be a
separate entity from its shareholders, directors and employees.

To prepare accounts, accountants keep several primary books of account:

The cash book “ records entries that match the company™s bank accounts.
The petty cash book “ records petty cash held outside the cash book.
The purchase ledger “ records buying transactions and creditor balances.
The sales ledger “ records sales transactions and debtor balances.
Stock records “ records details of each stock item, showing the stock balance
at any given time.
The plant (or fixed asset) register “ records asset purchases and disposals
together with the appropriate depreciation rates and charges.

A summary of the entries made in the primary books of account will be posted
to the secondary book of account “ the nominal ledger. Accounting is based
on the principle of double entry, where for every transaction there is a debit
(relating to what has come in) and a credit (relating to what has gone out).
For example, if an authorised employee of a company bought goods for resale
(stock) costing £100, the entry in the company™s books would be debit ˜stock™
for £100 and the credit entry would be credit ˜cash™ with £100 if cash was paid
(cash in this context means cash or any transaction involving a bank, such as a
cheque) or credit ˜creditors™ with £100 if the goods were not paid for at the time
they were bought. Sometimes a transaction requires two debits and two credits.
This happens when one transaction triggers another. For example, suppose the
stock purchased for £100 was sold for £160 to someone who agreed to pay
30 days later. In this case, the transaction would be debit ˜debtors™ with £160
and credit ˜sales™ with £160. But if the stock has been sold, then it must be
taken out of stock, so there need to be a second entry, which would be debit
˜cost of sales™ £100 and credit ˜stock™ £100.

4
Telling the story

From this example, it can be seen that ˜cash received™ is always a debit, while
˜cash paid™ is always a credit. Students often say that this cannot be correct as
if they have cash in the bank, it is always shown as a credit. Well the answer is
that accounting is all about opposites. If you have cash in the bank, it will be a
debit in your books, but a credit in the bank™s books because as far as the bank
is concerned, they owe you money and therefore they see you as a creditor.
Knowing that a credit balance on your bank statement means you have cash in
the bank leads to another misconception that credits must be good and debits
must be bad. The truth is that debits are neither good nor bad, likewise credits.
If you have a debit balance, then the account must either be an expense or an
asset, while a credit balance must be either income or liabilities.
Before the entries are complete for any accounting period, the accountant must
ensure that a number of accounting conventions, or rules, have been followed:
The matching concept states that sales must be matched with the total cost
of achieving those sales in a given period. This gives rise to accruals and
prepayments. An accrual arises when goods or services have been received
and the cost of such goods or services has not been recorded in the books.
For example, stock might be received on the last day of the accounting period,
and counted in stock, but the invoice from the supplier of that stock might not
arrive until well into the new accounting period. A prepayment is the opposite,
where a charge has been made in advance of the service being purchased. For
example, a company might negotiate a rent for a period of 2 years and has to
pay up front. Assuming that the company™s year end finished at the end of
the first year of rent, then one-half of the amount paid would be treated as a
prepayment.
The prudence concept states that assets in the Balance Sheet must not be
overstated and liabilities in the Balance Sheet must not be understated. This
means, in particular, that all assets should be reviewed before the entries are
finalised. Current assets (stocks, debtors and cash) should be reviewed to ensure
their valuation could be justified while fixed assets must be appropriately
depreciated (tangible assets) or amortised (intangible) assets. However, it will
be appreciated that such reviews will always be a matter of judgement.
Historical cost convention (UK Generally Accepted Accounting Practice) (GAAP)
states that costs are recorded in the books at their actual (historical) cost. For
example, a businessman buys a car privately for £7000, but believes the fair
value of such car, based on the car guides in his possession, is £10 000. The
debit and credit would be recorded as £7000. However, where an asset, such

5
Accounting and Business Valuation Methods

as land, has increased in value over time, then it is a standard practice to show
the correct value of the asset in the books. For example, a land was purchased
in 1980 for £50 000, but in 2006 it has a valuation of £750 000. Over this time,
the asset would have been debited with £700 000 and a capital reserve of an
equal amount would have been created.

Fair Value Accounting (International Financial Reporting Standard) (IFRS). With
effect from 2005, public companies™ published accounts must be prepared using
international standards. The main difference between UK GAAP and IFRS is
that the latter accounts are prepared not on an historical cost basis, but rather
on a ˜fair value™ basis. What this means is that the Profit and Loss Account
must be charged with the ˜fair value™ of any contracted position, even where
the actual transaction will take place in the future and might not even take
place at all.

Under IFRS, the Balance Sheet must reflect the ˜fair value™ of the assets and
liabilities at the Balance Sheet date. As an example, a company buys assets
costing £10 000 and believes that these assets will be in use for 5 years. At the
end of the second year, the directors believe that the assets in question could
be sold for £7000. Under UK GAAP, the assets would be valued at £6000 at
the end of the second year (£10 000 multiplied by 60%), while under IFRS, it
would be shown in the Balance Sheet with a value of £7000. To achieve this,
the cumulative depreciation charge of £4000 would be reduced to £3000.

It can be seen that under IFRS, those reading published accounts will be ever
more reliant upon the judgements made by the directors of the company being
reviewed. The implications of this and the significant differences between the
two systems will be discussed in following chapters.

Accounts tell a story and should be read like a book; sometimes a mystery
it has to be said, but nevertheless a book. Accounts are sometimes cryptic
and difficult to understand, but what the reader is trying to do is to deduce
the story. Reading accounts can be likened to solving a code or completing a
jigsaw puzzle, but get the storyline right and it can be very rewarding. In a set
of published accounts there are plenty of clues for as well as the main body
of the accounts there are attached notes and many individual reports. To the
uninitiated, some of the jargons will look like a secret code, but one of the
purposes of this book is to help the reader decipher such code.

To do this, we will first start with a story and show how this story builds
up into a full set of accounts. This story is all about Amanda and how she

6
Telling the story

became a sole trader with near fatal results, but was determined to learn from
the mistakes she had made and put herself on the road to recovery.



Case study “ Amanda
Amanda inherited £50 000 and her brother inherited £20 000, plus their fam-
ily™s secret recipe for salad dressing, a formula developed a few generations
earlier. The brother was not interested in this recipe, but Amanda saw that it
had the potential to generate a successful business.

Starting a new business and taking risks associated with being self-employed
seemed daunting. However, Amanda recalled a lecture on Entrepreneurship;
the lecturer had said that the opportunity to start your own business does not
often happen and you might wonder for the rest of your life what might have
been if you lacked courage at the very time it was needed.

Amanda approached her brother about buying the recipe but he was reluctant
to sell. It might be very valuable, he suggested, although he had no idea of
how he could make money out of it. Eventually, she persuaded him to sell
for £40 000. She put the remaining £10 000 into her newly opened business
account.

The amount of £10 000 was an insufficient capital to allow Amanda to set
up a factory, especially as she expected it would be some time before she
received her first order. Nevertheless, Amanda started to develop a plan to start
producing her product.

Her first step was to produce a sample batch in her jam pan and fill into old
bottles that had been sterilised. These samples cost £2000 to produce, which
she paid out of her business account. Amanda approached supermarket buyers
with samples of the dressing. She found them very accommodating, and four
companies agreed to give her a trial order paying 50 pence per bottle, or £50
per case, each case containing 100 bottles.

With this success, she started to put together a business plan, the starting point
being her forecasted sales for the first year. She wanted to make sure that her
bank manager had read and understood her plan and was willing to back it on
its merits. She felt that she had achieved this when the bank agreed to lend
her £250 000 and accept a fixed and floating charge on the business™s assets as
security, conditional upon debtors being insured. The premium for this turned
out to be £200 plus 2% of ˜debtor™ value, inclusive of all taxes. The ˜debtor™

7
Accounting and Business Valuation Methods

value was defined as ˜sales value plus VAT™, but as Amanda was going to sell a
product that was counted as food and was, therefore, zero rated, ˜debtor value™
was the same as ˜sales value™. The premium was paid in full before the year end.

The next step was to carry out some basic research to find out how much it
would cost to set up a small factory to manufacture the product. This took
several weeks making telephone calls, receiving e-mails and quotations, but at
the end of this process, Amanda realised that £250 000 simply was not enough
money. So she found a food manufacturer that was willing to produce her
salad dressing whilst ensuring that her intellectual property was safe. Zehin
Foods plc agreed to manufacture the salad dressing in accordance with the
formula supplied to them for 40 pence per bottle, or £40 per case. However,
in recognition of the product development costs associated with scaling up
from Amanda™s formula, it was agreed that she would pay a one-off charge of
£12 000 (plus VAT at the standard rate) and would agree to order a minimum
of 12 000 cases per year from Zehin Foods plc, for a minimum of 5 years. If in
any year during this period she failed to order the minimum quantity, she had
to pay the manufacturer an additional £10 000.
Amanda™s solicitor told her that she must register for VAT, which she did. He
also drew up the contract between Amanda and Zehin Foods plc for which he
charged £5000, plus VAT at the standard rate of 17.5%.
On 1 January 2004, Amanda placed an order for 12 000 cases of salad dressing
at £40 per case, the product to be delivered at the rate of 1000 per month. Credit
terms were agreed at strictly 30 days and at the year end, only one delivery
costing £40 000 was still to be paid.
In the year ended 31 December 2004, sales had been made to the customers
shown, as follows:


ABZ Ltd CDZ Ltd EFZ Ltd GHZ plc

Cases 3600 1400 1500 3300
180 000 70 000 75 000 165 000



Payments made by these companies during the year had been:


£ 150 000 35 000 60 000 132 000


8
Telling the story

Amanda needed to control the selling and supply operation, so she rented an
office for £20 000 and bought fixtures and fittings for this at a cost of £5875,
inclusive of VAT at the standard rate. She also bought a van for £17 625
(of which £2625 was VAT) and rented a warehouse at a cost of £12 000. In
Amanda™s case, there was no VAT on rented items. She had paid in full for all
these items by the year end.

The cost of delivering 9800 cases of salad dressing was £16 000 (plus VAT at the
standard rate), which included all costs associated with running the van. The
other expenditures that had been paid in full had been £600 for stationery (plus
VAT at the standard rate), £1500 for insurances, £9000 wages and £1000 for
national insurance. Insurances, wages and national insurance were not subject
to VAT.

As she had registered for VAT, this meant that although she had no output VAT,
she had input VAT, which was recoverable from Revenue and Customs. How-
ever, Amanda did not opt to go onto monthly VAT and submitted returns on a
quarterly basis. During the year she received a cheque for £7000 from Revenue
and Customs, being the amount of VAT she had paid in the first 9 months.

Fixtures and fittings were expected to last for 4 years and would be depreci-
ated using the straight line method. The van was expected to last for 3 years
and would be depreciated using the reducing balance method. The office and
warehouse rent paid covered 2 years and ended on 31 December 2005. £1800
wages and £200 national insurance had been incurred, but remained unpaid
on 31 December 2004.

Just before her year end, Amanda telephoned her accountant to ask how much
he would charge for preparing her accounts and for calculating her tax liabili-
ties. He told her that the amount he would have to charge would be dependent
on the time it took, but his best guess was that his charges would amount to
£1200. Not being registered for VAT, this would be the final figure.

At the end of January 2005, Amanda received a telephone call from CDZ Ltd.
They said that they had received several complaints from their customers about
the product and due to the volume of such complaints they had taken her
product off the shelves. They were returning 200 cases and wanted to receive
full credit. In addition, they said that it would cost £500 to return these cases
and wanted reimbursing for this also.

When these cases were returned, Amanda took a sample of 100 bottles and
tasted them. She believed that there was nothing wrong with them and believed

9
Accounting and Business Valuation Methods

she could sell the remaining 199 cases to cost cutter stores for £41 per case.
It would cost her £398 to deliver these 199 cases. This story now has to be
converted into a set of accounts, comprising a Profit and Loss Account and a
Balance Sheet, but before this we need to understand VAT.


Value added tax
VAT replaced purchase tax and was designed to cover services and goods. It
was called ˜value added tax™ as it was (and is) simply a tax on added value
with only the end user (the person getting the benefit of the cumulative added
value) actually paying any tax.

If you are in business with an annual turnover of £61 000 or more (with effect
from 1 April 2006), you must register as a taxable person, although you can
apply to be exempt if all your supplies are zero rated (Source: Revenue and
Customs website). If you do not have a business with an annual turnover of
£61 000, for example, if you are an employee in someone else™s business, then
you are exempt from VAT.

This notion of being ˜exempt™ is rather curious. The Concise Oxford dictionary
defines ˜exempt™ as ˜free from an obligation or liability, etc. imposed on others,
especially from payment of tax™. In the case of VAT, being ˜exempt™ means the
opposite of this, as it means being exempt from accounting for VAT and having
dealings with Revenue and Customs with regard to VAT. However, the only
people who actually pay VAT are those classified as ˜exempt™.

Goods and services supplied by business fall into four categories:
(1) Those that are subjected to VAT at the standard rate of 17.5%.
(2) Those that are subjected to VAT at the lower rate of 5%.
(3) Those that are zero rated.
(4) Those that are exempted.
If you are registered for VAT and your goods and services are chargeable at the
standard rate, then you charge your customer VAT at the standard rate (output
tax) and recover VAT on your purchases (input tax).

Wherever there is a chain, it works out as follows:
˜A™ makes a particular part and charges ˜B™ £40.
˜B™ continues to work on the part to refine it and sells it to ˜C™ for £120.
˜C™ takes the refined part, makes further adjustments and sells it to ˜D™, the
end user and exempt person, for £200.

10
Telling the story

With VAT added:

A charges B £40 + VAT £7 = £47.00 in total.
B charges £120 + VAT of £21 = £141 in total.
C charges £200 + VAT of £35 = £235 in total.

A pays £7 to Revenue and Customs, but as B has paid this, it has cost A nothing.
B pays £14 to Revenue and Customs, being £21 charged to C, less £7 paid to A.
Again this has cost B nothing. C pays £14 to Revenue and Customs, £35 being
charged to D, less £21 paid to B. Like A and B, C has paid nothing.

What has happened is D has paid £35 as VAT, which cannot be recovered, but
this money has been paid over to Revenue and Customs by A, B and C.

The entry for VAT in the books is straightforward. In the case of B, assuming
A offered credit and C was being allowed credit, the entries would be:


Purchases ¦¦¦.. Debit £40

VAT ¦¦¦.. Debit £7
Creditors ¦¦¦.. Credit £47




Sales Credit £120

VAT Credit £21
Debtors Debit £141



Whether goods and services are to be charged at the standard rate, reduced rate
or zero rate is not always easy to ascertain. For example, food is normally zero
rated, provided it is of a kind used for human consumption. A food is deemed
fit for human consumption if:

the average person, knowing what it is and how it is used, would consider
it to be food or drink; and it is fit for human consumption.

However, dietary supplements, food additives and similar products, although
edible, are not generally regarded as food and would not be zero rated, but
products like flour, although not eaten by themselves, are generally recognised
food ingredients and would be zero rated.

11
Accounting and Business Valuation Methods

With regard to ingredients and additives used in home cooking and baking,
prepared cake, sauce, soup and other mixes, vegetable oil, corn oil and olive
oil are all zero rated, while mixes for ice cream and similar frozen products,
linseed oil and essential oils are standard rated.

You can zero rate chocolate couverture, chips, leaves, scrolls, etc, for the pur-
pose of cake decorations, but chocolate buttons must be standard rated as these
are regarded as confectionery.

(Source of information with regard to VAT classification of food (as above): HMRC
Reference Notice 701/14 (May 2002) taken from HM Revenue and Customs
website.)

What this demonstrates is that with regard to VAT it is never safe to assume
anything and that any person registered for VAT should consult the Revenue
and Customs helpline (number available from their website) if they are in
any doubt as to how VAT should be charged on any of their products or
services.

An important aspect of this tax for such VAT-registered businesses is the ˜tax
point™. This is the point at which the VAT output must be put through the
books. The tax point is deemed to be the earlier of the date at which the sales
invoice is issued or payment for the goods or service is received. In the latter
case, a sales invoice will be raised to reflect the payment received. This rule
can create a problem for businesses with poor credit control as it can mean that
VAT is due to be paid to Revenue and Customs before the equivalent amount
has been received from the debtor.

Revenue and Customs recognises this problem and if a business has an annual
turnover of not more than £660 000 (excluding VAT) then it may opt to account
for VAT on a cash basis. This means that the tax point is determined by the
dates cash is received and paid, not by invoice dates. Obviously, this option is
not advisable for those businesses with good credit control, especially if they
tend to take extended credit from their suppliers. Businesses opting to pay VAT
on a cash accounting basis can continue to do so until their annual turnover
reaches £825 000 (excluding VAT).

(Source: Revenue and Customs website. Figures shown are as at the midpoint
of the 2006/7 tax year.)




12
Telling the story

There are other options available to small businesses, full details of which are
available from Revenue and Customs.


Amanda™s transactions
From the above storyline, we can list Amanda™s transactions in her first year:

(1) Received £50 000 inheritance, paid £40 000 for secret salad dressing
formula and banked £10 000.
(2) Produced samples costing £2000, paying cash.
(3) Borrows £250 000 from bank.
(4) Pays debtor insurance costing £10 000.
(5) Pays setting up costs of £12 000, plus VAT of £2100 (multiply £12 000
by 0.175 to calculate VAT of £2100).
(6) Pays legal costs of £5000, plus VAT of £875.
(7) Purchases 12 000 cases of salad dressing costing £480 000 and pays
supplier of salad dressing £440 000.
(8) Sells 9800 cases of salad dressing on credit for £490 000 and receives
£377 000 from debtors.
(9) Pays office rent of £20 000.
(10) Buys fixtures and fittings costing £5000, plus VAT of £875 (divide
£5875 by 1.175 to arrive at a cost excluding VAT), paying cash.
(11) Buys van for £15 000, plus VAT of £2625, paying cash.
(12) Rents warehouse for £12 000, paying cash.
(13) Incurs delivery costs of £16 000, plus VAT of £2800, paying cash
(14) Incurs stationery costs of £600, plus VAT of £105, paying cash.
(15) Pays general insurances of £1500.
(16) Pays wages of £9000.
(17) Pays national insurance of £1000.
(18) She received £7000 from Revenue and Customs.

We now have to complete a double entry to reflect all of these transactions.
These are shown in Figure 1.1, being transactions numbered 1 to 18. Having
completed the double entry for each transaction, the next step for Amanda is
to reconcile her nominal ledger with her primary books of account. Of course,
these days both the primary books and nominal ledger are computerised; nev-
ertheless, they must still be reconciled.




13
Accounting and Business Valuation Methods




Capital
Number Debit £ Number Credit £


1 50,000




Cash at bank
Number Debit £ Number Credit £


1 50,000 1 40,000
2 2,000
3 250,000
4 10,000
8 377,000
5 14,100
18 7,000
6 5,875
7 440,000
9 20,000
10 5,875
11 17,625
12 12,000
13 18,800
14 705
15 1,500
16 9,000
17 1,000
19 85,300
Balance 220
684,000 684,000
Balance b/d 220


Figure 1.1 Case study “ Amanda “ transactions (double entry)




14
Telling the story


Goodwill (intangible asset)
Number Debit £ Number Credit £


1 40,000 21 15,000
Balance 25,000
40,000 40,000
Balance b/d 25,000



Samples
Number Debit £ Number Credit £


2 2,000




Loan
Number Debit £ Number Credit £


19 50,000 3 250,000
Balance 200,000

250,000 250,000

Balance b/d 200,000



Debtor insurance
Number Debit £ Number Credit £


4 10,000




Setting-up costs
Number Debit £ Number Credit £


5 12,000


Figure 1.1 (Continued)

15
Accounting and Business Valuation Methods


VAT
Number Debit £ Number Credit £


5 2,100 18 7,000
6 875
10 875
11 2,625
13 2,800
14 105
Balance 2,380
9,380
9,380
Balance b/d 2,380



Legal costs
Number Debit £ Number Credit £


6 5,000



Stock
Number Debit £ Number Credit £


8 392,000
7 480,000
20 40
20 8,000
20 199
Balance 95,761
488,000 488,000
Balance b/d 95,761

Trade creditors
Number Debit £ Number Credit £


7 440,000 7 480,000
Balance 40,000
480,000 488,000
Balance b/d 40,000


Figure 1.1 (Continued)

16
Telling the story


Sales
Number Debit £ Number Credit £

20 10,000 8 490,000
Balance 480,000

490,000 490,000

Balance b/d 480,000



Trade debtors
Number Debit £ Number Credit £

8 490,000 8 377,000
20 10,500
Balance 102,500

490,000 490,000

Balance b/d 102,500



Cost of sales
Number Debit £ Number Credit £

8 392,000 20 8,000
Balance 384,000
392,000 392,000

Balance b/d 384,000




Rent (office)
Number Debit £ Number Credit £

9 20,000 24 10,000
Balance 10,000
20,000 20,000

Balance b/d 10,000


Figure 1.1 (Continued)

17
Accounting and Business Valuation Methods


Fixtures and fittings
Number Debit £ Number Credit £

10 5,000 22 1,250
Balance 3,750
5,000 5,000

Balance b/d 3,750




Van
Number Debit £ Number Credit £

11 15,000 22 5,000
Balance 10,000
15,000 15,000
Balance b/d 10,000




Warehouse Rent
Number Debit £ Number Credit £

12 12,000 24 6,000
Balance 6,000
12,000 12,000
Balance b/d 6,000




Delivery costs
Number Debit £ Number Credit £

13 16,000
20 500 Balance 16,500
16,500
16,500
Balance b/d 16,500


Figure 1.1 (Continued)

18
Telling the story


Stationery
Number Debit £ Number Credit £


14 600




General insurances
Number Debit £ Number Credit £


15 1,500




Wages
Number Debit £ Number Credit £


16 9,000
23 1,800
Balance 10,800
10,800 10,800
Balance b/d 10,800


National insurance
Number Debit £ Number Credit £


17 1,000
23 200
Balance 1,200
1,200 1,200
Balance b/d 1,200


Interest
Number Debit £ Number Credit £


19 20,000



Figure 1.1 (Continued)
19
Accounting and Business Valuation Methods




Bank charges
Number Debit £ Number Credit £


19 15,300




Stock losses
Number Debit £ Number Credit £


20 40
20 199
Balance 239
239 239
Balance b/d 239



Goodwill impairment
Number Debit £ Number Credit £


21 15,000




Depreciation
Number Debit £ Number Credit £


22 1,250
22 5,000
Balance 6,250
6,250 6,250
Balance b/d 6,250


Figure 1.1 (Continued)




20
Telling the story


Accruals
Number Debit £ Number Credit £


23 2,000
23 1,200
Balance 3,200
3,200 3,200
Balance b/d 3,200




Prepayments
Number Debit £ Number Credit £

24 16,000




Accounting and audit expenses
Number Debit £ Number Credit £

23 1,200



Figure 1.1 (Continued)



Amanda™s reconciliations
The first reconciliation that Amanda attempted was to reconcile her cash book
with the bank statement she had received. The bank had debited her account
with £85 300, made up of:

(1) First repayment of loan, £50 000
(2) Interest on loan, £20 000
(3) Bank charges of £15 300, including £600 penalty charges for overdraw-
ing without authorisation.

Amanda was surprised by this, but she put the above through her books,
as transaction number 19, and decided to see her accountant to see what
could be done. Her next reconciliation was reconciling the purchase ledger

21
Accounting and Business Valuation Methods

with suppliers™ statements, and these were found to be in order. However,
reconciling the sales ledger was much more difficult. Her age debt list (simply a
list of debtors analysed by age, showing not overdue, 30 days overdue, 60 days
overdue, etc.) showed that her credit control procedures were not good enough
and while her debtor insurance would ensure that she got paid in the end,
her insurance did not cover her for returned goods. She had to deal with the
returned goods from CDZ Limited and felt that, in order to maintain goodwill,
she had to reimburse that company with £500 it cost to return the goods to her.
Of course, she had to make a ˜judgement™ as to the value of the goods returned.
She believed that she could sell 199 cases to cost cutter stores for £41 per case,
but if these stores found out that they were buying returns rejected by other
companies, they might not want to deal. If this happened, then eventually the
goods would have to be written off.

The entries required to account for this returns are:

(1) Credit CDZ Limited £10 500 (sales ledger)
(2) Debit sales £10 000 and debit ˜delivery costs™ £500
(3) Debit stock £8000 and credit cost of sales £8000
(4) Credit stock £40 and debit stock losses £40 for the case written off
(5) Credit stock for £199 and debit stock losses £199, for the reduction in
value of returned stock

Based on the prudence concept, stock is valued at the lower of cost and net
realisable value, where net realisable value is defined as the selling price less
the cost of getting the goods to the customer. In this case, it will cost £398 to
deliver 199 cases, which is equal to £2 per case. If the selling price is going to be
£41 per case and it will cost £2 per case to get them to the cost cutter stores, then
the net realisable value is £39 per case. As this is lower than the cost of £40 per
case, this stock has to be written down to £39 per case. In Amanda™s case, all her
purchases are at the same price, but usually prices change over time. In such
cases, stock is usually charged to cost of sales on a first in first out (FIFO) basis.

These entries are shown as transaction 20 in Figure 1.1. After these adjustments,
stock is valued at £95 761 and this figure is reconciled to the actual stock
counted:
£
2200 cases at £40 per case 88 000
199 cases at £39 per case 7761
95 761

22
Telling the story

Now Amanda must note that while she is committed to buying 12 000 cases
per year, in her first year she has sold only 9600 cases. It could be argued that
a contingency reserve should be created to allow for the fact that Amanda may
in the future have to make a £10 000 penalty payment to Zehin Foods plc. She
chose not to; but, again, this is a matter of judgement that can materially affect
her declared profit.

The final reconciliation is to do with assets. Firstly, Amanda wanted to make
sure that the goodwill in her Balance Sheet reflected what the secret recipe
was really worth, given the experience of her first year of trading. She had paid
£40 000 for it, but concluded that £25 000 was a more reasonable valuation and
reduced goodwill in the Balance Sheet to this figure. This reduction in value
is called ˜impairment™ and is shown as transaction 21 in Figure 1.1.

Secondly, the fixed assets have to be depreciated. Most assets are depreciated
using the straight line method. Straight line means that the net cost of the asset
is depreciated at the same rate over the life of the asset. Suppose an asset was
bought for £30 000 and at the end of 6 years it was estimated that it would be
sold for £6000, then the net cost of the asset would be £24 000 and the annual
depreciation charge would be £4000.

Another method of depreciation is by using the reducing balance method. This
method calculates the depreciation over the expected life of the asset, but on
the basis of its written-down value, not original cost. Also, the asset™s estimated
residual value is ignored. Assets such as cars and vans are usually depreciated
this way as they depreciate more in their earlier years than in the later years,
although to compensate the cost of repairs increases over time. Suppose a car
was bought for £30 000 and it was estimated that it would sell for £10 000 at
the end of 4 years, then by using the reducing balance method, depreciation
would be calculated as follows:
£
Asset at cost 30 000
Depreciation in year 1 7500
Written-down value 22 500
Depreciation in year 2 5625
Written-down value 16 875
Depreciation in year 3 4219
Written-down value 12 656
Depreciation in year 4 3164
Written-down value (at the end of year 4) 9492

23
Accounting and Business Valuation Methods

Depreciation for Amanda™s fixtures and fittings and van is shown as transaction
22 in Figure 1.1.
Now the assets have been reconciled, the only other matter is to deal with the
matching concept and this means dealing with accruals and prepayments, so
that in timing terms the sales and the costs associated with those sales match.
The entries for accruals and prepayments are:
Accruals “ debit the appropriate expense and credit accruals.
Prepayments “ debit prepayments and credit the appropriate expense.
The entries for Amanda™s accruals are shown as transaction 23 in Figure 1.1
and the entries for Amanda™s prepayments are shown as transaction 24 in
Figure 1.1. Once these entries are completed, each account is ˜balanced off™, so
that only the net balance is showing. This is shown in Figure 1.1. Each of these
balances is then listed in the form of a Trial Balance, as shown in Figure 1.2.


The Trial Balance
The purpose of a Trial Balance is to make sure that the accounts are in balance
and this means that the sum of the debits must equal the sum of the credits.
Assuming they do, the next step is to review each of the accounts. Starting with
the debit side, the question is: Is what is being looked at something the business
owns? If the answer is yes, then the next question is: Is what is being looked at
something the business will own for 12 months or more? If the answer is yes
again, you are looking at a fixed asset, if no, you are looking at a current asset.
If the asset is a fixed asset, the next question is: Can this asset be seen and
touched? If the answer is yes, it is a tangible asset and if the answer is no, it is
an intangible asset. Both current assets and fixed assets appear in the Balance
Sheet.

If the answer to the first question is no, what was being looked at was not
something the business owns, then the item is an expense and appears in the
Profit and Loss Account. In this case, the next question is: Was this expense
incurred in the ordinary course of business to get the business™s product or
service to the point it was available to customers? If the answer to this question
is yes, then the expense appears in the top half of the Profit and Loss Account
and is shown before ˜gross profit™. If the answer to this second question is no,
then the third question is: Was this expense incurred in the ordinary course of
business and is it a type of expense that is likely to be repeated? If the answer
to this third question is yes, then the expense will be shown in the bottom half

24
Telling the story




Trial Balance at December 31 2004

Debit (£) Credit (£)

Capital 50,000
Cash at bank 220
Goodwill 25,000
Samples 2,000
200,000
Loan
10,000
Debtor insurance
12,000
Setting-up costs
2,380
VAT
5,000
Legal costs
95,761
Stock
40,000
Trade creditors
480,000
Sales
102,500
Trade debtors
384,000
Cost of sales
10,000
Rent (of¬ce)
3,750
Fixtures and ¬ttings
10,000
Van
6,000
Warehouse rent
16,500
Delivery costs
600
Stationery
1,500
General insurances
10,800
Wages
1,200
National insurance
20,000
Interest
15,300
Bank charges
239
Stock losses
15,000
Goodwill impairment
6,250
Depreciation
3,200
Accruals
16,000
Prepayments
1,200
Accounting and audit expenses

773,200 773,200

Figure 1.2 Case study “ Amanda “ Trial Balance

25
Accounting and Business Valuation Methods

of the Profit and Loss Account and is shown before ˜operating profit™. If the
answer to this third question is no, then it will be an extraordinary expense
that is shown below the ˜operating profit™ line.

To demonstrate this, we can go down the Trial Balance (Figure 1.2).

Cash at bank. Is it something owned? Yes. Will it be owned for a year or
more? No. Therefore, ˜cash at bank™ is a current asset.
Goodwill. Is it something owned? Yes. Will it be owned for a year or more?
Yes again, it must be a fixed asset. Can Amanda see and touch this asset?
The answer to this is no, so goodwill must be an intangible fixed asset.
Goodwill is simply the difference between what has been paid for an asset
and the tangible value of that asset based on its book value. In addition to
goodwill, other intangible assets might be patents, brands and intellectual
property rights.
Samples. Is it something owned? No, then it must be an expense. Did Amanda
need to make these samples to demonstrate that the product could be
manufactured to the secret formula? If yes, then the expense would appear
in the Profit and Loss Account before the ˜gross profit™ line. However, if the
samples were made to entice customers to buy the product, they would
be a selling expense and would appear below the ˜gross profit™ line. So
we are back to this word ˜judgement™ again! What were the samples really
made for?
Debtor insurance. Is it something owned? No, then it must be an expense.
Why did Amanda take out debtor insurance? Because taking out such
insurance was a condition for getting the loan. Therefore, debtor insurance
could be regarded as a finance cost and would come below the ˜gross
profit™ line.
Setting up costs. Is it something owned? No, then again it must be an expense.
Why were these costs incurred? The answer was that this expense related
to the costs Zehin Foods plc would incur in scaling up from Amanda™s
jam pan recipe. Here again, some judgement is required. Some would
argue that as these setting up costs related to a one-off cost that covered
contracts over a 5-year period, they should be capitalised, treated as a
fixed asset, and written off over 5 years. Amanda took the prudent view
and charged this expense to the Profit and Loss Account, but treated it as
an extraordinary item that comes below ˜operating profit™.
VAT. Is it something owned? Yes. Will it be owned for a year or more? No,
then VAT must be a current asset. It must be noted here that in the vast
majority of cases, VAT is a current liability, representing the amount owed

26
Telling the story

by the business to Revenue and Customs. It is only a debtor here because

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