Every business has to submit an income tax return to the Tax Authorities each year. Therefore, the proprietor will need to prepare accounts in order to identify the taxable profit of the business.
This will often be the prime reason for the preparation of accounts, but there are a number of other reasons why this task is undertaken.
The example of a business plan/finance application in Chapter 12 includes samples of accounts for reference purposes.
Why Do You Need to Prepare Accounts?
Apart from the need to prepare accounts for tax purposes, the other reasons for preparing accounts are as follows.
■ The need to prepare a profit and loss account to identify whether a profit or loss is being made, and to establish if the business can afford to pay its overheads.
■ The business needs to identify the level of profit being made in order to ascertain an affordable amount for the proprietor to withdraw.
■ The production of accounts will allow the proprietor to identify the efficiency of staff and the amounts of profits that can be paid as wages.
■ Without the production of accounts and the identification of expenses, it is difficult to ascertain the amounts that will need to be charged to customers to ensure a profit will be made.
■ The production of accounts will allow the proprietor to identify whether there are any excess profits that would allow a pay rise to be made to the staff, or additional amounts withdrawn.
■ The production of accounts will enable the proprietors to identify the prior shares of income and expenditure that will be due to/from them as part of their partnership or expense-sharing contract.
Often, when a bank loan or overdraft is used to finance the business, the bank may insist on the business submitting annual accounts to them so that they can monitor the business progress against forecasts.
It would be difficult to sell a business without some sort of profit and loss figures to show prospective purchasers, and those with more detailed figures (in a profitable business) will be able to ask more for their business.
What Accounting Records Do You Need to Keep?
While running a business, you will accumulate a lot of paperwork and documentation that you will need to keep so that year-end accounts can be prepared for the business. The more usual records are as follows.
■ Bank statements, checkbooks and paying-in books. As the analysis and balancing of a bank account are crucial to the preparation of business accounts, it is essential that these records are complete.
■ Petty cash records. A lot of the day-to-day expenses of a business are paid by way of cash and it is essential that a record is kept of these expenses, whether funded from cash withdrawn from the bank or from cash receipts from customers. It is preferable to bank the receipts from customers intact, as should the Revenue Authorities decide to investigate the business, it will have a clear audit trail of the receipts from customers being banked. The downside to this approach is that it is quite expensive for a business to bank cash, so it is cheaper to use the cash received to fund cash expenses.
It is expensive for a business to bank cash as the banks charge fees for this service.
■ PAYE/wages records. The amounts paid to staff represent the net wages they receive after deduction of PAYE and pension contributions etc. In order to ensure that the accounts are complete, those net wages need to be grossed up from the PAYE records etc., so that the gross cost is included.
As wages are usually paid one month in arrears, for completeness the post-year-end details need to be included in the accounting records.
■ Purchase and expense invoices. Invoices for all purchases need to be retained by the business and submitted to the business’s accountant, along with the accounting records. The reason is that different tax allowances are available for different types of expenditure, and the details of the type of expenditure are usually found on the invoice.
■ Details of income and expenses allocated to specific proprietors. In expense-sharing arrangements, certain elements of income and expenditure are identified as belonging to individual proprietors, and are shown as such in the business accounts.
■ Stock records. To ensure that the business has sufficient stock and can identify the unsold stock for the year-end accounts, some type of stock record needs to be kept. For smaller businesses, the system can be quite basic, while larger businesses would normally have computerized records to keep track of stock.
■ Expenses paid personally. Often, when away from the business, business proprietors will buy items for use in the business and will pay the amount due from their own resources. These items need recording or tax relief will not be given on the amounts.
■ Personal use of business expenses. There are a number of areas of expenditure where there is an element of both business and personal use (e.g., motor expenses), and it is important to identify the personal element that needs to be excluded from the accounts.
■ Statements from suppliers. It is especially important to keep these at the year-end date so that the creditors (the amounts that the business owes) can be identified for the accounts.
■ Details of income owed to the business. To ensure that customers pay, it is important that the business has some way of identifying the unpaid income of the business at any given time. This is especially important at the year-end date as these amounts need to be included in the accounts.
This list represents the basic source documents from which the business accountant will prepare the business accounts. While there are a few businesses that will deliver those records to their accountant and ask them to prepare their accounts from those source documents, most businesses will have completed some bookkeeping procedures prior to submission in order to reduce the work the accountant has to do. The main reason for this would be to reduce the accountancy costs, which could be significant given that the accountant will charge an hourly rate for the work done.
The source documents need to be kept for at least 6 years, and be available for inspection by the Tax Authorities at all times.
Bookkeeping and Management Accounts
By completing some bookkeeping procedures, the business will (i) reduce the accountants’ charges for the production of the year-end accounts, (ii) ensure that correct payments are made to staff and suppliers and (iii) ensure that all amounts due to the business are received.
The minimum bookkeeping procedures to put in place or to expect from an agency providing bookkeeping services are
■ To regularly balance the analysis of the bank transactions with the bank statements, usually monthly.
■ To provide a list of suppliers that need paying at the end of the month, and write checks or prepare bank automated clearing services (BACS) or similar banking instruction for automatic payment.
■ To provide a list of outstanding amounts due to the business each month, in order that the business staff can take action to collect those amounts.
The analyzed and balanced bank account summary will be the key document provided to the accountant at the end of the year for the purposes of preparing the accounts.
Some bookkeepers will also provide a payroll service to assist businesses with the paperwork necessary to process the payment of wages to staff. The rate of pay for a suitably qualified bookkeeper is in the region of £15/hour, or an online bookkeeping service for £30/month (in the UK).
Given the foregoing cost, a number of businesses will use a member of staff to complete the bookkeeping procedures, or in most cases the proprietors will complete the procedures themselves. If a business uses a member of staff to keep its books up to date, it needs to bear in mind the following:
■ Would the member of staff be more efficient in their original intended role, and would the cost of a bookkeeper be more or less than the cost of taking that member of staff away from their other duties?
■ Has the member of staff got the ability to do the task at the same speed, and as efficiently as a bookkeeper?
■ Would the use of a member of staff present problems with confidentiality as to the proprietor’s level of earnings and withdrawals from the business?
Bookkeeping can be undertaken manually in a cash book (increasingly rare), on an Excel spreadsheet or on a computerized accounting package, such as Sage or Quickbooks.
A number of businesses which employ a bookkeeper, or who have more advanced accounting skills, prepare management accounts regularly (either monthly or quarterly) by utilizing one of the aforementioned computer packages. Management accounts can show the business its level of profitability and solvency throughout the year by effectively producing an income and expenditure account and balance sheet at given dates.
It is not necessary for a business to prepare management accounts unless:
■ The level of bank funding is high, and the bank requires regular management accounts as a covenant of the loan agreement.
■ The business is new, or has cash flow issues which require it to keep a firm grip on the finances.
■ The business is large and/or has a profit/expense-share calculation which is dependent upon regular updates of the level of income and expenditure.
One task that should be subcontracted to a bookkeeper or accountant is that of the completion of the payroll records, as these are becoming increasingly difficult to keep. The reason for this is the move to process the payment of benefits and the collection of debts through the PAYE system. The weekly or monthly pay run can be complicated by the payment of working tax credits and maternity and paternity pay, and the deduction of student loans and other debts.
What Do the Accounts Look Like?
Usually, the first schedule in a set of accounts is a detailed summary of the income and expenditure, which is often called a profit and loss account, as this schedule summarizes the profit or loss made by the business in the selected period.
The following table (Table 7.1) shows a typical business profit and loss account. The figures included in the account are not intended to represent any industry averages, but provide ballpark figures purely for the sake of the example.
Profit and loss account example
As you can see from the account, the income of the business is usually shown at the top of the schedule and will typically be made up of amounts received (and receivable) from the business sales.
Table 7.1 Profit and loss account example
|
|
£ |
£ |
|
|
£ |
£ |
|
Income |
|
414,000 |
|
Expenses |
|
|
|
Cost of sales |
161,000 |
|
|
Wages and salaries |
64,000 |
|
|
Recruitment costs |
800 |
|
|
Courses and staff training |
500 |
|
|
Rates and water |
3,000 |
|
|
Light, heat and power |
3,500 |
|
|
Use of home as office |
1,000 |
|
|
Repairs and maintenance |
7,000 |
|
|
Telephone |
3,000 |
|
|
Printing, postage and stationery |
5,000 |
|
|
Subscriptions |
2,000 |
|
|
Equipment leasing |
15,000 |
|
|
Sundry expenses |
5,000 |
|
|
Insurance |
3,500 |
|
|
Motor expenses |
500 |
|
|
Advertising |
6,000 |
|
|
Accountancy |
3,000 |
|
|
Legal and professional fees |
500 |
|
|
Bank charges |
500 |
|
|
Credit card charges |
2,500 |
|
|
Depreciation charges |
5,000 |
|
|
Bank loan interest |
14,000 |
|
|
Hire purchase interest |
3,000 |
|
|
|
|
309,300 |
|
Profit for the year |
|
104,700 |
A business will incur many different types of expenditure. The more usual expenditures are as follows:
■ Cost of sales: This category of expense usually relates to the cost of the items that have been sold. In addition, this category includes all the consumables used in the sales process, such as dispatch costs.
■ Wages and salaries: This category is usually a significant cost in most businesses. This expense represents the gross salaries agreed payable plus employers’ insurance costs, pensions and any other costs of employing staff.
If the business has incorporated (i.e., operates as a limited company), the wages and salaries expense will often also include the proprietors’ salaries (and spouses if appropriate).
■ Recruitment costs: The costs of recruitment can be quite high, especially when advertising higher paid posts in the trade press. Even advertisements in the local press for administration staff vacancies can prove costly. If these amounts are not distinguished from general advertising costs, the benchmarking process can be adversely affected.
Occasionally, the business may use an agency to source staff members, and the fee payable for this service would also be included within recruitment costs.
■ Courses and staff training: Most businesses will benefit from their staff undertaking continuing professional development (CPD), which may cover areas such as basic customer care or the latest technological advances. The costs of this training may, in some cases, be quite significant.
■ Rates and water: Most businesses will be assessed for business rates, and that assessment will take into account location, property values and local economic conditions, among other factors dictated by government policy. The amount assessed will be payable to the local council.
In addition, the business will also pay water rates to a utility company.
■ Light, heat and power: This category of expense will include the costs of gas, oil and electricity. This is often a significant expense for a business.
■ Use of home as office: Often, the proprietor of a business will do a significant amount of work from home, whether it is dealing with suppliers or dealing with administration and financial matters. In addition, many business proprietors keep themselves updated by undertaking research on the Internet. As a result of these activities, they often incur additional expenses in their home, and it is these expenses that can be claimed as an expense against the business income.
■ Repairs and maintenance: Many items owned by a business need maintaining, thus service or maintenance agreements are taken out with manufacturers and suppliers of that equipment.
The expense of these agreements plus the cost of general repairs within the business are included within this category. However, any items of material value that are replaced would usually be shown within the equipment heading on the balance sheet (see later notes in this chapter on the balance sheet).
■ Telephone: This category of expense would usually include the costs of the business landline and broadband, plus on occasions a proportion of the proprietor’s home, mobile phone and broadband costs incurred on business matters.
■ Printing, postage and stationery: The cost of printer toners can account for a significant amount of this expense. This category also includes the costs of producing business-headed paper and associated stationery, postage of letters, etc.
■ Subscriptions: To keep up to date with business sector advances, most businesses join trade associations and other such bodies. The subscription costs, either upon joining or the annual subscription, can be quite significant.
■ Equipment leasing: It may be financially advantageous to lease the business equipment rather than buy it, as lease payments are allowed as an expense against the business income. Under a lease, the ownership of the equipment remains with the leasing company, and the business pays a rental while it effectively hires the assets.
■ Sundry expenses: The expenses within this category are usually smaller amounts that do not fit within another category. Examples of usual expenses posted to sundries are refreshments, newspapers and magazines, window cleaning, staff parties and entertainment.
■ Insurance: This expense heading will include the insurance costs for the following:
– Buildings
– Contents
– Public liability
– Professional liability (if appropriate)
– Employers liability
– Motor insurance (may alternatively be included in motor expenses)
Often, a proprietor may take out insurances to protect his income in the event of illness, or a life policy to repay loans etc. upon death. Depending on who the beneficiary of these policies is, the expense may not be allowed as a business expense, but charged to the proprietor as a personal expense.
■ Motor expenses: The costs of running the business’s vehicles, and the business element of the proprietor’s vehicle. The home-to-work trip for the proprietor or any staff with company cars is not allowed as a business expense, so only the motoring costs for visiting customers and suppliers, exhibitions, conferences and courses, and visiting the bank and professional advisors are allowable.
■ Advertising: Most businesses will have to incur advertising costs to attract new customers, whether this is in the traditional press or click-linked based advertising online.
The business should ask every new customer how they found out about the business, as this information is crucial to assess the effectiveness of the business’s advertising strategy. Many businesses do not do this and waste large amounts of money on ineffective advertising.
In the accountancy profession, for example, research has shown that in some cases fewer than 1% of new clients join the practice as a result of an advert in Yellow Pages, but many firms are unaware of this and spend thousands each year on expensive adverts in telephone directories.
■ Accountancy: The cost of preparing the business accounts and the proprietor’s tax returns is often shown as an expense of the business, but there are some businesses that treat the individual proprietor’s tax costs as their own, and do not include them within the accounts.
The accountancy costs should remain fairly static, except when advice is needed on changes of proprietors, property issues and tax-planning arrangements.
■ Legal and professional fees: From time to time, the services of professionals may be needed, whether it is a solicitor drafting a new partnership agreement or a surveyor providing a valuation of the business premises. These expenses will often be shown in the profit and loss account, but sometimes they may not be allowed as a tax-deductible expense given that they may relate to a capital project, such as the purchase of a property.
■ Bank charges: Most banks will provide free banking to new businesses for a period, but thereafter will calculate charges based on the number of items being paid in and out of the business bank account. It is worth exploring the options available, and free banking for the longer term should be available to businesses who do not need to borrow any money.
■ Credit card charges: Most customers tend to pay for their purchases by way of credit card, and it is essential that businesses provide the facilities for this type of payment. Only a small number of financial institutions provide these services and the costs they charge are very similar, and substantial.
Businesses are charged a percentage of their sales income, with the percentage charged based on the annual sales income. Basically, those businesses with a higher amount of credit card sales will pay a smaller percentage fee.
■ Depreciation: This is a non-cash expense often added to the accounts by the accountant while preparing the year-end accounts. The purpose of the charge is to show the decrease in the value of assets over time, and is usually charged as a fixed percentage of the cost of the asset each year. The rate of depreciation charged will depend upon what type of assets the business owns. For example, computers are often charged with 33.3% depreciation in order to write them off over 3 years.
■ Bank loan interest: The interest on any business loans can be included in the profit and loss account as an expense; however, the capital element of the repayment cannot.
■ Hire purchase interest: A hire purchase agreement is effectively a loan agreement, usually with a finance company allied to one of the main banks. Often, the rates charged can be in excess of those offered by the banks, except when the manufacturer of the equipment being purchased subsidizes the arrangement with a low rate of interest.
The names applied to different financial arrangements are many, but the basic concept remains the same, and the interest or hire charge element of the repayments is allowed as expenses against income.
The profit for the business is calculated by deducting all the aforementioned expenses incurred from the business income. The amount of profit varies significantly between different business sectors.
What Level of Profit Will You Make?
The answer to this question is basically up to you. How hard do you want to work? What motivates you? The level of profits you make will be dictated by the demand there is for your business, and how much money you want to make.
What Should You Do to Protect Your Income?
Those new to business should look at the liabilities (both business and personal) that need to be paid regularly and assess how long they could survive on a reduced (or nil) income as a result of an illness. This is an essential exercise as any financial problems of the proprietor soon have an impact on the business.
A principal will, therefore, need to make the following provisions:
1.Locum cover. A policy which provides funding for someone to undertake the principal’s role within the business, should he be incapacitated. This will ensure that the business continues to trade in the event that the principal is ill.
2.Business expenses policy. Should a locum not be found or if the business is considered that personal to the principal, an alternative arrangement would be to provide for the business overheads to be paid. This type of policy would normally pay out a fixed amount based on the level of expenses in the latest set of business accounts.
3.Critical illness policy. This policy can provide a personal income in addition to the above and would usually provide for the proprietor to receive a fixed level of monthly income for life (or until the receipt of pension). The amount of income will usually be based on the after-tax level of drawings of the principal.
4.Life cover. This policy will pay out an amount to repay the bank borrowings upon death should the business consider the short-term repayment of capital to the principal’s executors a problem.
The foregoing profit and loss information is useful for business owners to benchmark their performance against industry averages (if these have been prepared by industry specialists), and also provides the basis of the information that will be returned to the Tax Authorities. This is done by completing a tax return.
Once the return is completed, it will be submitted, probably online. Upon submission, the return is not usually checked by the Tax Authorities, but may be selected by exception reporting if it appears that items are omitted, or figures do not conform to those expected from a business in that sector. If a return is selected at this time, it will be subject to an aspect inquiry, which will usually be closed if a satisfactory answer to the query can be provided.
If a satisfactory answer cannot be provided at this stage, it is likely that a full inquiry will be initiated into the tax return, which may involve all the business records being requested.
If, following the investigation, the Tax Authorities find personal items being claimed for in a cavalier fashion or find significant under declaration of income, they have the right to investigate other years, and assess for the amount of tax they consider underpaid, along with interest and penalties.
Along with the costs of the tax and penalties, a tax investigation will generate a significant cost in terms of professional fees, so it is best avoided. There are a number of ways to reduce your tax burden legally, and these are looked at in Chapter 6.
The foregoing accounts concentrated on the income and expenditure of the business, but there is another element to a business’s accounts called a balance sheet, which focuses more on what the business is worth.
In order to get a complete picture of your financial position, you will need to have a balance sheet prepared. A balance sheet is made up of the following two parts.
1.A list of assets and liabilities that comprises the total worth of the business.
2.A capital/reserves/current account that equates to the list of assets and liabilities (hence the expression ‘balance sheet’).
An example of a balance sheet is shown in the following section, and the following notes provide explanations of the figures and the descriptions more commonly used by accountants.
Fixed assets comprise assets such as goodwill, property, plant, fixtures and equipment. The term ‘fixed assets’ is used in accountancy to describe assets and property that cannot easily be turned into cash.
These can be compared to current assets, such as stock, debtors, cash or bank accounts, which are described as liquid assets as they represent cash or items that can quickly be converted into cash.
The fixed assets that are usually found on a business balance sheet are goodwill, property, fixtures and equipment, and in some cases motor vehicles. Further details of these assets can be found in the following sections.
Fixed assets can be further divided into two subclasses: tangible and intangible assets. The tangible assets are those you can touch, such as property and equipment and so on, and intangible assets usually comprise goodwill and intellectual property. The intangible asset on the following balance sheet (Table 7.2) represents the goodwill of the business.
Upon a sale or transfer of a business, it is common for the proceeds to exceed the value of the tangible assets of the business. This excess payment or premium represents the ‘goodwill’ that will need to be paid to the proprietor selling the business, in order to buy the rights to the future profits of the business.
Table 7.2 Example of a business balance sheet
Goodwill is calculated by reference to the continuing business that the organization is likely to retain after the sale or transfer. The level of goodwill is dependent upon the level of business profits, with the more profitable businesses achieving higher levels of goodwill upon a sale or transfer.
The goodwill in the previous balance sheet example is £250,000.
The value of the goodwill of a business will not only depend upon the level of profits, but also the following:
1.The level of turnover/total sales.
2.The variety of different sources of sales.
3.The opportunities the business has to expand.
4.The ability of the staff employed.
5.The age and condition of the business’s fixtures and equipment.
6.The type of property from which the business operates.
From these factors a valuation can usually be made, but whether that amount is obtained upon a sale will depend upon the eagerness of the vendor to sell and the purchaser to buy. As always, a sale will be subject to market forces.
To maximize the goodwill you obtain on a sale or ensure that you pay the right amount upon a purchase, it is imperative that you secure the services of a specialist valuer. You can often find details of these in the trade press.
If you attempt to save money on professional fees by employing a non-specialist business valuer, you may pay dearly in the long term. Specialist valuers will hold benchmarks of goodwill valuations, which will not be available to the non-specialist.
Accurate valuations are not only necessary upon a purchase or sale, but upon the transfer of the business upon incorporation (where the Tax Authorities may take an interest in the values), or as part of a legal dispute, and when the business is breaking up.
As mentioned previously, goodwill is an area where the Tax Authorities take a keen interest, and it is paramount that specialist advice is sought regarding the valuation of goodwill.
The property that will usually be found on a business’s balance sheet will be the premises used by the business and will more often be shown at cost price.
The purchase of a business will often include the purchase or the assignment of a property, which will usually account for a large part of the purchase price.
In order to avoid the more common property pitfalls, it is essential to obtain specialist legal and taxation advice prior to the purchase.
A specialist adviser will have experience of all the things that can go wrong with property ownership and can advise accordingly, whether it is to reduce the tax upon the eventual sale of the property or to preserve the rights of all parties to the agreement.
What Type of Property Is Best for Your Business?
The type and standard of accommodation used by businesses can come in many forms. The more usual are as follows:
1.Converted residential or commercial property
2.Premises in purpose-built retail shopping areas
3.Purpose-built commercial property on industrial estates
4.Use of own domestic premises
The more common premises for business startups tend to be converted houses, shop units or small units on industrial estates.
Whether viewing a business to purchase or another property to move into, the following issues need to be taken into account:
1.The area in which the property stands can affect the type of business that can be run from it, with more deprived areas offering fewer opportunities for more expensive products. These areas tend to bring with them a higher cost in securing a property, with bars on windows and heavy-duty locks needed to protect the property from break-ins.
2.The accommodation that the property provides can affect the business’s ability to generate a decent level of profit.
3.A restriction on the available space can limit the business’s ability to expand and increase its income.
4.Do legislative changes (such as disabled access, etc.) preclude the property being used for its intended purpose?
5.Older properties and listed buildings can be a headache if planning permission is needed to obtain clearance to use the property.
6.If work is needed to bring the property up to the standard required, this needs to be factored into the offer made for the property.
7.Purpose-built properties tend to provide the best facilities but come at a cost.
8.Some properties are easy to sell: when buying it is advisable to think ahead and try to identify if there are any negative aspects to the property that may affect its eventual sale. (Consider neighboring properties and the area it is situated in.)
9.Will the property be suitable for the type of customer you are trying to attract?
10.Does the property provide good access for customers, in terms of disabled access and parking facilities?
Remember it is better to buy the worst house on the best street than the best house on the worst street.
Freehold or Leasehold: Should You Buy or Rent?
The distinction between freehold and leasehold property can be explained by the following definitions.
Freehold any interest in real property which is of uncertain or undetermined duration (having no stated end), as distinguished from a leasehold which may have declining value toward the end of a long-term lease.
Leasehold an estate, or interest, in real property held under a rental agreement by which an owner gives another the right to occupy or use land for a period of time.
Leasehold property can be further defined as
■ Short leasehold where the portion of the term remaining unexpired under the rental agreement is less than 5–10 years.
■ Long leasehold where the portion of the term remaining unexpired under the rental agreement is more than 10 years.
This distinction between short and long leasehold is not cast in stone, as different industries have their own classifications; for example, residential lets over 12 months can often be classed as long term!
It would be usual to pay a premium to buy a long leasehold as it effectively gives one the right to occupy a property for a substantial period; for example, there are long leasehold properties with leases of 999 years (effectively a freehold). Long leaseholds of such length are generally treated in the same way as freehold properties.
Famously, Arthur Guinness signed a lease for his brewery in Dublin in December 1759, for an annual rent of £45 a year for 9000 years. In retrospect, his landlord appears to have been badly advised at the time.
The company has since bought out the originally leased property, and during the 19th and early 20th centuries the brewery owned most of the buildings in the surrounding area, including many streets housing brewery employees and offices associated with the brewery.
It would be unusual to pay a premium for a short leasehold as it does not provide safety of tenure past the date of termination of the short-term rental agreement.
The exception to this rule is where a fee is paid for a short-term pitch at a sporting/music event for the purpose of providing refreshments. In these circumstances, the levels of profits over the short period are relatively high, hence the premium being charged.
The following issues need to be taken into account when deciding whether to buy a freehold or rent a leasehold property.
1.Risk: There is a school of thought that it is riskier to sign a mortgage deed and purchase a freehold (as the mortgage could be a ‘millstone around your neck’) than it is to sign a leasehold agreement.
2.My personal view is that it is a lot riskier to sign a long leasehold, say for 25 years, as the landlord can claim rent from you for the whole of the period of the lease, even if you have retired before the end of that period and assigned the lease to your successors! At least if you have purchased the property, you will have the option to sell it to pay off the mortgage.
3.Freehold property ownership problems: Where more than one person owns a freehold property, the owners will hold it as either:
Tenants in common: Each of the property owners own an agreed share of the property. That share can be bequeathed to dependents in a will.
Joint tenants: The property owners own all the property together. If one of the owners passes away, the surviving owners automatically own all of it, no matter what it says in the deceased’s will.
It is therefore important for the proprietor’s family that a commercial property is held by the principals as tenants in common.
4.Advantages: Taking on a lease rather than buying a freehold property can be of benefit in the following circumstances:
– Where there are no suitable properties in the chosen area.
– Where there are no funds to pay a deposit on the purchase of a property.
– Where there are no long-term plans to stay in that location.
– Where the retiring principal is not willing to sell the freehold to the purchaser.
5.Disadvantages: Leaseholders, however, suffer the following disadvantages.
– The payment of rent, although allowable as a taxable expense, is effectively dead money.
– The repayments on a loan to purchase a property will often be of a similar amount as the rental that property would attract. It is therefore often better to purchase a property with a loan, as the repayments will help buy an investment that should increase in value over time.
– The leaseholder will ultimately not benefit from the increase in value from any improvements that he or she makes to the property. This is often a reason why leaseholders do not make significant improvements to rented property.
– The leaseholder may be prohibited from extending or developing the property, which may impact upon the growth of the business.
– There may be aspects of the expenditure that the leaseholder incurs on the property that may not be allowed as a taxable expense, whereas if the property was owned these expenses would be allowed against any future capital gain made on the sale of the property.
– The leaseholder will ultimately have to vacate the premises at the end of the lease period, unless the lease provides otherwise.
– Accounts anomalies may arise in writing off the costs of improvements to the property, as there will be no net worth to the leaseholder.
Sale and Leaseback of Property and Gearing
There are financial institutions that specialize in buying profitable commercial premises and renting them back to the businesses that operate from them. These schemes offer taxation benefits to the parties involved and are often restricted to larger more valuable properties.
The advantage to the business owner of this type of arrangement is that the capital investment in the property is released and paid back to them to be available for other business or non-business use. The advantage to the property investor is a long-term investment in a property with the receipt of a rent in the interim.
The disadvantage to this sale and leaseback arrangement for the business owner is that they have lost any share in the growth in value of the property, and they will also lose out on any increase in value that would arise from any improvements they make to the property.
The business owner can also use their property another way, by reviewing the amount of equity they have tied up in the property, and increasing the level of business mortgage they have, in order to withdraw that amount. This procedure is known as ‘gearing’.
The higher the amount of equity the business owners have in the property, the more interested the financial institution will be in lending
An example of gearing is summarized next.
A business owner owns premises valued at £1,000,000, with a commercial mortgage of £600,000. His bankers inform him that they are willing to lend up to 80% on property loans.
He increases his business loan to £800,000 and uses the £200,000 released to buy three buy-to-let residential properties, which were priced at £450,000. He borrowed a further £250,000 in order to do this.
Before the financing, he owned properties of £1,000,000, which were mortgaged to £600,000, i.e., he had net equity of £400,000. After the deal, he owned properties worth £1,450,000, with mortgages of £1,050,000, and his equity remained the same.
As long as the tenants provide sufficient income to pay the additional borrowing of £250,000, he has potentially increased his worth by £450,000 by utilizing the £200,000 tied up in the business.
Many property tycoons have used this principle to amass fortunes.
Given the above, a refinancing of the equity is the more preferable option to sale and leaseback should the business wish to release capital tied up in the business.
Although it would be sensible for the business owners to own the business premises, there may be tax advantages where limited companies or pension funds (under the control of the business owners) take ownership.
In these cases, the business may be able to claim tax relief on the rentals paid, and the rentals received could be taxed at lower rates than those paid by the business owners, or be received tax-free.
I sold my share of my business premises to my pension fund and claimed tax relief on the rents paid while they were received tax-free. While the arrangement was very tax efficient, it fell down because the pension administrators saw it as an opportunity to charge excessive fees.
There are numerous ways to make tax savings and a myriad of tax pitfalls associated with business premises. I strongly advise that a tax adviser is consulted before the business premises are purchased.
Do You Need a Property Ownership Agreement?
Many areas of property ownership can lead to disputes when there is more than one proprietor involved, examples of which are as follows:
1.Disputes in respect of the valuation of the property upon changes in proprietors.
2.Disputes with new proprietors not wanting to take on shares of high fixed rate loans and early redemption penalty clauses.
3.Disputes regarding the costs of refurbishment expenditure near to a proprietor retiring.
4.Disputes regarding negative equity as a consequence of excessive development costs.
5.Disputes regarding the payment of a property share to a former proprietor.
In order to avoid these problem areas, business owners are strongly advised to have a property deed drafted to cover all matters that could relate to the property. The property deed should cover the procedures that will be adopted in the event of disputes.
An agreement is pretty standard, and most lawyers should be able to draft one for a modest fee.
How Do You Finance or Refinance the Property?
There will be occasions when a business owner will need to raise finance for the business, or for personal purposes. They can either provide the finance from their own resources or, as is more usual, approach the business bankers to ask them to provide the finance. The more usual situations where finance may be required are
1.Upon the purchase or construction of new premises.
2.Upon the retirement or appointment of a partner, where partners’ shares in the business are transferred.
3.Upon the refinancing of the business premises to allow a drawdown of the partner’s capital accounts (further in this chapter).
4.Upon the refinancing of the business premises to allow funding for further development of those premises.
5.Upon the transfer of the business borrowings to another lender to achieve savings from lower interest and bank charges.
When business owners approach a bank, they may be asked whether they would like a fixed or a variable loan. A fixed rate loan is one where the interest rate charged for the entire period of the loan is fixed at the start, whereas a variable rate loan is one where the rate of interest changes when the official base rates change.
Although a fixed rate loan will give the business financial stability, in that the repayments on the loan will remain fixed for the whole of the repayment period (even though interest rates may rise), the business could lose out should the rate of interest fall.
The rates offered under fixed rate deals tend to be higher than the current variable rates, so they should only be considered if it is thought that rates will rise (the banker selling the fixed rate deal will always predict interest rate rises!).
There are other interest rate deals available, including capped rate deals, which offer the protection of a fixed rate arrangement, with the flexibility that the borrower can benefit from a reduction in interest rates (i.e., the interest charge is capped at an agreed amount and will not rise should interest rates increase).
With hindsight, it is easy to advise on fixed, capped or variable rate offers, but the instability of the financial markets means that it is always going to be a gamble.
Those that opt for fixed rate borrowings gain financial stability, but do they do it at a cost or a benefit? In truth, there is no correct answer to this query without resorting to a crystal ball.
Interest on a loan taken out for business purposes will attract tax relief. In order to maximize this tax relief, some businesses opt for an interest-only loan with the intention that they will pay off all personal, non-tax-efficient borrowings prior to the repayment of the capital on the business loan.
As well as maximizing the tax relief, this arrangement ensures that there is more cash to draw and, as long as the additional drawings are used to pay down personal borrowings or build up investments, this arrangement will benefit the borrowers.
Normally, over time the property loan will be paid down, and the value of the property will increase with the result that the net equity in the premises will increase, but this may not always be in the best interest of the business.
If the net equity is allowed to build up over the years, it may become a problem upon the retirement of a partner as
1.The business may have to take on additional borrowings to pay the partner out.
2.The cost of buying a share of the property to a new partner may be prohibitive.
Negative Equity and Valuations
Given the vagaries of the property market and the high level of borrowings taken on by a number of businesses, the possibility of a negative equity situation arising is very real.
This can also occur upon the construction of a purpose-built property, where the building value after completion can be worth less than the cost of construction.
In many cases, however, businesses, particularly those with a relatively high level of income and composed of principals not nearing retirement, will be able to weather this problem without too much difficulty.
They can wait for a few years with the reasonable expectation that property prices will increase over the medium term so that the negative equity will be extinguished.
In the interim, however, it may be difficult to attract new partners to the business, as bankers will be reluctant to lend (especially as new partners do not tend to have a high level of personal wealth to utilize as security).
The potential new partners could be indemnified by the existing ones to ensure that they do not incur a loss on a business failure.
It is usual for each party to appoint their own professional valuer or surveyor to provide a valuation upon the sale or transfer of business premises.
The accepted basis for the valuation of business premises is that they are valued based on the continued use of the premises for their existing purpose.
However, there are instances where the premises may have a higher value for an alternative use.
It is important that any agreement between the business owners provides for differences in valuation and prescribes a course of action to prevent a dispute upon a change in principals.
Life insurance can be provided by various companies offering different policies, but the most common is term insurance. This is where the life of the policyholder is insured for a fixed amount in return for the payment of premiums over the term agreed.
The level of cover is dependent upon the health of the policyholder and the premiums that they are prepared to pay.
Most lenders will insist on borrowers taking out life insurance cover so that a business loan can be repaid upon their death.
This is understandable and quite straightforward when there is only one principal involved in the business. It gets complex, however, when there are multiple principals of different ages and with differing health issues, as the individual premiums may vary significantly.
This may be the cause of a dispute, as principals may be averse to subsidizing their colleagues. And some principals may already have significant personal cover that may be adequate for security purposes.
To prevent a dispute, it is usual that the principals are charged with the cost of their own premiums.
Where life insurance is taken out, the documentation needs to be checked to ensure that the beneficiaries are those with an interest in paying off the loan, and also that the insurance cover is flexible enough to provide for the reduction in the borrowing as it is repaid.
I have come across disputes where a principal of a business has died and his widow has received the life insurance proceeds in error, leaving his partners to pay off his share of the borrowings.
I have also found a business paying for term insurance against a repayment loan, which resulted in an excess on the death of a partner. This resulted in tax problems regarding the excess, and a dispute as to the payment of that excess to the widow.
Endowments are life insurance policies that have an investment element within them, in that the beneficiary receives a return at the end of the insurance term. There are specific tax rules regarding these policies.
They are not as popular as they used to be as the investment returns have decreased from the highs received in the late 1990s, and those wishing an investment return can find better financial products elsewhere.
Business owners who do not cover their borrowings with sufficient life insurance are gambling with the future of their families and employees, as an uninsured business is likely to fold upon the death of the principal.
It is essential that business owners use financial advisers with experience in their industry, as there have been many instances of inappropriate policies being sold. A testament to this are the mis-selling scandals that have nearly bankrupted a number of banks in recent years.
Critical Illness and Health Insurance
As covered in the What Should You Do To Protect Your Income section, it is important that a business takes out insurance to protect itself from key personnel falling ill. It is also important that those personnel protect themselves against their personal loss of income should their illness be serious.
The financial risks of a serious illness to the business and the individual are high as a study by the American Association for Critical Illness Insurance has found. A 25-year-old, non-smoker has a 24% chance of having a critical illness (i.e., cancer, heart attack or stroke) prior to reaching the age of 65. The odds on that individual increase to 49% if he is a smoker.
The cost of illness can be significant, with nearly two-thirds of US bankruptcies a result of medical expenses.
But how should the costs of insuring against illness be borne? The company should insure itself for the loss of income, and pay this cost itself?
The cost of private medical insurance policies of key personnel can be paid personally or (if incorporated) paid by the company as part of their remuneration package.
Next, we will look at the difference in the net cost of the employee and the company paying for private medical insurance.
1.If the employee pays the premium personally there is no benefit-in-kind, but the cost is met from income that has already been taxed.
For example, a premium of £1000 paid personally out of dividend income, which had been subject to tax of 32.5%, the employee would need to receive gross dividends of £1481.
And, as dividends are paid from the company’s net profits after tax, the profits needed to pay that dividend would need to be £1851.25.
2.If the company pays the premium on the employee’s behalf, it is treated as a business expense and a taxable benefit-in-kind. Tax of 40% is payable on this benefit-in-kind.
The company will have to pay 13.8% national insurance on the payment, bringing the total cost allowable against corporation tax to £1138.
This total cost of £1138 will attract tax relief of £227.60, bringing the net cost of the premium payment to £910.40.
As there will be tax of £400 to pay on the benefit-in-kind, a gross dividend of £670 would need to be paid to allow for this.
The profits needed to allow this dividend payment would be £837.50. When this amount is added to the net cost of paying the premium of £910.40, a profit of £1747.90 would be needed to pay the premium.
This represents a saving of £103.35, which on the face of it is very small, but if you were formulating a policy of how the medical insurance premiums of 200 staff should be paid, the total savings would be £20,670.00!
Please note how such a minor matter can have a significant effect on the profit. We will look at this further in Chapter 9.
The fixtures and equipment usually found in a business can be broken down into the following categories:
1.Furniture such as desks, chairs, filing cabinets, bookcases, cupboards and some floor coverings.
2.Specialist equipment for the specific business, for example, dental chairs.
3.Office equipment such as computers, printers, telephones and cash registers.
4.Sundry other equipment such as vacuum cleaners, tea- and coffee-making facilities, pictures and equipment to provide background music.
5.Items of plant which are integral to the building, such as fitted cupboards and ambient lighting systems.
These items will be shown in the accounts at their purchase cost less a provision for depreciation to write off that cost over the estimated useful life of those assets.
When a business is sold, it is usual to have the fixtures and equipment valued, and that value used as the purchase price for the new owner.
Tax allowances are available to reflect the loss in value of these assets over their estimated useful lives, with the allowance claimable dependent upon the type of asset and the date it was purchased.
Different options as to the financing of these assets can be found later in this chapter.
This category of assets within the accounts usually comprises the proprietor’s own cars, pool cars and commercial vehicles.
This category usually represents those vehicles owned by the business, and not those on lease. Leasing of vehicles has become a very popular way for businesses to meet their transport needs.
This is as a result of the vehicle manufacturers discovering that this method of financing vehicles encourages more frequent renewal of stock by customers.
The finance packages currently offered to businesses, and frequently to individuals, allow the customer to, effectively, hire and use the vehicle for a fixed period, and run it for a pre-agreed mileage.
There is an agreed future value assessed on the vehicle, based on the age and mileage, and the hirer is obliged to return the vehicle at the end of the period. A penalty is charged for excess mileage.
At the end of the period, the customer often replaces the vehicle with a new one on the same terms, and the manufacturer (or its retailer) can sell the original vehicle on the secondhand market.
The benefit to the manufacturer of these arrangements is that there is a continued demand for their vehicles.
The benefits to the customer are
1.They only pay for the depreciation of the vehicle over the period of ownership, often at a cost in line with the cost of purchase.
2.They can upgrade their vehicle on a regular basis.
The alternative to the leasing model is for the business to buy the vehicles by way of loan.
This can sometimes result in the value of the vehicle being less than the borrowings on it.
The allowances that can be claimed against business income on vehicles used by the business are covered in Chapter 6.
As previously mentioned, current assets usually comprise stock, debtors, cash and bank accounts, which can be described as liquid assets as they represent cash or items that can be quickly converted to cash.
A business needs to hold a stock of the goods that it sells so that it is able to satisfy demand for goods in a reasonable time frame.
The amount of stock held by a business can vary significantly depending upon the business’s internal procedures and the ability of suppliers to supply the business on a shorter time cycle.
There are two conflicting aims when it comes to buying stock for a business. The first aim is to hold as little stock as possible, as that stock represents the proprietor’s money that is tied up in the business.
The other aim is to buy stock as cheaply as possible, but as that often results in having to buy in bulk, the level of stock rises. Most businesses find a happy medium.
The cardinal rule is to have sufficient stock to deal with demand, and never to miss a sale due to lack of stock to sell.
Where significant stocks are held, a proper stocktake should take place at least once a year, and that valuation should be included within the accounts. Most businesses should be operating a computerized stock system, and the stocktake is a chance to measure the accuracy of that system and the stock levels it is disclosing.
There are other benefits to operating a stock system, which include identifying whether staff are recording (and charging) sales correctly and identifying any thefts.
If a business does not perform a stocktake, it may include an estimate of the amount of stock it holds on its balance sheet. If the estimate is for a round sum amount, it could lead to an inquiry into the accounts from the Tax Authorities, who expect accurate figures from businesses. While they do accept estimates from small businesses, they do expect better records from larger businesses.
A detailed stocktake would take place upon the sale or transfer of the whole or part of a business. For the retiring proprietor, this ensures that they are receiving their share of value, while the continuing business owners can take the opportunity to identify obsolete and outdated stock.
There is an art to the selection of the stocks purchased for resale, especially in the retail sector, where the impulse buy by the customer can provide a significant proportion of sales income. In these instances, if the staff can be rewarded for encouraging the sale of high‑value items, the profits can be improved significantly.
Business accounts need to be drafted on an earnings basis, and not merely to show receipts and payments during the accounting year. Therefore, at the year-end, an account needs to be taken of all outstanding items that remain due, but unpaid.
The debtors of a business represent the amounts that are owed to the business at any time, and most accounting software will produce those figures for the business when required. It is important that the business is able to determine the amounts due to it, so that it can chase up its debts. Most businesses do this on a monthly basis.
Producing a list of amounts due to the business on a regular basis will help to identify those amounts which remain long overdue, otherwise known as bad debts.
The production of this list is the responsibility of the credit controller, which is a key position within a business.
Businesses can also utilize the services of debt management companies to chase debts and help get their finances in order. To commence an action to collect a debt, it is essential that the company has the documentation in place to substantiate the debt, so it is important that adequate records are kept of sales, and payments thereof.
Many businesses accept credit card and mobile payments when selling their goods, and pay a fee to the credit card provider for that facility. The amount varies from bank to bank, and the costs can accumulate to a substantial amount.
This is why some businesses refuse to accept credit card payments for amounts below a de minimis level.
Accepting payments by credit card reduces the chances of bad debts and increases the market that the business is selling to, as a large number of customers will not buy from businesses that do not accept credit cards (up to 69% of millennials say they will not deal with businesses that do not accept credit cards).
Businesses wishing to provide credit/debit card facilities will incur the following costs:
1.Setup fees for merchant accounts: These fees can be anywhere between £40 and £160.
2.Credit card processing and transaction fees: These typically fall between 2% and 3% per transaction, but they can get as high as 4% for international transactions (which may or may not include a currency conversion fee).
3.Implementation costs for setting up equipment, such as point-of-sale (POS) terminals.
4.Customer charge fees if the purchaser decides to dispute a credit card transaction.
5.Fraud accountability: Some banks and credit card issuers may hold the business liable if fraudsters charge and receive products and services using stolen customer data.
Despite the costs of providing better payment facilities, businesses that don’t offer credit card facilities will not prosper.
With card and mobile payments likely to increase significantly over the next decade, implementing the systems to accept card payments is essential, as estimates have been made that only up to 23% of sales will have been in cash by the end of 2017.
Customers are more likely to undertake impulse buys if they can use a credit card/mobile payment, and there is less need for people to hold cash as more businesses are welcoming new methods of payments, such as Applepay.
The acceptance of credit/debit/mobile payments has resulted in safer money handling practices, as the time and expense of counting, sorting and transporting cash are reduced.
Additionally, holding less cash on the premises can make businesses less attractive to thieves, and in theory cheaper to insure!
New technology is increasing the security of credit transactions and decreasing the risk of fraud.
Credit cards have evolved into one of the most common methods of consumer payment, with nearly 60% of US consumers preferring cards over cash.
Debtors (Work in Progress and Prepayments)
Included within the debtors’ figure on the business balance sheet earlier in this chapter, there may also be work in progress to account for. This is when work has been undertaken on behalf of a customer, but it has not yet reached the stage where it can be invoiced. The work in progress provision is to ensure that the costs involved in this work are accounted for in the same period as the invoice.
Other forms of debtors that need accounting for are prepayments. These occur where expenses have been paid in advance, such as yearly insurance premiums. The advance payment is calculated and shown in the accounts as a prepayment, with the amount being carried forward.
The figures included on a business balance sheet for cash at bank represent the reconciled balances at the year-end. The reconciled current account bank balance in the business records rarely matches the actual amount on the bank statement, as the former represents the balance in the bank account at the year-end date, less the checks written out and not presented at that date, plus the receipts banked but not yet cleared.
Usually, a small amount of cash will be included on the balance sheet, this amount representing unbanked sales, the money held in cash registers and petty cash.
Petty cash will normally be held to fund trivial bills such as coffee, tea, newspapers, window cleaning, etc.
Those businesses which build up cash surpluses in deposit accounts will also show these amounts in this category on the balance sheet.
The liabilities of a business represent the amounts that the business owes to others, and are usually split in the accounts (especially in company accounts, where it is a legal requirement) between current and long-term liabilities.
Current liabilities are those that are due for payment within 12 months, and long-term liabilities represent those amounts due thereafter.
Current liabilities are usually those amounts due to suppliers, or bills for expenses, where it is usual to be given 30 days credit.
Also within the category of current liabilities are ‘accruals’. These are expenses that have been incurred by the business for which an invoice has not yet been raised. The accountancy bill for dealing with the year-end submissions etc. would be an example of an accrual, as the invoice is usually raised after all the procedures have been completed, which is often after the year-end itself.
A bank overdraft is another example of a current liability, as this is usually repayable upon demand.
If the business is incorporated, making profits and providing employment, it will create liabilities for both PAYE and corporate taxes. These would normally be provided in the accounts as current liabilities at the year-end date.
Balances due within 1 year on loans and finance arrangements would also be included as current liabilities. The balances due after 12 months would be shown as long-term liabilities (see section below).
Where businesses are incorporated, the transactions between the proprietor and his or her company would normally be recorded in a ‘director’s loan account’ and included within current liabilities. Examples of such transactions are
■ Capital introduced from own resources or financed by personal borrowings.
■ Amounts drawn from the business, usually in lieu of dividends declared.
■ Company expenses funded personally by the proprietor.
■ Personal expenses of the proprietor funded by the company.
It would be usual to find the director’s loan account in creditors, reflecting the fact that the company owed the director for funds introduced to the company. If it is found as a debtor, it means that the director has taken excess funds from the company and may be subject to a tax charge on the amount.
Often, the long-term liabilities of a business consist wholly of balances due on loans and finance arrangements.
Given the cost of buying stock for resale and the finances needed for ongoing expenses, a business requires a level of money to operate, known as working capital.
Often, this funding requirement is resolved by way of a loan.
In addition, funds may have been required to buy the business and to renovate the business premises to a reasonable standard. This funding is often provided by way of bank borrowing, either an overdraft or a loan.
A loan will be disclosed within the accounts, and the element within long-term liabilities will represent that part of the loan which is due for repayment after 1 year.
The purchase of equipment is often funded by finance agreements that can be taken out over a period of years, usually three to five.
From the repayment schedule, it is possible to identify the amounts that will be due within, and after, 1 year, and disclose those amounts in the accounts as appropriate.
If the amount of borrowing is significant, it is normal for the lender to ask the borrower for some form of security or guarantee, and proprietors often sign personal guarantees to secure their business borrowings.
These guarantees will give the banks access to the proprietor’s personal assets should the loan not be repaid within the agreed timetable.
Purchase of Assets and Equipment: Cash, Hire Purchase or Lease?
What is the best way to finance the purchase of new assets? In most cases, if cash is available, it is preferable to use that to buy the asset outright, although this may tie up limited cash resources.
The interest on a loan will often be more than the return the cash would receive on deposit, so it is better to use that cash, if no better use for it can be foreseen. Those setting up in business for the first time will have limited cash flow, and it is often preferable to spread the payments over a period of time. But is it better to buy an asset on hire purchase, with a loan or lease it?
The following paragraphs summarize the differences in the way assets are treated when they are financed by different methods.
Purchase with own cash: If proprietors use their own funds to buy the asset, they will own that asset from the outset, and be able to get tax relief on the cost in the year of purchase (and later years).
Purchase with an unsecured loan: Again, the proprietor will own the asset from the outset and be able to claim tax relief on the cost in the year of purchase (and later years). (An unsecured loan is one given by a lender free of any security. A secured loan would give the lender a security over the asset being purchased, or other assets of the borrower.)
Given that the lender is in a safer position with a secured loan, the rates charged on those loans are usually less than those on unsecured loans.
Purchase under a hire purchase agreement: Under a hire purchase agreement, the proprietors are treated as owning the asset from the outset, but legal ownership only passes to them on the payment of the final ‘option to purchase’ fee. Again, the full cost gets tax relief in the year of purchase (and later years). Usually, a hire purchase loan is secured on the asset to which it relates.
Purchase by way of a lease: Under this arrangement, the leasing company owns the asset for the period of the lease, and the periodic leasing payments attract tax relief, as they are paid, through the profit and loss account. Often, at the end of the initial lease period (usually 3–5 years), a secondary lease period will commence with the asset being leased to the business at a peppercorn rent in perpetuity, effectively giving the business ownership of the asset.
In order to strengthen the finance market, and to create ways to circumvent the tax regulations, financial institutions have invented hybrid finance arrangements under a myriad of names, which effectively provide the same financial benefits as above.
When an asset is bought, tax relief can usually be obtained in the year of purchase (and later years). If the asset is leased, tax relief can be obtained only over the period of the lease.
The following schedule explains the tax relief in detail:
JT’s Restaurant is planning to purchase a kitchen range for £10,000. The options it has been given are (1) to buy using available cash; (2) to lease over a period of 3 years at a cost of £320/month; or (3) to purchase using a loan of £10,000 repayable by 36 monthly payments of £320.22 (at 9.9% APR).
Under option (1), the tax allowances of 18% of the written-down cost can be claimed each year (on a reducing balance basis).
Total allowances of £4,486.
|
Year 1 Cost |
£10,000 |
|
Capital allowance claim |
(£1,800) |
|
Net value c/f to year 2 |
£8,200 |
|
Capital allowance claim |
(£1,476) |
|
Net value c/f to year 3 |
£6,724 |
|
Capital allowance claim |
(£1,210) |
|
Net value c/f to year 4 |
£5,514 |
Under option (2), the cost of the lease payments can be offset against income each year; therefore, £3840 of lease costs would be allowed as an expense against income in each of the 3 years. A total of £11,520.
Under option (3), the capital allowances of £4486 would be allowable, but in addition the interest on the loan (of £1,527.92) would be allowable as an expense. A total of £6,013.92.
The interest has been calculated as follows:
On the face of it, the leasing option looks the best until you consider that the ownership of the range is still with the leasing company, unless a peppercorn agreement is taken to obtain ownership in perpetuity.
|
Total loan amount |
£10,000.00 |
|
Total amount of repayments |
|
|
£320.22 × 36 |
£11,527.92 |
|
Difference (interest charge) |
£1,527.92 |
Also under options (1) and (3), there is still £5514 of costs to be claimed in capital allowances in future years.
Given how inconclusive the previous example is, it may be time to look at the Annual Percentage Rate (APR), as the APR is often hidden within the lease agreement paperwork, making it difficult to compare the cost of a loan and/or lease against a lease.
APR is a tool for understanding the cost of borrowing, whether it’s a loan, a credit card or a mortgage. Although APR is not perfect, it gives you a standard for comparing interest and fees from different lenders.
The official definition of APR is the yearly interest payable on the amount borrowed plus any other applicable charges, all expressed as an annual rate charge.
As the APR includes fees, not just interest charges, it gives a better understanding of the costs of finance.
In other words, it is the interest and expenses that you pay when you take a loan and repay it. For example, if you borrow £100 and the loan APR you are given is 56%, you would pay back £156 in total in the year you borrowed it.
APR allows you to evaluate the cost of the loan in terms of a percentage. If your loan has a 10% rate, you’ll pay £10 per £100 you borrow annually.
All other things being equal, you simply want the loan with the lowest APR.
If you are considering leasing or buying business equipment, it is usual to look at the available options in some detail. At this stage, it would be helpful to know how to calculate the APR on a leasing deal.
In order to calculate the APR on a leasing agreement, you need to know:
1.The capital value of the equipment
2.The term over which you wish to lease and the lease details
3.The lease rental payment
The following example will show how the APR can be calculated:
■ The equipment being acquired is a kitchen range with a Capital Cost of £10,000.00
■ The lease rental agreement is based on 36 monthly repayments with 1 month payable on delivery
■ The quoted lease rental payment is £320.00 per month
The total rental repayments come to £11,520.00, comprising the Capital Cost of £10,000 plus an additional cost of notional interest of £1,520.
Working Out the Leasing Deal APR
The first step is to work out what the flat rate interest is on your deal. To do this, you simply divide the total interest payable by the number of years. In our example:
■ Interest of £1,520.00 over 3 years equals £506.70 per year.
■ Divide this annual figure of £506.70 by the Capital Cost of your equipment; in this case £10,000. This gives you a flat interest rate of just over 5.067%.
■ The APR is roughly twice the flat rate, hence the APR in our example is 10.134%.
The reason for the simplistic/rough approach is the complexity of compound interest and the reduction in the balance as it is paid off. This makes an exact calculation very difficult.
This complexity can be seen in the following table:
A business has been offered a 5‑year loan for £100,000 at a rate of 10%, with the total amount being repayable at the end of the 5 years.
The business has been offered the loan on a simple interest or a compound interest basis, which one should it accept?
Compound interest reflects the interest on the principal as it changes each year. The complexity with compound interest loans is that the interest is charged on the principal as the repayments are being made. It is, as they say, a moveable feast. As you can see from the table, interest is charged on interest.
The above shows why it is difficult to calculate the APR without some very serious mathematics. The following is the equation for calculating an accurate APR:
where:
K is the number identifying a particular advance of credit
K ′is the number identifying a particular instalment
A K is the amount of advance K
A ′ K is the amount of instalment K′
Σ represents the sum of all terms indicated
m is the number of advances of credit
m ′is the total number of instalments
t K is the interval, expressed in years, between the relevant date and the date of the second advance and those of any subsequent advances numbers three to m
t K ′is the interval, expressed in years, between the relevant date and the dates of instalments numbered one to m′
This formula has been reproduced from the FCA.org.UK handbook.
Excessive APRs on Payday Loans
Payday loans are very expensive, but on the face of it appear cheap. These loans are often marketed as interest‑free or low‑interest rate loans, but the fees make them problematic. But even the fees are ‘sold’ as minimal, and when you look at them in terms of APR, there are much better ways to borrow money.
Take, for example, if you were to apply for an interest‑free payday loan for £500, on which a fee of £50 is charged. The loan is only needed for 14 days. The APR on this loan can be calculated as follows:
1.Divide the fee by the loan amount.
2.Multiply the amount by 365 (days).
3.Divide the result by the term of the loan (in days).
4.Multiply the result by 100.
If the preceding loan details are processed:
1.£50 divided by £500 is 0.01.
2.0.01 multiplied by 365 is 36.5.
3.36.5 divided by 14 is 2.6071.
4.2.6071 multiplied by 100 is 260.71 (this is the APR in decimal format).
Given that it is that difficult to calculate an exact APR, many loans are marketed using an estimate of what the APR will be, called the ‘representative APR’, which may not reflect the actual APR so the borrower needs to be wary of additional charges etc. that may be added to the loan after the initial agreement has been taken.
Credit card providers advertise an APR based on the interest rates they charge, but this does not include the effect of compounding, and the actual amount paid is almost always more than that quoted.
The APR paid by those who only make small or minimum payments against their credit card liability can be very high, as they will be paying interest on interest.
Credit card providers do not have to include their charges in their APR, only the interest costs. This means that their annual fees, balance transfer fees and other charges will have a significant impact on the APR, with the borrower being unaware of the true cost of their borrowing.
The sad fact is that those with the least, who are forced to borrow on credit cards and payday loans, are exploited by financial institutions. The fat cat, with the morality of a piece of wood, may call it market forces and wash his hands of the problem.
Which begs the question: do 21st-century financiers have a responsibility to use their skills and resources for the good? Have the days of greed gone?
From the evidence coming from current business practice, with the increase in child employment, the exploitation of third-world resources and questionable employment practices, I think not!
But enough of my socialist views, and let’s return to the topic of APRs.
The rules regarding the sales of some mortgages demand that the APR on a mortgage includes the fees and charges as well as the interest. The quotes provided by mortgage companies might or might not include other costs incurred to get the loan approved (such as insurances).
Lenders are able to choose what they include in their APR calculations, so it is important to look closely at what is included when comparing loans.
The ability of the borrower to pay the charges early can also have an impact on the loan’s APR.
The foregoing information shows that there are a number of matters that need reviewing when comparing loans and leases, and there is no universal right answer to financing assets.
This figure should represent the net worth of the business at the balance sheet date. In the example balance sheet, the net asset value is £498,000, and this is the amount, in theory, that would be generated by the sale of the business. So, if the goodwill and fixed assets were sold for £700,000, the stock sold, the debtors monies collected and the funds utilized in paying off the debts, including loans, the amount left in the bank would be £498,000.
This is a theoretical exercise, as the amount collected would depend upon whether the values on the balance sheet were up to date and actually achieved upon a sale.
However, the balance sheet is a good indicator of a business’s worth, and can be brought up to date quite easily by obtaining current valuations in the event of the sale of whole or part of the business.
Remember, this is the value that you are building up to retire with.
One aspect of business accounts that is often queried by entrepreneurs is that of capital. How does capital accumulate, how is it distributed between the principals and why can it not be drawn out?
These are the more common questions asked on this topic, along with the matters of (1) the introduction of the capital into the business, (2) how it is described in the accounts and (3) by what means should it be contributed to by an incoming partner.
Most of the following details apply to partnerships, but once the concepts are understood they can easily be applied to all business formats.
If the capital in a business is managed correctly, it can assist the principals in future planning and in some cases present significant tax advantages.
The capital of the majority of businesses can be fairly easily allocated to the following three headings:
Property capital: This usually represents the proprietors’ interest in the equity in the business premises and, in some cases, the fixed assets of the business. This is often separately identified in the accounts as the ‘capital accounts’ of those principals with an interest in those assets. As this capital is represented by physical assets, it cannot easily be withdrawn from the business.
Other (or fixed asset) capital: This represents the principals’ interest in the non-building fixed assets of the business, i.e., the fixtures and fittings, office equipment, computers, etc. These are assets from which the principals earn their income, and would normally be owned in the same proportions as those in which the principals would share the business income and expense.
However, a number of businesses operate a system whereby each principal owns their equipment personally: in these cases, the costs need to be attributed to the principals and shown as separate ‘capital’ accordingly.
Working capital: This represents the funds needed to finance the day-to-day operation of the business, and is often called the ‘current account’. This amount is usually made up by the net investment in the practice assets as follows:
Stocks for resale and consumables
Amounts owed to the business
Work in progress and uninvoiced work
Cash and bank balances
Amounts owed by the business
Although the capital has been broken down into the above three headings, it is more usual to see it broken down into two headings in most partnership accounts, more usually known as the ‘capital’ and the ‘current’ account.
Although there are no set rules as to which assets are financed by a principal’s capital and current accounts, it is usual to see the net equity in the premises reflected by the capital account, with the balance of the business finance being funded by the current account.
The capital and current accounts are often held in equal shares by the partners, or in line with the percentage of the business profits they will receive.
In the example balance sheet, the capital accounts of the principals would represent the costs of the property and all other fixed assets less the balance on the property loans, as follows:
Capital accounts are often based on the cost of the property on the balance sheet, and this cost is often an accumulation of the expense on the property over a number of years. It is important to regularly review the cost of the property against an estimation of its actual value, for the following reasons:
|
Fixed assets |
700,000 |
|
Loans |
(235,000) |
|
Capital account |
465,000 |
1.If the market value is less than the accumulated costs in the accounts, there is a negative equity situation and the principals would need to reflect the loss in value by reducing their capital account balances.
This can happen when there are construction costs on the property, and those costs are in excess of the added value to the property.
2.If the market value is in excess of the costs in the accounts, the equity position needs to be discussed, so that all principals are aware that they would need to provide the business with more funds to buy another principal out.
3.It is often useful to provide the business bankers with accounts that show the property at its current market value, so that they can assess the loan-to-value ratio on any funding secured on the property.
The business could renegotiate the terms of its loans if the value of the net equity in the property has increased significantly.
Current accounts reflect the amounts that the principals initially introduced to the business, as well as their accumulated undrawn profits of the business to date, and this provides the funding for the working capital of the business.
The principal’s profit share will be posted to his/her current account, plus any monies he/she has introduced to the business. Amounts in respect of his/her drawings and liabilities paid on his/her behalf are then deducted from the current account.
An increase in the current account balance in the year reflects the underdrawing of a principal’s profits. Likewise, a decrease would reflect an overdrawing.
The following is an example of a simple current account:
An understanding of how a current account is calculated is important for those wishing to take control of their business finances.
|
|
£ |
|
Amount introduced to the business |
10,000 |
|
Profit share for the year |
35,000 |
|
Amounts drawn in the year |
(27,000) |
|
Balance |
18,000 |
To encourage good working capital management, businesses should work to an agreed level of current account (i.e., agree to the level of funds that the principals should tie up in the business). This level should be sufficient to provide for cash that the business needs to operate, plus to provide for any future planned increases in fixed assets. It is important for the business to set this figure as it represents a target to aim for, and to ensure that excesses do not build up in the business that could otherwise be drawn.
Without detailed accounts being prepared on a regular basis, it is quite easy for the partners’ current accounts to get out of balance, and in equal share partnerships disputes can arise as to ‘who is financing who’ when the differences are significant.
Drawings and the Payment of Tax
The calculation of the principal’s withdrawals (drawings) from a business is a relatively simple operation when budgets are being drafted. The drawings should reflect the forecast profit.
If excess funds are building up in the bank account, it means that the budgeted profit is being exceeded.
Calculation of the drawings needs to take into account whether the business is also paying the proprietor’s tax from the profits.
It is important that the current accounts are being monitored in partnerships where the partners enjoy different shares of the business profit.
Where a business has agreed to pay the partners’ tax, calculation of the drawings is complicated, as it is unusual for each principal to have the same tax bill.
Where the partners have to account for their own tax bills, the business can pay equal drawings to each principal enjoying the same profit share.
It is important each year for the principals to review their individual current accounts as often differences in tax bills and bookkeeping errors can result in the partner’s capital accounts getting out of balance.
There are often disagreements between partners in a business and their accountants, when differences in the balances on their current accounts are pointed out, especially when they have overdrawn their profits and need to input funds into the business.
Following on from the previous mention of the accountant, it may be time to discuss the appointment of one. An accountant is a key professional who can be a focal member of your team, and guide you in the running of your business… but how do you decide which one to pick?
How Do You Find a Good Accountant?
Accountancy is one of the few professions where people can practice without having any type of qualification. Anyone can open an office and tell the world that they are the best accountant in the world. So, how do you ensure that the accountant you pick to deal with your personal and business affairs has sufficient knowledge of your business sector and the tax legislation that is relevant to your income?
The following suggestions should help in the selection of an accountant who is knowledgeable in your business sector.
■ Ask your competitors and other businesses in the same sector who their accountants are and whether they would recommend them to you; although this will not always ensure that the accountant is knowledgeable, as that business owner may not be aware of the better services being offered by other accountants, it at least shows that the accountant has sufficient skills to be recommended to you by his client.
■ Look in the trade press at both the advertisements in the classified section and also in the body of the magazine for any finance or taxation articles written by accountants specifically for your business sector.
■ Look on the websites of the Institute of Chartered Accountants in England and Wales (ICAEW: www.icaew.com) and the Association of Certified Accountants (ACCA: www.accaglobal.com) in the UK, or your local Certified Public Accountants Institute (www.aicpa.org) in the USA and worldwide, for the members nearest to you. These associations have strict membership criteria and usually demand that members hold professional negligence insurance, which will ensure some type of recourse should the service be failing in any way.
The benefit of appointing an accountant who specializes in your business sector is that they can advise on the following:
Benchmarking: With details of many businesses in the same sector, they are able to advise on the level of business profits, and where efficiencies and cost savings can be made.
Goodwill: The accountant should have details of a number of business sales in that sector and they can ascertain whether the value attributable to the goodwill you are being charged, or are going to charge, is reasonable.
Incorporation: They can advise on the tax planning, structural planning and pension issues involved in the incorporation process and can highlight issues with income protection, associated companies and VAT.
Business Sale or Purchase: They can advise on the sale or purchase of a business and assist in the raising of finance, and have a detailed knowledge of bank lending parameters.
In addition to the above, most specialist accountants can provide advice on strategy and profit improvement and provide valuations for lending purposes.
What Should You Expect from Your Accountant?
Non-specialist accountants often supply their business clients with a standard set of accounts and a completed tax return, but provide very little else within their service. This is often as a result of a lack of knowledge of the business sector.
Businesses should expect more than merely a set of account and a tax return; they should be provided with an interpretation of their results that will provide them with a high level of management information and advice. This is not something that accountants offering online services are capable of doing.
Your accountant should take an active role in the growth of your business, bringing to you the tips for success he has learned from his more successful clients. He has a vested interest in encouraging the growth of your business, as the bigger you get, the higher the fees he can charge.
Accountants tend to devote more of their time to their larger clients, as these clients’ needs for regular advice increase.
As previously discussed, a lot of the processes of running a business require the input of a legal advisor, and it is vital that a business appoints one that is competent.
Legal disputes can be very costly but can be avoided by getting things right in the first place. A good lawyer can ensure this happens.
Solicitors, How Do You Find a Good One?
The answer to this is very similar to that for accountants, in that you should look for an advisor who is knowledgeable of your industry and able to provide more than a basic legal service.
What Should You Expect from Your Solicitor?
A specialist advisor should already have experience of dealing with disputes specific to the industry and should provide advice on to how to avoid them.
They should also be able to provide draft documentation that takes into account the disputes that have arisen in the past. For example, property disputes within partnerships can be avoided by providing for them in the partnership agreement.
It is important that a business takes time out to review its performance and plan for the future. This should be done on a regular basis, at least annually.
The meeting should take place away from the distractions of running the business on a day-to-day basis to ensure that those concerned can give the process their full attention.
My firm booked a nice hotel in the Lake District for a weekend away each year, at a slack time of the year.
The review should include:
1.Review of annual accounts
2.Review of forecasts against actual
3.Preparation of forecasts for next year to include changes in wages, drawings, etc.
4.Plans for capital investment/mergers/acquisitions, etc.
5.Discuss the appointment of legal/accountancy advisors