Three Most Common Types of Small Businesses – Sole Proprietorships, Partnerships and Private Limited Companies

Sole Proprietorships

This is the type of business which legally the business entity is not separated from the owner. However, do not get yourself confused with the Separate Entity Concept in accounting. Usually the business is registered with government under a trade name (either with some association with the name of the owner or a different name altogether) and this trade name will represent the business entity in the conduct of its business activities.

Partnerships

This is the type of business with more than one owner. All the owners are called partners. In general all the partners contribute capital to the business and share common objectives of making the business successful and share the profits generated. Generally in law, the partners may have joint liability or joint and several liabilities. However, some countries may allow partnerships in which the liabilities of partners are limited. A partnership agreement could be used to set the terms and conditions among the partners.

Private Limited Companies

Some countries allow single member limited companies to be incorporated and some require minimum two members. The clear distinction of private limited companies from sole proprietorship and partnership is the liability of members is limited to the capital invested. Another distinct feature of limited private companies is that the governing body of the companies are the board of directors. The company incorporated carries its own identity under law and can sue and be sued by others. Of course when a company is found to have guilty legally, financial penalties are imposed because it is meaningless to impose jail terms on companies. In these circumstances, the relevant individuals behind the company (usually the directors) may be penalised financially, with jail terms or both. The relationship between the companies, the members/shareholders and the directors is unique and also can be a complex one whenever there are disputes between the company with third parties or disputes between members/shareholders or among the members of the board of directors. There are relevant sections in the Companies Act or Corporations Act of each country touching on this and of course there are common laws which have set down the legal principles since centuries ago.

You could find a lot of reading materials on the legal aspects of the above three types of business entities. Therefore, I only described them briefly in this post.

Example of Income Statement and Balance Sheet of a Sole Proprietor

Income Statement for the year ended 31 December 2006

$

Sales

159,270

Cost of Sales

– 90,875

Gross profit

68,395

Other income: –
Interest income

2,356

Operating expenses: –
Accountancy fee

– 800

Depreciation of property, plant and equipment

– 2,500

Donation

– 500

Electricity & water

– 3,340

Insurance premium

– 2,000

Printing & stationery

– 1,697

Rental of premises – 12,000
Salaries

– 35,579

Upkeep of office

– 3,547

Telephone charges

– 1,285

Travelling, petrol & toll charges

– 2,648

– 65,896

Net profit for the year

4,855

Retained profits B/F

27,654

Retained profits C/F

32,509

Balance Sheet as at 31 December 2006

$

Non-current assets
Property, plant and equipment

15,000

Current assets
Inventories

5,200

Trade receivables

6,000

Other receivables, deposits & prepayments

3,458

Cash and bank balances

10,639

25,297

Current liabilities
Trade payables

– 3,588

Other payables and accruals

– 2,575

– 6,163

Net current assets

19,134

34,134

Financed by: –
Capital

15,000

Retained profits

32,509

Net drawings

– 13,375

34,134

Example of Income Statement and Balance Sheet of a Partnership

Income Statement for the year ended 31 December 2006

$

Sales

159,270

Cost of Sales

– 90,875

Gross profit

68,395

Other income: –
Interest income

2,356

Operating expenses: –
Accountancy fee

– 800

Depreciation of property, plant and equipment

– 2,500

Donation

– 500

Electricity & water

– 3,340

Insurance premium

– 2,000

Printing & stationery

– 1,697

Rental of premises

– 12,000

Salaries

– 35,579

Upkeep of office

– 3,547

Telephone charges

– 1,285

Travelling, petrol & toll charges

– 2,648

– 65,896

Profit for the year

4,855

Add: –
Interest on partner’s drawings
Partner A 1,500
Partner B 2,000 3,500
Less: –
Partner’s salary
Partner A – 15,000
Partner B – 20,000 – 35,000
Partner’s commision
Partner A – 3,000
Partner B – 2,000 – 5,000
Interest charged on partner’s capital
Partner A – 2,500
Partner B – 3,500 – 6,000
Net loss for the year – 37,645
Shared as follows: –
Partner A – 60% – 22,587
Partner B – 40% – 15,058
– 37,645

Analysed as follows: –

Partner A

Partner B

Total

$

$

$

Shared net loss for the year

– 22,587

– 15,058

– 37,645

Less: –
Interest on partner’s drawings

– 1,500

– 2,000

– 3,500

Add: –
Partner’s salary

15,000

20,000

35,000

Partner’s commission

3,000

2,000

5,000

Interest charged on partner’s capital

2,500

3,500

6,000

Net profit for the year

– 3,587

8,442

4,855

Note 1

Note 1

Balance Sheet as at 31 December 2006

$

Non-current assets
Property, plant and equipment

15,000

Current assets
Inventories

5,200

Trade receivables

6,000

Other receivables, deposits & prepayments

3,458

Cash and bank balances

10,639

25,297

Current liabilities
Trade payables

– 3,588

Other payables and accruals

– 2,575

– 6,163

Net current assets

19,134

34,134

Financed by: –
Partner A Partner B

Total

$

$

$

Capital account

9,000

6,000

15,000

Current account
Balance B/F

45,874

24,280

70,154

Shared net loss for the year

– 22,587

– 15,058

– 37,645

Net drawings during the year

– 12,000

– 5,000

– 13,375

Balance C/F

11,287

4,222

19,134

20,287

10,222

34,134

Note 1: the net loss for the year for Partner A of $3,587 and net profit of Partner B of $8,422 were derived by calculating from the share of net loss for the year of $37,645, taken into account of the interest on capital, interest on drawings, salary and commission of each partner. You would not be able to know how much is each partner’s share of profit or loss directly from the net profit of $4,855.

Example of Income Statement and Balance Sheet of a Private Limited Company

Income Statement for the year ended 31 December 2006

$

Sales

159,270

Cost of Sales

– 90,875

Gross profit

68,395

Other income: –
Interest income

2,356

Operating expenses: –
Accountancy fee

– 800

Depreciation of property, plant and equipment

– 2,500

Donation

– 500

Electricity & water

– 3,340

Insurance premium

– 2,000

Printing & stationery

– 1,697

Rental of premises

– 12,000

Salaries

– 35,579

Upkeep of office

– 3,547

Telephone charges

– 1,285

Travelling, petrol & toll charges

– 2,648

– 65,896

Net profit for the year

4,855

Retained profits B/F

27,654

Retained profits C/F

32,509

Balance Sheet as at 31 December 2006

$

Non-current assets
Property, plant and equipment

15,000

Current assets
Inventories

5,200

Trade receivables

6,000

Other receivables, deposits & prepayments

3,458

Amount due by shareholders

13,375

Note 2
Cash and bank balances

10,639

38,672

Current liabilities
Trade payables

– 3,588

Other payables and accruals

– 2,575

– 6,163

Net current assets

32,509

47,509

Financed by: –
Share capital

15,000

Retained profits

32,509

47,509

Note 2: in this example, the net drawings of the owner in the example of a Sole Proprietor has been shown as amount due by shareholders for comparison purposes

Cash Basis Vs Accrual Basis of Accounting

Many small businesses use cash basis of accounting to record transactions, especially those who prepare the accounts once a year. Please refer to my post: Preparing Accounts of Small Businesses Once A Year – Tips and Pitfalls To Avoid for further illustrations.

Indications that cash basis of accounting is used includes the following:-

  • No books of original entry such as sales day book and purchases day book used to record sales and purchases.
  • No debtors ledger or creditors ledger maintained.
  • All receipts and payments are recorded directly in cash book.

Cash basis of recording transactions and presenting the financial statements produced has long been deemed an inappropriate basis to use. Accrual basis of accounting is the accepted basis and this is stated in International Accounting Standard (IAS) 1: Presentation of Financial Statements.

It is good if a business entity is aware of the difference between cash basis and accrual basis of accounting and records its transactions using accrual basis. However, for those businesses who have recorded the transactions using cash basis do not need to discard those set of accounts produced and record all past transactions using accrual basis of accounting all over again. What need to be done is re-examine all the account items that have been produced using cash basis of accounting to determine as to whether any adjustment is required to adjust those items should accrual basis of accounting is used. Some examples: –

  1. Sale of goods

    Under cash basis of accounting, all proceeds collected from sales are recorded in the accounting records upon receiving payments from customers. The balance sheets produced using cash basis of accounting do not show any trade debtor balances! Those sales figures shown in the income statements represent only cash sales. No credit sales are recorded.

    The solution is to identify all bills and invoices of those sales in which the transactions have occurred as at the end of the financial year, but still unpaid, i.e. those unpaid sales invoices or bills and put through a journal adjustment to recognise the credit sales and trade debtors as follows: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Trade debtors

    XXXX

    Sales

    XXXX

    A point to note on the criteria used to determine the occurrence of transactions (sales recognition in this case) is usually based on delivery and acceptance of goods by customers. You may have come across the solution because I have discussed this in Step 4a, The Worst Case Scenario of my post: Preparing Accounts of Small Businesses Once A Year – Tips and Pitfalls To Avoid.

  2. Purchase of goods

    This is the opposite of sales of goods discussed above. Similarly, the balance sheets produced under cash basis of accounting will not show any trade creditor balances. The purchases figures shown in the income statements represent only cash purchases. No credit purchases are recorded.

    The solution is the same as discussed in sale of goods above. You need to identify all unpaid bills and invoices in which the transactions have occurred as at the end of the financial year, but still unpaid, i.e. those unpaid purchase invoices or bills and put through a journal adjustment to recognise the credit purchases and trade creditors as follows: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Purchases

    XXXX

    Trade Creditors

    XXXX

  3. Prepayments
  4. Some expenses are paid now but part of them or the entire sums are meant for future period. This is the reason that they are called “Prepayments”. Under cash basis of accounting, prepayments are usually recorded as the respective expense accounts. What is required here is an adjustment to recognise the prepayments as current assets i.e. those portion of the payments that are meant for the next financial year.

    The original double entry recording the transactions when payments are made: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Expenses

    XXXX

    Cash at bank

    XXXX

    Adjustment for prepayments recognition:-

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Prepayments

    XXXX

    Expenses

    XXXX

    Example

    The financial period of ABC Co. Ltd. is from 1 January 2007 to 31 December 2007. On 1 November 2007, ABC Co. Ltd. paid the insurance premium for its fire policy covering the period from 1 December 2007 to 30 November 2008. The amount paid was $2,400. The prepayment for insurance is therefore $2,200 ($2,400/12 months x 11 months for the period from 1 January 2008 to 30 November 2008).

    The original double entry recording the transactions when payments are made: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Insurance premium

    2,400

    Cash at bank

    2,400

    Adjustment for prepayment recognition:-

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Prepayments

    2,200

    Insurance premium

    2,200

    The balance sheet and income statement of ABC Co. Ltd. before and after this adjustment for prepayment recognition are shown below to illustrate the impact of this adjustment: –

Example of Income Statement and Balance Sheet of ABC Co. Ltd.
Income Statement for the year ended 31 December 2007

BEFORE

Adjustment

AFTER

DR

CR

$

$

Sales

159,270

159,270
Cost of Sales

– 90,875

– 90,875
Gross profit

68,395

68,395
Other income: –
Interest income

2,356

2,356
Operating expenses: –
Accountancy fee

-800

– 800
Depreciation of property, plant and equipment

-2,500

– 2,500
Donation

-500

– 500
Electricity & water

-3,340

– 3,340
Insurance premium

-2,400

2,200 – 200
Printing & stationery

– 1,697

– 1,697
Rental of premises

-12,000

– 12,000
Salaries

-35,579

– 35,579
Upkeep of office

-3,547

– 3,547
Telephone charges

-1,285

– 1,285
Travelling, petrol & toll charges

-2,648

– 2,648

-66,296

– 64,096
Net profit for the year

4,455

6,655
Retained profits B/F

27,654

27,654
Retained profits C/F

32,109

34,309
Balance Sheet as at 31 December 2007

$

$

Non-current assets
Property, plant and equipment

15,000

15,000
Current assets
Inventories

5,200

5,200
Trade receivables

6,000

6,000
Other receivables, deposits & prepayments:
Sundry receivables

1,058

1,058
Deposits

2,000

2,000
Prepayments

2,200 2,200
Amount due by shareholders

13,375

13,375
Cash and bank balances

10,639

10,639

38,272

40,472
Current liabilities
Trade payables

-3,588

– 3,588
Other payables and accruals

-2,575

– 2,575

-6,163

– 6,163
Net current assets

32,109

34,309

47,109

49,309
Financed by: –
Share capital

15,000

15,000
Retained profits

32,109

34,309

47,109

49,309
  1. Interest income

    Business entities may place excess cash as term deposits with financial institutions to earn interest income. Under cash basis of accounting, there was no interest income recognised and recorded in the accounts until the business entities receive the interest upon maturity of the term deposits.

    However, under accrual basis of accounting, the amount of interest attributable to the relevant period of the deposits placement must be calculated and recognised accordingly. For examples, the financial period of ABC Co. Ltd. is from 1 January 2007 to 31 December 2007. On 1 July 2007, ABC Co. Ltd. placed $100,000 with its bank as term deposit for 1 year. The interest rate is 3.5% per annum. The interest earned from 1 July 2007 to 30 June 2008 is $350 ($100,000 x 3.5%). In respect for the accounts of ABC Co. Ltd. for the year ended 31 December 2007, the portion of the interest income to be recognised is $175 ($350 x 6months/12months for the period from 1 January 2007 to 31 December 2007).

    The journal adjustment to recognise this interest income is as follows: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Interest receivable

    175

    Interest income

    175

    The balance sheet and income statement of ABC Co. Ltd. before and after this adjustment for interest income recognition are shown below to illustrate the impact of this adjustment: –

Example of Income Statement and Balance Sheet of ABC Co. Ltd.
Income Statement for the year ended 31 December 2007

BEFORE

Adjustment

AFTER

DR

CR

$

$

Sales

159,270

159,270
Cost of Sales

-90,875

– 90,875
Gross profit

68,395

68,395
Other income: –
Interest income

175 175
Operating expenses: –
Accountancy fee

-800

– 800
Depreciation of property, plant and equipment

-2,500

– 2,500
Donation

-500

– 500
Electricity & water

-3,340

– 3,340
Insurance premium

-200

– 200
Printing & stationery

– 1,697

– 1,697
Rental of premises

-12,000

– 12,000
Salaries

-35,579

– 35,579
Upkeep of office

-3,547

– 3,547
Telephone charges

-1,285

– 1,285
Travelling, petrol & toll charges

-2,648

– 2,648

-64,096

– 64,096
Net profit for the year

4,299

4,474

Retained profits B/F

27,654

27,654
Retained profits C/F

31,953

32,128
Balance Sheet as at 31 December 2007

$

$

Non-current assets
Property, plant and equipment

15,000

15,000
Current assets
Inventories

5,200

5,200
Trade receivables

6,000

6,000
Other receivables, deposits & prepayments:
Interest receivable

175 175
Deposits

14,077

14,077
Prepayments

2,200

2,200
Fixed deposit with licensed bank

100,000

100,000
Cash and bank balances

10,639

10,639

138,116

138,291
Current liabilities
Trade payables

-3,588

– 3,588
Other payables and accruals

-102,575

– 102,575

– 106,163

– 106,163
Net current assets

31,953

32,128

46,953

47,128
Financed by: –
Share capital

15,000

15,000
Retained profits

31,953

32,128

46,953

47,128

On 30 June 2008, when the deposit matures and interest of $350 is received by ABC Co. Ltd., the double entry to record these transactions is as follows:-

Balance Sheet

Income Statement

DR

CR

DR

CR

Cash at bank

100,350

Fixed deposit with licensed bank

100,000

Interest receivable

175

Interest income

175

The balance sheet and income statement of ABC Co. Ltd. for the year ended 31 December 2008 before and after this adjustment are shown below to illustrate the impact of this adjustment: –

Example of Income Statement and Balance Sheet of ABC Co. Ltd.
Income Statement for the year ended 31 December 2008

BEFORE

Adjustment

AFTER

DR

CR

$

$

Sales

109,270

109,270
Cost of Sales

– 40,875

– 40,875
Gross profit

68,395

68,395
Other income: –
Interest income

175 175
Operating expenses: –
Accountancy fee

– 800

– 800
Depreciation of property, plant and equipment

– 2,500

– 2,500
Donation

– 500

– 500
Electricity & water

– 3,340

– 3,340
Insurance premium

– 200

– 200
Printing & stationery

– 1,697

– 1,697
Rental of premises

– 12,000

– 12,000
Salaries

– 27,865

– 27,865
Upkeep of office

– 3,547

– 3,547
Telephone charges

– 1,285

– 1,285
Travelling, petrol & toll charges

– 2,648

– 2,648

– 56,382

– 56,382
Net profit for the year

12,013

12,188
Retained profits B/F

27,654

27,654
Retained profits C/F

39,667

39,842
Balance Sheet as at 31 December 2007

$

$

Non-current assets
Property, plant and equipment

10,000

10,000
Current assets
Inventories

5,000

5,000
Trade receivables

17,030

17,030
Other receivables, deposits & prepayments:
Interest receivable

175

175

Deposits

14,077

14,077
Prepayments

2,200

2,200
Fixed deposit with licensed bank

100,000

100,000

Cash and bank balances

12,348

100,350 112,698

150,830

151,005
Current liabilities
Trade payables

-3,588

– 3,588
Other payables and accruals

-102,575

– 102,575

-106,163

– 106,163
Net current assets

44,667

44,842

54,667

54,842

Financed by: –
Share capital

15,000

15,000

Retained profits

39,667

39,842

54,667

54,842

Out of the $350 interest received, $175 was credited to the interest receivable account and $175 is credited to the interest income account for the year ended 31 December 2008 (for the interest earned for the period from 1 January 2008 to 31 December 2008.

The interest was calculated based on simple interest method. For illustrations on the difference between simple interest and compound interest, please refer to my post: Effective Interest? Simple Interest? Compound Interest? Nominal Interest?

Effective Interest? Simple Interest? Compound Interest? Nominal Interest?

Simple interest is usually discussed and compared with compound interest. Simple interest is named as such because the interest calculated is not compounded.

In contrast, when compound interest is calculated, nominal interest rate and effective interest rate would be the relevant interest rates involved in the calculations or discussions.

Example

  1. Simple Interest

    ABC Co Ltd. placed $100,000 deposit with Bank A for 1 year with interest of 3.5% per annum and calculated on simple interest method.

    Interest earned at the end of the one year period is therefore calculated as follows: –

    $100,000 x 3.5%

    = $3,500

  2. Compound Interest

    In the context of compound interest calculation, you need to specify the following: –

    1. The total length of the placement of deposit. In this example, one year.
    2. The frequency of compound interest calculation. E.g. daily, monthly, quarterly & etc.
    3. The nominal annual rate of interest used.

    Assume monthly compounding of interest is adopted, with 3.5% nominal annual rate of interest, we usually say:

    “ABC Co Ltd. placed $100,000 deposit with Bank A for 1 year with 3.5% nominal annual rate of interest monthly compounding”.

    The interest earned is calculated as follows:-

    FV = PV x (1 + i)n

    Where,

    FV = future value of the deposit (the total value of the $100,000 deposit at the end of the 1 year period.)

    PV = the present value of the deposit (the value of the deposit at the beginning of the 1 year period, which is $100,000)

    n = the number of period in terms of compounding. For example, if the period of the deposit placement is 2 years with monthly compounding, n = 24 ( 2years x 12)

    i = the interest rate in percent per period of compounding. In this example, i =0.29667% (3.5%/12). Word of caution here, when you do the calculation, i is 0.00296667. Many make mistake in the calculation because they did not realise that i is expressed in percentage!

    Therefore, for this $100,000 deposit placement,

    FV = $100,000 (1 + 3.5%/12)12

    = $103,556.70

    The interest earned is therefore $3,556,70 ($103,556.70 – $100,000)

    Conclusion

    On $100,000 deposit placement, interest at 3.5% per annum monthly compounding for 1 year period will yield an extra $56.70 compared to 3.5% per annum simple interest method.

    There could be instances whereby ABC Co Ltd. is offered different options for deposit placement with Bank A. For example:-

    Option 1

    $100,000 1 year at 3.5% per annum monthly compounding

    Option 2

    $100,000 2 years at 4.75% per annum quarterly compounding

    Option 3

    $100,000 5 years at 4.80% per annum yearly compounding

    How does ABC Co Ltd. evaluate these options? Which is the best option? As the period of the investment i.e. the length of the placement is different (Option 1 = 1 year; Option 2 = 2 years; Option 3 = 5 years), a meaningful comparison on “level field” is desired – using Effective Interest Rate.

    The formula for effective interest rate is:-

    R = (1 + i)n – 1

    Where,

    R = the effective interest rate

    i = the interest rate in percent per period of compounding

    n
    = the number of period in terms of compounding in a year

    Option 1

    R = (1 + 3.5%/12)12 – 1

    = 3.56%

    Option 2

    R = (1 + 4.75%/4)4 – 1

    = 4.84%

    Option 3

    R = (1 + 4.80%/1)1 – 1

    = 4.80%

    Based on the effective interest rates calculated for the three options, Option 2 gives the highest rate and appears to the best. However, in making the selection ABC Co Ltd. should also consider other factors including the future plan of ABC Co Ltd. in terms of when will the money is needed in future & etc. in one year? 3 years? 5 years?

    How much will ABC Co Ltd earn for each option?

    Option 1

    FV = $100,000 (1 + 3.5%/12)12

    = $103,556.70

    Interest earned at the end of 1 year placement is $3,556.70 ($103,556.70 – $100,000)

    Option 2

    FV = $100,000 (1 + 4.75%/4)8

    = $109,904.36

    Interest earned at the end of 2 years placement is $9,904.36 ($109,904.36 – $100,000). But take note that this is over 2 years if you compare to that of Option 1. If you calculate using straight-line time proportion basis, Option 2 gives $4,952.18 ($9,904.36 divided by 2 years) and appears to yield much higher interest. Straight-line time proportion basis does not give a good picture for the comparison because the interest is compounded. Using the effective interest method, the FV under Option 2 at the end of Year 1 is: –

    FV = $100,000 (1 + 4.75%/4)4

    = $104,835.28

    The interest earned for Year 1 under Option 2 is therefore $4,835.28 ($104,835.28 – $100,000) and not $4,952.18 calculated under the straight-line time proportion method.

    The interest earned during Year 2 under Option 2 is: –

    FV = $104,835.28 (1 + 4.75%/4)4

    = $109,940.36

    The interest earned for Year 2 is therefore 5,069.08 ($109,940.36 – $104,835.28).

    Perform a summation proof by adding the interest earned in Year 1 and Year 2:-

    Total interest (Year 1 + Year 2) = $4,835.28 + $5,069.08

    = $9,904.36!

    Option 3

    FV = $100,000 (1 + 4.80%/1)5

    = $126,417.17

    Interest earned at the end of 5 years placement is $26,417.27 ($126,417.17 – $100,000). But take note that this is over 5 years if you compare to that of Option 1 or Option 2. If you calculate using straight-line time proportion basis, Option 5 gives $5,283.54 ($26,417.27 divided by 5 years) and appears to yield much higher interest. Straight-line time proportion basis does not give a good picture for the comparison because the interest is compounded. Using the effective interest method, the FV under Option 3 at the end of Year 1 is: –

    FV = $100,000 (1 + 4.80%/1)1

    = $104,800

    The interest earned for Year 1 under Option 2 is therefore $4,800 ($104,800 – $100,000) and not $5,283.54 calculated under the straight-line time proportion method.

    The interest earned during Year 2 under Option 3 is: –

    FV = $104,800 (1 + 4.80%/1)1

    = $109,830.40

    The interest earned for Year 2 is therefore 5,030.40 ($109.830.40 – $104,800.00).

    The interest earned during Year 3 under Option 3 is: –

    FV = $109,830.40 (1 + 4.80%/1)1

    = $115,102.26

    The interest earned for Year 3 is therefore 5,271.86 ($115,102.26 – $109.830.40).

    The interest earned during Year 4 under Option 3 is: –

    FV = $115,102.26 (1 + 4.80%/1)1

    = $120,627.17

    The interest earned for Year 4 is therefore 5,524.91 ($120,627.17 – $115,102.26).

    The interest earned during Year 5 under Option 3 is: –

    FV = $120,627.17 (1 + 4.80%/1)1

    = $126,417.27

    The interest earned for Year 5 is therefore 5,790.10 ($126,417.27 – $120,627.17).

    Perform a summation proof by adding the interest earned in Year 1,Year 2, Year 3, Year 4 and Year 5:-

    Total interest (Year 1 + Year 2 + Year 3 + Year 4 + Year 5)

    = $4,800 + 5,030.40 + 5,271.86 + 5,524.91 + 5,790.10

    = $26,417.27!

    Note: The excess of 10 cents ($26,417.27 – $26,417.17) is due to rounding error.


Preparing Accounts of Small Businesses Once A Year – Tips and Pitfalls To Avoid

Many small business owners started the businesses on their own or with minimal staff strength. Usually, the major focus of the businesses is on revenue generation and leaves the function of transactions record keeping and accounting to inexperience staff. Many business owners leave it aside until the end of the financial year or when the deadline of accounts submission to the authorities coming close. The accounts and financial statements of the business entities are prepared once a year. Please take note that this practice of recording transactions once a year is definitely not encouraged and may even contravene the law imposed on businesses in some countries with the owners unaware of this. Depending on how the accounting documents are filed and kept, the accounting personnel assigned the task of preparing the accounts and the financial statements once a year may face the following three scenarios: –

First Scenario – The worst case scenario

The owners have little or no knowledge of accounting and transactions record keeping. No accounting records or transaction records listing kept. No separate recording of receipts and payments made. All the accounting documents including receipts, invoices & etc are probably not kept in files and in a mess. Personally, I have seen cases whereby all these source documents were just being thrown into a big box throughout the whole financial year! It puzzles me how these business owners monitor the daily cash flow position of the business operations. Many of them have to rely on constantly checking the bank account balances before payments are made or just relying on the fact that the bank account are allowed to be “overdrawn” because of overdraft facility. However, bank balances obtained from banks at any particular point in time do not necessary provide a reliable bank balances of the business available for use because of unpresented cheques and uncleared deposits. In addition, allowing unnecessary utilisation of overdraft facility is actually a waste of money for the business. This is a nightmare for the accounting personnel!

Steps: –

1. Sorting of documents

The first step is to sort all the accounting documents by types and in chronological order.

2. Identify and recover missing documents

Identify any obvious missing documents and take action to get a copy.

3. Key-in transactions in the accounts

Start with the cheque butts and bank statements by entering transactions into the cash book and the relevant accounts in the general ledger. Since there was no recording of transactions throughout the whole financial year, it serves little purpose now if you chose to record the transactions the conventional way to the books of original entry (Sales day book, purchase day book & etc) and then posts the transactions to the general ledger. However, it is good if you decide to do it the conventional way.

Important point: Key in or record the transactions MONTH BY MONTH. After the transactions of the first month have been completely recorded, prepare a bank reconciliation statement BEFORE you move on to the next month! This is important because if you proceed straight to key in all the transactions of the whole financial year in one go into the accounts, you still need to ensure that the bank balance reflected in the accounts as at the end of the financial year does in fact tally with the bank balance reflected on the bank statement (To prepare a bank reconciliation statement). Can you imagine what would happen if the reconciliation does throw out unreconciled differences? You have to go through all the transactions for the whole financial year (Both the entries recorded in the cash account and also the transaction entries reflected on the bank statements) and match each and every of them! By keying in transactions month by month and perform bank reconciliation also month by month, you are actually dividing this gigantic task into small parts and definitely much easier to manage and complete!

4. Further Adjustments

After all the entries have been recorded and reconciled to the bank statements, you still need to perform the following tasks before closing all the accounts and proceed to preparing the balance sheet and income statement: –

a. Credit transactions

Identify all bills, and invoices both for sales and purchases in which the transactions have occurred as at THE END OF THE FINANCIAL YEAR, but still have not been settled or paid. Go through all the invoices or bills settled or paid after the financial year and also all the unpaid or unsettled bills or invoices on hand. The criteria to determine the occurrence of transactions is usually based on the delivery and acceptance of goods and completion of services and NOT on the billing date as reflected on the invoice! Once you have completed this task, a listing of trade debtors, trade creditors, other debtors and other creditors should have also been compiled. Use journal entries to record and post these credit transactions in the respective accounts in the general ledger.

b. Year End Inventories or Stock Balance

The financial year end inventory balance is required to be ascertained. Usually, it is a required practice to conduct a year end stock counting exercise, and depending on the type of the business entities, if the financial statements of the business entities are subject to statutory audit requirement, the auditors should be informed of the stock counting date and be invited to observe the stock counting exercise. However, if the transactions record keeping of the business entities is in such a poor state, usually stock counting exercise at year end is also unlikely to have been conducted. Depending on the nature of the business entities, the task of identifying year end stock balances could be taking a lot of time and effort or just a simple and easy task. If the business is a service provider, no stock balances! If the business is selling only one type of goods, it is still fairly easy to identify the stock balance by way of identify the goods that have been purchased during the financial year (especially towards the end of the financial year) and SOLD in the NEXT FINANCIAL YEAR. Also identify those goods purchased during the financial year and remained unsold at the time of preparing the accounts. Of course if the stocks are beyond the usual stock holding period, the reason why the stocks are still unsold and any write down or write off required is the next issue to consider. However, if the business sells many different types of goods and also the volume of the businesses is large, this is a very time consuming task! Once the year end inventories or stock balance is ascertained, use journal entries to record the balance in the accounts.

c. Prepayment and deposits (balance sheet accounts with debit balances)

If all the prepayment and deposits have been calculated accordingly during the stage of keying in transactions into the accounts in the general ledger, it is of course no longer necessary to consider this. However, if there were no effort spend to calculate them before, you would now required to identify the possible prepayments and deposits which have most likely been recorded as expenses in the income statement items account and do the necessary adjustments by way of journal entries to recognise these items as balance sheet items.

5. Closing accounts and prepare trial balance, balance sheet and income statement

Once the above steps have been completed, it is time now to prepare the trial balance, balance sheet and income statement.

Second Scenario – Moderate cases

Accounting documents are filed by types and in chronological order. No cash book maintained but a listing or book that is used to record and describe each receipt and payment is maintained. In a way, this serves the role or cash receipts journal and cash payment journal.In this scenario, Step 1 and 2 described in the First Scenario are not necessary because the transactions record keeping are organised and in order. However, you need to go through the receipts and payments listing and segregate all the transactions into the respective types or groups and compute the total of each type or group of the transactions in accordance with the general ledger accounts items. You just need to post the total of each type or groups of transactions by way of journal entries the cash account and the respective general ledger accounts. Again, this should be performed month by month and also ensure the bank reconciliation is also performed month by month. After this, perform the tasks described in Step 4 and Step 5 of the First Scenario.

Third Scenario – Organised and Good Transactions Record Keeping

Cash book is used to record all receipts and payments and proper columns in the cash book are used to record each type of group of transactions in accordance with the accounts items in the general ledger. In these cases, the total of each column in the cash book is readily available at the end of each month. Most likely the monthly bank reconciliation statements are also prepared. You just need to record the total of each column in the cash book in the general ledger using journal entries. After this, perform the tasks described in Step 4 and Step 5 of the First Scenario.

Dividend Imputation

In some countries, dividends are distributed to shareholders under dividend imputation system. The purpose of this system is to avoid imposing tax “2 times” on the same income is first generated by companies (taxed the first time when the income is reported by companies), which is then distributed to shareholders as dividends (taxed the second time when the dividend income is reported by individual shareholders).

Example

Company A has 2 shareholders – Mr Big and Mr Small, each holding 50% of the shares in Company A. The details of the share capital of Company A are shown below: –

$

Authorised Share Capital:

100,000 ordinary shares or $1.00 each

100,000

Issued and Fully Paid-up Share Capital:

100,000 ordinary shares or $1.00 each

100,000

For the financial year ended 31 December 2007, Company A made $25,000 profit before taxation and declared and paid a dividend of 25 cents per share to its shareholders.

Based on the profit of $25,000, assume a corporate income tax rate of 20%, and there are no adjustments required to be made to the $25,000 accounting profit to arrive at the taxable profit, the corporate income tax paid by Company A is therefore $5,000 ($25,000 x 20%).

The summarised income statement of Company A for the year ended 31 December 2007 is shown below:-

$

Profit before taxation

25,000

Taxation

-5,000

Profit after taxation

20,000

Retained profits brought forward (Assume $10,000)

10,000

Profits available for appropriation

30,000

Dividends

-25,000

Retained profits carried forward

5,000

The $25,000 is the dividend distributed to both Mr Big and Mr Small in the following manner:-

$

Mr Big – 50% 12,500
Mr Small – 50% 12,500
TOTAL 25,000

In a simplified scenario and assuming there is no dividend imputation, both Mr Big and Mr Small would need to declare this dividend received as a source of income to the tax authority and be taxed accordingly. Assuming a personal income tax rate of 10%, and no other source of income, and no other deductions or rebates, Mr Big and Mr Small would need to pay $1,250 each as income tax to the tax authority.

The following table shows clearly that based on the same source of profit, originally the $25,000 profit before taxation made by Company A, and subsequently distributed to the shareholders as dividends – $12,500 to Mr Big and $12,500 to Mr Small, the total amount of income tax collected by the tax authority is $7,500 ($5,000 from Company A, $1,250 from Mr Big and $1,250 from Mr Small):-

$5,000

—–> on $25,000 profit reported by Company A

+

$1,250

—–> on $1,250 profit reported by Mr Big

+

$1,250

—–> on $1,250 profit reported by Mr Small
TOTAL TAX COLLECTED

$7,500

There is an argument that it is unfair for the tax authority to impose tax twice on the same income and therefore the dividend imputation system is introduced.

Under the dividend imputation system, the amount of tax paid by companies, in this example, the $5,000 tax charged on Company A, will be recorded in a tax credit account. This tax credit account is not an account created and maintained in the general ledger, it is just a memorandum account used to keep track of the income tax on companies which can be used to frank the payment of dividends to shareholders.

Based on the $5,000 tax charged on Company A (some countries require that the tax must be paid by companies before it is eligible to be used as tax credit to frank the payment of dividends), and assume it is eligible to be used as tax credit to frank the dividends, Company A would need to perform a calculation check to know the maximum amount of profits that can be distributed to its shareholders, WITHOUT additional tax to be paid as follows:-

Tax credit = $5,000
Maximum amount of profit that Company A can declare as dividend without incurring additional tax
= $5,000 X

(100% – income tax rate)

income tax rate

= $5,000 X

(100% – 20%)

20%

= $5,000 X

80%

20%

= $20,000

This $20,000 represents the profit of Company A that can be distributed as net dividend to that shareholders without paying additional tax and if Company A were to decide to declare its profit to the maximum without paying additional tax, the dividend is usually described as follows: –

“Company A declared and paid a gross dividend of $25,000 less tax of $5,000 (tax rate at 20%) amounted to $20,000 to its shareholders”.

Refer to the summarised income statement of Company A:-

$

Profit before taxation

25,000

> This is NOT the maximum amount of profit that Company A can distribute as dividends without incurring additional tax
Taxation

-5,000

> This is the tax credit available to be utilised to frank the payment of dividends
Profit after taxation

20,000

> This IS the maximum amount of profit that Company A can distribute as dividends without incurring additional tax

Assume now Company decided to declare $20,000 net dividends to its shareholders, instead of $25,000 (as described earlier where there is no dividend imputation)

In the books of Company A

The double entry for the recording of the dividends paid is:-

Balance Sheet

Income Statement

DR

CR

DR

CR

Retained profits – dividend*

20,000

Cash at bank

20,000

*Take note that dividend is not an expense. It is a distribution of profits to shareholders and therefore is shown as a deduction against retained profits.

In the books of Mr Big

The double entry for the recording of the dividend income is:-

Balance Sheet

Income Statement

DR

CR

DR

CR

Cash at bank

10,000

Tax recoverable

2,500

Dividend income

12,500

In the books of Mr Small

The double entry for the recording of the dividend income is:-

Balance Sheet

Income Statement

DR

CR

DR

CR

Cash at bank

10,000

Tax recoverable

2,500

Dividend income

12,500

Assume a personal income tax rate of 10% and both Mr Big and Mr Small have no other source of income, no other deductions and rebates, the tax computation prepared for tax purposes is as follows:-

Mr Big Mr Small

$

$

Dividend income

12,500

12,500

A
Tax @ 10%

1,250

1,250

B = A X 10%
Tax credit available for set-off

-2,500

-2,500

C = from the $5,000 tax credit in Company A split into 50% for Mr Big and 50% for Mr Small
Tax recoverable

-1,250

-1,250

D = B + C

As shown above, the $5,000 ($2,500 each for Mr Big and Mr Small) tax credit available for Mr Big and Mr Small to set off against the tax payable calculated on the dividend income, is from the tax credit of Company A on the $25,000 profit reported to the tax authority.

In the hand of the shareholders, Mr Big and Mr Small, as the amount of tax on the dividend income is only $1,250 each for Mr Big and Mr Small, both Mr Big and Mr Small are eligible to apply to the tax authority for the refund of the “excess” tax paid amounted to $1,250 each for Mr Big and Mr Small. This $1,250 of “excess” tax paid is therefore shown as tax recoverable.

The double entry to record the amount of tax payable of $1,250 calculated above is:-

In the books of Mr Big

Balance Sheet

Income Statement

DR

CR

DR

CR

Taxation

1,250

Tax recoverable

1,250

In the books of Mr Small

Balance Sheet

Income Statement

DR

CR

DR

CR

Taxation

1,250

Tax recoverable

1,250

The income statement of Mr Big and Mr Small after taken into account of the two adjustments is as follow:-

Mr Big Mr Small

$

$

Profit before taxation (Assume only dividend income. No other income or expenses)

12,500

12,500

Taxation

-1,250

-1,250

Profit after taxation

11,250

11,250

The extract of the balance sheet of Mr Big and Mr Small showing the tax recoverable is as follow:-

Mr Big Mr Small

$

$

Current Assets
Inventories

xxxx

xxxx

Trade receivables

xxxx

xxxx

Other receivables, deposits and prepayments

xxxx

xxxx

Tax recoverable ($2,500 – $1,250)

1,250

1,250

Cash at bank

xxxx

xxxx

A word of caution, I have seen many mistakes on the recording of dividend income in the books of the recipients when the dividend imputation system is applied. The mistakes done usually is because the following double entry is used to record the dividend income:-

Balance Sheet

Income Statement

DR

CR

DR

CR

Cash at bank

10,000

Dividend income

10,000

The tax computation prepared is as follows:-

$

Dividend income

10,000

Tax @ 10%

1,000

The journal adjustment to record the tax payable is:-

Balance Sheet

Income Statement

DR

CR

DR

CR

Taxation

1,000

Tax payable

1,000

Can you see the mistakes made?

  1. Instead of showing a tax recoverable of $1,250, a tax payable of $1,000 is shown.
  1. Taxation amount shown in the income statement of $1,000 instead of $1,250
  1. The tax of $1,000 not set off against the tax credit of $2,500.
  1. Dividend income shown in the income statement is $10,000 instead of $12,500

What if Company A decided to declare a net dividend of $25,000 to its shareholders?(i.e. $5,000 in excess of the $20,000 calculated where no additional tax liability required). Under the tax law and regulations in respect of dividend imputation, Company A is required to pay the tax on the excess of $5,000 ($25,000 – $20,000) for distributing the profit as dividend to its shareholders, i.e. $1,000 ($5,000 x 20%). I have seen many companies declared and paid dividends to the shareholders in excess of the maximum amount without realising that this is the case and attracted unnecessary tax penalties.

Separate Entity Concept

In accounting, a business entity is treated as a separate entity from the owner(s). Therefore, any capital injections made by the owner(s) are recorded as capital contribution from owners in the books of the business entity. The owner(s)’ private expenditure/spending are not recorded in the books of the business entity.

There are many instances whereby the owner(s) withdrew money from the business for their personal use. This is actually a lending of money from the business to the owner(s) and should be recorded as such in the books of the business entity. On the other hand, when the owner(s) inject cash into the business to help easing tight cash flow situation faced by the business entity, it is a lending of money from the owner(s) to the business and should also be recorded as such in the books of the business entity.

Many owner(s) of small businesses fail to see this “line” drawn between the business and the owner(s). The direct consequence is the recording of private/personal expenditure in the books of the business entities and therefore the financial position and results of the business entities do not show a “true picture” of the business entities. The business entities may face the following problems: –

• Private/personal expenses not adjusted from the profit/income reported for income tax purposes and therefore understating the income subject to tax. Unnecessary penalty and more seriously, jail terms are possible outcome.

• It may cause the application for banking facility unsuccessful should the assessor of the application notice that the owner(s)’ private expenditure is included in the financial statements of the business entities.

• In general, this does not do good to the application submitted by the business entities whereby financial statements are to be included in the application (e.g. project tender, grant application & etc.)
This problem of keeping the books/accounts of business entities “clean” from owner(s)’ private expenditure can be further compounded if the transactions record keeping of the business entities is poor, making any effort to identify these private expenditure recorded in the books of the business entities for adjustment purposes difficult.