Financial and management accounts: the basics

© Keith Williamson

The accounting needs of your business will vary according to its size, type and sector. As the business owner, it’s your responsibility to make sure your business keeps accurate records and accounts.

There are two types of accounting information — financial accounts and management accounts.

Financial accounts describe the performance of your business and have to be filed at Companies House. Management accounts are aimed at helping you to plan your business and make decisions about key areas such as sales, margins and stock.

This guide explains the basics of both types of accounts and what they should include. It outlines your financial accounting obligations and details how management accounting can help you run your business more effectively.

Financial accounts

Financial accounts are a historical record of your business’ performance over a past period — usually one year — for the benefit of external users such as shareholders, employees, suppliers, bankers and authorities.

Financial accounts normally include the following elements.

Profit and loss account

This measures your business’ performance over a given period of time, usually one year.

It compares the income of your business against the cost of goods or services and expenses incurred in earning that revenue. See our guide on how to set up a simple profit and loss account for your business.

Balance sheet

This is a snapshot of your business’ assets (what you own or are owed) and your liabilities (what you owe) on a particular day — eg the last day of your financial year.

Cash flow statement

This shows how your business has generated and disposed of cash and liquid funds during the period under review. A cash flow statement is different from a cashflow forecast, which is used to predict the expected rises and falls in cashflow over the coming year. See our guide on cash flow management: the basics.

Statement of recognised gains and losses

This records all gains and losses since the previous set of accounts. For example, changes caused by currency fluctuations, property revaluation, profits earned by associates and joint ventures not included in the normal accounts.

Unincorporated businesses

Unincorporated businesses such as sole traders and partnerships are required by HM Revenue & Customs (HMRC) to maintain proper books and records to support annual income tax returns. These must be kept for a minimum of six years.

Filing financial accounts

Limited companies are obliged by law to prepare a set of financial accounts each year and to file a copy with Companies House.

For accounting periods starting on or after 6 April 2008:

• private companies must file accounts within 21 months of the business’ formation, and within nine months of the end of each financial year thereafter
• public companies must file accounts within 18 months of the business’ formation, and within six months of the end of each financial year thereafter

Read guidance on preparing and filing accounts on the Companies House website.

There are statutory penalties for late or incorrect filing, for which the directors are liable. Find information about late filing penalties on the Companies House website.

Small and medium-sized companies are allowed to file accounts with certain information omitted.

Small companies

A small company is one which meets at least two of the following criteria:

• annual turnover must be £6.5 million or less
• the balance sheet total — fixed and current assets — must be £3.26 million or less
• the average number of employees must not exceed 50

Small companies may deliver a copy of the full accounts to Companies House or choose to deliver abbreviated accounts which include the following:

• abbreviated balance sheet and notes
• special auditors’ report — unless the company has a small company audit exemption

Medium-sized companies

A medium-sized company must meet at least two of the following criteria:

• annual turnover must not exceed £25.9 million (£22.8 million or less for accounting reference periods before 6 April 2008)
• the balance sheet total must not exceed £12.9 million (£11.4 million on or before 6 April 2008)
• the average number of employees must not exceed 250

Medium-sized companies may deliver a copy of the full accounts to Companies House or choose to deliver abbreviated accounts which include the following:

• full balance sheet
• abbreviated profit and loss account
• special auditors’ report
• directors’ report
• notes to the accounts

Management accounts

Management accounts can help you make timely and meaningful management decisions about your business.

Different businesses will have different management accounting needs, depending on the business areas that are important to them. These can include:

• the sales process — such as pricing, distribution and debtors
• the purchasing process — such as stock records and creditors
• a fixed asset register — details of all fixed assets, including identification numbers, cost and date of purchase, etc
• employee records

There is no legal requirement to prepare management accounts, but it is hard to run a business effectively without them. Most companies produce them regularly — eg monthly or quarterly.

Management accounts analyse recent historical performance and usually include forward-looking elements such as sales, cashflow and profit forecasts. The analysis is usually performed against forecasts and budgets that have been produced at the start of the year. See our guide on budgeting and business planning.

The information in management accounts is usually broken down so that the performance of different elements of the business can be measured. For example if a business has more than one sales outlet, there might be a separate report for each. There may also be a report produced to show how well a particular product has done across different outlets.

For businesses selling more than one product, it is advisable to provide a financial breakdown for each product category. This will allow you to ensure that profitable products are not subsidising those that are selling poorly, unless you intentionally promote loss leaders to attract further custom.

Uses of management accounting

Management accounts will enable you to:

• compare your accounts with original budgets or forecasts
• manage your resources better
• identify trends in your business
• highlight variations in your income or spending which may require attention

They should be used for the following:

Record keeping

• recording business transactions
• measuring results of financial changes
• projecting financial effects of future transactions
• preparing internal reports in a user-friendly format

Planning and control

• collecting cash
• controlling stocks
• controlling expenses
• co-ordination and monitoring of strategy/performance
• monitoring gross margins

Decision making

• using cost information for pricing, capital investment and marketing
• evaluating market and product profitability
• evaluating the financial effect of strategies and plans

The importance of maintaining accurate accounts

It’s important that your accounts are accurate and up to date so you can draw up ‘true and fair’ annual accounts. Your accounts should be backed up with full and detailed records of all business income and expenditure, such as receipts, invoices and purchase orders, payments in and out, etc. See the page on records required for producing a profit and loss account or completing a tax return in our guide on how to set up a simple profit and loss account for your business.

Why you should keep records and documents

Following careful record keeping procedures can also help you with tax returns and prevent fraud or theft. Using a good record keeping system will keep you up to date and help you to:

• track expenses, debts and creditors
• apply for additional funding — eg a bank loan or overdraft facility
• save time and accountancy costs
• pay tax, accurately and on time, avoiding penalties
• apply for and receive the correct amount of benefits or credits

If you are starting a new business it is essential that you get a proper record keeping system in place immediately.

You can use various storage methods to keep records — such as a computer, hard disc drive or CD — as long as they:

• show all information contained within a document
• allow information to be presented in a readable format

You should try to keep all original documents, and must keep any which show that tax has been deducted — eg your end of year certificate for PAYE (form P60).

Detailed and up-to-date records will help you comply with tax legislation, deal with mistakes and avoid penalties. You can be penalised for:

• not keeping adequate records
• failing to keep records for required periods of time
• inaccurate tax returns

Analytical accounting tools

Analysing your financial accounts enables you to compare your performance against previous years and with its competitors.

Ratios enable you to quickly compare relative values — eg two items on the balance sheet.

Ratio analysis can also be applied to non-financial data. For ease of reference, ratios are often split into the following areas of common control:

• liquidity ratios — these are used to measure solvency and short-term survival prospects
• capital structure ratios — these measure the adequacy of owners’ funding in relation to long-term debt
• activity and efficiency ratios — these measure the operating efficiency of the business in non-financial terms
• profitability ratios — these measure overall profitability and how well the business is using its assets and covering overhead costs

You can find guidance on key financial ratios and ratio analyses on the Lloyds TSB website.

False accounting

False accounting is fraudulent and usually occurs when a business or employee:

• deliberately records false financial information — eg to hide losses or appear more successful
• changes, defaces or destroys records
• exaggerates the business’ assets or understates its liabilities

In this way, an employee who adds only a few pounds to an expenses claim could constitute false accounting, even though it might not seriously affect your finances. But more serious fraud could mean that your business suffers major financial losses, or that it has been trading while insolvent.

What to do if you think an employee has been falsifying accounts

You should immediately report false accounting to the National Fraud Reporting Centre (NFRC), who may then pass it to the police to investigate. Your business can also take action to recover any losses if an employee was involved.

You can find information on fraud, scams and identity theft on the Action Fraud website or contact the Action Fraud Helpline on Tel 0300 123 2040.

To work out how much your business has lost and how the fraud occurred, you might need to use an accountant or auditor — possibly from outside the business. But you must still remember to report the fraud immediately.

You may suspend an employee while the investigations are carried out, but only if their contract of employment allows it. For further guidance on this, see the page on investigating disciplinary issues in our guide on disciplinary procedures, hearings and appeals.

Reduce the risk of false accounting

Common sense and sound business practices will help you to protect your business against the risks of theft and fraud. For example, you should:

• maintain thorough recruitment procedures and carry out pre-employment checks such as checking references — see our guide on pre-employment checks
• put in place a whistle-blowing policy and try to encourage a culture of fraud awareness across the business
• have a ‘zero tolerance’ approach to employee theft and fraud and clearly state this in employees’ terms and conditions or your discipline and grievance policy — see the page on policies on discipline, grievance, bullying and harassment in our guide on how to set up employment policies for your business
• restrict access to financial information and divide duties so that no single person is responsible for all accounts and have more than one person authorise payments
• check bank statements and other accounts — look into any unusual transactions or discrepancies, and audit processes and procedures regularly
• commission a registered auditor, who would usually be a qualified accountant, to conduct an external audit to examine the business’ financial report to check that they show a true and fair view of the business’ financial performance and its assets and liabilities
• undertake an assurance report — similar to an external audit but with more limited scope and objectives — possibly conducted by an external accountant, to review the entire business’ accounts, but with specific aspects checked where necessary

Thank you for reading.

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