6
Financial Accounting
After studying this chapter, you should understand the purpose of the three most
important items in the annual report:
the balance sheet;
the profit and loss account; and
the cash flow statement.
These are known as the financial statements and together they provide a picture of
the overall financial health of the business. You should be able to interpret them in
simple cases.
INTRODUCTION
The proprietors of limited liability companies are privileged, precisely
because their liability is limited – they can lose no more than the money
they invested in the company. In return for this privilege, the law requires
that, every year, the company produces an annual report, which must be
filed at Companies House. The annual report contains information about
the company and its activities during the preceding year. In particular, it
contains information about its financial health so that those who are con-
sidering dealing with the company can judge whether it is likely to meet
its obligations. If the company is a public one, that is, if its shares are
available for purchase by the public, through trading on a stock exchange,
the stock exchange will impose additional disclosure requirements. In
other words, it will require the company to make more information public.
In recent years, a series of scandals has led to calls for greater openness
and more extensive disclosure of companies’ activities, which has, in
turn, led to the inclusion of further statements and more extensive notes
in companies’ annual reports. Some are required by stock markets and
some have simply become regarded as good practice. On the whole, but
by no means universally, software companies set good examples in this
regard.
THE BALANCE SHEET
The purpose of the balance sheet is to show what the company owns – its
assets – and what it owes – its liabilities. It is a snapshot of the state of the
company at a particular point in time, normally at the end of the last day of
the company’s financial year.
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Professional Issues in Information Technology
Balance sheet for a student
Perhaps the easiest way to get to understand the idea of a balance sheet is to
look at the balance sheet not of a company but of an individual. We take an
imaginary student called Jemimah Puddleduck and, as is usual, we show her
present position side by side with the position a year ago, so that it is easy to
make a comparison (see Table 6.1). Notice also the common accounting con-
vention of putting a number in parentheses to indicate that it is negative,
rather than using a negative sign as is normal in science or mathematics.
T 6.1 Balance sheet for a student
Jemimah Puddleduck
Balance Sheet
As at 31 October 2004
ASSET
Cash in hand
Cash at bank
Pre-paid accommodation
Debts owed by friends
Computer
CD player
2004
25
361
300
18
400
160
2003
40
220
200
0
600
180
Total assets 1,264 1,240
64
1,900
LIABILITIES
Credit card bill
Student loans
174
4,800
Total liabilities
NET WORTH
4,974
(3,710)
1,964
(724)
Jemimah’s most obvious asset is money. She has, let us say, £25, in cash in
her purse and another £361 in her bank account.
The next two items are less obvious. The accommodation item refers to the
fact that Jemimah has paid a term’s fees to the hall of residence in advance;
since the balance sheet refers to the position on 31 October, some 60 per cent
(6 weeks out of 10) of this accommodation has not been used. Depending on
the regulations of the hall, if the accommodation is no longer required, the
student may be able to get a refund on the unused period or sell it to another
student; in other words, the student has paid for the right to live in hall for a
further six weeks and this right can be converted into cash and is therefore an
asset. In a similar way, the debt of £18 owed by friends can be turned into cash
and is also therefore an asset.
The next two items are more complex because they represent capital
items. Jemimah owns a computer, which cost £800 including the software
when her parents bought it for her, two years ago. She owns a CD player,
which she bought for £200 at the start of her 2003 year. These are examples of
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