Tax Covenants and Warranties

Scrutton Bland

Tax Covenants

A Practical Guide

TAX COVENANTS

FOREWORD

What is a Tax Covenant?

A tax covenant provides protection to a buyer of shares against unforeseen tax liabilities of the target company on a similar basis to an indemnity. The inclusion of a tax deed of covenant in an agreement therefore means that tax liabilities are treated on a very different basis to other liabilities. For other liabilities which are found to be understated, the general rule is that it is necessary for the buyer to prove that a loss has arisen from the breach of the relevant warranties. Under the Tax Covenant the seller normally has an obligation to pay once it is clear that an unforeseen tax liability has arisen.

A large part of the challenge in the drafting and negotiating of tax covenants is to capture the essence of “unforeseen tax liabilities” in respect of each transaction.

The Buyer is concerned to ensure that the tax covenant provides protection in respect of two specific matters: firstly, if unforeseen tax liabilities arise after Completion in respect of events before Completion, he is concerned that these liabilities are effectively the responsibility of the Sellers; secondly he seeks recovery from the Sellers to the extent that any of the tax assets in the Company do not materialise.

In contrast to warranties, disclosures made do not normally mitigate the absolute obligation to pay that exists under the tax covenant.

A simple example can be given to illustrate the difference between warranties and the tax covenant: the shareholders of Stowmarket Warehousing Limited sell their shares to a third party. The agreement is in the form of a standard share purchase agreement and tax covenant. After Completion the following matters are identified, all of which relate to pre- completion events:  the Company has not been dealing properly with National Insurance Contributions in respect of some Lithuanian temporary staff and employer contributions are payable of £2,800;

 the Company has been incorrectly reclaiming VAT on entertaining expenditure and is obliged to repay VAT of £6,500 as a result;

 one of the Lithuanian workers was injured by a fork lift truck and the company faces a fine of £80,000 and also an uninsured personal injury claim of £50,000. Total costs in respect of this incident therefore amount to £130,000.

With a conventional share purchase agreement and tax covenant, the Covenantors to the tax deed will be obliged to make payments of £2,800 and £6,500 if the tax deed of covenant has been properly drafted and also assuming that there is no de minimis clause.

However, the Buyer will need to demonstrate that he has suffered a loss and will need to bring a claim under the warranties proving that loss before he receives refunds from the sellers in respect of the third bullet point above. If the Sellers can demonstrate that the Company has flourished in the period after Completion and that the value received by the Buyer, as reduced by the liabilities of £130,000, was at least equivalent to the total consideration paid, then there may be no recovery of the losses relating to the forklift accident.

A tax covenant is a covenant, or promise, to make payment in certain stated circumstances; it is therefore a document of some considerable power.

The simple essence of a tax covenant is that the buyer wishes to be protected from unexpected tax liabilities. The conversion of this simple goal into a workable legal document involves a number of twists and turns, as we will demonstrate in this guide. There appears to be a deep mystery as to why buyers are still expected to have far greater protection in respect of unforeseen tax liabilities than in respect of other unexpected outgoings. Tax deeds originated with Estate Duty and claims that could be made on a company in respect of external Estate Duty liabilities in certain circumstances. In such a situation the Company suffered a loss: a tax deed of indemnity therefore resulted in the Company being indemnified against that loss. This has then led to the definition of Tax being broadened over time, so that all taxes, with the possible exception of business rates, are now normally covered. One argument put forward for this is that unexpected tax liabilities are far more common than other unexpected liabilities. There is also a growing number of circumstances in which tax authorities can impose a secondary tax liability on a company if there is a failure to pay in another group company. However, at the end of the day, the treatment of tax liabilities on something akin to an indemnity basis appears to be nothing more than a matter of custom and practice. It is also nothing more than custom and practice that the documents are prepared in the form of a deed: as the parties are now commonly the Buyer and the Sellers, or some of the Sellers, there is consideration and it is difficult to see the requirement for the document to be prepared as a deed. Happily practice is rapidly changing in this area. It is also a feature of tax covenants, as with so much other legal drafting, that the length of the document seems to increase inexorably as additional clauses are introduced into standard precedents. Very often the risks being covered are very poorly understood by the professionals involved: they will sometimes parry and thrust with an impressive vigour over points which are of very little real risk in the transaction being considered. It is probably an unavoidable result of modern drafting that a new clause, once seen, is seized upon and included in the precedent document. Once elevated to this status, it is a courageous professional acting for the buyer who does not insist on the protection possibly available from the inclusion of the additional clause. It is with such sets of circumstances that the standard precedents in use grow in size each year.

We recognise that shares in limited companies are amongst the most complex of assets: it is this very complexity that leads to the Buyer seeking whatever protections are available. The protections that the court of custom and practice consider are standard include undertakings to pay in respect of tax liabilities; such protection in respect of other liabilities is not considered as standard practice. Tax covenants are a feature of transactions involving the purchase of the shares of most companies which are not listed or on AIM. The more widely spread the shares, the less practical it is to obtain from the shareholders the protections envisaged in a tax covenant. The protection in the tax covenant takes the form of a series of covenants entered into by Covenantors (normally some or all of the Sellers of the shares). The Covenantors are not actually providing an indemnity against losses, as the losses are suffered by the Company and the Company is not normally a party to the tax covenant. (The reasons for this are explained in Section 3.) Therefore the Covenantors are promising to pay an amount equivalent to the relevant tax paid by the Company.

There are many standard definitions used in tax covenants. The first point to make is that we use the phrases “tax deeds”, “tax covenants”, and “tax deeds of covenant” interchangeably.

We are using many definitions which require no further explanation, such as Completion, Consideration, Buyer, Sellers, Covenantors, etc. However, we are introducing some of our own, which will appear very frequently:

 the “Company” refers to the target company which is being acquired;

 “Last Accounts” refers to statutory financial statements for the Company drawn up to the latest accounting reference date prior to Completion;

 “Completion Accounts” refers to accounts drawn up from the date of the Last Accounts to Completion (usually on the assumption that the level of the net assets stated by these Completion Accounts will determine all or part of the Consideration payable.)

 “Stub period” refers to the period between the Last Accounts and Completion, most notably if no Completion Accounts are prepared.

 We are using the standard definitions “ITA” to mean the Income Taxes Act 2007, “ITEPA” to mean the Income Tax (Earnings and Pensions) Act 2003, “ICTA” to mean the Income and Corporation Taxes Act 1988 and “TCGA” to mean the Taxation of Chargeable Gains Act 1992. The 2009 Corporation Taxes Act is referred to as CTA.

 HM Revenue and Customs are referred to as “HMRC”.

 We are also using abbreviations for various taxes, including PAYE, VAT, CGT and SDLT.

There are two main accounting conventions in use in the United Kingdom: International Financial Reporting Standards are now used by listed entities and by companies on the Alternative Investment Market or AIM. These accounting rules and practices are referred to as “IFRS”. Private companies in the UK still mainly use United Kingdom accounting standards and practices and this is referred to as generally accepted accounting principles and practice in the UK or “UK GAAP”. There are many presentational differences between the two systems.

Crucially there are measurement differences in respect of deferred taxation: these differences are summarised in this publication.

Many people assume that negotiation and agreement of tax covenants is best done by those with a detailed knowledge of tax legislation, specifically some of the more obscure parts of the corporation tax regime which can be relevant in certain corporate transactions. In fact, the intricacies of the tax covenant are very often related more closely to the rules covering the way that tax liabilities are accounted for in financial statements. Therefore some knowledge of the two accounting regimes of UK GAAP and IFRS, both relating to the reporting of current taxation and deferred taxation, is also very important if the client is to be fully protected.

The tax covenant can therefore be extremely challenging as knowledge is required in three areas:

 some of the more arcane aspects of the tax legislation relating to corporate transactions;

the drafting of legal documents;

 the way that tax liabilities are accounted for under UK GAAP and, increasingly, IFRS.

Tax covenants include some of the heaviest and most compacted drafting encountered in corporate transactions. They therefore need to be approached with considerable care.

There are many legal and accounting practitioners who appear to approach a tax covenant with a sense of dread and impending doom, as they so often seek to delay its negotiation to the latest possible moment. They then hide behind their computer screen, preferring salvoes of emails as a method of negotiation, rather than having a real engagement with the other side face to face or on the telephone. If they are asked to justify the inclusion of a particular clause within the tax covenant they explain, rather mysteriously, that this clause is now considered as standard. The response to a comment that a particular clause is not needed in this transaction is the sphinx-like retort that its inclusion will therefore do no harm to the other side. These documents cannot be taken lightly. However, we hope that this publication will help readers to navigate through some of the darker and more difficult passages. We also hope that they will be helped in understanding some of the technical tax, legal and accounting issues involved in the various clauses. If this is the case then they will be able to approach these complex documents with greater confidence and obtain rather greater job satisfaction from the experience! The first chapter contains a brief introduction to some of the mysteries of how accounts are bolted together. We hope that this may make non-accountant readers more comfortable in this area. Chapter 2 is a corporate tax computation primer and aims to give a very brief overview of the structure of corporation tax. The third chapter then continues the theme of tax charges, but delves into the world of deferred taxation, as this information can be relevant to understanding tax charges in accounts. Chapter 4 then addresses more deeply some of the tax issues that concern those advising the Buyer and help to provide a backdrop to some of the clauses that are in the classic tax covenant. Chapter 5 comprises a standard tax covenant, for a transaction with completion accounts: this tax covenant is far from being a model as it deliberately includes clauses which we consider to be inappropriate in the context or which are incorrect.

Chapter 6 deals with the question of the relevant accounts to be considered for the tax covenant: the reason for this being the first issue addressed after introducing the tax covenant is very simple: it is in this area that the greatest number of errors are made by practitioners in the drafting of tax covenants from the standard precedents that they hold. If firms of solicitors have two standard precedents then the number of errors in the first draft is likely to decline markedly. However, the differences involved in respect of the relevant accounts are so important that this matter is explored in some detail. It is our aim that the documents should be fully understood: we are not seeking a band of slavish followers to any particular form of words.

Thereafter the chapters are structured in line with a specimen tax covenant. The relevant parts of the tax covenant are included in italics within each chapter: the various clauses are therefore explained in the same order in which they tend to be encountered in the document itself.

We very much hope that this approach of dissecting a tax covenant will provide a simple and logical way of navigating through this publication.

There are a number of important assumptions which underlie the classic tax covenants. Some of these are:

 the Buyer expects to receive protection, on a basis similar to an indemnity, in respect of unforeseen tax liabilities, but not other liabilities;

 the losses to the Buyer are computed by reference to the cash flow implications on the Company, not the accounting implications of reductions in net assets;

 the Buyer accepts responsibility for the risks associated with rate changes and other tax risks which arise after completion, as part of the general risks associated with being in business. He should therefore also gain the benefit of such changes;

 the Buyer receives protection in respect of overstated deferred tax assets, but he does not have the same protection in respect of underprovided deferred tax liabilities;

 the Buyer is to be reimbursed for his cash flow losses. The tax Covenant is not designed to provide a profit to the Buyer;

 overprovisions, recoveries, understatements and corresponding savings do not produce a pool of cash to be paid to the Sellers as they arise: rather they represent a contingent asset for the Sellers, which can be used to absorb all or part of the impact of any claims that may arise under the tax covenant;

 the Covenantors should be protected from any tax which arises from the Buyer’s Group (excluding the Company)

Throughout this publication we comment on the intricacies of deferred taxation accounting and some of the inconsistencies that arise from the current approach: put simply the current versions of the tax covenant assume that the Buyer obtains protection under the tax covenant

for any diminution of deferred tax assets. There is not the same concern or protection in respect of deferred tax liabilities.

We consider that these inconsistencies can be avoided if deferred tax is treated differently in the tax covenant. We therefore have prepared an alternative structure of tax covenant which we believe takes a more logical approach to deferred taxes. It is our view that this alternative structure of measuring loss by reference to the reduction in the net assets of the Company, rather than by reference to its tax cash flows, is far more appropriate in the vast majority of corporate transactions. The situations where this may not be appropriate include those transactions involving long-life assets, high levels of tangible or intangible fixed assets, or large tax losses adjusted within the deferred tax account.

Jason Fayers Andrew Strickland

February 2010

TAX COVENANTS

CONTENTS

CHAPTER ONE .................................................................................................................... 1 UNDERSTANDING ACCOUNTS ...................................................................................... 1 Executive Summary ........................................................................................................... 1 1 Introduction ............................................................................................................... 2 2 Jane’s Windsurfing - A Simple Example .................................................................... 2 3 Jane’s Windsurfing Limited...................................................................................... 10 4 Financial Statements of Limited Companies ............................................................ 13 5 Liabilities and Provisions ......................................................................................... 15 6 Taxation Liabilities and Assets ................................................................................ 16 CHAPTER TWO ................................................................................................................. 18 CORPORATION TAX COMPUTATIONS - A PRIMER .................................................... 18 Executive Summary ......................................................................................................... 18 1 Introduction ............................................................................................................. 19 2 Tax Computations ................................................................................................... 20 3 Capital Allowances .................................................................................................. 24 4 Group Relief and Consortium Relief ........................................................................ 25 5 Trading Losses........................................................................................................ 25 6 Chargeable Gains ................................................................................................... 26 7 Payment of Corporation Tax.................................................................................... 27 CHAPTER THREE ............................................................................................................. 29 DEFERRED TAXATION - WHAT IS IT? .......................................................................... 29 Executive Summary ....................................................................................................... 29 1 Introduction ............................................................................................................. 30 2 The Accounting Standards ...................................................................................... 35 3 Timing Differences................................................................................................... 37 4 The Discounting of Deferred Tax Liabilities ............................................................. 38 5 Deferred Tax Relief - One of the Buyer’s Reliefs ..................................................... 39 6 The Deferred Tax Liabilities..................................................................................... 41 CHAPTER FOUR ............................................................................................................... 44 SOME TAX IMPLICATIONS OF CORPORATE TRANSACTIONS ................................. 44 Executive Summary ....................................................................................................... 44 1 Introduction ............................................................................................................. 45 2 The Carry-Back of Tax Losses ................................................................................ 45 3 Degrouping Charges ............................................................................................... 47 4 The Disallowance of Trading Losses after Completion ............................................ 49 5 Inheritance Tax Payable by a Company .................................................................. 50 6 Tax Covenants in Respect of Stamp Duty ............................................................... 52 7 The Tax Position of the Sellers ................................................................................ 52 8 Earn Out Consideration ........................................................................................... 54 9 Entrepreneur’s Relief............................................................................................... 56 10 Tax Position of the Buyer ........................................................................................ 57

CHAPTER FIVE .................................................................................................................. 58 THE TAX COVENANT .................................................................................................... 58 Executive Summary ......................................................................................................... 58 1 Definitions and Interpretation................................................................................... 59 2 Covenants ............................................................................................................... 63 3 Exclusions ............................................................................................................... 64 4 Due Date for Payment ............................................................................................. 67 5 Deduction from Payments ....................................................................................... 68 6 Claims ... ................................................................ …………………………………...68 7 Recoveries .............................................................................................................. 70 8 Overprovisions, Understatements, Sellers Relief and Corresponding Savings ........ 71 9 Tax Returns............................................................................................................. 71 10 Counter Covenant ................................................................................................... 73 11 General ................................................................................................................. 73 CHAPTER SIX .................................................................................................................... 74 THE RELEVANT ACCOUNTS AND THEIR TAX PROVISIONS ..................................... 74 Executive Summary ......................................................................................................... 74 1 Introduction ............................................................................................................. 75 2 The Issue: the “Pivot Point” .................................................................................... 76 3 The Solution ............................................................................................................ 76 4 The Status of Tax Provisions in The Relevant Accounts.......................................... 77 5 The Period Between the Last Accounts Date and Completion................................. 80 CHAPTER SEVEN ............................................................................................................. 82 THE PARTIES TO THE TAX COVENANT ...................................................................... 82 Executive Summary ......................................................................................................... 83 1 Introduction ............................................................................................................. 84 2 The Current Position................................................................................................ 86 3 Tax Position of the Seller......................................................................................... 87 4 Tax Position of the Buyer ........................................................................................ 89 5 Relationships Between Sellers ................................................................................ 89 CHAPTER EIGHT ............................................................................................................... 90 DEFINITIONS ................................................................................................................. 90 Executive Summary ......................................................................................................... 91 1 Introduction ............................................................................................................. 92 2 Buyer’s Relief .......................................................................................................... 92 3 Corresponding Saving ............................................................................................. 99 4 “Event” ............................................................................................................... 102 5 “IHT Liability” ......................................................................................................... 104 6 “Overprovision”...................................................................................................... 105 7 “Recovery”............................................................................................................. 106 8 “Relief” ............................................................................................................... 107 9 “Sellers’ Relief” ...................................................................................................... 109 10 “Tax” or “Taxation”................................................................................................. 110

11 “Tax Authority”....................................................................................................... 111 12 “Tax Claim”............................................................................................................ 112 13 “Tax Liability” ......................................................................................................... 112 14 “Understatement” .................................................................................................. 113 15 In the Ordinary Course of Business ....................................................................... 114

CHAPTER NINE ............................................................................................................... 118 THE COVENANTS ........................................................................................................ 118 Executive Summary ....................................................................................................... 118 1 Introduction ........................................................................................................... 119 2 The Main Covenant ............................................................................................... 120 3 Post Completion Liabilities..................................................................................... 121 4 Tax Related to Share Options ............................................................................... 122 5 Stamp Duty ........................................................................................................... 123 6 IHT Liabilities......................................................................................................... 123 7 Post-Completion Event .......................................................................................... 123 8 Costs ............................................................................................................... 124 9 Other Matters ........................................................................................................ 124 CHAPTER TEN ................................................................................................................ 126 THE EXCLUSIONS AND LIMITATIONS ....................................................................... 126 Executive Summary ....................................................................................................... 126 1 Introduction ........................................................................................................... 127 2 Provision for Tax in the Relevant Accounts ........................................................... 127 3 Transactions Between the Last Accounts Date and Completion ............................ 129 4 No Loss from Transaction Outside the Normal Course of Business....................... 131 5 Increase in Tax Rates with Retrospective Effect.................................................... 132 6 Retrospective Changes in Legislation.................................................................... 132 7 Changes to Published Practices or Procedures..................................................... 132 8 Change in Accounting Policy or Practice ............................................................... 133 9 Change in Accounting Reference Period ............................................................... 135 10 Voluntary Act of Buyer or Company after Completion............................................ 137 11 Disclaimer of Capital Allowances........................................................................... 138 12 Mitigation............................................................................................................... 138 13 Failure to make Elections ...................................................................................... 138 14 Failure by the Buyer to Comply ............................................................................. 139 15 Use of a Relief which is not a Buyer’s Relief.......................................................... 140 16 Impact of Joining Buyer’s Group............................................................................ 140 17 Cessation or Diminution or Change of Trade ......................................................... 141 18 Failure to Make Payment to HMRC or to Retain Records ...................................... 141 19 Stamp Duty Payable on Transaction ..................................................................... 142 20 No Double Claim ................................................................................................... 142 21 A Recovery Is Made From a Third Party................................................................ 142 22 Tax Already Paid or Cleared.................................................................................. 143 23 Timing Differences – Unmatched........................................................................... 144 24 Timing Differences - Loss of Buyer’s Deferred Tax Relief...................................... 146 25 Time Limits............................................................................................................ 147 26 Limitations Imported From Agreement................................................................... 147 27 Statutory Rights..................................................................................................... 147

CHAPTER ELEVEN ......................................................................................................... 149 THE DUE DATE FOR PAYMENT .................................................................................. 149 Executive Summary ....................................................................................................... 149 1 Introduction ........................................................................................................... 150 2 Actual Tax Payment .............................................................................................. 150 3 Reduction or Loss of a Deferred Tax Relief ........................................................... 150 4 Loss or Reduction of Accounts Relief .................................................................... 151 5 Use of Post Completion Relief or Buyer’s Relief .................................................... 152 6 Costs and Expenses.............................................................................................. 153 7 Effect of not Meeting Above Conditions ................................................................. 153 CHAPTER TWELVE ......................................................................................................... 155 DEDUCTIONS FROM PAYMENTS ............................................................................... 155 Executive Summary ....................................................................................................... 155 1 Introduction ........................................................................................................... 156 2 If Payments are Subject to Taxation ...................................................................... 156 3 Buyer has Obligation to Recover in Respect of Deductions ................................... 157 4 Refunds of Withholdings or Deductions ................................................................. 157 CHAPTER THIRTEEN ...................................................................................................... 158 CLAIMS ............................................................................................................. 158 Executive Summary ....................................................................................................... 158 1 Introduction ........................................................................................................... 159 2 Action to be Taken................................................................................................. 159 3 Ability of Buyer to Deal with a Tax Claim in Certain Circumstances ...................... 160 4 Pointless Actions ................................................................................................... 161 5 Access ............................................................................................................... 161 CHAPTER FOURTEEN .................................................................................................... 163 RECOVERIES FROM THIRD PARTIES ........................................................................ 163 1 Introduction ........................................................................................................... 164 2 Duty to Notify and to Take Reasonable Steps ....................................................... 165 3 Repayment to Covenantors ................................................................................... 165 4 Carry-Back and Carry Forward of Recovery .......................................................... 167 CORRESPONDING SAVINGS ...................................................................................... 169 Executive Summary ....................................................................................................... 169 1 Introduction ........................................................................................................... 170 2 Understatement..................................................................................................... 171 3 Sellers Relief ......................................................................................................... 171 4 Corresponding Savings ......................................................................................... 172 5 The Use of Such Offsets ....................................................................................... 174 6 The Carry-Back and Carry Forwards ..................................................................... 174 7 Requirement to Notify............................................................................................ 174 CHAPTER FIFTEEN ......................................................................................................... 169 OVERPROVISIONS, UNDERSTATEMENTS, SELLERS’ RELIEF AND

CHAPTER SIXTEEN ........................................................................................................ 176 TAX RETURNS ............................................................................................................. 176 Executive Summary ....................................................................................................... 176 1 Introduction ........................................................................................................... 177 2 Tax Computations Unsubmitted at Completion...................................................... 177 3 Duties of Covenantors Re Computations up to Completion ................................... 178 4 The Tax Computations for the Period Straddling Completion ................................ 179 CHAPTER SEVENTEEN .................................................................................................. 181 COUNTER COVENANT ................................................................................................ 181 Executive Summary ....................................................................................................... 181 1 Introduction ........................................................................................................... 182 2 Section 767A, ICTA............................................................................................... 182 3 Section 767AA, ICTA............................................................................................. 184 4 Section 132, Finance Act 1988.............................................................................. 185 5 Section 139, TCGA 1992....................................................................................... 185 6 Section 189, Taxation of Chargeable Gains Act 1992............................................ 186 7 Section 190, Taxation of Chargeable Gains Act 1992............................................ 187 8 Section 282, TCGA................................................................................................ 188 9 Schedule 28, Finance Act 2000............................................................................. 188 10 Section 43 and Sections 43A to 43D, Valued Added Tax Act 1994 ....................... 189 11 Other Valued Added Tax Contingent Liabilities...................................................... 190 12 Stamp Duty: Section 111 and Schedule 34, Finance Act 2002 - Withdrawal of Group Relief.................................................................................... 190 13 Stamp Duty: Section 113, and Schedule 35, Finance Act 2002 - Withdrawal of Relief For Company Acquisitions .................................................... 192 14 Inclusion of Other Seller Protections...................................................................... 192 15 Exclusion to Counter-Covenant ............................................................................. 193 16 Discharge of Tax ................................................................................................... 194 17 The Tax Treatment of Payments under the Counter-Covenant.............................. 194 CHAPTER EIGHTEEN ..................................................................................................... 195 1 Introduction ........................................................................................................... 195 2 Treatment of Payments ......................................................................................... 195 3 De Minimis Clauses, Ceilings and Other Limitations.............................................. 196 4 Treatment of Stub Period....................................................................................... 196 CHAPTER NINETEEN ...................................................................................................... 198 A NEW APPROACH TO TAX COVENANTS: THE REDUCTION IN NET ASSETS AS THE MEASURE OF LOSS: TRANSACTION BASED ON COMPLETION ACCOUNTS ............................................ 198 Executive Summary ....................................................................................................... 198 1 Introduction ........................................................................................................... 200 2 The “Net Asset Reduction” Tax Covenant, assuming Completion Accounts .......... 201 3 The New Format Tax Covenant In Practice ........................................................... 217

CHAPTER ONE

UNDERSTANDING ACCOUNTS

Executive Summary

A The profit and loss account includes the various components of sales, costs of sales, overheads and profit. The profit and loss account is referred to as a primary statement. It is for a period beginning on a certain date and ending on a later date. The profit and loss account does not reflect the cash effects of transactions but the economic effects: income is recognised when the sale is made and expenditure is recognised when the costs are incurred, without regard to the timing of the cash receipts and payments.

B The above approach to accounting is referred to as “matching” or the “accruals basis” and is one of the basic principles upon which accounts are built.

C The balance sheet is a second primary statement. It shows the assets and liabilities of an entity at a snapshot in time, namely the end of the accounting period.

D For non-accountants the proprietors’ funds (or the shareholders’ funds for the limited company) are conceptually the most difficult part of a balance sheet to grasp. “Funds” does not mean cash; reserves does not mean a chest full of treasure. These balances merely reflect the ownership interest: they are a statement of the total amounts that are invested in the business in the form of original capital and profits made and retained. They can be considered as a statement of the amount that the business “owes” to the proprietor or the shareholders.

E The word “capital” is probably one of the most confusing words in accounting as it has different meanings in different contexts.

F Accounts intended to give a true and fair view are prepared on the basis of substance over form.

G Accounts are fundamentally simple, once the concept of the bottom half of the balance sheet has been grasped.

H The financial statements of companies and groups include various assets and liabilities in respect of taxation which are payable or recoverable and also in respect of deferred tax.

1

1 Introduction

1.1 Many accountants have honed their skills over many years, and spend much of their time in discussions with their fellow professionals: they therefore have an unerring ability to confuse many a lay audience, without having the slightest realisation that they had done so. This is not entirely due to the rules of secrecy and the protectionist practices of the Beancounters Guild. Rather, it is based on the deeply-held belief of many accountants that what they do is stunningly obvious and requires no explanation. 1.2 The reason for this belief is simple: double entry accounting is a complete mystery until its code is cracked; however, once it is understood by the accounting student, virtually everything in accounting falls into place. 1.3 This chapter is designed to take the non-Accountant through some of the basic concepts, and also some of the terminology, involved in accounts. The words “accounts” is a generic term to describe virtually everything from the briefest of monthly management statements through to the 100 pages or so of financial information included within the annual report of a large plc. The phrase “financial statements” is rather narrower and tends to be reserved for accounts which are published, notably those which are required to comply with the various requirements of the Companies Act, and which are required to give a true and fair view. 2.1 Jane has decided to take a year out of a busy life in the City and to run a small business which imports and sells windsurfers. After 12 months she plans to return to her former life, having made a modest profit and having spent a significant amount of time on the water. She rents a small fully serviced shop in Poole, Dorset at £500 per month for the year in question. She is required to pay a deposit of £1,500 to the landlord. The rent is payable monthly in arrears, on the first day of the following month. She buys an ancient van for £1,200 and considers that it will have no value after 12 months. She pays the van running costs from her private bank account. She buys the windsurfers for £700 each and aims to sell them for £1,000 each, making a gross profit of £300 on each windsurfer. “Gross profit” is the amount of the sales less the direct costs of those items which have been sold. The gross profit percentage is the gross profit expressed as a percentage of the sales. A gross profit of £300 on a sale of £1,000 is a gross profit percentage of 300/1,000 or 30%. 2.2 In order to derive the gross profit it is necessary to derive the costs of those goods which have been sold: as a rigorous accountant Jane counts her stock at the end of every month so that she can do this. She then calculates the amounts of stock that have been used in achieving her sales. She does this in the expectation that she will make a gross margin of 30% a month. 1.4 In this book we use the words “accounts” and “financial statements” virtually interchangeably. 2 Jane’s Windsurfing - A Simple Example

2

2.3 She recognises that the van will gradually move from a value of £1,200 to nil over the 12 months that she is trading. She therefore needs to spread the cost over that period, and she does this by reducing its value by £100 a month. This reduction, reflecting the effective consumption of the fixed asset by its use, is called depreciation. 2.4 She therefore incurs a rental charge of £500 per month and depreciation of £100 per month. The net profit or loss is therefore the gross profit on the sales in the month, less the overhead costs in respect of the rent and depreciation. “Overhead costs” are those costs which are costs of the business but which are not the direct costs of those items which have been sold. Overhead costs might be described alternatively as “fixed costs” (on the basis that they are broadly constant, regardless of activity levels), or administrative expenses (borrowing some terminology from the Companies Acts). 2.5 As Jane has fixed costs of £600 per month, and she makes a gross profit on each windsurfer sold of £300, we can compute her break-even point: the break-even point is the fixed costs as divided by the gross profit percentage: we therefore divide £600 by 0.3, and this gives the level of break-even sales. This is £2,000. Therefore Jane needs to sell an average of 2 windsurfers every month in order to cover her rental cost and depreciation and to have nothing left.

2.6 We can follow her venture through the monthly accounts that she produces:

Month

January

February

March

Number sold

- -

2

3

Sales

2,000 _____

3,000 _____

_____

Purchases

7,000

-

3,500 5,600

Opening stock

-

7,000

Less: Closing stock

(7,000) _____

(5,600) _____ 1,400 _____

(7,000)

______

Cost of sales

-

2,100 _____

_____

Gross profit

-

600

900

_____

_____

_____

Overheads: rent

500 100 600 ___

500 100 600 ___ - ===

500 100 600

Overheads: depreciation

Total overheads

____

Net profit/(loss)

(600) ===

300 ===

Gross profit %

30%

30%

Net profit %

0%

10%

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2.7 It is important to recognise that the profit and loss account is not prepared on the basis of the cash effects of the various transactions: in January there are purchases of £7,000, and in March further purchases of £3,500. However the charge in the profit and loss account reflects the costs of the sales in that month, rather than the purchases. The purchases are paid for on delivery in January, but in March the supplier allows Jane 30 days credit. However the purchases in March are entered into the accounts when the delivery is made to Jane, not when the invoice from the supplier is settled. 2.8 Along similar lines, two windsurfers are sold in February and three are sold in March. However Jane does not receive the cash for these sales until the following month, as she has decided to give credit to her customers. However the sales are not recognised at the time that the cash is received, but at the point that the customer takes the goods from the premises and the sales invoice is created. 2.9 There are two payments made on the first day that Jane opens for business: she pays the landlord £1,500 as a rental deposit and she spends £1,200 for a van which has seen decidedly better days. Neither of these payments are reflected as an immediate cost to the business: the deposit to the landlord will be refundable at the end of December and is therefore shown as such; the value in the van will be gradually used up during the year. This consumption of the value is called “depreciation”; as previously noted this reflects the gradual usage of fixed assets by virtue of the passage of time and their use in the business. 2.10 This approach of moving away from the cash effects of transactions to look at the underlying commercial transactions is referred to as “matching” or the “accruals basis”. The concept of matching is addressed in the “statement of principles for financial reporting” which provides the conceptual framework that underpins United Kingdom Generally Accepted Accounting Principles and Practice (otherwise known as “UK GAAP”). In addition to this, paragraph 26 of Financial Reporting Standard 18 (“FRS 18”) states: “An entity should prepare its financial statements, except for cash flow information, on the accruals basis of accounting.”

2.11 The next point to make is that accounting deals with uncertainties: the following assumptions are implicitly included in the profit and loss account of Jane’s Windsurfing:

 the stocks will be sold for at least the cost price;

 the customers will pay the amounts owing;

 there will be no damage to the shop and therefore no claim by the landlord;

 the landlord will not become insolvent, and the rent deposit will therefore be returned;

 there will be no warranty claims in respect of defective goods sold, or such claims will be met by the supplier, with no cost to Jane;

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