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Accounting is the language of business. It is the system of recording, summarizing, and analyzing an economic entity's financial transactions. Effectively communicating this information is key to the success of every business. Those who rely on financial information include internal users, such as a company's managers and employees, and external users, such as banks, investors, governmental agencies, financial analysts, and labour unions. Accounting is a set of concepts and techniques that are used to measure and report financial information about an economic unit. The economic unit is generally considered to be a separate enterprise.
Accounting is concerned with the recording data, classifying and summarizing data, and lastly communicating what has been learnt from the data. The information is reported to a variety of different types of interested parties. These include business managers, owners, creditors, governmental units, financial analysts, and even employees. In one way or another, these users of accounting information tend to be concerned about their own interests in the entity.
Business managers need accounting information to make sound leadership decisions. Investors hope for profits that may eventually lead to distributions from the business (e.g., "dividends"). Creditors are always concerned about the entity's ability to repay its obligations. Governmental units need information to tax and regulate. Analysts use accounting data to form opinions on which they base investment recommendations. Employees want to work for successful companies to further their individual careers, and they often have bonuses or options tied to enterprise performance.
Accounting information about specific entities helps satisfy the needs of all these interested parties. The diversity of interested parties leads to a logical division in the discipline of accounting: financial accounting and managerial accounting. Financial accounting is concerned with external reporting to parties outside the firm.
Task 1: Describe FIVE (5) different users and their needs for Continental Limited financial statements. Explain five regulatory characteristics of these financial statements that will provide useful information to the users.
Businesses report information in the form of financial statements issued on a periodic basis. There is requires the four financial statements which are balance sheet, income statement, statement of owner's equity and statement of cash flows. The income statement is what shows the results of the company's operations for a set period of time. For example, it shows the gains, the expenses, and the losses, which lead to the company's final net income for that time period. Revenue is an inflow of cash and receivables that the company received by selling goods or services.
The balance sheet is basically what shows accompanies current position at an exact date. As the name suggests, it helps people see how the company is balancing their assets, liabilities, and stockholders' equity. Assets are resources the company currently has. Liabilities are what the company owes the other people or other companies. Finally, stockholders equity is what the stockholders claim against a company's assets.
The statement of stockholder's equity is what shows the change of stockholder's equity for a set period of time. It has both inflows and outflows. Inflows show how much the original shareholders had invested in the company. Outflows are the dividends that the company pays out to current stockholders.
The statement of cash flows is what the company uses to explain the changes in the amount of cash that they have on the balance sheet for a set period of time. On the statement, changes such as operating expenses, investing activities, and financing activities are explained. It shows how much cash the company started with and how much cash the company finished with at the end of the period of time.
There are a few of users of financial statements and they need the financial statements for running their work. Firstly are investors and shareholders.Investors and shareholders are particularly interested in a company's financial information, as they use it to determine whether the company would be worth making investments in. Investors and shareholders analyze the financial information to determine the company's overall financial strength and to see if the company can make wise spending decisions. Some shareholders and investors will compare the company's annual report to other companies to determine what is most beneficial for them. If one particular company is of interest, some investors will compare older financial statement information to see if the business is increasing its profits and income steadily over a longer period of time.
Second are lenders. Lenders have an interest in both a company's profit and cash flow. These users may have given loans to the business. Companies with an inability to repay the loans increase the lender's risk. Lenders often require several months of financial statements for review before lending money. Periodic updates are also necessary to ensure borrowers still have the ability to repay loans.
The employees in the company also are included as the users of financial statements. It is encouraging to note that some companies produce a separate employees report. Employees can also have an interest in their company's stock price, which has a close relationship to the company's accounting information. Employee stock options may increase or decrease precipitously based on the company's financial health.
Employees need this information to determine if they should buy more or hold their current investment level. There are two principal reasons for employees and their representatives require information on business performance which is wage and salary negotiation, assessment of current and forward opportunity in terms of employment
Suppliers are often open trade accounts with many companies in the business environment. This allows businesses to pay off purchases over a stated period of time rather than all at once. Financial stability of the business in terms of cash flow and the firm's ability to meet its short-term liabilities usually will be their interested elements.Suppliers prefers to work with financially healthy companies when selling goods. This often ensures payment in the future. Suppliers looking for new clients may also review financial statements to find profitable and stable clients.
Customers also consider as the users of financial statements. The businesses' short and longer term financial stability and its potential to supply high quality goods and services, with where appropriate, sound after sales service will be the interested of this group.
Government agencies are primarily those that assess business taxes to review financial information to ensure companies pay their fair share of tax revenue. Federal, state and local government agencies may have a stake in a company. Oversight agencies may also review a company's financial statements. Inappropriate or material financial misstatement may result in a fine against a company. These agencies attempt to protect a company's shareholders.
Financial institutions such as banks and lending institutions may be quite interested in the financial statements released by a company. This is because financial institutions are often the institutions that lend the company money during the start-up process or if the company needs money to develop a new product or marketing campaign. The financial institutions use the information on the financial statements to determine whether they want to provide the company with the loans and funding based on the business's ability to pay off loans on its income.
Qualitative characteristics of financial statements are attributes that enhance their meaningfulness to such users. However, the accounting framework does not leave compliance with these to anyone's whim and fancy. Financial statements and reports must possess specific characteristics; the four primary attributes are as follows understandability, relevance, reliability and comparability.
There are other qualitative characteristics of financial statements, but those four are the most important, especially as they rely on fundamental assumptions like consistency and fair presentation. These characteristics define what makes financial statements useful to the users particularly investors. While financial statements can be somewhat complicated for the uninitiated to understand, users must be able to understand the information within them. This applies to the format/ layout of the statement, the terms used in the statement and the policies, methods and assumptions utilized in preparing the statement. Users of financial statements are assumed to have sufficient knowledge to study the information properly. Understandability ensures that a user equipped with the basic knowledge can discern information pertaining to the performance and financial position of an enterprise.
The decision making process needs the information which adds value that considered as relevant by providing the required bits and pieces of past, present and future times. Information is relevant to the extent that it can potentially alter a decision. Relevant information helps improve predictions of future events, confirms the outcome of a previous prediction, and should be available before a decision is made. Since financial statements are for users to make economic decisions, the information must be relevant to the decisions that those users have to make. Once all items in a financial statement help users to assess historic or future events, the information in the statement relevant to the users. Whether the information affects the economic decisions of users (materiality) and the nature of information affect relevance as well.
In the context of accounting, reliable information is free from material error (errors that affect the economic decisions of users) and bias. In other words, a reliable financial statement must fairly and consistently present information about the performance and financial position of an entity. Users must have confidence in the financial statement, without it being misleading or deliberately constructed in a manner that presents the entity in a favorable light. Reliability is enhanced when few of principles are observed in the preparation of financial statements which are substance over form, neutrality, prudence and completeness.
Comparability is affected by consistency of presentation and disclosure of accounting policies particularly when comparing items among entities that might use different (but equally valid) methods like straight-line/ reducing balance depreciation/ average cost method. This indicates that comparable financial statements are not necessarily uniform, but merely allow suitable comparisons. The comparability is important to the users for evaluation of different aspects of entity's financial position and financial performance.
We can conclude here that besides understand ability, reliability, relevance and comparability, other qualitative characteristics of information include completeness, prudence, neutrality, faithful representation and substance over form. Sometimes, there exists a trade-off between or among qualitative characteristics. The financial accountant usually exercises discretion where any conflict might occur.
Task 2: Prepare the income statement and balance sheet of Continental Limited for year ending 31 Dec 2010 for the internal use by company directors and management. Show the necessary workings.
Income Statement as at 31 Dec 2010
Less Cost of Goods Sold :
Proceeds from Disposal of Vehicles (35,000-3,000)
Less Expenses :
Office Salaries (28,000-2,000)
Office Electricity & Water
Sales Commission (18,000+1,500)
Provision for Bad Debts
Depreciation : 1). Office Premises
Balance Sheet as at 31 Dec 2010
Depreciation of premise
Depreciation of vehicles
Provision for Bad Debts (5,000+7,000)
Accrued Sales Commission
Based on the income statement and balance sheet made in task 2 and 3, calculate the appropriate accounting ratios for year ending 31 Dec 2010 and compare them with the industry averages provided to assess the profitability and liquidity of Continental Limited.
Followings are the Industry Averages provided for comparison
: Percentage of gross profit on sales 30%
: Percentage of operating profit on sales 18%
: Return on capital employed (ROCE) 9%
: Current ratio 2: 1
: Stock turnover period 90 days
: Debtors collection period 45 days
: Creditors payment period 60 days
Percentage of gross profit on sales
= ------------------ x 100
= ------------------ x 100
Percentage of operating profit on sales
= Net Profit
----------------- x 100
= ------------------ x 100
Return on capital employed (ROCE)
= Net Profit
--------------- -- x 100
= ---------------- x 100
= Current asset
= 6.96 : 1
= Cost of Sales
--------------------------x 30 Days
= Sales - Gross Profit
---------------------- ------ x 30 Days
(Opening Stock + Closing Stock) / 2
= 360,000 - 175,000
--------------------- ------ x 30 Days
(50,000 + 65,000) / 2
= 96 Days
Debtors Collection Period
---------------- X 365 Days
---------------- X 365 Days
= 69 Days
Creditors Collection Period
---------------- X 365 Days
---------------- X 365 Days
= 47 Days
From the calculation of the accounting ratio above, We know that, the percentage of gross profit on sales and the percentage of net profit on sales of Continental Limited is higher than the one in Industry Averages which is 30% and 18 % ; 48.61% and 28.75% respectively. By this, we can say that Continental Limited is increasing compared to the industry averages. Continental Limited is gaining more profit than industry averages. This is because of the labours are getting good salary so that the labours can work over time. Due this can increase the company sales. Furthermore, labour are well trained due to this labours can perform well in the production line. At the same time is the level of output is different. Then, Continental Limited might use some alternative channel to promote and increase their sales. This growth strategy involves pursuing customers in a different way such as, for example, selling products online.
Return on Capital Employed (ROCE) for both Continental Limited and Industry Averages is the same which is 9.38%. The decision making on investment for both industry and Continental Limited is same.
Current ratio of both industry and Continental Limited also quite high which is 2:1 and 6.96:1 respectively. The ratio is mainly used to give an idea of the company's ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more capable the company is of paying its obligation. A higher ratio is generally an indication of a stronger financial position. Continental Limited is more capable to pay back its short-term liabilities than Industry Averages. This may because of Continental Limited have higher ability to manage the financial problems.
Stock turnover period of Industry Averages and Continental Limited is difference of about six days which is 90 days and 96 days respectively. This is means that Continental Limited needs to use longer time period to sell out their stocks compared to Industry Averages. This may because of the lack of promotions and marketing to sell out their products.
The debtors' collection period and creditor's payment period for both companies have greater difference compared to others accounting ratio had explained above. The debtors' collection period and creditors' payment period of Industry Averages are 45 days and 60 days respectively. However, the Continental Limited has the amount of 69 days of debtors' collection period and 47 days of creditors' payment period.
In conclusion, companies rely on accounting procedures to evaluate their operating performance and share with the rest of the world information about their profit levels. All organizations, including nonprofits and government agencies, use accounting mechanisms to record operating data. A corporate controller works in tandem with accounting managers to provide the technical guidance necessary to report accurate financial information.
There is various importance of accounting information to a business entity. Getting to know what accounting information is and the importance (need) of it is a great step to improving one's capital base, both from the finance aspect to the resources (raw materials) an organisation uses in carrying out its objectives.