This work-based assignment discusses the key elements of accounting in part 1 (1.1-1.3), provides an understanding of financial information in part 2 (2.1-2.3) and interprets financial information in part 3 (3.1-3.3) by examining the financial health of a small business called Card Fun.
- Identify principles of accounting
According to Atrill & McLaney (2011: 498), accounting is "the process of identifying, measuring and communicating information to permit informed judgments and decisions by users of the information".
Accounting is part of a companies' overall information system (Wood, 2002). The common features to all valid information systems within a company that influence the usefulness of accounting information are (Atrill & McLaney, 2011):
â€¢ Identification of information
â€¢ Recording of information
â€¢ Analyzing of information and
â€¢ Reporting of information.
Over a period of many years accounting theories and principles have developed in response to the needs of the financial community (Weetman, 2003). They are more like agreed practices or guidelines that companies are required to follow when reporting financial information, rather than strict rules or fundamental laws and regulations. The ordinary set of accounting principles is known as generally accepted accounting principles (GAAP) (Siegel & Shim, 2000). "GAAP includes the standards, conventions and rules accountants follow in recording and summarizing transactions and in the preparation of financial statements" (Siegel & Shim, 2000: 489).
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Providing financial data through balance sheets, income statements and the statement of cash flow (will be defined in 2.1) is the ultimate product from accounting information (Siegel & Shim, 2000).
No less important components of financial statements are the director's report (providing financial and non-financial information to shareholders on an annual basis), the auditor's report (provides an opinion of the validity and reliability of a company or organization's financial statements) and the accounting policies (will be defined in point 1.3) (Atrill & McLaney, 2011).
Accounting can be categorized into two sections whose main objectives may be dissimilar, but collectively they tend to represent the financial position of the company to its internal and external users (Weetman, 2003). Those two sections can be classified as financial accounting and management accounting.
Financial accounting is "the measuring and reporting of accounting information for external users" (Atrill & McLaney, 2011: 503). The main task of financial accounting is to present the financial health of a company to its external stakeholders. Financial accounting reports must be filed on an annual basis (Atrill & McLaney, 2011).
Management accounting on the other hand is "the measuring and reporting of accounting information for managers of a business" (Atrill & McLaney, 2011: 505) and is based on current and future trends (not on past performance). It is used by managers to make decisions concerning the everyday operations of a company (Weetman, 2003).
- Describe standards of accounting
"Accounting standards are necessary so that financial statements are meaningful across a wide variety of businesses; otherwise, the accounting rules of different companies would make comparative analysis almost impossible" (Investopedia, 2012). In the UK the Financial Reporting Council is the regulator for accounting standards. It is accountable to the UK Parliament and sets UK accounting standards through the Accounting Standards Board (ASB), which issues Financial Reporting Standards (FRS) + (FRSSE - for small businesses) (Financial Reporting Council, 2012).
However, since there is a growing trend towards global perspective, this assignment describes the International Financial Accounting Standards (IFRS) more detailed. IFRS are "transnational accounting rules that have been adopted, or developed, by the International Accounting Standards Board [IASB] and which should be followed in preparing the published financial statements of listed companies. (Also known as International Accounting Standards [IAS].)" (Atrill & McLaney, 2011: 504). IAS were issued from 1973 to 2001 and are now replaced by IFRS (IRFS-Portal, 2012). IASB is an independent, standard-setting body set up to develop IFRS and is located in London. The main objective of the IASB is to develop a set of high-quality and globally accepted IFRSs. Those IFRSs deal with issues such as (Atrill & McLaney, 2011):
â€¢ Disclosure of information
â€¢ Presentation of information
â€¢ Valuation of assets and
â€¢ Measurement of profit.
IFRSs consist of standards and official interpretations of these standards; there is a conceptual framework for them (IRFS-Portal, 2012). The main goal of IFRS is to synchronize accounting standards across the globe to make international comparability as easy as possible and to ensure the creation of an efficiently and effectively functioning, integrated capital market. All listed European Union companies (including banks and insurance companies) have to prepare their consolidated financial statements in accordance with the IFRS since 2005 (IRFS-Portal, 2012).
- Outline accounting conventions
Always on Time
Marked to Standard
The theory of accounting created the concept of a "true and fair view" to make sure and assess whether accounts do indeed depict precisely the companies' activities (MTD Training, 2010). Accounting concepts and conventions assist to make sure that accounting information and facts are presented precisely and consistently (Atrill & McLaney, 2011).
"Accounting conventions are the rules of accounting that have evolved to deal with practical problems experienced by those preparing financial statements" (Artill & Mc Laney, 2011: 65). According to tutor2u (2012), the major accounting convention is the historical cost convention. This means that transactions need to be recorded by using the (historic) cost of the transaction and that assets need to be valued at their acquisition costs (Atrill & McLaney, 2011). The other conventions can be summarized as (tutor2u, 2012):
â€¢ Monetary measurement
This means that accounting information includes only those items which are capable of expression in money terms. For example, the name of a company (e.g. Apple) may be highly valuable within the multimedia business, but because this value is difficult to quantify, it will therefore not be treated as an asset. Another example could be quality of management (tutor2u, 2012).
â€¢ Separate entity
The separate entity convention attempts to make sure that private transactions regarding those who own an organization are separated from transactions directly regarding to the organization (Atrill & McLaney, 2011).
â€¢ Realization and
Realization can be described as the procedure of transforming non-cash assets and rights into cash or the other way around (Atrill & McLaney, 2011).
This convention is an important one for auditors of financial information because it says that financial reports just have to include information that will be meaningful (material) to their users (Atrill & McLaney, 2011). A large organization like a hospital would not need to include the number of paper-clips used by them in their auditor's report, for example. An expenditure of a few thousand pounds might not be as material for a large organization as it might be for a small one.
The following four accounting concepts substantiate the preparation of any sets of accounts (tutor2u, 2012):
â€¢ Going concern
The going-concern concept indicates valuing organizations' liabilities and assets on the basis that it is continuing to perform (Atrill & McLaney, 2011). "In other words, there is no intention, or need, to liquidate the business" (Atrill & McLaney, 2011: 504).
The consistency concept suggests making use of similar accounting methods for generating financial statements in different fiscal years or periods because this procedure makes it easier to compare the financial statements of various fiscal years or periods (Atrill & McLaney, 2011).
â€¢ Prudence and
The prudence concept is all about being cautious when making accounting judgments, especially for judgments concerning future problems and expenses for an organization, because revenues aren't acknowledged in accounts until a purchase is completed.
â€¢ Matching (or "Accruals").
The accrual concept disregards the function of time and just considers which expenses create which profits, regardless of whether payments haven't already been made, not like other accounting systems, which recognize profits and expenses in the order that they are received (Atrill & McLaney, 2011).
Accounting policies on the other hand are "the specific policies and procedures used by a company to prepare its financial statements. These include any methods, measurement systems and procedures for presenting disclosures [e.g. depreciation and income recognition]" (Investopedia, 2012). Accounting policies and standards are not the same. Standards are rules and policies are a company's method how to follows those rules (Atrill & McLaney, 2011).
2.1 - Explain types of financial information
Finance is "a branch of economics concerned with how businesses raise funds and select appropriate investments" (Atrill & McLaney, 2011: 503).
The key product of an accounting system is a set consisting of three main financial statements which are (Atrill & McLaney, 2011):
â€¢ Balance sheet
â€¢ Income statement and
â€¢ Cash flow.
A financial statement that is utilized to assess an organization's standing at any given point in time creates the balance sheet (Atrill & McLaney, 2011). The balance sheet is the only financial statement that relates to a single point in time rather than a particular time period; it therefore is a snapshot in time (Weetman, 2003). The fundamental formula for balance sheets is the relationship of the organization's assets being equal to the liabilities and owner's equity (A=L+OE) (Atrill & McLaney, 2011). Both sides of the equation must equal each other, be in balance. Assets include inventory, cash, machinery, accounts receivable, etc. Some assets are hard to determine from the monetary point of view, for example trademarks. Liabilities can be accounts payable, loans, interest, etc. The owner's equity is the distinction between liabilities and assets (OE=A-L), including cash brought in by the owner (Atrill & McLaney, 2011). The creation of balance sheets doesn't have a certain span, but typically take place at the end of the fiscal year. The differences between balance sheets of various points in time produce the income statement (profit and loss account) (Atrill & McLaney, 2011). Summarizing transactions like expenses, revenues, losses and losses are contained in the income statement. The statement of cash flows is "a statement that shows the sources and uses of cash for a period" (Atrill & McLaney, 2011: 509). It provides detailed information about how changes in balance sheet accounts and income statements influence cash and cash equivalents.
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These financial statements create the basis for the financial information needed to plan, control and make decisions (Atrill & McLaney, 2011). A method of planning financial information is a budget (will be defined in 2.2), a plan for the future, prepared by analyzing financial statements (Fridson & Alvarez, 2002). For example, a ratio analysis (will be defined in 2.2) answers questions that are of interest for various stakeholder groups, e.g. how an organization operates, how the current financial position looks like and how the future outlook is (McKenzie, 2003).
According to tutor2u (2012), the main characteristics of financial information that are relevant to stakeholders are:
â€¢ Reliability and
2.2 - Analyze methods of comparing financial information
Different stakeholder groups have different interests in a business and also they vary in their power to influence decisions (Wood, 2002).
As the author works for a hospital, the interests and needs of the external stakeholder groups will be described in detail by practical examples of the German hospital market. The Hospital Rating Report is published annually in June and analyzes the balance sheets and the financial situation of German hospitals (Siekerkötter & Fehn, 2005). The Hospital Rating Report examines the economic situation of the hospitals in detail. The report describes the current situation and provides an outlook for the coming years. Furthermore it answers questions like: "In which regions are the highest increases in patient numbers expected in the future?". Its main goal is to improve the transparency in the German hospital market. Derived from this, there is the claim to give decision makers at various levels (hospitals and their business partners, policy, health insurances, banks and investors) empirically based insights into this market. Those stakeholder groups can inspect the audited financial statements online as well, because every German limited liability company is required to publish them at the Federal Gazette (Siekerkötter & Fehn, 2005).
By looking at the German hospital market from another perspective, as a patient, the interests of this stakeholder group are different. Therefore the German Hospital Directory (DKV) provides an overview of the current medical supply structure and the individual service areas as well as the extensive care service offers of German hospitals (Siekerkötter & Fehn, 2005). Hospitals are not only in the patients' focus of attention. Practitioners, health professionals, associations, public authorities, universities and the media are interested in the numbers and facts and figures about hospital care in Germany as well (Siekerkötter & Fehn, 2005).
Within the author's company, the internal information is mostly communicated through monthly e-mail newsletters about the company's financial situation, issues, accomplishments and news. Also there is a big employee meeting at the end of each year and open days every summer. Within the different clinics, there are annual staff appraisals and staff meetings in irregular intervals. Of course the hospital is present at almost every national and international fair in the healthcare field.
There are of course different methods of comparison to get the information needed. For example, a ratio analysis can help to prepare a budget, which is helps to accomplish the financial objectives set by an organization (Eakins, 2002).
A ratio analysis is a method of comparison applied by organizations to perform a quantitative analysis of the organization's financial statements information, usually from the same set of financial statements (McKenzie, 2003). "Ratios are calculated from current year numbers and are then compared to previous years, other companies, the industry, or even the economy to judge the performance of the company. Ratio analysis is predominately used by proponents of fundamental analysis" (Investopedia, 2012). This procedure assists identifying trends, overall performance and efficiency as well as changes in risk profile.
The main categories a ratio analysis examines are (Atrill & McLaney, 2011):
â€¢ Asset management/Efficiency
â€¢ Leverage and
â€¢ Cash flow.
It is extremely important for any organization to compare and contrast data from past accounting periods to create a view, compare it to similar organizations and then use it for planned performance (Atrill & McLaney, 2011).
Another example is the SWOT-analysis, which is an important tool for organizations to understand their strengths and weaknesses (Reilly and Brown, 2003). SWOT means:
Figure 1 SWOT Analysis (Wikipedia, 2012)
SWOT is a simple model that analyzes what an organization may and may not do along with its prospective opportunities and threats (Reilly and Brown, 2003). This method is designed for taking information from an environmental analysis and split it into internal (strengths and weaknesses) and external concerns (opportunities and threats). After complementation, it establishes what might help the organization in achieving its objectives, along with what challenges need to be overcome or decreased to achieve the results wanted (Reilly and Brown, 2003).
A budget is "a financial plan for the short term, typically one year or less" (Atrill & McLaney, 2011: 499), therefore they are the "short-term means of working towards the business's objectives" (Atrill & McLaney, 2011: 345).
Budgets include a list of all planned expenses and revenues, are prepared in advance and then compared to actual performance to determine any variations (Bhar, 2008). The following examples describe some of the purposes of budgeting (Atrill & McLaney, 2011):
â€¢ Control of resources
â€¢ Communication of plans and strategies
â€¢ Motivation of managers and staff to make an effort to accomplish budget objectives
â€¢ Evaluation of performance and efficiency
â€¢ Providing visibility into the organization's performance
Budgetary control on the other hand is the procedure through which financial control is practiced within an organization (Bhar, 2008). "Budgetary control is the establishment of budgets relating to the responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results either to secure by individual action the objective of that policy or to provide a base for its revision" (Bhar, 2008:14.1).
2.3 - Discuss the purpose of the reporting of information
The main objectives of financial reporting are to provide information that is useful in investment and credit decisions, in assessing cash flow prospects as well as information about enterprise resource, claims to those resources and changes in them (Carmichael & Graham, 2012).
Accounting and financial information are important for every informed business decision. Accounting information presents details about the past and future financial status of the company, which enable managers to comprehend what worked out good and what didn't work out for the organization in the past as well as what needs to be changed (McKenzie, 2003). Finance information is important as it presents information about the viability of future plans and projects (Carmichael & Graham). Figuring out whether a project is financially, economically and socially viable can keep an organization from being unsuccessful and losing money. The relationship of risk and return is the central goal of finance (MTD Training, 2010). No matter what decisions are made by an organization, there is definitely a trade of one that has to appear in the terms of risk.
3.1 - Apply accounting ratios correctly
The financial management abilities of Emma are evaluated in this section by utilizing a number of profitability and liquidity ratios. These are computed in Appendix A. The trend in key items present in the final accounts is also examined. This financial analysis is also helpful to provide a recommendation to Emma's brother about the viability of investing in this organization.
Figure 2 Trend Analysis - Profitability (own draft)
The trend analysis portrayed in figure 1 shows three salient elements pertinent to profitability. The turnover is a key driver to the earnings of the organization. It represents the goods sold to customers (Weetman, 2003). Turnover is increasing in the time frame considered which is positive for the firm since the day-to-day operations are generating more earnings. The gross profit is also increasing which means that the gap between turnover and cost of sales is getting wider (Wood & Sangster, 2002). Despite these two key elements are rising, the operating profit remained stable at £37,900. This implies that the additional turnover is being eroded by higher operating expenditure. Such rising cost inefficiency is not desirable for the profitability of the firm.
Gross Profit Margin
Operating Profit Margin
Table 1 Profitability Ratios (own draft)
The profitability ratios computed in Appendix A are summarized in Table 1. The gross profit margin indicates the gross profit generated from sales in percentage terms. There is a decline in this ratio which means that the cost efficiency in cost of sales is diminishing (Fridson & Alvarez, 2002). This is unfavorable for the firm's profitability. The operating profit margin shows the operating profit stemming from every £100 of sales (Fridson & Alvarez, 2002). This ratio also declined by 2.28%. This means that cost inefficiency is also increasing in the operating expenses of the organization. Such ratio sustains the trend analysis performed above.
Nowadays organizations are operating in a more turbulent and competitive business environment (Atrill & McLaney, 2011). This is due to more complex customer needs, globalization, fast changes in technologies and deregulation in local markets (Atrill et al., 2011). This change in the business environment necessitates a sound financial performance. The cost inefficiency problem noted for this organization is an undesirable factor that may put the firm into a weak competitive position. This may lead to severe consequences like loss in market share and losses.
Stock Turnover (days)
Debtor Collection Period (days)
Creditor Collection Period (days)
Table 2 Liquidity Ratios (own draft)
The liquidity ratios of Card Fun computed in Appendix A are summarized in Table 2. The stock turnover in days indicates the number of days that the organization takes on average to sell inventory to customers (Kieso et al., 2012). This ratio diminished substantially by 91 days. Such movement is favorable for the liquidity and profitability of the organization. A decline in this ratio means that inventory is sold more quickly to customers. Therefore, holdings costs will decrease and money will be tied up in inventory for a shorter period (Eakins, 2002).
The working capital ratio indicates the ability of the current assets to cover the current liabilities (Kieso et al., 2012). This ratio decreased materially because the rise in current assets of 33.27% is lower than the increase in the current liabilities of 100%. Such movement indicates a weaker liquidity. However the working capital ratio of 2011 is much higher than the target ratio of 1.75. This means that the working capital management of the firm is exceeding the benchmark set.
The debtors collection period shows the number of days taken on average by debtors to pay the firm for credit sales (McKenzie, 2003). This ratio increased to 33 days, which exceeds the credit policy of the firm. Such movement is not desirable for cash flow because it will affect negatively the cash from operations (McKenzie, 2003). The creditors collection period also increased significantly by 49 days. This means that the firm is taking more time to pay its creditors (McKenzie, 2003). Such aspect is favorable for the cash flow of the organization. However the organization is exceeding the time allowed by creditors of 30 days. This can negatively affect the relationship of the firm with suppliers and there is the risk that credit is stopped to Card Fun by suppliers. Such liquidity risk may lead to an adverse impact on the company's cash flow in the future.
3.2 - Report accurately on financial ratios
Financial Health of Card Fun
Emma was able to keep the same operating profit as previous year. However the financial performance of the organization deteriorated because the increase in sales revenue was not able to generate a rise in operating profits. This took place due to rising cost inefficiency in operating expenses. The liquidity of the organization is also getting weaker as indicated by the working capital ratio. This is mainly due to the rising creditors collection period. Therefore, there is a deterioration in profitability and liquidity. This shows that the financial health of Card Fun is getting weaker and the financial management of Emma was not effective.
3.3 - Evaluate the impact of financial ratios on the organization and
Conclusion - Recommendation on Investment
Shareholders are interested into two main factors when evaluating an investment decision. One consists of the return that can be attained from the investment, while the other is the risk of investing in the firm (Reilly & Brown, 2003). The organization examined in this assignment is not able to provide a higher return to shareholders since the operating profit remained stable. The prospects of future profits are also dull in light of the cost inefficiency in operating costs. Therefore, there is the risk of a lower ability to provide a return in the future if the efficiency problem is not resolved. The risk of investing in the organization is also increasing due to a deteriorating financial health. Therefore, it is advisable that Fergus seeks other firms that are portraying a stronger and improving financial health and financial performance.
Accounting is "the language of the business world" - a language that every businessman needs to be a master of. The procedures of accounting play an essential rule in the process of strategic decision making and influence both business and non-business entities. This process of decision making has consequences not only for production, sales and employees, but it also affects the shareholders' interests in the company.
The author's conclusion based on the personal research on the topic is that the major rule for those people operating within the financial business, e.g. managers, owners, etc. should be to follow fundamental organizational, methodical and ethical ways of thinking when facing accounting and finances. Taking more time on verifying facts and information to make sure each side of the sheet is balanced is very important. Lastly, making sure those who audit the information in the future can understand each bit of assets, liabilities and equity certainly is the highest of importance.