Internal Use of Financial Statements

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Executive summary

Changde Dongding Power Machinery Co., Ltd. is a medium company in China. The company dominates the local market and also doing the international business. About 70% of its products are sold to other country, and the company wants to expand their business to more areas.

For this purpose, the company is intent to more development in corporate governance. As we know, that in China, the financial statements are always not paid much attention. The company sees the financial reports as a kind of data record rather than use it as a management tool. And Changde Dongding Company has this problem as well.

The objective of this report is to find out how to improve the internal use of financial statements in the company. The research can be described as a case study, and the primary research is the interview with the owner and managers of the company which followed by the secondary data sources.

The entire report is following three main research themes: Financial statements users, the reliability of the financial statements and Management's attitude on the financial statements. Derived from these research themes are the following research questions:

Are people who should use the financial statements all included and do they make full use of these statements?

Does the company have internal auditing to increase the reliable of the statements?

How often do the managements use the financial statements? Do they attach great importance to the statements?

We found out that Changde Dongding Company use the Chinese GAAP as its standards, and the reports are all in Chinese which is a big weakness for an international company. And its internal audit system is not being valued, so it undermines the faith in the reliability of the financial reports which may result for imprecise evaluation in the company. In order to improve the internal use of financial statements, management's attitude on the reports plays a decisive part. The management should give great concern and sufficient attention on it.

Main recommendations for Changde Dongding Company are to make the financial statements more international so that more people understand it. Furthermore, the company should improve its internal auditing system to increase the reliability of the financial reports. Finally, the management needs to pay more attention on it for the guidance of better development.

Chapter 1: Case Introduction

Introduction case company


Changde Dongding Power Machinery Co., Ltd. was founded in Zhejiang province in 1990. In 2002, the company moved to Hunan province. As a member of Light Automobile Repairing Association of China, the company mainly manufactures spare parts of automobile engines, and the products are series of Cylinder Heads, Cylinder Blocks, Crankshafts, and Connecting Rods.

Current situation

Now, the company is located in Hunan province where the transportation is convenient and the raw material is cheap. The annual production capacity of this company reaches 150,000pieces. 70% - 80% of these products are sold to North America, South America, Southeast Asia, Africa, Middle East and Eastern Asia. Beside this, more markets should be reached from now on, such as Europe.

In recent years, although this company expanded its business, its net profits did not increase as their expected. And Mr. Kesong Gao who is the owner of Changde Dongding Co. is wondering where they went wrong and how he can find the problem.

Department characteristics:

Purchasing department

The purchasing department is responsible for looking for suppliers and issuing orders of raw materials and equipments.

Warehousing department

The company has its own private warehouse. The warehousing department manages the storage of raw materials and products.

Research and development team

The work of the research and development team is to research new products and to find more information about target market.

Production department

The production department is the largest department in Changde Dongding Company, it has 50 workers in this team and it is responsible for the physical manufacture of the products.

Sales department

The duties of the sales department are dealing with consumers and advertising.

Shipping department

The shipping department is coordinating with the warehousing department and sales department to receive raw materials and to send products to the customers.

Human resources department

The human resources department is responsible for organizing people, and also providing policies within the company.

Department of finance

The department of finance is work with all company reports. They are preparing financial statements, planning budget, and managing and organizing all of the financial activities.

Management department

The management team consists of people who have shares in this company.


From the current situation, we can find that Changde Dongding Power Machinery Company has good products, good reputation and relatively well organized teams. But from the financial reports of the company, we can find there are still some problems, such as the expense of raw material is high which result the profits go down, but the management did not pay attention on it.

The next topic, we will discuss the problem definition which identified with the main research themes.

Problem definition

Our problem definition can be identified by starting with the main research objective:

How to improve the internal use of financial statements to evaluate performance and planning for the future in China?

In this report, we want to know how the company uses financial statements currently, and then find out how we can improve the internal use of financial statements, in order to understand the financial position clearly, to evaluate performance accurately, and to plan the future reasonably.

There are three main research themes:

Financial statements users

The reliability of financial statements

Managements' attitudes on financial statements

The problem definition can be identified when looking at the current status of those research themes.

Financial Statements Users

Financial statements users are the people who use the financial statements for different purposes. The financial statements can be utilized as tax liquidation, performance evaluation, budgeting and the company position confirmation.

2. Reliability

After we know who uses the financial statements, we may ask, does the company have internal control on the financial statements, and is the information reliable? The reliability of the financial statements is very important for company to use it as both in external and internal use. And the accurate financial statements can decrease the risks of finance decisions.

3. Managements' attitude on Financial Statements

The management attitude on financial statements is significant for the use of the financial reports. If the management can pay much attention on it, it will be very helpful for the improvement of use of financial statement.


In order to give a visual presentation on the problem (fish head) and causes (bones) a fishbone diagram is presented on the next page


Now, we want to examine if all people that should use the statements are all included in Changde Dongding co., because the shortage of financial statements utilization results difficulties for the company to plan budget, evaluate performance. In order to solve these problems, we start to do the research from finding the financial statements users, the reliability of the reports, and the management attitude on the financial reports.

Next topic will set the research objectives which derived from the five research themes.

Research objectives

1. Financial Statements Users: To find out if all users who should use the financial reports are included and, if not, to give suggestions on who need to be included.

2. Reliability: To find out if the financial statements are reliable and, if not, to give recommendations on what the company can do to increase the reliability of its financial reports.

3. Managements' attitude on Financial Statements: To find out how the management use the financial statements to evaluate the performance and budgeting.

The next topic will come up with research questions which can help us to reach the research objectives.

Research questions

1. Financial Statements Users

Who use the financial statements in Changde Dongding Co. and do they make full use these statements?


How is the company's internal control on the financial statements? Does the company have internal auditing to increase the reliable of the statements?

3. Managements' attitude on Financial Statements

How often do the managements use the financial statements? Do they attach great importance to the statements?

Chapter's summary

In this chapter, we discussed the history and the current situation of Changde Dongding Power Machinery Co., Ltd. In order to improve the use of the financial statements, there are five research themes which need to be considered: Financial Statements Users, Reliability, Management attitude on Financial Statements, Budgeting system, and Standards for preparing financial statement.

In the second chapter, literature review will support some secondary data to help us to find answers of the research questions and reach the research objectives.

Chapter 2: Literature review


In this chapter, we will analyze some secondary data which will be used to help us to answer our research question in order to meet our research objectives. There also will be several theories which may be explained. And it will show why we should use these theories in answering and understanding the research questions.

Users of financial statements

For purpose of improve the internal using of financial statements, the most basic thing is to find out who are the users of financial statement.

Figure 1 shows the internal and external users of financial statements and what do they look for [1] .

Internal users:

Owners: owners use the financial statement to review the performance of management, and the owners take more attention on its profits.

Managers: managements use the financial statement to assess its own performance, and to plan the future.

Current employees: They focus on the profits that the company made, so that they can consider that if they can ask for more salaries.

External users:

Suppliers: suppliers want to know if the company has the ability to pay off on time. And they need to know is the company going concern from the financial report.

Lenders: lenders expect to know if the company can pay back, and how much interest they can get.

Customers: customers also require the financial report to consider if the company can go on. If not, the customers will never want to have cooperation with this company.

General Mass and Media: General mass and media want to know the financial situation of the company and to announce to the public.

Government agencies: Government agencies use the financial report to know how much taxes the company should to pay.

Perspective employees: perspective employees will look for the related data from the financial report to know if the company has a future.


Changde Dongding Company must to understand who should or might use the financial statements and what are their purposes. There are two kinds of users: internal users and external users. Firstly, the internal users are the crucial to improve the internal use of financial reports. Especially for managers, the financial statements provide orientation and ways for the development of the company. However, we cannot ignore the external users. The reaction of the external users on financial reports could provide a large amount of information for the internal users, such as what are their expectations on the company.

Internal audit

Internal auditing has been defined by the IIA [2] (The Institute of Internal Auditors) as follows:

"Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organization's operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes.

Independence is established by the organizational and reporting structure. Objectivity is achieved by an appropriate mind - set. The internal audit activity evaluates risk exposures relating to the organization's governance, operations and information systems, in relation to:

effectiveness and efficiency of operations;

reliability and integrity of financial and operational information;

safeguarding of assets;

Compliance with laws, regulations, and contracts." [3] 

The internal audit function is part of the internal monitoring system of the organization and therefore should be positioned within the organization such that the independence of internal auditors can be guaranteed. Ideally, internal audit should report functionally to the Audit Committee of the Board of Directors and administratively to the Chief Executive Officer (CEO) of the organization. And internal audit is a multi-step process aimed at determining whether existing processes and procedures (the condition) comply with applicable rules and regulations (the criteria) or deviate in any way from these criteria. [4] 

Internal Audit Process [5] 


In order to confirm the reliability of the financial statements, it is required a professional and effective internal auditing process in the company. By understanding the internal auditing system we can find out if this system may increase the credibility of the financial statements.

Financial Ratio Analysis [6] 

Financial ratios help us identify some of the financial strengths and weaknesses of a company. The ratio give us two ways of making meaningful comparisons of a firm's financial data: (1) We can examine the ratios across time to identify any trends; and (2) We can compare the firm's ratios with those of other firms.

The following four questions as a map in using financial ratios:

How liquid is the firm?

Is management generating adequate operating profits on the firm's assets?

How is the firm financing its assets?

Are the owners receiving an adequate return on their investment?

Firm Liquidity

Approach 1: the first approach compares cash and the assets that should be converted into cash within the year with the debt that is coming due and payable within the year. The assets here are the current assets, and the debt is the current liabilities in the balance sheet. Thus we could use the following measure, called the current ratio, to estimate a company's relative liquidity:

Furthermore, remembering that the three primary current assets include (1) cash, (2) accounts receivable, and (3) inventories, we could make our measure of liquidity more restrictive by excluding inventories, the least liquid of the current assets, in the numerator. This revised ratio is called the acid - test (or quick) ratio, and is calculated as follows:

Approach 2: the second view of liquidity examines the firm's ability to convert accounts receivable and inventory into cash on a timely basis. The conversion of accounts receivable into cash may be measured by computing how long it takes to collect the firm's receivables; that is, how many days of sales are outstanding in the form of accounts receivable? We can answer this question by computing the average collection period:

We could have reached the same conclusion by measuring how many times accounts receivable are "rolled over" during a year, or the accounts receivable turnover ratio.

We now want to know the same thing for inventories that we just determined for accounts receivable: How many times are we turning over inventories during the year? In this manner, we gain some insight into the liquidity of inventories. The inventory turnover ratio is calculated as follows:

Operating Profitability

To examine the level of operating profits relative to the assets, we could use the operating income return on investment (OIROI):

Financing Decisions

We now turn for the moment to the matter of how the firm is financed. We shall return to the firm's profitability shortly. The basic issue is the use of debt versus equity: Do we finance the assets more by debt or equity? In answering this question, we will use two ratios. Many more could be used. First, we simply ask what percentage of the firm's assets are financed by debt, including both short - term and long - term debt, realizing the remaining percentage must be financed by equity. We should compute the debt ratio as follows:

A times interest earned ratio is commonly used when examining the firm's debt position and is computed in the following manner:

Return on Equity

Our one remaining question looks at the accounting return on the common stockholders' investment or return on common equity; that is, we want to know if the earnings available to the firm's owners or common equity investors are attractive when compared to the returns of owners of companies in the peer group.

We measure the return to the owners as follows:


Financial ratios are the main tools to help the company to evaluate its financial performance, and to know its financial strengths and weaknesses.

Chapter 3: Research Methodology


In this chapter the way of executing the research will be discussed. Firstly, in 3.1, the research type will be shown. Secondly, we will discuss the research design. And the research framework will give you a brief explanation. Finally, the research phases and the planning will be reported.

Research type

The research can be described as a case study. The methods used for data collection during this research will be explained as follows:

Interview with the owners and top manager of the company.

Interview with the financial manager or his assistant.

Ask the company for financial reports


The telephone interview will be chosen. In order to understanding the company deeply, Mr. Gao who is the top manager and an owner of the company will be interview in the first. Then, I will phone the financial manager several times to find out the answers of the research questions.

Secondary research

The purpose of use secondary research is gather information, and compare with the theory which shows in chapter 2. It mainly depends on documentary data collection, such as financial reports, journals and marketing research reports.

Research design

Research design is taking the research to the real process. The research design shows how the research has been undertaken.

The research framework explains the order of the research process. Firstly, we make a main objective of the research. Then, we can find what problem we need to solve before we reach the research objective. In order to figure out the research problem, six research objectives should be achieved. And below is six research questions correspond to the research objectives. After, the research methods will be showed which related to the theories and existing company information. Finally, the conclusions and recommendation are presented.

Research framework

The research framework will be showed on the following page.

Research phases

The research includes three phase division. The phases will be showed as follows:


This phase contained the overall orientation on the research. Preparing the research proposal and setting up the research objectives are also in this phase.


This phase is data collection which includes existing company information and theories.


In this phase, we will design the recommendations after we compared the existing company information and theories that we used in the research.

Research planning

The research planning will be revealed as a Gantt chart.

Chapter 4: Research Findings


In this chapter, research findings are presented. The findings are related to the three research questions. By the end of each section of this chapter, the reader should be able to find the answer of the research questions.

Financial Statements Users

Research question 1: "Are people who should use the financial statements all included in and do they make full use these statements?"

Firstly, we should know what standards that the company implemented. After checked the financial statement of Changde Dongding Co. and the interview with Mr. Zeng, we found out that from 1990 to 2009, the company implemented Chinese GAAP. But on the other hands, Mr. Zeng said, on 9 July, 2009 the International Accounting Standards Board published an international Financial Reporting Standard designed for use by small and medium - sized entities. At the same time, considering their expanding overseas market, the company is beginning to study the IFRS for SMEs. Thus, the current situation is that the foreigners cannot understand the financial reports of Changde Dongding Company.

The financial statements users can be divided into two groups: Internal users and External users. In Changde Dongding Co, the main financial statements users are the owners, managers and government agencies.

Internal users


After the interview with Mr. Gao, it is obviously to find that in Changde Dongding Co., the owners usually use the financial statement every quarter to review the management performance.


The financial manager is Mr. Zeng Daqing; he said that his assistant is responsible for preparing financial statements and the internal audit, and the work of planning budget.

Preparing financial statements is their basic duty. Every transaction will be recorded in the financial statements.

The internal auditing process is usually done by the financial manager at the end of every year.

Changde Dongding Co., always make a yearly budget for sales, production and expenditure. The project budget is done at the very beginning, and it could help the manager to decide if they should start this project, such as to buy new machines.

External users

The government agencies use the financial statements to examine if the company pay the tax and if they fraud. The lenders use the financial statement to know if the company can pay back on time.

Reliability of the Financial Statement

Research question 2: "How is the company's internal control on the financial statements? Does the company have internal auditing to increase the reliable of the statements?"

As we mentioned in 4.1, Changde Dongding Co. has internal audit system, but it does not have independent people to do this work. This whole process is done by the financial assistant who is also responsible for making the financial statements.

Mr. Zeng said their accounting system is prudent, so there is no strict regulation for internal audit in their company. The bookkeepers in this company record every transaction on the computer every day. Then, the accounting assistant can arrange all the data and prepare the financial statement, and this work will be done every week. After the accounting assistant give the financial statement to the financial manager, the manager will check and give a final decision on it.

The financial assistant of Changde Dongding Company plays several roles simultaneously. At the end of year, the financial assistant as the internal auditor and begins to plan the internal audit. The objective of this activity is determined by both the owners and managers. Then, the financial assistant will assess the risks of material misstatement of the financial statements. After she will test all evidence, the financial assistant may complete the audit procedures and issue an opinion.

Figure: the process of internal audit in Changde Dongding Company

Managements' attitude on Financial Statements

Research question3: "How often do the managements use the financial statements? Do they attach great importance to the statements?"

There are three main financial statements: income statement, balance sheet and cash flow. The owners and managers could use all of them to evaluate the performance. But in Changde Dongding Co., the owners and managers pay more attention on the profits and they ignore the cost all the time. If the profit goes up, they will maintain a positive attitude on previous performance, but if there is smaller and less rewarding than before, the owners will think the management team has problems.

Case 1

In 2007, the gross profit of Changde Dongding Co. is 14,040,425.21;

In 2008, the gross profit is 10,452,359.52;

In 2009, the gross profit is 7,248,056.65.

Compared to the profit in 2007, the gross profit in 2009 decreased 6,792,368.56. After Mr. Gao notice that, he said may be there is a problem on their marketing strategy which result to the sales decreased, and the profits went down as well.

However, when we look at the income statement, we get the numbers of the revenue.

In 2007, the revenue is 75,384,150.23

In 2008, the revenue is 74,812,782.30

In 2009, the revenue is 77,323,877.75

From this financial data, we can easily to find that the problem is not the sales decreased, because even the revenue increased in recent years, the gross profit is decreased year by year.

After we calculated the operating income return on investment (which will be displayed in 4.6 case 2), the truth is that the operating income return on investment became less and less from 2007 to 2009 which means the operating income decreased from year to year.

Budgeting System

The company uses the flexible budgeting system to planning which provides more meaningful comparison as it flexes to the actual volume. It computes costs according to the actual level of activity. And the flexible budget could help the managers to deal with uncertain factors, such as to give the expected outcomes for a range of activity.

Financial Statement analysis

In Changde Dongding Co., there is no complete system to analyze its financial statements. Although the financial department could do this work; there is no requirement from the owners and managers.

Case 2

Firm Liquidity

Year 2007:

Year 2008:

Year 2009:

So, in terms of the quick ratio, Changde Dongding Co. was less liquid in year 2009 than it in 2007 and 2008. In 2009, the company had 0.39 in floating assets less inventories per 1 of floating debt, compared to 0.94 for 2008 and 0.96 for 2008. Thus, Changde Dongding Co. has much less ability to meet its maturing obligations in 2009. But the management team did not realize this problem. And they said the balance sheet of year 2009 show that there is no long-term debt.

Operating Profitability

Year 2007:

Year 2008:

Year 2009:

Hence we see that in 2007, Changde Dongding Co. was earning over twice the return on investment than it did in 2009. Which means the operating income became less and less. Thus, the company needs to solve the operating problem, but not the sales problem. However, from first half of last year, the company increased the advertisement cost to raise the product awareness which in fact increased the operating cost. If the company continues to ignore this problem, this will be a vicious circle.

Financing Decisions

Year 2007:

Year 2008:

Year 2009:

Thus, the company used more debt in 2009. But from the reports we can find that the company did not have long-term debt. The short-term debt may result in fast fund flow which may have potential risks on holding funds.


In this chapter, we used the research methods to find the answers for the research question. And in the next chapter, the conclusion of these finding will be presented to the readers.

Chapter 5: Conclusions and Recommendations


This is the last chapter of the report. In this chapter, the conclusions which based on the research findings will be presented to readers. And according to the conclusions, there are followed recommendations which may help the company for improvement.


Financial Statements Users

In the past years, Changde Dongding Co. prepared the financial statements according to the Chinese GAAP and all in Chinese. Now, above 70% of their products are sold to foreign markets and they are intent on expanding their overseas market in future. Thus, it is necessary to implement IFRS in this company which could let more groups to use the financial statement, such as foreign customers, investors, and foreign workers. However, it is worth mentioning that the company noticed this problem and began to change the standards.

The internal users of financial statements in Changde Dongding Co. are the owners and managers, which means the main internal users are included. But its current employees do not deal with it, so the employees have no idea about the situation of their company, and the rumor from outside may cause panic. Therefore, there is risk for the company to keep the talents stay in and well cultivate them.

From marketing view, Changde Dongding Co. do not provide its customers financial statements, thus, customers is uncertain about to buy their products, especially the customers who want to keep long business relationships with the company.


The company needs an independent people to do the internal audit which is the most essential requirement to do this procedure. However, Changde Dongding Co., do not have an independent person to do this work. The accounting assistant collects all transaction data, and makes the financial statements. At the end of the year, the internal audit is also her responsibility, thus, it cannot perform the function of internal audit. In order to increase the internal use of the financial statements, the company should have a fairly complete internal audit system to enhance the reliability of the financial statements.

Management' attitude on Financial Statements

Even the net profit is an element to evaluate the previous performance, it is a not that overall summary. Every data in the financial statement should be taken in consideration of evaluate performance. Only when the company finds the root problem, the company can get more money and have better development.

Budgeting System

Changde Dongding Co. uses the flexible budget to planning sales and cost at the end of every year. On one hand, the flexible budgeting system can make full advantage of the financial statement. On the other hand, the company only uses the budget once a year; it is far from enough. So, the management should pay more attention to the company's budgeting system, and often to make use of the budget system to compare realistic and adjust cost to planning future.

Financial Statement Analysis

Financial statement analysis is the main method to help the company to evaluate performance and to know the financial strengths and weakness. But it not valued in Changde Dongding Co. If the company could enhance the utilization of financial statement analysis, the internal use of financial statements will improve as well.


Financial Statements Users

In order to improve the internal use of financial statements in your company, the first work of the company should be providing other language version for the financial reports. As we know, your company is an international company. The suppliers are from China, and the customers are from all over the world. Thus, there is an urgent need for the English version of the financial reports which could let more people to use it. Also, your company should better to put the financial statements on your website together with the company news. Therefore, more people could use it and increase its transparency.


Option 1: Your company requires a complete internal audit system. So that an independent people needs to be set up to does this whole work, but not the person who prepare the financial statements. You can appoint another accountant from your company as the internal audit. It can make objective evaluation of company's financial statements.

Option 2: You may choose an accounting firm; they also can help you to do the internal auditing. They will do more work than the option 1. The first step of auditing procedure which is client acceptation is required, although the accounting firm has less knowledge about your company, they will do more research on understanding you company from multi-aspect. It may make more objective evaluation.

Management' attitude on Financial Statements

It is important to the owners and managers of your company to use more data from financial statement to evaluate the performance. There are four financial statements are needed: income statement, balance sheet, budget report and cash flow.


At the end of every month, your management can compare the budget numbers and the real numbers. And to check if there is a wide spread between them. For the abnormal numbers, managers should appoint the financial department to review them. After, you can use the financial statement analysis report to review the whole business. Also, there are some general financial rule should be considered and set up, such as the company should not lend 40% of their assets with debt. Moreover, the owners and managers need to pay more attention on the internal audit report at the end of every year.

Performance evaluation

Furthermore I advise you to analysis the financial statement every month, and to do the research of other companies' data in order to compare to your data. Thus, you can find that if your company has problem on liquidity, operating and financing. To commit to the charge of accounting assistant, she needs to submit the analysis report with the financial statement to the financial manager.