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Management Accounting helps in preparing reports that help for future looking and forecasting to the organisations. These are use by the top management as they are responsible for taking decisions whereas Financial Accounting focus on creating financial reports that basically gives an idea of profitability, solvency and liquidity. These can be used by both internal and external users.
"Financial Accounting reports are prepared for the use of external parties such as shareholders and creditors whereas Management Accounting reports are prepared for managers inside the organisation."
Management Accounting involves directing, planning and helps in motivation and evaluation. No need to follow Generally Accepted Accounting Principles (GAAP) and no specific time period is required whereas Financial Accounting involves preparing reports for outside owners, creditors, debtors. They must follow Generally Accepted Accounting Principles (GAAP) and these are prepared according to specific period of time.
"Both Financial Accounting and Management Accounting involve financial reports and analysis but that is where similarities end. Financial Accounting and Management are two distinct disciplines that differ in several areas namely: purpose, the scope and the information being considered and regulatory oversight."
Financial Accounting gives focus on preparing standard reports like Income Statement, Balance sheet and Cash Flows Statement etc for external users like creditors, shareholders. These reports are prepared on quarterly and annual basis whereas Management Accounting involves preparation of internal reports on daily, hourly or on operational basis. These help managers for making future decisions and directing & controlling day to day operations.
"The term Accounting Ratios is used to describe significant relationship between figures shown on balance sheet, in a profit or loss account, in a budgetary control system or in any other part of accounting organisation. Accounting Ratios thus show the relationship between accounting data."
Ratios show the relationship between two numbers and Ratio can be found by dividing on one number with another. It can be expressed in the form of proportion, percentage or rate. "Ratio Analysis is a tool used by individuals to conduct a quantitative analysis of information in a company's financial statements." It helps to identify the performance of an organisation and by this one can compare current year numbers to the previous numbers. Ratio Analysis helps in sales forecasting, budgeting and for this it uses different modes and thus one can assess profitability, solvency. Ratio Analysis helps in describing the efficiency of business for example the Current Assets and the Current Liabilities of a business on a specific date is:
Current Assets: £600,000
Current Liabilities: £ 200,000
Thus the ratio of current assets and current liabilities could be 3(i:e 600,000/200,000) or 300% or 3:1.
Advantages of Ratio Analysis
Analyzing Financial Statements: It facilitates the sense of financial statements. Ratio tells us about the changes in financial condition of an organisation.
Expedite inter firm comparison: It arranges data for inter firm comparison and gives focus on the factors related with successful and unsuccessful firms.
Assists in Planning: It assists in planning and forecasting. It helps management in directing, planning, controlling and decision making process.
Drive for inter firm comparison: Ratio Analysis helps in describing efficiency and performance of an organisation and provides outlines for future forecasting.
Benefits in Investment Decision: It benefits in investment decisions in case of investors.
Limitations of Ratio Analysis
Limitation of Financial Statements: Ratio is based on the information provided by the financial statements since financial statements subject to few limitations.
Equivalent study required: In order to the performance one has to do deep comparative study of past year numbers with current year numbers.
Difficulty in Price fluctuations: Change in price level has a direct relationship with ratios calculated and thus it is not an indicator for profitability and solvency.
Constrict use of Single ratios: Single Ratio does not convey any meaning and thus there have to number of ratios which is a difficult task.
Personal Bias: Ratios have to elucidates and different people in elucidate in different way.
Break Even Point is defined as the point where revenue equals expenses and there is no profit earned & no losses bearded at this point by the organisation. It is a point where gains equal to losses or at this point total costs equal to total revenues. The importance of breakeven point is that it shows the effect of decisions taken by the manager as every organisation has the same goal to make profit and hence breakeven point is a good yardstick to know how much revenue is required to equal expenses.
"Breakeven Point of a business is the level of output or sales at which the revenue received by the business is exactly to the cost of making that output."
Breakeven Point can be calculated by using the formula and it includes total costs. Total cost includes fixed costs and variable costs.
Fixed Cost: These are the costs that vary with sales. For Example: Rent paid by for a shop or property, Interest paid and supplies etc.
Variable Cost: These are the cost that varies with sales. For example: raw materials, labour cost and fuel cost etc.
By Edward Niedermeyel (2009)
"A bookshop has fixed costs to £5,000per week. It buys books from the publisher at an average cost of £5 each and sells them for an average of £10 each. How many books does he need to sell break even?
For every book sold the bookshop takes in £5 more of revenue and then it pays out in variable cost.
Contribution= Sales Revenue- Variable Cost
We use the term contribution to describe the difference between sales revenue and variable cost per item. As each £5 is contributing to paying off fixed costs of£5,000.
Breakeven Point= Fixed Cost/Contribution per book
= 1,000 books per week."
Relevant Cost is decision definite, meaning that relevant costs can be meaningful in one spot but inapplicable to the other. The concept of relevant costs exclude irrelevant data that distorts the decision making process. Relevant costs are costs that differ with respect to specific decision. According to Ray D. Dillon and John F. Nash (1978) says "Relevant Costing and Incremental analysis are often used as decision making tools. Irrelevant costs are excluded from any incremental decision making problem because they are supposed to have equal effects on all the available alternatives."
Relevant Costs are also known as differential cost. Sunk Cost is irrelevant cost and is defined cost that was beared in the past. Unavoidable costs are the cost which the organisation has to bear irrespective of management decision. Avoidable costs are the cost can be avoided by the organisation because of the availability of options.
"ABC Ltd wishes to know the relevant cost of material X for a special contract. The contract will need 200 litres of Q.
Currently in stock
Original cost of Q in stock
$2 per litre
Current purchase price of Q
$4 per litre
If not used on the contract stocks of Q would be scrapped for proceeds of $1 per litre
Cost of purchasing 50 litres of Q= (50x$4) =$200 plus Opportunity cost of scrap (150 litres x$1) =$150 =$35."
There are several reasons why the Profit/Loss does not equate with the increase/decrease in cash during the year and following are the main reasons:
Accrual Accounting: In this type of accounting method entries are recorded when they occur not when they are paid. It basically focus on accounts receivable and in this type of accounting the effect of transaction is taken into account when it occur rather than the time when cash is actually received. For Example: "If a sale is made in January but the payment is not expected until the February, the revenue from the sale would be recognized in January and the amount due to the company is recorded in accounts receivable."
Sale on Account
Payment on Account
Depreciation of assets is also an important reason for profit/ loss and cash flow inequality. Depreciation of assets is a non cash flow expense. Depreciation occurs yearly and is not recorded as cash entry. For Example: If Company XYZ purchases Plant & Machinery of £100,000. As Plant & Machinery comes under assets and it suffers depreciation of£10,000 per year.
Account Payable is the money that the company has to pay creditors on a certain date. No cash has gone out of the company since the payment is made on credit. For Example: Company A purchases raw materials from Company B of £50,000 on credit and the amount is payable after two months.