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Accounting or accountancy is a process used for the collection, processing and communication of financial information. Accounting is an information system. Its main purpose is to communicate financial information to interested parties about economic events that relate to the business organizations. Accounting information is used for decision making about possible future operations. It enables or should not, the efficient and effective utilization of scarce resources.
Therefore, the objective of financial statements is to satisfy the information requirements of decisions makers in the acquisition and allocation of scarce resources. This is turn facilitate the operational efficiency and financial viability of business operations.
Besides that, the end results of the accounting information are collectively referred to as financial statements. They include the Income Statement, Balance Sheet and Cash Flow Statement.
A Balance Sheet shows in statement formed the relationship between Assets, Liabilities and Owner's Equity at a point time. The Balance Sheet is a representation of the Accounting Equation in action; the term "balance" refers to the equality of Assets and Equities.
The Income Statement is a financial report to the owner of the business which shows the revenue for an accounting period matched with the expenses of earning that income. Information is shown in the Income Statement in a narrative form. Items are grouped together to help with analysis and interpretation.
The Cash Flow Statement reports the performance of a business in terms of its cash movements, for instance, the cash receipts and cash payments of the business for a period.
Furthermore, the objective of the accounting information system is to satisfy the financial information requirements of the end users of accounting information. There are some examples of the users:
Purposes and benefits
Manager is to make decision relating to the allocation of scarce resources in order to meet corporate objectives.
Financial information as input into the decision- making process.
Financial information enables the achievement of objectives or goals with the limited amount of existing resources available.
They have the rights to know all assets and profits after the repayment of the business debts.
Accounting systems with the task of reporting financial information to owners about their ownership interest.
Financial information enables them to make decisions, such as:
Expand business operations by investment further funds
Reinvest profit into expansion
Sell or hold shares in the company
Lenders of finance are mainly concerned with the short-term liquidity of the business.
They need to get the accounting information for the business ability to repay its debts.
Before a business is given long-term finance, it must be able to prove its long term credit-worthiness by providing accounting information.
They need to ensure the company is able to make interest payments.
They show an active interest in the financial position and profitability of organizations to enable the claim for increased salaries.
Question 2: What makes accounting information useful?
What makes financial information useful?
Disclosure of accounting policies
Substance over form
The IASB framework comes out a set of qualitative characteristics that make the information given in financial statements useful to all the users. There have four main qualitative characteristics which are understandability, relevance, reliability and comparability.
First, understandability means the expression, with clarity, of accounting information in such a way that it will be understandable to users who are generally to have a reasonable knowledge of business and economic activities. Thus, information on complicated issues should not be lost from financial statements just on the argument that some users may find it hard to understand.
For accounting information to be useful, it must be relevant to a decision. Information has the value of relevance when it manipulates the economic judgments of users by helping them evaluate past, present or future dealings or confirming, or correcting their past evaluations. Information has two roles in helping the users.
It is helping users to look to the future.
Explaining unusual features of current performance helps users to understand prospect potential.
Showing users how the entity has or has not met their expectations.
In addition, concept of materiality is intimately related to relevance and deals with the amount of an error in accounting information. The question is the error big enough to affect the decision of someone to rely on the information.
Accounting information is reliable when it is liberated from material error and can depend by the user to represent the economic situation or occasion that is implies to represent. Information may be relevant but so unreliable that it could be misleading. In contrast, information could be reliable but quite non-relevant. Additionally, reliability has five basic characteristics:
It is the addition of an extent of caution in the exercise of judgments needed in making approximates under circumstances of insecurity, whereas fair presentation should be essential to all financial statements.
Good accounting information is complete.
That means it provides intended users with all information that is necessary to fulfill their information needs and requirements.
The assumption is there no error of omission.
Financial information must be neutral.
If the financial information is not neutral, it will influence the decisions or judgments in order to achieve a predestined results or conclusion.
It is important if accounting information is to be reliable.
It involves the words as well as the figures in the financial statement when match up in an actual occasion.
Substance over form
If the information is to meet a test of faithful representation, then the method of account must reflect the substance of the economic reality of the transaction and not just a legal form.
Both of the qualitative characteristics of relevance and reliability are associated with the comparability. For accounting information, comparability allows a user to evaluate two or more corporations and look for similarities and differences. It also means users able to compare the financial statements of a company eventually to determine the development in its financial performance. The concept of comparability has two important roles which are:
It means that financial statements can be compared within a company from one accounting period to the next or between the different companies in the same period.
Disclosure of accounting policies
It means the users of financial statements must be informed of the accounting policies employed in the preparation of financial statements.
Question 3: Briefly identify the difference between an income statement and the balance sheet. Using relevant example and clearly illustrated format, explain what is accounted for in the balance sheet.
The income statement is a summary of the income and expenses for a period. Its preparation involves matching the income or revenue for a period against the costs or expenses for the period. The net result is the profit or loss for the period.
Besides that, the income statement reports hoe the owner/shareholders' equity increased or decreased as a result of business activities. The income statements display the sources of net income, generally classified as revenue (value coming in from selling products) and expenses (value going out in earning revenue).
Format of income statement:
The basic format of an income statement is as follows:
Income Statement for the year ended 31 December 20xx
Less: Sales Return
Less: Cost of goods sold
Less: Purchase Return
Less: Closing Inventoryã€€
Add: Other Incomes
Net Profit/ Net Loss
The balance sheet is a statement of the assets and liabilities of a business at take on of time, especially at the end of an accounting period. It represents the balances of the accounts remaining open after the Income Statement account has been prepared. It will represent the balances of accounts carried forward to the next accounting period.
The balance sheet reports the financial position of a business as to its assets and equities at a specific point in time, as disclosed by:
The resources at its disposal, referred to as Assets
The ownership interest (equities) in these assets, referred to as Owner's equity (Internal equity) and Liabilities (External equities).
Classification in a Balance Sheet
Assets - Things of value which belong to the business and which will provide benefit in the future.
Current Assets - Assets which are cash or convertible into cash within twelve months, or which will provide a benefit to the business within twelve months, e.g. motor vehicles, account receivables.
Non- current Assets - Assets which will provide benefit to the business beyond twelve months (i.e. no more than one year remaining on the date of the balance sheet), for example land and buildings, machinery.
Liabilities- Amounts owing by the business which have to be repaid in the future
Current Liabilities- Debts which have to be paid within twelve months from the date on the balance sheet, for example account payables, overdraft.
Non-current Liabilities- amount owing by the business which are payable more than 12 months after reporting date, for example long-term loan, mortgage.
Net assets- Total Assets less total liabilities
Equals Owner's Equity in accordance with the Proprietorship Equation,
OE = A - L
Owner's Equity (Capital) - The financial interest that the owner has in the business representing any capital contribution by the owner and any profits retained in the business.
Capital = Opening Capital + Net Profit - Drawings
Format of a balance sheet
The basic format of a balance sheet is as follows:
In conclusion, the difference between the income statement and balance sheet is based on the terms of what it's explained. An income statement covers an accounting period of a company. Income statement also describes how much capital came into an organization during an accounting period; the amount went out as expenses and what was missing at the end of the period.
On the other hand, a balance sheet is generally produced to show what an organization has or owes on the end of the period enclosed by the income statement. The balance sheet explains what the organization owns or owes to carry on production or paying money during the next period of time covered by the next income statement.
Question: Your friend mark is thinking of starting his own business as he wants to be his own boss and have total control over his income but he is not sure how to set prices for his products. He has read some books and come across terms like 'mark up and profit margin'. He has sought your advice and as an accounting student, you are to explain to him how he is able to do the appropriate pricing and make profits from his business venture. What factors would Mark need to consider to ensure the success of his business?
Markup and margin are measures businesses use to set and manage prices to maximize profitability. As the mark up and margin is referring to the same things but calculate price or profit in different ways. In general, mark up is calculated based on the cost whereas margin is calculated based on the sales/selling price.
A markup is percentage of the cost price plus to get the selling price.
Mark-up = Gross profit x 100
The margin is the percentage of the final selling price that is profit.
Margin = Gross profit x 100
Business people usually apply markup for setting prices, while margin is more useful for considering and improving the profitability of the products in a business markets. In order to use the markup of inventory to predict the future gross margins, the business owner must understand the distribution between the markup and gross margin. The markup of his inventory is frequently called initial markup, because it is where the business owner begin. Nevertheless in order to sell it, business owner may have to discount it, promote it or distribution it down for clearance at the end of the season. Gross margin is the profit actually earn when sell it after any discounting or markdowns therefore it is frequently called maintained margin. This spread will be specific to the business, depending upon the level of promotional and clearance activity.
For instance, Mark wants to open a muffins store. Assumed the cost of production is £2.00 per muffin.
To find out a muffin's selling price using the mark-up method, we must know the cost/muffin. Total cost is supposed to take account of all of the costs incurred in producing the muffins to the end of sale.
The method for determining a muffin's selling price using a preferred mark-up percent is:
Selling Price = Total Cost x (1 + Mark-Up %)
Selling Price = £2.00 x (1 + 0.30)
Selling Price = £2.00 x (1.30)
Selling Price = £2.60
Consequently, if want a mark-up of 30% (a profit equal to 30% of total cost) the selling price must be set at £2.60. Mark-up percent is the amount of total cost represented by profit.
Within some occasions, the selling price may be set belong to the comparison of the cost of production with the market price. For instance, if cost of production is £2.00 per muffin and the market comes out to maintain a selling price of £2.80, the selling price may be set around £2.60. These figures can be used to establish the mark-up percent. In this situation, the method for the mark-up % is:
Mark-up % = (Selling Price - Total Cost) ÷Total Cost
Mark-up %= [(£2.60 - £2.00) ÷ £2.00] x 100
Mark-up % = £0.60 ÷ £2.00 x 100
Mark-up %= 30%
The idea of mark-up pricing should not be confused with profit margins and gross margins. The profit margin is the monetary value difference in the selling price and total cost. So, the profit margin in the earlier illustration is (£2.60 - £2.00) £0.60 per unit. Consequently, as the gross margin is usually considered of as gross margin which is the percentage of the selling price accounted for by the profit margin. Gross margin is calculated as the profit margin divided by the selling price. The method for gross margin percentage is:
Gross Margin % = (Selling Price - Total Cost) ÷ Selling Price
Gross Margin % = [(£2.60 - £2.00) ÷ £2.60] x 100
Gross Margin % = £0.60 ÷ £2.60 x 100
Gross Margin % = 23%
If a preferred level of gross margin is recognized, the method for gross margin can be adapted to calculate the selling price. With a preferred gross margin percent, the method for calculating the selling price is:
Selling Price = Total Cost ÷ (1 - Gross Margin)
Selling Price =£2.00 ÷ (1 - 0.23)
Selling Price = £2.00 ÷ £0.77
Selling Price = £2.60
There is understandable that the gross margin of 23% is different than the mark-up of 30%, even though both examples used a selling price of £2.60 and a total cost of £2.00. Mark-up and gross margins are frequently used in calculating and estimating selling prices. Nevertheless, mark up and margin should not be used cross-over for they are distinct and calculated in a different way.
Besides the mark up and margin, the evaluation of liquidity and profitability as well can determine the performance of a business. Liquidity ratios and profitability ratios use the components of classified financial statements to show how well a firm has performed in expressions of maintaining liquidity and achieving profitability.
Means having enough money on hand to pay bills when due to date and to take care of unexpected needs of cash.
Liquidity evaluate that is calculated by dividing net cash flows from operating activities by average total assets.
There are some methods to measure liquidity, which are:
Current Ratio = Current Assets
Acid test = Current Assets - inventories
Means the capability to earn adequate income.
As an objective, profitability participated with liquidity for managerial attention because liquid assets are not the profit producing resources.
To evaluate profitability of a company, the needs of comparison of the past and the present performance.
There are some ratios to calculate the profitability:
Profit margin = Net income
Asset turnover = Net sales
Average total assets
Return on assets = Net sales
Average total assets