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Defining Accounting

Overview of Task 1: The role of accounting in an organization

The main purpose of this task is to prepare a brief for the junior accountants that have been hired recently at Al Ansari Auditors & Chartered Accountants. The rationale of preparing this brief is to highlight the role of the accounting department in the organization helping the newly hired junior accountants to understand the purpose and role of accounting in a wider array of contexts. The brief will discuss the main role of accounting in an organization and assess the ethical and regulatory constraints that concern the function. Furthermore, the brief will discuss the main users of accounting information and how the function provides necessary information that allows these users and stakeholders for making effective and informed decisions.

Accounting is often considered one of the most important functions of any business organization. It is often also referred to as the ‘language’ of any business. There is no single way to define accounting because of its broad context. It is best defined as the process or business function that includes the identification, measurement, and communication of financial information concerning a particular business entity which allows the users of accounting information to engage in meaningful, informed, and effective decision making. The above definition of ‘accounting’ helps to conclude upon two main procedures that concern the business function (Weetman 2019). These are divided into two main parts. The first part comprises generating the financial information which involves the scope of record-keeping, classification, summarization, analysis, interpretation, and communication. The second part comprises all stakeholders using the financial information for respective decision-making.

The six main purposes of the accounting function in any business organization have been elucidated as follows:

  1. Systematic Transaction Records:One of the main purposes of the accounting function is to maintain systematic records of financial transactions. These records are then later on classified and summarised for preparing and presenting the financial statements that can be used for analysis and interpretation.
  2. Ascertainment of Results:An accountant is expected to prepare an income statement either on a quarterly or annual basis for knowing the operational results of the business. If the sources of revenue exceed the expenses, the business is said to be running profitably while the business may be generating losses in a reverse situation. The income statement can be analyzed for making rational decisions. For example, if the business is not running profitably, the root causes can be investigated which allows the business to take remedial measures.
  3. Ascertainment of Financial Position:Knowing the profitability results of the business is not sufficient as stakeholders may be interested in knowing the liabilities which the business owes or the assets that it owns and operates at a particular date. This allows for preparing the statement of financial position which is also referred to as the Balance Sheet. It helps the stakeholders in understanding the financial health of the business at a particular date. Furthermore, one can also evaluate the liquidity position and the solvency position of the business which provides an insight into the entity’s capability of meeting its debts during the short and long run respectively.
  4. Monitoring of Cash Flows:It is rightfully said that ‘Cash is considered to be the lifeblood of any business. Although profits are a popular metric to evaluate the success of any business, it is possible that a profitable business may generate negative operating cash flows. A proper accounting function allows for keeping track and monitoring cash flows for ensuring that the business does not run out of immediate liquidity for running the operations with a high level of efficiency.
  5. Communication of Results and Information:Since the accounting function is the language of business, it communicates the financial results of the business to all stakeholders with the help of financial statements. Accounting as a business function aims to cater to the decision-making needs and expectations of all stakeholders such that they can make effective decisions.
  6. Budget Planning and Forecasting:The accounting function in the business allows for budget planning which assists the organization to develop strategies for saving funds and allowing for an efficient allocation of resources. The accounting function, therefore, serves as the basis for budget planning and forecasting (Warren, Jonick and Schneider 2020).

The external users of accounting information of any business entity will never have daily access to the financial records which a business maintains. Hence, they are at the reliance upon the integrity and judgment of management for providing accurate and high-quality financial information. However, the honesty of the management in today’s world amid business scandals is questionable. In an ideal world, investors should not have a problem concerning such dependence as the shareholders appoint the Board of Directors. However, it is not an ideal world for business organizations that may be large scale whose shareholders tend to change as shares are traded. Moreover, there are high chances of agency conflicts that exist as well which may allow managers to think about their benefits at the expense of shareholders’ interests (Shim et al. 2015). As a result, the need for an accounting regulation is paramount. A regulation will allow managers to exercise control and the accounting information to exhibit the fundamental qualitative characteristics as per the Conceptual Framework. While most of the world adheres to the IFRS accounting standards, the United States follows the US GAAP which serves are the regulatory guidelines governing the accounting function.

Accountants are often faced with ethical dilemmas during their course of a profession. Over the years, there have emerged several business scandals where accountants have been also proved guilty of engaging in unethical conduct. This allows for discrediting the accounting profession as a whole. Hence, the need to remain ethical while discharging their duties and responsibilities is all the more important. This will allow the external users of accounting information to rely upon the quality of accounting information for making decisions. Ethical accounting practices also allow an organization to be transparent and accountable to the interests of stakeholders. Over the years accountants have found themselves under several ethical issues which include the likes of pressure to project better, falsification of records, creative accounting, and earnings management activities. Making the correct ethical choice is the responsibility of the accountant. Therefore, there exist certain rules and guidelines that accountants have to adhere to for engaging in ethical decision-making. Some of these rules comprise the AICPA Code of Professional Conduct and the Code of Ethics for Professional Accountants (Brewer, Garrison and Noreen 2015).

The Main 6 Purposes of Accounting

There are several groups of people who may be interested in the financial information of a particular organization for making relevant decisions concerning it. These users may be internal to the organization with most users being external to the organization. The figure represented below provides a list of possible users who may have accounting information needs from an organization:

(Source: Atrill and McLaney 2018)

The accounting function of any business strives to meet the information expectations and needs of a wide variety of identified users also collectively referred to as stakeholders. The information requirements of these stakeholders and how the accounting function tends to cater to the expectations have been discussed citing appropriate examples as follows:

  1. Investors:These stakeholders bear risk by seeding capital to the company. Hence, they require access to information to assess whether to hold on to or sell their investments. Furthermore, they are also interested in knowing the investment appeal, dividend-paying capacity, and long-term survival & growth of the company. Accounting information from financial statements can help with decision-making.
  2. Management:The management of the company is also interested in accounting information for making several managerial decisions. Management based on accounting information can judge the impact of decisions on the functioning of the business.
  3. Employees:Employees are keen on reassuring their growth prospects which are correlated to the growth of the company. These users are interested in the ability of the company to provide benefits, bonuses, salaries, and opportunities.
  4. Lenders:These stakeholders require access to financial statements for judging the principal and interest repaying capacity of the company. Furthermore, they also require access to financials for imposing covenants or accepting securities against debt provided.
  5. Creditors & Suppliers:These parties require access to accounting information for determining the creditworthiness of the company which can help make decisions concerning the terms of credit to be offered for credit transactions. Often, they may be interested in the long-term continuity of the business if they heavily depend upon business with the company.
  6. Customers:Customers may source relevant information from the sales literature or trade journals concerning existing & projected supply, sales terms, prices, and other sales-related details. However, they may require access to accounting information for judging the reliability of the company concerning the continuing source of supply in cases when customers pay in advance.
  7. Government and Agencies:They tend to regulate companies and require access to information for ensuring public good, fair allocation of scarce resources among competing businesses, price controls, and tax legislation.
  8. General Public:The general public may be interested in the functioning of the business enterprise and expect the company to be transparent and accountable to their needs especially in terms of community contributions in exchange for resources that are provided to the business (Weygandt et al. 2019).

Overview of Task 2

This section of the paper will prepare and present the financial statements (income statement and balance sheet) for several clients that include a sole proprietorship, a partnership firm, and a non-profit seeking organization. These financial statements will be prepared with the help of the provided trial balance. This section also requires calculating the financial ratios for the two financial years provided for an international client with the intent of evaluating the overall financial health of the organization by comparing results across the two financial years. Lastly, this section also looks to prepare a cash budget for a local client who is facing certain financial difficulties due to not adapting budgetary controls. In doing so, the overall benefits and limitations of budgeting will be discussed alongside recommendations being made to improve the financial situation of the client. The calculations about financial ratios have also been presented in the appendices section of this paper.

Introduction to Financial Ratios:

The financial statements of an entity are the primary sources of financial information that can be relied upon by the users of the information for making decisions. However, the financial statements do not showcase all aspects of financial performance as these do not detect the strengths and weaknesses of performance. As a result, the need to rely upon analytical tools arises (Block, Hirt and Danielsen 2018). Financial ratios are a common financial statement analysis tool that makes use of selected financial information extracted from the financial statements and helps provide meaning to the reported figures. With the help of quantitative formulas, financial ratios are calculated using two or more variables which provides an insight into an entity’s position of profitability, liquidity, efficiency, and solvency (Martin, Keown and Titman 2020). These results can be compared against prior year performance or peer results to better understand strengths and weaknesses concerning financial performance (Collis and Hussey 2017). This is what is referred to as benchmarking.

Analysis of Profitability Ratios:

The profitability performance of the client can be evaluated with the help of the gross margin, operating margin, and the return on capital employed ratio. The gross margin ratio is a financial ratio that evaluates the margin of revenue that is left behind after covering the direct expenses incurred by the entity. It is the profit generated by sales after meeting the cost of sales. The gross profit margin ratio of the client has remained consistent over the two financial years through 2019-2020 at 55.8%. Hence, there is no decline in the gross margins of the company despite a significant loss in total revenue which is because the company managed to reduce its cost of sales. However, the operating margins of the client have been affected significantly. The operating margin is a profitability metric that gauges the margin of revenue that is left behind after covering the direct expenses as well as the indirect expenses. It is the profit generated in the ordinary course of operations after meeting the cost of sales and operating expenses incurred by the entity (Jiambalvo 2019). The metric has declined significantly from 16.8% in 2019 to 7.3%. The main reason for a compromise in the operating margins of the company is a decline in total net sales from €28,286 million in 2019 to €20,402 million in 2020. Furthermore, the amortization and depreciation expense has also increased from €2,826 million in 2019 to €3,045 million in 2020. Consequently, the return on capital employed ratio has also been affected from 22.6% in 2019 to 7.5% in 2020 which is because of the decline in net operating profits of the client. The ROCE is a metric that gauges the capital efficiency of an organization during the course of operations. Because of a decline in metric results, the client’s capital utilization can be considered inefficient.

Ethical and Regulatory Constraints

Analysis of Efficiency Ratios:

This set of financial ratios looks to evaluate the operating efficiency of the client. The asset turnover ratio is a financial ratio that evaluates the efficiency with which an entity makes use of its resources for generating sales (Shah 2020). The metric has declined from 1.3 times in 2019 to 1.0 times in 2020 which is because of a significant loss in net sales of the company. Hence the efficiency of resource utilization has been affected in the current financial year. Another common metric that helps to evaluate the efficiency of inventory management is the inventory turnover period ratio. This metric can be evaluated as the total time an entity is required to hold on to its inventory levels before the same is sold. The metric has been affected significantly as the results have increased from 66.3 days in 2019 to 93.9 days in 2020. This is indicative of slower sales as the company is taking more amount of time to sell its inventory. Furthermore, the closing inventory has also increased resulting in the metric declining as a result of slower sales. In such a circumstance, the client should reduce their inventory levels to avoid costs. Conclusively, the inventory management of the client requires attention.

The liquidity ratios of an entity aim to gauge the liquidity or the short-term financial solvency performance. The term liquidity refers to the availability of cash or other assets that can be converted into cash for meeting the short-term debt requirements of the entity. The two common metrics that can help evaluate the liquidity position of an entity are the current ratio and the acid test ratio. The current ratio is the reliance an entity can place upon its total current assets for meeting its total current liabilities. On the contrary, the acid test ratio only considers the reliance an entity can place upon ‘quick’ assets for meeting short-term debts. This metric is a prudent measure of liquidity as it does not consider inventories to be a quick asset when it comes to converting into cash for paying off debts. The current ratio of the client has improved from 1.56 times in 2019 to 1.72 times in 2020. It is worth mentioning that a current ratio that exceeds 1 indicates a sufficient amount of current assets for covering the current liabilities. The acid test ratio of the client has also improved from 1.25 times in 2019 to 1.36 times in 2020, therefore, indicating the client has sufficient quick assets for meeting debts. An improvement in the liquidity position of the client is because of a decline in total current liabilities from €7,306 million in 2019 to €6,338 in 2020. Almost all the sources of current liabilities have been reduced which consist of financial debts, other liabilities, lease liabilities, taxes payable, and trade payables (Robinson 2020).

The solvency group of ratios helps to evaluate the dependence of an organization upon debt sources of finance and its ability to pay off/service the debts. The gearing ratio is a common solvency metric that gauges the proportion of debt capital to the total capital structure of an organization. A high gearing tends to increase the exposure towards financial leverage which increases the risk of default (Mowen, Hansen and Heitger 2015). The client’s gearing in reality is quite low as the gearing ratio has declined from 29.1% in 2019 to 27.5% in 2020. The gearing has reduced in the current financial year because of a minor decline in total debt capital which is suggested by a reduction in the non-current liabilities of the client. Hence, the financial risk exposure is low for the client as dependence upon debts is lower than that of equity. The interest coverage ratio is another solvency measure that evaluates the ability of the entity to service the cost of debt (interest expense) from the available operating profits that the company generates. The rationale of this metric is to gauge if the company generates enough profits to meet its interest obligations (Pernamasari 2020). The interest coverage ratio of the client in 2020 is worth 10.8 times which indicates that it can cover the interest expense a total of 10.8 times. However, the metric has deteriorated when compared to the previous year at 31.3 times which is because of the decline in the net operating profit of the client.

Users of Accounting Information

Justified Conclusion:

On the basis of analysis of the calculated financial ratios, it can be concluded that the client has a favourable liquidity position and solvency position in 2020 when compared against the prior year 2019. This is validated with the current and acid test ratio to have increased and in excess of 1 along with a relatively low level of gearing. However, a decline in sales and an inefficiency in managing inventory are a cause of concern. The client must strive to increase its net sales in the forthcoming year. This can be done by increasing marketing and sales promotion efforts and identifying newer market trends and customer preferences. An increase in net sales can help increase the profitability position of the company. Furthermore, the client is also required to reduce their average inventory levels and forecast the inventory needs as per demand. This will help in reducing holding costs and will also decrease the risk of damages or obsolescence. Hence, the client can consider investing in inventory management software.

A budget is best explained as any financial instrument which can help assist the management with planning, programming, and controlling business activities. It is a quantitative statement that is prepared and approved for a defined period of time which helps the business in attaining some form of goals and objectives. It is more of a blue print of any projected action plan expressed in quantitative terms for a specific time period. Budgeting is more of a process that inculcates the preparation, implementation, and operation of the budget with the main emphasis being on providing resources to support plans that are being implemented (Drury 2018).

There are several advantages and benefits of preparing budgets that the client has to consider. These are elucidated as follows:

  1. Planning:Most planning decisions form a part of the long-term process of planning. The annual process of budgeting helps to refine these plans even further. Without budgeting, the pressure of routine operations may be tempting for the management to discourage long-term plans. The annual budgeting allows management to consider long-term plans with further consideration of how things may change in the near future thus anticipating problems at an earlier stage.
  2. Coordination: With budgets, the actions of the different parts of an entity can be reconciled into one common plan of action. If there does not exist any proper guidance, departmental managers will tend to make their own set of decisions which may not necessarily be in the best interests of the overall organization. Budgeting, therefore, serves the purpose of examining inter-departmental relationships and resolving conflicts towards attaining a common set of goals and objectives.
  3. Communication: The organization must have a definite communication line as a result of which all the parts of an entity are well informed about the policies and plans to which they are expected to conform. This means that everyone should be aware of their individual role in attaining the set budget. The process of budgeting allows for communication between the top management and lower management so expectations are clear.
  4. Motivation: The annual budget can be used as an influencing tool for motivating the managers to perform in a way that the overall goals and objectives of the organization are attained. Furthermore, a budget can also act as a standard or a benchmark for which managers can strive and feel motivated to attain. If individuals are made to participate in the budget-setting process it can also result in an increase in their motivation.
  5. Performance Evaluation:The budget can also be used for evaluating the performance of managers in terms of attaining the budget. Some entities tend to reward management for their ability of attaining the budget. Management may also review their performance through the means of the budget.
  6. Control:The budget can help the managers in controlling and managing activities for which they are accountable. The actual results attained can be compared against the set budgets for different line items of expenses and income to determine deviations and variances. Further investigations into the causes of discrepancies can allow the entity to get rid of such inefficiencies (Griffin and Mahajan 2019).

There are several limitations and criticisms of the annual budgeting process as well which have been outlined as follows:

  1. The annual budgeting process is considered to encourage rigid planning and incremental thinking for these are derived from prior period budgets with certain current year adjustments being made.
  2. The process of budgeting is a time taking process. Almost 30% of the managerial time is spent on budgeting throughout the budget period.
  3. Because the budget is developed by focusing on short-term financial members, it misses the main driver of shareholder value.
  4. A budget is made for a 12-month engagement, which is problematic because it is dependent on a prediction that is unclear.

The process of preparing budgets for various operations is known as budgetary control. It analyses budgeted data to identify budgetary control deviations that must be rectified or resolved in the upcoming year. As a result, the budget is treated as means to a goal, and budgetary control is the final result. The financial control method aids in strategy and coordination with organizations and different departments. It also has a control mechanism.

The following are examples of budgetary control:

  • Budgeting is the process of putting together a budget.
  • Budgets are being revised in light of changing conditions.
  • The actual budget required continuous comparison which is helpful for the achievement of targets.
  • All income and expenditures are checked on a daily, weekly, fortnightly, monthly, and quarterly basis as part of the budgetary control process. It keeps a constant eye on the procedures to see how they are carried out.
  • Budget management is a method of preparing a budget that is aligned with the purpose, business strategy, and individual goals.
  • It serves as a foundation for comparing actual performance to the specified objective and looking into deviations.
  • It aids in the coordination of numerous commercial and management tasks.
  • It serves as a foundation for revising current and future policy.

In order to understand any requirement for corrective actions the organisation must make use of financial management reports to understand the available financial information. The organisation has to source information from different sources to establish their actual position. After understanding the actual performance of the organisation, these need to be compared against the budgeted figures which are mostly set during the beginning of the financial year. This is what is referred to as variance analysis that forms the most important technique of exercising budgetary control. The difference between the actual and budgeted performance for different sources/line items of income and expenses is what is referred to as variances. After identifying the variances, the management will inspect the reason for such discrepancies which is critical to an effective budgetary control. These variances may be positive or negative which may showcase a situation of overspending or underspending, underperformance or overperformance. All variances require a proper investigation. After making such investigations, budgets can then be controlled by taking corrective actions as an appropriate response to variances which will ultimately result in deploying resources to different activities with a rationale of effectiveness and efficiency. A proper implementation of the action plan will then result in variances to diminish and match up to the budgets over time which is necessary in regaining control.

References

Atrill, P. and McLaney, E., 2018. Accounting and Finance for Non-Specialists 11th Edition. Pearson Education, Limited.

Block, S.B., Hirt, G.A. and Danielsen, B.R., 2018. Foundations of financial management. McGraw-Hill Education.

Brewer, P.C., Garrison, R.H. and Noreen, E.W., 2015. Introduction to managerial accounting. McGraw-Hill Education.

Collis, J. and Hussey, R., 2017. Cost and management accounting. Macmillan International Higher Education.

Drury, C., 2018. Cost and management accounting. Cengage Learning.

Eldenburg, L.G., Brooks, A., Oliver, J., Vesty, G., Dormer, R., Murthy, V. and Pawsey, N., 2020. Management accounting. John Wiley & Sons.

Griffin, P.A. and Mahajan, S., 2019. Financial Statement Analysis. Finding Alphas: A Quantitative Approach to Building Trading Strategies, pp.141-148.

Jiambalvo, J., 2019. Managerial accounting. John Wiley & Sons.

Martin, J.D., Keown, A.J. and Titman, S., 2020. Financial management: principles and applications. Prentice Hall.

Mowen, M.M., Hansen, D.R. and Heitger, D.L., 2015. Cornerstones of managerial accounting. Cengage Learning.

Pernamasari, R., 2020. Analysis of Performance Company: Based on Value Added and Financial Statement. Jurnal ASET (Akuntansi Riset) Vol, 12(2).

Robinson, T.R., 2020. International financial statement analysis. John Wiley & Sons.

Shah, N.K., 2020. Financial Statement Analysis Through Ratio Analysis of Selected Pharmaceutical Companies. GAP Interdisciplinarities, 3(6), pp.321-331.

Shim, J.K., Siegel, J.G., Dauber, N.A. and Qureshi, A.A., 2015. Accounting handbook. Barrons Educational Series, Incorporated.

Warren, C.S., Jonick, C. and Schneider, J., 2020. Financial accounting. Cengage Learning.

Weetman, P., 2019. Financial and management accounting. Pearson UK.

Weygandt, J.J., Kieso, D.E., Kimmel, P.D., Trenholm, B., Warren, V. and Novak, L., 2019. Accounting Principles, Volume 2. John Wiley & Sons.

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