The accounting department plays a significant role in the success of a business enterprise. It is mandated to keep records of all financial activities and ensure all bills are paid on time. Other accounting roles include scheduling payments such as payroll, inventory, and all additional expenses incurred by an organization. Entrepreneurs must empower the accounting section to ensure professionalism, efficiency, and integrity are upheld for success.
The Need for Business Accounts
Users of Accounting Information
Accounting information is critical for daily decision-making and is used by internal and external business users. Internal users are the business managers, owners, and employees, which rely on the information for strategic decisions. The internal users use the provided information to determine whether the business is achieving its goals. After the assessment, the information is further used to shape essential decisions on borrowing or investment of company resources. A critical decision cannot be made without financial information (Franklin et al., 2019). It must be accurate for effective decision-making. The management uses the information to determine whether the company is expanded or downsized.
External users of the accounting information include banks, suppliers, investors, tax authorities, and potential investors. The suppliers use the information to determine whether or not the company pays its debts on time. When a company does not pay on time and has overdue payments, it will likely be denied access to goods on credit. The government authorities in charge of tax and regulations need the information to determine the rate and whether the company charges fair prices for its services (Weygandt et al., 2018). The external users of the information decide whether to support the business or not. The financial information must be accurate and appealing for a business to thrive.
Differences Between Financial and Management Accounting
Financial accounting works on transaction records and summarizes the data into reports presented to users for decision-making. On the other hand, management accounting is a contemporary field that focuses on a business’s managerial issues. Financial accounting is oriented toward history, while managerial accounting develops ratios that extrapolate the business’s future and help form accurate and informed decisions. The financial accounting reports are prepared based on the rules and are produced annually per the law’s requirement (Weygandt et al., 2018). On the other hand, managerial accounting information does not follow specified laws and can be produced whenever needed. Further, the financial statements are made for all users, while the managerial accounting reports are mainly for internal users who use them for planning and decision-making. Therefore, management must leverage both to ease the planning process and build a brand reputation.
The Foundation of Accounts
Concepts in accounting are the terms, ideas, conditions, and assumptions used in bookkeeping and financial transaction recording. The critical concepts used in accounting include a business entity, accounting period, duality aspect concept, and the matching concept. The analysis of the concepts helps the users of the accounting information use it from an informed point of view and makes it possible for accounting information prepared by one person to be understood by the other person (Franklin et al., 2019). The duality aspect, for example, is a common concern that states that any transaction in an organization affects the financial records in two ways: similar in magnitude but different in nature. The concepts are essential to ensure that the information produced is accurate.
Accounting conventions are new guidelines that ventures use to record transactions that accounting standards have not fully addressed. The four fundamental accounting conventions that assist accountants include conservatism, consistency, full disclosure, and materiality. Conservatism reduces errors by picking the lower value when two transaction values are available. Consistency is a convention that encourages accountants to use similar methods in different reporting periods. Full disclosure is a convention requiring companies to reveal all critical information regardless of the impact it may have on the business (Franklin et al., 2019). Materiality is a convention that operates similarly to full disclosure and encourages all companies to share all critical material owned without hiding any information.
Contents of the Published Accounts
Purpose and Structure of Profit And Loss Accounts and Balance Sheets
Profit and Loss Accounts
The essential purpose of the profit and loss accounts is to determine an organization’s gross and net profits. A profit and loss account structure begins with a known revenue, generally at the top line. The revenue then subtracts the cost of doing business, such as the cost of goods sold, interest, and tax expenses, and the net profit is the final result at the bottom.
A balance sheet is a document that gives investors a snapshot of how a business is fairing at any given time. The user can view the assets and liabilities of the business after viewing the balance sheet. The primary purpose of the balance sheet is to give investors, executives, and regulators the ability to determine an organization’s financial health. The structure of the balance sheet is created based on three key elements, assets, shareholders’ equity, and liabilities. The business is considered fairing when the liabilities are higher than the assets and the equity. Its credibility is achieved when both sides of the document are equal.
Layout and Main Headings of Simple Profit And Loss Accounts
The profit and loss account is divided into three main sections, COGS, revenue, and income. Cost of goods sold (COGS) is the second section which involves all the resources used to produce the goods sold. Operational expenses are costs used to cover critical operations such as labor, electricity, and consultation charges (Weygandt et al., 2018). All records in the profit and loss accounts are placed under the three main headings.
Depreciation Provisions on Accounts
A depreciation provision is a computed value to determine the gradual deterioration of value the fixed assets undergo over time. For example, a delivery car is a fixed asset whose value depreciates over time. The essential purpose of the depreciation provisions on accounts is to allow the organization to understand the current and future value of the assets for better decision-making of the organization (Ainsworth & Deines, 2019). The formula used to calculate the depreciation value using the straight-line method is:
The useful life is given by the number of years that the asset has been in use. After the depreciation, the balance sheets and the profit and loss accounts are amended by replacing the original value with the new values computed after the depreciation. Alternatively, the depreciation can be calculated using the diminishing balance method formula, which is given below:
The critical difference between the diminishing balance method and the straight-line method is that the straight-line method uses the exact value of the asset for the entire Year. In contrast, the diminishing method uses different values. It is prudent to note that the straight-line method is the easiest to use and gives accurate outcomes, while the diminishing method is critical when one wants to match the revenue and expenses.
Simple Balance Sheets and Profit and Loss Accounts From Given Data
ABC Ventures has a company delivery car worth $40,000, $55,000 cash in the bank, and office equipment worth $10,000 in the assets section. The liabilities include the advertisement, rent, salaries, and taxes as $500, $10,000, $11,000, and $300, respectively, and starting capital of $83,000. The balance sheet is shown in table 1 below.
Table 1. ABC Venture Balance Sheet for the Year Ending 31st October 2022
|Assets ||$40,000 |
|Liabilities ||$500 |
|Owner’s Equity |
|Total Liabilities and owners’ equity||$105,000|
Profit and Loss Account
The profit and loss account has three key sections that must be covered to determine the profit or loss. For example, ABC ventures have operated for thirteen months and have data: The revenue from supplying products was $47,000, while the non-operating revenue from renting the car was $21,000. The cost of goods sold, advertisement, rent, and labor expenses were $15,000, $500, $10,000, and $11,000 respectively. The profit and loss account for the data shown in table 2.
Table 2. ABC Venture Profit and Loss Account for the Year Ending 31st October 2022
|Revenue ||$47,000 |
|Expenses ||$15,000 |
|Net income (Revenue-expenses)||$31.500|
Cash Flow Statements
The cash flow statement shows how cash is received and spent in the organization. The accounts break down all the corporate transactions into financing, investing, and operating to understand all the monies received and spent by the business. The primary purpose of the cash flow statement is to enable the users of the financial statement to understand what happened during a specified period.
Goodwill in Accounts and Stock Valuation
Goodwill is a term used in accounting to represent an intangible value used to buy a business at a fair market rate. The value placed on a business is based on the competitive advantage, and a business with an advantage over its competitors is likely to have a higher goodwill value (Ainsworth & Deines, 2019). Stock valuation is a process of determining the cost of all the stock and can be constantly adjusted when the market changes.
Current Issues in Analysis of Published Accounts
Financial analysis is an essential function of managerial accounting, where the given data is analyzed to make crucial decisions. The analysis is helpful because it helps in determining the trends and helps the business forecast (Stevanovic et al., 2019). The primary analysis tools include profit and liquidity ratios, efficiency, and investor ratios. The analysis is crucial because it can help investors make accurate decisions for the sustainability of their business.
Profitability, Efficiency, and Liquidity Ratios
Gross profit margin (GPM) and net profit margin (NPM) are ratios used to determine a business’s profitability and efficiency. The formulas are given as shown below:
A lower ratio may be caused by an increase in COGS, overvaluation of the starting stock, and undervaluation of the ending stock. ABC ventures, for example, have a gross profit and a net profit of $53,000 and $31,500, respectively. Assuming that the products are sold at $ $0.25, the sales turnover is computed as 60,000. The GPN and NPM are calculated as follows:
The investor must therefore reduce the expenses to increase the net profits.
Liquidity ratios help the organization understand the cash at hand to help it determine short-term projects using the money available. The liquidity ratios help an organization to determine its efficiency and therefore make its forecast. The current ratio is the primary liquidity ratio used to determine how fast the company can convert inventories to cash. For the case of the ABC ventures, the current ratio is computed as shown below:
The high value proves that the organization can convert its inventory into cash and solve business challenges. The stock turnover ratio is an efficiency ratio that determines how well a business converts stock into profits. The efficiency ratio at ABC Ventures is calculated as follows:
The higher ratio means that many people are buying the goods from the venture, which means that the marketing plan was effective, and many people purchased the product. The ratio indicates to the management that the business is profitable and that they can expand it further (Stevanovic et al., 2019). A gearing ratio is an important ratio that a company uses to determine its financial leverage and how much it can borrow. The gearing ratio is calculated as follows:
An investor ratio is used to determine how profitable a business has become. An example of an investor ratio is the Return on equity which is calculated as shown below:
The investor ratio shows that for every dollar they commit to the business, they are likely to obtain 39%, which may encourage the investor to put more resources into the business. Trend Analysis Inter-Firm Comparisons and Investment Appraisal.
When firms are operating in the same industry, potential investors compare them to determine which is more probable for a better choice to be made. Trend analysis is an intra-firm comparison ratio where a business compares its performance over different reporting periods, while cross-sectional analysis compares firms to determine where to put in more resources. Investment appraisal is conducted to determine efficiency by determining the key performance indices for an organization and uses the ratios to predict how the business will perform. For example, ABC ventures, for example, have an ROE of 39%, meaning that putting in more resources yields more profits.
Forecasting Future Cash Flows and Improvement
Cash flow determines the amount of money getting into the business and the money leaving the business. A cash flow is essential because it helps a business understand its current financial obligation and gives them the ability to forecast and plan for the future. Cash flow is not similar to profit a documentation of the money received and paid by the organization to facilitate its operation. Forecasting future cash flows is paramount to helping organizations make informed decisions. Forecasting cash flow is helpful as it enables manager’s plan for the future of their business effectively (Ningsih & Sari, 2019). However, lack of automation is the main difficulty in forecasting because most organizations use spreadsheets. Other difficulties include unexpected expenditures, such as additional resources to fight the covid-19 pandemic. In the case of multinational corporations, they may be affected by external factors. The cash flows may be improved by negotiating short payment terms and cutting down all additional expenses. Net present value is calculated as the difference between cash inflows and cash outflows at the moment and is used to determine profitability.
Budgeting, Variance, and Payback period
Budgeting is a vital estimation process where an organization plans for the future using the estimates and reduce additional costs. Budgets ensure that the business focuses only on the critical expenditure. Budgeting is essential because it ensures that the business does not plunge into losses (Ningsih & Sari, 2019). Budget variances are the differences between budgeted and actual values and are used to help managers make informed decisions. Favorable variations mean that the business is operating effectively. A payback period is the estimated time required for the business to profit. It is calculated by dividing the investment by the cash flow. Discounted future cash flow is a unique concept used to determine the profit margins the business will likely make, given the fixed projections.
Qualitative Factors Influencing Investment Decisions and Internal Value of Return
Investment success is determined by numerous qualitative factors such as management integrity, corporate governance, competitive advantage, and the robustness of the business model. Before investing resources into the business, the management must prepare a checklist to ensure that all the factors favor the investment before proceeding. A net present value graph determines how the organization’s profits may be improved. The graphs are essential because they are sensitive to different discount rates, and therefore it is vital to help businesses make better decisions on discounts after noting the market dynamics.
Ainsworth, P., & Deines, D. (2019). Introduction to accounting: An integrated approach. John Wiley & Sons.
Franklin, M., Graybeal, P., & Cooper, D. (2019). Principles of Accounting Volume 2 Managerial Accounting. OpenStax, Rice University.
Ningsih, S., & Sari, S. P. (2019). Analysis Of The Effect Of Liquidity Ratios, Solvability Ratios, And Profitability Ratios On Firm Value In Go Public Companies In The Automotive And Component Sectors. International Journal of Economics, Business, and Accounting Research (IJEBAR), 3(04).
Stevanovic, S., Minovic, J., & Ljumovic, I. (2019). Liquidity profitability trade-off: Evidence from medium enterprises. Management: Journal of Sustainable Business and Management Solutions in Emerging Economies, 24(3), 71-81.
Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2018). Financial and managerial accounting. John Wiley & Sons.