The Differences between Financial and Management Accounting - Assignment Example

The Major Differences Between Financial Accounting and Management Accounting Financial and management accounting are very important tools in accounting and are used to serve different purposes. Businesses uses accounting in the determination of the future operation plans, review past performance and also check the current internal business functions. Financial accounting is mainly used in presenting the financial health of the company to the stakeholders. The stockholders, board of directors, financial accounting, and investors are the audience to know the performance of the company. The accounting reports must be filled on an annual basis. Management and a managerial accounting are used by the management to make decisions with regards to the daily operation of the business. It is based on the past performance of the business. It relies majorly on the forecasting of the market trends and markets. Differences Management accounting is internally presented while the financial accounting is meant for the external stakeholders. Financial management is important to the current potential investors while the management accounting is used by managers in making current and future financial decisions. Finally financial accounting is succinct and adheres to the Generally Accepted Accounting Principles (GAAP) while management accounting is usually a guess or estimate given that a myriad of managers rarely have time for exact numbers when they need to take decisions. Three key financial statements and the fundamental differences between the types of information presented in each of the three key financial statements Some of the key financial statements include; Income statement (profit and loss account) Balance sheet Cash flow Income statement The statement tells the users about the earnings and the profitability of the business. The statement is for a specific period of time. The periodic statements are important given that the owners can know the periodic performance of the company. It shows the sales first then cost of sales, the differences of which gives the gross profit. Then it explains the operating expenses which are subtracted from the gross margin to show Earnings Before interests and Taxes (EBIT). It then subtracts expenses and taxes to get the net profit. Balance sheet The balance sheet shows the financial position of the business. It tells the investors whether the company is able to pay its bills on time and the flexibility in the acquisition of capital and the distribution of cash distribution in terms of dividends. The key items are the assets, liabilities and equity. Assets = Liabilities + Owners Equity, It starts with the assets (current assets and non-current assets), liabilities (current and non-current liabilities) and the owner’s equity. Cash flow Cash flow statement explains the source and uses of cash during the financial period. It gives information about the firm various investing and financing activities during the period. The format of the cash flow is as below Net cash flow from operating activities Cash flow from investing activities Cash flow financing activities Exchange rate impact Net increase in cash Cash and equivalents at start of period Cash and equivalent at end of period Scheduled of non-cash financing and investing activities The different types of business entity and the main advantages and disadvantages of setting up a limited company as opposed to a sole trader Business entity Sole proprietorship Partnership Limited liability Company Corporations Limited liability Company This is a business entity where by its members cannot be held liable of the business assets and liabilities. Advantages The business owners enjoy limited liability for the debts of the business, judgements and other liabilities Business profits and losses can be easily allocated to the owners along different lines than the ownership interests Owners are able to choose how the Company can be taxed Higher take home pay for the owners due to bigger operations Anything that is classed as business coast can be easily claimed back to the business. The personal assets are covered in the company and therefore in incidences of losses the company owners can easily take there private assets. The company gives more credibility given its legal entity; people and other investors often prefer dealing with companies as opposed to individual businesses. There is the control of the company name even without contracting Disadvantages More expensive to establish compared to proprietorship and partnership. A lot of bureaucratic procedures in taking decisions given the company board should always sit and taken some key decisions. A lot of legal paper work required given that the government regulations with regards to Limited Liability Company is higher compared to other entities. What are accruals and prepayments and in what ways do businesses adjust their accounts for accruals and prepayments? Accruals- This refers to an item that is owed at the end of the financial period. An example is the expenses incurred in the period but is likely to be invoiced after the end of the period. When one has an accrued expense, there should be an increase of the expense in the income account so as to show the entire cost which is incurred and not yet paid Dr. ----------------Expense Cr---------------Accrual Prepayments- These are payments which are made in advance of the specific period in which it pertains. When an expense is prepaid then one needs to reduce the actual cash paid to what has been incurred. This is done by reducing the expense in the income statement and recognition of the services and the costs paid in advance in form of assets. Dr. --------------Prepayment Cr. ---------------Accrual An example of adjusting accountings Accrued expense On June 30th 2014, the water bill account had an accrual of USD150 and the credit balance brought down at 1 July 2014. During the year, the water bill invoices totalling 1500 were paid which includes an invoice of USD120 for the quarter that ended in 30th April 2015. On June 30th 2014, the adjustment in the accrued water bill will be Dr – Water expense ---------------USD 150 Cr; Accruals ------------------USD 150 USD Cash paid during the year to the quarter that ended April 2015 --------1500 Less brought forward accrual from 2014 --------150 Prepayments On 1 May 2014 the business pays rent of USD 1800 for the period up to 30th April 2015. The charges to the income statement are; The cash paid is 1800 for 12 months. 1800/12 = 150 per month. USD 150 X 7 = USD 1050 which is charged to the income statement. Critical evaluation of the following statement: “surely the purchase of non-current assets is expenditure just like spending on stationery or photocopy expenses, so why should it appear as an entry in the balance sheet?” (ps71-73) To have an imperative understanding of the above, it is in order to delineate the concept assets and non-current assets. Assets are items that are owned and purely controlled by an individual or organization. Assets are mainly current or non-current assets. Non-current assets are the assets whose full values cannot be realized within the 12 months of the balance sheet. Current assets appear are defined as future economic benefits. When used in the income statement, they will appear as if they are current benefits as opposed to future. They will give a wrong impression of the financial position of the firm. At the same time, it will fail to take into consideration, depreciation which is an important aspect when calculating the value of the non-current assets. An expense is regarded as the consumption of the economic benefit. Expense consumes the benefits with the view of bringing another benefit within the financial year of the company. The non-current assets benefits are for the future and therefore cannot be treated in the same manner as expenses. What is trade receivable and what factors influence the accurate valuation of a company’s trade receivables? Trade receivables are delineated as the amounts that the business bill to its customers when the goods are delivered to them in the ordinary business time. The billings are usually documented on the invoices which are succinctly summarized on the documented formal invoices summarized in the accounts receivables section of the aging report. The firm usually record trade receivables that is due from its customers when the sale is recorded. The business usually adopts a consistent practice of establishing accounts allowances that if perceives to become uncollectable by reviewing the aging records of its receivables and also analyzing some of the losses that are incurred because of this. If the company realizes that some of its customers are not able to meet their financial obligations, they will be forced to establish the allowance for the bad debt in order to reduce the recognized receivables to the amounts that were collected. Some of the factors that influences the valuations of the company’s trade receivables includes Ability of the customers to meet their financial obligations The value of goods sent to customers The financial performance of the business The business environment The financial status of the entire economy The performance of other companies in the industry Possibilities of establishing bad debt accounts What is depreciation and what are the problems encountered in dealing with the depreciation of non-current assets? Depreciation is delineated as the method of allocating the cost of tangible assets over its useful life. Business usually depreciates its long term assets for both the accounting and tax purposes. Depreciation represents the value of an asset that has been used up. It is simply the part of the asset that has been consumed. It refers to the accounting procedure that helps in the creation of depreciation expense. There are a number of problems encountered when dealing with the depreciation of non-current assets. One of the main challenges is the identification of the method to be used which has different weaknesses. Some of the methods like straight line method are associated with weaknesses. Another challenge is the possibility of knowing and measuring the real present value of the asset. In most cases, the projections are made; making it is hard to know the real value of the asset or the proportion that has depreciated. How a business can make a loss during an accounting period if it has not been involved in any trading during the period? The intention of the business is to make profits, however due to either predictable or non-predicted issues; the businesses can sometimes make losses. In most cases, profits can only be generated in the businesses when it is involved in the operations. Without any business activity, it is not easy for the company to make any profit. The case is however different with the losses that the company might incur. One of the ways by which a company may make losses without operations is when there are expenses which must be paid for. For the business entity to run, there area levies which is paid to the government on an annual basis besides other expenses such as the rents, water bills, and electricity among others. The payment for the premises is inevitable. There is also the depreciation of the company assets. As the expenses go high without any operations going on, it is likely that its net loss will be high. The main sources of long-term external finance available to a company Long term sources of finance to a company are the finances which are required over longer periods of time, over a year. The reasons for the long term finance are different from the short term loan requirements. Some of the sources include; Shares- These are part of ownership to the company. If the company wants to undertake a particular project or expand, it can issue shares to the public. Through the purchase of the shares, they are able to raise funds which can be used in financing specific projects. Venture capital – Venture capitalists are individuals, groups or companies that are set to invest in companies. The investors will inject their funds on companies they believe have prospects. They will offer capital to help in the growth of the company. It is therefore one of the ways a company can raise the finances they have. Bank loans- Banks are sources of long term finance to the company. Banks may lend large sums of money to the company to enable that fund some projects. The repayment period can be spread over a period of time. Mortgage- This is a specific loan for the purchase of a property. Company have an option of getting finance to purchase a property through a mortgage. Retained profit- This is available to businesses that have been in operations. From the business can be used by the owner to facilitate the expansion of the business. Selling assets- The Company can sell part of its assets to help in the funding of some of its long term business needs. Owner’s capital- Owners can inject part of their finances to the company operations Why the ratio analysis is a useful tool to evaluate a company’s financial performance? Ratio analysis is pat of management’s tool that is used to analyze the performance of various businesses. It is often used by the investors to measure the financial performance of the company. Ratio analysis is very critical when it comes to the understanding the financial statements for the identification of trends over time. They are very critical quantitative analysis tools. One of the most important parts lies in their capacity to be lagging indicators in the identification of both positive and negative financial trends. The information obtained makes it possible to make and also the implementation of the financial plans and also to make course actions to the financial plans. Ratio analysis gives away o f comparing the financial state of the business against competitors in the industry. The company is also able to analyze the efficiency of the business. Investors can measure the efficiency of the business in terms of its management and operations. Ratios help in the allocation of some of the weaknesses of the businesses. Management are able to take actions and measures to deal with some of the weaknesses. It also helps in the formulation of the plans. Th5rough the analysis of the past financial performance, the company can focus their present operations to know the next steps in terms of planning. What are the main limitations encountered in using the ratio analysis to review a business’s performance? Despite the importance of financial ratios with regards to measuring the performance of the company, it is in order to note some of the limitations of various ratios which are adopted. Some of the limitations include Historical: All the ratios used in the analysis are from the historical results. It does not mean that the results will not be carried in the future. Historical verses current cost- The information that is carried in the income statement is mainly stated in current costs while those in the balance sheet are the historical costs. Operations- A number of large firms operates different divisions within different industries. For such companies, it is not easy to find, a meaningful set of various industry average ratios. Inflation – A change in the inflation will mean that the results will that the figures will also change, meaning that numbers are not comparable across all periods. Aggregation: The information that is available in the financial statement used in the financial analysis have been aggregated differently in the past, and therefore running the analysis on a line is not comparable to the information across the period. Accounting policies- Different companies have different policies for the recording of the various accounting transactions. Therefore comparing companies might give different results. Business conditions- The business conditions are different on an annual basis. Interpretation- It is not easy to ascertain the results that are obtained from the ratios. Company strategy- Conducting analysis of companies that are pursuing different strategies might be dangerous. The major profitability ratios and explain how those profitability ratios can tell us about the accounting and financial performance of a business Profitability Ratios Profit ratios explain how good a company is when converting operations into profits. One of the key drivers of the company is to make profit. Some of the profit ratios are below Net Profit Margin (Return on Sales) It measures the net income dollars that is generated by a dollar of sales. Through this, the company can know whether it’s profitable or not. Net Income * Net Sales Return on Assets ROA shows how good the company is using its assets to make money. Return on Assets = Net Income / Average Total Assets It analyzes the efficiency of the business with regards to its assets Return on Investment This ratio measures the income that is earned on the invested capital Net Income * Long-term Liabilities + Equity The company can analyze whether to continue with the injections or not Return on Equity This ratio measures the income that is earned on the investment of the shareholders. Net Income * Equity Through the ratio, the company can know whether the investments are connected to returns. Gross Profit Margin It explains the relationship between the revenue on sales and the cost of goods sold. Gross Profit Net Sales It shows whether the company is controlling its costs. Return on equity Return on equity measures the money that the investors have injected into the company Net Income/Stockholder's Equity The higher the percentage, the better What are financial ratios and why are they so important in commenting on the financial structure of an organisation? A financial ratio is defined as the relative magnitude of two different values that are obtained from the financial statements of an enterprise. There are number financial ratios that are used to analyze the performance of the business. The evaluation of the performance of the business is vital and it is only through the ratios that the management and investors can make reasonable decisions on whether to invest in the company or not. The financial structure of a company is the blend that agents the values and risks of the business. The main concern of a business analysts or the manager is what to be borrowed and the best mixture of the debt and equity. It is through the financial ratios that the firm can know the ability of the company to pay its debts. Its also through this that its possible to measures the returns on equity and various investments. Therefore by understanding the ratios, it will be easier for the analysts to decide on the amounts to be borrowed. What is the agency problem and how may the agency problem occur between the shareholders, directors and lenders of a business? An agency problem is usually delineated as the conflict of interest that of occurs between the company’s stockholders and the management. It is an inherent conflict of interest in any relationship when one of the involved parties is expected to act in the best interest of another party. The problem that usually occurs is that the agent who is supposed to take the decisions that is intended to serve the principal is solely and naturally driven and motivated by his/her self interest and the interest of the agent may not be the same with the interest of the principal’s best interests. It is also referred to as the principal agent problem. Shareholders versus the managers If a manager has less than 100% of the stock in a firm then there is an agency problem between the shareholders and the managers. Managers may take some decisions that conflict with the interests of the shareholders. Shareholders versus creditors Creditors usually decide the loan money to the corporation taking into consideration the risk level of the business, potential capital structure and its current structure. These factors will affect the cash flow in the company. Given that shareholders will only consider the interests when making decisions, there will be an agency problem between creditors and shareholders. The implications of the ‘expectation gap’ with regard to external auditors The expectation gap is delineated as the existing differences on what the public and the users of the financial statements believe are the responsibilities of the auditors and the auditors believe they are responsible of. There are existing implications of the expectation gap with regards to the external auditors and that is; There is the expectation of detecting fraud, which the users believe is the responsibility of the auditor. Therefore they expect the auditor to act as the investigator and the auditor is expected to unearth some sophisticated events. The implication is that the auditor will be going into the work of the management who should be detecting fraud. There is also the loan quality which is adversely affected by the audit expectations gap. When the external auditors unearth some vital information, lenders will be reluctant to offer loans to the company. There is also the implication with regards to designing and understanding the responsibilities of the internal auditors. The internal standard should be able to analyze the internal existing weaknesses. What are the differences between wrongful trading and fraudulent trading? Fraudulent trading – This is the trading that occurs when the company conducts its business operations with the main aim of deceiving and defrauding its creditors. It is a criminal offenses and punishable with heavy fines by the law depending on the level and the severity of the fraud. During the process of liquidating the company assets and winding up the wrongful findings may b e re ported by the liquidator to the court. The court will then weigh the presented evidences before taking the decisions to charge the managers. Wrongful trading- This is when a company continuous with operations in the full knowledge of management despite the fact that the company is going out of business. It is a civil offense and therefore nay of the directors who are found guilty are held liable for the debts in the company and are subsequently banned from acting as directors. It is usually a case of management whereby the directors hope that things will be better despite the continuous downward spirals. It is a failure of directors to carry out their responsibilities and make reasonable judgements. The obligations of directors of limited companies in terms of a duty of care and fiduciary duty Directors are expected to charge tow main fiduciary duties; The duty of care and the duty of loyalty The duty of care requires all the directors to ensure that all the business decisions are mainly based on the present information and also to act in an informed and deliberate manner. The board members are expected to act in good faith for the best interest of the company. They are also expected that their actions should promote company’s best interest based on the available reasonable investigations and various options. A court will adopt the business judgement rule to know whether the board of directors charged their responsibilities as required by the law. The duty of loyalty requires that the board members protect the interests of the company and that they should refrain from any possible conduct that might injure the operations of the company. They are expected to avoid any conflict between their self interests and the duty as board members. It is required that there should be allegiance that is undivided to the interests of the company. What is overtrading and explain the steps which can be taken by a company to avoid the condition of overtrading? Overtrading is delineated as the excess buying and the selling of various stocks by the investors so as to increase the commission obtained by the brokers who trades on their behalf. It is simply the engagement of many businesses that can be supported easily by the available funds and the market. It is also a situation whereby a company is grower its sales in a faster way than they can finance. Some of the steps include 1. Before trading or involving in trade, ensure that your mind is very clear 2. Ensure that there is a trading plan and stick to it 3. Perceive each and every trade as a single transaction 4. Ensure that there is a creation of a routine that better works for the company 5. Try to come from the abundance given that there are many opportunities 6. Be patient and look for the right opportunities 7. Ensure the daily journals are kept 8. Remember that it is a process and therefore takes time and experience 9. Conduct a clear market analysis 10. Develop a clear follow up system What is working capital and explain the main components of working capital? Working capital refers to a measure of the efficiency of the company and the financial health of the firm in the short term. It is calculated as It shows whether the firm has sufficient short term assets to cover the short term debts of the company. Some of the main components of the working capital include; Cash; This is one of the most liquid components of the working capital. Excess cash should not be kept given that it is not an earning asset. Marketable securities- The market securities don’t give a required yield to the business because they are used as temporary assets and because they act as substitutes for cash. Accounts receivables- A lot of debtors usually lock the resources of the company during inflationary incidences. The debtor’s quantum depends on the average length of time between collection and sales and the volume of the credit sales. Inventory- This represents the substantial amount of assets that the firm has. It should be managed well so that the investment doesn’t become too large as it will lead to a blocked capital. Too little capital is also not healthy a sit might lead to loss of sales. Explain a company’s need for investment in operations in terms of the operating cycle Operating cycle is the average amount of time between the business acquisition of the services or materials and the final realization of cash from the total acquisitions. It is simply the time of the acquisition of an asset and the sale of the asset. A myriad of companies often require Short operating cycle given that it helps in the creation of a cash flow to cover the liabilities of the company. A operating cycle that is long forces the firm to increase its borrowing and therefore reduces the possibility of profitability. Most companies usually inject a lot of their investments in the operating cycle because it influences the level of profitability in the firm. The efficiency in terms of management is also measured by the operating cycle. Therefore the management will ensure that the best resources are directed towards the operating cycle. When there is enhanced efficiency, it means that the operating cycle will be reduced, that will in turn translate to high amounts of profits that is garnered by the company. Inefficient or long operating cycle translated to low profitability. Read More