Advanced Financial Accounting - Economica Plc - Essay Example

Financial Accounting Section A Introduction: The financial ments of Economica Plc have been prepared using historical costs convention for the years 2006 and 2007, as well as using current cost accounting for 2007 financial statements. The financial performance and position have been analyzed under the categories of profitability, liquidity and gearing or leverage of capital structure of the company. The review and analysis of financial performance and position of Economica Plc have been made in this report using ratio analysis technique in two parts. Part A contains the review and analysis of financial statements of 2007, prepared under historical costs convention, in comparison with financial statements of 2006 also prepared under historical cost convention. On the other hand Part B covers the analysis of financial statements of 2007, prepared under current costs convention, in comparison with financial statements for the year 2007 prepared under historical costs convention. Part A: Profitability The financial performance of Economica Plc is assessed on its profitability achievements of the year 2007 in comparison with 2006. The relevant profitability ratios are calculated as under: Gross profit margin is defined as the difference between net sales and cost of goods sold. Gross profit margin ratio shows the margin left after meeting manufacturing and/ or trading costs. It measures the efficiency of production as well as pricing. The company has performed exceptionally well in 2007 as its gross profit has risen from 39.8% in 2006 to 71.6% in 2007. It is true that turnover of the company has also increased from $38250000 to $42500000 but the real contributory factor for such rise in gross profit margin ratio is huge decline in cost of sales. Cost of sales has come down from 60.9% in 2006 to mere 28.4% in 2007. Such a fall in cost of sales reflects that either there are changes in products being dealt in by the company in 2007 as compared to those dealt in by the company in 2006; or there may be effects of some technological changes in production of products resulting in such a huge decline in costs of sales. Net profit margin measures the overall efficiency of production, administration, selling, financing, pricing, and tax management. Net profits have increased from 16.59% in 2006 to 40% in 2007. This increase in net profits is the result of huge increase in gross profit margin resulting from decline in cost of sales. There is also a marginal contrition from decline in distribution and administrative costs from 10.64% in 2006 to 9.6% in 2007. Jointly considered, the gross and net profit margin ratios provide a valuable understanding of the cost and profit structure of Economica Plc and enable to identify the source of company’s business efficiency. As both gross profit margin and net profit margin ratios have shown a rising trend in 2007 as compared 2006, it can be safely said that efficiency with regard to managing costs and pricing structure has improved a lot for Economica Plc in 2007 as compared to 2006. The third tool used to assess the profitability is Return on total assets (ROA). “Return on total assets (ROA), often called the return on investment (ROI), measures the overall effectiveness of management in generating profits with available assets. The higher is the firm’s return on total assets, the better.”(Lawrence J Gitman, page 68)i The assets of the company have been exploited very well by the management and with the result the ROA has increased from 6.24% in 2006 to 13.33% in 2007. This is certainly a tremendous performance on profitability front. Liquidity Liquidity refers to the ability of a firm to meet its obligations in the short run, usually one year. Liquidity of a firm is measured by current ratio. Current ratio is based on relationship between current assets (the sources for meeting short term obligations) and current liabilities. Current ratio is the barometer of short term solvency of the firm. Apparently, the higher the current ratio, the greater the short term solvency. Current ratio of Economica Plc for both years is calculated hereunder: Current ratio of 2:1 for any industry is considered optimum. From the point of view of this standard, Economica Plc has improved upon from the current ratio 1.67:1 in 2006 to achieve an almost optimum current ratio of 1.97:1 in 2007. The company has almost attained the short term solvency status and it is able to meet short term obligations as and when those become due. Capital Gearing Gearing or leverage of the capital structure of a company reflects the financing pattern of total assets of the company. Gearing or leverage of capital structure of a company can be measured through the calculations of debt ratio. The debt assets ratio measures the extent to which borrowed funds support the firm’s assets. The debt ratio shows the relative contributions of creditors and owners. Debt ratios of Economica Plc for both years are calculated as under: In 2006 as well as in 2007 the debt ratio is less than 50% indicating that the capital structure of the company is low geared, as mostly equity capital have been used to finance its total assets. Low gearing is a safe proposal but not enterprising from the point of view of equity holders. Equity holders are residual beneficiaries and thus enjoy the benefit of trading in equity. That means during periods of rising profits equity holders have the benefit of entire profits left after meeting the fixed interest liabilities of debt capital. Lower debt ratio also indicates the higher degree of protection enjoyed by the creditors. Some form of debts, like term loans, secured debentures, and secured short term bank borrowings, are usually protected by charges on specific assets, and when debt ratio is lower such protection becomes superior. Low gearing capital structure is safe as it covers lesser amount of fixed interest debt liabilities. Part B In this section the performance and position of Economica Plc have been assessed using financial statements of the firm prepared under current cost accounting (CCA) convention for the year 2007 with financial statements prepared using historical cost accounting (HCA) convention for the same year 2007. The required ratios to analyze the performance and position of the firm are calculate as under: As per Bob Rayon (page 110)ii “Current cost accounting is based upon the concept of deprival value, i.e., what would be the value of an asset to the firm if it were deprived of it. If the value of asset in use (its business value) is greater than its replacement cost then the replacement cost would be the deprival value. Presumably, in such a situation if it were deprived of the asset it would replace it and hence its replacement cost is appropriate basis for valuing the asset concerned. If the value of asset in use is less than its sale value, then deprival of asset would mean that it has lost its possibility of disposing of the asset and hence its realizable value is its current cost.” The review and assessment of financial statements of Economica Plc prepared on basis of these principles in comparison with financial statements prepared under historical cost convention hereunder. Profitability: Profitability is assessed this tome on basis of operational profits of the Economica Plc. Operational profits are earnings before interest and taxes. ‘The operating profit margin measures the percentage of each sales dollar remaining after all costs and expenses other than interest, taxes, and preferred stock dividend is deducted. It represents the pure profits earned on each sales dollar.” Economica Plc under CCA has operational profits of 36.5% and that are much lower than 62% of operational profits calculated under HCA. The reason for such a difference is the adjustments of current cost on cost of sales, depreciation and monetary working capital. Liquidity: Current ratio after adjustments of current assets with current costs is 1.98:1 as compared to current ratio of 1.96:1 calculated under HCA. Current ratio is almost similar under two different accounting systems. Generally higher current ratio indicates a strong liquidity of the firm. The current ratio under both accounting system is almost near optimum standard of 2:1. That once again strengthens the fact that Economica Plc is solvent for meeting the short term obligations as those become due. Capital Gearing: Debt ratio is a financial leverage ratio. Capital gearing, also called financial leverage, refers to the use of debt finance. It is true that debt capital is a cheaper source of finance as compared to equity capital, but it is riskier source of finance as well. Leverage or gearing helps to assess the risk arising from the use of debt capital. When gearing of capital structure is measured on basis of financial statement prepared under CCA, it further reduces the low gearing of capital structure. CCA shows that only 29.12% of total assets are financed through debt capital, whereas HCA reflects that 39.22% of total assets have been financed by debt capital. The reason for lowering of gearing of capital structure under CCA is increased valuation of non- current assets and inventory on the basis of current replacement costs. These adjustments have made major difference in the gearing of capital structure of Economica Plc. As stated earlier low gearing of capital structure may be safe from the point of view of liabilities of interest but such status shows that firm lacks risk taking abilities, and thus lowering the shareholders ability of trading in equity. Section B (i) Accounting involves two basic functions. First is recording of data and information and the second is measurement and reporting function. Measurement of data and information is the complex process and the reporting function is entirely dependent upon measurement of data. Measurement of data has to take care of provisions of different applicable laws, accounting standards, and accounting conventions for a suitable reporting presentation. However, it is observed that that data collected or gathered by financial accounting system cannot be measured in a suitable manner to report for actual operations of the business. John A Caspari and Pamela Caspari (page 76)iii believe that data generated by accounting system ‘are not based on well established cost world measurement because: The date provided by the accounting system are generally too late for operational decision making The data provided by accounting system are generally too aggregated for operational decision making. Most aspects of the business have not been precisely defined and quantified by accounting measurement. Data in accounting system is created to satisfy legal and external reporting requirements but are inappropriate for planning and control. The accounting measurements do not capture much of our employees’ intuition. Accounting measurements are not intuitively reliable.’ As per his paper ‘The Poverty of Accounting Discourse’, Professor Raymond J. Chambers believes that when income is not definable accountants only mix the facts and present them in pre- defined reports and believe that they have measured the data. According to him accountants are just making calculations and they are not in a position to measure the date. The opinion of R.J.Chamber is based on the basic belief that income is not definable and thus not measureable. It is a fact that income that is irregular, say income from bartering or illegal activities is not definable for the purpose of data collection. Such income is also included in statistics on estimate basis as it is considered un- measureable. Income that is regular grows at compound interest rate. As per Ryuzo and Rama V. Ramachandarn (page 67)iv this growing income is the same as wealth is defined to grow. But all such returns or growth depends on the assumption of laws of constant returns. In other words in order to define income or wealth we have to believe in an hypothetical situation of constant return and only then it can be said that regular income grows at compounding rate. When assumptions are required to express some thing like growth of income, we should believe that income is not definable. Thus the belief of R J Chambers and others is not unfounded about the fact that income is not definable. When something is not definable then what is that accounting is going to measure. R.J. Chambers is right when he states accountants confuse measurement with calculations. There is an opinion about conventional accounting that it employs methods and procedures that are conservatively biased. When something does not work as planned the methodology is changed to suit the purpose. Take the case of present economic and credit crisis world over. It is seen that fingers are being raised at fair value accounting as introduced under IFRS (International Financial Reporting Standards). When such accusations will become sharp and start hurting the accounting profession, it is believed that fair value standards will be changed back to historical accounting of assets. The fact is that accountants do not measure the indefinable income in absolute sense but only in a relative sense. Assessments of financial statements are generally based on relative approach. Ratios based analyses is a great example. These are relative comparisons of data and information with earlier achievements of the firm or competitive achievements in the same industry. The result is that improvement or achievement in accounting sense of one period when compared to the earlier period should not be treated as an achievement in non- accounting sense. This is because nothing economic has been created or procured by accountants as accountants have only quantified the data. Further, accountants are not contributory to the growth of income or capital, and they distinguish the same thing using two different notions. As per Nicholas Kaldor (page 64, 65)v ‘capital and income are two different ways of expressing the same thing, not two different things. In Hicks approach the source or corpus from which the income is derived disappears altogether as a separate entity- capital appears as a capitalized value of certain future prospects.’ Therefore present accounting system is nothing beyond quantifying the returns or expenditures in a disciplinary manner. Accounting is not a creator of income as it helps only in quantifying the income in manners predefined under laws or by accounting standards. That is why R J Chambers wonders as to what purpose such quantified will serve for the recipients of financial statements. ii) Criticism to present day corporate financial transparency is raving because of current economic crisis. Profitability in reported financial statements in annual reports is emphasized with broad letters, perhaps to attract future investors. “Profit figure is the key note of financial reports, encouraging short- termism, and audited profit figure is itself subject to uncertainties.” (ASSC, page 47)vi Similarly lot of emphasis is provided on reporting earning per share that encourages caring only for these numbers instead of general economic growth through corporate operations in the economy. The approach of accounting reporting is centered only to the interests of the corporate body. “Accounting procedures are regarded as too flexible, permitting companies to hide problems for too long. Accounting rules are determined by private sector organizations. The major accounting firms which handle the bulk of accounting work are also criticized for being too cozy with their clients.”(Margaret M. Blair, page 84)vii The criticism with regard to corporate financial transparency is healthy and needs some dramatic changes in the accounting and reporting procedures and systems. In fact R J Chambers has pointed out in his paper that ‘the formal procedures of modern accounting were devised somewhere in the twelfth to fourteenth centuries of present era, probably by some mathematician acute insight and inventiveness.’ It was the great farsightedness of the inventor that procedures of accounting are still working in this century as well. But these methods require overhaul as the information provided by reports following these procedures is orthodox and serve only the petty objectives of the corporations. Chambers has also expressed that accountants have only fixed ideas or approach of past and present figures and this actually jeopardize reporting through the financial statements. The actual worth of businesses is never reflected from the financial statements. That is the reasons that actual merger and takeovers are strike at different value than values reflected in the balance sheets. Such situations arise even when the assets are valued at fair prices. According to Chambers, the present accountancy is full of vagueness, internal contradictions, and prevarication by course to the law. Chambers (page 9)viii states that ‘accountants well know that the dated money’s worth of property and debts are crucial in the administration of affairs of bankruptcy, legally instituted to secure fairness in dealings as between bankruptcies and their creditors’; but the accounting information is dated and is helpful only to the extent of telling about bankruptcies. Accounting does not provide reasons for bankruptcies as reasons are located elsewhere in business and economic dealings that are nor reported or accounted for in any manner in this conventional accounting system. It is necessary to have pre- information about eventualities but such information should emerge from the accounting system itself and corroborated from available circumstances. Experts were aware of consequences of sub- prime mortgages, but accounting never reflected fall out till that actually happen. There is no use of a system that offers no reasons or explanation but only provides the amount of losses that have occurred. Again this accounting system provided leverage to manipulators as the accounting terminology, procedures and systems are understandable by handful of experts and not by those whose fortunes are at stake. The objections raised by R.J.Chambers in his paper ‘The Poverty of Accounting Discourse’ are worth consideration by regulators and the practitioners alike. Otherwise accounting will go on providing information about failures and successes of the businesses and not the reasons for such failures and successes. Present economic crisis is a great example of the failure of accounting system exactly in the manners of deficiencies of the system pointed by R J Chambers. Chambers is right when he states that what accounting needs is the Copernican revolution and not just the adjustments here and there. Reference Read More