What is Accounting?
Accounting is the process of recording and summarizing financial information in a useful way.
You may have already noticed the use of some form of accounting in your daily life.
My mom for example is the chief accountant and treasurer of our house. She keeps a simple diary to record major home expenses such as grocery, utilities, fees and so on. It gives her peace of mind knowing where she has spent the monthly income. The diary also serves as a reminder in case she forgets whether she has already paid someone. She keeps all the receipts in a folder. At the start of each month, she prepares a small budget that lists all major payments expected to be made in the following month. Even though my mom doesn’t realize, she is basically performing functions of accounting to manage the home finances.
Accounting, what we normally refer to, is a more formal, efficient and effective version of such processes in a business context.
Importance of Accounting
Accounting provides a basis for decisions through the process of recording, summarizing and presenting historical and prospective information.
The recording part of accounting, often known as book-keeping and financial accounting, is obviously crucial to ensure that those running a business have a formal record of business transactions in order for them to know basic information such:
- How much they owe to suppliers, tax authorities, banks, employees and others?
- How much each customer owes the business?
- How much capital is invested by the owners in the business?
- How profitable is the business?
Such information is necessary for a business to fulfill its legal obligations and asserting its own legal rights. Without proper accounting, it would be very difficult for a business to determine for example the exact amount (net of any discounts, VAT, etc.) it needs to pay a certain supplier (who could be one of dozens of suppliers for that business) from whom they may have made several purchases in last month alone. Organizations need to have a reliable way of recording information relating to transactions and that is where accounting is so vital.
Historical accounting information is summarized to produce financial statements. Financial Statements provide an overview of financial activities of a business during a period (e.g. income and expenses) as well as information relating to its financial position on a certain date (e.g. the amount of cash and inventory). Financial Statements help owners in assessing the performance and position of their business can guide their investment decisions (e.g. whether they should invest more in the business, diversify or dispose their investment).
Maintaining accounting records and preparing financial statements is often a legal responsibility for most businesses above a certain size.
Accounting nowadays is no longer concerned only with historical information. Budgeting, appraisal and analysis based on prospective information has become an important aspect of management accounting.
Management accounting is concerned with providing information to managers for decisions, planning and control of business. Examples of such information include:
- Variance Analysis
- Investment Appraisal
- Relevant Cost Analysis
- Limiting Factor Analysis
- Ratio Analysis
Definition – What are Financial Statements?
Financial Statements represent a formal record of the financial activities of an entity. These are written reports that quantify the financial strength, performance and liquidity of a company. Financial Statements reflect the financial effects of business transactions and events on the entity.
Four Types of Financial Statements
The four main types of financial statements are:
- Statement of Financial Position
Statement of Financial Position, also known as the Balance Sheet, presents the financial position of an entity at a given date. It is comprised of the following three elements:
- Assets: Something a business owns or controls (e.g. cash, inventory, plant and machinery, etc)
- Liabilities: Something a business owes to someone (e.g. creditors, bank loans, etc)
- Equity: What the business owes to its owners. This represents the amount of capital that remains in the business after its assets are used to pay off its outstanding liabilities. Equity therefore represents the difference between the assets and liabilities.
View detailed explanation and Example of Statement of Financial Position
- Income Statement
Income Statement, also known as the Profit and Loss Statement, reports the company’s financial performance in terms of net profit or loss over a specified period. Income Statement is composed of the following two elements:
- Income: What the business has earned over a period (e.g. sales revenue, dividend income, etc)
- Expense: The cost incurred by the business over a period (e.g. salaries and wages, depreciation, rental charges, etc)
Net profit or loss is arrived by deducting expenses from income.
View detailed explanation and Example of Income Statement
- Cash Flow Statement
Cash Flow Statement, presents the movement in cash and bank balances over a period. The movement in cash flows is classified into the following segments:
- Operating Activities: Represents the cash flow from primary activities of a business.
- Investing Activities: Represents cash flow from the purchase and sale of assets other than inventories (e.g. purchase of a factory plant)
- Financing Activities: Represents cash flow generated or spent on raising and repaying share capital and debt together with the payments of interest and dividends.
View detailed explanation and Example of Cash Flow Statement
- Statement of Changes in Equity
Statement of Changes in Equity, also known as the Statement of Retained Earnings, details the movement in owners’ equity over a period. The movement in owners’ equity is derived from the following components:
Purpose of Financial Statements
The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions (IASB Framework).
Financial Statements provide useful information to a wide range of users:
Managers require Financial Statements to manage the affairs of the company by assessing its financial performance and position and taking important business decisions.
Shareholders use Financial Statements to assess the risk and return of their investment in the company and take investment decisions based on their analysis.
Prospective Investors need Financial Statements to assess the viability of investing in a company. Investors may predict future dividends based on the profits disclosed in the Financial Statements. Furthermore, risks associated with the investment may be gauged from the Financial Statements. For instance, fluctuating profits indicate higher risk. Therefore, Financial Statements provide a basis for the investment decisions of potential investors.
Financial Institutions (e.g. banks) use Financial Statements to decide whether to grant a loan or credit to a business. Financial institutions assess the financial health of a business to determine the probability of a bad loan. Any decision to lend must be supported by a sufficient asset base and liquidity.
Suppliers need Financial Statements to assess the credit worthiness of a business and ascertain whether to supply goods on credit. Suppliers need to know if they will be repaid. Terms of credit are set according to the assessment of their customers’ financial health.
Customers use Financial Statements to assess whether a supplier has the resources to ensure the steady supply of goods in the future. This is especially vital where a customer is dependant on a supplier for a specialized component.
Employees use Financial Statements for assessing the company’s profitability and its consequence on their future remuneration and job security.
Competitors compare their performance with rival companies to learn and develop strategies to improve their competitiveness.
General Public may be interested in the effects of a company on the economy, environment and the local community.
Governments require Financial Statements to determine the correctness of tax declared in the tax returns. Government also keeps track of economic progress through analysis of Financial Statements of businesses from different sectors of the economy.
Financial Statements Template
Limitations of Accounting & Financial Reporting
Accountancy assists users of financial statements to make better financial decisions. It is important however to realize the limitations of accounting and financial reporting when forming those decisions.
Following are the main limitations
of accounting and financial reporting:
1. Different accounting policies and frameworks
Accounting frameworks such as IFRS allow the preparers of financial statements to use accounting policies that most appropriately reflect the circumstances of their entities.
Whereas a degree of flexibility is important in order to present reliable information of a particular entity, the use of diverse set of accounting policies amongst different entities impairs the level of comparability between financial statements.
The use of different accounting frameworks (e.g. IFRS, US GAAP) by entities operating in different geographic areas also presents similar problems when comparing their financial statements. The problem is being overcome by the growing use of IFRS and the convergence process between leading accounting bodies to arrive at a single set of global standards.
2. Accounting estimates
Accounting requires the use of estimates in the preparation of financial statements where precise amounts cannot be established. Estimates are inherently subjective and therefore lack precision as they involve the use of management’s foresight in determining values included in the financial statements. Where estimates are not based on objective and verifiable information, they can reduce the reliability of accounting information.
3. Professional judgment
The use of professional judgment by the preparers of financial statements is important in applying accounting policies in a manner that is consistent with the economic reality of an entity’s transactions. However, differences in the interpretation of the requirements of accounting standards and their application to practical scenarios will always be inevitable. The greater the use of judgment involved, the more subjective financial statements would tend to be.
Audit is the main mechanism that enables users to place trust on financial statements. However, audit only provides ‘reasonable’ and not absolute assurance on the truth and fairness of the financial statements which means that despite carrying audit according to acceptable standards, certain material misstatements in financial statements may yet remain undetected due to the inherent limitations of the audit.
5. Use of historical cost
Historical cost is the most widely used basis of measurement of assets. Use of historical cost presents various problems for the users of financial statements as it fails to account for the change in price levels of assets over a period of time. This not only reduces the relevance of accounting information by presenting assets at amounts that may be far less than their realizable value but also fails to account for the opportunity cost of utilizing those assets.
The effect of the use of historical cost basis is best explained by the use of an example.
Company A purchased a plant for $100,000 on 1st January 2006 which had a useful life of 10 years.
Company B purchased a similar plant for $200,000 on 31st December 2010.
Depreciation is charged on straight line basis.
At the end of the reporting period at 31st December 2010, the balance sheet of Company B would show a fixed asset of $200,000 while A’s financial statement would show an asset of $50,000 (net of depreciation).
The scenario above presents an accounting anomaly. Even though the plant presented in A’s financial statements is capable of producing economic benefits worth 50% of Company B’s asset, it is carried at a historical cost equivalent of just 25% of its value.
Moreover, the depreciation charged in A’s financial statements (i.e. $10,000 p.a.) does not reflect the opportunity cost of the plant’s use (i.e. $20,000 p.a.). As a result, over the course of the asset’s life, an amount of $100,000 would be charged as depreciation in A’s financial statements even though the cost of maintaining the productive capacity of its asset would have notably increased. If Company A were to distribute all profits as dividends, it will not have the resources sufficient to replace its existing plant at the end of its useful life. Therefore, the use of historical cost may result in reporting profits that are not sustainable in the long term.
Due to the disadvantages associated with the use of historical cost, some preparers of financial statements use the revaluation model to account for long-term assets. However, due to the limited market of various assets and the cost of regular valuations required under revaluation model, it is not widely used in practice.
An interesting development in accounting is the use of ‘capital maintenance’ in the determination of profit that is sustainable after taking into account the resources that would be required to ‘maintain’ the productivity of operations. However, this accounting basis is still in its early stages of development.
Accounting only takes into account transactions that are capable of being measured in monetary terms. Therefore, financial statements do not account for those resources and transactions whose value cannot be reasonably assigned such as the competence of workforce or goodwill.
7. Limited predictive value
Financial statements present an account of the past performance of an entity. They offer limited insight into the future prospects of an enterprise and therefore lack predictive value which is essential from the point of view of investors.
8. Fraud and error
Financial statements are susceptible to fraud and errors which can undermine the overall credibility and reliability of information contained in them. Deliberate manipulation of financial statements that is geared towards achieving predetermined results (also known as ‘window dressing’) has been a unfortunate reality in the recent past as has been popularized by major accounting disasters such as the Enron Scandal.
9. Cost benefit compromise
Reliability of accounting information is relative to the cost of its production. At times, the cost of producing reliable information outweighs the benefit expected to be gained which explains why, in some instances, quality of accounting information might be compromised.
Cash transactions are ones that are settled immediately in cash. Cash transactions also include transactions made through cheques. Cash transactions may be classified into cash receipts and cash payments.
Cash receipts are accounted for by debiting cash / bank ledger to recognize the increase in the asset.
Following are common types of cash receipt transactions along with relevant accounting entries:
Cash receipt from receivable:
Capital contribution from shareholders:
Receipt of loan from a bank:
Cash payments are accounted for by crediting the cash / bank ledger to account for the decrease in the asset.
Following are common types of cash payment transactions along with relevant accounting entries:
Cash payment to a payable:
Purchase of inventory for cash:
Purchase of a machine for cash:
|Debit||Machinery – Asset|
Cash Drawings by owner:
Repayment of loan installment:
Businesses generally keep small amounts of cash to meet small miscellaneous payments such as entertainment expenses and stationery costs. Such payments are generally handled by a petty cash imprest system whereby an amount of ‘Float’ is fixed. This is the maximum amount of cash that can be held at any time. Each time cash level runs low, the petty cash imprest is injected with cash by drawing a cheque. The amount of reimbursement is equal to the expenses paid through petty cash since the time of last reimbursement. Petty cash balance after reimbursement reverts to back to the level of the float.
Every time a payment is made through petty cash, it is recorded in the petty cash register usually by the cashier. When the cashier requests for reimbursement of petty cash, he creates a petty cash voucher detailing the payments made through petty cash during the period since the last reimbursement along with any supporting invoices acting as documentary evidence for the claim. If everything appears in order, the authorized signatory (e.g. operations manager) draws a cheque equal to the amount of expenses detailed in the petty cash voucher.
Petty cash imprest system is an effective way to manage small day to day expenses. However, since cash is the most liquid resource of the entity, strong controls over it are necessary to avoid possible misappropriation. Following controls may be applied over petty cash:
- Petty cash must be kept at a secure place (e.g. a cash box)
- Petty cash must be locked away in a safe when not in use
- Cashier must be responsible to keep supporting invoices in respect of payments made through petty cash
- Surprise cash counts must be conducted time to time to ensure the accuracy of the cash balance stated in the petty cash register
- The amount of petty cash float should not be set too high
Since petty cash register does not form part of the double entry system, payments made through petty cash are subsequently posted into the cash ledger and the general ledger.
On 1st January, petty cash of $100 is introduced. Petty cash register shows the following payments in the month of January:
Petty cash is reimbursed on 31st January.
Following entries must be recorded:
Initial injection of petty cash will be recorded as follows:
Petty cash payments will be recorded as follows:
As the total expenditure in the month was $80, this will be the amount reimbursed on 31st January:
Current Ratio – Liquidity Ratio – Working Capital Ratio
Current ratio, also known as liquidity ratio and working capital ratio, shows the proportion of current assets of a business in relation to its current liabilities.
|Current Ratio||=||Current Assets|
Current ratio expresses the extent to which the current liabilities of a business (i.e. liabilities due to be settled within 12 months) are covered by its current assets (i.e. assets expected to be realized within 12 months). A current ratio of 2 would mean that current assets are sufficient to cover for twice the amount of a company’s short term liabilities.
ABC PLC has the following assets and liabilities as at 31st December 2012:
|Non Current Assets|
|Cash in hand||25|
|Cash in bank||50|
|Income tax payables||60||160|
|Non Current Liabilities|
|Deferred tax payable||25||75|
Current ratio will be calculated as follows:
|Current Ratio||=||Current Assets||=||200||=||1.25|
5. Interpretation & Analysis
Current ratio is a measure of liquidity of a company at a certain date. It must be analyzed in the context of the industry the company primarily relates to. The underlying trend of the ratio must also be monitored over a period of time.
Generally, companies would aim to maintain a current ratio of at least 1 to ensure that the value of their current assets cover at least the amount of their short term obligations. However, a current ratio of greater than 1 provides additional cushion against unforeseeable contingencies that may arise in the short term.
Businesses must analyze their working capital requirements and the level of risk they are willing to accept when determining the target current ratio for their organization. A current ratio that is higher than industry standards may suggest inefficient use of the resources tied up in working capital of the organization that may instead be put into more profitable uses elsewhere. Conversely, a current ratio that is lower than industry norms may be a risky strategy that could entail liquidity problems for the company.
Current ratio must be analyzed over a period of time. Increase in current ratio over a period of time may suggest improved liquidity of the company or a more conservative approach to working capital management. A decreasing trend in the current ratio may suggest a deteriorating liquidity position of the business or a leaner working capital cycle of the company through the adoption of more efficient management practices. Time period analyses of the current ratio must also consider seasonal fluctuations.
6. Industry standards
Current ratio must be analyzed in the context of the norms of a particular industry. What may be considered normal in one industry may not be considered likewise in another sector.
Traditional manufacturing industries require significant working capital investment in inventory, trade debtors, cash, etc, and therefore companies operating in such industries may reasonably be expected to have current ratios of 2 or more.
However, with the advent of just in time management techniques, modern manufacturing companies have managed to reduce the size of buffer inventory thereby leading to significant reduction in working capital investment and hence lower current ratios.
In some industries, current ratio of lower than 1 might also be considered acceptable. This is especially true of the retail sector which is dominated by giants such as Wal-Mart and Tesco. This primarily stems from the fact that such retailers are able to negotiate long credit periods with suppliers while offering little credit to customers leading to higher trade payables as compared with trade receivables. Such retailers are also able to keep their own inventory volumes to minimum through efficient supply chain management.
Current ratios of Wal-Mart Stores, Inc and Tesco PLC as per 2011 annual reports are 0.88 and 0.65 respectively.
Current ratio is the primary measure of a company’s liquidity. Minimum levels of current ratio are often defined in loan covenants to protect the interest of the lenders in the event of deteriorating financial position of the borrowers. Financial regulations of various countries also impose restrictions on financial institutions to lend credit facilities to potential borrowers that have a current ratio which is lower than the defined limits.