Accounting in a Business Context - Essay Example

Financial accounting is concerned with determining profits and balance sheet position (Atrill and McLaney, 2003; Berry & Jarvis, 1997; Dyson, 2003; Glynn & Murphy, 1998; Wood & Sangster,2002). Financial accounting information is mainly used for communication to outside parties and to satisfy legal requirements (Atrill & McLaney, 2003; Berry & Jarvis, 1997; Glynn & Murphy, 1998). Management accounting is the process of identifying, recording, classifying, analysing and reporting of all cost aspects of information for management decisions, planning and control, performance evaluation, and even strategic purpose (Berry & Jarvis, 1997; Dyson, 2003; Glynn & Murphy, 1998; Wood & Sangster, 2002). Management accounting information is mainly used for internal purposes and communication to management (Berry & Jarvis, 1997). The use of financial and management accounting information to the running of an organisation are discussed in the first and second part of this essay respectively. One of the main uses of financial accounting information is for funding purpose. Capital from shareholders and loans and credit from creditors require reporting of financial accounting information to solicit funds (Atrill & McLaney, 2003; Berry & Jarvis, 1997). Since the owners or shareholders provide the funds for the organisation to run, they are interested in the returns earned on their investments. Financial ratios such as return on shareholders' funds can be calculated to assess the returns earned on their investments. They use information on past performance obtained from the financial statements comprising the profit and loss statement, balance sheet, and cash flow statement together with the present economic market conditions to predict the future returns. Also, since the shareholders elect the board of directors, they would want to regularly evaluate the management's performance. Profitability ratios, indications of earning capacity and ability to make profits, can be used by the shareholders to evaluate the management's performance. Examples of profitability ratios are the gross profit ratio, the net profit ratio, and the return on total assets. Loan creditors, such as bankers are interested in the financial stability and liquidity of the organisation, as assessed by the liquidity ratios, solvency ratios, and capital structure ratios, such as the fixed assets to long-term liabilities ratio and the capital gearing ratio. Loan creditors would also like to know whether the organisation is able to pay interest on time and to repay the principal of the loan. They can use financial ratios such as the coverage of fixed interest charges to assess the organisation's ability in this regard. They are also interested in the amount of security existing for their debt, other liabilities the organisation has and security offered for them. The balance sheet offers this information. Trade creditors let the organisation obtain goods or services with postponed payment. They are interested in the ability of the organisation to pay its debts as they fall due, as revealed by liquidity ratios, such as the current ratio and the acid test ratio/liquidity ratio/quick ratio. Both shareholders and creditors use financial accounting information to assess the timing and uncertainty of prospective cash receipts. The prospects of cash receipts depend on the organisation's ability to generate enough cash to meet its obligations when due and its other cash operating needs. The cash flow statement, when used in conjunction with the rest of the financial statements, provides information that enables users to evaluate the changes in net assets of an enterprise, its financial structure (including its liquidity and solvency) and its ability to affect the amounts and timing of cash flows in order to adapt to changing circumstances. Another use of financial accounting information is to solicit investments from potential investors (Atrill & McLaney, 2003, Berry & Jarvis, 1997). Potential investors require information on various matters, including solvency, financial strength, earning capability, and the ability of the management in order to decide whether or not to invest in the organisation. The financial statements and the various financial ratios derived from the financial statements as mentioned in the above paragraph can be used by potential investors to make this decision. In addition, financial accounting information is used to satisfy statutory requirements (Atrill & McLaney, 2003; Berry & Jarvis, 1997; Glynn & Murphy, 1998). This information is used for purposes of taxation. It also has to comply with the provisions of the Companies Act, designed to control activities of companies and to protect the interest of investors and others. Lastly, financial accounting information is used to facilitate wage and employment negotiations (Berry & Jarvis, 1997). Information on an organisation's performance is also an assurance of steady employment and can also boost employee morale. Management accounting information is used for decision making such as to accept or reject special sales order, fix selling or tender price, add or delete a product line or department, maximise profits with a limited productive capacity or scarce resources, make or buy a component, or further process joint products (Berry & Jarvis, 1997; Dyson, 2003; Glynn & Murphy, 1998; Mott, 1991). The management accounting information used in decision making is relevant costs such as differential and marginal costs. Differential costs or incremental costs are differences in costs between alternatives when there is a change in the activity level. Marginal costs are variable costs incurred as a result of undertaking a certain activity or the costs that can be avoided if the activity was not undertaken. A special sales order, such as an order of a particularly large quantity such that certain costs can be reduced, can be accepted if it gives a positive contribution margin (sales minus marginal costs), provided the organisation has idle capacity, fixed costs will not change, normal sales at regular prices will not be disrupted, and no other special order that is more profitable can be obtained. The selling or tender price is used to determine the target market of the organisation's products. Some products may be sold in a luxury market where prices may be higher but quantities are lower, or at lower prices to the general market where higher quantities can be expected. The target market should be the one whereby the product generates the highest contribution margin. Similarly, in the decision of the addition or deletion of a product line or department, only relevant information such as the sales generated by the product line or department, as well as the direct costs, variable costs, and avoidable fixed costs of the product line or department should be considered. In resource allocation, the management accounting information used is contribution per unit of constraining resource, provided that fixed costs do not vary. Very often organisations find that their output is constrained by the limited availability of certain factors of production like materials, labour, machine capacity, etc. When there is a limiting factor operating, the organisation must try to maximise its profits every time it uses ups its scarce resources. In deciding whether to make or buy a component, the differential costs of making the component would be compared to the cost of buying the component minus the differential revenue from the alternative use of the resources used to produce the component. The alternative with the lower differential costs would be considered. Joint products are products that are produced simultaneously by a single process, the joint process. The products are not identifiable as individual products until a certain stage of production called the split-off point. All costs incurred before the split-off point are joint-product costs. Costs incurred after the split-off point are separable costs. Examples of joint products can be found in the petroleum industry, dairies, chemicals, etc. A dairy does not produce powdered milk only, it starts with raw fresh milk which is then separated into other dairy products like cream, butter and milk. In deciding whether joint products should be further processed, only the separable costs should be considered. Another use of management accounting information is for planning and control (Berry & Jarvis, 1997; Glynn & Murphy, 1998; Mott, 1991). Planning begins with the setting of general goals, proceeds to the cost-volume-profit analysis of various alternatives, and end with the preparation of a detailed, quantitative plan of action - the budget. Cost-volume-profit analysis is the study of the relationships between revenue (sales), costs (expenses) and profits (Atrill & McLaney, 2003; Berry & Jarvis, 1997). The information used for cost-volume-profit analysis cannot be taken directly from the profit and loss account. Expenses in the profit and loss account must first be broken down into their fixed and variable elements. An organisation may have the goal of being a cost leader or market penetration by offering competitive price. It can use cost-volume-profit analysis to study the effect on net income when there is a change in selling prices or costs. The organisation might have set a target profit. In this case, it can use cost-volume-profit analysis to find out the change in sales needed to achieve a certain level of profits. In the organisational context, management accounting information can be used for performance evaluation and management (Atrill & McLaney, 2003; Berry & Jarvis, 1997; Glynn & Murphy, 1998). The budget provides a motive and guide to action for all responsible managers in all segments of the organisation. When the results of actual performance become available, they are tabulated and compared with the budget for purposes of highlighting off-standard performance as a basis for taking corrective action. Budgets provide definite expectations that are the best framework for judging subsequent performance. Budgets are means of informing employees what is expected of them. Employees do not like to fumble along, not knowing what his or her boss expects or hopes to achieve. As a basis for judging actual results, budgeted performance is generally viewed as being more appropriate than past performance. The news that a company had sales of $10 million this year, as compared with $8 million the previous year, may or may not indicate that the company has been effective and has achieved maximum success. Perhaps sales should have been $11 million this year. A major weakness of using historical data for judging performance is that inefficiencies may be buried in the past performance. Furthermore, the usefulness of comparisons with the past may be hampered by intervening changes in technology, economic condition, competition, personnel and so forth. Management accounting information also ensures coordination in the environment context (Berry & Jarvis, 1997). For example, budgets promote coordination and communication among the various segments of the organisation. Coordination is the meshing and balancing of an organisation's resources so that its overall objectives are attained - so that the objectives of the individual manager harmonise with objectives of the organisation as a whole. The master budget is the means for communicating overall objectives and for blending the objectives of all departments (Atrill & McLaney, 2003). Coordination requires, for example, that purchasing officers integrate their plans with production requirements, and that production officers use the sales budget to help them anticipate and plan for manpower and plan facilities they will require. The budgetary process obliges executives to visualise the relationship of their department to other departments and to the organisation as a whole. Lastly, management accounting information can be used for strategic purpose. For example, budgets compel managers to think ahead - to anticipate and prepare for changing conditions. Organisations can then plan how to use their strengths and weaknesses in the face of opportunities and threats (Needham & Dransfield, 1995). Budgets express objectives (Atrill & McLaney, 2003). Without such objectives, operations lack direction, problems are not foreseen and results are hard to interpret. Bibliography Atrill, P & McLaney, E 2003, Accounting and Finance for Non-Specialists, Financial Times: Prentice Hall, Harlow. Berry, A & Jarvis, R 1997, Accounting in a Business Context, International Thomson Business Press, London. Dyson, JR 2003, Accounting for Non-Accounting Students, Financial Times: Prentice Hall, Harlow. Glynn, JJ, Perrin, J, & Murphy, MP 1998, Accounting for Managers, International Thomson Business, London. Mott, G 1991, Management Accounting for Decision Making, Pitman, London. Needham, D & Dransfield, R 1995, Advanced Business, Heinemann, Oxford. Wood, F & Sangster, A 2002, Business Accounting 1, Pitman Publishing, London. Read More