Advanced Financial Accounting - Research Paper Example

Advanced Financial Accounting SECTION A 1) Financial statements need to be interpreted properly to give out a better understanding and meaning. Proper economic decisions are taken after these interpretations of financial statements. Many different measures can be adopted to interpret financial statements and one way is to conduct ratio analysis. There are different types of ratios; each ratio describes its own perspective. Later on, it is compared with appropriate industry standards or prior period performance to analyze current period’s financial position and performance. Bloomsbury plc’s financial position is analyzed in this way and is compared with prior year performance. Profitability Ratios Measure Formula 2009 (£’000) 2008 (£’000) Return on Capital Employed (ROCE) Profit before interest and tax/ Capital Employed * 100 26,350/ 89,500 * 100 = 29.4% 21,475/ 75,500 * 100 = 28.4% Gross Profit Margin Gross Profit/ Sales * 100 30,430/ 92,500 * 100 = 32.9% 25,225/ 88,250 * 100 = 28.6% Net Profit Margin Net Profit/ Sales * 100 19,000/ 92,500 * 100 = 20.5% 16,345/ 88,250 * 100 = 18.5% A company needs to remain profitable if it is to maximize its shareholder’s wealth and obvious checks on profitability are; - Whether the company has made a profit or a loss on its ordinary activities - By how much this year’s profit or loss is bigger or smaller to last year’s profit or loss Profitability Ratios is a financial measure which looks upon a business’s ability to generate profit as compared to the expenses incurred during the tenure. Some measures used in calculating profitability ratios are: Return on Capital Employed (ROCE); Profits and Profit growth cannot be properly related without relating them to the amount of funds employed in making the profits. Hence Return on Capital Employed is the most important profitability ratio. There are three comparisons that can be made; The change in ROCE from one year to the next The ROCE being earned by other companies, if this information is available. Comparison of the ROCE is made with the current market borrowing rates, firstly to find out the cost of extra borrowing to the company if it needed an more funding hence the ROCE suggests that whether the company is making enough profits to make such borrowing worthwhile, secondly whether the company is making a ROCE that suggests it is making a profitable use of its borrowings. This ratio gives out an indication of how well a business is utilizing the funds invested in it. The ROCE For Bloomsbury plc has increased by 1% approximately, clearly indicating that the company’s return on its investment has increased. Gross Profit Margin; A financial metric used to review a firm's financial strength by disclosing the proportion of cash left over from revenues after accounting for the cost of goods sold. Gross profit margin serves as the basis for paying further expenses and future savings. It expresses the gross profit as a percentage of sales. The Gross Profit margin for Bloomsbury plc has increased from 28.6% in 2008 to 32.9% in 2009 bringing an increase of approximately 4.3%. This ratio clearly suggests that there is an increase in the conversion revenue to gross profit of 4.3%. Net Profit Margin; It is also a financial ratio that measures how much out of every pound of sales; a company retains in earnings. A higher Net Profit margin indicates a more profitable company which has better control over its costs and expenditure (expenditure being the costs other than the costs to sell the goods already being considered in the gross profit margin. Considering the position of Bloomsbury plc, its net profit margin has increased from 18.5% in 2008 to 20.5% in 2009. This suggests that Bloomsbury plc has got better measures to control its expenditure (other than those considered in the cost of goods sold) in 2009 as compared to 2008. Better controls over expenditure and overheads have resulted in increased profit after tax for Bloomsbury plc for the year 2009. As compared to 2008, the profit after tax for 2009 has increased by £2,655,000. LIQUIDITY RATIOS Measure Formula 2009 (£’000) 2008 (£’000) Current Ratio Current Assets/ Current Liabilities 66,500/ 37,000 = 1.8 42,250/ 25,250 = 1.67 Quick Ratio Current Assets less Inventory/ Current Liabilities 51,000/37,000 = 1.38 25,250/ 25,250 = 1 Profitability is an important aspect of a company’s performance; however, it doesn’t directly address the key issue of liquidity. It is a financial metric to ascertain a company’s ability to pay back its short term debts when the fall due. A company’s inability to do so ends up in bankruptcy for the company. Common ratios used to ascertain the liquidity of a company are the current ratio and the acid test ratio. These liquidity ratios are a guide to the risk of cash flow problems and insolvency. If a company suddenly finds that it is unable to renew its short-term liabilities, there will be a danger of insolvency unless the company is able to turn enough of its current assets into cash quickly and pay off the obligations. Current Ratio; This is one of the working capital ratios. Working capital ratios describe a company’s ability to meet the financing requirements of the day to day operations. The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts to the parties it owes over the next 12 months. This is a going concern factor. In the year 2009, the current ratio for Bloomsbury plc is 1.8; as compared to 2008 it stood at 1.67. This shows that Bloomsbury plc’s liquidity has improved in 2009 suggesting that the company’s liquidity position has become strong. Acid Test Ratio/ Quick Ratio; The quick ratio is an indicator of the extent to which a company can pay its current liabilities without relying on the sale of its stock. The Acid Test Ratio for Bloomsbury plc has elevated from 1 in 2008 to 1.38 in 2009. This indicated that the company has got enough liquid assets besides inventory/stock to pay off its debts. GEARING RATIOS Measure Formula 2009(£’000) 2008(£’000) Debt to Equity Long term debt/ Shareholder funds * 100 11,000/ 89,500 * 100 = 12.3% 1000/ 89,500 * 100 = 1.1% Interest Cover Profit before interest and tax/ Interest charges 26,350/ 880 = 30 times 21,475/ 80 = 268 times These ratios measure the ability of the company to meet its long term liabilities. This ratio determines the balance between the funds invested in a company by shareholders and the long term creditor i.e. loans to be repaid after one year. Debt to Equity Ratio; This ratio discusses the issue of financial risk of a company, as a general guide; 50% is considered to be a safe limit to debt. The Debt to Equity for Bloomsbury plc has increased by around 11% (12.3% less 1.1%); this is because the company had a minimal amount of 1 million in 2008 as compared to 11 million in 2009. Interest Cover; Interest cover is a measure of financial risk which is designed to show the risks in terms of profit rather than in terms of capital values. The interest cover for Bloomsbury plc has decreased to approximately 30 times in 2009 as compared to 268 times in 2008. This is only because of a sudden rise in the debenture, which has eventually increased the interest being paid by the company. Interest cover goes on to show the interest to be paid being covered by the profit made by a company. 2) The Chief Financial Officer for Bloomsbury plc has given in a statement to the shareholders of the company stating few strategies that have been adopted by the company throughout the year 2009. The CFO has stated that the year 2009 was a difficult time financial year because of the global financial downturn and the recession, to adjust and address these issues the CFO initiated few strategies that seem to have worked for Bloomsbury plc. The strategy related to increase sales over the years has worked on for Bloomsbury plc and the company has achieved it as well. The sales figure for 2009 has increased by £4.25 million as compared to 2008 Besides this the company has been able to reduce its operating costs as well, it has reduced its cost of sales by £955,000 in 2009 as compared to 2008. The third strategy pointed by the CFO sets up a direction for the company to target those particular markets that tend to give greater margins. This has led to an increased profit figure for Bloomsbury plc in 2009. The liquidity ratios calculated clearly suggest that Bloomsbury plc has managed its working capital situation very smoothly. 3) Measure Formula HCA 2009 (£’000) CCA 2009(£’000) ROCE Profit before interest and tax/ Capital Employed * 100 26,350/89,500 * 100 = 29.4% 15,512/ 121,729 * 100 = 12.7% Net Profit Margin Net Profit/ Sales * 100 19,000/ 92,500 * 100 = 28.4% 8,846/ 92,500 * 100 = 9.6% Current Ratio Current Assets/ Current Liabilities 66,500/ 37,000 = 1.8 77,379/ 39,000 = 1.98 Quick Ratio Current Assets less Inventory/ Current Liabilities 66,500 – 15,500 / 37,000 = 1.38 77,379 – 26379/ 39,000 = 1.3 Historical cost convention values asset in the financial statements at the original price paid to purchase that particular asset, in contrast, Current Cost Convention values the asset at their replacement cost i.e. the cost that might be available for that particular market in an active market or any other buyer easily identified. This is the reason that the ratios calculated above are different from each other. The current ratio clearly shows that the replacement cost of the current assets would have been higher and that is the reason that the current assets and the current liabilities in the current ratio and the quick ratio have been calculated using the replacement cost for that particular asset. The ROCE also suggests that the expenditure paid and any other provisions are higher in current cost convention and it is because of this reason that the Profit before interest and tax or the Net Profit is lower in the CCA convention. SECTION B The article starts by pointing out that accounting, 40 years before, was never noticed as a professional coursed at any university but all this has changed with the last decade leading to some good popularity of this profession. This increase in popularity has led to the emergence of big accounting firm which have lend their names to university scholarships, etc; but approximately each of these firms have faced legal contingencies which were resolved by damages being paid by these accounting firms. These legal issues arose because the accounting firms lacked the ability to demonstrate professionalism. A newspaper pointed out that major financial scandals that have occurred around the globe have been done in companies whose financial statements were audited by great accounting firms. The article discusses the subject of accounting and the meaning of it. The author describes it as a profession that is to keep record of money, property, etc. the money is earned and spent, invested or kept safe and all this is either because of personal or other business affairs. All the records kept are to avoid any future losses by looking at previous records. Audits can help resolve the agent – principal conflict where the agents perform in accordance with their principal’s demand. The formal way of keeping record i.e. book keeping was introduced by a mathematician in between the 12th and 14th century. The author states that this system can protect against wrong record keeping but it cannot protect against errors in the amounts that are to enter the record, hence as with every formula; it is important to enter correct data to receive a proper record, any error in input would lead to wrong conclusion. An economic historian later concluded that accounting is very much linked to scientific and technological progress. The book keeping ways of the 15th to 19th century were manually written so as to record transactions, if anyone wanted to look at any number of transaction, it could have been looked up in t record kept; any future changes or discrepancies found were corrected accordingly; leading the trader to neither trust or deceive the financial statements. Trading became more complex in the 19th century; the limited liability clause and the laws relating to protection of shareholders and creditors led to publishing annual statements. This led to the use of periodical valuations of assets so as to tackle financial publicity laws and keeping strategies secret for competitive advantages. The accountants did not know anything about property valuation, capital or profit; they were merely just book keepers with simple knowledge of posting transaction into the books, so they had to rely on the directions of their managers and accept all valuations. This thing was usually done to deceive. All this led to the biggest blunder in the accounting history. The writer has further held that accountants have preserved themselves and their art from consequence of this blunder by recourse to many well established systems of ideas. Arithmetical Propriety; In 1864, an American accountant wrote a book on book keeping; in it he mentioned that the application of accounting is an elementary rule of addition and subtraction. The main way of doing is this is that similar numbers are added or subtracted to receive a resultant of the same class. Under this rule money amounts or money worth or property at any particular time can be added to obtain total wealth at that particular time and if this amount is subtracted from money amount of debt owed, the resultant would be net wealth. This principle is not followed at all in the current accounting practice. On the other hand, the accountants are accustomed to the idea of using past, present and future quantities of tangible money as well as other fictional prices and values are added up to derive the statement of financial position. All this leads to a difference between the balance sheet finding and the original worth of a business. This issue has not been addressed by accountant or any other accounting body. Wealth Income and All That; Economists and accountants are concerned with wealth, money, value, income, investment, etc. Wealth is the general purchasing power whilst income is the general increase in that purchasing power. Every normal man gets all of the above and he manages it appropriately. Accountants should also prepare financial statements objectively without taking any biased direction and orders from the managers concerned. Law and Order; Laws of any particular land should be kept up to date and they should not be vague. Proper law should be made for proper preparation of financial statements of companies. Accounting can be preserved with the help of laws. Laws have always required a true presentation of wealth in the financial statements. The word “true” is not used up to its level and past facts, present assumptions, managerial assumptions, accounting conventions and wrong arithmetic procedure leads to the misuse of the term “true” and clearly violates the law. Judgment and Choice; Accounting should be defended against the corruption of its ideal processes. There are external circumstances to almost everything. Proper choice and appropriate judgment should be made when it comes to accounting. Financial statements should be regularly monitored as this would lead to better understanding about the expenditure being incurred but in today’s world past decision are taken to judge about the future, e.g. budgeting. This way the prices of other goods and money equivalents are disregarded. Language and understanding; Every investor is interested in profits. To judge whether a company performs good or bad there is no such standard. There are numerous ways of calculating different book values. Hence, comparison of wealth and income of different companies would seem irrational and nugatory. Measures and Measurements; Accounting uses the term measures and measurement; there is a misconception that measurement is same as calculation, where present and past facts are mixed to obtain measurement. Financial accounting is an undisciplined mode of quantification; though wide knowledge of measurement is available but it is rarely used in accounting. Politics and Ethics; The discrepancies in accounting could have been eliminated with reference to accountability and responsibility but with accountability and responsibility there is conflict of interest between the person responsible and the organization own interest, this interest of the organization is its overriding purpose of existence. Performances of the delegates need to be observed and appraised accordingly. Accounting functions could have helped in reducing fraudulent acts but its makers by giving out their false and hollow arguments have in fact increased the wrong and unethical processes. Every single discipline of the above discussed seven can provide the basis for an up to date realistic accounting. The writer has gone up to show that accounting practices are labeled as ‘standard, but they are in fact inconsistent with the established knowledge. Initially the accounting measurement basis in the United Kingdom has always been the historical cost convention. But this practice has been substituted in accounting practice with fair value or current cost convention technique. This option to value assets at fair value or market value has been incorporated in the accounting standards given out by the IASB. The measurement issue is the lack of proper understanding of the fair value technique and the inconsistency between some assets being valued at historical cost and some at Current cost/ fair value. To address these issues and few other measurement issues, the IASB took some steps in 2006 to publish an Exposure Draft and enable public and other accounting body response on such issues. The ASB’s “Statement of Principles for Financial Reporting” and the IASB pointed out certain issues. The issues discussed were: Proper decision making for the user by including investment and credit decision. Proper control and stewardship over financial statement to be addressed with focus on the amount of assets and reason for any subsequent changes in the asset’s value. Only comparable, understandable and relevant information to be included in the financial statements The report further elaborated the feature, benefits and the drawbacks of using techniques such as historical cost technique or fair value technique. Further the report discussed on Net Realizable Value (NRV), Replacement Cost and Value in Use. References: Accounting Standard Board. Measurement bases for financial reporting (2006) http://www.iasplus.com/uk/0604measurementpaper.pdf Bull, Richard. Financial Ratios: How to Use Financial Ratios to Maximise Value and Success for Your Business. Oxford: CIMA, 2008. Friedlob, G. Thomas, and Lydia L. F. Schleifer. Essentials of Financial Analysis. Hoboken, N.J.: John Wiley, 2003. "The Poverty of Accounting Discourse." Accounting Education. 14. 1 (2005): 5-15. Wiehle, Ulrich. 100 IFRS Financial Ratios. Know-how-Box. Wiesbaden: Cometis, 2006. Read More