Regulatory Framework for Financial Reporting and Ratio Calculation of an Engineering Business - Coursework Example

Financial Accounting work Table of Contents TASK- A 3 Introduction 3 The Regulatory Framework for Financial Reporting 3 International Accounting Standards (IAS) 4 Conclusion 6 TASK- B 7 Ratio Calculation of an Engineering Business 7 Ratio Analysis 8 Liquidity Ratio 8 Profitability Ratio 9 Efficiency Ratio 10 Gearing Ratio 12 References 15 TASK- A Introduction Steady improvements have been seen in the quality of financial reporting since the last twelve years. One of the major changes that were introduced by European Union in the year 2002 was the requirement to adopt International Accounting Standards (IAS) from January 2005 onwards. This initiative was taken by European commission. The initiative was taken to strengthen the capital market, by creating a common accounting standard for reporting. It was also decided that the auditors would also have to follow the International Standards of Auditing (ISA), so that it would be easier to analyze the financial statements of the company on a global platform. The objective of this study is to discuss the improvement in the quality of information that users of financial statement get in IAS environment. Developing a strong accounting system is of significant importance because ability of the investors and the banks to calculate and assess the financial strengths and the performances of the companies depends on the transparent corporate accounting system. There should be mandatory consolidation of accounts along with the subsidiary accounts for ascertaining the true profitability. There was lack of segmented reporting of income, other disclosures, extent of deferred tax liabilities, etc. These were few reasons for which a common accounting standard was introduced. The Regulatory Framework for Financial Reporting All the companies in UK have to comply with the company laws regardless of its size. It was also important for companies to develop financial statements for the investors to analyze the financial position of the company. It is also the legal responsibility of the directors to see that the company is working in compliance to the accounting standards. According to the Companies Act of 1985, companies must represent a true and fair view of their accounting statements. In 1990s, the Financial Reporting Council (FRC) was set up for setting the accounting standards in UK. It was a solely independent body set up by the Department of Trade and Industry (DTI) and the City institutions. In the year 2000, the International Organization of Securities Commissions (IOSCO) reviewed the IAS. It was proposed that all the EU companies would have to prepare their accounts or financial statements by following the IAS standards. It was estimated that about 7000 companies in EU were accountable for using IAS, whereas there were only 275 companies who were using IAS till then. All the measures required were taken to establish IAS as a law in EU. This regulation was applicable for the detailed accounting provisions. It was on the member states to choose whether they wanted to permit their unlisted companies to follow the IAS standards. However the UK Accounting Standard Board (ASB) did take several initiatives to narrow down the gap between IAS and Generally Accepted Accounting Principles (GAAP). IAS is still being modified and it has become IASB in the process of converging IAS and GAAP. A survey was conducted by Pricewaterhouse Coopers in the year 2002 among 650 Chief Financial Officers (CFOs), all across the European Union to find the response of the companies towards the usage of IAS. It was found that 62 percent of the CFOs agreed to the fact that IAS would help in establishing an effective and transparent accounting system for them. 85 percent of the companies still did not use IAS, 92 percent of the CFOs were confident of meeting their deadlines of 2005 and about 60 percent did not even begin their planning for transition. International Accounting Standards (IAS) The study aims at discussing the different aspects of IAS, in order to analyze the improved quality of information to users of financial statements. In order to understand the contribution of different IAS standards towards the improvement, we would also study the IAS acts and its contribution. IASB was established keeping in mind the global need for establishing a common accounting standard. The common accounting language would be helpful in understanding the financial statements better, but sometimes in a principle based environment, some differences are bound to occur. IAS follows three basic assumptions: Going on Concern: It states that an entity will continue its activities and any form of hindrance would not stop it from doing so The assumption for proper and stable measuring units: The changes in the purchasing ability of functional currency excluding the 26 percent p.a. for consecutive 3 years can be considered immaterial for not considering the capital maintenance as stated in the guidelines of IFRS. Purchasing Power: It considers the constant power to purchase at all levels of inflation and deflation in relation to the consumer price index. There are different IAS set to take care of different aspects in accounting practices of companies. We would use the examples of different IAS to understand the improvements. According to IAS 1 Presentation of Financial Statements, a company should develop well-structured financial statement based on the accrual accounting basis. The standard comprises of financial statement, which would include profit and loss statements, a comprehensive income statement, statement of changes in equity and also cash flow statement. The objective behind establishing IAS 1 was to establish a well-structured financial statement which would be transparent enough to be globally assessed by investors. The difference could be observed between the accounting quality of the firms using IAS and those who are using normal financial accounting systems, in terms of their economic environments and incentives. Since the applicability of IAS is voluntary, incentives of firms that have adopted the IAS standards can change the pre and post adaptation periods. IAS has much higher quality than the domestic standards. In case of economic environment, firms should adopt IAS as it would become mandatory in future. The IAS was reviewed in the year 2007. In the previous IAS 1 comparative information was required before the reporting period, but in case of the revised version, all the changes in equity of non-owners have to be presented in a separate income statement. Apart from all the above facilities, the IAS also helps in assisting the accounting practices of SMEs in the country. IAS board is going to come up with several tailor made policies for the SME sector too. For the SMEs converting their accounting system into IAS or IFRS was a significant step. It helped the owners to develop a clear vision and realistic expectation from the business they were doing. It would support in making the financial statements of the company, an effective communication tool for the stakeholders (Deloitte Global Services Limited, 2012). Conclusion It can be concluded from the above discussion that IAS accounting systems are of higher quality than the domestic accounting system. We can see that companies applying IAS accounting system take minimal help of creative accounting practices or indulge in less amount of earning smoothing. They put less effort on highlighting their earnings and target mainly on recognizing losses, returns and share prices. It has been found that the transparencies in financial statements are present in companies, who have adopted IAS, rather than the non-adopters. It can be also assessed that IAS or IFRS improves the companies information environment. Though transition from GAAP to IAS or IFRS can be challenging, but IAS is an improved and refined version of the other traditional accounting standard. The IAS standards are welcomed by the investors, financial analysts, and other users of the financial statements. It becomes very difficult to compare the financial information without a high quality uniform accounting standard. The policies of IAS or IFRS are more advanced and precise for meeting the changes in the new accounting and audit systems. So the world is moving towards adopting IAS or IFRS accounting systems. TASK- B Ratio Calculation of an Engineering Business Calculation of Ratios Ratios Formula 20X0 20X1 Current ratio Current Assets/Current Liabilities 28500/20000 1.43 30500/24000 1.27 Quick assets ratio (Current Assets-Inventory)/Current Liabilities (28500-13000)/20000 0.78 (30500-14000)/24000 0.69 Stock turnover days (Stock/Cost of Sales)*365 (13000/34000)*365 140 (14000/42000)*365 122 Receivables turnover in days (Receivables/Sales)*365 days (15000/50000)*365 110 (16000/60000)*365 97 Payables turnover in days (Payables/Cost of Sales)*365 days (20000/34000)*365 215 (24000/42000)*356 203 Gross profit % Gross Profit/Sales 16000/50000 32.00% 18000/60000 30.00% Net profit % (before taxation) Profit before Tax/Sales 1700/50000 3.40% 300/60000 0.50% Interest cover EBIT/Interest Expense (1700+1300)/1300 2.31 (300+2200)/2200 1.14 Dividend cover Net Income/Dividend Paid 1100/600 1.83 (-50)/600 -0.08 ROCE EBIT/(Total Assets-Current Liabilities) (1700+1300)/(19500) 15.38% (300+2200)/(19000) 13.16% Gearing Non-Current Liabilities/(Non-current Liabilities + Equity) 5500/(5500+14000) 0.28 6000/(6000+13000) 0.32 Ratio Analysis Ratio Analysis is a very important tool for conducting a quantitative analysis of the companys financial information. Ratios are generally calculated for the current year and compared to the previous years ratios to judge the performance of the organization. There are many ratios which are generally calculated from the financial statements of the company with respect to the performance, financing, and liquidity of the company. Ratio Analysis helps in systematically analyzing huge amount of financial data that are available in the company. The financial data are represented in a report form with the help of ratio analysis. In this study we have analyzed the financial health of an Engineering firm. The ratios that are calculated for the engineering firm are the liquidity ratios, which mainly include the current and quick asset turnover ratio. Furthermore the profitability ratios, such as the gross profit, net profit percentage and the return on capital employed ratio to assess the profitability position of the company. The third set of ratio was the efficiency ratio, which included the stock turnover ratio, receivables, and the payable turnover in days. Lastly, the Gearing ratios are calculated which consist of interest cover, dividend cover and gearing ratio. Liquidity Ratio Liquidity Ratios consist of current and quick ratio. The liquidity ratios predict the company’s ability to convert its short-term assets into cash for covering the debts of the company. In figure 1 we can see the current ratio and the quick asset ratio for the year 20X0 and in figure 2 we will see the same ratios for the year 20X1. Figure 1: 20X0 Figure 2: 20X1 20X1 As we can see from the calculated ratios, the liquidity position of the company is quite good and it would not face difficulty in meeting its liabilities. However, we can see that both the current and quick asset ratio have declined in the year 20X1. This denotes that the current assets of the company have not increased over the year compared to the liabilities of the company. This might be the inability of the company to generate cash revenue in 20X1. Profitability Ratio Profitability ratios help to measure the ability of the company to generate revenue compared to the cost incurred, and expenses over a period of time. The profitability ratios measured here for the engineering company are gross profit percentage, net profit percentage, and the return on capital employed. In figure 3 and figure 4, we will see the calculated result of the three profitability ratios. Figure 1: 20X0 Figure 2: 20X1 As we can see from the calculation the gross profit percent of the company has decreased from 20X0 to 20X1. Even the net profit has declined from 3.40 percent to 0.5 percent in 20X1. According to the given income statement of the company, it has also suffered loses of £50,000 in the year 20X1. So we can say that the company lacks operational efficiency. The return on capital employed of the firm for the company has also declined. This proved that the company was not capable enough to utilize its capital efficiently for generating revenue. Efficiency Ratio Efficiency ratios are used to analyze the company’s ability to efficiently utilize their assets and liabilities. It helps to calculate the receivable, payables and repayment of liabilities. Some of the efficiency ratios which are calculated in this study are the receivable turnover ratio, payable turnover ratio, and stock turnover ratio. In figure 5 and figure 6, we would see the calculated figures of all these three ratios. Figure 1: 20X0 Figure 2: 20X1 In the graph we can see that the company can reduce its stock turnover from 140 to 122 days in the year 20X1. The receivable turnover has also declined in the year 20X1. This signifies that the collection period of the company for goods sold on credit is shorter. The payable turnover has also declined. This also means that the company has to make payment frequently for the goods purchased on credit. This also proves the inefficiency of the company to utilize its resources well, thus increasing the cash outflow and gearing ratios. Gearing Ratio The term gearing refers to the measure of the financial leverages. It demonstrates the degree of the firm activities that are funded by owners’ fund compared to the creditors’ fund. The gearing ratios which are calculated in this study are the interest coverage ratio, dividend coverage ratio and the gearing ratio. In the figure 7 and figure 8, we see the calculated figure of these ratios for the year 20X0 and 20X1. Figure 1: 20X0 Figure 2: 20X1 Here we can see the interest coverage ratio has decline over the year in 20X1, from 2.31 to 1.14. We also find a sharp decline in the dividend coverage ratio, but a rise in gearing ratio. The decline in interest coverage ratio proves that the company has not generated enough revenue to pay off its interest. The sharp decline in dividend ratio shows that the company was not able to generate enough profits and it suffered considerable losses. The company is standing in a risky situation and may face issues in future. References Deloitte Global Services Limited, 2012. Standards. [Online] Available at: [Accessed 14 August 2012]. Read More