Business Units, Difference between Financial Accounting and Management Accounting - Term Paper Example

Accounting Assignment Table of Contents Introduction 2. Business Units 2 Sole Proprietorship………………………………………………………………...1 2.2 Partnership…………………………………………………………………………1 2.3 Limited Liability Partnership (LLP)……………………………………………….2 2.4 Merits of Incorporation…………………………………………………………….2 2.5 Limitations of Incorporation……………………………………………………….2 3. Difference between Financial Accounting and Management Accounting………...3 4. The sources of Finance for a Business Unit……………………………………….5 4.1 Short-term Finance………………………………………………………………...5 4.2 Medium- and Long-term Finance………………………………………………….6 5. Conclusion and Recommendation…………………………………………………7 Introduction Formation of business unit with a proper form is crucial for not only success and growth of the business but also to safeguard individual interests apart from the firm. Short-term benefits must be overlooked in favour of the long-term benefits and consequences. The report explores these aspects in more detail in the ensuing paragraphs. Business Units Businesses in the UK can be run mainly in three ways and they are: sole proprietorship, limited partnership or as a limited liability partnership. An unincorporated business "does not have its own legal personality and as such it is comprised of the people who run the business" (NickWis). Sole Proprietorship When a single individual owns the firm, the firm is called or known as sole proprietorship. As far as liability is concerned the sole proprietor is responsible for firm’s full liability. Sole proprietorship does not enjoy any tax benefits and they are liable to tax similar to any individuals. Individuals need to pay income tax of 50% for the incomes above £37,400; in contrast, corporations pay 20% income tax for incomes up to £300,000. Individuals pay income tax at the rate of 20% for the incomes below £37,400. Advantage is that the firm need not prepare accounts as per the Company Act and outsiders cannot know the firm’s profitability (Corporation Tax rates and reliefs, 2014). Partnership When two or more individuals come together to form a business unit, it will take the form of a partnership business. As such, it does not form a legal entity rather each partner will be assumed to work in lieu of another in Partnerships. Lawyers and accounting firms are usually partnership firms. They are taxed individually as per their share in the partnership venture. In this case, like sole proprietorship each partner will bear his or her firm’s full liability and will not be restricted to his or her share in the firm. The provision of Limited Liability Partnership (LLP) firm has come precisely for this reason. On advantage side, the firm has not to prepare accounts as per the Company Act and outsiders cannot know the firm’s financial standing (NikWis). Limited Liability Partnership (LLP) In the Limited Liability Partnership (LLP) business unit, nothing changes except the liability of partners restricted to their capital involvement in the business. Its management and tax treatment remains similar to ordinary Partnership Business Unit. Partners’ obligations and statutory requirements remain similar to a Limited Liability Company. In this case, while the firm bears the full liability; partners are liable to the extent of their contribution in the firm. (NikWis). Merits of Incorporation Incorporation proposes numerous advantages. On incorporating the business, one can draw tax-deductible salary from his firm. As such, government does not charge any tax to the incorporated firm for the profit up to £10,000. Taxation rate is 19% if the profits is less than or equal to £300,000. The biggest advantage is that firm’s liability remains restricted to the one’s share in the firm; thus, shareholder safeguards personal property if the firm is to wind up to pay its liability. Usually, incorporation is preferred by small firms for its tax provisions. Moreover, investors, suppliers, buyers prefer incorporated companies because of the statutory procedures that they are supposed to follow such as proper accounting and auditing procedures (This is Money, 2008). Limitations of Incorporation Incorporation causes considerable amount of paper work such as preparing and submitting annual accounts, filing tax return including personal self-assessment tax return. Books of accounts needs to be prepared and submitted as per the Companies Act and this leads to increase in accounting and auditing book keeping expenses (This is Money, 2008). Incorporation forces one to disclose information through profit and loss statements, balance sheet and cash flow situations. Even one needs to disclose the salary that one draws from the firm. Suppliers and customers can gather such details, if they desire. Firm’s profitability or gross margin of profits can also be known by them. Accountancy costs could be in the range of £3,500 to £5,000 depending upon where the firm operates (This is Money, 2008). Nevertheless, apart from limited liability and lower corporation tax applicability, there are certain other benefits of incorporating the firm. In the event of death of the director, the company continues to exist and maintain its separate legal entity. Its market value is not jeopardised. The word Limited behind the entity enhances its status that is an important element in business. It is easier to transfer shares instead of selling whole business in case, one wants to exit from the running business. A director can borrow from the firm without going to bank or paying high credit card interest provided the loan amount does not exceed £5,000 and interest charge is not less than 4%. Tax free benefits or perks can be availed; that is not possible in the firms without incorporation. If the business premises or building is held in directors name, then the director can receive rents from the company. Dividends can be declared suitably to manage fund transfer to director’s account (Adams, 2011). Difference between Financial Accounting and Management Accounting Company accounting is done to derive two types of information about the organisation: financial accounting and management accounting. Financial accounting provides information for external users or stakeholders such as suppliers, institutional or individual investors, customers, customers, creditors. In contrast, management accounting is made use by internal users of the company. Major differences between these two can be described as per the following (Riley, 2012). Financial accounting reveals the business performance over a given period that includes profit and loss statement, balance sheet at the end of the period, and increase or decrease in cash flows. Usually, the given period is one year long. Against this, the management accounting is done to help in decision making process for planning and controlling the activities of a business. There is no specific period involved in management accounting and it could be as per the need of business to know about daily, weekly or monthly figures related to inventory turn around, profit margins and so on. While financial accounts are prepared under the Companies Act as promulgated by law, there is no legal compulsion for preparing management accounts. However, firms are fully aware how difficult it is to survive without them. Several regulatory institutions govern the preparation of published financial accounts that include the company law, accounting standards and stock exchange regulatory laws. Being purely an internal need, management accounts do not have any external compulsions; it is entirely a creation of management as per the need. Financial accounts make available overall information such as total revenue without providing product-wise, market-wise, segment -wise or location wise information on sales. Management accounts can provide any information at micro levels necessary for the decision making. Management accounts can have innumerable possibilities to generate information to be used as a tool for managerial decision making. Most financial accounting is reported in monetary terms; in contrast, management accounting could be entirely non-financial such as customer satisfaction, employee turnover, employee satisfaction, productivity per employee, employee skill improvement and so on. Financial accounts provide historic information on business performance but management accounts aim at providing an analysis of achieved performance. It also peeps into future to do a sales forecast, or calculate raw material requirements, forecasting likely price rise of raw materials and so on. The Sources of Finance for a Business Unit Small businesses are often faced with the difficulty to decide about its source or sources of funds to conduct business activities. Usually, it is the nature of business that decides the quantum and source of fund required. Options for raising funds for business are many and can be described as per the following (Stokes and Wilson, 2010). Short-term Finance Often, businesses are in need of short-term finance to meet its short-term obligations that include statutory payments, government taxes, or employee salaries and so on. In order to meet such needs, short-term sources of finance are availed such as overdrafts, trade credit, or short-term bank loans issued for working capital requirements. A predetermined overdraft facility as agreed by the banker allows the firm to draw needed fund within the sanctioned limit for its short-term needs. The company will borrow only a needed amount for which interest will be charged. Overdrafts levy daily interest for the actual amount withdrawn. The bank may ask for collateral to cover its risk for nonpayment. It is a flexible source of funds to be used only for a very short term because interest rates are higher than normal. Banks can provide a short-term loan for a year or so at fixed or variable interest rates. A short-term loan is less flexible when compared with overdraft facility as fixed amount needs to be borrowed in one go; the firm commits to provide interest on entire amount for agreed duration. Necessary collateral needs to be provided as a security against a short term loan issued by the bank. Short-term finance can also be availed in the form of trade credits. Suppliers agree to take payments after certain fixed period for the goods or services rendered to the firm. For businesses, trade credit is an important source of short-term finance. Invoice financing is a way to source short-term funding. Loans can be availed up to 90% of the invoice value with remaining amount paid after full collection. However, loan provider places certain conditions such as minimum turnover and number of invoices prepared in a month. Certain loan providers will ask for a prior trading history with the customer before granting loans against invoices. Selection of the right provider – flexible enough to meet the business needs is crucial to avail invoice financing. Usually, businesses collect advance from the customer depending upon the nature of business. The customer advance is the source of short-term funding until the goods is delivered and invoice is raised to collect the contracted value. Medium- and Long-term Funding Sources When fund requirements in a business are for medium to long-term period, they can be availed from numerous sources as per the following details (The Start up Donut, 2014). Venture capital funding is an important source of financing for promising ventures. The fund often comes in the form of equity and not as liability for the firm. Venture capitalists invest in high risks and high return businesses with a possibility of management participation in running the venture. In such setup, entrepreneur’s total decision making power is compromised to a certain extent. Government grants are available when the venture is started at some specific place where economic development is badly needed. For example, Cornwell is the area where government of the UK provides grant to start a business so that the area can come at par with other areas of the UK and income levels of the locals can be raised. However, this involves a lot of paper work. Banks provide funds for medium to long-term requirements. The funding period may be as long as 25 years or even more in specific cases. The interest rates can vary in line with the Bank of England setting the interest rates time to time. Mortgage Funding is relatively an easy way of fund raising; it is also a popular way of long- term fund raising among small businesses. However, the risk component is certainly high in the event when business owner fails to repay the loan to the financial institution. Crowd funding is also an emerging option for small businesses. Here, a group or groups of investors come forward to fund businesses by owning a small equity in the business. Currently, numerous crowd funding platforms are available; however, they must be chosen meticulously considering all implications on a new business. Conclusion and Recommendation Summing up, it is crucial to form a business unit with appropriate form so that business can be sustained for a long period of time. Managerial accounting must be given due importance along with financial accounting so that decision making process becomes effective. The Right kinds of funding sources are equally crucial for business success based on short-term or long-term fund requirement. A business unit with limited liability such as partnership or a company is highly recommended to safeguard self from the firm’s liability. References Adams, J. A. (2011). Accounting Web. accountingweb.co.uk. [Online] Available from http://www.accountingweb.co.uk/topic/tax/incorporation-why-bother/514243 [Accessed 22 March 2015] NikWis (2012). A guide to unincorporated business structures. wisteriaformations.co.uk. [Online] Available from http://www.wisteriaformations.co.uk/articles/index.php/a-guide-to-unincorporated-business-structures/ [Accessed 22 March 2015] Riley, J. (2012). Accounting - financial & management accounting compared. tutor2u.net. [Online] Available from http://tutor2u.net/business/accounts/financial_management_accounting_comparison.htm [Accessed 21 March 2015] Stokes and Wilson (2010). Small Business Management and Entrepreneur. 6th ed. Cengage Learning. Hampshire. The Start up Donut (2014). Startup Funding. [Online] Available from http://www.startupdonut.co.uk/startup/financing-a-business/start-up-funding [Accessed 21 March 2015] This is Money (2008). Incorporating: pros and cons. thisismoney.co.uk. [Online] Available from http://www.thisismoney.co.uk/money/article-1585171/Incorporating-pros-and-cons.html [Accessed 22 March 2014] Read More