Management Accounting, Financial Accounting and Cost Accounting for the Optimal Decision-Making in Business - Coursework Example

Course Work I Introduction: Accounting systems take the economic events and transactions, such as sales and materials purchases, and process the data into information helpful to managers, sales representative, production supervisors and others. Managers often need the information presented through an accounting which can be used according to their purposes and uses. For an example, a sales manager may require to know the total amount of revenues which can be used to determine the commission to be pad to sales team. A distribution manager as against may require to know the sales order quantities from different geographic locations to ensure the timely delivery. Similarly, a manufacturing manager may be interested in knowing the quantities of various products and their expected demands and delivery dates to produce them accordingly. Three important accounting systems have been used by managers and other stakeholders of the company for their decision making choices namely Management accounting, financial accounting and cost accounting (Horngren et al. 2006). While Financial Accounting deals with reporting to external stakeholders, Management Accounting measures, analyzes, and reports financial and non-financial information that helps mangers make decisions to achieve the goals of an organization (Horngren et al. 2006). Much management accounting information is financial in nature but has been organized in a manner relating directly to the decision on hand (Institute of Management Accountants, Inc, 2008). Cost Accounting provides information about the costs related to acquiring and using resources which is useful in financial and management accounting. Limitations of Financial Accounting: Financial accounting is concerned with the preparation of final accounts. The business has become so complex that mere final accounts are not sufficient in meeting financial needs. Financial accounting is like a post-mortem report. At the most it can reveal what has happened so far, but it can not exercise any control over the past happenings. The limitations of financial accounting are as follows:- It records only quantitative information. It records only the historical cost. The impact of future uncertainties has no place in financial accounting (Decoster et al. 2007). It does not take into account price level changes. It provides information about the whole concern. Product-wise, process-wise, department-wise or information of any other line of activity cannot be obtained separately from the financial accounting. As there is no technique for comparing the actual performance with that of the budgeted targets, it is not possible to evaluate performance of the business (Decoster et al. 2007). It does not tell about the optimum or otherwise of the quantum of profit made and does not provide the ways and means to increase the profits. In case of loss, whether loss can be reduced or converted into profit by means of cost control and cost reduction? Financial accounting does not answer this question (Decoster et al. 2007). It does not reveal which departments are performing well? Which ones are incurring losses and how much is the loss in each case? It is not helpful to the management in taking strategic decisions like replacement of assets, introduction of new products, discontinuation of an existing line, expansion of capacity, etc. It provides ample scope for manipulation like overvaluation or undervaluation. This possibility of manipulation reduces the reliability. Nature and Scope of Management Accounting: Management accounting involves furnishing of accounting data to the management for basing its decisions. It helps in improving efficiency and achieving the organizational goals. The following paragraphs discuss about the nature of management accounting. Provides accounting information: Management accounting is based on accounting information. Management accounting is a service function and it provides necessary information to different levels of management. Management accounting involves the presentation of information in a way it suits managerial needs (Chadwick, 1993). The accounting data collected by accounting department is used for reviewing various policy decisions. Cause and effect analysis: The role of financial accounting is limited to find out the ultimate result, i.e., profit and loss; management accounting goes a step further. Management accounting discusses the cause and effect relationship. The reasons for the loss are probed and the factors directly influencing the profitability are also studied. Profits are compared to sales, different expenditures, current assets, interest payables, share capital, etc. Use of special techniques and concepts: Management accounting uses special techniques and concepts according to necessity to make accounting data more useful. The techniques usually used include financial planning and analyses, standard costing, budgetary control, marginal costing, project appraisal, control accounting, etc (Chadwick, 1993). Taking important decisions: It supplies necessary information to the management which may be useful for its decisions. The historical data is studied to see its possible impact on future decisions. The implications of various decisions are also taken into account. Achieving of objectives: Management accounting uses the accounting information in such a way that it helps in formatting plans and setting up objectives. Comparing actual performance with targeted figures will give an idea to the management about the performance of various departments. When there are deviations, corrective measures can be taken at once with the help of budgetary control and standard costing. No fixed norms: No specific rules are followed in management accounting as that of financial accounting (Chadwick, 1993). Though the tools are the same, their use differs from concern to concern. The deriving of conclusions also depends upon the intelligence of the management accountant. Increase in efficiency: The purpose of using accounting information is to increase efficiency of the concern. The performance appraisal enables the management to pin-point efficient and inefficient spots. Effort is made to take corrective measures so that efficiency is improved. Need of Management Accounting at Apple Inc.: The fundamental objective of management accounting is to enable the management to maximize profits or minimize losses. The evolution of management accounting has given a new approach to the function of accounting. The need of management accounting may be justified as follows: Planning and policy formulation: Planning involves forecasting on the basis of available information, setting goals; framing polices determining the alternative courses of action and deciding on the program of activities (Anthony, 2005). Management accounting can help Apple Inc. greatly in this direction. It facilitates the preparation of statements in the light of past results and gives estimation for the future. Interpretation process: Management accounting is to present financial information to the management. Financial information is technical in nature. Therefore, it must be presented in such a way that it is easily understood. It presents accounting information with the help of statistical devices like charts, diagrams, graphs, etc. which could be understood by a manager. (Anthony, 2005). Assists in Decision-making process: With the help of various modern techniques management accounting makes decision-making process more scientific. Data relating to cost, price, profit and savings for each of the available alternatives are collected and analyzed and provides a base for taking sound decisions (Anthony, 2005). Controlling: Management accounting is a useful for managerial control. Management accounting tools like standard costing and budgetary control are helpful in controlling performance (Vinayakam et al. 2007). Cost control is effected through the use of standard costing and departmental control is made possible through the use of budgets. Performance of each and every individual is controlled with the help of management accounting. Reporting: Management accounting keeps the management fully informed about the latest position of the concern through reporting. It helps management to take proper and quick decisions (Hansen et al. 2006). The performance of various departments is regularly reported to the top management. Facilitates Organizing: “Return on Capital Employed” is one of the tools of management accounting. Since management accounting stresses more on Responsibility Centers with a view to control costs and responsibilities, it also facilitates decentralization to a greater extent. Thus, it is helpful in setting up effective and efficiently organization framework (Hansen et al. 2006). Facilitates Coordination of Operations: Management accounting provides tools for overall control and coordination of business operations. Budgets are important means of coordination (Tracy, 2002 ). Use of Management Accounting in Planning and Control: Apple Inc. has a strategy to differentiate itself from its competitor by offering high range products focusing on youth. The fundamental foundation of its success lies on its innovative product lines. It has substantial capabilities to deliver on this strategy. Now if Apple Inc. wants to increase its revenue then it has to go through the number of steps involving planning, control, performance etc. to choose the best possible option in doing that. For example, consider Apple wants to analyze the option of increasing the prices of its products to increase the revenue. Following illustration presents how it would be achieved through Management Accounting systems and tools: Conclusion: Management accounting is not a specific system of accounting. It could be any form of accounting which enables a business to be conducted more effectively and efficiently. It is largely concerned with providing economic information to mangers for achieving organizational goals. Course Work II Introduction: Finanacial analysis is a part of business analysis. Analysts use financial statements for their analysis, which provide them with the fundamental information that is useful to analyze firms. Ratios are simply relationships between two financial balances or financial calculations. Financial ratios enable an analyst or decision-maker to develop insights into the financial performance of companies. It requires comparisons with industry norms, comparisons in a prior period, comparison with a competitor organization, or with planned and budgeted amounts (Bhattacharyya, 2007). The ease with which ratios can be manipulated and the danger in using them as criteria lead many analysts to concentrate on trends in ratio measurements rather than on the absolute value or proportion expressed by the ratio itself (Brigham et al. 2005). When a trend in the value of a ratio between financial attributes is observed, questions can be raised about why the trend is occurring. The answers to such questions provide new information, not necessarily contained in financial reports, but perhaps highly relevant and useful to the decision maker and the problem at hand. Similarly, comparisons of firms only on the basis of ratios can lead to erroneous conclusions. The diversity inherent in available accounting practices and principles can lead to differences in ratios between organizations being compared (Brigham et al. 2005). Comparisons between companies should be made with full attention to the underlying differences in basic accounting methods used in the reports as well as in the companies themselves. Various Types of Ratios: Ratios can be divided into following four categories on the basis of their nature and significance: 1. Efficiency Ratios: Efficiency ratios provide an indication of how well assets are utilized by the organization. Efficiency in using assets minimizes the need for investment by lenders or owners. Following are some of the efficiency ratios: Asset Turnover: This ratio measures the company's effectiveness in utilizing all of its assets (Internet Center for Management and Business Administration, Inc., 2007). Asset Turnover = Net Sales/Total Assets A high asset turnover rate implies that firm can generate strong sales from a relatively low level of capital. Low turnover would imply a very capital-intensive organization (Palat, 1996). Days' Receivables: The number of days for collection i.e. time between sales and receipt of payment from customers can reveal significant information on the cash flow of the company. Day's Receivables = Accounts Receivable/Average Day's Sales Inventory Turnover: The number of times that inventory is sold during the year provides measure of its liquidity and the ability of the company to convert inventories to cash quickly if needed. A slow turnover may indicate that inventories are not a liquid asset (Palat, 1996). On the other hand, a rapid turnover indicates the liquid character of inventory which can provide funds if needed in the short term and may protect the firm against inventory obsolescence. Inventory Turnover = Cost of Goods Sold/Average Inventory Inventory Turnover Period in Days = 365/Inventory Turnover Working Capital Turnover: Working capital turnover is a measure of the speed with which funds are provided by current assets to satisfy current liabilities. Working Capital Turnover = Net Sales/(Average Current Assets - Average Current Liabilities) 2. Profitability Ratios: Profitability Ratios measure the level of earnings in comparison to a base, such as assets, sales, or capital. Ideally, the company should maximize income with a given amount of resources or earn the same income using lesser resources (Williams J. , 2005). Some of the profitability ratios are as follows: Return on Investment (ROI): Dividing net income by the amount of investment expresses the idea of economic efficiency. Return on assets (ROA), return on investment capital (ROIC), and return on owners' equity (ROE) are all used in financial analysis as measures of the effectiveness with which assets have been employed. Return on assets (ROA) is a measure of the effectiveness of utilization of resources at the command of management (Williams J. , 2005). Return on Assets (ROA) = Net Income i.e. Profit after Tax/Assets Return on invested capital (ROIC) relates all net income to all resources committed to the firm for long periods of time. Return on Invested Capital (ROIC) = Net income/(Total Liabilities - Current Liabilities) Return on Equity (ROE) is a measure of how well management has used the capital invested by shareholders (Williams J. , 2005). Return on Equity = Net Income/ (Shareholders’ Funds – Revaluation Reserves – Deferred Expenses) Profit Margin: This ratio gives some indication of the sensitivity of income to price changes or changes in cost structure. Profit Margin = Net Income/Sales It is important to note that neither a high nor low profit margin necessarily means good performance. A company with a high profit margin but high investment may not be returning a great amount to investors while, a firm with a very low profit margin but with a very small investment may prove highly profitable (Loth, 2009). Earning Per Share (EPS) Ratio: Because companies have many owners and not all of them own an equal number of shares so, it is quite common to express earnings of a company on a per-share basis (Earnings per share: EPS, 2009). Earnings per Share (EPS) = (Net Income - Preferred Stock Dividends)/(Number of Shares of Common Stock + Equivalents) 3. Solvency Ratios and Liquidity Ratios: Liquidity is the ability of a firm to honor short term liabilities and solvency is the ability of firm to honor its long term commitments (Williams M. T., 2008). A firm’s liquidity and solvency can be measured by following ratios: Current Ratio: This ratio is commonly used for testing liquidity. Current Ratio = Current Assets/Current Liabilities The ideal current ratio for a firm depends upon the relationship between cash inflows and the demands for cash payments. A company with a continuous cash-inflow or other liquid assets may meet currently maturing obligations easily despite its low current ratio (Williams M. T., 2008). Ironically, a manufacturing firm with a long product development and manufacturing cycle may need to maintain a high current ratio. Acid Test Ratio: This ratio reflects the absolute liquidity of an organization. Typically, it is the ratio of so-called "quick" assets (cash, marketable security, and some forms of accounts receivable) to current liabilities. Acid Test Ratio = (Current Assets –Inventories)/Current Liabilities Debt Ratio: The degree to which the activities of a company are supported by liabilities and long-term debt as opposed to shareholder funds is referred to as leverage. A firm with high proportion of debt to shareholder funds would be referred to as being highly leveraged (Williams M. T., 2008). The advantage of having high debt is that net profits earned accrue to a smaller group of owners. On the other hand, a high leveraged increases risk when profits and cash-flows fall. The debt ratio is widely used in financial analysis because it reveals the effect of financial leverage. Debt-to-Equity Ratio = Long Term Debt/Owners' Equity Care must be taken in interpreting the ratio because there is no absolute level that can be referred to as being better than another. Differences in the size of the ratio may reveal management attitude toward risks and alternative strategies toward financing the activities of the respective entities. Times Interest Earned: Almost every company has continuing commitments in the form of interest payments that must be met by future flows if the company is to remain solvent (Williams M. T., 2008). The common ratio that measures the ability of a company to meet its interest payments is times interest earned. Times Interest Earned = (Pretax Operating Income + Interest Expense)/Interest 4. Market Prospects Ratios: Following are some of the market prospects ratios: Price Earnings Ratio (PE): The ratio reflects how much market is willing to pay for per unit of profits earned by the firm. Companies with high growth and good future prospects are traded at much higher multiple than companies thought to have less promise (Bull, 2007). Price Earnings Ratio (PE) = Market Price per Share of Stock/Earnings per Share Dividend Payout Ratio: The dividend payout ratio shows the proportion of net income that was paid in dividends. Dividend payout ratio is useful for forecasting future dividend streams to investors in the company's common stock. Dividend Payout = Dividends/Net Income (available to equity shareholders) Using Ratios to Think about Management Strategies: Combination of ratios can be used to know the interrelationships between ratios and to use them to think about the strategies that management has adopted or might adopt. The du Pont model developed by financial analysts at the E.I. du Pont de Nemours & Co. in 1919 allows such analysis (Kennon, 2009). Return on Owners' Equity = (Income/Sales) * (Sales/Assets) *(Assets/Owners' Equity) The first ratio, profit margin, can be used to focus management's attention on the relationship between the price and cost of products or services sold. The second ratio, asset turnover, emphasizes the efficient use of resources in producing products and services. The third ratio, assets over equity, focuses on the ability of management to leverage the firm properly to provide maximum return to shareholders. Each of these major classes of decisions that managers must make, can be examined in light of its ability to provide the overall objective of increasing return to shareholders. Limitations of Ratio Analysis: Followings are some of the limitations of Ratio Analysis: Ratios by themselves do not provide any insight into the performance of a firm. For example, a current ratio of 2:1 can be good in one situation and bad in other. No inference can be drawn in the absence of a benchmark ratio (Bhattacharyya, 2007). Meaningful inferences can be drawn only by comparing ratios of the firm with those of similar firms. However, a firm can not be completely similar to another firm, in some way it must be operating in different manner. So comparison of such firm may not give the fruitful result (Bhattacharyya, 2007). The ratio analysis is historical in nature. The historical perspective is used to forecast the future performance of the firm. So, it might not capture changes taking place inside or outside the firm, which might significantly affect the business of the firm. Meaningful inferences can only be drawn if the performance is analyzed over a significantly long period of time. So, it might be tedious process. Conclusion: Ratio analysis is an important tool to analyze the financial statements of a firm. They can be used to determine the places where the firm needs improvement. At the same time it also provides insights to where the competitor firm is better than the firm at center of analysis. These ratios are used by the investors to know the future prospects of the firm and to know whether the firm is run properly by its managers. Although some limitations are also attached with ratio analysis but their usefulness outweighs these limitations. References: 1. Anthony, R. (2005). Management Accounting. Mumbai. 2. Bhattacharyya, A. K. (2007). Essentials of Financial Accounting. New Delhi: Prentic-Hall of India. 3. Brigham, E. F., & Ehrhardt, M. C. (2005). Financial Management. South-Western. 4. Bull, R. (2007). Financial Ratios: How To Use Financial Ratios To Maximise Value And Success For Your Business . Cima . 5. Chadwick, L. (1993). Management Accounting. Routledge. 6. Decoster, T., D., & Schater, E. L. (2007). Management Accounting: A Decision. New York: John Wiley and Sons Inc. 7. Earnings per share: EPS. (2009). Retrieved May 24, 2009, from Biz/ed: http://www.bized.co.uk/compfact/ratios/investor4.htm 8. Hansen, R., D., & Moreen, M. M. (2006). Management Accounting. Cincinnati, Ohio: South-western College Publishing. 9. Horngren, C. T., Datar, S. M., & Foster, G. (2006). Cost Accounting - A managerial emphasis. New Jersey: Pearson Education Inc. 10. Institute of Management Accountants, Inc. (2008). Management Accounting. Retrieved May 24, 2009, from Institute of Management Accountants: http://www.imanet.org/about_management.asp 11. Internet Center for Management and Business Administration, Inc. (2007). Financial Ratios. Retrieved May 24, 2009, from Net MBA: http://www.netmba.com/finance/financial/ratios/ 12. Kennon, J. (2009). Return on Equity - The DuPont Model. Retrieved May 24, 2009, from About.com: http://beginnersinvest.about.com/od/financialratio/a/aa040505.htm 13. Loth, R. (2009). Profitability Indicator Ratios: Profit Margin Analysis. Retrieved May 24, 2009, from Investopedia: http://www.investopedia.com/university/ratios/profitability-indicator/ratio1.asp 14. Palat, R. (1996). Understanding Financial Ratios In Business. Jaico Book House. 15. Tracy, J. A. ( 2002 ). The Fast Forward MBA in Finance. New York: John Wiley & Sons, Inc. 16. Vinayakam, N., & Sinha, I. (2007). Management Accounting – Tools and Techniques. Mumbai: Himalaya Publishing House. 17. Williams, J. (2005). Financial And Managerial Accounting: The Basis For Business Decisions. Tata Mgraw Hill . 18. Williams, M. T. (2008). Financial Ratios Explained. Xlibris Corporation. Read More