This report comprehensively discusses the significance of keeping financial records and how financial information available in the financial statements of an entity help wide range of stakeholders in assessing company’s performance to make viable economic decisions. Moreover, as follows the report also defines the budgetary control process and different costing methods and their effects on short term and long term performance of the business. I would also like to discuss the statutory requirements of recording and reporting financial information for entities operating in the United Kingdom.
There are several reasons for companies to retain their financial records. In United Kingdom, limited companies are required under the law to keep records of all cash and equivalents received and paid by the entity. The company must also maintain record of the assets it owns and liability it owes. An entity is also obliged to record its ending stock at the year-end using any appropriate methods such as FIFO, LIFO or Weighted Average. The company must retain record for at least six year subsequent to the year in which transactions have taken place. In addition to the statutory requirements, the company needs to record all financial transactions that have taken place during a fiscal year. This information forms the basis of budget preparation in the subsequent periods. It also ensures the reconciliation of accounting transactions if any dispute arises. The proper financial recording helps the organization pay the right amount of income tax, VAT and other duties and taxes. It entitles the organization to claim benefits and tax credits and also prevent paying less or more and also minimizes the chances of incursion of various kinds of penalties. It clearly differentiates in the amount that is owed by others how much an entity owes them. It allows the company to apply for a bank loan and other credit facilities by showing them the business track record. The financial recording allows the managers to quickly reach at the target information because under financial recording system the separate accounts are maintained for all accounting transactions. For instance, records of cash and credit sales and purchase. It presents the actual position of the activities necessary to determine working capital cycle. It keeps information about the payables, receivables and other assets and liabilities. It separately tells the exact amount of expenses incurred during a year and what non cash transactions occurred in a period in consideration (Gov.uk, 2013)
TECHNIQUES FOR RECORDING FINANCIAL INFORMATION
In the modern business environment, various accounting systems or software have been developed that facilitates completion of accounting cycle in an efficient manner. The basis of all techniques is the book keeping system. It is regarded as the mechanism to transform accounting transactions into financial information. Book keeping starts with recording into journal, posting it into ledger and prepare income statement and balance sheet with the help of a trial balance. The initial recording is done through invoices and receipts of transactions. The bookkeeping is composed of two methods, single entry system and double entry system. The earlier records one sided accounting entry and the latter changes at least two different accounts. The earlier is quite common in small businesses where there are no complexities. The double entry system is used where the transactions are in large numbers and effect two or more accounts. One more method of recording accounting transactions is mercantile or accrual system in which all transactions pertaining to particular period regardless of cash or credit transactions are recorded in the book. The foundation of this system can be traced into accrual concept which indicates that sales is recognized only when all risk and rewards are transferred to the buyer and expense is recognized when payment is made (Wood and Sangster, 2002).
USEFULNESS OF FINANCIAL STATEMENTS TO STAKEHOLDERS
In the United Kingdom, organizations have to produce financial statements to ensure transparency in the system. The financial statements are presented on the format as specified in IAS 1. The consolidation is also required for entities meeting criteria as laid down in IAS 27, 28 and 31. The presentation of financial statements is necessary to provide accounting information to wide range of stakeholders in making rationale economic decisions. It helps them understand the nature of the business and industry trends. The investor group is interested in ratios such as ROCE, P/E and EPS to make sell and holding decisions. It enables them to understand the extent of risk involved in the investment being made. The Financial institutions make decision about the lending or debt ceiling keeping in view the interest covering capacity of the entity (Accounting-simplified.com, 2013). The suppliers of goods and other creditors look for information that assists them in deciding whether or not to supply products and services. For this user group, computation of working capital ratios or WCC with special reference to creditors’ day would be appropriate.
The regulatory authorities and revenue functions are the main users of the financial statements. They may be able to compute the right amount of taxation and could also conduct a benchmarking exercise by comparing the revenue and taxation figures of the companies operating in the same industry. The employees are the most significant stakeholders of the company and look for Employee benefits and share based schemes and an entity’s financial ability to meet post-retirement benefits. The ABC UK limited has to apply IAS 19 for the disclosure of contribution and defined benefits plan and IFRS 2 for Share based payment settlements. The competitors and rival firms are also interested in the financial statements of another entity because it helps them understand the entire business position and segmental information. Competitors may look for market share, dividend policy and inventory valuation method. The accounting figures presented in the financial statements assist the users in calculating ratios to arrive at an investment decision. With the help of published financial information, the stakeholders may be able to calculate and understand the liquidity and capital generating ability of the entity against the available resources. It also enables the users estimate the future outlook of the company and risk factors associated with business growth (Robertson and Sibley, 2009).
DIFFERENCE BETWEEN MANAGEMENT AND FINANCIAL ACCOUNTING
Management accounting is all about decision making that assists corporate managers in achieving strategic goals. Management accounting deals with planning, forecasting budgeting, controlling and costing techniques. On the contrary, financial accounting is all about external reporting that is guided by International Financial Reporting Standards (IFRS). Management accounting is not constrained by accounting and reporting principles whereas financial accounting has specific reporting guidelines to be followed (Horngren and Foster et al., 1997).
COSTING METHODS
The most important part of management accounting is cost management. The modern day accounting provides various methods of costing that affects pricing decisions such as Absorption and Marginal costing, Activity based costing, Throughput accounting, Target costing and Life cycle costing etc. All these methods produce different results but the main difference lies in allocation and apportionment of overheads. Usually marginal costing is used in pricing decisions to maximize profitability in the short term. Activity based costing gives a more realistic view of product cost by rationally allocating the overheads to activities or cost pools. Throughput emphasis on direct material costs and considers it as the only variable cost whereas all other costs are fixed. Target costing intends to reduce life cycle costs of goods and services without compromising on quality and other specifications. Life cycle costing costs products over its expected life cycle. It is used to maximize the return over the product and services entire life cycle (Avis, 2009).
BUDGETARY CONTROL PROCESS
The Budgetary control system is designed to assist management through reporting of information to make timely changes to inputs to produce required outputs in an efficient and effective manner. There are various mechanisms to control budgetary process such as feedback control, feed forward control, control reports and preparation of flexible budgets. In the modern times, it is also believed that there are behavioral methods of controlling budgets too such as Motivation and cooperation, bottom up budgeting, goal congruence, and divisional autonomy and beyond budgeting. The budgetary control process has three components; sensor, comparator and effector. The sensor collects information regarding costs and revenue and forwards it to comparator where the budgeted information is compared with the actual information and a monthly control report is prepared and reasons for variances are defined. The report containing information about the differences in the budgeted plan with the actual figures are forwarded to the effectors’ who is usually a manager or supervisor for corrective actions to bring the plan back on its course (Scarlett and Barnett, 2007).
The direct material price variance is favorable and usage is adverse which might be due to the purchasing of low quality material which was cheap as compare to the budgeted price and hence the consumption had been more because of low quality. The direct labour rate variance clearly indicates that company has used an expensive and skilled labour that made it possible to produce 1100 units in 1075 hours. The fixed overhead volume favorably increased because of efficient operations and resulted in the production of 1100 units which is 100 extra as budgeted. The details of variable cost will be useful in determining more information and the detail of acquisition of material and hiring of labour should be further elaborated to arrive at the conclusion. The reason of increased direct labour charges could be due to the shortage of skilled labour and for material the company might have had the opportunity to avail discount by buying in bulk or clearance sale (Malone, 2005).
The NPV appears to be negative and not producing fruitful results for both investment opportunities. However, on the contrary, surprisingly the ARR and IRR of both the investments seem to be viable for the company. The ARR of the project B is comparatively high as compare to A. The ARR method is not considered correct in making capital investment decisions because it produces false results. It is also believed that it produces results contrary to NPV method. IRR method is basically a variation of present value method. Similar to NPV the selection of correct discount rates is always a problem in IRR method. On the basis of the NPV and payback method, I would not recommend the company to go ahead with both the opportunities. But if there is still a need to go for at least one investment opportunity then Project 2 seems less risky. Investments can be obtained through many sources such as IPO, issuing equity or debt instrument under IAS 32. The company should go for off balance sheet borrowing because no financial institution would be willing to provide funds after keeping at the Payback and NPV results.
WORKING CAPITAL MANAGEMENT
Working capital is all about management of cash for daily business operations or to keep current assets in excess of current liabilities. The working capital cycle can be better managed by reducing inventory days and receivable days and by increasing payable days but the delay in supplier’s payment may be detrimental to business relationship in long term. To maintain working capital cycle to an adequate level the ABC UK Limited has to manage its cash and liquidity position. Moreover, it has to divide current and fixed assets funding adequately in short term and long term. The companies usually employ three approaches to manage their working capital, Conservative where all assets of permanent nature are financed using long term funding. The second approach is aggressive because it finances all assets using short term finances and it is considered highly risky because it is likely to result in liquidity problems. The third approach is moderate and considered as best among all because it uses short term finances to meet current assets requirements and long term sources of finance to meet noncurrent assets requirements as well as permanent portion of current assets (Malone, 2005).
COMPONENTS OF WORKING CAPITAL CYCLE
The working capital cycle is consists of current assets and current liabilities. It finances routine business operations. If the current assets are in excess of current liabilities then it means that company is a position to meet its short term obligations when they fall due. On the contrary, if current liabilities are more than current assets then company may have difficulty in meeting its obligations and it will experience a liquidity problem. There are four components of working capital, cash, and accounts receivables, inventory and accounts payables. Following is the brief description of the components of working capital;
Fig1 (Small Business, 2014)
CASH
It comprises of available cash and bank balance. It also includes short term investments and securities readily convertible into cash. A company may have sufficient cash available but it has possibly been sourced through a loan or a bank overdraft. The working capital calculation does not take into account a long term debt. It only contains short term liabilities which are to be paid within a one year period. The loan or a bank overdraft mostly has an interest amount attached to it which increases company’s expenses and adversely affects the net profit margin (Scarlett and Barnett, 2007).
DEBTORS
The debtors or accounts receivables are payment obligation on our customers and clients because they have acquired goods or services on credit. The accounts receivables are paid off by the customers within a due time which is usually less than a year. The drawback of accounts receivables is that there is always a chance of a bad debt or payment default. Mostly large organisations use factoring of receivables services from third parties to secure their accounts receivables. The factoring organisation charge an interest or service charges by deducting a minor percentage of the total value of accounts receivables. While calculating working capital, the analyst needs to consider that if the company has more current assets than current liabilities but major portion of current assets is constituted by debtors (Scarlett and Barnett, 2007).
INVENTORY
The inventory is an integral part of the current assets. The high inventory holding has a risk of obsolescence. Inventory consumes organisational cash in the form of insurance and storage costs. Despite several weakness of holding high value of stocks, the company still needs an adequate amount of inventory to meet market demand and requirements. In manufacturing organisations inventory is divided into three parts, raw material, work in process and finish goods. In a working capital calculation the most significant are the finish goods because they have a customer demand and a fair value in the market.
ACCOUNTS PAYABLE
The creditors are individuals and organisations to whom the company owe a certain amount or obliged to pay a sum of money on the due date. The creditors are usually vendors and suppliers of raw material and other inputs. The company can accumulate its capital by delaying supplier’s payment and invest the same amount in short term incentives. This is considered as the cheapest source of financing. But it may adversely affect the relationship with the suppliers or they may discontinue supplying products to the company. Alternatively, they can withdraw discount or may impose a penalty on late payments (Ibid, 2007).
SOURCES OF FINANCE FOR A BUSINESS PROJECT
There are several sources of financing available for a business project. It depends upon the size, company’s image and tenure of the project. Following are some general sources of financing a business project;
PROJECT SPONSORS
The projects main stakeholders are sponsors who are ready to invest in full or a partially in the project. There could be a single sponsor or a group of sponsors. For instance, a public service project is financed by a local government, NGO and a multinational corporation (Malone, 2005).
BANK FINANCING
The company undertaking a project can acquire a long term bank financing by producing a feasibility report. The long term bank financing can be acquired by mortgaging fixed assets or in special circumstances a bank can become a major beneficiary of the profit.
DEBT OR EQUITY INSTRUMENTS
A company can acquire financing by issuing debt or equity instruments under IAS 32 to meet its project’s financial requirements. The financial instruments have an interest or a dividend attach to it and a company is obliged to pay when they fall due (Ibid, 2005).
SHARES ISSUE OR INITIAL PUBLIC OFFERING
A company can acquire financing for a project by issuing right shares to its existing share holders. An existing company or a new enterprise can also launch its initial public offering in the stock exchange to source finance for a project.
REFERENCES
Accounting-simplified.com. 2013. Purpose of Financial Statements and Users of Financial Statements. [online] Available at: http://accounting-simplified.com/purpose-of-financial-statements.html [Accessed: 13 Oct 2013].
Avis, J. 2009. P2 - Performance management. Oxford, U.K.: CIMA/Elsevier.
Gov.uk. 2013. Running a limited company - GOV.UK. [online] Available at: https://www.gov.uk/running-a-limited-company/company-and-accounting-records [Accessed: 13 Oct 2013].
Horngren, C., Foster, G. and Datar, S. 1997. Cost accounting. Upper Saddle River, NJ: Prentice Hall.
Malone, S. and Malone, S. 2005. Better exam results. Burlington, MA: CIMA Pub./Elsevier.
Robertson, L. and Sibley, C. 2009. CIMA managerial level. Oxford: Elsevier.
Scarlett, R. and Barnett, I. 2007. CIMA managerial level. Oxford: Elsevier.
Wood, F. and Sangster, A. 2002. Frank Wood's business accounting 1. India: Prentice Hall.
Unknown. "Working Capital." Smallbusiness.wa.gov.au, 2014. Web. 22 Jan 2014. <http://www.smallbusiness.wa.gov.au/working-capital/>.
