Book 3.1 Accounting & Finance in Business Why are we studying what is accounting?? Accounting is crucial to the running of any business. It is concerned with the flow of economic resources in and out of the business and providing information for decision making. Economic Activities The accounting process Accounting links decision makers with economic activities and with the results of their Decision Makers Accounting Information Figure 1: The main role of accounting Accounting. Is about the provision of financial information to help with decision about resource allocation, and about the preparation of financial reports which describe the results of past resource allocation decisions Purpose of Accounting: Accounting is often called the language of business. Accounting is the common language used to communicate useful information from the business to users in the world of business. The purpose is to: 1- Provide useful information to users (stakeholders); 2- Provide assistance in decision making; 3- Performance evaluation; 4- Control activities (e.g. assessing management stewardship). The users and usefulness of financial information: 1- The users of financial information (stakeholders): - Internal users: make decisions that directly affect the internal operations of the company (investors owners, managers, and employees); - External users: make decisions concerning their relationship to the enterprise (investors owners, lenders, customers, suppliers, government, public). Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 1
2- The characteristics of good financial information: i. Relevance: To be useful, the accounting information must be relevant to the needs of decision makers. Capable of making a difference in a decision. In other words, it should be capable of influencing the economic decisions of users. Relevance is a function of predictive value, feedback value and timelines Helpful in making predictions about ultimate outcomes of past, present and future events (Predictive value). Helps users to confirm or correct prior expectations (Feedback value). ii. iii. iv. Reliability: To be useful, information must also be reliable. Reliability of information means that the information is free of error and bias, it can be depended on. Reliability is a function of representational faithfulness, verifiability and neutrality. To be reliable, the accounting information must be a faithful representation of what actually happened (the entity s transactions and events), when similar results achieved if use same measurement methods verifiable (in other words, when, given the same information, independent users can arrive at similar conclusions), and Information is neutral, when it free from material error and bias. The information should not favor one group of users over another group. Comparability: Users should be able to make valid comparisons about the financial statements across time. Users should be able to make valid comparisons about the financial statements between different organisations in the same field. Understandability: Financial reporting should provide information that is understandable to one who has a reasonable knowledge of accounting and business and who is willing to study and analyze the information presented. Users are assumed to be financially literate. Complex or detailed information should be included in financial statements because of its relevance to economic decision making. v. Timeliness: Information must be available to decision makers before it loses its capacity to influence their decisions (Timeliness). Timeliness means having information available to decision makers before it loses its capacity to influence decisions. Having relevant information available sooner can enhance its capacity to influence decisions, and a lack of timeliness can rob information of its potential usefulness. vi. Materiality: Information is material if its omission or misstatement could influence the decisions that users make on the basis of an entity s financial information. Relates to an item s importance to a firm s overall financial operations. An item must make a difference to be material and be provided (disclosed). Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 2
Book 3.2 Business and cash accounting Accounting in different types of business: 1- The profit-making sector. 2- The not-for-profit sector. Financial stakeholders: Stakeholders are groups of people who have an interest in a business organization. They can be seen as being either external to the organization, or internal, but some may be both! Owners and Shareholders: The number of owners and the roles they carry out differ according to the size of the firm. In small businesses there may be only one owner (sole trader) or perhaps a small number of partners (partnership). In large firms there are often thousands of shareholders, who each own a small part of the business. Stakeholders' needs in the profit sector: The satisfaction of stakeholders needs is essential in order to induce them to provide resources (inputs) to the organization so as to sustain the creation of value over the long term. The conception of wealth should reflect the long term satisfaction of shareholders rather than short term profitability. Financial stakeholders Owners: has a vested interest in the business's future and success; tends to be financially conservative. Investors/shareholders: invests money or has shares in a business; their analysis is often detailed and focused on short-term returns. Lenders: gives loans; needs to know that the interest is affordable and that the debt can be repaid. Competitor: has an interest in the relative financial performance and business statistics of rivals. Manager/employee: works for and is paid by the business on a full-time or regular basis. Customer/supplier: needs to know whether they are dealing with financially sound and reputable business. Taxation official: reviews financial statements for accuracy and reasonableness, then checks the amount of tax payable. Financial information needed How well the business is doing compared with previous years and with competitors. Reassurance that the family source of income is safe and secure. Information on the business to allow comparisons with other businesses, with a view to choosing between them. Indications that financial returns will be maximized. Evidence that a business will be able to pay the interest on any debts. The worth of a business should the debt be unpaid and the business forced to close. Growth in sales, market share, net profits, and overall business efficiency. Information about the cost structure and operations of competitors. Reassurance that the business will continue to operate competitively. End-of-year figures that reflect their competence favourably. Continuity of supply and business without disruption to the flow of goods or services Ability of the business to pay for goods and deliver on time. Properly prepared and computed accounts and profit and loss statements. Validity of accounts when compared with similar businesses. Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 3
Stakeholders' needs in the not-for-profit sector: Owners in the public or not-for-profit entities (electors or citizens or members) have a less direct interest in the worth of the business and any profits it makes compared with owners in the commercial sector. Their interest may be more concerned with looking for evidence that the business has provided what it was supposed to provide with the funds the contributed. Accounting Methods: Two alternative methods may be used for calculating a business s net income: 1- Cash accounting: the easy way! Recognizes cash inflows and cash outflows only; non-cash revenues and expenses are not recognized. The accountant does not record a transaction until cash is received or paid (revenues are recorded when cash is received and expenses are recorded when cash is paid). Cash may be received at the same time that the revenue is earned, after the revenue is earned, or before the revenue is earned. 2- Accrual accounting: recognizes revenues when earned (i.e., when the service is performed or the goods are delivered), and expenses when incurred, regardless of when the cash inflow or outflow occurs (i.e., when used or consumed). January February March Goods are manufactured Goods are delivered Cash is collected Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 4
Book 3.3 The accounting statements The three main accounting statements: 1- The income statement (the profit and loss account). I/S It shows the difference of revenues or earning & expenses over period of time. Gross profit: is a heading used in the income statement to show the profit from activities before the remainders of the costs of running the business are deducted. Net Profit: shows what is left of the income after all the costs related to it have been allowed for. R > E = Profit R < E = Loss R E = Net Profit. 2- The balance sheet (the statement of financial position). B/S A statement showing the resources of a company (the assets), the company s obligations (the liabilities), and the equity of the owners at a certain point in time. The balance sheet is a snapshot of the entity s assets and liabilities at a given point in time. It shows the financial position over a point in time about the assets, liabilities & equity. Assets: An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. Liabilities: A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Equity (capital or net worth or shareholders' equity): Refers to the value of the company after liabilities are deducted from assets. Equity = Assets Liabilities E = A L 3- The cash flow statement. CFS It shows the cash movement (cash in & out) in the business over a period of time. Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 5
Book 3.4 Accounting & Finance in Business Branches of Accounting What is Management Accounting? Companies have discretion to design systems that provide information in order to make decisions about the organization s financial, physical, and human resources. Managerial Accounting is the process of identifying, measuring, accumulating, analysing, preparing, interpreting, and communicating information that managers use to fulfill organizational objectives. Financial Accounting and Managerial Accounting are two major specialised fields in Accounting. Financial Accounting mainly reports information on the financial position and operating results of a business for both the external users and the business as well. Managerial Accounting provides special information for the managers of a company ranging from broad, long-rang plans to detailed explanations of a specific operating result.therefore, Managerial Accounting information focuses on the parts of a company and is reported timely as required for the efficient decisions. The differences between financial and management accounting: Similarities: - Both deal with the same accounting data. - Both deal with economic events of a business. - Both require that economic events be quantified and communicated to interested parties. Note: - Determining unit cost: managerial accounting, - Reporting Cost of Goods Sold: financial accounting. Differences: Management accounting Produces information that is mainly used for management purpose within the organisation Financial accounting Produces information that is mainly used by parts external to the organisation Helps management to record, plan and control activities and aids the decision-making process No legal requirements Focus on specific areas of a business s activities Time focus: historical and future (planning tool) Emphasis on relevance for planning and control Not Mandatory No specified format and no specific, required statements Behavioral Issues: Designed to influence employee behavior Provides a record of the performance of an organisation over a financial year and the financial position at the end of that financial year Governed by legal (law) Concentrates on the whole organisation Time focus: historical picture of past operations Emphasis on verifiability Mandatory for external reports Has a format specified by accounting standards and by law Behavioral Issues: Indirect effects on employee behavior Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 6
Book 3.5 Budgets and the budgeting process Budgets and budgetary control: If a business does not produce high-quality accounting information for internal use, it is in danger of being poorly run and may get into financial difficulties. Some researchers observed a clear link between poor-quality management accounting information and financial distress in small and medium-sized enterprises. What is a budget? A budget is a financial or non-financial expression of an organization s plan of action for a specified period; it identifies the resources and commitments required to achieve the organization s goals for the period identified. Budgets are quantitative representations. For example: a firm may prepare cash budget to predict cash inflows and outflows or a production budget to plan its production levels. What is a Budgeting? The process of preparing a budget is called budgeting. One of the three main functions of management is to control. Budgets are useful in controlling operations. The essential features of a formal budget: Policies A budget is based on the policies needed to fulfill the objectives of the entity Data Quantitative data contained in a budget are usually translated into monetary terms Documentation Details of a budget are normally contained within a formal written document Period Budget details will refer to a defined future period of time Types of budgets: Master Budget: summarizes the planned activities of all subunits of an entity. A master budget is a comprehensive budget for a specific period. The master budget is made up of operating and financial budgets: - Operating budgets: are plans that identify resources needed to carry out the budgeted activities, such as budgeted sales and budgeted production. - Financial budgets: identify sources and uses of funds for the budgeted operations. It include the budgeted cash flow, budgeted income, the budgeted balance sheet, and the capital expenditures budget. The importance of budgets: Compels strategic planning Provides a framework for judging performance Motivates employees and managers. Promotes coordination and communication Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 7
Different types of costs and their impact on budgets: Variable costs: are costs that vary in relation to chosen measure of activity (a cost that changes in total as the volume of activity changes), (e.g., raw materials, wages, heating, lighting costs). - Example: raw materials cost KD 3 per unit, 10 units is KD 30, 100 units are KD 300, etc. Fixed costs: are costs that do not vary in relation to chosen measure of activity (remain the same in total, as volume changes), (e.g., rent, depreciation of equipments). - Example: depreciation, if equipment depreciation expense is KD 300 a month, it will be KD 300 regardless of the number of units produced. Discretionary Costs: costs that can be adjusted in the short run at management s discretion or not essential for decision on hand. E.g. training workers cost, research & development 'R&D' cost, and advertising and sales promotion costs. Contingency costs: One of the most common project failure is to start with an inadequate budget. How to assess uncertainties affecting cost in order to be able to set competitive targets and achievable commitments. Contingency is an amount added to an estimate to allow for additional costs that experience shows will likely be required (Total Budget = Base Estimate + Contingency). E.g. insurance for employee liability, public liability and property. Budget Variance Report: Standard costing is a control technique which compares standard costs and revenues with actual results to obtain variances which are used to stimulate improved performance. Procedures: Forecast: what is likely to happen? A forecast is a prediction. (E.g. sales would increase by 10% by next year). Budget: what should happen? A budget is a plan. (E.g. sales must go up by 10% by next year). Both forecasts and budgets are necessary. Forecast is useful for planning while budget is useful for both planning and for controlling. Author; Dr. Helal Afify ~~ Editor; Omar Abu Jbara Page 8