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Financial management assignment

Part 1

Introduction to accounting
Accounting is the language that communicates financial and non-financial information to people who have an interest in an organization. (Drury, 2001) Accounting is concerned with gathering financial data, making analysis of this data and presenting it in an international standard format that different user groups can use depending on their purposes of need. The accounting information includes some data that must be published publicly like the financial statement. (McLaney & Artill, 2006) This statement includes a cash flow statement showing the inflows and outflows of cash into the organisation including taxes, an income statement (profit and loss statement) and a balance sheet which includes assets, depreciation and claims. These three statements can provide an over view of the overall financial health of a corporation. (McLaney & Artill, 2006) The accounting information also includes some internal information like the budget, projected financial position and cost volume profit analysis, these statements gives an overview of the near future financial capabilities of the business.

User groups for financial data


The user groups are people with interest in an organisations current status and its future, the groups can be internal or external to the organisation and these user groups include the following.

External groups:The organisations customers is the first group that needs accounting information they need it to help them decide whether to buy more products or services from the organisation and would want to be assured of the organisations ability to survive hence the service they bought will be supported in future and any claims can be met. Data from income statement and balance sheet can give them an overview of the sustainability of the business. The organisations competitors is the second group, they need the accounting information to decide on how to compete against the organisation or maybe to withdraw from the market if its impossible for them to compete, they need to study

the competitive strengths of the organisation and any changes made by the organisation to expand or shrink. The organisations suppliers is the third group, they need the accounting information to help them decide whether they want to continue to supply or not and if they will continue to supply whether they supply on credit or only cash. The income statement and cash flow statement should give an indication of the co mpanys ability to pay its debtors. The organisations lenders is the fourth group, they need the accounting information to decide whether to carry on lending or not, to request immediate payment of any loans or if to request guarantees for loans, loan insurance or higher premiums for risky loans. The income statement and cash flow statement should give an indication of the companys ability to pay its debts and the balance sheet should give an estimate of the assets to guarantee payments. The governing authorities is the fifth group, they need the accounting information to know if the organisation need to pay tax or not and how much tax it need to pay, whether the organisation is working on the guide lines or doing any sort of suspicious behaviour, whether the organisation need any financial support or not, whether the interests of all parties are safe or if there is any risky behaviours. The investment funds and consultants is the sixth group, they need the accounting data to decide whether to invest in the organisation or to give advice to invest or not. The local community is the seventh group, it needs to know whether the company is safe in the future as an employer providing opportunities to local society and paying its taxes, whether its giving fair competing opportunities to other local businesses or if its making some type of monopoly or unfair means of competition.

Internal groups:The first internal group is the organisations managers, they need the information to know how the business is performing, they need to bench mark every interval against previous intervals and they also need to benchmark the business against similar businesses and competitors. The accounting data can also help them decide how their future plans need to look, whether they need to invest in new products or expand in current products, it also help them decide on ways of funding the business whether its buy borrowing or disposing of assets, it gives them idea of the cost of purchasing and whether they need to change suppliers, it also helps in the make buy decision and expanding plans. The second internal group is the owners and shareholders, they need the accounting information to decide whether to hold their investment, sell it or invest more into it, they also need to know their risks and returns from the business, theyre also need it

to decide whether to appoint new senior management or keep the existing ones if they are happy with their performance. The third internal group is the organisations employees, they need the accounting information to know whether the companys future looks safe for them to carry on working for it or whether they should start to look elsewhere, they also need to know whether theyre rewarded enough or not depending on the companys profits and losses.

Part 2

Historical background for development of accountancy and financial statements


Accounting has developed slowly over many centuries, where it was originally prepared for stewardships and the evolved to be common use recently. Till the middle of the nineteenth century accounting had no rules it was only conventions that became acceptable practices and at 1948 it was the start of introducing accounting laws to govern companys accounting. A major change happened at 1971 when a number of major accounting bodies issued a set of guides called statements of standard accountancy practice this was done by a body called the accountancy standards steering committee. At 1991 the responsibility was transferred to accounting standards board. Even though statements of standard accountancy practice lay down the way how financial statements should be presented but their main problem is that they were not made by any theoretical or conceptual bases they were just a set of accepted practices.at 1989 the international accounting standards committee came to life and later changed its name to international accounting standards board and it issued its frame work of accounting rules. (Dyson, 2007)

Accountancy rules and conventions


The frame work divides the rules into three main categories: Ethical rules, Measurement rules and Boundary rules. (Dyson, 2007) As a result of the accounting rules Cash flow statements, Income statements and Balance sheets came to existence and became a requirement. The cash flow statement represents what cash the business had at the start, what cash came from running the business (in flows), what expenses where paid out (out flows) and the closing balance at the end of the accounting period. (McLaney & Artill, 2006) The income statement represents the revenues from running the business, the expenses paid to generate this income and the balance between revenue and expense in the form of profit or loss at the end of the accounting period. (McLaney & Artill, 2006) The balance sheet adds another dimension as it gives an overall idea of the business worth at the end of the accounting period; it looks at the cash (claims and liability accounts) and assets (current and non-current) to give an estimate net worth value of the business at a specific moment on time. (McLaney & Artill, 2006)

Well now start to explain some of the rules that derived the need of the above mentioned statements and some Pros and cons of these rules. If we start with the boundary rules which indicates types of data needed to be included in the accounting systems and look at the Entity rule The entity rule is about separation between the business and the owners in such a way that each of them has separate accounts, the accountants are only interested in the business side. This rule is especially important for owner run businesses where the personal finance of the owner must be separated from the business finances. The second rule well discuss is periodicity Periodicity is about arbitrary intervals for reporting as when a new business starts it assumes that it will run for an undetermined period and in this case it should be only reported at the closure of business hence the need of periodic reports which are usually one calendar year. The third rule is going concern arises from periodicity and assumes that the entity will carry on existence in the seen future. The fourth rule is accounts need to be quantitative so anything that cant be counted wouldnt be considered. (Dyson, 2007) The second set of rules is the measurement rules which explains how the data should be recorded. The first rule is monetary measurement principle which simply states that we cant compare different types of quantities so we need to convert them into something common which is money. The second rule is the historic cost which is an extension to the monetary measurement rule; it requires that transactions are recorded at the original value and ignoring value changes or inflation. The third rule is the realization rule; this rule fixes one of the problems appearing by the periodicity rule, by is rule sales transactions are treated as sale when the debtor has paid for it. So the profits are only realized in the period that the cash transaction or cash equivalent has gone into the companys accounts. The forth rule is the matching rule also known as the accruals: this rule is closely linked to the realization rule as once you have decided on which period the transaction appears then the non-cash effect need to appear to match the periods. An accrual is the amount owned by an entity at the end of a period for services given during this period.

The fifth rule is materiality; the materiality rule allows other rules to be ignored if the effects are not considered to be material or not significant. In the case that you consider an item to be immaterial then it does not matter how you treat it financially as it cannot possibly have a great effect on results. The sixth rule is dual aspect; this rule is a practical rule which states that every transaction has two folds, once youve spent cash to buy an item then the cash balance reduces by this amount while the stock balance or assets balance go up by the same value. (Dyson, 2007) The third set of rules is the Ethical rules which explain objectives and constraints regarding data recording. The first rule is the relevance rule; this rule specifies that the data presented on the accounting information must be useful, useful suggests that it has three qualities (Dyson, 2007) it is presented in time to make decisions, it can influence the decisions being made, it either confirms what the users already think and/or it helps them predict what might happen. The second rule is reliability; this rule is about the accuracy of data, the data need to be sustainable, error free, neutral, prudent and complete. However there can be a conflict between the above mentioned criteria and each other for example neutral and prudent concepts because if you follow a conservative approach you tend to recognize the downside rather than the upside, you might understate the effect of profits to avoid distributing dividends and then having to recollect money again for future projects but in this case you are not being neutral, so careful consideration needs taking to the balance of profits. The third rule is comparability; the financial data is useful if it can be compared fairly to other quarters or similar entities. The financial information need to be prepared on similar basis and consistent overtime. The fourth rule is understand-ability; the financial data need to be useful as per the previous rule and to be useful it must be understood by the users and receivers. (Dyson, 2007)

Criticisms of accountancy conventions


The use of accountancy conventions has led to the dependence on historical cost and profit realisation as basis of accountancy; however these conventions are not free of adjustments. For example in the case of asset valuation things like land and building tend to be revaluated on balance sheets when needed while motor vehicles tend to have a standing value as of purchase date. The financial statement in this case tends to be a list of current values and outstanding costs. Also the rule doesnt consider the replacement value of an asset or non-tangible assets like good well or know how assets. While realization convention helps in determining when the profit is recorded on the accounting books it overlooks the profit gained by growth on assets value as it will only be recorded when the asset is sold and paid for. As a result of the above the profit gained when assets are disposed is realized only on one period while the growth in value might have happened over many periods. The prudence convention, the rule is that profits are recorded but not realised in the system till cashed while expenses need to be realized immediately, also in the case of long term contracts profits tend to be realized before the financial year end while they might still be in progress. The entity convention, the problem caused by the entity principle is that complex organizational structures are not always clearly identifiable as an entity. Any joint ventures and sub business units accounts can be kept of the balance sheets for reporting purposes; this could lead to a lot of transactions been invisible to balance sheets. The periodicity convention, even though its good to have periodic reports but the annual reporting does not really consider the business cycles. The reporting is done at the end of the financial year while the business cycles might end at the end of the fiscal year for trading businesses or after harvest of some certain crops for agricultural companies or at the annual shutdown like in automotive companies. Also there is a problem with determining in which period a transaction has took place like in the case of future sales. The going concern convention assumes indefinite life time of the business entity the problem in that is the assets value in the balance sheet represents historic values while in case of sudden liquidation the value will be much less. This convention justifies periodic reports basing the asset values on carrying forward figures of unallocated costs. The money value convention, the criticism of this principal is that it ignores any other measures of performance such as stock levels, quality of stored items, human aspects, and environmental facts.

The accruals convention, even though the accruals method provides a more meaningful picture of the business financial performance but one criticism is that companies tend to smooth their reported performance to satisfy the expectations of financial analysts and shareholders. The quantitative convention, even though it is one of the basics of accountancy but it does not consider soft skills value, trademarks or good will, in the case of football clubs the players skills cant be quantified but its also an important asset. (Elliot, 2010)

Conclusion
The accounting conventions though they form the basic assumptions from which the financial statements were derived and though there is a legal requirement for preparing financial statements but the rules do not cater for all assumptions and as a result financial statements can still be within the rules but smoothed to reflect either unclear messages or specific directive messages which might not reflect the real financial status and in depth analysis for a financial statement is always recommended.

Summary
Accounting has developed slowly over centuries but it was not till 1989 when the international accounting standards came to life. It changed its name after to international accountancy board and issued a frame of accountancy rules. The frame work has three main categories and fourteen rules, the rules are mainly acceptable practices and conventions that became standard practices. The categories are Ethical, Measurement and Boundary rules. The sub categories are Entity rule, Periodicity rule, Quantitative principal, Going concern principle, Materiality rule, Monetary value rule, Historic cost rule, Realization rule, Dual aspect principle, Matching principle, Relevance rule, Reliability rule, understand-ability rule and Matching rule As a result of the frame work the main accountancy statements were developed. The accountancy statements are; the cash flow statement, the income statement and the balance sheet. These statements are the main source of financial data to the different users and receivers of the accounting statements. There are different users for the financial data some of which are internal with in the issuing organisation and some are external to it. Each group uses needs different data and uses the data differently. The rules by which the financial statements are prepared are not free from adjustments, they tend to use historical data and neglect important factors like current market value and inflation. The rules also neglect things like brand name, good will and sudden liquidation of assets.

Bibliography
Drury, C. (2001). Management Accounting for business decisions. Second Edition: Thomson Learning. Dyson, J. R. (2007). Accounting for non-accounting students. Seventh Edition: Prentice Hall. Elliot, B. E. (2010). Financial accounting and reporting. Fourtenth Edition: Prentice Hall. McLaney, E. & Artill, P. (2006). Accounting And Finance for Non- Specialists. Fifth Edition: Prentice Hall.