Why Is Financial Reporting Important
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Accounting or accountancy is a process used for the
collection, processing and communication of financial information. Accounting
is an information system. Its main purpose is to communicate financial
information to interested parties about economic events that relate to the
business organizations. Accounting information is used for decision making
about possible future operations. It enables or should not, the efficient and
effective utilization of scarce resources.
Therefore, the objective of financial statements is to
satisfy the information requirements of decisions makers in the acquisition and
allocation of scarce resources. This is turn facilitate the operational
efficiency and financial viability of business operations.
Besides that, the end results of the accounting
information are collectively referred to as financial statements. They include
the Income Statement, Balance Sheet and Cash Flow Statement.
A Balance Sheet shows in statement formed the
relationship between Assets, Liabilities and Owner’s Equity at a point time.
The Balance Sheet is a representation of the Accounting Equation in action; the
term “balance” refers to the equality of Assets and Equities.
This essay is an example of a
student's work
The Income Statement is a financial report to the
owner of the business which shows the revenue for an accounting period matched
with the expenses of earning that income. Information is shown in the Income
Statement in a narrative form. Items are grouped together to help with analysis
and interpretation.
The Cash Flow Statement reports the performance of a
business in terms of its cash movements, for instance, the cash receipts and
cash payments of the business for a period.
Furthermore, the objective of the accounting
information system is to satisfy the financial information requirements of the
end users of accounting information. There are some examples of the users:
Users
Purposes and benefits
Managers
Manager is to make decision relating to the allocation
of scarce resources in order to meet corporate objectives.
Financial information as input into the decision-
making process.
Financial information enables the achievement of
objectives or goals with the limited amount of existing resources available.
Owners/ shareholders
They have the rights to know all assets and profits
after the repayment of the business debts.
Accounting systems with the task of reporting
financial information to owners about their ownership interest.
Financial information enables them to make decisions,
such as:
Expand business operations by investment further funds
Reinvest profit into expansion
Short-term creditors
Lenders of finance are mainly concerned with the
short-term liquidity of the business.
They need to get the accounting information for the
business ability to repay its debts.
Long-term creditors
Before a business is given long-term finance, it must
be able to prove its long term credit-worthiness by providing accounting
information.
They need to ensure the company is able to make
interest payments.
Employees
They show an active interest in the financial position
and profitability of organizations to enable the claim for increased salaries.
Question
2: What makes accounting information useful?
What makes financial information useful?
Comparability
Understandability
Consistency
Disclosure of accounting policies
Relevance
Reliability
Prudence
Completeness
Neutrality
Faithful representation
The IASB framework comes out a set of qualitative
characteristics that make the information given in financial statements useful
to all the users. There have four main qualitative characteristics which are
understandability, relevance, reliability and comparability.
First, understandability means the expression, with
clarity, of accounting information in such a way that it will be understandable
to users who are generally to have a reasonable knowledge of business and
economic activities. Thus, information on complicated issues should not be lost
from financial statements just on the argument that some users may find it hard
to understand.
For accounting information to be useful, it must be
relevant to a decision. Information has the value of relevance when it
manipulates the economic judgments of users by helping them evaluate past,
present or future dealings or confirming, or correcting their past evaluations.
Information has two roles in helping the users.
Predictive role
It is helping users to look to the future.
Explaining unusual features of current performance
helps users to understand prospect potential.
Confirmatory role
Showing users how the entity has or has not met their
expectations.
In addition, concept of materiality is intimately
related to relevance and deals with the amount of an error in accounting
information. The question is the error big enough to affect the decision of
someone to rely on the information.
Accounting information is reliable when it is
liberated from material error and can depend by the user to represent the
economic situation or occasion that is implies to represent. Information may be
relevant but so unreliable that it could be misleading. In contrast,
information could be reliable but quite non-relevant. Additionally, reliability
has five basic characteristics:
Prudence
It is the addition of an extent of caution in the
exercise of judgments needed in making approximates under circumstances of
insecurity, whereas fair presentation should be essential to all financial
statements.
Completeness
Good accounting information is complete.
That means it provides intended users with all
information that is necessary to fulfill their information needs and
requirements.
The assumption is there no error of omission.
Neutrality
Financial information must be neutral.
If the financial information is not neutral, it will
influence the decisions or judgments in order to achieve a predestined results
or conclusion. essay is an example
of a student's work
Disclaimer
Faithful representation
It is important if accounting information is to be
reliable.
It involves the words as well as the figures in the
financial statement when match up in an actual occasion.
Substance over form
If the information is to meet a test of faithful
representation, then the method of account must reflect the substance of the
economic reality of the transaction and not just a legal form.
Both of the qualitative characteristics of relevance
and reliability are associated with the comparability. For accounting
information, comparability allows a user to evaluate two or more corporations
and look for similarities and differences. It also means users able to compare
the financial statements of a company eventually to determine the development
in its financial performance. The concept of comparability has two important
roles which are:
Consistency
It means that financial statements can be compared
within a company from one accounting period to the next or between the
different companies in the same period.
Disclosure of accounting policies
It means the users of financial statements must be
informed of the accounting policies employed in the preparation of financial
statements.
Question 3: Briefly identify the difference between an
income statement and the balance sheet. Using relevant example and clearly
illustrated format, explain what is accounted for in the balance sheet.
The income statement is a summary of the income and
expenses for a period. Its preparation involves matching the income or revenue
for a period against the costs or expenses for the period. The net result is
the profit or loss for the period.
Besides that, the income statement reports hoe the
owner/shareholders’ equity increased or decreased as a result of business
activities. The income statements display the sources of net income, generally
classified as revenue (value coming in from selling products) and expenses
(value going out in earning revenue).
Classification in a Balance Sheet
Assets - Things of value which belong to the business
and which will provide benefit in the future.
Current Assets – Assets which are cash or convertible
into cash within twelve months, or which will provide a benefit to the business
within twelve months, e.g. motor vehicles, account receivables.
Non- current Assets – Assets which will provide
benefit to the business beyond twelve months (i.e. no more than one year
remaining on the date of the balance sheet), for example land and buildings,
machinery.
Liabilities- Amounts owing by the business which have
to be repaid in the future
Current Liabilities- Debts which have to be paid
within twelve months from the date on the balance sheet, for example account
payables, overdraft.
Non-current Liabilities- amount owing by the business
which are payable more than 12 months after reporting date, for example
long-term loan, mortgage.
Net assets- Total Assets less total liabilities
Equals Owner’s Equity in accordance with the
Proprietorship Equation,
OE = A – L
Owner’s Equity (Capital) – The financial interest that
the owner has in the business representing any capital contribution by the
owner and any profits retained in the business.
Capital = Opening Capital + Net Profit - Drawings
Format of a balance sheet
The basic format of a balance sheet is as follows:
In conclusion, the difference between the income
statement and balance sheet is based on the terms of what it’s explained. An
income statement covers an accounting period of a company. Income statement
also describes how much capital came into an organization during an accounting
period; the amount went out as expenses and what was missing at the end of the
period.
This essay is an example of a
student's work
On the other hand, a balance sheet is generally
produced to show what an organization has or owes on the end of the period
enclosed by the income statement. The balance sheet explains what the
organization owns or owes to carry on production or paying money during the
next period of time covered by the next income statement.
Section B
Question: Your friend mark is thinking of starting his
own business as he wants to be his own boss and have total control over his
income but he is not sure how to set prices for his products. He has read some
books and come across terms like ‘mark up and profit margin’. He has sought
your advice and as an accounting student, you are to explain to him how he is
able to do the appropriate pricing and make profits from his business venture.
What factors would Mark need to consider to ensure the success of his business?
Markup and margin are measures businesses use to set
and manage prices to maximize profitability. As the mark up and margin is
referring to the same things but calculate price or profit in different ways.
In general, mark up is calculated based on the cost whereas margin is
calculated based on the sales/selling price.
A markup is percentage of the cost price plus to get
the selling price.
Mark-up = Gross profit x 100
Cost
The margin is the percentage of the final selling
price that is profit.
Margin = Gross profit x 100
Sales
Business people usually apply markup for setting
prices, while margin is more useful for considering and improving the
profitability of the products in a business markets. In order to use the markup
of inventory to predict the future gross margins, the business owner must
understand the distribution between the markup and gross margin. The markup of
his inventory is frequently called initial markup, because it is where the
business owner begin. Nevertheless in order to sell it, business owner may have
to discount it, promote it or distribution it down for clearance at the end of
the season. Gross margin is the profit actually earn when sell it after any
discounting or markdowns therefore it is frequently called maintained margin.
This spread will be specific to the business, depending upon the level of
promotional and clearance activity.
For instance, Mark wants to open a muffins store.
Assumed the cost of production is £2.00 per muffin.
To find out a muffin's selling price using the mark-up
method, we must know the cost/muffin. Total cost is supposed to take account of
all of the costs incurred in producing the muffins to the end of sale.
The method for determining a muffin's selling price
using a preferred mark-up percent is:
Selling Price = Total Cost x (1 + Mark-Up %)
Selling Price = £2.00 x (1 + 0.30)
Selling Price = £2.00 x (1.30)
Selling Price = £2.60
Consequently, if want a mark-up of 30% (a profit equal
to 30% of total cost) the selling price must be set at £2.60. Mark-up percent
is the amount of total cost represented by profit.
Within some occasions, the selling price may be set
belong to the comparison of the cost of production with the market price. For
instance, if cost of production is £2.00 per muffin and the market comes out to
maintain a selling price of £2.80, the selling price may be set around £2.60.
These figures can be used to establish the mark-up percent. In this situation,
the method for the mark-up % is:
Mark-up % = (Selling Price - Total Cost) ÷Total Cost
Mark-up %= [(£2.60 - £2.00) ÷ £2.00] x 100
Mark-up % = £0.60 ÷ £2.00 x 100
Mark-up %= 30%
The idea of mark-up pricing should not be confused
with profit margins and gross margins. The profit margin is the monetary value
difference in the selling price and total cost. So, the profit margin in the
earlier illustration is (£2.60 - £2.00) £0.60 per unit. Consequently, as the
gross margin is usually considered of as gross margin which is the percentage
of the selling price accounted for by the profit margin. Gross margin is
calculated as the profit margin divided by the selling price. The method for
gross margin percentage is:
Gross Margin % = (Selling Price - Total Cost) ÷
Selling Price
Gross Margin % = [(£2.60 - £2.00) ÷ £2.60] x 100
Gross Margin % = £0.60 ÷ £2.60 x 100
Gross Margin % = 23%
If a preferred level of gross margin is recognized,
the method for gross margin can be adapted to calculate the selling price. With
a preferred gross margin percent, the method for calculating the selling price
is:
Selling Price = Total Cost ÷ (1 - Gross Margin)
Selling Price =£2.00 ÷ (1 – 0.23)
Selling Price = £2.00 ÷ £0.77
Selling Price = £2.60
There is understandable that the gross margin of 23%
is different than the mark-up of 30%, even though both examples used a selling
price of £2.60 and a total cost of £2.00. Mark-up and gross margins are
frequently used in calculating and estimating selling prices. Nevertheless,
mark up and margin should not be used cross-over for they are distinct and
calculated in a different way.
Besides the mark up and margin, the evaluation of
liquidity and profitability as well can determine the performance of a
business. Liquidity ratios and profitability ratios use the components of
classified financial statements to show how well a firm has performed in
expressions of maintaining liquidity and achieving profitability.
Liquidity
Means having enough money on hand to pay bills when
due to date and to take care of unexpected needs of cash.
Liquidity evaluate that is calculated by dividing net
cash flows from operating activities by average total assets.
There are some methods to measure liquidity, which
are:
Current Ratio = Current Assets
Current Liabilities
Acid test = Current Assets – inventories
Current liabilities
Profitability
Means the capability to earn adequate income.
As an objective, profitability participated with
liquidity for managerial attention because liquid assets are not the profit
producing resources.
To evaluate profitability of a company, the needs of
comparison of the past and the present performance.
There are some ratios to calculate the profitability:
Profit margin = Net income
Net sales
Asset turnover = Net sales
Average total assets
Return on assets = Net sales
Average total assets
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