Unit 14 Financial Accounting Assignment

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Final accounts of a business are the formats within which the financial information about the business is presented and reported to the users of such information and are the parties associated with the business or the stakeholders of the business entity. This assignment includes many scenarios with regards to recording of transactions, preparation of final accounts of a business, analysis and interpretation of accounts, comparing the financial performance on periodic basis using ratio analysis, understanding accounting misconception in relation to a given situation and application of accounting principles and policies. There are different portfolios to address all these situations.

Portfolio 3 – Accounting Misconception

Accounting misconception refers to as the situation where the users of accounting information interpret the accounting data inaccurately. The fundamental accounting principles are the generally accepted principles which provide a uniform basis for the correct and intended interpretation of accounting and financial information by the users. In absence of defined accounting principles and uniform policies, different users of accounting information interpret the data in accordance with their accounting perception and understanding. This creates the situation of accounting misconception with regards to the financial information presented to the users through final accounts of a  business management  or organization (Cairns, 2013). Thus it is essential that the final accounts of a business are prepared in accordance with the fundamental accounting assumptions which are as follows:

• Going Concern concept – This accounting fundamental assumes that the accounting entries are made and accounting transactions are performed by a business with the intention of operating it for a long term. There are no objectives of dissolving the business in the near future and thus the business will be a going concern for long term.
• Accrual basis of accounting – This accounting principle states that the accounting records shall be prepared on accrual basis which means that the expenses and income for a period shall be recorded as and when they become due rather than recording them on the basis of receipt and payment of cash for the same (Cordery, 2014).
• Consistency – This fundamental accounting assumption states that the final accounts shall be prepared on a consistent basis which means that the policies and estimates used in the beginning for once shall be continued for the overall accounts. This ensures uniformity of policies, procedures and estimates in all the items of final accounts.

Mr. Loaded is a sole trader engaged in the business on his own. The final accounts of Mr. Loaded have been prepared using its trial balance for the year ended 31 December, 2015 applying the generally accepted accounting principles and fundamental accounting assumptions as follows:

From the above final accounts which include the Statement of profit and loss account for the year ending 31 December 2015 and the statement of financial position as at 31 December 2015, it can be observed that Mr. Loaded suffered a net loss £25,400 from his business operations. There was a gross profit of £44,400 from the trading operations, but due to large amount of expenses including repairs and insurance of assets, depreciation on assets and sundry expenses which exceeded the amount of gross profit, the gross profit turned to net loss. On the other hand from the statement of financial position, it can be observed that there is a positive bank balance in the business bank account of Mr. Loaded. Also he has a cash balance of £500 apart from the balance of £9,800 in his bank account. There are current liabilities which include trade payables of £25,000 and wages payable of £2,000. Also there are current assets which include prepaid rates of £100. All these items are the result of accrual basis of accounting which has been used in the preparation of final accounts. The current assets also include trade receivables and inventory. It can be observed that the business has suffered a net loss, despite of this there is a positive bank balance and cash balance. The major reason for this is the presentation of the accounting information extracted from the trial balance in the form of final accounts since the accounting assumptions and general accounting principles have been used in presenting the accounting information in the required format and structure of final accounts of a sole trader. The other reasons which resulted in the presentation of net loss and bank balance in the final accounts of Mr. Loaded simultaneously for a specific period are as follows:

• Outstanding wages - The accrual basis of accounting suggests that the period expenses and period income shall be recorded in the accounts of business on accrual basis rather than cash basis. Due to this prepaid rates and outstanding wages have been included in the statement of profit and loss. This has resulted in an increase of the bank balance since the payment of prepaid rates has already been made and at the same time the payment of outstanding wages is still due. The outstanding wages relate to expenses of current period to be deducted from the profit resulting in decrease of profit. This is one of the reasons of net loss even after the positive bank balance since the bank balance has not been deducted for £2,000 but the profit has been reduced (Richardson, 2010).
• Depreciation – The depreciation charged in the profit and loss statement on fixed assets including motor and furniture and fittings is a non-cash expense. The non-cash expense means the expense which is charged from the profits of the business but do not require outflow of cash. The total amount of depreciation charged by the business on fixed assets is £13,200. This means that this amount has been reduced from the profits of business but no payment has been made for such expense from the bank in relation to such expense. As a result the bank balance is not reduced even after the reduction in profits. This has resulted in net loss for the business. Depreciation expense is not an actual expense which involves cash outflows but is a depletion in the value of assets which is a non-cash expense.
• Changes in working capital – Another reason which gave rise to the situation of net loss and the bank balance at the same time are the changes in working capital of the business. In accordance with the accrual system of accounting, the purchases from the creditors which relate to the specific p[period and the sales made to the debtors which relate to that specific period, are all included in the profit and loss statement which has affected the profit. On the other hand the bank account reflects only those items of sales and purchases for which the payment has been made in the given period. Thus the trade receivables and trade payables of the current as well as previous period affect the net profit as against the bank balance 0 of the business (Szpulak, 2015).

Thus, it can be said that the even after the net loss in the statement of profit and loss, the business may have positive bank balance due to the above mentioned reasons. Hence it can be concluded that the interpretation which believes that net loss and bank balance cannot be reported simultaneously in the books of accounts, is an accounting misconception. This is not an error, omission and misstatement of accounting or financial information or data (Xie, 2015).

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Portfolio 4 - Interpretation of Final Accounts

Calculation of Ratios

Report on company’s performance

Ratio analysis is the technique or method which is used to interpret the financial statements of a company with regards to its financial performance. Ratios are used to define the efficiency of operations of business, profitability potential, liquidity position and gearing capability. The ratios calculated above for Luxury Inn for last two years indicate the financial reporting performance of company during the period of two years as follows:

• Profitability – The return on capital employed was 30.95% in 2014 which declined substantially to 18.82% during 2015. Also the net profit margin as well as gross profit margin of the company declined to a large extent during the current year as compared to previous year. However, even after the decline the returns in form of net profit and gross profit are high. This shows that the company has a high profit potential even after decline in profitability ratios during the year.
• Liquidity – During the year 2015, both the current ratio as well as liquidity ratio which is also known as quick ratio have increased for the company as compared to previous year. The current ratio increased from 1.24 to 1.66 whereas the liquid ratio increased from 0.48 to 0.67. This means that the current assets of the company are sufficient enough to finance its current liabilities and thus the company has a sound liquidity position.
• Efficiency – The number of outstanding trade receivable days for the company has increased from 32 days to 48 days and the number of outstanding trade payable days has declined from 123 days to 104 days. This means that the efficiency of operations of company has deteriorated since the payment days to creditors have increased on one hand and on the other hand the receipt days from debtors have decreased at the same time. This indicates deficiency in operations (Cordis, 2014).
• Gearing – During the year 2014, the company did not have any gearing as there was no fixed interest bearing funds in that year. During the year 2015, the company acquired long term debts amounting to £50,000 which increased the capital gearing of the company with the gearing ratio of 15.90. Thus the capital structure of the company which comprised of only equity capital previous year, now also includes fixed interest bearing funds as debts.

Thus, on the basis of analysis of financial ratios of the performance of company during the period of two years, it can be concluded that the profitability and efficiency of operations of company have declined during the period of two years, but the company has maintained sound liquidity position for both the years. Also in spite of decline in profitability, the rate of returns and profit margins are higher which means that the company has a high growth and profit potential (Dickinson, 2012).

Conclusion

From the above discussed accounting portfolios which include preparation of final accounts of a sole trader, scenario with regards to a situation of accounting misconception and ratio analysis for the comparison of performance of a company for two years on the basis of financial data, it can be concluded that the accounting information which relates to a business is an important factor which determines the relationship of business with its stakeholders. It can also be concluded that this assignment has been able to develop the understanding of financial accounting methods and principles.

References

Cairns, R.D. 2013, "The fundamental problem of accounting", Canadian Journal of Economics/Revue canadienne d'économique, vol. 46, no. 2, pp. 634-655.
Cordery, C.J. & Sim, D. 2014, "Cash or accrual: What basis for small and medium-sized charities' accounting?", Third Sector Review, vol. 20, no. 2, pp. 79-105.
Cordis, A.S. 2014, "Accounting Ratios and the Cross-section of Expected Stock Returns: ACCOUNTING RATIOS AND EXPECTED STOCK RETURNS", Journal of Business Finance & Accounting, vol. 41, no. 9-10, pp. 1157-1192.
Dickinson, V. & Sommers, G.A. 2012, "Which Competitive Efforts Lead to Future Abnormal Economic Rents? Using Accounting Ratios to Assess Competitive Advantage", Journal of Business Finance & Accounting, vol. 39, no. 3?4, pp. 360-398.
Richardson, S., Tuna, ?. & Wysocki, P. 2010, "Accounting anomalies and fundamental analysis: A review of recent research advances", Journal of Accounting and Economics, vol. 50, no. 2, pp. 410-454.
Szpulak, A. 2015, "Evaluating net investments in the operating working capital under certainty: The integrated approach to working capital management", Business and Economic Horizons, vol. 11, no. 1, pp. 28-40.
Xie, Y. 2015, "Confusion over Accounting Conservatism: A Critical Review", Australian Accounting Review, vol. 25, no. 2, pp. 204-216.