19 Financial Accounting

P.G. Padma Gowri

Introduction:

Accounting has rightly been termed as the language of the business. Like language accounting also communicates the results of business operations to various parties who have some stake in the business viz., the proprietor, creditors, investors, Government and other agencies.

The main purpose of financial accounting is to ascertain profit or loss during a specified period. Accounting records are required to be maintained to measure the income of the business and communicate the information so that it may be used by managers, owners and other interested parties.

Objectives of Financial Accounting:

Accounting is a discipline which records, classifies, summarises and interprets financial information about the activities of a concern so that intelligent decisions can be made about the concern.

Book-keeping is a part of accounting and is concerned with the recording of transactions which is often routine and clerical in nature, whereas accounting performs other functions as well, viz., measurement and communication, besides recording. An accountant is required with a much higher level of knowledge, conceptual understanding and analytical skill than is required of the book-keeper

Accounting supplies the following information to the manager or the proprietor:

• How much the business has in the form of (a) fixed assets, (b) cash in hand, (c) cash at bank, (d) stock of raw materials, work-in-progress and finished goods?
• The businessman must know about his financial position i.e. where he stands? What he owes and what he owns?
• This objective is served by the Balance Sheet or Position Statement. The Balance Sheet is a statement of assets and liabilities of the business on a particular date. It serves as barometer for ascertaining the financial health of the business.

To ascertain the operational profit or loss: Accounting helps in ascertaining the net profit earned or loss suffered on account of carrying the business. This is done by keeping a proper record of revenues and expense of a particular period.

To facilitate rational decision making:

Accounting has taken upon itself the task of collection, analysis and reporting of information at the required points of time to the required levels of authority in order to facilitate rational decision-making.

Information System: Accounting functions as an information system for collecting and communicating economic information about the business enterprise.

Introduction to finance:

Finance has the objectives of meeting obligations, preventing insolvency and maintaining credit standing of the enterprise. Many policies are formed for adequate financing of the business. The programme concerning finance is presented through the preparation of the cash budget, the capital expenditure budget, and the revenue and expense budget.

Financial Planning:

Finance is an area of the business which is concerned with earning of spending, saving or investing, owning borrowing funds. Total resources of a business are invested partly in fixed assets in the form of fixed capital.

The amount of fixed capital is directly related to the system of production to be adopted, the nature of products to be manufactured and the extent of mechanization to be effected.

The term ‘funds’ means working capital.working capital requirements is obtained from the quantity, cost and time of manufacturing. In addition, purchasing and marketing practices cast a significant influence on the estimate of working capital needs.

Companies, the work of estimating capital requirements, or capitalization as it is called, is a direct upshot of calculating the expected return on investments. As one of the basic objectives of finance is to guarantee a certain minimum return on investments, the company’s capital structure mustbe designed on the bedrock of its anticipated income.

The amount of capitalization is determined by the totality of all such investments, with the exception of short-term investments made through temporary borrowings, all funds invested in the business are computed in what is meant by effective capitalization of a company

Whenever a company cannot pay the usual minimum rate of return on its investments, it is said to be over-capitalized. On the country, where company earnings account for more than usual rate, the enterprise is looked upon as an under-capitalized one.

Sound financing is to aim at effective capitalization, neither over-nor under-capitalization. But effective capitalization is also dependent upon determining a correct proportion of securities in the capital structure.

Financial Policies:

Finance is planned and controlled by formulating a number of policies for the guidance of all management members throughout the enterprise. For financing purposes, important terms may be briefly stated as follows:

Block Capital:

Block capital represents the amount invested in land and building, plant and machinery; office and factory equipment, furniture and fixture and other fixed assets of a sunk and tied nature. The investment in fixed assets influences the future success ofa business to a great extent, because scarce funds are sunk in the on-period of waiting.

Working Capital:

Working capital is taken to be the excess of current assets over current liabilities. As current liabilities include bank credit and other short-term obligations which go to well the amount of current assets to an equal extent, it is shareholders and debenture holders who must be credited with supplying the amount of working capital.

Working capital policy centres round the availability of cash for meeting day-to-day expenses and obligations of the business. To ensure a steady supply of cash money, cash planning or budgeting is undertaken so that the normal working of the enterprise is not affected despite the requirement of occasional heavy payments for divided distribution, purchase of materials, acquisition of fixed assets etc.

Depreciation of Fixed Assets:

The policy questions in respect of depreciation relate to the rate of depreciation to be charged and to the investment of depreciation funds to be made in the business. Some fixed assets, particularly machines, have short lives because of their frequent design changes and improvements.

Such assets are to be depreciated at a heavier rate so as to write off their valuewithin a short period. Depreciation reserves provide the largest single source for the financing of new plant machinery on the part of established concerns.

Profit Disposition

Policy issues in relation to the profit disposition are concerned with determining the amount of profit to be held back as reserves and the amount to be distributed as dividends.

Retained profits permit the company to become financially solvent, to improve the market standing of products, to expand production and marketing facilities and to pay a stable rate of dividend.

Internal financing is controlled and circumscribed by the policy for divided distribution. For the fulfilment of one basic financial objective, companies are required to pay a certain minimum return to their investors.

In the absence of the profit distribution, companies can never be assured of having any additional capital from investors in the future. For ensuring a steady supply of capital, companies are therefore required to distribute reasonable dividends among their shareholders. To serve as an investment appeal, the rate and frequency of dividend distribution are material questions.

Accordingly, a sound dividend policy is one which calls for the regular distribution of profit at an increasingly higher rate. But policy questions vary according to the nature of the company, whether closely held or publicly held.

Organizing for Finance:

The finance department requires an effective organization structure for performing multifarious activities involved in this area of the business. Various finance activities are organized according to the nature and size of the business.

The process of division and subdivision of activities is a matter of workload and the competence of finance personnel. For a medium-sized concern, the usual organizational arrangement is explained by the diagram.

The finance department is generally headed by a director or a controller. Whatever might be the title, the departmental head is a finance manager who has an overall responsibility and authority for this segment of the business.

As can be observed from the diagram, total activities are divided into three major groups which are assigned to three different subordinate managers under the title of assistant controllers and the treasurer.

The first group of activities is concerned with accounting is placed under the charge of a chief accountant who sources necessary co-ordination in his section. As financial accounting has two important functions, viz., record keeping for shareholder’s information and for tax computation, it is bifurcated into relevant parts. The cost accountant is responsible for cost finding and for assisting his superior manager, i.e, the assistant controller, in exercising cost control over the whole organization.

Under the second group of activities, the work of budgeting, budgetary control and internal auditing is encompassed. Budgetary control is exercised by the second assistant controller with the help of the budget section. The internal control section is concerned with internal auditing which appraises both the operational and financial aspects of the organizational performance.

Usually, in addition to giving a general assistance for the exercise of budgetary and cost control, the internal control section reviews policies, procedures and methods so as to keep them in tune with time and circumstances. The last group of activities centres round cash handling and credit management in the enterprise.

FINANCIAL CONTROL

Controlling a activities of the finance department of the business are effected by a number of tools like budgetary control, cost control, break-even point analysis , profit and loss control, return on investment, internal auditing and ratio analysis.

Ratio analysis involves the calculation of both operational and financial ratios.

SAMPLE: BALANCE SHEET:

At the end of the financial year

Total asset = total sources of finance-A balance sheet lists what a business owns and owes

Ratio Analysis:

1. Current assets to current liabilities.

The excess of current assets over current liabilities represents the amount of working capital, or net working capital as it is differently known. Because of this interrelationship, this ratio is also referred to as the working-capital ratio. Since current liabilities are met from the realized funds of current assets, this ratio indicates the working-capital position and expenses.

Above balance sheet: 1,80,000/80,000

Cash and bills receivable to current liabilities

The amount of working capital alone cannot indicate the solvency of a business, but the more important question is whether current assets are held in the liquid form or not. If working capital is tied up in inventories and accounts receivable which cannot be converted into cash promptly, the enterprise may fail to honour its obligations for the want of cash funds.

Cash is the most crucial component of working capital, current assets which are already realized or easily realizable in cash are utilized in computing a different ratio of such current assets to current liabilities. The solvency of the business is better tested by this ratio, and as such it goes by the name of acid test ratio.

Fixed assets to tangible net worth:

The term “tangible net worth “has a different connotation from that of net worth. When the net worth of an enterprise is reduced by the amount of intangible and fictitious assets like goodwill, patent rights, preliminary expenses, commission and brokerage on shares, etc., the difference represents the amount of tangible net worth. In the above balance sheet, the net worth of the business is Rs.1, 80,000, but tangible net worth is Rs.1,70,000. And this ratio figure stands at 12 to 17 or 70.6 %( per cent).

Current liabilities to tangible net worth:

As pointed out in the previous ratio, if fixed assets absorb too great a part of the net worth the enterprise is forced to increase its liabilities, whether current or fixed, for inflating the value of current assets.

But increasing current assets through the expansion of current liabilities is a deceptive practice and it does not improve the net working-capital position because the excess of current assets over current liabilities is what is meant by real working capital.

Fixed liabilities to working capital:

Effective working capital does not increase by securing funds from short-term loans. On the contrary, it is financed from the net worth and fixed liabilities of the business. It is apparent from the given balance sheet that net working capital is Rs.1,00,000 which is the difference between current assets and current liabilities. The aggregation of working capital and fixed capital, as represented by fixed assets, comes to Rs.2, 20,000. And this entire amount is financed from the net worth and fixed liabilities of the business, i.e., the sum total of Rs.1,80,000 and Rs.40,000.

Total liabilities to tangible net worth:

The ratio of total liabilities, both current and fixed to tangible net worth explains the relative use of owned funds and borrowed funds in the enterprise. The larger the proportion of borrowed funds to owned funds, the higher becomes the speculative character of the business.

Sales to tangible net worth:

The ratio of sales to tangible net worth indicates whether sales of a particular year are adequate for the amount of ownership investment or not. Since capital are primarily effected for obtaining certain returns thereon, and since the business makes earnings through the sale of products or services, it follows that increased investment.

Sales to working capital:

As the major part of working capital is supplied by owners, it is to be seen by them how sales are related to working capital. Working capital represents the value of net current assets, i.e. current assets minus current liabilities. By linking sales to working capital, the use and turnover of current assets can be tested and the managerial performance revealed.

Sales to finished-products inventory:

It is a ratio for testing the operating efficiency of an enterprise rather than for finding the inventory turnover of finished products. Since the stock-in-trade, as shown in the balance sheet is valued at the cost price, no effective comparison can be made with sales which are at selling price.

Materials used in production to materials Inventory:

As investments in raw materials absorb a significant part of capital, this ratio is compiled to see whether materials have been utilized properly or not. Like the inventory turnover of finished products, the turnover of materials inventory is calculate

Net profit to tangible net worth:

For all practical purposes, this ratio indicates the return on investments in a business. As the comparative progress of the business can be measured by the return on investments, this ratio finds application in both large and small business undertakings.

Conclusion:

Financial accounting aims at providing financial information to people outside the business.In this lesson we are concerned only with financial accounting. Financial accounting is the oldest branch of management and other branches of management have developed from it. The objects of financial accounting, are stated above can be achieved only by recording the financial transactions in a systematic manner according to a set of principles. The art of recording financial transactions and events in a systematic manner in the books of account is known as book-keeping.

In addition with the record of transactions, the recorded information has to be classified, analyzed and presented in a manner in which business results and financial position can be ascertained.

Web links:

• https://en.wikipedia.org/wiki/Financial_accounting https://en.wikipedia.org/wiki/Accounting
• www.learnfinancialaccounting.com/textbooks.html financialaccounting.ua.edu/policiesandreferences/
• www.oxfordreference.com/view/ https://www.utmb.edu › Finance › Accounting