This report intends to give a brief financial outlook of company E 215. The report starts with an introduction of a number of traditional accounting concepts and international accounting standards that are applicable in preparing the financial statements of Company E 215. It also gives the main characteristics of financial statements that make them useful for their intended users along with a brief review of the main users of financial statement users. The role of external auditors is also reviewed along with its relationship to internal auditors and the difference in scope of work of internal and external auditors. The report concludes with an analysis of the financial statements of Company E 215 through a number of ratios.
Task a)
A number of traditional accounting concepts have been applied in arriving at the information presented in the trial balance and the adjustments there of. Following is a brief description of each concept along with the calculations to arrive at the final figures to be presented in financial statements.
Going Concern: Going concern infers that "the business is going on steadily trading from year to year without reducing its operations." (Financial Accounting QCF Level 6 Unit, p14)
It implies that all non-current assets should be measured at their net book value (cost less accumulated depreciation) rather than on a break up basis. The treatment of tools & equipment and vehicles is in accordance with the going concern concept.
Matching Concept: Matching concept infers that "the revenue earned in a period to be linked with related costs." (Financial Accounting QCF Level 6 Unit, p17)
Matching concept is regarded same as the accruals concept and it gives rise to accruals and prepayments in the balance sheet. The treatment of Insurance, Travel & Subsistence and Provision for Corporation tax is in accordance with the matching concept.
The insurance premium includes a premium of £2,196 but the whole of this premium doesn't relate to this year's revenue so we'll only recognize the amount that is related to this year. As a result, we'll reduce the insurance premium by the amount that doesn't relate to this year and recognize same amount as a prepayment, £549 (£2196 X 3/12). The insurance premium will be recognized in an amount of £6,018 = £6,567 - £549.
Travel & Subsistence expense excludes a transaction of £1,278 since it wasn't paid but we'll recognize this amount in accordance with the matching concept because it related to this year's revenue. So Travel & Subsistence expense will be recognized in an amount of £19,619 =£18, 341 + £1,278
Debenture interest for the year is £3,150 = £45,000 X 7% but it is recognized in trial balance at an amount of £1,575. We'll recognize the whole amount of debenture interest since the whole expense is incurred in earning this year revenue so the debenture interest for the year will be £3,150.
The Provision for Corporation Tax during the year is £24,873 and we'll recognize the whole amount as an expense since it related to this year's revenue and profit.
Business Entity Concept: Business entity concept infers that "the affairs of a business are distinguished from the personal affairs of the owners." (Financial Accounting QCF Level 6 Unit, p18)
In accordance with the business entity concept, the capital (which includes the investment and retained earnings) is treated as a liability that is payable to the owner of the business.
Task b)
The following IAS needs to be applied to the adjustment in order to calculate the final figures to be presented in financial statements.
IAS 2 Inventory: IAS 2 deals with the treatment of inventory and requires that the inventory should be treated at the lower of cost and NRV. The treatment of closing inventory of £89,409 in adjustment 2 is in accordance with IAS 2. (IAS 2)
IAS 16 Property, Plant and Equipment: IAS 16 deals with the treatment of tangible non-current assets and require that these items should be valued at their net book value (Historical Cost less Accumulated Depreciation). The treatment of Vehicles and Tools & Equipment is in accordance with IAS 16. (IAS 16)
Tools & Equipment Motor Vehicles
Historical Cost £292,410 £268,600
Depreciation basis (Straight Line) 5% 25%
Depreciation (Cost X Dep. Basis) £14,621 £67,150
Accumulated Depreciation £63,494 £98,105
Net Book Value £228,916 £170,495
IAS 23 Borrowing Costs: IAS 23 deals with the treatment of borrowing costs and requires that borrowing costs should be capitalized if they relate to the construction of non-current asset. There's no such indication for the debentures of £45,000 and its associated cost of £3,150 so we'll expense the whole amount. (IAS 23)
IAS 12 Income Tax: IAS 12 deals with the treatment of corporation tax and requires that this year's income tax should be matched against this year's revenue in the statement of comprehensive income. In accordance with IAS 12, we'll expense the provision for corporation tax of £24,873. (IAS 12)
The treatment of Insurance Premium has already been discussed in task a.
Task c)
IAS 18 Revenue: deals with the treatment of revenue and requires that "Revenue shall be measured at the fair value of the consideration received or receivable." (IAS 18) Fair Value is generally the amount of cash or the amount at which an asset would be purchased or a liability settled between knowledgeable willing parties in an arms-length transaction. The sales revenue £423,677 has been recognized in accordance with IAS 18.
IAS 23 Borrowing Costs: describes the treatment of borrowing cost. The treatment of debenture interest is in accordance with IAS 23 and has been described in detail in task b.
IAS 37 Provisions, Contingent Assets and Contingent Liabilities: deals with the treatment of provisions and contingent items like provision for bad debts. The provision for corporation tax is in accordance with the treatment of IAS 37.
Task D)
IASB describes four main characteristics of financial statements.
Understandability: Understandability means that information presented to the users should not be so complex such that a user with considerable business, economics and accounting knowledge would not be able to understand it.
Relevance: Information should be relevant to its intended purpose. An important sub characteristic of relevance is Materiality which means that all information whose omission or misstatement could influence the economic decision of users should be presented in financial statements.
Reliability: Reliability is an important characteristic of useful financial statement and incorporates the following sub characteristics.
Faithful Representation: All information presented must represent faithfully its transactions.
Substance over Form: Information should represent the economic reality of transactions rather than mere its legal form.
Neutrality: All information should be free from bias and objective.
Prudence: Prudence requires that information should be presented in such a way that assets and income are not overstated and expenses and liabilities are not understated.
Completeness: All material information should be presented in financial statements.
Comparability: Information should be comparable over time and against other company's financial statements. (Financial Accounting QCF Level 6 Unit, p14-15)
Users of Financial Statements:
Equity Investors: Investors require financial information to make investment decisions regarding the company.
Banks and other Financial Institutions: Banks require financial information to assess whether the business will likely be able to repay its loans.
Creditors and Debtors: Customers and suppliers need financial information to keep an eye on the business and ensure that their own business may not be affected by the financial failure of business
Employees: Employee requires information to assess their job security and for future promotion and bonuses
Government: Government requires financial information through Inland Revenue to determine the tax liability of the business. (Financial Accounting QCF Level 6 Unit, p5)
Task E)
"An external auditor is someone from outside the company who investigates the accounting systems and transactions and ensures, as far as they are able, that the financial statements have been prepared in accordance with the underlying books, the laws and applicable accounting standards." ((Financial Accounting QCF Level 6 Unit, p24)
External auditors are not responsible to detect or prevent fraud. Compared to external auditors, internal auditors part of the company and they help to ensure the adequacy of internal controls within the company and to detect and prevent fraud. An external auditor need is a qualified accountant while there is no such requirement for internal auditors. External auditors report to the owners while internal auditors report directly to the management.
Task F)
Company 215 uses two main sources of long term finance.
Share Capital: Share capital is the main source of finance for companies. It is considered expensive compared to the loan capital because of the higher risk. Its big advantage is that management doesn't have to pay dividend each year and can skip dividend in case the company is short of cash. Another advantage is that shareholders are owners of the company and take part in decision making regarding appointment of the board of directors.
Debentures: Debentures are less expensive compared to share capital. Its second advantage is that the cost is fixed for debentures. The disadvantage is that the interest has to be paid each year even if the company doesn't earn any profit. Another disadvantage is that debenture holders are not owners of the company and don't take part in decision making.
Task G)
Analysis of Financial Statements: Company 215's financial statements show a good financial position. The statement of Comprehensive Income reports a healthy gross profit of £294,555 and net profit of £84,030. Depreciation represents more than 40% of total expense representing a good investment in tangible non-current assets. Statement of Financial Position also shows a healthy investment in non-current assets comprising 65% of whole assets. Retained earnings are 56% of total liabilities, representing a cash retention policy by the management.
Profitability Analysis: Profitability ratios show the ratio of gross and net profit compared to the revenue. E 215's reports a gross profit margin of almost 70% and net profit margin around 20%. Gross profit margin of 70% shows that the company is working at a higher end of the market, selling premium products which are mostly sold at a higher profit margin.
Liquidity Analysis: Liquidity ratios show the ratio of current assets compared to current liabilities. The current ratio of 1.9 represents that current assets are almost double compared to current liabilities which is a good sign for the company. The quick ratio of 1.1 also shows a good sign for the company's financial strength.
Efficiency Analysis: The efficiency ratio's show the quality of management in managing company's working capital i.e. receivables, payables and inventory. The receivables collection period shows how long it takes the company to recover its receivables while payables payment period show how long it takes the company to pay its current payables. Receivables collection period of 103 days and payables payment period of 182 days shows good control over receivables and payables. The inventory turnover period indicates how long it takes the company to sell its inventory on average. An inventory turnover period of 253 days represent that the company sells slow moving inventory, most probably premium products as indicated in the financial statement analysis
Gearing Ratio : Gearing ratio shows the ratio of loan capital to share capital in a company. A gearing ratio of 9% for E 215 represents that the company only uses 9% loan capital and the remaining of the capital is financed through shares.
Appendix:
Statement of Comprehensive Income for the year end 30 Apr 2006
Revenue 423,677
Cost of Sale
Opening Stock 41,214
Purchases 177,317
Closing Stock (89,409)
(129,122)
Gross Profit 294,555
Other Income
Interest Received 1,630
Expenses
Employee costs 50,317
Depreciation 81,771
Debenture Interest 3,150
Gas & Electricity 10,720
Insurance Expense 6,018
Rent & Rates 15,091
Travel & Subsistence Expenses 19,619
Sundry Expenses 596
Total Expenses (187,282)
Net Profit 108,903
Corporation Tax (24,873)
Net Profit After Tax 84,030
Dividends Paid (8,190)
Retained Earnings for the year 75,840
Retained Earnings b/f 271,857
Retained Earnings c/f 347,697
Statement of Financial Position as at 30 April 2006
Assets £
Non Current Assets:
Tools & Equipment 228,916
Motor Vehicles 170495
Current Assets
Trade Debtors 119,799
Cash 12,619
Stock 89,409
Prepayments 549
Total 621,787
Capital & Liabilities
Capital
Ordinary Shares 91,000
Share Premium Account 22,000
Retained Earnings 347,697
Liabilities
Non Current Liabilities:
Debenture 45,000
Current Liabilities:
Trade Creditors 88364
Corporation Tax 24873
Accruals 2853
Total 621,787
Ratios
Profitability Ratios
Gross Profit Margin = Gross Profit
Revenue
= 294,555 = 69.5%
423,677
Net Profit Margin = Net Profit
Revenue
= 84,030 = 20%
423677
Liquidity Ratios
Current Ratio = Current Assets….
Current Liabilities
= 222,376 = 1.91 Times
116090
Quick Ratio = Current Assets less Stock
Current Liabilities
= 132,967 = 1.15
116,090
Efficiency Ratios
Receivables Collection Period = Trade Receivables X 365
Total Sales
= 119,799 X 365 = 103 Days
423,677
Payables Payment Period = Trade Payables X 365
Total Purchases
= 88,364
177,317 X 365 = 182 Days
Inventory Turnover Period = Closing Stock X 365
Cost of Sale
= 89,409 X 365 = 253 Days
129,122
Gearing Ratios
Gearing Ratio = Loan Capital
Loan + Share Capital
= . 45,000
45000 + 91000 + 22000 + 347,697
= 9 %
