Accrual Accounting and Stakeholders

Assignment 01

Part A

1(a). A stakeholder is any individual or entity that has an interest in the success or failure of an enterprise or venture. Stakeholders have a significant influence on decisions relating to the financial and operational aspects of an organization (Smart, Awan & Baxter, 2013). Some of the notable stakeholders who have an interest in accounting information include owners and investors, managers, creditors and lenders, employees, and the government.

1(b)

Owners and Investors: Owners need accounting information to decide whether they should use additional resources in the business or invest elsewhere. This is dependent on the profitability of the overall business, and such information will be derived from the income statement. Investors rely on accounting information to decide whether investing in the business is a good fit in their investment portfolio or not (Smart, Awan & Baxter, 2013). They will use the balance sheet to assess the financial position of the company and the income statement to assess the stability of business revenues and hence the risk of investment.

Managers: The budget preparation process and monitoring the implementation of the budget is a critical role of the managers and to make decisions on what items to include in the budget, accounting information is essential. To come with reliable estimates of costs and revenues, the managers will heavily rely on the income statement, cash flow statement and balance sheet.

Creditors and Lenders: Before extending loan or credit facilities to business, creditors and lenders must evaluate the business’ creditworthiness (Smart, Awan & Baxter, 2013). Creditors and lenders will, therefore, require information on liquidity and securable assets which are obtained from the statement of financial position.

Employees: Before and after joining a company, an employee will evaluate the financial health of the business to determine his/her job and income security and stability. Profitability and employee benefits (which can be extracted from the income statement) are essential when making this decision.

Government: To ensure all businesses comply with established laws, rules, and regulation, the government must first decide the sizes of each business and what regulations apply to them. The net profit is usually used to determine the sizes of enterprises, and it is extracted from the statement of comprehensive income or the income statement.

1(c). Current and Prospective Investors

Current and prospective investors are interested in the profitability and risk of their investments. Current investors will use this information to decide whether to increase or decrease their investment in the venture while the prospective investors will rely on this information when deciding the fitness of the intended investment in their portfolio.

1(d). Managers have three general information need, that is, to plan, monitor, and make strategic decisions. Planning involves the allocation of resources towards achieving the business objectives such as through the budgetary process (Smart, Awan & Baxter, 2013). Monitoring involves ensuring that the allocated resources are not only used well but effectively. Making long-term decisions entails forecasting future events and their effects and making sure the business doesn’t sink because of such occurrences. Managers use accounting information to perfect these three critical aspects of management and to ensure the decisions they make are backed by reliable estimates.

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1(e). Solvency refers to the ability of a business to meet its long-term financial obligations. It determines the ability of the business to continue operations into the foreseeable future. If the business is having solvency problems, it could be declared insolvent in the foreseeable future, and the creditors will lose their loaned funds. Security, on the other hand, relates to the size and value of assets that can act as collateral for the credit facilities extended (Smart, Awan & Baxter, 2013). If the assets have low market value or the business lack title to them, the creditors will not be able to recoup their loaned funds if the business is liquidated or declared insolvent.

2. General Purpose Vs. Special Purpose Financial Statements

A special purpose financial statement is prepared and presented to a limited number of users and for a special purpose. Tax reporting, bank reporting, and industry-specific reporting are some of the specific purposes for which specific-purpose financial statements. General purpose financial statement, on the other hand, are prepared and presented to an open-ended number of users and for the provision of financial information about the reporting entity (Garrison, 2010). They are issues throughout the year and include statement of financial position, income statement, statement of changes in equity, and cash flow statement. The significance of this distinction is to ensure the businesses not only meets its reporting requirements but provide relevant information to all and intended stakeholders.

3. Steps to Ensure Reliability of Financial Statements

To ensure financial statements are reliable, they should be presented free of errors. Training of accounting staff is the first step in ensuring the financial statements are accurate and free of errors. After training, the staff should be monitored, and their work regularly reviewed to avoid erroneous financial reporting (Collins, 2012). This two steps will ensure the process of capturing transactional data is accurate, the codification of the data is reliable, and competency of those reviewing the codified data is professional.

4. Implications of Following Assumptions/Principles

Going concern: the business will not under any circumstance be forced to liquidate its assets or to stop its operations in the foreseeable future. Therefore by relying on this principle accountants can defer revenue recognition until a later period.

Accrual basis: Revenue is recognized when earned despite when it is received and expenses deducted when incurred irrespective of whether it is paid or not. If a fiscal business year ends in December and an invoice is generated in November but actual pay received in January the following year, under accrual basis, the company will be forced to pay tax on that invoice even though it hasn’t received the cash.

Period Reporting: If the accounting period includes the preparation of internal reports frequently, such as weekly reports, it becomes challenging to measure and capture business performance effectively. This is because business activities will have to be captured and apportioned among the narrow period and one transaction may be allocated to more than one periods.

Understandability: The accountants responsible for the preparation of financial statements should prepare them with the view of the user as opposed to their own needs. That is, understandability of the financial reports by the intended users takes precedence over the accountant needs over such reports.

Relevance: The accounting information should be provided more frequently to ensure its relevance. This implies complicating the measurement of business performance since frequent preparation of reports leads to one transaction appearing in more than one period.

Reliability: Only those transactions which can be verified with objective evidence ought to be recorded in the financial reports. This implies forcing the business to keep track of all its purchase receipts, canceled checks, and promissory notes. It is also challenging to observe this principle when recording reserves such allowance for doubtful debts.

Comparability: Financial statements should be comparable across time and industry and must, therefore, be prepared using similar accounting standards and principles. This has the implication of denying business flexibility in changing its accounting methods since it has to consider what others in the industry or what the business is currently using.

5. Accounting Entity Concept

The business and its owners are treated as two separate parties in accounting. As such the entity concept states that transactions relating to the business owners should be recorded and reported separately from those of the business entity. This has the implication of dictating that different accounting records should be used to maintain the transactions of the business and those of its owners and the assets and liabilities of owners are entirely excluded from the business’ financial reports (Garrison, 2010). On the positive side, this concept has the implication of ensuring records of the business and the owners are not intermingled therefore easing the process of discerning the financial and taxable results of the business.

6. Monetary Convention

The monetary convention in accounting refers to the requirement that only monetary transactions ought to be recorded in the financial statements, and such transactions should be recorded in the same monetary unit to avoid confusion. The main advantage of this convention is to ensure the balance of transactions by converting all transactions into a single currency using a specified exchange rate (Needles, 2013). The rationale is that every transaction must have a value, that value should be converted into money, and the money must be converted into a single monetary unit.

7. Internal Control Measures

Segregation of duties: under this internal control measure, various steps in the accounting process are allocated to different people. This is done to ensure that no one single individual has absolute control over the process and cannot, therefore, engage in fraudulent activities. This has the implication of ensuring the recording, physical custody, and authorization to dispose and asset should not be done by one person.

Independent internal verification: This ensures that strict observance of rules and no employee in the organization is shortcutting the internal controls. Independent here means people who aren’t associated with the accounting department will audit the internal accounting controls and their effectiveness (Needles, 2013). This has the implication of strengthening the separation of duties by addressing the problem of collusion among accounting personnel to defraud the company.

Part C

1. Cash Vs. Accrual Basis of Accounting

The dissimilarity between cash and accrual basis of accounting rests in the timing of when revenues and expenses are recorded in the financial reports. Under the cash basis of accounting, revenues and expenses are only recorded when money is received or paid out. Accrual accounting, on the other hand, recognizes revenue when earned irrespective whether cash is received or not, and expenses when incurred but not necessarily paid for (Weil, 2013). The cash method is usually used by small businesses with annual profits of less than $5 million and for personal financial management. The accrual basis is a requirement under tax law for companies making more the $5 million in profits per year and only accounts prepared under accrual basis can be audited.

2. Capital Vs. Revenue Expenditure

The difference between capital and revenue expenditure lies in the usage of the assets, that is, whether they will be used over an extended period or a short period. Capital expenditure includes all fixed assets that are projected to be productive assets over a long period. Revenue expenditure, on the other hand, includes costs related to specific items or operating periods such as repairs and maintenance costs (Warren, 2013). While revenue expenditures are expensed in the current accounting period, capital expenditures are depreciated over a long period

The distinction between revenue and capital expenditures is very crucial since the way these expenditures are treated and classified can adversely affect the financial health of a company (Warren, 2013). For instance, purchase of a production plant is a capital expenditure and the purchase cost should not be expensed in the year of purchase but should be gradually expensed via depreciation over the useful life of the plant. Expensing such an expenditure in the year of purchase may lead to a company reporting a net loss when in essence it made profits.

3. Accrual Accounting

Accrual accounting requires businesses to record revenues when they are earned (when a sale occur) and expenses when incurred (when billed). The timing of actual payment or receipt of money in these transactions is not essential (Weil, 2013). That is, revenues and expenses are recorded in the accounting period when they are earned or incurred, and the actual payments and receipt of cash may be in a different accounting period. Similarly, companies are required by GAAP to match their expenses with revenues, that is the matching principle. Under this principle revenues and expenses should be recorded at the same time.

References

Collins, D. L., Pasewark, W. R., & Riley, M. E. (2012). Financial reporting outcomes under rules-based and principles-based accounting standards. Accounting Horizons, 26(4), 681-705.

Garrison, R. H., Noreen, E. W., Brewer, P. C., & McGowan, A. (2010). Managerial accounting. Issues in Accounting Education, 25(4), 792-793.

Needles, B. E., Powers, M., & Crosson, S. V. (2013). Principles of accounting. Cengage Learning.

Smart, M. J., Awan, N., & Baxter, R. (2013). Principles of accounting (5th Ed.). New Zealand: Pearson.

Warren, C., Reeve, J. M., & Duchac, J. (2013). Financial & managerial accounting. Cengage Learning.

Weil, R. L., Schipper, K., & Francis, J. (2013). Financial accounting: an introduction to concepts, methods, and uses. Cengage Learning.