Anoa viewed accounting from four angles. As an activity performed by accountants and their surrogates; as a system comprising several interrelated and inter-dependent parts; as a technique of management; and as a discipline of study, It is in the light of the third perception of management that accounting is being viewed in this topic.
The American Institute of Certified Public Accountants (AICPA) has defined accounting as “the art of recording, classifying and Summarizing in a significant manner and in terms of money, transactions and events which are in part at least of a financial character and interpreting the result thereof.
The American Accounting Association (AAA) sces accounting as the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information”.It is important to note that neither book-keeping nor finance is synonymous with accounting, Book-keeping is the record making phase or documentation phase of accounting, Accounting involves both book keeping as well as the analysis and interpretation of the records so kept.
There are two basic functions of accounting, These are the planning function and the control function. The planning function of accounting helps to capture in quantitative terms the managerial decisions and the impact they have on such variables as cash flow, cost or profits.
The planning function helps to identify the financial implication of future transactions, For this purpose it is necessary to prepare pro-forma or projected financial statements such as trading, profits and loss accounts, funds flow statement and the balance sheet.
The control function of accounting helps to ensure accountability for resources vested in the care of managers. Managers are held accountable for being competent, diligent, and honest. Accounting provides the scorecard and auditing is designed to ensure that the scorecard is correct.
Auditing is the analytical process of gathering sufficient evidential matter on a test sampling basis to enable a competent professional to express an opinion as to whether a given set of financial statements meets established standards of financial reporting.
Basic Records of Accounting
In order to accomplish the planning and controlling aims of accounting a number of records, accounts and statements are kept. It is important to describe some of these here. Readers are advised to consult accounting texts to further appreciate their practical use.
Ledger
This is the principal book of account where accounts are maintained for assets, income, expenses, and also organisations or individuals who may be debtors or creditors to the organisation.
Journals
The journals are .subsidiary books of accounts because they exist to provide periodic total for posting into the ledger. The journals include purchases day books- for recording daily purchases, sales day book-for daily sales and general journal – a multi-purpose book for recording items not categorised as sales or purchase.
Trial Balance
This is two-sided record or list of all balances in the ledger accounts of the firm. It is used to check if the totals in the credit and debit sides of firm books are correctly recorded and thus equal. Where an inequality exists an error in one or more of the accounts subsist although the equality of the two sides may not necessarily imply correctness of the account.
Trading, Profit and Loss Accounts
The trading account is used to determine the gross profits of the trading company. It gives the difference between the revenue from sales and the cost of making such sales. The profit and loss account is used to determine the net profit or net loss from operations. It gives the difference between the gross profit and the operating expenses.
Manufacturing Account
This is prepared for a manufacturing establishment alongside the trading, profit and loss account to help, in the determination of the total cost of production. The cost of production is made up of prime cost and factory over head expenses. Prime cost includes the cost of direct materials, direct labour and, direct expenses.
Balance Sheet
The balance sheet is an abstract of balances of all assets and liabilities of a firm as at a particular date. Assets are tangible and intangible things of value owned by the firm. Liabilities are short-term and long-term borrowing and credits provided by outsiders to the company.
Funds Flow Statement
Funds are the total value available to an entity for the pursuit of its objectives. The funds flow statement is a tool for establishing the liquidity position of the firm it therefore to confirm the liquidity decision of the firm. It shows movement in and out of cash.
Management Use of Accounting Information
The output of the accounting procedure is the provision of accounting information with regards to revenue cost, profits, funds, assets and liabilities. On the basis of information so provided management can take a decision to improve performance.
Accounting information helps the rational manager take decision on the utilisation of the firm’s scarce resources. The ability to effectively use accounting information depends to a large extent on the analytic capability of management.
Ratio analysis is the analytic tool used by management to bring out.for interpretation the salient information hidden in accounting records. It is .convenient to classify accounting ratios into short-term solvency, long term solvency; and profitability ratios.
Short-Term Solvency
This measures the ability of the firm to meet short-term financial obligations. Short-term solvency ratio include.
(i) Current Ratio: This is the ratio of total assets to total liabilities. It indicates the company’s ability to meet current obligations out of its current resources. The safe ratio depends to a large extent on the nature of the firm’s business. Notwithstanding, a current ratio of greater than two is needed to provide a margin of safety.
(ii) Acid-Test or Quick Ratio: The acid test ratio is a further test of liquidity based on the belief that stocks take longer time to realise during liquidity crisis. Quick ratio is the ratio of current assets less stock to current liabilities. A ratio of greater than one is convenient to guarantee liquidity
Long-Term Solvency
This measures a firm’s ability to meet its obligations to pay interest and principal on long-term debt. The ratios include
(i) Times Interested Earned: this is the ratio of earnings before interest and taxes to the interest on long-term debt. The higher the number of times interest is covered by earning the more certain interest on debt would be paid.
(ii) Debt Ratio: This measures the safety of principal or debt. It is the ratio, of long-term debt to total long-term capital of the firm. Long-term capital is made up of long-term debt plus Owners’ equity made up of ordinary shares, preference shares
and retained earnings. An acceptable level of the debt ratio depends on the stability or volatility of the industry. However, a ratio greater than 50% may potent dangers.
Profitability
This measures the profitability of sales or assets of the firm. There are two forms of profitability ratios. The first is the percentage of sales ratio and the second the return on investment. Percentage of sales method express a variable as a percentage of sales to determine the movement over time which may indicate decline or improvements. The ratios include
(i) Cross Profit Percent: The ratio of gross profit to sales. The higher the ratio, the higher the gross profits from sales.
(ii) Net Profit Percent: The ratio of net profit to sales. The higher the ratio the lower the operating expenses.
(iii) Operating Expenses Percent: This is a complement of net profit percent. The higher the ratio, the higher the operating cost and the lower the net profits.
The return on investment ratios takes account the amount of capital invested and indicates the profit earned on the investment as a percentage yield. The ratios include:
Return on Total Assets
This is the ratio of earnings before interest and tax (EBIT) or the operating profit to total assets. The ratio measures the earnings power of the assets of the firm. The ratio may also be obtained for earning after tax.
Return on Equity (ROE)
This is the ratio of net income (less preferred dividends to equity capital.
Earnings Per Share (EPS)
EPS is net income less preferred stocks dividend divided by the number of common shares outstanding. The higher the EPS given an amount of shares the higher the profitability of the equity- share capital.
Price Earning Ratio: This is the ratio of the market price of the stock to earning per Share. An increasing price earnings ratio implies that the market value of the firm’s assets is increasing as a result of proper management.
Summary
This chapter looks at the two related but distinct activities of management-Accounting and Finance. Finance was conceptualised as the money used in business as well as the activities involved in managing the money to ensure profitability and liquidity of operations Accounting includes the recording, classifications, summarizing and interpretation of the monetary transactions of a firm. The management use of accounting and records of accounting as they relate to managerial decisions was also discussed.