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Accounting and Financial Processes in an Organization

Abstract

Accounting and Finance is a very important function of any business either for profit-making or for non-profit making institutions. It provides an avenue where a business analyses its operations in terms of what they own, what comes, and what goes out. Butt(2008) defines accounting as ” a service activity [which] provides interested parties with quantitative financial information that helps them to make decisions about the deployment and use of resources in the entities and in the economy. As a descriptive/analytical discipline, it identifies the great mass of events and transactions that characterize economic activity and, through measurement, classification, and summarization, reduces those data to relatively small, highly significant and interrelated items that, when properly assembled and reported, describe the financial condition and results of operation of a specific economic entity.” This write-up looks deeper into the accounting and financial processes in an organization and the problems associated with these processes. The introduction part tries to look into the meaning of accounting and finance and the processes involved in each case. The main discussion focuses on a deeper diagnosis of the problems encountered in accounting and financial processes.

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Introduction

Accounting can be considered as consisting of two elements:

  • Recording the transactions of a business to provide information for day-to-day management.
  • Summarizing the transactions of a period to provide interested parties with information about the performance and position of an enterprise.

The purpose of accounting is to provide information to users of financial statements. Users of financial information include the management shareholders and potential shareholders, employees and their trade union representatives, lenders, and government agencies. Financial accounting is mainly concerned with the production of financial statements for users outside the organization, although the records from which the statements are prepared are, of course, also essential for the day-to-day running of the business. (Brealy,1999).

Accounting processes in an organization are listed below:

  1. Preparation of financial reports to all internal and external user groups.
  2. Preparation and control of budgets
  3. Pricing policies
  4. Capital investment appraisals.
  5. Management of working capital.

On the other hand, financial processes include the following:

  1. The setting of the company’s broad financial strategy.
  2. Decisions on major capital expenditure on new assets and the acquisition of other companies.
  3. Interpretation and implications of macro and micro economic-financial developments for the company.
  4. Implications for the company of Government economic and fiscal (tax) legislation and proposals.
  5. The dividend decision.

Limitations of accounting processes

When using accounting information, a problem arises as to what information is useful. Some criteria are listed briefly, together with problems in meeting them.

  • Relevance: The information should be relevant to the needs of the users so that it helps them to evaluate the financial performance of the business and to draw conclusions from it. A difficulty arises in identifying these needs, given the variety of users.
  • Understandability: The information should be in a form that is understandable by user groups. Users have very different levels of financial sophistication. Also, the very complexity of business transactions makes it difficult to provide adequate disclosure whilst maintaining simplicity.
  • Reliability: The information should be of a standard that can be relied upon by external users so that it is free from error and be depended upon by users in their decisions. However, the complexity of modern business makes reliability difficult to achieve in all cases.
  • Completeness: Accounting statements should show all aspects of the business. The only problem this leads to is the resultant volume of the information.
  • Lack of bias: Accounting statements should not be biased towards the needs of one user; they should be objective. The problem associated with this is that accounts are prepared by one user group, namely management. The external audit should remove this bias, but some authorities question the effectiveness of the audit in this respect.
  • Timeliness: Accounting statements should be published as soon as possible after the year’s end. There is a conflict between this criterion and that of reliability, in that quicker accounts mean more estimates, and hence reduce reliability.
  • Comparability: Accounts should be comparable with those of other similar enterprises, and from one period to the next. The main problem has been the use of different accounting policies by different enterprises. Accounting standards have reduced this problem but have not eliminated it.

According to Woods (1988), the present state of the art of accounting is such that we have not yet arrived at producing specific financial reports for each group of users, tailored to their special needs. At times, companies do produce special reports for certain groups of users. A bank, for instance, will almost certainly want to see a forecast of future cash flows before granting a loan or overdraft. The Revenue Authority will often require various analyses to agree on the tax position. Some companies produce special reports for the use of their employees. In total, such extra reports are a very small part of the reports which could be issued. To produce special reports, exactly tailored to every possible group of users, would be extremely costly and time-consuming. Most companies produce one set of accounts for all the users, with the exception that management will have produced its management accounts for its internal purposes. Such a multi-purpose document cannot satisfy all the users. Published accounts are, therefore, a compromise between the requirements of users and the maintenance of accounting concepts, subject to the overriding scrutiny of the auditor. Judgment forms so much a part of presenting information, that it can be said that if it were possible to have two large companies with identical share capitals, numbers of employees, fixed assets, turnover, costs, etc, the published accounts of the two companies would not be identical. Depreciation methods and policies may vary, as may stock valuation assessments, bad debt provisions, figures for revaluation of properties, and so on.

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Final accounts are only partial information. They show the reader of them, in financial terms, what has happened in the past. This is better than having no information at all, but one needs to know much more. There are a whole lot of factors that the past accounts do not disclose. The desire to keep the money measurement concept, and the desire to be objective, excludes a great deal of desirable information.

Some typical desirable information is listed below:

  1. What are the plans of the business? Without this, an investment in a business would be sheer guesswork.
  2. Has the firm got good quality staff?
  3. Is the business situated in a location desirable for such a business? A ship-building business situated a long way up a river that was becoming unnavigable could soon be in trouble.
  4. What is its position as compared with its competitors? A business manufacturing a single product, which has s foreign competitor which has just invented a much-improved product that will capture the whole market, is obviously in for a bad time.
  5. Will future government regulations affect it? Suppose that a business that is an importer of goods from country X, which is outside the EEC, finds that the EEC is to ban all imports from country X?
  6. Are its plant and machinery obsolete? If so, the business may not have sufficient funds to be able to replace it.
  7. Is the business of a high-risk type or in a relatively stable industry?
  8. Has the business got good customers? A business selling largely to country Y, which is getting into trouble because of a shortage of foreign exchange, could soon lose most of its trade. Also if one customer was responsible for, say, 60% of sales, then the loss of that one customer would be calamitous.
  9. Has the business got good suppliers of its needs? A business in wholesaling could, for example, be forced to close down if manufactures decided to sell directly to the general public.

Problems are concerned with the effects of distortion of accounting figures caused by inflation (or deflation).

Ballwieser (n.d) states that “The function of financial reporting is to provide information that is useful to those who make economic decisions about business enterprises and about investments in or loans to business enterprises.” From a theoretical point of view, it is not clear if and how these objectives can be achieved by financial reporting.

He [Ballwieser (n.d)] goes ahead to say that contracting partners of an enterprise are constantly making decisions. For example, owners must decide whether to remain owners or exit from ownership, whether to employ new managers or keep the existing ones and what the remuneration policy will be for managers. To make such decisions, owners need information about the enterprise and the management’s performance. A standard-setter of financial reporting rules cannot know in advance what information is useful in the sense just described because usefulness depends on individual decision contexts. If he ignores information costs, an individual decision-maker would prefer finer, more accurate information systems to coarser information systems. But the ordering of information systems concerning fineness is incomplete, and many users with different orderings will run into the choice-paradox to Arrow, as Demski (1973) has shown, the choice paradox means that if decisions follow simple majority rules, even if there are transitive individual preference orderings, the collective preference ordering can be intransitive. The individual decision model is excellent for explaining the concept of decision usefulness, but it cannot advise a financial reporting standard-setter. Therefore, we need another approach.

It is plausible to assume that as a measurement of their economic wealth, owners are interested in the market value as an approximation of the potential market price of their enterprise. If management increases the market value by taking actions with a positive net present value, rather than by using accounting gimmicks or cheating owners and others, this is a good sign (Ballwieser [n.d]). Ballwieser further goes ahead to give reasons for the difference between book and (potential) market value of equity as the accounting principles that govern financial statements:

  1. Assets and liabilities are usually measured by a mixture of historical costs and fair values. Fair values are often only used when they are less than the carrying amounts of assets because the anticipation of unrecognized profits is avoided. The lower-of-cost or market rule leads to asymmetric handling of fair values and of expected losses and profits. Historical costs no longer represent fair value after an asset has been acquired or produced, and they differ from the value in use of an asset.
  2. Assets are normally measured using an individual valuation that is an item-by-item approach, which does not take into consideration the synergies between assets.
  3. In general, self-produced goodwill must not be recognized, because of the concept of reliability of financial statements. Self-produced goodwill is the difference between the value of the firm, measured by discounting estimated future cash flows to equity, and the book value of equity, where fair values are used to measure assets and liabilities. The estimation of future cash flows is to a great extent subjective and conflicts with the principle of using reliable data and giving reliable information to the users of financial statements.
  4. According to some regulations, for example, U.S. Generally Accepted Accounting Principles (GAAP), firms are not allowed to write up an asset in the case that the reasons for impairment no longer exist.

Income measurement

Income is a change in wealth. Therefore, it does not make sense to distinguish between wealth and income measurement at first glance. But a second look shows that “good” income measurement can require balance sheet positions that can hardly be interpreted as assets or liabilities.

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Assume that the financial accounting standard-setter wants users of income statements to be able to extrapolate the actual income figure into the future, which would be a certain kind of predictive ability. Then it would be harmful if formation expenses, expenditure on start-up activities, or costs of raising equity were expensed in the year of formation. This expense would lead to a single, one-year reduction of income that cannot be expected again in the future. The Framework of the IFRS defines an asset as “a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise.” What resource has the enterprise gained by formation? Is it the existence of the enterprise? What is the value of existence? Is it the formation costs? As IAS 38.57 shows, those formation or start-up costs do not represent assets in the IAS sense. They must be expensed, whereas equity costs are deducted from equity capital (Standards Interpretations Committee, SIC-17.6). There have been concepts developed in accounting theory on what kind of information should be provided by an income figure. For example, the income could be understood as an approximation of the average payments that owners could expect if the sales of the actual year were to be the same for all future periods. But this income could only be shown under very restrictive assumptions, and the duty to show such an income would ignore all the agency problems between owners and management that result from information asymmetry and different goals. What incentives would the management have to give such information truthfully? The problem inherent in a prediction of cash flows using financial statements is that there is no discussion of how we can learn about the timing and uncertainty characteristics of the cash generation. Assets and liabilities contain no explicit information about the time structure of future cash flows. Of course, if the user of financial statements looks at inventories, he or she expects cash inflows that are near to the period of the current financial statements. But does this mean that non-current assets do not support cash inflows within the near future?

Budgeting is an important process in accounting and finance. However, budgeting managers always make several mistakes in the process. Some of these pitfalls are listed below:

  • Overestimating revenue: budgeting managers always make the mistake of overestimating the revenue for the unit. The estimates should always be conservative and backed up by details that clarify the assumptions for the stated revenue goal.
  • Postponing a problem: when taking new budget management responsibilities, financial managers try to apply the strategy of postponing. Avoidance only causes problems.
  • Failing to ask for help: fear of looking foolish is no excuse for not asking for help when it is needed. The greatest skill that a financial manager can have is recognizing an issue before a larger problem. The second greatest skill is asking for help to solve the problem.
  • Failing to identify hidden costs: all programs have hidden as well visible costs. Hidden costs usually involve space and other overhead issues; when budget proposals to support new programs are presented, those hidden costs must be identified.
  • Failing to plan for the end: financial managers dealing with grant funds often encounter this shortcoming. When the grant is awarded, euphoria is high and it is difficult to get persons involved with the grant to engage in developing alternate scenarios for the end of the funding period.
  • Failing to identify multiyear consequences: both people and programs change. And the wise financial manager views change through the lens of multiple-year fiscal consequences.
  • Failing to understand implications for others: there are both intended and unintended consequences for any decision. Part of the task of a financial manager is to minimize the unintended consequences of a decision for the entire institution.
  • Assuming the good times will continue: assuming that budgets will constantly increase and that inflationary allocations will also be provided is a major error in budgeting. The astute financial manager should develop plans to include a downturn in the funding picture for the organization.

Connect using

The financial management function can be divided up into five principal areas:

  1. Translating the company’s business plan into a financial plan.
  2. Evaluating the financial plan to ensure its validity, given the company’s objective as far as shareholder wealth maximization is concerned.
  3. Ensuring that sufficient finance is made available to undertake the planned activities.
  4. Controlling the plan’s implementation.
  5. Reporting the outcome of the business plan’s implementation to all interested parties.

References

ACCA (2001), preparing financial statements, Foulks Lynch Ltd Middlesex.

Butt, D. (2008): Accounting Web.

Leuz,C.,Pfaff, D. and Hopwood A.(n.d); The Economics and Politics of Accounting, 2008. Web.

Lumby, S;Investment appraisal & financing decisions, 3rd ed. Van Nostrand Reinhold (international).

Manas’she,P. a text book of business finance (revised version, 2004/2007), Mcmoore Accounting books, Nairobi. Kenya Questia On-line Library; Wood,F. (2000), Financial Accounting 5th ed, Longman publishers, Hong Kong.

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