Last Updated 10 Aug 2020

Accounting For Non-Specoalists

Category Accounting
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Accounting is indeed of great importance to any business organisation. It is the lifeblood of any business as its helps managers to keep track of what is going on in their organisation and to structure information in a clear and consistent manner. Companies use accounting to make decisions and to communicate information about their business to outsiders including regulators, investors and general public.

In general, accounting is defined “either as the art of recording, classifying, and summarizing (in monetary terms) transactions and events that are of a financial character or as a service activity whose function is to communicate quantitative information (primarily financial) about economic entities to assist in decision making” (Belkaoui & Monti-Belkaoui 1991:138).

The main function of the accounting profession is to collect and organize information about a business. The accountant is a reliable source of important information that is expressed in numbers and organized in a clear format, according to specified guidelines. This makes understanding and exploration of this information much easier. The accountant provides the most important information in financial statements such as an income statement, a balance sheet and a statement of change in financial position (SCFP) (Byrd & Byrd 1986). It is up to the managers to make sense and interpret this information for their own purposes of decision-making.

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This decision-making is highly useful for the organisation as it provides managers with a way to manage resources effectively. For instance, the manufacturing organisation collects information about various costs that go into production and then summarizes these costs, seeing where its expense is the greatest. Later on, managers can build strategies for cost reduction, seeing where their organisation has the highest costs.

They can also see the dynamics of these costs, for instance, a rise in the cost of fuel and a decline in the cost of parts. In this way, they can predict future trends and act accordingly. Without accounting information, they would be wandering in the dark and would have no reliable guidance for decision-making.

Based on the vast amount of accounting information, the company can analyze its strengths and weaknesses and assess its progress in terms of losses, profits, revenues and expenses. As the accounting information in one nation is summarised based on the same standards, managers can compare the progress of their company to that of the others and make conclusions as to their position in the industry. They can see, for instance, that their manufacturing costs are about the same as the industry average, but their sales and administrative costs are way above average. This means that the company should take action to bring its sales and administrative costs down in accordance with those of the competing companies.

To ensure the uniformity of standards, in the US all companies follow Generally Accepted Accounting Principles that form a framework which “consists of principles and practices that have won acceptance by the profession because of their alleged usefulness and logic” (Belkaoui & Monti-Belkaoui 1991:138).

Accountants using the same theoretical framework of Generally Accepted Accounting Principles can supply the public and their managers with information that is the same according to the guidelines. As a result, investors can also compare the progress of different companies and make their investing decisions, choosing to buy the stock of those companies that make the highest profits or show greatest improvements.

Accounting is also useful for non-profits. Even if stakeholders in these companies should not be interested in making a profit, they can see how the company is doing financially. For example, they would be able to detect fraud using accounting information.

Thus, accounting is necessary for any organisation of any type. It provides useful information about the organisation’s activities and offers tools for decision-making.

Works Cited

Byrd, David B. & Sandra D. Byrd. “Using the Statement of Change in Financial Position.” Journal of Small Business Management 24, (1986): 31+.

Belkaoui, Ahmed & Janice Monti-Belkaoui. Accounting in the Dual Economy. New York: Quorum Books, 1991.

Appendix 1

Byrd, David B. & Sandra D. Byrd. “Using the Statement of Change in Financial Position.” Journal of Small Business Management 24, (1986): 31+.

An accountant can provide a vast amount of financial data about a business. The three financial statements provided by the accountant include an income statement, a balance sheet and a statement of change in financial position (SCFP). Most business managers know how to interpret and use the information provided on the balance sheet and the income statement. However, some statement users have difficulty understanding, interpreting, and utilizing the information provided by the statement of change in financial position.1 Therefore, the SCFP is often under-utilized. This is unfortunate, because it is often the most useful statement for small business managers.

1 Allen H. Seed III, The Funds Statement: Structure and Use (Morristown, New Jersey: Financial Executive Research Information, 1984), pp. 16-17.

The SCFP is important to the small business manager for the following reasons: (1) the information provided on the SCFP can be compared with the cash budget to assist in the prediction of future cash flow; (2) the quality of income can be better assessed, because estimates are not included on the SCFP and it is easier to see what was received and what was spent in terms of dollars; (3) the possibility of expanding or reducing operating capacity can be addressed by analyzing the funds provided by operations; (4) the financial flexibility and liquidity of the company can be analyzed; and (5) the small business manager can see at a glance the financing and investing activities which have taken place in the last time period.

The purpose of this article is to describe the SCFP and to explain how small business managers can use the important information contained in this statement.

HISTORY OF THE SCFP

The accounting profession has been struggling with the SCFP for over twenty years. In 1963, the Accounting Principles Board (APB) issued APB Opinion No. 3, which encouraged the presentation of an SCFP (then called a funds statement) as an integral part of a company's financial statements. The SCFP was not required, however, and no specific format or definition of funds was given. Needless to say, all companies did not present a SCFP as part of their statements, nor did the SCFPs which were presented follow any set format.

In 1971, the APB issued APB Opinion No. 19, which required that the public accounting profession provide, as a basic component of financial statements, not only a balance sheet and income statement, but also an SCFP. The SCFP was required for each period for which an income statement and a balance sheet was presented. APB Opinion No. 19 also required that a broad concept of funds be used. This meant that changes in cash, working capital, cash and temporary investments, or in all quick assets had to be reported along with all important aspects of a company's financing and investing activities. The accountant could decide whether the statement should be prepared on the working capital or the cash basis; however, APB No. 19 called for specific disclosure requirements.

The specific disclosure requirements included the disclosure of funds provided by operations, the separate reporting of extraordinary items and other sources and uses of funds, and the disclosure of other significant financial resources provided and used not affecting funds.2 During the period preceding these requirements, very little was published in the accounting literature on this "third' type of statement. Therefore, very few accountants were trained to prepare SCFPs, and most small business managers were not exposed to the statement, even during academic training. Accountants tended to prepare SCFPs and charged clients for them without explaining why they were necessary.

2 Accounting Principles Board, APB Opinion No. 19-- Reporting Changes in Financial Opinion (New York, New York: AICPA, 1971).

While APB Opinion No. 19 allowed a wide interpretation of funds, the Financial Accounting Standards Board (FASB) issued Concepts Statement No. 5 in 1984, which suggested that the SCFP should be a cash basis statement.3 The FASB is presently considering the requirement of a cash flow statement as a part of a full set of financial statements. The cash basis statement is probably the concept which can help the small business manager most if used properly. The SCFP is required for all financial statement presentations, audited or unaudited (reviews or compilations). Failure to present an SCFP is considered a departure from generally accepted accounting principles; therefore, the SCFP should be presented even if the accountant feels the small business manager does not need one.

3 Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 5 (Stamford, Connecticut FASB, 1984), p. 19.

Why would an accountant feel there is no need for a SCFP? Usually because the accountant feels the small business manager does not know how to interpret the information provided in the SCFP, and because the small business manager expresses a desire to keep the accounting fee as low as possible. Small business managers should ask for and learn to use SCFPs for the reasons outlined below.

DEFINITION AND ANALYSIS OF THE STATEMENT

What is an SCFP? Perhaps if the alternative name for the balance sheet, "Statement of Financial Position' were used, the statement of "change' in financial position would explain itself, because the SCFP does exactly that--it shows the items that caused changes in the balance sheet accounts, summarized by either a working capital or a cash basis definition of funds. This is a natural result of providing statement users with full cycle accounting information.

The balance sheet shows what economic resources (assets), obligations (liabilities), and residual value (owner's equity) the business has at any one point in time. The income statement shows the revenues and expenses which have been recognized over a time period--partially explaining the change in the equity section of the balance sheet (as a component of retained earnings--see exhibit 1). Therefore, common sense dictates that another statement should be provided which summarizes how the assets, liabilities, and the remaining owner's equity items on the balance sheet changed over this same time period. The changes in these items, and the reasons for change, can be important information for financial management.

An example will be used to illustrate the information presented in the SCFP and how to interpret that information for decision-making purposes. Exhibit 1 shows a very simple balance sheet and income statement, while exhibits 2 and 3 present the SCFP prepared on a cash basis, and exhibit 4 illustrates a working capital basis SCFP. The following discussion concentrates on the cash basis SCFP, because it is probably more useful to the small business manager.

The general format of the cash basis SCFP (exhibit 2) involves two major sections: first, sources of cash, and, second, uses of cash. Within the sources of cash section, two sub-sections are used: cash from operations and cash from other sources.

The cash from operations section summarizes the sources and uses of cash generated by normal operational transactions (collection of receivables and payment of liabilities associated with buying and selling of inventory and other income statement transactions involving cash) into a net source of cash. The cash from operations section can be prepared using either the direct or indirect method. The indirect method (illustrated in exhibit 2) involves starting with the net income figure from the income statement and then making adjustments for transactions that were included on the income statement which did not affect cash.

These adjustments (in this example, the depreciation expenses and the changes in accounts receivable, accounts payable, inventory, and other current liabilities) reflect the difference between net income and cash generated from operations. Thus, the approach is to start with net income, which includes non-cash transactions, and then adjust out all non-cash items included in the determination of net income, leaving only the cash generated from operations.

Another way to prepare the cash from operations section is the direct method (see exhibit 3). Under this method, the approach is simply to net together all receipts and disbursements of cash that were related to normal operations. Exhibit 3 shows a reconciliation of the income statement prepared under accrual basis accounting with a cash from operations section of an SCFP prepared using the direct method.

The direct method may be easier to understand; however, it can be misunderstood as representing a cash basis income statement, which is not acceptable under generally accepted accounting principles. Therefore, the direct method has not been widely adopted by accountants. Both exhibits show that cash from operations in this simple example was $5,000.

The cash from other sources section of the SCFP simply lists cash received from transactions not considered part of normal operations. Such things as cash sales of old equipment, the proceeds from issuance of long-term debt, and the proceeds from issuance of capital stock would be considered as items of cash receipts to be included in the cash from other sources section of the SCFP. In exhibit 2, only one other source of cash was illustrated, the $2,000 from issuance of common stock.

The uses of cash section of the SCFP simply lists the cash paid for long-term assets acquired, long-term liabilities paid, dividends paid, and any other payments not considered part of normal operations. Thes items totaled $8,000 in this example. The difference between total sources of cash and total uses of cash is the increase or decrease in cash for the period (i.e., the difference is equal to the change in the cash account). In this example, the cash account decreased by $1,000.

Besides providing a detailed analysis of sources and uses of cash, the SCFP can be used (in conjunction with the balance sheet) to analyze changes in specific accounts. For example, looking at the XYZ Company's balance sheet in exhibit 1, a small business manager may ask: Why did the equipment account change? By looking at the SCFP along with the balance sheet, the small business manager can see that the change in the equipment account was as follows:

Equipment (12/31/X1 balance) $40,000

Purchase of equipment in 19X2 (Uses of cash--SCFP) 4,000

Equipment (12/31/X2 balance) $44,000

Similarly, the retained earnings account can be analyzed:

Retained earnings (12/31/X1 balance) $25,000

Net income for 19X2 (Sources of cash--SCFP) 4,000

Dividends declared and paid in 19X2 (Use--SCFP) (2,000)

Retained earnings (12/31/X2 balance) $27,000

All of the remaining long-term asset and liability accounts could be analyzed in the same manner. In this simple example, it is easy to see that the increases in the accumulated depreciation accounts are due to 19X2 depreciation expenses shown in the "From operations' section of the SCFP, the reduction in the long-term payable account is a result of the 19X2 payment (Uses section of SCFP), and the increase in the common stock account is due to selling $2,000 of common stock ("Other sources' section of SCFP) in 19X2.

Some small business managers may prefer to define funds more broadly as working capital. Working capital is defined as current assets minus current liabilities. When the SCFP is prepared on this basis, the statement (see exhibit 4) summarizes how working capital was obtained (sources such as selling long-term assets or borrowing money, as well as normal operations) and how it was used (applications such as buying long-term assets or paying on long-term liabilities). The changes in the current asset and current liability accounts are summarized in the "Analysis of working capital' section of the SCFP and must yield the same total increase or decrease in working capital shown in the first section of SCFP. In this example, an increase in working capital of $1,000 is shown in both sections.

The SCFP prepared on a working capital basis simply explains the change in working capital for a given period in terms of the changes in the long-term accounts as well as the current accounts. Thus, the statement user can see how working capital was provided and what uses were made of working capital during the period. Comparison of the two types of SCFP shows that the major format difference is that under the cash basis, the changes in the current asset and current liability accounts are reflected in the computation of cash from operations, and there is no analysis of working capital section in the cash basis SCFP. However, the analysis of the changes in the long-term asset and liability accounts is the same.

Predicting future cash flows from analyzing changes in working capital can sometimes be a difficult task. For those businesses that have exhibited fairly constant accounts receivable and inventory turnover ratios in the past, increases or decreases in working capital will usually correlate with increases or decreases in cash within a normal operation cycle.

However, where the ratios have behaved irregularly, there will not necessarily be any correlation between changes in working capital and changes in the cash balance. In this example, the fact that working capital increased by $1,000 does not explain why cash decreased by $1,000 during the same period, and may not help predict future cash flows. The cash basis SCFP can assist in resolving this problem.

ADVANTAGES OF THE CASH BASIS SCFP

A major advantage of the cash basis SCFP is to help answer the small business manager's most common accounting question: "If my income increased this year, where did all of my cash go?' Both the working capital and cash basis SCFPs can be utilized in answering this question; however, the cash basis SCFP provides a clearer explanation of why XYZ Co.'s cash position weakened when the income statement reflected profitable operations.

The SCFP in exhibit 2 shows why cash decreased by $1,000 during the period in spite of $4,000 net income shown on the income statement. In this example, as in many small businesses, cash generated in the short term (less than one year) is not sufficient for longer term needs, such as purchases of long-term equipment and payment of long-term debt. Some small business managers have difficulty understanding that profitable operation does not automatically strengthen the cash position. The SCFP on a cash basis shows the sources and uses of cash during the period. It is vitally important for small business managers to realize that revenue and expense recognition under accrual basis accounting does not usually coincide with the related cash flows.

Another advantage of the SCFP (cash basis) is that it can be compared with the cash budget that had been prepared for 19X2 should yield important information for planning future transactions and the resulting cash flow.

There has been a definite trend toward the use of the cash basis SCFP, and the cash basis may become the required reporting format for publicly traded companies.4 Even though many small business managers do not have to worry about reporting requirements for public companies, there is a tendency among accountants to try for consistency. In theory, a small business manager should request an SCFP prepared on the basis that helps most in managing the business and the related cash flows. In most cases, this will be the cash basis SCFP.

4 Financial Accounting Standards Board, Financial Accounting Series Status Report No. 168 (Stamford, Connecticut: FASB, July 10, 1985), p. 1.

CONCLUSION

The importance of cash flow in small business is well documented in the literature and is well understood by small business managers. The SCFP is a very useful statement to use in analyzing past performance in order to predict future activity, and should therefore help small business managers do a more effective job. The SCFP explains to the reader what the sources of funds (cash or working capital) were, and tells what uses were made of those funds. This analysis helps the reader to understand that profitability as shown on the income statement does not automatically prevent cash flow problems, and that cash projections and analysis of past cash flows are necessary to manage cash flow effectively.

The SCFP is considered the "third' financial statement and may not be read is it should be by the users of financial statements. Small business managers should examine the SCFP more closely when analyzing the results of a business and when planning for the future of the small business. Those who have not previously been exposed to the statement should ask questions of their accountants regarding the SCFP and learn to utilize this valuable information.

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