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«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»

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This recognizes that a small proportion (often about 20%) of the number of stock items accounts for a relatively large proportion (say 80%) of the total value. In stock control, ABC analysis takes the approach that, rather than attempt to manage all stock items equally, efforts should be made to prioritize the ‘A’ items that account for most value, then ‘B’ items and only if time permits the many smaller-value ‘C’ items. Some businesses adopt just-in-time (JIT) methods to minimize stockholding, treating any stock as a wasted resource. JIT requires sophisticated production planning, inventory control and supply chain management so that stock is only received as it is required for production or sale.

Stock may be written off because of stock losses, obsolescence or damage. For this reason, firms establish a provision to cover the likelihood of writing off part of the value of stock.

Managing creditors Just as it is important to collect debts from customers, it is also essential to ensure that suppliers are paid within their credit terms. As for debtors, the main measure of how effectively creditors are managed is the number of days’ purchases

outstanding. Days’ purchases outstanding is:

creditors average daily purchases

Using the previous example, the firm has cost of sales (usually its main credit purchases, as many expenses – e.g. salaries, rent etc. – are not on credit) of £1.5 million and creditors of £300,000. Average daily purchases are £4,110 (£1.5 million/365).

There are therefore 73 average days’ purchases outstanding (£300,000/£4,110).

This figure has to be reported in a company’s annual report to shareholders (see Chapter 7).

The number of days’ purchases outstanding will reflect credit terms offered by the supplier, any discounts that may be obtained for prompt payment and the collection action taken by the supplier. Failure to pay creditors may result in the loss or stoppage of supply, which can then affect the ability of a business to satisfy its customers’ orders.


A theoretical perspective on financial statements A necessary ingredient for shareholder value (see Chapter 2), given the separation of ownership from control in most large business organizations, is the control of what managers actually do. Control is considered in the rational-economic paradigm (see Chapter 4) through the notion of contract, in which the role of control is to measure and reward performance such that there will be greater goal congruence, i.e. that individuals pursuing their own self-interest will also pursue the collective interest.

There are two main versions of contractual theory: agency theory and transaction cost economics. Agency theory sees the economy as a network of interlocking contracts. The transaction cost approach sees the economy as a mixture of markets and hierarchies (transaction cost economics is discussed further in Chapter 13).

Agency theory Agency theory is concerned with contractual relationships within the firm, between a principal and an agent, whose rights and duties are specified by a contract of employment. This model recognizes the behaviour of an agent (the manager), whose actions the management accounting and control system seeks to influence and control. Both are assumed to be rational-economic persons motivated solely by self-interest, although they may differ with respect to their preferences, beliefs and information.

The principal wishes to influence what the agent does, but delegates tasks to the agent in an uncertain environment. The agent expends effort in the performance of these tasks. The outcome depends on both environmental factors and the effort expended by the agent. Under the sharing rule, the agent usually receives a reward, being a share of the outcome. The reward will depend on the information system used to measure the outcome. Consequently, financial reports play an important role in regulating the actions of agents. The assumption of agency theory is that the agent obtains utility (a benefit) from the reward but disutility from expending effort. Both principal and agent are assumed to be risk averse and utility maximizers.

The agency model involves seeking an employment contract that specifies the sharing rule and the information system. An accounting system can provide output measures from which an agent’s efforts can be inferred, but the measures may not accurately reflect the effort expended. This leads to uncertainty about the relationship between the accounting measure and the agent’s effort. If the principal cannot observe the agent’s effort, or infer it from measured output, the agent may have an incentive to act in a manner different to the employment contract – this is called moral hazard. A principal who can observe the agent’s effort but does not have access to all the information held by the agent does not know whether the effort expended has been based on the agent’s information or whether the agent has ‘shirked’. This is called adverse selection.

Moral hazard and adverse selection are a consequence of information asymmetry.

This happens because principal and agent have different amounts of information. A


function of accounting under agency theory is to improve efficiency by minimizing the losses caused through moral hazard and adverse selection.

Seal (1995) gives the example of renting a holiday home that is used by the owner only a few weeks of the year. The owner (the principal) may appoint a local agent to let out the home. The agency problem is how to motivate and monitor the agent in return for the commission earned by the agent. The owner will expect regular accounts of income and expenditure. Agency theorists use this reasoning to explain the development of financial accounting and auditing in more complex agency relationships.

There are problems with agency theory, however. It ignores the effect of capital markets by assuming a single owner rather than a group of owners. The model focuses on single-period behaviour; many individuals violate the assumptions of rational self-interested behaviour and the agency perspective is narrow because there is no regard given to power, trust, ethical issues or equity, all of which may affect behaviour. We consider alternative theories in the next chapter.

Conclusion This chapter has covered the main financial statements. It has introduced the regulations governing those statements and described the most important principles underlying the construction of accounts. The chapter has also discussed the management of working capital. The chapter concluded with an introduction to what has been historically one of the main theories underlying the construction of financial statements, agency theory. In the next chapter, we introduce the tools and techniques that are used to interpret financial statements and consider some alternative theoretical perspectives.

References Blake, J. (1997). Accounting Standards. (6th edn). London: Financial Times/Pitman Publishing.

Seal, W. (1995). Economics and control. In A. J. Berry, J. Broadbent and D. Otley (eds), Management Control: Theories, Issues and Practices, London: Macmillan.

Part II

Using Accounting Informationfor Decision-Making, Planningand Control

Part II shows the reader how accounting information is used in decision-making, planning and control. The accounting tools and techniques are explained and illustrated by straightforward examples. Case studies, drawn mainly from real business examples, help draw out the concepts. Theory is integrated with the tools and techniques, and the use of quotations from the original sources should encourage readers to access the accounting academic literature that they may find of interest.

Chapter 7 helps the reader to interpret the main financial statements. Chapters 8, 9 and 10 consider the accounting techniques that are of value in marketing, operations and human resource decisions respectively. Chapters 8, 9 and 10 do not take an approach to accounting that is common to other books. These chapters provide a practitioner- rather than an accounting-centred approach, demonstrating techniques that do not require any prior management accounting knowledge. The more traditional accounting focus is left to Chapter 11, by which time the reader should have little difficulty in understanding the more complex concepts. Chapter 12 focuses on strategic decisions such as capital investment and Chapter 13 on divisional performance measurement. Chapter 14 covers the subject of budgeting and Chapter 15 discusses budgetary control.

Interpreting Financial Statementsand Alternative TheoreticalPerspectives

This chapter introduces the content of a company’s Annual Report and shows how ratio analysis can be used to interpret financial statements. This interpretation covers profitability, liquidity (cash flow), gearing (borrowings), activity/efficiency and shareholder return. A case study demonstrates how the use of ratios can look ‘behind the numbers’ contained in an Annual Report. The chapter concludes with several alternative theoretical frameworks on financial reporting.

Interpreting financial statements Financial statements are an important part of a company’s Annual Report, which is required for all companies listed on the Stock Exchange. For companies not listed, the Companies Act requires the preparation of financial statements. The process of

interpreting financial statements begins with a consideration of the wider context:

economic conditions; changes in the industry (e.g. regulation, technology); and the competitive advantage (e.g. marketing, operations, distribution etc.) held by the business. Within this context, often gained through the financial press and trade periodicals, the Annual Report itself can be considered.

The Annual Report for a listed company typically contains:

1 A financial summary – the key financial information.

2 The chairman’s or directors’ report. This provides a useful summary of the key factors affecting the company’s performance over the past year and its prospects for the future. It is important to read this information as it provides a background to the financial statements, in particular the company’s products and major market segments. It is important to ‘read between the lines’ in this report, since the intention of the Annual Report is to paint a ‘glossy’ picture of the business. However, as competitors will also read the Annual Report, the company takes care not to disclose more than is necessary.

3 The statutory reports (i.e. those required by the Companies Act) by the directors and auditors. These will help to identify any key issues that may be found in the accounts themselves.


4 The financial statements: Profit and Loss account, Balance Sheet and Cash Flow statement. The consolidated figures should be used, as these are the total figures for the group of companies that comprise the whole business.

5 Notes to the accounts, which provide detailed figures and explanations to the accounts. These often run to many pages.

6 A five-year summary of key financial information (a Stock Exchange Yellow Book requirement).

The Accounting Standards Board recommends that listed companies include an operating and financial review that provides ‘a framework for the directors to discuss and analyse the business’s performance and the factors underlying its results and financial position, in order to assist users to assess for themselves the future potential of the business’ (quoted in Blake, 1997). The operating and financial review would replace much of the information contained in the chairman’s or directors’ reports (item 2 above).

The Profit and Loss account, Balance Sheet and Cash Flow statement can be studied using ratios. Ratios are typically two numbers, with one being expressed as a percentage of the other. Ratio analysis can be used to help interpret trends in performance year on year and by benchmarking to industry averages or to the performance of individual competitors. Ratio analysis can be used to interpret

performance against five criteria:

ž the rate of profitability;

ž liquidity, i.e. cash flow;

ž gearing, i.e. the proportion of borrowings to shareholders’ investment;

ž how efficiently assets are utilized; and ž the returns to shareholders.

Ratio analysis There are different definitions that can be used for each ratio. However, it is important that whatever ratios are used, they are meaningful to the business and applied consistently. The most common ratios follow. The calculations refer to the example Profit and Loss account and Balance Sheet provided in Tables 6.1,

6.2 and 6.3 in Chapter 6. Ratios are nearly always expressed as a percentage (by multiplying the answer by 100).

Profitability Return on (shareholders’) investment (ROI)

–  –  –

Gross profit/sales gross profit 500 = 25% sales 2,000 Each of the profitability ratios provides a different method of interpreting profitability. Satisfactory business performance requires an adequate return on shareholders’ funds and total capital employed in the business (the total of the investment by shareholders and lenders). Profit must also be achieved as a percentage of sales, which must itself grow year on year. The operating profit and gross profit margins emphasize different elements of business performance.

Liquidity Working capital

–  –  –

The higher the gearing, the higher the risk of repaying debt and interest. The lower the interest cover, the more pressure there is on profits to fund interest charges.

However, because external funds are being used, the rate of profit earned by shareholders is higher where external funds are used. The relationship between risk and return is an important feature of interpreting business performance.

Consider the example in Table 7.1 of risk and return for a business whose capital employed is derived from different mixes of debt and equity.

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