Accounts Essay 3000 words

Answer to Part a

In the which show how they have managed the assets entrusted to them by the shareholders. This information is provided through the annual financial statements in most cases[1]. Given the inherent conflict of interest in the principal agent relationship, shareholders need to be assured that the financial statements do not contain material misstatements arising as a result of fraud or error. (Eilifsen et al., 2007). Therefore for shareholders to be satisfied with this statements the statements must be audited by an independent third party referred to as an auditor who expresses an opinion to the truth and fairness modern form of business organisation, ownership is separated from control. (Watts and Zimmerman, 1983). The corporation is owned by shareholders and it is managed by managers. The relationship between the shareholders and management is similar to the principal-agent relationship. In this case the shareholders are considered principals and managers, agents. (Jensen and Meckling, 1976). Managers provide information about their stewardship of the company to the shareholders of the financial statements.

Despite this audit, financial statements still turn out to be unreliable. There are a number of factors that make financial statements to be unreliable. Firstly the nature of the accounting standards that govern the preparation of financial statements have an important role to play in quality of the statements. Two main accounting standards including rules based accounting standards and principles based accounting standards have often been employed by companies to prepare financial statements. Rules based standards allow companies to based the preparation of financial statements on the legal substance of transactions rather than on the economic substance of the transaction thereby making it possible for management to exploit “bright lines” or loopholes in the standards to benefit their selfish interests and the expense of the interests of shareholders. For example, Enron employed a lot of made use of such loopholes to mislead its shareholders that it was providing them with superior returns on their investment.

Secondly, the presence of different options in preparing financial statements can provide managers with an easy way out to manipulate shareholders. For example, the option to capitalise or not to capitalise certain costs provides companies with a means to manipulate earnings and assets in the balance sheet. For example, a manager may decide to use conservative methods of accounting such charging excessively high depreciation to assets or failing to capitalise development costs that ought to have been capitalised with the objective of meeting long-term performance targets set by imposed on him by shareholders. (Penman, 2007). This will result in understatement of profit in early years only for profits to significantly increase in later years. By so doing, the manger portrays his/herself as superior over other managers in the industry. Failing to capitalise costs that have long-term economic benefits as well as charging excessively high depreciation leads to the build-up of reserves. These hidden reserves which ought to have been reported as profit in earlier years are thus reported in later years. (Penman, 2007). For example, under U.S GAAP research and development (R&D) costs are expensed while under IFRS Research costs are expensed by development costs are capitalised if the company can demonstrate the technical feasibility of completing the intangible asset as well as the intention to use or sell the asset. (Epstein, and Jermacowicz, 2007; IAS 38 cited in Henry and Gordon, 2009).

In some cases, the company can decide to capitalise an expense even if capitalisation does not reflect the economic substance of the transaction. This practice overstates earnings in the income statement and assets in the balance and overstates profitability and liquidity ratios. It also understates solvency ratios such as the debt-to-equity ratio. The practice portrays the company as being in a good profitability, liquidity and solvency position meanwhile that is not the case. Another egregious practice of accounting manipulation is through the use of off-balance sheet financing. A common example is reporting leases, which ought to be reported as financing leases as operating leases, thus understating liabilities in the balance sheet.

The auditor cannot question the above practices if the company can justify that it is operating in line with the law. Therefore to reduce the above practices, it is essential to use a principles based set of accounting standards that mandate preparation of financial statements to be based on the economic substances of transactions rather than on their legal forms.

Answer to Part b.

Following the comment by Atkionson (1997) one can say that the author is justified to a certain extent. An organisation is made up of a number of stakeholders including customers, shareholders, employees, management, the government, regulatory bodies, and other interested parties. Among these different group of stakeholders, shareholders have been singled out as the most important stakeholder. Whatever the company does is to make sure that shareholders are satisfied in the end. That is, satisfying other stakeholders is only done if doing so is in the best interest of shareholders. For example, the company manufactures and sells products and services to customers in order to generate revenue that will ultimately be translated into profit to be distributed to shareholders. In order to sell goods and services the company must ensure that the goods and services on offer meet the specific needs of customers. Thus the company portrays itself as if it is acting in the best interest of customers which is not the case in the final analysis. The company only meets the needs of customers because it is a prerequisite for meeting the needs of shareholders. Also, employees are paid because they are the ones that work in the factories, conduct customer surveys, market and distribute products to customers, chase customer for payments as well as carry out other administrative duties. The company again by paying employees portrays itself as acting in the best interest of employees meanwhile it is only a means to an ultimate goal – “generating superior shareholder value”.  In like manner the needs of the other stakeholders are also satisfied as a means toward meeting the satisfaction of shareholders.

In addition to the above, the liability of the shareholder is limited only to the amount committed as investment in the company. Other stakeholders suffer significantly when the company goes bankrupt. Employees in particular suffer significantly from such a failure. This therefore means that there is bias towards meeting the goals of shareholders at the expense of other employees. During good times shareholders eat up all the benefits generated from the company, limiting the employees only to the compensation provided to them for their services to the company. But during bad times shareholders simply walk away from the trouble living employees to decide their fate. Moreover, companies cause a lot of damage to the environments in which they operate thereby passing part of their costs to the citizens. Yet shareholders have limited liability. Based on these one can say that the statement by the author is correct.

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Answer to part (c)

Profitability ratios

Profitability ratios are used to assess a business’ ability to generate earnings as compared to expenses over a specified time period. These ratios show how profitable is the business, measuring its overall performance. They examine the profits made by a firm and compare the figures with the size of the firm, the assets employed by the firm or its level of sales. These ratios can be used to examine how well the firm is operating or how well current performance compares to past records or to other firms.

Profit margin

It is calculated by finding the profit as a percentage of the sales (Profit / Sales x 100)

Profit before taxation is generally thought to be a better figure to use than profit after taxation, because there might be unusual variations in the tax charge from year to year which would not affect the underlying profitability of the company’s operations. Therefore, taxation is ignored in the calculations of profitability ratios.

Another profit figure that should be calculated is Profit Before Interest and Tax (PBIT) because this is the amount of profit which the company earned before having to pay interest to the providers of loan capital. However, it is not possible to work out this profit figure as the finance cost is not given.

Tesco Plc

Although Tesco’s sales increased by 4.3% over the year profit increased by nearly 6% due to the fact that purchases did not rise in the same proportion as sales. This is reflected in the profit margin by improvement from 7.5% to 7.6%.

Sainsbury has had a good growth in revenue (13.3%) but the profit margin has dropped by 0.3 percentage point. This is due to the percentage increase in cost of sales being more than percentage growth in revenue. It could be due to poor cost control, one-off high expenses during the period, increased costs of stock, as stock has risen by £50m, or even could be because of fixed cost behave in a manner that they are fixed up to a certain level of volume, and then they increase to an even higher level of fixed cost to a certain level of volume (step-fixed costs). The reason can be analysed with further information.

ROCE

It is impossible to assess profits or profit growth properly without relating them to the amounts of funds (capital) that were employed in making the profits. The most important profitability is therefore return on capital employed (ROCE), which states the profit as a percentage of the amount of capital employed. Capital here means the share capital and reserves plus long-term liabilities and debt capital, thus profit must mean the profit earned by all this capital together. This is PBIT, since interest is the return for loan capital and dividend is the return for the equity providers

ROCE = Profit before interest and taxation   x 100

Capital employed

From the calculations it can be argued that Tesco’s ROCE has fallen but Sainsbury’s ROCE has gone up. As ROCE is a measure of how well the capital of a business are being used to generate profits it is certain that Sainsbury’s capital returned more profit than Tesco’s.

It can also be argued that Sainsbury’s ROCE has improved over the year (from 20.1% to 21.7%) whereas Tesco’s ROCE has dropped (from 20.6% to 19.4%). Some of this may be due to the increase in fixed assets of Tesco which will have increased capital employed and reduced profit by larger depreciation charges. Because Tesco’s fixed assets are £794m higher than previous year, its equity and reserves are also £728m higher. The effect of this should be considered.

It is also worth commenting on the change in sales revenue from one year to the next. It is noticed that Sainsbury achieved sales growth of over 13% from £14,500m to £16,433m over the year and this is certainly one of the most significant aspect of higher ROCE than Tesco, which has attained only 4.3% sales growth.

Liquidity ratios

The standard test of liquidity is the current ratio. It can be obtained from the balance sheet.

Current ratio = Current assets

Current liabilities

The idea behind this is that a company should have enough current assets that give a promise of cash to come to meet its future commitments to pay off its current liabilities. A ratio in excess of 1 should be expected.

Both Tesco and Sainsbury’s current ratio from the calculations is just below 1 but cash is excluded in the figure because it is not known.

Most inventories are not very liquid assets, because the cash cycle is so long. For these reasons, an additional liquidity ratio known as the quick ratio or acid test ratio should be calculated.

Quick ratio: Current assets less inventory

Current liabilities

Quick ratio should be ideally at least 1. However, different businesses operate in very different ways. Tesco and Sainsbury are a supermarket group thus have low receivables (people do not buy groceries on credit), low cash (good cash management), medium inventories (high inventories but quick turnover, particularly in view of perishability) and very high payables. Therefore, it is normal to expect both current and quick ratios to be lower than 1 for retailers such as supermarkets as we cannot compare this with manufacturing organisations.

What is important us the trend of these ratios. From thus, we can easily ascertain whether liquidity is improving or deteriorating. If Tesco and Sainsbury have traded for the last ten years with current ratios of 0.8 and quick ratio 0.7 then it should be supposed that they can continue in business with those levels of liquidity. It is the relative position that is far more important than the absolute figures.

To understand the liquidity position of organisation we need also to analyse the efficiency ratios; control of receivables and inventories.

Accounts receivable collection period

A rough measure of the average length of time it takes for a company’s customers to pay what they owe is the accounts receivable collection period and is calculated as:

Trade receivables x 365 days

Sales

From the calculations Tesco’s and Sainsbury’s receivable collection period is pretty similar in the range of 30.3 days to 31.0 days.

This ratio does not help in identifying whether or not the companies in retail business are doing well. It is because majority of the sales of supermarket groups are in cash therefore they have hardly any trade receivables at all, which is as low as 0.5% in this case.

It is also the estimate of the accounts receivable collection period is only approximated, because:

(a)    The balance sheet value of receivables might be abnormally high or low compared with the normal level the company usually has

(b)   Sales revenue in the P&L s exclusive of sales taxes, but trade debtors in the balance sheet are inclusive of sales tax. We are not strictly comparing like with like.

Accounts payable period

This is ideally calculated by the formula:

Trade creditors x 365 days

Purchases

The payment period often helps to assess a company’s liquidity; an increase is often a sign of lack of long-term finance or poor management of current assets, resulting in the use of extended credit from suppliers, increased bank overdraft and so on.

From the calculation we see that Sainsbury’s payable period is 1 ½ days shorter than Tesco’s in this year whereas it is almost same in the previous year.

Both supermarket chains show similar characteristics just below 30 days. If we assume normal credit given by the suppliers is 30 days and both pays before due dates it may be because they receive a good discount if payments are made earlier. Because Tesco and Sainsbury is cash rich business they have no problems in paying the suppliers, as it is the case in manufacturing businesses.

Stock turnover period

Another ratio worth calculating is the stock turnover period, which indicates the average number of days that items of inventory are held for. It is calculated as follow:

Stock turnover =           Stock x 365 days

Cost of sales

This is another measure of how vigorously a business is trading. A lengthening stock turnover period from one year to the next indicates:

(a)    slowdown in trading; or

(b)   a build-up stock levels, perhaps suggesting that the investment in inventories is becoming excessive.

From the calculations it can be argued that Sainsbury converts inventory into cash quicker than Tesco, about 6 – 8 days faster. However, Sainsbury’s stock turnover increased by 1.1 day at the same time as Tesco’s improved by 1.4 day. Presumably if the stock turnover period and receivables collection period are added together, this should give us an indication of how soon the stock is converted into cash. This year Tesco converts the stock into cash in 55.8 days (30.4 + 25.4) but Sainsbury did it in 49.3 days (30.3 + 19), whereas last year it was 57.8 days for Tesco and 48.3 days for Sainsbury. This definitely indicates that Sainsbury receives the cash back from the inventories quicker which can be stated that it gives better liquidity position to Sainsbury than Tesco.

However, it is difficult to say higher the stock turnover the better or the lower the better because there are several other aspects of stock holding policy have to be balanced such as lead times, alternative use of warehouse space, bulk buying discounts and seasonal fluctuations in orders. Cost of stock to businesses like Tesco and Sainsbury is quite high, as there are hundreds of products to store and some of them are highly perishable. Companies try to use Just in Time stock policy to reduce the cost of holding stock and product obsolescence.

References

Eilifsen A., Messier W. F. Jr., Glover S. M., Prawitt, D. F. 2007, “Auditing and Assurance Services”, International Edition, McGraw-Hill.

Epstein, B. J., Jermacowicz, E. K. 2007, “Interpretation and Application of International Financial Reporting Standards”, Wiley and Sons Inc.

Henry, H., Gordon, E. 2009, “Long-Lived Assets” in Financial Reporting and Analysis, CFA Program Curriculum, vol. 3, Pearson Custom Publishing.

Penman, S. 2007, “Advanced Financial Statement Analysis and Securities Valuation”, 3^rd Edition, McGraw-Hill.

Watts, R.L., Zimmerman, J.L. 1983, “Agency problems, auditing and the theory of the firm: some evidence”, Journal of Law & Economics, Vol. 26 pp.613-34

Jensen, M. C., Meckling, W. H. 1976, “Theory of the firm: Managerial behavior, agency costs, and ownership structure”, Journal of Financial Economics, vol. 3, pp. 305-360.

APPENDIX

[1] Some jurisdictions require companies to also file quarterly financial reports; e.g., the U.S Securities and Exchange Commission (SEC) Requires Quarterly Financial Reports from companies listed in the United States.