Cambridge AS & A Level9706

Users of accounting information

Accounting 9706 Chapter Notes

What this chapter covers

Users of accounting informationCalculation and evaluation of ratios
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In this chapter

  1. 1Introduction to Users and Stakeholders
  2. 2Internal Users of Accounting Information
  3. 3External Users of Accounting Information
  4. 4Investors: Assessing Performance and Risk
  5. 5Limitations of Financial Statements

1. Introduction to Users and Stakeholders

Every business, from a small local shop to a large multinational corporation, produces financial statements. These aren't just for the owners; they are essential documents for many different groups. These groups are called 'stakeholders' because they have a 'stake' or interest in the company's performance and position. The primary purpose of financial statements is to provide a 'true and fair view' of the business, allowing these stakeholders to make informed decisions. Stakeholders can be split into two main categories: internal (those inside the business) and external (those outside the business).

Key term

Stakeholder: Any individual, group, or organisation that has an interest in the activities and performance of a business.

Examiner insight

Marks are often awarded for demonstrating an understanding that different stakeholders exist and have their own unique information needs.

Common pitfall

Confusing stakeholders with shareholders. Shareholders are a type of stakeholder, but not all stakeholders (like employees or customers) are shareholders.

Worked example 14 marks

A new local coffee shop has just opened. Identify two internal and two external stakeholders of the business.

  1. 1

    Step 1: Identify internal stakeholders. These are groups directly involved in the running of the business. For a coffee shop, this would include the owner/manager and the employees (baristas).

  2. 2

    Step 2: Identify external stakeholders. These are groups outside the daily operations but still affected by the business. This includes suppliers (of coffee beans, milk), customers, the bank that provided a start-up loan, and the local government/tax office.

  3. 3

    Answer: Internal stakeholders could be the owner and the employees. External stakeholders could be customers and suppliers.

Recap

  • Stakeholders are any group with an interest in a business.
  • Financial statements provide information for stakeholder decision-making.
  • The core principle is that statements must give a 'true and fair view'.
  • Stakeholders are classified as either internal or external to the business.

Quick check

  1. What is the key difference between an internal and an external stakeholder?2 marks

2. Internal Users of Accounting Information

Internal users are individuals or groups inside the organisation who use accounting information to plan, organise, and run the business. They need detailed, up-to-date information that is not usually available to the public. Their decisions directly impact the daily operations and future strategy of the company.

  • Managers: Need information for planning (setting budgets), controlling (comparing actual results to budgets), and decision-making (e.g., launching a new product, closing a department).
  • Employees: Are interested in the stability and profitability of the business to assess their job security, potential for pay rises, and bonuses.
  • Owners/Shareholders (in their capacity of managing the business): In smaller companies, owners are managers. In larger companies, the Board of Directors (elected by shareholders) acts as a key internal user group, overseeing the company's strategy and performance.

Key term

Management Accounting: The process of preparing management reports and accounts that provide accurate and timely financial and statistical information required by managers to make day-to-day and short-term decisions.

Examiner insight

Examiners look for answers that connect a specific internal user to a specific piece of accounting information and the resulting decision.

Common pitfall

Simply stating that 'managers need information' without specifying what kind of information (e.g., costs, revenues, profits) and for what specific purpose (e.g., pricing, budgeting, performance evaluation).

Worked example 13 marks

The manager of 'TechGadget Ltd' is considering awarding a 5% pay bonus to all staff. Which financial statement would be most useful to them, and why?

  1. 1

    Step 1: Identify the relevant financial statement. A decision about pay bonuses relates to the company's profitability and ability to afford the extra expense. This information is found in the Income Statement.

  2. 2

    Step 2: Explain the reason. The manager needs to look at the 'Profit for the Year' on the Income Statement.

  3. 3

    Step 3: Link the information to the decision. If profits are high, the company can likely afford the bonus. If profits are low or there is a loss, awarding a bonus could put the company in financial difficulty. The manager would use this information to justify their decision to the directors.

Recap

  • Internal users are people inside the business, such as managers and employees.
  • Managers use accounting information for planning, controlling, and decision-making.
  • Employees use financial information to gauge job security and negotiate pay.
  • Internal information is often more detailed than information provided to external users.

Quick check

  1. State two decisions a manager might make using accounting information.2 marks

3. External Users of Accounting Information

External users are groups outside the business who use its financial statements to make decisions. They rely on the published, audited accounts as they do not have access to the detailed internal records.

  • Lenders (e.g., Banks): Assess the company's ability to repay loans and interest. They look at liquidity (can it pay short-term debts?) and gearing (how much debt does it already have?).
  • Suppliers (Trade Payables): Want to know if the company can pay for goods supplied on credit. They are interested in the company's liquidity and cash flow.
  • Customers: Especially those with long-term contracts or who rely on the company for specialist products or after-sales service, are interested in its stability and ability to continue trading (the 'going concern' concept).
  • Government (e.g., Tax Authorities): Need to calculate the correct amount of tax the company owes (e.g., Corporation Tax, VAT). They also ensure the company is complying with regulations.
  • The Public: May be interested in the company's impact on the economy (e.g., job creation), its environmental impact, and its ethical practices.

Key term

Going Concern: An accounting principle that assumes a business will continue to operate for the foreseeable future and is not at risk of being liquidated.

Fun fact

When a company wants to be listed on a stock exchange, its financial statements are scrutinised not just by investors, but by regulators, lawyers, and investment banks in a process that can cost millions of pounds.

Worked example 14 marks

‘BuildIt Supplies’ sells materials to construction companies on credit. A new customer, ‘Grand Designs Ltd’, has placed a large order and wants 60 days to pay. Why would the credit manager at BuildIt Supplies want to see Grand Designs Ltd's financial statements?

  1. 1

    Step 1: Identify the user and their primary concern. The user is a supplier (BuildIt Supplies). Their main concern is getting paid for the goods they supply.

  2. 2

    Step 2: Identify the key information needed. The credit manager needs to assess Grand Designs Ltd's ability to pay its short-term debts. This is known as assessing liquidity.

  3. 3

    Step 3: Link to the financial statements. The manager would look at the Statement of Financial Position to compare current assets (like cash and receivables) with current liabilities (like amounts owed to other suppliers). A healthy ratio of current assets to current liabilities indicates a lower risk.

  4. 4

    Step 4: Conclude the reason. By analysing the statements, BuildIt Supplies can make an informed decision on whether to grant credit to the new customer and reduce the risk of incurring a bad debt.

Recap

  • External users are groups outside the business.
  • Lenders assess risk and the ability to be repaid.
  • Suppliers assess a company's ability to pay for goods on credit.
  • Customers may need to know if their supplier is stable and will continue to trade.
  • The government uses accounts to assess tax liabilities.

Quick check

  1. State one reason why a bank (lender) is interested in a company's financial statements.1 mark

4. Investors: Assessing Performance and Risk

Investors (existing shareholders) and potential investors are a critical group of external users. They risk their capital in the business and want to know two main things: 1) How profitable is the company? and 2) How safe is my investment? They use financial statements to assess the performance of the directors and to decide whether to buy, hold, or sell shares. To make meaningful comparisons between companies or over time, investors often calculate financial ratios.

Profitability Ratio (e.g., Profit Margin) = (Profit for the Year / Revenue) x 100

Key term

Dividend: A payment made by a company to its shareholders, usually as a distribution of profits.

Examiner insight

Top-level answers will recognise that a single number (like profit) is not enough; analysis requires comparison, which is why ratios are so important for investors.

Worked example 15 marks

An investor is choosing between Company A and Company B. Company A made a profit of $50,000 from revenue of $500,000. Company B made a profit of $60,000 from revenue of $800,000. Calculate the profit margin for both companies and suggest which company is more profitable relative to its size.

  1. 1

    Step 1: State the formula for profit margin. Profit Margin = (Profit for the Year / Revenue) x 100.

  2. 2

    Step 2: Calculate the profit margin for Company A. ($50,000 / $500,000) x 100 = 10%.

  3. 3

    Step 3: Calculate the profit margin for Company B. ($60,000 / $800,000) x 100 = 7.5%.

  4. 4

    Step 4: Compare and conclude. Although Company B made a higher absolute profit ($60,000 vs $50,000), Company A is more profitable in relative terms. For every $100 of revenue, Company A makes $10 profit, while Company B only makes $7.50. This indicates Company A has better control over its costs.

Recap

  • Investors use financial statements to assess profitability and risk.
  • They want to see a good return on their investment through dividends and share price growth.
  • Profitability is often assessed using ratios like profit margin to allow for comparison.
  • The Statement of Financial Position helps investors assess the long-term stability and risk of the business.

Quick check

  1. What is the main purpose of calculating financial ratios for an investor?2 marks

5. Limitations of Financial Statements

While essential, financial statements have limitations and do not tell the whole story about a business. It is crucial to be aware of these when interpreting them.

  • Historical Information: Accounts are a look back at the past. They may not be a good indicator of future performance, especially in a fast-changing industry.
  • Comparability Issues: Companies can use different (but still acceptable) accounting methods for things like depreciation and inventory valuation. This can make it difficult to compare one company directly with another.
  • Lack of Non-Financial Information: The accounts won't tell you about employee morale, customer satisfaction, the quality of management, or the impact of a new competitor. These factors are vital for a company's long-term success.
  • Based on Estimates: Many figures in the accounts are based on estimates, such as the useful life of an asset or the value of irrecoverable debts. These estimates can be subjective.
  • Window Dressing: Management may take actions to make the accounts look more favourable than they really are, for example by delaying payments to suppliers to improve cash balances at the year-end.

Key term

Window Dressing: Actions taken by management to make financial statements appear more favourable than they actually are, especially at the end of an accounting period.

Common pitfall

Assuming that financial statements are 100% factual. Many items, such as provisions and depreciation, are based on professional judgement and estimates.

Worked example 14 marks

A company's income statement shows a record high profit. However, a news report reveals the company has a very high staff turnover and has been criticised for its poor environmental record. Explain why an investor should be cautious despite the high profit.

  1. 1

    Step 1: Acknowledge the positive information. The high profit is a good sign of current financial performance.

  2. 2

    Step 2: Introduce the limitation of financial statements. State that financial statements only show a partial, financial view of the business.

  3. 3

    Step 3: Explain the significance of the non-financial information. High staff turnover is a non-financial indicator that suggests problems with morale or management. This can lead to higher recruitment and training costs in the future, hurting profits.

  4. 4

    Step 4: Explain the risk of the second non-financial factor. A poor environmental record can lead to government fines, legal action, and damage to the brand's reputation, which could cause customers to switch to competitors. Both of these could negatively impact future profitability and the long-term value of the investment.

Recap

  • Financial statements are historical and may not predict the future.
  • Different accounting policies can make company-to-company comparisons difficult.
  • Crucial non-financial information like staff morale is not included.
  • Some figures are based on estimates and can be subjective.
  • Accounts can be 'window dressed' to look better than reality.

Quick check

  1. State two examples of non-financial information that could be important when assessing a company.2 marks

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

  1. Identify two internal and two external users of accounting information and state one reason for each user's interest.4 marks
  2. Explain why a supplier and a lender would be interested in the liquidity of a business.4 marks
  3. The directors of a company are paid a bonus based on the profit for the year. Explain how this might influence the way they prepare the financial statements.3 marks
  4. A potential investor is looking at the financial statements of a company for the first time. Explain two key pieces of information they would look for and why.4 marks
  5. Discuss why financial statements alone may not provide a complete picture of a business's performance and position.6 marks
  6. Analyse the different information needs of employees and shareholders of a large public limited company.5 marks
  7. ‘Financial statements are only useful to people who have studied accounting.’ To what extent do you agree with this statement?8 marks
  8. Explain the concept of a 'true and fair view' and why it is important for the users of financial statements.4 marks
  9. A business has seen its revenue increase by 20% but its profit has fallen. Explain which user groups would be most concerned by this and why.6 marks
  10. Evaluate the usefulness of a company's income statement to (a) a bank considering making a long-term loan and (b) the company's marketing manager.8 marks

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