Financial statements are produced in order to help stakeholders understand the financial condition of the entity in question. Different types of entities, however, have different reporting requirements. A self-employed individual has very different needs from a limited company, and these are different from not-for-profit organisations as well. This paper will examine some of these differences.
The first class of business is the self-employed individual. There are no reporting standards for self-employed individuals. Such individuals, when engaged in business for themselves, need only report to Her Majesty's Revenue and Customs their revenues and expenses for the year. A self-employed individual has no other stakeholder besides himself/herself and Her Majesty, so there is no need for complex standardized reporting. The self-employed individual can choose what method of accounting they want to follow -- accrual or cash basis. Cash basis accounting is accepted for the self-assessment tax return, whereas it would not be for a limited company. Cash basis can only be used for self-employed individuals earning up to £81,000 in the year. Having standardized accounting requirements would be burdensome for self-employed individuals, hence why there is no such requirement and even cash basis is accepted. A self-employed individual, therefore, might not have financial statements at all, just a simple ledger of cash incomes and disbursals.
Limited companies, by contrast, are prescribed to use standards outlined by law. The rules are in a state of flux at the moment, with some entities using generally accepted accounting principles (GAAP) and some entities using the International Financial Reporting Standards (IFRS). The system is comprised of tiers, such that IFRS are required of Tier 1 companies -- those considered to be publicly accountable. Tier 2 companies - those that are neither publicly accountable nor small, may opt to use IFRS should they choose, but are not obligated to do so. Alternately, they may choose to use the Financial Reporting Standard for Small- and Medium-Sized Entities (FRSME), a UK standard but based on IFRS for companies of a similar size. Tier 3 companies are small, and report based on the Financial Reporting Standards for Smaller Entities (FRSSE). A tier 3 company may also apply FRSME or IFRS, should it choose (BDO, 2011).
Regardless of the methodology, limited companies must create financial statements and reports according to an accepted system, and there are mechanisms in place for the enforcement of these standards. Limited companies that are publicly accountable must also make regular reports to the public, in particular quarterly and annual reports. These reports are in standard format, and this allows external stakeholders like investors and regulatory agencies to evaluate the content of the reports in order to understand the financial condition of the reporting entity. Limited companies are also typically subject to audit.
Not-for-profit organisations are also seeing changes in their reporting standards as the result of the move towards IFRS. IFRS standards for public benefit organisations are different from the ones for limited companies, but the principle of using specific reporting standards remains. Public benefit entities requires such standards because they receive taxation benefit, and it is essential that Her Majesty is able to determine the financial health of not-for-profit entities, and that they are truly operating as NFP entities. With the new IFRS requirements going into place, NFPs are all but required to have specialized accounting abilities to meet these requirements, as they apply even to smaller NFPs (BDO, 2010). A key difference of course between the way that NFPs report their performance is with the matter of profit -- and by extension the matter of taxation. Their reports show a balance sheet, and outline their incomes and expenditures, but not as a profit statement per se. The unique nature of NFPs in this grouping highlights the need for a slightly different set of objectives in financial reporting.
Thus, the level of sophistication in financial reporting for entities is dependent on the public interest of the organisation. Whereas there is no real public interest in self-employed individuals, both limited companies and not-for-profit entities have a higher level of public interest, and the result is that they are required to produce standardized statements according to a regular timetable, and to make these available for public and regulatory scrutiny. The self-employed individual needs only to produce a basic ledger and their financial reporting is between them and Her Majesty, with no public reporting requirement.
Part II. A) My chosen company is Sainsbury's. The following table illustrates the company's key financial ratios for the past three years.
Sainsbury's Key Ratios
Acid Test Ratio
Total Asset Turn
As these numbers indicate, the financial performance of Sainsbury's over the past three years has been fairly stable. The company operates in a stable industry, mainly groceries, and the British economy has been basically flatlined over the same period of time. Thus, it would not be expected that there would be a major swing in Sainsbury's performance, and there was not. Revenues have steadily increased over the past three years, increasing 5.6% in 2012 and 4.5% in 2013. Net income declined by 6.4% in 2012 then increased by 2.6% in 2012.
One of the reasons or the lower net margin is that Sainsbury's experienced a lower gross margin. There are a number of possible explanations for the decrease in the gross margin, but it typically reflects a decrease in pricing power over either buyers or suppliers. Competition often is the cause of this, especially as a firm like Sainsbury's is for the most part a price-setter with suppliers and with customers. Increased competition in its space, however, will result in the company having to lower its prices to customers in order either to move inventory or to increase market share. It is possible that Sainsbury's', whose revenue outpaced the growth in the British economy the past two years, sought to lower its prices in certain areas to win more market year, and the increase revenues are reflective of that. Whatever the case, the fact that the company saw a restoration -- somewhat anyway -- of its gross margin in 2013 is encouraging. What is less encouraging is that the net margin continues to decline. Net margin losses in this case reflect operating expenses, which grew faster than revenues. For Sainsbury's, it is essential to control costs in order to continue to see margin growth. Where costs outpace revenues, there may be extenuating circumstance but in general this reflects slightly weaker managerial control over costs.
The company's returns are fairly stable, however. The overall size of the company means that the return on assets in particular did not change much the past two years. However, it did drop in 2012 to 4.8% from 5.6% in 2011. This decline also occurred with the return on capital employed. These figures indicate that the apparent decline in pricing power with Sainsbury's has affected the returns that the company earns as well, something that is detriment to shareholders.
However, it should be noted that such minor deviations in performance may simply be cyclical or happenstance. Changes do occur from year to year, and it is only when they form a trend that management truly needs to be worried. However, management can take this as a sign that it might want to control its costs and start to undertake steps to improve its pricing power, as these trends have been occurring for the past two years.
Another ratio that can be used to analyse the performance of Sainsbury's For example, the company's liquidity and gearing can be analysed. With respect to liquidity, two good ratios are the current ratio and the acid test ratio. The first is a measure of financial health of the company in terms of its ability to meet its pending obligations for the next year. In this, the current ratio is today at 0.58, down from 0.65 last year, but on par with the level of 0.58 in 2011. This indicates that there might have been an outlier result in 2012. The level of 0.58 itself is not particularly stellar, as 1.0 is more of a normal benchmark for this ratio. However, there might be extenuating circumstances to be taken into consideration. One is that the company has maintained a stable current ratio. It is clearly able to handle this ratio, and there is no major downward trend based on the past three years. Indeed, further research indicates that this level is healthy because the company has strong inventory turnover.
The acid test ratio is similar to the current ratio, but using the current assets less the inventory. The reason for taking out the inventory is that inventory may need to be marked down in order to be sold, or it might be unsellable, therefore it is…