Summary of Accounting: What the numbers mean (Marshall, McManus, Viele)
Summary based on the 9th edition of Accounting: What the numbers mean by Marshall, McManus, Viele
What is accounting?
Accounting is the process of identifying, measuring and communicating economic information about an organization, with the purpose of taking and assessing decisions based on this information.
Accountants often use the term entity instead of organization, because it involves more than just the organization.
This definition of accounting can be showed in the following diagram:
Accounting is the process of
Identifying Economic information To make and assess
Measuring of an entity decision based on this
But who use this accounting information? The users of this information are the management of the organization, the owners/investors/shareholders, the creditors of the organization, the employees and various government agencies involved in the regulation and taxation for organizations.
The decisions taken by the users refer to the profit of the organization, investment and credit issues, employment characteristics and the compliance of laws. Financial statements support these decisions, because they communicate important financial information about the entity.
Accounting falls into six major categories:
- Financial accounting
- Management accounting / Business administration
- Control / public reports
- Internal audits
- Governmental and non-profit accounting
- Income tax reporting
Financial accounting refers to the process that results from the preparation and reporting of financial statements of an entity. Financial statements reflect the financial position of an entity at a certain moment in time, the results of the operations over a given period, the cash flow activities for the same period and other information related to the financial resources, obligations and interests of the owners and the management of the entity.
Financial reporting focuses mainly at the external user. The financial statements are aimed at individuals who are not in the position to be aware of the day-to-day financial and operational activities of the entity. Financial accounting focuses primarily on the historic results of the performance of an entity.
Accounting procedures are used for accumulating the financial performance of the numerous activities of the entity. These procedures are part of the financial accounting process.
Management accounting / Business administration
Management accounting focuses on the use of economic and financial information for planning and controlling purposes of the entity’s activities and supports the decision-making process of the entity’s management.
Business administration is a subpart of management accounting that is related to the identification and accumulation of products, processes or cost of services.
Management accounting and business administration are focused internally, as opposed to financial accounting, which is focused externally.
Control / public reports
Many entities have their financial statements examined by an independent third party. Public reports agencies provide these control services.
An annual report shows the financial statements and clarifications, together with a detailed discussion and analysis by management.
Organizations with multiple plant locations or activities related to many financial transactions, often hire professional accountants for the internal control.
Governmental and non-profit accounting
Government agencies at municipal, state and federal level and non-profit entities such as universities, hospitals and voluntary health and welfare organizations, are required to meet the same accounting standards as other reporting entities.
Income tax reporting
The growing complexity of federal, state, local and foreign income tax rules have led to a demand for professional accountants who are specialized in the various aspects of taxation.
How did accounting develop?
Recently, accounting developed in response to the needs of users of financial statements of financial information, to support the decisions and judgments based on this information.
Financial accounting standards are established by various organizations throughout the years. These standards grew more and more complex over time. As a result, there is a growing interest in harmonizing U.S. financial accounting standards by using international financial accounting standards, which tend to be more general and were developed from general principles.
The “Securities & Exchange” committee, the “Financial Accounting Standards Board” (FASB) and the “International Accounting Standards Boards” are working on a project that will merge existing financial accounting standards as soon as possible. At this moment, the FASB is the standard setting for financial accounting. One feature often associated with the accounting profession, is that the accountant is aware of the ethical code.
Integrity, objectivity, independence and competence are different characteristics of ethical behaviour required of a professional accountant. High standards of ethical behaviour are suitable for all people, but professional accounts have a special responsibility, because a lot of people rely the information they provide when they make decisions.
Integrity means being honest and sincere in transactions and communicating with others.
Objectivity implies being unbiased and free of conflicts of interests.
Independence involves objectivity and is especially important for the accountant, who has to be independent in his reports and the evaluations of the numbers.
Competence means having sufficient knowledge and professional skills to adequate complete an assignment.
At the end of 1970, the FASB started the process of identifying a structure / framework for financial accounting concepts. New users of financial statements may benefit from an overview of these concepts, because they indicate the basis for understanding financial accounting reports. These statements describe the concepts and relations that form the base for the future financial accounting standards and will eventually serve as the base for evaluating existing standards and practices.
The main points in the declaration of concepts that relate to the goals of financial accounting, suggest that financial information must be relevant for the “concerns” investors and creditors have with regard to the cash flows, recourses, liabilities and the profit of the organization. Financial accounting is not designed to directly measure the value of a business enterprise.
Financial accounting is conducted for individual companies rather than for industries or the economy as a whole. Its primary goal is to meet the needs of external users of accounting information, who otherwise would not have access to the records of the organization. Financial accounting keeps historical data and is not aimed at the future. However, if the accounting data are to some extent a fair basis for the evaluation of past performance, it might be useful in assessing the prospects of an entity in the future.
Accounting based on transactions means that the accounting for the effect of an economic activity or transaction takes place when the activity took place, instead of when the cash receipt or payment was conducted. The objectives of financial accounting for non-business enterprises are not significantly different, except that the providers of resources are more concerned about the results of the entity, rather than the profit.
Outline of the book.
The book starts with a big picture of financial accounting and continues with some basic financial interpretations based on these data. An overview of the accounting process is followed by a discussion about specific elements and information about the annual report. The financial accounting information concludes with a chapter on the analysis of the annual report and the use of the data that is generated from this analysis. The management accounting chapters focus on the development and the use of financial information for managerial planning, control and decision making.
Annual reports are the product of the financial accounting process. They are used for communication economic information about the entity to those who are responsible for taking decisions on the financial position, results of the operations and the cash flows of the entity.
2.1 Annual report
From transactions to an annual report
The annual report of an entity is the end product of a process that starts with transactions between the entity and other organizations and individuals.
Transactions are economic exchanges between entities, such as a sale or purchase. The flow of transactions to an annual report can be illustrated as followed:
Procedures for sorting, classifying
and presenting (accounting)
Transactions Annual report
Selecting alternative methods for
reflecting the effects of certain
Transactions are summarized into accounts, and these accounts are further summarized into an annual report. The bookkeeping and accounting processes result in numerous transactions of an entity with other entity, which is reflected in the financial statements.
The annual report of an entity contains the following elements:
Mutation overview of owner’s equity
Cash flow statement
Explanations and definitions
The balance sheet is a list of the assets of an organization, the liabilities and equity at a certain moment in time. The balance sheet is sometimes called an overview of the financial position, because it contains the resources (assets), responsibilities (liabilities) and claims of owners (equity).
The left side of the balance sheet contains the assets, while the liabilities and equity are on the right side of the balance sheet. The total amount on both sides of the balance sheet is always equal.
This equality is sometimes referred to as the accounting equation or the balance sheet equation. It is the equation of these two amounts of which the term balance sheet is derived.
Assets = Liabilities + Owner’s Equity
Assets are obtained probable future economic benefits, or controlled by a certain entity as a result of transactions or events from the past. Assets represent the amount of resources an entity owns.
Liabilities are amounts the entity owes to other entities.
Owner’s Equity is the difference of the assets and liabilities. This equation is called the accounting equation. Sometimes, owner’s equity is referred to as net assets or net value of an entity. This can be proved by deriving the basic accounting equation:
Assets – liabilities = owner’s equity of the organization
Net assets = owner’s equity of the organization.
The left side of the balance sheet enlists cash. Cash represents the cash or money of the entity deposited at a bank account.
Debtors show the sum money that customers owe the entity. This can be a result of buying products on credit or agreements to pay later within a certain period.
Stock shows the costs of the entity for purchased goods, that haven’t been sold yet.
Accumulated depreciation shows the spreading of the costs of the equipment that is expected to be used in the process of running the organization.
Depreciation in accounting is the process of spreading the purchase price of assets over the useful life of that asset.
Creditors reflect the amount that the entity owes the suppliers of purchased goods, because the entity bought on credit or agreed upon a delayed payment within a certain period of time.
Other accrued liabilities reflect the amount the entity owes to various creditors, including the wages owed to employees.
Current assets are ‘money’ and these assets can be converted into cash within a year, such as short term debtors and stock.
Current liabilities are liabilities that will (probably) be paid within a year.
The balance at the end of a fiscal period is the balance of the beginning of the next fiscal period.
The income statement is an account of the results of the operational activities of an entity for a certain period. The income is first reported, then the costs are deducted. This leads to the net income or net loss of the certain period
The net income is the profit of that period. If the costs exceed the net sales, than there is a net loss.
While the income statement focuses on a certain period of time, the balance sheet focuses on one moment.
The gross profit is the difference between net sales and the costs of goods sold.
The operating profit is one of the key measures of operational activities. The operating profit can be related to the available assets of a company.
Earnings per share of outstanding shares are a separated part of the income statement, because it is significantly important for the evaluation of the market value of a share.
The mutation overview of owner’s equity is a detailed overview of the equity of an entity and explains the changes that have taken place in the components of the equity during the year.
Equity consists of two main components, namely:
Invested capital (shareholders).
Invested capital is the total amount of investments owners put into the entity.
Retained earnings represent the cumulative net income of the entity that is held for the use of the company.
Dividend is the distribution of profits made by the shareholders, so that the retained earnings go down.
Retained earnings increases by the amount of net income and decreased by the amount of dividend paid to shareholders. Retained earnings link the income statement to the balance sheet.
The purpose of the cash flow statement is to identify the sources and use of cash during the year. A cash flow statement consists of the following activities:
- Operating activities.
- Investing activities.
- Financing activities.
A cash flow statement gives a summary of the impact on the cash from the operating, investing and financing activities of an entity during a certain period.
The bottom line of the statement of cash flow is the change is money that is shown on the balance sheet at the beginning of the period compared to the end of the period.
Similar survey over several years
Financial statements are often presented on a comparative basis (over several years) so that the users of these statements can easily detect significant changes in the financial position or the results of the operation.
Illustration of relationships between financial statements.
The relationship between the balance sheet and the income statement can be showed as followed:
Assets = liabilities + equity
Net income = income – costs
The net income in the income statement influences the owner’s equity on the balance sheet because of the retained earnings.
We can show this relation in a balance equation.
A (Assets) = L (liabilities) + OE (owner’s equity)
The net income for a period (from the income statement) is added to the retained earnings, which is part of the owner’s equity (which is on the balance sheet).
The mutation overview of owner’s equity explains the differences between the amounts of owner’s equity at the beginning and end of the fiscal period.
The cash flow statement explains the mutation in the amount of cash from the beginning till the end of the fiscal period.
2.2 Accounting concepts and principles.
Accounting principles and concepts reflect generally accepted practices, developed over time. They can be linked together in a schematic model of the data streams of transactions in relation to the annual report.
Assets = liabilities + equity
Procedures for sorting, (continuity)
classifying and presenting
Transactions Selecting alternatives methods Annual report
reflecting the effects of certain
Unit of measure - Accounting period - Consistency
Cost principle - Matching income and expenses - Full disclosure
Objectivity - Revenues at time of sale - Materiality
- Built concept - Conservatism
Concepts/principles relating to the model.
The basic accounting equation, as previously described, is the mechanic key to the whole financial accounting process, because this equation must hold after each and every transaction.
Accounting entity refers to the entity for which the financial statements are prepared. The entity can be an ownership, partnership, corporation of even a group of corporations.
The current business concept refers to the assumption that the entity will continue to operate in the future and that it will not liquidate.
Concepts/principles with regard to transactions
The cost principle means that transactions are recorded according to their original (historical) cost to the entity, measured in currency.
Objectivity refers to the desire of the auditor to treat each transaction the same way.
Concepts/principles related to accounting procedures and reporting process.
These concepts or principles relate to the accounting period: the period that is selected for reporting the results of the operations and changes in the financial position. This means that the revenues that occur because of the sale of product are combined with all the expenses related to generating these revenues, during a certain period of time.
This matching of revenues and expenses is crucial and fundamental for understanding accounting.
The constructed concept is used to implement the ‘matching concept’ by recognizing revenue when it is earned and expenses when they are made, without regard if the cash is received or paid in the same fiscal period.
Concept/principles related to financial statements.
Consistency in accounting is essential if meaning trend comparisons are to be made, based on the financial statements of an entity over several years.
Full disclosure means that the financial statements and disclosures must include all necessary information to ensure that the user of these financial statements isn’t misled.
Materiality means that absolute accuracy is not necessary in the amounts shown in the financial statements.
Conservatism involves making judgments and estimates that result in lower profits, instead of higher profits.
Consistency, full disclosure, materiality and conservatism have to do with the presentation of the financial reports.
Limitations of the annual report.
The annual report has certain limitations attached to the presented information. These limitations relate to the concepts and principles that have become generally accepted over time. This means that subjective, qualitative factors, current values, the impact of inflation and opportunity costs are not reflected in the annual report. A lot of financial statements are based on estimates. The use of alternative permitted accounting practices may mean that comparisons between companies are no longer suitable.
Financial statements report on the quantitative economic information, and don’t reflect qualitative economic variables.
The cost principles require that assets are noted at their original costs.
In general, the balance sheet doesn’t reflect the current market value or the replacement value of the assets. Some assets are recorded at a lower value than their market value.
Financial reports don’t reflect opportunity cost, which is an economic concept related to income lost, because a chance to make money is not used.
2.3 The annual report of a company.
The annual report is the document that is distributed to shareholders, employees, potential investors and other interested parties in the entity, and includes the financial reports for the fiscal year together with the report of external audit on the financial statements.
3.1 Financial ratios and trend analysis
The high amounts of dollars in the reports of financial overviews of a lot of companies and the varying size of these companies, lead to the point that ratio analysis is the only sensible approach for evaluating different financial characteristics of a company. A ratio shows the relationships between two numbers.
Users of financial statements express the data in the financial statements in ratios to facilitate the process of assessing and making decisions based on this information. The users are primarily interested in the trend of the ratios of a company and the comparison of these trend ratios of the company with those of the industry as a whole.
Return on investment.
The return on investment is a universal measure of profitability. It is calculated as followed:
Return on investment (ROI) = return / investment
The ROI is expressed as an annual percentage rate and is significant for most users of the financial statements, because it shows which return on the investment was able to earn on the assets acquired during the year at its disposal.
In other words: the ROI is one of the key measures of profitability because it indicates the relationship between the income earned during a period over which the assets were invested to generate that income.
The ROI can also be calculated based on the net income and the average total assets:
ROI = net income / average total assets
Some financial experts prefer to use the operational result and the average total assets to calculate the ROI.
ROI = operational result / average total assets
The DuPont model: an extension of the ROI
The DuPont model extends the basic model for calculating the ROI by introducing sales margin (net income / sales) and the total sales of the assets (sales / average assets).
This can be shown as followed:
ROI = (net income / sales) * (sales / average total assets)
ROI = Marge * turnover assets
The margin describes the profit that is made of each dollar sold, and the sales of assets reflect the capacity to generate sales from the corporate assets.
Return on equity.
The return on equity (ROE) shows the relationship between net income that is earned in one year compared to the equity in that year.
Return on equity = net income / average owner’s equity
The return on equity is an important measure for current and future owners, because it makes a link between income relative to the investment of owners.
Working capital and measures for liquidity.
Creditors are often interested in the liquidity of an entity.
Liquidity refers to the ability of a company to meet its current obligations and is measured by linking current assets and current liabilities.
Working capital is the excess of current assets of a company relative to its current liabilities.
Current assets are cash and other assets that are likely to be converted into cash within the year.
Current liabilities are obligations due within one year, including loans, debtors.
Most financially healthy companies have a positive working capital.
Liquidity is measured in three ways:
Working capital = current assets – current liabilities
Current ratio = current assets / current liabilities
Acid-test ratio = (Cash + Debtors) / current liabilities
The acid-test ratio is also called “quick ratio”. This quick ration is a more conservative short term liquidity measure, because the stock/inventory is not included.
A general rule is that a current ratio of 2,0 and an acid-ratio of 1,0 is considered to be an indication for sufficient liquidity.
In term of ability to pay debts, the higher the current ratio the better.
Illustration of trend analysis.
When ratio trend data is showed graphically, it is easy to see the importance of ratio changes to determine and to evaluate business performance.
However, it is necessary to pay attention to how graphs are drawn, as the presented visual image can be influenced by the scale.
In order to understand how various transactions influence the financial reports and to make sense of the information in the financial statements, it is necessary to understand the mechanical operation of the accounting process.
4.1 The accounting process
The accounting process starts with transactions (economic exchanges between entities, processed and displayed in the financial statements) and culminates in the annual report.
Annual reports result from accounting (procedures for sorting, classifying and presenting the effects of a transaction) and reporting (the selection of alternative methods for displaying the effects of certain transactions) processes.
The balance sheet equation: a mechanic key.
Accounting procedures for registering transaction are built on the framework of the balance sheet equation.
Assets = Liabilities + Owner’s Equity
We can rewrite the balance sheet equation, by adding revenues and expenses:
Assets = liabilities + invested capital – retained earnings
Assets = liabilities + invested capital – retained earnings (beginning of period) + revenues – expenses.
Revenues and expenses of the income statements are subsections of the retained earnings that are separately registered as the net income. The net income for a fiscal period is then added to the retained earnings from the beginning of the fiscal period, in the process of determining the income at the end of the fiscal period.
Bookkeeping jargon and procedures.
Due to the complexity of most business operations and the frequent need to refer to transactions in the past, the accounting system developed to make it easier to follow mutations.
Transactions are recorded initially into a journal entry. A journal entry is day-to-day chronological list of transaction. After that, the transactions are booked into a general ledger.
The general ledger is a large field with a column for each asset, liability item, equity category and there is an account for each category.
A chart of accounts is used as an index for the general ledger account and each is numbered, so that the booking of regular journal entry is easier.
For several years, the same calculating format has been used, namely the T accounts. One side of the T keeps track of the debits and the other side keeps track of the depreciations. The account balance at any moment in time, is the difference between the previous balance plus the debits minus the depreciation.
The left side of the T-account is called the debit side and the right side is called the credit-side.
The essence of the accounting process is that transactions are analyzed to determine which assets, liability or category of equity is affected and how it is affected.
Accounting procedures include the introduction of an account for each asset, liability, equity component, income and expense. These accounts can be display by a D of debit side on the left and the C of credit sight on the right.
The transactions are recorded in journal entry formats. The journal entry is the source of the amounts registered on an account. The closing balance of an account is the positive difference between the debit and credit amounts that are registered on the account, including the opening balance.
Asset accounts and expenditure accounts normally have a debit balance. Increases in assets are noted as debit posts on these accounts and decreases in assets as credit posts.
Liabilities, equity and income amounts normally have a credit balance.
Revenues are increases in equity and therefore normally have a credit balance and the credit items will increase.
Expenses are decreases in equity, so will spending accounts normally have a debit balance and will increase with debts.
The debit or credit behavior accounts for assets, liabilities, equity, income and expenses that can be summarized as followed:
Debit post rises:
Credit post rises:
Debit post declines:
Credit post declines:
The format of the journal entries has the following characteristics:
The date is recorded to provide a cross reference to transactions.
The name of the accounts, which is debited and the amount are on the left of the name of the account that is credited and the amount.
The abbreviations Dr. and Cr. Are used for debit and credit.
Dr. Account name
Cr. Account name
A requirement for the journal entry is that the total of the debit amounts is equal to the total of the credit amounts.
The following diagram illustrates the accounting process:
Transactions registered in Journal submitted into General Ledger.
Understanding the effects of transactions on the financial statements.
T-accounts and journal entries are models used by accountants for explaining and understanding the effects of transactions on the financial statements.
An alternative to the T-account and the model of journal entries that is useable for everyone, is the horizontal financial account relationship model as discussed in chapter 2. The horizontal model is an easy and useful way to understanding the effect of a transaction on the balance sheet.
Assets = liabilities + owner’s equity
Net income = revenues - expenses
The key to using this model is to balance the balance sheet.
For a transaction that affects both the balance sheet as the income statement, the balance sheet will be in equilibrium when the effect on equity is included in the income statement.
In the horizontal model, the account number is entered under the appropriate category of the financial statement and the dollar effect of that transactions on that account is entered with a + or – sign under the account name.
Suppose the owners of a company make an investment of $30. This is how it is entered in the horizontal model:
Assets = liabilities + owner’s equity
Net income = revenues - expenses
Cash Invested capital
+ 30 +30
Suppose: the company makes a transaction and pays $12 for advertising. The financial overview now looks like this:
Assets = liabilities + owner’s equity
Net income = revenues - expenses
The horizontal model can be abbreviated to the following single equation:
Assets = liabilities + owner’s equity + revenues – expenses.
After the end of the accounting period, accountants normally make a summary of every adaption on the account balance to maintain a good image of the accrual accounting in the financial reports. Adjustments result in income and revenue that are reported in the correct fiscal period.
There are two types of adjustments.
Accrued liabilities: transactions for which no money is received or paid, but the effect of which is included into the accounts in order to match the revenues with the expenses and for an accurate presentation of financial statements.
Reclassifications: the initial registration of a transaction does not result in declaring the income allocated to the period in which they were earned, and the expenses allocated to the period in which they occurred. The result is that a publication should be reclassified from one account to another to find the right balance in each account to display.
Adjustments describe accrued liabilities or reclassification rather than transactions and often affect both the balance sheet as the income statement.
Adjustments are a part of the accrued liabilities bookkeeping and are a requirement for achieving a match between revenues and expenses, so that financial statements accurately reflect the financial position and results of operations of an entity.
4.2 Transaction analysis methodology.
Transaction analysis is the process of determining how a transaction affects the financial statements. It asks and answers five questions:
Which accounts are affected?
How are they affected?
Is the balance in equilibrium?
Is my analysis useful?
To analyze each transaction, it is necessary to understand the transaction. This means understanding the activity that takes place between the entity for which the accounting is done and the other entity involved.
Finding out which accounts are affected refers to specific account names to which the transaction relates.
How the account is affected refers to it being an increase or decrease and translating it to debit or credit.
If the horizontal model is used, is it possible to easily determine that the balance equation is in equilibrium by observing the arithmetic sign and the amounts involved in the transaction.
It should be determined whether the effects of the horizontal model or the journal entries, cause changes in the account balance. If the analysis doesn’t make sense, you should go back to step 1.
Transaction can be initially introduced in virtually any way that makes sense at that time. Prior to the preparation of the final periodic financial statements, a reclassification adjustment can be made to display the correct assets/liabilities and revenues/expenses and the consequent activities.
Current assets refer to cash and other assets that are expected to be converted into cash within one year, or that are consumed within one operating cycle.
An operating cycle of an entity is the average time needed for the conversion of an investment of stock, back to money.
This can be shown in the following diagram:
Cash used for the purchase of goods, raw materials and labor
Stock which is held until it is being sold, usually on credit
Debtors which need to be collected.
Current assets contains the following items on the balance sheet.
Cash and cash equivalents
Deferred tax assets
5.1 Cash and cash equivalents
Cash includes cash in hand for changing funds, small liquid resources, unregistered income and every fund that is directly available for the company on its accounts.
Cash equivalents are short-term investments that are ready to be converted into cash with a minimal risk of price change due to interest rate changes.
The amount of cash on the balance sheet, report the available money that the entity has at its disposal at the time of the closing balance.
Bank details combined as a control for cash
Cash that is available on the bank account is determined by combining the bank balance statement with the booking balance of the entity. Combining items is necessary because there are time difference and errors, making the balance of the bank differ from the balance of the accounts of the entity.
Timing differences arise because the entity is aware of the fact that some transaction will influence the cash balance, but the bank doesn’t know about them yet or the bank has book certain transactions of which the entity is not aware.
The most common time differences are:
Deposits “in transit”: these deposits have been recorded in the cash account of the entity, but are not credited into the bank balance.
Outstanding checks: these are registered as credit terms on the cash account, but are not yet transferred to the bank to get paid.
Service bank charges: which are deducted from the bank account of the entity during the period of the bank.
Non-sufficient funds control: controls that are held payments, because not enough funds were present on the bank account.
5.2 Short term marketable securities
Entities invest a surplus of cash temporarily in short term marketable securities, in order to improve the ROI of the company.
Balance sheet evaluation
Cash managers invest in short term securities with a low-risk profile, of which it is not expected that the market will fluctuate greatly.
Marketable securities that held to maturity are registered under costs. Securities that are sold or available for selling are registered at market value.
Sometimes interest incomes on short-term marketable securities are classified as earning, so that both the balance sheet and the income statement account a more accurate representation of the financial position at the end of the period.
The asset that is involved in this, is called interest receivable and interest is the corresponding post on the income statement.
Assets = liabilities + equity
Net income = income - expenses
5.3 Accounts receivable
Accounts receivable are valuated at the amount they are expected to raise, or the yield value. This accounting principle requires that they estimated losses from uncollectible accounts are recognized in the fiscal period in which the right to those accounts lies.
A valuation adjustment for recognizing uncollectible debts and by the use of a provision for doubtful accounts receivable make this complete. When a specific account receivable is determined to be uncollectible, it is depreciated against the allowance account. This can be shown as followed:
Assets = liabilities + owner’s equity
Net income = revenues – expenses
- Accounts receivable
+ Allowance doubtful accounts receivable
The depreciation charged to the post doubtful accounts receivable has no effect on the income statement.
Companies encourage their customers to pay their bills faster by providing a discount if the customer pays within a specific period.
Discounts on sales are often deducted from the sales in the income statement, because the discount is in fact a reduction of the selling price. It is better to reduce the accounts receivable with a provision for estimated discounts.
5.4 Outstanding claim
If a company has a claim by a customer who has difficulty paying, the company can convert the claim to still to outstanding claims. The effect of these transactions is as follows:
Assets = liabilities + owner’s equity
Net income = revenues – expenses
- Accounts receivable
+ outstanding claims
Outstanding claims often have a longer period than accounts receivable and they carry interest. The bookkeeping of outstanding claims is equal to the bookkeeping of accounts receivable.
Assets = liabilities + owner’s equity
Net income = revenues – expenses
- Interest receivable
+ Interest revenues
For trade and production companies, the sale of inventory is an ordinary thing and an ongoing source of revenue. Recognizing costs of goods sold is an accounting process for the cost flow from the inventories account (assets) to the balance of cost of goods sold accounts (expenses) on the income statement.
Accounting of inventories involves selecting and applying a cost flow assumption for the expected pattern of the current cost of the inventories accounts to the cost of goods sold account.
Inventory cost flow assumption
The alternative cost flow assumptions are:
First in, first out
Last in, first out
Specific identification: when an item is sold, the cost of that item is determined by the statements of the company and that amount shall be transferred from the inventory account to the costs of goods sold.
The weighted average: this option is applied to individual items of inventory. It involves calculating the average cost of the items in the initial stock plus sales made during the year. Then these average costs are used to determine the goods sold and the value of the closing stock.
First in, first out (FIFO): this means that the initial cost of the inventory are the costs of the goods that were sold first.
Last in, first out (LIFO): the opposite of FIFO. The most recent costs incurred for the purchase of production are transferred to the income statement when items are sold.
The assumed cost flow will likely differ from the physical flow of the product.
The impact of cost changes (inflation/deflation).
It is important to understand how the inventory cost flow assumption used by a company, is related to the direction of the cost change and influences both the stock and the cost of goods sold.
When the costs are rising, LIFO results in a lower stock and a higher cost of goods sold than FIFO. These changes arise because the LIFO assumption leads to the most recent and higher costs, which are transferred to the cost of goods sold. When the purchase costs are descending, the opposite theory applies.
So when price levels change, different cost flow assumptions will result in different amounts of cost of goods sold on the income statement and the several stock accounts on the balance sheet.
The influence of inventory quantity changes.
The cost flow assumption also influences the effect of stock quantity changes on the balance, as well as the cost of goods sold and the ending inventory.
When using FIFO and the costs rise, the cost of goods sold will be lower and the profits will be higher than using LIFO.
Selecting an inventory cost flow assumption.
When the inflation rate was relatively low, a lot of financial managers chose the FIFO cost flow assumption, because this lead to lower cost of goods sold and led to a higher net income.
If the FIFO cost flow assumption is used in a period of rapid rising costs, there are stock gains.
Inventory accounting alternatives.
There are two basic inventory systems.
In a perpetual inventory system, an overview of each purchase and sale is made, along with a continuous overview of the quantity and cost of each item in the inventory.
In a periodic inventory system, there is a periodic inventory count at the end of the fiscal year and the cost of inventory is based on the cost flow assumption that is used. The cost of inventory are subtracted from the sum of the beginning inventory and purchased for determining the cost of goods sold.
Given the importance of inventories on most balances and the direct relationship between inventory and cost of goods sold, an accurate record of quantities should be pursued when the financial statements are important.
Errors in the amount of the closing stock have a direct effect on the cost of goods sold and the net income.
Balance sheet valuation against the lower cost price or the market price.
The inventory based on the carrying value is reported at lower cost or the market price. If the market price is lower than the cost price, then a loss is reported in the accounting period in which the decline in inventory value occurred.
5.6 Prepaid expenses and other current assets
Prepaid expenses arise in the accounting period at the accrual process. To achieve a suitable matching of income and expenses, prepaid expenses such as insurance, rent and other similar items, must be recorded as assets (rather than expenses) to the accounting period in which the benefits of these prepaid expenses are received.
5.7 Deferred tax assets.
Deferred tax assets occur when an expense is used for financial accounting purposes in a year, before it is deductible for income tax purposes.
Fixed assets include land, buildings, equipment and intangible assets (such as patents
and goodwill). This chapter shows how you can say something about fixed assets related to the balance in a meaningful way.
Under fixed assets fall:
Buildings and equipment
Assets required in case of capital lease
Natural resources and other assets
Property, equipment and installation of the entity are reported on the balance sheet against their original costs, minus the accumulated depreciations.
Land that is used in the operations of the company, is valuated on the balance sheet against the original costs. Because land is not used until there is nothing left (there is no ending), there is not accounting entry associated with land.
When land is sold, the difference between the selling price and the cost price is either a profit or a loss. This will be accounted for in the income statement of the period in which the transaction occurred.
6.2 Buildings and equipment
Buildings and equipment are stated at their original cost, namely the purchase price plus all ordinary and necessary costs that occurred by the task of preparing the building or equipment for business operations. Expenses that reflect the cost of purchasing an asset and that will ultimately benefit the entity, in a period longer than the current fiscal period, will be capitalized.
Depreciation for financial accounting purposes.
In accounting, depreciation is an application of the matching principle. The original cost of fixed assets represents expenses paid in advance of the economic benefits, which will be received in the future.
The depreciation process involves allocating the cost of an asset over the years in which the benefits of the assets are expected to be received. The depreciation expense is included every fiscal period and the effect on the annual report is shown below:
Assets = liabilities + owner’s equity
Net income = revenues – expenses
- Cumulative depreciation
Cumulative depreciation is the cumulative total of all depreciation expenses that are reported in the life of the assets until the date of the balance sheet. It is classified with the associated asset on the balance as a deduction from the cost of the asset.
The difference between the cost of an asset and the cumulative depreciation of the asset is the net carrying value of the asset.
There are two broad categories of depreciation calculation methods.
The linear methods are often used for booking purposes and accelerated methods are often used for income tax purposes.
The accelerated method results in higher depreciation expenses and a lower net income than the linear approach in the first year of the life of the asset. In the last years of the asset, the annual depreciation expense is lower with the accelerated method than with the linear method and this result in a higher net income.
Maintenance and repair expenses.
Routine repair and maintenance costs are spent in the fiscal period they occur.
Removal of depreciable assets.
When a depreciated asset is sold, both the assets as the related accumulated depreciation account are removed from the accounts.
Normally, there is a resulting profit or loss, depending if there was money received in the transaction in relation to the net book value of the asset.
Net book value = cost – cumulative depreciation
6.3 Assets acquired through capital lease
An operational lease is a contract for the use of an asset that contains not a single attribute of ownership.
A capital lease (or finance lease) assumes that the lessee carries all the risks and benefits of the ownership of the asset that is leased.
When the use of an asset is acquired through the use of a capital lease, the asset and the related lease obligations are reported on the balance sheet.
The cost of the asset is the present value of the lease payments, calculated by using the interest rate determined by the lesser before paying the periodic lease payments.
The asset is depreciated and the interest expenses associated with the lease are reported.
The importance of capital lease accounting, is that the economic impact of capital lease is no different from when the lease was directly purchased, so the impact on the annual report is also not allowed to vary.
6.4 Intangible assets
Intangible assets are assets with a long life, that differ from property and equipment purchased by capital lease, because the intangible asset is represented by a contractual right. This is because the asset is the result of a purchase transaction, but is not physically identifiable (such as a lease, license, trademark, patent, copyright or goodwill).
Because the cost of an installation and equipment are transferred to expenses over time by the use of depreciation accounting, the cost of most intangible assets are spent over time.
Amortization is spreading an amount over time and is used to describe the process of cost allocation of the intangible asset form the balance sheet to the profit and loss account as an expense. The cost of a tangible asset is depreciated and amortized on an intangible good.
6.5 Natural resources
The cost of natural resources are recognized as depletion costs, which are allocated to the restored natural resources.
Liabilities are obligations of the entity or as defined: probable future sacrifices of economic benefits arising from the current obligations of a certain entity for the transfer of assets or the delivery of services to another entity in the future as a result of transactions from the past.
Many liabilities are accounted for using the cost increase, which ensures a match between revenues and expenses.
Current liabilities are the debts due within one year after the balance sheet.
Under current liabilities fall:
Short term debt
Long term debt
Earned income or deferred credits
Other accrued liabilities
Long term obligations are:
Long term debts
Deferred tax obligations
Non-controlling interests in subsidiaries
Of long term liabilities is expected they are paid back after more than one year after the balance sheet datum.
7.1 Current liabilities
Short term liabilities.
Most liabilities arise because funds are borrowed or an obligation is promised as a result of a process of accrual accounting.
Long term debts such as a bank loan, is contracted to provide funds for the construction of seasonal stock. The loan is expected to be repaid when the inventory is sold and the debtors related to this sale have been paid.
A working capital loan is a type of short term loan. The short term loan usually has a maturity, specifically indicating when the loan must be repaid.
The short term loan resulting from this type of transaction is sometimes called a note payable. This is a formal promise to pay a fixed amount, usually with interest at a fixed rate and secured against collateral.
Interest expenses are associated with almost all loans and it is correct to book the interest expenses for each fiscal period, during which the money is borrowed.
Prime rate is the term used to express the interest rate on short term loans. The prime rate is determined by the lender and is increased or decreased by the lender in response to the credit market.
Interest calculation methods.
Interest on a discount loan is based on the principal sum of the loan, but the interest is deducted from the principal at the beginning of the loan and the only difference is made available to the borrower. This means that the borrower pays the interest in advance.
Suppose that $1.000 is borrowed for one year at an interest rate of 12%.
The interest rate (on a linear base) is calculated as follows:
Interest = principal sum * rate * time (in years)
Interest = $1.000 * 0,12 * 1
Interest = $120
At the maturity date of the note, the borrower will pay back the $1.000 and the owed interest of $120.
The borrowers effective interest rate (according to the annual percentage rate (APR)) is 12%.
APR = interest paid / (available cash * time (in years))
APR = $120 / $1000 * 1
APR = 12%
For a loan on which the interest is calculated based on the linear basis, the interest is built each period.
The interest calculation on discount base is calculated the same way as the linear base, except that the amount of interest is deducted from the principal sum of the loan and the borrower receives the differences.
In this case, the loan would yield $880 ($1.000 - $120). At the maturity date of the note, the borrower will just have to pay the principal sum of $1.000 because the interest has already been paid.
Because the entire principal amount is not available for the borrower, the annual percentage rate is higher than the rate stated in the loan agreement.
APR = interest paid (available cash * time (in years))
APR = $120 / $880 * 1
APR = 13,6%
Interest payable is a current liability because it will be paid within one year form the balance sheet date. For a loan on which the interest rate is calculated on a discount base, the amount of cash represents the initial carrying amount of the passive.
Discount rate results in a higher annual interest rate than a linear rate, because the discount rate is based on the maturity value of the loan and the proceeds available for the borrower are calculated as the principal sum minus the interest.
Discount is booked as a contra liability and is amortized against interest expenses. The amount of discount on the short term debt is shown as a liability on the balance sheet, as the decay value minus the amortized discount.
Current maturities of long term debt.
Long term debt with principal sum payments that are paid within one year from the balance sheet date are classified as current liabilities.
Debts represent the amounts owed to suppliers of inventory and other resources. Some debts get a cash discount if they pay within a specified time slot to the supplier.
Unearned revenue or deferred credit.
Customers often pay for services or products, before the service or product is delivered. An entity that collects money for the related revenues, must account for unearned revenue or deferred credit, which is included in current liabilities.
These must then be assigned to the tax periods in which the service is provided or the products are delivered in accordance with the matching principle. Unearned revenue, other deferred credits and other accrued liabilities arise primarily by accounting procedures on an accrual basis, which leads to the recognition of expenses/income in the fiscal period in which they arise.
Many of these obligations are estimated because the actual debt is not known during the preparation of the financial statements.
Payroll taxes and other deductions.
The total wages earned by workers in a certain payroll period, are called gross income or gross wages.
When the various taxes and contributions are deducted from this amount, what is left is called net wages for the employee.
The liabilities for accrued salaries, wages and accrued payroll deductions are usually classified as other liabilities for the current liabilities section of the balance sheet.
Other accrued liabilities.
The other accrued liabilities include accrued property taxes, accrued interest, accrued estimated warranty liabilities and other expenses such as advertising and insurance.
Each of these items represents an expense that is incurred but not yet paid. This is another application of the matching principle. The expense is recognized and the obligation is shown so that the financial statements give a complete summary of the results of the operations (income statement) and the financial position (Balance sheet) that would presented without the accrual.
The accrual for income taxes is usually displayed separately because of the significance. The current liability for income taxes is related to the long term provision of deferred taxes.
7.2 Noncurrent liabilities
Long term debt.
The capital structure of a company is the mix of debt and equity that is used to finance the acquisition of the business assets.
For most non-financial companies, long term stands for more than half of the capital structure of the company. One of the advantages of using debt is that the interest payments can be deducted from the income, which results in a tax advantage, while dividends are not deductible.
Financial leverage refers to the difference between the ROI and ROE. Funds are borrowed rather than the owners invest their own funds, as the company expects a benefit from the financial leverage associated with debt.
If borrowed money can be invested to earn a higher return on investment (ROI) than the interest cost, than the return on equity (ROE) will be greater than the ROI. However, the reverse is also true.
Leverage contributes to the risks associated with making an investment in an entity. Most long term debts are issued in the form of bonds.
A bond or bonds payable is a formal document, usually issued in nomination of $1.000.
The nominal amount is the amount of the principal sum that is printed on the bond. The amount of the bond premium represents the excess of its market value over its normal value.
A bond discount is the excess of the nominal amount compared to the market value.
Suppose two companies have the same assets and operating income. The company unlevered (I) has no long term debts. The company with financial leverage has a capital of 40% long term debt at an interest rate of 10% and 60% equity.
Determine the ROI and ROE for each company.
Company I without leverage
Company II with financial leverage
Liabilities (10% rate)
Total liabilities + equity
Total assets +equity
ROI and ROE calculation company I
Return on investment = operational income / assets
ROI = %1.200 / $10.000
ROI = 12%
Return on equity = net income / equity
ROE = $1.200 / $10.000
ROE = 12%
ROI and ROE calculation company II
Return on investment = operational income / assets
ROI = %1.200 / $10.000
ROI = 12%
Return on equity = net income / equity
ROE = $800 / $6.000
ROE = 13.3%
In this case the ROI is the same for both companies, because the operating result does not differ from each other, each company was able to get 12% of its assets available to earn.
The difference can be seen in the way the assets were financed (capital). The company with the financial leverage has a higher ROE, because the company was able to borrow money against the cost of 10%, and used the money to buy assets which earn 12%.
So ROE will be higher for a company with a positive financial leverage. The surplus on the return of borrowed funds is the rewards for the owners, to take the risk of lending money at a fixed cost.
Bonds have a fixed interest rate, a nominal value or principal sum and an expiration date when the principal sum should be repaid. Because the interest rate is fixed, changes in the market interest rate lead to fluctuations in the market value of a bond. If the market interest rate increases, the bond prices will go down and vice versa.
The market value of a bond is the present value of the interest payments and maturity value, discounted at the marked rate.
When bonds are issued and the market rate of that date is different from the noted price on the bond, there is a premium (agio) or a discount. Both bond premiums and discounts are amortized over the interest expense over the life of the bond.
Bond premiums amortization lowers the interest expense below the amount of the interest paid. Discount amortization increases the interest expense above the amount of interest paid.
Bond premium is on the balance sheet classified as an addition to the bond payable liability.
A bond is sometimes expired before its expiry date, because the market interest rates are significantly below the level of the noted rate of the bond. For a user, prematurely expired bonds can lead to a profit, most usually it leads to a loss.
Deferred tax liabilities.
Deferred tax liabilities result from temporary differences between booked income and taxable income. Normally, deferred tax liabilities are long term liabilities and they represent the income tax that is expected to be paid after more than one year after the balance sheet date.
For many companies, deferred taxes are one of the most significant obligations on the balance sheet to see. The most significant and temporary difference is cause by the different depreciation methods used for any purpose. If income tax rates do not decline, the deferred income tax liability of most companies rise over time. The amount of deferred income tax is the amount of income tax expected to be paid in future years, based on the tax rates that are expected to be applied in future years, multiplied by the total amount of temporary differences.
Other long term liabilities.
Other long term liabilities may be associated with obligations, other post-retirement obligations, warranties or estimated liabilities arising from ongoing lawsuits. Expenses of these plans are allocated and reflect on the income statement of the fiscal period in which the benefits are earned by the employee.
Provisions are potential gains or losses whose determination depends on one or more future events. Contingent liabilities are potential claims on the assets arising from lawsuits, environmental hazards, casualty losses from property and product warranties. Because of accounting conservatism, provisions are not accounted for on the income statement.
Equity is the claim of owners of the entity in relation to the assets shown on the balance sheet. Another term for equity is net assets, that is the assets minus liabilities.
For sole proprietorships and partnerships, the term capital is often used instead of equity. For a company, equity consists of multiple components:
Cumulative total other income
8.1 Paid-up capital
Paid-up capital includes ordinary shares and preferential shares and may involve additional paid-in capital.
Ordinary shares represent the basic assets of a company. Ordinary shareholders have a claim on all assets of the entity that are left, after all other obligations and preferential shareholders have been paid.
Under equity falls:
Additional paid-in capital
Accumulated other overall result
Ordinary shares may have a par value or no par value. The nominal value is usually a nominal amount assigned to each share in an organized enterprise.
Additional paid-in capital represents the difference between the nominal value of the ordinary shares issued and the total amount paid to the company when the share was issued.
The number of issued shares is amount of shares which are actually transferred from the company to the shareholders.
Additional paid-in capital is sometimes described as capital in surplus of par value.
If one ordinary share of no par value has no quoted value, the total amount paid when the share was issued to the company, is reported as the dollar amount of an ordinary share.
The fundamental rights and obligations of the ordinary shareholders are choosing the board of directors for the company. The voting for directors can be done on an accumulation or slate basis.
A preferential share is different from an ordinary share as the preferred holders have a priority claim on dividends and assets if the company is liquidated. A preference share has no electoral privilege.
A dividend is a distribution of the profits of the enterprise to its owners (shareholders). The dividend requirement of a preference share must be met, before dividend can be paid to ordinary shareholders.
A cumulative dividend means a dividend payment to preferred shareholders is not done, then the total amount of such dividends missed are to be paid before dividends can be paid to ordinary shareholders.
Additional paid-in capital
Additional paid-in capital is a category of equity, that the surplus of the amounts received from the sale of preferential or common shares of the nominal value reflects.
Excess capital in nominal value and capital surplus are terms sometimes used to describe additional paid-in capital.
In other words, the paid up capital of an enterprise reflects the amount invested by the owners.
8.2 Retained earnings
Retained earnings reflect the cumulative income of the company, which are retained for use in the business rather than distributed to shareholders as dividends.
So retained earnings represent the cumulative income invested in the company. If the income is not reinvested, they will be distributed as dividends to shareholders.
Retained earnings are not cash. The retained earnings account is increased by the net income and reduced by dividends.
Dividends are declared by the board of directors, and from the date of record paid to the owners of the share. Although cash dividends can be paid with whatever frequency preferred, the most common payments are quarterly or semi-annually.
Stock dividend and split shares
Stock dividend represents the issuance of additional shares of the portfolio of the shareholders in proportion to the amount of shares held on the date of record.
Stock dividend will not affect the assets, liabilities or total equity of the company, but move an amount of retained earnings to paid-in capital.
Share dividend is expressed as a percentage of the number of issued shares pre-dividend and that percentage is usually relatively small.
A stock split means: the issue of additional shares to existing shareholders and if the share has a nominal value, the proportional reduction of the nominal value.
Share split also involves the issue of additional shares of stock of shareholders in proportion to the number of shares held on the date of record.
Stock splits are expressed as a ratio of the number of shares, which are held after the split with respect to the amount required for the cleavage took place (for example, 2 to 1).
The reason for splitting of a share is lowering the market value of the portfolio. Reverse stock splits take place to for opposite reasons, namely to increase the market value per share of the issuer portfolio.
8.3 Accumulated other overall result
The cumulative foreign currency conversion adjustment is the amount of equity the company stated that it holds in foreign subsidiaries.
The adjustment occurs in the process of translating the financial statements of the subsidiaries (expressed in foreign currency units) compared to U.S. dollars.
Since exchange rates can fluctuate, the net income can be distorted as the adjustments would be reported in the income statement. To avoid this distortion, the adjustment is reported in equity as a component of accumulated other total income (loss).
8.4 Treasury shares
Treasury shares of the company are shares that were purchased back from shareholders for future re-issue or other use.
Treasury shares are reported as a contra account of equity. When shares are issued at a price that is different from its cost, no gain or loss recognized but the paid-up capital is affected.
Since private equity transactions are capital transactions (between the company and its shareholders), the income statement is never affected by the purchase or sale of treasury shares.
On own shares no cash dividend is paid, because a company cannot pay dividends to itself.
However, on its treasury shares, dividends paid in shares and stock split affects the shares.
This means that cash dividends are based on the number of outstanding shares, while shares in dividends and stock splits are based on the number of previously issued shares.
8.5 Reporting of changes in equity accounts
It is desirable that the reasons for changes in each account of the equity during a fiscal period at the balance sheet, are presented in a separate statement of changes in equity that have occurred or in the footnotes of the financial statements.
8.6 Non-controlling interest
Non-controlling interest, sometimes called minority interest, is the portion of the equity in a subsidiary not owned by the parent (reporting entity). This item represents the carrying value of the minority interest and not the market value of their assets. It must be presented in the consolidated balance sheet, together with the power, but separate from the assets of the parent.
Equity components that are often seen on the balance sheet, consist of:
Preferential shares (sometimes issued)
Ordinary shares (always issued)
Additional paid-in capital
Retained earnings (accumulated deficit if negative)
Accumulated other Total profit (loss)
Non-controlling interest (in fact the ability is important that non-owners in the reporting entity
It is possible that a company has only ordinary shares (sometimes called capital shares) or retained earnings as a component of equity.
8.7 Equity for other types of entities
Changes in equity are usually reported in a comprehensive statement that summarizes the changes of each element of equity. However, if no significant changes in the paid-up capital accounts have been conducted, a statement of changes in retained earnings in itself can be presented. Sometimes the statement of changes in retained earnings is combined with the income statement.
Proprietorship, partnership and non-profit organizations report changes in equity through the use of terminology for each type of entity. In the final analysis, the purpose of the explanation is the same for these entities as for the company, namely the change in net assets of the entity to explain during the reporting period.
Non-profit and government organizations
These types of organizations do not have owners who have a direct financial interest. The equity in this organization is called fund balance.
The income statement answers some of the most important questions that users of financial statements have, namely:
What were the financial results of the business performance of the entity for the fiscal period?
How much profit or loss did the company make?
Did the sales rise to the cost of goods sold and other operating expenses?
Due to the importance of the net income for managers, shareholders, potential investors and others, it is important to focus on the form and content of the financial report. The income statement summarizes the results of the profit generating activities for a fiscal period. The statement of cash flows explains the change in the cash of the company, from the beginning to the end of the fiscal period by summarizing the cash flow effects of the business operating, investing and financing activities during the period.
9.1 The income statement
Revenues are reported at the beginning of the income statement.
The FASB defines revenues as "inflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination of both) from the supply of manufactured goods, provision of services or other activities, which are major on-going or central operations of the entity forms ". This means that when a business sells a product or a service to a customer and receives money, a receivable account is created and there is revenue for the company.
Revenues are measured by the amount of money received or expected to be received from the transaction. If the money within one year is expected to be received, then the revenue is often measured by the net present value of the amount expected to be received.
Selling is the term used to describe the revenue or income of companies, which purchased or manufactured products to sell.
Net sales are:
1. Gross sales - returns and compensations.
Net sales is usually the first caption of the income statement.
Suppose a company gives sales discounts to companies that pay quickly, than these discounts are also deducted from the gross sales.
Income is calculated as follows:
2. Sell $ ........
3. - Returns and reimbursements ( ) -
4. - Sales Discounts ( ) -
5. Net sales $ ........
Profits, which are increases in net assets of an entity arising from individual transactions or non-operational activities, and are usually not included in income at the beginning of the income statement.
The FASB defines expenses as the outflow or other ways of using assets or the creation of liabilities (or a combination of both) from the supplying manufactured goods, provision of services or the promotion of other activities, which are large parts of on-going or central operations of the entity.
Expenses are recognized in accordance with the matching principle, because they arise to support the income generating process. The amount of the expenses is measured by the cash or other assets that have been consumed to obtain economic benefits. Examples of expenses are: the cost of goods sold, compensation of employees, bad debt and depreciation of fixed assets.
Losses are decreases in net assets of an entity to arising from occasional or non-operational activities and are not included in the expenses. Losses are reported after the income from operations.
Cost of goods sold
Expenses are deducted from income in the income statement. A significant issue for many companies is the cost of goods sold. The inventory cost flow assumption used by the company is used, affects this expense. Inventory reduction (loss of stock) is usually included in the cost of goods sold unless the amount included material.
The determination of the amount of the cost of goods sold is a function of the inventory cost flow assumption and the inventory accounting system (periodic or perpetual). In a perpetual inventory system, cost is determined and recognized when a product is sold. In a periodic inventory system, cost of goods sold calculated at the end of the fiscal period by using beginning and ending inventory amounts and purchase amounts (or the cost of manufactured goods).
The expected cost of goods model looks like this:
Cost of initial stock $ 3.370
+ Net purchases 17,116
= Cost of goods available for sale $ 20.486
- Cost of closing stock (3,744)
Cost of goods sold = $ 16.742
When the periodic inventory system is used, the net purchase price is calculated as follows:
Purchases $ ............
+ Freight ............
- Purchase Discounts ( )
Purchases Returns and Allowances ( )
Net purchases = $ ............
Although the periodic system is less complicated stock tracking system, than the perpetual system, the need to take a complete physical inventory to accurately determine the cost of goods sold, is a disadvantage. Inventory reduction is not known if the periodic system is used, because these losses are included in the total cost of goods sold.
Gross profit or gross margin.
The difference between the sales revenue and the cost of goods sold, is the gross profit or gross margin. Gross profit is frequently expressed as a ratio.
• Net income $ 35.382
• Sales -17,164
• Gross margin $ 18.218
When gross profit is expressed as a percentage of the sales amount, then we speak of the gross profit ratio (or gross margin ratio). This is a particularly important measure for managers of trade companies. The gross profit ratio can be used to monitor profitability, determining sales and estimating the final inventory and cost of goods sold.
Net sales (or net income) is $ 37.586
Cost of goods sold (sales) are 16.742
Gross margin $ 20.844
The gross profit ratio is calculated as follows:
Gross margin = Gross profit / Net sales
= $ 20.844 / $ 37.586
A company expects a gross profit ratio of 30% for the current fiscal year. Initial stock is known, because it is the amount of physical inventory at the end of the fiscal year. Net sales and net purchases are known from the accounting data of the current fiscal period. Calculate, based on this data, the estimated stock.
Net sales $ 100,000 100%
Cost of goods sold
Initial stock $ 19,000
Net purchases $ 63,000
Cost of goods available for sale $ 82,000
Closing stock $ ?
Cost of goods sold $ ?
Grossed $ ? 30%
Calculation of estimated stock:
Gross profit = 30% x $ 100,000 = $ 30,000
Cost of goods sold = $ 100,000 - $ 30,000 = $ 70,000
Closing stock = $ 82,000 - $ 70,000 = $ 12,000
The gross profit ratio can be used to estimate the cost of goods sold and the ending inventory of periods in which a physical inventory has not been measured. Another important use of the gross profit margin for the determination of sale. If the manager knows the gross profit ratio, which is required to achieve profitability at a given level of sales results, the cost of the item is to be divided by the complement of the gross profit ratio for determining the selling price.
For a retailer, the cost for purchasing a particular rug $ 8 per square meter. What price per m² should be maintained for this product if a 20% gross profit ratio is desired?
Selling price = Cost of product / (1 - desired gross profit ratio)
= $ 8 / (1 - 0.2)
= $ 10
Calculated price $ 10 per m²
Cost of the product $ 8 per m²
Gross profit $ 2 per m²
Gross profit ratio = Gross profit / sales
= $ 2 / $ 10
The major categories of other operating expenses that are regularly reported on the income statement are:
General and administrative expenses
Research and development expenses
These expenses are deducted from the gross profit to determine the operating income, an important measure of the performance of management.
Income from operations
The difference between gross profit and operating expenses represents the income from operations (or operating income), as shown in the example below:
Consolidated income statement
Net income $ 37.586
Cost of sales $ 16.742
Gross margin 20,844
Marketing, general and administrative 5.458
Restructuring and asset impairment 710
Operating expenses $ 11.890
Operating income $ 8.954
The operating income is often interpreted as the most appropriate measure to exploit the operating assets of the company. The operating income normally doesn’t include the effects of interest expense, interest income, gains and losses, income taxes and other non-operational transactions. Interest expenses are usually shown as a separate item in the other income and expenditure category of the income statement.
Other income and expenses.
Other income and expenses are reported after income from operations. These non-operating items consist of interest expense, interest income, gains and losses.
Income before income tax and income tax expense.
Income before income tax is frequently reported as a subtotal before the income tax expense, because taxes are a function of all items reported to this point in the income statement.
Net income and earnings per share (EPS)
Net income (or net loss), sometimes called the bottom line, is the arithmetic sum of the earnings and profits minus expenses and losses. Because the net income lets the retained earnings rise, which is usually a prerequisite for dividends, the shareholders and potential investors are especially interested in the net income. For an easier interpretation of the net income (or loss), it is also reported on the basis of each share of the outstanding equity portfolio.
Earnings per share (EPS) is calculated by dividing net income by the average number of shares of the outstanding equity portfolio during the year.
Suppose: A company has a net income of $ 1,527,000 and 80,000 shares at 7% and $ 50 nominal value of the outstanding preference shares during the year.
Calculate the earnings per share as follows:
Net income $ 1,527,000
Less preferred share dividends required
(7% x $ 50 nom. Value x 80,000 shares) 280,000
Net income attributable to common shares $ 124.7000
Earnings per share = Net income available for common shares
Weighted average number of shares outstanding equity
= $ 1,247,000 / 224,167
= $ 5.56
Given their importance, the earnings are shown immediately below the net income on the income statement. If there is a potential dilution of convertible debt, convertible preferred shares or stock options, or diluted earnings per share, these will also be reported.
The reduction in earnings per share (for example by reduction of interest payments) of the ordinary share is called dilution.
Presentation alternatives to the income statement.
There are two principal alternative presentations for presenting the income statement, namely the single format and multiple format. The main difference between these two formats is that the multiple format provides subtotals for gross profit and income from operations.
Unusual items that sometimes shown on an income statement.
To easily compare the net income with previous years and providing a basis for future expectations income or loss from discontinued operations and extraordinary items are reported separately in the income statement and on a per share basis.
Extraordinary items mean that a transaction is unusual in nature and occurs irregularly, and that is reported as an extraordinary item if the transaction has an important after-tax effect on the income statement. Examples of these items are pension plan terminations, some legal settlements et cetera.
9.2 Cash Flow statement
Content and format of the summary
The cash flow statement shows the change in cash during the year, and report money that is provided or used by operating activities, investing activities and financing activities.
Cash flow from operating activities
There are two alternative approaches to the presenting part of the operations of the cash flow summary:
The direct method
The indirect method
Ad 1: This method involves making a list of each major class of transactions, cash receipt and cash disbursement transactions for each of the three areas of activity.
Ad 2: The indirect method declares the cash flows from operations by explaining the change in non-cash operating each account on the balance sheet.
The difference between the two methods is the presentation of cash flows from operating activities. Most companies use the indirect method.
Cash flows from investing and financing activities.
Investing activities may include: the purchase of equipment and installations, investments in other companies, loans to other entities and the sale of collection of these assets.
Financing activities: include: the issuing and the redemption of bonds and shares, including treasury shares transactions and cash dividend on shares stock.
Interpreting the cash flow statement.
Interpretation of the cash flow statement involves observing the relationship between the three broad categories of cash flows (operating activities, investing activities and financing activities) and the change in the cash balance for that year. It is desirable to have money from operations equal to, or greater than the cash used for investing activities, although large investment requirements in any year may cause a decrease at the beginning of the year balance. Money can also be obtained from financial activities for major investments to compensate.
The detailed activities of each cash flow category will be reconsidered for assessing their impact on the overall cash position of the company. The statement of cash flows provides important information that is not easily obtained from other financial statements.
10.1 Corporate Governance
Corporate governance issues continue to raise the attention of legislators, regulators, investors and senior management teams of public companies. Corporate governance is more than simply a set of structures, control mechanisms, rules and laws that the directors, officers and employees must follow.
Financial reporting misconceptions.
The Sarbanes-Oxley Act (SOX) of 2002 and the creation of the Public Company Accounting Oversight Board (PCAOB) has led to significant improvements in the development of a viable corporate financial reporting model.
10.2 General organization of explanatory notes
The explanatory note, which refers to specific items of financial statements, is generally in the same order as the financial statements and in the same order as the items within the individual charts appears.
The order of the financial statement is usually:
Statement of cash flows
These explanatory notes are an integral part of the financial statements, because they contain important disclosures, which are not included in the financial statements themselves. These statements are sometimes called the financial statement and result from the application of the full disclosure concept that has been discussed in chapter two.
The explanatory notes details of amounts, summarized for financial statement presentation, and state which allowed alternative accounting practices are used by the entity and provide a detailed explanation of information that is necessary to fully understand the financial statements.
10.3 Explanatory notes (or financial statement)
Significant accounting policies
Management must make some choices between alternative accounting practices and generally accepted accounting principles. Since these choices differ between companies, the openness of the specific practices that are followed in a given company is necessary for the readers in order for the financial statement to be useful.
Accounting policies disclosure, includes:
The depreciation method
The inventory cost flow assumption
The basis of consolidation
Ad depreciation method: the amount of depreciation expense may also be included in the notes, although it is reported in the statement of cash flows as a back addition to the net income.
Ad inventory valuation method: the method (weighted average, FIFO, LIFO) used, is also included.
Ad basis of consolidation: a brief overview confirms that the financial information contains all subsidiaries, or if this is not the case, why not.
Furthermore, the reporting of income taxes, employee benefits and amortization of intangible assets of an entity are also described. Also, sometimes the details of the calculation of earnings per ordinary share are included.
There is a discussion of employee stock options and share purchase plans. Many companies have a stock option plan which indicates that a certain number of shares at some point in the future, are able for you to buy, at a price equal to the market value of the share when the option is granted.
In a stock purchase plan, the employees can buy a share of the common stock portfolio of the company at a slight discount rate compared to the market value. The aim is to encourage employees to allow them part owners of the company.
Details of other financial statement amounts
Many companies will include in the notes details of record companies, which are reported as a single item in the financial statements.
Accounting modification: a change in the application of an accounting policy that has a material effect on the comparability of the financial statements of the current period with those of the previous periods. The effects of recently adopted accounting changes must also be attached.
Business combinations: if the company has been involved in a business combination, the included transactions described and the effect on the financial statements will be explained.
Risks and liabilities: significant risks and liabilities, such as litigation or loan guarantees, but also significant events that have taken place since the balance sheet date, are disclosed. This is a specific application of the concept of full disclosure.
Impact of inflation: it has already been stressed that the financial statements does not reflect the impact of inflation. The original cost concept and objectivity principle result in assets, which are recorded in their historical costs of the entity, based on current dollars at the time the transactions were initially recorded.
The impact of inflation on the historical cost amounts in the financial statements can be used, although this information must be reported at this time.
Segment information: segment information summarizes certain financial information about the main activities of the company together. The purpose of this note is to allow an assessment of the significance for the overall results of its activities in certain business segments and geographic areas.
Segment data split a company into smaller components so that the readers more useful information for decision making.
Management Overview of responsibilities
Many businesses provide an explanatory statement of management responsibility, which states that the responsibility for the financial statements lies within the management of the company and not with the external accounts and the statement of management's responsibility recognizes this. This recognition usually includes a reference to the system of internal control.
10.4 Management discussion and analysis
Management discussion and analysis of financial condition and operating results of the company provide an important and useful summary of the business. It is a part of the annual report that must be read by current and potential investors.
10.5 Five-year (or longer) summary of financial data
Most annual reports of companies will be a summary of the financial data for at least the five most recent years present. Many companies report these data for longer periods. This summary is for users of financial statements, so that they can evaluate trends easier. The five-year summary is not included in the scope of work of the independent auditor. The summary is not part of the notes to the financial statements, but is an additional explanation.
10.6 Report of the independent auditor
The independent auditor's report includes an opinion on the fair presentation of the financial statements in accordance with accounting principles generally accepted in the United States and to draw attention to special situations. Accountants are no guarantee that the company will be profitable or they give assurance that the financial statements are absolutely accurate.
10.7 Financial statement compilations
Companies also provide accounting services to clients whose debt and equity securities are not publicly traded and for which financial statements are not required that they be checked. As the accountancy company is not bound to a control, it is necessary that a report is issued to the user. This report clearly communicates that the accounting company gives no form of assurance on the fairness of the financial statements. Such a report is called a compilation report.
The process of interpreting the financial statements of an entity can be supported by some ratio calculations and if the financial condition and results of operations of a company should be compared with those of another entity, the use of ratio analysis of financial statements is essential.
11.1 Financial statement analysis ratios
The ratios used to simplify the interpretation of the financial position of an entity and results of operations may be grouped into four categories that deal with:
Ad 1: Liquidity measures
The creditors are primarily interested in the liquidity of the entity. The liquidity measures of working capital, current ratio and acid-test ratio have been discussed in chapter three.
One point that should be emphasized, is the effect of inventory cost flow assumption on working capital.
Although the companies may be the same in all other respects, they will report different amounts of working capital, and they will have different current ratios. Therefore, a direct comparison of the liquidity of two companies through the use of these measures is not possible.
Ad 2: Activity measures
Activity measures reflect the efficiency of how assets are used to generate a sales revenue. The impact of efficient use of assets on the ROI of the company was explained in chapter three, in the discussion of asset sales component of the DuPont model (ROI = Margin x Turnover). Activity measures primarily focus on the relationship between asset levels and sales (turnover).
The general model for calculating the turnover is:
Turnover = sales / average assets
Turnover is calculated regularly for:
Equipment and facilities
Total operating assets
The use of alternative inventory cost flow assumptions and amortization methods influence the comparability of sales between companies.
The accounts receivable turnover is calculated as:
Accounts receivable turnover = sales / average accounts receivable
The inventory turnover is calculated as:
Inventory turnover = cost of goods sold / average inventory
The installation and equipment sales is calculated as follows:
Installation and equipment turnover = sales / average plant and equipment
Activity can also be expressed in terms of the number of days of activity (= sales) in the final balance (= debtor).
Average sales per day = annual sales / 365 days
Debtors by average sales per day = accounts receivable / average sales per day
Number of days of sales per day in stock:
Average cost of goods sold per day = annual cost of goods sold / 365
Sales of stock per day = stock / average cost of goods sold per day
When evaluating the operational efficiency of a company, the trend of the calculation results is important. This is because the trend contains more information than a single calculation result at a given moment in time.
Trend Comparisons between the entity and broad industry averages are also useful.
In general, the higher the turnover, the fewer the number of sales per day in the ledger accounts receivable and inventory, the greater the efficiency.
Ad 3 Profitability measures
Two of the most significant measures of profitability, ROI and ROE have already been explained in chapter three.
An ROI based on operating income is an evaluation of the operational activities of the company mentioned. The balance sheet items for these calculations are average total assets for ROI, and average power of ordinary shareholders for ROE.
Profitability analyses will be valid when they are based on the trend of the ROI and ROE of a company relative to the trend of the industry and the yields of competitors.
The price earnings ratio, simply called P / E ratio, can be calculated by dividing the market price of a share by the earnings per share. The P / E ratio is used extensively by investors to evaluate the market price of an ordinary share of a company relative to the overall market.
Earnings ratio is another term for the price earnings ratio. This term does reflect the fact that the market price of a share is equal to earnings per share, multiplied by the P / E ratio.
Diluted earnings per share is normally used in the P / E calculation:
Price earnings ratio = market price of an ordinary share / diluted earnings per share of common stock portfolio
The price earnings ratio is one of the most important criteria, the investor uses to evaluate the market price of the ordinary shares of a portfolio company.
Another ratio that is used by both ordinary share and preference share investors is the dividend yield. This is expressed by dividing the annual dividend by the current market price of the share.
Dividend yield = annual dividend per share / market price per share
A dividend yield should be compared with the available return on alternative investments to the investor to help evaluate the extent that its investment objectives were achieved.
Another ratio with respect to the dividend on ordinary shares is the dividend pay-out ratio.
Dividend pay-out ratio = annual dividend per share / earnings per share
The preferential dividend coverage ratio is calculated as follows:
Preferential dividend coverage ratio = net income / required preference dividend
Ad 4 Financial leverage metrics
Financial leverage indicates the use of debt to finance assets of the entity. Leverage adds risk to the operation of the company, because if the company does not generate enough money to pay the principal and interest payments, creditors can force the company into bankruptcy.
Because the cost of debt (interest rates) is a fixed fee regardless of the amount of revenue, increased leverage, the return for the owners (ROE) relative to the return on assets (ROI). Borrowing money at an interest rate that is lower than the return that can be earned on that money, increases the return on equity.
There are two measures of financial leverage:
The debt ratio
The debt / equity ratio
These ratios are used to determine the size of the extent to which a financial lever is used. The debt ratio is the ratio of total debt to total liabilities and equity of an entity.
The debt / equity ratio is the ratio of total debt to total equity.
So a debt ratio of 50% would be the same as a debt / equity ratio of 1.
Debt: $ 40,000
Equity: $ 60,000
Total Debt + EV $100,000
Debt ratio = total liabilities / total liabilities and equity
= $ 40,000 / $ 100,000
Debt / equity ratio = total debt / total equity
= $ 40,000 / $ 60,000
The interest coverage ratio shows the relationship between income before interest and taxes (operating income) relative to the interest expenditure.
The larger the ratio, the more debt providers have confidence about the prospects of the company for the continuity to have enough income to cover interest payments, even if the company is a decline in the demand for its products or services experience.
Interest coverage ratio = earnings before interest and taxes / interest expense
11.2 Other analytical techniques
Book value per share of ordinary share.
The book value per share of common stock portfolio is calculated by the ordinary shareholders' equity divided by the number of shares of outstanding common shares.
Book value per share = Common shareholders' equity / number of shares of outstanding common shares.
The book value per share of a common share is regularly reported, but because it is based on the financial statement value of the business assets rather than their market value, the book value is not very useful in most situations.
Common size financial statements.
An effective way to compare the financial condition and results of operations of different sizes of firms, is the expression of the balance sheet data as percentages of sales.
This process results in a vertical common measure of financial statements. It is also useful to prepare financial statements in accordance with a common horizontal measure to prepare, which show trends in individual items over several years compared to the base year.
Other operating statistics.
Physical measures of an activity rather than financial measures, included in the financial statements are usually helpful. For example, reporting the number of employees may be more useful for some purposes than reporting salaries.
Investors, managers, employees and others are more interested in other operational statistics, information that is not in the financial statements are included. There is more than just financial data needed to develop a complete picture of a company.
The financial statement analysis ratios are listed by category ratios summarized:
I. Profitability measures:
Return on investment (ROI)
ROI = return / investment
Return is often the net income, and investment is often the average total assets. This ratio indicates the return on invested assets was earned and is the main measure of profitability.
ROI = margin x turnover
= (net income / sales) x (sales / average total assets)
The margin represents the net income resulting from sales back into dollars. Turnover shows the efficiency of which assets are used to generate sales.
Variations of the general model use the operating income, income before taxes, or other intermediate income statement amounts in the numerator, and average operating assets in the denominator to focus on the return from operations before tax.
Return on equity (ROE)
ROE = net income / average total equity
This ratio shows the return on the part of the assets by that is provided by the owners of the entity.
A variation of the general model arises when there are preferential shares. The net income is reduced by the required amount of the preferential share dividends, and only the ordinary equity of the shareholders in the denominator. This distinction is made because the property rights of preferential and common shareholders differ.
Price earnings ratio (P / E ratio)
Price earnings ratio = market price per share / earnings per share
This ratio indicates the relative costliness of a share of the ordinary company shares, because it shows how much investors are willing to pay for the share compared to earnings.
In general, the larger the ROI and the rate of profit of a company, the higher the P / E ratio of its ordinary shares will be. Usually the amount of diluted earnings per share is used in this calculation.
Yield = annual dividend per share / market price per share
The dividend yield shows a portion of the shareholders' ROI: the return represented by the annual cash dividend. The other part of the total shareholder return on investment comes from the change in the market value of the share during the year, which is often called capital gain or loss.
Dividend pay-out ratio = annual dividend per share / earnings per share
The dividend pay-out ratio indicates the proportion of the profits that was paid as dividends to ordinary shareholders. It can be used for estimating future dividends for years as the profit can be estimated. The amount of diluted earnings per share is often used in this calculation.
Preferential dividend coverage
Preferential dividend coverage ratio = net income / required preference dividend
The preferential dividend coverage ratio indicates the ability of a business to meet its preferential stock dividend requirement. The higher the coverage, the lower the probability that dividends on ordinary shares will not be continued due to low profits and the non-payment of dividends on preferential shares.
II. Liquidity Measures
Working capital = current assets / current liabilities
The mathematical relationship between current assets and current liabilities is a measure of the ability of the company to meet its obligations.
Current ratio = current assets / current liabilities
This ratio is an evaluation of the liquidity increase, which is more comparable over time between companies than the amount of working capital.
Acid test ratio
Acid test ratio = cash (including temporary cash investments) + receivables) /
By excluding inventories and other non-cash current assets This ratio gives a conservative assessment of the company's ability to pay its bills.
III. Activity Measures
Total assets turnover
Total assets turnover = sales / average total assets
Turnover shows the efficiency of which assets are used to generate sales. See also the DuPont model in the profitability measures.
Variations include: revenue calculations for debtors, plant and equipment and total operating assets. Any variation uses sales in the numerator and the correct average value in the denominator.
Inventory Turnover = cost of goods sold / average inventory
Inventory turnover focuses on the efficiency of inventory management practices of the company. The cost of goods sold in the numerator because inventories are recognized as expenses rather than selling.
Numbers of days of sales per day
Debtors by average sales per day = accounts receivable / average sales
Average sales per day = annual sales / 365
This measure shows the average age of the receivable and indicates the efficiency of the company's relative performance against its maturities.
Number of days sales in inventory = inventory / average cost of goods
sold per day
Average cost of goods sold per day = annual cost of goods sold / 365
This measure shows the number of days of sales show that the existing stock could be converted.
IV. Financial leverage metrics
Debt ratio = total liabilities / total liabilities and equity
Debt / equity ratio
Debt / equity ratio = total liabilities / total equity
Each of these measures shows the proportion of debt in the capital structure see. Please note that a debt ratio of 50% is the same as a debt / equity ratio of 100%. These ratios reflect the risk caused by the interest and principal requirements of the debt.
Variations of these models relate to the full definition of total debt. Current and deferred tax liabilities are excluded by some analysts, because they carry no interest and do not add much risk as a long-term debt.
Interest coverage ratio
Interest coverage ratio = earnings before interest and taxes / interest
This is a measure of the company's ability to earn enough to cover its annual interest requirements.
In management accounting, economic and financial information is used to plan and manage many activities of the entity and to support the management process.
Cost-volume-profit (CVP) analysis means: the use of cost behaviour patterns for interpreting and predicting changes in revenues, costs or volume of activity.
12.1 Management Reporting in contrast to financial accounting
Management is the process of planning, organizing and controlling the activities of an organization to achieve its goals. Management reporting supports the management process.
Management accounting differs in several ways from financial reporting.
Management accounting has an internal orientation and a future perspective. It often focuses on individual units within the company rather than the organization as a whole.
Planning is the key to the management process, a model is shown below:
Decision making Decision making
Performance Analysis: Planning & control
planning versus cycle operational
actual results activities
This model suggests that control is achieved through feedback. The actual results are compared with the planned results. If there is a difference between the two, or the actions or the plan or both changed. Reasonably, accurate data is acceptable for internal analysis, and performance reports often tend to be used for management control and decision making.
12.2 Cost Classifications
Costs are classified differently for different purposes. Cost terminology is important to understand when cost data are used appropriately.
Relationship between total cost and volume of activity
The relationship between the total cost and volume of activity describes the cost behaviour. The behavioural patterns of cost establish a relationship between the changes in the total costs, given a change in activity.
Variable costs are costs that change in total, as the volume of activity changes. Costs that do not change in total as the volume of activity changes are called fixed costs. These costs remain constant for a change.
Examples of variable costs are:
Examples of fixed costs are:
Variable costs change in total as the activity changes but remain constant on unit basis. Fixed costs do not change in total as the activity changes, but will vary as they are based on activity per unit basis.
We can show this in a table as followed:
If the activity changes
Total Per unit
Fixed costs remain constant change reversibly
Variable costs change directly remain constant
The most fundamental assumption involves the range of activities on which the identified or presumed cost behaviour pattern exists. This is the relevant assumption, and is most applicable to fixed costs. Several fixed expenses will have different sets of relevant subject of a cost behaviour pattern.
Another important simplified assumption is that the cost behaviour pattern is linear and not a curve. This assumption applies primarily to variable costs. It is clear that not all of the costs can be classified as a variable or fixed. Some costs are partly fixed and partly variable. Sometimes costs with this mixed behaviour also called semi-variable costs.
Costs can be expressed in a formula:
Total costs = fixed costs + variable costs
= fixed cost + (variable rate per unit activity * units of activity)
This cost formula reflects the total amount of operating expenses, for a given level of activity by combining the fixed and variable components of total costs. It is wrong and perhaps misleading to express the fixed costs on the basis of a unit, because by definition fixed costs are constant over a range of activity.
12.3 Applications of cost-volume-profit analysis
Cost behaviour pattern: the key
Cost-volume-profit (CVP) analysis is a valuable and useful tool, which can be used in many situations, but the costs behavioural assumptions are critical to the validity and applicability of its results and must be kept in mind when evaluating these results.
The CVP analysis uses the knowledge of cost behaviour patterns for interpreting and predicting changes in operating income results from changes in yield and / or volume of activity.
A cost estimation of a specific behaviour pattern is determined by analysing the cost and activity over time. When certain costs are partly fixed and partly variable, the high-low method can be used for the development of a cost formula which takes into account both the variable costs as well as with the fixed costs.
A customized income statement
The income statement format used in the CVP analysis is called the contribution margin. The contribution margin format classifies expenses according to their cost behaviour pattern, variable or fixed.
The difference with the traditional format is the classification of expenses. In the traditional format they are functional and in the contribution margin format, expenses are classified according to their cost behaviour pattern.
Contribution margin is the difference between revenues and variable expenses. Unless there are changes in the composition of variable costs, the contribution margin changes in proportion to the change in the income. The contribution margin ratio is the relation of the contribution margin as opposed to the revenues. This ratio can be used directly for the calculation of the change in the contribution margin by a change in the yields.
An expanded contribution margin model
The expanded contribution format model provides a framework for analysing the effects of revenue and volume changes in the operating income. A key for the use of this model is that fixed costs are recognized only in totality.
The expanded model is as follows:
Per unit X Volume
= Total %
Variable expenses …………….
Contribution margin …………… X ………… = $..............
The contribution margin ratio can sometimes be used to evaluate the effect of a volume change on operating income, because it is faster and easier than to use the unit revenues and variable expenses and volume.
Multiple products or services and sales considerations
If the contribution margin model is applied to the use of data for more than one product or service, then one must question the sales mix. The sales mix describes the relative proportion of total sales for the account of specific products.
When different products or product lines have significantly different contribution margin ratios, changes in the sales mix will ensure that the percentage change in the total contribution margin differs from the percentage change in income.
Break-even point analysis
The break-even point is usually expressed as the amount of revenue to be realized for the company to neither gain nor loss, that is, the operating income is equal to zero.
The break-even point is useful for managers because it expresses a minimum yield target. In the contribution margin model, the break-even point is achieved when the total contribution margin equals fixed costs.
Volume in units to break even: fixed costs / contribution margin per unit
Total revenue at breakeven: fixed costs / contribution margin ratio
Volume in units to break even: total revenue requirement / yield per unit
Break even analysis can also be graphically illustrated, in order to provide a visual representation of income areas and to demonstrate the impact of the contribution margin per unit on the operating income (or loss).
The safety margin is a measure of risk that describes the current sales performance of a company in relation to its break-even sales. This measure informs the manager about the amount of sales that the company can handle before a loss would arise.
The safety margin is calculated as:
Safety margin = total sales - break-even sales
The safety margin ratio is calculated as follows:
Margin of safety ratio = margin of safety / total sales
Operating leverage describes the change (in percentages) in the operating income for a given change (in percentages) in income. The higher the fixed costs of a company relative to its variable costs, the greater the operating leverage and the greater the risk that a change in the level of activity a relatively larger change in operating income will produce, with lower lever.
Operating leverage can affect the decisions of management to make no variable or fixed expenses.
Cost accounting is a subset of management accounting, which is primarily related to the accumulation and determination of the product, process or cost of the service. In this chapter we explore the cost accounting and reporting systems that serve the financial and management reporting.
From the planning and management cycle, we have already seen that management should give attention to planning, implementation and control of the activities of the entity so that the organization can achieve its strategic goals.
13.1 Cost Management
Cost management is the process of using cost information from the accounting system for managing the activities of the organization. Accurate and timely cost information is critical to the success of the decision.
The value chain of an organization is the sequence of functions and related activities that add value for the customer over the lifetime of a product or service. Given that the organization is evaluated in terms of its value chain, it is emphasized that many questions have to be answered about the activities, by analysing and managing their costs.
13.2 Cost accumulation and allocation
Cost accumulation is the process of collecting and maintaining transaction data through the accounting system. The total amount of the costs accumulated by the system is then logically categorized in various ways, such as by the production department referred to as a cost centre.
Cost allocation is the process of assigning a correct cost amount to the cost centre of each cost object.
Costs relationship of products or activities.
Direct costs and indirect costs are terms for relating costs to a product or activity (cost object).
Direct costs are clearly traceable to a product, but indirect costs are not traceable.
Costs for reporting purposes
Cost accounting is related to the determination of product, process or service costs.
Product costs are used by manufacturing and trading companies to determine the stock values and when the product is sold, the amount of the cost of goods sold.
Cost accounting systems distinguish between product costs and period costs. Product cost of a trading company are the costs associated with the products that are held for sale.
Product cost of production consists of raw materials, direct labour and manufacturing overhead.
Period costs such as selling, general and administrative expenses are reported as expenses in the fiscal period in which they occur (in the income statement).
13.3 Cost accounting systems
Cost accounting systems - general characteristics.
A production accounting system contains three stock accounts:
Raw material (accounts for the cost of parts and materials collection)
Work in progress (accounts for accumulating all production including direct labour and raw materials)
Finished goods (when the manufacturing process is complete, the cost of the items moved to "finished goods inventory").
Cost accounting systems take the flow of product costs to "work in progress" stock, the transfer of the cost of goods produced from the "work in progress" stock to "finished product" stock and ultimately to cost of goods sold when the product is sold, into account.
One of the especially challenging goals of the cost accounting system is the allocation of production overheads to the manufactured products.
The cost of a single unit of the product is the sum of the cost that occurred for a number of units to be produced, divided by the number of units produced.
If the periodic system is used, the cost of the end stock is determined by making use of the cost of goods sold model:
Initial stock $ ...............
Cost of goods manufactured ...............
Cost of goods available for sale $ ...............
- / - Closing stock ...............
Cost of goods sold $ ...............
If the perpetual system is used, the cost of each unit can be calculated, and the cost of goods sold will be the number of units sold multiplied by the cost of each unit.
In summary we can say that:
Product costs are added to the product that is produced, and these costs are treated as an expense when the product is sold.
Periodic costs are reported in the income statement account of the period in which such costs are occur.
Another way to distinguish between product and period costs, is to remember that product costs are production costs and period cost are non-production costs.
Cost accounting systems - job order cost price calculation, process cost price calculation and hybrid cost price calculation.
A work order cost system is used when discrete products such as sailboats, are manufactured.
Each product run is treated as a separate task and unit costs are determined by dividing the total costs, which occur by the number of units made.
When the production consists of essentially homogeneous products, which are made in a more or less continuous process, it is not feasible to calculate the costs by the task, so a process cost system is used.
In a process cost system, costs accumulated per department and assigned to the products that are produced by the department.
Cost accounting methods - absorption costs and direct costs.
So far, the cost accounting method that has been described, is one of absorption costs, because all the produced costs that have occurred, can be absorbed in the cost of the product.
An alternative method is the direct costing or variable costing method and allocates only variable costs to the products. Fixed manufacturing costs are treated as operating expenses of the period in which they occurred. The distinction between absorption costs and direct costs only focuses on the production overhead.
Raw materials and direct labour are always product costs, while selling, general and administrative expenses are always treated as operating expenses in the period in which they occurred.
When using absorption costs, the fixed production overhead are product costs. In direct (or variable) costs, fixed manufacturing overhead are periodic costs.
Cost accounting systems in service organizations
Apart from the type of services that a company provides, the basic cost accounting principles are identical to those of production, especially costs directly regarding a particular service activity that is measured. Other costs will simply be allocated to all services provided by an organization.
Activity-based cost (ABC).
The increased importance of overhead costs has led to the development of an activity-based cost system as a tool for more accurate allocation of overhead by defining a relationship between the costs relative to the activities that create these costs.
The advantage of activity-based costing is that it clearly focuses on the activities causing costs and management attention focuses on those activities.
Activity Based Management (ABM) is the use of activity-based costing information to support the decision.
Planning is an essential part of the management process and represents the initial activity in the planning and management cycle.
A budget quantifies financial plans, budgeting is the process of financial planning. It includes the use of financial accounting concepts, because the results of the activities of the organization will ultimately be reported in terms of income, cash flows and financial position or the financial statements.
Budgets are useful, because the preparation of a budget forces management to plan. The budget provides a standard by which actual results are to be compared.
14.1 Cost classification
Relationship between total volume and cost of the activity
For planning purposes it is necessary to understand how costs are expected to change as the level of planned activity changes.
Variable costs vary in total with the volume of activity, but remain constant when they are expressed at unit basis. Fixed costs will not change as the volume of activity changes.
Cost classification according to a timeframe perspective
Fixed costs which are classified according to a timeframe perspective, are called committed costs and discretionary costs.
Committed costs are costs that will occur before performing long-range policy decisions to which the company is linked.
Discretionary costs are costs that can be adjusted in the short term, according to management’s decisions.
The budgeting process in general
A budget is a financial plan. Many organizations have a policy that requires budgets, because budgets incite planning.
The budgeting process is largely influenced by behavioral considerations. How the budget is used by management, will influence the validity of the budget as a planning and management tool.
Budgets can be prepared for a single period or multiple periods. Different activities can have different budget timeframes. In most cases an interactive, participatory approach to budget preparation, along with an attitude that the budget is an operational plan, is most useful in the budget documents.
Zero-based budgeting involves identifying and giving preference to the activities carried out by a department, of which the costs associated with each activity are determined and then only those activities that satisfy certain priority constraints are authorized for the future.
The budget period
A single budget period for a fiscal year would be prepared in the months prior to the beginning of the year, and used for the whole year. The disadvantage of this approach is that some budget estimates, need to be made more than a year in advance.
A multi-period budget means planning for one-year segments on a repetitive basis. The advantage of such a continuous budget is that the end budget for each quarter is more accurate, because it was more recently prepared. The striking disadvantage of this process is the time, effort, and cost that are required.
The budgeting process
The first step in the budgeting process is to develop and communicate a set of broad assumptions about the economy, industry and the strategy of the organization for the budget period.
The operational budget, sometimes also called main budget, is the operational plan expressed in financial terms and is composed of a large number of detailed budgets as:
The sales / revenue budget (or forecast)
The purchase / production budget
The cost of goods sold budget
The operating expense budget
The income statement account budget
The cash budget
The balance budget
The sales forecast (or revenue budget) is the starting point for all other budgets, which are part of the operational budget. There is a hierarchy of budgets. The results of a budget will provide input for the preparation of a new budget.
The purchase / production budget is prepared when the sales estimate is established and an inventory policy is formulated. When the sales estimate is made, the other budgets can be prepared because the items budgeted are a function of sales. After income and expenses are estimated, the income statement account can be finished.
Then the cash budget can be prepared, given the budgeted operating results and plans for investing and financing activities.
In the end, with all of these expectations taken into account, the balance at the end of the period can be prepared.
Closing stock is expressed as a function of expected sales or the use of the following period. The final stock of a period is the opening stock of the next period (see figure below).
Opening stock Closing stock
+ Goods available +
Purchases Quantity Cost (of quantity of goods sold)
The purchase / production budget
Suppose the following model was used to determine the cost of goods sold under a periodic inventory system:
Opening stock $ ...............
Purchases + ..............
Goods available for sale $ ...............
- / - Closing stock ...............
Cost of goods sold $ ...............
By the replacing the $ character with the physical quantities, the same model can be used for the determination of the quantity of goods to be purchased or to be produced.
The model can be rewritten as follows:
Purchasing or production = sales volume - opening stock + closing stock
The cost of goods sold budget
The cost of goods sold budget summarizes the changes in the inventory account of goods, and the changes in the finished goods inventory account, as indicated by the results of the sales budget, the purchase / production budget and the required closing stock levels established by management.
The operating expenditure budget
Operational managers have a natural tendency to build some tolerance space into their budget estimates. When budget managers departmental budgets combine in an overall organizational budget, the cumulative tolerance space can make that the overall budget loses its significance. Budget managers should be aware of the tolerance issue and thus handle it in a way leads to the achievement of organizational goals.
The operating expenditure budget is a function of the sales estimate, cost behavior pattern and planned changes in the past with respect to levels of advertising, administration and other activities.
Budgeted income statement.
The sales forecast, cost of goods sold budget and operational budget are used by management accountants to prepare a budgeted income statement.
A budgeted income statement shows the projected operating results of the entity as a whole. If top management is not satisfied with the budgeted net income, changes in operations are planned and / or different elements of the operating budget can be returned to operational managers for improvements.
The cash budget
If the income statement budget is adopted, a cash budget can be prepared. Cash flows from operating activities are estimated by adjusting net income for non-cash items included in the income statement, as well as expectations about cash receipts and payments related to income and expenditure.
The cash flows from investing and financing activities are estimated, and the estimated cash balance at the end of the fiscal period is determined.
Excess money of a minimum operating balance is available for investment. A shortage of money means that plans should be made for the liquidation of temporary investments or borrowing money, or money payment assumptions need to be revised.
The budgeted balance
The budgeted balance uses data from all other budgets. Management uses this budget to evaluate the projected financial position of the entity. If the result is not satisfactory, the operational investment and financing plans are revised.
The challenge for accurate budgeting is to have an accurate estimation of activity and assumptions and policies, which indicates what is likely to happen in the future.
Computer spreadsheet models can make the budget calculation a relatively easy process, which can be repeated many times for determining the influence of changes in the estimates and assumptions. If desired, a budgeted statement of cash flows can be prepared from the budgeted income statement and balance sheet data.
14.3 Standard Cost
Use of standard costs
Standard costs are unit budgets for a component of a product or service, which are used in the planning and management cycle phases of the management process and financial accounting for the value of the stock of a manufacturing company. Standards can also calculate product costs for inventory valuation purposes support.
Since the standard shows a unit budget, standards are extensively used in the budget preparation process. Standards also provide a standard for evaluating performance. Standards are usually expressed in monetary terms ($ / unit) but can also be useful when they are expressed in physical quantities.
Because standards are unit budgets, all considerations of management philosophy and individual behavior that is identified in the discussion of the budget process, is also applicable to standards.
The three approaches for the development of standards are:
Attainable norms of standards
Standards based on past experience standards
An ideal standard assumes that operating conditions will be perfect and that material and labor input will be provided at maximum levels of efficiency at all times. An achievable norm standard recognizes that there will be some operational inefficiency compared to ideal conditions. A standard based on past experience norms has the disadvantage of taking all the inefficiencies that over time have crept into the operation. Such standards reflects current performance, but will likely provide more incentive for improvement.
Ideal standards and norms based on past experience standards are less useful because they will probably not serve as positive motivation factors.
Costing products with standard costs
The standard cost of a product is the sum of the standard costs for raw materials, direct labor and manufacturing overhead used in making the product.
A fixed manufacturing overhead standard is a fixed expense and therefore should be used with caution because the fixed costs do not behave on the basis of per unit. It is only used for allocating fixed overhead costs to individual products for the manufacturing purposes.
Other use of standards
Standards are applicable to the entire range of planning and management activities. They are not limited to the use in product cost calculation.
14.4 Budgeting for other analytical purposes
Many service organizations and manufacturing companies have developed standards for periodic expenses. Standards can also be developed for qualitative purposes, which can’t be expressed in financial terms.
Performance reporting is a control activity and includes:
Comparing actual results with planned results, with the aim to emphasize those activities of which the planned and actual results differ (favorably or unfavorably), so that the appropriate action can be taken by changing the way activities propagated or adjusting goals.
Ideally, a well-designed control system provides leading indicators, which show when performance starts to deviate from expectations, so that proper action can be taken as soon as possible.
Variance is the difference between planned and actual results.
15.1 Cost classifications
Relationship between total cost and volume of activity
For control purposes, it is important to understand the behavior of fixed and variable cost items. The total estimated cost would not change if the actual and expected levels of activity were different.
Cost classification according to a timeframe perspective
All costs are controllable by someone at some point, but in the short term, some costs are classified as non-manageable, because a manager can do nothing to reduce the amount of costs in the short term influence.
15.2 Performance Reporting
Characteristics of the performance reporting
The performance report compares the actual results with the budgeted amounts. The performance reporting is an integral part of the management process, because the activities that perform differently from the expectations, are singled out and the managers who are responsible for achieving goals, are provided with information about the activities that need attention.
The general format of a performance report:
(1) (2) (3) (4) (5)
Activity Budget amount Actual amount Variance Explanation
(2) – (3)
The variance is usually described as favorable or unfavorable, depending on the nature of the activity and the relationship between the budget and actual amounts. For income a favorable variance is the surplus of actual earnings in the budget amount. An actual expense that is larger than a budgeted expense, causes an unfavorable variance.
In the same way, we can say that if actual revenues fall short compared to the budget amount, it causes an unfavorable variance. When actual expenses are lower than budgeted expenditures, it creates a favorable variance. Sometimes, the positive or negative nature of the variance can be determined on the basis of the relationship of the variance compared to the others.
Management by exception means: the focus of attention on those activities that have a significant variance. The purpose of this analysis is to understand why the variance occurred and if true, actions are taken to eliminate unfavorable variance and obtaining favorable variances.
The flexible budget
What can we do to the performance report useful to managers? The purpose of flexible budgeting is recognizing cost behavior patterns.
The original budget amount for variable items, based on planned activities, is adjusted by calculating a budget allowance based on actual activity for the period. This leads to a variable cost variance, which is important because the effect of a difference between the anticipated and actual volumes of activity is left out of the variance.
Direct materials, direct labor and variable overhead are used to calculate a budget allowance for each level of activity, but especially for the level of activity in this period was achieved so that a valid comparison can be made with the actual costs occurred at that level of activity.
Modifying the original budget so that the budgeted amounts are shown for the actual activity, is called the flexibility of the budget. Only variable costs budgets are more flexible.
The performance report which the flexible budget is used, it would look like this:
The variances are relatively insignificant and the initial conclusion from this report is that the production manager acts in accordance with the plan to perform for the number of products, which were actually produced.
Flexible budgeting means that the budget allowance for the variable costs should be made more flexible in order to show the costs that would have occurred in the level of activity that was actually experienced.
15.3 Standard cost variance analysis
Analysis of variable costs variance
The total variance for a given cost component refers to the budget variance, because it shows the difference between budgeted costs and actual costs.
The budgeted variance is caused by two factors:
The difference between the standard and actual quantities of inputs.
The difference between the two standards, namely quantity and price.
It would be desirable to split the budget variance in a quantity variance and the cost per unit of input variance. This is necessary because different managers are responsible for each component of the total variance.
Making variance reports makes that the appropriate manager takes action to eliminate unfavorable variances and creating favorable variances. To accomplish this goal, communication between managers is essential.
The amount of variance (caused by the difference between standard allowed hours and hours actually worked), is called the direct labor efficiency variance, because the relationship reflects the efficiency with which labor was used.
The cost per unit of input variance (caused by the difference between actual and standard hourly pay rates) is called the direct labor rate variance.
The variances are named favorable or unfavorable, based on the arithmetic difference between standards and reality, but these names do not necessarily mean good or bad.
Variances can be formulated in many ways, but a commonly used classification is as follows:
Variance due to difference between standards and reality
Cost per unit of input
Raw materials Usage
Direct labor Efficiency
Variable overhead Efficiency
The terms usage and efficiency to refer to the quantity of the input. The variable overhead quantity variance is called the efficiency variance, because it is assumed that variable overhead is related to the direct labor hours. Expenses will be used for variable overhead, due to the number of different cost items, which consist of overhead.
The standard model for the computation of each variance is:
Quantity variance =
standard quantity -allowed
actual quantity used *
standard cost per unit
Cost of unit of input variance
standard cost per -unit
actual cost per unit *
actual quantity used
This model can also be expressed as follows:
Actual used quantity
Actual used quantity
Standard quantity allowed
Actual cost per unit
Standard cost per unit
Standard cost per unit
Cost per unit Quantity
of input variance variance
A favorable variance is mathematically indicated with a plus sign and a negative with a minus sign.
Variance analysis information should lead to actions for maintaining or increasing the profitability of the company.
Quantity variances for raw materials and direct labor are frequently expressed in volume, but also in money value, because the manager responsible for controlling the variance often thinks in terms of quantities.
Analysis of fixed overhead variance.
The fixed production overhead variance is analyzed differently than the variable cost variance due to the difference in cost behavior.
The fixed overhead budget variance is the difference between the total budgeted and actual total fixed overhead.
The fixed overhead volume variance is formed, because the actual level of activity is different from what is used in the calculation of the fixed overhead allocation rate.
If the actual activity varies, the amount of fixed overhead allocated to production will be different from what was planned to be allocated. This variance is called a volume variance.
Since fixed costs are not carried per unit, it is not correct to calculate the fixed overhead variance based on units. The volume variance explains the effect of the different treatment of fixed overhead costs for planning and control purposes, as opposed to product cost purposes.
Accounting for variances.
If the net total of all favorable and unfavorable variances is not significant compared to the total of all production costs, which arose during the period, net variance are included in the cost of goods sold on the income statement.
If the net variance is significant in relation to the total costs of production, it can be allocated on the standard cost, which are included in these accounts.
In most standard cost systems, standard costs are recorded in work-in-progress inventory and finished goods inventory. Variances are usually immediately taken to the income statement in the tax period in which it occurred, as an adjustment to cost of goods sold.
15.4 Analysis of organizational units
Reporting for segments of an organization
A segment of an organization is a division, product line, territory or other organizational unit.
Management regularly reports operating results per segment in a way so that the total income for each segment is equal to the total company net income.
Thus, segment reporting for an organization involves allocating revenues and expenses to divisions, product lines, geographic areas and so on. In this process, costs for a group of segments, should not be allocated arbitrarily to the individual segments in that group.
Direct fixed costs: the sum of the fixed costs that occur in each division.
Normal fixed expenses: an allocated share of the overheads.
Sometimes the segments of an organization are called responsibility centers, cost centers, profit centers, or investment centers.
A responsibility center is an element of the organization for which a manager's responsibility and authority has received and whose performance is evaluated.
A cost center does not directly generate revenue for the organization.
An organization segment that is responsible for selling a product, can be a profit center or investment center.
The analysis of investment centers.
The manager of an investment center has a much higher level of responsibility for decision-making in the organization than the manager of a cost center or profit center.
Investment center performances are measured by ROI and are separated into margin and turnover as defined in the DuPont model. Managers are able to focus on each component of the DuPont formula to understand where performance improvements can be achieved.
In relation to sub-optimization, the ROI is not the only measurement to secure the performance of the investment center to measure. Another approach for evaluating the performance of an investment center, that does eliminate the risk of sub-optimization, is called residual income.
This technique evaluates the ability of the manager to generate a minimum requirement ROI. Residual income is a ROI alternative, that measures if the amount of income that is generated by an investment center above a minimum required ROI. This method seeks to maximize dollar amounts and eliminates the risk of sub-optimization.
Sub-optimization are decisions that result when an investment manager of the center rejects an opportunity to invest in a project, that could have increased the ROI of the whole organization, but would have decreased the ROI of the investment center.
Residual income = Operating income - $ Required ROI (Operating assets required * % ROI)
The residual income is positive when the investment center earns a ROI, that is greater than the required ROI.
A negative income means that a divisional organization loses value by not earning the required ROI.
The balanced scorecard
An approach to high level for the measuring and reporting of organizational performance is accomplished by the use of a balance scorecard.
A balanced scorecard is a set of integrated financial and operational performance measures, that emphasizes en communicates the strategic objectives and priorities of an organization.
The balanced scorecard approach takes a "big picture" and provides an analytical framework to support the integrated planning and performance measure system of an organization.
The balanced scorecard framework is integrated into four main perspectives:
Financial perspective, which deals with financial and performance improvements.
Customer perspective, dealing with customer satisfaction and the ability of the organization to serve the customer in time.
Internal business process perspective, which is concerned with improvements in key operational areas for achieving greater efficiency and productivity.
Learning and growth perspective, which is concerned with empowering employees with new knowledge resources.
Decision-making covers the entire planning and management cycle and covers all functional areas of the organization.
Capital budgeting is the process of analyzing proposed capital expenses, including investments in plant, equipment, new products etc. to determine whether the investment will generate a sufficiently high return over time, to be able to contribute to the overall ROI objective of the organization.
16.1 Cost classification
Cost classifications for other analytical purposes.
Significant cost classifications for analyzing alternative decisions, consist of differential costs, allocation of costs, sunk costs and opportunity costs.
Differential costs are costs that will differ are among the alternatives and should be considered in the analysis.
Allocation costs are the costs that are allocated to a product or activity (cost object), using a type of systematic process. Many cost allocation methods are arbitrary and do not result in the awarding of costs in a way that the reason why these costs are incurred reflects. Therefore, managers must be very careful about the conclusions drawn from any analysis made on the basis of allocated costs.
A general rule regarding the allocation cost is:
Don’t allocate costsarbitrarily to an accountability center, because the allocated costs do not need to behave in a way that the allocation method is assumed.
Sunk costs are costs that have already occurred and can’t be reversed by any future action whatsoever. Sunk costs are not relevant to the analysis of alternative future actions (they are not differential costs), because they have already been made and will not change.
Opportunity cost is an economic concept that is too often overlooked in the accounting analysis.
Opportunity cost is the income that could have been earned, but is lost, because there will be no investment in a certain asset against a specified yield rate. In an economic analysis, one would have to take account of these costs.
16.2 Short-term decision analysis
Relevant costs are future costs that show difference between decision alternatives and are the key to effective decision making.
Transaction costs of the past, though they kept track of in a right way in the accounting system, are never relevant and the manager can only be confused with the proper analysis of the costs for a particular decision.
The discussion on many types of cost classification concepts presented in chapter 12 untill15, has emphasized that there are "different costs for different purposes" by describing how costs are seen from different perspectives for planning and management purposes. The same costs are analyzed as relevant or not relevant to the decision, depending on the question raised by the decision alternatives.
Variable or fixed costs may or may not be relevant to a decision. It depends simply on the fact whether it is a difference between the alternatives displayed or not.
Relevant costs in action - selling decision or continue
Understanding costs for decision making purposes is seen as a way of thinking about their relevance to any decision by asking the fundamental question: "does it makes a difference?"
The cost classification concepts can be used as follows in the decision analysis:
Will vary in accordance with the alternative activities that are considered.
Regular costs that were arbitrarily assigned to a product or activity.
Income that is lost because another alternative is chosen above the other.
These costs have already occurred and will not change.
Relevant costs in action - special pricing decision
The product or service price decision is generally a long-term decision. In the long term, the product or service price must be adequate to cover all costs identified in the value chain of the organization (R & D, design, production, marketing, distribution and customer service) and provide the necessary ROI.
But in the short term, in certain situations, the company may be saddled with a special offer for its product or service at a price that is below the normal retail price.
Target cost price calculation is the maximum cost that can occur and result in an amount equal to the market price when added to the amount of the desired ROI.
Any price quoted above the relevant variable costs, will generate a positive contribution margin and should be accepted as long as no other more profitable opportunity for unused capacity can be identified, or unless the moving on qualitative factors influencing the decision.
If the company is operating at full capacity, there is no reasonable explanation for considering a price lower than the normal selling price unless there is an opportunity to avoid more costs than the related decline in the selling price.
Relevant costs in action - the target costing question
Target cost price calculation is a long-term concept and is calculated as follows:
Target cost = market price - desired profit
Target cost price analysis is primarily used to identify cost reduction initiatives in the value of an organization, when it becomes clear that it no longer is able to achieve desired level of profit at the current market price for its products or services. The company must either find a way to reduce its costs or it will eventually drifted away from the marketplace.
Relevant costs in action - the make or buy decision
Another decision situation that illustrates the use of relevant costs, is the make or buy decision.
In a make or buy decision, the relevant cost of making a component or the internal provision of a service, are the costs that can be avoided by obtaining the resources or services from outside the company. Therefore avoidable costs are relevant costs for decision.
In evaluating each cost item is the important question: "will these specific costs still continue to act as the resources can be bought from outside the company?". If costs continue to occur apart from whether the product is produced internally or purchased from outside, it is not relevant to the decision.
Relevant costs in action - the continue or stop in a segment decision
Since the company's total operational management often results in split segment results, it is possible that a segment will have an operating loss. The inevitable question arises whether we should continue or stop in that segment.
Relevant costs in action - the short-term allocation of scarce resources
In the short-term allocation of scarce resources, the goal is to maximize the contribution margin, given the demand and capacity constraints.
When capacity is constrained, it is important to view the contribution margin of each product in terms of the capacity limitations.
16.3 Long-term investment analysis
Capital budgeting is the process of analyzing proposed capital expenses, including investments in plant, equipment, new products, etc., to determine whether the investment is a sufficiently high return on investment (ROI) will generate over time to contribute to the overall ROI goals of the organization.
Capital budgeting differs from operational budgeting with respect to the time slot in which it is considered.
While dealing with capital budgeting and investment returns, which are distributed over a number of years, operational budgeting is concerned with the planning for a period usually no longer than one year.
The operating budget reflects the strategic plans of the company to achieve profitability in the current period, and the capital budget provides an overall blueprint for the company to help its long-term growth and profitability goals.
Investment decision-making special considerations
Capital budgeting procedures should include the use of the net present value analysis, because today is an investment with a return expectation that far into the future. This time value of money should be recognized when the right capital expenditure decisions should be made.
Cost of capital
The cost of capital means the minimum ROI that must be earned on the proposed investment.
The risk that belongs with the proposal, will influence the cost of capital or the desired ROI. Thus, the return on investment is a primary concern of financial managers, who evaluate the proposes capital expenses of the investment.
The cost of capital represents the return on assets, that must be earned so that the company can meet its interest obligations and the can provide the expected return to the owners. Of more riskier proposals, it is required that they will provide a higher return than less risky proposals.
The cost of the capital contains the discount rate (the interest rate at which the cash flows of future periods are discounted), which is used to determine the present value of the investment proposal under analysis.
Capital budgeting techniques
Of the four commonly used capital budgeting techniques, the present value analysis is used with only two.
Methods that use the present value analysis:
Net present value method (NPV)
Internal rate of return method (IRR)
Methods that do not use the present value analysis:
Accounting rate of return method
Each of these methods uses the amount invested in the capital project. The net present value, internal rate of return and payback methods use the amount of money that is generated by the investment each year.
The accounting rate of return method uses net income on an accrual basis, arising from the investment. For most investment projects, the difference between the money generated each year and net income is on an accrual basis, is called the investment expense. That is a non-cash item that reduces net income on an accrual basis.
Due to the recognition of the time value of money and the focus on cash flows, the NPV and IRR methods are more suitable than the payback or accounting rate of return method.
The net present value approach uses the cost of capital as the discount rate for calculating the difference between the present value of future cash flows of the investment and the amount invested.
Based on this analysis, we can draw the following conclusions:
If the present value of the expected cash flow is:
The net present value (NPV)
The expected return on the project is:
Bigger than the investment
Bigger than the cost of capital
Less than the investment
Less than the cost of capital
Equal to the investment
Equal to the cost of capital
If the net present value is zero or positive, than the ROI of the proposed investment is equal to or greater than the cost of capital and the investment is an appropriate choice.
The present value ratio or profitability index provides a tool for arranging alternative proposals. The present value ratio is especially useful when a selection has to be made between different positive NPV projects.
The internal rate of return method and the net present value method differ from each other, because the discount rate (cost of capital) is a given in the net present value approach, while in the IRR approach indicates the actual return that will be earned by the proposed investment. This is the discount rate at which the present value of the cash flows from the projects will be equal to the investment (the discount rate at which NPV equals zero).
So the IRR method would require several calculations with different discount rates are used. If the IRR is greater than the cost of capital, the investment will be recommended. If the IRR is lower than the cost of capital, the investment will not be recommended.
Some analytical considerations
Estimates: the validity of present value calculations will be a function of the accuracy with which future cash flows can be estimated. Most companies will demand a post audit of the project requirements to determine whether the anticipated benefits can be realized or not.
Cash flows in the future, given the challenges of estimating capital budgeting, many analysts will not take the potential cash flows that are expected to rise over more than ten years in the in their consideration. The project is too risky to accept.
Planning of the cash flows within the year: The present value factors assume that all cash flows are received every year at the end of the year. It is much more likely that the cash flows will be received evenly throughout the year will.
Investment made over a period of time: the interest rate on cash payments during the construction of the pre-operational period should be considered, so that the investment includes the time value of money or invested during that period.
Income tax effect of cash flows from a project: cash flows that are identified by a proposed capital expenses, should keep track of all related inflows and outflows, including income tax.
Working capital investment: some projects will require an increase in the capital, which is considered to be a part of the investment.
Lowest cost project: not all capital expenses are done to reduce costs or increase revenues. This can be environmental costs, which let the operational cost rise. Alternative expenses in this category should also be evaluated by using the present value analysis.
Pay-back time: the payback method for evaluating the proposed capital expenditures answers the question: "how many years are needed to until the amount of the investment is paid back?".
Accounting yield: the accounting rate of return method focuses on the impact of the investment project on the financial statements.
The payback and accounting rate of return are two methods of investment analysis that do not recognize the time value of money, and are therefore unsuitable analysis methods.
Nevertheless, many analysts and managers use the results of these methods together with the results of the NPV and IRR methods.
In addition to considering the results of different quantitative models that can be used for evaluating investment proposals, the management identifies and considers also qualitative factors when deciding whether the investment should or should not be put. These qualitative factors are often more important than the quantitative model results.
Integration of the capital budget with operational budget
Different aspects of the capital budget are related to the development of the operational budget.
The capital budget is integrated into the operating budget. The production, depreciation expense and cash outflow for the purchase of new plant and equipment are directly influenced by the capital budget.
So the development of the capital budget is an integral part of the overall budgeting and strategic planning.