Month: August 2021

Management Notes

Plant-wide versus departmental overhead

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Plant or Factory Wide (Single) Overhead Absorption Rate

Plant or factory wide (single or blanket) rate is used for the whole factory and is assigned to all cost units irrespective of the departments in which they were produced.

Plant-wide overhead absorption rate = (Estimated FOH for the whole factory/ Estimated activity level for the whole factory) *100

Conditions for using plant wide overhead absorption rate:

  • All production departments contribute in equal proportion to the fabrication of every product.
  • Company produces only one type of product.

The above conditions restrict its usefulness and in the absence of above conditions. This does not produce satisfactory results.

Departmental Overhead Absorption Rate:

In case of departmental overhead absorption rate, separate overhead absorption rates are used for different producing departments. Though use of departmental overhead absorption rate is considered better than using a single (factory wide) overhead absorption rate but it has certain pros and cons which are given below:

Advantages:

  • Per unit and total costs of a product can be more accurately.
  • Use of separate rates for different departments facilities better control, as the departmental managers being responsible for costs of their respective departments have a closer look on overheads incurred.

Disadvantages:

  • The departmental managers often do not have a significant role in the apportionment of overheads.
  • This basis used for apportionment of overheads to different departments may not be fair or correct as overheads may not be incurred for the departments in the same way as shown by basis for apportionment.
Management Notes

Actual and Normal costs

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Actual Cost

Actual cost is the actual expenditure made to acquire an asset, which includes the supplier-invoiced expense, plus the costs to deliver, set up, and test the asset. This is the cost of an asset when it is initially recorded in the financial statements as a fixed asset.

The actual cost approach is different from the use of estimates to derive costs that may occur in the future. The two approaches are commonly blended together, so that budgeted costs derived in advance are compared to actual costs to create a variance. The variance can be used to control operations and/or to work on improving the accuracy of predictions.

Well keep in mind in managerial accounting, you also have budgeted and forecasted costs. Neither of these costs reflects reality or actual costs most of the time. Management might set a budget to buy a new piece of equipment, but this budget does not always happen. Sometimes companies can get discounts from vendors and other times product prices increase.

Actual Cost = Direct Costs + Indirect Costs + Fixed Costs + Variable Costs + Sunken Costs

Direct Costs: Obvious costs directly related to your projects like fixed costs and variable costs.

Indirect Costs: Additional cost that supports your project but is not easily measured like administrative services.

Fixed Costs: Costs that remain consistently the same throughout the project, such as cost to rent equipment.

Variable Costs: Changing costs during the course of the project. An example the hours of anticipated labor for a project might be greater than the actual time it took for labor to be complete.

Sunken Costs: These are costs that have incurred due to an error or change of scope that must be included in the total cost of the project.

Normal costs

Normal costing uses a predetermined annual overhead rate to assign manufacturing overhead to products. In other words, the overhead rate under normal costing is based on the expected overhead costs for the entire accounting year and the expected production volume for the entire year.

Normal costing uses actual direct materials and direct labor costs, but adds budgeted factory overhead to track manufacturing costs. The budgeted factory overhead is calculated using your indirect costs and production estimates. Estimates are based on actual indirect costs and units produced from prior manufacturing runs. Since indirect costs like utilities, rent and depreciation remain fixed over time, normal costing can be used as a benchmark to monitor production costs.

It is a general rule that in the calculation of actual overhead rate, actual overheads will be divided with the actual quantity and not with the budgeted quantity. The vice versa also applies. The reason for this rule is simple as this provides more authentic results as you are comparing the like terms. However, contradictory as the may sounds, these rules do not apply in normal costing as in this method, the budgeted manufacturing overhead rate is multiplied with the actual quantity to derive the actual overhead costs. The reason for this is that it provides for the more authentic allocation base, and the overheads are allocated properly this way.

The overhead rate is the only figure that is budgeted in this method. To determine the material and labor costs, the actual figures are used. The same goes with the quantity of allocation.

Normal costing is used to derive the cost of a product. This approach applies actual direct costs to a product, as well as a standard overhead rate. It includes the following components:

  • Actual cost of labor
  • Actual cost of materials
  • A standard overhead rate that is applied using the product’s actual usage of whatever allocation base is being used.
Management Notes

Cost Objects and Cost Behavior

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COST OBJECT

Cost Object is anything for which a separate measurement of cost is desired. It is the specific item, activity, service, department, or product to which costs are identified, measured, and assigned. In cost accounting, identifying the correct cost object is essential for accurate cost determination and cost control.

A cost object may vary depending on the purpose of costing. For example, a product may be a cost object for pricing decisions, while a department or activity may be a cost object for performance evaluation.

Definition of Cost Object

According to cost accounting principles,

“A cost object is any activity, product, service, or unit for which costs are measured.”

Examples of Cost Object

Common examples of cost objects include:

  • A product (e.g., a chair manufactured by a furniture company)

  • A service (e.g., cost per patient in a hospital)

  • A job or contract (e.g., printing job, construction contract)

  • A department (e.g., production department, maintenance department)

  • An activity (e.g., machine setup, quality inspection)

Types of Cost Object

In cost accounting, a cost object refers to anything for which costs are separately identified, measured, and analyzed. The nature of a cost object depends on the purpose of cost measurement such as pricing, cost control, performance evaluation, or decision-making. Different types of cost objects are used in organizations depending on their operational structure and managerial requirements. The major types of cost objects are explained below.

1. Product as a Cost Object

A product is the most common type of cost object in manufacturing organizations. When costs are accumulated and measured for a specific product or unit of output, the product becomes the cost object. All costs such as direct material, direct labour, and manufacturing overheads are assigned to the product to determine its total and per-unit cost.

Product cost objects are essential for pricing decisions, profitability analysis, inventory valuation, and cost comparison. For example, in a furniture manufacturing company, the cost of producing a chair or table is separately calculated to determine selling price and profit margin. Accurate product costing helps management remain competitive in the market.

2. Service as a Cost Object

In service-oriented organizations, services are treated as cost objects instead of tangible products. The cost of providing a specific service is measured and analyzed to ensure efficiency and profitability.

Examples include cost per patient in hospitals, cost per student in educational institutions, cost per room in hotels, or cost per kilometer in transport services. Service cost objects help management in fixing service charges, controlling operational costs, and improving service quality. Since services are intangible, careful identification and measurement of costs are necessary for accurate costing.

3. Job or Contract as a Cost Object

Under job costing and contract costing systems, each job or contract is considered a separate cost object. Costs are collected job-wise or contract-wise to determine the total cost and profit of each job.

This type of cost object is suitable for industries where production is based on customer orders or large projects, such as printing presses, repair workshops, construction companies, and shipbuilding industries. Treating each job or contract as a cost object helps management assess job profitability, cost efficiency, and performance evaluation.

4. Department as a Cost Object

A department can also be treated as a cost object, especially in large organizations with multiple functional or production departments. Costs are accumulated department-wise to measure the efficiency and performance of each department.

For example, production, maintenance, quality control, and packing departments may be treated as separate cost objects. Departmental cost objects are useful for overhead allocation, cost control, inter-departmental comparison, and managerial accountability. This approach encourages departmental managers to control costs and improve efficiency.

5. Activity as a Cost Object

In modern costing systems, particularly Activity-Based Costing (ABC), an activity is treated as a cost object. Activities such as machine setup, material handling, inspection, and order processing consume resources and incur costs.

By identifying activities as cost objects, overheads are allocated more accurately based on actual resource usage. This method provides better cost information for pricing, product mix decisions, and cost reduction strategies. Activity cost objects are especially useful in organizations with complex production processes and high overhead costs.

6. Customer as a Cost Object

In some organizations, particularly service and marketing-oriented businesses, a customer is treated as a cost object. Costs incurred in acquiring, servicing, and retaining a customer are identified and analyzed.

This helps management understand customer profitability, design customer-specific pricing strategies, and improve customer relationship management. Customer cost objects are increasingly important in competitive markets where customer satisfaction and retention are critical.

Cost Object vs Cost Unit vs Cost Centre

Basis of Comparison Cost Object Cost Unit Cost Centre
Meaning Anything for which cost is measured A unit of product or service for cost measurement A location, department, or person where cost is incurred
Nature Broad and flexible concept Specific and quantitative Organizational and functional
Scope Very wide Limited and definite Medium
Purpose To identify and assign costs To express cost per unit To control and accumulate costs
Focus What cost is calculated for How cost is measured Where cost is incurred
Measurement May or may not be measurable in units Always measurable in units Not measured in units
Example Type Product, service, job, activity Per unit, per kg, per km Production department, machine
Basis of Identification Managerial requirement Nature of output Organizational structure
Use in Costing Used for cost assignment Used for cost expression Used for cost collection
Role in Cost Control Indirect role No direct role Direct role
Flexibility Highly flexible Rigid Moderately flexible
Relationship with Costs Costs are traced to it Cost is divided by units Costs originate here
Time Orientation Can be short or long term Usually short term Continuous
Relevance in ABC Central concept Secondary Supporting
Practical Example Cost of a hospital patient Cost per patient per day ICU ward, OPD department

COST BEHAVIOR

Cost behavior is an indicator of how a cost will change in total when there is a change in some activity. In cost accounting and managerial accounting.

Cost behavior is the manner in which expenses are impacted by changes in business activity. A business manager should be aware of cost behaviors when constructing the annual budget, to anticipate whether any costs will spike or decline. For example, if the usage of a production line is approaching its maximum capacity, the relevant cost behavior would be to expect a large cost increase (to pay for an equipment expansion) if the incremental demand level increases by a small additional amount. Understanding cost behavior is a critical aspect of cost-volume-profit analysis.

cost drivers provide two important roles for the management accountant:

(1) Enabling the assignment of costs to cost objects.

(2) Explaining cost behavior: how total costs change as the cost driver changes. Generally, an increase in a cost driver will cause an increase in total cost. Occasionally, the relationship is inverse; for example, assume the cost driver is degree of temperature, then in the colder times of the year, increases in this cost driver will decrease total heating cost. Cost drivers can be used to provide both the cost assignment and cost behavior roles at the same time. In the remainder of this section, we focus on the cost behavior role of cost drivers. Most firms, especially those following the cost leadership strategy, use cost management to maintain or improve their competitive position.

Cost management requires a good understanding of how the total cost of a cost object changes as the cost drivers change. The four types of cost drivers are activity-based, volume-based, structural, and executional. Activity-based cost drivers are developed at a detailed level of operations and are associated with a given manufacturing activity (or activity in providing a service), such as machine setup, product inspection, materials handling, or packaging. In contrast, volume-based cost drivers are developed at an aggregate level, such as an output level for the number of units produced. Structural and executional cost drivers involve strategic and operational decisions that affect the relationship between these cost drivers and total cost.

FOUR types of cost behavior are usually:

  • Fixed costs. The total amount of a fixed cost will not change when an activity increases or decreases.
  • Variable costs. The total amount of a variable cost increases in proportion to the increase in an activity. The total amount of a variable cost will also decrease in proportion to the decrease in an activity.
  • Mixed or semivariable costs. These costs are partially fixed and partially variable.
  • Stepped fixed costs This is a type of fixed cost that is only fixed within certain levelsof activity. Once the upper limit of an activity level is reached then anew higher level of fixed cost becomes relevant.
Management Notes

Allocation of Service department costs

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There are three methods for allocating service department costs: direct, sequential, and reciprocal. The first step of each method is to classify each organizational unit as either an operating or service department. Operating departments directly produce or distribute the company’s output, such as machining and assembly departments. Service departments provide services and support to operating departments as well as other support departments. Examples include human resources and information systems departments.

The problem in allocating service department costs is complicated by multiple-department relationships, where each service department may provide service to all of the other departments, including other service departments and itself. The three-service cost-allocation methods vary in terms of ease and accuracy because of how they approach this problem.

Production cost centers are directly involved in the production process as changing the shape of the material on worked upon, or just assembling the parts into a finished product. Typical examples of producing departments include cutting, stitching, spinning, assembly, weaving or etc.

Service cost centers refer to those costs that produce nothing but indirectly help in production by providing services to production cost centers. In certain cases service departments render services not only to the producing departments but also to other service departments. Typical examples of service departments include maintenance, stores, canteen, personnel, etc.

The direct method allocates costs to the operating departments directly, with no allocations to the other service departments. The method is easy to implement, but it ignores the fact that other service departments require services from each other, so it’s less accurate.

The sequential method (also known as the step-down method), allocates costs to operating departments and other service departments sequentially, but only in one direction. There is no set order in the sequence used: One common technique is to begin with the service department that incurs the most costs supporting other service departments and work downward to the department with the least costs. Once a service department’s cost is allocated out, however, no portion of its cost is allocated back to it from other service departments. This method partially recognizes other service departments, which makes it more accurate than the direct method.

The reciprocal method fully recognizes the other service departments by allowing reallocations back to each service department. As such, it’s more difficult to calculate but also more accurate than the other methods.

An algebraic method sometimes called the reciprocal method. This method allocates cost by explicitly including the mutual services rendered among all departments, causes of under and over absorption of overhead.

Procedure in Cost Allocation:

As products are not processed in service departments, their costs cannot be charged directly to products or cost units. Firstly, cost of service departments is built up by the usual process of allocation and primary apportionment. Afterwards their costs are allotted to production cost centers on some equitable or fair basis according to the use which producing departments make of service departments. Lastly, after calculating overhead absorption rates, costs of producing departments (including their share in the costs of service departments) are charged to jobs or products.

Service Departments Basis of Apportionment to Cost Centers
Canteen, personnel, inspection, medical Number of workers
Stores Number of store requisitions
Maintenance Number of maintenance hours/value of asset subject to maintenance

Management Notes

Major differences between US GAAP and IFRS

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GAAP vs IFRS is the most debatable topic in accounting where the former is defined as the financial reporting method having universal applicability while the latter are the set of guidelines made for financial accounting. As an account professional or business owner, it is vital to know the variations of these accounting methods, in order to successfully manage your company globally, as well as domestically.

The IFRS vs US GAAP refers to two accounting standards and principles adhered to by countries in the world in relation to financial reporting. More than 110 countries follow the International Financial Reporting Standards (IFRS), which encourages uniformity in preparing financial statements.

On the other hand, the Generally Accepted Accounting Principles (GAAP) are created by the Financial Accounting Standards Board to guide public companies in the United States when compiling their annual financial statements.

GAAP

The GAAP is a set of principles that companies in the United States must follow when preparing their annual financial statements. The measures take an authoritative approach to the accounting process so that there will be minimal or no inconsistency in the financial statements submitted by public companies to the US Securities and Exchange Commission (SEC). It enables investors to make cross-comparisons of financial statements of various publicly-traded companies in order to make an educated decision regarding investments.

IFRS

The IFRS is a set of standards developed by the International Accounting Standards Board (IASB). The IFRS governs how companies around the world prepare their financial statements. Unlike the GAAP, the IFRS does not dictate exactly how the financial statements should be prepared but only provides guidelines that harmonize the standards and make the accounting process uniform across the world.

Both individual and corporate investors can analyze a company’s financial statements and make an informed decision on whether or not to invest in the company. The IFRS is used in the European Union, South America, and some parts of Asia and Africa.

Differences between IFRS and GAAP accounting:

Methodology

GAAP focuses on research and is rule-based, whereas IFRS looks at the overall patterns and is based on principle.

Adoption

IFRS is a globally adopted method for accounting, while GAAP is exclusively used within the United States.

Developed by

The principles of IFRS are issued by the International Accounting Standard Board (IASB), while GAAP are issued by Financial Accounting Standard Board (FASB)

Inventory Reversal

IFRS and GAAP accounting also differ when it comes to inventory write-down reversals. In GAAP, the amount of the write-down cannot be reversed. However, under IFRS, the amount of the write-down can be reversed.

Inventory Methods

GAAP uses the Last In, First Out (LIFO) method for inventory estimates. However, in IFRS, the LIFO method for inventory is not allowed.

Income Statements

Extraordinary or unusual items are included in the income statement and not segregated under IFRS. While, under GAAP, they are separated and shown below the net income portion of the income statement.

Fixed Assets

In fixed assets, companies using GAAP accounting must value these assets using the cost model. IFRS uses a different model for fixed assets called the revaluation model.

Intangible Assets

When it comes to intangible assets, IFRS takes into account whether an asset will have a future economic benefit as a way of assessing the value. Intangible assets measured under GAAP are recognized at the fair market value and nothing more.

Quality Characteristics

Finally, the qualitative characteristics to how the accounting methods function. GAAP works within a hierarchy of characteristics, such as relevance, reliability, comparability and understandability, to make informed decisions based on user-specific circumstances. IFRS also works with the same characteristics, but with the exception that decisions cannot be made on the specific circumstances of an individual.

Development Costs

Development costs can be capitalized under IFRS, as long as certain criteria are met. With GAAP, development costs are not allowed to be capitalized.

Management Notes

Valuation of Liabilities

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Verification of liabilities is equally important as that of verification of assets. The Balance Sheet will reveal the true and fair view of the state of affairs of the business concerns only when the liabilities as well as assets are properly valued and verified.

Verification of liabilities aims at ascertaining whether all the liabilities of the business are properly disclosed, valued, classified, and shown in the Balance Sheet. The auditor should see that they are correctly stated in the Balance Sheet. He should obtain a certificate from the responsible official as to the correctness of liabilities.

Objectives of Verification

  • Legal and official documents relating to assets are checked to confirm the ownership of assets.
  • Confirmation about the existence of assets through physical verification.
  • It is confirmed that assets are free from any charge of lien.
  • To confirm that assets are properly accounted for in the books of accounts.
  • Proof regarding proper valuation of assets.

The auditor should have to examine and see that:

  • They Are All Relate to The Business Itself.
  • All The Liabilities Have Been Clearly Stated in The Liability Side of The Balance Sheet.
  • They Are All Correct and Authorized by The Responsible Official.
  • They Are Shown in The Balance Sheet at Their Actual Figures.

Verification

Verification and Valuation of Taxation Liability

Now-a-days, taxation has become an important liability and so the companies are required to make full provision in the accounts in this regard. The auditor should see whether the provision made therefor is sufficient to meet the estimated liability. Usually, auditors are required to advise on the adequacy of the liability and in such a case, they work as tax consultant.

Verification and Valuation of Income Received in Advance

Sometimes the firm receives some amount in advance, which is to be actually received in the next year. It is treated as a liability and should be shown in the liability side of the Balance Sheet. The auditor should verify whether the items of incomes received in advance are recorded in books. The auditor should obtain a Certified Schedule of income received in advance and verify the same. He should ensure that income received in advance is fully shown in the liability side of the Balance Sheet.

Verification and Valuation of Reserves and Fund

Reserves and funds are appropriations out of profits. The directors of a company determine the amount of reserves and funds to be created taking into account the circumstances of the business. The reserve and funds are to be shown on the liability side of the Balance Sheet with footnotes.

Verification and Valuation of Outstanding Liabilities for Expenses

  • He should see whether necessary provision for all the outstanding expenses have been made by checking receipts and other vouchers.
  • In case of outstanding liabilities, the auditor should obtain a certificate from a responsible officer of the company stating that all expenses become payable have been brought into account.
  • He should compare the expenses shown as unpaid during the current year with those of the last year and if he finds any difference, the same should be enquired into.

Verification and Valuation of Bills Payable

In case of bills payable, the auditor should follow the following verification procedure:

  • The bills paid after the Balance Sheet date should be examined with the entries passed in the Cashbook.
  • The auditor should obtain a Schedule of bills payable and its totals should be compared with the Bills Payable Book and Bills Payable Account.
  • He should pay special attention to the bills that have been paid between the date of the Balance Sheet and the date of his audit have been duly written in the books.
  • The auditor should obtain confirmatory statements from the drawers directly with the permission of his client.

Verification and Valuation of Employees Deposits

In commercial and industrial establishments, it is usual to require the employees who deal with cash or stores to give security deposit. It acts as a safeguard against some possible misappropriation or pilferage on the part of such employees. Sometimes, the employees instead of paying cash as security deposit endorse trustee securities in favor of the employers. In such cases, the auditor should see whether such a security in cash or in securities deposited separately in the bank. He should see whether they are shown distinctly in the liabilities side of the Balance Sheet. He should verify the amount of deposits by reference to the Certified Schedule received from the client.

Verification and Valuation of Debentures

  • He should verify the Debenture Trust Deed to verify the amount of debentures issued and securities offered. If necessary, he can obtain a certificate from the debenture holders to verify the amount of debentures issued.
  • In case of debentures, the auditor should verify the Memorandum of Association and the Articles of Association of the company and ascertain the power of the company to issue debentures. He should find out what is the borrowing limit and ensure that the company has not exceeded the same.
  • He should enquire as to what arrangement has been made for the redemption of debentures. In case debenture redemption fund has been created, he should verify the Articles of Association.
  • He should verify Register of Charges and Register of Debenture Holders to see that the debentures shown in the Balance Sheet agree with the debentures recorded in the books of account.
  • If the debentures are issued at premium or at discount, the auditor should see that the debenture premium and discount on issue of debenture are properly dealt with in the books of account.

Verification and Valuation of Capital

Capital is not the liability of an entity but still the auditor is required to verify it in order to report the genuineness and correctness of the Balance Sheet. In case of a firm, the auditor should verify capital with the help of Partnership Deed, Cashbook and the Passbook. He should see that it has been properly recorded in the books of account. In the case of a company, verification of capital can be discussed under the two heads:

First Audit

In case of first audit, the auditor should examine the Memorandum of Association to see what is the maximum capital, which the company is authorized to raise. He should also check the Articles of Association.

The Cashbook, Passbook, and Minute book of the Board of directors should be examined by the auditor in order to find the amount of shares and different classes issued, the amount collected on each shares, and the balance due from the shareholders in respect of calls, etc.

The shares allotted to vendors, should be examined with the contract between the vendors and the company.

Subsequent Audit

Normally, in case of subsequent years, the share capital would be the same as in the previous year unless the company has made any alteration or addition by fresh issue or otherwise. If he come across any change, he should see that the relevant provisions of Secs. 94, 95 and 100 to 105 of the Companies Act have been duly complied with.

Verification and Valuation of Loans

  • The auditor should ascertain the terms of loan, amount of loan, period and nature of loan, etc. by referring to the loan agreement.
  • The auditor should verify the existence of loans, if any. In case of a company he should examine the correspondence, contracts, and Directors’ Minute Book.
  • He should confirm the balances of the unpaid loans directly from the creditors of the company with the permission of his client.
  • The auditor should see whether the interest due has been paid or not. If the interest is due but not paid till the date of the Balance Sheet, he should see whether the same has been clearly shown as liability therein.
  • In case of loans or overdrafts taken from a bank, an agreement with the bank and a certificate to that effect should be obtained and examined.
  • It should be seen that the interest on loans has been paid up to date. If not he should see whether the amount due is recorded as unpaid in the books of accounts.
  • In case of a Joint Stock Company, the auditor should examine the borrowing powers of the company. He should also examine the Register of Charges, and should see that a charge created has been registered with the Registrar.

Verification and Valuation of Trade Creditors

  • The auditor should obtain a Schedule of creditors and verify them with the balances of ledger accounts and statements of account received from creditors.
  • The correctness of liabilities depends upon the correctness of purchases. Hence, the auditor should compare the percentage of gross profits to purchase with that of the previous years to verify the correctness of purchases.
  • He should check the Purchases Book and Purchases Returns Book with the help of invoices, credit notes, etc. He should also check the postings into the Ledger.
  • If any debt is found unpaid for a long time, an enquiry should be made since it is possible that instead of paying to the creditor, the amount might have been misappropriated.
  • He should see that all the purchases made during the year have been accounted for especially at the end of the year.
  • He should examine the Goods Inward Book to ensure that the goods purchased have been actually received.
  • He should examine the discount allowed to creditors during the period and see that these substantiate the credit balances.
  • He should examine the entries made at the beginning as well as at the end of year to check the employees have passed any fictitious entries in this regard.
  • In case of hire purchases, the auditor should see that the conditions of Hire Purchase Agreement are properly complied with.
Management Notes

Equity transactions

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The equity method is a type of accounting used for intercorporate investments. It is used when the investor holds significant influence over the investee but does not exercise full control over it, as in the relationship between a parent company and its subsidiary. In this case, the terminology of “parent” and “subsidiary” are not used, unlike in the consolidation method where the investor exerts full control over its investee. Instead, in instances where it’s appropriate to use the equity method of accounting, the investee is often referred to as an “associate” or “affiliate”.

There are several types of equity accounts that combine to make up total shareholders’ equity. These accounts include common stock, preferred stock, contributed surplus, additional paid-in capital, retained earnings, other comprehensive earnings, and treasury stock.

Equity is the amount funded by the owners or shareholders of a company for the initial start-up and continuous operation of a business. Total equity also represents the residual value left in assets after all liabilities have been paid off, and is recorded on the company’s balance sheet.

Types of Equity Accounts

Preferred Stock

Preferred stock is quite similar to common stock. The preferred stock is a type of share that often has no voting rights, but is guaranteed a cumulative dividend. If the dividend is not paid in one year, then it will accumulate until paid off.

Common Stock

Common stock represents the owners’ or shareholder’s investment in the business as a capital contribution. This account represents the shares that entitle the shareowners to vote and their residual claim on the company’s assets. The value of common stock is equal to the par value of the shares times the number of shares outstanding.

Contributed Surplus

Contributed Surplus represents any amount paid over the par value paid by investors for stocks purchases that have a par value. This account also holds different types of gains and losses resulting in the sale of shares or other complex financial instruments.

Retained Earnings

Retained Earnings is the portion of net income that is not paid out as dividends to shareholders. It is instead retained for reinvesting in the business or to pay off future obligations.

Additional Paid-In Capital

Additional Paid-In Capital is another term for contributed surplus, the same as described above.

The following formula and calculation can be used to determine the equity of a firm, which is derived from the accounting equation:

Shareholders’ Equity = Total Assets – Total Liabilities

This information can be found on the balance sheet, where these four steps should be followed:

  • Locate total liabilities, which should be listed separately on the balance sheet.
  • Locate the company’s total assets on the balance sheet for the period.
  • Note that total assets will equal the sum of liabilities and total equity.
  • Subtract total liabilities from total assets to arrive at shareholder equity.

Components of Shareholder Equity

Retained earnings are part of shareholder equity and are the percentage of net earnings that were not paid to shareholders as dividends. Think of retained earnings as savings since it represents a cumulative total of profits that have been saved and put aside or retained for future use. Retained earnings grow larger over time as the company continues to reinvest a portion of its income.

At some point, the amount of accumulated retained earnings can exceed the amount of equity capital contributed by stockholders. Retained earnings are usually the largest component of stockholders’ equity for companies that have been operating for many years.

Treasury shares or stock represent stock that the company has bought back from existing shareholders. Companies may do a repurchase when management cannot deploy all the available equity capital in ways that might deliver the best returns. Shares bought back by companies become treasury shares, and their dollar value is noted in an account called treasury stock, a contra account to the accounts of investor capital and retained earnings. Companies can reissue treasury shares back to stockholders when companies need to raise money.

Common variations on equity:

  • On a company’s balance sheet, the amount of the funds contributed by the owners or shareholders plus the retained earnings (or losses). One may also call this stockholders’ equity or shareholders’ equity.
  • A stock or any other security representing an ownership interest in a company.
  • In margin trading, the value of securities in a margin account minus what the account holder borrowed from the brokerage.
  • When a business goes bankrupt and has to liquidate, equity is the amount of money remaining after the business repays its creditors. This is most often called “ownership equity,” also known as risk capital or “liable capital.”
  • In real estate, the difference between the property’s current fair market value and the amount the owner still owes on the mortgage. It is the amount that the owner would receive after selling a property and paying any liens. Also referred to as “real property value.”
Management Notes

Integrated reporting

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Integrated reporting in corporate communication is a “process that results in communication, most visibly a periodic “integrated report”, about value creation over time. An integrated report is a concise communication about how an organization’s strategy, governance, performance and prospects lead to the creation of value over the short, medium and long term”.

Integrated Reporting brings together material information about an organisation’s strategy, governance, performance and prospects in a way that reflects the commercial, social and environmental context within which it operates. It leads to a clear and concise articulation of your value creation story which is useful and relevant to all stakeholders.

But is not only about reporting; Integrated Reporting encompasses Integrated Thinking.  It is as much about how companies do business and how they create value over the short, medium and long term as it is about how this value story is reported.

It means the integrated representation of a company’s performance in terms of both financial and other value relevant information. Integrated Reporting provides greater context for performance data, clarifies how valuable relevant information fits into operations or a business, and may help make company decision making more long-term. While the communications that result from IR will be of benefit to a range of stakeholders, they are principally aimed at providers of financial capital allocation decisions.

IR helps to complete financial and sustainability reports. A framework has been published, but some questions remain in order to know how to apply it. Do we need a new report? Do we need one report ? Will this report be useful for investors, and for other stakeholders? Other questions could have been raised, such as who is really working for an integrated reporting, and who has interests in it.

There are a multitude of benefits associated with Integrated Reporting – both within an organisation and from an external perspective.

  • Clearer articulation of strategy and business model.
  • Encouraging your organisation to think in an integrated way.
  • A single report that is easy to access, clear and concise.
  • Linking of non-financial performance more directly to the business.
  • Better identification of risk and opportunities.
  • Improved internal processes leading to a better understanding of the business and improved decision-making process.
  • Creating value for stakeholders through identification and measurement of non-financial factors.

Long-term benefits

Integrated reporting offers a more cohesive and efficient approach to corporate reporting across the short, medium and long-term, says Howitt. Academic and other research on adopting non-financial reporting demonstrates evidence of these benefits:

  • Lower costs of raising capital
  • A more stable long-term investor base
  • Higher share price

Advantages:

Performance

This area of IR addresses how an organisation has performed against its strategy and what are its key outcomes. These outcomes can be internal or external for example, revenue, cash flow, customer satisfaction, brand loyalty, environmental impacts, etc.

Business model

An organisation’s business model is ‘its system of transforming inputs, through its business activities, into outputs and outcomes that aims to fulfil the organisation’s strategic purposes and create value over the short, medium and long term’ (IIRC). Many of the performance management models are particularly relevant here: for example, the value chain explicitly sets out inputs, processes and outputs and requires organisations to understand how value is added so that profits can be made. If a company does not understand where it adds value then the company is existing in a temporary state of good fortune. It is making profits now, but does not understand why, so chance of continued success must low.

Opportunities and Risks

These must cover both internal and external matters. The traditional SWOT analysis usually categorises opportunities and threats (risks) as external, but it is essential to also look internally. A weakness (for example arising from gaps in new product development) is a risk to future revenues.

Management Notes

Marginal Costing for Decision Making

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Marginal costing system is not a method of costing like job or batch costing or process costing or contract costing or operating costing which are used for the purpose of calculating the cost of products or services.

Marginal costing is very helpful in managerial decision making. Management’s production and cost and sales decisions may be easily affected from marginal costing. That is the reason, it is the part of cost control method of costing accounting. Before explaining the application of marginal costing in managerial decision making, we are providing little introduction to those who are new for understanding this important concept.

Marginal costing is used for managerial decision-making. It can be used in conjunction with any method of costing, such as job costing or process costing. It can also be used with other techniques of costing like standard costing and budgetary control. In this, only variable cost are considered.

Marginal cost is change in total cost due to increase or decrease one unit or output. It is technique to show the effect on net profit if we classified total cost in variable cost and fixed cost. The ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs. In marginal costing, marginal cost is always equal to variable cost or cost of goods sold. We must know following formulae

a) Contribution ( Per unit) = Sale per unit – Variable Cost per unit

b) Total profit or loss = Total Contribution – Total Fixed Costs

or  Contribution = Fixed Cost + Profit

or  Profit = Contribution – Fixed Cost

c) Profit Volume Ratio = Contribution/ Sale X 100 (It means if we sell Rs. 100 product, what will be our contribution margin, more contribution margin means more profit)

d) Break Even Point is a point where Total sale = Total Cost

e) Break Even Point (In unit) = Total Fixed expenses / Contribution

f) Break Even Point (In Sales Value) = Breakeven point (in units) X Selling price per unit

g) Break Even Point at earning of specific net profit margin = Total Contribution / Contribution per unit

or = fixed cost + profit / selling price – variable cost per unit

Profits Planning:

The process of profit planning involves the calculation of expected costs and revenues arising out of operations at different levels of plant capacity for the production of different types of goods during a given period of time. The cost and revenues at different level of operating are different and a concern has to choose one level at which its profits are maximum.

Pricing in Home and Foreign Markets:

Pricing of a product is governed primarily by its cost of production and the nature of competition being faced by the production unit. Once a price is fixed by market forces, it remains stable at least in the short period. During short period when selling period, marginal cost and fixed costs remain the same, an entrepreneur is in a position to establish relationship between them.

On the basis of such a relationship, it is very easy to fix the volume of sales and selling price during normal and abnormal times in the home market. How far the prices can be cut in case of foreign buyer to effect additional sales is a problem which is realistically answered by the marginal costing technique.

Pricing in Foreign Markets:

A foreign market can be kept separate from the domestic market due to many legal and other restrictions imposed on imports and exports and as such a different price can be charged from foreign buyers. Any company which enjoys surplus production capacity can increase its production to sell in the foreign market at lower price if its full fixed cost already stands recovered from the production from home market.

Price under Recession/Depression:

Recession is an economic condition under which demand is declining. During depression the demand is at its lowest ebb, and the firms are confronted with the problem of price reduction and closure of production. Under such conditions, the marginal costing technique suggests that prices can be reduced to a level of marginal cost. In that case, the firm will lose profits and also suffer loss to the extent of fixed costs. This loss will also be borne even if the production is suspended altogether. Selling below marginal cost is advisable only under very special circumstances.

Determining Profitability of Alternative Product-Mix:

Since the objective of an enterprise to maximise profits, the management would prefer that product-mix which is ideal one in the sense that it yields maximum profits. Products-mix means combination of products which is intended for production and sales. A firm producing more than one product has to ascertain the profitability of alternative combinations of units or values of products and select the one which maximises profits.

Production with Limiting Factor:

Sometimes, production has to be carried with certain limiting factor. A limiting factor is the factor the supply of which is not unlimited or freely available to the manufacturing enterprise. In case of labour shortages, the labour becomes limiting factor. Raw material or plant capacity may be a limiting factor during budget period.

The consideration of limiting factors is essential for the success of any production plan because the manufacturing firm cannot increase the production to the level it desire when a limiting factor is combined with other factors of production. The limiting factor is also called by the name of ‘scarce factor’ or ‘key factor,’ ‘principal budget factor’ or ‘governing factor.’

Make or Buy Decision (When Plant is not Fully Utilised):

If the similar product or component is available outside, then a manufacturing firm compares its unit cost of manufacture with the price at which it can be purchased from the market. The marginal cost analysis suggests that it is profitable to the total manufacturing cost. In other words the firm should prefer to buy if the marginal cost is more than the Bought-out price and Make when the marginal cost is lesser than the purchase price. However, the available plant capacity will exert its own influence in such a decision-making.

Equation:

Firm should buy when PP+FC is lesser than total cost of manufacture

Firm should manufacture when PP+FC is greater than total cost of manufacture

Expand or Buy Decision:

In case unused capacity is limited or does not exist, then an alternative to buying is to make by purchasing additional plant and other equipment. The firm should evaluate the capital expenditure proposal resulting out of expansion programme in terms of cash flows and cost of capital. If the installed capacity of the existing plant is partially being used, then it can be utilised by producing more internally. The additional production may necessitate purchase of some specialised equipment and thus involve interest and depreciation cost. It is advisable to expand and produce if the enterprise is able to save some costs by doing so.

Ascertaining Relative Profitability of Products:

A manufacturing concern engaged in the production of various products is interested in the study of the relative profitability of its products so that it may suitably change its production and sales policies in case of those products which it considers less profitable or unproductive. The concept of P/V Ratio provided by the marginal costing technique is much helpful in understanding the relative profit/ability of products. It is always profitable to encourage the production of that product which shows a higher P/V ratio.

Sometimes, the management is confronted with a problem of loss and it has to decide whether to continue or abandon the production of a particular product which has resulted in a net loss. Marginal costing technique properly guides the management in such a situation. If a product or department shows loss, the Absorption Costing method would hastily conclude that it is of no use of produce and run the department and it should be close down.

Sometimes this type of conclusion will mislead the management. The marginal costing technique would suggest that it would be profitable to continue the production of a product if it is able to recover the full marginal cost and a part of the fixed cost.

Management Notes

Operate or Shut-down

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A shut-down decision is that the firm is temporarily suspending production. It does not mean that the firm is going out of business. The shut Down decision depends on Shut Down Point. The shutdown point denotes the exact moment when a company’s revenue is equal to its variable costs.

A Shutdown point is a position of operation at which a company is receiving no advantage for continuing operations Thus, decides to shut down temporarily or in some cases permanently.

Loss-making segments of a business such as products, customers, and locations can be a significant drain on the resources of an organization.

Keeping a segment of business that is consistently generating a loss can be hard to justify, especially if its economics are unlikely to improve in the future.

Shutdown decisions can, however, be daunting for a business because of the time and resources invested in the failing enterprise. Shutdown problems should also consider the long-term implications of the decision.

The shutdown point denotes the exact moment when a company’s revenue is equal to its variable costs. Variable costs such as wages, production supplies, etc. It results from the combination of output and price where the company earns just enough revenue to cover its total variable costs.

Reasons of shut down production

  • Financial problem
  • Fall in demand
  • Change in technology
  • Inadequate availability of raw material
  • High rate of taxes
  • Recession in market
  • Mismanagement

Shutdown Point

Theoretically, a business should discontinue any activity that does not generate sufficient funds to pay for its expenses in the long term (i.e., positive net cash flow).

When assessing shutdown problems, it is essential to consider only the relevant costs of business activity.

Examples of relevant costs include:

  • Direct fixed costs which are avoidable in case of a closure.
  • Variable expenses such as direct material and direct labor.
  • Opportunity cost of continuing a business activity.

Examples of non-relevant costs include:

  • Sunk cost (e.g., cost of machinery).
  • Non-cash expenses (e.g., depreciation)
  • Committed expenses which are unavoidable;
  • ‘One-off’ revenues and expenses (e.g., sale of machinery, redundancy payments, etc.) that do not reflect the underlying profitability of the business.

Types of Shutdown Points

The length of a shutdown can be temporary or permanent, this depends on the nature of the economic conditions which is leading to the shutdown. For the non-seasonal goods, in an economic recession, this may reduce the demand from the consumers, after forcing a temporary shutdown (partially or totally) until the economy recovers from this.

Yet at other times, the demand dries up completely for the changing consumer preferences, also for the technological upgrade. For example, nobody produces the cathode-ray tube (CRT) televisions or computer monitors any longer, and thus this would be a losing prospect to open a factory such as these days to produce the same.

Other businesses also may experience the fluctuations or produce some goods year-round, while others are merely produced seasonally. For example, the Cadbury chocolate bars are produced year-round, while the Cadbury Cream Eggs are considered as a seasonal product. The main operations will be focused on the chocolate bars, which may remain operational year-round, while the cream egg operations will have to go through periods of a shutdown during the off-season as well.

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