Tag: Cost Control and Management AccountingOsmania University b.com Notes

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.

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.”

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.

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.

The sell or process further decision is the choice of selling a product now or processing it further to earn additional revenue. This choice is based on an incremental analysis of whether the additional revenues to be gained will exceed the additional costs to be incurred as part of the additional processing work.

For example, if a green widget can be converted into a red widget at an incremental cost of Rs. 1.00 per unit, then processing further is a good idea as long as the incremental price gain to be achieved is at least Rs. 1.01 per unit.

The decision to sell now or process further boils down to which choice will result in higher profits. Split-off point refers to the moment in the manufacturing process when different products become separately identifiable.

If the incremental sales revenue is greater than incremental costs, it makes sense to process further. Otherwise, it is better to sell at the split-off point.

The sell or process further decision most commonly arises when two or more products are generated by a manufacturing process. At the point when the products can be split apart (the split-off point), there is a choice to sell the goods immediately or attempt to capture additional value by engaging in more processing. This decision may vary over time, based on changes in the market prices of a product at each stage of processing. If the market price declines for a later-stage product, it can make more sense to sell it without additional processing. Conversely, if the market price increases for a later-stage product, the better choice may be to continue with additional processing in order to reap higher profits.

Example

Hyderabad XYZ Company manufactures three products. In one production batch, the company incurs Rs.25,000 manufacturing costs up to the split off-point (the point in the manufacturing process when the products can be separately identified). The following summarizes the further processing costs beyond the split-off point and ultimate sales value.

The company can sell the products at split-off point. The expected sales revenues at split-off point are: Product 1 – Rs.24,000, Product 2 – Rs.8,000, Product 3 – Rs.7,000. Which products should be sold at split-off point and which products should be processed further?

Solution:

Product 1 should be sold at split-off point. The increase in sales revenue amounting to Rs.66,000 (i.e., from Rs.24,000 to Rs.90,000) is less than the costs to process the product further (Rs.72,000). Hence, it is better to sell the product at split-off point than process it further. Product 2 and Product 3 could be processed further since it will result in incremental profits.

Special order pricing is the price which the company can offer to their customers due to the large quantity or building a good relationship with customers in order to make potential next order. Due to these reasons, the company will try to offer a special price which is usually below the standard price.

One short-term decision that businesses continuously have to make is whether or not to accept special orders. This decision can prove somewhat of a complication to companies because they do not anticipate it when creating their yearly budget.

Special order pricing is a technique used to calculate the lowest price of a product or service at which a special order may be accepted and below which a special order should be rejected. Usually, a business receives special orders from customers at a price lower than normal. In such cases, the business will not accept the special order if it can sell all its output at normal price. However when sales are low or when there is idle production capacity, special orders should be accepted if the incremental revenue from special order is greater than incremental costs.

A company is producing, on average, 10,000 units of product A per month despite having 30% more capacity. Costs per unit of product A are as follows:

The company received a special order of 2,000 units of product A at Rs. 17.00 per unit from a new customer. Should the company accept the special order, provided that the customer has agreed to pay the variable selling expenses in addition to the price of the product?

Solution

The increment cost per unit for the special order is calculated as:

To further determine if you should accept a special order or not, use the contribution margin approach to do your analysis. This analysis will ascertain if the order will lead to a profit or loss. Follow these steps;

1. Determine the contribution margin per unit

The formula for calculating the contribution margin per unit is:

Order Price – Variable Costs per unit.

Exclude irrelevant costs like fixed costs from the calculation.

2. Determine the total Contribution Margin

You can determine this by multiplying the contribution margin per unit by the number of units in the special order.

3. To determine Profit or Loss, less any Incremental Fixed Costs from the Contribution Margin

If there are any incremental fixed costs, you’ll have to subtract them from the contribution margin. But if there are no fixed costs, your contribution margin is your total profit. It’s that simple.

4. Decide whether or not to accept the Job

The general rule is to take the job if it generates a profit and decline if it incurs a loss.

Providing a Framework for Evaluation:

Budgeting provides a basis to evaluate the performance of different departments. A comprehensive budget, properly developed, will contain initially organisational goals and expectations and subsequently can be used as an effective evalu­ation technique.

Acceptance and Cooperation:

Successful budgeting also requires that budgets should be accepted by the people who must execute them. Budgeting should have the active cooperation of the entire organisation from the top to the bottom. Cooperation for the budget can be achieved in a number of ways.

Coordinating Business Activities:

Budgeting needs to coordinate all the individual budgets into an integrated plan as each budget has certain implications for the other budgets. There must be coordination between sales, production, purchasing, personnel budgets.

Efficient Organisation:

Preparation of Budget and its operation requires efficient, adequate and best organisation. Therefore, a budgeting system should always be supported by a sound organisational structure demarcating clearly the lines of authority and responsibility.

Moreover, there should be true delegation of authority from top to lower levels of management so that executives at all levels may get the opportunity to make best decisions and get themselves involved in budget making exercise.

Reasonable Flexibility:

The budgeting programme should contain reasonable flexibility if the situation so demands. However, it should be noted that too much flexibility and too much tightness are both undesirable. Too much flexibility will weaken the cost control and the budget will become inoperative. Similarly, too much rigidity not permitting reasonable deviations will create problems and restrictions in the implementation of the budget. If conditions have changed making the estimates and budgets inaccurate, the budgets should be revised.

Communicating the Budgets:

The success of a comprehensive budgeting programme depends on communication of individual budgets to the different units in the organisation. The basic point is that the preparation of the budget is of no value unless it is known to the person for whom it is meant. Managers are not responsible for budget unless the budget is communicated clearly, concisely and in an authoritative manner to them.

Accurate Forecasting of Business Activities:

Forecasting is a prerequisite in a budgeting process. It is not only the starting point, but is also critical to the development of an accurate budget.

An Adequate, Planned and Reliable Accounting System:

There should be a proper flow of accurate and timely information in the business which is ‘must’ for the preparation of budgets. The finance department should continuously supply financial data on the basis of which budget estimates and forecasts are to be made. If the data are wrong all the estimates will be wrong and the very objectives of budget will be misguiding.

Formation of Budget Committee:

It is the Budget Committee that receives the forecasts and targets of each department as well as periodic reports and finalizes the final acceptable targets in form of Mater Budget. The Budget Committee also approves the departmental budgets. It is imperative that opportunities must be provided to the executives of all the departments for their participation in the process of budget making.

It is a budget known as constant budget, never registers the changes in the preparation of a budget, being prepared for irrespective level of output or production. This budget is mainly meant for the fixed overheads of the firm which are constant in volume irrespective level of production. The ultimate utility of the budget is to control the cost as a cost controlling measure, but the fixed budget is meaningless in having comparison with the actual performance.

A fixed budget is a financial plan that is not modified for variations in actual activity. Since most companies experience substantial variations from their expected activity levels over the period encompassed by a budget, the amounts in the budget are likely to diverge from actual results. This divergence is likely to increase over time. The only situations in which a fixed budget is likely to track close to actual results are when:

• The industry is not subject to much change, so that revenues are reasonably predictable.
• Costs are largely fixed, so that expenses do not change as revenues fluctuate.
• The company is in a monopoly situation, where customers must accept its pricing.

Mitigate

A good way to mitigate the disadvantages of a fixed budget are to combine it with continuous budgeting, where a new budget period is added onto the end of the budget as soon as the most recent budget period has been concluded. By doing so, the most recent projections are incorporated into the budget, while also maintaining a full-year budget at all times.

Another way to mitigate the effects of a fixed budget is to shorten the period covered by it. For example, the budget may only encompass a three-month period, after which management formulates another budget that lasts for an additional three months. Thus, even though the amounts in the budget are fixed, they apply to such a short period of time that actual results will not have much time in which to diverge from expectations.

The fixed budget is not effective for evaluating the performance of cost centers. For example, a cost center manager may be given a large fixed budget, and will make expenditures below the budget and be rewarded for doing so, even though a much larger overall decline in company revenues should have mandated a much larger expense reduction. The same problem arises if revenues are much higher than expected – the managers of cost centers have to spend more than the amounts indicated in the baseline fixed budget, and so appear to have unfavourable variances, even though they are simply doing what is needed to keep up with customer demand.

Features of Fixed budget

• The performance report does not contain useful information and misleading one.
• Fixed budget is rarely prepared and used. The reason is that the actual output is differing from the budgeted output. Hence, the management cannot exercise cost control.
• If units are overlooked in the cost-to-cost comparison, accurate result is not available.
• Fixed budget is limited by the costs and expenses which are affected by fluctuations in volume. This is a well known accepted fact.
• The performance report gives merely whether the actual costs are higher or lower than budgeted costs.
• There is no meaning of comparing one activity level with some other activity level. A fixed budget can be usefully employed when budgeted output is close to the actual output.

Example

let’s assume that a company pays a 5% sales commission on all of its sales. If the company prepares a fixed budget and it is projecting sales of Rs.1 million, the budget for sales commissions will be fixed at Rs.50,000. If the actual sales end up being only Rs.900,000 the budget for sales commissions will remain unchanged at the fixed amount of Rs.50,000. If the actual sales are Rs.1,100,000 the budget for sales commissions will also be Rs.50,000.

Had the company prepared a flexible budget, the budget for sales commissions would be expressed as 5% of sales. This means that the budget for sales commissions will be Rs.50,000 only when sales are Rs.1 million. If the company has actual sales of Rs.900,000, the budget for sales commissions will flex and will be Rs.45,000 (5% of Rs.900,000). If the actual sales are Rs.1,100,000 the budget for sales commissions will be Rs.55,000.

The term “financial analysis”, also known as analysis and interpretation of financial statements’, refers to the process of determining financial strengths and weaknesses of the firm by establishing strategic relationship between the items of the balance sheet, profit and loss account and other operative data.

“Analyzing financial statements,” according to Metcalf and Titard, “is a process of evaluating the relationship between component parts of a financial statement to obtain a better understanding of a firm’s position and performance.”

Objectives and Importance of Financial Statement Analysis:

The primary objective of financial statement analysis is to understand and diagnose the information contained in financial statement with a view to judge the profitability and financial soundness of the firm, and to make forecast about future prospects of the firm. The purpose of analysis depends upon the person interested in such analysis and his object.

However, the following purposes or objectives of financial statements analysis may be stated to bring out the significance of such analysis:

• To assess the operational efficiency and managerial effectiveness.
• To assess the earning capacity or profitability of the firm.
• To assess the short term as well as long term solvency position of the firm.
• To make inter-firm comparison.
• To identify the reasons for change in profitability and financial position of the firm.
• To make forecasts about future prospects of the firm.
• To assess the progress of the firm over a period of time.
• To guide or determine the dividend action.
• To help in decision making and control.
• To provide important information for granting credit.

Users Objectives

Prediction of Bankruptcy and Failure:

Financial statement analysis is a significant tool in predicting the bankruptcy and failure probability of business enterprises. After being aware about probable failure, both managers and investors can take preventive measures to avoid/minimise losses.

Prediction of Net Income and Growth Prospects:

The financial statement analysis helps in predicting the earning prospects and growth rates in the earnings which are used by investors while comparing investment alternatives and other users interested in judging the earning potential of business enterprises. Investors also consider the risk or uncertainty associated with the expected return.

The decision makers are futuristic and are always concerned with the future. Financial statements which contain information on past performances are analysed and interpreted as a basis for forecasting future rates of return and for assessing risk.

Assessment of Past Performance and Current Position:

Past performance is often a good indicator of future performance. Therefore, an investor or creditor is interested in the trend of past sales, expenses, net income, cash flow and return on investment. These trends offer a means for judging management’s past performance and are possible indicators of future performance.

Loan Decision by Financial Institutions and Banks:

Financial statement analysis is used by financial institutions, loaning agencies, banks and others to make sound loan or credit decision. In this way, they can make proper allocation of credit among the different borrowers. Financial statement analysis helps in determining credit risk, deciding terms and conditions of loan if sanctioned, interest rate, maturity date etc.