Tag: Financial Management Osmania University B.com Notes

A best practice is a method or technique that has been generally accepted as superior to any alternatives because it produces results that are superior to those achieved by other means or because it has become a standard way of doing things, e.g., a standard way of complying with legal or ethical requirements.

Best practices are a set of guidelines, ethics, or ideas that represent the most efficient or prudent course of action in a given business situation.

Best practices may be established by authorities, such as regulators, self-regulatory organizations (SROs), or other governing bodies, or they may be internally decreed by a company’s management team.

Best practices are used to maintain quality as an alternative to mandatory legislated standards and can be based on self-assessment or benchmarking. Best practice is a feature of accredited management standards such as ISO 9000 and ISO 14001.

Some consulting firms specialize in the area of best practice and offer ready-made templates to standardize business process documentation. Sometimes a best practice is not applicable or is inappropriate for a particular organization’s needs. A key strategic talent required when applying best practice to organizations is the ability to balance the unique qualities of an organization with the practices that it has in common with others.

Good operating practice is a strategic management term. More specific uses of the term include good agricultural practices, good manufacturing practice, good laboratory practice, good clinical practice and good distribution practice.

Best practices serve as a general framework for a variety of situations. For instance, in businesses that produce physical products, best practices that highlight efficient ways to complete tasks might be given to employees. Best practices lists may also outline safety procedures in order to minimize employee injuries.

For corporate accountants, the generally accepted accounting principles (GAAP) represent best practices. GAAP is a common set of accounting standards which aim to improve the clarity, consistency, and comparability of the communication of financial information.

GAAP facilitates the cross-comparison of financial information across different companies within the same sector. This benefits investors and the companies they invest in by promoting transparency.

Investment managers may follow best practices when handling a client’s money by prudently investing in a well-diversified portfolio and adhering to a client’s risk tolerances, time horizons, and retirement goals.

Business process improvement (BPI) is an approach used to identify and evaluate inefficiencies within the organization. It redesigns existing business tasks, improving their effectiveness, enhances the workflows involved, and optimizes performance.

Operational: The most popular tasks repeating every day. Examples: opening accounts, reporting, manufacturing, logistics

Management: Focus on human resource development, budgeting, corporate governance

Supporting: All other tasks not classified into the previous categories, like recruiting, accounting, tech support, and others.

BPI can be attributed to a number of reasons including:

• Reduce the time required to get work done
• Eliminate waste & friction in processes
• Ensure better compliance with rules and regulations

BPI structured initiative and it works in the following way:

• Analyze processes and identify areas of potential improvement.
• Identify existing processes within your organization.
• Run various simulations about any changes you can apply to these processes and their effect on the business.
• Focus on redesigning and reorganizing processes.
• Assess and reassess the people behind those processes.

Capacity management refers to the act of ensuring a business maximizes its potential activities and production output at all times, under all conditions. The capacity of a business measures how much companies can achieve, produce, or sell within a given time period.

Capacity management’s goal is to ensure that information technology resources are sufficient to meet upcoming business requirements cost-effictively. One common interpretation of capacity management is described in the ITIL framework. ITIL version 3 views capacity management as comprising three sub-processes: business capacity management, service capacity management, and component capacity management.

Since capacity can change due to changing conditions or external influences including seasonal demand, industry changes, and unexpected macroeconomic events companies must remain nimble enough to constantly meet expectations in a cost-effective manner. For example, raw material resources may need to be adjusted, depending on demand and the business’s current on-hand inventory.

Implementing capacity management may entail working overtime, outsourcing business operations, purchasing additional equipment, and leasing or selling commercial property.

Companies that poorly execute capacity management may experience diminished revenues due to unfulfilled orders, customer attrition, and decreased market share. As such, a company that rolls out an innovative new product with an aggressive marketing campaign must commensurately plan for a sudden spike in demand. The inability to replenish a retail partner’s inventory in a timely manner is bad for business.

Businesses thus face inherent challenges in their attempts to produce at capacity while minimizing production costs. For instance, a company may lack the requisite time and personnel needed to conduct adequate quality control inspections on its products or services. Furthermore, machinery might break down due to overuse and employees may suffer stress, fatigue, and diminished morale if pushed too hard.

Capacity management also means calculating the proportion of spacial capacity that is actually being used over a certain time period. Consider a company operating at a maximum capacity that houses 500 employees across three floors of an office building. If that company downsizes by reducing the number of employees to 300, it will then be operating at 60% capacity (300 / 500 = 60%). But given that 40% of its office space is left unused, the firm is spending more on per-unit cost than before.

Consequently, the company might decide to allocate its labor resources to only two floors and cease leasing the unused floor in a proactive effort to reduce expenditures on rent, insurance, and utility costs associated with the empty space.

Capacity management is concerned with:

• Monitoring the performance and throughput or load on a server, server farm, or property.
• Performance analysis of measurement data, including analysis of the impact of new releases on capacity.
• Performance tuning of activities to ensure the most efficient use of existing infrastructure
• Understanding the demands on the service and future plans for workload growth (or shrinkage).
• Influences on demand for computing resources.
• Capacity planning of storage, computer hardware, software and connection infrastructure resources required over some future period of time.

Factors affecting network performance

Not all networks are the same. As data is broken into component parts (often known frames, packets, or segments) for transmission, several factors can affect their delivery.

• Delay: It can take a long time for a packet to be delivered across intervening networks. In reliable protocols where a receiver acknowledges delivery of each chunk of data, it is possible to measure this as round-trip time.
• Packet loss: In some cases, intermediate devices in a network will lose packets. This may be due to errors, to overloading of the intermediate network, or to the intentional discarding of traffic in order to enforce a particular service level.
• Retransmission: When packets are lost in a reliable network, they are retransmitted. This incurs two delays: First, the delay from re-sending the data; and second, the delay resulting from waiting until the data is received in the correct order before forwarding it up the protocol stack.
• Throughput: The amount of traffic a network can carry is measured as throughput, usually in terms such as kilobits per second. Throughput is analogous to the number of lanes on a highway, whereas latency is analogous to its speed limit.

Capacity Limitations

It is important to understand your capacity limitations so that you can identify areas of improvement and develop a capacity plan that is just right for your organization.

Many factors contribute and detract from the available capacity. These include the quality and quantity of labor, machine availability, waste levels, government regulations, required machine maintenance, and other external factors.

Physical distancing requirements reduced the total available capacity for many manufacturers, leading to a decreased output. Some of these companies chose to add overtime capacity, while others chose to outsource some of their operations or even added automation to increase the output of their production lines.

The prevailing theme for businesses that thrived during the pandemic had one thing in common agility. These companies were able to quickly identify the effects of losing capacity in order to make the right choices to meet their business goals quickly and efficiently.

Capacity Analysis

The first step to take when you are constantly operating under constrained capacity is to identify the bottleneck.

A capacity bottleneck is a process or operation that has limited capacity and reduces the capacity of the entire production plant.

Bottlenecks cause delays in production, too much work-in-process items, and can be costly to the company. Identifying capacity bottlenecks can help identify the real cause of the problem and develop a plan to resolve it.

There are many ways to increase resource capacity within your facility:

• Purchase another machine (best for inexpensive resources, if possible).
• Perform regular maintenance on machines to increase their efficiency.
• Hire another employee.
• Re-allocate existing capacity to increase the capacity of the bottleneck operation.
• Invest in employee training.
• Optimize your production schedule to reduce sequence-dependent setups.

The theory of constraints (TOC) is a management paradigm that views any manageable system as being limited in achieving more of its goals by a very small number of constraints. There is always at least one constraint, and TOC uses a focusing process to identify the constraint and restructure the rest of the organization around it. TOC adopts the common idiom “a chain is no stronger than its weakest link”. That means that organizations and processes are vulnerable because the weakest person or part can always damage or break them, or at least adversely affect the outcome.

The Theory of Constraints provides a powerful set of tools for helping to achieve that goal, including:

• The Five Focusing Steps: A methodology for identifying and eliminating constraints
• The Thinking Processes: Tools for analyzing and resolving problems
• Throughput Accounting: A method for measuring performance and guiding management decisions

The five focusing steps

Theory of constraints is based on the premise that the rate of goal achievement by a goal-oriented system (i.e., the system’s throughput) is limited by at least one constraint.

The argument by reductio ad absurdum is as follows: If there was nothing preventing a system from achieving higher throughput (i.e., more goal units in a unit of time), its throughput would be infinite which is impossible in a real-life system.

Only by increasing flow through the constraint can overall throughput be increased.

Assuming the goal of a system has been articulated and its measurements defined, the steps are:

• Identify the system’s constraints.
• Decide how to exploit the system’s constraints.
• Subordinate everything else to the above decisions.
• Alleviate the system’s constraints.
• Warning! If in the previous steps a constraint has been broken, go back to step 1, but do not allow inertia to cause a system’s constraint.

Constraints

A constraint is anything that prevents the system from achieving its goal. There are many ways that constraints can show up, but a core principle within TOC is that there are not tens or hundreds of constraints. There is at least one, but at most only a few in any given system. Constraints can be internal or external to the system. An internal constraint is in evidence when the market demands more from the system than it can deliver. If this is the case, then the focus of the organization should be on discovering that constraint and following the five focusing steps to open it up (and potentially remove it). An external constraint exists when the system can produce more than the market will bear. If this is the case, then the organization should focus on mechanisms to create more demand for its products or services.

Types of (internal) constraints

• People: Lack of skilled people limits the system. Mental models held by people can cause behaviour that becomes a constraint.
• Equipment: The way equipment is currently used limits the ability of the system to produce more salable goods/services.
• Policy: A written or unwritten policy prevents the system from making more.

Plant types

There are four primary types of plants in the TOC lexicon. Draw the flow of material from the bottom of a page to the top, and you get the four types. They specify the general flow of materials through a system, and also provide some hints about where to look for typical problems. This type of analysis is known as VATI analysis as it uses the bottom-up shapes of the letters V, A, T, and I to describe the types of plants. The four types can be combined in many ways in larger facilities, e.g. “an A plant feeding a V plant”.

• V-plant: The general flow of material is one-to-many, such as a plant that takes one raw material and can make many final products. Classic examples are meat rendering plants or a steel manufacturer. The primary problem in V-plants is “robbing,” where one operation (A) immediately after a diverging point “steals” materials meant for the other operation (B). Once the material has been processed by A, it cannot come back and be run through B without significant rework.
• A-plant: The general flow of material is many-to-one, such as in a plant where many sub-assemblies converge for a final assembly. The primary problem in A-plants is in synchronizing the converging lines so that each supplies the final assembly point at the right time.
• T-plant: The general flow is that of an I-plant (or has multiple lines), which then splits into many assemblies (many-to-many). Most manufactured parts are used in multiple assemblies and nearly all assemblies use multiple parts. Customized devices, such as computers, are good examples. T-plants suffer from both synchronization problems of A-plants (parts aren’t all available for an assembly) and the robbing problems of V-plants (one assembly steals parts that could have been used in another).
• I-plant: Material flows in a sequence, such as in an assembly line. The primary work is done in a straight sequence of events (one-to-one). The constraint is the slowest operation.

Applications

The focusing steps, this process of ongoing improvement, have been applied to manufacturing, project management, supply chain/distribution generated specific solutions. Other tools (mainly the “thinking process“) also led to TOC applications in the fields of marketing and sales, and finance.

A successful Theory of Constraints implementation will have the following benefits:

• Fast Improvement: a result of focusing all attention on one critical area; the system constraint.
• Increased Profit: the primary goal of TOC for most companies.
• Improved Capacity: optimizing the constraint enables more product to be manufactured.
• Reduced Inventory: eliminating bottlenecks means there will be less work-in-process.
• Reduced Lead Times: optimizing the constraint results in smoother and faster product flow.

The term “value-added” describes the economic enhancement a company gives its products or services before offering them to customers. Value-added helps explain why companies are able to sell their goods or services for more than they cost to produce. Adding value to products and services is very important as it provides consumers with an incentive to make purchases, thus increasing a company’s revenue and bottom line.

Value-added could thus apply to instances when a firm takes a product that may be considered homogeneous with few differences from that of a competitor, if any and provides potential customers with a feature or add-on that gives it a greater perception of value. Adding a brand name to a generic product can be just as valuable as producing something new or in a way that no one has thought of before.

Value addition and Supply Chain

• Supply Chain basically starts from raw material suppliers, OEM, Distributor, Retailer and ends at Customer (or the other way around)
• Value can be roughly formulated as (Quality/Cost)

Value Addition in Supply Chain Management is about processes and activities that enables products (goods or services) to be more desirable by the customer  it has nothing to do with price or cost of production.

When you undergo a through analysis of supply chain systems (processes and activities) and you identify those that are not directly linked to ensure customer satisfaction and you remove such from the system, you are doing Value Addition.

Value-added is the difference between the price of a product or service and the cost of producing it. The price is determined by what customers are willing to pay based on their perceived value. Value is added or created in different ways.

These may include, for instance, extra or special features added by a company or producer to increase the value of a product or service. The addition of value can thus increase either the product’s price that consumers are willing to pay. For example, offering a year of free tech support on a new computer would be a value-added feature. Individuals can also add value to services they perform, such as bringing advanced skills into the workforce.

Consumers now have access to a whole range of products and services when they want them. As a result, companies constantly struggle to find competitive advantages over each other. Discovering what customers truly value is crucial for what the company produces, packages, markets, and how it delivers its products.

Bose Corporation, as an example, has successfully shifted its focus from producing speakers to delivering a “sound experience,” or when a BMW car rolls off the assembly line, it sells for a much higher premium over the cost of production because of its reputation for stellar performance, German engineering, and quality parts. Here, the additional advantage has been created through each brand’s symbolic value and years of refinement.

The purpose of supply chains is to add value to production and distribution. Depending upon the markets and the value chains they are servicing, supply chains can be differentiated according to criteria such as costs, time reliability, and risk. Efficient logistics contributes to added-value in four major interrelated ways:

Location. Logistics adds value by taking better advantage of various locations, implying access to expanded markets (more customers), and lower distribution costs.

Production costs. Derived from the improved efficiency of manufacturing with appropriate shipment size, packaging, and inventory levels. Thus, logistics contributes to the reduction of production costs by streamlining the supply chain.

Control. Added value derived from controlling most, if not all, the stages along the supply chain, from production to distribution. By better synchronizing cycles and lead times, logistics enables better marketing and demand response, thus anticipating flows and allocating distribution resources accordingly.

Time. Added value derived from having goods and services available when required along the supply chain (e.g. lower lead times) with better inventory and transportation management.

A variety of factors are jointly shaping the configuration of supply chains:

Transit time. A factor that is increasingly being considered since it strongly influences inventory carrying costs and inventory cycle time in supply chain management. So, for cargo with a higher value (clothing) or is perishable (refers), the routing option that is the fastest and/or shortest will be preferred.

Logistics costs. Considers the full array of costs to make products available to the final consumer, namely transport, warehousing, and transshipment. Supply chain managers are particularly sensitive to the stability of the cost structure (consistent costs), implying that routes having cost fluctuations may be discarded in favor of routes of a higher cost but with less volatility. Therefore, costs are a standard criterion where the cheapest routing option is sought, as long as the cost structure remains stable as supply chains are unlikely to be modified if a cost advantage is only temporary. The concept of cost is relative since its importance is concerning the value of the cargo being carried. Cost considerations tend to concern more containerized goods with a low value, such as commodities (e.g. paper), than high-value goods (e.g. electronics).

Supply chain risk. Relates to a generally imponderable factor and involving the level of confidence that the shipment will reach its final destination within expected costs, time, and reliability considerations. In some cases, risk can also involve potential cargo damage or theft. Low risks routes are obviously preferred over higher-risk routes.

Reliability. Relates to a factor that is mitigated by contemporary supply chain management practices. For several supply chains, time can be a secondary factor as long as shipments arrive at the distribution center within an expected time frame. If shipments are regular and that this reliability remains consistent, it is possible to organize supply chains accordingly by having more inventory in transit.

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.

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.

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.

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.”