MARGINAL COSTING - It is a costing technique where only variable cost or
direct cost will be charged to the cost unit produced. Marginal costing also shows
the effect on profit of changes in volume/type of output by differentiating between
fixed and variable costs.
Salient Points: 1. Marginal costing involves ascertaining marginal costs. Since
marginal costs are direct cost, this costing technique is also known as direct
costing; 2. In marginal costing, fixed costs are never charged to production. They
are treated as period charge and is written off to the profit and loss account in the
period incurred;
3. Once marginal cost is ascertained contribution can be computed. Contribution
is the excess of revenue over marginal costs.
4. The marginal cost statement is the basic document/format to capture the
marginal costs.
Features: 1. It is a method of recording costs and reporting profits;
2. All operating costs are differentiated into fixed and variable costs;
3. Variable cost charged to product and treated as a product cost whilst, 4. Fixed
cost treated as period cost and written off to the profit and loss account
Advantages: 1. It is simple to understand re: variable versus fixed cost concept;
2. A useful short term survival costing technique particularly in very competitive
environment or recessions where orders are accepted as long as it covers the
marginal cost of the business and the excess over the marginal cost contributes
toward fixed costs so that losses are kept to a minimum; 3. Its shows the
relationship between cost, price and volume; 4. Under or over absorption do not
arise in marginal costing; 5. Stock valuations are not distorted with present years
fixed costs; 6. Its provide better information hence is a useful managerial decision
making tool; Disadvantages: 1. Marginal cost has its limitation since it makes use
of historical data while decisions by management relates to future events;
2. It ignores fixed costs to products as if they are not important to production; 3.
Stock valuation under this type of costing is not accepted by the Inland Revenue
as it’s ignore the fixed cost element; 4. It fails to recognize that in the long run,
fixed costs may become variable
COST-VOLUME-PROFIT ANALYSIS - is a form of cost accounting. It is a
simplified model, useful for elementary instruction and for short-run decisions.
Cost-volume-profit (CVP) analysis expands the use of information provided by
breakeven analysis. A critical part of CVP analysis is the point where total
revenues equal total costs (both fixed and variable costs). At this breakeven point
(BEP), a company will experience no income or loss. This BEP can be an initial
examination that precedes more detailed CVP analyses.
Cost-volume-profit analysis employs the same basic assumptions as in breakeven
analysis. The assumptions underlying CVP analysis are:
The behavior of both costs and revenues is linear throughout the relevant range
of activity. (This assumption precludes the concept of volume discounts on either
purchased materials or sales.) Costs can be classified accurately as either fixed
or variable. Changes in activity are the only factors that affect costs. All units
produced are sold (there is no ending finished goods inventory). When a company
sells more than one type of product, the sales mix (the ratio of each product to
total sales) will remain constant. Assumptions: 1. Constant sales price; 2.
Constant variable cost per unit; 3. Constant total fixed cost; 4. Constant sales mix;
5. Units sold equal units produced
Models: Basis Graph: The assumptions of the CVP model yield the following
linear equations for total costs and total revenue (sales):
Total Costs = Fixed Costs + Unit Variable Cost x Number of Units
Total Revenue = Sales Price x Number of Units
These are linear because of the assumptions of constant costs and prices, and
there is no distinction between Units Produced and Units Sold, as these are
assumed to be equal. Note that when such a chart is drawn, the linear CVP model
is assumed, often implicitly.
Break Down: Costs and Sales can be broken down, which provide further insight
into operations. One can decompose Total Costs as Fixed Costs plus Variable
Costs: TC = TFC + V x X. Following a matching principle of matching a portion of
sales against variable costs, one can decompose Sales as Contribution plus
Variable Costs, where contribution is "what's left after deducting variable costs".
One can think of contribution as "the marginal contribution of a unit to the profit",
or "contribution towards offsetting fixed costs".
BALANCE SHEET: In financial accounting, a balance sheet or statement of
financial position is a summary of a person's or organization's balances. Assets,
liabilities and ownership equity are listed as of a specific date, such as the end of
its financial year. A balance sheet is often described as a snapshot of a company's
financial condition. Of the four basic financial statements, the balance sheet is the
only statement which applies to a single point in time.
A company balance sheet has three parts: assets, liabilities and ownership equity.
The main categories of assets are usually listed first and are followed by the
liabilities. The difference between the assets and the liabilities is known as equity
or the net assets or the net worth of the company and according to the accounting
equation, net worth must equal assets minus liabilities.
Another way to look at the same equation is that assets equals liabilities plus
owner's equity. Looking at the equation in this way shows how assets were
financed: either by borrowing money (liability) or by using the owner's money
(owner's equity).
Characteristics: 1. Balance Sheet is a statement. 2. Prepared on a specified
date. 3. It is a statement of assets and liabilities. 4. Knowledge of nature of assets
and liabilities. 5. Knowledge of financial position 6. Asses and liabilities tally each
other. Objects: Balance sheet is a vital part of final account. It has to be
compulsorily prepared as per legal provision. Objects of the Balance Sheet have
been summarised as under: Main Objects: The mail object of Balance sheet is
to assess the financial position of the firm. It is the list of assets and liabilities of
the firm on a specific date. The short term and long term financial position of the
firm can be obtained from the analysis of the Balance Sheet. Subsidiary
Objects: 1. Knowledge of proprietary ratio. 2. Protection against possible losses.
3. Calculation of financial ratios. 4. Calculation of working capital. 5. Ascertaining
funds from operation 6. Knowledge regarding sources and application of funds.
INVENTORY VALUATION: An inventory valuation allows a company to provide a
monetary value for items that make up their inventory. Inventories are usually the
largest current asset of a business, and proper measurement of them is
necessary to assure accurate financial statements. If inventory is not properly
measured, expenses and revenues cannot be properly matched and a company
could make poor business decisions.
Objectives: Determination of Income, Determination of financial position
INVENTORY SYSTEMS: The two most widely used inventory accounting systems are
the periodic and the perpetual.
Perpetual: The perpetual inventory system requires accounting records to show
the amount of inventory on hand at all times. It maintains a separate account in
the subsidiary ledger for each good in stock, and the account is updated each
time a quantity is added or taken out.
Periodic: In the periodic inventory system, sales are recorded as they occur but
the inventory is not updated. A physical inventory must be taken at the end of the
year to determine the cost of goods sold. Regardless of what inventory
accounting system is used, it is good practice to perform a physical inventory at
least once a year.
Methods: Specific Identification is a method of finding out ending inventory
cost. It requires a very detailed physical count, so that the company knows exactly
how many of each goods brought on specific dates remained at year end
inventory. When this information is found, the amount of goods are multiplied by
their purchase cost at their purchase date, to get a number for the ending
inventory cost.
On theory, this method is the best method, since it relates the ending inventory
goods directly to the specific price they were brought. However, this method
allows management to easily manipulate ending inventory cost, since they can
choose to report that the cheaper goods were sold first, hence increasing ending
inventory cost and lowering Cost of Goods Sold. This will increase the income.
Alternatively, management can choose to report lower income, to reduce the
taxes they needed to pay.
FIFO: FIFO accounting is a common method for recording the value of inventory.
It is appropriate where there are many different batches of similar products. The
method presumes that the next item to be shipped will be the oldest of that type in
the warehouse. In practice, this usually reflects the underlying commercial
substance of the transaction, since many companies rotate their inventory
(especially of perishable goods). This is still not in contrast to LIFO because FIFO
and LIFO are cost flow assumptions not product flow assumptions.
In an economy of rising prices (during inflation), it is common for beginning
companies to use FIFO for reporting the value of merchandise to bolster their
balance sheet. As the older and cheaper goods are sold, the newer and more
expensive goods remain as assets on the company's books. Having the higher
valued inventory and the lower cost of goods sold on the company's financial
statements may increase the chances of getting a loan. However, as it prospers
the company may switch to LIFO to reduce the amount of taxes it pays to the
government.
LIFO: LIFO is an acronym for "last in, first out." (Sometimes the term FILO ("first
in, last out") is used synonymously.) In LIFO accounting, a historical method of
recording the value of inventory, a firm records the last units purchased as the first
units sold. LIFO accounting is in contrast to the method FIFO accounting covered
below.
Since prices generally rise over time because of inflation, this method records the
sale of the most expensive inventory first and thereby decreases profit and
reduces taxes. However, this method rarely reflects the physical flow of
indistinguishable items.
LIFO valuation is permitted in the belief that an ongoing business does not realize
an economic profit solely from inflation. When prices are increasing, they must
replace inventory currently being sold with higher priced goods. LIFO better
matches current cost against current revenue. It also defers paying taxes on
phantom income arising solely from inflation. LIFO is attractive to business in that
it delays a major detrimental effect of inflation, namely higher taxes. However, in a
very long run, both methods converge.
“Last in first out” (LIFO) is not acceptable in the IFRS.
Weighted Average: Under the weighted average approach, both inventory and
the cost of goods sold are based upon the average cost of all units currently in
stock at the time of reporting. When inventory turns over rapidly this approach will
more closely resemble FIFO than LIFO.
P&L ACCOUNT: Income statement, also called profit and loss statement (P&L)
and Statement of Operations, is a company's financial statement that indicates
how the revenue (money received from the sale of products and services before
expenses are taken out, also known as the "top line") is transformed into the net
income (the result after all revenues and expenses have been accounted for, also
known as the "bottom line"). The purpose of the income statement is to show
managers and investors whether the company made or lost money during the
period being reported.
The important thing to remember about an income statement is that it represents
a period of time. This contrasts with the balance sheet, which represents a single
moment in time.
Charitable organizations that are required to publish financial statements do not
produce an income statement. Instead, they produce a similar statement that
reflects funding sources compared against program expenses, administrative
costs, and other operating commitments.
Purpose & Importance: 1. Knowledge of net profit or net loss. 2. Ascertaining
ratio between net profit and sales. 3. Calculation of expenses ratio to sales. 4.
Comparison of actual performance with desired performance. 5. Maintaining
provision and reserves 6. Determining future line of action.
Explanation: Salaries, Rent, Interest, Commission, Trade expenses, Carriage
and Freight outward, Printing and stationary, Advertisement, Samples, Discount,
Insurance premium, Loss on gain on sale of assets, any other loss.
BRS: The cash Book and Pass Book are prepared separately. The Businessman
prepares the Cash Book and the Pass Book is prepared by the Bank (here by
cash book we mean three column cash Book). But as both the books are related
to one person and same transactions are recorded in both the books so the
balance of both the books should match i.e. the balance as per Pass Book should
match to balance at bank as per cash book. But many a times these two balances
do not agree then, it becomes necessary to reconcile them by preparing a
statement which is called Bank Reconciliation Statement. A BANK
RECONCILIATION STATEMENT may be defined as a statement showing the
items of differences between the cash Brook balance and the pass book balance,
prepared on any day for reconciling the two balances.
Causes of Difference: A transaction relating to bank has to be recorded in both
the books i.e. Cash Book and Pass Book but sometimes it happens that a bank
transaction is recorded only in one book and not recorded simultaneously in other
book this causes difference in the two balances
Difference may raise: Cheques drawn but not yet presented to the bank.,
Cheques received but not yet deposited in the bank., Interest credited and not
recorded in the organization's books., Bank charges debited but not recorded in
the organization's books.
Importance: 1. The reconciliation process helps in bringing out the errors
committed either in cash Book or Pass Book. 2. Bank reconciliation statement
may also show any undue delay in the clearance of cheques. 3. Sometimes the
cashier may have the tendency of cheating like he may made entries in the Cash
Book only but never deposit the cash into bank. These types of frauds by the
entrepreneur’s staff or bank staff may be detected only through bank
reconciliation statement. So this way bank reconciliation statement acts as a
control technique too.
DEPRECIATION: In accounting, depreciation is a term used to describe any
method of attributing the historical or purchase cost of an asset across its useful
life, roughly corresponding to normal wear and tear. It is of most use when dealing
with assets of a short, fixed service life, and which is an example of applying the
matching principle per generally accepted accounting principles. Depreciation in
accounting is often mistakenly seen as a basis for recognizing impairment of an
asset, but unexpected changes in value, where seen as significant enough to
account for, are handled through write-downs or similar techniques which adjust
the book value of the asset to reflect its current value. Therefore, it is important to
recognize that depreciation, when used as a technical accounting term, is the
allocation of the historical cost of an asset across time periods when the asset is
employed to generate revenues.
Features: Depreciation is loss in the value of assets, Loss should be gradual and
constant, Depreciation is the exhaustion of the effective life of business,
Depreciation is the normal feature, Maintenance of assets is not depreciation, It is
the allocation of cost of assets to the period of its life, It is continuing decrease in
the value of assets.
Specific Words: Obsolescence is the state of being which occurs when a
person, object, or service is no longer wanted even though it may still be in good
working order. Obsolescence frequently occurs because a replacement has
become available that is superior in one or more aspects.
Depletion is an accounting concept used most often in mining, timber, petroleum,
or other similar industries. The depletion deduction allows an owner or operator to
account for the reduction of a product's reserves. Depletion is similar to
depreciation in that, it is a cost recovery system for accounting and tax reporting.
For tax purposes, there are two types of depletion; cost depletion and percentage
depletion.
Amortization or amortisation is the process of increasing, or accounting for, an
amount over a period of time. The word comes from Middle English amortisen to
kill, alienate in mortmain, from Anglo-French amorteser, alteration of amortir, from
Vulgar Latin admortire to kill, from Latin ad- + mort-, mors death. Amortization is
also used in the context of zoning regulations and describes the time in which a
property owner has to relocate when the property's use constitutes a preexisting
nonconforming use under zoning regulations.
Fluctuation: In economics, conjuncture (fluctuation) is a critical combination of
events. -- Boom is a time of high business activity, prosperity, peak of business
cycle, "bull" market, and/or strong expansion. Depression is a time of acutely low
business activity, "bear" market, slumping prices and demand, recession, bust.
Causes of depreciation: 1. By constant use. 2. By expiry of time, 3. By
obsolescence, 4. By depletion 5. Permanent fall in price, 6. By accidents.
Importance: 1. For determination of net profit or loss, 2. For showing assets at
fair and true value in the balance sheet. 3. Provision of funds for replacement of
assets, 4. Ascertaining accurate cost of production, 5. Distribution of dividend out
of profit only. 6. Avoiding over payment of income tax.
Factors affecting: 1. Total cost of assets, 2. Estimated useful life of assets 3.
Estimated scrap value, 4. Chances of obsolescence, 5. Addition to assets., 6.
Legal provision
METHODS OF DEPRECIATIONS
Straight-line depreciation: Straight-line depreciation is the simplest and most-
often-used technique, in which the company estimates the salvage value of the
asset at the end of the period during which it will be used to generate revenues
(useful life) and will expense a portion of original cost in equal increments over
that period. The salvage value is an estimate of the value of the asset at the time
it will be sold or disposed of; it may be zero or even negative. Salvage value is
also known as scrap value or residual value.
For example, a vehicle that depreciates over 5 years, is purchased at a cost
of Rs. 17,000, and will have a salvage value of Rs. 2000, will depreciate at Rs.
3,000 per year: (Rs. 17,000 - Rs. 2,000)/ 5 years = Rs. 3,000 annual straight-
line depreciation expense. In other words, it is the depreciable cost of the asset
divided by the number of years of its useful life.
Declining-Balance Method: Depreciation methods that provide for a higher
depreciation charge in the first year of an asset's life and gradually decreasing
charges in subsequent years are called accelerated depreciation methods. This
may be a more realistic reflection of an asset's actual expected benefit from the
use of the asset: many assets are most useful when they are new. One popular
accelerated method is the declining-balance method. Under this method the Book
Value is multiplied by a fixed rate.
Annual Depreciation = Depreciation Rate * Book Value at Beginning of Year
The most common rate used is double the straight-line rate. For this reason, this
technique is referred to as the double-declining-balance method. To illustrate,
suppose a business has an asset with Rs. 1,000 Original Cost,Rs. 100 Salvage
Value, and 5 years useful life. First, calculate straight-line depreciation rate. Since
the asset has 5 years useful life, the straight-line depreciation rate equals (100% /
5) 20% per year. With double-declining-balance method, as the name suggests,
double that rate, or 40% depreciation rate is used.
Activity depreciation: Activity depreciation methods are not based on time, but
on a level of activity. This could be miles driven for a vehicle, or a cycle count for a
machine. When the asset is acquired, its life is estimated in terms of this level of
activity. Assume the vehicle above is estimated to go 50,000 miles in its lifetime.
The per-mile depreciation rate is calculated as: (Rs. 17,000 cost - Rs. 2,000
salvage) / 50,000 miles = Rs. 0.30 per mile. Each year, the depreciation expense
is then calculated by multiplying the rate by the actual activity level.
Sum-of-Years' Digits Method: Sum-of-Years' Digits is a depreciation method that
results in a more accelerated write-off than straight line, but less than declining-
balance method. Under this method annual depreciation is determined by
multiplying the Depreciable Cost by a schedule of fractions. -- Depreciable Cost =
Original Cost - Salvage Value -- Book Value = Original Cost - Accumulated
Depreciation
Units-of-Production Depreciation Method: Under the Units-of-Production
method, useful life of the asset is expressed in terms of the total number of units
expected to be produced. Annual depreciation is computed in three steps.
First, a Depreciable Cost is computed. -- Depreciable Cost = Original Cost -
Salvage Value. Second, Depreciation per Unit is computed. Depreciation charge
per unit is computed by dividing Depreciable Cost by Total Units, expected to be
produced during the useful life of the asset. -- Depreciation per Unit = Depreciable
Cost / Total Units of production. Third, annual depreciation, or Depreciation
Expense, by another name, is computed.
from the Original Cost. -- Book Value = Original Cost - Accumulated Depreciation
Units of time depreciation: Units of Time Depreciation is similar to units of
production, and is used for depreciation equipment used in mine or natural
resource exploration, or cases where the amount the asset is used is not linear
year to year. A simple example can be given for construction companies, where
some equipment is used only for some specific purpose. Depending on the
number of projects, the equipment will be used and depreciation charged
accordingly.
Composite Depreciation Method: The composite method is applied to a
collection of assets that are not similar, and have different service lives. For
example, computers and printers are not similar, but both are part of the office
equipment. Depreciation on all assets is determined by using the straight-line-
depreciation method.
FINANCIAL STATEMENTS: Financial statements (or financial reports) are formal
records of the financial activities of a business, person, or other entity. In British
English, including United Kingdom company law, financial statements are often
referred to as accounts, although the term financial statements is also used,
particularly by accountants. Financial statements provide an overview of a
business or person's financial condition in both short and long term. All the
relevant financial information of a business enterprise, presented in a structured
manner and in a form easy to understand, are called the financial statements.
There are four basic financial statements:
Balance sheet: also referred to as statement of financial position or condition,
reports on a company's assets, liabilities, and net equity as of a given point in
time. Income statement: also referred to as Profit and Loss statement (or a
"P&L"), reports on a company's income, expenses, and profits over a period of
time. Profit & Loss account provide information on the operation of the enterprise.
These include sale and the various expenses incurred during the processing
state. Statement of retained earnings: explains the changes in a company's
retained earnings over the reporting period.
Statement of cash flows: reports on a company's cash flow activities, particularly
its operating, investing and financing activities.
LIMITATIONS: 1. As the historical costs and money measurement concepts
govern the preparation of the balance sheet and income statements, hence these
financial statements are essentially statements reflecting historical facts. It ignore
inflationary trend and does not reflect the true current worth of the enterprise,
2. Certain important qualitative elements are omitted from the financial statements
because they are incapable of being measured in monetary terms like the quality
and reputation of the management team, employee and other,
3. There are still items in the assets side of the balance sheet which has no real
value and are merely deferred charges to future incomes like preliminary / pre-
incorporation expenses and other.
STOCKS: A share of stock is the smallest unit of ownership in a company. If you
own a share of a company’s stock, you are a part owner of the company.
You have the right to vote on members of the board of directors and other
important matters before the company. If the company distributes profits to
shareholders, you will likely receive a proportionate share.
One of the unique features of stock ownership is the notion of limited liability. If the
company loses a lawsuit and must pay a huge judgment, the worse that can
happen is your stock becomes worthless. The creditors can’t come after your
personal assets. That’s not necessarily true in private-held companies. When you
hear or read about “stocks” being up or down, it always refers to common stock.
There are two types of stock: 1. Common stock - Common stock represents the
majority of stock held by the public. It has voting rights, along with the right to
share in dividends 2. Preferred stock - Despite its name, preferred stock has
fewer rights than common stock, except in one important area – dividends.
Companies that issue preferred stocks usually pay consistent dividends and
preferred stock has first call on dividends over common stock.
Investors buy preferred stock for its current income from dividends, so look for
companies that make big profits to use preferred stock to return some of those
profits via dividends.
Other Types: Authorized Shares – These shares represent the total number of
shares of stock authorized when the company was created. Only a vote by the
shareholders can increase this number of shares.
However, just because a company authorized a certain number of shares doesn’t
mean it must issue all of them to the public. Most companies retain shares for use
later called unissued stock or shares.
Unissued Shares – Shares a company retains in its treasury and not issued to
the public or to employees are unissued shares.
Restricted Shares – Restricted shares refer to company stock used for employee
incentive and compensation plans. Restricted stockowners need permission of
the SEC to sell. There is a waiting period after a company first goes public where
insiders’ restricted stock is frozen. When insiders want to sell their stock, they
must file a form with the SEC declaring their intention. Even insiders of
established companies must file with the SEC before selling their restricted stock.
Float Shares – Float refers to the number of shares actually available for trade on
the open market. You and I can buy these shares.
Outstanding Shares – Outstanding shares includes all the shares issued by the
company, which would be the restricted shares plus the float.
Blue chip stocks are stocks of well-established companies that have stable
earnings and no extensive liabilities. They have a track record of paying regular
dividends, and are valued by investors seeking relative safety and stability. The
name comes from the blue-colored chips in the game of poker, which are typically
the most valuable.
Penny stocks are low-priced, speculative and risky securities which are traded
over-the-counter (OTC); i.e. outside of one of the major exchanges.
Income stocks offer a higher dividend in relation to their market price. They are
especially attractive to investors who are looking for current income that will
gradually grow over the years as a way to offset inflation.
Growth stocks are securities which appreciate in value and yield a high return.
Their profits are typically re-invested to expand the business. Investors gain
because the stock prices increase as the business grows, thus increasing the
value of the investment.
Value stocks are securities which investors consider to be undervalued. They
feel that the stock is being traded below market value, and they believe in the
long-term growth of the issuing company.
PROCEDURE OF ISSUE STOCKS: 1. Determine the number of shares of stock
you will issue each owner. Laws in the various states generally specify a minimum
number of shares that should be issued. If you exceed that amount, you may pay
higher fees to the state. 2. Know that each share is worth a proportionate amount
of the company's total net worth. 3. Decide what class of shares you will offer -
preferred or common. In elections, holders of common stock generally have one
vote for each share they hold. They have a right, upon dissolution of the company,
to a proportionate share of the assets. Preferred shareholders take certain
preferences over common shareholders. 4. Hire a printer to print the stock
certificates. 5. Issue certificates to the shareholders. 6. Establish a shareholder
agreement, also known as a buyout agreement, dealing with issues relating to
stock ownership. The agreement will cover the death or departure of
shareholders, protection of proprietary information, transfer or sale of stock, and
the method by which a shareholder or group of shareholders can buy out other
shareholders. 7. Ensure that shareholders' spouses sign the agreement if the
shareholders live in states in which community-property laws govern joint
ownership of property. 8. Consider selling shares to a venture-capital firm as a
means by which to raise additional capital to buy equipment, hire employees,
conduct research and develop, or intensify your marketing efforts.
DEBENTURES: A debenture is defined as a certificate of agreement of loans
which is given under the company's stamp and carries an undertaking that the
debenture holder will get a fixed return (fixed on the basis of interest rates) and
the principal amount whenever the debenture matures. In finance, a debenture is
a long-term debt instrument used by governments and large companies to obtain
funds. It is defined as "any form of borrowing that commits a firm to pay interest
and repay capital. In practice, these are applied to long term loans that are
secured on a firm's assets. ". Where securities are offered, loan stocks or bonds
are termed 'debentures' in the UK or 'mortgage bonds' in the US.
The advantage of debentures to the issuer is they leave specific assets burden
free, and thereby leave them open for subsequent financing. Debentures are
generally freely transferable by the debenture holder. Debenture holders have no
voting rights and the interest given to them is a charge against profit. Types
There are two types of debentures: 1. Convertible Debentures, which can be
converted into equity shares of the issuing company after a predetermined period
of time. In finance, a convertible note (or, if it has a maturity of greater than 10
years, a "convertible debenture") is a type of bond that can be converted into
shares of stock in the issuing company or cash of equal value, at some pre-
announced ratio. It is a hybrid security with debt- and equity-like features.
Although it typically has a low coupon rate, the holder is compensated with the
ability to convert the bond to common stock at an agreed upon price and thereby
participate in further growth in the company's equity value.
From the issuer's perspective, the key benefit of raising money by selling
convertible bonds is a reduced cash interest payment. However, in exchange for
the benefit of reduced interest payments, the value of shareholder's equity is
reduced due to the stock dilution expected when bondholders convert their bonds
into new shares. Non-Convertible Debentures, which cannot be converted into
equity shares of the liable company. They usually carry higher interest rates than
the convertible ones.
Provisions regulating issue of Debentures: The power to issue debentures can
be exercised on behalf of the company at a meeting of the Board of Directors
{Section 292(1)(b) of the Companies Act}. A public company may, however,
require the approval of shareholders to borrow money in excess of the aggregate
of its paid up capital and free reserves.{Section 293 (1) (d)}. Consent of the
shareholders would also be required for selling, leasing or disposing of the whole
or substantially the whole of the undertaking of the company under section 293
(1) (a) Debentures have been defined under Section 2 (12) of the Act to include
debenture stocks, bonds and any other securities of the company whether
constituting a charge on the company's assets or not.
The attributes of a debenture are: a. A movable property., b. Issued by the
company in the form of a certificate of indebtedness., c. It generally specifies the
date of redemption, repayment of principal and interest on specified dates.
d. May or may not create a charge on the assets of the company.
CASH FLOW STATEMENT: In financial accounting, a cash flow statement or
statement of cash flows is a financial statement that shows how changes in
balance sheet and income accounts affect cash and cash equivalents, and breaks
the analysis down to operating, investing, and financing activities. As an analytical
tool, the statement of cash flows is useful in determining the short-term viability of
a company, particularly its ability to pay bills. International Accounting Standard 7
(IAS 7), is the International Accounting Standard that deals with cash flow
statements.
Preparation Methods: Direct method: The direct method for creating a cash
flow statement reports major classes of gross cash receipts and payments. Under
IAS 7, dividends received may be reported under operating activities or under
investing activities. If taxes paid are directly linked to operating activities, they are
reported under operating activities; if the taxes are directly linked to investing
activities or financing activities, they are reported under investing or financing
activities.
Indirect method: The indirect method uses net-income as a starting point, makes
adjustments for all transactions for non-cash items, then adjusts for all cash-
based transactions. An increase in an asset account is subtracted from net
income, and an increase in a liability account is added back to net income. This
method converts accrual-basis net income (or loss) into cash flow by using a
series of additions and deductions.
Rules: The following rules are used to make adjustments for changes in current
assets and liabilities, operating items not providing or using cash and
nonoperating items. 1. Decrease in noncash current assets are added to net
income 2. Increase in noncash current asset are subtracted from net income 3.
Increase in current liabilities are added to net income 4. Decrease in current
liabilities are subtracted from net income 5. Expenses with no cash outflows are
added back to net income 6. Revenues with no cash inflows are subtracted from
net income (depreciation expense is the only operating item that has no effect on
cash flows in the period) 7. Nonoperating losses are added back to net income 8.
Nonoperating gains are subtracted from net income.
RATIO ANALYSIS: In finance, a financial ratio or accounting ratio is a ratio of two
selected numerical values taken from an enterprise's financial statements. There
are many standard ratios used to try to evaluate the overall financial condition of a
corporation or other organization. Financial ratios may be used by managers
within a firm, by current and potential shareholders (owners) of a firm, and by a
firm's creditors. Security analysts use financial ratios to compare the strengths
and weaknesses in various companies. If shares in a company are traded in a
financial market, the market price of the shares is used in certain financial ratios.
Ratios may be expressed as a decimal value, such as 0.10, or given as an
equivalent percent value, such as 10%.
FINANCIAL RATIO: Financial ratios are calculated from one or more pieces of
information from a company's financial statements. For example, the "gross
margin" is the gross profit from operations divided by the total sales or revenues
of a company, expressed in percentage terms. In isolation, a financial ratio is a
useless piece of information. In context, however, a financial ratio can give a
financial analyst an excellent picture of a company's situation and the trends that
are developing.
Types: Meaning, Objective and Method of Calculation: -
a. DEBT-EQUITY RATIO: Debt equity ratio shows the relationship between
long-term debts and shareholders funds. It is also known as External-
Internal equity ratio. -- Debt Equity Ratio = Debt/Equity
Where Debt (long term loans) include Debentures, Mortgage Loan, Bank Loan,
Public Deposits, Loan from financial institution etc.
Equity (Shareholders Funds) = Share Capital (Equity + Preference) + Reserves
and Surplus Fictitious Assets
Objective and Significance: This ratio is a measure of owners stock in the
business. Proprietors are always keen to have more funds from borrowings
because:
(i) Their stake in the business is reduced and subsequently their risk too
(ii) Interest on loans or borrowings is a deductible expenditure while computing
taxable profits. Dividend on shares is not so allowed by Income Tax Authorities.
The normally acceptable debt-equity ratio is 2:1.
b. DEBT TO TOTAL FUNDS RATIO: This ratio gives same indication as the
debt-equity ratio as this is a variation of debt-equity ratio. This ratio is also
known as solvency ratio. This is a ratio between long-term debt and total
long-term funds.
Debt to Total Funds Ratio = Debt/Total Funds
Where Debt (long term loans) include Debentures, Mortgage Loan, Bank Loan,
Public Deposits, Loan from financial institution etc.
Total Funds = Equity + Debt = Capital Employed
Equity (Shareholders Funds) = Share Capital (Equity + Preference) + Reserves
and Surplus Fictitious Assets
Objective and Significance: - Debt to Total Funds Ratios shows the proportion
of long-term funds, which have been raised by way of loans. This ratio measures
the long-term financial position and soundness of long-term financial policies. In
India debt to total funds ratio of 2:3 or 0.67 is considered satisfactory. A higher
proportion is not considered good and treated an indicator of risky long-term
financial position of the business. It indicates that the business depends too much
upon outsiders loans.
c. FIXED ASSETS RATIO: Fixed Assets Ratio establishes the relationship of
Fixed Assets to Long-term Funds.
Fixed Assets Ratio = Long-term Funds/Net Fixed Assets
Where Long-term Funds = Share Capital (Equity + Preference) + Reserves and
Surplus + Long- term Loans Fictitious Assets
Net Fixed Assets means Fixed Assets at cost less depreciation. It will also include
trade investments.
Objective and Significance: This ratio indicates as to what extent fixed assets
are financed out of long-term funds. It is well established that fixed assets should
be financed only out of long-term funds. This ratio workout the proportion of
investment of funds from the point of view of long-term financial soundness. This
ratio should be equal to 1. If the ratio is less than 1, it means the firm has adopted
the impudent policy of using short-term funds for acquiring fixed assets. On the
other hand, a very high ratio would indicate that long-term funds are being used
for short-term purposes, i.e. for financing working capital.
d. PROPRIETARY RATIO: Proprietary Ratio establishes the relationship
between proprietors funds and total tangible assets. This ratio is also
termed as Net Worth to Total Assets or Equity-Assets Ratio.
Proprietary Ratio = Proprietors Funds/Total Assets
Where Proprietors Funds = Shareholders Funds = Share Capital (Equity +
Preference) + Reserves and Surplus Fictitious Assets
Total Assets include only Fixed Assets and Current Assets. Any intangible assets
without any market value and fictitious assets are not included.
Objective and Significance: This ratio indicates the general financial position of
the business concern. This ratio has a particular importance for the creditors who
can ascertain the proportion of shareholders funds in the total assets of the
business. Higher the ratio, greater the satisfaction for creditors of all types.
e. INTEREST COVERAGE RATIO: Interest Coverage Ratio is a ratio between
net profit before interest and tax and interest on long-term loans. This ratio
is also termed as Debt Service Ratio.
Interest Coverage Ratio = Net Profit before Interest and Tax/Interest on Long-term
Loans
Objective and Significance: This ratio expresses the satisfaction to the lenders
of the concern whether the business will be able to earn sufficient profits to pay
interest on long-term loans. This ratio indicates that how many times the profit
covers the interest. It measures the margin of safety for the lenders. The higher
the number, more secure the lender is in respect of periodical interest.
MANAGEMENT ACCOUNTING: According to the Chartered Institute of
Management Accountants (CIMA), Management Accounting is "the process of
identification, measurement, accumulation, analysis, preparation, interpretation
and communication of information used by management to plan, evaluate and
control within an entity and to assure appropriate use of and accountability for its
Resource (economics)resources. Management accounting also comprises the
preparation of financial reports for non-management groups such as
shareholders, creditors, regulatory agencies and tax authorities" (CIMA Official
Terminology).
Aims: Formulating strategy|strategies, Planning and constructing business
activities, Helps in making decision, Optimal use of Resource (economics),
Supporting financial reports preparation, Safeguarding asset
Role: Consistent with other roles in today's corporation, management accountants
have a dual reporting relationship. As a strategic partner and provider of decision
based financial and operational information, management accountants are
responsible for managing the business team and at the same time having to
report relationships and responsibilities to the corporation's finance organization.
The activities management accountants provide inclusive of forecasting and
planning, performing variance analysis, reviewing and monitoring costs inherent in
the business are ones that have dual accountability to both finance and the
business team. Examples of tasks where accountability may be more meaningful
to the business management team vs. the corporate finance department are the
development of new product costing, operations research, business driver
metrics, sales management scorecarding, and client profitability analysis.
Conversely, the preparation of certain financial reports, reconciliations of the
financial data to source systems, risk and regulatory reporting will be more useful
to the corporate finance team as they are charged with aggregating certain
financial information from all segments of the corporation.
Scope: (i) Financial accounting – Management accounting is mainly concerned
with the rearrangement of the information provided by financial accounting, hence
management (ii) Cost accounting – Standard costing, marginal costing,
opportunity cost analysis, differential costing and other cost techniques play a
useful role in operation and control of the business undertaking. (iii) Revaluation
accounting – This is concerned with ensuring that capital is maintained intact in
real terms and profit is calculated with this fact in mind. (iv) Inventory control – It
includes control over inventory from the time it is acquired till its final disposal. (v)
Statistical methods – Graphs, Charts, Pictorial presentation, Index numbers and
other statistical methods make the information more impressive and intelligible.
(vi) Budgetary control – This includes framing of budgets comparison of actual
performance with the budgeted performance, computation of variances, finding of
their causes etc. Limitations: 1. It is based on the information that is derived from
financial and cost accounting and management accounting depends upon the
accuracy of that information and hence it is dependent on it. 2. Since
management accounting requires knowledge of subjects like economics,
statistics, technology etc… and hence management accountant needs to have full
information on all these subjects which is very difficult in practice and hence in this
age of specialization it is very difficult to have such type of person who can handle
management accountancy with expertise. 3. It is subjective because of lack of
certain rules and hence it is more dependent on the person who is handling the
management accounting rather than on anything else. 4. It is very costly and
hence few organizations can adopt it which limits its use
Utility: Planning, Controlling, Coordinating, Organizing, Motivating,
Communicating.
COST SHEET: All the elements, cost of a product, job or a process, can be put in
the form of a statement which is technically called as a Cost Sheet or a Cost
Statement. According to CIMA, London cost sheet is a document which provides
for the assembly of the estimated detailed cost in respect of a cost centre or a
cost unit. It analysis and classified in a tabular form the expenses on different
items for a particular period. Additional columns may also be provided to show the
cost per unit pertaining to each item of expenditure and the total per unit cost.
Variations of stock are also recorded and proper adjustments made to arrive at
the correct figures of raw material consumed and the cost of goods sold.
Types: Historical: Such a cost sheet is prepared periodically after the costs have
been incurred. The period may be a year, half-year, a quarter or a month. Actual
costs are complied and presented through such a cost statement.
Estimated: Such a cost sheet is prepared before the actual commencement of
production. The estimating process is repeated at regular intervals. Estimated
cost sheets may be prepared on a yearly, half-yearly, quarterly or monthly basis.
Importance: Ascertaining of cost, Controlling costs, Fixation of selling price,
Submitting of tenders.
COST
In accounting, costs are the monetary value of expenditures for supplies,
services, labour, products, equipment and other items purchased for use by a
business or other accounting entity. It is the amount denoted on invoices as the
price and recorded in bookkeeping records as an expense or asset cost basis.
Opportunity cost, also referred to as economic cost is the value of the best
alternative that was not chosen in order to pursue the current endeavour—i.e.,
what could have been accomplished with the resources expended in the
undertaking. It represents opportunities forgone.
Elements: 1. Material: The substance from which the product is made in known
ad material. It may be in raw, semi-manufactured or a manufactured state. It can
be direct as well as indirect. (a) Direct Material: All material becomes an integral
part of the finished product and which can be conveniently assigned to specific
physical units is termed as “Direct Material”. Following are some examples of
direct material: (i) All material or components specifically purchased, produced or
requisitioned from stores. (ii) Primary packing material (iii) Purchased or partly
produced components. (b) Indirect material: All material which is used for
purpose ancillary to the business and which cannot be conveniently assigned to
specific physical units is termed as “Indirect Material”. Consumable stores, oil and
waste, printing and stationary material etc are a few examples. Indirect material
may be used in the factory, the office or the selling and distribution divisions.
2. Labour: For conversion of materials into finished goods, human effort is
needed, such human effort is called labour. Labour can be direct as well as
indirect. (a) Direct: Labour which takes an active and direct part in the production
of a particular commodity is called direct labour. Direct labour costs are, therefore,
specifically and conveniently traceable to specific products. (b) Indirect: Labour
employed for the purpose of carrying out tasks incidental to goods, or services
provided, is indirect labour. Such labour does not alter the construction,
composition or condition of the product.
3. Expenses: Any other cost besides material and labour is termed as expense.
Expenses may be direct or indirect. (a) Direct: These are expenses which can be
directly, conveniently and wholly allocated to specific cost centres or cost units.
These are also called Chargeable Expenses. (b) Indirect: These are expenses
which cannot be directly, conveniently and wholly allocated to cost centres or cost
units.
CLASSIFICATION: Fixed Cost: In management accounting, fixed costs are
defined as expenses that do not change in proportion to the activity of a business,
within the relevant period or scale of production. For example, a retailer must pay
rent and utility bills irrespective of sales.
Along with variable costs, fixed costs make up one of the two components of total
cost. In the most simple production function, total cost is equal to fixed costs plus
variable costs.
Variable Cost: Variable costs are expenses that change in proportion to the
activity of a business. In other words, variable cost is the sum of marginal costs. It
can also be considered normal costs. Along with fixed costs, variable costs make
up the two components of total cost. Direct Costs, however, are costs that can be
associated with a particular cost object. Not all variable costs are direct costs,
however; for example, variable manufacturing overhead costs are variable costs
that are not a direct costs, but indirect costs.
Semi-Variable Cost: Semi variable cost is an expense which contains both a
fixed cost component and a variable cost component. The fixed cost element shall
be a part of the cost that needs to be paid irrespective of the level of activity
achieved by the entity. On the other hand the variable component of the cost is
payable proportionate to the level of activity.
It shows similarities to telephone bills. One must pay line rental and on top of that
a price that depends on how heavy one is using the service. So it changes with
output. Another example is satellite television. A price for the box must be paid
monthly and to get additional movies, more money has to be given.
Product Cost: Cost which become part of the cost of the product rather than an
expense of the period in which they are incurred are called as ‘Product Costs’.
They are included in inventory values. In financial statements such costs are
treated as assets until the goods they are assigned to are sold. They become an
expense at that time. These costs may be fixed as well as variables, e.g., cost of
raw materials and direct wages, depreciation on plan and equipment, etc.
Period Cost: Cost which are not associated with production are called ‘Period
Cost’. They are treated as an expense of the period in which they are incurred.
They may also be fixed as well as variable. Such costs include general
administration costs, salesman salaries and commission, depreciation on office
facilities, etc. They are charged against the revenue of the relevant period.
Direct Cost: Direct Costs, however, are costs that can be associated with a
particular cost object. Not all variable costs are direct costs, however; for
example, variable manufacturing overhead costs are variable costs that are not a
direct costs, but indirect costs. Variable costs are sometimes called unit-level
costs as they vary with the number of units produced.
Indirect Cost: which are not directly chargeable to production.
Sunk Cost: The sunk cost is distinct from the economic loss. For example, when
a car is purchased, it can subsequently be resold; however, it will probably not be
resold for the original purchase price. The economic loss is the difference
(including transaction costs). The sum originally paid should not affect any rational
future decision-making about the car, regardless of the resale value: if the owner
can derive more value from selling the car than not selling it, it should be sold,
regardless of the price paid. In this sense, the sunk cost is not a precise quantity,
but an economic term for a sum paid, in the past, which should no longer be
relevant; it may be used inconsistently in quantitative terms as the original cost or
the expected economic loss. It may also be used as shorthand for an error in
analysis due to the sunk cost fallacy, non-rational decision-making or, most
simply, as irrelevant data.
Methods: the various methods of costing available are as below:
• Job Costing - This is done, as the name suggests, on job works which may
differ from case to case basis. By giving different job numbers and debiting the
costs on the jobs, cost of each job work can be ascertained.
• Batch Costing - This is similar to job costing but pertains to batches.
• Contract or Terminal Costing - This is done for large contracts. Such
businesses need not maintain costs separately as financial accounting will
indicate the costs and expenses. In such contracting firms, the cost sheets are
maintained for individual contracts. In the absence of expense budgets,
inefficiencies are often hidden in such cost sheets.
• Single or Output Costing - This is done when the end product is single like a
colliery or a power station. Cost sheets are maintained.
• Process Costing - This is useful when a product passes through various
processes, yielding different by products of commercial value. This is useful in
industries like refineries.
• Operation Costing - This is followed by mechanical engineering industries
which make products or parts. Each manufacturing operation cost is taken into
account. There is no difference between this and process costing.
• Operating Costing - This method is followed when the company does not have
a specific product as output like the service industries.
• Departmental Costing - When an end product is ultimately manufactured by
different departments this method can be useful.
• Multiple Costing - This is useful when a product is manufactured in an
assembly line like an automobile.
It is important to choose the most appropriate method of costing for your business
or industry. Most businesses do not like to engage cost accountants and leave it
to financial accountants to take care of this job. It is not recommended. There are
many free lance cost accountants available and they can be engaged on need
basis.