The financial, managerial and corporate aspect of accounting

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Accounting is a vast concept that envisages the daily life of a corporate person. It roams around from the offices of the auditors, directors of companies to the homes of share holders. This study aims upon the financial, managerial and corporate aspect of accounting. This study deals with a practical case study, and illuminates the accounting process in a practical environment. It also deals with costing. The main objective under consideration has been to high light the fact that accounting is not restricted to summarizing, recording and proceeding data. Rather it acts as a milestone towards managerial decisions with its strong costing system. Owing to its vast and rich history of more than 7000 years, the subject of accounting has various concepts, phenomenon, criterion and school of thoughts. The study is also aimed upon differentiating between financial and management accounting. It entails that accounting is vast subject and has to be classified under some more categories, so that it can be easily interpreted and studied. The accounting techniques apply a range of methods and procedures and these are reflected by the study. We have tried to emphasize upon the practical aspects of the subject and this has been reflected in the study. The study has also worked upon the methods of inventory valuation with respect to FIFO, LIFO and AVCO.

Introduction

Accounting is a practice that has been going on since centuries. The Wikipedia reports that the first accounting records were found in Egypt which date back more than 7000 years ago. The dual aspect concept, commonly known as the double entry concept, is well known among the accountancy professionals. It is the basic concept which found the roots of the accounting techniques, currently in practice. Emerging as a popular concept in the 14th century, the dual aspect concept originated from Italy where the traders expanded their activities to various circles. Today the term accountancy is written with the golden ink in the Dictionary, and stands as the most prestigious and notorious practice in world history. With the passage of time trade expanded, barter trade abolished and money took form, making transactions easier and easier. Laterally, the trade activities had been limited to exchange of goods for money/gold/other goods. However with the arrival of paper money, business activity began comprising of services too. Hence the paper money started to be used for goods as well as services. The Italians further expanded their activities and began joint ventures and partnerships among each others. Business sizes grew hugely and today we have joint stock companies, public limited companies, guarantee limited companies, etc. Although the words mentioned above might seem brilliant, the functions of these types of entities are complex in nature. The more complex are the accounting procedures involved, and the relevant tasks carried out. To ease this complexity of accounting and to manage its functions, and meet its objectives, accounting bodies all over the world now classify there profession into two types:

Financial Accounting

Management Accounting

Financial versus Management

The further advancements in the trading and business procedure lead to the further classification of accounting. This advancement is also known as the measure factor behind, what we call the "divorce between ownership and control." The increasing status and continuous expansion in business activities roused differences between actual owners of the business and those who run the organizations. The word organizations took over the word business when the business was not restricted to one owner or employer. The past centuries witnessed the business in an entire different manner. Business was used to be referred as trade whereby a person took goods from his homeland to sell them at some other place. However, the new century replaced this phenomenon by the word organizations, meaning consisting of organs. This meant that an organization had several organs associated to itself making the business terminology and procedure more complex in nature. An organization can have thousands of shareholders (owners), hundreds of employees, tens of departments and it can operate in as many countries and as many segments, as it wishes and is able to.

This phenomenon of organizations leads the accountants to distinguish between the accounting information that is for the use of external users and internal users.

A business in inter related with a lot of stake holders.1There are the shareholders, government, employees, creditors, customers and even the society/community itself.

The Financial Accounting is the procedure which provides that accounting information, which is needed for external users. A chart of internal and external users is given below. E.g. a tax inspector might need to check the amount of profit generated by the company, so that the tax percentages can be applied and government's revenue generated. This information would be provided in the income statement, which is produced by financial accounting. Similarly, a shareholder might need to know the total worth of his company and could judge so by seeing the balance sheet. This again is provided by the financial accounting. Potential investors might also need to review financial information to speculate whether it's worth investing in the company. The financial accounting can be described as the classification and recording of monetary transactions of an entity un accordance with established concepts, principles, accounting standards and legal requirements and their presentation, by means of presentation, various financial statements, during and at the end of accounting period. (Elsevier)

The five statements produced by the financial accounting are:

Balance Sheet

Income Statement

Cash flow Statements

Statement of Changes in Equity

Notes to Accounts

These statements are required to be drawn regularly, and in prescribed formats employing certain formalities and conventions.

The Management Accounting produces information relevant to decision making purposes and for those who actually are in the management of business and run it. They might not necessarily be the owners of the business. E.g. a business production manager might need to know how much goods need to be produced for the period. This information would be available in the budget of the organization, which would be calculated using management accounting. Management accounting might also include cost accounting which determines the costs incurred upon producing goods, and pricing them in the market to earn profits. A marketing executive, for instance, might require the price of the newly produced machineries to quote to a customer. This information might be provided in the cost card again a production of management accounting. Management accounting also calculates the risks for the trading activities of the business. This might include forecasting, calculating break evens (no profit/no loss), etc. Management accounting is regarded as the process of identification, measurement, accumulation, analysis, preparation, interpretation & communication of information used by managers to plan. Evaluate and control within an entity and to assure appropriate use of and accountability for its resources. (Elsevier)

Previously, cost accounting was merely considered to be a technique for the ascertainment of costs of products or services on the basis of historical data. In course of time, due to competitive nature of the market, it was realized that ascertaining of cost is not so important as controlling costs. Hence, cost accounting started to be considered more as a technique for cost control as compared to cost ascertainment. Due to the technological developments in all fields, cost reduction has also come within the ambit of cost accounting. Cost accounting is, thus, concerned with recording, classifying and summarizing costs for determination of costs of products or services, planning, controlling and reducing such costs and furnishing of information to management for decision making.

According to Charles T. Horngren, cost accounting is a quantitative method that accumulates, classifies, summarizes and interprets information for the following three major purposes:

Operational planning and control

Special decisions

Product decisions

According to the Chartered Institute of Management Accountants, London, cost accounting is the process of accounting for costs from the point at which its expenditure is incurred or committed to the establishment of the ultimate relationship with cost units. In its widest sense, it embraces the preparation of statistical data, the application of cost control methods and the ascertainment of the profitability of the activities carried out or planned.

Cost accounting, thus, provides various information to management for all sorts of decisions. It serves multiple purposes on account of which it is generally indistinguishable from management accounting or so-called internal accounting. Wilmot has summarized the nature of cost accounting as "the analyzing, recording, standardizing, forecasting, comparing, reporting and recommending" and the role of a cost accountant as "a historian, news agent and prophet." As a historian, he should be meticulously accurate and sedulously impartial. As a news agent, he should be up to date, selective and pithy. As a prophet, he should combine knowledge and experience with foresight and courage.

The management accounts have no specific types and they can have unrestricted procedures, statements, accounts and calculations. The management accounts do not need to be produced regularly, and can be produced/drawn anytime complying with the requirement of management. Some examples of the procedures of management accounting are given below:

Budgets Pay back period

Forecasts Costing

Break even Variance analysis

The major difference between the financial and management accounting is that the financial accounting might illustrate past figures and present ones, but it would never forecast for future values. Forecasting and planning for the future is the work that is carried out by the management accounting.

Cost and Business:

In a business where selling and distribution expenses are quite nominal the cost of an article may be calculated without considering the selling and distribution overheads. At the same time, in a business where the nature of a product requires heavy selling and distribution expenses, the calculation of cost without taking into account the selling and distribution expenses may prove very costly to a business. The cost may be factory cost, office cost, cost of sales and even an item of expense. For example, prime cost includes expenditure on direct materials, direct labor and direct expenses. Money spent on materials is termed as cost of materials just like money spent on labor is called cost of labor and so on. Thus, the use of term cost without understanding the circumstances can be misleading.

Different costs are found for different purposes. The work-in-progress is valued at factory cost while stock of finished goods is valued at office cost. Numerous other examples can be given to show that the term "cost" does not mean the same thing under all circumstances and for all purposes. Many items of cost of production are handled in an optional manner which may give different costs for the same product or job without going against the accepted principles of cost accounting. Depreciation is one of such items. Its amount varies in accordance with the method of depreciation being used. However, endeavor should be, as far as possible, to obtain an accurate cost of a product or service

A business incurs several types of costs while carrying on its activities. There are two types of costs:

Production Costs

Non-Production Costs

Productions costs, as the name suggests are those which are incurred while the goods are being produced. E.g. labor costs, material costs, heating and lighting of the factory, etc. Non-production costs are those which are incurred after or before the goods are being produced, but having no direct relation to the production itself. E.g. sale and distribution costs, advertising costs, etc. There are various ways to classify costs.

Classification by nature: Costs can be classified by nature, according to whether they are materials, expense or labor costs.

Classification by purpose: Costs can be classified by purpose, i.e. whether they are direct or indirect. Direct costs are those which can be identified easily and associated to the production. Indirect costs are some what hard to be identified and can not be directly associated to the production. E.g. paying wages to the labor would be a direct cost of production, but paying wages to sweepers to clean factory equipment might be termed as indirect labor.

AVCO stands for cumulative weighted average cost method. This method of inventory valuation does not go for the actual prices of inventory units; rather it focuses upon finding out an average cost of all the units bought up till a period in relation to the total number of units bought. This type of valuation, gives values some where between the values calculated by FIFO and LIFO. This type of valuation is used for those types of goods which are relatively small in size and do not have much of value attached to them. E.g. fast moving consumer goods which are not much costly and have a high turnover. AVCO is used where the stock turn over is very high and it is not possible to record the issues and receipts of the goods at a timely manner. E.g. stock of tablets in a local store.

The AVCO method provides a unit cost for all the units of inventory at a common basis, by dividing the total cost of inventory by the total number of units in inventory at present.

Marginal costing may be defined as the technique of presenting cost data wherein variable costs and fixed costs are shown separately for managerial decision-making. It should be clearly understood that marginal costing is not a method of costing like process costing or job costing. Rather it is simply a method or technique of the analysis of cost information for the guidance of management which tries to find out an effect on profit due to changes in the volume of output.

There are different phrases being used for this technique of costing. In UK, marginal costing is a popular phrase whereas in US, it is known as direct costing and is used in place of marginal costing. Variable costing is another name of marginal costing.

Marginal costing technique has given birth to a very useful concept of contribution where contribution is given by: Sales revenue less variable cost (marginal cost) Contribution may be defined as the profit before the recovery of fixed costs. Thus, contribution goes toward the recovery of fixed cost and profit, and is equal to fixed cost plus profit (C = F + P).In case a firm neither makes profit nor suffers loss, contribution will be just equal to fixed cost (C = F). This is known as break even point. The concept of contribution is very useful in marginal costing. It has a fixed relation with sales. The proportion of contribution to sales is known as P/V ratio which remains the same under given conditions of production and sales.

Apart from Marginal costing, there is one other technique used to cost a production. This is known as absorption costing. This technique involves finding an overhead absorption rate and absorbing the fixed costs in all of the units produced. With absorption costing, fixed production costs are absorbed into product unit costs using a predetermined overhead absorption rate, based on the normal level of production for the period. If the actual production is different from the normal level, or actual expenditure on fixed production costs is different from that budgeted, there may be an under or over absorption of fixed production costs for the period. This amount is written off against the absorption costing profit for the period. The principles of absorption costing are as follows.

(a) Fixed production costs are an integral part of the production cost of an item and so should be absorbed into product costs.

(b) Inventories are valued at their full production cost including absorbed fixed production costs.

If there are changes in inventories during a period, marginal costing and absorption costing systems will report different profit figures. If inventory levels increase, absorption costing will report a higher profit than marginal costing. If inventory levels decrease, absorption costing will report the lower profit. If the opening and closing inventory volumes and values are the same, marginal costing and absorption

costing will report the same profit figure. In the long run, the total reported profit will be the same whether marginal or absorption costing is used. The difference in reported profit is equal to the change in inventory volume multiplied by the fixed production overhead rate per unit.

(a) Fixed production costs are incurred in order to make output; it is therefore 'fair' to charge all output with a share of these costs.

(b) Closing inventory values, include a share of fixed production overhead, and therefore follow the requirements of the international accounting standard on inventory valuation (IAS 2).

(c) Absorption costing is consistent with the accruals concept as a proportion of the costs of production are carried forward to be matched against future sales.

(d) A problem with calculating the contribution of various products made by an enterprise is that it may not be clear whether the contribution earned by each product is enough to cover fixed costs, whereas by charging fixed overhead to a product it is possible to ascertain whether it is profitable or not. This is particularly important where fixed production overheads are a large proportion of total production costs. Not absorbing production would mean that a large portion of expenditure is not accounted for in unit costs.

(e) In a job or batch costing environment (see section 5 below), absorption costing is particularly useful in the pricing decision to ensure that the profit markup is sufficient to cover fixed costs?

Marginal Costing is

(a) Simple to operate.

(b) There are no apportionments, which are frequently done on an arbitrary basis, of fixed costs. Many costs, such as the marketing director's salary, are indivisible by nature.

(c) Fixed costs will be the same regardless of the volume of output, because they are period costs. It makes sense, therefore, to charge them in full as a cost to the period.

(d) The cost to produce an extra unit is the variable production cost. It is realistic to value closing inventory items at this directly attributable cost.

(e) Under or over absorption of overheads is avoided.

(f) Marginal costing provides the best information for decision making.

(g) Fixed costs (such as depreciation, rent and salaries) relate to a period of time and should be charged against the revenues of the period in which they are incurred.

(h) Absorption costing may encourage over-production since reported profits can be increased by increasing inventory levels.

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