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Financial statements are structured financial representation of the financial position of and transactions undertaken by an enterprise. Because financial statements are used by so many different groups (investors, creditors, managers etc), there are sometimes called general-purpose financial statement. The objective of general- purpose financial statements is to provide information about the financial position, performance and cash flow of an enterprise that is useful to a wide range of users in making economic decisions. Financial statements also show the result of management's stewardship of the resources entrusted to it. To meet this objective, financial statements provide information about an enterprise's assets, liabilities, equity, income and expenses (including gains and losses) and cash flows. This information, along with other information in the notes to financial statements, assists users in predicting the enterprise's future cash flows and , in particular, the timing and certainty of the generation of cash and cash equivalents.
Component of financial statements:
- Balance Sheet (or statement of financial position)
- Income Statement (or the profit and loss account)
- Cash Flow Statement
- Statement of Changes in Equity
- Accounting Policies and explanatory notes
The balance sheet shows the assets belonging to the company; its liabilities and equity as at year- end. Assets are the economic resources that are owned or controlled by a company. For example, cash, account receivable, inventory, land and buildings are categorized as assets. As for liabilities, it is the obligations to pay cash, transfer other assets or provide services to someone else. The examples are unpaid phone bills, short term loans and account payable. Next, owner's equity is the residual amount; net assets available after all obligations have been satisfied. It increases when owners make additional investment in a business. On the other hand, it decreases when the owners take back part of their investment. The items mentioned above are related to one another and can be arranged into an accounting equation:
Assets= Liabilities + Owner's Equity
Performance of the company is reflected in this statement. The income statement shows revenues, expenses, and net income or net loss. Revenues are the amount of assets created through business operations while expenses are the amount of assets consumed through business operation. Net income or net loss is the measure of performance of a company. If the revenues are more than expenses, it is net income. In contrast, if the expenses are more than revenues, it is net loss.
Cash Flow Statement
This statement reports the amount of cash collected and paid out by a company in the operation, investing and financing activities. Operating activities are those activities that are part of the day-to- day business of a company. Investing activities are activities associated with buying and selling long- term assets. Financial activities are those activities whereby cash is obtained from or repaid to owners and creditors.
Statements of Changes in Equity
It reports amount of profit for the period and the changes in equity. The statement shows a beginning capital balance, the net income for the period, a deduction for any drawing made and the ending capital balance.
Accounting policies and explanatory notes
It is the important additional notes to define statement prepared. Any additional information that is not shown in the financial statement will effect fairly presentation.
2) Planning, Directing and Motivating and Controlling
Planning involves establishing a basic strategy, selecting a course of action, and specifying how the action will be implemented. An important part of planning is to identify alternatives and then select among the alternatives the one that best fits the organization's strategy and objectives. For instance, if the company's basic objective is to earn profit for their owners, top management must choose the alternative that can achieve this objective. Also, top management must balance the potential benefits against the cost and demand on the company resources when they are selecting the alternative. All the important alternatives considered by management in the planning process impact revenues or cost, and management accounting data are essential in estimating those impacts.
Directing and Motivating
Managers also look after day-to-day activities and try to keep the organization functioning smoothly. This requires motivating and directing people. Managers assign tasks to employee, arbitrate, answers questions, solve on-the-spot problems, and make many small decisions that affect customers and employees. Therefore, directing is that part of a manager's job that deals with the routine. Managerial accounting data such as daily sales reports are always used in this type of day-to-day decision making.
In controlling function, managers seek to ensure that the plan is being followed. The key to effective control is feedback, which signals if the operations are on the track. This feedback is provided by various details reports. One of it is performance report, which compares budgeted to actual results. Performance reports suggest where operations are not proceeding as planned and where some parts of the organization may require additional attention.
The Planning and Control Cycle
This cycle involves the smooth flow of management activities from planning through directing and motivating, controlling and then back to planning again. All of these activities involve decision making, which is the hub around which the other activities revolve.
3) Going Concern Concept
Businesses today are formed without deciding as to the particular time it will cease. In other words, accounting records are prepared with the assumption that there are no signs or indication that the entity will cease operations in the foreseeable future. Thus, the main purpose of the business is to carry out business with the sole objective of making profits. All existing resources such as land and buildings and vehicles are to be used in the normal course of operation for the intended purpose of reaping profits. Most resources of the firm are acquired to be used rather than to be sold. Thus, this concept gives priority to the use of historical cost in the preparation of financial statements. That is, it allows accountant to record assets at what they are worth to a company in normal use, rather than what they would sell for in a liquidation sale.
4) Break- Even Point
Break- even point is the level of sales at which profit is zero. Once the break- even point has been reached, net operating income will increase by the amount of the unit contribution margin for each additional unit sold. The break- even point can be computed using either the equation method or the contribution margin method. These two methods are equivalent.
The Equation Method:
Profits= (Sales- Variable expenses)- Fixed expenses
It is widely used in CVP (Cost-Volume- Profit) analysis. Rearranging the above equation:
Sales= Variable expenses+ Fixed expenses+ Profits
At the break- even point, profits are zero. Therefore, the break- even point can be computed by finding the point where sales equal the total of the variable expenses plus the fixed expenses. The break- even point in total sales dollars can be computed by multiplying the break- even level of unit sales by the selling price per unit.
The Contribution Margin Method:
The contribution margin method is a shortcut version of the equation method already described. To find how many units must be sold to break even, divide the total fixed expenses by the unit contribution margin.
Break- even point in units sold= Fixed expenses
Unit contribution margin
A variation of this method uses the CM ratio instead of the unit contribution margin. The result is the break- even point in total sales dollars rather than in total units sold.
Break- even point in total sales dollar= Fixed expenses
This approach, based on the CM ratio, is particularly useful when a company has multiple products and wishes to compute a single break- even point for the company as a whole.
5) Control Activities
Control activities are those policies and procedures, in addition to the control environment and accounting system that management has adopted to provide reasonable assurance that the company's established objectives will be met and that financial reports are accurate. Generally, there are five categories of control activities.
i) Adequate segregation of duties
Company who has appropriate segregation of duties is said to be having a good internal control system. Under this control system, no one department or individual should be responsible for handling all phases of a transaction. This segregation is not possible for small businesses because the limited number of employees prevents division of all the different functions. Nevertheless, there are three functions that should be performance by separate departments or by different people.
- Authorization - Authorizing and approving the execution of transactions. For example, approving the sale of a building or land.
- Record keeping - Recording the transactions in the accounting journals.
- Custody - Having a physical possession of or control over the assets involved in transactions, including operational responsibility. For example, having control over the production function.
By separating the responsibility for these duties, a company realizes the efficiency derived from specialization and also reduces the errors, both intentional and unintentional that might be occurring.
ii) Proper procedures for authorization
A strong system of internal control requires proper authorization for every transaction. In corporate organization, this authorization originates with the stockholders who elect a board of directors. It is then delegated from the board of directors to upper- level management and eventually throughout the organization. While the board of directors and upper- level management possess a fairly general power of authorization, a clerk usually has limited authority. Thus, the board would authorize dividend, a general change in policies, or a merger. A clerk would be restricted to authorizing credit or a specific cash transaction. Only certain people should be authorized to enter data into accounting records and prepare accounting reports.
iii) Adequate documents and record
Adequate documents and record is a key to good controls. Documents are the physical, objective evidence of accounting transactions which allows management to review any transaction for appropriate authorization. In short, adequate documentation provides evidence that the recording and summarizing functions that lead to financial reports are being performed properly. Easily interpreted and understood, designed with all possible uses in mind, pre-numbered for easy identification and tracking, and formatted to enable quickly and efficient handled are the characteristics of a well- designed document.
iv) Physical control over assets and records
Some of the most crucial policies and procedures involve the use of adequate physical safeguards to protect resources. For example, a bank would not allow significant amounts of money to be transported in an ordinary car. Similarly, a company should not leave its valuable assets unprotected. Examples of physical safeguard are fireproof vault for the storage of classified information, currency, and marketable securities. Records and documents are also important resources and must be protected. Re-creating lost or destroyed records can be costly and time-consuming, so companies make backup copies of records. Thus, providing proper safeguard reduces opportunities for employees to misappropriate assets.
v) Independent check on performance
Having independent checks on performance is a valuable control technique. Independent checks incorporate reviews of functions, as well as the internal checks created from a proper segregation of duties. There are many ways to independently check performance. Using independent reviewers such as auditors, is one of the most common. In addition, mandatory vacations, where another employee performs the vacationing person's duties, periodic rotations or transfers, or merely having someone independent of the accounting records reconcile the bank statement are all types of independent checks
6) Matching Principle
The matching principle is based on the accrual concept that requires all costs and expenses incurred to generate revenues must be recognized in the same accounting period as the related revenues. This means that if a cost is incurred to acquire or make something that will eventually be sold, then the cost should be recognizes as an expense only when the sale take place. For example, the cost of the merchandise sold should be matched to the revenue derived from the sale of that merchandise during the period. Expenses that cannot be matched with revenues are assigned to the accounting period in which they are incurred. For instance, the exact amount of electricity used to make an automobile generally cannot be determined, but since the amount for a month or year is known, that amount can be matched to the revenues earned during the same period.
As shown in Exhibit 1, this process of matching expenses with recognizes revenues determines the amount of net income reported on the income statement.Net income is the most widely used indicator of how well a company has performed during a period.
Beginning of reporting period End of reporting period
= Net income for period
7) Schedule of Cost of Goods Manufactured (COGM) and Cost per unit
Schedule of cost of goods manufactured contains the three elements of product costs which are direct materials, direct labor, and manufactured overhead. It is use to calculate the cost of raw materials, direct labor, and manufactured overhead used in production. By the way, it is also use to calculate the manufacturing costs associated with goods that were finished during the period. In fact, we can calculate the cost per unit of finished goods by dividing the total unit produced from the total manufactured cost.
Statement of Cost of Goods Manufactured
Beginning inventory xxx
(+) Purchases xxx
Materials available xxx
( -) Ending inventory xxx
Materials used xxx
Direct labor xxx
Indirect materials xxx
Indirect labor xxx
Maintenance xxx xxx
Total manufacturing costs xxx
(+) Beginning work in process xxx
( -) Ending work in process xxx
Cost of Goods Manufactured xxx
Cost per unit is equal to the total of Cost of Goods Manufactured over the number of unit produced. It may be dependent on the time period considered and thus it can affect the supply curve and are a fundamental component of supply and demand. Cost per unit will vary depends on the quantity produced. Cost per unit is distinct from the price and depends on the interaction with demand through elasticity of demand and supply. In the case of perfect competition, price may be lower than cost per unit due to marginal cost pricing.
Cost per unit = Cost of Goods Manufactured
Number of unit produced
8) Cost Classifications (Manufacturing costs and Non-manufacturing cost)
Consist of direct materials, direct labor, and manufacturing overhead.
- Direct materials
Direct materials are those materials that become an integral part of the finished product and whose costs can be conveniently traced directly to the finished product. For example: engine that installed in a car.
- Direct labor
Labor costs that can be easily and conveniently traced to individual units of product. Since direct workers typically touch the product while its production, it is sometimes called as touch labor. For example: electricians who install equipment on car.
- Manufacturing overhead
Manufacturing costs that cannot be traced directly to specific units produced. It consists of indirect materials, indirect labor, and all manufacturing costs other than direct materials and direct labor. All costs which are associated with operating the factory are classified as manufacturing overhead. For example: maintenance and repairs on manufacturing facilities.
There are two categories of non-manufacturing costs which are selling costs and administrative costs.
- Selling costs
Costs necessary to get order and deliver the finished product to the customer. It is also known as order-getting and order-filling costs. For example: sales commissions.
- Administrative costs
All executives, organizational, and clerical costs associated with the general management of an organization rather than with manufacturing and selling. It is often called selling, general, and administrative (SG& A) costs. For example: salaries of clerk.
All costs involved in acquiring or making a product. Direct materials, direct labor, and manufacturing overhead are included in product costs. Product costs are first assigned to an inventory account on the balance sheet. After the goods are sold, the costs are released from inventory as expenses (cost of goods sold) and matched against sales revenue. Product costs are also known as inventoriable costs since they are initially assigned to inventories. In fact, not all product costs are treated as expenses in the period they incurred. They are treated as expenses in the period in which the related products are sold. Meaning that a product cost (direct materials or direct labor) might incur during one period but not recorded as an expense until a period when the completed product is sold.
All the costs that are not product cost. Sales commissions and the rental costs of administrative offices are period costs. Instead of manufactured goods, period costs are expenses on the income statement in the period in which they are incurred using the usual rules of accrual accounting. All selling and administrative expenses are considered period costs. For example: advertising and executive salaries.
Direct Materials Direct Labor Manufacturing Overhead
Selling Costs Administrative Costs
Sheema de Florist Sdn. Bhd. found that their company's Income Statement was suffered from an operating loss of RM 155,000 in the past quarter. The new accounting manager's assistant had doubled checked the figures but the result was still the same.
At the end of the 2009, the company's transportation truck has involved in a road accident and 5,000 boxes of their potpourri destroyed. The 5,000 boxes were part of the 25,000 boxes of potpourri products completed in the three month of the factory's operation which awaiting for the sale in January 2010. The company intended to claim from insurance company for their losses but unfortunately the insurance company said that their claim was inflated. To determine whether the potpourri factory is profitable, then make a decision if the factory should continue operating in the future.
According to the income statement of Sheema de Florist Sdn. Bhd. ,the accountant made a major mistake in income statement. She did not record manufacturing(direct materials, direct labor and manufacturing overhead) and non manufacturing costs( selling and administrative costs) separately. It is essential to distinguish between manufacturing and non-manufacturing cost while producing the income statement.
Hence, the income statement must be corrected. First, we have to calculate the cost of goods manufactured. Then, raw materials, work in process and finished goods have to be identified and calculated to find out the cost of goods manufactured. According to the additional information given by Cik Normee, only 80% of indirect material cost and 90% of the utilities cost relate to manufacturing operations. The remaining account relates to selling and administrative activities.
Besides, cost of goods sold has to be calculated in income statement because it is the cost from factory for producing goods which is different from the operating expenses. After identifying the cost of goods sold, we will be able to calculate the gross profit as shown in the income statement below.
The Potpourri Factory
Statement of Cost of Goods Manufactured
For the quarter ended December 31, 2009
Direct Materials used:
Beginning raw materials inventory 0
+ Raw materials purchased 384,500
Raw materials available 384,500
- Ending raw materials inventory 50,000
Direct labor 80,000
Cleaning supplies, production 6,500
Indirect labor cost 50,000
Maintenance, production 47,000
Indirect materials (80% x RM 65,000) 52,000
Insurance, production 9,000
Utilities (90% x RM 40,000) 36,000
Depreciation, production equipments 35,000 235,500 Total manufacturing costs
+Beginning work in process 0
Total manufacturing costs 650,000
- Ending work in process (25,000)
Cost of goods manufactured 625,000
The Potpourri Factory
For the quarter ended December 31, 2009
Sales (20,000 boxes) 930,000
Less cost of goods sold:
Beginning finished goods inventory 0
+Cost of goods manufactured 625,000
Cost of goods available for sale 625,000
- Ending finished goods inventory (125,000)
Cost of goods sold 500,000
Gross profit 430,000
Less operating expenses:
Selling & administrative salaries 90,000
Depreciation, office equipment 18,000
Indirect materials 13,000
Travel, salesperson 60,000 385,000
Net profit 45,000
Besides that, problem occurs when Potpourri Factory tries to claim for their 5,000 boxes of product which are lost in the truck caused by an accident. However, the factory is not able to claim from insurance company. This is due to insurance company, Insurful Sdn. Bhd claims that the amount is inflated.
Cik Normee has made mistake by taking total operating expenses, RM 1,085,000, as the total cost for the period. She made another mistake by taking only 20,000 boxes as number of boxes produced in calculating cost per box. It is supposed to be 25,000 of boxes as it is total production for quarter year.
With the cost of goods sold we calculated above, we are able to calculate accurate cost for the 5,000 boxes of potpourri products which was involved in accident.
Total cost of the period = RM 625,000
No. of boxes 25,000
= RM 25
Thus, actual cost per box of the potpourri product is RM25 and not RM 54.25. Therefore, the costs for 5,000 boxes @ RM 25 per box = RM 125,000. Total amount that the Potpourri Factory should claim is only RM125, 000 and not RM271.250. It is inflated than actual amount that the factory supposed to claim. With this reasonable amount, insurance company should be liable to compensate for the factory's claim.
In conclusion, we learnt that planning, directing and motivating and controlling are playing essential role in running a business. And these three activities involve decision making all the time. In addition, we understand that financial performance and position can be judged by financial statements. Also, a company is preparing their accounting records by assuming that company will not lease in foreseeable future. Furthermore, we learnt how to compute break-even point as it is a level of sales which profit is zero. It is impossible for a company to execute this point immediately. They can only gain profit by selling more units than the break-even point.
Next, we know that internal control is important to detect fraud and avoiding employees to manipulate accounts. Cik Normee mentioned that she has double- checked the figures. However, according to internal control, segregation of duties is needed mainly is to reduce errors. As for matching principle, we know that expenses can only be recognized in the same period where revenues are recognized. Furthermore, we learn the cost term: manufacturing and non manufacturing cost. Manufacturing cost includes direct materials, direct labors, manufacturing overhead while non manufacturing cost includes those indirect cost such as indirect labor and indirect materials.
Finally, we found that the Potpourri Factory is actually earning a profit of RM45,000 for the quarter year ended December 31, 2009 in the income statement which is not same as what Cik Normee found. This is because the income statement she did was incorrect while she double-checked these figures. Income statement is crucial in business performance. Thus, it is needed to calculate accurately and reliability as it is used to measure company's performance. After recalculating the amount, we found that total of the Potpourri Factory should claim is only RM125, 000 and not RM271.250 which is inflated than the actual the factory supposed to claim. According to the corrected income statement, the Potpourri Factory was earning net profit RM 45,000 instead of the IncomeStatement prepared by Sheema de Florist Sdn Bhd. which was net loss RM155,000.Therefore, this company should continue the business of potpourri.