ShortNotes Revised

ICSI Executive Programme Company Accounts, Costing & Management Accounting Accounting Standards Standard accounting practices require
publicly-traded companies to follow certain accounting rules when presenting financial statements so that the readers of the statements can easily compare different companies. Private companies are also often required by banks and shareholders, for example, to present information according to their specified rules. Usually, countries practicing civil law system write standards into law and countries with English common law systems have private organizations to set the rules. International Financial Reporting Standards (IFRS) are principles-based Standards, Interpretations and the Framework (1989) adopted by the International Accounting Standards Board (IASB). Many of the standards forming part of IFRS are known by the older name of International Accounting Standards (IAS). IAS were issued between 1973 and 2001 by the Board of the International Accounting Standards Committee (IASC). On 1 April 2001, the new IASB took over from the IASC the responsibility for setting International Accounting Standards. During its first meeting the new Board adopted existing IAS and SICs. The IASB has continued to develop standards calling the new standards IFRS. The Institute of Chartered Accountants of India (ICAI) has announced that IFRS will be mandatory in India for financial statements for the periods beginning on or after 1 April 2011. This will be done by revising existing accounting standards to make them compatible with IFRS. Reserve Bank of India has stated that financial statements of banks need to be IFRS-compliant for periods beginning on or after 1 April 2011. The ICAI has also stated that IFRS will be applied to companies above Rs.1000 crore from April 2011. Phase wise applicability details for different companies in India: Phase 1: Opening balance sheet as at 1 April 2011* i. ii. a. b. Companies which are part of NSE Index Nifty 50 Companies which are part of BSE Sensex BSE 30 Companies whose shares or other securities are listed on a stock exchange outside India Companies, whether listed or not, having net worth of more than INR1,000 crore
Phase 2:
ExecutiveShortNotesCompanyAccounts,CostingandManagement ICSIeLearningCoachingProgram
GOLS 2011
Opening balance sheet as at 1 April 2012* Companies not covered in phase 1 and having net worth exceeding INR 500 crore Phase 3: Opening balance sheet as at 1 April 2014* Listed companies not covered in the earlier phases If the financial year of a company commences at a date other than 1 April, then it shall prepare its opening balance sheet at the commencement of immediately following financial year. On January 22, 2010 the Ministry of Corporate Affairs issued the road map for transition to IFRS. It is clear that India has deferred transition to IFRS by a year. In the first phase, companies included in Nifty 50 or BSE Sensex, and companies whose securities are listed on stock exchanges outside India and all other companies having net worth of Rs 1,000 crore will prepare and present financial statements using Indian Accounting Standards converged with IFRS. According to the press note issued by the government, those companies will convert their first balance sheet as at April 1, 2011, applying accounting standards convergent with IFRS if the accounting year ends on March 31. This implies that the transition date will be April 1, 2011. According to the earlier plan, the transition date was fixed at April 1, 2010. The press note does not clarify whether the full set of financial statements for the year 2011-12 will be prepared by applying accounting standards convergent with IFRS. The deferment of the transition may make companies happy, but it will undermine Indias position. Presumably, lack of preparedness of Indian companies has led to the decision to defer the adoption of IFRS for a year. This is unfortunate that India, which boasts for its IT and accounting skills, could not prepare itself for the transition to IFRS over last four years. But that might be the ground reality. Transition in phases Companies, whether listed or not, having net worth of more than Rs 500 crore will convert their opening balance sheet as at April 1, 2013. Listed companies having net worth of Rs 500 crore or less will convert their opening balance sheet as at April 1, 2014. Un-listed companies having net worth of Rs 500 crore or less will continue to apply existing accounting standards, which might be modified from time to time. Transition to IFRS in phases is a smart move. The transition cost for smaller companies will be much lower because large companies will bear the initial cost of learning and smaller companies will not be required to reinvent the wheel. However, this will happen only if a significant number of large companies engage Indian accounting firms to provide them support in their transition to IFRS. If, most large companies, which will comply with Indian accounting standards convergent with IFRS in the first phase, choose one of the international firms, Indian accounting firms and smaller companies will not benefit from the learning in the first phase of the transition to IFRS. It is likely that international firms will protect their learning to retain their competitive advantage.
GOLS 2011
Therefore, it is for the benefit of the country that each company makes judicious choice of the accounting firm as its partner without limiting its choice to international accounting firms. Public sector companies should take the lead and the Institute of Chartered Accountants of India (ICAI) should develop a clear strategy to diffuse the learning. Size of companies The government has decided to measure the size of companies in terms of net worth. This is not the ideal unit to measure the size of a company. Net worth in the balance sheet is determined by accounting principles and methods. Therefore, it does not include the value of intangible assets. Moreover, as most assets and liabilities are measured at historical cost, the net worth does not reflect the current value of those assets and liabilities. Market capitalisation is a better measure of the size of a company. But it is difficult to estimate market capitalisation or fundamental value of unlisted companies. This might be the reason that the government has decided to use net worth to measure size of companies. Some companies, which are large in terms of fundamental value or which intend to attract foreign capital, might prefer to use Indian accounting standards convergent with IFRS earlier than required under the road map presented by the government. The government should provide that choice. Conclusion The government will come up with a separate road map for banking and insurance companies by February 28, 2010. Let us hope that transition in case of those companies will not be deferred further. Indian Accounting Standards, abbreviated as Ind AS are a set of accounting standards notified by the Ministry of Corporate Affairs which are converged with International Financial Reporting Standards(IFRS). These accounting standards are formulated by Accounting Standards Board of Institute of Chartered Accountants of India. Now India will have two sets of accounting standards viz. existing accounting standards under Companies (Accounting Standard) Rules, 2006 and IFRS converged Indian Accounting Standards(Ind AS). The Ind AS are named and numbered in the same way as the corresponding IFRS. NACAS recommend these standards to the Ministry of Corporate Affairs. The Ministry of Corporate Affairs has to spell out the accounting standards applicable for companies in India. As on date the Ministry of Corporate Affairs notified 35 Indian Accounting Standards (Ind AS). But it has not notified the date of implementation of the same. Share Capital Share capital or issued capital or capital stock refers to the portion of a company's equity that has been obtained (or will be obtained) by trading stock to a shareholder for cash or an equivalent item of capital value. For example, a company can set aside share capital, to exchange for computer servers instead of directly purchasing the servers from existing equity. Share capital usually comprises the nominal values of all shares issued, less those repurchased by the company. It includes both common stock (ordinary shares) and preferred stock (preference shares). If the market value of
GOLS 2011
shares is greater than the their nominal value (value at par), the shares are said to be at a premium (called share premium, additional paid-in capital or paid-in capital in excess of par). Authorised Share Capital is also referred to, at times, as registered capital. This is the total of the share capital which a limited company is allowed (authorized) to issue to its shareholders. It presents the upper boundary for the actually issued share capital (hence also 'nominal capital'). Issued Share Capital is the total of the share capital issued to shareholders. This may be less than the authorized capital. Subscribed Capital is the portion of the issued capital, which has been subscribed by all the investors including the public. This may be less than the issued share capital as there may be capital for which no applications have been received yet ('unsubscribed capital'). Called up Share Capital is the total amount of issued capital for which the shareholders are required to pay. This may be less than the subscribed capital as the company may ask shareholders to pay by installments. Paid up Share Capital is the amount of share capital paid by the shareholders. This may be less than the called up capital as payments may be in arrears ('calls-in-arrears'). Paid in capital (Paid-in capital or Contributed capital) refers to the capital contributed to a corporation by investors through purchase of stock from the corporation (primary market - not through purchase of stock in the open market from other stockholders - secondary market). It includes share capital (i.e. capital stock) as well as additional paid-in capital. However, the term has different definitions in different contexts. For example, it could refer to the money that a company gets from potential investors in addition to the stated (nominal or par) value of the stock, which coincides with the definition of Additional paid-in capital (Paid-in capital in excess of par). The user should be aware of the use of the term and abbreviation, otherwise it may be misleading. Debentures In law, a debenture is a document that either creates a debt or acknowledges it. In corporate finance, the term is used for a medium- to long-term debt instrument used by large companies to borrow money. In some countries the term is used interchangeably with bond, loan stock or note. Debentures are generally freely transferable by the debenture holder. Debenture holders have no rights to vote in the company's general meetings of shareholders, but they may have separate meetings or votes e.g. on changes to the rights attached to the debentures. The interest paid to them is a charge against profit in the company's financial statements. There are two types of debentures - Convertible debentures, which are convertible bonds or bonds that can be converted into equity shares of the issuing company after a predetermined period of time. "Convertibility" is a feature that corporations may add to the bonds they issue to make them more attractive to buyers. In other words, it is a special feature that a corporate bond may carry. As a result of the advantage a buyer gets shares from the ability to convert; convertible bonds typically have lower interest rates than non-convertible
GOLS 2011
corporate bonds. Non-convertible debentures, which are simply regular debentures, cannot be converted into equity shares of the liable company. They are debentures without the convertibility feature attached to them. As a result, they usually carry higher interest rates than their convertible counterparts. A floating charge is a security interest over a fund of changing assets of a company or a limited liability partnership (LLP), which 'floats' or 'hovers' until conversion into a fixed charge, at which point the charge attaches to specific assets. The conversion (called crystallisation) can be triggered by a number of events; it has become an implied term in debentures that a cessation of the company's right to deal with the assets in the ordinary course of business will lead to automatic crystallisation. Additionally, according to express terms of a typical loan agreement, default by the charger is a trigger for crystallisation. Such defaults typically include non-payment, invalidity of any of the lending or security documents or the launch of insolvency proceedings. Floating charges can only be granted by companies. If an individual person or a partnership was to purport to grant a floating charge, it would be void as a general assignment in bankruptcy. Strictly speaking, it is not possible to enforce a floating charge at all - the charge must first crystallise into a fixed charge. In the absence of any special provisions in the relevant document, a floating charge crystallises either upon the appointment of a receiver or upon the commencement of liquidation. It has also been suggested, relying upon obiter dictum comments that a charge should also crystallise upon the company ceasing to trade as a going concern. However, this view is not yet supported by judicial authority. A security interest is a property interest created by agreement or by operation of law over assets to secure the performance of an obligation, usually the payment of a debt. It gives the beneficiary of the security interest certain preferential rights in the disposition of secured assets. Such rights vary according to the type of security interest, but in most cases, a holder of the security interest is entitled to seize, and usually sell, the property to discharge the debt that the security interest secures. In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals. Thus a bond is like a loan: the issuer is the borrower (debtor), the holder is the lender (creditor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure. Certificates of deposit (CDs) or commercial paper are considered to be money market instruments and not bonds. Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in the company (i.e., they are owners), whereas
GOLS 2011
bondholders have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely. An exception is a consol bond, which is a perpetuity (i.e., bond with no maturity). Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process of issuing bonds is through underwriting. In underwriting, one or more securities firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer and re-sell them to investors. The security firm takes the risk of being unable to sell on the issue to end investors. Primary issuance is arranged by book-runners who arrange the bond issue, have the direct contact with investors and act as advisors to the bond issuer in terms of timing and price of the bond issue. The book-runners' willingness to underwrite must be discussed prior to opening books on a bond issue as there may be limited appetite to do so. In the case of government bonds, these are usually issued by auctions, called a public sale, where both members of the public and banks may bid for bond. Since the coupon is fixed, but the price is not, the percent return is a function both of the price paid as well as the coupon. However, because the cost of issuance for a publicly auctioned bond can be cost prohibitive for a smaller loan, it is also common for smaller bonds to avoid the underwriting and auction process through the use of a private placement bond. In the case of a private placement bond, the bond is held by the lender and does not enter the large bond market. The most important features of a bond are: the amount on which the issuer pays interest, and which, most commonly, has to be repaid at the end of the term. Some structured bonds can have a redemption amount which is different from the face amount and can be linked to performance of particular assets such as a stock or commodity index, foreign exchange rate or a fund. This can result in an investor receiving less or more than his original investment at maturity. the price at which investors buy the bonds when they are first issued, which will typically be approximately equal to the nominal amount. The net proceeds that the issuer receives are thus the issue price, less issuance fees. the date on which the issuer has to repay the nominal amount. As long as all payments have been made, the issuer has no more obligation to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or tenor or maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Some bonds have a term of up to thirty years. Some bonds in US have been issued with maturities of up to one hundred years, and some even do not mature at all.
GOLS 2011
the interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the bond. It can also vary with a money market index, such as LIBOR, or it can be even more exotic. The name coupon originates from the fact that in the past, physical bonds were issued which had coupons attached to them. On coupon dates the bond holder would give the coupon to a bank in exchange for the interest payment.
The "quality" of the issue refers to the probability that the bondholders will receive the amounts promised at the due dates. This will depend on a wide range of factors. An indenture is a formal debt agreement that establishes the terms of a bond issue, while covenants are the clauses of such an agreement. Covenants specify the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document generally requiring approval by a majority (or super-majority) vote of the bondholders. High yield bonds are bonds that are rated below investment grade by the credit rating agencies. As these bonds are more risky than investment grade bonds, investors expect to earn a higher yield. These bonds are also called junk bonds. Most bonds are semi-annual, which means that they pay a coupon every six months. Occasionally a bond may contain an embedded option; that is, it grants option-like features to the holder or the issuer: Some bonds give the issuer the right to repay the bond before the maturity date on the call dates; These bonds are referred to as callable bonds. Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a premium, the so called call premium. This is mainly the case for high-yield bonds. These have very strict covenants, restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost. Some bonds give the holder the right to force the issuer to repay the bond before the maturity date on the put dates; (Note: "Putable" denotes an embedded put option; "Puttable" denotes that it may be put.) Fixed rate bonds have a coupon that remains constant throughout the life of the bond. Floating rate notes (FRNs) have a variable coupon that is linked to a reference rate of interest, such as LIBOR or Euribor. For example the coupon may be defined as three month USD LIBOR + 0.20%. The coupon rate is recalculated periodically, typically every one or three months. Zero-coupon bonds pay no regular interest. They are issued at a substantial discount to par value, so that the interest is
GOLS 2011
effectively rolled up to maturity (and usually taxed as such). The bondholder receives the full principal amount on the redemption date. Inflation linked bonds, in which the principal amount and the interest payments are indexed to inflation. The interest rate is normally lower than for fixed rate bonds with a comparable maturity. However, as the principal amount grows, the payments increase with inflation. Other indexed bonds, for example equity-linked notes and bonds indexed on a business indicator (income, added value) or on a country's GDP. Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities, collateralized mortgage obligations and collateralized debt obligations. Perpetual bonds are also often called perpetuities or 'Perps'. They have no maturity date. Bearer bond is an official certificate issued without a named holder. In other words, the person who has the paper certificate can claim the value of the bond. Often they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risky because they can be lost or stolen. Registered bond is a bond whose ownership (and any subsequent purchaser) is recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity, are sent to the registered owner. Treasury bond, also called government bond, is issued by the Federal government and is not exposed to default risk. It is characterized as the safest bond, with the lowest interest rate. A treasury bond is backed by the full faith and credit of the federal government. For that reason, this type of bond is often referred to as risk-free. Some companies, banks, governments, and other sovereign entities may decide to issue bonds in foreign currencies as it may appear to be more stable and predictable than their domestic currency. Issuing bonds denominated in foreign currencies also gives issuers the ability to access investment capital available in foreign markets. The proceeds from the issuance of these bonds can be used by companies to break into foreign markets, or can be converted into the issuing company's local currency to be used on existing operations through the use of foreign exchange swap hedges. Foreign issuer bonds can also be used to hedge foreign exchange rate risk. Some foreign issuer bonds are called by their nicknames, such as the "samurai bond." These can be issued by foreign issuers looking to diversify their investor base away from domestic markets. These bond issues are generally governed by the law of the market of issuance, e.g., a samurai bond, issued by an investor based in Europe, will be governed by Japanese law. Not all of the following bonds are restricted for purchase by investors in the market of issuance. The interest rate that the issuer of a bond must pay is influenced by a variety of factors, such as current market interest rates, the length of the term and the creditworthiness of the issuer. These factors are likely to change over time, so the market price of a bond will vary after it is issued. This
GOLS 2011
price is expressed as a percentage of nominal value. Bonds are not necessarily issued at par (100% of face value, corresponding to a price of 100), but bond prices converge to par when they approach maturity (if the market expects the maturity payment to be made in full and on time) as this is the price the issuer will pay to redeem the bond. This is referred to as "Pull to Par". At other times, prices can be above par (bond is priced at greater than 100), which is called trading at a premium, or below par (bond is priced at less than 100), which is called trading at a discount. The market price of a bond is the present value of all expected future interest and principal payments of the bond discounted at the bond's redemption yield, or rate of return. That relationship defines the redemption yield on the bond, which represents the current market interest rate for bonds with similar characteristics. The yield and price of a bond are inversely related so that when market interest rates rise, bond prices fall and vice versa. Thus the redemption yield could be considered to be made up of two parts: the current yield and the expected capital gain or loss: roughly the current yield plus the capital gain (negative for loss) per year until redemption. The market price of a bond may include the accrued interest since the last coupon date. The interest rate adjusted for (divided by) the current price of the bond is called the current yield (this is the nominal yield multiplied by the par value and divided by the price). There are other yield measures that exist such as the yield to first call, yield to worst, yield to first par call, yield to put, cash flow yield and yield to maturity. Underwriting Underwriting refers to the process that a large financial service provider (bank, insurer, investment house) uses to assess the eligibility of a customer to receive their products (equity capital, insurance, mortgage, or credit). The name derives from the Lloyd's of London insurance market. Financial bankers, who would accept some of the risk on a given venture (historically a sea voyage with associated risks of shipwreck) in exchange for a premium, would literally write their names under the risk information that was written on a Lloyd's slip created for this purpose. Once the underwriting agreement is struck, the underwriter bears the risk of being able to sell the underlying securities, and the cost of holding them on its books until such time in the future that they may be favorably sold. If the instrument is desirable, the underwriter and the securities issuer may choose to enter into an exclusivity agreement. In exchange for a higher price paid upfront to the issuer, or other favorable terms, the issuer may agree to make the underwriter the exclusive agent for the initial sale of the securities instrument. That is, even though third-party buyers might approach the issuer directly to buy, the issuer agrees to sell exclusively through the underwriter. In summary, the securities issuer gets cash up front, access to the contacts and sales channels of the underwriter, and is insulated from the market risk of being unable to sell the securities at a good price. The underwriter gets a nice profit from the markup, plus possibly an exclusive sales agreement. Also, if the securities are priced
GOLS 2011
significantly below market price (as is often the custom), the underwriter also carries favor with powerful end customers by granting them an immediate profit, perhaps in a quid pro quo. This practice, which is typically justified as the reward for the underwriter for taking on the market risk, is occasionally criticized as unethical. Securities underwriting refers to the process by which investment banks raise investment capital from investors on behalf of corporations and governments that are issuing securities (both equity and debt capital). This is a way of selling a newly issued security, such as stocks or bonds, to investors. A syndicate of banks (the lead-managers) underwrite the transaction, which means they have taken on the risk of distributing the securities. Should they not be able to find enough investors, they will have to hold some securities themselves. Underwriters make their income from the price difference (the "underwriting spread") between the price they pay the issuer and what they collect from investors or from broker-dealers who buy portions of the offering. Underwriting can also refer to the purchase of corporate bonds, commercial paper, government securities, municipal general-obligation bonds by a commercial bank or dealer bank for its own account or for resale to investors. Bank underwriting of corporate securities is carried out through separate holding-company affiliates. In investment banking, an underwriting contract is a contract between an underwriter and an issuer of securities. The following types of underwriting contracts are most common: In the firm commitment contract the underwriter guarantees the sale of the issued stock at the agreed-upon price. For the issuer, it is the safest but the most expensive type of the contracts, since the underwriter takes the risk of sale. In the best efforts contract the underwriter agrees to sell as many shares as possible at the agreed-upon price. Under the all-or-none contract the underwriter agrees either to sell the entire offering or to cancel the deal. Stand-by underwriting, also known as strict underwriting or old-fashioned underwriting is a form of stock insurance: the issuer contracts the underwriter to purchase the shares the issuer failed to sell under stockholders' subscription and applications. Valuation Valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., bonds issued by a company). Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial
GOLS 2011
reporting, taxable events to determine the proper tax liability, and in litigation. Valuation of financial assets is done using one or more of these types of models: Absolute value models that determine the present value of an asset's expected future cash flows. These kinds of models take two general forms multi-period models such as discounted cash flow models or single-period models such as the Gordon model.
These models rely on mathematics rather than price observation. Relative value models determine value based on the observation of market prices of similar assets. Option pricing models are used for certain types of financial assets (e.g., warrants, put options, call options, employee stock options, investments with embedded options such as a callable bond) and are a complex present value model. Common terms for the value of an asset or liability are fair market value, fair value, and intrinsic value. The meanings of these terms differ. For instance, when an analyst believes a stock's intrinsic value is greater (less) than its market price, an analyst makes a "buy" ("sell") recommendation. Moreover, an asset's intrinsic value may be subject to personal opinion and vary among analysts. Businesses or fractional interests in businesses may be valued for various purposes such as mergers and acquisitions, sale of securities, and taxable events. An accurate valuation of privately owned companies largely depends on the reliability of the firm's historic financial information. Public company financial statements are audited by Chartered Accountants and overseen by a government regulator. Alternatively, private firms do not have government oversightunless operating in a regulated industryand are usually not required to have their financial statements audited. Moreover, managers of private firms often prepare their financial statements to minimize profits and, therefore, taxes. Alternatively, managers of public firms tend to want higher profits to increase their stock price. Therefore, a firm's historic financial information may not be accurate and can lead to overvaluation and undervaluation. In an acquisition, a buyer often performs due diligence to verify the seller's information. Financial statements prepared in accordance with generally accepted accounting principles (GAAP) show many assets based on their historic costs rather than at their current market values. For instance, a firm's balance sheet will usually show the value of land it owns at what the firm paid for it rather than at its current market value. But under GAAP requirements, a firm must show the fair values (which usually approximates market value) of some types of assets such as financial
GOLS 2011
instruments that are held for sale rather than at their original cost. When a firm is required to show some of its assets at fair value, some call this process "mark-to-market." But reporting asset values on financial statements at fair values gives managers ample opportunity to slant asset values upward to artificially increase profits and their stock prices. Managers may be motivated to alter earnings upward so they can earn bonuses. Despite the risk of manager bias, equity investors and creditors prefer to know the market values of a firm's assetsrather than their historical costsbecause current values give them better information to make decisions. Discounted cash flows method estimates the value of an asset based on its expected future cash flows, which are discounted to the present (i.e., the present value). This concept of discounting future money is commonly known as the time value of money. For instance, an asset that matures and pays 1 in one year is worth less than 1 today. The size of the discount is based on an opportunity cost of capital and it is expressed as a percentage. Some people call this percentage a discount rate. In finance theory, the amount of the opportunity cost is based on a relation between the risk and return of some sort of investment. Classic economic theory maintains that people are rational and averse to risk. They, therefore, need an incentive to accept risk. The incentive in finance comes in the form of higher expected returns after buying a risky asset. In other words, the more risky the investment, the more return investors want from that investment. For a valuation using the discounted cash flow method, one first estimates the future cash flows from the investment and then estimates a reasonable discount rate after considering the riskiness of those cash flows and interest rates in the capital markets. Next, one makes a calculation to compute the present value of the future cash flows. Comparable company analysis method determines the value of a firm by observing the prices of similar companies (guideline companies) that sold in the market. Those sales could be shares of stock or sales of entire firms. The observed prices serve as valuation benchmarks. From the prices, one calculates price multiples such as the price-to-earnings or price-to-book value ratios. Next, one or more price multiples are used to value the firm. For example, the average price-to-earnings multiple of the guideline companies is applied to the subject firm's earnings to estimate its value. Many price multiples can be calculated. Most are based on a financial statement element such as a firm's earnings (price-to-earnings) or book value (price-to-book value) but multiples can be based on other factors such as price-per-subscriber. The third common method of estimating the value of a company looks to the assets and liabilities of the business. At a minimum, a solvent company could shut down operations, sell off the assets, and pay the creditors. Any cash that would remain establishes a floor value for the company. This method is known as the net asset value or cost method. Normally, the discounted cash flows of a well-
GOLS 2011
performing exceed this floor value. However, some companies are "worth more dead than alive", such as weakly performing companies that own many tangible assets. This method can also be used to value heterogeneous portfolios of investments, as well as non-profit companies for which discounted cash flow analysis is not relevant. The valuation premise normally used is that of an orderly liquidation of the assets, although some valuation scenarios (e.g. purchase price allocation) imply an "in-use" valuation such as depreciated replacement cost new. In finance, valuation analysis is required for many reasons including tax assessment, wills and estates, divorce settlements, business analysis, and basic bookkeeping and accounting. Since the value of things fluctuates over time, valuations are as of a specific date e.g., the end of the accounting quarter or year. They may alternatively be mark-to-market estimates of the current value of assets or liabilities as of this minute or this day for the purposes of managing portfolios and associated financial risk (for example, within large financial firms including investment banks and stockbrokers). Some balance sheet items are much easier to value than others. Publicly traded stocks and bonds have prices that are quoted frequently and readily available. Other assets are harder to value. For instance, private firms that have no frequently quoted price. Additionally, financial instruments that have prices that are partly dependent on theoretical models of one kind or another are difficult to value. Intangible business assets, like goodwill and intellectual property, are open to a wide range of value interpretations. It is possible and conventional for financial professionals to make their own estimates of the valuations of assets or liabilities that they are interested in. Their calculations are of various kinds including analyses of companies that focus on price-to-book, price-to-earnings, price-to-cashflow and present value calculations, and analyses of bonds that focus on credit ratings, assessments of default risk, risk premia and levels of real interest rates. All of these approaches may be thought of as creating estimates of value that compete for credibility with the prevailing share or bond prices, where applicable, and may or may not result in buying or selling by market participants. Where the valuation is for the purpose of a merger or acquisition the respective businesses make available further detailed financial information, usually on the completion of a Non-disclosure agreement. There are different circumstances and purposes to value an asset (e.g. distressed firm, tax purposes, mergers & acquisitions, financial reporting). Such differences can lead to different valuation methods or different interpretations of the method results. All valuation models and methods have limitations (e.g., degree of complexity, relevance of observations, mathematical form). Model inputs can vary significantly because of necessary judgment and differing assumptions. Users of valuations benefit when key information, assumptions, and limitations are disclosed to them. Then they can weigh the degree of reliability of the result and make their decision. Valuation models can be used to value intangible assets such as patents, copyrights, software, trade secrets, and customer relationships.
GOLS 2011
Since few sales of benchmark intangible assets can ever be observed, one often values these sorts of assets using either a present value model or estimating the costs to recreate it. Regardless of the method, the process is often time consuming and costly. Valuations of intangible assets are often necessary for financial reporting and intellectual property transactions. Stock markets give indirectly an estimate of a corporation's intangible asset value. It can be reckoned as the difference between its market capitalisation and its book value (by including only hard assets in it). The capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk. The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta () in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. The model assumes that either asset returns are (jointly) normally distributed random variables or that investors employ a quadratic form of utility. It is however frequently observed that returns in equity and other markets are not normally distributed. As a result, large swings occur in the market more frequently than the normal distribution assumption would expect. The model assumes that the variance of returns is an adequate measurement of risk. This might be justified under the assumption of normally distributed returns, but for general return distributions other risk measures (like coherent risk measures) will likely reflect the investors' preferences more adequately. Indeed risk in financial investments is not variance in itself, rather it is the probability of losing: it is asymmetric in nature. The model assumes that all investors have access to the same information and agree about the risk and expected return of all assets. In finance, arbitrage pricing theory (APT) is a general theory of asset pricing, that has become influential in the pricing of stocks. APT holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient. The modelderived rate of return will then be used to price the asset correctly - the asset price should equal the expected end of period price discounted at the rate implied by the model. If the price diverges, arbitrage should bring it back into line. Cost Accounting In management accounting, cost accounting establishes budget and actual cost of operations, processes, departments or product and the analysis of variances, profitability or social use of funds. Managers use cost accounting to support decision-making to cut a company's costs and improve profitability. As a form of management accounting, cost accounting need not follow standards such as
GOLS 2011
GAAP, because its primary use is for internal managers, rather than outside users, and what to compute is instead decided pragmatically. Costs are measured in units of nominal currency by convention. Cost accounting can be viewed as translating the supply chain (the series of events in the production process that, in concert, result in a product) into financial values. There are various managerial accounting approaches: standardized or standard cost accounting lean accounting activity-based costing resource consumption accounting throughput accounting marginal costing/cost-volume-profit analysis
Classical cost elements are: raw materials labor indirect expenses/overhead
Cost accounting has long been used to help managers understand the costs of running a business. Modern cost accounting originated during the industrial revolution, when the complexities of running a large scale business led to the development of systems for recording and tracking costs to help business owners and managers make decisions. In the early industrial age, most of the costs incurred by a business were what modern accountants call "variable costs" because they varied directly with the amount of production. Money was spent on labor, raw materials, power to run a factory, etc. in direct proportion to production. Managers could simply total the variable costs for a product and use this as a rough guide for decision-making processes. Some costs tend to remain the same even during busy periods, unlike variable costs, which rise and fall with volume of work. Over time, the importance of these "fixed costs" has become more important to managers. Examples of fixed costs include the depreciation of plant and equipment, and the cost of departments such as maintenance, tooling, production control, purchasing, quality control, storage and handling, plant supervision and engineering. In the early twentieth century, these costs were of little importance to most businesses. However, in the twenty-first century, these costs are often more important than the variable cost of a product, and allocating them to a broad range of products can
GOLS 2011
lead to bad decision making. Managers must understand fixed costs in order to make decisions about products and pricing. Elements of cost 1. Material (Material is a very important part of business) A. 2. Labor A. 3. Direct labor Direct material
Overhead A. B. Indirect material Indirect labor
(In some companies, machine cost is segregated from overhead and reported as a separate element) They are grouped further based on their functions as, 1. 2. 3. 4. Production or works overheads Administration overheads Selling overheads Distribution overheads
Classification of costs Classification of cost means, the grouping of costs according to their common characteristics. The important ways of classification of costs are: By nature or element: Materials Labor Expenses
By functions Production Selling
GOLS 2011
Distribution Administration R&D Development
By traceability Direct Indirect
By variability Fixed Variable Semi variable
By controllability Controllable Uncontrollable
By normality Normal Abnormal
ABC analysis The ABC analysis is a business term used to define an inventory categorization technique often used in materials management. It is also known as Selective Inventory Control. The ABC analysis provides a mechanism for identifying items that will have a significant impact on overall inventory cost, while also providing a mechanism for identifying different categories of stock that will require different management and controls. The ABC analysis suggests that inventories of an organization are not of equal value. Thus, the inventory is grouped into three categories (A, B, and C) in order of their estimated importance. 'A' items are very important for an organization. Because of the high value of these A items, frequently value analysis are required. In addition to that, an organization needs to choose an
GOLS 2011
appropriate order pattern (e.g. Just- in- time) to avoid excess capacity. 'B' items are important, but of course less important, than A items and more important than C items. Therefore B items are intergroup items. 'C' items are marginally important. ABC analysis categories A items 20% of the items accounts for 70% of the annual consumption value of the items. B items - 30% of the items accounts for 25% of the annual consumption value of the items. C items - 50% of the items accounts for 5% of the annual consumption value of the items. ABC Analysis is similar to the Pareto principle in that the 'A' items will typically account for a large proportion of the overall value but a small percentage of the overall volume of inventory. FIFO vs. LIFO accounting When a merchant buys goods from inventory, the value of the inventory account is reduced by the cost of goods sold. This is simple where the cost of goods has not varied across those held in stock; but where it has, then an agreed method must be derived to evaluate it. For commodity items that one cannot track individually, accountants must choose a method that fits the nature of the sale. Two popular methods that normally exist are: FIFO and LIFO accounting (first in - first out, last in - first out). FIFO regards the first unit that arrived in inventory as the first one sold. LIFO considers the last unit arriving in inventory as the first one sold. Which method an accountant selects can have a significant effect on net income and book value and, in turn, on taxation. Using LIFO accounting for inventory, a company generally reports lower net income and lower book value, due to the effects of inflation. This generally results in lower taxation. Due to LIFO's potential to skew inventory value, UK GAAP and IAS have effectively banned LIFO inventory accounting. Standard cost accounting In modern cost accounting, the concept of recording historical costs was taken further, by allocating the company's fixed costs over a given period of time to the items produced during that period, and recording the result as the total cost of production. This allowed the full cost of products that were not sold in the period they were produced to be recorded in inventory using a variety of complex accounting methods, which was consistent with the principles of GAAP (Generally Accepted Accounting Principles). It also essentially enabled managers to ignore the fixed costs, and look at the results of each period in relation to the "standard cost" for any given product. This method tends to
GOLS 2011
slightly distort the resulting unit cost, but in mass-production industries that made one product line, and where the fixed costs were relatively low, the distortion was very minor. An important part of standard cost accounting is a variance analysis, which breaks down the variation between actual cost and standard costs into various components (volume variation, material cost variation, labor cost variation, etc.) so managers can understand why costs were different from what was planned and take appropriate action to correct the situation. Activity-based costing (ABC) is a system for assigning costs to products based on the activities they require. In this case, activities are those regular actions performed inside a company. "Talking with customer regarding invoice questions" is an example of an activity inside most companies. Accountants assign 100% of each employee's time to the different activities performed inside a company (many will use surveys to have the workers themselves assign their time to the different activities). The accountant then can determine the total cost spent on each activity by summing up the percentage of each worker's salary spent on that activity. A company can use the resulting activity cost data to determine where to focus their operational improvements. For example, a job-based manufacturer may find that a high percentage of its workers are spending their time trying to figure out a hastily written customer order. Via ABC, the accountants now have a currency amount pegged to the activity of "Researching Customer Work Order Specifications". Senior management can now decide how much focus or money to budget for resolving this process deficiency. Activity-based management includes (but is not restricted to) the use of activity-based costing to manage a business. While ABC may be able to pinpoint the cost of each activity and resources into the ultimate product, the process could be tedious, costly and subject to errors. As it is a tool for a more accurate way of allocating fixed costs into product, these fixed costs do not vary according to each month's production volume. For example, an elimination of one product would not eliminate the overhead or even direct labor cost assigned to it. ABC better identifies product costing in the long run, but may not be too helpful in day-to-day decision-making. Lean accounting has developed in recent years to provide the accounting, control, and measurement methods supporting lean manufacturing and other applications of lean thinking such as healthcare, construction, insurance, banking, education, government, and other industries. There are two main thrusts for Lean Accounting. The first is the application of lean methods to the company's accounting, control, and measurement processes. This is not different from applying lean methods to any other processes. The objective is to eliminate waste, free up capacity, speed up the process, eliminate errors & defects, and make the process clear and understandable. The second (and more important) thrust of Lean Accounting is to fundamentally change the accounting, control, and measurement processes so they motivate lean change & improvement, provide information that is suitable for
GOLS 2011
control and decision-making, provide an understanding of customer value, correctly assess the financial impact of lean improvement, and are themselves simple, visual, and low-waste. Lean Accounting does not require the traditional management accounting methods like standard costing, activity-based costing, variance reporting, cost-plus pricing, complex transactional control systems, and untimely & confusing financial reports. Process Costing Process costing is an accounting methodology that traces and accumulates direct costs, and allocates indirect costs of a manufacturing process. Costs are assigned to products, usually in a large batch, which might include an entire month's production. Eventually, costs have to be allocated to individual units of product. It assigns average costs to each unit, and is the opposite extreme of Job costing which attempts to measure individual costs of production of each unit. Process costing is a type of operation costing which is used to ascertain the cost of a product at each process or stage of manufacture. CIMA defines process costing as "The costing method applicable where goods or services result from a sequence of continuous or repetitive operations or processes. Costs are averaged over the units produced during the period". Process costing is suitable for industries producing homogeneous products and where production is a continuous flow. A process can be referred to as the sub-unit of an organization specifically defined for cost collection purpose. Costing is an important process that many companies engage in to keep track of where their money is being spent in the production and distribution processes. Understanding these costs is the first step in being able to control them. It is very important that a company chooses the appropriate type of costing system for their product type and industry. One type of costing system that is used in certain industries is process costing that varies from other types of costing (such as job costing) in some ways. In Process costing unit costs are more like averages, the process-costing system requires less bookkeeping than does a job-order costing system. So, a lot of companies prefer to use processcosting system. When process costing is applied? Process costing is appropriate for companies that produce a continuous mass of like units through series of operations or process. Also, when one order does not affect the production process and a standardization of the process and product exists. However, if there are significant differences among the costs of various products, a process costing system would not provide adequate product-cost information. Costing is generally used in such industries such as petroleum, coal mining, chemicals, textiles, paper, plastic, glass, and food.
GOLS 2011
Reasons for use A company may manufacture thousands or millions of units of product in a given period of time. Products are manufactured in large quantities, but products may be sold in small quantities, sometimes one at a time (automobiles, loaves of bread), a dozen or two at a time (eggs, cookies), etc. Product costs must be transferred from Finished Goods to Cost of Goods Sold as sales are made. This requires a correct and accurate accounting of product costs per unit, to have a proper matching of product costs against related sales revenue. Managers need to maintain cost control over the manufacturing process. Process costing provides managers with feedback that can be used to compare similar product costs from one month to the next, keeping costs in line with projected manufacturing budgets. A fraction-of-a-paise cost change can represent a large rupee change in overall profitability, when selling millions of units of product a month. Managers must carefully watch per unit costs on a daily basis through the production process, while at the same time dealing with materials and output in huge quantities. Materials part way through a process (e.g. chemicals) might need to be given a value, process costing allows for this. By determining what cost the part processed material has incurred such as labor or overhead an "equivalent unit" relative to the value of a finished process can be calculated. Process cost procedures There are four basic steps in accounting for Process cost: Summarize the flow of physical units of output. Compute output in terms of equivalent units. Summarize total costs to account for and Compute equivalent unit costs. Assign total costs to units completed and to units in ending work in process inventory.
Contract Costing A cost-plus contract, also termed a Cost Reimbursement Contract, is a contract where a contractor is paid for all of its allowed expenses to a set limit plus additional payment to allow for a profit. Cost-
GOLS 2011
reimbursement contracts contrast with fixed-price contract, in which the contractor is paid a negotiated amount regardless of incurred expenses. Cost-plus contracts first came into use in the United States during the World Wars to incentivize wartime production by large American companies Types There are four general types of cost-reimbursement contracts, all of which pay every allowable, allocable, and reasonable cost incurred by the contractor, plus a fee or profit which differs by contract type. Cost Plus Fixed Fee (CPFF) contracts pay a pre-determined fee that was agreed upon at the time of contract formation. Cost-Plus-Incentive Fee (CPIF) contracts have a larger fee awarded for contracts which meet or exceed performance targets, including any cost savings. Cost Plus Award Fee (CPAF) contracts pay a fee based upon the contractor's work performance. In some contracts, the fee is determined subjectively by an awards fee board whereas in others the fee is based upon objective performance metrics. An aircraft development contract, for example, may pay award fees if the contractor achieves certain speed, range, or payload capacity goals. Cost Plus Percentage of Cost pay a fee that rises as the contractor's cost rise. Because this contract type provides no incentive for the contractor to control costs it is rarely utilized. The U.S. Federal Acquisition Regulations specifically prohibit the use of this type for U.S. Federal Government contracting. Usage A cost-reimbursement contract is appropriate when it is desirable to shift some risk of successful contract performance from the contractor to the buyer. It is most commonly used when the item purchased cannot be explicitly defined, as in research and development, or in cases where there is not enough data to accurately estimate the final cost. Advantages: In contrast to a fixed-price contract, a cost-plus contractor has little incentive to cut corners. A costplus contract is often used when long-term quality is a much higher concern than cost, such as in the United States space program. Final cost may be less than a fixed price contract because contractors do not have to inflate the price to cover their risk.
GOLS 2011
Disadvantages: There is limited certainty as to what the final cost will be. Requires additional oversight and administration to ensure that only permissible costs are paid and that the contractor is exercising adequate overall cost controls. Properly designing award or incentive fees also requires additional oversight and administration. There is less incentive to be efficient compared to a fixed-price contract. Recent trends Between 1995 and 2001 fixed fee cost-plus contracts constituted the largest sub group of cost-plus contracting in the U.S. defense sector. Starting in 2002 award-fee cost plus contracts took over the lead from fixed fee cost plus contracts. The distribution of annual contract values by sector category and award types indicates that cost plus contracts in the past carried the largest importance in research, followed by services and products. In 2004, however, services replaced research as the dominant sector category for cost plus contracts. For all other contract vehicles combined the relative ranking is reversed to the original cost-plus order, meaning that products leads, followed by service and research. With cost-plus contracting being primarily designed for research and development tasks, the percent share of cost-plus contracting within a contract is expected to be in correlation with the percent share of research undertaken in any given program. However, several programs, such as the F-35, the Trident II, the CVN 68, and the CVN 21 deviate from this pattern by continuing to make extensive usage of cost-plus contracting despite programs progressively moving beyond the research and development state Cost Plus Pricing Cost-plus pricing is a pricing method used by monopolistic companies. It is used primarily because it is easy to calculate and requires little information. There are several varieties, but the common thread is that one first calculates the cost of the product, then includes an additional amount to represent profit. It is a way for companies to calculate how much profit they will make. Cost-plus pricing is often used on government contracts (Cost-plus contracts), and has been criticized as promoting wasteful expenditures. The method determines the price of a product or service that uses direct costs, indirect costs, and fixed costs whether related to the production and sale of the product or service or not. These costs are converted to per unit costs for the product and then a predetermined percentage of these costs is added to provide a profit margin. Advantages of cost-plus pricing Easy to calculate Minimal information requirements
GOLS 2011
Easy to administer Tends to stabilize markets - insulated from demand variations and competitive factors Insures seller against unpredictable, or unexpected later costs
Ethical advantages Simplicity It is readily available Price increases can be justified in terms of cost increases
Disadvantages of cost-plus pricing Provides incentive for inefficiency Tends to ignore the role of consumers Tends to ignore the role of competitors Uses historical rather than replacement value Uses normal or standard output level to allocate fixed costs Includes sunk costs rather than just using incremental costs Ignores opportunity cost
Marginal costing This method is used particularly for short-term decision-making. Its principal tenets are: Revenue (per product) variable costs (per product) = contribution (per product) Total contribution total fixed costs = (total profit or total loss)
Thus, it does not attempt to allocate fixed costs in an arbitrary manner to different products. The shortterm objective is to maximize contribution per unit. If constraints exist on resources, then Managerial Accounting dictates that marginal cost analysis be employed to maximize contribution per unit of the constrained resource. Marginal Cost In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of goods. If the goods being produced is infinitely divisible, so the size of a marginal cost will change with volume, as a non-
GOLS 2011
linear and non-proportional cost function includes variable terms dependent to volume, constant terms independent to volume and occurring with the respective lot size, jump fix cost increase or decrease dependent to steps of volume increase.
In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. If producing additional vehicles requires, for example, building a new factory, the marginal cost of those extra vehicles includes the cost of the new factory. In practice, the analysis is segregated into short and long-run cases, and over the longest run, all costs are marginal. At each level of production and time period being considered, marginal costs include all costs which vary with the level of production, and other costs are considered fixed costs. If the cost function is differentiable, the marginal cost is the cost of the next unit produced referring to the basic volume. Economies of scale Economies of scale is a concept that applies to the long run, a span of time in which all inputs can be varied by the firm so that there are no fixed inputs or fixed costs. Production may be subject to economies of scale (or diseconomies of scale). Economies of scale are said to exist if an additional unit of output can be produced for less than the average of all previous units that is, if long-run marginal cost is below long-run average cost, so the latter is falling. Conversely, there may be levels of production where marginal cost is higher than average cost, and average cost is an increasing function of output. For this generic case, minimum average cost occurs at the point where average cost and marginal cost are equal (when plotted, the marginal cost curve intersects the average cost curve from below); this point will not be at the minimum for marginal cost if fixed costs are greater than zero. Relationship to fixed costs Marginal Costs are not affected by changes in fixed cost. Fixed costs do not vary with (depend on) changes in quantity. Thus if fixed cost were to double MC would not be affected and consequently the profit maximizing quantity and price would not change. This can be illustrated by graphing the short run total cost curve and the short run variable cost curve. Each curve initially increases at a decreasing rate reaches and inflection point then increases at a decreasing rate. The distance of the origin of the SRTC above the origin represents the fixed cost - the vertical distance between the curves. Zero Based Budgeting
GOLS 2011
Zero-based budgeting is a technique of planning and decision-making which reverses the working process of traditional budgeting. In traditional incremental budgeting, departmental managers justify only increases over the previous year budget and what has been already spent is automatically sanctioned. By contrast, in zero-based budgeting, every department function is reviewed comprehensively and all expenditures must be approved, rather than only increases. No reference is made to the previous level of expenditure. Zero-based budgeting requires the budget request be justified in complete detail by each division manager starting from the zero-base. The zero-base is indifferent to whether the total budget is increasing or decreasing. The term "zero-based budgeting" is sometimes used in personal finance to describe "zero-sum budgeting", the practice of budgeting every rupee of income received, and then adjusting some part of the budget downward for every other part that needs to be adjusted upward. Zero based budgeting also refers to the identification of a task or tasks and then funding resources to complete the task independent of current resourcing. Advantage of zero-based budgeting Efficient allocation of resources, as it is based on needs and benefits. Drives managers to find cost effective ways to improve operations. Detects inflated budgets. Useful for service departments where the output is difficult to identify. Increases staff motivation by providing greater initiative and responsibility in decision-making. Increases communication and coordination within the organization. Identifies and eliminates wasteful and obsolete operations. Identifies opportunities for outsourcing. Forces cost centers to identify their mission and their relationship to overall goals. It helps in identifying areas of wasteful expenditure and, if desired, it can also be used for suggesting alternative courses of action. Disadvantages of zero-based budgeting Difficult to define decision units and decision packages, as it is time-consuming and exhaustive. Forced to justify every detail related to expenditure. The R&D department is threatened whereas the production department benefits.
GOLS 2011
Necessary to train managers. Zero-based budgeting must be clearly understood by managers at various levels to be successfully implemented. Difficult to administer and communicate the budgeting because more managers are involved in the process.
In a large organization, the volume of forms may be so large that no one person could read it all. Compressing the information down to a usable size might remove critically important details.
Honesty of the managers must be reliable and uniform. Any manager that exaggerates skews the results.
Incremental budgeting Incremental Budgeting uses a budget prepared using a previous periods budget or actual performance as a base, with incremental amounts added for the new budget period. The allocation of resources is based upon allocations from the previous period. This approach is not recommended as it fails to take into account changing circumstances. Moreover, it encourages spending up to the budget to ensure a reasonable allocation in the next period. It leads to a spend it or lose it mentality. Advantages of incremental budgeting The budget is stable and change is gradual. Managers can operate their departments on a consistent basis. The system is relatively simple to operate and easy to understand. Conflicts are avoided when departments appear to be treated similarly. Co-ordination between budgets is easier to achieve. The impact of change can be seen quickly.
Disadvantages of incremental budgeting Assumes activities and methods of working will continue in the same way. No incentive for developing new ideas. No incentive to reduce costs. Encourages spending up to the budget so that the budget is maintained next year. The budget may become out-of-date and no longer relate to the level of activity or type of
GOLS 2011
work being carried out. The priority for resources may have changed since the budgets were originally set. There may be budgetary slack built into the budget, which is never reviewed. Managers might have overestimated their requirements in the past in order to obtain a budget which is easier to work within, and which will allow them to achieve favourable results. Cash Flow In financial accounting, a cash flow statement, also known as funds flow statement, is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities. Essentially, the cash flow statement is concerned with the flow of cash in and cash out of the business. The statement captures both the current operating results and the accompanying changes in the balance sheet. 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. People and groups interested in cash flow statements include: Accounting personnel, who need to know whether the organization will be able to cover payroll and other immediate expenses Potential lenders or creditors, who want a clear picture of a company's ability to repay Potential investors, who need to judge whether the company is financially sound Potential employees or contractors, who need to know whether the company will be able to afford compensation Shareholders of the business.
The cash flow statement was previously known as the flow of Cash statement. The cash flow statement reflects a firm's liquidity. The balance sheet is a snapshot of a firm's financial resources and obligations at a single point in time, and the income statement summarizes a firm's financial transactions over an interval of time. These two financial statements reflect the accrual basis accounting used by firms to match revenues with the expenses associated with generating those revenues. The cash flow statement includes only inflows and outflows of cash and cash equivalents; it excludes transactions that do not directly affect cash receipts and payments. These non-cash transactions include depreciation or write-offs on bad debts or credit losses to name a few. The cash
GOLS 2011
flow statement is a cash basis report on three types of financial activities: operating activities investing activities financing activities
Non-cash activities are usually reported in footnotes. The cash flow statement is intended to provide information on a firm's liquidity and solvency and its ability to change cash flows in future circumstances provide additional information for evaluating changes in assets, liabilities and equity improve the comparability of different firms' operating performance by eliminating the effects of different accounting methods indicate the amount, timing and probability of future cash flows
The cash flow statement has been adopted as a standard financial statement because it eliminates allocations, which might be derived from different accounting methods, such as various timeframes for depreciating fixed assets. Cash basis financial statements were very common before accrual basis financial statements. The "flow of funds" statements of the past were cash flow statements. In 1863, the Dowlais Iron Company had recovered from a business slump, but had no cash to invest for a new blast furnace, despite having made a profit. To explain why there were no funds to invest, the manager made a new financial statement that was called a comparison balance sheet, which showed that the company was holding too much inventory. This new financial statement was the genesis of Cash Flow Statement that is used today. In the United States in, the Financial Accounting Standards Board (FASB) defined rules that made it mandatory under Generally Accepted Accounting Principles (US GAAP) to report sources and uses of funds, but the definition of "funds" was not clear."Net working capital" might be cash or might be the difference between current assets and current liabilities. The FASB discussed the usefulness of predicting future cash flows. FASB Statement No. 95 (FAS 95) mandated that firms provide cash flow statements. In 1992, the International Accounting Standards Board issued International Accounting Standard 7 (IAS 7), Cash Flow Statements, which became effective in 1994, mandating that firms provide cash flow statements. Cash flow activities The cash flow statement is partitioned into three segments, namely: cash flow resulting from operating
GOLS 2011
activities, cash flow resulting from investing activities, and cash flow resulting from financing activities. The money coming into the business is called cash inflow, and money going out from the business is called cash outflow. Operating activities Operating activities include the production, sales and delivery of the company's product as well as collecting payment from its customers. This could include purchasing raw materials, building inventory, advertising, and shipping the product. Operating cash flows include: Receipts from the sale of goods or services Receipts for the sale of loans, debt or equity instruments in a trading portfolio Interest received on loans Dividends received on equity securities Payments to suppliers for goods and services Payments to employees or on behalf of employees Interest payments (alternatively, this can be reported under financing activities in IAS 7, and US GAAP) Items which are added back to [or subtracted from, as appropriate] the net income figure (which is found on the Income Statement) to arrive at cash flows from operations generally include: Depreciation (loss of tangible asset value over time) Deferred tax Amortization (loss of intangible asset value over time) Any gains or losses associated with the sale of a non-current asset, because associated cash flows do not belong in the operating section.(unrealized gains/losses are also added back from the income statement) Examples of Investing activities are Purchase or Sale of an asset (assets can be land, building, equipment, marketable securities, etc.)
GOLS 2011
Loans made to suppliers or received from customers Payments related to mergers and acquisitions
Financing activities include the inflow of cash from investors such as banks and shareholders, as well as the outflow of cash to shareholders as dividends as the company generates income. Other activities which impact the long-term liabilities and equity of the company are also listed in the financing activities section of the cash flow statement. Preparation methods The direct method of preparing a cash flow statement results in a more easily understood report. The indirect method is almost universally used, because FAS 95 requires a supplementary report similar to the indirect method if a company chooses to use the direct method. Direct method The direct method for creating a cash flow statement reports major classes of gross cash receipts and payments. 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 from all cash-based transactions. An increase in an asset account is subtracted for 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.
GOLS 2011

ShortNotes Revised

Hochgeladen von

Dokumentinformationen

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

ShortNotes Revised

Hochgeladen von

Copyright:

Verfügbare Formate

ICSI Executive Programme Company Accounts, Costing & Management Accounting Accounting Standards Standard accounting practices require

Classical cost elements are: raw materials labor indirect expenses/overhead

Overhead A. B. Indirect material Indirect labor

By functions Production Selling

Distribution Administration R&D Development

By traceability Direct Indirect

By variability Fixed Variable Semi variable

By controllability Controllable Uncontrollable

By normality Normal Abnormal

Das könnte Ihnen auch gefallen