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Framework of Accounting Theory

In order to appreciate fully the role of management accounting in the business organization it is
necessary to have some knowledge of the basic concepts of accounting. In the beginning, accounting
did not have a comprehensive body of theory to which than accountant could turn for guidance. An
accountant often had to consult several books for specific rules and procedures for recording each
event that occurred in a business. Accounting is an art rather that an exact science and in order to have
some uniformity in the system it is necessary to have certain guidelines without which accounting
would flounder ultimately. Generally accepted accounting principles evolved in the profession which
today constitute the backbone of modern theory. Now accounting is structured with great deal of logic
and order through the employment of the "principles of accounting". This theoretical structure must
be realistic in terms of the economic environment and designed to meet the needs of major users
of accounting information. These principles or concepts are broad rules upon which present
accounting practice in based. They tend to serve as unifying force. Fair presentation of financial
affairs is the essence of accounting theory and practice.

Although it is evident that accounting is now based upon deeply-rooted principles, no universally
acceptable list of them has ever been compiled. There is a wide disagreement among accountants
as to what constitute a principle. However, they generally agreed that accounting principles cannot
be derived from or proven by the laws of nature. They are rather in the category of conventions or
rules developed by man from experience to fulfill the essential and useful needs and purposes in
establishing reliable financial and operating information control for business entities.

The accounting and reporting techniques followed in the "free world" are based upon a society and
government structure that believe and honour property rights. Accordingly, the accounting and
reporting procedures we employ are designed to account for a business which has been organized to
to make a profit. The free enterprise system in which citizens have the right to invent is a necessary
condition. This does not mean that we cannot account for a non-profit enterprise or a government unit.
It simply means the two cannot use the same principles. Since the rules are different, the accounting
techniques must also differ.

A. Specific Business Entity

Basic to all accounting must be the establishment of boundaries of accounting and reporting activity.
Accountants are primarily concerned with economic entities rather than legal entities. The accountant's
focus is the business enterprise, an in particular, the financial aspect of the business. Each business
unit (whether, proprietorship, partnership, or corporation) is considered as a separate entity, regardless
of its legal form. Ownership and management is not considered the business. The transactions of the
owner are kept separate from those of the business so that financial statements reflect only the
transactions of the respective economic entities. The assumption is that a business activity shall be
accounted for independent of its owners.

B. Going Concern

The accounting methods and techniques are based on the assumption, in the absence of other
evidence, that the business entity will continue to operate indefinitely. Where this assumption is
not valid, conventional accounting techniques must not be used. For instance, a balance sheet
prepared following conventional accounting will not disclose the true financial position of a company
facing bankruptcy in the near future or actually in the process of liquidation. In this instance the
accountant would depart from conventional practice which assumes "going concern". Many rules
followed in the preparation of the financial statements especially the balance sheet, are not valid
unless the firm is going to continue in business.
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C. Monetary Expression in Accounts

Accounting is based on the assumption that money is the unit of measure for recording and reporting
business transactions and the results thereof. In order to account promptly for a business enterprise,
we must have some common unit of measure. In our economy, money not only serves as a medium
of exchange, but also as a basis of accountability. Business transactions are all recorded and
summarized in terms of the monetary unit. The monetary unit assumption has two aspects, namely,
quantifiability and stability of the monetary unit.

The quantifiability aspect means that assets, liabilities, capital, income, expenses should be stated
in terms of the monetary units used. A transaction or event is quantifiable when it has an effect on the
three accounting values- assets, liabilities, and capital.

D. Historical Costs

The accountant generally, considers the cost or value of a financial resource to be the cash outlay to
acquire that resource. If property other than cash is given up in the exchange, the cost of the item
acquired is the cash equivalent of the property given up. The exchange price, which emerges under
conditions of arms-length bargaining, establishes the historical cost of the item.

E. Periodicity

Although the accountant assumes that the business has a continuous life, users of the financial
statements and information require periodic reports of the firm's financial condition. Government
entities and other institutions requires submission of annual reports of business firms. Accountants,
therefore, usually prepare financial statements and reports at periodic intervals during the company's
life to reflect the company's financial condition and the results of operations. The calendar year of
natural business year normally serves as the basic accounting period. The natural business year is
the period of twelve consecutive months that ends when the activities of the business reach the
lowest point in the annual operating cycle.

F. Accrual and Matching of Expenses and Revenue Concepts

Accrual accounting is closely related to the going-concern, periodicity and matching concepts. Accrual
accounting may be defined as the recognition of revenue and expense without regard to the flow of cash
to or from the business enterprise. Revenue is recognized when earned and expenses recognized
when incurred . Under the matching principle, the cost and expenses incurred in earning the revenue
are matched with the revenue to determine net income. A critical aspect of the matching concept is
recognition. The accrual concept, therefore, is a natural consequence of the matching principle.

G. Realization Concept

The realization concept usually pertains to the recording of revenue from sales of products and services
to customers. When is revenue realized-when the goods are purchased, when the order is received from
the buyer, when the order is put in process, when it is finished, when it is delivered or when the sales
proceed are collected? Generally, revenue is realized when the goods or services are delivered
despite the fact that delivery is only one of the series of events related sales. Generally, revenue
to be considered realized must meet two tests: (a) the earning process must be virtually complete
in that the goods or services must be fully rendered, and (b) an exchange of resources evidenced
by a market transaction must occur. The exceptions are in long-run construction contracts and long-run
instalment sales.
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H. Consistency and Comparability Between Periods for the same Entity

There are several acceptable methods of performing certain accounting functions. While the
accountant may choose from a variety of methods, he must be consistent in their application between
accounting periods for the same entity. Consistency, as used in accounting, means that similar
accounting procedures should be used over a number of years so that comparable financial information
is furnished to interested parties. However, consistency does not mean that no change in accounting
procedure can be made. Where changes in procedure would result in more useful and meaningful
information, then such change should be made provided the effect of such change on the financial
statements is properly disclosed.

I. Full Disclosure

Probably the most useful products of an accounting system are the financial statements prepared
from accumulated and classified data. Therefore, it is imperative that adequate disclosure be made
on the financial statements to make them as informative as possible. The principle of full disclosure
dictates that all significant information leading to the preparation of financial statements should be
clearly reported. Full disclosure is synonymous with completeness of financial statements. Disclosure
however, does not mean disclosure of just any data. The purpose of disclosure is to inform and not to
mislead. A working rule should be "when in doubt, disclose".

J. Conservatism

The accounting process requires the exercise of careful judgment and countless estimates. The
concept of conservatism means that all losses should be recognized and reflected in financial records,
if it is reasonably certain that they will occur. On the other hand, anticipated gains and other
financial benefits should not be reflected until they are actually realized.

K. Materiality and Practicality

Absolute appreciation of full disclosure is tempered by the concept of materiality and practicability.
The concept of materiality enables the accountant to disregard almost any principle or rule of conduct
where the results are not material in amount and therefore do not affect the fairness of the
financial statements. "A statement, fact, or item is material if giving full consideration to the
surrounding circumstances, as they exist at the time, it is of such nature that its disclosure, or the
method of treating it, would be likely to influence or to make a difference in the judgment and
conduct of a reasonable person. The same test apply to such words as "significant, consequential,
or important."

L. Objectivity and Verifiability

The doctrine of objectivity requires that each financial event that is recorded be substantiated with
objective and verifiable evidence. Express in another way, objectivity means that the financial
statement must be free from bias and prejudices.

M. Conformity with the Law

The accountant must be aware of legal requirements which pertains to his area of responsibility. He
must alert company officials to operating procedures that he believes to be illegal.

N. Diversity in Accounting among Independent Entities

Accountants recognize and support the position that no one method can properly be used in all
instances. Business entities necessarily must adopt accounting methods and practices best suited
for their purposes and which will present their statement as fairly as possible.
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O. Timeliness in Financial Reporting and the Use of Estimates in Financial Statements

Any report to be useful must be timely. Users of the financial reports are not content to wait for
prolonged periods for such reports. They need to know how the business is doing before it is too
late to do something about it. Since transactions do not fit exactly into periods (monthly, quarterly,
semi-annually, annually) estimates and arbitrary allocations are necessary. Profits and other key data
are of necessity, estimated.

Qualitative Objectives of Financial Accounting

1. Relevance

Relevant financial accounting information bears on the economic decisions for which it is used.
Relevance is the primary qualitative objective.

2. Understandability

Understandable financial accounting information presents data that can be understood by users of
the information and is expressed in a form and with terminology adopted to users' range of

3. Verifiability

Verifiable financial accounting information provides results that would be substantially duplicated
by independent measurer using the same measurement methods.

4. Neutrality

Neutral accounting information is directed towards the common needs of users and is independent of
presumptions about particular need and desire of specific users.

5. Timeliness

Timely financial accounting information is communicated early enough to be used for the economic
decisions which it might influence and to avoid delays in making those decisions.

6. Comparability

Comparable financial accounting information presents similarities and differences that arise from
basic similarities and differences in the enterprise or enterprises and their transactions and not
merely from differences in financial accounting treatments.

7. Completeness

Complete financial accounting information includes all financial accounting data that should be
reported and that reasonably fulfills the qualitative objectives of relevance, understandability,
verifiability, neutrality, timeliness and comparability.

The essential link in the communication function of accounting is the preparation an issuance of
financial statements. Financial statements are the end-products of the accounting process which
serve the financial information needs of various interested parties like, stockholders, prospective
investors, creditors, government, labour unions and general public.

A. General objectives of Financial Accounting Information and Financial Statements

a. Provide reliable information about the company's economic resources and obligations. This
information is helpful in judging the ability of the business to survive and to grow in an ever-
changing environment.

b. Provide reliable information on the profitability of the enterprise.

c. Provide financial information helpful in estimating the future earning potential of the

d. Provide other needed information about changes in economic resources and obligations.

e. Provide other information relevant to the needs of the external users.

Balance Sheet

A balance sheet is a formal statement showing the financial condition of a company as of a given
date. The balance sheet is basically a historical report showing the cumulative effect of past
completed transactions. It is the detailed expansion of the accounting equation:

Assets = Liabilitie + Capital

A. Forms of Balance Sheet

a. Customary or convention form

a1. Account form
a2. Report form

b. Financial position form

B. Order of Presenting Balance Sheet Items

It is preferred to present the items in the balance sheet in order of liquidity. In conformity with
this approach the order of presenting balance sheet items should be as follows:
Assets Liabilities
Current assets Current Liabilities
Investments Long-term liabilities
Plant, property and equipment Other long-term liabilities
Intangibles Deferred revenues
Other assets Capital stock
Additional paid-in capital
Retained earnings
Appraisal capital

A. Current assets

Includes cash and other assets or resources which are reasonably expected to be realized in cash
or sold or consumed during the normal operating cycle.
Ex: Cash which includes cash on hand and in bank
Marketable securities
Trade receivables such as accounts receivables, notes receivables
Nontrade receivables such as advances to officers and employees, subscription
receivables, creditors accounts with debit balances,
Prepaid expenses, such as prepaid insurance, prepaid rent

B. Investments

Investments are of two kind: temporary and permanent. As a balance sheet caption, investments
pertain to permanent investments.

Temporary investments are short term investments that are readily marketable and intended to
meet the working capital requirements either currently or when the need arises.

Permanent investments are those investments which do not qualify as temporary investments.

C. Fixed assets

In order that an asset may be categorized as fixed, three requisites should be present:

a. The asset is "permanent" meaning can be used for more than one year.
b. The asset is used in the operation of the business.
c. The asset is not intended for sale.

D. Other assets

A balance sheet caption under which are listed noncurrent items which cannot appropriately be
included in the usual asset categories.


A. Current liabilities

Obligations which are payable within one year or normal operating cycle if it exceeds one year and
and whose payment requires the use of current assets or the creation of other current liabilities.
Ex: Trade payables such as accounts payable, notes payables, tax payables, accrued

B. Long-term liabilities

obligations which are not due within one year or normal operating cycle if it exceeds one year, or
those obligations which do not require the use of current assets for their liquidation.

C. Deferred revenues

Revenues receive in advance but not yet earned. If the revenue is realizable within one year it
is classified as current liabilities otherwise recorded as long-term liabilities.
E. Estimated liabilities

Obligations which exist on balance sheet date although their amount is not definite yet. Estimated
liabilities are either current or long-term in nature.
Ex: Estimated premiums payable, estimated warranties payable, estimated gift
certificates payable

F. Contingent liabilities

Possible or potential obligations which may or may not become actual liabilities depending
upon the occurrence of certain circumstances or event in the future. Therefore, these liabilities
are not accounting liabilities because they don not exist as yet on balance sheet date.


Capital is a very broad term. Thus, the following terms are now commonly used depending on the
form of business organization.
a. Owner's equity in a sole proprietorship
b. Partner's equity in a partnership
c. Stockholders' equity or Shareholders' equity in a corporation.

A. Stockholders' equity

1. Paid in capital or contributed capital

a. Capital Stock
b. Additional paid in capital or additional contributed capital
c. Donated capital
2. Retained earnings
3. Appraisal capital

B. Paid-in capital

Represents the investment of the stockholders including retained earnings capitalized as stock
dividends and gifts or donation of assets from any source, including persons or entities other than
the stockholders.

Capital stock is the portion of the paid in capital representing the total par or stated value of the
shares of stock issued or the total consideration received in case of no-par, no stated value shares
of stock. Any subscribed capital stock and stock dividends payable are added to capital stock.

Additional paid in capital is the capital contribution by the stockholders in excess of the par or
stated value of the stock subscribed and issued.

Donated capital represents capital received by way of gifts or donation from the stockholders or
from parties other than the stockholders.

Treasury stock is a corporation's own stock that has been issued then reacquired but not cancelled.
C. Retained earnings

The cumulative balance of periodic earnings, dividends distributions, prior period adjustments,
and special distribution to stockholders resulting from the capital adjustments.

Retained earnings can be appropriated or unappropriated.

a. Unappropriated retained earnings represents that portion whish is free and can be declared
as dividends to stockholders.

b. Appropriated retained earnings represent that portion which has been restricted and therefore
is not available for any dividend declaration.

D. Appraisal Capital

Represents the excess of the appraised value over historical cost.

Income Statement

The income statement shows the results of operations of a company for a period of time. This is
the measure of economic performance of the company for the period.

A. Revenue and cost

When properly prepared, the income statement is based on the concept of matching revenues
and cost. The matching process requires inclusion of all revenues that was earned during a
designated time period and all costs that were incurred un earning the revenues for the same

B. Forms of income statement

a. Single - step form

All revenues are grouped together and totalled and all expenses are listed together and
totalled. A net income or loss figure is then computed by deducting the expense from the
b. Multiple-step form
More detailed income statement.
Exhibit 4 Statement of Retained Earnings

Statement of Retained Earnings
For the Year ended December 31, 2008

Retained Earnings Unappropriated

Balance, January 1, 2008
Correction of errors of prior periods:
Add: Purchase of machinery incorrectly charged to expense xx
in 2005
Less: Depreciation not taken in 2005 thru 2008 xx
Corrected balance, January 1, 2008

Transactions of the current year

Add: Net income for the year xxx
Gain on sale of land xx
Deduct: Income tax applicable xx xx
Transfer from appropriation for contingencies
(see below) xx
Total xx

Less: Organization cost written-off xx

Cash dividend xx
Stock dividend xx
Transfer to appropriation for plant expansion
(see below) xx
Total xx

Total Unapproriated Retained Earnings, December 31, 2008

Retained Earnings Appropriated

Appropriation for Contingencies:
Balance, January 1, 2008 xx
Less: Transfer to Unappropriated retained earnings
(see above) xx
Balance, December 31, 2008 xx

Appropriated for Plant Expansion:

Balance, January 1, 2008 xx
Add: Additional appropriation during the year
(see above) xx
Balance, December 31, 2008 xx

Total Appropriated Retained Earnings

Total Retained Earnings, December 31, 2008







A. Economic Function

In a free society, economic activities are carried mostly by privately managed organization. An
organization is a group of people united together for some common purpose. The management of
these organizations must find ways of utilizing limited resources to produce and distribute services
or commodities that satisfy men's need. The management must be able to combine natural and
productive resources, accumulate capital and human effort (both physical and mental) to satisfy
all interested parties, namely:
a. Customers or consumers
b. Owners or investors
c. Employees and workers

The primary obligations of management, therefore, is the maximation of profits consistent with
its social responsibility. The responsibility is threefold:
1. To continue to provide useful goods and services to consumers at a price they are willing to pay.
2. To continue to provide employees with jobs at an appropriate level of compensation.
3. To preserve the financial wellbeing and profit making capacity of the firm in order to provide a
fair return on its capital to owners.

B. Administrative Function

Planning - relates to the setting up of goals for the firm, both immediate and long-range; considering
the various means by which such goals may be achieved and deciding which of the alternative
means would be best suited to the attainment of the goals sought, under the conditions
expected to prevail.

Organizing ad Directing - the process of deciding how to put together the scarce human and non-
human resources available in some orderly fashion best suited to carrying
out plans.

Controlling - consist of checking the performance of activities against the plan, noting deviations
from it and deciding what corrective actions, if nay, ought to be taken.

Decision Making - this is not a separate function. It is an inseparable part of the functions already
discussed above.
Planning and Control Cycle

Planning (long and short term)

Evaluating differences - - - - - - - - - - - - - - - - - Decision - - - - - - - - - - - - Implementing the Plans
between Plans and Actual Making (organizing and directing)
Performance (controlling) ¦

Measuring Performance

In a going concern, these functions are carried on simultaneously. These management functions have
one thing in common-each requires that decisions be made. All management decisions have two
characteristics: (1) they involve choosing among available alternatives; and (2) they culminate in action
from which certain consequences flow.

C. Organizational Structure

Organizations are made up of people and management accomplishes its objectives by working through
people. Management of the company cannot execute all responsibilities by themselves. They have
to rely on other people to share the responsibilities.

an organization chart shows responsibility relationships between the officers of an organization. It

shows line and staff authority in a company. A line unit is any unit whose activities are directly
related to the basic objectives of the organization. A staff unit is one which provides services and
assistance to the other units of the organization.

D. Management Accounting Defined

Management Accounting is the application of appropriate techniques and concepts in processing

the historical and projected economic data of an entity to assist management in establishing
plan for reasonable economic objectives and in the making of rational decisions with a view
toward achieving these objectives. It is concerned with providing information to those who are
inside an organization and who are charged with directing and controlling its operations.

Management accounting is the term used to describe the accounting methods, systems and techniques
which, coupled with knowledge and ability assist management in its task of maximizing profits and
or minimizing losses.

In order to discharge his planning and control responsibilities, the manager needs information about
his organization. Most of the information needed are data for costs of the enterprise.

Management accounting, therefore, will necessarily include the following inportant task:

Cost determination important for financial reporting as well as for management function. For
example, management wants to know what is the fair value to place upon the
ending inventory of finished goods so as to report an acceptable asset value
on the balance sheet and a proper figure for net income on the income

Cost control - goes a step beyond cost determination and considers what cost should be and
what corrective action should be taken when costs are excessive.

Performance evaluation - is a special case of the control process. Effective management of an

organization requires the delegation of management tasks to various
individuals. This requires comprehensive reporting system to
monitor the operation of the various managers and to assure that
their performance is consistent with the set goals of the organization.

In financial accounting, "cost" is defined as the sacrifice made in order to obtained some goods of

In management accounting, "cost" is used in many different ways. The reason is that they are
classified differently according to the immediate needs of management.

Overall Classification of Costs

A. Manufacturing Costs
Direct materials
Direct labor
Manufacturing overhead

Manufacturing overhead and Direct Labor = Conversion Cost

Direct Materials and Direct labor = Prime Cost

B. Non-manufacturing Costs
Selling/marketing expenses
Administrative/general expenses

C. Period Costs

Period costs are those costs that can be identified with measured time intervals. Rent of an office
space is a period cost. This expense will have to be paid without regard to the degree of business
activity during the period. Most non-manufacturing costs are classified as period costss and are
deducted from revenues earned in the period they are incurred.
D. Product Costs

Any cost incurred in the manufacture of a product is a product cost. Such cost should not be treated
as expense in the period they are incurred rather they should be treated as expenses in the period
in which the related product is sold.

Cost and Control

The cost classifications used for recording purposes and used in preparing financial statements
are not the same classifications used in management accounting to control operations and to
plan for the future. For these purposes costs are classifies as :

A. Variable and Fixed Costs

Cost behaviour refers to how cost will change with respect to changes in the level of activity of the
businesses. A cost may increase or decrease n or remain the same as the volume of business
increases or decreases.

Variable costs - cost which vary in direct proportion to changes in the volume or level of
business activity. Ex: direct materials and direct labor.

Fixed costs - costs that remain constant in total regardlessof the change in the volume
or level of business activity. Ex: depreciation, property tax, rent,
supervisory salaries, etc.

Fixed costs are sometimes referred to as capacity cost since they result from outlays made
for the plant facilities, equipment, etc, to provide the basic capacity for sustained end
continues operations. For planning purposes, fixed cost is classified either as committed
or discretionary.

Commited Fixed Costs - those which relate to investments in fixed assets and the
basic organization of the business. Ex: depreciation, of fixed
assets, taxes on property, salaries of key management. The
basic characteristic of committed costs is that they cannot be
reduced to zero for a short period of time without impairing
profitability or the long-term goals of the organization.

Discretionary Fixed Costs - fixed cost arising from annual decisions of management.
The key factor about discretionary fixed cost is that management
is not locked into a decision for any more than a single budget
period. Each year management can review the expenditure
level in the various discretionary fixed cost areas-whether to
continue, increase, decrease, or discontinue altogether.

B. Mixed or Semi-variable Costs

Cost that contains both variable, and fixed cost element. For example, a department store
leases its building for a $100,000 annual rental plus $0.5 for every $10 sale. This cost is a
mixed cost composed of $100,000 fixed cost and $0.5 variable.

C. Direct and Indirect Costs

Costs that can easily be identified with specific departments, products, processes are direct
costs. Costs that cannot be easily identified with the product or processes are indirect costs.
1. If costs can be conveniently and physically traced to a unit under consideration, then it is
a direct cost with respect to that unit.

2. If a cost is allocated in order to be assigned to a unit under consideration then it is indirect

cost with respect to that unit.

D. Controllable and Non-controllable Costs

Whether a cost is controllable or non-controllable depends in the point of reference. All costs
are contollable at some level or another in a company. It is probably only at the lower level of
management where cost can be considered non-controllable.

E. Avoidable and Unavoidable Costs

Avoidable cost is the amount of decrease in cost or the cost eliminated as a result of discontinuing
an activity or substituting one activity for another.

Unavoidable costs are costs the organization is committed to incur or has already incurred.

F. Relevant and Irrelevant Costs

All costs are relevant in a decision except:

1. Sunk cost - past or historical costs having been incurred are not relevant to future events
and decisions.

2. Future costs that do not differ between the alternatives at hand. If cost will be incurred
regardless of the alternatives choses than it cannot be of help in deciding which
alternative to choose.

Other Cost Concepts

A. Differential Costs

In the decision-making function of management, comparison of alternatives in imperative. Each

alternative will have certain costs associated with it. The difference in costs between one
alternative and another is know as differential cost.

B. Opportunity Costs

The potential benefit foregone in rejectingsome course of action is called opportunity cost and to
the extent it can be quantified it should be considered as part of the cost of a decision.

C. Imputed Costs

Imputed costs are theoretical costs that must be assigned if the correct decision is to be made.
Imputed costs are costs that have not been recorded and in most instances will never be recorded
in the accounting records. The most common imputed cost is interest.
D. Out of Pocket Costs

Costs that requires utilization of current resources. Out of pocket costs may be fixed, like salary of
the president or variable, like raw materials and direct labor.

Cost Accumulation for Product Costing

A. Costing Systems

The type of costing system used to determine the unit cost will depend on the nature of the
manufacturing process involved. The two basic cost system are process costing and job
order costing:

Process Costing - employed in industries that produce large volume of uniform products on a
continous repetitive basis. It is used in those situations where the
manufacturing process involves a single product that is produced for long
periods at a time. These industries are characterized by a basically
homogeneous product that flows evenly through the production process
on a continous basis.

Basic formula to determine the unit cost:

Total Manufacturing Costs

Total Units produced = Unit Cost

Job Order Costing used when each product manufactures is different or jobas are completed
according to specification of customers. Ex: printing companies, furmiture
manufacturers, etc.

Control Through Standard Costing

To control costs we must know-

What the cost should be
What the actual costs are
Who is responsible for the control of each cost.

This means that costs must be preplanned, budgeted and accumulated by responsibility centers.
This means that cost accounting has two functions: to measure profit acurately by assignment of
costs to specific products and to control costs by assigning them to a particular responsibility

In attemting to control costs, management has two decisions to make:

1. Decisions relating to prices paid, and
2. Decisions relating to quantities used.

Standard Costs

Precise measurement requires standards. A standard is a rule of measurement established by

a duly constituted authority. The setting up of standard costs is a complex matter. It involves
the combined effort and expertise of several persons which necessarily must include the
managerial accountant, production engineers and the manager who will be working under
the standard cost that are set.

An understanding of the following is necessary before standard can be developed:

1. The fundamental factors of costs.

2. The design and material specification of the product.
3. the nature and productive labor operations and their departmental locations.

Advantages of Standard Costs

1. They make possible the concept of "management by exceptions".

2. They facilitate cash and inventory planning.
3. They promote economy and efficiency in that employees became more "cost concious".
4. In income determination, they are more economical and simplier to operate that historical
cost system.
5. They assist in the implementation of responsibility accounting.

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I. Budget Preparation

To illustrate how the separate budgets making up the master budget are prepared we now look
at the Grassroots Company which manufactures and sells a single product:

The Grassroots Company

Balance Sheet
December 31, 2008
(in US Dollar)


Current Assets:
Cash 16,000
Accounts receivable 63,000
Finished Goods, 200 units 6,900
Raw Materials, 832 kilos 4,992 90,892

Fixed assets:
Land 50,000
Building and equipment 180,000
Less: Accumulated Depreciation 40,000 140,000 190,000

Total Assets 280,892


Current Liabilities:
Accounts Payable-Raw Materials 11,995

Stockholders' Equity

Capital Stock 200,000

Retained Earnings 68,897 268,897

Total Liabilities and Stockholders' Equity 280,892

I.1 Sales Budget

The Grassroots Company

Sales Budget
For the year ended December 31, 2009
(in US Dollar)

1 2 3 4 Year
Expected sales in units 2,000 2,800 3,000 2,800 10,600
Expected selling price per unit 60 60 60 60 60
Total sales 120,000 168,000 180,000 168,000 636,000

I.1A Schedule of Expected Cash Collections

For Grassroots Company, 30% of the quarter sales are collected in the quarter of sale; the balance
in the quarter following.
1 2 3 4 Year
Accounts receivable, 12-31-08 63,000 63,000
1st Quarter Sales 36,000 84,000 120,000
2nd Quarter Sales 50,400 117,600 168,000
3rd Quarter Sales 54,000 126,000 180,000
4th Quarter sales 50,400 50,400
99,000 134,400 171,600 176,400 581,400

I.2 Production Budget

Grassroots Company desired inventory level is 10% of next quarter sales. Assume expected sales
for year 2010: 1st quarter, 2,500 units; 2nd quarter, 3,000 units:

1 2 3 4 Year
Expected sales in units (Sch. I.1) 2,000 2,800 3,000 2,800 10,600
Add: Desired ending inventory
(10% of next quarter sales) 280 300 280 250 250
Total 2,280 3,100 3,280 3,050 10,850
Less: Beginning inventory 200 280 300 280 200
Units to be Produced 2,080 2,820 2,980 2,770 10,650

I.3 Direct Materials Budget

Assume Grassroots needs 2 kilos of raw materials to produce on unit of their product. Assume
also that the desired ending inventory of raw materials is 10% of next quarter's production needs.
Also for Grassroots company, 40% of the quarter's purchases are paid for in the quarter of
purchase and the remainder are paid in the quarter following. Expected production needs in
year 2010: 1st quarter, 5,100 kilos.

1 2 3 4 Year
Units to be produced 2,080 2,820 2,980 2,770 10,650
Raw materials need per unit of product 2 2 2 2 2
Production needs in kilos 4,160 5,640 5,960 5,540 21,300
Add: Desired ending inventory of raw
materials (20% of next quarter's
production needs) 1,128 1,192 1,108 1,020 1,020
Total needs 5,288 6,832 7,068 6,560 22,320
Less: Raw materials beginning 832 1,128 1,192 1,108 832
Raw materials to be purchased 4,456 5,704 5,876 5,452 21,488
Raw materials cost per kilo 6 6 6 6 6
Cost of Raw Materials to be Purchased 26,736 34,224 35,256 32,712 128,928
I.3A Schedule of Expected Cash disbursements for Raw Materials

1 2 3 4 Year
Accounts payable, 12-31-2008 11,995 11,995
1st Quarter Purchases 10,694 16,042 26,736
2nd Quarter Purchases 13,690 20,534 34,224
3rd Quarter Purchases 14,102 21,154 35,256
4th Quarter Purchases 13,085 13,085
Total Raw Materials disbursements 22,689 29,732 34,636 34,239 121,296

I-4. Direct Labor Budget

1 2 3 4 Year
Units to be produced (Sch. I.2) 2,080 2,820 2,980 2,770 10,650
Direct labour time per unit 3 hrs. 3 hrs. 3 hrs. 3 hrs. 3 hrs.
Total direct labor hours needed 6,240 8,460 8,940 8,310 31,950
Direct labor cost per hour 5 5 5 5 5
Total direct labor cost 31,200 42,300 44,700 41,550 159,750

I.5 Manufacturing Overhead Budget

The Grassroots Company

Manufacturing Overhead Budget
For the year ended December 31, 2009
(in US Dollar)

Manufacturing Overhead Costs:

Indirect labor 26,300
Indirect materials 19,450
Maintenance 10,525
Utilities 14,900
Factory supplies 8,700
Total 79,875
Maintenance 17,500
Depreciation 14,000
Supervision 22,500
Property taxes 3,125
Insurance 5,000
Total 62,125

The predetermined overhead rate :

Total Variable Manufacturing Overhead = MOH Cost per Direct

Total Direct Labor Hour labor Hour

79,875 = 2.50/direct labor hour

Assume that cash disbursements for manufacturing overhead are estimated to be
evenly distributed over the budget period, therefore per quarter is computed as:
Variable manufacturing overhead 79,875
Fixed manufacturing overhead 62,125
Less: Depreciation 14,000 48,125
Total Cash Disbursement for MOH 128,000

128,000/4= 32,000 per quarter

I.6 Finished Goods Inventory Budget

Variable Production Cost per unit:

Item Qty. Cost Total
Raw materials 2 kilos 6.00 12.00
Direct labor 3 hours 5.00 15.00
Variable manufacturing overhead 3 hours 2.50 7.50
Budgeted Finished Goods Inventory
Sch. 1.2 250 units
Total variable production cost per unit 34.50
Total Ending Finished Goods Inventory 8,625.00

I.7 Selling and Administrative Expense Budget

Selling and Administrative Expense:

Sales Commission 14,000
Clerical 5,125
Freight out 12,500
Total 31,625
Advertising 10,000
Salaries 30,000
Insurance 4,000
Property tax 2,875
Total 46,875
Total 78,500

Cash Disbursement per quarter: 78,000 /4 = 19,625

I.8 Cash Budget

The Grassroots Company

For the year ended December 31, 2009
(in US Dollar)

1 2 3 4 Year
Cash balance, beginning 16,000 15,486 15,229 15,788 16,000
Add: Collections from customers (Sch. I.1A) 99,000 134,400 171,600 176,400 581,400
Total cash available 115,000 149,886 186,829 192,188 597,400
Less: Cash Disbursements
Direct materials (Sch. I.3A) 22,689 29,732 34,636 34,239 121,296
Direct labor (sch. I.4) 31,200 42,300 44,700 41,550 159,750
MOH (Sch. I.5) 32,000 32,000 32,000 32,000 128,000
Selling and Adm Exp (Sch. I.7) 19,625 19,625 19,625 19,625 78,500
Income Taxes (estimated) 9,000 9,000 9,000 9,000 36,000
Equipment purchases (planned) 10,000 15,000 25,000
Dividends (estimated) 3,000 3,000 3,000 3,000 12,000
Total Disbursements 117,514 145,657 157,961 139,414 560,546
Excess (Deficiency of Cash over
Disbursements) (2,514) 4,229 28,868 52,774 36,854
Borrowings (beginning) 18,000 11,000 29,000
Repayments (12,000) (17,000) (29,000)
Interest (12% per annum) (1,080) (1,740) (2,820)
Total Financing 18,000 11,000 (13,080) (18,740) (2,820)
Cash Balance, ending 15,486 15,229 15,788 34,034 34,034
I.9 Budgeted Income Statement

The Grassroots Company

Budgeted Income Statement
For the year ended December 31, 2009
(in US Dollar)

Sales 636,000
Less: Variable costs and expenses:
Variable Cost of Goods Sold (10,600 x $34.50) 365,700
Variable selling and administrative expenses 31,625 397,325
Contribution Margin 238,675
Less: Fixed cost and expenses:
Manufacturing overhead 62,125
Selling and administrative expense 46,875 109,000
Net Operating Income 129,675
Less: Interest expense 2,820
Net Income before tax 126,855
Income Tax 36,000
Net Income before tax 90,855

I-10. Budgeted Balance Sheet

The Grassroots Company

Budgeted Balance Sheet
December 31, 2009
in US Dollar)


Current Assets:
Cash (sch. 1.5) 34,034
Accounts receivable 117,600
Finished Goods (250 units @$34.50) 8,625
Raw materials (1,020 kilos @ $6.00) 6,120 166,379

Fixed Assets:
Land 50,000
Building 180,000
Accumulated Depreciation (40,000) 140,000
Equipment 25,000
Accumulated Depreciation (14,000) 11,000 201,000

Total Assets 367,379

Liabilities and Stockholders' Equity

Current Liabilities:
Accounts payable 19,627

Stockholders' Equity:
Capital Stock 200,000
Retained Earnings 147,752 347,752
Total Liabilities and Stockholders' Equity 367,379

One of the most important aspects of cost planning and control is an understanding of the behavior
patterns and influences of costs. Management analyze cost behavior in order to have a basis for
predicting how cost will respond to changes in activity levels throughout the organization. The ability
to predict costs is vital to a wide range of decision making situations.


Variable cost are those which are expected to fluctuate, in total, in proportion to sales,
production or other measures of activity. If the level of activity doubles, then the variable
costs will double as well. The most common activity bases are units produced and units

The number and type of variable costs will depend on the type of organization involved.
A few of the more commonly encountered variable cost items are:

Manufacturing firm: Merchandising Service firm

Direct materials Costs of goods sold Supplies
Direct labor Salesmen's commission Travelling
Indirect materials Delivery expenses
Utilities Utilities
Repairs and maintenance
Salesmen's commission
Freight out

The cost listed under variable manufacturing overhead should not be considered as being
inclusive. Not all variable costs behave in exactly the same pattern. All variable costs are
expected to vary with some measure of activity, though, sometimes not necessarily in
direct relationship to sales or product volume.

True variable costs-Some costs behave in true variable pattern. For example, raw materials
may be purchased in exact quantities needed and quantities used will
vary directly with production. Excess raw materials can be stored for
future use.

Cost Cost

Volume Volume
Direct materials (true variable) Clerical help (step-variable)

Step-variable costs- Example, clerical help may represent a variable cost that
increases or decreases in steps. Excess clerical help cannot be
stored for future use.
Linearity assumption

In dealing with variable costs management assumes a strictly linear relationship between
cost and volume except in the case of step-variable costs. For practical purposes, costs
do not have to vary in a strictly linear fashion to be considered variable. Many costs
which accountants classify as variable actually vary in curvilinear fashion, which economists
correctly portray as behaving differently at low and high volumes of activity. A strictly linear
relationship does not exist either at very low or very high levels of volume. The accountant
usually takes a straight line approach as he assumes that the curve is straight within the
relevant range of activity. The relevant range is the range over which volume is expected
to fluctuate during the period of time under review.



Curvilinear Costs and the Relevant Range


Fixed costs are costs which remain constant in total, within the current period regardless
of changes in the level of activity. The fixed nature of costs must always be evaluated in
relation to given conditions because all costs vary in the long-run. Fixed costs are
sometimes called capacity costs because the outlays for plant, equipment, research
facilities, advertising, and key officers are incurred by management in order to maintain
a capability for sustaining a planned volume of capacity.

Fixed costs can be divided into either committed fixed costs or discretionary fixed costs.


A mixed costs has both fixed and variable elements. The fixed element represents the
minimum cost of supplying a service which is ready and available for use and the variable
element is that portion which is made for the actual consumption of the service and
which is affected by changes in levels of activity. For purposes of planning and control,
the variable and fixed elements of mixed costs should be isolated. The analysis of mixed
costs is usually done on an aggregate basis considering the past behavior of a cost at
various levels of activity.
D. The Contribution Approach and the Traditional Approach of Income Statement

Contribution Approach Traditional approach

Sales xx Sales xx
Less: Variable Expenses xx Less: Cost of goods sold** xx
Contribution margin xx Gross Profit xx
Less: Fixed expenses xx Less: Selling and Administrative
Operating Income xx Expenses** xx
Operating Income xx

**Mixture of fixed and variable expenses

E. Cost-Volume-Profit Relationship

The study of the interrelationships of sales, costs, and net income is called cost-volume-
profit analysis. This involves the study of the interrelationship between the following
factors: prices of products, volume or level of activity, per unit variable costs, total
fixed costs, and mix of products sold.


The Jig-O Company operates a sandwich stand at the Time Square Stadium selling
hotdog sandwiches during game days. The company is now in the process of negotiating
for a lease of a sandwich stand at the Colonial Coliseum during the NBA games. The
company has determined that the following costs and prices will probably characterize
the new stand:

Selling price per sandwich $2.00 100%

Variable expenses per sandwich:
Hotdog $0.75
Sandwich bread 0.30
Mustard/tomato sauce 0.05
Commission to Colonial Coliseum 0.10 1.20 60%
Contribution margin $0.80 40%
Fixed expenses per game day:
Rental of stand 500.00
Wages for 8 employees at $37.50 300.00
Other fixed expenses 200.00
Total 1,000.00

Question: Should The Jig-O Company enter into a lease agreement with the Colonial
Coliseum? The company will have to answer certain questions before a decision
can be made.

Question No. 1. What would be the break-even-point of the company in terms of

number of units (sandwiches) sold and dollar of sales?

Break-even-point-the point of zero net income-is just a part of the cost volume-profit
concept and is often only incidental to the planning decision at hand.
Three ways to compute break-even-point:

A. The equation technique

Sales = Variable expenses + Fixed expenses + Profit

At break-even-point, profits will be zero thus, using the formula, the break-even-point
is that point where sales is just equal the total of variable expenses plus fixed expenses.

Therefore: Let X = number of sandwiches to be sold at break-even

Then $2.00X = $1.20X + $1,000 + 0
$0.80 X = $1,000 + 0
X = $1,000/$0.80
X = 1,250 sandwiches

The break-even-point dollar sales is then computed:

1,250 sandwiches x $2.00 = $2,500

Another way is using the percentage relationship if dollar relationship between variable
expenses and sales are not known.

Let X = Sales is dollar to break-even

X = .60X + $1,000 + 0
.40X = $1,000 + 0
X =$1,000/.40
X = $2,500

Sales (1,250 x $2.00) 2,500
Less: Variable expenses (2,500 x 60%) 1,500
Fixed expenses 1,000 2,500
Net profit 0

B. Unit Contribution Margin

This approach is based on the fact that every unit sold generates or provides a certain
amount of contribution margin or marginal income that goes toward the covering of
the fixed costs. The contribution margin is the excess of sales price over the variable
expenses pertaining to the unit is question:

Using the same illustration, thus:

Unit sales price $2.00

Unit variable expenses (1.20)
Unit contribution margin to fixed expenses and net profit $0.80

To find how many units must be sold to break-even the following formula is used:

Total fixed expenses = BEP in units

Unit contribution margin

Thus: $1,000
0.8 = 1,250 sandwiches

If onlt the percentage relationship between variable expenses and sales is known,
the formula can still be used to compute the break-even- point in terms of dollar
Sales price 100%
Variable expenses 60%
Contribution margin 40%

Total fixed expenses = BEP in dollar sales

Unit contribution margin ratio

40% = $2,500
C. Graphical Technique-Break-even Chart



6000 BEP (1,250 sandwiches or $2,500)





1000 Step 1 (Fixed expense

500 1000 1500

Sales Volume

F. Working With Target Net Profit Requirements

Question: If JIG-O Company needs a minimum $1,400 profits per game day, how
many sandwiches will have to be sold? Waht will the dollar sales be?

A. The cost-volume-profit equation approach

Sales = Variable expenses + Fixed expenses + Profit

Let X = number of sandwiches to be sold to realized profit of $1,400

$2.00X = $1.20 X + $1,000 + $1,400
0.80X =$1,000 + $1,400
X $2,400
X 3,000 sandwiches

Thus: 3,000 x $2.00 = $6,000 dollar sales

B. Incremental approach

Fixed Cost + Net Profit

Contribution Margin

$1,000 + $1,400
0.40 = $6,000

G. Changes in Fixed Assets

Question: If the sandwich stand is successful and the management of the

coliseum decides to double the rental cost, what will be the new break-
even-point? How many sandwiches will have to be sold to realized the
minimum desired profit of $1,400?

Sales Variable expenses + Fixed expenses + Profit

$2.00 X $1.20 + $1,500 + 0

0.80 X $1,500 + 0
X $1,500
X 1,875 sandwiches

Therefore: 1,875 sandwiches x $2.00 = $ 3, break-even dollar sales

To maintain the desired minimum profit of $1,400:

Sales Variable expenses + Fixed expenses + Profit

$2.00 X $1.20 + $1,500 + $1,400

0.80 X $2,900
X $2,900
X 3,625 sandwiches

H. Change in Variable Cost or Change in Contribution Margin

Question: Assuming the original data, if the cost of bread doubles, what will be the effect
on the break-even-point in number of sandwiches sold? How many sandwiches
will have to be sold to realized the desired profit of $1,400.

Selling price per sandwich $2.00 100%

Variable expenses per sandwich:
Hotdog $0.75
Sandwich bread 0.60
Mustard/tomato sauce 0.05
Commission to Colonial Coliseum 0.10 1.50 75%
Contribution margin $0.50 25%
Fixed expenses per game day:
Rental of stand 500.00
Wages for 8 employees at $37.50 300.00
Other fixed expenses 200.00
Total 1,000.00

Thus: Break-even-point in units

0.50 = 2,000 sandwiches

Break-even-point in dollar sales

25% = $4,000

To generate profit of $1,400:

$1,000 + $1,400
0.50 = 4,800 sandwiches

$1,000 + $1,400 Dollar

25% = $9,600 sales
-even Chart

Step 3 (Total sales revenue)

dwiches or $2,500)

Step 2 (total expenses)

ep 1 (Fixed expenses)

2000 2500 3000 3500

ales Volume

The accountant prepares accounting reports for the benefit of both management and non-management
groups. In order to make these reports more meaningful they should be analyzed and interpreted.
Financial statements analysis refers to the quantitative and qualitative evaluation of information
contained on the reports. It is a process of selection, relation, and evaluation.

Financial statement analysis stresses a broader investigation of the liquidity, profitability and stability
of a company.

A. Liquidity or short-term solvency refers to a company's ability to meet current obligation when they
fall due. This is of primary interest to short-term creditors.

B. Profitability is measured by the success of a business in maintaining a satisfactory dividend

policy while at the same time being able to show a steadily increasing ownership equity.

C. Stability refers to a company's ability to meet interest and principal on long-term obligations
when they fall due and also the company's ability to pay dividends to stockholders regularly.

The proper analysis of data appearing on the financial reports will:

1 Enable the management to control operations more effectively and to judge the efficiency of the
performance and soundness of the financial condition of the business.

2 Furnish creditors with information required in establishing a credit rating.

3 Make available information to investors to determine whether the investment should be

continued, disposed of, or increased.

4 Provide others with financial and operating data for general purposes.

This refers to development of percentages or ratios indicating the proportionate change in the
same item from period to period.

Comparative Balance Sheet
December 31, 2007 and December 31, 2008
Increase (Decrease)
Assets 2008 2007 Amount %

Current assets:
Cash 500,000 1,285,000 (785,000) -61.09%
Accounts receivable (net) 3,000,000 2,000,000 1,000,000 50.00%
Inventory 4,000,000 5,000,000 (1,000,000) -20.00%
Prepaid expense 250,000 100,000 150,000 150.00%
Total Current Assets 7,750,000 8,385,000 (635,000) -7.57%

Plant, Property and Equipment

Land 2,000,000 2,000,000 0 0.00%
Building & Equipment 4,750,000 3,000,000 1,750,000 58.33%
Total Plant, Property & Equipment 6,750,000 5,000,000 1,750,000 35.00%

Total Assets 14,500,000 13,385,000 1,115,000 8.33%


Current liabilities:
Accounts payable 3,000,000 2,100,000 900,000 42.86%
Accrued expenses payable 250,000 150,000 100,000 66.67%
Bonds payable (current portion) 250,000 250,000 0 0.00%
Total Current Liabilities 3,500,000 2,500,000 1,000,000 40.00%

Long-Term liabilities
Bonds payable (5%) 3,750,000 4,000,000 (250,000) -6.25%

Total Liabilities 7,250,000 6,500,000 750,000 11.54%

Stockholders' Equity

Paid-in capital
Preferred stock, $100 par, 6%, $110 liquidation value 1,000,000 1,000,000 0 0.00%
Common stock, $10 par 3,000,000 3,000,000 0 0.00%
Additional paid-in capital 500,000 500,000 0 0.00%
Total paid-in capital 4,500,000 4,500,000 0 0.00%

Retained earnings 2,750,000 2,385,000 365,000 15.30%

Total Stockholders' Equity 7,250,000 6,885,000 365,000 5.30%

Total Liabilities and Stockholders' Equity 14,500,000 13,385,000 1,115,000 8.33%


Vertical analysis involves the expression of each item on a particular statement as a percent or ratio of one specific
item which is referred to as the base.

Comparative Balance Sheet
December 31, 2007 and December 31, 2008
Assets 2008 2007 2008 2007

Current assets:
Cash 500,000 1,285,000 3.45% 9.60%
Accounts receivable (net) 3,000,000 2,000,000 20.69% 14.94%
Inventory 4,000,000 5,000,000 27.59% 37.36%
Prepaid expense 250,000 100,000 1.72% 0.75%
Total Current Assets 7,750,000 8,385,000 53.45% 62.64%

Plant, Property and Equipment

Land 2,000,000 2,000,000 13.79% 14.94%
Building & Equipment 4,750,000 3,000,000 32.76% 22.41%
Total Plant, Property & Equipment 6,750,000 5,000,000 46.55% 37.36%

Total Assets 14,500,000 13,385,000 100.00% 100.00%


Current liabilities:
Accounts payable 3,000,000 2,100,000 20.69% 15.69%
Accrued expenses payable 250,000 150,000 1.72% 1.12%
Bonds payable (current portion) 250,000 250,000 1.72% 1.87%
Total Current Liabilities 3,500,000 2,500,000 24.14% 18.68%

Long-Term liabilities
Bonds payable (5%) 3,750,000 4,000,000 25.86% 29.88%

Total Liabilities 7,250,000 6,500,000 50.00% 48.56%

Stockholders' Equity

Paid-in capital
Preferred stock, $100 par, 6%, $110 liquidation value 1,000,000 1,000,000 6.90% 7.47%
Common stock, $10 par 3,000,000 3,000,000 20.69% 22.41%
Additional paid-in capital 500,000 500,000 3.45% 3.74%
Total paid-in capital 4,500,000 4,500,000 31.03% 33.62%

Retained earnings 2,750,000 2,385,000 18.97% 17.82%

Total Stockholders' Equity 7,250,000 6,885,000 50.00% 51.44%

Total Liabilities and Stockholders' Equity 14,500,000 13,385,000 100.00% 100.00%

Comparative Income Statement
For the year ended Dec. 31, 2008 and Dec. 31, 2009
2008 2007 2008 2007
Sales 26,000,000 24,000,000 100.00% 100.00%
Cost of goods sold 18,000,000 15,750,000 69.23% 65.63%
Gross Margin 8,000,000 8,250,000 30.77% 34.38%
Operating expenses:
Selling expenses 3,500,000 3,250,000 13.46% 13.54%
Administrative expenses 2,500,000 2,600,000 9.62% 10.83%
Total operating expenses 6,000,000 5,850,000 23.08% 24.38%
Net income from operation 2,000,000 2,400,000 7.69% 10.00%
Interest expense 187,500 200,000 0.72% 0.83%
Net income before tax 1,812,500 2,200,000 6.97% 9.17%
income tax 1,087,500 1,320,000 4.18% 5.50%
Net income 725,000 880,000 2.79% 3.67%


A. Liquidity or Debt Paying Ratio Analysis

1 Current Ratio
2008 2007
Current Assets 7,750,000 8,385,000
Current Liabilities 3,500,000 2,500,000

= 2.21 : 1 3.35 : 1

Its purpose is to measure the firm's debt paying ability within the near future, generally, one
year from date of computation.

2 Quick Asset or Acid Test Ratio

2008 2007
Cash + MS + AR 3,500,000 3,285,000
Current Liabilities 3,500,000 2,500,000

= 1.00 : 1 1.31 : 1

An even finer measure or a more severe test of a company's ability to meet current debts.

3 Current Debt to Inventory

2008 2007
Current Liabilities 3,500,000 2,500,000
Inventory 4,000,000 5,000,000

= 0.88 : 1 0.50 : 1

This ratio indicates the extent to which a company relies on its inventory as a source of funds to meet
its current debts.

B. Productivity of Working Capital

1 Inventory Turnover

Cost of Good Sold 18,000,000

Average Inventory 4,500,000 = 4 times

365 365
Inventory Turnover 4 = 91.25 days to sell
entire inventory
This measures the effectiveness of inventory management. It indicates how many times the
average inventory has been replenished.

2 Net Sales to Inventory

Net sales 26,000,000

Average Inventory 4,500,000

= 5.78 : 1

This ratio indicates the dollar sales produced from the average inventory.

3 Receivable Turnover

Sales 26,000,000
Average Receivables 2,500,000 = 10.40 times

365 365
AR Turnover 10 = 35.10 days

This is used in determining and evaluating the relative collectability of the accounts receivable.
the ratio provides a rough gauge as to how well receivables are turning into cash.

C. Profitability

1 Net Profit to Sales

2008 2007
Net Income 725,000 880,000
Net sales 26,000,000 24,000,000

= 2.79% = 3.67%

This is one measurement that can be read directly from the commonsized income statement. The
purpose of sales is to earn profits. The ratio indicates how well management is achieving this

2 Net Profit to Net Working Capital

2008 2007
Net Income 725,000 880,000
Net working Capital 4,250,000 5,885,000

= 17.06% = 14.95%

Working capital is equal to Current Assets less Current Liabilities. This ratio help to measure how
effectively the working capital is being utilized.

3 Return on total Assets

Net Income + Interest 912,500

Average total Assets 13,942,500

= 6.54%

This measures a company's general earning power. It measures the use of assets without
considering whether the assets were financed by contributes or borrowed funds.

4 Return on common Stockholders' Equity

Net Income - PS Dividend 665,000

Common Stockholders' Equity 6,250,000
(Total SHE-Preferred Stock)
= 10.64%
This is one of the measurements designed to indicate the profitability of the business to the
owners. It relates current profits to the book value of the stock.

D. Stability or Balance of Equity Structure

1 Debt to Equity Ratio

2008 2007
Total Liabilities 7,250,000 6,500,000
Total Stockholders' Equity 7,250,000 6,885,000

= 1.00 : 1 0.94 : 1

The debt to equity ratio shows what extent the company is levered. The computation attempts to
measure the relative proportion of total assets supplied respectively by the owners and creditors.

2 Times Interest Charges Earned

Income before interest + Income tax 2,000,000

Interest Expense 187,500 = 10.67 times

This is the most common measure of the ability of a firm's operation to provide protection of the
long-term creditors. The purpose of this ratio is to measure the extent of cushion available to
the funded debt in case future earnings do not meet expectations.