Accounting Theory Flashcards
What are the characteristics of financial accounting?
- For external users (shareholders, government)
- Purpose: legal, stewardship and economic decision-making
- Prepared periodically (once a year in annual report or interim-based if public company (every 3 or 6 months)
- Historical data (from transactions and past events)
- Composes of financial information
- Regulated by local and international accounting standards
What are the characteristics of management accounting?
- For internal users (directors, managers, stewards, employees)
- Purpose: plan, monitor and control business activites
- Prepared frequently when needed (monthly and daily information)
- Future-oriented information (forecasts and budgets)
- Comprises of non-financial information (quantity of product sold or customer complaints)
- Unregulated (can produce whatever information is required subject to available data and tech)
What are the qualitative accounting characteristics?
- Relevance
- Reliability
- Comparability
- Understandability
What are the accounting boundary rules?
Determines what should/should not be reported in financial statements
1. Entity
2. Periodicity
3. Going concern
What are the accounting recording rules?
Determines how and when data should be recorded
1. Money measurement
2. Cost
3. Realisation
4. Accruals
5. Matching
6. Duality -> 2 effects from any economic event (every transaction has 2 effects)
7. Materiality
What are the accounting ethical rules?
Limits room for data manipulation to mislead users
1. Prudence
2. Consistency
3. Objectivity
What are the types of main books of prime entries?
- Cash book
- Sales day book
- Purchases day book
What are the types of ledgers?
- Sales (or receivables) ledger
- Purchases (or payables) ledger
What are the types of entities?
- Sole trader
-unlimited liability
-taxed personally for profits earned - Partnership
-unlimited liability - Limited Liability Company
+separate legal entity
+pay corporation tax
+easier to raise finance
-rigid rules and regulations that must be complied to -> costs money and time
-business information becomes public information
-loss of control/ownership to shareholders
-dividend payment restrictions to protect creditors - Limited Liability Partnership
- Public
+traded on stock exchange -> easier to raise finance
Why do companies issue shares?
To raise finance
What are the factors that directors consider to determine ordinary dividends proposal?
- Legal position (dividends can only be paid from cumulatiev retained profits)
- Availability of cash or agreement by bank for overdraft
- Investment opportunities available to company (if projects are appealing, should pay lower dividend and use money to invest into project instead, vice versa)
- Consistency with dividend policy (shareholders either like large portion of profit to be used as dividend payout or prefer to retain profit for company’s growth)
- Dividend paid signals stock market regarding company’s confidence in prospects (cut in dividend may indicate retrenchment, increasing it indicates director’s confidence in company’s future)
What are the usages of a cash flow statement?
- Assess ability of company to generate cash to operate (pay wages, invoices, tax and repay loans)
- Understand cash inflow (from where) /outflows (spent on what)
- Shows information not found in SFP and IS (accrual-based financial statements) like investment (capital expenditure) and financing activities
- Explains change in cash from 1 SFP to the next
- Reveals cash effect of working capital movement (e.g. if trade payables increase, cash increases now but may lead to future issues)
- Shows quality of profits in the operating activities section (EBITDA vs net cash flow operations)
- Assess solvency and liquidity of firm
- Indicates future expansion
- Inaffected by accounting policies -> more objective relative to income statement
What is overtrading?
When a business makes a profit but runs out of cash
When a business expands its operations too fast, eventually running out of cash and/or working capital
Common for start-ups or rapidly-growing firms
What is a budget?
A forecast showing the effect of company-objective-oriented actions and expected future events on parts of the financial statements
What is lack of goal congruence?
Where different managers or divisions of the organisation have differing objectives
The organisation’s strategic objectives are unaligned with its overall goals
What are the 5 main functions of management?
- Planning (strategic decision-making and budget) -> C16 & 17 and Decision-making -> C14 (costing methods), 15 (Short-term/operating decisions), 18, 19 (Long-term)
- Coordination (ensure differing parts of organisation perform activities in correct order at the correct time)
- Control (compare plan vs actual activities to find deviations and correct it),
- Communication (w/ other managers and employees working in differing areas of the business)
- Motivation (involvement of staff in planning can motivate them to achieve it)
Management accounting reports
- Budget
- Break-even analysis
- Future project appraisal
What are the characteristics of management accounting reports?
- Subjective (based on forecasted activity levels, costs and benefits in the future)
- Unverifiable (cannot be verified before the event/project takes place)
Fixed costs
- doesn’t change when production output level changes
e.g. factory rental, administrative, heating & lighting, and supervisor salary - expressed with time periods (e.g. rent charged monthly/quarterly/yearly)
Variable costs
- varies when production output level changes
e.g. raw materials to manufacture, hourly or unit-basis labour, electricity to run machinery - expressed with units of quantity (e.g. weight/volume of material)
Direct costs
Associated with individual cost units
e.g. cost of material & labour, department manager salary in running their respective department
Indirect costs
Not directly associated with individual cost units
e.g. factory rent, heating & lighting, department manager salary in running the whole firm
Types of cost behaviour relative to production output
- Fixed costs
- Stepped costs (more units produced, more workers, hence need more catering staff in factory canteen)
- Variable costs
- Semi-variable costs (e.g. telephone, electricity)
- Fixed costs with an upturn (factor supervisor that has fixed salary + overtime)
Marginal Costing
Only includes direct costs in valuating inventory
Marginal cost = Total variable cost per output
VC e.g. material per kg and labour costs per hour
Indirect costs: rental and clerk salary
Fixed production overhead fully charged against profit in period where goods are PRODUCED (regardless of when actually sold) bc indirect costs aren’t included in inventory valuation
Full costing (Total Absorption Costing)
= Direct costs + indirect costs
Indirect costs are absorbed into individual unit costs (through splitting cost up relative to production)
Fixed production overhead carried forward in closing inventory value and charged against profit when goods are SOLD
Traditional Total Absorption Costing
Treats indirect costs based on business organisational structure Apportionment: Incurred by all departments
Absorption: Incurred by departments purely in production
Reapportionment: Service departments costs that help production departments to function can be included in product costs
Other departments (marketing, finance, other central administration functions) aren’t included in the product costs
Total indirect costs = production + production-related service departments
Grand total indirect costs per production department: absorbed into unit costs (usually using direct labour hours)
What factors should be considered when choosing full vs marginal costing?
- Full costing: more subjective -> vulnerable to misstatement/manipulation
- Pricing using full cost calculation should enable profit
- Assuming prices: stead, Marginal costing more useful for short-term decisions bc it gives approximate replacement cost (economics short-run marginal cost)
- Marginal costing results in lower valuation of inventory and net assets of SFP
- Gross profit differs under marginal costing (affected by lower inventory valuation) vs ful costing
- Regulations (full costing required for financial reporting in certain countries)
What is the criteria to allocate costs?
- Reflect cause & effect relationship (e.g. the more floor space required, the more allocated rent)
- Reflect benefits received (e.g. clerk’s salary apportioned among departments that receive their service)
- Fair and equitable application among departments, considering cost absorption ability
Why do we absorb the indirect overheads into a production unit?
- To understand full cost of producing 1 unit
- To price the unit of aforementioned product
What are the advantages of using marginal costing?
1.Decide to continue/discontinue
2. Decide make/buy
3. Decide pricing
4. Identify minimum activity level (break-even analysis)
5. Routine control
6. Translate strategic targets (profit) to operational target (sales volume)
Short-term decision-making
- Volume of output production
- Decide make/buy components (material)
- Accept/reject customer contract
Long-term decision-making
- Investing in new business projects
Cost-Volume-Profit Analysis
Level of output to achieve target profit level
Observe effects of changing costs or sales price
Relationship btwn (1) costs (2) revenues (3) output levels
Relies on fixed (doesn’t vary with output) vs variable costs (varies directly with otput)
Break-even Point (BEP) Analysis
Level of activity/output (units) where
TR = TC AKA Profit = 0
or use total contribution = total fixed costs:
(SP - VC) = TFC
CVP Limitations
- Assumptions about cost and revenue behaviour before applying analysis are unrealistic -& limited to situations where assumptions hold
- Realistically many costs combine fixed and variable elements
- Limited to particular range of output levels considered
- Only valid for time period cost behaviour is classified in
Cost and Revenue Behaviour Assumptions
- Cost & revenue patterns: known with certainty
- cost: classified as either fixed OR variable
- Cost & revenue: linear over range of output considered
-> constant TFC
-> constant VC per output unit
-> constant SP per output unit - Volume: sole factor affecting COSTS
- There’s a single product or constant product mix
- ALL output is sold
If BEP output x unknown
BEP units x = TFC/(SP-VC)
e.g. 1,000 bicycles sold @ 100/unit, VC @ $60/unit, TFC @ 16,000
16,000/$40 = 400 bicycles to break-even
If BEP revenue unknown
BEP units x Revenue per unit 2
e.g. BEP units @ 400, revenue per bike @ $100
400 x $100 = $40,000
or use contribution margin ratio
contribution per unit / revenue per unit
= (100-60) / 100 = 0.4
then TFC x CMR = BEP revenue
Total Contribution
Contribution per unit x No. of units (x)
Contribution per unit
Selling Price (or revenue per unit) - Variable Cost
Contribution margin ratio (CMR)
Contribution per unit (SP-VC) / Revenue per unit = 0.x
Then BEP Revenue: TFC/CMR
Target Profit using BEP
TR = TFC + TVC + Target Profit
Total Contribution (TR-TVC*units) = TFC + Target Profit
So then BEP units = (TFC + Target Profit)/Contribution per unit
BEP revenue = BEP units x Revenue per unit
Margin of safety
(Expected Sales - BEP Sales) or (Expected Output - BEP Output)
Margin of Safety ratio
Margin of safety / Expected X = x%
Interpretation: output has to fall by x% before firm makes a monthly loss
Relevant Costs for Short-term Decisions
(1) Have not been incurred yet (2) differs when alternatives are considered
Units x $Cost per unit + Incremental Cost(s) + Opportunity Cost(s) = $x
Key feature of relevant costs
Future incremental cash flows
Implicates relevant costs
-> arise in FUTURE (cash hasnt changed hands)
=/ sunk cost (market research to compare product demand)
-> incremental (changes decision made)
=/ committed cost (CEO salary and fixed costs)
-> cash flows (not purely accounting flow)
=/ pure accounting flow cost (depreciation)
Opportunity Cost
Relevant
Value of next-best opportunity foregone
e.g. Using machine to produce Good A, opportunity cost is producing good B and C (take highest value)
e.g. using funds to buy MD new car, opportunity cost is improving staff catering facilities (not immediately quantifiable, you lose employee goodwill over time)
If have Limiting Factors
Shortage of labour, material, equipment and/or factory space
Also can’t sell unlimited output without reducing price (bc of sales demand)
e.g. Strawberry costs 60p per portion
Mixed fruit jam needs 0.3 strawberries, so can make 1 jar using half of strawberry portion (0.5)
So contribution becomes 0.60 per portion (higher than the strawberry jams that need more strawberry to produce)
So if there’s only 500 strawberry portions, make 1000 mixed fruit jam (total contribution: $300) rather than 250 strawberry deluxe (total contribution: $175)
Multiple limtiing factors (selling quantity)
See next best use of remaining portion (next highest total contribution)
Fixed and variables costs in long-run
FC and VC varies in the long-run because production capacity can change in LR (FC can be scaled up or sold off)
Allocate by distributing among individual products (full absorption costing)
Marginal Cost Analysis
Incremental costs required to produce output
Remove (1) fixed costs as they aren’t affected whether we produce or not and (2) sunk costs as they have already been incurred
Decision: proceed if marginal/incremental revenue > marginal/incremental cost -> short-term profit
Pricing strategy: if transitioning from 1 product to another, set old product at a discount to maintain customer relations
