Concepts in The Measurement of Income, The Price Level Problem, and Basic Concepts of Management Control

I.
INTRODUCTION In any business, measurement of the performance is necessary to determine the status
of the business, to have a guide for future investment, to determine how much profit has been earned, and to measure the overall efficiency and credit worthiness of the business. Prior to the development of large-scale enterprises, if a measure of performance was needed, it was not uncommon for it to be arrived at by valuing assets and liabilities directly, computing the net asset position at two different dates and comparing one with the other to arrive at income. The emergence of large-scale enterprises in the nineteenth century, and the consequent separation of ownership and management control, created a need for financial statements for the purpose of accountability in order to ensure that managers rendered a reliable report of their activities to owners. If a measure of performance was needed, accounting focused on tracking the cost of resources obtained and used by the enterprise and on matching cost with the revenue realized by the enterprise through time to arrive at income. t some point of its business life, it e!periences changes in prices due to the varying value of money from time to time as a result in the general level of prices. Price of goods and services change over the time. The change in price as a result of various economic and social forces brings about a change in the purchasing power of money. In effect, the forecasted income changes especially when the time of forecasting the income has a relatively large gap of realizing it.
"oncepts in the #easurement of Income, The Price $evel Problem, nd %asic "oncepts of #anagement "ontrol& A Term Paper in Management Accounting
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'hile the measurement of business( performance is necessary and the ad)ustment due to different price levels, so as management control is necessary to address these and to assure that resources are obtained and used effectively and efficiently in the accomplishment of the company(s ob)ectives. II. CONCEPTS IN THE MEASUREMENT OF INCOME n accounting for income is not merely a question of reporting in a different format but involves issues of recognition and measurement. The recognition, measurement and reporting of income depends on the construction of an accounting theory and is important for the use of accounting information. A. Objectives The measurement of income is useful for more than one purpose and therefore its ob)ectives may be studied from different points of view& 1. As a guide to utu!e i"vest#e"t The current income positively influences the e!pectations about the future. The prospective investor looks to the income of the business enterprise as a guide to his investments decisions of the future. The investors attempt to ma!imize their returns on their investments and their decisions will be guided by income. *o the allocation of investment funds and selections of securities depend upon income levels of an enterprise. $. As a ta% base
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Though the Income Ta!
ct does not define yet it does specify what is ccounting
ta!able and what is deductible in arriving at the ta!able income.
income provides income of a business enterprise. The ta! authorities can conveniently mobilize the revenues through ta!es which are one of the main sources of the +overnment(s income. &. As a guide to divide"d 'o(ic) The dividend policy at present is directed to determine the proportion of the current income which should be retained and the proportion which should be distributed as dividends. *o long as dividends are aid out of current income, the rights of the creditors are adequately protected since other resources of the business enterprise would not be used to pay dividends. There are clear rules for measurement of distributable profits in the "ompanies the interests of the creditors. ct with a view to protect
*. As a" i"dicato! o #a"age!ia( e icie"c) The efficiency of management as decision makers and as trustees of resources is )udged by the reported income of the current year. The auditors therefore certify that the income statement presents true and fair view of operational results. The measurement of business income therefore provides a suitable criterion for the efficiency of management in a competitive economy. +. As a #easu!e o ove!a(( e icie"c) a"d c!edit ,o!t-i"ess
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Income is the lifeblood of any business enterprise and therefore it provides that basic standard by which the overall efficiency of the business is assessed. ,or creditors, profitable enterprise faces no difficulty in making timely payment on its debts. %anks and other credit institutions too depend upon current income levels as a guide about a firm(s ability to repay loan out of future income. .. As a guide to socio/eco"o#ic decisio"s number of decisions affecting the society and economy as a whole are taken keeping in mind the level of business income. ,or instance, price increases are )ustified in terms of income levels. Trade unions demand more wages for their employees on the basis of reported income and employers too plead that increase in wages would have adverse effects of the income. The economic policies of the +overnment are also guided by levels of business income since it constitutes a ma)or source of ta! revenues. 0. T-e Acc!ua( Co"ce'ts Income arises from operating events that increase owners( equity, and only from such events. The sale of merchandise at a profit is one such event. In understanding how this profit came about, consider two aspects of this event separately& merchandise sold for -.// would decrease inventory by -0//. If we look at the -.// only, we see an increase in asset and a corresponding increase in owner(s equity. The -0//, taken by itself, is a decrease in the asset, inventory, and a corresponding decrease in owner(s equity. These are the two
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aspects that illustrate the two ways in which business operations can affect owners( equity& they can increase it, or they can decrease it. This concept is also known as the accrual theory of accounting or accrual accounting. This concept applies equally to revenues and e!penses. In the accrual basis of accounting, revenue is recognized when it is realized, that is, when the sale is complete or not. %usiness transactions are recorded when they occur and not when the related payments are received or made. ccording to accrual concept, e!penses incurred and revenue earned
during the accounting period should be recorded in the same period of accounts regardless of the actual receipt of payment of cash. n accrual is a )ournal entry that is used to recognize revenues and e!penses that have been earned or consumed, respectively, and for which the related cash amounts have not yet been received or paid out. ccruals are needed to ensure
that all revenue and e!pense elements are recognized within the correct reporting period, irrespective of the timing of related cash flows. 'ithout accruals, the amount of revenue, e!pense, and profit or loss in a period will not necessarily reflect the actual level of economic activity within a business. ccruals are a key part of the closing process used to create
financial statements under the accrual basis of accounting1 without accruals, financial statements are considerably less accurate. C. T-e Rea(i1atio" Co"ce't basic accounting concept is that revenue is considered as being earned on the date at which it is realized; that is, on the date when goods or services are furnished to the customer in e!change for cash or some other valuable consideration. ,or services, revenue is
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recognized in the period in which the service is rendered. ,or tangible products, revenue is recognized not when a sales order is received, not when a contract is signed, not when the goods are manufactured, but rather when the product is shipped or delivered to the customer. There is no ob)ective way of measuring how much profit is created during the manufacturing process. The outcome of the whole process is known with reasonable
certainty only when the buyer and seller have agreed on a price and the goods have been delivered. lso, at this time there is usually an invoice, a cash register record, or some other
tangible evidence as to the revenue arising from the transaction 2 evidence that permits the facts to be verified by some outside party.
III.
THE PRICE 2E3E2 PRO02EM The power of monetary unit of measurement is different at different times. balance
sheet prepared at one moment of time contains some items, such as cash, that are stated at current purchasing power1 other items such as inventory that may be stated in monetary units that reflect purchasing power of recent past1 and still other items, such as plants and equipment, stated amounts that reflect purchasing power of several years previous to current date. To deal this problem, several proposals have been advanced and these are1 The $I,3 #ethod, The ,I,3 #ethod and The average cost method.
A. T-e 2IFO Met-od
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$ast in, first out method. 4nder the $I,3 method, you are assuming that items bought last are sold first, which also means that the items still in stock are the oldest ones. This policy does not follow the natural flow of inventory in most companies1 in fact, the method is banned under International ,inancial 5eporting *tandards. In periods of rising prices, assuming that the last units bought are the first ones used also means that the cost of goods sold tends to be higher, which therefore leads to a lower amount of operating earnings, and fewer income ta!es paid. 0. T-e FIFO Met-od ,irst In, ,irst 3ut. 4nder the ,I,3 method, you are assuming that items bought first are also used or sold first, which also means that the items still in stock are the newest ones. This policy closely matches the actual movement of inventory in most companies, and so is preferable simply from a theoretical perspective. In periods of rising prices 6which is most of the time in most economies7, assuming that the earliest units bought are the first ones used also means that the least e!pensive units are charged to the cost of goods sold first. This means that the cost of goods sold tends to be lower, which therefore leads to a higher amount of operating earnings, and more income ta!es paid. C. 2IFO/FIFO Co#'a!iso" Issue Materials flow FIFO Met-od In most businesses, the actual flow of materials follows ,I,3, which makes this a logical choice. 2IFO Met-od There are few businesses where the oldest items are kept in stock while newer items are sold first.
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Inflation
If costs are increasing, the first items sold are the least e!pensive, so your cost of goods sold decreases, you report more profits, and therefore pay a larger amount of income ta!es in the near term. If costs are decreasing, the first items sold are the most e!pensive, so your cost of goods sold increases, you report fewer profits, and therefore pay a smaller amount of income ta!es in the near term. There are no + P or I,5* restrictions on the use of ,I,3 in reporting financial results.
If costs are increasing, the last items sold are the most e!pensive, so your cost of goods sold increases, you report fewer profits, and therefore pay a smaller amount of income ta!es in the near term. If costs are decreasing, the last items sold are the least e!pensive, so your cost of goods sold decreases, you report more profits, and therefore pay a larger amount of income ta!es in the near term.
Deflation
Financial reporting
Record keeping
I,5* does not all the use of the $I,3 method at all. The I5* allows the use of $I,3, but if you use it for any subsidiary, you must also use it for all parts of the reporting entity. There are usually more inventory layers to There are usually fewer inventory layers to track in a $I,3 system, since the oldest layers track in a ,I,3 system, since the oldest can potentially remain in the system for years. layers are continually used up. This This increases record keeping. reduces record keeping.
Reporting fluctuations
*ince there are few inventory layers, and those layers reflect recent pricing, there are rarely any unusual spikes or drops in the cost of goods sold that are caused by accessing old inventory layers.
There may be many inventory layers, some with costs from a number of years ago. If one of these layers is accessed, it can result in a dramatic increase or decrease in the reported amount of cost of goods sold.
D. T-e Ave!age Cost Met-od 4sing the weighted average method, you divide the cost of goods available for sale by the number of units available for sale, which yields the weighted-average cost per unit. The cost of goods available for sale is the sum of beginning inventory and net purchases. 'eighted-average figure to assign a cost to both ending inventory and the cost of goods sold.
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Weighted average costing is commonly used in situations where: Inventory items are so intermingled that it is impossible to assign a specific cost to an individual unit. The accounting system is not sufficiently sophisticated to track ,I,3 or $I,3 inventory layers. Inventory items are so commoditized 6i.e., identical to each other7 that there is no way to assign a cost to an individual unit.
I3.
MANA4EMENT CONTRO2 #anagement controls may be briefly defined as the organisation, policies, and procedures
used to help ensure that government programmes achieve their intended results1 that the resources used to deliver these programmes are consistent with the stated aims and ob)ectives of the organisations concerned1 that programmes are protected from waste, fraud and mismanagement1 and that reliable and timely information is obtained, maintained, reported, and used for decision making. ,or instance, some companies have used responsibility centers to e!tend its control over its operation in different division of the company. These responsibilities are as follows&
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A. E%'e"se Ce"te!s If the control system measures the e!penses incurred by an organization unit, but does not measure the monetary value of its output, the unit is an expense center. lthough every organization unit has an output, in many cases it is neither feasible nor necessary to measure this output in monetary terms. Thus, most individual production departments and most staff units are e!pense centers. ,or these, the accounting system records e!penses incurred, but not revenue earned. 0. P!o it Ce"te!s 5evenue is a monetary measure of output, and e!pense is a monetary measure of inputs, or resources consumed. Profit is the difference between revenue and e!pense. Thus if performance in a responsibility center is measured in terms of both the revenue it earns and the cost it incurs, it is called a profit center. lthough in financial accounting,
revenue is considered only when it is realized, in management accounting it is quite all right to define revenue as the output of the center, whether realized or not. Thus, the factory may be a profit center, 8selling9 its production to the sales department. The profit center concept is a powerful one. If properly operated, it has the effect of 8putting the supervisor in business for himself,9 a business in which he can earn a profit. The development of this concept is one of the factors that has made possible he tendency for large companies to decentralize.
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C. I"vest#e"t Ce"te!s The ultimate e!tension of the responsibility center idea is the investment center, in which the supervisor is responsible, not only for the profits, but also for the assets that he uses. The investment center idea is not yet widely adopted and is usually restricted to large units, such as the several divisions of a company making a variety of products. ,urthermore, the management must consider the following to assure cost control will be effective in its implementation in the company& a. ,or all important activities, detailed work breakdown structures with
e!plicit operational milestones have to be applied. They must be used as the standard basis for a daily communication process. b. The detailed inputs for all the work packages should be provided by the
responsible engineer or group leader, to ensure a bottom-up planning and information updating process. c. The operational work breakdown structures should be automatically
combined with the financial management tools 6in particular the financial accounting software system7. %oth parts have to be set up in a bottom-up:topdown process, where the assigned engineers or technical group leaders feed in technical information, which is then combined with the financial data and updated
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on a short time basis 6e.g. weekly7. This integrated tool must show the planned and actual, weekly updated data and any deviations. ,inally, these reports have to be approved by the upper management levels in the top-down process to ensure consistency across the whole pro)ect. d. ll these data should be integrated and aggregated into a management
information system, which provides the decision makers with up-to-the-minute data and comprehensive cost and risk information.
culture of openness, transparency and trust, in which problems can be communicated as soon as possible without a rush to )udgement, is essential. This should be accompanied by an attitude of developing and proposing countermeasures in parallel to the decision-making boards for optimal outcomes a collaborative environment needs to be fostered, in which activity is directed towards achieving delivery on time, to required specifications and on budget. This culture of openness should e!tend across the whole pro)ect and during all pro)ect phases, to the use, e!change and regular updating of all relevant data 6planned and actual7 on a detailed and timely basis. "ultural differences between the different partners, in particular with respect to terminology, processes and practices, need to be identified and addressed from the outset with openness 6and sensitivity7 in order to minimise misunderstandings. In collaborations with e!ternal industry the same transparent controlling and reporting systems must be applied as internally. The management must be able to get access to all relevant information whenever it appears necessary
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0ib(iog!a'-) #iller, Peter 6;<<=7. 8The #argins of ccounting,9 European Accounting Review >, no. ?. Potter, %radley 63ctober 0//@7. 8 ccounting as a *ocial and Institutional Practice& Perspectives to Anrich our 4nderstanding of ccounting "hange,9 A acus, 0B@C0=<. 5ichardson, lan D. 6Eecember 0//07. 8Professional Eominance& The 5elationship %etween ,inancial ccounting and #anagerial ccounting, ;<0BC;<=B,9 Accounting !istorians "ournal, <;C;0;. 5osenfield, Paul 6Dune 0//.7. 8Presenting Eiscounted ,uture "ash 5eceipts and Payments in ,inancial *tatements,9 A acus, 0..C0?<. 'eber, +.,. F;<B/G, HPrice $evel ccountingI, The ccounting 5eview .@, B?;-B?<.
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Joung, . . F;<0=G, HIncreasing 5eturns and Aconomic ProgressI, The Aconomic Dournal .=, @0>-@?0. Joung, K.P. 6ed.7, F;<=@G, "ost llocation& #ethods Principles, pplications, msterdam& Lorth-Kolland. Joung, K.P. F;<<?G, H"ost llocationI, pp. ;;<.-;0.@ in Kandbook of +ame Theory, Molume 0, 5.D. umann and *. Kart 6eds.7, msterdam& Alsevier. Kaig, 5.#. 6;<@<7, 8The "oncept of Income& Aconomic and $egal spects9, pp. @?->B in Readings in t#e Economics of $axation, 5. . #usgrave and ".*. *houp 6eds.7, Komewoo %erentsen, leksander, and "hristopher 'aller. 60/;;7 8Price-$evel Targeting and *tabilization Policy.9 "ournal of Mone%& 'redit and (anking, ?.6>, *uppl.7, @@<C=/.
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Concepts in The Measurement of Income, The Price Level Problem, and Basic Concepts of Management Control

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Concepts in The Measurement of Income, The Price Level Problem, and Basic Concepts of Management Control

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I.

Though the Income Ta!

ct does not define yet it does specify what is ccounting

ta!able and what is deductible in arriving at the ta!able income.

A. T-e 2IFO Met-od

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