Professional Documents
Culture Documents
Contents
Introduction to Financial Accounting .................................................................................................... 2
Measuring and Evaluating Financial Position and Performance ........................................................... 3
Double Entry System ............................................................................................................................. 5
Record-Keeping ..................................................................................................................................... 6
Accrual Accounting Adjustments .......................................................................................................... 8
Special Journals, Subsidiary Ledgers and Control Accounts .............................................................. 11
Internal Control .................................................................................................................................... 12
Inventory and Non-Current Assets ...................................................................................................... 16
Financial Reporting Principles, Accounting Standards and Auditing ................................................. 21
Ratio Analysis ...................................................................................................................................... 23
Management Accounting: Introduction and Cost Concepts ................................................................ 27
Management Accounting: Cost-Volume-Profit Analysis .................................................................... 30
1.
2.
Equity
Equity (owner for private, shareholders for public) is the residual interest in the assets after deducting
all of its liabilities. Sources of equity include:
- Direct contributions from owners or shareholders
- Accumulation of profit not withdrawn by owners
- Profit not distributed as dividends to shareholders
Manipulating the accounting equation:
A L SE
Net Assets
SC
Share Capital
RP
Re tained Pr ofits
R E
Re venue
Expenses
D
Dividends
Definitions:
- Share capital: equity obtained through trading stock to shareholder for cash
- Retained profits: net income not distributed as dividends to shareholders
- Revenue: income received from normal business activities
- Expenses: outflow of cash to another company or person
- Dividend: portion of profit paid out to shareholders. This is NOT an expense
Income Statement: For period ending/As of
An income statement presents information through accrual accounting on the profit or loss for a
certain period of time. Profit or loss is calculated using:
Net Profit Revenue Exp enses
Revenue
Revenue is defined as gross inflows of economic benefit (increase in wealth) during the period
arising from ordinary activities of the company (provisions of services or sales of goods).
Expenses
Expenses are decreases in economic benefits (wealth) during the period that are incurred when
generating revenue. It is in the form of outflows or depletions of assets or incurrence of liabilities
that results in a decrease in equity.
Relationship between profit and retained profits:
Retained profit at end of period Retained profit at beginning of period Net profit dividend
Income statement and balance sheet cam be combined to gain useful information. This is called
articulation of the two statements. E.g. income statement tells how much profit a company has made,
on the balance sheet this contributes to total equity, but the balance sheet also explains where these
profits come from.
Capital Expenditure vs. Expenses
Capital expenditures are costs that create future benefits through purchase of fixed assets or adding
value to existing assets. When a firm spends money, if the resulting benefit is to be realised in the:
- Current accounting period, then it is an expense
- Next or future accounting period, then it is an asset
4
3.
Transaction analysis is the analysis of how various transactions affect the accounting equation. The
golden rule as always is that the accounting equation must balance:
Assets Liabilities Equity
Double Entry Bookkeeping
Under the double entry system, every transaction always affects at least two different accounts in
order to maintain the balance in the accounting equation. The net effect of these amounts is called the
accounts balance, and it is influenced by:
- Debit (Dr) : increase to resources/assets, anything on the left hand side of a balance sheet
- Credit (Cr) : increase to sources/liabilities or equity, anything on the right hand side of a
balance sheet
Ever transaction incurs a debit and a credit entry so at any point in time:
Normal balance
Debit
Credit
Credit
Credit
Credit
Increase
Debit
Credit
Credit
Credit
Debit
Decrease
Credit
Debit
Debit
Debit
Credit
Journal entries are a method of recording transactions in terms of debit and credit. It can list as
many accounts as needed to record the transaction, but for each journal entry, debit must equal credit.
E.g. Company A bought $450 worth of supplies by paying $100 cash up front and the rest as credit
to be paid in the next month.
$
$
Inventory (asset)
100
Dr
Cash (asset)
100
Cr
Inventory (asset)
350
Dr
Accounts Payable (liability)
350
Cr
E.g. Company B made credit sales of $40 000 on goods that costed $16 000
$
$
Accounts receivable
40 000
Dr
Sales Revenue
40 000
Cr
Cost of goods sold
16 000
Dr
Inventory
16 000
Cr
4.
Record-Keeping
The accounting cycle is the collective process of recording and processing accounting events of a
company, starting from transactions to the preparation of financial statements. The stages are:
Source Documents
Source documents are documents that serve as evidence to show transactions have occurred. They
permit auditing and verifying of errors and also reflect the various events in the operation of the
business. Common source documents are:
- Cheques for cash payment
- Receipts for cash received
- Invoices for credit sales
Prepare Journal Entries
Accounting transactions are recorded based on source documents using journal entries. A journal
entry can list as many accounts as needed to record the transaction, but the sum of debits must
always be equal to the sum of credits.
Each journal entry has a posting reference to indicate which ledger account it affects. This number
corresponds to the companys chart of accounts, the list of all ledger accounts.
Post to Ledgers
Ledgers are used to determine the total change to an account, e.g. cash, after all the journal entries in
a period. The general ledger is the complete set of all accounts: assets, liabilities, equity, revenues
and expenses.
A simplified version of ledgers is the T-account, which only lists debits and credits without
calculating balance after every entry.
The journal entries are still necessary, because ledgers split up the transactions so we won't know
what the debit and credit is in a particular transaction
Prepare a Trial Balance
A trial balance is an initial check for any mechanical errors while posting all journal entries to
ledgers. Since the general ledger contains all accounts which come from balanced journal entries, it
must also balance. In a trial balance, the credit and debit of every account is totalled and their sums
should equal.
However, some errors are NOT can occur even if a trial balance balances:
- If a journal entry was not posted
- If a journal entry debited/credit the wrong account
- If the amount debited and credit is equal but both wrong
Adjusting Journal Entries
At the end of each accounting period, it is necessary to adjust the revenue and expense accounts
(and all related asset/liability accounts) to reflect:
- Expenses incurred but not yet paid
- Revenues earned but not yet received
- Cash received from customer in advance for work
- Using up of assets, which creates an expense such as depreciation
Prepare an Adjusted Trial Balance
Any adjusted entries are then posted to the relevant ledger accounts, which require another trial
balance to be prepared to make sure no mechanical error has occurred.
Prepare Closing Journal Entries
Closing entries formally translates the balances of revenue and expense accounts to a profit-loss
summary and then transfer the balances to retained profits. This is to prepare the company for the
next accounting period. Two types of accounts when preparing closing entries are:
o Temporary Accounts
- Accounts closed at end of accounting period, i.e. revenue and expense accounts
- DEBIT all revenue accounts and CREDIT profit-loss summary
- CREDIT all expense accounts and DEBIT profit-loss summary
- DEBIT profit-loss summary then CREDIT it to retained profits
- Credit balance in profit-loss summary is a PROFIT
- Debit balance in profit-loss summary is a LOSS
o Permanent Accounts
- Accounts NOT closed at end of accounting period, i.e. assets, liabilities and equity
- Balances in these accounts are carried forward to the next accounting period
Prepare a Post-Closing Trial Balance
Again, another trial balance is prepared after closing entries are made to ensure total credit equal to
total debit
Prepare Financial statements
The accounts in post-closing trial balance can then be used to prepare the balance sheet. The
accounts in the profit-loss summary translate to the retained profits.
5.
Accrual accounting is the recognition of events, estimates and judgements that are important to the
measurement of financial performance and position regardless of whether they are realised:
- Revenues are recorded in the period when they are earned, not received.
- Expenses are recorded in the period when they are incurred, not paid.
- Collection of cash when revenue/expense has been previously recognised only affects
assets/liabilities
Revenue and Expense Recognition
Recognition at the SAME time as cash flow
When the revenue/expense occurs at the same time as cash is exchanged, there is NO difference in
entries between cash and accrual accounting:
Recognition BEFORE cash flow
Revenue and expenses are recognised when they are made, not when the actual cash has exchanged
hands. Cash accounting doesnt account for this and therefore UNDERSTATES revenue/expenses
E.g. manufacture estimates it will incur future warranty costs next year for goods sold in the current
financial year. Warranty expense should therefore be recognised in the current year, since it is the
year which the goods were sold
Cash Accounting
Accrual Accounting
Dr
Nothing
Dr
Warranty expenses (+E)
Cr
Nothing
Cr
Warranty liability (+L)
Cash collection/payment for PREVIOUSLY recognised revenue/expenses
When cash is finally collected or paid, they are recorded as a change in assets or liabilities and do not
affect the revenue/expense account
E.g. manufacture makes payment under warranty
Accrual Accounting
Dr
Warranty liability (-L)
Cr
cash (-A)
Cash Flow BEFORE Recognition
Sometimes, cash is received or paid in advance before the sale is made. These revenue/expenses are
yet to be realised. Cash accounting ignores this and thus OVERSTATES the sales or expenses.
E.g. prepaid insurance for a 24 month period starting next month. This should be recognised as an
asset because it provides benefit, the expense is deferred until next year.
Cash Accounting
Accrual Accounting
Dr
Insurance Expense (+E)
Dr
Prepaid Insurance (+A)
Cr
Cash (-A)
Cr
Cash (-A)
8
6.
Special Journals
Special journals are journals that record common transactions of the same type to streamline the
recording of transactions. Entries made in special journal are posted directly to their corresponding
ledger account. Transactions not included in special journals, such as depreciation, are recorded in
the general ledger instead. Common special journals are:
o Sales Journal: records credit sales of inventory
o Purchases Journal: records credit purchase of inventory
o Cash Receipts: records all cash inflows using cheques, including cash sales
o Cash Payment: records all cash outflows using cheques, including cash purchases
Subsidiary Ledger and Control Accounts
Subsidiary ledgers are a set of ledger accounts that collectively represent a detailed analysis of one
general ledger account, the control account. The aggregate balance and data in the control account
can be periodically against all the subsidiary ledgers for that category to ensure accuracy. The debit
and credit entries made to each subsidiary ledger must equal to the total debit and credit in the
control account.
Subsidiary ledgers are separate from the general ledger:
o Accounts receivable (debtors): separate account for each debtor
o Accounts payable (creditors): separate account for each creditor
o Property, plant and equipment: separate account for each property, plant and equipment,
commonly called the fixed asset register
o Raw materials inventory: separate account for each type of raw material held
o Finished goods inventory: separate account for each type of finished good held
Trade Discount
Trade discounts are reductions in the price charged to a customer for a good or service from the
standard price depending on the category of customer or their volume of business. For example,
manufacturer sells at standard price to general public, while giving trade discounts to retailers and
even bigger discounts to wholesalers. The amount of trade discounts are rarely recorded, only the
net amount of transactions are normally included in the accounting systems
Cash Discount
Cash discounts are conditional reductions after determining the selling price as an incentive for
credit customers to quickly settle debts, e.g. a 5% cash discount if payment made on credit purchases
is made within 10 days; otherwise net amount is payable within 30 days, which would be written as
5/10, n/30. Therefore, it does not actually change the original sale price, so it is normally recorded as
an extra transaction, incurring a discount allowed expense.
11
7.
Internal Control
Internal control systems are a process, affected by an entitys board of directors, management and
other personnel, designed to provide reasonable assurance in achieving:
- Effectiveness and efficiency of operation
- Accurate and reliable financial data
- Compliance with applicable laws, regulations and management policies
Internal control consists of 5 components (C.R.I.M.E):
o Control activities: policies that ensure management directives are carried out and necessary
actions are taken to manage risks
o Risk assessment: assessment of risks to objectives both internally and externally.
o Information and communication: information must be identified and relayed in the
appropriate timeframe, such as financial reports
o Monitoring: the control system itself is monitored to assess its quality and any deficiencies
o Environment: a control environment that encourages good control activities
Effective Control Activities are:
- Separation of asset handling and recordkeeping so all power does not fall on one person
- Establish clear lines of responsibility
- Physical protection of assets using locks and safes
- Independent approval and reviews for transactions to spot irregularities
- Matching independently generated documents, such as checking sales invoices against orders
Internal Control over Cash
Cash is the asset that is most commonly the subject of theft or fraud, because of its liquidity and
anonymity, i.e. cash can be transferred easily and does not belong to a particular person.
Cash Control Activities:
- Separation of duties for receiving and paying cash
- Separation of duties for recording and handling cash
- All cash receipts and cheques banked in its entirety daily
- Authorised supporting documentation for payments
- Cheques signed by 2 people independent of accounting and invoice approval duties
- Payment invoices stamped so they cannot be fraudulently reused
- Mail opened by someone not involved in record keeping
For example, when a cheque payment comes by mail it should be opened by more than 1 person.
These people should not have duties involved with recordkeeping. Then the cheque should be
recorded on a list of cheque receive
12
Bank Reconciliation
Bank statements are monthly statements from banks that summarise all financial transactions in a
bank account. However, usually the ending monthly balance of bank statements will not match the
cash at bank account of the companys records, due to timing differences in recording.
Bank reconciliations the process to explain the information asymmetry of balances between bank
statements and cash accounts:
Items in company records but NOT bank statement
o Deposits in transit: deposits in company records but not yet processed by bank, e.g. if it was
deposited on the last day of the month
o Outstanding cheques: payment cheques written and recorded by company but not yet
presented to the bank or paid from the bank account
o Require reconciliation with bank statement
Items in bank statement but NOT in company records
o Non-sufficient funds (NSF): payments dishonoured due to lack of funds in account
o Interests collected by bank and notes receivable
o Interest earned on the account
o Bank service charges
o Require adjustments in accounting system, i.e. journal entries
Error in bank statement or accounting system
Steps in Preparing Bank Reconciliation:
1) Tick all information in both cash records, i.e. cash payment journal, cash receipt journal and
the last bank reconciliation and current bank statement.
2) Items in bank statement that are NOT ticked must be added to CPJ or CRJ to give an adjusted
cash balance, these are transactions not recorded by company yet, e.g. dishonoured cheques
3) Items in cash records that are NOT ticked must be outstanding deposits or cheques
Bank Reconciliation at 30th June 2011
Ending balance per bank statement
Add
Increases recorded on company records but not on bank statement
Less
$
xxx
xxx
xxx
XXX CR
xxx
xxx
xxx
XXX DR
13
Petty Cash
A petty cash fund is established for making small payments, especially those that are cheques are
impractical for. They are made by cashing a cheque from a companys regular bank account. The
documents providing evidence for disbursements from petty cash account are vouchers. The petty
cash account is an asset and it is regularly replenished.
They are made by cashing a cheque from a companys regular bank account.
Dr
Petty Cash
$200
Cr
Cash
$200
Disbursement from Fund
When a voucher is placed in the petty cash box, i.e. a payment is made; NO journal entries are
recorded at the time. This is to avoid a lot of troublesome bookkeeping for small amounts of cash
Reimbursing the Fund
The petty cash fund needs to be replenished when the fund becomes low due to small expenses. At
that time, the vouchers are used to record the expense entries and CASH is credited. The petty cash
account is NOT affected by the reimbursement entry
E.g. after some time, only $32.40 is left in the petty cash fund. Record the reimbursement entries
Dr
Cr
Dr
Postage expenses
$27.50
Dr
Stationary expenses
$50.80
Dr
Motor vehicle expenses
$73.40
Cr
Cash at bank
$167.60
Value of Accounts Receivable
With accounts receivable there is always some uncertainty regarding whether all of it can be
collected due to accrual accounting. So reductions are often necessary to measure its true value.
There are two ways to record uncertainties in the amount collectable:
Direct Write-off
Debts are written off when there is direct evidence to suggest that the debt is unlikely to be repaid,
e.g. if a customer company goes into liquidation. To record this, the accounts receivable for that
company is directly credited
Dr
Cr
1,000
1,000
However, this method is rarely used as it doesnt give a full picture of what accounts receivable is
worth. It doesnt relate to the revenue that has been earned either.
14
Allowance Method
This method credits a contra asset account called allowances for doubtful debts for payments that
may not be collected, while debiting a bad debts expense account. The allowances for doubtful debts
reflect the percentage of the accounts receivable that might not be received, it doesnt actually state
which customers will not pay.
Dr
Cr
Dr
Cr
Dr
Cr
Dr
Cr
Recognising bad debts are adjusting journal entries made at the balance date:
Bad debts expense
Allowance for doubtful debts
1,000
1,000
When the debt is determined to be definitely uncollectable, it is written off accounts receivable:
Allowance for doubtful debts
Accounts receivable
1,000
1,000
However, if the bad debt ended up being recovered, then the accounts receivable needs to be
reinstated first, before cash is debited
Accounts receivable
Allowance for doubtful debts
Cash
Accounts receivable
1,000
1,000
1,000
1,000
5,000
5,000
8.
Inventory
Businesses that involve purchase, sale or transformation of goods are referred to as merchandising
operations. Merchandising operations hold a current asset called inventory:
- Held for sale in the ordinary course of business, e.g. merchandise
- In the process of production for sale, e.g. unfinished goods
- Materials or supplies to be consumed in the production process, e.g. raw material
Recording the sales of inventory and the cost of goods sold (COGS) uses 2 methods:
Perpetual Method
A method of controlling inventory that maintains continuous records on the flow of units of
inventory for ALL transactions.
- Begins with opening balance of inventory, supported with physical count
- Add cost of purchased inventory, supported with records
- Less cost of goods sold, supported with records
- Ends with closing balance of inventory, supported with physical count
If the physical count in the end does not match the closing balance, e.g. $5000 less, then managers
know that there is a shortage of inventory. Then adjusting journal entries are required:
Dr
Cr
5,000
5,000
Perpetual method is the preferred method that we have been dealing with:
- Purchase involve crediting cash or accounts receivable
- Sales involves revenue and cost of goods sold
- Closing entries closes all revenues and expenses to P&L summary
Advantage
Disadvantage
Provides more accurate control as it records
Costly, managers must pay someone to
everything, stock losses easily determined
constantly record, sort and compile data
Conclusion: perpetual method is better for firms that sell expensive goods. E.g. car dealerships,
since cars are a large investment for the dealers so it needs to be better protected.
Periodic Method
A method of calculating inventory that uses data of opening inventory, additions to inventory, and
end of period count to DEDUCE cost of goods sold. No records are maintained for individual
inventory items. In this method, changes to inventory ledger account only made at END of year.
Purchases Expense Account
Purchases of inventory are NOT recorded on inventory, but rather a purchase expense account.
Dr
Cr
Purchase expense
Cash/Accounts payable
cost price
cost price
16
Sales of inventory only needs to have revenue recorded, NOT changes to inventory and the COGS.
Dr
Cr
Cash/Accounts receivable
Sales revenue
selling price
selling price
Sales Revenue
P&L summary
P&L summary
Purchase Expenses
P&L summary
Inventory (opening)
Inventory (closing)
P&L summary
$
xxx
$
xxx
xxx
xxx
xxx
xxx
xxx
xxx
Advantage
Disadvantage
Lower costs and faster
Does not reveal shortage of stock
Conclusion: periodic method is better for stock of low unit value with a large number of sales, such
as retail shops
Cost of Goods Sold
In reality, the cost of each unit of good varies, since goods can become cheaper or more expensive
throughout the year, so often stocks consist of goods purchased at different prices.
Specific Identification
This method tracks each individual item through inventory flow using barcodes or serial numbers:
- An accurate approach
- Based on physical flow of goods
- Time consuming and expensive, but improving with technology
- Used for high value items, e.g. cars and house
Cost Flow Assumption
For most low value items, it is not worthwhile to keep track of every item. Instead, of calculating the
exact COGS and inventory on hand, we make assumptions on cost flow to get a general idea. The 3
major types of cost flow assumptions with periodic systems are:
First-in First-out (FIFO)
Assumes that items acquired first are the first ones sold, so any remaining inventory on balance sheet
are the most recently acquired. This assumption:
- Results in a higher profit and inventory in times of rising prices
- Suitable for perishable items or those subject to obsolescence
- Closing balance is closer to current cost
17
Assumption
Spread evenly over assets life
Falls over the assets life
Variable over the assets life
Method of Allocation
Straight line depreciation constant expense
Reducing balance method increasing expense
Units of production expense depends on volume of production
Residual Value
Book Value 1 n
Cost
Exception:
If residual value is 0, then this formula cannot be used. In general, the depreciation rate is taken to be
150% of the straight-line percentage of depreciation.
E.g. If a truck was purchased at $40,000, has an estimated useful life of 5 years and can be sold for
$5,000 after 5 years, what is the depreciation expense for the first 2 years?
5000
34%
40000
First Year : Depreciation Expense 5000 0 34% $13610
Depreciation Rate 1 5
Depreciation Expenes Depreciation for ONE unit of use / production no. of units used / produced
19
E.g. If a truck was purchased at $40,000, has an estimated useful life of 5 years and can be sold for
$5,000 after 5 years. The truck can drive for up to 200,000 km with 20,000 in first year and 80,000
in second years what is the depreciation expense for the first 2 years?
40000 5000
Depreciation per km
$0.175 per km
200000
First Year : Depreciation Expense 20000 0.175 $3500
Second Year : Depreciation Expense 80000 0.175 $14000
Subsequent Expenditure
Any expenditure made on an asset can either increase the value of the asset or become an expense. If
the expenditure:
- Increase productivity, efficiency, output quality or useful life, then it IMPROVES the asset.
Therefore the expenditure is capitalised and added to the asset account
- MAINTAIN current level, i.e. needed for the asset to continue production, then the
expenditure is expensed
Disposal of Non-Current Assets
When PPE needs to be disposed, i.e. sold or scrapped, the steps to record it are:
1) Record depreciation up to the date of disposal
2) Record proceeds or losses from sale
3) Remove the non-current asset from companys book
E.g. a machine with original cost of $50000 has accumulated depreciation of $24000 as of 30 June
2012. It is sold on 1 August 2012 for $21000 cash. The straight line depreciation is $12000 per year.
1
Depreciation expense from 30 June to 1 August is
12000 $1000
12
$
Dr
Cr
Depreciation Expense
Accumulated Depreciation
$
1,000
1,000
Cash
Accumulated Depreciation
Loss on Sale
Machinery
21,000
25,000
4,000
50,000
Intangible Assets
An intangible asset is an identifiable non-monetary asset without physical substance. It must also
fit the criteria for an asset in general. Intangible assets include: brand names, trademarks, patents and
copyrights. Intangible assets can also have limited life, in which case the depreciation is called
amortisation.
20
9.
21
23
High days in debtor indicate a problem with granting of credit and/or collection policies
Low days in debtor indicate the credit granting and/or collection policies are too strict
Liquidity Ratios
Liquidity ratios aim to give financial statement users some indication of the companys ability to pay
its short term debts as they fall due. A company may be forced into liquidation if it cannot pay its
short term debts, even if it might be profitable in the long run
Types of Liquidity Ratios
Current Ratio
Gives indication whether a firm can pay its debts in the current period
Current Assets
Current Ratio
Current Liabilities
-
Quick Ratio
Quick ratio, or acid test, measures the ability of a company to use its cash or quick assets to pay its
short term debts. Quick assets are cash, accounts receivable and short-term investments, i.e. current
assets not including inventory. It indicates whether current liabilities could be paid without having to
sell the inventory, useful for companies that cannot quickly convert its inventory to cash.
Cash + Accounts Receivable + Short -Term Investment
Quick Ratio =
Current Liabilities
Financial Structure Ratio
Gives indication of the companys ability to continue operations in the long term, i.e. the risks
Types of Financial Structure Ratio:
Debt-to-Equity Ratio
D/E ratio measures how a company is financed, through debts or shareholder investment.
- Value higher than 1 indicates the assets are mostly financed with debt, which is risky
- Value less than 1 indicates the assets are mostly financed by owners
Total Liabilities
Debt to Equity Ratio
Total Shareholder ' s Equity
Debt-to-Asset Ratio
Debt-to-asset ratio (D/A) measures the proportion of assets that are financed via debts. The higher
the value, the greater the risks in firms operation
Total Liabilities
Debt to Asset Ratio
Total Assets
Leverage Ratio
Leverage ratio measures the proportion of assets financed by equity. The higher the ratio, the less is
funded by equity and more by debt
Total Assets
Leverage Ratio
Total Shareholder ' s Equity
Du Pont System of Ratio Analysis
The Du Pont system of analysis links the ratios together using the concept of a leverage. Leverage
refers to any technique to multiply gains and losses.
Tota l Assets
Leverage
Total Shareholder ' s Equity
However, leverage is a double edge sword. E.g. a company can leverage its equity by borrowing
money because the more it borrows the less equity capital it needs. Thus, any profits are shared
among less owners so it is proprotionally larger. However, any losses are also burdened more on the
company and borrowing too much money may lead to bankruptcy in a financial downturn.
25
Sales Revenue
Total Assets
Operating Profit After Tax
=
Total Assets
ROE = ROA Leverage
Operating Profit After Tax
Total Assets
=
Total Assets
Total Shareholder's Equity
Operating Profit After Tax
=
Total Shareholder's Equity
Limitations of Financial Statement Ratios
o Ratios rely on past information
- Ratios assume past relationships are useful in forecasting future performance
- Numerous factors can prove otherwise
o Ratios rely on historical cost financial statements
- Failure to adjust for inflation or market values result in current dollar amounts being
compared to past dollar amounts. E.g. current dollar profits with historical dollar assets
o Ratios are based on year end data
- Year-end data may not be reflective of the typical situation of company
- Management may improve ratios, e.g. current ratio, by using cash to pay off debts
o Not all required information will be disclosed
- E.g. foreign companies may not disclose COGS so inventory turnover hard to calculate
o The balance sheet and income statement may not provide all information
- Financial statement users should also examine directors report, auditors report and etc.
Normal
$500,000
$384,000
Common Size
100.00
76.80
26
27
Manufacturing Costs
Manufacturing costs are the costs associated with the process of converting raw materials into
finished goods. It can be further classified as:
o Direct Manufacturing Costs: costs that can be traced to a cost object, i.e. items/activities to
which costs are assigned, e.g. cost raw materials and cost of labour
- Direct materials: raw materials that can be directly traceable to product
- Direct labour: cost of labour used to covert raw material to a finished product
o Indirect Manufacturing Costs: other overhead costs that are common to all products, i.e.
ones that cannot be associated with a particular cost object
- Indirect materials: generally material necessary for production that do not become or
become an insignificant part of finished product, e.g. glue
- Indirect labour: generally factory labour other than those that actually transform raw
materials into a finished good, e.g. supervisors, maintenance
Non-Manufacturing Costs
Costs not associated with the direct production of finished goods:
o Selling Costs: cost necessary to market and distribute a product, e.g. shipping, advertising
o Administrative Costs: costs associated with the general administration of the organisation
that cannot be assigned to either marketing or manufacturing, e.g. legal fees, R&D
Related Cost Concepts
o Period Cost: costs that are expensed in the period in which they are incurred. ALL selling
and administrative costs are period costs
o Product Cost: costs that have potential to produce revenues beyond current period. All
manufacturing costs that that leads to products not sold in the current period are product costs
o Prime Costs: combination of direct materials and direct labour
o Conversion Costs: combination of direct labour and manufacturing overhead
28
Beginning WIP is added because thats the cost of unfinished goods from last period
Ending WIP is subtracted because thats the cost of unfinished goods for next period
Work in progress (WIP) consists of all partially completed units found in production at a given
point in time. A manufacture usually has 3 types of inventory:
- Raw materials
- Work in progress
- Finished goods
The detail calculation of cost of goods manufactured is shown in a supporting schedule called the
statement of cost of goods manufactured:
Statement of Cost of Goods Manufactured
Direct Materials:
Beginning Raw Inventory
Add Purchases
Materials Available
Less Ending Inventory
Direct Materials Used
Direct Labour
Manufacturing Overhead
Add Beginning Work in Progress
Total Manufacturing Costs
Less Ending Work in Progress
Cost of Goods Manufactured
$400,000
$900,000
$1,300,000
-$100,000
$1,200,000
$700,000
$900,000
$400,000
$3,200,000
-$800,000
$2,400,000
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Sales-Revenue Approach
This approach of CVP analysis measures sales activity in terms of the total dollars of revenue. This
approach is useful for when units are difficult to identify, e.g. service industry
Variable cost ratio (vr): the proportion of each sales dollar used to cover variable cost
Contribution margin ratio (1-vr): the proportion of each sales dollar available to cover
fixed costs and provide a profit
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