Certified Management Accountant US Part 1

2017
Study Guide
CMA PART 1
ZUBAIR SYED
TABLE OF CONTENTS
EXTERNAL FINANCIAL REPORTING DECISIONS ............................................................................................ 11
PURPOSE OF FINANCIAL STATEMENTS: ...............................................................................................................11
Financial Statement Orientation ....................................................................................................................................11
Who Are Users of Financial Statement .........................................................................................................................11
COMPONENTS OF FINANCIAL STATEMENTS .......................................................................................................11
BALANCE SHEET: PICTURE IN TIME (AS ON DATE BASIS) ..................................................................12
CLASSIFICATION OF ASSETS & LIABILITIES .............................................................................................12
Uses and Limitations of Balance Sheet ............................................................................................................13
INCOME STATEMENT ...................................................................................................................................................13
Types of Income Statements ..............................................................................................................................13
RECOGNITION OF REVENUE .....................................................................................................................................14
DISCONTINUED OPERATIONS (NET OF TAX) ............................................................................................14
Uses and Limitations of Income Statement ......................................................................................................15
STATEMENT OF COMPREHENSIVE INCOME (OCI) ..............................................................................................15
STATEMENT OF CHANGES IN EQUITY: ...................................................................................................................15
STATEMENT OF CASHFLOW ......................................................................................................................................15
USES OF CASH FLOW ......................................................................................................................................15
CASHFLOW ACTIVITIES ...............................................................................................................................................16
OPERATING ACTIVITIES: .................................................................................................................................16
INVESTING ACTIVITIES ....................................................................................................................................16
FINANCING ACTIVITY .......................................................................................................................................16
CASH EQUIVALENTS ....................................................................................................................................................16
FOREIGN CURRENCY CASH FLOW ..............................................................................................................17
PREPARING THE SATEMENT OF CASH FLOW ..........................................................................................17
INDIRECT METHOD ...........................................................................................................................................17
INVESTING ACTIVITIES ....................................................................................................................................18
FINANCING ACTIVITIES ....................................................................................................................................18
RECOGNITION, MEASUREMENT, VALUATION AND DISCLOSURE ............................................................. 18
Limitation of FINANCIAL STATEMENTS .....................................................................................................................18
ASSET VALUATION .......................................................................................................................................................18
ACCOUNTS RECEIVABLE ................................................................................................................................18
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FACTORING RECEIVABLES ............................................................................................................................ 20
INVENTORY ..................................................................................................................................................................... 21
CLASSIFICATION ............................................................................................................................................... 21
What is our inventory ........................................................................................................................................... 21
INVENTORY VALUATION ................................................................................................................................. 22
Initial valuation ...................................................................................................................................................... 22
COST FLOW ASSUMPTION ......................................................................................................................................... 22
INVENTORY IN BALANCE SHEET .............................................................................................................................. 23
SUBSEQUENT VALUATION OF INVENTORY .............................................................................................. 23
INVENTORY SUBSEQUENT VALUATION DIFFERENCE BETWEEN IFRS AND GAAP ...................... 25
LIFO and LCM ...................................................................................................................................................... 25
PURCHASE COMMITMENTS ........................................................................................................................... 26
INVESTMENTS ................................................................................................................................................................ 26
TRADING AND AVAILABE FOR SALE ........................................................................................................................ 26
Fair value method ................................................................................................................................................ 26
SMALL EQUITY INVESTMENT ........................................................................................................................ 26
LARGER EQUITY INVESTMENT ..................................................................................................................... 26
METHODS OF PRESENTATION & DISCLOSURE ....................................................................................... 27
FAIR VALUE METHOD ....................................................................................................................................... 27
EQUITY METHOD ............................................................................................................................................... 27
PROPERTY PLANT & EQUIPMENTS (FIXED ASSETS) .................................................................................... 27
Measurement .................................................................................................................................................................... 27
Initial Recognition: ................................................................................................................................................ 28
Depreciation & methods: ..................................................................................................................................... 28
DEPLETION.......................................................................................................................................................... 29
GROUP & COMPOSITE DEPRECIATION – FOR GROUP OF ASSETS AS A WHOLE ........................ 30
TAX DEPRECIATION ......................................................................................................................................... 30
Non-Current Asset Valuation: ........................................................................................................................................ 30
Initial Valuation ..................................................................................................................................................... 30
Subsequent Valuation ......................................................................................................................................... 30
IMPAIRMENT OF NON-CURRENT ASSET .......................................................................................................... 31

IMPAIRMENT OF FIXED ASSET ..................................................................................................................................31
DISPOSAL OF FIXED ASSET .......................................................................................................................................31
INTANGIBLE ASSETS ............................................................................................................................................ 32
VALUATION OF LIABILITIES ( Including Short-term debt ) ........................................................................... 32
REFINANCING SHORT TERMS DEBT .......................................................................................................................32
ACCOUNTING FOR WARRANTIES ............................................................................................................................32
Accounting for Bonds ......................................................................................................................................................33
Nature of Bonds....................................................................................................................................................33
Amortization of Premium of Discount ................................................................................................................33
Effective interest method.....................................................................................................................................33
Types of Bonds .....................................................................................................................................................34
Working your way with Questions on bonds ....................................................................................................34
Liabilities Valuation – Disclosure requirements ...........................................................................................................34
INCOME TAXES ..............................................................................................................................................................35
Fundamental Concept: ........................................................................................................................................35
Deferred Tax .........................................................................................................................................................35
OBJECTIVE OF DEFERRED TAXES ..............................................................................................................35
Deferred Tax Liabilities & Assets .......................................................................................................................35
Deferred Income Tax Expense / Benefit ...........................................................................................................37
EQUITY TRANSACTIONS .............................................................................................................................................38
TYPES OF business formations: .......................................................................................................................38
STOCK OF THE COMPANIES ..........................................................................................................................38
TREASURY STOCK ........................................................................................................................................................41
REVENUE RECOGNITION ..................................................................................................................................... 41
INTALLMENT METHOD OF PROFIT RECOGNITION ..............................................................................................41
Cost recovery method .....................................................................................................................................................42
Deposit Method ................................................................................................................................................................42
Revenue with RIGHT OF RETURN ..............................................................................................................................42
SALE WITH BUY BACK AGREEMENT .......................................................................................................................42
Channel Stuffing & Trade Loading ................................................................................................................................42
LONG TERM CONTRACTS ...........................................................................................................................................43
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COMPLETED CONTRACT METHOD .............................................................................................................. 43
COST MANAGEMENT SYSTEM ........................................................................................................................... 46
BASIC DEFINITIONS: ......................................................................................................................................... 46
COST CLASSIFICATION ................................................................................................................................... 46
COST BEHAVIOUR AND RELEVANT RANGE .............................................................................................. 47
Mixed Cost (semi variable) ................................................................................................................................. 47
High-low method of splitting the mixed cost ..................................................................................................... 47
RELEVANT RANGE AND MARGINAL COSTING ......................................................................................... 47
Cost classifications .......................................................................................................................................................... 47
COST ACCUMULATION SYSTEM ............................................................................................................................... 47
Job Order Costing ................................................................................................................................................ 47
TERMS FREQUENTLY USED IN JOB ORDER COSTING ...................................................................................... 48
Waste: 48
Scrap: 48
Spoil: 48
ACTIVITY BASED COSTING ........................................................................................................................................ 50
Activity Based Costing Step Analysis ............................................................................................................... 50
PROCESS COSTING ......................................................................................................................................... 51
STEPS IN PROCESS COSTING ...................................................................................................................... 51
JOINT PRODUCT AND BY-PRODUCT COSTING .............................................................................................. 54
Joint Product Cost allocation method ........................................................................................................................... 54
Relative sales value at split-off point ................................................................................................................. 54
Estimated net realizable value ........................................................................................................................... 54
Physical Unit allocation ....................................................................................................................................... 55
Average Cost method .......................................................................................................................................... 55
Constant Gross Profit Percentage ..................................................................................................................... 56
ACCOUNTING FOR BYPRODUCTS ..................................................................................................................... 58
The Production Method: Inventory the Byproduct Costs ............................................................................... 58
The Sales Method: Revenue from the Byproduct ........................................................................................... 58
Comprehensive Example .................................................................................................................................... 58
VARIABLE AND ABSORPTION COSTING .......................................................................................................... 59

Fixed Factory Overheads Under Variable Costing: ....................................................................................................59
Effects of Changing Inventory Levels................................................................................................................59
INCOME STATEMENT UNDER ABSORPTION COSTING ..........................................................................60
The Income Statement under Variable (Direct) Costing ................................................................................60
COSTING SYSTEMS............................................................................................................................................... 60
Cost Management Systems ...........................................................................................................................................61
OVERHEAD ALLOCATION .................................................................................................................................... 63
Categories of Overheads ................................................................................................................................................63
Traditional Overhead method (standard) .....................................................................................................................64
Determining Level of Activity ..........................................................................................................................................64
Level of Activity Notes .........................................................................................................................................64
ALLOCATING THE COST TO UNITS ................................................................................................................... 64
Service Department Cost Allocation .............................................................................................................................64
Why it’s important .............................................................................................................................................................64
Two Treatments of Service Costs .................................................................................................................................65
Allocation of Service Cost ...............................................................................................................................................65
Multiple Service Department ..........................................................................................................................................65
JUST IN TIME INVENTORY AND MATERIAL REQUIREMENT PLANNING.................................................... 65
PULL SYSTEM: ................................................................................................................................................................65
Push system .....................................................................................................................................................................66
Implementing JIT ..............................................................................................................................................................66
KANBAN ............................................................................................................................................................................66
The major kanban principles are: ......................................................................................................................66
Material Requirement Planning ......................................................................................................................................67
GOAL OF MATERIAL REQUIREMENT PLANNING ..................................................................................................67
MRP Calculation:..................................................................................................................................................67
MRP II ................................................................................................................................................................................67
ERP ....................................................................................................................................................................................67
Extended ERP ......................................................................................................................................................68
Benefits of ERP ....................................................................................................................................................68
Outsourcing .......................................................................................................................................................................68
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Benefits are ........................................................................................................................................................... 68
Demerits are ......................................................................................................................................................... 68
THEORY OF CONSTRAINTS ................................................................................................................................. 68
Theory of Constraint Terms:........................................................................................................................................... 69
Theory of Constraints (TOC) Terms.............................................................................................................................. 69
Steps in Management the constraint ............................................................................................................................ 70
DRUM – BUFFER – ROPE SYSTEM ........................................................................................................................... 70
BUSINESS PROCESS IMPORVEMENT ............................................................................................................... 70
The Value Chain .............................................................................................................................................................. 70
Value Chain Analysis ...................................................................................................................................................... 71
Value chain measure ....................................................................................................................................................... 71
The Supply Chain ............................................................................................................................................................ 71
Supply Chain Analysis .................................................................................................................................................... 71
CRITICAL SUCCESS FACTORS FOR VALUE CHAIN & SUPPLY CHAIN........................................................... 71
Value Engineering............................................................................................................................................................ 71
PROCESS ANALYSIS .................................................................................................................................................... 71
Processes interdependence ........................................................................................................................................... 72
Process value analysis .................................................................................................................................................... 72
Business Process Reengineering ................................................................................................................................. 72
Bench Marking ................................................................................................................................................................. 72
Steps of Bench Marking .................................................................................................................................................. 73
Balanced Scorecard ........................................................................................................................................................ 73
Typical Score Card .......................................................................................................................................................... 73
Costs of Quality ................................................................................................................................................................ 73
Efficient accounting processes ...................................................................................................................................... 73
PLANNING, BUDGETING AND FORECASTING ................................................................................................. 74
STRATEGIC PLANNING ................................................................................................................................................ 74
A STRATEGY ....................................................................................................................................................... 74
Superior Performance ..................................................................................................................................................... 74
Competitive Advantage ................................................................................................................................................... 74
Shareholder value ............................................................................................................................................................ 74

PURPOSE OF STRATEGIC PLANNING .....................................................................................................................74
The Role of Management in Attaining Profitable Growth ...........................................................................................74
Business Model ................................................................................................................................................................75
DRAWBACKS/ DEMERITS OF PLANNING ................................................................................................................76
THE STRATEGIC PLANNING PROCESS ............................................................................................................ 76
Strategic Planning Process-Mission and External ......................................................................................................76
STRATEGIC PLANNING STEPS IN DETAILS ...........................................................................................................76
PORTER’S FIVE FORCES MODEL .................................................................................................................77
Strategic Planning Process-Internal Analysis ..............................................................................................................78
Distinctive competencies ................................................................................................................................................78
Superiority - Generic ........................................................................................................................................................79
UTILITY AND PROFITABILITY .....................................................................................................................................79
Durability of Competitive Advantage .............................................................................................................................79
Using INTERNAL ANALYSIS .........................................................................................................................................79
Formulating Strategy .......................................................................................................................................................79
Growing the Company.....................................................................................................................................................80
DEVELOPING AND IMPLEMENTING STRATEGIES ...............................................................................................80
Other Planning Tools .......................................................................................................................................................81
THE BUDGET AND CONTROL PROCESS .......................................................................................................... 82
Who should prepare the Budget ........................................................................................................................83
BUDGET APPROACHES ...................................................................................................................................83
Kinds of budgets ...................................................................................................................................................83
The Budget and Control Process .......................................................................................................................83
BUDGETING BEST PRACTICE GUIDELINES ...............................................................................................83
GOAL CONGRUENCE ...................................................................................................................................................84
BUDGETARY SLACK .....................................................................................................................................................84
STANDARDS COSTS .....................................................................................................................................................84
BUDGETING METHODOLOGIES ................................................................................................................................85
Control Loop .........................................................................................................................................................86
Forecasting Techniques ..................................................................................................................................................86
Forecasting and Budgeting .................................................................................................................................86
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Causal Forecasting .............................................................................................................................................. 88
Learning Curve ................................................................................................................................................................. 88
Doubling of Production ........................................................................................................................................ 88
Cumulative Average Model ................................................................................................................................ 88
PROBABILITY AND EXPECTED VALUE ............................................................................................................. 89
Terms in Probability ......................................................................................................................................................... 89
EXPECTED VALUE ........................................................................................................................................................ 89
HOW TO WORK IT IN EXAMS ..................................................................................................................................... 89
Using Expected Values ....................................................................................................................................... 90
Variance and Standard Deviation ...................................................................................................................... 90
The Normal Distribution ...................................................................................................................................... 90
Z Score 91
Property for Normal Distribution ........................................................................................................................ 91
Using Normal Distribution ................................................................................................................................... 91
The Coefficient of Variation ............................................................................................................................................ 91
Expected Value of Perfect Information ......................................................................................................................... 92
VARIANCE ANALYSIS ........................................................................................................................................... 93
COST AND VARIANCE MEASURES ........................................................................................................................... 93
Benefits of Variance Analysis ......................................................................................................................................... 93
STANDARD COST .......................................................................................................................................................... 93
Flexible budget ................................................................................................................................................................. 93
Level of Activity ................................................................................................................................................................ 93
Sources of Standard Cost ................................................................................................................................... 93
Variance Analysis Levels ................................................................................................................................................ 93
Level 1 Variance .................................................................................................................................................. 94
Level 2 Variance .................................................................................................................................................. 94
Level 3 Variance .................................................................................................................................................. 94
SALES VARIANCE .............................................................................................................................................. 94
Performance management ......................................................................................................................................... 94
Responsibility Centers ........................................................................................................................................................ 94
Evaluating Manager / Department ........................................................................................................................ 95

Allocate common cost ........................................................................................................................................................95
Consideration for cost allocation ............................................................................................................................95
Ways of Allocating common costs ..........................................................................................................................95
INTERNAL CONTROL ............................................................................................................................................ 96
GOVERNANCE, RISK AND COMPLIANCE ....................................................................................................96
Principals of Good Corporate Governance ......................................................................................................96
Hierarchy of Corporate Governance .............................................................................................................................96
Companies Formation: ....................................................................................................................................................97
Internal Controls ...............................................................................................................................................................98
Benefits of Internal Control .............................................................................................................................................98
Definition of Internal Control ...........................................................................................................................................98
Objectives of Internal Control: ............................................................................................................................98
Fundamental Concepts .......................................................................................................................................98
Reasonable Assurance .......................................................................................................................................98
Who is Interested in the Internal Control of a Company? ..............................................................................98
Responsibility for Internal Control ......................................................................................................................98
FIVE COMPONENTS OF INTERNAL CONTROL (17 principals) ................................................................98
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EXTERNAL FINANCIAL REPORTING DECISIONS
PURPOSE OF FINANCIAL STATEMENTS:

Why users of FINANCIAL STATEMENTS require financial statements
1 To make decisions
2 The company communicates outside the company its results. Compulsory on public listed/traded
company. Family/ Private owned company don’t require by law to create Financial Statements.
3 To borrow money from the bank by any company including family-owned or private company.
Financial Statement Orientation

Financial statements are backwards looking, presents the history of the company. It deals with the past
performance and activity.
Who Are Users of Financial Statement

Users may directly and indirectly have and economic interest in a specific business. Users with direct interests
usually have invested in or manage the business, and users with indirect interests advise, influence, or
represent users with direct interests.
Users classification according to Influence in the operations
External Users
a. Shareholders of Publicly Trading Company.

b. Tax authorities
c. Banks
d. Suppliers
e. Financial advisors and analysts
Internal Users
a. Owners (Shareholders of Partnership, Private limited or Sole proprietorship)

b. Management of the company
c. Employees of the company
d. Board of directors.
Division of users on basis of ECONOMIC INTERESTS in financial statements
DIRECT INTERESTS
a) Investors & potential investors

b) Suppliers & creditors
c) Employees
d) Management
INDIRECT INTERESTS
a) Financial Advisors and consultants

b) Stock market & exchange houses
c) Regulatory Authorities
COMPONENTS OF FINANCIAL STATEMENTS

Financial statements include the following statements:
1) Balance Sheet
2) Income Statements
3) Statement of comprehensive income
4) Statement of Changes in Stockholders equity
5) Statement of Cash flows
Notes to the Financial Statements are not component of the financial statement but it forms an INTEGRAL PART
of Financial Statements. Notes provide details to the Financial Statements. Notes cannot be used to correct the
mistake on Financial Statement.
BALANCE SHEET: PICTURE IN TIME (AS ON DATE BASIS)

What the company owns – Assets
What the company owes to creditors– Liabilities (other parties)
What the company owes to owners’ – Equity (owners)
Presentation Style
The way the Assets and Liabilities presented are called Proprietary theory.
PROPRIETARY THEORY is where no fundamental distinction is drawn between a legal entity and its owners, i.e.
the entity does not exist separately from the owners for accounting purposes.
Balance sheet accounts are permanent accounts and are not closed they are permanent.
Elements to the balance sheet:
Accounting Equation
𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑒𝑠 + 𝐸𝑞𝑢𝑖𝑡𝑦
What is an Asset?
To a 6-year-old... Something we own. But We also own the car loan or mortgage.
Short definition: Asset is something that is good for you.
Technically: There are 3 parts to it. The asset is something you control, that will provide future economic benefit, that
arose from a past transaction.
1) Control
2) Future economic benefit
3) Past transaction
This definition in vital for understanding Intangible
What is a liability?
to 6-year-old is something that is bad.
Technically: There are 3, something you owe, that will cause a future outflow of economic resources, that arose from past
transaction.
What is Equity?
It’s a difference between Assets and Liabilities.
CLASSIFICATION OF ASSETS & LIABILITIES

In the balance sheet, Asset and Liabilities are broken down into current and non-current.
Current Asset:
An asset which is converted into Cash within 12 months or Operating Cycle, whichever is longer. Example: Cash, Bank,
Receivables, Inventories etc.
Non-Current Asset:
An Asset which takes longer than 12 months to convert into Cash. Example: Property Plan Equipment, Intangibles.
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Term: Operating cycle is a duration of time that starts from purchase to sale of the product. Some business has
longer operating cycle than 12 months’ example construction company.
Current liabilities: Same 12 months or operating cycle. Examples are Accounts payable, Dividends payable & Current
portion of long-term debt
EXCEPTION: Current portion of the long-term debt will not be considered as a current liability if the company is
planning to refinance it by long term obligation.
Long-term Liability: Long-term notes payable, Car Loan payable & mortgage.
EQUITY:
Capital stock, additional paid-in capital, retained earnings, treasury stock, Minority (others) interests.
Term: Bond retirement fund is same as a Sinking fund.
Uses and Limitations of Balance Sheet

Uses of Balance Sheet:
1) Liquidity & Solvency
2) Financial Flexibility
3) It’s a “PICTURE at given date”
4) Provides basis for RATE OF RETURN, CAPITAL STRUCTURE, LIQUIDITY AND FINANCIAL
FLEXIBILITY
Limitations of balance sheets

1) It holds Historical Amounts
2) There are a lot of estimates that are used in accounting, for non-accounting persons such estimates cause
confusion. Examples of estimates are below:
a. Bad debt allowance
b. Warranty allowance
3) Some Assets are not recorded at all, intangible assets such as internally generated Goodwill, brand
reputation. (result of past transaction criteria conditions is not met). They might worth a lot.
4) IT DOESN’T ALLOW US TO EVALUATE PAST PERFORMANCE OF SPECIFIC PERIOD.
INCOME STATEMENT
If a balance sheet is a picture, the income statement is a movie. It shows a period. The company can prepare a monthly,
quarterly, yearly. But it should mention the time frame “for the year ended” Or “for the quarter ended”. It shows temporary
accounts. Revenues and Expense accounts are temporary because they are closed into retained earnings and not carried
forward to the next year. Once we pay dividends it goes out of Retained Earnings.
Types of Income Statements

Multi-Step:
Sales
– Cost of sale
= Gross Profit
– Selling & general and admin expenses
= operating income
+ interest income
SINGLE STEP:
Revenues – expenses = Net Income
ELEMENTS OF INCOME STATEMENT

Revenue = are the economic benefits we get from our primary business operations.
Expenses = are the expense we get from our primary business operations
Gains = Secondary incomes
Losses = Secondary losses
RECOGNITION OF REVENUE
Revenue is generally recognised when transfer or exchange takes place. RISKS & REWARDS associated with
the ownership of the Asset or Inventory should depart from the Seller to the Buyer. There is some situation where
revenue is recognised bit differently.
DISCONTINUED OPERATIONS (NET OF TAX)
1) Operations
2) Disposals
Extra Ordinary Items (NET OF TAX) are of Material Amount and of UNUSUALL AND INFREQUENT nature.
MINORITY INTERESTS – non-controlling interests.
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Uses and Limitations of Income Statement
Uses of income statement
It allows us to know Past performance
Basis for predicting future
Helps to assess risks
IT ALLOWS US TO EVALUATE PAST PERFORMANCE OF SPECIFIC PERIOD.
LIMITATION OF INCOME STATEMENT

Net income is also full of assumption and estimates
Example depreciation is calculated by estimated useful life and estimated salvage value.
Income is also effected by Accounting methods
Items that can’t be measured reliably aren’t included
Its past transitions it not telling future, but we can forecast
STATEMENT OF COMPREHENSIVE INCOME (OCI)

The results of all transactions except the transaction with the owners. Four (4) items as per standards (net of tax) or need
to be disclosed if not net of tax
Net Income after Tax
+ (-) Foreign currency translation adjustments (net of tax)
+ (-) Gains or losses and prior service cost or credits related to defined benefit pension plan that have not been
recognized as components of net periodic benefit cost (net of tax)
+ (-) Unrealized holding gains or losses on the AVAILABLE – FOR –SALE securities (net of tax), and
+ (-) effective portion of the gain or loss on the derivative designated as a cash flow hedge (net of tax)
Net Comprehensive income
KEY TO REMEMBER: F G H S
STATEMENT OF CHANGES IN EQUITY:
Elements are:
1) Preferred Stock
2) Common Stock
3) Additional paid-in capital
4) Retained earning
5) Appropriated retained earning
6) Accumulated other Comprehensive Income
STATEMENT OF CASHFLOW
A statement that Shows Cash received and paid
USES OF CASH FLOW

It all comes down to CASH. If you don’t have positive cash flow your company gets bankrupt.
1) Perhaps one of the ways to have positive cash flow is we haven’t paid our vendors.
2) The indirect method isn’t obvious about sources of funds.
CASHFLOW ACTIVITIES
OPERATING ACTIVITIES:
General rule any transaction that is not classified as investing and financing are Operating. These are the events and
transaction that generates the revenues and expenses.
 Cash collections from customers and cash paid to suppliers.

 Interest paid & received are operating activities.
 Dividends received are operating (but paid is Financing Activity)
 Cash flows from securities classified as trading are operating activities. Taxes paid and received are operating
activities.
INVESTING ACTIVITIES
These relate to the acquisition and disposal of long-term assets and other investments that are not considered to be cash
equivalents.
 Purchasing and Sale of Property Plant & Equipment (fixed assets).

 Making and Collecting Loan.
 Buying and Selling Shares of other companies.
 Acquiring and Disposing of debt in other companies.
 Buying and selling available for sale & held to maturity investments.
FINANCING ACTIVITY
These relate to the activities that cause changes to the contributed equity and borrowings of the entity.
 Issuance of Stock (shares)

 Treasury Stock transactions (shares buy back)
 Paying dividends (dividends only cash, stock dividends and Property dividends are not included)
 Issuing debt and repaying debt is a financing activity
 Obtaining and repaying a loan.
 Some tax connected to share-based compensation
WE NEED TO PRESENT EACH SIDE OF TRANSACTION IN CASH FLOW, we need to show cash received and paid
separately. Why it’s necessary:
EXAMPLE: A Company purchases $500K New fixed asset and company sold an old fixed asset for $500k. It will look like
the there are no transactions. But the reality is one company have upgraded the fixed asset. That’s why both sides are
shown separately.
However, for some transactions its ok net off inflow and outflow but not all, such transactions are outside of the scope of
the exam.
NON-CASH INVESTING AND FINANCING TRANSACTION

Example: A company acquired fixed asset but instead of cash company paid for it by issuing shares. By putting these two
transactions together shows there is NO cash paid.
DISCLOSURE REQUIREMENT OF NON-CASH TRANSACTIONS: Should such items be included in Cash flow? The
Answer is NO, but they are presented separately in at the end of Statement of Cash flow as a note.
CASH EQUIVALENTS
Cash Equivalents are the short term HIGHLY LIQUID ASSETS which have maturity of 30 days or 90 days. Company
buys massive amount of money as Cash Equivalents. TRANSACTIONS WITH CASH EQUIVALENTS are not shown in
CASH FLOW STATEMENT.
Example: a company purchase Cash equivalent for a month of 250Million, and sold it at Maturity, then again after
a day or two Purchased 200 million cash equivalents and then it sold it again within a month. Upon preparation of
Cash flow if we consider such transactions its distorts the cash flow statement, and it appears like purchasing and
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selling cash equivalents are the principal activity of the business. Even though it transactions occur many time
within a year but TECHNICALLY this is a same money.
FOREIGN CURRENCY CASH FLOW

Rate in effect at time of Cash flow is used. If the company has lot of these transactions, then an average rate can be used
if it gives similar result. If there are few transactions it should be valued at the rate oat time of cash flow.
PREPARING THE SATEMENT OF CASH FLOW

First thing is we know the answer of cash flow
1) We know the cash received

2) We know the cash paid
3) We know the asset purchased
There are two methods of preparing CASHFLOW
1) Direct
2) Indirect
Difference between the two methods:
1) Presentation of Operating Activity

2) Investing & Finance activity are exactly copy paste in both methods.
INDIRECT METHOD
This method is the reconciliation between Net Profit and Cash. In operating activity, we start with NET INCOME. Then we
remove non-cash expenses example depreciation, bad debt expense. Then we take out investing & financing incomes.
Then we adjust for operating accounts. Then we remove trading securities.
OPERATING ACTIVITY starts with NET INCOME
1) Eliminate non-cash items (to add it back to NET INCOME)

a. Depreciations
b. Amortization
2) Eliminating non-operating accounts (GAINS to be minus from NET INCOME, LOSSES to be added back to
NET INCOME)
a. Gain & losses on sales of PPE
b. Gain & losses on sale of Investments
3) Individual Account Adjustments.
a. Differences of RECEIVABLES (Increase Minus, Decrease Addition)
b. Differences of PAYABLE (Increase Addition, Decrease Minus)
c. Differences of INVENTORIES (Increase Minus, Decrease Addition)
d. If any operating account Is an ASSET and it decreases this mean ADDDITION and INCREASES, this
is an DEDUCTION
e. If any operating account Is liability and it decreases this mean DEDUCTION and INCREASES, this is
an ADDITION
4) CASH FLOWS FROM TRADING ACTIVITIES
a. Generally trading activities are classified as operating activity, however if the company chooses to
classify it under Investing section it can do it.
5) DISCLOSURES
You need to have a separate disclosure

a. Cash paid for interest
b. Cash paid for taxes
Reasons of this disclosures are how much we pay interest and how much we paid taxes.
INVESTING ACTIVITIES
REMEMBER: We all are interested in cash received and cash paid separately for investing activity. Gain or Loss has
already been adjusted in Operating activity. We don’t care if we made Gain or Loss here. But the sales proceeds from Sale
of PPE & investments. And how much cash we paid to acquire new Assets.
Note: We don’t have to add or less if transaction is non-cash. Example Stock issued against Acquisition of PPE
for $50,000. But this will not be included in Cash flow, just a disclosure is requiring as a note.
Example: If a XYZ company sold plant costing $100,000 for $150,000. Then we have to ignore the gain in Investing
activities and just put the sale proceeds of $150,000.
FINANCING ACTIVITIES
This is same, however accounts held in equity side are discussed including dividends paid. Dividends received is
investing activity, cause it’s a result of investment in other But paid if outflow from financing activity.
RECOGNITION, MEASUREMENT, VALUATION AND DISCLOSURE
Limitation of FINANCIAL STATEMENTS

1) Monetary
2) Estimations, Judgement involved
3) Past transactions e.g. historical costs
4) Going concerned assumption
5) But all the different users required different information’s
ASSET VALUATION
ACCOUNTS RECEIVABLE
1) Valuations
2) Bad debts
3) Factoring
Unfortunately, some receivables can’t pay. That’s why we need to keep allowance for bad debt. We legally have right to
collect 100% receivables but this really doesn’t happen. So, on Dec 31, when we are making Financial Statement, we don’t
know for sure that we collect 100%.
So, we create allowance of bad debt based on our experience and judgement, cause don’t know for certain who isn’t going
pay.
There are two methods of calculate Allowance for Bad debt.

1) % of Sales
2) % of Accounts Receivables
3) Direct Write Off method – this is not acceptable under GAAP due to incompatibility with matching concept.
The matching concept is one of the primary differentiators between accrual accounting and cash basis
accounting. With the matching concept, revenues are reported along with the expenses that brought them in the
same period
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PERCENTAGE OF SALES METHOD or INCOME STATEMENT METHOD
Under Percentage of Sales Method, we take CREDIT SALES and apply percentage to it. This is also called INCOME
STATEMENT method. We charge % to Profit & Loss Account.
PERCENTAGE OF ACCOUNTS RECEIVABLES METHOD OR BALANCE SHEET METHOD

Under Percentage of Accounts Receivables method, we take ENDING Accounts Receivables and apply the x percentage
to it. This difference of balance in Allowance for Bad debt account and % of receivables are charge as Bad debt expense
if its more than the allowance balance or We credit Bad debt Expense account to bring it to the amount that it reaches x%
of Accounts Receivables. So the Allowance for bad debt should be exactly x% of Receivables.
How do we get this percentage? we analyze the HISTORIC DATA. If we have change our credit terms or our
clients are changed, we adjust that. We charge on basis of estimates. Example by experience we know that 5%
of Accounts Receivables will not pay or 5% of Credit Sales will not be paid.
Accounts we use are:
BAD DEBT EXPENSE (DR)

ALLOWANCE FOR DOUBTFUL DEBTS (CR)
Best of approach to solve Exams Question is T account.
If we are certain that Customer is not going to pay, then it will come out from Allowance.
Allowance for Doubtful Debts (DR)

Receivables (CR)
In this entry balance sheet & Profit & Loss doesn’t change. Because we were keeping allowance for it throughout the years.
Recovery: if we can recover the amount
Cash or Bank (DR)

Allowance for Doubtful Debts (Cr)
INCOME STATEMENT METHOD BALANCE SHEET APPROACH
% OF SALES BALANCING AMOUNT OF OPENING ALLOWANCE ACCOUNT AND %

OF RECEIVABES
BAD DEBT EXP (DR) BAD DEBT EXPENSE (DR)
ALLOWANCE FOR BAD DEBT (CR) ALLOWANCE FOR BAD DEBT (CR)
BAD DEBT EXPENSE ACCOUNT
BAD DEBT EXPENSE -> TO PROFIT & LOSS ACCOUNT
ALLOWNACE FOR BADDEBT -> CONTRA TO RECEIVABLES in balance sheet.
ENDING BALANCE:
It needs to be credit balance

% of A/R is the percentage of Accounts receivables
% of Sales, it’s a balancing Amount
Question: An internal auditor is deriving cash flow data based on an incomplete set of facts. Bad debt expense was $2,000.
Additional data for this period follows:
Credit sales $100,000
Gross accounts receivable -- beginning balance 5,000
Allowance for bad debts -- beginning balance (500)
Accounts receivable written off 1,000
Increase in net accounts receivable (after subtraction of allowance for bad debts) 30,000
How much cash was collected this period on credit sales?
A. $64,000
B. $68,500
C. $70,000
D. $68,000
Answer (D) is correct.
The beginning balance of gross accounts receivable (A/R) was $5,000 (debit). Thus, net beginning A/R was $4,500 ($5,000
– $500 credit in the allowance for bad debts). The allowance was credited for the $2,000 bad debt expense. Accordingly,
the ending allowance (credit) was $1,500 ($500 – $1,000 write-off + $2,000). Given a $30,000 increase in net A/R, ending
net A/R must have been $34,500 ($4,500 beginning net A/R + $30,000), with ending gross A/R of $36,000 ($34,500 +
$1,500). Collections were therefore $68,000 ($5,000 beginning gross A/R – $1,000 write-off + $100,000 credit sales –
$36,000 ending gross A/R).
FACTORING RECEIVABLES
Receivables as an immediate source of CASH
Its selling of receivables against cash. Its discounting of receivables. Selling receivables also transfer risks from seller to
buyer. Obviously, the buyer going to charge.
If the seller of the receivables withdraws the funds in the account immediately, the factor charges interest on the advance.
The interest is prepaid, so the amount available to the seller to withdraw is reduced by the amount of the interest charged.
Face value of the accounts receivable
− Factoring fee (a percentage of the face value of the receivables)
− Factor’s holdback for merchandise returns (a percentage of the face value of the receivables)
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= Funds deposited to the seller’s account with the factor
− Interest expense (Funds withdrawn × annual interest rate17 ÷ 360 days18 × the weighted aver-age number of days to
maturity of the receivables sold19)
= Cash available to the seller to withdraw
If the seller of the receivables does not withdraw the funds before the maturity date of the receivables sold, no interest is
charged. Another alternative available to the firm is to leave the funds on deposit in its factoring account beyond the
weighted average maturity date of the receivables sold and receive interest on the funds for the period left on deposit
beyond the receivables’ maturity.
FACTORING RECEIVBALES
RESERVCE – it’s the protection against the bad debt. Factor keeps this amount for some time.
Fee % -> this will be some fee against which factor going do work to collect
Interest % is based on the amount loan not on actual receivable
RISK
WITH RECOURSE – Bad receivables will come back to the seller
WITHOUT RECOURSE - Bad receivables are not liability of seller
WITHOUT RECOURSE: MORE RISK to the FACTOR mean factor will charge more fee and more interest.
FORMULA:
Face Value
(-) factor fee
(-) factor’s reserve
= Gross Amount
(-) interest = funds taken * interest % * number of months’ receivable will be owned by the bank
= CASH RECEIVED FROM THE FACTOR
RESERVE WILL ALSO COME BACK IF ALL CUSTOMERS PAY.
Disclosing FACTORED RECEIVABLES
With Recourse -> A Recourse Liability on Books
INVENTORY
Inventory is the raw materials, work-in-process products and finished goods that are considered to be the portion of a
business's assets that are ready or will be ready for sale. Broadly there are three classes of Inventory.
CLASSIFICATION
1) RAW MATERIALS
2) WORK IN PROCRESS
3) FINISHED GOODS
What is our inventory

We only include inventory which is ours. If it’s not ours we don’t include it.
1) In Transit
a. FOB shipping point.
b. FOB Destination.
2) Consigned goods
a. When company A gives goods to company B to sell. Goods still belongs to A. Ownership goes from A to
B. Ownership goes from A to Customer. A keeps the goods in his balance sheet.
3) Goods out on approval – where customer keeps it or return it till a fixed time.
Obsolete Inventory – old stuff is written off in P&L.
INVENTORY VALUATION
Initial valuation
All cost necessary to get the item ready & available for sale. Inventory Cost includes Price, Shipping, Taxes in case of
manufactured goods, direct labor involved, Raw material, spares used, Factory overheads etc. It also included Work in
Process.
COST FLOW ASSUMPTION

Which unit do we sell? Because prices change. if we have 50 units, we should consider that all these 50 units are bought
at same price.
1) FIRST IN FIRST OUT

2) LAST IN FIRST OUT
3) Weighted average / Moving average
The weighted-average method determines an average cost only once (at the end of the period) and is therefore
applicable only to a periodic system. In contrast, the moving-average method requires determination of a new
weighted-average cost after each purchase and thus applies only to a perpetual system.
4) Specific identification: We value each inventory unit at the specific cost. With computers and bar coding & RFIDS.
Is best method but cost of doing it should not outweigh the benefit. This has become possible by use of Computers
and Modern Technologies.
FIFO (FIRST IN FIRST OUT)
Means Units which are purchased First will be sold First. Assume Prices are rising. Ending inventory is of higher value.
LIFO (LAST IN FIRST OUT)
Units purchased Later will be sold First. Means It’s the opposite of FIFO, we have higher COGS which leads to lower profit.
Ending inventory has old cheaper units. Not Allowed under IFRS.
Weighted Average method
Total cost paid / total units = Average cost for the year.
The weighted-average method determines an average cost only once (at the end of the period) and is therefore applicable
only to a periodic system. In contrast, the moving-average method requires determination of a new weighted-average
cost after each purchase and thus applies only to a perpetual system.
Periodic vs. Perpetual
Periodic is once a year and Perpetual is every time a sale.
FIFO in Perpetual & Periodic Every time the customer comes in we going to sell the oldest Unit. FIFO in Perpetual
has no difference between perpetual & periodic.
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Moving Average (perpetual)
Every time you buy new unit, you calculate new average.
FIFO, LIFO AND moving average are assumptions
GAAP requires we need to do Physical Count at regular intervals.
INVENTORY IN BALANCE SHEET

What ending inventory should be on Balance Sheet? Company must adjust the inventory to make it correct. There will be
inventory gain or loss.
ERRORS IN INVENTORY
If we make a mistake in recording Purchases, or we made a mistake in inventory count. Example if we overstate the ending
inventory we will be wrong in Year 1 and year 2 both. There can be question where a company is over stated Opening,
Purchases and understated Closing.
Such question should be answered by making the two scenarios. One correct one and One which is already been done.
What u did and what should have been done get the difference and it’s your answer.
SUBSEQUENT VALUATION OF INVENTORY

Subsequent valuation for GAAP & IFRS.
IFRS says Inventory should be valued at Lower of Cost or NRV at the year-end or even at the Interim periods. NRV is
the estimated selling price in the ordinary course of business minus estimated costs of completion and sale.
GAAP says inventory should be valued at Lower of Cost or Market (restricted by floor & ceiling), but if at interim accounts
Market is lower but management believes that at year end Market will be higher than cost then we don’t use Lower of Cost
or Market (LCM) method at interim. Lower of Cost or Market is mentioned below.
LOWER OF COST OR MARKET (RESTRICTED BY CEILING AND FLOOR)

If Market or Replacement cost of the inventory is lower than historic cost, we have to write down the Inventory Value.
Initially Inventory is recorded at Cost (defined by FIFO/LIFO & Weighted Average). However, inventory must be written
down if its utility is no longer as great as its cost.
CURRENT MARKET VALUE

Is the cost we have to pay to replace it or re-produce it. Also, called REPLACEMENT COST
CELING
NRV = SELLING PRICE – COST TO COMPLETE OR DISPOSE (SELL)
FLOOR
NRV- NORMAL PROFIT MARGIN
Normal Profit margin will be provided in question.

CURRENT REPLACEMENT COST or MARKET VALUE
The term replacement cost or replacement value refers to the amount that an entity would have to pay to replace an asset
at the present time, according to its current worth.
REPLACEMENT COST/MARKET SHOULD BE BETWEEN CELEING AND FLOOR.

NOW IF MARKET IS LOWER THAN COST WE GO FOR MARKET AND WRITE DOWN INVENTORY. IF MARKET IS
HIGHER THAN INVENTORY THEN WE STAY AT COST.
FOR SUBSEQUENT VALUATION OF INVENTORY (LOWER OF COST OR MARKET) following steps should be applied
in exams. (LCM)
1) Determine if Current Replacement Cost is lower than historic Cost.

2) If yes, then workout our Market Value by using market price restricted by Ceiling and Floor method (Ceiling = NRV
& Floor = Ceiling – Normal Gross Profit)
3) If the current replacement cost is between the floor and the ceiling, the current replacement cost is the market
amount. If the current replacement cost is greater than the ceiling, the ceiling amount is the market amount. If the
current replacement cost is lower than the floor, the floor amount is the market amount.
IN SHORT Designated Market Value = Take middle value of Ceiling, Floor & Replacement Cost. DONOT TAKE
AVERAGE OF THESE.
4) Now that we have Designated Market Value.
5) Compare Designated Market Value Vs Historic Cost. Take whichever is lower as Inventory Value.
6) Multiply this with Quantity of units to come up at Inventory Value (if this is required in Question)
7) The journal entry for the write-down will be:
DR Inventory Loss or Cost of Goods Sold .................................. X

CR Allowance to Reduce Inventory to Market ............................... X
EXAMPLE:
Based on a physical inventory taken on December 31, a company determined its chocolate inventory
on a FIFO basis at $26,000 with a replacement cost of $20,000. The company estimated that, after
further processing costs of $12,000, the chocolate could be sold as finished candy bars for $40,000.
The company’s normal profit margin is 10% of sales. Under the lower-of-cost-or-market rule, what
amount should the company report as chocolate inventory in its December 31 balance sheet?
A. $26,000
B. $20,000
C. $28,000
D. $24,000
Answer (D) is correct.
Market equals current replacement cost subject to maximum and minimum values. The maximum is
NRV, and the minimum is NRV minus normal profit. When replacement cost is within this range, it is
used as market. Historic Cost is given as $26,000. NRV is $28,000 ($40,000 selling price – $12,000
additional processing costs), and NRV minus a normal profit equals $24,000 [$28,000 – ($40,000 ×
10%)]. Because the lowest amount in the range ($24,000) exceeds replacement cost ($20,000), it is
used as market. Because market value ($24,000) is less than cost ($26,000), it is also the inventory
amount.
Note: The LCM Method can be applied to the entire inventory as one group, to groups or pools of inventory items,
or to each item individually. Applying it to each item individually will provide the lowest amount for ending
inventory. When each item is calculated separately, each item that has decreased in value will be written down.
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However, when groups, or pools, of inventory are used the decline in the value of one item may be offset
by an increase in the value of another item.
For example, if item A (cost $2, market $1) and item B (cost $3, market $4) are aggregated for LCM purposes, the
inventory measurement is $5. If the rule is applied separately to A and B, the LCM measurement is $4.
INVENTORY SUBSEQUENT VALUATION DIFFERENCE BETWEEN IFRS AND GAAP
IFRS subsequently values Inventory as Lower of Cost or NRV, even at interim accounts or at final. Reversal in later period
is allowed up to the amount written down.
GAAP subsequently values inventory at Market price restricted by Ceiling and Floor, but if Floor or NRV minus Gross Profit
is expected to rise above Replacement Cost within same year then no need to reduce value of inventory in interim period.
GAAP doesn’t allow reversal of amount written down.
Example:
A company determined the following information for its inventory at the end of an interim period on June 30, Year 2:
Historical cost $80,000

Net realizable value (NRV) 77,000
Current replacement cost 76,000
Normal profit margin 2,000
The company expects that on December 31, Year 2, the inventory’s NRV reduced by a normal profit margin will
be at least $81,000. What amount of inventory should the company report in its interim financial statements under
IFRS and under U.S. GAAP on June 30, Year 2?
IFRS U.S. GAAP

A. $80,000 $80,000
B. $77,000 $80,000
C. $80,000 $81,000
D. $77,000 $76,000
Answer (B) is correct. Why? Because Under U.S. GAAP, inventory is reported at its historical cost of $80,000
because no write-down of inventory is reasonably anticipated for the year. Under IFRS, the inventory is measured
at the lower of cost ($80,000) and NRV ($77,000) for each interim reporting period. Whether a market decline is
expected to be reversed by the end of the annual period is not considered. Thus, the inventory is reported at its
NRV of $77,000.
Under U.S. GAAP, the inventory loss from a market decline is deferred if no loss is reasonably anticipated
for the year. The amount of $76,000 (current replacement cost is less than NRV but greater than NRV minus
a normal profit margin) is reported only if a reversal of the market decline is not expected by year end.
Moreover, unlike U.S. GAAP, IFRS permit inventory to be written up to the lower of cost and NRV if
previously written down.
LIFO and LCM

As mentioned previously, U.S. GAAP does not prescribe rules for applying the LIFO cost flow assumption in valuing
inventory. Instead, IRS regulations provide the rules. LCM may not be used with a LIFO cost flow assumption under
IRS regulations. As we mentioned earlier, if a company uses LIFO for tax purposes, the IRS requires it to also use LIFO
for its financial reporting. However, the company is not required to use the same LIFO applications for its tax reporting and
its financial reporting. A company may use different LIFO applications for tax reporting and financial reporting. The use of
lower of cost or market with LIFO costing is an example of this flexibility.
Although IRS regulations do not permit the use of LCM with LIFO on the income tax return, LCM is applied with LIFO for
financial reporting purposes. However, when prices are rising, the instances in which inventory is written down will be fewer
under LIFO than under the other inventory cost flow assumptions because the historical cost of the inventory on the books
will be lower. It will be more likely that cost will be lower than market value when LIFO is being used than when other cost
flow assumptions are being used.
If inventory is written down to market value under LIFO, the application of LCM with LIFO internally but not for tax purposes
will cause a temporary difference in the carrying value of the inventory between the financial statements and the income
tax return.
PURCHASE COMMITMENTS
A loss is accrued in the income statement on goods subject to a firm purchase commitment if the market price of these
goods declines below the commitment price. This loss should be measured in the same manner as inventory losses.
Disclosure of the loss is also required.
INVESTMENTS
Methods of investments
1) Fair value method up to 20% ownership

2) Equity method 20-50% Equity method
3) Consolidation method 50% or more
Trading securities and available-for-sale securities are reported at their fair values at each balance sheet date.
Held-to-maturity securities are reported at amortized cost.
INVESTMENT IN DEBT SECURITIES
1) TRADING – for short term price fluctuations

2) AVAILABLE FOR SALE – everything else
3) HELD TO MATURITY – desire to hold till the maturity
TRADING AND AVAILABE FOR SALE

Securities are accounted for Fair Value
Trading: UNREADLISED gain or loss to Income Statement
Available for Sale: UNREALISED gain or loss goes to OTHER COMPREHENSIVE INCOME
HELD TO MATURITY: carried at amortized cost.
Investments in debt securities must be classified as held-to-maturity and measured at amortized cost in the balance
sheet if the reporting entity has the positive intent and ability to hold them to maturity. Investments in equity securities are
classified as either trading or available-for-sale. Equity securities that are not expected to be sold in the near term should
be classified as available-for-sale. These securities should be reported at fair value, with unrealized holding gains and
losses (except those on securities designated as being hedged in a fair value hedge) excluded from earnings and reported
in OCI.
Fair value method

SMALL EQUITY INVESTMENT
Investment is Less than 20% of the Shares.
If its Trading: UNREADLISED gain or loss to Income Statement
SHARES are not HELD TO MATURITY
LARGER EQUITY INVESTMENT

20% to 50% EQUITY METHOD
50% +1 CONSOLIDATION
26
METHODS OF PRESENTATION & DISCLOSURE
FAIR VALUE METHOD
It applies to SMALL EQUITY INVESTMENT if it’s Less than 20% of the Shares in a Company. Initially valued at Cost.

If its Trading: UNREADLISED gain or loss to Income Statement
SHARES ARE NOT HELD TO MATURITY INVESTMENTS
EQUITY METHOD
RECORD AT COST
ADJUST FOR OUR SHARE OF PROFIT & LOSS
REDUCED BY DIVIDENDS
THIS Can’t GO BELOW ZERO
INTERCOMPANY TRANSACTION ARE ELIMINATED
INTERCOMPANY P&L – ELIMINATED UNTIL SOLD OUTSIDE PARTY
INTERCOMPANY ACCOUNTS RECEIVABLES AND PAYABLES ARE SHOWN SEPERATELY
GOODWILL IS NOT RECORDED SEPRATELY
CONSOLIDATION METHOD
Consolidation should be applied in two situations
1) VOTING INTEREST 50%+1 SHARE
2) Entity should have controlling interest
Note: Consolidation is based on control.
Inter-company transactions are eliminated
(NO PROFITS, NO GAINS & LOSSES, NO REVENUES) WE ARE INTERESTED IN WHAT THEY HAVE DONE
OUTSIDE OF RELATED PARTIES.
Example:
Entity X owns 90% of Entity Y. Early in the year, X lent Y $1,000,000. No payments have been made on the debt
by year end. Proper accounting at year end in the consolidated financial statements would;
Eliminate 100% of the receivable, the payable, and the related interest.
Eliminate 90% of the receivable, the payable, and the related interest.
Eliminate 90% of the receivable and the payable but not any related interest.
Eliminate 100% of the receivable and the payable but not any related interest.
Answer (A) is correct.
In a consolidated statement of financial position, reciprocal balances, such as receivables and payables,
between a parent and a consolidated subsidiary should be eliminated in their entirety regardless of the portion
of the subsidiary’s shares held by the parent. Thus, all effects of the $1,000,000 loan should be eliminated in the
preparation of the year-end consolidated statement of financial position.
PROPERTY PLANT & EQUIPMENTS (FIXED ASSETS)

Recognize when it is probable that:
1) The future economic benefits associated with the asset will flow to the entity,
2) and the cost of the asset can be reliably measured.
Measurement
• Initially recorded at cost.
• Subsequent costs are only recognized if costs can be reliably measured and these will lead too additional economic
benefits flowing to the entity.
Initial Recognition:
Assets should initially be recorded at Cost, and all the costs that’s necessary to bring asset under existing location and
condition. It also includes major upgrades which enhances the future cash flow. But ordinary maintenance due to normal
wear and tear shouldn’t be classified as asset.
DEPRECIATION & METHODS:

Depreciation is systematic allocation of cost of asset over its useful life. There are method to calculate depreciation are as
follows.
STRAIGHT LINE:
Cost of Asset Minus Salvage or Scrap Value will give us depreciable cost. Which is then evenly allocated over useful of
Asset. This depreciation remains constant over its useful life.
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑏𝑙𝑒𝐶𝑜𝑠𝑡
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 =
𝐿𝑖𝑓𝑒𝑜𝑓𝐴𝑠𝑠𝑒𝑡
Declining Balance Method (reducing balance Method)

Here Carrying Value is applied with depreciation rate to arrive at Depreciation Expense. Carrying Value will reduce every
year resulting depreciation expense will be reduced. That’s why this is called Declining balance method. REMEMBER the
value to apply rate is Carrying Value Not Depreciable cost or cost.
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝐸𝑥𝑝𝑒𝑛𝑠𝑒 = 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔𝑉𝑎𝑙𝑢𝑒𝑋𝑟𝑎𝑡𝑒𝑜𝑓𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
DOUBLE DECLINING BALANCE METHOD

DEP EXP = DOUBLE THE STRAIGHT-LINE RATE X BOOK VALUE OF ASSET AT THE BEGINNING OF THE YEAR
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔𝑉𝑎𝑙𝑢𝑒 ∗ (𝑟𝑎𝑡𝑒 ∗ 2)
SALVAGE VALUE SHOULD BE BOOK VALUE AT LAST YEAR.
GOOD NEWS EXAM WILL HAVE MAX 2ND YEAR DEPRECIATION CALCULATION
SUM OF YEAR DIGIT METHOD
Here we multiply the DEPRECIABLE AMOUNT x Fraction. Fraction is Number of useful life / sum of number of years.
Example:
Plant with cost of 10,000 with salvage is 1000. life is 4 years.
4 4
Y 1) Depreciation Expense year 1(10000 − 1000) ∗ ( ) = 9000 ∗ ( ) = 3600
4+3+2+1 10
3 3
Y 2) Depreciation expense year 2 (10000 − 1000) ∗ ( ) = 9000 ∗ ( ) = 2700
4+3+2+1 10
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UNITS OF PRODUCTION METHOD
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑏𝑙𝑒 𝐴𝑚𝑜𝑢𝑛𝑡 ∗ 𝑈𝑛𝑖𝑡𝑠𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑑
𝐶𝑎𝑝𝑎𝑐𝑖𝑡𝑦
DEPLETION
Depletion is a periodic charge to expense for the use of natural resources. Thus, it is used in situations where a company
has recorded an asset for such items as oil reserves, coal deposits, or gravel pits. The calculation of depletion involves
these steps:
1) Compute a depletion base

2) Compute a unit depletion rate
3) Charge depletion based on units of usage
The resulting net carrying amount of natural resources still on the books of a business do not necessarily reflect the market
value of the underlying natural resources. Rather, the amount simplify reflects an ongoing reduction in the amount of the
original recorded cost of the natural resources.
The depletion base is the asset that is to be depleted. It is comprised of the following four types of costs:
1) Acquisition costs. The cost to either buy or lease property.

2) Exploration costs. The cost to locate assets that may then be depleted. In most cases, these costs are charged to
expense as incurred.
3) Development costs. The cost to prepare the property for asset extraction, which includes the cost of such items
as tunnels and wells.
4) Restoration costs. The cost to restore property to its original condition after depletion activities have been
concluded.
To compute a unit depletion rate, subtract the salvage value of the asset from the depletion base and divide it by the total
number of measurement units that you expect to recover. The formula for the unit depletion rate is:
𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑝𝑙𝑒𝑡𝑖𝑜𝑛 𝑏𝑎𝑠𝑒 − 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑡𝑜 𝑏𝑒 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑒𝑑

𝐷𝑒𝑝𝑙𝑒𝑡𝑖𝑜𝑛 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 =
𝑇𝑜𝑡𝑎𝑙 𝑈𝑛𝑖𝑡𝑠
You then create the depletion charge based on actual units of usage. Thus, if you extract 500 barrels of oil and the unit
depletion rate is $5.00 per barrel, then you charge $2,500 to depletion expense.
The estimated amount of a natural resource that can be recovered will change constantly as you gradually extract assets
from a property. As you revise your estimates of the remaining amount of extractable natural resource, you should
incorporate these estimates into the unit depletion rate for the remaining amount to be extracted. This is not a retrospective
calculation.
Depletion Method Example

Pensive Corporation’s subsidiary Pensive Oil drills a well with the intention of extracting oil from a known reservoir. It incurs
the following costs related to the acquisition of property and development of the site:
Land purchase $280,000
Road construction 23,000
Drill pad construction 48,000
Drilling fees 192,000
Total $543,000
In addition, Pensive Oil estimates that it will incur a site restoration cost of $57,000 once extraction is complete, so the total
depletion base of the property is $600,000.
Pensive’ s geologists estimate that the proven oil reserves that are accessed by the well are 400,000 barrels, so the unit
depletion charge will be $1.50 per barrel of oil extracted ($600,000 depletion base / 400,000 barrels).
GROUP & COMPOSITE DEPRECIATION – FOR GROUP OF ASSETS AS A WHOLE

Method to apply is Straight Line to the collection of Asset as they are single Asset. The Composite method applies to group
of dissimilar assets with varying useful life. Example Aircraft and GROUP DEPRECIATION is used to depreciate group
of similar assets. A weighted average useful life and a depreciation rate are applied to a group of Assets. When asset
accounted for in a group depreciation is disposed of, THERE IS NO GAIN OR LOSS ON SALE OF ASSETS. They also
result in the offsetting of under-and overstated depreciation estimates.
Accounting entry for Disposal is as under:
DR Cash………………………………………………………. XXX
DR Accumulated Depreciation …………………. XXX (balancing figure)
Cr Fixed Assets …………………………………… XXX Original Cost.
Students will not be required to calculate depreciation expense under the group method on the exam, but you need to
know what the group method is and that there is no gain or loss on disposal of an asset that’s is depreciate in this manner.
TAX DEPRECIATION
Should be done according to TAX CODE. Country’s TAX law defines useful life and method
Year of acquisition and sale
1) Actual time – counting days methods.

2) Full year depreciation on acquisition and no depreciation on year of disposal
3) Mid year convention (or half year convention) six months depreciation in year of acquisition and six months in the
year of disposal
WHICH DEPRECIATION METHOD WE SHOULD USE
WE NEED TO USE A METHOD THAT BEST MATCHES WITH THE REVENUE AND EXPENSES
WE NEED TO USE A METHOD THAT BEST REFLECTS HOW IT IS THE ASSET BEEN USED.
Non-Current Asset Valuation:

Initial Valuation
Usually Assets are valued at cost, including all cost incurred to bring Asset to existing condition and location. It includes
cost of transportation, Govt. non-claimable duties e.g. duties, installations etc.
Subsequent Valuation
There are two models
COST MODEL
The asset is carried at cost less Accumulated Depreciation and Impairment losses.
REVALUATION Model (under IFRS)

Under the revaluation model, if the fair value of an item of property, plant, and equipment can be reliably measured, it must
be carried subsequent to initial recognition at a revalued amount. This amount is fair value at the date of the revaluation
minus any subsequent accumulated depreciation and impairment losses. The revaluation model is permitted by IFRS, not
U.S. GAAP.
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1) Revaluations should be carried out regularly (the carrying amount of an asset should not differ materially from its
fair value at the reporting date – either higher or lower).
2) Entire class of assets to which that asset belongs should be revalued.
3) Revalued assets are depreciated the same way as under the cost model.
4) An increase in value is credited to other comprehensive income under the heading “revaluation surplus” unless it
represents the reversal of a revaluation decrease of the same asset previously recognized as an expense, in this
case the increase in value is recognized in profit or loss.
IMPAIRMENT OF NON-CURRENT ASSET

All assets, except: inventories, construction contracts, deferred tax assets, employee benefits, financial assets under IAS
39, investment property, biological assets, insurance contract assets under IFRS 4, and held for sale assets under IFRS
5.
Assets to be reviewed
• Individual assets
• Cash generating units (‘CGU’)
The smallest identifiable group of assets that generates cash flows that are independent of the
cash inflows from other assets or group of assets.
Impairment: Carrying Amount > Recoverable Amount
Recoverable amount of an asset or cash generating unit is the higher of its fair value less
costs to sell and its value in use. Recoverable Amount in short is NRV
IMPAIRMENT OF FIXED ASSET

There are two broad Steps, first we must make sure that the Value of Asset is no overstated. To find out we need to follow
the following steps;
Step No. 1 to find if Asset is impaired or not?
1) We compare:
a. Book Value of the Asset
b. Undiscounted future cash flows (it’s the future cash flows which entity might get with the use of asset
example Cash generated by selling products manufactured by the Asset)
2) If Book Value is greater than undiscounted future Cash flow this means Asset is Impaired, we need to write it down
to the FAIR VALUE.
3) Otherwise keep it at Book value.
Step No. 2 What’s the impairment value?
If its impaired, we write it down to Present Value of Future Cash Flows (Fair Value). Amount of difference between Fair
Value and Carrying Value will be charged to Income Statement as Impairment Loss and Asset will be reduced.
Fair Value here is determined by calculating Present value of the future cash flows expected to be generated by the
machine.
Under IFRS, an impairment loss on an asset may be reversed in subsequent periods if a

change in the estimates used to measure the recoverable amount has occurred. But an
impairment loss recognized for goodwill must not be reversed. Under U.S. GAAP, a
previously recognized impairment loss must not be reversed.
DISPOSAL OF FIXED ASSET

CASH (DR) OR INVENTORY OR RECEIVABLE
ACCUMULATED DEPRECIATION (DR) BALANCE
LOSS ON SALE OF FIXED ASSET (DR)
FIXED ASSET (CR) COST
GAIN ON SALE OF FIXED ASSET (CR)
INTANGIBLE ASSETS
They don’t have physical value. But they have abstract value.
1 PATENT
2 FRENCHISE
3 TRADE MARK
4 COPYRIGHT
5 GOOD WILL
INTERNALLY GENERATED INTANGIBLE ASSETS usually are not recorded. Because don’t meet the definition of the
Asset, not a result of past event. Internally generated goodwill not recorded but purchased GOODWILL should be recorded.
PURCHASED INTANGIBLE ASSETS are recorded.
Impairment can happen in different way. It’s difficult to determine the value. EXAMPLE if a company defends its right to
use a patent exclusively but court determines that others who are using same or similar patent doesn’t make a difference
then immediately intangible asset will lose its value and impaired.
AMORTISED over Legal life or Useful life.
Like depreciation Intangible Assets Are Amortized over shorter its useful life and legal life.
GOOD WILL CACULATION
Goodwill is the excess of (1) the sum of the acquisition-date fair values of (a) the consideration transferred (b) any no
controlling interest in the acquire, and the acquirers previously held equity interest in the acquire (2) over the net of the
acquisition-date fair values of the identifiable assets acquired and liabilities assumed ($350,000). The amount of goodwill
is calculated as follows:
Consideration transferred $600,000
Acquisition-date fair value of net assets acquired ($850,000 – $350,000) (500,000)
Goodwill $100,000
VALUATION OF LIABILITIES ( Including Short-term debt )
REFINANCING SHORT TERMS DEBT

Big issue is reclassifying short terms debt, that is going to be financed. Many ratios depend upon it.
Example: 19 years and 10 months ago, we issued bonds. Its short terms liabilities. If we have made a commitment,
ability to refinance and demonstrated that, we can refinance we can classify it as non-current liabilities. It improves
the current ratios.
ACCOUNTING FOR WARRANTIES

a. Expense warranty – its manufacturer’s warranty included in the price of product.
b. Sales Warranty – it is sold separate from the product.
a) Expense Warranty – its recorded as liability. If it’s a liability it can be current or non-current liability. If we expect
to pay within a year its current or else non-current. Or may be split between them.
Issues are:
i) Estimating expense warranty
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Warranty Expense (Dr)
Estimated Warranty Liability (Cr)
ii) If warranty claims arise we fix it.
We make following entry
Estimated Warranty Exp (Dr)
Cash (Cr)
iii) At year end, there is balance in the Estimated Warranty Expense account, we need to make
sure it’s reasonable (by analyzing historic trends)
b) Sales Warranty – its sold separately.
a. We don’t recognize it as income, until Sales Warranties effect. Its recognized throughout the life of
extended warranty contract.
b. Expenses are charged to expenses.
c. Don’t estimate future expense.
d. Unearned revenue is already a liability
Journal entries are
Cash (Dr)
Sales (Cr)
Unearned Warranty Revenue (CR)
Amortization entry:
Unearned Warranty Revenue (Dr)
Warranty Revenue (Cr)
Accounting for Bonds
Nature of Bonds: A bond is natural contract to pay an amount of money (face amount) at the maturity date plus interest at
the stated rate at specific intervals.
Bond issuance: It’s not necessary that cash proceeds from Sale of bonds are equal to the face value of the bond, this is
due to the bonds’ stated rate of interest to the Market interest rate at the time of Sale.
1) If the stated rate is equal to the market, the cash proceeds are equal to the face value.
2) If the stated rate is greater than the current market rate, the cash proceeds are greater than the face value, and
the bonds are sold at Premium.
3) If the stated rate is lower than the current market rate, the cash proceeds are lower than the face value, and the
bonds are sold at Discount.
To Discounts the Bonds, Face value is discounted by the current market interest rate.
Amortization of Premium of Discount

Bond premium or discount must be amortized over the life of the bonds, using effective-interest method.
Effective interest method
𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 = 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑 𝑎𝑡 𝑡ℎ𝑒 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 ∗ 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
The annual interest expense is consisted of cash interest paid plus the effect of amortization of premium or discount
Situation 1 : Bond issued at premium, annual interest expense equals cash interest paid minus the amount of premium
amortized.
Situation 2: Bonds issued at a discount, annual interest expense equals cash interest paid plus the amount of discount
amortized.
Carrying amount of Bonds as they are presented in the financial statement = Face value + Premium – Discount.
At the maturity date, the discount or premium is fully amortized, and the carrying amount of the bonds equals the face
value of the bond.
Types of Bonds
There are following different types of Bonds
1) Term bond: single maturity date also known as regular term bond.
2) Serial Bonds: matures is stated amounts at regular intervals.
3) Income bonds pay interest contingent on debtor’s profitability
4) Revenue Bonds are issued by government and are payable from specific revenue sources.
5) Mortgage bonds are backed by Assets Usually Real estate
6) Debentures are backed by borrower’s general credit but not through specific collateral
7) Guaranty Bonds are guaranteed by a third-party example parent of the subsidiary
8) Collateral trust bonds are secured by financial assets, such as stock or other bonds.
9) Equipment trust bonds are secured by a mortgage on movable equipment, such as airplane or railroads cars.
10) Variable or floating rate bonds pay interest that is dependent on the market conditions.
11) Zero-Coupon or deep-discount bonds bear no stated interest rate and have no periodic cash payment, the interest
components consist entirely of the bond discount.
12) Commodity backed bonds are payable at the prices related to a commodity such as gold.
13) Callable bonds or redeemable bonds may be repurchased by the issue at a specified price before maturity.
a. During the period of falling interest issuer can replace high-interest debt with low-interest debt
b. Convertible bonds may be converted into equity securities of the issuer at the option of the holder subject
to specified conditions. Convertible bonds usually pay lower yield than non-convertible.
Working your way with Questions on bonds

Premium/Discount on bond = Surplus or deficit from Face value and Proceeds of issuance
Annual Interest expense = (Interest on book value)
Amortization of Premium or discount = Interest on face value – interest on book value
Liabilities Valuation – Disclosure requirements
OFF BALANCE SHEET FINANCING
1) OPERATING LEASES
2) SALE OF RECEIVABLES (FACTORING)
3) JOINT VENTURES
4) NON-CONSOLIDATED SUBSIDIARIES
5) VARIABLE INTEREST ENTITIES
1) OPERATING LEASES
They are changing accounting standard for leasing. But currently it’s still effective. There is no liability on the
balance sheet for the future payments. Because the lease is structured as operating lease it doesn’t have
Asset and Corresponding liability.
2) FACTORING RECEIVABLES
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It’s a sale of receivable to some parties at discount and charges. They just show cash in the account and
reduced receivables.
3) JOINT VENTURES – has their own books of accounts, company don’t have risks and rewards documents in
parent or participating company.
4) NON-CONSOLIDATED SUBSIDIARIES – liability of the subsidiary doesn’t make it to the company’s balance
sheet.
5) Variable Interest Entities – are special purpose companies made to perform specific task.
Why Use off Balance Sheet Financing, its objective shouldn’t be to deceive Users. Examples: Operating leases
INCOME TAXES
Fundamental Concept:
There are fundamental differences in the amount of income and expenses reported for GAAP and Income tax purposes.
The objective of GAAP is to report the economic activities of the entity to the users of financial statements. The objective
for income tax is to raise the revenue for the government. Income tax is assessed on the basis of Tax Law but Financial
Statements are based on GAAP or IFRS. Naturally there arises differences in the Pre-tax income which results in different
calculations for Tax purposes.
Deferred Tax
Deferred tax arises because of such temporary differences between income tax as per GAAP/IFRS and Tax Code.
1) DEFERRED TAXES (its prepaid tax or tax payable)
There are two ways of calculating income.
1) US GAAP OR IFRS
How much TAX company want to pay
2) ACCORDING TO TAX CODE (IRC) – Government
How much TAX company has to pay
Company decided to keep their books as per US GAAP. So the tax we want to pay is calculated correct, but TAX Company
has to pay is according to TAX code (IRC) to stay away from Jail term.
Note: US GAAP & IFRS are accrual basis but TAX code is mostly Cash basis.
OBJECTIVE OF DEFERRED TAXES

There are two objectives in accounting for deferred tax
1) To recognize the income taxes payable for the current accounting period
2) To record the future tax liabilities because of items recognized in the income statement but not the tax return OR
recognized in tax return but not recorded in Income Statement.
Deferred Tax Liabilities & Assets

If Income tax expense as per IFRS/GAAP is higher than the current income tax liability, the difference is called a Deferred
Tax Liability. If Income tax expense as per IFRS/GAAP is lower than the current income Tax liability, the difference is
called a Deferred Tax Asset.
DEFERRED TAX ASSET - It is a Prepaid tax

What are the causes of Deferred Tax?
1) REVENUE gets taxable earlier than recognized as revenue in books – unearned revenue example advances from
customers.
2) EXPENSE is recognized in Books earlier then it gets Taxable – unpaid expenses example Accounts Payable.
3) Depreciation charged on higher rate in books and lower rate in tax example Company uses St line at 40% and tax
code says 33% reducing balance in 1 year.
DEFERRED TAX LIABILITIES – it’s a Taxes payable, we had to pay less then we wanted to.
1) REVENUE gets recognized in books earlier than becomes taxable – example Credit Sales or installment sales.
2) Expense becomes tax-deductible earlier than its recognized in books - example Prepaid Rent.
3) Depreciation charged on lower rate in books and higher rate in tax example Company uses St line at 20% and tax
code says 33% reducing balance in 1 year.
EXAMPLE 1
At the end of its first year in business, a corporation reported pretax financial statement income of $50,000. Included in
pretax income were $10,000 of revenue from installment sales and depreciation expense of $12,000. On the tax return,
$5,000 of installment sales revenue was reported, and depreciation expense of $16,000 was deducted. The income tax
rate was 40%. The corporation reports installment sales receivables as current assets. On its year-end statement of
financial position, the corporation should report deferred tax balances of:
A. $2,000 as a current liability and $1,600 as a current asset.
B. $4,000 as a current asset and $5,000 as a noncurrent asset.
C. $2,000 as a current liability and $1,600 as a noncurrent liability.
D. $4,000 as a noncurrent liability and $5,000 as a current liability.
Answer is :
Since Revenue from installment sales are recognized earlier than it becomes taxable Entity should report current deferred
tax liability of $ 5000. Since Depreciation is charged in the books is lower than allowed in tax the difference of $4000 should
be recorded as non-current liability as depreciation. Hence the correct answer is “D”.
EXAMPLE:
Fact Pattern: Lucas Company computed the following deferred tax balances for the 2 most recent years. Deferred tax
assets are considered fully realizable.
Year 1 Year 2
Current deferred tax assets $3,000 $10,000
Noncurrent deferred tax assets 6,000 7,000
Current deferred tax liabilities 8,000 9,000
Noncurrent deferred tax liabilities 5,000 14,000
If Lucas calculates taxable income of $1,000,000 for Year 2 and is taxed at an effective income tax rate of 40%, how much
income tax expense will be reported on Lucas’s income statement for Year 2?
Answer:
Deferred tax expense or benefit is the net change during the year in the entity’s deferred tax liabilities and assets. It is
aggregated with the current tax expense or benefit to determine total income tax expense for the year. The amount of
income taxes payable (current tax expense) is $400,000 ($1,000,000 × 40%). The deferred tax assets increased by $8,000
($10,000 – $3,000 + $7,000 – $6,000) and the deferred tax liabilities increased by $10,000 ($9,000 – $8,000 + $14,000 –
$5,000). Thus, Lucas’s income tax expense for Year 2 is $402,000 ($400,000 current tax expense – $8,000 increase in
the deferred tax assets + $10,000 increase in the deferred tax liabilities).
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Journal Entries will be:
Dr Income tax expense 400,000
Dr Income Tax Expense-Deferred 2,000
Cr Deferred Income Tax Asset 8,000
Cr Income Tax Payable 394,000
Presentation on the Income Statement of Deferred Tax
1) Current Income tax (CI)

2) Deferred Tax Benefit or Expense (DT)
TOTAL INCOME TAX EXPENSE IS CI+DT
JOURNAL ENTRY
Income Tax Expense (dr)
Deferred Tax (dr/cr) this is balancing figure
Cash (cr)
This is account with temporary timing differences.
TAXES PRESENTED IN INCOME TAX EXPENSES
1) CURRENT INCOME TAX EXPENSE

Taxable income according to TAX code X tax rate = who much we have to pay.
2) Deferred income tax expense/benefit
Change in deferred tax asset or deferred tax liability position during the year.
Deferred Income Tax Expense / Benefit
Example of DEFERRED TAX difference is
1) RENT Expense DR & Rent Payable CR (this is no cash payment that’s why no deduction allowed in taxable
income). But when next year when cash is paid its deduction will be allowed as deduction.
CALCULATING THE DEFERRED TAX ASSET OR DEFERRED TAX LIABILITY
Amount that will “REVERSE” X ENACTED TAX RATE
ENACTED TAX RATE: Is either future tax rate announced, if not then current rate.
ENDING POSITION comparison with START POSITION
Example:
Depreciation Expense
Periods Depreciation in Depreciation as Diff Enacted tax Deferred Tax

Books per tax code rate Liability
Year 1 20000 40,000 -20,000 25% -5000
Year 2 20000 24,000 -4,000 30% -1200
Year 3 20000 14,400 5600 30% 1680
Year 4 20000 10,800 9,200 35% 3220
Year 5 20000 10,800 9,200 40% 3680
7380
Question: 12 On a statement of financial position, all the following should be classified as current liabilities except
A. Accounts payable for inventory items to be shipped on consignment.
B. Deferred income taxes for differences based on depreciation methods.
C. Salaries payable for work performed during the previous month.
D. Advances from customers for services to be performed.
Answer (B) is correct.
Deferred tax amounts are classified as current or noncurrent based on the classification of the related asset or liability
(assuming such an asset or liability exists). Because depreciable assets are noncurrent, a deferred tax liability for
differences based on depreciation methods is noncurrent.
EQUITY TRANSACTIONS
OWNER’S EQUITY is the difference between Assets and Liabilities.
Owner’s equity is what company owes the owners.
TYPES OF business formations:

1) Sole Proprietor will have (1) Equity Account
2) Partnership at least one equity Account per Partner. So that each individual partner knows how much of the asset
he owns.
3) Corporation
It doesn’t have Account for each owner. We can’t say that Corporation have how many number of owner, because
its Equity divided into number of shares.
a. CONTRIBUTED CAPITAL
i. COMMON STOCK (share capital)
When owner bought shares from the company. It’s not represent sale of 2 nd hand shares, because
that doesn’t add value to the company.
ii. ADDITIONAL PAID IN CAPITAL (APIC) ACCOUNT -
b. RETAINED EARNINGS
Its undistributed profits from all over the years which has not been distributed among the owners.
STOCK OF THE COMPANIES

COMMON STOCK
This is very frequent and common. They are Par value is stated value of the Stock, very low. There is also non-
par value stock.
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RIGHTS & EXPECTATIONS OF COMMON SHARE HOLDER.
a. Right to Vote
b. Right to Dividend – if dividend is declared.
c. Right to share in a distribution of asset. If the liquidation happens, not by bankruptcy, shareholder get right
in asset.
d. Preemptive – allow the share holder to purchase newly issue share. If shareholder is offered a right but if
he doesn’t have capability to buy it, he couldn’t use his right. However, he can sell his right.
e. Common stock does not have the right to accumulate unpaid dividends. This right is often attached to
preferred stock.
JOURNAL ENTRIES
Dr CASH
Cr Common Stock
Cr Additional Paid in Capital Common Stock (APIC-CS)
Difference between Cash collected on issuing of share and par value of each share issued. If shares without par
value issued, entire sum goes to APIC-CS account
If Shares issued against the Asset other than Cash
Dr Asset
Cr Common Stock
Cr Additional Paid in Capital Common Stock (difference)
Fair Market value of shares should be equal to fair market value of shares. If the share is traded in Stock Market
use the fair value of the Shares. If shares are not traded in the market use Fair Value.
EXAMPLE
On January 1, Evangel Company issued 9% bonds in the face amount of $100,000, which mature in 5 years. The
bonds were issued for $96,207 to yield 10%, resulting in a bond discount of $3,793. Evangel uses the effective
interest method of amortizing bond discount. Interest is payable annually on December 31.
Answer (A) is correct.
An amortization schedule for the first 2 years of Evangel’s bonds can be prepared as follows:
Year Beginning Times: Equals: Minus: Equals: Ending

Carrying Effective Interest Cash Discount Carrying
Amount Rate Expense Paid Amortized Amount
1 $96,207 10% $9,621 $9,000 $621 $96,828
2 96,828 10% 9,683 9,000 683 97,510
DIVIDENDS
Its distribution of Profits or Retained Earnings.
CASH DIVIDENDS: Very Common
There are three dates,
1) date of declaration, how much and to whom. We make it estimated amount.
2) Record of Customer date.
3) And Payment date. On date of declaration:
Declaration of Dividends
Retained Earnings (DR) $xxx

Dividend Payable (CR) xxx
Date of Record of Share Holder: No Entry
Date of Payment of Dividend.

Dividend Payable (DR) $xxx
Cash (CR) xxx
LIQUIDATING DIVIDENDS
they are not RETURN ON INVESTMENT (ROI) for investor but its Return OF Investment. If there is no balance in
retained earnings.
ASSET DIVIDENDS:
It consists of two transactions
1. Sale of Asset (assume Sell Asset for Fair Market Value & record gain or loss)
2. Distributive proceeds for Sale.
STOCK DIVIDENDS
Lot of company does it. There are two type
1) Small – 25% or less
Retained Earnings (Dr) xxxx (fair market value)
Common Stock – Issuable (Cr) xxxx (at Par value)
Additional Paid in Capital (Cr) xxxx(balancing Accounts)
What’s will be the value of the transaction. In Small Stock dividend, we take the FMV of Share and we debit
Retained earnings, par value CREDIT at Common Stock.
2) LARGE – 25% More
They are valued at Par value of Stock.
Retained Earnings (Dr)
Common Stock – issuable (cr)
3) STOCK SPLIT
It can be 2:1 or 3:1. If it’s 2:1 then it means shareholder’s number of shares multiply by 2. There is no
Accounting entry for Stock Split. Since in Stock Split no cash received or nothing paid. Not Asset change.
Percentage in ownership stays same, it’s just reduction of par value and shareholders own twice as many
shares at reduced value.
2) PREFERRED STOCK
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Right of Preferred Share Holder
1) No voting right
2) Priority dividend payment.
TREASURY STOCK
Treasury stock is a corporation’s own stock that has been reacquired but not retired. In the balance sheet, treasury stock
recorded at cost is subtracted from the total of the capital stock balances, additional paid-in capital, retained earnings, and
accumulated other comprehensive income.
REVENUE RECOGNITION
REVENUE is recognized when customer buys the goods and services by paying for goods or services or Promise to pay.
Revenue should be recognized when it is;
1) Realized or Realizable; or
2) Earned
Earned part means we have done substantially everything we can do to earn revenue.
RECOGNISED AT COMPLETION OF PRODUCTION
Recognized revenue at the time completion of production. If the all the conditions are full filled.
1) If the item is readily salable

2) Known market price
3) Units are Homogenous (similar)
Example:
1) Agricultural products
2) Precious metals
3) If there is a contract to sell it. Or they are under the contract which they already sold the product.
INTALLMENT METHOD OF PROFIT RECOGNITION

Collection amount is not certain
1) We are not going to recognize all of the profit at the time of sale. We recognize profit only when we receive
collection
Journal entry
At the time of Sale:
Installment receivable (Dr)
Inventory (Cr)
Deferred Gross Profit (Cr)
Determine profit:
Profit/ Sales price = Profit Margin %
At the time of Installment
Cash (DR)
Installment Receivable (CR)

Deferred Profit (DR)
Realized Profit (CR)
Balance Sheet reporting
Installment Receivables
Less: Deferred Gross Profit
Net Installment Receivables
Deferred Gross Profit is Contra to the Installment Receivable Account. It’s not reported in Liability side.
It’s possible to charge interest in Installment method.
Interest is accounted for separately
Questions likely to be asked
1) How much profit to be recognized in the specific period

that is Cash received X profit %
2) How much remaining deferred profit is there:
that is total cash received X Profit % = total profit recognized
Beginning deferred profit - Total Profit recognized = balance deferred Profit
3) Remaining Receivable: How much cash is to be collected?
Cost recovery method

This is more conservative method to profit recognition.
All the profit in the beginning is to be deferred and no profit is recognized until cash collected exceeds the cost of goods
sold. This method is used when we have no basis for determination.
If there is interest, we can’t have recognized interest income either until cash collection exceeds COGS. We take money
and recover COGS first.
Deposit Method
if we have collected any deposit before
Cash Dr
Deposit Cr
If sale don’t happen we have to return the funds. Deposit are advance from customers. Its liability.
Revenue with RIGHT OF RETURN

This sale is time bound, we recognize the revenue but we also need to setup allowance for return account. Treatment is
same of allowance for doubtful debt account.
SALE WITH BUY BACK AGREEMENT

A company is selling the product but selling company has right to buy back product in 5 years or 10 years down the line.
What happens if product loses the value. there is a risk of value reduction.
If repurchase is at fair market price at the future date -> risk is buyers (here risks are transferred) Sale happens and revenue
recognized.
If repurchase is at stated price at the future date -> risk is sellers (here risks are not transferred) Sale doesn’t happen and
revenue not recognized.
Channel Stuffing & Trade Loading

DEC sales made by Seller at huge quantity and discounts but this can return with-in 3 months a trade term of returning
goods.
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Such practice to increase revenue in the books are misleading for users and shouldn’t be done. But if it’s done without
INTENTION OF DECEIVING to users of financial statement. A selling company should create and huge allowance account
to cover the financial impact of return.
LONG TERM CONTRACTS

If the contract takes more than one year to complete. Question we have when to recognize profit.
1) COMPLETED CONTRACTS method

2) PERCENTAGE COMPLETION method
In both methods, we need to Calculate every year estimated profit and loss from the contract
FORMULA =
Contract price (or Selling Price)
Less: costs actually incurred
Less: expected costs to be incurred
EXPECTED PROFIT / LOSS
This calculated has to be done every year. so, figure may change, so are the profit may change etc.
COMPLETED CONTRACT METHOD

Profit when completed – but if we found expected losses at any point of the project, it will be recognized immediately. We
don’t wait for project to complete.
PRECENTAGE COMPLETION METHOD

Profit is recognized based on percentage of cost incurred/ (cost incurred + estimated future cost)
1) Calculated total expected profit

Contract price (or Selling Price)
Less: costs actually incurred
Less: expected costs to be incurred
EXPECTED PROFIT / LOSS
2) Determine what percentage complete we are?
COST incurred to date / Total Expected Cost = Percentage completion.
3) Calculated the profit to recognize this period

Expected profit X percentage complete = total profit recognized to date.
This period or year = Total profit recognized – Profit recognized earlier
𝐶𝑜𝑠𝑡 𝐼𝑛𝑐𝑢𝑟𝑟𝑒𝑑 𝑡𝑜 𝑑𝑎𝑡𝑒

∗ 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 − 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠𝑙𝑦 𝑟𝑒𝑐𝑜𝑔𝑛𝑖𝑠𝑒𝑑 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑟𝑒𝑐𝑜𝑔𝑛𝑖𝑠𝑒 𝑡ℎ𝑖𝑠 𝑝𝑒𝑟𝑖𝑜𝑑
𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡
Notes about the formula:

1) We can come up with negative number: this doesn’t mean we incurred a loss on project, but it means we have
recognized too much profit last year and we need to de-realized
2) It also works perfectly on the expected losses, but losses are to be recognized immediately. Hence formula
becomes as under:
RECORDING COST OF CONSTUCTION
Example
Project price = 2 Million
Estimated Cost = 1.2 million
Term 3 years
At the end of year 1 cost incurred is 300,000. Percentage of completion will be 300000/1200000 = 25%. Company
made progress billings of 500,000
Date Account Ref Debit Credit
Dec y1 Work in Progress 300,000
Cash 300,000
Work in Progress 200,000
Project Gross Profit 200,000
Accounts Receivables 500,000
Progress Billings 500,000
Here in balance sheet Progress Billings and Work in Progress off-sets each other, as they have same amount.
At the end of year 2 cost incurred is 900,000 . expected further cost is 600,000. Estimated GP is
900,000/(900,000+600,000) = 60% i.e. new total GROSS PROFIT (2MILLION – 900K-600K) 500,000 will be applied with
60% = 300,000. 200,000 of this has been recognized last year. Current year will be 100,000. Company made PROGRESS
BILLINGS OF 500,000 again.
DATE ACCOUNT REF DEBIT CREDIT
DEC Y2 Work in Progress 600,000
Cash 600,000
44
Here we have Work in Progress balance of 1,200,000 and Progress Billings balance is 1,000,000. We will have WIP asset
of 200,000 in balance sheet.
At the end of year 3 project completed at cost of 1,450,000. Company billed the balance amount. Percentage of completion
will be 100%. Gross Profit is 550,000. Profit recognized prior years 200,000 + 100,000.
DATE ACCOUNT REF DEBIT CREDIT
DEC Y3 Work in Progress 550,000
Cash 550,000
Cash 2000,000
Accounts receivable 2000,000
Progress Billing 2,000,000
Progress billing account is contra to Work in Progress Account in balance sheet.
 If WIP greater Progress billing, we have an asset.

 If Progress Billing are greater than we have a liability.
COST MANAGEMENT SYSTEM
Cost Management Terms:
1) FINANCIAL ACCOUNTING: concerned with reporting to external users, usually through set of financial statement
produced in accordance with GAAP or IFRS.
2) MANAGEMENT ACCOUNTING: is concerned principally with reporting to internal users. Goal of Management
accountant is to produce reports that improve organizational decision making. Management accounting is thus
future-oriented.
3) COST ACCOUNTING: Supports both Financial and Management accounting. Information about the cost of
resources acquired and consumed by an organization underlies effective reporting for both internal and external
users.
BASIC DEFINITIONS:
COST: IMA defines cost as:
“In management accounting, a measurement in monetary terms of the amount of resources used for some purpose. The
terms by itself is not operational. It becomes operational when modified by a term that defines the purpose, such as
acquisition cost, incremental cost, or fixed cost.
In financial accounting, the sacrifice measured by the price paid or required to be paid to acquire goods or services. The
Term ‘cost’ is often used when referring to the valuation of a good or service acquired. When cost is used in this sense, a
cost is an asset. When the benefits of the acquisition (the goods or services) expire, the cost becomes an expense or loss.
COST POOL:
A cost pool is an account into which a variety of similar cost elements with a common cause are accumulated.
1) It is preferable for all the cost in a cost pool to have the same cost driver.
2) Manufacturing overhead is a commonly used cost pool into which various untraceable cost of the
manufacturing process are accumulated prior to being allocated.
COST CLASSIFICATION
1) CONTROLLABLE VS NON-CONTROLLABLE
a. Controllable are those which are under the discretion of a manager.
b. Non-Controllable are those which another level of the organization has committed, removing the
manager’s discretion.
2) AVOIDABLE vs COMMITTED
a. Avoidable costs are those that may be eliminated by not engaging in an activity or by performing it more
efficiently. Example direct material cost which can be saved by ceasing production.
b. Committed Cost arise from holding property, plant and equipment. Example are insurance, real estate
taxes, lease payment and depreciation. They are long term and cannot be reduced to short term.
3) INCREMENTAL vs DIFFERENTIAL
a. Incremental Cost is the additional cost inherent in a given decision.
b. Differential Cost is the difference in Total Cost between two decisions.
4) ENGINEERED vs DISCRETIONARY
a. Engineered Costs are those having a direct observable quantifiable cause-and-effect relationship between
level of output and the quantity of resources consumed.
b. Discretionary Cost are those characterized by an uncertainty in the degree of cause between the level of
output and the quantity of resources consumed. They tend to be the subject of a periodic (e.g. annual)
outlay decision. Example Direct Material and Direct Labor. Advertising, research and development (R&D)
and employee training are usually given as examples of discretionary costs. Discretionary costs may be
fixed costs, variable costs, or mixed costs.
46
5) OUTLAY vs OPPORTUNITY
a. Outlay Cost is a cost which require actual disbursement. They are also called explicit cost, accounting or
out-of-pocket costs.
b. Opportunity Cost is the maximum benefit foregone by using the scarce resources for a given purpose and
not for the next best alternative.
6) Economic cost is the sum of explicit cost and implicit cost.
7) Imputed cost is type of opportunity cost; these should be involved in decision making process even though no
transaction has occurred that would be routinely recognized.
COST BEHAVIOUR AND RELEVANT RANGE

Relevant range
The relevant range defines the limits which per-unit variable cost remain constant and fixed cost are not changeable. Its is
synonymous with the short run.
Variable cost
Variable cost per unit remains constant in the short run, regardless of the level of production.
Variable cost in total vary and directly proportionally with changes in volume. Volume of production goes it it goes up,
volume of production goes down it goes down.
Fixed Cost
Fixed cost per unit acts opposite to the volume of production. Increase in volume of production decreases the Fixed cost
per unit.
Fixed Cost in total doesn’t vary at all in short term, it remains constant over the relevant range.
Mixed Cost (semi variable)

Mixed cost combine fixed and variable elements e.g. rental expense on car that carries a flat fee per month plus additional
fee for each mile driven.
Methods of estimating mixed costs are in general use:
1) The regression, or scatter graph, method is by far the more complex and accurate, but its out of scope of exam.
2) The high-low method is the less accurate but quicker of the two methods.
High-low method of splitting the mixed cost
(𝐶𝑜𝑠𝑡 𝑎𝑡 ℎ𝑖𝑔ℎ𝑒𝑠𝑡 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 − 𝐶𝑜𝑠𝑡 𝑎𝑡 𝑙𝑜𝑤𝑒𝑠𝑡 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦)

𝐶𝑜𝑠𝑡 𝑑𝑟𝑖𝑣𝑒𝑟 𝑎𝑡 ℎ𝑖𝑔ℎ𝑒𝑠𝑡 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 − 𝑐𝑜𝑠𝑡 𝑑𝑟𝑖𝑣𝑒𝑟 𝑎𝑡 𝑙𝑜𝑤𝑒𝑠𝑡 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦
RELEVANT RANGE AND MARGINAL COSTING

Marginal cost is the cost incurred by a one-unit increase in activity level of a particular cost driver
1) Therefore, marginal costs remain constant across the relevant range.
Cost classifications
COST ACCUMULATION SYSTEM

1) Job order costing – accumulating costs by specific job
2) Activity based costing -
3) Process Costing
Job Order Costing

Steps:
1) Receipt of Sales order from a customer requesting a product or special group of products.
2) Sales order approved and production order is issued.
3) Direct Material and Direct Labor are recorded by classification on a job sheet, which is specifically prepared for
each job.
4) Under Job order costing, the third component, Factory OH has been applied to job on estimated rate, because
outputs are customized and the processes vary from period to period. OH are absorbed by each job based on
FOH application rate. FOH applied rate is calculated by following formula:
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑𝑇𝑜𝑡𝑎𝑀𝑎𝑛𝑢𝑓𝑎𝑐𝑡𝑢𝑟𝑖𝑛𝑔𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑
𝐴𝑝𝑝𝑙𝑖𝑐𝑎𝑡𝑖𝑜𝑛𝑅𝑎𝑡𝑒 =
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦𝑜𝑓𝐴𝑙𝑙𝑜𝑐𝑎𝑡𝑖𝑜𝑛
Application rate is calculated by dividing the estimate of the total amount that will be spent for manufacturing
overhead during that year by the estimated total amount of allocation base.
5) FOH are paid throughout the year, they are collected in the manufacturing overhead control account.
6) When the job-order is complete, all costs are transferred to finished goods.
7) When the output is sold, the appropriate portion of the cost is transferred to cost of Goods Sold.
LUCY SPORTSWEAR MANUFACTURES A SPECIALTY LINE OF T-SHIRTS USING A JOB-ORDER COSTING SYSTEM. DURING MARCH, THE
FOLLOWING COSTS WERE INCURRED IN COMPLETING JOB ICU2: DIRECT MATERIALS, $13,700; DIRECT LABOR, $4,800;
ADMINISTRATIVE, $1,400; AND SELLING, $5,600. OVERHEAD WAS APPLIED AT THE RATE OF $25 PER MACHINE HOUR, AND JOB ICU2
REQUIRED 800 MACHINE HOURS. IF JOB ICU2 RESULTED IN 7,000 GOOD SHIRTS, THE COST OF GOODS SOLD PER UNIT WOULD BE
A. $6.50 B. $6.30 C. $5.70 D. $5.50
ANSWER (D) IS CORRECT. COST OF GOODS SOLD IS BASED ON THE MANUFACTURING COSTS INCURRED IN PRODUCTION BUT DOES
NOT INCLUDE SELLING OR GENERAL AND ADMINISTRATIVE EXPENSES. MANUFACTURING COSTS EQUAL $38,500 [$13,700 DM +
$4,800 DL + (800 HOURS × $25) OH]. THUS, PER-UNIT COST IS $5.50 ($38,500 ÷ 7,000 UNITS).
TERMS FREQUENTLY USED IN JOB ORDER COSTING

Waste:
THIS IS A LOSS CONNECTED WITH RAW MATERIAL OR INPUTS TO THE PRODUCTION PROCESS AND USUALLY MEANS TO REFER THAT
INPUT HAS BEEN LOST DUE TO ANY REASON EITHER BECAUSE OF ITS NATURE OF THE MATERIAL ITSELF, NATURE OF THE PROCESS OR
SOME OTHER CONDITIONS. SOMETIMES SUCH OUTPUT THAT DOES NOT HAVE ANY SALES OR USE IS ALSO REFERRED AS WASTE.
Scrap:
THIS IS A LOSS CONNECTED WITH THE OUTPUT. MOST OF THE TIME AT THE END OF PRODUCTION/CONVERSION PROCESS SUCH
OUTPUTS ARE GENERATED THAT WERE NOT INTENDED BUT CANNOT BE ELIMINATED DUE THE NATURE OF MATERIAL OR PROCESS
ITSELF. USUALLY THEY ARE OF NO TO INSIGNIFICANT VALUE AS COMPARED TO THE MAIN PRODUCT THAT WAS INTENDED. W E USUALLY
KNOW THEM WITH THE TERM BY-PRODUCTS. THIS IS CONSIDERED AS LOSS AS NOT ALL OF THE RAW MATERIAL IS CONVERTED INTO
INTENDED PRODUCT.
SPOIL:
THIS IS ALSO A LOSS CONNECTED WITH THE OUTPUT. IN THE PRODUCTION PROCESS IF THE OUTPUT IS PRODUCED WHICH IS NOT UP
TO THE QUALITY STANDARD DUE TO ANY PROBLEM AND NOW THE PRODUCT CANNOT BE BROUGHT BACK IN GOOD STATE EVEN AFTER
FURTHER PROCESSING OR REPROCESSING OR IT IS SIMPLY NOT FEASIBLE TO DO SO THEN SUCH OUTPUT IS CALLED SPOIL OR SPOILED
OUTPUT OR SPOILAGE. THIS IS CONSIDERED AS LOSS AS IT IS SUCH FINISHED GOOD WHICH IS NOT WORTHY OF SALE AND THUS
CANNOT GENERATE INTENDED REVENUE.
DEFECT:
THIS IS ANOTHER TYPE OF LOSS CONNECTED WITH THE OUTPUT BUT IT CAN BE IN THE INPUT AS WELL. THIS IS CLOSE TO WASTE BUT
WITH THE DIFFERENCE THAT IT IS SUCH OUTPUT WHICH DOES NOT QUALIFY ALL THE QUALITY STANDARDS DUE TO SOME PROBLEM
BUT THAT PROBLEM CAN BE FIXED BY FURTHER PROCESSING OR REPROCESSING AND IT IS ALSO FEASIBLE TO DO SO. THIS IS
CONSIDERED AS LOSS AS MORE THEN NORMAL EFFORT WILL BE REQUIRED TO BRING THE GOODS INTO SALEABLE CONDITION.
48
Irrespective of the nature, Management needs to keep tight control over waste, scrap, spoilage, obsolescence, rejects
and stock losses through specific control reports.
Generally, normal losses will be charged to the cost of production and abnormal losses will then charge into a separate
account.
Terms Definition
Unusable materials having little or no value.

Nowadays, with good technology, companies can convert waste into
Waste
useful and saleable products. Example of such conversion is the waste
into fertilizers.
Materials that cannot be used for its original purpose

Difference between scrap and by-products are:
Scrap  By-products have greater sale value than scrap
 By-products are often processed further to make it saleable
while scrap is usually sold on an “as is where is” basis.
Those that cannot be used for its intended purpose.

A form of waste.
Arises due to inefficient production, poor workmanship, poor material,
etc.
Spoilage
The cost of spoilage comprises material, labor and overheads at the
point of defects.
Either additional cost is incurred in rectifying the spoilt work or in
converting the spoilt work into new products.
Items that are outdated hence obsolete. Reasons could be due to

Obsolescence change in consumer demand, change in fashion, change in
specification.
Materials that are not accepted on inspection.

May be rejected when purchases are received or during the course of
Rejects manufacturing.
Where possible, rectification will be carried out or otherwise the rejected
item will be disposed off.
Losses that are due to improper storage, inherent defects, accidents

Stock Losses
and errors in recording and measuring
ACTIVITY BASED COSTING
Use: ABC is a response to the significant increase in the incurrence of indirect cost resulting from the rapid advance of
technology. ABC is a refinement of an existing costing systems.
ABC is upgrade to Traditional Costing system.
In Traditional (Volume-based) costing system, overhead is simply dumped into a single cost pool and spread evenly
across all end-product. The inaccurate averaging or spreading of indirect costs over products or service units, that use
different amounts of resources is called peanut-butter costing. Peanut-butter costing results in Product-cost cross-
subsidization, the condition in which the miscasting of one product causes the miscasting of other products.
Traditional: Accumulation of cost in G/L, using single cost pool, using single cost driver, Allocating the indirect cost pool.
Activity
1) Identify the activity that cause overhead.
2) Assigning the specific OH consumed by activities.
3) Assigning the cost of the activities to final cost object, based on the driver that causes the cost.
Activity Based Costing Step Analysis

1) Activity Analysis – Unit level activity are performed for each unit; batch level activity occurs for each group of outputs.
Product-sustaining activities supports production of a particular period and facility-sustaining activities concerned overall
operations.
2) Assign Resource Drivers to Resource Cost- Once the resources have been identified, resource driver are designated
to allocate resources to the activity cost pools.
3) Allocate resource cost to Activity cost pools. One method of doing this could be dividing the total $ amount of a resource
by the value of resource driver used by the entire entity. Example Inspection & Testing Cost / no of hours
4) Allocate activity cost pools to final cost object- This could be done by dividing the total $ amount assigned to an activity
cost pool by the value of activity driver used by entire entity.
5) Indirect Cost assignment: following diagram illustrates it better than words.
6) Process Value Analysis
a. Design of an ABC system starts with process value analysis. Process Value Analysis involves a
determination of which activities that use resources are value-adding or non-value adding and how the
later may be reduced or eliminated.
b. Linking product costing and continuous improvement of process is Activity Based Management (ABM).
c. Using a four-level driver analysis model (Unit, Batch, Product, Facility), activities are grouped, and drivers
are determined for activities. Only difficulty is facility level activity do not pertain to specific
product/Services. So, the best solution is to treat it as a period cost instead of product cost.
7) Cost Drivers – Drivers must be chosen based on a cause-and-effect relationship with the resources or activity cost being
allocated, it shouldn’t be just high-positive correlation.
a. Cost object may be job, product, process, activity, service or anything else for which cost measure is desired.
8) Advantages & Disadvantages of ABC.
1) Advantages: Process value analysis is performed as part of ABC; this provides elimination of non-value adding
activities. The real benefits of ABC are for a company who have high level of fixed costs and produces a wide
variety of products.
50
2) Disadvantages: ABC are its cost of implementation and the increased time and efforts need to maintain, it probably
requires separate accounting system. Initial costs are high. Benefits may not be as high as cost.
PROCESS COSTING
The costs in the department that require allocation can come from one of three places:
1) They are incurred by the department during the period (we will usually have materials and con-version costs in a
question).
2) They are transferred in from the previous department.
3) They were in the department on the first day of the period in the form of beginning work-in-process (BWIP).
Conversion costs is a term that is used in process costing questions to refer to direct labor and factory overhead. It
encompasses everything except raw materials. Conversion costs are the costs necessary to convert the raw materials into
the finished product. Placing these different costs into one category simply reduces the number of individual allocations
that you need to make on a question.
Transferred-in costs are the total costs that come with the new product from the previous department. They are similar to
Raw Materials but in reality, will include all of the costs (material and conversion costs) from the previous department. The
previous department’s “completed units” are this department’s transferred-in costs and the costs for both of these items
should be the same.
ACCOUNTING OF PROCESS COSTING

The basic accounting for this type of system is as follows: all the costs incurred are put into a WIP account. These costs
include direct material (though direct materials are usually allocated differently from the conversion costs and may be
accounted for separately), direct labor, indirect materials, indirect labor and factory overhead. These costs that are
in WIP then need to be allocated between units completed during the period and units remaining in ending WIP at the end
of the period. Costs for units completed during the period are transferred to either finished goods or to the next department.
This allocation will be done based on a per unit allocation basis, in a manner similar to the standard allocation of overhead.
However, you do not need to be familiar with the accounting steps in this process, just the allocation process. This
information is presented because it may help you see what is happening in this process.
STEPS IN PROCESS COSTING

It is important that you are very comfortable with equivalent units of production (covered in much more detail later) and
how they are calculated. This is an important part of process costing and one that is likely to be tested. The steps in process
costing are:
1) Determine the physical flow of goods

Formula:
Units in Beginning WIP + Units Transferred In* = Units in Ending WIP + Units Completed/Transferred Out
* This may also be the number of units started during the period if the process is the first in the assembly line.
2) Calculate how many units were started and completed during the period
# Units Completed – # Units in Beginning WIP = Units Started and Completed This Period
3) Determine when materials are added to the process.
However, this is an important item for later steps so it is important that you identify whether the materials are
added:
At the beginning of the process
At the end of the process
At some point in the middle of the process
Evenly throughout the process (in which case they will behave like conversion costs)
Usually, conversion costs are added evenly throughout the process, but if conversion costs are added
4) Calculate the equivalent units of production for materials and conversion costs
Essentially, there are three different amounts of work that may apply to an individual unit during the period:
1) Completed (beginning work-in-process inventory that has been completed) meaning that some of the work
was done in the previous period.
2) Started and Completed (calculated above), meaning that the unit was started on or transferred in during the
period and was completely finished during this period.
3) Started, meaning that these are units that were started on or transferred in during the period, but were not
finished at the end of the period and thus have not yet been transferred out of the process.
We need to determine how many equivalent units were needed for each of these three categories of work done
on units. In the second example is a formula that we will use for this calculation.
Example:
Let us assume that in addition to the 100 units in beginning WIP (still 25% complete), there were also 100 units
(empty bottles to be filled) transferred in during the period, and at the end of the period there are 10 units in ending
WIP that are 40% complete. Calculate:
1) The number of units completed,
2) The number of units started and completed, and
3) The number of EUP during the period.
Solutions:
1) The number of units completed is 190. This is calculated using the formula: Units in BWIP (100) + Units
transferred in (100) = Units in EWIP (10) + Units Completed (must be 190).
2) Having calculated the number of units completed, we can now determine that there were 90 units started and
completed (190 units completed – 100 units in BWIP). This is used to calculate the number of equivalent units
produced.
3) To calculate the EUP we need to use the three steps of what could be done to a unit during the period.
The calculation of equivalent units of production is:
To Complete BWIP (100 × 0.75) = 75
Started and Completed (90 × 1.00) = 90
To Start EWIP (10 × 0.40) = 4
Total EUP = 169
5) Calculate the costs incurred during the period for materials and conversion costs
6) Calculate the cost per equivalent unit for materials and conversion costs. In weighted average cost incurred in
Opening balance to be taken as well in calculating per unit cost.
7) Allocate the costs for materials and conversion costs separately between EWIP and Transferred Out according to
the equivalent units in each.
Below is the table to help to create EUP in examination Questions.
Key Equation of Process Costing is:

Transferred Out + Ending Inventory = Started + Beginning
Started & Completed can be calculated by two ways
Transferred Out -Beginning
Or
Started - Ending
52
This started and completed Units will be used in the following table:
MATERIALS ADDED IN THE MATERIAL OR CONVERSION ADDED
BEGINNING EVENLY
Weighted Avg FIFO Weighted Avg FIFO
BWIP 100% 0% 100% YTC
STARTED & 100% 100% 100% 100%
COMPLETED
EWIP 100% 100% DOC DOC
There are cases where Materials are added at specific point of completion:
EUP calculated above will be multiplied by following line by line to arrive at correct EUP
1) If Opening Stage of Completion is Greater than Material added stage, there is no EUP of BWIP. If its opposite it
all All EUP.
Example: BWIP is 60% Complete and Material added point is 50%. EUP of BWIP will be zero as material is already
added to the cost in last period. If BWIP is 20% and Material added point is 50% then EUP calculated on BWIP
will be full.
2) If Closing Stage of Completion is Less than Material added Stage, there will be no EUP of EWIP. If its opposite it
will be ALL EUP.
Example: EWIP is 60% complete and Material added point is 50%, we will take full EUP because all materials are
added to the units during the process in current period. If EWIP is 20% and Material added Point is 50%, since we
didn’t reach that point EUP will be Zero.
JOINT PRODUCT AND BY-PRODUCT COSTING
Joint Product Cost allocation method
Joint Cost allocation there are 4 methods.
Relative sales value at split-off point

This can be used only if all the joint products can be sold at split off point. This mean it can be sold
without further processing. It can be sold but it’s not necessary that it is sold. Management may decide it
would be more profitable to the company to process some of the joint products further; but the Sales
Value at Splitoff method can still be used to allocate joint costs up to the splitoff point, as long as sales
prices at the splitoff point do exist for all of the joint products.
Here we take at the split off point Sales value of Product A and Sales value of Product B and
work out proportion.
Example: Joint cost incurred is $1000, Sale value of product A is $650 and Sale value of Product
B is $700. Cost to be allocated as for
Product A = 650/1350 X 1000 = 480
Product B = 700/1350 X 1000 = 520
𝑆𝑎𝑙𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝐴

∗ 𝐽𝑜𝑖𝑛𝑡 𝐶𝑜𝑠𝑡𝑠
𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑙𝑙 𝐽𝑜𝑖𝑛𝑡 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑠
= 𝐴𝑚𝑜𝑢𝑛𝑡 𝑡𝑜 𝑏𝑒 𝑎𝑙𝑙𝑜𝑐𝑎𝑡𝑒𝑑 𝑡𝑜 𝑡ℎ𝑒 𝑖𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡
Note: Relative Sales Value = Units Produced X Unit price should be taken not the per unit
value nor selling price. This is important.
Benefits are: Limitation are:
Costs are allocated to products in proportion to their To use this method, selling prices at the splitoff
expected revenues, which is in proportion to the point must exist for all of the products. If they
individual products’ ability to absorb costs. do not, this method cannot be used.
The method is easy to calculate and is simple, Market prices of joint products may vary
straightforward, and intuitive. frequently, but the Sales Value at Splitoff
method uses a single set of selling prices
The cost allocation base is expressed in terms of a throughout an accounting period. This can
common basis – amount of revenue – that is introduce inaccuracies into the allocations.
recorded in the accounting system.
This is the best measure of the benefits received

from the joint processing. It is meaningful because
generating revenues is the reason why the company
would incur the joint costs.
It can be used even if further processing is to be

done, as long as selling prices do exist for all the joint
products. Thus, it does not require information on
processing after the splitoff, even if further
processing is to be done.
Estimated net realizable value

Here we must stop at a given time that is at Split off point. Here we calculate NRV estimated for all
products. Then we do proportion and apply same Relative Sales value. This method applies if one or
more of the joint products must be processed after Split off point.
The estimated NRV for a product to be processed further is calculated as:
Sales price of items produced that will be sold in the future
54
− Separable costs that are incurred after the split off point
= Estimated Net Realizable Value
If one (or more) of the joint products is not processed further but is sold at the splitoff point,
instead of using NRV for those products, the company will simply use the Sales Value(s)
at the splitoff point for the product(s) that can be sold at the splitoff point, while using the
NRV(s) for the product(s) that must be processed further to be marketable. The Net
Realizable Value method is generally used in preference to the Relative Sales Value at
Splitoff method only when selling prices for one or more products at splitoff do not exist.
However, sometimes when sales prices at the splitoff do exist for all of the joint products
but one or more products can be processed further, an exam problem will say to use the
Net Realizable Value method to allocate the joint costs. If the problem says to use the Net
Realizable Value method, use the net realizable value(s) for the product(s) that can be
processed further even though sales prices at splitoff do exist, but only if the cost to process
further is less than the additional revenue to be gained from the further processing.
If the problem does not say to use the Net Realizable Value method and sales values at
the splitoff exist for all products, then use the sales values of all of the joint products for the
allocation, even if one or more of the products can be or will be processed further.
Physical Unit allocation

The Joint costs are allocated on the basis on Weight or Volume. In the average cost method, it’s done
based on unit of output. Joint costs are most often assigned based on relative sales values or net realizable
values. Basing allocations on physical quantities, such as pounds, gallons, etc., is usually not desirable
because the costs assigned may have no relationship to value. When large items have low selling prices
and small items have high selling prices, the large items might always sell at a loss when physical quantities
are used to allocate joint costs.
It stands to reason that it must be possible to measure all of the joint products in
the same unit of measurement. If all of the output that results from a joint
process cannot be measured in the same terms, this method cannot be used.
Average Cost method

This method may also be called the Physical Unit method. It is used when the joint costs are to be
allocated based on physical units of output in completed form. It is basically the same as the Physical
Measure method, but because physical units of completed product are used, it is called by the name
Average Cost, or sometimes Average Unit Cost method.
The total joint cost is divided by the total number of units of all of the joint products produced to calculate
the average cost per unit. Then that average cost per unit is multiplied by the number of units of each
product produced to find the amount of cost to be allocated to each product.
Benefits
• The physical measure and average cost methods are easy to use.
• The allocation is objective.
• The methods are useful when rates or prices are regulated. In a regulated environment when rates are
regulated and the seller is limited to a certain amount of markup over and above its costs, using selling
prices or net realizable values to allocate the costs on which the prices are based leads to circular
reasoning. If the seller tries to allocate joint costs according to selling prices or net realizable values of the
products, it cannot be done. The seller does not know what the selling prices of the products will be until
they know what their costs are, because the selling price is the cost plus a regulated amount of profit. But
since the seller does not know what the selling price of each product is, they cannot know how much joint
cost to allocate to each product. So using either the Relative Sales Value method or the Net Realizable
Value method in a regulated environment just does not work. In that case, the Physical Measure method
and the Average Cost method can be used to avoid the problem.
Limitations
• The Physical Measure and Average Cost methods can result in a product cost that is greater than their
market value for some of the joint products. The physical measures of the individual products may have
no relationship to their respective abilities to generate revenue. If weight or size is used, the heaviest or
largest product will be allocated the greatest amount of the joint cost; but that product may have the
lowest sales value. Products with a high sales value per weight or size would show large profits, while
products with a low sales value per weight or size would show large losses.
• Physical measures are not always comparable for products. For example, some products might be in
liquid form (i.e., petroleum), whereas some might be in gaseous form (i.e., natural gas). Or some might be
measured by weight whereas others might be measured by size. In this situation, the Physical Measure
method cannot be used.
Constant Gross Margin Percentage method. (least likely to be tested)
This method allocates the joint costs so that all of the joint products will have the same gross margin
percentage. It is done by “backing into” the amount of joint cost to be allocated to each of the joint
products.
Step 1: Calculate the gross margin percentage for the total of both (or all, if more than two) of the joint
products to be included in the allocation by subtracting the total joint and total separable costs from the
total final sales value and dividing the remainder by the total final sales value. This is done for all of the
joint products produced during the period, not for all of the joint products sold during the period. This is
the total gross margin percentage.
Step 2: Calculate the gross profit for each of the individual products by multiplying the total gross margin
percentage calculated in Step 1 by each individual product’s final sales value.
Step 3: Subtract the gross profit calculated in Step 2 and any separable costs from each individual
product’s final sales value. The result of this subtraction process will be the amount of joint costs to
allocate to each product.
Constant Gross Profit (Gross Margin) Percentage Method of Allocating Costs to Joint Costs
Benefits
• This method is the only method for allocating joint costs under which products
may receive negative allocations. This may be necessary to bring the gross
margin percentages of relatively unprofitable products up to the overall
average, if that is desired.
• This method allocates both joint costs and profits. Gross margin is allocated
to the joint products to determine the joint cost allocations so that the resulting
gross margin percentage for each product is the same.
• This method is relatively easy to implement, so it avoids the complexities of

the NRV method.
Limitations
• This method assumes that all products have the same ratio of cost to sales
value, which is probably not the case.
Constant Gross Profit Percentage

This method allocates the joint costs so that all of the joint products will have the same gross margin
percentage. It is done by “backing into” the amount of joint cost to be allocated to each of the joint products.
This method is most unlikely to be tested in the exam. But know it, its better. There are 3 steps involved.
56
Step 1: Calculate the gross margin percentage for the total of both (or all, if more than two) of the
joint products to be included in the allocation by subtracting the total joint and total separable costs
from the total final sales value and dividing the remainder by the total final sales value. This is done
for all of the joint products produced during the period, not for all of the joint products sold during
the period. This is the total gross margin percentage.
Step 2: Calculate the gross profit for each of the individual products by multiplying the total gross
margin percentage calculated in Step 1 by each individual product’s final sales value.
Step 3: Subtract the gross profit calculated in Step 2 and any separable costs from each individual
product’s final sales
Example of the Constant Gross Profit (Gross Margin) Percentage method:

Pineapple Co. produces pineapple juice and canned slices at its Pineapple Processing Plant in
Hawaii. The information about the process and the two joint products is as follows:
10,000 pineapples are processed.
The process results in 2,500 kg of juice and 7,500 kg of slices.
The juice can be sold for $10 per kg and the slices can be sold for $15 per kg.
The joint costs of production are $120,000.
The juice can be processed further into a premium juice. This will cost an additional $8,000, but
the sales price per kg will be $15.
The slices can be further processed into chunks. This will cost $4,000 and the chunks can be sold
for $2 per kg more than the slices.
Solution:
First, we will calculate the overall gross margin for all products produced:
Premium Chunks Total Gross Margin

Juice
Final sales value $37,500 $127,500 $ 165,000
Separable costs ( 12,000)
Joint Cost (120,000)
Total Gross profit $ 33,000 20%
We will now do the calculations to allocate enough of the joint costs so that each product has a 20%
gross margin by working a bit more with the table started above:
Premium Chunks Total Gross Margin

Juice
Final sales value $37,500 $127,500 $ 165,000
Separable costs (given) (8,000) (4,000) ( 12,000)
Joint Cost (J) (C) (120,000)
Total Gross profit $7,500 $ 25,500 $ 33,000 20%
Required gross profit $ 7,500 $ 25,500 $ 33,000 20%

We can now solve for J and C using these formulas to determine the amount of joint costs to allocate to
each product:
$37,000 − $8,000 − J = $7,500 J = $22,000
$127,500 − $4,000 − C = $25,500 C = $98,000
The $120,000 of joint costs is allocated $22,000 to juice and $98,000 to chunks.
Calculations:
1 2,500 × $15
2 7,500 × ($15 + $2)
3 $33,000 ÷ $165,000
4 $37,500 × 0.20
5 $127,500 × 0.20
ACCOUNTING FOR BYPRODUCTS
The Production Method: Inventory the Byproduct Costs
Byproducts are inventoried in a separate inventory account at their estimated NRV. Inventoried costs
allocated to the main product or joint products are reduced by the NRV allocated to the byproduct. When
the byproduct is sold, the company recognizes no revenue or cost of goods sold but simply debits cash or
accounts receivable and credits Byproduct Inventory. And when the main product or joint products are sold,
the COGS for the main product or joint products is lower because their inventory cost has been decreased
by the NRV of the byproduct.
The reason it is done this way is because the NRV of the byproduct was used to determine its cost in
inventory. Therefore, its cost will be the same as the revenue received for it, and there will be no gross
profit on the sale. There would be no reason to record the sale of the byproduct by increasing revenue and
COGS by the same amount, since the transactions would have no effect on net income. So, the journal
entry is simply the debit to cash or accounts receivable and the credit to byproduct inventory.
The Sales Method: Revenue from the Byproduct

In the Sales Method, the byproduct costs are not put into inventory separately from the main product or
joint products. Instead, all of the costs of production are allocated to the main product or joint products in
inventory. When the main product or joint products are sold, their COGS will be higher than it would have
been under the Production Method. Since the byproduct is not put into inventory at all, when it is sold the
sale is recorded the way service revenue would be recorded, with no associated COGS. So, the company
debits cash or accounts receivable and credits revenue for the amount of the sale.
Which Method is Better?

Both methods are acceptable. The Production Method, where the byproduct is inventoried at the time of
production is conceptually correct because it is consistent with the matching principle. Byproduct
inventory is recognized as an asset in the accounting period in which it is produced, and it reduces the
inventory cost assigned to the main product or joint products. However, the Sales Method, where the
byproduct is recognized at the time of sale, is simpler and is used more frequently in practice if the dollar
amounts of the byproduct(s) are immaterial.
Note: A question on the Exam will outline the treatment of the costs or revenue
associated with the byproduct and you just need to follow the math that is required. If
the question states that the company inventories the byproduct, this means that it treats
the revenue as a reduction of the costs of production; this is the first method above.
Exam approach of By Product Questions
Usually in exams By-Product Questions are asked with Joint products. You won’t get By-Product in solo.
There what you have to do is, reduce the joint cost by the sale value of By-Products.
Comprehensive Example
Lankin Corp. produces two main products and a byproduct out of a joint process. The ratio of output
quantities to input quantities of direct materials used in the joint process remains consistent from month-
to-month. Lankin has employed the physical-volume method to allocate joint production costs to the two
main products. The net realizable value of the byproduct is used to reduce the joint production costs
before the joint costs are allocated to the two main products. Data regarding Lankin’s operations for the
current month are presented in the chart below. During the month, Lankin incurred joint production costs
of $2,520,000. The main products are not marketable at the splitoff point and, thus, have to be processed
further.
1st Main Product 2nd Main Product Byproduct
Monthly input in pounds 90,000 150,000 60,000
Selling price per pound $30 $14 $2
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Separable process costs $540,000 $660,000
The amount of joint production cost that Lankin would allocate to the Second Main Product by using the
physical-volume method to allocate joint production costs would be:
a) $1,200,000
b) $1,260,000
c) $1,500,000
d) $1,575,000.
Solution:
1st We have to establish the sales value of by product i.e. 60000*2 = 120,000
2nd We have to reduce the Joint cost by sale value of by Product = 2520,000 – 120,000 = 2,400,000
150,000
3rd allocate the reduced joint cost to 2nd main product = ∗ 2400000 = 1,500,000
90000+150000
4th Mark the correct answer is C. left over cost are allocated to 1st main product i.e. 900,000
VARIABLE AND ABSORPTION COSTING

Variable and absorption costing are two different methods of inventory costing. Under both variable and
absorption costing, all variable manufacturing costs (both direct and indirect) are inventoriable costs. The
only two differences between the two methods are in:
1) Their treatment of fixed manufacturing overhead 2) The income statement presentation of the different
costs
Fixed Factory Overheads Under Variable Costing:

Under variable costing (also called direct costing), fixed factory overheads are a period cost that are
expensed in the period when they are incurred. This means that no matter what the level of sales, all the
fixed factory overheads will be expensed in the period when incurred. This is not for GAAP. GAAP
requires Absorption costing.
Note: It is important to remember that the only difference in the profit between these two methods relates
to the treatment of fixed factory overheads. Under absorption costing, fixed factory overhead costs are
included, or absorbed, into the product cost. Under variable costing, they are excluded from the product
cost and treated as a period cost, because they are not variable costs.
Effects of Changing Inventory Levels

Because fixed factory overheads are treated differently in these two methods, it is most certain that these
two methods (variable and absorption) will result in different amounts of net income or net loss for the same
period of time.
Note: In addition to producing different amounts of profit, these two methods will
always produce different values for ending inventory because they include
different costs in each unit of inventory. Ending inventory under absorption
costing will be higher because each unit of inventory will include some fixed
factory overhead costs and under variable costing this is not included in the
inventory.
Only when production and sales are equal in a period (meaning that there is no change in inventory levels
and everything that was produced was sold) will there not be a difference between the incomes reported
under these two methods.
The following table summarizes the effect of changing inventory levels (production compared to sales)
under the two methods
Production & Sales Profit
Production = Sales Absorption = Variable
Production > Sales Absorption > Variable
Production < Sales Absorption < Variable
If production is greater than sales, the net income calculated under the absorption method is greater
If production is lower than sales, the variable method will result in a greater net income
INCOME STATEMENT UNDER ABSORPTION COSTING

The income statement under absorption costing is as follows:
Sales revenue
− Cost of goods sold – variable and fixed manufacturing costs of items sold
= Gross profit
− Variable nonmanufacturing costs (expensed)
− Fixed nonmanufacturing costs (expensed)
= Operating Income
The Income Statement under Variable (Direct) Costing

The income statement under variable costing is as follows:
Sales revenue
− Variable manufacturing costs of items sold
= Manufacturing contribution margin
− Variable nonmanufacturing costs (expensed)
= Contribution Margin
− All fixed manufacturing costs (expensed)
− All fixed nonmanufacturing costs (expensed)
= Operating Income
COSTING SYSTEMS
Product costing involves accumulating, classifying and assigning direct materials, direct labor, and factory
overhead costs to products, jobs, or services. In developing a costing system, management accountants
need to make choices in three categories of costing methods:
1) The cost measurement method to use in allocating costs to units manufactured (standard, normal,
extended normal, or actual costing).
2) The cost accumulation method to use (job costing or process costing).
3) The method to be used to allocate overhead (volume-based or activity-based).
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Cost Management Systems
There are three main systems plus 1 variation
1) Standard
In a standard cost system, direct materials and direct labor are applied to production by
multiplying the standard price or rate per unit of direct materials/direct labor by the standard
amount of direct materials/direct labor allowed for the actual output. For example, if 3 direct labor
hours can produce one unit and 100 units are actually produced, the standard number of direct
labor hours for those 100 units is 300 hours (3 hours per unit × 100 units).
In a standard cost system, overhead is generally allocated to units produced by calculating a

predetermined, or standard, manufacturing overhead rate (a volume-based method).
Note: The standard cost for each input per completed unit is the standard rate per unit of input
multiplied by the amount of inputs allowed per completed unit, not multiplied by the actual
amount of inputs used per completed unit.
2) Normal
In a normal cost system, direct materials and direct labor costs are applied to production
differently from the way they are applied in standard costing. In normal costing, direct materials
and direct labor costs are applied at their actual rates multiplied by the actual amount of the
direct inputs used for production.
To allocate overhead, a normal cost system uses a predetermined annual manufacturing
overhead rate, called a normal or normalized rate. The predetermined rate is calculated the
same way the predetermined rate is calculated under standard costing. However, under normal
costing, that predetermined rate is multiplied by the actual amount of the allocation base that
was used in producing the product, whereas under standard costing, the predetermined rate is
multiplied by the amount of the allocation base allowed for producing the product. Often used in
Job order costing
3) Extended Normal
In extended normal costing (a variation on normal costing), the costs for direct materials and
direct labor are applied to production by multiplying estimated or normal rates (not the actual
rates that are used in normal costing) by the actual amount of the direct inputs used. The
estimated or normal rates are not called standard costs, though, because this is not a standard
cost system and because the costs are applied by multiplying the estimated/normal rate by the
actual amount of the resource used, not by the standard amount allowed as in standard costing.
In extended normal costing, overhead is applied the same way as in normal costing: the
predetermined (normal or normalized) manufacturing overhead rate is multiplied by the actual
amount of the allocation base that was used in producing the product.
4) Actual Costing System

In an actual costing system, no predetermined or estimated or standard costs are used. Instead,
the actual direct labor and materials costs and the actual manufacturing overhead costs are
allocated to the units produced. The cost of a unit is the actual direct cost rates multiplied by the
actual quantities of the direct cost inputs used and the actual indirect (overhead) cost rates
multiplied by the actual quantities used of the cost allocation bases.
Note :
It is important in answering a question to identify what type of costing the company uses.
• If the company uses standard costing, the costs applied to each unit will be the standard costs for the
standard amount of inputs allowed for production of the actual number of units produced.
• Actual amount of inputs used for the actual production are used in calculating the costs applied to
each unit only when the company uses normal, extended normal, or actual costing.
Example
Example of standard costing, normal costing, extended normal costing, and actual costing used for the
same product under the same set of assumptions:
Log Homes for Dogs, Inc. (LHD) manufactures doghouses made from logs. It offers only one size and
style of doghouse. For the year 20X4, the company planned to manufacture 20,000 doghouses.
Overhead is applied on the basis of direct labor hours. The company’s planned costs were as follows:
Direct materials $45 per doghouse (5 units of DM/doghouse @ $9/ unit)
Direct labor $30 per doghouse (2 DLH/doghouse @ $15/ DLH)
Variable overhead $10 per doghouse (2 DLH/doghouse @ $5/DLH
Fixed overhead $260,000, or $13 per doghouse (2 DLH/doghouse @ $6.50 per DLH)
LHD actually produced and sold 21,000 doghouses during 20X4.
LHD’s actual costs incurred were:
Direct materials $882,000: 5.25 units of DM used per doghouse @ $8/unit of DM
Direct labor $617,400: 2.1 DLH used per doghouse @ $14/DLH
Variable overhead $224,910
Fixed overhead $264,600
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Total Costs Applied Under Standard Costing:
Direct materials cost applied: $9 std. cost/unit of DM × 5 units allowed/house × 21,000 = $945,000
Direct labor applied: $15 std. rate/DLH × 2 DLH allowed/house × 21,000 = $630,000
Variable overhead applied: $5 std. rate/DLH × 2 DLH. allowed/house × 21,000 = $210,000
Fixed overhead applied: $6.50 std. rate/DLH × 2 DLH. allowed/house × 21,000 = $273,000
Total Costs Applied Under Normal Costing:
Direct materials cost applied: $8 actual rate/DM unit × 5.25 units used/house × 21,000 = $882,000
Direct labor cost applied: $14 actual rate/DLH. × 2.1 DLH. used/house × 21,000 = $617,400
Variable overhead applied: $5 est. rate/DLH × 2.1 DLH used/house × 21,000 = $220,500
Fixed overhead applied: $6.50 est. rate/DLH × 2.1 DLH used/house × 21,000 = $286,650
Total Costs Applied Under Extended Normal Costing:
Direct materials cost applied: $9 est. rate/DM unit × 5.25 units used/house × 21,000 = $992,250
Direct labor cost applied: $15 est. rate/DLH × 2.1 DLH used/house × 21,000 = $661,500
Variable overhead applied: $5 est. rate/DLH × 2.1 DLH used/house × 21,000 = $220,500
Fixed overhead applied: $6.50 est. rate/DLH × 2.1 DLH used/house × 21,000 = $286,650
Total Costs Applied Under Actual Costing:
Direct materials cost applied: $8 actual rate/DM unit × 5.25 units used/house × 21,000 = $882,000
Direct labor cost applied: $14 actual rate/DLH × 2.1 DLH used/house × 21,000 = $617,400
Variable overhead applied: $5.101 actual rate/DLH × 2.1 DLH used/house × 21,000 = $224,910
Fixed overhead applied: $6.002 actual rate/DLH × 2.1 DLH used/house × 21,000 = $264,600
The costs applied per unit under each of the cost measurement methods was:
Cost Applied per Unit Under Standard Costing:
Direct materials ($9 std. cost/unit of DM × 5 units of DM allowed) $45.00
Direct labor ($15 std. rate/DLH × 2 DLH allowed) 30.00
Variable overhead ($5/DLH allowed × 2 DLH allowed) 10.00
Fixed overhead ($6.50/DLH allowed × 2 DLH allowed) 13.00
Total cost per unit $98.00
Cost Applied per Unit Under Normal Costing:
Direct materials ($8 actual cost/DM unit × 5.25 units used) $42.00
Direct labor ($14 actual rate/DLH × 2.1 DLH used) 29.40
Variable overhead ($5 est. rate/DLH × 2.1 DLH used) 10.50
Fixed overhead ($6.50 est. rate/DLH × 2.1 DLH used) 13.65
Cost Applied per Unit Under Extended Normal Costing:
Direct materials ($9 est. cost/DM unit × 5.25 units used) $47.25
Direct labor ($15 est. rate/DLH × 2.1 DLH used) 31.50
Variable overhead ($5 est. rate/DLH × 2.1 DLH used) 10.50
Fixed overhead ($6.50 est. rate/DLH × 2.1 DLH used) 13.65
Cost Applied per Unit Under Actual Costing:
Direct materials ($8 actual cost/DM unit × 5.25 units) $42.00
Direct labor ($14 actual rate/DLH × 2.1 DLH used) 29.40
Variable overhead ($5.10 actual rate/DLH × 2.1 DLH used) 10.71
Fixed overhead ($6.00 actual rate/DLH × 2.1 DLH used) 12.60
OVERHEAD ALLOCATION
it’s a mathematical method to allocate Cost overt products
Categories of Overheads
1) Indirect Material
2) Indirect Labor
3) Manufacturing Overhead
a. Fixed overhead e.g. Rent
b. Variable Overhead e.g Electricity, Water
c. Mixed Overhead
Traditional Overhead method (standard)

In this method, only one allocation base is present. Here we allocate on the basis of only one activity. At
the start of of the year we determine one activity. It can be labour hour or it can be machine hours. If it’s
the automatic manufacturing, then machine our will be best or if manufacturing department is labor
extensive then it should be Labor hour.
On Jan 1, we calculate predetermine rate and then we allocate the rate on each unit of production based
on the activity.
Budgeted Dollar Amount of Manufacturing Overhead
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝐿𝑒𝑣𝑒𝑙 𝑜𝑓 𝑡ℎ𝑒 𝐴𝑙𝑙𝑜𝑐𝑎𝑡𝑖𝑜𝑛 𝐵𝑎𝑠𝑒
Allocation base can be Machine hours or Labor Hours etc.
This raise the question of Activity.
Determining Level of Activity

Level of Activity should be Realistic, it’s not the time to pessimistic or optimistic. This is era of realistic.
There are Four Level of Activity
1) Expected Actual – Master budget

2) Practical or Currently attainable - best used for Pricing
3) Normal Capacity – Used in long term planning
4) Theoretical Capacity – make butterflies everywhere, it assumes all is working well. It’s not used
anymore
Level of Activity Notes

If production is greater than expected, Fixed Overhead should have been adjusted (reduced) because it
might allocate higher OH to the product resulting in higher cost.
If production is lower than expected, Fixed OH should be increased.
Variable OH are allocated on Actual Usage.
ALLOCATING THE COST TO UNITS

Service Department Cost Allocation
Shared services are administrative services that are provided by a central department to the company’s
operating units. Shared services are usually services such as human resources, information technology,
maintenance, legal, and many accounting services such as payroll processing, invoicing and accounts
payable.
Allocation of shared service costs to products does not change the fact that for external financial reporting
purposes, the costs of service departments are period expenses and are expensed as they are incurred.
Allocation of shared service costs does not make them product costs.
Why it’s important

It’s Important for
1) Price
Variable & Fixed
Production & Non-Production
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2) Evaluation
In evaluation
Two Treatments of Service Costs

1) Allocate – its more accurate representation of cost, but we need to keep in mind the cost of
allocation
2) Expense – if cost of allocation is high best to expense it. It’s easy.
Allocation of Service Cost

1) Single Rate – here variable and fixed cost of service department are combined.
2) Double Rate – here we have 1 rate of variable cost and 2nd rate for Fixed. Double rate is more
accurate. It may have better reflection. Here we need to make certain when production
department taking decision right for us.
Example: Accounting department cost have fixed and variable cost. Production department must think
that there is fixed cost to be incurred even if the outsider accounting firm has cheaper offer. Production
department cannot avoid its company’s Accounting department’s fixed cost.
Multiple Service Department

There are three methods
1) Direct Allocation – in the direct method we ignore the services provided to services department by
other service department. Service department cost are not allocated to each other. Allocation is
based on machine hours or labor hour. Also, ignore total hours in line, but calculate hours total of
production department by yourself.
2) Step method – If Question doesn’t say which department 1st then start with the service
department which provides highest % of its services to other service department. Calculate
percent by activity in service with total service. Don’t transfer allocation back to service
department.
3) Reciprocal Method – here we are going to recognize all the service provides by services
department to each other and production departments. We have to make 2 variables and 2
equations
Dept A = Dept A’s own Cost + % Dept B
Dept B = Dept B’s own cost + % Dept A
JUST IN TIME INVENTORY AND MATERIAL REQUIREMENT PLANNING

Just in time inventory management
Here we reduce or eliminate the inventory pile up. Our daily example are Breads, Milk etc. Because of
items are of perishable nature these items are not kept in inventory. That was day to day example. JIT
has bigger scope. Objective is to reduce inventory carrying cost, this increases inventory turnover.
Since there are benefits there are risks as well. If supply doesn’t reach on time, then production get
delayed.
PULL SYSTEM:
A pull system is a lean manufacturing strategy used to reduce waste in the production process. In this
type of system, components used in the manufacturing process are only replaced once they have been
consumed so companies only make enough products to meet customer demand. This means all the
company's resources are used for producing goods that will immediately be sold and return a profit.
Essentially, a pull system works backwards, starting with the customer's order then using visual signals to
prompt action in each previous step in the process. The product is pulled through the manufacturing
process by the consumer's demand.
Push system
Another system used in supply chains is a push system, which sharply contrasts with a pull system. In a
push system, units are produced based on forecasted demand and then pushed into the market, whereas
a pull system uses actual demand. Companies using a push system must predict what the customer will
want to purchase and in what quantity, which is difficult as sales can be unpredictable and vary from
previous years.
Implementing JIT
Lean production – by keeping the waste down.
Good relationship with suppliers – because all we need is every single delivery is on time and every
product needs to be prior inspected and should be perfect.
Frequent deliveries – no defects in the delivery process. Since this is too much to ask from supplier.
Supplier may charge extra. Because technically we are asking supplier to do our storage at his risk and
his Quality Control.
KANBAN
This is Japanese term which mean Visual Record. Kanban is an integral part of lean manufacturing and
JIT systems. Kanban provides the physical inventory control cues that signal the need to move raw
materials from the previous process.
The core of the kanban concept is that components are delivered to the production line on an “as needed”
basis, the need signaled, for example, by receipt of a card and an empty container, thus eliminating
storage in the production area. Kanban is part of a chain process where orders flow from one process to
another, so production of components is pulled to the production line, rather than pushed (as is done in
the traditional forecast-oriented system).
A kanban can be a card, a labeled container, a computer order, or some other device that is used to
signal that more products or parts are needed from the previous production process. The kanban
contains information on the exact product or component specifications that are needed for the next
process. Reusable containers may serve as the kanban, assuring that only what is needed gets
produced.
The major kanban principles are:

 Kanban works from upstream to downstream in the production process, starting with the
customer’s order. At each step, only as many parts are withdrawn as the kanban instructs,
helping ensure that only what is ordered is made. The necessary parts in a given step always
accompany the kanban to ensure visual control.
 The upstream processes produce only what has been withdrawn. This includes producing items
only in the sequence in which the kanban are received and producing only the number indicated
on the kanban.
 Only products that are 100 percent defect-free continue through the production line. In this way,
each step recognizes and corrects the defects that are found before any more can be produced.
 The number of kanban should be decreased over time. As mentioned above, kanban are used
when the needed components do not show up on time. As areas of needed improvement are ad-
dressed, the total number of kanban is minimized. By constantly improving production control and
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reducing the total number of kanban, continuous improvement is facilitated while concurrently
reducing the overall level of stock in production.
Different types of kanban include supplier kanban (orders given to outside parts suppliers when parts are
needed for assembly lines); in-factory kanban (used between processes in the factory); and production
kanban (indicating operating instructions for processes within a line).
It should be mentioned that kanban can be extended beyond being a lean manufacturing and JIT
technique because it can also support industrial reengineering and HR management.
Material Requirement Planning

We use computer systems to do depended demand requirement planning. Here we setup a system,
where systems know the Bill of Materials. So depending on demand Computer systems creates Material
requisition if not in our warehouse. If in warehouse it issues to the production.
Risk is if system is not programmed correctly it can mess it up.
It is a system for ordering and scheduling of dependent demand inventories.
Dependent demand is demand for items that are components, or subassemblies, used in the production
of a finished good. The demand for them is dependent upon the demand for the finished good.
MRP is a “push-through” inventory management system. In a push-through system, finished goods are
manufactured for inventory on the basis of demand forecasts.
GOAL OF MATERIAL REQUIREMENT PLANNING

1) Right Part
2) Right Quantity
3) Right time
MRP Calculation:
MRP uses the following information in order to determine what outputs will be necessary at each stage of
production and when to place orders for each needed input component:
 Demand forecasts for finished goods.

 A bill of materials for each finished product. The bill of materials gives all the materials,
components, and subassemblies required for each finished product.
 The quantities of the materials, components, and product inventories to determine the necessary
outputs at each stage of production
MRP II
An MRPII system is designed to centralize, integrate and process information for effective decision
making in scheduling, design engineering, inventory management and cost control in manufacturing.
If a firm wants to integrate information on its non-manufacturing functions with the information on its
manufacturing functions, it needs an ERP system.
ERP
Enterprise Resource Planning (ERP) is a successor to Manufacturing Resource Planning. It is usually a
suite of integrated applications that is used to collect, store, manage and interpret data across the
organization. Often the information is available in real-time. The applications share data, facilitating
information flow among business functions.
ERP systems integrate not only production information but also the sales, marketing, customer service
and all accounting functions. ERP systems track all of a firm’s resources (cash, raw materials, and fixed
assets, for example) as well as the status of its commitments (orders, purchase orders, and payroll, for
example).
 Reduction in operational costs. Communication is improved across departments, leading to

greater efficiencies in production, planning, and decision-making that can lead to lower production
costs, lower marketing expenses, and other efficiencies.
 Inventory management facilitated. Detailed inventory records are available, simplifying inventory
transactions. Inventories can be managed more effectively to keep them at optimal levels.
 Day-to-day operations are facilitated. All employees can easily gain access to real-time
information that they need to do their jobs. Ready access by managers facilitates their decision-
making and con-trol over the factors of production.
 Resource planning as a part of strategic planning is simplified. Senior management has access to
the information it needs in order to do strategic planning.
Extended ERP
If ERP connect us with our suppliers and customers, it’s called extended ERP.
Benefits of ERP
Reduced Cost/ Inventory
Day to Day operations gets smoother
Reduces the surprises
Outsourcing
Company’s do outsource various functions example
1) Accounting
2) Internal Audit
3) Human Resources etc.
Benefits are
May be cheaper, since they are not dedicated to one client, outsourced companies are managed to
distribute their fixed cost over various clients. This makes them more price competitive.
May be better, since they are specialized in their jobs, example Audit, Accounting and HR. they are more
professional and more trusted.
Demerits are
The only demerit of Outsourcing is Organization who outsource their division lose control over that
division.
THEORY OF CONSTRAINTS
This is basically the slowest Machine. This slowest Machine is our constraint. Here we are talking about
constraint, how to manage it. There is always a constraint. There is always a department or Machine
which has lowest capacity.
We need to see it according to demand. Example if lowest machine has capacity of 5000 units a month
but demand is 4000 this means its ok. But if demand get higher than the capacity then we must manage it
for max profit.
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Theory of Constraint Terms:
Throughput – we make
Throughput – time
Throughput – contribution
Revenue - Totally Variable (Direct Material)
Theory of Constraints (TOC) Terms

 Inventory -> Only DM
 Direct Labor - > is considered as Operating Cost not as inventoriable cost
 Operation Cost is everything except direct Material.
 Throughput is product produced and shipped.
 Throughput time or manufacturing cycle time is the time that elapses between the receipt of a
customer’s order and the shipment of the order.
 Throughput contribution margin is revenue minus direct materials cost for a given period of time.
 Only strictly variable costs – which are usually only direct materials – are considered inventory
costs. All other costs, even direct labor, are considered operating, or fixed costs.
 Theory of Constraints assumes that operating costs are fixed costs because they are difficult to
change in the short run.
 Theory of Constraints focuses on short-run maximization of throughput contribution margin by
managing operations at the constraint in order to improve the performance of production as a
whole.
Theory of constraints (TOC) analysis describes three basic measurements:
throughput contribution (sales – direct materials),
investments (raw materials; work-in-process; finished goods; R&D costs; and property, plant, and
equipment),
and operating costs (all costs except direct materials).
Through-put Margin Question
Example: Using the garment manufacturer again, let’s say the manufacturer has two different
styles of jackets: a down-filled jacket for winter and a light jacket for spring. For both jackets, the
constraint is the hemming operation. The winter jacket sells for $125, and the direct materials
cost is $75. The spring jacket sells for $75, and the direct materials cost is $30. The hemming
process takes 30 minutes for the winter jacket and 25 minutes for the spring jacket. Demand for
the winter jacket is 6,000 jackets per month, whereas demand for the spring jacket is 8,000
jackets per month. The company has 4,543 hours available for hemming. Which jacket should the
company give priority to in scheduling production?
The company should give priority to the product with the higher throughput margin per minute,
calculated using the time required in the constraint process.
Winter Jacket Spring Jacket
Price $125.00 $75.00
Direct Materials cost 75.00 30.00
Throughput contribution margin $ 50.00 $45.00
Constraint time for hemming 30.00 25.00
Throughput margin per minute $ 1.67 $ 1.80
The company should manufacture the 8,000 spring jackets needed before manufacturing any
winter jackets, because the spring jacket’s throughput margin per minute in the constrained
resource is higher. That will mean using 3,334 hemming hours for the 8,000 spring jackets (8,000
× 25 minutes per jacket ÷ 60 minutes per hour). That will leave 1,209 hemming hours available for
the winter jackets (4,543 hours available – 3,334 hours used for the spring jackets). With those
1,209 hours, the company can manufacture 2,418 winter jackets (1,209 hours × 60 minutes per
hour ÷ 30 minutes per jacket). That will maximize the company’s total contribution margin.
Steps in Management the constraint

1) Identify the constraint or bottle neck
2) Most profitable product mix for constraint
3) Maximize the constraint utilization
4) Add Capacity
5) Redesign of Manufacturing process
In Exams, most question appears for (2) and (3)
DRUM – BUFFER – ROPE SYSTEM

DRUM is the constraint – it should never run out of material. All production flows must be synchronized to
the drum.
BUFFER is the inventory for the Constraint. Production schedules are planned so that workers in the non-
constrained processes will not produce any more output than can be processed by the drum, the
constraint process; but at the same time, they will produce enough to keep the buffer full.
ROPE is simply the schedule of getting the material to be floor to get the processing through Constraint.
So, that it gets to the drum. We don’t have to build up huge inventory before drum and we also can’t keep
our constraint idle.
BUSINESS PROCESS IMPORVEMENT

The Value Chain
The Value Chain are all those activities that companies do to add value to the Customer.
There are two type of Value Chain Activities
1) Primary Value Chain Activities

a. Research & Development
b. Production
c. Marketing (for prestige goods), Sales and Distribution
d. Customer Service
2) Support Value Chain Activities
a. Infrastructure (Accounting, General Management, Legal, Corporate)
b. Information Systems
c. Materials Management/ Logistics
d. Human Resources
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Value Chain Analysis
1) Identify value-adding activities
2) Identify the cost drivers
3) Increase value and/or reduce cost
Value chain measure

Formula:
𝑉𝑎𝑙𝑢𝑒 𝑎𝑑𝑑𝑒𝑑 𝑚𝑎𝑛𝑢𝑓𝑎𝑐𝑡𝑢𝑟𝑖𝑛𝑔 𝑡𝑖𝑚𝑒
𝑉𝑎𝑙𝑢𝑒 𝐶ℎ𝑎𝑖𝑛 𝑀𝑒𝑎𝑠𝑢𝑟𝑒 =
𝑡𝑜𝑡𝑎𝑙 𝑚𝑎𝑛𝑢𝑓𝑎𝑐𝑡𝑢𝑟𝑖𝑛𝑔 𝑐𝑦𝑐𝑙𝑒 𝑡𝑖𝑚𝑒
The Supply Chain

The supply chain is the flow of materials and services from their original sources to final consumers.
Moreover, it usually encompasses more than one firm.
The process is initiated by purchase requisitions issued by the production control function.
1. Purchase requisitions ultimately result from insourcing vs. outsourcing. For non-manufacturing
purchase decision is the same as the decision to sell.
2. Choosing vendor depends on Price, Quality, delivery, shipping cost, credit terms, and service.
3. Purchaser and vendor coordination often termed as committed to partnership.
Supply Chain Analysis

Inventory management by sharing info and reducing uncertainty. Reduction of bullwhip or backlash
effect. This phenomenon occurs when demand variability increases at each level of the supply chain.
Retailer face only customer demand variability.
CRITICAL SUCCESS FACTORS FOR VALUE CHAIN & SUPPLY CHAIN

1) Cost reduction
2) Efficiency
3) Continuous Improvement of Quality to meet customer demands
4) Minimization of defects
5) Quick product development and reduced customer response time
6) Constant innovation
Value Engineering
It means reaching target cost levels. Its systematic approach to assessing all aspects of the value chain
that build up a product.
Cost incurrence is the actual consumption of resources. Some are locked-in the product Value
engineering emphasize on controlling the cost at the design stage, meaning before locked-in stage.
Sometimes it uses Life cycle costing as well to emphasize on costs.
PROCESS ANALYSIS
It means linking firm’s internal processes to its overall strategy.
Types of Processes:
1) Continuous, example candy bar

2) Batch such as beer brewing
3) Hybrid, which is mix of both continuous and batch
4) Make to Stock
5) Make to Order
Processes interdependence
1) The degree of interdependence among the stages in a process is referred to as “tightness”
2) Tight process is one in which a breakdown in one stage stops activity of next stage. This happens
in continuous processes, that don’t keep buffer WIP inventories.
3) Loose process is one which don’t stops the next stage, if earlier stage stops.
4) Bottle neck process, this is the Part of process which is slowest. Discussed in Theory of
Constraints.
Process value analysis

Process value analysis is a comprehensive understanding of how an organization generates its output.
1) This linkage of product costing and continuous improvement of processes is activity-based
management (ABM).
2) A continuous improvement process (CIP) is an ongoing effort to improve products, services, or
processes.
3) Kaizen1 is the Japanese word for the continuous pursuit of improvement in every aspect of
organizational operations.
4) Activity Analysis determines
a. what is to be done
b. by whom
c. at what cost
Need to seek out Value Added Activity, Value Added Cost and non-value added activities and
non-value adding cost.
5) Financial and Non-Financial measures of Activity performance addresses efficiency, quality and
time. Need to assess how activities addresses customer demands.
6) Time management, product development time is of crucial factor. Earlier product reaches the
market has obvious advantages.
Business Process Reengineering

BPR is rethinking how business functions are performed to provide value to customers.
1) Technological advances
2) Reengineering a process and core process redesign. Old controls will be broken, and new
implemented.
3) Extensive monitoring of internal controls for corrective actions.
4) Reassessment of quality of internal control.
Bench Marking
“Benchmarking involves continuously evaluating the practices of best-in-class organizations and adapting
company processes to incorporate the best of these practices.” It “analyzes and measures the key
outputs of a business process or function against the best and also identifies the underlying key actions
and root causes that contribute to the performance difference.”
1
Kaizen is the Japanese word for the continuous pursuit of improvement in every aspect of
organizational operations. For example, a budget prepared on the Kaizen principle projects costs based
on future improvements. The possibility of such improvements must be determined, and the cost of
implementation and the savings therefrom must be estimated.
Key Features of Kaizen is as under

1) Improvement are small changes than big radical change
2) Ideas comes from workers, easier to implement
3) Small improvement doesn’t require big budgets
4) Ideas are developed internally without external research or consultant advise. Consultant and
research have costs.
5) Continuous improvement in performance by employees and management
6) Reinforce team work by encouraging workers to ownership of the work.
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Benchmarking is an ongoing process that entails quantitative and qualitative measurement of the
difference between the company’s performance of an activity and the performance by the best in the
world. The benchmark organization need not be a competitor.
Steps of Bench Marking

1) Understanding critical success factors and business environment to develop the parameter
defining what processes to benchmark
2) Establishing criteria for selecting what to benchmark
3) Organize benchmarking teams
a. For equitable division Labour, participation by those responsible for implementing
changes, and functional expertise and work experience
b. Team should be knowledgeable enough to have insight of functions to be benchmarked,
also professional and educated.
4) Through investigation and documentation of internal process.
a. Organization should be viewed as series of processes not as infrastructure.
b. Development of measures that are true indicators of process performance
5) Researching and identifying best-in class performance
6) Data analysis phase, understanding existence, key activities.
7) Leadership in the implementation of approved changes.
Balanced Scorecard
The balanced scorecard approach employs multiple measures of performance to permit a determination
as to whether the organization is achieving certain objectives at the expense of others that may be
equally or more important.
The scorecard is a goal congruence tool that informs managers about the nonfinancial factors that top
management believes to be important.
Typical Score Card

A typical scorecard includes measures in four categories:
1) Financial
2) Customer
3) Learning, growth, and innovation
4) Internal business processes
Costs of Quality
The IMA’s Statement on Management Accounting Managing Quality Improvements, issued in 1993,
describes four categories of costs of quality:
1) Prevention - attempts to avoid defective output.
2) Appraisal - statistical quality control programs, inspection, and testing.
3) Internal failure - defective products are detected before shipment.
4) External failure - lost opportunity include lost profits from a decline in market share as dissatisfied
customers make no repeat purchases, return products for refunds, cancel orders, and
communicate their dissatisfaction to others.
Efficient accounting processes

1) Improving accounting processes can increase a company’s ability to minimize the costs of these
processes while also maximizing their usefulness.
2) Four important areas where companies can optimize their accounting processes include
a. Accounts payable,
b. Cash cycle,
c. Closing and reconciliation processes, and
d. Data analysis.
PLANNING, BUDGETING AND FORECASTING
STRATEGIC PLANNING
Planning in general refers to the process that provides guidance and direction regarding what an
organization needs to do throughout its operations. It determines the answers to the “who, what, when,
where and how” questions of a business operation. Planning is the first activity that management must
undertake when creating yearly budgets and making other critical decisions that will affect the company’s
future. A company’s plan serves as its guide or compass for the activities and decisions made by individuals
throughout the entire organization. The planning process not only defines the company’s objectives and
goals, it sets the stage for prioritizing how to develop, communicate and carry out accomplishing them.
Furthermore, good planning puts the company in a better position to anticipate and respond quickly to
sudden changes in its environment. And finally, one of the primary success factors in a company is
management’s competence in planning and controlling the firm’s activities. Management’s responsibility is
to plan and control the long-range destiny of the company through decisions that either create or seize a
positive opportunity, or escape a decline.
A STRATEGY
A strategy is a set of actions taken by managers of a company to increase the company’s performance.
The strategy-making process includes both strategy formulation and strategy implementation.
Strategy formulation is the process of selecting strategies.
Strategy implementation is the process of putting the selected strategies into action. It involves designing,
delivering and supporting products; improving efficiency and effectiveness of operations; and designing the
organization structure, control systems, and culture.
Superior Performance
For most companies, if not all, the ultimate objective is to achieve superior performance in comparison with
the performance of their competitors. When superior performance is achieved, company profitability will
increase. When profits are growing, shareholder value will grow.
Competitive Advantage
The result of attaining superior performance will be competitive advantage. A company is said to have
competitive advantage when it is more profitable than the average company in its industry.
To increase profitability and sustain profit growth, managers need to formulate strategies that will give
their company a competitive advantage.
Shareholder value
Shareholder value is the returns that shareholders earn because of having purchased shares in a company.
Shareholders’ returns come from both capital appreciation of their shares’ value and from dividends
received. Profitability and profit growth are the primary means by which shareholder value increases.
PURPOSE OF STRATEGIC PLANNING

The purpose of strategic planning is to guide the company in its efforts to achieve superior performance,
competitive advantage, and maximized shareholder value.
The Role of Management in Attaining Profitable Growth

There are two opposing philosophies with respect to the role of management in reaching profit growth:
1. The market theory gives management a passive role and views its function basically as making
reactive decisions in response to environmental events as they occur.
2. The planning and control theory views the role of management as an active one that emphasizes
the planning function of management and its ability to control the activities of the business.
Most companies’ managements operate somewhere between these two extremes. At times, events will
occur that are outside the control of management and may even be important enough to determine the
firm’s destiny.
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Business Model
A company’s business model is its managers’ idea of how the set of strategies and capital investments that
the company makes should fit together to generate above-average profitability and, at the same time, profit
growth.
It means long term planning, here we talk about next year and beyond next year.
1) Planning and performance: if you have a proper plan, greatly improves your chances to increase
the performance. If a poor plan it lowers your chances to increase the performance. All the plan
should contribute towards the main plan.
2) STRATEGIC PLANS
The longer the time frame of the plan, the higher up in the organization the planning should be
done. Similarly, the shorter the time frame of the plan, the lower in the organizational hierarchy the
planning should be prepared. Features of Strategic Plan are:
a. Many years into Future
b. High Level or Top management
c. Directional
d. Capacity / Capital
Strategic planning is neither detailed nor focused on specific financial targets, but instead looks
at the strategies, objectives and goals of the company by examining both the internal and
external factors affecting the company. Internal factors include current facilities, current products
and market share, corporate goals and objectives, long-term targets, technology investment, and
anything else within the direct control of the company itself.
External factors also need to be considered in strategic planning. Some of the external factors
are the economy, labor market, domestic and international competition, environmental issues,
technological developments, developing new markets, and political risk in other countries (or the
home country).
3) INTERMEDIATE PLANS
The strategic plan is then broken down into intermediate or tactical plans (one to five years),
which are designed to implement specific parts of the strategic plan. Upper and middle managers
develop tactical plans.
Short-term or operational plans (one week to one year) are developed from the tactical plans.
Operational plans focus on implementing the tactical plans to achieve operational goals, and
operational plans include budgeted amounts. Operational plans drive the day-to-day operations of
the company. Middle and lower-level managers develop operational plans.
a. 1-5 Years
b. Tactical
c. Helps to achieve objectives of Strategic plan
4) SHORT TERM PLAN

Operational plans refine the overall objectives from the strategic and tactical plans in order to
develop the programs, policies, and performance expectations required to achieve the company’s
long-term strategic goals.
Most budgets are developed for a period of one year or less. Thus, the budget formulates action
steps from the organization’s short-term objectives. The budget reflects the company’s operating
and financing plans for a specific period (generally a year or a quarter or a month). The budget
contains the action plans to achieve the short-term objectives.
a. Up to a year, week or months
b. Middle & Lower management
c. Basis for Annual Budget
5) SINGLE PURPOSE PLAN
Single-purpose plans, which are developed for a specific item such as construction of a fixed asset,
the development of a new product, or the implementation of a new accounting system. These are
also incorporated into the operating and financial budgets during the relevant years.
a. Has single purpose
b. Limited Scope
6) STANDING PURPOSE PLAN
Standing-purpose plans have relevance and use for many different items. Plans such as marketing
and operation plans fall into this category.
a. It happens on every routine procedure
b. Marketing and Operation plans are example
7) CONTINGENCY PLAN
Contingency planning is planning that a company develops to prepare for possible future events
(especially negative events). This is “what if?” planning. Preparing different plans for different
situations is more expensive because it entails developing multiple plans. However, multiple plans
for different situations enable the company to be better prepared for what may occur. Companies
do this when they think that the contingency planning will eventually lead to greater savings than
the cost of the planning itself.
a. It is What if plan.
b. A plan where things happens what it doesn’t supposed to happen.
DRAWBACKS/ DEMERITS OF PLANNING

Despite the benefits of having a formal plan, there are also some drawbacks to this process. A plan that is
too formal can constrain creativity, or a strict dedication to the plan can cause the company to miss some
opportunities that would be beneficial to them.
THE STRATEGIC PLANNING PROCESS

Strategic Planning Process-Mission and External
There are 5 steps of Strategic Planning.
1) Defining the company’s Missions, vision, Values & Goals

2) Analyzing the organization’s external competitive environment
3) Analyzing the internal operating environment to identify strengths, weaknesses and limitations
4) Formulating and selecting strategies that, consistent with the organization’s mission and goals,
will optimize the organization’s strengths and correct its weaknesses and limitations for the purpose
of taking advantage of external opportunities while countering external threats (SWOT analysis)
5) Developing and implementing the chosen strategies.
STRATEGIC PLANNING STEPS IN DETAILS

1) Missions, vision, Values & Goals We need to know what our Mission is, we need to know our
Vision, our Values and Goals. These generally comes together in company’s MISSION
STATEMENT.
Mission Statement are few lines about;
1. Our company’s REASON TO BE

2. Our VISION
3. VALUES
4. Major GOALS
1. MISSION is our reason to be, it should be targeted to CUSTOMER GROUP, their NEEDS,
MEANS to provide those.
a. What customer groups are being served?
b. What customer needs are being served?
c. And by what means (skills, knowledge or distinctive competencies) are customers’
needs being served?
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2. OUR VISION This should MOTIVATE (AMBITIOUS) DRIVING FORCE (what will help us
achieve)
NOTE: The difference between a company’s mission and its vision is

that a company’s mission is what it does, whereas its vision is what it
wants to achieve. The mission is what is, whereas the vision is a
desired future state.
3. COMPANY’S VALUES
a) Organization Culture
b) Not only words, but needs to be action as well.
4. MAJOR GOALS
They need to be MOST IMPORTANT for us.
They need to be CHALLENGING as well.
They need to be MEASUREABLE not just be better or bigger.
They need to have TIME-FRAME, when this is going to be.
This is also something that’s need to be COMMUNICATED.
They need to be ACCEPTED by the people. It’s impossible to get everyone to agree on
something, but if they accept them they will work towards to those goals and objectives, their
agreement.
i) GOALS & OBJECTIVES
The terms “goals” and “objectives” are often used interchangeably. GOAL is a
corporate goal. Objectives are the smaller steps needed to be taken to achieve Goals.
ii) ACHIEVING GOALS
Two terms that are related to the accomplishments of goals and objectives are
efficiency and effectiveness. Efficiency is the attempt to fulfill the goals and objectives
of the company while using the least amount of inputs. Effectiveness. it’s kind of Yes
or No VS Efficiency: - it has something to with how many resources we used to achieve
the Goal.
Example: For a Student, effectiveness means you pass or didn’t pass. Efficiency
means the resources he used. Example 100% result means they were effective but
not efficient. A person who is just pass with minimum marks is the person was Effective
and Efficient.
Analyzing External Environment
a. Opportunities – anything that creates chance of Profit

b. Threats – anything that poses risk to our Profitability
Three External Environments
1) Industry – our clients, supplier and competitor
2) National Environment or International Environment - Politics, taxes laws & regulations
3) Macro-Economic – example interest rate, exchange rate, inflation, economic rate.
PORTER’S FIVE FORCES MODEL

1) RISK OF ENTRY OF NEW COMPETETOR – easy is bad difficult is good.
2) INTENSITY OF RIVALRY – low intensity is good high is bad for profit as prices will cut
down.
3) BARGAINING POWER OF BUYERS – low bargaining power is good, high bargaining
power is bad. It depends on their bargaining position, if lots of substitute they have high
bargaining power.
4) BARGAINING POWER OF SUPPIER – low bargaining power is good, high bargaining
power is bad.
5) CLOSENESS OF SUBSTITUTES – more close -substitutes is bad, less close-substitutes
are good.
Strategic Planning Process-Internal Analysis

1) Strengths
2) Weakness
Competitive Advantage – It’s something we do better than our competitor makes customer choose us. If
we do something better than our competitor, we should turn it into Profit.
1) We need to have distinctive competencies.

2) We need to have Superiority (efficiency, quality, Innovation & Customer responsiveness)
Distinctive competencies
1) Differentiation advantage; somehow, we can provide services to our customers better than our
competitors and/or
2) Cost advantage ; means we can deliver above services better cost, in result will increase the
shareholder value.
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There are 2 sources of to gain distinctive competencies.
1) Resources – can be tangible or intangible, people, knowledge, skill, patent etc.

2) Capabilities – is our ability to take these resources and put them to productive use.
Superiority - Generic
1) Superior Efficiency – inputs & output, technology, man power conversion into output. Fewer
inputs better output, fewer input means lower cost, which leads to competitive advantage. We look
at Employee, Productivity, Capital Productivity etc.
2) Superior Quality – what’s is it that is Quality. It depends on customer, if it meets the customer’s
expectations, its quality product otherwise not. Quality doesn’t necessary mean premium quality.
Example if someone goes to expensive restaurant, and comes out saying food wasn’t that good.
Quality lies in the eyes of customer. It’s about Utility to Customer. Its value of money. Best scenario
is customer saying “Wow! I would have paid more for that”
3) Superior Innovation – Its creating new product and processes. If we are the one who comes up
with new process or product this mean, we are the only ones who have it. This makes us Unique.
If we improve our process this mean we reduce the cost, either we keep same price earn more
profit or reduce the price to gain competitive advantage.
4) Customer Responsiveness – Company should identify that what Customer needs, may be
customers don’t know they need that. We need to be responsive to the customer needs, this creates
brand loyalty, and allows to charge higher profit.
In perfect world, we have all of it.
UTILITY AND PROFITABILITY

1) Utility – more utility the customer receives, customer willing to pay more. Usually the price that we
charge going to be less than utility received by customer.
Utility – Price = Consumer Surplus
Utility – Cost = Created Value
We need to increase Utility and reduce Cost.
Durability of Competitive Advantage

How long this Competitive Advantage last? All good things end so does the bad things.
1) Barriers to imitation – how easily

2) Can competitors compete – how easily
3) Rapidly changes in industry/Market – how fast industry or Market is changes.
Using INTERNAL ANALYSIS

We may have two or more factors which are prime, but we cannot ignore other factors for few.
1) Continuous improvement
2) Continuous learning
3) Be able to change
Formulating Strategy
A. Functional-level strategy – read in book
B. Business-level strategy
a. Decision about customer needs
b. Decision about what products should be offered
c. Decision about how customer needs to be satisfied, using the company distinctive.
d. Some competencies Competitive Strategies
1) Cost leadership
2) Focused cost leadership
3) Differentiation- you can’t get what we provide anywhere else
4) Focused differentiation – we are specific and different to specific areas
C. Global Strategy
a. Global Standardization
Economies of Scale, Cost reduction through local economies- no product customization
for different market
b. Localization
Work to increase profitability by offering goods and services that are customized for each
national market. This strategy can work if the value addition supported by higher pricing
and enable company to recoup higher cost
c. Transnational
Used when requirement for local responsiveness are high and at the same time cost
pressures are strong.
d. International
Used by companies that do not have great pressure to produce low-cost goods and do not
have great pressure to be locally responsive. The risk is that eventually competitor do
emerge.
Other Global Questions
1) Which market to enter?
2) When to enter, first or last
3) What Scale
D. Corporate-Level Strategy – Corporate-level strategy involves a long-term perspective. Managers
need to continually consider how changes takes place in industry in technology, in customer
preferences and the competition will affect the company’s current business model. It requires
constant review and tweaking.
Growing the Company

Different strategies for growing the company
1) Horizontal integration – merging with competitors

2) Vertical integration – buying a Supply chain
3) Strategic alliance – long term cooperation
4) Diversification – new industries. However, there are risks as follows:
a. Changing conditions
b. Diversification for wrong reasons
c. Additional cost created
DEVELOPING AND IMPLEMENTING STRATEGIES

The strategy needs to be implemented. Organizational design which includes:
A. Organizational structure
Specifies who should do what, how they should do it and they should work together.
The three decision to be made about organizational structure are:
1. How group task into functions, and how to group functions into business units or divisions.
2. How to allocate authority and responsibility to the functions and division.
3. How do we increate coordination or integration between and amount functions and division,
and how to maintain and increase them as the structure evolves.
B. Control Systems
Provide managers with incentives to motivate their employees to work increase efficiency, quality,
innovation and responsiveness to customers.
C. Organization Culture
Includes all the norms, values, belief and attitudes that people in an organization share.
Implementing Strategies, A strategy that is not implemented is a waste – read more in book
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Other Planning Tools
Will look at a few other terms and tools and techniques that you need to aware of:
Situation analysis
The systematic collection and valuation of external and internal forces that can affect the organization’s
performance and choice.
PEST Analysis
P= POLITICAL FACTORS
E=ECONOMICAL FACTORS
S= SOCIAL FACTORS
T=TECHNOLOGICAL FACTORS
COMETITIVE ANALYSIS
Competitive analysis is also like SWOT analysis but for competitors
1) Strength and weakness of competitors

2) Demographics and needs of the market
3) Strategies to improve the company’s position in the market place
4) Impediments to the company’s entering new markets
5) Barriers the company can erect to limit competitors’ ability to erode the company’s place in the
market.
Contingency Planning
Planning a company does to prepare for possible events. This planning should be done before the crisis.
We should prepare for the event which shouldn’t happen.
BCG – Growth Share Matrix

The growth–share matrix (aka the Product Portfolio Matrix, Boston Box, BCG-matrix, Boston matrix,
Boston Consulting Group analysis, portfolio diagram) is a chart that was created by Bruce D. Henderson
for the Boston Consulting Group in 1970 to help corporations to analyze their business units, that is, their
product lines.
This helps the company allocate resources and is used as an analytical tool in brand marketing, product
management, strategic management, and portfolio analysis. Some analysis of market performance by
firms using its principles has called its usefulness into question.
Situation in the BCG Growth Share Matrix

a. The best situation to be in is at high growth rate and high relative market share – denoted as
STARS
b. Low Market Growth Rate but High Market Share is Cash Cows
c. Worst is Low Market Growth rate and Low Market Share – we should leave such product
immediately. It’s a dog.
d. High Market growth share with low relative market share is “?” we must increase market share
to make it STAR, if we can’t do that we have Dog.
THE BUDGET AND CONTROL PROCESS

A budget is a realistic plan for the future expressed in quantitative terms. The process of budgeting forces
a company to establish goals, determine the resources necessary to achieve those goals, and anticipate
future difficulties in their achievement. A budget is also a control tool because it establishes standards and
facilitates comparison of actual and budgeted performance. Because a budget establishes standards and
accountability, it motivates good performance by highlighting the work of effective managers. Moreover, the
nature of the budgeting process fosters communication of goals to company subunits and coordination of
their efforts. Budgeting activities by entities within the company must be coordinated because they are
interdependent. Thus, the sales budget is a necessary input to the formulation of the production budget. In
turn, production requirements must be known before purchases and expense budgets can be developed,
and all other budgets must be completed before preparation of the cash budget.
Ineffective budget control systems are characterized by each of the items noted. The use of budgets for
planning only is a problem that must be resolved through the education process. Management must be
educated to use the budget documents for control, not just planning. Management must learn that budgets
can motivate and help individuals achieve professional growth as well as the goals of the firm. Ignoring
budgets obviously contributes to the ineffectiveness of the budget system. Finally, feedback must be timely
or lower management and employees will soon recognize that budget feedback is so late it provides no
information, making the budget a worthless device.
Planning to Budget to Evaluation (Cycles)
1) Plan
2) Budget
3) Revisions
4) Final
5) Actual Results
6) Comparison – Variance analysis
7) Information
Budgeting is a Quantitative plan or our goals or objectives.
1) Master Budget
2) Operating Budget
3) Financial Budget
Advantages of Budget:
1) Coordination & Communication

2) Motivation for Managers and Employees
3) Efficient allocation of resources
4) Controlling operation
5) Evaluation
Successful Budgeting
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1) Management support for the budget.
2) Correct people involvement
3) Motivational – It shouldn’t be optimistic shouldn’t be so easy.
4) Accurate Representation
5) Flexible – adaptable to the reality – Shouldn’t be too strict
6) Coordinated between all the parts of the business
TIME FRAMES FOR BUDGET
This can be One year or Quarterly Budget, monthly or project budget. There is problem in doing 1 year
budget. Example to make budget for next year Jan – Dec we must start in Sep prior year. We must make
a budget will be for 16 months in advance a lot can change in 16 months. Longer the time higher the
guesswork it will be. To fix this we have a rolling budget method.
ROLLING BUDGET
Whenever month we are in we make budget for example 4 months in advance. If we pass current month
we add one more month of future, so it stays same. Here we don’t do guesswork far in the future.
Who should prepare the Budget

1) Top Management – approvals
2) The people who knows the most
a. Marketing Department – Marketing Budget
b. Production Department – Material Budget
BUDGET APPROACHES
Top-down and bottom-up are two different approaches to the setting of budgets.
A TOP DOWN BUDGET is a budget that is set without allowing the ultimate budget holder to have the
opportunity to participate in the budgeting process.
A BOTTOM UP BUDGET is a system of budgeting in which budget holders have the opportunity to
participate in setting their own budgets. Also, called participative budgeting.
Kinds of budgets
1) Participative
2) Authoritative
3) Consultative
The Budget and Control Process
1) Budget guidelines – structure, process guidelines

2) Initial budget -
3) Review, revise, approve – determine what’s working what’s not working etc.
4) Continuous review – always look at what’s has changed in the reality
5) Variances – We compare actual results with budgets i.e. Variances
6) Use variances – use variances to fix the problems with next budget
BUDGETING BEST PRACTICE GUIDELINES

This might be good for essay question.
1) Strategy – our budget should relate to our strategy. Our planning drives the budget
2) Communication – Involvement of all directions and all different department is critical. Production
department cannot make budget in isolation without knowing Sales budget
3) Evaluation of Budget – Evaluation is of manager and people are only partially based. Not only
budget based, balanced scorecard and other things should also be in place
4) Variances analysis – are vital part of the budget best practices
5) Review/ revised – we need to have a budget that’s is revised if needed throughout the year and
constantly reviewed throughout the year.
GOAL CONGRUENCE
Goal Congruence is a process of making sure that every departments are moving in same direction.
Everybody moving in same direction. If one department achieve their budget it should help another
department to achieve their budget.
BUDGETARY SLACK
It makes budget easy to achieve, which is wrong. Budgets should reflect Realistic amounts. Pessimistic
Revenue numbers and exaggerating expenses side, to show department has done well through revenue
variance and cost variance will lead the management to make Poor decisions. Since information provided
is not correct, and actuals will be overly different and favorable on department side will not provide
correctness in budget. Times have already passed for pessimistic and optimistic budgets. It’s now era of
realistic budgets. This leads to poor decisions because information is not correct.
STANDARDS COSTS
How much it should cost, based on various factors. Important factors are discussed below. Standard is how
much it should require and how much material it should take, how much hours it should take. If we have
good standard we can make good budget, bad standard make budget bad.
Activity Analysis
1) Historic data
2) Target costing
3) Strategic divisions
4) Benchmarking
STANDARD SETTING PROCESS
First, we should make sure correct people are involved.
1) Authoritative
2) Participative – Asking feed back
Direct Material standards
1) Quality – what Quality we need

2) Quantity – How much we need to buy, more we buy cheaper it gets
3) Price per unit
Direct Labor Standards
1) Quantity of labor – manpower or machine decision

2) Labor rate or depreciation or repairs
Overhead Standards
1) Calculate pre-determined rate

We take the budgeted overhead cost and divide it over budgeted allocation base
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑂𝐻
𝑃𝑟𝑒𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑟𝑎𝑡𝑒 =
𝐵𝑢𝑑𝑒𝑔𝑒𝑡𝑡𝑒𝑑 𝑂𝑣𝑒𝑟 ℎ𝑒𝑎𝑑 𝑎𝑙𝑙𝑜𝑐𝑎𝑡𝑖𝑜𝑛 𝑏𝑎𝑠𝑒
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Budgeted Allocation base can be machine hours or labor hour. How to we set budgeted allocation
base
a) Based on supply
1. Theoretical – is very optimistic – assumption is we can sell everything we can
make.
2. Practical – is currently attainable, this is preferred method
b) Based on demand
1. Master Budget capacity utilization – Expected Demand or Capacity
2. Normal capacity utilization – this what we can produce in long run, considered
seasons changes in the demand, this is preferred method
BUDGETING METHODOLOGIES
1) BUDGETING CYCLE – is the process which is ongoing throughout the year
2) THE MASTER BUDGET – is the end process, its consolidation of all operational budget, we also
call it comprehensive budget.
a. Budgeted Balance Sheet
b. Budgeted Income Statement
c. Budgeted Statement of Cashflow
3) OPERATING BUDGET AND FINANCIAL BUDGET
a. Operating Budget – Income Statement, including Sales, expenditure
b. Financial Budget – Capital expenditure, Cash budget, Statement of Cashflows.
4) CAPITAL EXPENDITURE BUDGET - This is for large capital expenditures, mostly its fixed assets.
Our capacity in Operation budget depends on this. This is usually made years in advance. This is
strategic budget made my Top Management. It is connected to the current budget, but its kind of
outside the current year budget.
5) INDIVIDUAL BUDGETS
i. First Budget – Sales Budget
ii. Last Budget – Cash Budget
a. THE SALES BUDGET – it is most difficult because we don’t know how many consumers
will come, how many competitors enter or leave the market, what will be the situation of
Economy. Rest of the budget will be based on this.
b. PRODUCTION BUDGET – how much we want to sell, changing inventory, outsourcing,
Question is How many and When. There can be seasonal effect, sales will not be
distributed throughout the year. Formula for Units to be produced is below formula is tested
in exam.
𝑈𝑛𝑖𝑡 𝑡𝑜 𝑏𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑 = 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑆𝑎𝑙𝑒𝑠 + 𝐸𝑛𝑑𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
c. PRODUCTION SUB-BUDGETS
a. Direct Materials Budget: this is based on how efficiently we use the direct material
we buy, this also based on Quality. Better the quality lesser it would damage while
production. How much we should produce. Quality standards. Method is like
finished good inventory.
𝐷𝑀 𝑡𝑜 𝑏𝑢𝑦 = 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐷𝑀 𝑈𝑠𝑒𝑑 + 𝐸𝑛𝑑𝑖𝑛𝑔 𝐷𝑖𝑟𝑒𝑐𝑡 𝑀𝑎𝑡𝑒𝑟𝑖𝑎𝑙 − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐷𝑖𝑟𝑒𝑐𝑡 𝑀𝑎𝑡𝑒𝑟𝑖𝑎𝑙
d. LABOUR BUDGET – It’s not only works around salary. But it involves all cost pertaining to
labor. It’s all the cost that company have connected to labor. Problem we have here is
some of the cost is fixed and some are variable. Larger companies cannot do exact
calculation. In exams if there is different labor hour rate or different classes of labor. It
doesn’t make it difficult, but it may make it longer.
e. MFG. OVER HEAD COST – Overheads are applied over production based on various
drivers. It can be direct labor hour, or Machine hours.
f. ENDING INVENTORY BUDGET – we need to learn to work on ending inventory of
Finished Goods and Materials.
g. COST OF GOODS SOLD – formula is as under:
Opening + Production or purchases = Available for Sale – ending inventory = budgeted

COGS
h. NON-MANUFACTURING BUDGETS - some of the non-mfg. budget are

a. Selling & Admin
b. Marketing
c. Accounting & Finance
d. Research & Development
e. Logistics
i. FINANCIAL BUDGET – this is in financial statement format.
a. Cash budget – is the last budget prepared. We must plan our Cash.
b. MASTER BUDGET FINANCIAL STATEMENT – This helps us in determining how
our financials look when year ends.
i. BALANCE SHEET
ii. PROFIT & LOSS ACCOUNT
iii. STATEMENT OF CASH FLOW
6) PROJECT BUDGET – is based on project.
7) ACTIVITY BASED BUDGETING – is based on Activity based costing. Here company makes
budget based on cost and cost driver or cost activity.
8) ZERO BASED BUDGETING – it starts each year with a blank page. It’s more difficult, because it’s
not incremental budget. (incremental budget is last year’s result add 10%). In Zero based
budgeting, there is more emphasis on Expenses.
9) Budget reports and control loop – we analyze variance, we correct the process. We review/ revise.
Control Loop
Investigating the causes of unexpected variances is one of the most important steps in the budgeting
process. This analysis is part of the control loop, which is the process by which the activities of the
company are controlled.
The major steps in the control loop are:

1) Establish the budget or standards of performance.
2) Measure the actual performance.
3) Analyze and compare actual results with the budgeted results (this is the budget report).
4) Investigate unexpected variances.
5) Devise and implement any necessary corrective actions.
6) Review and revise the budget or standards if necessary.
Forecasting Techniques
Forecasting and Budgeting
One of the most important parts of the planning and budgeting process is the identification of the
assumptions that a company must make about the future. Since planning and budgeting involve considering
the future, the company must make some assumptions about the outlook for the environment in which its
business operates. These assumptions are called premises.
REGRESSION ANALAYSIS
Through regression analysis, we do forecasting. Regression analysis gives a Future value by a

Mathematical Model.
Steps in forecasting
1) Collecting data for forecast

a. Time series method – it looks at historical pattern of one variable, and general forecast by
extrapolating the pattern using one or more of the components of the time series.
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b. CAUSAL forecasting method – this method looks at cause-and-effect relationship.
a. Time Series Analysis:

i. We calculate Trends
ii. Cyclical
iii. Seasonal
iv. Irregular
SMOOTHING
We take all past data which is called Smoothing.
We can do this by taking Average of the Actuals results and No. of Years.
we can also take Weighted Average/ Moving Average, We take reduced confidence on date of earlier
years.
Example:
Years Rate Actual Result
1 60% $XXX
2 30%
3 10%
Total
b. Exponential Smoothing
Here we take last period’s budgeted or expected result was and Last period’s actual value.
A= Last year Budgeted or expected value <– this is called Smoothing constant
1-A = Last year Actual Value
The Smoothing Constant = A. it can be O or 1
We take all the data of previous years and apply rates from 0 – 1
c. Trend Projection
a) Regression Analysis:
𝑦 = 𝑎 + 𝑏𝑥
(b = Variable coefficient or slope X= independent variable a= y intercept)
Co-efficient of Correlation or R
If R = +1 or R-1 is Perfect relationship either positive or negative. R=0 means no relationship.
d. Coefficient of Determination
It is R Square = R2
Causal Forecasting
It discusses the cause & Effect relationship. It is used when we use the values we are looking for is
depended on some other factor.
1) Simple Regression Analysis – (Theoretically good, based on 1 variable)

a. Y = mx + C
2) Multiple Regression Analysis – (Practically Good, based on more variables)
a. Y=mx1+mx2+mx3+C
Benefits of Regression Analysis

Its numerical and Quantitative, we can use it to forecast with Fixed and Variable Costs.
Limitation of Regression Analysis:

1) Need Historical Data
2) Good Data
3) Ranges
4) Risk of Choosing Wrong Variable
Learning Curve
The formula to consider learning curve. Learning curve is going to state between 50.01% and 100%.
50.01% is maximum learning and 100% means no learning.
Doubling of Production
How often learning take place? Every time Number of production run or Batches double learning takes
place.
Cumulative Average Model

There are 3 things.
1) Average time per unit (total time / Units)

2) Total time (average time * units)
3) Total time for a certain block (1, 2, 3-4, 5-8, 9-16)
We can be asked to calculate block of units not individual units.
Two formulas
1) Calculate Total time

Time required for first unit X (2 X LC) n
LC is between 50.01% - 100%

n= number of doubling
2) Cumulative Average time
Cumulative Average time = Time Required for 1st Unit X LC n
Calculating Block of Units. In question, they will ask what’s the cost of producing 5-8 Units. Its simply a
difference between 5-8 and 3-4.
Example:
The average labor cost per unit for the first batch produced by a new process is $120. The cumulative
average labor cost after the second batch is $72 per product. Using a batch size of 100 and assuming the
learning curve continues, the total labor cost of four batches will be
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A. $10,368
B. $4,320
C. $17,280
D. $2,592
Answer (C) is correct.

The learning curve reflects the increased rate at which people perform tasks as they gain
experience. The time required to perform a given task becomes progressively shorter. Ordinarily,
the curve is expressed in a percentage of reduced time to complete a task for each doubling of
cumulative production. One common assumption in a learning curve model is that the cumulative
average time (and labor cost) per unit is reduced by a certain percentage each time production
doubles. Given a $120 cost per unit for the first 100 units and a $72 cost per unit when
cumulative production doubled to 200 units, the learning curve percentage must be 60% ($72 ÷
$120). If production is again doubled to 400 units (four batches), the average unit labor cost
should be $43.20 ($72 × 60%). Hence, total labor cost for 400 units is estimated to be $17,280
(400 units × $43.20).
PROBABILITY AND EXPECTED VALUE
Rules of Probability
1) Single Even – change will be from 0 to 1 that is 0% to 100%

a. Probability of all possible outcome = 1
2) Independent Evens – Joint probability – this mean probability of occurrence one or more even all
occurring one after the other but each are independent of each other. Here we multiply each
probability. Example getting two heads in two toss = ½ * ½ = ¼
3) Independent Events – Either or Both – probability of A + B – AUB
4) Mutually exclusive event – happening of one event cancels the other. If A happens then B can’t
happen
5) Dependent Events – Conditional Probability – if A happens what the probability what the
probability of B happening.
Method of Assigning Probability
1) Classical Method – where each outcome has equal chance of occurring example Rolling of Dice
or Tossing of Coin
2) Relative Frequency – When we have past information, when we have sample. It is also called
Objective method as well.
3) Subjective method – it’s based on some assumptions, we don’t have evidence, we don’t have
history, we must start with something.
Usually we start with Relative Frequency then we add to it Subjective frequency.
Terms in Probability
Discrete normal variable -- this is whole number 1, 2, 7
Continuous Variable – these are fractions or decimals
EXPECTED VALUE
This is nothing more than 1 number that we going to use in budget.
HOW TO WORK IT IN EXAMS

We apply the probability to every possible scenario:
Scenarios Result
A% X $
B% X $
C% X $
Expected Value $$$
Using Expected Values

Variance and Standard Deviation
Variance is denoted by σ2
Standard Deviation is denoted by Symbol σ
More diverse the results are its higher risky it is, and makes it difficult to budget.
Variability = Risk
The Normal Distribution

Here we discuss a bell curve.
Sum of Area under Curve = 1
This diagram is perfect bell curve diagram.

Curve from 0 to right show the percent chance
the result will be higher than mean. And left area
shows the percent chance the result will be
lower than mean. This is normal distribution bell
curve
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Z Score
How many STD deviations the result is from the mean.
Property for Normal Distribution

1) Curve turn at -1 and +1. This is called inflection point
2) Mean, Median, and Mode are the Same
3) Mean divides the population in half.
4) Curve never ends. This mean curve never crosses the x-axis.
5) Probabilities of evens and ranges are constant, using the Z Score.
Using Normal Distribution
The Coefficient of Variation

Risk per unit of return, it’s not a decision maker.
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛
𝐶𝑜𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 𝑜𝑓 𝑉𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 =
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛
Example #1: We are comparing two investment projects. Both have expected returns of 20%, but the
standard deviation of Project A’s returns is 15%, while the standard deviation of Project B’s returns is
9%. Which one is relatively riskier?
CV of Project A = 0.15 ÷ 0.20 = 0.75
CV of Project B = 0.09 ÷ 0.20 = 0.45
Because it has a higher coefficient of variation, Project A is the relatively riskier project.
Example #2: Two investments have different expected returns. Project A’s expected return is 20%
and the standard deviation of its returns is 15% (the same as in Example #1). Project B’s expected
return is only 10%, while the standard deviation of its returns remains at 9%. Which project is
relatively riskier?
CV of Project A = 0.15 ÷ 0.20 = 0.75
CV of Project B = 0.09 ÷ 0.10 = 0.90
Because Project B’s expected return has decreased from 20% to 10%, Project B’s coefficient of
variation has increased from 0.45 to 0.90. Therefore, Project B is now the relatively riskier project.
Bigger the Coefficient of Variation Riskier the project gets.

Expected Value of Perfect Information
How much a person is willing to pay to know the future.
Here we calculate the Answer with Perfect information and then subtract the Answer with Imperfect
Information
92
VARIANCE ANALYSIS
COST AND VARIANCE MEASURES

1) Comparison between Actual Results & Budgeted
2) Why there are difference
Benefits of Variance Analysis

1) It tells Management where things have gone wrong
2) We should figure out why other areas which are working well. What makes them work well &
try to implement those factors in areas that are working well.
STANDARD COST
We use standard costing method to determine how much should have paid for the particular cost
element.
Flexible budget
Shows budget at various levels of output. It’s basically multiple budget at various levels of activity.
Level of Activity
There are 4 basic levels of activity in a production cycle.
1) Ideal
2) Practical
3) Normal
4) Master budget
Note: Review of Standard cost is required periodically. Just because a product cost is $15 last year
doesn’t mean it cost same today
Sources of Standard Cost

1) Activity Analaysis
2) Historic data
3) Bench marking
4) Target costing
5) Strategic decisions
Variance Analysis Levels

Level 1: Static Budget variance
Level 2: Flexible budget variance
Level 3: Manufacturing Input & Sales variance

Level 1 Variance
It’s just a comparison between actual results and Master budget (static result)
Level 2 Variance
1) Flexible Budget Variance
(𝐴𝑐𝑡𝑢𝑎𝑙 𝑅𝑒𝑠𝑢𝑙𝑡𝑠) − (𝐹𝑙𝑒𝑥𝑖𝑏𝑙𝑒 𝐵𝑢𝑑𝑔𝑒𝑡 𝐹𝑖𝑔𝑢𝑟𝑒)
2) Sales Volume Variance

(𝐹𝑙𝑒𝑥𝑖𝑏𝑙𝑒 𝐵𝑢𝑑𝑔𝑒𝑡 𝐹𝑖𝑔𝑢𝑟𝑒) − (𝑆𝑡𝑎𝑡𝑖𝑐 𝐵𝑢𝑑𝑔𝑒𝑡)
Note: Flexible Budget Variance + Sales Volume Variance = Static Variance
Level 3 Variance
They are difficult ones and requires to memorize formulas:
1) Direct Material Variance

a. Price Variance
b. Quantity or Efficiency Variance
i. Mixed Variance
ii. Yield Variance
2) Direct Labor Variance
a. Price Variance
b. Quantity or Efficiency Variance
i. Mixed Variance
ii. Yield Variance
3) Factory Overhead variances
a. Total Variable Overhead variance
b. Variable OH spending variance
c. Variable OH Efficiency Variance
d. Total fixed overhead variance
i. Fixed OH spending or Budget
ii. Fixed OH Production Volume Variance
SALES VARIANCE
1) Sales price Variance
2) Sales Volume Variance
a. Quantity Variance
b.
Performance management
Responsibility Centers
In a responsibility accounting system, managerial performance should be evaluated only on the basis of those
factors directly regulated (or at least capable of being significantly influenced) by the manager. For this
purpose, operations are organized into responsibility centers. Costs are classified as controllable and
94
noncontrollable, which implies that some revenues and costs can be changed through effective management.
If a manager has authority to incur costs, a responsibility accounting system will charge those costs to the
manager’s responsibility center.
There basically 4 centers
1) Cost Centers
a. Service
b. Training
c. Maintenance
d. Efficiency is the measure of performance
2) Revenue Centre
a. Generate the revenue
b. Effectiveness is the measure of performance (Quantity)
3) Profit Centre
a. Both Revenue expenses and revenue
b. Example is a department in large store such as grocery, bakery etc. they are
responsible for sales and their purchases and expenses
c. Efficiency and effectiveness
4) Investment Centre
a. Expected to provide Return on Investment
b. Examples are Branch of Office
c. Independent Unit
Evaluating Manager / Department

We can evaluate people based on the factors they control but not on things they don’t control.
Allocate common cost

Now the problem arises of allocating common costs.
1) Accurate allocation
2) Motivate Managers
3) Evaluation
Consideration for cost allocation

1) Cause & Effect relationship example HR and Size of team
2) Benefits received by others from service center
3) Fairness and equity – there is not rule but we need to look at if people may see it and say it’s
fair.
4) Ability to bear <- least acceptable
Ways of Allocating common costs

1) Stand Alone
a. Means to allocate the cost proportionately among all of the users based on some
proportion of the service
b. It’s some formula based
2) Incremental cost allocation
a. We see how much each department uses the service
b. We determine the primary user and we charge service cost to the extend if the
primary user solo have used it.
c. Everybody else are incremental user and whatever are less share it proportionately.
d. Smaller users pay little and primary users are paying most.
e. It should be reasonable as well.
Alternative for Allocating Common Costs
Allocate some % of Departments Contribution. Example

ResponsibilityCentre1 = 20%
INTERNAL CONTROL
GOVERNANCE, RISK AND COMPLIANCE
Corporate Governance - It is how the company behaves, how it’s going to operate.
The way the Business is;
1) Directed & Controlled

2) Rights and Responsibilities
3) Goals of the organization
Principals of Good Corporate Governance

1) Board Purpose – Promote & Protects Interest of Owners
2) Responsibilities of Board
a. Monitoring CEO
b. Overseeing Strategy
c. Oversight
3) INTERATION between Board, Management, Internal Auditor, External Auditor
4) Independence of Director – should be objective of their Judgement- Clear majority should be
independent. Shouldn’t have emotional attachment to the company
5) Expertise and Integrity: Mix of backgrounds, this Board should have all the skills and integrity
to run the business.
6) Leadership: Board overseas the CEO. Earlier CEO was Chairman of the board. But now
Board Oversees the CEO.
7) Committees: Committee made up of independent directors are formed. Some Committees
are most common like Internal Audit committee etc.
8) Meeting and Information – Should be extended Periods
9) Internal Audit function – they report to Audit Committee not CEO.
10) Compensation:
a. Full board should very carefully consider the Amount and
b. Mix of Compensation. How much compensation in terms of Cash or Equity
c. Short term/ Long term compensation – should have balance of both.
11) Disclosure: All the transactions are being done in transparent and in timely manner.
12) Proxy Access: Board have a process of Shareholder to nominate their candidate for the
board.
13) Evaluation: Board should have procedures in place to evaluate CEO, Committees, Board and
Directors. There can be changes, these changes can be done only if these are for the
benefits of the Share Holder.
Hierarchy of Corporate Governance

Areas under this heading covered are:
1) Charter
2) Bylaws
3) Policies and Procedures
96
Companies Formation:
1) State Level: Incorporation are done at State Level. Laws of the State should be followed.
2) The Charter or Articles of Incorporation:
a. Name of Companies – some names can’t be used.
b. Length of the corporation’s life – Perpetual usually
c. Purpose of the business
d. Number of Shares
e. Provision for amending the articles of Incorporation
f. Rights of existing share holders
g. Names and Addresses of 1st Board of Directors
h. Company Registered Agent usually called Registrar
3) Incorporators: these are the people who signs the Articles of incorporation. Demographics of
Incorporation depends on state to state
4) Certification of Incorporation is issued by State. It’s a formal recognition of existence of
company.
5) After incorporation:
a. Elect Directors
b. Incorporators resigns from their Incorporator capacity.
c. Meeting of Director
i. They adopt by laws – bylaws should be in line with State Laws
ii. How the bylaws are amended
iii. Elect officers (CEO, CFO etc.)
iv. Ratify the contracts
v. To adopt Company Seal
vi. Any other thing needed to be done to run the operations of the company.
6) Amending Articles of Incorporation
a. Generally, must be approved by the Share Holders.
b. Once approved should have been filed with State.
7) Main Responsibility of Board
a. Make certain that company is operating in the best interests of the shareholders.
b. It’s the shareholders who hires the board.
8) Other responsibilities of the board
a. Governance
b. Internal Control
c. Select and oversee management
d. Guide the Management
e. Key Decisions
f. Setting strategy
g. Familiar with the business environment
h. Attend the meeting
i. Investigate or consider the matters
j. Should stay INDEPENDENT, they should stay independent
9) Committees of the Board
a. Audit Committee
i. Oversee internal audit function
ii. Appoints external auditor
iii.
b. Compensation Committee
c. Finance Committee
d. Nominating Committee
10) Responsibilities of CEO
a. These are set by Board of Directors
b. CEO should not be the Chairman of BOD
11) Electing and Removing Directors
a. Should be laid out in by laws
b. It can be majority of Share holders
c. It can be plurality of Share holders
d. Length of the term
e. Removal also been done by votes.
Internal Controls
Benefits of Internal Control
1) Lower External Audit Cost
2) Better control
3) More Reliable Information
Definition of Internal Control

Internal Control is a process, effected by an entity’s Board of directors, management and other
personnel, designed to provide reasonable assurance regarding the achievement of objective relating
to operations, reporting, and compliance.
This mean everyone in the company is involved in Internal Control.
Objectives of Internal Control:

1) Effective & Efficient Operations
2) Reliable Financial Reporting
3) Compliance with Laws and Regulations
Fundamental Concepts
1) Achieve its Objectives
2) Ongoing process
3) People
4) Reasonable Assurance
5) Flexible
Reasonable Assurance
1) Mistakes
2) Collusion
3) Cost/Benefits
Who is Interested in the Internal Control of a Company?

1) Investors / Potential
2) External Auditors
3) Regulatory body
4) Management
5) Customers
Responsibility for Internal Control

Nobody and Everybody. Every employee has the responsibility to follow internal control and report
when they are not working.
FIVE COMPONENTS OF INTERNAL CONTROL (17 principals)
98
(CE RA CA IC M) Remember this abbreviation. Memorize it.
List of Components are as under:
1) The Control Environment – this is most important it’s the foundation. Tone at the top. If BOD
don’t take internal control seriously, nobody else takes it as seriously. If it doesn’t start well at
the top, then any other employee will not consider it worth wile.
a. Integrity and Ethical values this make corporate culture
b. BOD exercise overseeing
c. Management establishes
d. Right people with right mindset
e. Accountability
2) Risk Assessment –
a. Risk identification
i. External and Internal
ii. Entity level risk & Activity level risk
iii. Significance
b. Clear Objectives
c. Fraud
d. Changes that can impact system of internal control
3) Control Activities – Policies are developed and procedures are established but Cost need to
be less than the benefits we are getting
a. Selection of Control to reduce risk
i. Preventive
ii. Detective
iii. Segregation of Duties
b. Control over Technology
c. Policies and Procedures
Example of Control Activities
1) Authorization of Documents
2) Physical control over assets
3) Petty cash controlled by specific person
4) Independent review
5) Performance indicators comparison with budget
4) Information and Communication
a.
5) Monitoring
a.
100

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2017

PURPOSE OF FINANCIAL STATEMENTS: ...............................................................................................................11

Financial Statement Orientation ....................................................................................................................................11

Who Are Users of Financial Statement .........................................................................................................................11

COMPONENTS OF FINANCIAL STATEMENTS .......................................................................................................11

BALANCE SHEET: PICTURE IN TIME (AS ON DATE BASIS) ..................................................................12

CLASSIFICATION OF ASSETS & LIABILITIES .............................................................................................12

Uses and Limitations of Balance Sheet ............................................................................................................13

INCOME STATEMENT ...................................................................................................................................................13

Types of Income Statements ..............................................................................................................................13

RECOGNITION OF REVENUE .....................................................................................................................................14

DISCONTINUED OPERATIONS (NET OF TAX) ............................................................................................14

Uses and Limitations of Income Statement ......................................................................................................15

STATEMENT OF COMPREHENSIVE INCOME (OCI) ..............................................................................................15

STATEMENT OF CHANGES IN EQUITY: ...................................................................................................................15

STATEMENT OF CASHFLOW ......................................................................................................................................15

USES OF CASH FLOW ......................................................................................................................................15

CASHFLOW ACTIVITIES ...............................................................................................................................................16

OPERATING ACTIVITIES: .................................................................................................................................16

INVESTING ACTIVITIES ....................................................................................................................................16

FINANCING ACTIVITY .......................................................................................................................................16

CASH EQUIVALENTS ....................................................................................................................................................16

FOREIGN CURRENCY CASH FLOW ..............................................................................................................17

PREPARING THE SATEMENT OF CASH FLOW ..........................................................................................17

INDIRECT METHOD ...........................................................................................................................................17

INVESTING ACTIVITIES ....................................................................................................................................18

FINANCING ACTIVITIES ....................................................................................................................................18

RECOGNITION, MEASUREMENT, VALUATION AND DISCLOSURE ............................................................. 18

Limitation of FINANCIAL STATEMENTS .....................................................................................................................18

ASSET VALUATION .......................................................................................................................................................18

ACCOUNTS RECEIVABLE ................................................................................................................................18

What is our inventory ........................................................................................................................................... 21

INVENTORY VALUATION ................................................................................................................................. 22

Initial valuation ...................................................................................................................................................... 22

COST FLOW ASSUMPTION ......................................................................................................................................... 22

INVENTORY IN BALANCE SHEET .............................................................................................................................. 23

SUBSEQUENT VALUATION OF INVENTORY .............................................................................................. 23

INVENTORY SUBSEQUENT VALUATION DIFFERENCE BETWEEN IFRS AND GAAP ...................... 25

LIFO and LCM ...................................................................................................................................................... 25

PURCHASE COMMITMENTS ........................................................................................................................... 26

TRADING AND AVAILABE FOR SALE ........................................................................................................................ 26

Fair value method ................................................................................................................................................ 26

SMALL EQUITY INVESTMENT ........................................................................................................................ 26

LARGER EQUITY INVESTMENT ..................................................................................................................... 26

METHODS OF PRESENTATION & DISCLOSURE ....................................................................................... 27

FAIR VALUE METHOD ....................................................................................................................................... 27

EQUITY METHOD ............................................................................................................................................... 27

PROPERTY PLANT & EQUIPMENTS (FIXED ASSETS) .................................................................................... 27

Initial Recognition: ................................................................................................................................................ 28

Depreciation & methods: ..................................................................................................................................... 28

GROUP & COMPOSITE DEPRECIATION – FOR GROUP OF ASSETS AS A WHOLE ........................ 30

TAX DEPRECIATION ......................................................................................................................................... 30

Non-Current Asset Valuation: ........................................................................................................................................ 30

Initial Valuation ..................................................................................................................................................... 30

Subsequent Valuation ......................................................................................................................................... 30

IMPAIRMENT OF NON-CURRENT ASSET .......................................................................................................... 31

DISPOSAL OF FIXED ASSET .......................................................................................................................................31

INTANGIBLE ASSETS ............................................................................................................................................ 32

VALUATION OF LIABILITIES ( Including Short-term debt ) ........................................................................... 32

REFINANCING SHORT TERMS DEBT .......................................................................................................................32

ACCOUNTING FOR WARRANTIES ............................................................................................................................32

Accounting for Bonds ......................................................................................................................................................33

Amortization of Premium of Discount ................................................................................................................33

Effective interest method.....................................................................................................................................33