Accounting is a vast concept that envisages the daily life of a corporate person. It roams around from the offices of the auditors, directors of companies to the homes of shareholders. This study aims upon the financial, managerial and corporate aspect of accounting. This study deals with a practical case study and illuminates the accounting process in a practical environment. It also deals with costing. The main objective under consideration has been to high light the fact that accounting is not restricted to summarizing, recording and proceeding data. Rather it acts as a milestone towards managerial decisions with its strong costing system. Owing to its vast and rich history of more than 7000 years, the subject of accounting has various concepts, phenomenon, criterion and school of thoughts. The study is also aimed upon differentiating between financial and management accounting. It entails that accounting is vast subject and has to be classified under some more categories so that it can be easily interpreted and studied. The accounting techniques apply a range of methods and procedures and these are reflected by the study. We have tried to emphasize upon the practical aspects of the subject and this has been reflected in the study. The study has also worked upon the methods of inventory valuation with respect to FIFO, LIFO and AVCO.
Accounting is a practice that has been going on for centuries. The Wikipedia reports that the first accounting records were found in Egypt which date back more than 7000 years ago. The dual aspect concept, commonly known as the double entry concept, is well known among the accountancy professionals. It is the basic concept which found the roots of the accounting techniques, currently in practice. Emerging as a popular concept in the 14th century, the dual aspect concept originated from Italy where the traders expanded their activities to various circles. Today the term accountancy is written with the golden ink in the Dictionary and stands as the most prestigious and notorious practice in world history. With the passage of time trade expanded, barter trade abolished and money took form, making transactions easier and easier. Laterally, the trade activities had been limited to exchange of goods for money/gold/other goods. However, with the arrival of paper money, business activity began comprising of services too. Hence the paper money started to be used for goods as well as services. The Italians further expanded their activities and began joint ventures and partnerships among each others. Business sizes grew hugely and today we have joint stock companies, public limited companies, guarantee limited companies, etc. Although the words mentioned above might seem brilliant, the functions of these types of entities are complex in nature. The more complex are the accounting procedures involved, and the relevant tasks carried out. To ease this complexity of accounting and to manage its functions, and meet its objectives, accounting bodies all over the world now classify there profession into two types:
- Financial Accounting
- Management Accounting
Financial versus Management Accounting
The further advancements in the trading and business procedure lead to the further classification of accounting. This advancement is also known as the measure factor behind, what we call the “divorce between ownership and control.” The increasing status and continuous expansion in business activities roused differences between actual owners of the business and those who run the organizations. The word organizations took over the word business when the business was not restricted to one owner or employer. The past centuries witnessed the business in an entire different manner. Business was used to be referred as trade whereby a person took goods from his homeland to sell them at some other place. However, the new century replaced this phenomenon by the word organizations, meaning consisting of organs. This meant that an organization had several organs associated to itself making the business terminology and procedure more complex in nature. An organization can have thousands of shareholders (owners), hundreds of employees, tens of departments and it can operate in as many countries and as many segments, as it wishes and is able to.
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This phenomenon of organizations leads the accountants to distinguish between the accounting information that is for the use of external users and internal users.
A business in interrelated with a lot of stakeholders.There are the shareholders, government, employees, creditors, customers and even the society/community itself.
The Financial Accounting is the procedure which provides that accounting information, which is needed for external users. A chart of internal and external users is given below. E.g. a tax inspector might need to check the amount of profit generated by the company so that the tax percentages can be applied and government’s revenue generated. This information would be provided in the income statement, which is produced by financial accounting. Similarly, a shareholder might need to know the total worth of his company and could judge so by seeing the balance sheet. This again is provided by the financial accounting. Potential investors might also need to review financial information to speculate whether it’s worth investing in the company. The financial accounting can be described as the classification and record of transactions related to the money of a business according to the standard concepts and principles. Also, accounting principles and international standards are taken into notice when records are prepared so that they fulfill the legal requirements (Elsevier).
The five statements produced by the financial accounting are:
- Balance Sheet
- Income Statement
- Cash flow Statements
- Statement of Changes in Equity
- Notes to Accounts
These statements are required to be drawn regularly, and in prescribed formats employing certain formalities and conventions.
The Management Accounting produces information relevant to decision-making purposes and for those who actually are in the management of the business and run it. They might not necessarily be the owners of the business. E.g. a business production manager might need to know how much goods need to be produced for the period. This information would be available in the budget of the organization, which would be calculated using management accounting. Management accounting might also include cost accounting which determines the costs incurred upon producing goods and pricing them in the market to earn profits. A marketing executive, for instance, might require the price of the newly produced machineries to quote to a customer. This information might be provided in the cost card again a production of management accounting. Management accounting also calculates the risks for the trading activities of the business. This might include forecasting, calculating breakevens (no profit/no loss), etc.
The management accounts have no specific types and they can have unrestricted procedures, statements, accounts and calculations. The management accounts do not need to be produced regularly, and can be produced anytime complying with the requirement of management. Some examples of the procedures of management accounting are given below:
- Pay back period
- Break even
- Variance analysis
The major difference between the financial and management accounting is that the financial accounting might illustrate past figures and present ones, but it would never forecast for future values. Forecasting and planning for the future is the work that is carried out by the management accounting.
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Cost and Business
A business incurs several types of costs while carrying on its activities. There are two types of costs:
- Production Costs
- Non-Production Costs
Productions costs, as the name suggests are those which are incurred while the goods are being produced. E.g. labor costs, material costs, heating and lighting of the factory, etc. Non-production costs are those which are incurred after or before the goods are being produced, but having no direct relation to the production itself, e.g. sale and distribution costs, advertising costs, etc. There are various ways to classify costs.
Classification by nature
Costs can be classified by nature, according to whether they are materials, expense or labor costs.
Classification by purpose
Costs can be classified by purpose, i.e. whether they are direct or indirect. Direct costs are those which can be identified easily and associated to the production. Indirect costs are somewhat hard to be identified and can not be directly associated to the production, e.g. paying wages to the labor would be a direct cost of production, but paying wages to sweepers to clean factory equipment might be termed as indirect labor.
Marginal costing may be defined as the technique of presenting cost data wherein variable costs and fixed costs are shown separately for managerial decision-making. It should be clearly understood that marginal costing is not a method of costing like process costing or job costing. Rather it is simply a method or technique of the analysis of cost information for the guidance of management which tries to find out an effect on profit due to changes in the volume of output.
There are different phrases being used for this technique of costing. In UK, marginal costing is a popular phrase whereas in US, it is known as direct costing and is used in place of marginal costing. Variable costing is another name of marginal costing.
Marginal costing technique has given birth to a very useful concept of contribution where contribution is given by: Sales revenue less variable cost (marginal cost) Contribution may be defined as the profit before the recovery of fixed costs. Thus, contribution goes toward the recovery of fixed cost and profit, and is equal to fixed cost plus profit (C = F + P).In case a firm neither makes profit nor suffers loss, contribution will be just equal to fixed cost (C = F). This is known as break-even point. The concept of contribution is very useful in marginal costing. It has a fixed relation with sales. The proportion of contribution to sales is known as P/V ratio which remains the same under given conditions of production and sales.
Apart from Marginal costing, there is one other technique used to cost a production. This is known as absorption costing. This technique involves finding an overhead absorption rate and absorbing the fixed costs in all of the units produced. With absorption costing, fixed production costs are absorbed into product unit costs using a predetermined overhead absorption rate, based on the normal level of production for the period. If the actual production is different from the normal level, or actual expenditure on fixed production costs is different from that budgeted, there may be an under or over absorption of fixed production costs for the period. This amount is written off against the absorption costing profit for the period. The principles of absorption costing are as follows.
- Fixed production costs are an integral part of the production cost of an item and so should be absorbed into product costs.
- Inventories are valued at their full production cost including absorbed fixed production costs.
If there are changes in inventories during a period, marginal costing and absorption costing systems will report different profit figures. If inventory levels increase, absorption costing will report a higher profit than marginal costing. If inventory levels decrease, absorption costing will report the lower profit. If the opening and closing inventory volumes and values are the same, marginal costing and absorption
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Costing will report the same profit figure. In the long run, the total reported profit will be the same whether marginal or absorption costing is used. The difference in reported profit is equal to the change in inventory volume multiplied by the fixed production overhead rate per unit.
- Fixed production costs are incurred in order to make output; it is therefore ‘fair’ to charge all output with a share of these costs.
- Closing inventory values, include a share of fixed production overhead, and therefore follow the requirements of the international accounting standard on inventory valuation (IAS 2).
- Absorption costing is consistent with the accruals concept as a proportion of the costs of production are carried forward to be matched against future sales.
- A problem with calculating the contribution of various products made by an enterprise is that it may not be clear whether the contribution earned by each product is enough to cover fixed costs, whereas by charging fixed overhead to a product it is possible to ascertain whether it is profitable or not. This is particularly important where fixed production overheads are a large proportion of total production costs. Not absorbing production would mean that a large portion of expenditure is not accounted for in unit costs.
- In a job or batch costing environment (see section 5 below), absorption costing is particularly useful in the pricing decision to ensure that the profit markup is sufficient to cover fixed costs?
Marginal Costing is:
- Simple to operate.
- There are no apportionments, which are frequently done on an arbitrary basis, of fixed costs. Many costs, such as the marketing director’s salary, are indivisible by nature.
- Fixed costs will be the same regardless of the volume of output, because they are period costs. It makes sense, therefore, to charge them in full as a cost to the period.
- The cost to produce an extra unit is the variable production cost. It is realistic to value closing inventory items at this directly attributable cost.
- Under or over absorption of overheads is avoided.
- Marginal costing provides the best information for decision making.
- Fixed costs (such as depreciation, rent and salaries) relate to a period of time and should be charged against the revenues of the period in which they are incurred.
- Absorption costing may encourage over-production since reported profits can be increased by increasing inventory levels.