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FINANCIAL ACCOUNTING
ACCOUNTING CONCEPTS => ASSUMPTIONS
1) Business entity concept: organization is separate &
distinct from its owners and other organizations
2) Going concern concept: business is going to last
indefinitely in the future
3) Accounting period concept: business life is split into
annual intervals (calendar or fiscal year)
4) Matching concept: expenses match revenues in the
same accounting period => only costs related to the
accounting period are accounted for
5) Cost concept: assets/services acquired are recorded
at historical cost
6) Money measurement concept: events/transactions
are expressed in stable monetary units
7) Dual aspect concept: each transaction has two
aspects => receiving the benefit OR giving the benefit
a. Assets = Liabilities + Equity
8) Revenue recognition (realization) concept: revenue
is recorded at the cash value of goods/services when it
is earned (i.e. services rendered/goods delivered)
9) Accrual concept: events are recorded as they occur
regardless when cash is paid/received
ACCOUNTING CONVENTIONS => PRACTICES
1) Materiality: material events (i.e. knowledge of such
events would influence decisions of informed investors)
should be recorded and reported
2) Consistency: accounting practices/policies are
consistent from one period to the other
3) Conservatism (Doctrine of Prudence): businesses
provide for all possible losses but not the anticipated
gains
4) Full disclosure: organizations should disclose all
significant information pertaining to their financial affairs
THE ACCOUNTING EQUATION: A = L + OE
ASSETS = LIABILITIES + OWNERS’ EQUITY
ASSETS = CLAIMS
Asset: economic resource expected to benefit the
company’s future operations
Liability: economic obligations (debts)
Owners’ Equity: claims held by owners
ASSETS:
Current assets: are expected to be realized in cash or
be consumed during the normal operating cycle
1) Cash & cash equivalents: coins, currency,
checks, money orders, US Treasury bills
2) Receivables: notes/account/employee receivables
3) Short-term investments: marketable securities
4) Inventories: goods available for sale, raw materials
5) Prepaid expenses: expenses paid in advance for
future use of assets or receipt of services
Noncurrent assets: all other assets which are not
current assets
1) Long-term investments: debt & equity securities,
sinking funds, land (as investment) held for sale
2) Property, plant & equipment: land, buildings,
machinery, furniture, natural resources
3) Intangible assets: goodwill and legal/contractual
rights expected to provide future economic benefits
4) Other assets: deferred income taxes, bond issue
costs, restricted cash
LIABILITIES:
Current liabilities: are expected to be liquidated by
using current assets or creating other current liabilities
during the normal operating cycle
1) Accounts payable: liability arising from purchasing
inventory/supplies/services on account (credit)
2) Current maturing portion of long-term debt
3) Dividends/wages/taxes payable
Noncurrent liabilities: are all other liabilities which are
not current liabilities
1) Notes payable: written agreement to pay money to
the bearer on a specific date
2) Debt/debentures
Can be current/noncurrent:
1) Interest payable
2) Unearned revenue
3) Warranties/premium & coupon obligations
4) Advances and refundable deposits
5) Accrued liabilities: accumulate in a systematic
manner (e.g. compensated absences)
OWNERS’ EQUITY:
Paid-in (contributed) capital: contributions by owners
Retained earnings: income from operations
Treasury stock: corporate stock shares bought back
by issuing corporation (contra equity account)
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FINANCIAL ACCOUNTING
PRESENTATION OF THE BALANCE SHEET:
FINANCIAL STATEMENTS (F/S):
1) Balance Sheet: shows a financial position on a certain
date (usually, month-end or year-end)
a. Other name(s): Statement of Financial Position
b. As of specific date
c. Focus: financial position
2) Income Statement: presents revenues & expenses and
resulting net income or loss over an accounting period
a. Other name(s): Statement of Operations,
Earnings Statement, Profit & Loss Statement
b. For a period in time
c. Focus: profitability
3) Statement of Changes in Equity: shows all changes in
owner's equity for a period of time
a. Other name(s): Owners’ Equity Statement
4) Statement of Cash Flows: summarizes information
about cash outflows (payments) and inflows (receipts)
a. Other name(s): Cash Flow Statement
b. Focus: liquidity
c. Is directly related to other 3 statements
d. Sections:
i. Operating activities
ii. Investing activities
iii. Financing activities
PRESENTATION OF THE INCOME STATEMENT:
Friends Company
Income Statement
For the Period Ended 20X0
Sales
Less: Sales returns & allowances
Sales discounts
Net sales
Cost of goods sold
Gross profit
Selling, general & administrative expenses
Income from operations
Other expense (income):
Interest expense
Interest income
Total other expense (income)
Income before income taxes
Income tax expense
Net income
$ 500,000
30,000
20,000
450,000
150,000
300,000
120,000
180,000
400
(1,400)
(1,000)
181,000
61,540
$ 119,460
Friends Company
Balance Sheet
Period Ended 20X0
ASSETS
Current Assets:
Cash
Accounts receivable (net)
Inventory
Prepaid insurance
Total Current Assets
182,060
211,000
164,000
1,200
558,260
Long-term Assets:
Land
Building (net of accum. depreciation)
Machinery (net)
Total Long-term Assets:
120,000
68,000
240,000
428,000
TOTAL ASSETS:
986,260
LIABILITIES
Current Liabilities:
Accounts payable
Wages payable
Unearned revenue
Total Current Liabilities
65,000
48,000
72,000
185,000
Long-term Liabilities:
Notes payable
150,000
TOTAL LIABILITIES
335,000
STOCKHOLDERS’ EQUITY
Common stock
Paid-in excess of par
Retained earnings
TOTAL STOCKHOLDERS’ EQUITY
300,000
100,000
251,260
651,260
TOTAL LIABILITIES & ST. EQUITY
986,260
CASH FLOW STATEMENT: INDIRECT METHOD
1) Convert net income from accrual to cash basis
2) Analyze changes in noncurrent assets & liabilities
3) Compare net cash change to the balance sheet
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FINANCIAL ACCOUNTING
PRESENTATION OF THE STATEMENT OF CASH FLOWS:
Friends Company
Statement of Cash Flows
For the Period Ended 20X0
Cash Flows from Operating Activities:
Net income
Add: Depreciation
Allowance for doubtful accounts
Decrease in prepaid expenses
Deduct: Increase in inventory
Decrease in accounts payable
Net Cash Flow from Operating Activities
$ 119,460*
10,000
20,000
5,000
(50,000)
(12,000)
92,460
Cash Flows from Investing Activities:
Cash received from equipment sold
Net Cash Flows from Investing Activities
24,000
24,000
Cash Flows from Financing Activities:
Cash Receipts from Capital Acquisitions
Cash Payments for Distributions
Net Cash Flow from Financing Activities
60,000
(40,000)
20,000
Net Increase in Cash
136,460
Plus: Beginning Cash Balance
45,600
Ending Cash Balance
$ 182,060**
* See income statement & statement of changes in equity
** See balance sheet
PRESENTATION OF THE STATEMENT OF CHANGES IN
EQUITY:
Friends Company
Statement of Changes in Equity
Period Ended 20X0
Beginning Contributed Capital
Plus: Capital Acquisition
Ending Contributed Capital
Beginning Retained Earnings
Plus: Net Income
Less: Distribution
Ending Retained Earnings
Total Equity
$ 240,000
60,000
300,000
171,800
119,460
(40,000)
251,260
$ 651,260
STATEMENT OF CASH FLOWS: SECTIONS
1) Operating activities: cash generated through
revenue and cash spent for expenses
a. Example: changes in noncash current
assets; depreciation expense
2) Investing activities: cash received or spent on
productive assets and investments in the debt or
equity of other companies
a. Example: purchase or sale of long-term
assets (e.g., land, building, equipment)
3) Financing activities: cash transactions
associated with resource providers (i.e., owners
and lenders).
a. Example: repayment of bank loans;
dividend payment; issuance of capital
stock
Significant noncash activities: issuance of
common stock to purchase assets; exchange of
assets, issuance of debt to purchase assets
USERS OF ACCOUNTING INFORMATION:
External users: parties outside the reporting entity
(company) who are interested in the accounting
information. Example: investors, creditors, taxing
authorities, customers.
Internal users: parties inside the reporting entity
(company) who are interested in the accounting
information. Example: company’s management,
employees.
ACCOUNTING FIELD REGULATION:
Generally Accepted Accounting Principles
(GAAP) are common standards that indicate how to
report economic events.
Standard-setting organizations: Financial
Accounting Standards Board (FASB); Securities and
Exchange Commission (SEC); Public Company
Accounting Oversight Board (PCAOB).
ACCOUNTS:
Permanent (real): are not closed each period (e.g.
balance sheet accounts)
Temporary (nominal): are closed at the end of each
period (e.g. revenue, expenses). Closing entries
produce a zero balance in each temporary account.
Closing entries are recorded in the general journal.
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FINANCIAL ACCOUNTING
ACCOUNTING CYCLE:
1) Open ledger accounts
2) Record (journalize) transactions
3) Post to the ledger
4) Calculate unadjusted balances
5) Develop a trial balance (verify, total an balance accounts)
6) Record and post adjusting entries
a. 5 categories
b. Each entry effects one income statement account
and one balance sheet account
7) Prepare financial statements
8) Close books (journalize and post closing entries)
9) Prepare post-closing trial balance
RECORDING TRANSACTIONS:
Transactions: events that affect financial position
1) Record in journals (date, account title, posting
references, debits and credits)
a. Journal entries are not totaled
2) Post to the ledger (date, special notations,
journal reference, debits and credits)
3) Prepare a trial balance
a. Journal entries are totaled
Compound entry: is used when a transaction affects
multiple (>2) accounts
Trial balance: a list of all accounts and their
balances at a specific date (point in time)
ADJUSTING ENTRY CATEGORIES:
1) Depreciation: allocation of the cost of property, plant, and
equipment to expenses over their useful (economic) life in
a systematic and rational manner
2) Prepaid expenses: expenses paid in cash and recorded
as ASSETS before they are consumed
3) Unearned revenues: cash received and recorded
as LIABILITIES before revenue is earned
4) Accrued expenses: are expenses incurred but not yet
paid in cash => BEFORE cash is paid
5) Accrued revenues: revenue earned but not yet received
=> BEFORE cash is received
MERCHANDISE BUSINESS: OPERATING CYCLE
1) Purchase merchandise inventory
a. Inventory: items held for resale
b. Dr Purchases => net of discounts
c. Cr Accounts Payable
2) Return some purchased inventory
a. Purchase returns & allowances = contra
asset account (credit balance)
b. Dr Accounts Payable
c. Cr Purchase Returns & Allowances
3) Transportation costs
a. FOB Shipping Point
i. When placed on carrier
ii. Buyer pays shipping cost
b. FOB Destination
i. When received by buyer
ii. Seller pays shipping cost
c. Freight-in: cost incurred to deliver
inventory from seller to buyer
i. Product (inventory) cost
d. Freight-out: cost incurred to deliver
inventory from buyer to seller
i. Period cost => expense
4) Sale of inventory
a. Dr Cash or Accounts Receivable
b. Cr Sales Revenue
i. Sales Discount (contra revenue)
ii. Sales Returns & Allowances
5) Receive returned merchandise
a. Dr Sales Returns & Allowances
b. Cr Account Receivable
6) Cost of goods sold
T-ACCOUNTS:
T account: an individual accounting record that shows
information about increases and decreases in one balance
sheet or income statement account.
Debit is the LEFT side of a T account => Dr
Credit is the RIGHT side of a T account => Cr
Normal
Account
Debit
Credit
balance
Assets
Increase
Decrease
Debit
Contra Assets
Decrease
Increase
Credit
Liabilities
Decrease
Increase
Credit
Equity
Decrease
Increase
Credit
Contra Equity
Increase
Decrease
Debit
Contributed Capital Decrease
Increase
Credit
Revenue
Decrease
Increase
Credit
Expenses
Increase
Decrease
Debit
Distributions
Increase
Decrease
Debit
Normal balance: is the side of a T-account where increases
are recorded.
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FINANCIAL ACCOUNTING
CASH
It is the first item on the balance sheet
1) Petty cash: fund established for paying small cash
expenses
a. Fund disbursements are supported by petty cash
voucher
b. Replenish fund: cash disbursement procedures
c. There is a petty cash fund custodian
d. A special journal may be created
e. Imprest fund: advanced money
2) Cash Short and Over: difference between actual and
recorded (total) cash
a. Cash shortage: Dr Cash Short and Over
b. Cash excess: Cr Cash Short and Over
RECEIVABLES
Accounts receivable: due from customers => current asset
Notes receivable: a written promise from a debtor
1) Due within one year: current asset
2) Due in one year or longer: noncurrent (long-term)
Uncollectible accounts => bad debt
1) Allowance method => report at net realizable value
a. Report A/R at the net realizable value
b. Estimate uncollectible accounts each period
c. Allowance for doubtful accounts => contra asset
d. To write off an uncollectible account:
i. Dr Allowance for Uncollectible Accounts
ii. Cr Accounts Receivable
e. To recover written-off account:
i. Dr Accounts Receivable
ii. Cr Allowance for Uncollectible Accounts
2) Direct write-off method => report at gross
a. Write off when a particular account is determined
to be uncollectible
INVENTORY
1) Raw materials: goods used in production
2) Work-in-process: started but not finished production
3) Finished goods: completed manufactured items
4) Inventory systems:
a) Perpetual: inventory account is adjusted perpetually
b) Periodic: adjusts the inventory account only at the
end of an accounting period
5) Cost of goods sold: the difference between the cost of
goods available for sale and the cost of goods on hand at
period end
COST OF GOODS SOLD (PERIODIC SYSTEM):
Beginning Inventory
Plus: Purchases
Plus: Transportation-in
Less: Purchase Returns and Allowances
Less: Purchase Discounts
Cost of Goods Available for Sale
Less: Ending Inventory
Cost of Goods Sold
LONG-TERM ASSETS:
Long-term operational assets: resources with
economic lives of more than a year that a business
possesses and uses in generating revenue.
Tangible assets: are those which one can touch and
include natural resources, machinery, tools,
equipment, land, etc.
Intangible assets: may be represented by a piece of
paper or document. Value = rights and privileges
extended to their owners. Example: patent,
trademark, copyrights, customer list, goodwill.
Historical cost: includes the purchase price and any
additional costs necessary to obtain the asset and
prepare it for the intended use
1) Purchase of a building: purchase price, title
search and transfer documents, real estate fees,
remodeling costs, etc.
2) Purchase of equipment: purchase price,
delivery costs, installation, costs for modifications
to prepare the asset for intended use, etc.
3) Purchase of land: purchase price, removal of
old buildings, title search and transfer
documents, real estate fees, etc.
COST ALLOCATION METHODS:
1) Depreciation: allocation of the cost of property,
plant, and equipment to expenses over their
useful life in a systematic and rational manner
a. Dr Depreciation
b. Cr Accumulated Depreciation
c. Accumulated depreciation => total
2) Depletion: allocation of the cost of natural
resources to expenses in a systematic and
rational manner over the resources useful life
3) Amortization: allocation of the cost of intangible
assets to expense in a systematic and rational
manner over the useful life of the asset
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FINANCIAL ACCOUNTING
INVENTORY COSTING METHODS:
1) Specific identification: an actual physical flow inventory
costing method in which items still in inventory are
specifically cost to arrive at the total cost of the ending
inventory:
a. difficult to apply by companies that deal with
massive inventory volumes with low unit costs
b. management can manipulate the cost of goods
sold by selecting which cost will be used in a
particular sale transaction.
2) First-in, first-out (FIFO): assumes that the costs of
earliest inventories acquired are the first to be recognized
as the cost of goods sold.
3) Last-in, first-out (LIFO): assumes that the costs of latest
inventories acquired are the first to be recognized as the
cost of goods sold.
4) Weighted-average (average cost): assumes that the
average cost of inventories is to be recognized as the cost
of goods sold.
INVENTORYCOST FLOWS:
Beginning Inventory 100 units x $15
Purchase One
120 units x $18
Purchase Two
80 units x $20
= $1,500
= $2,160
= $1,600
Sale
Sale
= $10,800 (at SP)
= TBD*
(at cost)
270 units x $40
270 units x TBD*
(at cost)
(at cost)
(at cost)
FIFO => ending inventory $5,260 – 4,660 = $600
Beginning Inventory
100 units x $15 = $1,500
Purchase One
120 units x $18 = $2,160
Purchase Two
50 units x $20 = $1,000
Total (COGS)
270 units
$4,660
LIFO => ending inventory $5,260 – 4,810 = $450
80 units x $20 = $1,600
Purchase Two
Purchase One
120 units x $18 = $2,160
70 units x $15 = $1,050
Beginning Inventory
Total (COGS)
270 units
$4,810
Weighted-average => ending inventory $527
The cost of goods available for sale:
100 x $15 + 120 x $18 + 80 x $20 = $5,260
The number of goods available for sale:
100 + 120 + 80 = 300 units
Weighted-average cost ÷ unit: $17.53 ($5,260 ÷ 300 units)
Cost of goods sold: $4,733.1 ($17.53 x 270 units)
LOWER OF COST OR MARKET:
Market value: the amount that would have been paid
to replace the merchandise.
Lower of cost or market rule states that if the
market value of ending inventory is lower than the
book value of such inventory, the resultant loss must
be recognized in the current period.
Market Lower of Cost
Item
Cost
Value
or Market
A
$500
$520
$500
B
$650
$590
$590
C
$50
$50
$50
D
$12
$13
$12
Total
$1,212
$1,173
$1,152
$1,212 – 1,173 = $39 => inventory loss or ↑ COGS
Perpetual: Dr COGS and Cr Inventory for $39
Periodic: loss automatically reflected in financials
DEPRECIATION:
1) Straight-line depreciation: a depreciation
method in which periodic depreciation is the
same for each period of the asset useful life.
a. (Cost – Salvage) ÷ Useful life
b. Same depreciation each year
2) Double-declining method: applies a constant
rate (double of the straight-line rate) to the net
book value of the asset and produces a
decreasing annual depreciation expense over
the asset useful life.
a. DDB rate = (1 ÷ Useful Life in Years) x 2
b. Only method that ignores salvage value
c. Apply DDB rate to carrying (net book) value
3) Units-of-production method: determines the
useful life of an asset based on the units of
production.
a. Depends on units of output (i.e. units used)
b. Cost per unit = (Cost – Salvage) ÷ Estimated
Units
c. Cost per unit x Actual units used
4) Sum-of-the-years-digits method: applies a
decreasing rate to the asset depreciable value
and produces a decreasing depreciation
expense over the useful life of the asset.
a. Numerator = last year of life (backwards)
b. Denominator = sum of years’ digits (N)
i. N = n x (n + 1) ÷ 2, n – useful life
c. (Cost – Salvage) x (Step a ÷ Step b)
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FINANCIAL ACCOUNTING
LIABILITIES:
Payroll liabilities: obligations for employees’ compensation
Contingent liability: a potential liability in the future arising
out of past events (transactions)
1) Recorded when probable and reasonably estimable
2) In other cases: disclose in the notes to F/S
3) Potential events: lawsuit, standby letter of credit,
expropriation threat, product defects
4) Different from commitments => legal obligations not
recorded as liabilities (e.g. purchase agreements)
Discounted note payable: receives face value less interest
1) Dr Cash (maturity value – interest)
2) Cr Discount on Note Payable (Interest) & Note Payable
Bond payable: a written promise to pay the face amount at
the maturity date
1) Interest rate: stated and market
a. Stated: rate on the bond
b. Market: effective rate => demanded by investors
2) Issued at premium or discount
Lease liabilities: operating and capital leases
1) Operating lease: short-term
a. Dr Rent Expense and Cr Cash
2) Capital lease: long-term
a. Transfers ownership; bargain purchase option;
lease for ≥ 75% of asset’s economic life; present
value ≥ 90% asset fair value
b. Dr Asset and Cr Cash & Lease Liability (PV)
BONDS PAYABLE (B/P): => effective interest method
Issued @premium: stated > market => A6 – A4 (see table)
1) Dr Cash and Cr Bonds Payable & Premium on B/P
2) Amortize premium: Dr Premium and Interest Expense &
Cr Cash (maturity value x stated rate x period)
Issued @discount: stated < market => A6 + A4 (see table)
1) Dr Cash & Discount on B/P and Cr Bond Payable
2) Amortize discount: Dr Interest Expense and Cr Discount &
Cash (maturity value x stated rate x period)
$10,000 bond @ 10% due in 3 years for $9,520 =>
effective interest rate 12%
Interest Interest
Unamort. Carrying
Year
paid
expense Discount
discount amount
(@10%) (@12%)
A1
A2
A3
A4=A3-A2
A5-A4
A6 + A4
480
9,520
1
1,000
1,142
142
338
9,662
2
1,000
1,159
159
179
9,821
3
1,000
1,179
179
0
10,000
STOCKHOLDERS’ EQUITY:
1) Contributed capital:
a. Capital stock: par value common and
preferred stock, common (preferred)
stock subscribed, stock warrants, stock
dividends to be distributed
b. Additional paid-in capital: excess of par
on common (preferred) stock or other
sources (e.g. stock split, treasury stock)
2) Earned capital: retained earnings
ISSUING STOCK:
1) Common stock at par
a. Dr Cash and Cr Common Stock
2) Common stock at premium (for other assets)
a. Dr Cash (Other Asset)
b. Cr Common Stock (@par)
c. Cr Paid-in Capital in Excess of Par
TREASURY STOCK:
Reasons: distributions under bonus plans; support
market price; ↑ net assets; avoid take over.
Purchase: Dr Treasury stock & Cr Cash
1) Shared issued: no effect
2) Shared outstanding: decrease
DIVIDENDS:
Stock dividend: paid in the form of additional shares
1) Reasons: conserve cash; ↓stock market price
2) Small stock dividend: <25% of stock issued
a. Record @fair value (FV)
b. Dr Retained Earnings (FV)
c. Cr Common Stock Dividend Distributable
d. Cr Paid-in Capital in Excess of Par
e. Distribute: Dr Common Stock Dividend
Distributable and Cr Common Stock
3) Large stock dividend: > 25% of stock issued
a. Record @par value
b. Dr Retained Earnings (par)
c. Cr Common Stock Dividend Distributable
Stock split: ↑ number of shares authorized, issued,
and outstanding
1) ↓par value per share
2) No formal journal entry
3) Affect no accounts
4) Reasons ↓market price per share
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MANAGERIAL & COST ACCOUNTING
COSTS:
1) Manufacturing (product) costs: the costs that a
company incurs in producing a product.
a. Direct materials: raw materials that become an
integral part of the finished goods.
b. Direct labor: the cost of wages to be paid to
individuals who work on specific products or in
other words, the cost of wages of employees who
are directly involved in converting raw materials
into finished goods.
c. Factory overhead: any manufacturing cost that is
not direct materials or direct labor. Can have
variable or fixed nature.
2) Nonmanufacturing (period) costs: costs necessary to
maintain business operations but are not a necessary or
integral part of the manufacturing process.
Conversion Costs = Direct Labor + Factory Overhead
Prime Cots = Direct Materials + Direct Labor
COST DRIVERS & COST BEHAVIOR:
1) Cost: a payment of cash or its equivalent for the purpose
of generating revenues.
a. Financial accounting: costs and expenses are
used interchangeably.
b. Managerial accounting: costs differ from
expenses (cost => asset)
i. Cost: the amount of resources given up in order
to receive some good or service and represents
future economic benefit to a company
2) Cost driver: any activity that causes a change in costs
over a given period of time. These activities are also
called activity bases or activity drivers.
3) Cost behavior: the manner in which a cost changes
in relation to changes in the related activity.
a. Variable cost (VC) changes in direct proportion
to changes in the level of activity (cost driver).
b. Fixed costs (FC) remain constant within a
relevant range of time or activity.
c. Step-variable costs are costs that stay fixed over
a range of activity and then change after this
range is overcome.
d. Mixed costs contain components of both variable
and fixed cost behavior patterns.
i. Fixed component: minimum cost
ii. Variable component: costs that
fluctuate with ∆ activity levels
4) Relevant range: the volume of activity, over which cost
behavior stays valid (FC/VC assumption).
METHODS FOR SEPARATING MIXED COSTS:
High-method: the highest point and the lowest point
are used to create the cost formula.
Scatter-graph method: involves estimating the
fixed and variable elements of a mixed cost visually
on a graph.
Method of least squares: identifies the line that best
fits the data points (30 or more data observations for
the activity level and the total cost)
COSTS AS ASSETS/EXPENSES:
Capitalized costs: expenses incurred in financing or
building a fixed asset => become an expense
through depreciation
Inventoriable costs: expenses incurred in
purchasing products for resale
COST & DECISION MAKING:
Opportunity cost: value of best forgone alternative
Outlay cost: explicit cost => can be identified in the
past, present, and future. Requires cash outlay
Opportunity + outlay costs determine transfer price
Differential (incremental) cost: difference in cost
between any two alternatives. Decisions include: sell
or process further; special order; make or buy; close
a department/segment; sell obsolete inventory;
scarce resources.
Relevant cost: expected future cost; cost that differs
between alternatives
Irrelevant cost: past cost that cannot be changed or
future cost that will not differ between alternatives
RELEVENAT INFO & DECISION MAKING
1) Deletion/addition of new department/products
a. Avoidable cost: will not continue
b. Unavoidable cost: will continue
2) Pricing decisions
a. Marginal cost: additional cost for one
more unit produced
b. Marginal revenue: additional revenue
from one more unit sold
c. Costs; competition; demand; regulation
3) Make-or-buy decisions: qualitative & quantitative
4) Joint product costs: differential analysis;
opportunity cost analysis
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MANAGERIAL & COST ACCOUNTING
COST-VOLUME-PROFIT (CVP) ANALYSIS:
Break-even point: revenue = expenses or profit = zero
Contribution margin (CM): the difference between sales and
variable costs (expenses). CM ratio => CM ÷ sales
1) Break-even in units: FC ÷ CM per unit
2) Break-even in dollars: FC ÷ CM ratio
3) Add targeted income
4) Multi-product company: use weighted-average CM
Margin of safety: amount by which target or existing sales
volume exceeds (or falls short of) the break-even point
COST ACCUMULATION METHODS:
1) Job costing: a product costing system when costs are
accumulated by specific job orders (e.g. Job Order XX2,
Job Order 02357) and assigned to batches of products.
a. Industries: professional services, advertising
agencies, construction, shipbuilding, etc.
2) Process costing: a product costing system when costs
are accumulated by departments or processes (e.g.
Printing Department) and assigned to a large number of
homogenous, identical products.
a. Industries: textiles, food processing, automobile
manufacturing, electronics, drugs, paper, etc.
COST MEASUREMENT METHODS:
1) Actual costing: a product costing system when a
company measures actual costs of direct materials, direct
labor, and factory overhead.
2) Normal costing: a product costing system when a
company measures the actual costs of direct materials
and direct labor, but uses predetermined factory overhead
rates to measure the factory overhead cost for a period.
3) Standard costing: a product costing system when a
company measures all costs using standard quantities
and costs.
OVERHEAD ASSIGNMENT METHODS:
1) Volume-based (traditional) costing: a product costing
system when a company allocates factory overhead costs
to a single cost pool and then uses volume-based cost
drivers to allocate factory overhead to individual products
2) Activity-based costing (ABC): a product costing system
when a company allocates factory overhead costs
to activity centers and then uses activity cost drivers to
allocate factory overhead costs to individual products
ABC DEVELOPMENT:
1) Identify available resources and resourceconsuming activities
a. Transaction drivers count the number
of times an activity occurs
b. Duration drivers measure the time
required to perform an activity
c. Activity levels: unit, batch, product,
customer, facility
2) Assign costs of available resources to activities
3) Assign costs of activities to cost objects
a. Cost objects: individual products or
services, job orders, projects, etc.
ACCOUNTING SYSTEMS:
Activity-based cost system: accumulate cost for
each activity & assign cost to cost objects
Just-in-time (JIT) system: produce required
products at required quantity & quality when required
Cost management system (CMS): analyze cost
data for decision-making; measure resources used
PRODUCT COSTS:
1) Absorption costing: includes all variable and
fixed manufacturing costs
2) Contribution approach: only variable
manufacturing costs are product costs
a. Contribution margin - FC = Oper. income
INVENTORY COSTS
Absorption (full) costing: product cost includes all
variable manufacturing cost + fixed overhead
1) GAAP: used for external reporting
2) Separate costs: product v. period costs
3) Fixed overhead rate = budgeted fixed overhead ÷
expected cost driver activity
4) Production-volume variance: applied fixed
overhead – budgeted fixed overhead
Variable costing: product cost includes all variable
manufacturing costs
1) Fixed overhead is expensed => not GAAP
2) Cannot be used for external reporting
3) Separate costs: variable v. fixed cost
Throughput costing: only direct materials cost =>
not GAAP (use for internal reporting)
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MANAGERIAL & COST ACCOUNTING
BUDGETING:
Budget: plan of activities in terms of assets, liabilities,
revenues, and expenses
Process: set objectives; arrange strategy; prepare &
implement budgets; monitor budgets & actual figures;
feedback: review objectives
Difficulties: all budgets rely on sales budget => past patterns,
estimates, and volatile environment
Master budget: projection of all budgets
1) Prepare operating budget => estimate income
a. Sales budget
b. Estimate cash collections
c. Purchases budget
d. Estimate cash disbursements for purchases
e. Operating expense budget
f. Estimate disbursements for operations
2) Prepare financial budget
a. Cash budget
b. Budgeted balance sheet
BUDGET TYPES:
1) Rolling budget: a continuous budget
2) Operating budget: schedule of expected revenues,
support, and expenses => budgeted income statement +
accompanying schedules
3) Financial budget: part of master budget; consists of:
a. Cash budget: schedule of expected cash
disbursements and receipts
b. Capital budget: plan for the purchase or sale of
long-term assets
c. Budgeted balance sheet
d. Budgeted cash flow statement
4) Activity-based budget: determines necessary resources
based on planned output
a. From activities & drivers to underlying costs
b. Separate indirect costs into activity cost pools
5) Kaizen budget: plan based on future improvements
a. Cost reductions are built into the budget
RESPONSIBILITY ACCOUNTING:
Responsibility accounting: collect and report revenue and
cost information by responsibility areas => trace costs to the
activity that caused the costs and to the individual who knows
the best about the cost
Responsibility center: business segment, part, subunit.
Centers: cost, revenue, profit, investment.
MANAGEMENT CONTROL SYSTEM (MCS):
1) Identify responsibility centers
a. Cost center: accumulates costs
b. Profit center: revenue less expense
c. Investment center: net income to invested
capital
2) Analyze costs and benefits
3) Design internal controls: accounting controls and
administrative controls
4) Motivate employees
5) Develop and measure performance
a. Financial performance: uncontrollable and
controllable costs; contribution by segment,
un-allocated costs
b. Non-financial performance: quality control,
cycle time control, productivity control
STATIC & FLEXIBLE BUDGETS:
Static budget: shows expected results (of a
responsibility center) only @1 activity level
1) Actual results vs. original plan
2) Disadvantage: do not adjust to ∆ activity level
3) Master budget variances: (un)favorable
Flexible budget: variable budget => shows results of
a responsibility center for several activity levels
1) Prepared for a range of activity
2) Flexible budget variance: flexible v. actual result
a. Direct materials and direct labor
variances (price & efficiency variances)
b. Variable overhead variances (spending
and efficiency)
c. Efficiency: inputs to outputs
3) Activity level variance: flexible v. master budget
CAPITAL BUDGETING:
1) Discounted cash-flow method: time value of
money => cash flow at specific point in time
a. Net present value: discount all expected
cash flows using a required rate of return
b. Internal rate-of-return: NPV = 0
2) Payback method: net receipts = investment
outlays => Investment ÷ Annual net cash inflows
3) Accrual accounting rate-of-return method:
considers financial reporting effects on
investment (Average annual net income ÷
average investment cost)
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MANAGERIAL & COST ACCOUNTING
PRICING:
Market-based: based on customer demand
Cost-based: based on costs to manufacture goods
Predatory pricing: charging very low prices (below shutdown
point) for a short time to gain market share
Peak-load pricing: charging higher prices during busy times
Collusive pricing: pooling pricing efforts together to maintain
a higher price than competition
Dumping: selling goods in another country for a price lower
than goods’ market value in the producing country
PROCESS COSTING SYSTEM:
1) Identify units that went into production and where those
units are at the end => flow of output
2) Output in unit equivalency
3) Determine the amount of production costs
4) Compute cost of ending Work-in-process (WIP)
5) Compute equivalent cost per unit (Step 4 ÷ Step 2)
6) Assign total cost to finished units & units in ending WIP
Weighted-average method: includes costs in beginning
inventory and current period costs
First-in first-out: divide current costs by equivalent units of
work done during the current period => assume first units
completed are the first transferred-out
HYBRID COSTING:
Hybrid costing: combination of process and job order costing.
Used by mass production companies with customer-order
manufacturing
Operation costing: used when batches of products pass
through a specific sequence of repetitive activities. Direct
materials are traced to each batch (like job costing) while
conversion costs are allocated to all units (like process costing)
Backflush costing: focuses on output and then attributes
costs to stock and cost of sales. Entries are made when job is
complete. Often accompanies JIT production system.
JOINT PRODUCTS & BY-PRODUCTS:
Joint products: two or more products produced
simultaneously which cannot be individually identified until
split-off has been made. Have significant market value
Joint costs: common manufacturing costs => a single
process that creates many different products
Byproduct: has lower sales value => doesn’t affect decisions
Scrap: remaining items with a minimal value
ALLOCATING JOINT COSTS:
1) Physical-unit method: based on physical
measure of units (e.g. gallons, pounds). Has no
relationship to product revenue-producing ability
2) Relative-sales-value method: based on relative
sales value at split-off point
3) Net realizable value (NRV) method: based on
final sales value less projected costs to produce
and sell
4) Constant gross margin % NRV method:
allocates costs so gross margin is the same for
all products
ALLOCATING COMMON COSTS:
1) Incremental method: primary user is allocated
costs (as if only one user) and secondary user is
allocated the balance
2) Stand alone method: based on percentage of
costs incurred by each user
ALLOCATING SERVICE DEPARTMENT COSTS:
1) Direct allocation: allocates cost of each service
department directly to production departments.
Does not consider services performed by one
service department to another
2) Step-down (sequential) allocation: based on a
sequence of allocation. Starts with department
that renders services to the greatest number of
other service departments.
3) Reciprocal allocation: allocates service
department costs to production departments.
Reciprocal services are allowed between service
departments. Uses simultaneous equations. Also
called, simultaneous allocation; matrix method.
SPOILAGE & SCRAP:
Normal spoilage: spoilage under normal, efficient
conditions. It is unavoidable. Product cost.
Abnormal spoilage: beyond the normal spoilage
rate; arises under other than normal and efficient
conditions. It is recognized as a loss. Period cost. It is
controllable (result of inefficiency).
Process costing and spoilage:
1) Approach 1: recognize spoilage as unit output
2) Approach 2: do not include spoilage in unit output
a. Spread spoilage costs over good units
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