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I. INTRODUCTION
In any business, measurement of the performance is necessary to
determine the status of the business, to have a guide for future
investment, to determine how much profit has been earned, and to
measure the overall efficiency and credit worthiness of the business.
Prior to the development of large-scale enterprises, if a measure of
performance was needed, it was not uncommon for it to be arrived at by
valuing assets and liabilities directly, computing the net asset position at
two different dates and comparing one with the other to arrive at
income.
The emergence of large-scale enterprises in the nineteenth
century, and the consequent separation of ownership and management
control, created a need for financial statements for the purpose of
accountability in order to ensure that managers rendered a reliable
report of their activities to owners. If a measure of performance was
needed, accounting focused on tracking the cost of resources obtained
and used by the enterprise and on matching cost with the revenue
realized by the enterprise through time to arrive at income.
At some point of its business life, it experiences changes in prices
due to the varying value of money from time to time as a result in the
general level of prices. Price of goods and services change over the time. Concepts in the Measurement of Income,
The Price Level Problem, And Basic Concepts of Management Control: A Term Paper in Management Accounting
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The change in price as a result of various economic and social forces
brings about a change in the purchasing power of money. In effect, the
forecasted income changes especially when the time of forecasting the
income has a relatively large gap of realizing it.
While the measurement of business’ performance is necessary and
the adjustment due to different price levels, so as management control is
necessary to address these and to assure that resources are obtained and
used effectively and efficiently in the accomplishment of the company’s
objectives.
II. CONCEPTS IN THE MEASUREMENT OF INCOME
An accounting for income is not merely a question of reporting in a
different format but involves issues of recognition and measurement.
The recognition, measurement and reporting of income depends on
the construction of an accounting theory and is important for the use
of accounting information.
A. Objectives
The measurement of income is useful for more than one
purpose and therefore its objectives may be studied from
different points of view:
1. As a guide to future investment
Concepts in the Measurement of Income, The Price Level Problem, And Basic Concepts of Management Control:
A Term Paper in Management Accounting
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The current income positively influences the expectations
about the future. The prospective investor looks to the income of
the business enterprise as a guide to his investments decisions
of the future. The investors attempt to maximize their returns
on their investments and their decisions will be guided by
income. So the allocation of investment funds and selections of
securities depend upon income levels of an enterprise.
2. As a tax base
Though the Income Tax Act does not define yet it does
specify what is taxable and what is deductible in arriving at the
taxable income. Accounting income provides income of a
business enterprise. The tax authorities can conveniently
mobilize the revenues through taxes which are one of the main
sources of the Government’s income.
3. As a guide to dividend policy
The dividend policy at present is directed to determine the
proportion of the current income which should be retained and
the proportion which should be distributed as dividends. So long
as dividends are aid out of current income, the rights of the
creditors are adequately protected since other resources of the
business enterprise would not be used to pay dividends. There
are clear rules for measurement of distributable profits in the Concepts in the Measurement of Income,
The Price Level Problem, And Basic Concepts of Management Control: A Term Paper in Management Accounting
16
Companies Act with a view to protect the interests of the
creditors.
4. As an indicator of managerial efficiency
The efficiency of management as decision makers and as
trustees of resources is judged by the reported income of the
current year. The auditors therefore certify that the income
statement presents true and fair view of operational results. The
measurement of business income therefore provides a suitable
criterion for the efficiency of management in a competitive
economy.
5. As a measure of overall efficiency and credit worthiness
Income is the lifeblood of any business enterprise and
therefore it provides that basic standard by which the overall
efficiency of the business is assessed. For creditors, profitable
enterprise faces no difficulty in making timely payment on its
debts. Banks and other credit institutions too depend upon
current income levels as a guide about a firm’s ability to repay
loan out of future income.
6. As a guide to socio-economic decisions
A number of decisions affecting the society and economy
as a whole are taken keeping in mind the level of business Concepts in the Measurement of Income,
The Price Level Problem, And Basic Concepts of Management Control: A Term Paper in Management Accounting
16
income. For instance, price increases are justified in terms of
income levels. Trade unions demand more wages for their
employees on the basis of reported income and employers too
plead that increase in wages would have adverse effects of the
income. The economic policies of the Government are also
guided by levels of business income since it constitutes a major
source of tax revenues.
B. The Accrual Concepts
Income arises from operating events that increase owners’ equity, and
only from such events. The sale of merchandise at a profit is one such
event. In understanding how this profit came about, consider two
aspects of this event separately: merchandise sold for $300 would
decrease inventory by $200. If we look at the $300 only, we see an
increase in asset and a corresponding increase in owner’s equity. The
$200, taken by itself, is a decrease in the asset, inventory, and a
corresponding decrease in owner’s equity. These are the two aspects
that illustrate the two ways in which business operations can affect
owners’ equity: they can increase it, or they can decrease it.
This concept is also known as the accrual theory of accounting or
accrual accounting. This concept applies equally to revenues and
expenses. In the accrual basis of accounting, revenue is recognized when Concepts in the Measurement of Income,
The Price Level Problem, And Basic Concepts of Management Control: A Term Paper in Management Accounting
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it is realized, that is, when the sale is complete or not.
Business transactions are recorded when they occur and not when the
related payments are received or made. According to accrual concept,
expenses incurred and revenue earned during the accounting period
should be recorded in the same period of accounts regardless of the
actual receipt of payment of cash. An accrual is a journal entry that is
used to recognize revenues and expenses that have been earned or
consumed, respectively, and for which the related cash amounts have not
yet been received or paid out. Accruals are needed to ensure that all
revenue and expense elements are recognized within the correct
reporting period, irrespective of the timing of related cash flows. Without
accruals, the amount of revenue, expense, and profit or loss in a period
will not necessarily reflect the actual level of economic activity within a
business. Accruals are a key part of the closing process used to create
financial statements under the accrual basis of accounting; without
accruals, financial statements are considerably less accurate.
C. The Realization Concept
A basic accounting concept is that revenue is considered as being
earned on the date at which it is realized; that is, on the date when goods
or services are furnished to the customer in exchange for cash or some
other valuable consideration. For services, revenue is recognized in the
Concepts in the Measurement of Income, The Price Level Problem, And Basic Concepts of Management Control:
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period in which the service is rendered. For tangible products, revenue
is recognized not when a sales order is received, not when a contract is
signed, not when the goods are manufactured, but rather when the
product is shipped or delivered to the customer.
There is no objective way of measuring how much profit is created
during the manufacturing process. The outcome of the whole process is
known with reasonable certainty only when the buyer and seller have
agreed on a price and the goods have been delivered. Also, at this time
there is usually an invoice, a cash register record, or some other tangible
evidence as to the revenue arising from the transaction ― evidence that
permits the facts to be verified by some outside party.
III. THE PRICE LEVEL PROBLEM
The power of monetary unit of measurement is different at different
times. A balance sheet prepared at one moment of time contains some
items, such as cash, that are stated at current purchasing power; other
items such as inventory that may be stated in monetary units that reflect
purchasing power of recent past; and still other items, such as plants and
equipment, stated amounts that reflect purchasing power of several
years previous to current date.
To deal this problem, several proposals have been advanced and these
are; The LIFO Method, The FIFO Method and The average cost method.Concepts in the Measurement of Income,
The Price Level Problem, And Basic Concepts of Management Control: A Term Paper in Management Accounting
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A. The LIFO Method
Last in, first out method. Under the LIFO method, you are
assuming that items bought last are sold first, which also means
that the items still in stock are the oldest ones. This policy does not
follow the natural flow of inventory in most companies; in fact, the
method is banned under International Financial Reporting
Standards. In periods of rising prices, assuming that the last units
bought are the first ones used also means that the cost of goods
sold tends to be higher, which therefore leads to a lower amount of
operating earnings, and fewer income taxes paid.
B. The FIFO Method
First In, First Out. Under the FIFO method, you are assuming
that items bought first are also used or sold first, which also means
that the items still in stock are the newest ones. This policy closely
matches the actual movement of inventory in most companies, and
so is preferable simply from a theoretical perspective. In periods of
rising prices (which is most of the time in most economies),
assuming that the earliest units bought are the first ones used also
means that the least expensive units are charged to the cost of
goods sold first. This means that the cost of goods sold tends to be
Concepts in the Measurement of Income, The Price Level Problem, And Basic Concepts of Management Control:
A Term Paper in Management Accounting
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lower, which therefore leads to a higher amount of operating
earnings, and more income taxes paid.
C. LIFO-FIFO Comparison
Issue FIFO Method LIFO Method
Materials flow
In most businesses, the actual flow of materials follows FIFO, which makes this a logical choice.
There are few businesses where the oldest items are kept in stock while newer items are sold first.
Inflation
If costs are increasing, the first items sold are the least expensive, so your cost of goods sold decreases, you report more profits, and therefore pay a larger amount of income taxes in the near term.
If costs are increasing, the last items sold are the most expensive, so your cost of goods sold increases, you report fewer profits, and therefore pay a smaller amount of income taxes in the near term.
Deflation
If costs are decreasing, the first items sold are the most expensive, so your cost of goods sold increases, you report fewer profits, and therefore pay a smaller amount of income taxes in the near term.
If costs are decreasing, the last items sold are the least expensive, so your cost of goods sold decreases, you report more profits, and therefore pay a larger amount of income taxes in the near term.
Financial reporting
There are no GAAP or IFRS restrictions on the use of FIFO in reporting financial results.
IFRS does not all the use of the LIFO method at all. The IRS allows the use of LIFO, but if you use it for any subsidiary, you must also use it for all parts of the reporting entity.
Record keeping
There are usually fewer inventory layers to track in a FIFO system, since the oldest layers are continually used up. This reduces record keeping.
There are usually more inventory layers to track in a LIFO system, since the oldest layers can potentially remain in the system for years. This increases record keeping.
Concepts in the Measurement of Income, The Price Level Problem, And Basic Concepts of Management Control:
A Term Paper in Management Accounting
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Reporting fluctuatio
ns
Since there are few inventory layers, and those layers reflect recent pricing, there are rarely any unusual spikes or drops in the cost of goods sold that are caused by accessing old inventory layers.
There may be many inventory layers, some with costs from a number of years ago. If one of these layers is accessed, it can result in a dramatic increase or decrease in the reported amount of cost of goods sold.
D. The Average Cost Method
Using the weighted average method, you divide the cost of goods
available for sale by the number of units available for sale, which
yields the weighted-average cost per unit. The cost of goods
available for sale is the sum of beginning inventory and net
purchases. Weighted-average figure to assign a cost to both ending
inventory and the cost of goods sold.
Weighted average costing is commonly used in situations
where:
• Inventory items are so intermingled that it is impossible to
assign a specific cost to an individual unit.
• The accounting system is not sufficiently sophisticated to
track FIFO or LIFO inventory layers.
• Inventory items are so commoditized (i.e., identical to each
other) that there is no way to assign a cost to an individual unit.
Concepts in the Measurement of Income, The Price Level Problem, And Basic Concepts of Management Control:
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IV. MANAGEMENT CONTROL
Management controls may be briefly defined as the organisation,
policies, and procedures used to help ensure that government
programmes achieve their intended results; that the resources used to
deliver these programmes are consistent with the stated aims and
objectives of the organisations concerned; that programmes are
protected from waste, fraud and mismanagement; and that reliable and
timely information is obtained, maintained, reported, and used for
decision making.
For instance, some companies have used responsibility centers to
extend its control over its operation in different division of the company.
These responsibilities are as follows:
A. Expense Centers
If the control system measures the expenses incurred by an
organization unit, but does not measure the monetary value of its
output, the unit is an expense center. Although every organization
unit has an output, in many cases it is neither feasible nor necessary
Concepts in the Measurement of Income, The Price Level Problem, And Basic Concepts of Management Control:
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to measure this output in monetary terms. Thus, most individual
production departments and most staff units are expense centers. For
these, the accounting system records expenses incurred, but not
revenue earned.
B. Profit Centers
Revenue is a monetary measure of output, and expense is a
monetary measure of inputs, or resources consumed. Profit is the
difference between revenue and expense. Thus if performance in a
responsibility center is measured in terms of both the revenue it earns
and the cost it incurs, it is called a profit center. Although in financial
accounting, revenue is considered only when it is realized, in
management accounting it is quite all right to define revenue as the
output of the center, whether realized or not. Thus, the factory may
be a profit center, “selling” its production to the sales department.
The profit center concept is a powerful one. If properly operated, it
has the effect of “putting the supervisor in business for himself,” a
business in which he can earn a profit. The development of this
concept is one of the factors that has made possible he tendency for
large companies to decentralize.
Concepts in the Measurement of Income, The Price Level Problem, And Basic Concepts of Management Control:
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C. Investment Centers
The ultimate extension of the responsibility center idea is the
investment center, in which the supervisor is responsible, not only for
the profits, but also for the assets that he uses. The investment center
idea is not yet widely adopted and is usually restricted to large units,
such as the several divisions of a company making a variety of
products.
Furthermore, the management must consider the following to
assure cost control will be effective in its implementation in the
company:
a. For all important activities, detailed work breakdown
structures with explicit operational milestones have to be
applied. They must be used as the standard basis for a daily
communication process.
b. The detailed inputs for all the work packages should be
provided by the responsible engineer or group leader, to ensure
a bottom-up planning and information updating process.
c. The operational work breakdown structures should be
automatically combined with the financial management tools (in
particular the financial accounting software system). Both parts Concepts in the Measurement of Income,
The Price Level Problem, And Basic Concepts of Management Control: A Term Paper in Management Accounting
16
have to be set up in a bottom-up/top-down process, where the
assigned engineers or technical group leaders feed in technical
information, which is then combined with the financial data and
updated on a short time basis (e.g. weekly). This integrated tool
must show the planned and actual, weekly updated data and any
deviations. Finally, these reports have to be approved by the
upper management levels in the top-down process to ensure
consistency across the whole project.
d. All these data should be integrated and aggregated into a
management information system, which provides the decision
makers with up-to-the-minute data and comprehensive cost and
risk information.
A culture of openness, transparency and trust, in which
problems can be communicated as soon as possible without a rush to
judgement, is essential. This should be accompanied by an attitude of
developing and proposing countermeasures in parallel to the decision-
making boards for optimal outcomes a collaborative environment
needs to be fostered, in which activity is directed towards achieving
delivery on time, to required specifications and on budget.
This culture of openness should extend across the whole project
and during all project phases, to the use, exchange and regular Concepts in the Measurement of Income,
The Price Level Problem, And Basic Concepts of Management Control: A Term Paper in Management Accounting
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updating of all relevant data (planned and actual) on a detailed and
timely basis. Cultural differences between the different partners, in
particular with respect to terminology, processes and practices, need
to be identified and addressed from the outset with openness (and
sensitivity) in order to minimise misunderstandings. In collaborations
with external industry the same transparent controlling and reporting
systems must be applied as internally. The management must be able
to get access to all relevant information whenever it appears
necessary
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A Term Paper in Management Accounting
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