Introduction Etc

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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,


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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,


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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,


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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



http://accountingexplained.com/financial/introduction/transaction

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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,


16

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



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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.



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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.



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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



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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.



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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,


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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,


16

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

Bibliography



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Miller, Peter (1998). “The Margins of Accounting,” European Accounting Review 7, no. 4.

Potter, Bradley (October 2005). “Accounting as a Social and Institutional Practice:

Perspectives to Enrich our Understanding of Accounting Change,” Abacus, 265–289.

Richardson, Alan J. (December 2002). “Professional Dominance: The Relationship Between Financial Accounting and Managerial Accounting,

1926–1986,” Accounting Historians Journal, 91–121.

Rosenfield, Paul (June 2003). “Presenting Discounted Future Cash Receipts and Payments in Financial Statements,” Abacus, 233–249.

Weber, G.F. [1960], \Price Level Accounting", The Accounting Review 35, 641-649.

Young, A.A. [1928], \Increasing Returns and Economic Progress", The Economic Journal 38, 527-542.

Young, H.P. (ed.), [1985], Cost Allocation: Methods Principles, Applications, Amsterdam: North-Holland.

Young, H.P. [1994], \Cost Allocation", pp. 1193-1235 in Handbook of Game Theory, Volume 2, R.J. Aumann and S. Hart (eds.), Amsterdam: Elsevier.

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Readings in the Economics of Taxation, R.A. Musgrave and C.S. Shoup (eds.), Homewoo

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Introduction Etc