Financial & Managerial Accounting

(MPMF-621)
After completing this course you should be able to
• Explain the features of financial and managerial accounting
• Understand the steps in the accounting cycle
• Prepare the four financial reports, make financial Analysis and
interpret the result
• Distinguish the different product costing systems
• Apply budgeting for planning and control purpose
• Use the steps in decision making to give solution to non routine
problems in the business environment
• Aware of the different modern management accounting tools

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Chapter 1: Introduction to Financial Accounting

1.1 Accounting and Users of Accounting Information

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 What are the Accounting Information

Accountants prepare four financial statements :

Statement of
Income Statement of
Shareholders Balance Sheet
Statement Cash Flows
Equity

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 Who Uses Accounting Information?
Management

Internal
Employees
Users

Functional
Departments

Users Investors

Customers

Labour
External Users
Unions

Tax Authority

Academicians

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 Why they Use Accounting Information?
Common Questions Asked Users

1. Can we afford to give our

employees a pay raise?
Human Resources

2. Did the company earn a

satisfactory income?
Investors

3. Should any product lines be

eliminated?
Management
4. Is cash sufficient to pay dividends
to stockholders?
Finance

5. What price for our product will

maximize net income?
Marketing

6. Will the company be able to pay

its debts as they become due?
Creditors
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 What are the Qualities of Useful Accounting
Information?
• To be useful, accounting information should be both
relevant and reliable

• Information has the quality of relevance when it

influences the economic decisions of users by helping
them evaluate past, present or future events or
confirming or correcting their past evaluations

• Information has the quality of reliability when it is free

from material error and bias and can be depended
upon by users to represent faithfully what it is
expected to represent

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 1.2 Financial & Managerial Accounting
• We can divide accounting into two fields—
1.Financial accounting and
2.Managerialaccounting.
• Financial accounting provides information for
external decision makers, such as outside
investors and lenders.
• Managerial accounting focuses on information
for internal decision makers, such as the
company’s managers.

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 Financial Accounting Vs. Managerial Accounting

Areas of Comparison Financial Accounting Management Accounting

1. Primary users of Persons and organizations Various levels of internal

information outside the business entity management

2.Purpose of the Communicate organization’s Help managers make

Information financial and operating decisions to fulfill an
information to outside parties organizations goal

3. Types of accounting Double entry system Not restricted to double

systems entry system; any useful
system can be used
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4. Restrictive guidelines
5. Units of measurement
6. Focal point for analysis
7.Report
7. Frequency of reporting
8. Degree of objectivity
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Adherence to GAAP No formal guidelines or
restrictions, only criterion is
usefulness
Historical (past) Monetary unit Any useful monetary (historical
and future) or physical measure
$, euro birr etc
such as machine hours, labor hours
etc
Business entity as a whole Various segments of the business
entity.
Summarized report; concerned Detailed report; concerned about
primarily with the entity as a details of parts of the entity’s
whole products, departments, territories
Periodical on a regular basis Whenever needed; may not be on
a regular basis
Demands objectivity; historical in Heavily subjective for planning
nature purposes, but objective data are
9
used when relevant and future in
1.3 Accounting Principles & Standards

Financial Statements
Various users  1. Balance Sheet
need financial  2. Income Statement
 3. Statement of Stockholders’ Equity
information  4. Statement of Cash Flows
 5. Note Disclosure

The accounting profession

has attempted to develop a
set of standards that are Generally Accepted
Accounting Principles
generally accepted and (GAAP)
universally practiced.

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 What are Generally Accepted Accounting Principles?

Generally Accepted Accounting Principles (GAAP) are

Standards that are generally accepted and universally
practiced. These standards indicate how to report economic
events. The followings are accounting concepts and principles
that serves as building block for Accounting practices
1. Business entity concept: an organization that stands apart as a separate economic
unit.
2. Going concern assumption: entity will remain in operation for the foreseeable future.
business will remain in operation long enough to use existing resources for their intended
purpose.
3. Historical cost principle: assets and services should be recorded at their
actual cost (also called historical cost).
4. Objectivity Principle: any recording should have document evidence based such as
recipient for what purpose it has been paid.

5. Monitory unit principle: we record transactions in dollars because the dollar

is the medium of exchange. The stable monetary unit concept
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means stable currency buying power.
• 6. Periodicity principle
• 7. Revenue Realization principle: if sales are credit it
should be considered/ recorded as sale

• 8. Matching Principle
• 9. Adequate disclosure principle: accountants has
obligation to develop 4 report but for additional explanation the can develop further .
• 10. Consistency principle: if one methods of financing starts it
should continuous until the end.

• 11. Materiality principle; for accuracy purpose accountants should

never be busy in calculation of more than two digit decimals. eg12,000.075 if he/she
omit this decimal the firm cannot be affected.

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 Who set Generally Accepted Accounting Principles?

 GAAP setting bodies for business Organizations

 Financial Accounting Standards Board (FASB) usa

 International Accounting Standards Board (IASB) uk of

which Ethiopia has adopted.

 These organization are coordinators. In fact, accounting

principles and standards are prepared under the
participations of professionals, academicians and different
organization.

 In addition, accounting regulations will discipline accounting

choices in a given country

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1.4 Bases of Accounting & Recording Systems
1. Cash-Basis Accounting
• Revenues and expenses are recognized only
when cash is received or payments are
made.
• Mainly used by small business
organizations.
• Do not show accurate picture of true
profitability.

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 2. Accrual Bases of Accounting
• A system of accounting in which revenues
and expenses are recorded as they are
earned and incurred, not necessarily when
cash is received or paid.
• Provide a more accurate picture of a
company’s profitability.
• Statement users can make more informed
judgment concerning the company’s earning
potential.
• It is an acceptable method under GAAP

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 Cash-Basis Vs. Accrual Accounting
Illustration: During 2014, Crown Consulting billed its client for
$48,000. On December 31, 2010, it had received $41,000, with the
remaining $7,000 to be received in 2015. Total expenses during
2014 were $31,000 with $3,000 of these costs not yet paid at
December 31. Determine net income under both methods for the
year 2014.

Cash-Basis Accounting Accrual-Basis Accounting

Cash receipts $41,000 Revenues earned $48,000
Cash disbursement 28,000 Expenses incurred $31,000
Income $13,000 Income $17,000

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 Accounting Record Systems
• There are two record keeping systems in
accounting
– Single entry : is record system where by only one
part of a transaction is recorded (Cr or Dr)
– Double entry systems is a record system where by
both sides are recorded in the form of debit and
credit
• Double entry system is generally more
acceptable these days
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 1.5 Forms of Business Organizations &
Accounting
Based on legal formation, Business Organizations in
Ethiopia are classified as:
1. Sole proprietorship: by single person owner manager etc
2. Partnerships:2 or more friends
– Ordinary Partnership
– Joint Venture : works not more than 25y
– General partnership
– Limited partnership
3. Companies: 2 or more individual established by sailing aksion
– Private Limited Companies:15.000 capital, 2-50 friends, no
advertisement to sale SHARE (closed)
– Share Companies:50,000 capital,≥ 5 peoples, sailing share must
displayed
4. Cooperatives (Unions): ≥ 10 , to solve their problems by group, it
is half business and social eg farmers association
5. Public enterprises: Air line Tele, big factories, owned by gov.t

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Based on their activity, business organization can also
be classified
1. Service giving business organizations
– Financial institutions such as Banks
– Hotels & Tourism
– Schools & Health centers
2. Merchandizing business organizations
– Wholesalers
– Retailers
3. Manufacturing business organizations
– Food & Beverages factories
– Chemical factories
– Plastic & Metal tools factories
• Accounting is applicable in every type of
organizations

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 Chapter 2: Financial Accounting Procedures
2.1 Accounting Equation and Rule of Debit & Credit

Assets = + Stockholder’s Equity

Liabilities

Assets: are all properties under the ownership of an

organization such as cash, inventories and fixed assets.
Assets are claimed by either creditors or owners. Claims of
creditors must be paid before owners claims. Assets are the
economic resources of a company that are expected to benefit the
company’s future operations.
Liabilities are creditors claim such as accounts payable and
bank loan. Liabilities are a business’s present obligations to pay cash, transfer assets, or20
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provide services to other entities in the future.
Revenues result from business activities entered into for the purpose
of earning income. Common sources of revenue are: sales, fees,
services, commissions, interest, dividends, royalties, and rent.
Expenses are the cost of assets consumed or services used in the
process of earning revenue. Common expenses are: salaries expense,
rent expense, utilities expense, tax expense, etc
Dividends are the distribution of cash or other assets to stockholders.
Dividends reduce retained earnings. However, dividends are not an
expense
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 Chart of Accounts
Chart of accounts is accounts and account numbers arranged
in sequence in which they are presented in the financial
statements.

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 The Account
 Is used to record increases and
Account decreases in a specific asset, liability,
equity, revenue, or expense items.
 An account has two sides
 Debit = “Left side”
 Credit = “Right side”
An account can be Account Name
illustrated in a T- Credit / Cr.
Debit / Dr.
account form.

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 Debits/Credits Rules
Liabilities
Debit / Dr. Credit / Cr.
Normal Normal
Balance Balance
Debit Credit Normal Balance

Assets Chapter
3-24

Stockholders’ Equity
Debit / Dr. Credit / Cr.
Debit / Dr. Credit / Cr.

Normal Balance
Normal Balance

Chapter
3-23

Expense Chapter
3-25
Revenue
Debit / Dr. Credit / Cr.
Debit / Dr. Credit / Cr.

Normal Balance
Normal Balance

Chapter
3-27 Chapter
3-26

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 Debits/Credits Rules

Balance Sheet Income Statement

Asset = Liability + Equity Revenue - Expense =

Debit

Credit

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LO 2 Define debits and credits and explain their
25
use
in recording business transactions.
 The Accounting Cycle

1. Analyze business transactions

9. Prepare a post-closing 2. Journalize the

trial balance transactions

8. Journalize and post

3. Post to ledger accounts
closing entries

7. Prepare financial
4. Prepare a trial balance
statements

6. Prepare an adjusted trial 5. Journalize and post

balance adjusting entries

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2.2 Recording & Summarizing Transactions

1. The Journal
 Book of original entry where transactions are recorded for
the first time .

 Transactions are recorded in chronological order.

 Contributions to the recording process:

1. Discloses the complete effects of a transaction.

2. Provides a chronological record of transactions.

3. Helps to prevent or locate errors because the debit and

credit amounts can be easily compared.

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 2. Journalizing

Journalizing - Entering transaction data in the journal.

Illustration: On September 1, stockholders’ invested $15,000 cash
in the corporation in exchange for share of stock, and Softbyte
purchased computer equipment for $7,000 cash.

General Journal

Date Account Title Ref. Debit Credit

Sept. 1 Cash 15,000
Common stock 15,000

Equipment 7,000
Cash 7,000
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 2. Journalizing

Compound Entries
Illustration: On July 1, Butler Company purchased a delivery truck
costing $14,000. It pays $8,000 cash now and agrees to pay the
remaining $6,000 on account.

General Journal

Date Account Title Ref. Debit Credit

July 1 Equipment 14,000
Cash 8,000
Accounts payable 6,000

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 2. Posting

•Posting is the process of summarizing accounts from a

journal to a ledger (preparing each account’s name
using double entry i.e. both Dr and Cr)
•A Ledger is a book of secondary entry unlike journal
.
/original entry/
•General Ledger contains the entire group of accounts
maintained by a company

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 Posting

Standard Form of an Account

02-11-2017 LO 5 Explain what a ledger is and how it helps in the recording process.
31
 Posting

Posting –
process of
transferring
amounts from
the journal to
the ledger
accounts.

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 Illustration 2-31
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 Trial Balance

02-11-2017 LO 7 Prepare a trial balance and explain its purposes.

34
 2.3 The Basics of Adjusting Entries

Adjusting Entries
 Ensure that the revenue recognition and expense
recognition principles are followed.

 Necessary because the trial balance may not contain

up-to-date and complete data.

 Required every time a company prepares financial

statements.

 Will include one income statement account and one

balance sheet account.

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 Types of Adjusting Entries
Deferrals
1. Prepaid Expenses.
Expenses paid in cash and
recorded as assets before
they are used or consumed.
E.g. Supplies,
Prepaid Insurance
2. Unearned Revenues.
Cash received and recorded
as liabilities before revenue is
earned.
E.g. Unearned Rent
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Accruals
3. Accrued Revenues.
Revenues earned but not yet
received in cash or recorded
E.g. Interest Income.
4. Accrued Expenses.
Expenses incurred but not
yet paid in cash or recorded.
E.g. Salary expense, Interest
Expense
36
 Types of Adjusting Entries

Trial Balance –
Each account is
analyzed to
determine whether
it is complete and
up-to-date.

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 Depreciation
 Buildings, equipment, and vehicles (assets with long
lives) are recorded as assets, rather than an expense,
in the year acquired.

 Depreciation allocates a portion of the asset’s cost as

an expense during each period of the asset’s useful life.

 Depreciation does not attempt to report the actual

change in the value of the asset.

02-11-2017 LO 5 Prepare adjusting entries for deferrals.

38
Summary of Basic Relationships

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 Using a Worksheet

Steps in Preparing a Worksheet

 Multiple-column form used in preparing financial
statements.

 Not a permanent accounting record.

 Five step process.

 Use of worksheet is optional.

02-11-2017 LO 1 Prepare a worksheet.

40
 Preparing a Worksheet

Adjusted Income
Trial Balance Adjustments Trial Balance Statement Balance Sheet
Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 15,200 15,200 15,200
Supplies 2,500 (a) 1,500 1,000 1,000
Prepaid Insurance 600 (b) 50 550 550
Equipment 5,000 5,000 5,000
Notes Payable 5,000 5,000 5,000
Accounts Payable 2,500 2,500 2,500
Unearned Revenue 1,200 (d) 400 800 800
Common Stock 10,000 10,000 10,000
Dividends 500 500 500
Service Revenue 10,000 (d) 400 10,600 10,600
(e) 200
Salaries Expense 4,000 (g) 1,200 5,200 5,200
Rent Expense 900 900 900
Totals 28,700 28,700
Supplies Expense (a) 1,500 1,500 1,500
Insurance Expense (b) 50 50 50
Accumulated Depreciation (c) 40 40 40
Depreciation Expense (c) 40 40 40
Accounts Receivable (e) 200 200 200
(f)
Interest Expense 50 50 50
Interest Payable (f) 50 50 50
Salaries and Wages Payable (g) 1,200 1,200 1,200
Totals 3,440 3,440 30,190 30,190 7,740 10,600 22,450 19,590
Net Income 2,860 2,860
Totals 10,600 10,600 22,450 22,450

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 2.4 Completing the Accounting Cycle

Preparing Statements from a Worksheet

 Income statement is prepared from the income
statement columns.

 Balance sheet and retained earnings statement are

prepared from the balance sheet columns.

 Companies journalize and post adjusting entries.

02-11-2017 LO 1 Prepare a worksheet.

42
 Preparing Statements from a Worksheet
Illustration 4-4

02-11-2017 LO 1 Prepare a worksheet.

43
 Preparing Statements from a Worksheet

02-11-2017 LO 1 Prepare a worksheet.

44
 Preparing Statements from a Worksheet

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45 1
 Closing the Books

At the end of the accounting period, the company makes

the accounts ready for the next period.

02-11-2017 LO 2 Explain the process of closing the books.

46
 Preparing a Post-Closing Trial Balance
Purpose is to prove the equality of the permanent account
balances after journalizing and posting of closing entries.

02-11-2017 LO
47 3
 2.5 Accounting for Merchandizing Operation

Merchandising Companies
Buy and Sell Goods

Wholesaler Retailer Consumer

The primary source of revenues is referred to as

sales revenue or sales.
02-11-2017 LO 1 Identify the differences between service and merchandising companies.
48
 Merchandising Operations

Income Measurement
Not used in a
Service business.

Cost of goods sold is the total cost

of merchandise sold during the
period.

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 Merchandising Operations

Operating
Cycles

The operating cycle

of a merchandising
company ordinarily
is longer than that of
a service
company.

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 Merchandising Operations

Flow of Costs

Companies use either a perpetual inventory system or a periodic inventory

system to count for inventory.

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 Merchandising Operations

Flow of Costs
Perpetual System
 Maintain detailed records of the cost of each inventory
purchase and sale.
 Records continuously show inventory that should be on
hand.
 Company determines cost of goods sold each time a
sale occurs.

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 Merchandising Operations

Flow of Costs
Periodic System
 Do not keep detailed records of the goods on hand.
 Cost of goods sold are determined by count at the end
of the accounting period.
 Calculation of Cost of Goods Sold:

Beginning inventory $ 100,000

Add: Purchases, net 800,000
Goods available for sale 900,000
Less: Ending inventory 125,000
Cost of goods sold $ 775,000
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53 1
 FOB Shipping Point & FOB Destination

Freight Costs – Terms of Sale

Seller places goods Free On

Board the carrier, and buyer pays
freight costs.

Seller places goods Free On

Board to the buyer’s place of
business, and seller pays freight
costs.

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LO 2
 Purchase Returns and Allowances

Purchaser may be dissatisfied because goods are damaged

or defective, of inferior quality, or do not meet specifications.

Purchase Return Purchase Allowance

Return goods for credit if the May choose to keep the
sale was made on credit, or for a merchandise if the seller will
cash refund if the purchase grant an allowance (deduction)
was for cash. from the purchase price.

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 Purchase Discount

Credit terms may permit buyer to claim a

cash discount for prompt payment
2/10, n/30 1/10 EOM

2% discount if 1% discount if
paid within 10 paid within first 10
days, otherwise days of next
net amount due month.
within 30 days.

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 Recording Sales of Merchandise

 Made using cash or credit (on account).

 Normally recorded when

earned, usually when
goods transfer from seller
to buyer.

 Sales invoice should

support each credit sale.

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 Chapter 3: Financial Statement Preparation and
Interpretation
3.1 International Financial Reporting Standards (IFRS)
• A set of global accounting and reporting standards,
issued by the IASB
• Increasingly used by many large and multinational
companies
• Accepted by most security market authorities
• Used as a basis for national accounting requirements
(partially or in full) or as a benchmark for the
development of national accounting rules
• Accepted by Ethiopian government in 2014 (
Proclamation No. 847/2014)

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International Accounting Standards Board (IASB)

• A private sector body

• Operates under the International Accounting
Standards Committee Foundation (IASCF)
• Has no responsibility to any governmental
organization
• Has no enforcement authority
• Develops and issues both main standards (IAS / IFRS)
and interpretations

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 Standard-setting due process of the IASB
Standard Setters
Others

Research

Discussion Comment Exposure Comment Effective

Standard
paper analysis draft analysis Date

9-15 months 9-15 months 6-18 months

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 IFRS in the world
• Recent decisions of various governments
result in the requirement or permission of the
use of IFRS by more than one hundred
countries
• Europe: IAS Regulation of 2002
– Requirement of use of IFRS for
consolidated financial statements of EU
qouted companies as from 1 January 2005
– Member state option to extend the
application of IFRS to not-listed companies
and to individual financial statements
• Adoption of IFRS as national accounting rules in
a number of countries (Australia, Singapore, Hong
Kong, Ethiopia …)
• US: convergence process of US accounting
rules and IFRS started in 2002.

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 Primary Financial Statements
• Primary financial statements answer basic
questions including:
– What is the company’s current financial status?
– What was the company’s operating results for the
period?
– How did the company obtain and use cash during
the period?
• Basic financial statements includes
1. Income Statement
2. Statement of Retained Earnings
3. Balance Sheet
4. Statement of Cash Flows
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 Structure and Content of Financial Statements
• Each component of the financial statements must be
clearly identified and the following should be disclosed:
 Name of the enterprise
 Whether individual or consolidated statements
 Reporting date or period covered by the statement
 Reporting currency
 The level of precision in the presentation of figures
• Where, in exceptional circumstances, an enterprise is
required to, or decides to, change its reporting date, it is
required to state why the change occurred and the fact
that the comparative amounts are not comparable

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 3.2 The Income Statement
• Shows the results of a company’s operations
over a period of time.
• What goods were sold or services performed
that provided revenue for the company?
• What costs were incurred in normal
operations to generate these revenues?
• What are the earnings or company profit?

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 The Income Statement
Revenues
• Assets (cash or A.Recivable) created through
business operations
Expenses
• Assets (cash or A. Payable) consumed
through business operations
Net Income or (Net Loss)
• Revenues - Expenses

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 The Example Company
Income Statement
For the Years Ended December 31, 2013 and 2014

2014 2013
Revenues:
Sales $100 $ 85
Other revenue 30 15
Total revenues $130 $100
Expenses:
Cost of goods sold $ 62 $ 58
Operating & admin. 16 12
Income tax 20 18
Total expenses $ 98 $ 88
Net Income $ 32 $ 12
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3.3 Statement of Change in Shareholders Equity

• Shows the increase or decrease in net asset

of owners or share holders
• It is a bridge between Income statement and
balance sheet

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 Statement of Changes in Shareholders Equity
Share Other Retained
Capital Reserves Earnings Total
€’000 €’000 €’000 €’000
Opening balance x x x x
Changes in accounting policy - - x x
Restated balance x x x x

Changes in equity for year

Dividends (x) (x)
Total comprehensive income x x x
Issue of share capital x - - x
Total changes in equity x x x x

Closing balance x x x x
 3.4 The Balance Sheet
• Balance sheet (Statement of Financial position)
answers the following questions
– What are the resources of the company?
– What are the company’s existing obligations?
– What are the company’s net assets?
• Summary of the financial position of a company
at a particular date
– Assets: cash, accounts receivable, inventory, land,
buildings, equipment and intangible items (such as
trade mark, copy right)
– Liabilities: accounts payable, notes payable and
mortgages payable( )
– Owners’ Equity: net assets after all obligations have
been satisfied
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 Sample Balance Sheet
Assets Liabilities
Cash $ 40 Accounts payable $ 50
Accounts receivable 100 Notes payable 150
Land 200 $200
Owners’ Equity
Total assets $340
Capital stock $100
Retained earnings 40
$140
Must Total liabilities
Equal and owners’ equity $340
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 Exercise 1
The following accounts and amounts are from the records of Jackson
company for the year ended April 30, 2010, the company’s first year of
operations. Prepare an income statement, statement of retained
earnings, and balance sheet for Jackson Company.
Accounts payable $ 19,000
Accounts receivable 104,000
Cash 90,000
Commissions earned 375,000
Common stock 100,000
Dividends 10,000
Equipment 47,000
Income taxes expense 27,000
Income taxes payable 6,000
Marketing expense 18,000
Office and equipment rental expense 91,000
Salaries and commission expense 172,000
Salaries payable 78,000
Supplies 2,000
Utilities expense 17,000

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 3.5 Statement of Cash Flows
• Reports the amount of cash collected and paid
out by a company in operating, investing and
financing activities for a period of time.
– How did the company receive cash?
– How did the company use its cash?
• Indicates ability of a company to generate
income in the future.
• It has three components: Cash flow from
Operating, Investing and financing activities
• Can be prepared in two ways: Direct or Indirect
method
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 1. Operating Activities
Cash In flow Cash Out flow
• Sale of goods or • Inventory payments
services provision
• Interest payments
• Sale of investments
• Wages
in trading securities
• Utilities, rent
• Interest revenue
• Taxes
• Dividend revenue

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 2. Investing Activities
Cash Inflow Cash Outflow
• Sale of plant assets • Purchase of plant
• Sale of securities, assets
other than trading • Purchase of securities,
securities other than trading
• Collection of principal securities
on loans
• Making of loans to
other entities

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 3. Financing Activities
Cash Inflow Cash Outflow
• Issuance of own stock • Dividend payments
• Borrowing • Repaying principal on
borrowing
• Treasury stock
purchase

02-11-2017 78
 Statement of Cash Flows
Operating Investing Financing
CASH Activities Activities Activities
INFLOWS

CASH
OUTFLOWS

Operating Investing Financing

Activities Activities Activities
02-11-2017 79
 The Example Company
Statement of Cash Flows
December 31, 2014

Cash Flows From Operating Activities:

Receipts 48
Payments (43) 5

Cash Flows From Investing Activities:

Receipts 0
Payments (4) (4)

Cash Flows Used By Financing Activities:

Receipts 10
Payments (6) 4

Net Cash Flow 5

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 Cash Flow Statement
Cash--Op. Act. $ 973,000
Cash--Inv. Act. (1,188,000)
Cash--Fin. Act. 245,000
Net increase $ 30,000
Beg. cash 80,000
End. cash $ 110,000 Balance
Sheet 12/31/14

Balance Sheet 12/31/13 Cash $ 110,000

Income Statement Other 4,975,000
Cash $ 80,000
Revenues $12,443,000 Total $5,085,000
Other 4,550,000
Expenses 11,578,400
Total $4,630,000
Net income $ 864,600 Liabilities $2,860,400
Cap. stock 1,000,000
Liabilities $2,970,000
R/E 1,224,600
Cap. stock 900,000 Stmt of Retained Earnings
Total $5,085,000
R/E 760,000 R/E 12/31/10 $ 760,000
Total $4,630,000 Net income 864,600
Dividends (400,000)
02-11-2017
R/E 12/31/11 $1,224,600 81
 Exercise 2
Martin Service Corporation began the year 2009
with cash of $55,900. In addition to earning a
net income of $38,000 and paying a cash
dividend of $19,500, Martin Service borrowed
$78,000 from the bank and purchased
equipment with $125,000 of cash. Also, Accounts
Receivable increased by $7,800, and Accounts
Payable increased by $11,700. Determine the
amount of cash on hand at December 31, 2009.

02-11-2017 82
 3.6 Notes to the Financial Statements
Notes are used to convey information required by
GAAP or to provide further explanation.
Four general types of notes:
Summary of significant accounting policies:
assumptions and estimates. summary totals
Additional information about the.
Disclosure of important information that is not
recognized in the financial statements.
Supplementary information required by IFRS

02-11-2017 83
 Chapter 4: Financial Statement Analysis and
Interpretation
Analyzing financial statements involves:

Comparison Tools of
Characteristics
Bases Analysis

 Liquidity  Intra company  Horizontal

 Activity  Industry  Vertical
averages
 Profitability  Ratio
 Intercompany
 Solvency

LO 1 Discuss the need for comparative analysis.

02-11-2017 84
LO 2 Identify the tools of financial statement analysis.
 4.1 Horizontal Analysis

Horizontal analysis, also called trend analysis, is a

technique for evaluating a series of financial statement
data over a period of time. I.E the same institution for
different years.

 Purpose is to determine the increase or decrease that

has taken place.

 Commonly applied to the balance sheet, income

statement, and statement of retained earnings.

02-11-2017 LO 3 Explain and apply horizontal analysis.

85
 Horizontal Analysis

Changes suggest
that the company
expanded its asset
base during 2009
and financed this
expansion primarily
by retaining income
rather than assuming
additional long-term
debt.

02-11-2017 86
 Horizontal Analysis

Overall, gross profit

and net income were
up substantially.
Gross profit
increased by
17.1%, and net
income,26.5%.
Quality’s profit trend
appears favorable.

02-11-2017 87
 Horizontal Analysis

In the horizontal analysis of the balance sheet the ending

retained earnings increased 38.6%. As indicated earlier,
the company retained a significant portion of net
income to finance additional plant facilities.

02-11-2017 88
 4.2 Vertical Analysis

Vertical analysis, also called common-size analysis, is a

technique that expresses each financial statement item
as a percent of a base amount.

 On an income statement, we might say that selling

expenses are 16% of net sales.

 Vertical analysis is commonly applied to the balance

sheet and the income statement.

02-11-2017 89
 Vertical Analysis

These results
reinforce the earlier
observations that
Quality is
choosing to
finance its growth
through retention
of earnings rather
than through
issuing additional
debt.

02-11-2017 90
 Vertical Analysis

Quality appears
to be a profitable
enterprise that is
becoming even
more successful.

02-11-2017 91
 Vertical Analysis
Enables a comparison of companies of different sizes.

02-11-2017 92
 4.3 Ratio Analysis
Ratio analysis expresses the
relationship among selected items of
financial statement data. There are
five types of ratios analysis
1. Liquidity Ratio
2. Asset management Ratio
3. Debt management Ratio
4. Profitability Ratio
5. Market value Ratio

02-11-2017 93
 Ratio Analysis

A single ratio by itself is not very meaningful.

The discussion of ratios will include the

following types of comparisons.

02-11-2017 94
 Ratio Analysis

Liquidity Ratios

Measure the short-term ability of the company to pay its

maturing obligations and to meet unexpected needs for
cash.

 Short-term creditors such as bankers and suppliers are

particularly interested in assessing liquidity.

 Ratios include the current ratio, the acid-test ratio

02-11-2017 95
 Ratio Analysis Liquidity Ratios

1. Current Ratio

$1,020,000
2.96
344,500

Ratio of 2.96:1 means that for every dollar of current liabilities, Quality has
$2.96 of current assets.

02-11-2017 96
 Ratio Analysis Liquidity Ratios

2. Acid-Test Ratio

02-11-2017 97
 Ratio Analysis Liquidity Ratios

2. Acid-Test Ratio

$100,000 20,000 230,000

1.02
344,500

Acid-test ratio measures immediate liquidity.

02-11-2017 98
 Ratio Analysis Asset Management Ratio

3. Receivable Turnover

$2,097,000
10.23
230,000 + 180,000
2

Measures the number of times, on average, the company collects

receivables during the period.
02-11-2017 99
 Ratio Analysis Asset Management Ratio

Average Collection Period

ACP = 365/ Receivable Turnover Ratio
A variant of the Receivable turnover ratio is to convert it to an
average collection period in terms of days.

365 days / 10.2 times = every 35.78 days

Receivables are collected on average every 36 days.

02-11-2017 100
 Ratio Analysis Asset Management Ratio

4. Inventory Turnover

$1,281,000
2.3 times
600,000 + 500,000
2

Measures the number of times, on average, the inventory is sold

during the period.
02-11-2017 101
 Ratio Analysis Asset Management Ratio

Inventory Holding Period

= 365 days/ Inventory Turnover Ratio

A variant of inventory turnover is the inventory holding Period.

365 days / 2.3 times = every 159 days

Inventory turnover ratios vary considerably among

industries.

02-11-2017
LO 5 Identify and compute ratios used in analyzing 102
a
firm’s liquidity, profitability, and solvency.
 Ratio Analysis Asset Management Ratio

5. Asset Turnover

$2,097,000
1.22 times
1,835,000 + 1,595,000
2

Measures how efficiently a company uses its assets to generate sales.

02-11-2017 103
 Ratio Analysis

Solvency Ratios

Solvency ratios measure the ability of a company to

survive over a long period of time.

 Debt to Total Assets and

 Times Interest Earned

are two ratios that provide information about debt-

paying ability.

02-11-2017
LO 5 Identify and compute ratios used in analyzing 104
a
firm’s liquidity, profitability, and solvency.
 Ratio Analysis Solvency Ratios

6. Debt to Total Assets Ratio

$832,000
45.3%
$1,835,000

Measures the percentage of the total assets that creditors provide.

02-11-2017 105
 Ratio Analysis Solvency Ratios

7. Times Interest Earned

$468,000
13 times
$36,000

Provides an indication of the company’s ability to meet interest

payments as they come due.
02-11-2017 106
 Ratio Analysis
Profitability Ratios
Measure the income or operating success of a company for
a given period of time.
 Income, or the lack of it, affects the company’s ability to
obtain debt and equity financing, liquidity position, and
the ability to grow.
 Ratios include the:
 profit margin,,
 return on assets,
 return on common stockholders’ equity,
 earnings per share, and

02-11-2017  payout ratio. 107

 Ratio Analysis Profitability Ratios

8. Net Profit Margin (NPM)

$264, 000
12.6%
2097,000

Measures the percentage of each dollar of sales that results in

net income.

02-11-2017 108
 Ratio Analysis Profitability Ratios

9. Return on Asset (ROA)

$264,000
13.4%
1,835,000 + 1,595,000
2

An overall measure of profitability.

02-11-2017 109
 Ratio Analysis Profitability Ratios

10. Return on Equity ( ROE)

$264,000
29.4%
$1,003,000 + $795,000
2

Shows how many dollars of net income the company earned for
each dollar invested by the owners.
02-11-2017 110
 Ratio Analysis Profitability Ratios

11. Earnings Per Share (EPS)

$264,000
$0.97
275,400 + 270,000
2

A measure of the net income earned on each share of common

stock.

02-11-2017 111
 Ratio Analysis Profitability Ratios

12. Payout Ratio

$61,200
23.2%
$264,000

Measures the percentage of earnings distributed in the form of cash

dividends.
02-11-2017 112
 Ratio Analysis Market Value Ratios

13. Price-Earnings Ratio

$8.00
8.23 times
$0.97

Measures the net income earned on each share of common stock.

02-11-2017 113
 The Du Pont Model
This model relates the different types of ratios as
follows

( Profit
margin )( TA
turnover )( Equity
) = ROE
multiplier
NI Sales TA = ROE
Sales x TA x CE

02-11-2017 114
 Advantages of Ratio Analysis
• They facilitate inter-company comparison
• They downplay the impact of size and allow
evaluation over time or across entities
without undue concern for the effects of size
difference
• They serve as benchmarks for targets such as
financing ratios and debt burden
• They help provide an informed basis for
making investment-related decisions by
comparing an entity’s financial performance
to another
02-11-2017 115
 Limitations of Ratio Analysis
 It is restricted to information reported in the
financial statements
 It is based on past performance
 Comparability is hampered when accounting policies
are not uniform across an industry
 The past may not predict the future
 “Window dressing” techniques can make statements
and ratios look better
 Comparison with industry averages is difficult for a
conglomerate firm that operates in many different
divisions
02-11-2017 116
 Individual Assignment 1
Select any private bank of your choice in Ethiopia, Review the
2013/14 annual report and answer the following questions
1. Which of the financial Reports were prepared by the bank?
2. Calculate the following ratios from the 2014/15 financial
report?
a) Loan to Deposited Ratio
b) Non Performing Loan to Total Loan Ratio
c) Total Debt to Total Asset Ratio
d) Return on Asset
e) Return on Equity
f) Earning Per Share
3. What especial thing have you observed from the financial
statement you have reviewed?
02-11-2017 117
 Contract Accounting

Long-Term Construction
Accounting Methods

Percentage of Completion Completed Contract

Method Method

1) Terms of contract must 1) To be used only when

be certain, enforceable the percentage method is
Certainty of performance inapplicable [uncertain]
by both parties For short-term contracts
 i. Percentage Completion
• Percentage completion method permits periodic
billing

• The amount of gross profit recognized depends upon

the percent of work done

• Application of percentage completion method

requires a basis for measuring the progress toward
completion at interim dates
 Percentage Completion: Steps

1 Costs incurred to date = Percent complete

Most recent estimated total costs
2 Percent complete X Estimated total revenue =
Revenue to be recognized to date

3 Revenue to be recognized to date –

Revenue recognized in prior periods =
Current period revenue

4 Current Period Revenue – Current costs = Gross Profit

 ii. Completed-Contract Method
• Revenue and gross profit recognized on completion
of contract
• Advantage: reported revenue is based on actual
results, not estimates
• Disadvantage: does not reflect current performance;
creates distortion of earnings
• Construction in Progress used to accumulate contract
costs
• Progress billings are reported contra to ‘Construction
in Progress’ account on the Balance Sheet
 Exercise 1
Sun shin construction company is constructing abridge beginning from year
1.The contract price of The bridge is $900,000 with estimated construction
cost of $750,000.The bridge is expected to be completed in year 3 .The
construction cost incurred in each year and cost estimate to complete The
bridge at The end of each year is given below
Year 1 Year 2 Year3
Construction cost incurred $125,000 $495,000 $145,000
Estimated cost to complete 625,000 155.000 0
Other administrative exp. 50,000 25,000 15,000
Required: Calculate
1. The net income realized under Completed contract method for the three
years
2. The net income realized under percentage completion method for the three
years
 Exercise 2
Satcon Construction Company has entered in to a contract with Jimma
University to construct a building starting in January,2002 having a total
price of $5 million which is expected to be completed in Nov.2004 at a
total estimated cost of $4,500,000.Data relating to the construction of the
building is shown below:

2002 2003 2004

Costs incurred to date $1,200,000 $2,120,000 $4,580,000
Estimated cost to complete 3,300,000 1,250,000 __
Administrative expenses 65,000 73,000 84, 0000

Required: Calculate
1. The net income realized under Completed contract method for the three
years
2. The net income realized under percentage completion method for the
three years
 Unit 5: Introduction to cost and Managerial
Accounting
5.1 What is Management Accounting?
The followings are important characteristics of management
accounting
•It is a separate branch of accounting which provides
information for management decision
•It is futuristic in its approach
•Collection of accounting data for analysis and interpretation
is made according to the need of the management.
•It only gives useful information for decision making, it does
not take part in execution of decision.

02-11-2017 124
 5.2 Cost Concepts & Classifications
What is the difference between Price, Cost,
Expense and Loss?
 Price: is the amount at which goods or services are sold
Cost: refers to an outlay or expenditure of money to acquire
Fixed assets, goods and services. All costs initially
represent an asset
 Expense: is an expired cost or amount incurred in
generating revenue
 Loss: is cost incurred because of catastrophe or
unfavorable business condition

02-11-2017 125
 What is Cost Accounting?
• Cost accounting is an accounting
information system that records, measures
and reports information about cost.
• Cost accounting deals with accumulating
cost of manufacturing a product and other
functional processes and identifying these
costs with units produced or some other
cost object to enable the determination of
profit.
• Cost accounting can be applied in any
organization but the detail concept will be
applied in manufacturing organizations.
02-11-2017 126
 Classifications of Cost
Cost can be classified in different ways from
different points of view
1. Time period points of view
• Budgeted cost/future cost
• Historical/sunk cost
2. Management function points of view
• Manufacturing cost
• Marketing cost
• Administrative cost

02-11-2017 127
 3. From Cost Assignment points of view
• Direct cost
• Indirect cost
4.From GAAP Points of view
• Product cost/capitalized cost
• Periodic cost/non capitalized cost
5. Cost behavior point of view
• Fixed cost
• Mixed cost
• Variable cost

02-11-2017 128
 6. From decision making points of view
• Relevant cost
• Irrelevant cost
7. From controllability of cost points of view
• Controllable cost
• Uncontrollable cost
8. From commitment to expenditure point of
view
• Committed cost
• Programmable cost
9. Other cost classifications
• Opportunity cost
• Incremental cost
• Out of pocket cost
• Joint cost
02-11-2017
129
 Manufacturing cost
Types of inventories in manufacturing Companies
– Raw materail inventory
– Work in process inventory
– Finished goods inventory
The three main manufacturing cost are
1.Direct material cost
2.Direct labor cost
3.Manufacturing overhead cost

02-11-2017 130
 What is Manufacturing Overhead cost(MOH cost)?

MOH Cost Includes:

– Indirect materials, such as glue, nails, screws
– Indirect labor, such as supervisor’s salary and
Janitorial services.
– Tax on manufacturing facilities.
– Utilities for the manufacturing process.
– Depreciation on manufacturing facilities
– Repair and maintenance cost
– Plant Insurance
– Plant Rent
02-11-2017
131
5.3 Financial Statement for a Manufacturing
Organization
In order to prepare financial statements for manaufacturing
organizations, we have to go through the following
schedules which makes it more sophisticated than
merchandizing business:

Schedule1: Cost of Direct Material Used

Beginning direct material inventory XX
Add: Purchase in the period XX
Direct material available for use XX
Less: Ending direct material inventory (XX)
Cost of direct material used XX

02-11-2017 132
 Schedule 2: Cost of Goods Manufactured
Work in process at the beginning----------------------- XX
Add: Cost of direct material used -------------XX
Direct labor cost -------------------------- XX
Manufacturing over head cost -----------XX
Cost incurred in current period ----------------------- (XX)
Total cost incurred to date ------------------------------ XX
Less: Work in process ending ---------------------------XX
Cost of goods manufactured ----------------------------XX

02-11-2017 133
 Schedule 3: Cost of Goods Sold
Finished goods beginning --------------------- XX
Add: Cost of goods manufactured -----------XX
Cost of goods available for sale -------------- XX
Less: Finished goods ending ---------------- (XX)
Cost of Goods Sold ----------------------------- XX
Schedule 4: Income Statement
Revenues XX
Cost of goods sold XX
Gross profit XX
Operating expenses (XX)
Operating income XX
02-11-2017 134
 Exercise 3: Consider the following account balance for ABC
manufacturing company in the year 2014.
Beginning Balance End Balance
Direct material inventory $22,000 $26,000
WIP inventory 21,000 20,000
Finished goods inventory 18,000 23,000
Purchase of direct material 75,000
Direct labor cost 25,000
Indirect labor cost 15,000
Plant insurance 4,000
Insurance- administrative 5,000
Depreciation - plant building and equipment 9,000
Depreciation - administrative building 3,000
Repair and maintenance – factory equipment 4,000
Marketing, distribution and customer service cost 93,000
General and administrative cost 29,000

02-11-2017 135
 Required
1. Calculate cost of direct material used
2. Calculate cost of goods manufactured
3. Calculate cost of goods sold
4. Prime cost ( DM + DL)
5. Conversion cost ( DL + MOH)
6. If revenue for the year is $300, 000, calculate
operating income

02-11-2017 136
 5.4 Marginal Costing Vs Absorption Costing

Absorption/Full costing is a costing system

which treats all manufacturing costs
including both the fixed and variable MOH
costs as product costs
Direct material cost XX
Direct labor cost XX
Variable MOH Cost XX
Fixed MOH cost XX
Total Inventor able cost XX

02-11-2017
137
 ABSORPTION COSTING INCOME STATEMENT
SALES XXXX
LESS: COST OF GOODS SOLD:
BEG. FIN.GOODS INV. XXX
PLUS: COGM XXX
GOODS AVIABLE FOR SALE XXX
LESS: END. FIN. GOODS INV. (XXX)
COST OF GOODS SOLD ( XXX)
GROSS MARGIN(PROFIT) XXX
LESS:
SELLING EXPENSES (FIXED &VARIABLE) XXX
ADMINISTRATIVE EXPENSES (F&V) XXX (XXX)
NET INCOME BEFORE TAXES (NIBT) XXX
LESS: TAXES ( XXX)
NET INCOME AFTER TAXES (NIAT) XXX

02-11-2017 138
 Variable/Marginal costing
It is a costing system which treats only the
variable manufacturing costs as product costs.
The fixed manufacturing overheads are
regarded as periodic cost
Direct material cost XX
Direct labor cost XX
Variable MOH Cost XX
Total invent arable cost XX

02-11-2017
139
 VARIABLE COSTING INCOME STATEMENT
SALES XXXX
LESS: TOTAL VARIABLE COSTS:
VARIABLE MFG. COSTS XXX
VARIABLE SELLING COSTS XXX
VARIABLE ADMINISTRATIVE COSTS XXX (XXXX)
-------- -------
CONTRIBUTION MARGIN XXX
LESS: TOTAL FIXED COSTS:
FIXED MFG. COSTS XXX
FIXED SELLING COSTS XXX
FIXED ADMIN. COSTS XXX ( XXX)
----------- ---------
NET INCOME BEFORE TAXES XXX
LESS: TAXES ( XXX)
-----------
NET INCOME AFTER TAXES (NIAT) XXX

02-11-2017 140
 Exercise 4
ABC Company’s management wants to prepare
an income statement for the year 2008. The
operating information for the year are given
below:
Required: using absorption and marginal
costing
1. Compute the inventor able cost per unit
2. Prepare Income statement for the year 2008

02-11-2017 141
 Beginning inventory 0
Production 800 units
Sales 600units
Ending Inventory 200 units
Selling price Br.100
Variable manufacturing cost per unit:
 Direct material cost per unit 11
 Direct manuf. labor cost per unit 4
 Manufacturing overhead cost per unit 5
Total variable manufacturing cost per unit 20
Variable selling & Adm cost per unit 19
Total Fixed manufacturing Overhead cost 12,000
Total Fixed selling & Adm Expenses
02-11-2017 10,800 142
 5.5 Job order Vs. Process Costing

Job Order Cost System

 Costs are assigned to each job or batch.

 Key feature: Each job or batch has its own

distinguishing characteristics.

 Objective: Compute the cost per job.

 Measures costs for each job completed – not for set

time periods.

 Furniture companies, service firms and repair shops

are some examples that use job order costing
02-11-2017 143
 Process Costing System
 Used when a large volume of similar products are
manufactured – cement production, refining of
petroleum, production of ice cream.

 Costs are accumulated for a time period – (week or

month).

 Costs are assigned to departments or processes

for a specified period of time.

02-11-2017 144
 Nature of job order & Process Cost Systems

Illustration 17-3

02-11-2017 145
 Job order Vs. Process Costing Systems

02-11-2017 146
 5.6 Traditional Costing vs Activity-Based Costing

i. Traditional Costing Systems

 Allocates overhead using a single predetermined rate.

► Job order costing: direct labor cost may be the relevant
activity base.
► Process costing: machine hours may be the relevant
activity base.
 Assumption was satisfactory when direct labor was a major
portion of total manufacturing costs.
► Wide acceptance of a high correlation between direct labor
and overhead costs.

02-11-2017 147
 Traditional Costing and Activity-Based Costing

ii. Activity-Based Costing

 ABC allocates overhead costs in two stages:

Stage 1: Overhead costs are allocated to activity cost pools.

Stage 2: Assigns overhead allocated to the activity cost

pools to products, using cost drivers.

 The more complex a product’s manufacturing operation,

the more activities and cost drivers are likely to be
present.

02-11-2017 148
Over Head cost Allocation in Activity-Based
Costing

02-11-2017 149
 Exercise 5
Sino-Afro Optics produces two types of eyeglasses – standard
and deluxe. Operational data for 2013 is provided below
Items Standard Deluxe
Unit direct material cost 900.00 1,200.00
Unit direct labor cost 144.00 192.00
Unit direct labor hour 0.60 0.80
Estimated annual production units 70,000.00 10,000.00
The company has a traditional costing system in which
manufacturing overhead is applied to units based on direct
labor-hours. Data concerning manufacturing overhead and
direct labor-hours for 2013 appear below:
Estimated total manufacturing overhead 2,900,000
Estimated total direct labor hours 5,000

02-11-2017 150
Required:
1. Determine unit product costs of the Standard and Deluxe
products under the company’s traditional costing system.
2. The company is considering replacing its traditional costing
system with an activity-based costing system. Below is data
relevant to the activity-based costing system which has three
activity cost pools:

Estimated Expected activity

Activity and activity measures
overhead cost Standard Deluxe Total
Supporting direct labor (direct labor hrs) Br.1,500,000 4,200 800 5,000
Batch setups (setups) 600,000 50 200 250
Safety testing (tests) 800,000 20 80 100
Total manufacturing overhead cost Br.2,900,000
Determine unit product costs of Deluxe and Standard under
the activity-based costing system.
02-11-2017 151
 Unit 6: Cost – Volume – Profit (CVP)
Analysis
6.1 What is CVP analysis?
Cost-Volume-Profit is the manner of evaluating the
total revenues, the total costs and operating profit,
as changes occur in volume of production, sales
price, unit variable cost and fixed costs of a product.
CVP Assumptions:
1. All costs can be analysed into their fixed and variable elements.
2 . Fixed costs remain fixed even over a wide range of activity.
3. Variable costs always vary directly with activity.
4. Selling prices & variable costs are constant per unit.
5 . Only levels of activity affect costs and revenues
02-11-
2017 6. Only one product can be effectively dealt with
152
 The importance of CVP
• Managers use this analysis to answer different
questions like
• How will incomes and costs be affected if we still
sell 1.000 units? But if you expand or reduce selling
prices? If we expand our business in foreign markets ?
• The cost-volume-profit is a necessary tool for
forecasting and management control.
• We use the following abbreviations in CVP analysis
SP Unit selling price
VC Unit variable cost
CM Unit Contribution Margin
FC Total Fixed cost
Q Quantity of out put
TOI Target Operating Income
NI Net Income
02-11-2017 t Tax rate 153
 6.2 Applications of CVP Analysis
1. Break-Even Analysis : Break even point (BEP) is
the level of sales at which profit is zero. I.e total
revenue= total cost. According to this definition,
at break even point sales are equal to fixed cost
plus variable cost . Formula to calculate BEP can
be derived from the following equation.
[Break even sales = fixed cost + variable cost]
TR-TC = Profit TR-TC=0
Where: Q= output and SP=price
if: (Q*SP)-FC-(Q*VC)=0
(Q*SP)-(Q*VC)-FC=0
Q(SP-VC)=FC
FC
Q 
02-11-2017 SP  VC 154
02-11-2017 155
 2. Target Operating Income
How many units of product X should be produced
and sold to reach a target operating income of TOI.
The following formula will be used to calculate
quantity produced to attain target operating
income of TOI.

FC  TOI
Q
SP  VC
02-11-2017 156
 3. Net income after tax

Quantity for target net income after tax (NI)

will be calculated using the following formula
NI
FC 
Q 1  t
SP  VC

02-11-2017 157
 4. Sensitivity Analysis
• Sensitivity analysis is a “what if” technique that
managers use to examine how a result will change if the
original predicted data are not achieved or if an underlying
assumption changes.
• In the context of CVP analysis, sensitivity
analysis answers the following questions:
– What will be the operating income if units sold
decrease by 15% from original prediction?
– What will be the operating income if variable
cost per unit increases by 20%?

02-11-2017 158
 5. Safety Margin:
 is the difference between budgeted
sales revenue and break-even sales
revenue. The amount by which sales can
drop before losses begin to be incurred.
Margin of Safety = Actual/budgeted Sales - Breakeven Sales

02-11-2017 159
 Exercise 6
ABC Company is a retailer of office soft ware packages .ABC
sells each office soft ware package at $200 to customers. ABC
purchases each packages for $120 from a whole seller .In
addition a fixed cost of $2000 will be incurred with in a
relevant range of 0- 120 soft ware packages bought and sold
Requirements (solved independently)
a. What is the break-even point in quantity and in dollar
amount?
b. Show the break-even point using break-even chart
c. How money units must be sold to earn target operating
income of $1200. What is the dollar value of unit sold?
d. Calculate the margin of safety in quantity and in dollar
considering requirement “b” & “ c” above
e. What quantity of soft ware package should be sold to earn a
net income of $960 assuming an income tax rate of 40%
02-11-2017 160
 f) Assume that currently ABC Company is selling 50 units
of office software package; ABC is considering placing an
advertisement that will increase sales by 10%. Additional
fixed cost of $500 will be incurred because of the
advertisement. Should ABC advertise or not? Why? or
why not?
g) Assume that currently ABC Company is selling 50 units
of office soft ware package. ABC is contemplating
whether to reduce the selling price to $185. At this price,
it will sell 60 unites. At this quantity the soft ware whole
seller who supplies the office soft ware will sell the
package to ABC for $115 per unit instead of $120.Should
ABC reduce the selling price or not? Why? Or why not?
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 Unit 7: Alternative Choice Decisions
7.1 Steps in Decision Making?
Decision making is the process of choosing the best course of
action from alternatives available for a given problem. Decision
process involves several steps. These steps include:
1. Recognize and define the problem
2. Identify alternative solution to the problem
3. Identify the cost and benefits of each alternatives
4. Evaluate each alternatives solution from there cost and
benefit point of view
5. Assess qualitative factors related to each solution.
6. Select the alternatives with the greatest benefit
7. Implement the alternatives selected
8. Follow up

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 Relevant and Irrelevant Information
The cost or
Is the item a future No
benefit is not
cost or benefit?
a relevant item.
Yes

Does the cost or

The cost or
benefit differ No
benefit is not
from decision
a relevant item.
alternatives?
Yes

The cost or benefit

is a relevant item.
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 Decision Problems
The followings are some of the non routine decision
making problems which managers will encounter:
1. One time only special order
2. Make or buy (in sourcing or outsourcing)
3. Eliminate or keep an Unprofitable Segment
4. Sell at split off or process further decision
5. Pricing decision
6. Carrying cost of inventory
7. Equipment replacement decision
8. Product mix under capacity constraint

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 7.2 One-Time-Only Special Orders
Accepting or rejecting special orders when
there is idle production capacity and the
special orders has no long-run implications
Decision Rule: does the special order generate
additional operating income?
– Yes – accept
– No – reject
Compares relevant revenues and relevant
costs to determine profitability

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 Exercise 7

Sunbelt Company produces 100,000 Smoothie blenders per month,

which is 80% of plant capacity. Variable manufacturing costs are $8 per
unit. Fixed manufacturing costs are $400,000, or $4 per unit. The
blenders are normally sold directly to retailers at $20 each. Sunbelt has
an offer from Kensington Co. (a foreign wholesaler) to purchase an
additional 2,000 blenders at $11 per unit. Acceptance of the offer would
not affect normal sales of the product, and the additional units can be
manufactured without increasing plant capacity. What should
management do?

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 7.3 Make or Buy Decision

Baron Company incurs the following annual costs in producing

25,000 ignition switches for motor scooters.

Instead of making its own switches, Baron Company might

purchase the ignition switches at a price of $8 per unit. “What do
you advice Baron Company?”
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 Cont’d -----
1. Assume that through buying the switches,
Baron Company can use the released productive
capacity to generate additional income of
$38,000 from producing a different product.
Should the management make or Buy switches?

2. Assume that through buying the switches,

Baron can rent the idle capacity for $ 12,000.
Should the management make or Buy switches?

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 7.4 Sell or Process Further Decision
Exercise 8: Woodmasters Inc. makes tables. The cost to
manufacture an unfinished table is $35. The selling price per
unfinished unit is $50. Woodmasters has unused capacity that can
be used to finish the tables and sell them at $60 per unit. For a
finished table, direct materials will increase $2 and direct labor costs
will increase $4. Variable manufacturing overhead costs will increase
by $2.40 (60% of direct labor). No increase is anticipated in fixed
manufacturing overhead. Should Woodmasters process further?

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7.5 Eliminate or keep an Unprofitable Segment

Exercise 9: Venus Company manufactures three models of tennis

rackets:
 Profitable lines: Pro and Master
 Unprofitable line: Champ Should Champ
be eliminated?
Illustration 21-16

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 7.6 Pricing Decision

The price of a good or service is affected by many factors.

 Company must have a good understanding of market forces.

 Where products are not easily differentiated from competitor

goods, prices are not set by the company, but rather by the
laws of supply and demand – such companies are called price
takers.

 Where products are unique or clearly distinguishable from

competitor goods, prices are set by the company.
 Target Costing

 Laws of supply and demand significantly affect product price.

 To earn a profit, companies must focus on controlling costs.

 Requires setting a target cost that will provide the company’s

desired profit.

 Target cost: Cost that provides the desired profit when the
market determines a product’s price.

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 Target Costing
 First, company should identify its market niche where it wants to
compete.
 Second, company conducts market research to determine the
target price – the price the company believes will place it in the
optimal position for the target consumers.
 Third, company determines its target cost by setting a desired
profit.
 Last, company assembles a team to develop a product to meet
the company’s goals.

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Cost-Plus Pricing

 In an environment with little or no competition, a company

may have to set its own price.

 When a company sets price, the price is normally a function of

product cost: cost-plus pricing.

 Approach requires establishing a cost base and adding a

markup to determine a target selling price.

 In determining the proper markup, a company must consider

competitive and market conditions.

 Size of the markup (the “plus”) depends on the desired return

on investment for the product:
 Cost-Plus Pricing

Exercise 10: Thinkmore Products, Inc. is in the process of setting a

selling price on its new video camera pen. It is a functioning pen that
will record up to 2 hours of audio and video. The per unit variable
cost estimates for the new video camera pen are as follows.

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 Cost-Plus Pricing

In addition, Thinkmore has the following fixed costs per unit at a budgeted
sales volume of 10,000 units. If Thinkmore is planning to use 30% markup on
Cost, what will be the selling price under each of the following alternative
conditions

1. Total cost is used as a base

2. Variable cost is used as a base

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Unit 8: Budgetary Planning and Control

8.1 Fundamentals of Budgeting

A Budget is a formal written statement of management’s

plans for a specified future time period, expressed in
financial terms.
 Primary way to communicate agreed-upon objectives
to all parts of the company.
 Promotes efficiency.
 Control device - important basis for performance
evaluation once adopted.
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 Length of Budgeting
• Strategic plan is a plan that sets the overall goals
and objectives of the organization
• Long-range planning produces forecasted financial
statements for 5- or 10-year periods. Long-range
planning are coordinated with capital budgets
• Capital budget is a budget that details the planned
expenditures for facilities, equipment, new
products, and other long - term investments
• The master budget is an annual business plan that
includes a coordinated set of detailed operating
schedules and financial statements .
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 8.2 Operating and Financial Budget
The two major parts of a master budget are the operating budget and
the financial budget.

Operating budget (profit plan)

A major part of a master budget that focuses on the
income statement and its supporting schedules.

Financial budget

The part of a master budget that focuses on the effects that

the operating budgets and other plans (such as capital
budgets) will have on cash.
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 Sales Budget

Ending inventory Purchases Budget

Budget

Cost- of- Goods - Sold Budget

Operating Budget
Operating Expenses Budget

Budgeted Statement
Of income

Capital Cash Budgeted

Financial Budget
Budgets Budget Balance
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Benefits of Budgeting

 Requires all levels of management to plan ahead.

 Provides definite objectives for evaluating performance.

 Creates an early warning system for potential problems.

 Facilitates coordination of activities within the business.

 Results in greater management awareness of the entity’s

overall operations.

 Motivates personnel throughout organization to meet

planned objectives.

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 Exercise 11
On January 1, 2014, Hardin Company budget
committee has reached agreement on the
following data for the 6 months ending June 30,
2014.
– Sales : First quarter 5,000; second quarter 6,000; third
quarter 7,000.
– The selling price in the three quarters is $30 per unit
– Ending raw materials inventory: 40% of the next
quarter’s production requirements.
– Ending finished goods inventory: 25% of the next
quarter’s expected sales units.
– Third-quarter production: 7,200 units.

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 • The ending raw materials and finished goods
inventories at December 31, 2013, follow the same
percentage relationships to production and sales that
occur in 2014.
• Three pounds of raw materials are required to make
each unit of finished goods. Raw materials purchased
are expected to cost $4 per pound
• 2 hours of direct labor hours are required to produce
each unit at the rate of $3 per hour
Instructions: Prepare the following budgets for Hardin Company by
quarters for the 6-month period ended June 30, 2014.
a) Sales budget
b) Production budget
c) Raw material usage budget
d) Raw material purchase budget
e) Direct labor budget

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 Budgeting Techniques
• Zero Base Budgeting
• Incremental Budgeting
• Line Item Budgeting
• Program Budgeting
• Rolling Budgeting

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 8.3 Static Budget & Flexible Budget

Budgetary control involves the following activities.

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 Static Budget

Static budget is a projection of budget data at the

beginning level of activity.

 When used in budgetary control, each budget

included in the master budget is considered to be
static.

 Ignores data for different levels of activity.

 Compares actual results with budget data at the

activity level used in the master budget.
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 Flexible Budgets

Flexible budget projects budget data for various levels of

activity.

 Budgetary process is more useful if it is

adaptable to changes in operating
conditions.

 Essentially a series of static budgets at

different activity levels.

 Can be prepared for each type of budget in

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 8.4 Flexible Budget and sales volume variance
• The difference between static budget and actual
performance is called static budget variance
• There are basically two reasons why actual
results might differ from the master budget
– Sales and other cost-driver activities were not the
same as originally forecasted (sales volume
variance).
– Revenue or variable costs per unit of activity and
fixed costs per period were not as expected (
Flexible budget variance)

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 Static-budget
variance

Flexible-budget Sales-volume
variance variance
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 8.5 Cost Variances
In order to find out the real cause of a
variance, further variance analysis should be
made. The followings are the different levels
of variance analysis that can be made.
Level 0 variance analysis
Level 1 variance analysis
Level 2 variance analysis
Level 3 variance analysis
Level 4 variance analysis
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 Exercise 12
XYZ Company manufactures and sells jackets to
retailers. The company has three variable costs
and one fixed cost. There are no other
operating expenses. The followings are the
budgeted and actual data for XYZ Company for
the year ended 2015
Budget Actual
Units sold 12,000 units 10,000units
Selling price $120 $125
DM cost per unit 60 62.16
DL cost per unit 16 19.8
VMOH cost 12 13.05
FMOH cost $276,000 $285,000

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There is no beginning or ending inventories and the
relevant rang in which fixed cost remains constant
is from 0-12,000 units
Requirements:
1. Prepare budgeted income statement for 2005
2. Prepare actual income statement for 2005
3. Make level 0 variance analysis
4. Make level 1 variance
5. prepare the flexible budget at the end of 2005
6. Make level 2 variance analysis

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8.6 Standard Costing
A standard is a norm against which the actual
performance can be measured.
– Ideal standard – a standard that a company
sets in which they meet their maximum degree
of efficiency. Does not take inefficient
conditions & wastages into consideration.
– Attainable standard – includes factors such as
lost time and normal wastes and spoilages.

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 Determining Standards
• Materials cost standard
– Material Quantity standard is determined based on the
production or engineering department’s estimate of
the amounts and types of materials needed for
production of one unit of a product.
– Material price standard is based on the purchasing
agent’s knowledge of suppliers’ prices for one unit of
direct material.
• Labor cost standard
– Labor time standard is the time necessary to perform
one unit of a product established by experts under
normal condition.
– Labor rate standard :Human resource department will
provide the prevailing wage rates in the mkt.

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Determining Variances
• A variance is the difference between the actual
and the standard costs of materials, labor, and
overhead.
• The differences may be in usage and in prices.
• Therefore, the are four types of variance for
direct material and direct labor
– Materials price variance
– Materials quantity variance
– Labor rate variance
– Labor efficiency variance
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 Materials and labor Variances
• DM Price or DL Rate Variances

• DM Quantity or DL Efficiency Variance

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Exercise 13
Assume XYZ Company that produces Male’s jacket in illustration 11 above and has
made the following standards for direct costs
Direct material
• Standard direct material for one Jacket---------- 2 squar yard
• Standard price per square yard of direct material------ $30
Direct labor
• Standard direct labor per Jacket----------------------- 0.8 hour
• Standard rate per hour ---------------------------------- $20
Actual result for each direct cost category for the 10,000 Jacket manufactured and sold
in 2015 are:
Direct material purchased and used
• inputs purchased and used ------------ 22,200 square Yard
• Actual price incurred per square yard -------------- $28
Direct manufacturing labor
• Direct manufacturing labor hours used ----------- 9000 hours
• Actual price incurred per labor hour ---------------- $22

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Required:
a) compute the flexible budget variance for direct
material
b) compute the flexible budget variance for direct
labor
c) compute the price and efficiency variance for
direct material cost and compare their sum with
the flexible budget variance you obtained in “a”
d) compute the price and efficiency variance for
direct labor cost and compare their sum with
the flexible budget variance you obtained in “b”
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 8.7 Causes of variances
Causes of Direct material variance
• Raw material price fluctuations
• Poor planning resulting in emergency purchase
• loss of discount
• high transportation cost
• failure to take advantage of seasonal purchase
• uneconomical size of order
• Poor quality material resulting in more wastage
• Careless in handling of material in stores and on
shop floor

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 Causes of Labor Variances

1. Revision in pay scale

2. Industrial unrest
3. Overtime working
4. Use of incorrect grade of workers
5. Use of trainees in place of regular workers
6. Poor planning and scheduling
7. Poor supervision
8. Poor maintenance of machines
9. Poor quality of material
10. Increase in labor turnover

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 Chapter 9 : Managerial Accounting Today

Just-In-Time Inventory Methods

 Inventory system in which goods are manufactured or
purchased just in time for sale.

Total Quality Management (TQM)

 Reduce defects in finished products progressively with
the goal of zero defects in the long run.

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Balanced Scorecard
• The Balanced Scorecard is a strategic-based performance
measurement system that typically identifies objectives
and measures for four different perspectives
• In the early 1990s, Robert Kaplan and David Norton
introduced the balanced Scorecard
• Adopted by many companies in the 90’s
• More popular in Europe
• Popular with Government organizations
• Widely used in Education

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 The Balanced Scorecard perspectives

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 Managerial Accounting Today

Focus on the Value Chain

Refers to all business process associated with providing a
product or service.
For a manufacturing firm these include the following:

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LO 8 Identify trends in managerial accounting.
 What Does Kaizen Mean?

KAI + ZEN
To modify, to change Think, make good, make better

= KAIZEN
Make it easier by studying it, and making the improvement
through elimination of waste.

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 5s of Kaizen

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