INTERMEDIATE GROUP - II PAPER 8 COST ANDDDDDDDDD D MANAGEMENT ACCOUNTING The Institute of Cost Accountants of India 12, SUDDER STREET, KOLKATA - 700 016 Repro India Limited Plot No. 50/2, T.T.C. MIDC Industrial Area, Mahape, Navi Mumbai 400 709, India. Website: www.reproindialtd.com CONTENTS Page No. Study Note 1 Financial Accounting, Cost Accounting and Management Accounting 1 - 22 Study Note 2 Material Control 23-48 Study Note 3 Labor Cost Computation and Control 49-88 Study Note 4 Overheads 89-118 Study Note 5 Methods of Costing-Job Batch and Contract Costing 119-146 Study Note 6 Process Costing 147-180 Study Note 7 Joint Product and By-products 181-196 Study Note 8 Inter-Locking Accounts Cost Control Accounts 197-210 Study Note 9 Integrated Accounting System 211-230 Page No. Study Note 10 Reconciliation of cost and fi nancial Accounts 231-246 Study Note 11 Operating Costing 247-258 Study Note 12 Marginal Costing and Break even Analysis 259-304 Study Note 13 Budgets and Budgetary Control 305-348 Study Note 14 Standard Costing 349-396 Study Note 15 Uniform Costing and Inter Firm Comparison 397-406 Study Note 16 Activity Based Costing 407-416 Study Note 17 Transfer Pricing 417-428 Sets of Objective Questions Cost and Management Accounting 429-440 Appendix One - Formulae 441-447 Financial STUDY NOTE 1 Accounting, Cost Accounting and Management Accounting Learning Objectives After studying this topic, you should be able to, 1. Understand the concept of Financial Accounting, Cost Accounting and Management Accounting. 2. Understand role of Financial Accounting, Cost Accounting and Management Accounting. 3. Understand the various concepts in the three types of Accounting Systems. 4. Understand the difference between the three systems of Accounting. Financial Accounting, Cost Accounting and Management Accounting 1.1 Introduction Accounting is a very old science which aims at keeping records of various transactions. The accounting is considered to be essential for keeping records of all receipts and payments as well as that of the income and expenditures. Accounting can be broadly divided into three categories. Financial Accounting, aims at fi nding out profi t or losses of an accounting year as well as the assets and liabilities position, by recording various transactions in a systematic manner. Cost Accounting helps the business to ascertain the cost of production/services offered by the organization and also provides valuable information for taking various decisions and also for cost control and cost reduction. Management Accounting helps the management to conduct the business in a more effi cient manner. The scope of management accounting is broader than that of cost accounting. In other words, it can be said that the management accounting can be considered as an extension of cost accounting. Management Accounting utilises the principles and practices of fi nancial accounting and cost accounting in addition to other modern management techniques for effi cient operation of a company. The main thrust in management accounting is towards determining policy and formulating plans to achieve desired objectives of management. Management Accounting makes corporate planning and strategies effective and meaningful. In the present chapter all these concepts are discussed in detail in order to make the concepts more clear. 1.2 Financial Accounting Financial Accounting aims at fi nding the results of an accounting year in terms of profi ts or losses and assets and liabilities. In order to do this, it is essential to record various transactions in a systematic manner. Financial Accounting is defi ned as, ‘Art and science of classifying, analyzing and recording business transactions in a systematic manner in order to prepare a summary at the end of the year to fi nd out the results of the concerned accounting year.’ The defi nition given above is self explanatory, however for understanding clearly, the following terms are explained below. A Business transactions :- A transaction means an activity, a business transaction means any activity which creates some kind of legal relationship. For example, purchase and sale of goods, appointing an employee and paying his salary, payment of various expenses, purchase of assets etc. B Classifi cation of transactions :- Before recording any transaction, it is essential that it is to be classifi ed. A transaction can be classifi ed as cash transaction and credit transaction. Similarly transactions of receiving income and payment of expenditure can be segregated. Even in case of expenditure, transactions involving revenue expenditure and capital expenditure can be segregated. C Recording of transactions :- The essence of fi nancial accounting is recording of transaction. In accounting language, recording of the transaction is known as entry. There are well defi ned rules for recording various transactions in books of accounts. As per the rules of fi nancial accounting, each and every transaction is recorded at two places and hence it is called as ‘Double Entry’ system of accounting. 2 Cost and Management Accounting D Summary of transactions :- After recording all transactions, it is essential to prepare a summary of them so as to draw meaningful conclusions. The summary will help in fi nding out the Profi t/Loss of a particular year and also ascertaining Assets and Liabilities on a particular date. In fact, the very purpose of fi nancial accounting is to know the results of a particular year. From this angle, the process of preparing the summary is extremely important. 1.2.1 Concepts and conventions of Financial Accounting :- There are some well defi ned concepts and conventions of fi nancial accounting system. Concepts can also be termed as ‘principles’ while conventions are those which have been followed over a period of time and are accepted as norms to be followed in fi nancial accounting systems. The concepts and conventions of fi nancial accounting are explained in the following paragraphs. 1.2.2 Concepts of Financial Accounting:- The following are the concepts of fi nancial accounting. A. Separate Entity :- This concept implies that the businessman is different from business. Thus if X starts his business known as X and Sons, X as a person shall be different from his fi rm, i.e. X and Sons. Actually in Law, separate entity concept is recognized only in the case of joint stock companies registered under Companies Act, 1956. In case of partnerships and sole proprietorship business, separate entity concept is not recognized under Law. However in accounting, separate entity concept is recognized and the accounting entries are passed in the books of the business and not in the books of the proprietor as such. Thus when X starts his business and invests his own money as capital, it is shown as liability in the Balance Sheet of the business. On the other hand, if the proprietor incurs any private expenditure from the resources of the business, it is shown as recoverable in the books of accounts of the business. Thus the principle of separate entity is applied in practice. B. Double Entry :- This principle can be called as ‘Heart’ of the entire accounting mechanism. Double entry means a transaction is recorded at two places in the books of accounts, the reason being that any transaction has two fold effects and hence it is to be recorded at two places. The following example will clarify the point. 1. If goods are purchased for cash, the cash goes out and goods come in. Thus one effect is the cash going out and the second effect is that goods come in. 2. When goods are sold for cash, the fi rst effect is that the cash comes in and the second one is that the goods are going out. 3. In case of credit transactions like purchase of goods, one effect is that goods come in and the person from whom the goods are purchased becomes the creditor of the business. Thus in double entry system, each and every transaction has the two fold effects. There is another system of recording the transactions, which is known as single entry system. In single entry system, every transaction is recorded only once and hence no double effect is given. There are very few organizations where single entry system is still implemented. However the double entry system is now being accepted everywhere. C. Money Measurement Concept :- Another important concept of fi nancial accounting is the money measurement concept. This concept means that only the transactions which are capable of being expressed in monetary terms will be recorded in the books of accounts. In other words, transactions which cannot be expressed in monetary terms cannot be recorded 3 Financial Accounting, Cost Accounting and Management Accounting in the books of accounts. For example, in books of accounts monetary value of assets or goods will be recorded and not the quantity of the same. Furniture will not be recorded as 1 table or 12 chairs or 100 cupboards, but the values of the same in monetary terms will be recorded. This principle means that items like Human Resources will not be recorded in the books of accounts as they cannot be converted into monetary terms. This principle is important as it brings uniformity in recording transactions in the books of accounts. D. Going Concern Concept :- As per Glossary of terms, International Accounting Standards, 1999, the defi nition of ‘Going Concern’ is as follows ‘That enterprise is normally viewed as a going concern, that is as continuing in operation for the foreseeable future. It is assumed that the enterprise has neither the intention nor the necessity of liquidation or curtailing materially the scale of its operations.’ The implications of this concept is that the fi nancial statements, fi xed assets are shown at the cost of acquisition less depreciation accumulated up to the date of closure. The reason is that it is assumed that the enterprise is going to continue for a long period of time and there is no intention to close it down in the near future. Therefore the market values of the same are not relevant at all, the cost prices are relevant and hence the assets should be shown at the cost value. E. Matching Concept :- Matching of costs and revenues concept is explained below in the International Accounting Standards ‘Expenses are recognized in the income statement on the basis of a direct association between the costs incurred and the earnings of specifi c items of income. This process involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same association or other events. However, the application of the matching concept does not allow the recognition of items in the Balance Sheet which do not meet the defi nition of assets or liabilities.’ In other words, matching concept means that it is necessary to periodically match the costs and revenues in order to fi nd out the results of a particular period. This period is called as accounting year. For any business it is essential to fi nd out the profi t or loss after periodic intervals. Actually, real profi t or loss can be found out only after the business is closed down. But in the earlier concept we have seen that any business organization is a going concern and not likely to shut down in the near future. Therefore it is necessary to match the revenue and expenditure on periodic basis. This period is normally for one year and is called as accounting year. In case of limited companies established under the Companies Act, 1956, fi rst accounting year in case of a company can be of 18 months but subsequent accounting years must be of 12 months duration. A business organization is free to choose the accounting year, i.e. a calendar year can be adopted as accounting year or fi nancial year starting from 1st April to 31st March can be an accounting year. The assessment year for income tax purpose is always from 1st April to 31st March and hence many organizations adopt this period as accounting year. 1.2.3 Accounting Cycle : It is essential to describe the accounting cycle in brief. The cycle commences with the happening of a transaction and ends with the preparation of fi nal accounts, i.e. Profi t and Loss Account and Balance Sheet. The following chart will show the accounting cycle. 4 Cost and Management Accounting Transaction | Entry | Books of Prime Entry – Journal and Subsidiary Books | Posting in Ledger – Book of Secondary Entry | Trial Balance | Final Accounts – Profi t and Loss Account and Balance Sheet As mentioned above, the accounting cycle starts with a transaction. As soon as a transaction takes place, it is recorded in the books of Prime Entry, i.e. either Journal or subsidiary books. After recording the same in these books, the transaction is posted in the ledger which is called as book of secondary entry. All ledger accounts are closed and a list of the same is prepared which is called as ‘Trial Balance’. From the trial balance, fi nal accounts, Profi t and Loss Account and Balance Sheet are prepared. 1.2.4 Utility of Financial Accounting : The utility of fi nancial accounting can be explained in the following manner. A. Financial Accounting provides well defi ned rules and principles of recording business transactions. This provides uniformity in recording the transactions and thus results of various organizations become comparable. B. For any organization, whether it is profi t making or non-profi t making, it is essential to fi nd out the results of a particular accounting period, i.e. accounting year. Financial accounting mechanism enables them to prepare Profi t and Loss Account and Balance Sheet at the end of the fi nancial year. C. Financial Accounting helps the taxation authorities for determining the tax liability in a fair manner. Income Tax is levied on the profi ts and fi nancial accounting helps to disclose true and fair view of the business as regards to profi ts. Thus the assessment of tax liability becomes rational and free from any controversies. D. Financial Accounting is also helpful for the investors who are interested in fi nding out the profi tability of the business in which they want to invest the money. Financial accounting information helps in ascertaining profi tability so that decision-making is easier. E. In the course of the business, a fi rm has to borrow money for various objectives such as expansion, diversifi cation, modernization and so on. The lenders have to ensure that the money lent by them will be repaid back. For this, they study fi nancial statements viz. Profi t and Loss Account and Balance Sheet to ascertain the fi nancial condition of the business. Thus the fi nancial accounting helps them in decision-making regarding granting of loan. 5 Financial Accounting, Cost Accounting and Management Accounting F. Financial accounting also provides useful information for the purpose of valuation of business during merger and acquisition process. 1.3 Cost Accounting As compared to the fi nancial accounting, the focus of cost accounting is different. In the modern days of cut throat competition, any business organization has to pay attention towards their cost of production. Computation of cost on scientifi c basis and thereafter cost control and cost reduction has become of paramount importance. Hence it has become essential to study the basic principles and concepts of cost accounting. These are discussed in the subsequent paragraphs. 1.3.1 Cost :- Cost can be defi ned as the expenditure (actual or notional) incurred on or attributable to a given thing. It can also be described as the resources that have been sacrifi ced or must be sacrifi ced to attain a particular objective. In other words, cost is the amount of resources used for something which must be measured in terms of money. For example – Cost of preparing one cup of tea is the amount incurred on the elements like material, labor and other expenses, similarly cost of offering any services like banking is the amount of expenditure for offering that service. Thus cost of production or cost of service can be calculated by ascertaining the resources used for the production or services. 1.3.2 Costing :- Costing may be defi ned as ‘the technique and process of ascertaining costs’. According to Wheldon, ‘Costing is classifying, recording, allocation and appropriation of expenses for the determination of cost of products or services and for the presentation of suitably arranged data for the purpose of control and guidance of management. It includes the ascertainment of every order, job, contract, process, service units as may be appropriate. It deals with the cost of production, selling and distribution. If we analyze the above defi nitions, it will be understood that costing is basically the procedure of ascertaining the costs. As mentioned above, for any business organization, ascertaining of costs is must and for this purpose a scientifi c procedure should be followed. ‘Costing’ is precisely this procedure which helps them to fi nd out the costs of products or services. 1.3.3 Cost Accounting :- Cost Accounting primarily deals with collection, analysis of relevant of cost data for interpretation and presentation for various problems of management. Cost accounting accounts for the cost of products, service or an operation. It is defi ned as, ‘the establishment of budgets, standard costs and actual costs of operations, processes, activities or products and the analysis of variances, profi tability or the social use of funds’. 1.3.4 Cost Accountancy :- Cost Accountancy is a broader term and is defi ned as, ‘the application of costing and cost accounting principles, methods and techniques to the science and art and practice of cost control and the ascertainment of profi tability as well as presentation of information for the purpose of managerial decision making.’ If we analyze the above defi nition, the following points will emerge, A. Cost accounting is basically application of the costing and cost accounting principles. B. This application is with specifi c purpose and that is for the purpose of cost control, ascertainment of profi tability and also for presentation of information to facilitate decision making. 6