Question

select 2 techniques /concepts examining the relationship between the selected techniques /concepts and strategic allocation of financial resources with respect to revenue and expenses

Answer 1

TWO CONCEPTS

1) Accounting cost concept

Accounting cost concept states that all assets are recorded in the books of accounts at their purchase price, which includes cost of acquisition, transportation and installation and not at its market price. It means that fixed assets like building, plant and machinery, furniture, etc are recorded in the books of accounts at a price paid for them. For example, a machine was purchased by XYZ Limited for Rs.500000, for manufacturing shoes. An amount of Rs.1,000 were spent on transporting the machine to the factory site. In addition, Rs.2000 were spent on its installation. The total amount at which the machine will be recorded in the books of accounts would be the sum of all these items i.e. Rs.503000. This cost is also known as historical cost. Suppose the market price of the same is now Rs 90000 it will not be shown at this value. Further, it may be clarified that cost means original or acquisition cost only for new assets and for the used ones, cost means original cost less depreciation. The cost concept is also known as historical cost concept. The effect of cost concept is that if the business entity does not pay anything for acquiring an asset this item would not appear in the books of accounts. Thus, goodwill appears in the accounts only if the entity has purchased this intangible asset for a price.

Significance

* This concept requires asset to be shown at the price it has been acquired, which can be verified from the supporting documents.

* It helps in calculating depreciation on fixed assets.

*The effect of cost concept is that if the business entity does not pay anything for an asset, this item will not be shown in the books of accounts.

The cost concept of accounting states that all acquisition of items (such as assets or things needed for expending) should be recorded and retained in books at cost. Thus, if a balance sheet shows an asset at a certain value it should be assumed that this is its cost unless it is categorically stated otherwise. Under cost concept of accounting, an asset should be recorded on its cost in which it was purchased regardless of its market value e.g. If a building is purchased for $5,00,000, it will continue to appear in the books at that figure irrespective of its market value. Under this concept stability in prices of assets while recording is achieved. There are also some limitations of this concept e.g. in case of inflation there will be an overstatement of net profit etc. Above all its limitations this concept is considered to be the best one when compared with alternatives. The cost of an item may well be different from its true value but since ascertainment of true value would be judgmental and therefore subjective, stating assets at historical cost is generally accepted as fairway of maintaining records.Following the cost concept means that unless there are special reasons for doing otherwise cost of an item should be assumed to be its true value and that all accounting entries should be made at cost.

Example

For example, a business buys a building worth $1,00,000 in cash. In the accounting records, the value of the building will be entered at its cost price, i.e. $1,00,000. After four years, the value of the building goes up to $5,00,000. However, the accounting records would continue to show the value of the building at the cost price of $1,00,000 less depreciation.Historical cost is verifiable. It represents the cost that was objectively agreed upon the buyer and the seller. Hence the basic objective of the cost concept is the measurement of accurate and reliable profits and losses for a business over a period of time. However, some accountants have argued that in today’s inflationary environment, the gaining popularity, as is evidenced by many large companies, who now prepare supplementary information after taking into account the changes in the purchasing power. Nevertheless, historical cost continues to be used for the preparation of the primary financial statements.

2) ACCRUAL CONCEPT

The meaning of accrual is something that becomes due especially an amount of money that is yet to be paid or received at the end of the accounting period. It means that revenues are recognised when they become receivable. Though cash is received or not received and the expenses are recognised when they become payable though cash is paid or not paid. Both transactions will be recorded in the accounting period to which they relate. Therefore, the accrual concept makes a distinction between the accrual receipt of cash and the right to receive cash as regards revenue and actual payment of cash and obligation to pay cash as regards expenses. The accrual concept under accounting assumes that revenue is realised at the time of sale of goods or services irrespective of the fact when the cash is received. For example, a firm sells goods for Rs 55000 on 25th March 2005 and the payment is not received until 10th April 2005, the amount is due and payable to the firm on the date of sale i.e. 25th March 2005. It must be included in the revenue for the year ending 31st March 2005. Similarly, expenses are recognised at the time services provided, irrespective of the fact when actual payment for these services are made. For example, if the firm received goods costing Rs.20000 on 29th March 2005 but the payment is made on 2nd April 2005 the accrual concept requires that expenses must be recorded for the year ending 31st March 2005 although no payment has been made until 31st March 2005 though the service has been received and the person to whom the payment should have been made is shown as creditor. In brief, accrual concept requires that revenue is recognised when realised and expenses are recognised when they become due and payable without regard to the time of cash receipt or cash payment.

Financial statements are prepared under the Accruals Concept of accounting which requires that income and expense must be recognized in the accounting periods to which they relate rather than on cash basis. An exception to this general rule is the cash flow statement whose main purpose is to present the cash flow effects of transaction during an accounting period. Under Accruals basis of accounting, income must be recorded in the accounting period in which it is earned. Therefore, accrued income must be recognized in the accounting period in which it arises rather than in the subsequent period in which it will be received. Conversely, prepaid income must be not be shown as income in the accounting period in which it is received but instead it must be presented as such in the subsequent accounting periods in which the services or obligations in respect of the prepaid income have been performed. Expenses, on the other hand, must be recorded in the accounting period in which they are incurred. Therefore, accrued expense must be recognized in the accounting period in which it occurs rather than in the following period in which it will be paid. Conversely, prepaid expense must be not be shown as expense in the accounting period in which it is paid but instead it must be presented as such in the subsequent accounting periods in which the services in respect of the prepaid expense have been performed. Accruals basis of accounting ensures that expenses are "matched" with the revenue earned in an accounting period. Accruals concept is therefore very similar to the matching principle.

Accrual concept is the most fundamental principle of accounting which requires recording revenues when they are earned and not when they are received in cash, and recording expenses when they are incurred and not when they are paid. GAAP allows preparation of financial statements on accrual basis only (and not on cash basis). This is because under accrual concept revenues and expenses are recorded in the period to which they relate and not when they are received or paid. Application of accrual concept results in accurate reporting of net income, assets, liabilities and retained earnings which improves analysis of the company’s financial performance and financial position over different periods. At the end of each reporting period, companies pass adjusting journal entries to record any accruals, for example accrual of utilities expense, interest expense, accrual of wages and salaries, adjustment of prepayments, etc.

Significance

* It helps in knowing actual expenses and actual income during a particular time period.

* It helps in calculating the net profit of the business.

Examples

The following examples elaborate the accrual concept.

1. An airline sells its tickets days or even weeks before the flight is made, but it does not record the receipts as revenue because the flight, the event on which the revenue is based has not occurred yet.
   The airline journalizes receipt of cash as follows:

   Bank	ABC
   Unearned revenue		ABC

   Unearned revenue is a current liability which extinguishes when the flight is made.

   Unearned revenue	ABC
   Revenue		ABC

2. An accounting firm obtained its office on rent and paid $120,000 on January 1 as annual rent. It does not record the payment as an expense because the building is not yet used. Instead it records the cash payment as prepaid rent (which is a current asset):

   Prepaid rent	DEF
   Bank		DEF

   The firm recognizes rent expense over the period. For example, in preparing its quarterly income statement on March 31, the firm expenses out three months' rent i.e. 30,00 (= $120,000/12 × 3] because 3 months equivalent of time has expired (from 1 January till 31 March).

   Rent expense	G H I
   Prepaid rent		G H I

3. A business records its utility bills as soon as it receives them and not when they are paid, because the service has already been used. The company ignores the date when the payment will be made.

Cash basis

An alternative to accrual basis is the cash basis of accounting. Under the cash basis, transactions are recorded based on their underlying cash inflows or outflows. Cash basis is normally used while preparing financial statements for tax purposes, etc.

Relationship between concepts and  strategic allocation of financial resources with respect to revenue and expenses

^Cost accounting is a form of managerial accounting that aims to capture a company's total cost of production by assessing the variable costs of each step of production as well as fixed costs, such as a lease expense.

KEY TAKEAWAYS

*Cost accounting is used internally by management in order to make fully informed business decisions.

*Unlike financial accounting, which provides information to external financial statement users, cost accounting is not required to adhere to set standards and can be flexible to meet the needs of management.

*Cost accounting considers all input costs associated with production, including both variable and fixed costs.

*Types of cost accounting include standard costing, activity-based costing, lean accounting, and marginal costing.

Cost accounting is used by a company's internal management team to identify all variable and fixed costs associated with the production process. It will first measure and record these costs individually, then compare input costs to output results to aid in measuring financial performance and making future business decisions. There are many types of costs involved in cost accounting, which are defined below.

Types of Costs

*Fixed costs are costs that don't vary depending on the level of production. These are usually things like the mortgage or lease payment on a building or a piece of equipment that is depreciated at a fixed monthly rate. An increase or decrease in production levels would cause no change in these costs.

*Variable costs are costs tied to a company's level of production. For example, a floral shop ramping up their floral arrangement inventory for Valentine's Day will incur higher costs when it purchases an increased number of flowers from the local nursery or garden center.

*Operating costs are costs associated with the day-to-day operations of a business. These costs can be either fixed or variable depending on the unique situation.

*Direct costs are costs specifically related to producing a product. If a coffee roaster spends five hours roasting coffee, the direct costs of the finished product include the labor hours of the roaster and the cost of the coffee beans.

*Indirect costs are costs that cannot be directly linked to a product. In the coffee roaster example, the energy cost to heat the roaster would be indirect because it is inexact and difficult to trace to individual products.

While cost accounting is often used by management within a company to aid in decision making, financial accounting is what outside investors or creditors typically see. Financial accounting presents a company's financial position and performance to external sources through financial statements, which include information about its revenues, expenses, assets, and liabilities. Cost accounting can be most beneficial as a tool for management in budgeting and in setting up cost control programs, which can improve net margins for the company in the future. One key difference between cost accounting and financial accounting is that, while in financial accounting the cost is classified depending on the type of transaction, cost accounting classifies costs according to information needs of the management. Cost accounting, because it is used as an internal tool by management, does not have to meet any specific standard such as generally accepted accounting principles (GAAP) and, as a result, varies in use from company to company or department to department.

Types of Cost Accounting

Standard Costing

Standard costing assigns "standard" costs, rather than actual costs, to its cost of goods sold (COGS) and inventory. The standard costs are based on an efficient use of labor and materials to produce the good or service under standard operating conditions, and they are essentially the budgeted amount. Even though standard costs are assigned to the goods, the company still has to pay actual costs. Assessing the difference between the standard (efficient) cost and actual cost incurred is called variance analysis. If the variance analysis determines that actual costs are higher than expected, the variance is unfavorable. If it determines the actual costs are lower than expected, the variance is favorable. Two factors can contribute to a favorable or unfavorable variance. There is the cost of the input, such as the cost of labor and materials. This is considered to be a rate variance. Additionally, there is the efficiency or quantity of the input used. This is considered to be a volume variance. If, for example, XYZ company expected to produce 400 widgets in a period but ended up producing 500 widgets, the cost of materials would be higher due to the total quantity produced.

Activity-Based Costing

Activity-based costing (ABC) identifies overhead costs from each department and assigns them to specific cost objects, such as goods or services. The ABC system of cost accounting is based on activities, which is any event, unit of work, or task with a specific goal, such as setting up machines for production, designing products, distributing finished goods, or operating machines. These activities are also considered to be cost drivers, and they are the measures used as the basis for allocating overhead costs.Traditionally, overhead costs are assigned based on one generic measure, such as machine hours. Under ABC, an activity analysis is performed where appropriate measures are identified as the cost drivers. As a result, ABC tends to be much more accurate and helpful when it comes to managers reviewing the cost and profitability of their company's specific services or products.

For example, cost accountants using ABC might pass out a survey to production line employees who will then account for the amount of time they spend on different tasks. The cost of these specific activities are only assigned to the goods or services that used the activity. This gives management a better idea of where exactly time and money is being spent. To illustrate this, assume a company produces both trinkets and widgets. The trinkets are very labor intensive and require quite a bit of hands-on effort from the production staff. The production of widgets is automated, and it mostly consists of putting the raw material in a machine and waiting many hours for the finished good. It would not make sense to use machine hours to allocate overhead to both items, because the trinkets hardly used any machine hours. Under ABC, the trinkets are assigned more overhead related to labor and the widgets are assigned more overhead related to machine use.

Lean Accounting

The main goal of lean accounting is to improve financial management practices within an organization. Lean accounting is an extension of the philosophy of lean manufacturing and production, which has the stated intention of minimizing waste while optimizing productivity. For example, if an accounting department is able to cut down on wasted time, employees can focus that saved time more productively on value-added tasks. When using lean accounting, traditional costing methods are replaced by value-based pricing and lean-focused performance measurements. Financial decision making is based on the impact on the company's total value stream profitability. Value streams are the profit centers of a company, which is any branch or division that directly adds to its bottom-line profitability.

Marginal Costing

Marginal costing (sometimes called cost-volume-profit analysis) is the impact on the cost of a product by adding one additional unit into production. It is useful for short-term economic decisions. Marginal costing can help management identify the impact of varying levels of costs and volume on operating profit. This type of analysis can be used by management to gain insight into potentially profitable new products, sales prices to establish for existing products, and the impact of marketing campaigns. The break-even point, which is the production level where total revenue for a product equals total expense, is calculated as the total fixed costs of a company divided by its contribution margin. The contribution margin, calculated as the sales revenue minus variable costs, can also be calculated on a per unit basis in order to determine the extent to which a specific product contributes to the overall profit of the company.

History of Cost Accounting

Scholars believe that cost accounting was first developed during the industrial revolution when the emerging economics of industrial supply and demand forced manufacturers to start tracking their fixed and variable expenses in order to optimize their production processes. Cost accounting allowed railroad and steel companies to control costs and become more efficient. By the beginning of the 20th century, cost accounting had become a widely covered topic in the literature of business management.

^Accruals are revenues earned or expenses incurred which impact a company's net income on the income statement, although cash related to the transaction has not yet changed hands. Accruals also affect the balance sheet, as they involve non-cash assets and liabilities. Accrual accounts include, among many others, accounts payable, accounts receivable, accrued tax liabilities, and accrued interest earned or payable.Revenues are recognized in the accounting period when the sale is made and expenses are recognized in the period in which they relate to the sale of the product. Revenues are recognized when cash is received and expenses are recognized when cash is paid. Revenues and expenses are recognized based on the choices of management. Revenues and expenses are recognized equally over a twelve month period.

KEY TAKEAWAYS

*Accruals are needed for any revenue earned or expense incurred, for which cash has not yet been exchanged.

*Accruals improve the quality of information on financial statements by adding useful information about short- term credit extended to customers and upcoming liabilities owed to lenders.

*Accruals and deferrals are the basis of the accrual method of accounting.

*Accruals are created via adjusting journal entries at the end of each accounting period.

Accruals and deferrals are the basis of the accrual method of accounting, the preferred method by generally accepted accounting principles. Using the accrual method, an accountant makes adjustments for revenue that has been earned but is not yet recorded in the general ledger and expenses that have been incurred but are also not yet recorded. The accruals are made via adjusting journal entries at the end of each accounting period, so the reported financial statements can be inclusive of these amounts.The use of accrual accounts greatly improves the quality of information on financial statements. Before the use of accruals, accountants only recorded cash transactions. Unfortunately, cash transactions don't give information about other important business activities, such as revenue based on credit extended to customers or a company's future liabilities. By recording accruals, a company can measure what it owes in the short-term and also what cash revenue it expects to receive. It also allows a company to record assets that do not have a cash value, such as goodwill. In double-entry bookkeeping, the offset to an accrued expense is an accrued liability account, which appears on the balance sheet. The offset to accrued revenue is an accrued asset account, which also appears on the balance sheet. Therefore, an adjusting journal entry for an accrual will impact both the balance sheet and the income statement. Accruals and deferrals are the basis of the accrual method of accounting, the preferred method by generally accepted accounting principles (GAAP). Using the accrual method, an accountant makes adjustments for revenue that has been earned but is not yet recorded in the general ledger and expenses that have been incurred but are also not yet recorded. The accruals are made via adjusting journal entries at the end of each accounting period, so the reported financial statements can be inclusive of these amounts. The use of accrual accounts greatly improves the quality of information on financial statements. Before the use of accruals, accountants only recorded cash transactions. Unfortunately, cash transactions don't give information about other important business activities, such as revenue based on credit extended to customers or a company's future liabilities. By recording accruals, a company can measure what it owes in the short-term and also what cash revenue it expects to receive. It also allows a company to record assets that do not have a cash value, such as goodwill. In double-entry bookkeeping, the offset to an accrued expense is an accrued liability account, which appears on the balance sheet. The offset to accrued revenue is an accrued asset account, which also appears on the balance sheet. Therefore, an adjusting journal entry for an accrual will impact both the balance sheet and the income statement.

Let's look at an example of a revenue accrual for an electric utility company. The utility company generated electricity that customers received in December. However, the utility company does not bill the electric customers until the following month when the meters have been read. To have the proper revenue figure for the year on the utility's financial statements, the company needs to complete an adjusting journal entry to report the revenue that was earned in December. It will additionally be reflected in the receivables account as of December 31, because the utility company has fulfilled its obligations to its customers in earning the revenue at that point. The adjusting journal entry for December would include a debit to accounts receivable and a credit to a revenue account. The following month, when the cash is received, the company would record a credit to decrease accounts receivable and a debit to increase cash. An example of an expense accrual involves employee bonuses that were earned in 2019, but will not be paid until 2020. The 2019 financial statements need to reflect the bonus expense earned by employees in 2019 as well as the bonus liability the company plans to pay out. Therefore, prior to issuing the 2019 financial statements, an adjusting journal entry records this accrual with a debit to an expense account and a credit to a liability account. Once the payment has been made in the new year, the liability account will be decreased through a debit, and the cash account will be reduced through a credit. Another expense accrual occurs for interest. For example, a company with a bond will accrue interest expense on its monthly financial statements, although interest on bonds is typically paid semi-annually. The interest expense recorded in an adjusting journal entry will be the amount that has accrued as of the financial statement date. A corresponding interest liability will be recorded on the balance sheet.

In financial accounting or accrual accounting, accruals refer to the recording of revenues that a company has earned but has yet to receive payment for, and the expenses that have been incurred but that the company has yet to pay. In simple terms, it is the accounting adjustment of accumulated debits and credits. Such accounting practices, therefore, have a general impact on the handling of the income statement and the balance sheet. The affected accounts include accounts payable, liabilities and non-cash-based assets, goodwill, future tax liabilities, and future interest expenses, among others. What exactly is an “accrual”? If companies received cash payments for all revenues at the same time when they were earned, and made cash payments for all expenses at the time when they were incurred, there wouldn’t be a need for accruals. However, since most companies have some revenues in the year that were earned (i.e., good/services were delivered) but for which payment was not received, they need to account for those unpaid revenues. The same applies to expenses. If companies incurred expenses (i.e., received goods/services) but didn’t pay for them with cash yet, then they need to be accrued. The purpose of accrual accounting is to match revenues and expenses to the time periods during which they were incurred, as opposed to the timing of the actual cash flows related to them.

Categories in Accrual Accounting

In accounting, accruals in a broad perspective fall under either revenues (receivables) or expenses (payables).

1. Accrued Revenues

Accrued revenues are either income or assets (including non-cash assets) that are yet to be received. In this case, a company may provide services or deliver goods, but does so on credit.

Example

An example of accrued revenue is electricity consumption. An electricity company usually provides the utility to its consumer prior to receiving payment for it. The consumer uses the electricity and the meter counts the reading. Then, at the end of the billing period, the consumer is billed. During the month, the company pays its employees, it fuels its generators, and it incurs logistical costs and other overheads. The electricity company needs to wait until the end of the month to receive its revenues, despite the during-the-month expenses that it has. Meanwhile, it must acknowledge that it expects future income. Accrual accounting, therefore, gives the company a means of tracking its financial position more accurately. At the end of the month, when the company receives payment from its debtors (customers), receivables go down, while the cash account increases.

2. Accrued Expenses

An accrued expense refers to when a company makes purchases on credit and enters liabilities in its general ledger, acknowledging its obligations to its creditors. In accounting, it is an expense incurred but not yet paid. Common accrued expenses include:

• Interest expense accruals – Interest expenses that are owed but unpaid.
• Suppliers accruals – Operating expenses for goods or services rendered by a third-party supplier.
• Wage or salary accruals – These include salaries owed to employees who work for part of the month without having received their full earned monthly salary.

Example

Let’s take an example of a start-up company (Y) with an employee (Joe) who is under a cliff vesting plan, and who is also getting a vesting schedule incentive after five years of commitment. Joe becomes faithful, hardworking, and diligent in the course of working for the company. He makes it through the first year and thus receives his cliff vesting bonus, and qualifies for the subsequent five years of the rest of his vesting schedule bonuses. However, during this period, Joe is not receiving his bonuses materially, as would be the case with cash received at the time of the transaction. Instead, Joe’s bonuses have been accruing. Parallel to that, Company Y’s liabilities have also been increasing. In this case, it’s obvious that Company Y becomes a debtor to Joe for five years. Therefore, to carry an accurate recording of Joe’s bonuses, the company must make a bonus liability record to record these bonus expenses. When the company pays out Joe’s owed bonuses, the transaction will be recorded by the company crediting its liability account and debiting its cash account.

Prepaid Expenses vs. Accrued Expenses

Prepaid expenses are the payment opposite of accrued expenses. Rather than delaying payment until some future date, a company pays upfront for services and goods, even if it does not receive the total goods or services all at once at the time of payment. For example, a company may pay for its monthly internet services upfront, at the start of the month, before it actually uses the services.

Impact of Accrual Accounting

In addition to accruals adding another layer of accounting information to existing information, they change the way accountants do their recording. In fact, accrual helps in demystifying accounting ambiguity relating to revenues and liabilities. As a result, businesses can often better anticipate revenues while keeping future liabilities in check.Accruals assist accountants in identifying and monitoring potential cash flow or profitability problems and in determining and delivering an adequate remedy for such problems.

Recording Accruals

To record accruals, the accountant must use an accounting formula known as the accrual method. The accrual method enables the accountant to enter, adjust, and track “as yet unrecorded” earned revenues and incurred expenses. For the records to be usable in the financial statement reports, the accountant must adjust journal entries systematically and accurately, and they must be verifiable. Such meticulous accountability means that the recording procedure must adhere to accounting’s double-entry principle. That is, a record of an accrued liability must appear on the balance sheet. Also, a record of the accrued assets must be evident on the balance sheet and income statement.

The Relationship between Accrual Accounting and Cash Accounting

Even though both accrual accounting and cash accounting methods serve as a yardstick of performance and the economic position of a company in a given fiscal year, financial transactions in accrual accounting are reported as they happen – both debits and credits. However, the recording of transactions in cash accounting occurs at the time of cash transactions.

FASB and IFRS Example

The Financial Accounting Standards Boards (FASB) has set out Generally Accepted Accounting Principles (GAAP) in the U.S. dictating when and how companies should accrue for certain things. For example, “Accounting for Compensated Absences” requires employers to accrue a liability for future vacation days for employees.