Management Accounting

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### Introduction to Management Accounting - **Definition:** According to Robert Anthony, "Management accounting is concerned with accounting information which is useful to management." - **Nature:** - Provides accounting information - Aids decision-making - Studies cause and effect relationships - Uses special techniques - Quantitative and qualitative information - Multidisciplinary - Accounting for the future - Management-oriented - **Objectives:** - Collect and supply data for financial analysis - Help in future planning, controlling, and decision-making - Evaluate performance - Motivate employees - Communicate up-to-date information - Help in policy formulations - Prepare reports - **Scope:** - Financial accounting - Cost accounting - Statistical methods - Budgeting - Tax accounting - Reporting - Office services - Internal auditing - Interpretations - **Functions:** - Helps management in planning - Helps in analysis and interpretations - Provides internal and external communication - Useful in controlling operations - Helps in coordinating activities of various departments - Helps in decision-making ### Principles and Limitations - **Basic Principles:** 1. Principle of exception 2. Principle of objectivity 3. Principle of consistency 4. Principle of relevancy - **Need/Importance/Advantages:** 1. Proper planning 2. Effective control 3. Increased efficiency 4. Measurement of performance 5. Maximizing profitability 6. Increase in production 7. Better customer service 8. Quick decision-making - **Limitations:** 1. Based on accounting information 2. Lack of knowledge 3. Not a substitute for management 4. Personal judgement 5. Costly 6. Resistance - **Tools and Techniques:** 1. Financial Accounting 2. Financial Analysis 3. Historical Cost Accounting 4. Budgetary Control 5. Standard Costing 6. Marginal Costing 7. Decision Accounting 8. Revaluation Accounting ### Role of Management Accountant - **A. Analytical and Advisory Functions:** 1. Planning and control of operations 2. Measuring the performance of the organisation 3. Reporting the operational performance 4. Evaluating policies and programs 5. Preparing reports and statements 6. Evaluating external factors of the business - **B. Administrative and Procedural Functions:** 1. Installation of accounting system 2. Arranging audit 3. Introduction of budgeting system 4. Making capital expenditure decisions 5. Management of cash 6. Preparation of financial statement - **Installation of Management Accounting System:** 1. Preparing organizational manual 2. Preparing forms and returns 3. Requisite staffing 4. Classifying records and integrating the systems 5. Introducing standard cost techniques 6. Setting up budgetary control system 7. Introducing operation research techniques - **Recent Trends in Management Reporting:** 1. Cash flow reporting 2. Segment reporting 3. Financial reporting using XBRL (eXtensible Business Reporting Language - assumed based on context) 4. Interim financial reporting 5. Economic value added (EVA) 6. Corporate governance report 7. Environmental reporting 8. Brand valuation 9. Vertical form of financial analysis 10. Uses chart, graphs and diagrams 11. Business responsibility reporting 12. Management discussion and analysis report ### Accounting Comparisons #### Management vs. Financial Accounting | Feature | Management Accounting | Financial Accounting | | :---------------------------- | :--------------------------------------------------- | :----------------------------------------------------- | | **Purpose** | Provide information for management decision-making | Ascertain profit/loss and financial position | | **Focus** | Future plans and operations | Historical data relating to past | | **Requirement** | Optional | Compulsory | | **Reporting Emphasis** | Quick and prompt reporting | Accuracy | | **Principles** | Not based on rigid principles | Based on GAAP (Generally Accepted Accounting Principles) | | **Periodicity** | No specific period | Prepared for a particular period | | **Scope** | Wider scope | Limited scope | | **Users** | Internal parties (management) | External parties (investors, creditors) | | **Audit** | Not compulsory | Compulsory | | **Stock Valuation** | No such principle followed | Cost or market price, whichever is less | #### Management vs. Cost Accounting | Feature | Management Accounting | Cost Accounting | | :---------------------------- | :------------------------------------------------------- | :------------------------------------------------ | | **Primary Goal** | Managerial decision-making | Cost control and cost reduction | | **Scope** | Broader | Narrower | | **Transactions** | Deals with both present and future transactions | Deals with future transactions | | **Audit** | No statutory audit requirement | Statutory audit mandatory for big businesses | | **Users** | Only for management | Management, shareholders, and vendors | | **Data Type** | Considers both quantitative and qualitative data | Considers only quantitative data | | **Principles Used** | Principles of cost accounting and financial accounting | Only cost accounting principles | | **Data Source** | Uses financial as well as cost accounting data | Restricted to cost-related data | ### Financial Analysis & Interpretation - **Financial Analysis:** Analysis of a company's financial statements. - **Financial Statements:** Formal records of financial activities and position. - **Analysis and Interpretation:** Determining the significance and meaning of financial statement data. - **Features/Significance:** - Know the profitability of the firm - Know the solvency of the firm - Know the liquidity of the firm - Make interfirm and intrafirm comparison - Know the efficiency of the management of the firm - Know the financial strength and weakness of the firm - **Types of Financial Analysis:** 1. **Internal Analysis:** Done by internal parties, detailed. 2. **External Analysis:** Done by external parties, less detailed. 3. **Long-Term Analysis:** Ascertaining long-term profitability, solvency, stability. 4. **Short-Term Analysis:** Ascertaining short-term solvency. 5. **Horizontal Analysis:** Comparison of financial data over several years. 6. **Vertical Analysis:** Study of relationships of items in one accounting period. #### Horizontal vs. Vertical Analysis | Feature | Horizontal Analysis | Vertical Analysis | | :-------------------- | :-------------------------------------------------------- | :-------------------------------------------------------- | | **Information Type** | Provides information in absolute and percentage figures | Provides information in percentages | | **Data Focus** | Deals with the same item over different periods | Deals with different items of the same period | | **Typical Use** | Generally used for time series analysis | Generally used for interfirm analysis | | **Other Name** | Also called dynamic analysis | Also called static analysis | - **Tools and Techniques for Financial Statement Analysis:** 1. Comparative statements 2. Common size statements 3. Trend analysis 4. Ratio analysis 5. Cash flow analysis ### Statements #### Comparative Statements - Used to compare a particular financial statement with prior period statements. - **Comparative Balance Sheet:** Shows financial position over different periods. - **Comparative Income Statement:** Presents results of multiple account periods in separate columns. #### Common Size Statements - A tool for financial managers, expressed in percentage form. - **Utilities:** - Establish a relationship - Provide a common base for comparison - Present changes in various items - Help in analysis of companies' performance - Help in time series analysis - Identify financial health of the business - Provide comparison - Present changes in various items - **Common Size Income Statement:** Each line item expressed as a percentage of revenue/sales. - **Common Size Balance Sheet:** Displays numerical value and relative percentage for total assets, liabilities, and equity. #### Trend Analysis - Analysis of a firm's trend by comparing its financial statements to analyze market trends or future. #### Other Definitions - **Income Statement:** Shows revenues and expenses during a particular period. - **Inter-firm Comparison:** Comparison of two or more similar business units to assess competitive position. - **Intra-firm Comparison:** Comparison among different units, products, or business units of a firm. ### Ratio Analysis - **Ratio:** Simple arithmetic expression of the relationship of one number to another. - **Ratio Analysis:** Technique of analysis and interpretation of financial statements. - **Accounting Ratio:** Ratio calculated based on accounting information. - **Objectives/Purpose:** - Study short-term solvency of a firm - Study long-term solvency of a firm - Determine profitability of a firm - Facilitate comparison - Help in managerial decision-making - Measure the performance of a firm - Communicate strength and weakness of a firm - **Advantages/Importance:** - **To Management:** Helps in formulating policies, planning, forecasting, decision-making. - **To Shareholders:** Helps in selecting best companies, evaluating performance, calculating share values. - **To Government:** Helps in tax planning, studying cost structure of industries. - **To Creditors:** Helps in measuring liquidity positions, knowing strengths and weaknesses. - **To Employees:** Demand more wages and benefits, know financial health of companies. - **Limitations:** - Inherent limitations of accounting - Non-monetary factors ignored - Qualitative factors ignored - Window dressing - Not a substitute for judgement - Price level changes - Lack of adequate standard - Need for comparative analysis ### Functional Classification of Ratios #### I. Liquidity Ratios - Ability of a concern to meet its current obligations. - **Current Ratio:** Current assets to current liabilities. (Ideal 2:1) - **Quick Ratio (Acid Test Ratio):** Quick assets to current liabilities. (Ideal 1:1) - **Window Dressing:** Improving current ratio through manipulation (e.g., increasing inventory values, postponing fixed asset purchases). #### II. Solvency / Leverage Ratios - **Debt-Equity Ratio:** Relationship between debt and equity. (Also known as security ratio or external-internal ratio.) - **Total Asset to Debt Ratio:** Relationship between total assets and total liabilities. (Also called solvency ratio.) - **Proprietary Ratio:** Relationship between shareholders' funds and total assets. (Also known as equity ratio or net worth ratio.) - **Fixed Asset Ratio:** Ratio of fixed assets to long-term funds or capital employed. - **Capital Gearing Ratio:** Relationship between fixed interest-bearing securities and equity shareholders' funds. - **Interest Coverage Ratio:** Relationship between operating profits and interest charges. - **Dividend Coverage Ratio:** Measures ability to pay dividends on preference shares. - **Overall Coverage Ratio:** Measures ability to service all fixed obligations out of earnings. #### III. Activity / Turnover Ratios - Show how effectively a firm uses its resources/assets (efficiency in asset management). - **Inventory Turnover Ratio (Stock Turnover Ratio):** Cost of goods sold to average inventory. - **Stock Velocity:** Inventory turnover ratio expressed in time (days/months). - **Debtors Turnover Ratio (Receivable Turnover Ratio):** Net credit sales to average debtors. - **Average Collection Period:** Debtors turnover ratio expressed in days/months. - **Creditors Turnover Ratio (Payable Turnover Ratio):** Net credit purchases to average creditors. - **Average Payment Period:** Creditors turnover ratio expressed in days/months. - **Working Capital Turnover Ratio:** Relation between sales and working capital. - **Fixed Asset Turnover Ratio:** Relationship between net sales and fixed assets. #### IV. Profitability Ratios - Ability of a firm to earn income. - **Gross Profit Ratio:** Gross profit to sales (expressed as percentage, also gross margin). - **Operating Ratio:** Operating cost to sales (indicates overall operating efficiency). - **Operating Profit Ratio:** Operating profits to net sales. - **Net Profit Ratio:** Net profit to net sales (measures overall profitability). - **Return on Investment (ROI):** Measures overall profitability, profit to investment. - **Uses/Advantages of ROI:** Measures overall profitability/success, helps in investment decisions, useful for capital structure planning, foundation of optimum asset utilization, can determine product price. #### V. Market Test Ratios (Investor Ratios / Stock Market Ratios / Market Valuation Ratios) - Used for evaluating shares and stock traded in the market. - **Earnings per Share (EPS):** Profits available for each equity share. - **Dividend per Share (DPS):** Amount of profit distributed per equity share. - **PE Ratio (Price-Earnings Ratio):** Company's share price to EPS. - **Du Pont Chart:** Analysis of profitability breaking down ROI into profit margin and capital turnover. Shows interaction of operating net profit ratio and capital turnover ratio. ### Fund Flow and Cash Flow Analysis #### Fund Flow - **Fund:** Working capital (excess of current assets over current liabilities). - **Fund Flow (Flow of Fund):** Inflow and outflow of funds in a business. - **Fund Flow Statement:** Shows sources and applications of funds. - **Objectives:** - Serve as a technique for managing working capital - Know changes in working capital - Anticipate position of working capital - Reveal short-term financial strength and weakness - Provide basis for budgeting - Assess growth of a firm - **Importance/Uses/Benefits:** - Financial analysis and control - Financial planning and budget preparation - Helpful in comparative study - Knowledge of managerial policies - Useful to bankers and moneylenders - Acts as a future guide - Proper allocation of resources - **Limitations:** - Does not reveal cash positions - Not as useful as cash flow statement - Not a substitute for income statement or balance sheet - Cannot reveal continuous changes - Not original in character - **Preliminary Techniques:** - Classification of items into current and non-current - Identification of transactions causing flow of fund - Calculation of fund from operation - Preparation of fund flow statement - **Fund from Operation:** Fund generated from business operation (internal source). - **Schedule of Changes in Working Capital:** Statement recording changes in current assets and liabilities. #### Fund Flow Statement vs. Balance Sheet | Feature | Fund Flow Statement | Balance Sheet | | :---------------------- | :---------------------------------------------- | :-------------------------------------- | | **Purpose** | Show sources and uses of fund | Show financial position | | **Content** | Statement of changes in assets and liabilities | Statement of assets and liabilities | | **Requirement** | Optional | Statutory | | **Users** | Useful to internal parties | Useful to external parties | | **Classification** | Supplementary financial statement | Primary financial statement | | **Timing of Preparation** | Prepared after balance sheet is prepared | Prepared at the end of accounting period | #### Schedule of Changes in Working Capital vs. Fund Flow Statement | Feature | Schedule of Changes in Working Capital | Fund Flow Statement | | :---------------------- | :---------------------------------------------- | :---------------------------------------------- | | **Components** | Current assets and current liabilities | Non-current assets and non-current liabilities | | **Information Shown** | Changes in current assets and current liabilities | Sources and applications of fund | | **Fund from Operation** | Not shown | Shown | | **Purpose** | Know changes in working capital | Know overall operation of a firm | | **Preparation Basis** | With the help of balance sheet | With the help of P/L account and balance sheet | #### Sources and Applications of Funds - **Sources of Fund:** Issue of shares/debentures, medium/long-term loans, sales of fixed assets, sales of investment, fund from operation. - **Applications of Fund:** Redemption of shares/debentures, repayment of loans, purchase of fixed assets, purchase of investment. #### Cash Flow - **Cash:** Cash in hand and demand deposits with bank. - **Cash Equivalents:** Short-term, highly liquid investments readily convertible into cash. - **Non-Cash Items:** Entries not involving actual cash transactions (e.g., depreciation). - **Cash Flow:** Inflow and outflow of cash and cash equivalents. - **Cash Flow Statement:** Describes cash inflow/outflow during a specified period. - **Objectives:** - Assess and monitor liquid resources - Control liquid resources - Prevent excessive cash holdings - Help in capital budgeting - Maintain optimum level of cash resources - **Importance/Uses/Advantages:** - Helpful in short-term planning - Helpful in formulation of financial policies - Provides a basis for cash budget - Helpful in control and financial decision-making - Reveals liquidity and solvency - Helps in efficient cash management - **Limitations:** - Ignores non-cash transactions - Not a substitute for income statement - Historical in nature - Limited scope - Does not present true picture of liquidity - Easily influenced by managerial decisions #### Cash Flow Statement vs. Fund Flow Statement | Feature | Cash Flow Statement | Fund Flow Statement | | :---------------------- | :-------------------------------------- | :-------------------------------------- | | **Basis of Preparation** | Cash basis, cash concept | Working capital basis, accrual concept | | **Format** | Presented in prescribed format | Not presented in prescribed format | | **Usefulness** | Useful for short-term analysis | Useful for long-term analysis | | **Planning Focus** | Used for cash planning | Used for financial planning | | **Working Capital Schedule** | Not required | Required | #### Classification of Cash Flows 1. **Operating Activities:** Cash flows from regular operations. - *Examples:* Cash sales, cash received from debtors, cash purchase of goods, cash paid to suppliers/employees. 2. **Investing Activities:** Purchase and sale of fixed assets. - *Examples:* Cash payment/receipts for fixed assets, purchase/sale of shares/debentures. 3. **Financing Activities:** Issuing/redeeming share capital, debentures, raising/repaying loans. - *Examples:* Cash proceeds from issue of shares/debentures/loans, redemption of shares/debentures, repayment of loans. - **Steps for Preparation:** - Compute net increase/decrease in cash or cash equivalents. - Calculate net cash flow from operating, investing, and financing activities. - Prepare a formal cash flow statement. - Make an aggregate net cash flow. - Report significant non-cash transactions. ### Marginal Costing and CVP Analysis #### Cost Concepts - **Variable Cost:** Costs that vary in proportion to changes in production volume. - **Fixed Cost:** Costs that do not change with production volume. - **Marginal Cost:** Additional cost of producing an additional unit. - **Marginal Costing:** Ascertainment by differentiating between fixed and variable costs. - **Characteristics:** Technique for managerial decision-making, costs classified as fixed/variable, fixed costs charged against profit of the period, selling price equals variable cost plus contribution. - **Assumptions:** All costs divided into fixed/variable, fixed costs constant, total variable costs vary but per unit constant, no stock, selling price constant, material/labor rates constant. - **Advantages/Importance:** Easy/simple, simple stock valuation, better cost control, ascertainment of profitability, profit planning, decision-making, pricing policy. - **Disadvantages:** Difficulty in separating costs, undervaluation of stock, time factor ignored, wrong basis for pricing, more emphasis on sales, short-run analysis, difficulty in application. - **Absorption Costing:** Technique where both fixed and variable costs are allotted to cost units. #### Absorption Costing vs. Marginal Costing | Feature | Absorption Costing | Marginal Costing | | :------------------------ | :---------------------------------------------- | :---------------------------------------------- | | **Cost Treatment** | All costs are charged | Only variable costs are charged | | **Decision Making** | Not useful for decision-making | Useful for decision-making | | **Reporting** | Suitable for external reporting | Suitable for internal reporting | | **Decision Basis** | Decisions based on profit | Decisions based on contribution | | **Cost per Unit (Production Increase)** | Cost per unit reduces | Cost per unit same at all levels of production | - **Direct Costing:** Specialized cost analysis using only variable costs for decisions. #### Cost-Volume-Profit (CVP) Analysis - Study of the effect on future profit of changes in fixed cost, variable cost, sales price, quantity, and mix. - **Objectives/Uses:** - Forecast profit - Determine pricing policies - Evaluate business performance - Facilitate budget preparation - Achieve cost control - Help in decision-making - Determine break-even point - **Techniques:** 1. Contribution margin analysis 2. Margin of safety analysis - **Contribution:** Excess of sales over variable costs (marginal profit, also gross margin). - **Uses/Importance:** Helps in fixing selling price, determines break-even point, finds profitability of products, helps in make-or-buy decisions, determines key factor, indicates profit potential, highlights cost-sales-profit relationship. - **Break-Even Point (BEP):** Point at which total sales revenue equals total cost (no profit, no loss). - **Break-Even Analysis:** Method of studying relationships among sales, revenue, fixed costs, and variable costs to determine BEP. - **Assumptions of CVP/Break-Even Analysis:** - All costs divided into fixed/variable. - Variable costs vary in direct proportion. - Fixed costs remain constant. - Selling price per unit remains constant. - Sales mix remains constant. - Efficiency of plant and productivity per worker remain constant. - **Break-Even Chart:** Graphical presentation of BEP, showing relationship between sales, volumes, variable, and fixed costs. - **Angle of Incidence:** Angle caused by intersection of total sales line and total cost line at BEP. - **Margin of Safety:** Difference between actual sales and break-even sales. - **Cash Break-Even Point:** Number of units to be produced to give a contribution equal to cash fixed cost. - **Profit-Volume Chart (P/V Chart):** Shows profit or loss at different output levels. #### Marginal Costing in Managerial Decision-Making (Applications) 1. Fixation of selling price. 2. Whether to accept a special order or not. 3. Whether to accept an export order or not. 4. Selection of suitable sales mix. 5. Make or buy decision. 6. Whether to discontinue a product or not. 7. Key factor. 8. Shut down point. 9. Contribution analysis. 10. Profit planning. - **Make or Buy Decision:** Deciding whether to produce a component internally or purchase from outside. - **Key Factor:** A factor that restricts the volume of operation of the firm.