A budget encourages planning, coordinates functions within an organisation, acts as a form of communication, provides a basis for responsibility accounting (where an entity is structured into strategic units and the performance is measured in terms of accounting results), provides a control mechanism, authorises expenditure and motivates employees. The budget process is the sequence of operation necessary to produce a budget for a particular organisation with the sequence depending on the perceived requirements for planning and control.
Decisions are (a) where there are no resource constraints (i.e., an action does not affect other opportunities), (b) there are resource constraints (an action limits the possibility of other choices, requiring a ranking system) and (c) mutually exclusive decisions (one choice means others will be rejected).
Sunk costs are those costs which are already paid or a firm is committeed to. They are irrelevant for future decision making.
A cost is fixed if it does not change in response to change in the level of activity and variable if the total cost changes per unit of activity. Total variable costs increase or decrease in direct proportion to the activity level. The total costs of production are made up of fixed and variable costs.
The linear cost function is a straight-line cost function that can be shown as y = a + bx
y is the total cost to be predicted, a is a constant (fixed cost) and b is the cost that will be the same for eact unit of activity and x is the number of units of actibity.
Multi-product firms have to account for costs that can be tied to a product, direct costs. They also have to account for indirect costs not directly measurable (e.g., electricity). A 'cost object' can be a product, service, process or any items which management requires cost information. The way that costs are assigned depends on their nature. A direct costs is easily traceable with a high degree of accuracy and indirect, or overhead, cost cannot be easily identifiable with a particular object.
The Accounting Rate of Return (ARR) is a simple method of calculation based on net profit or book value. It is little used now as it does not take into account the time value of money.
ARR = average net profit / average book value of investment * 100
ARR = average net profit / total initial investment value * 100
The average book value, method alpha, will give a higher result.
Annual reports provide an overview of an entities financial performance in the past year. They are of little use to managers who require frequent, up-to-date information tailored to their needs for decision and control.
External users may have access to internal information through statutory right (e.g., the tax office) or those who are able to exert influence (e.g., a lender or banker).
The information needs of various entity users in relation to financial statements vary. Some core groups include investors (RoI, profitability, solvency, risk), lenders (risk), employees (profitability, liquidity), audtors (trends, accounting policies), analysts, management (performance).
External information includes government publications (e.g., statistics), trade journals, etc and internal information includes the chairman's report, director's report, balance sheet, income statement, equity statement, cash flow statement, accounting policy, notes, auditor's report.
Recent corporate failures are due to the use of special-purpose entities to hide debt. the incorrect recognition of revenue, the incorrect classification of expenditure as assets instead of expenses and an underestimation of liabilties. As a result, there has been a review of corporate governance requirements in many countries. In the U.S. the practise of establishing estimate of next quarter's profit creates pressure to meet targets or face a fall in share price. This in turn creates an incentive for fraud.
Cash includes cash on hand and cash equivalents, such as highly liquid investments (money-market accounts, treasury bills) and borrowings used as part of an entities cash management process. Cash is difficult to control because anyone can spend cash; it is easily misappropriated. Internal controls, the procedures and processes for managing cash, is therefore necessary and usually involves separate duties so that the same person is not responsible for receiving and recording cash. Collusion however may still be an issue.
Under the traditional approach assets are shown as debit balances and liabilities and equities are shown as credit balances. Increases in assets are recorded as debits and decreases as credits; reverse for liabilities and equities.