It is difficult to infer organizational performance from one or two simple numbers. Nevertheless, in practice a number of different ratios are often calculated in strategic planning endeavors and, taken as a whole and with some caution, these ratios do provide some information about the relative performance of an organization. In particular, a careful analysis of a combination of these ratios may help you to distinguish between firms that will eventually fail and those that will continue to survive. Evidence suggests that, as early as five years before a firm fails, one may be able to detect trouble from the value of these financial ratios.1
In this note, the basic financial ratios are reviewed, and some of the caveats associated with using them are highlighted. The ratios tend to be most meaningful when they are used to compare organizations within the same broad industry, or when they are used to make inferences about changes in a particular organization's structure over time.
LIQUIDITY RATIOS
In order to survive, firms must be able to meet their short-term obligations—pay their creditors and repay their short-term debts. Thus, the liquidity of the firm is one measure of a firm's financial health. Two measures of liquidity are in common:
Current ratio = current assets / current liabilities
Quick ratio = (cash + marketable securities + net receivables) / current liabilities
The main difference between the current ratio and the quick ratio is that the latter does not include inventories, while the former does.
Which ratio is a better measure of a firm's short-term position? In some ways, the quick ratio is a more conservative standard. If the quick ratio is greater than one, there would seem to be no danger that the firm would not be able to meet its current obligations. If the quick ratio is less than one, but the current ratio is considerably above one, the status of the firm is more complex. In this case, the valuation of inventories and the inventory turnover are obviously critical.
A number of problems with inventory valuation can contaminate the current ratio. An obvious accounting problem occurs because organizations value inventories using either of two methods, last in, first out (LIFO) or first in, first out (FIFO). Under the LIFO method, inventories are valued at their old costs. If the organization has a substantial quantity of inventory, some of it may be carried at relatively low cost, assuming some inflation in overall prices. On the other hand, if there has been technical progress in a market and prices have been falling, the LIFO method will lead to an overvalued inventory. Under the FIFO method of inventory valuation, inventories are valued at close to their current replacement cost. Clearly, if we have firms that differ in their accounting methods, and hold substantial inventories, comparisons of current ratios will not be very helpful in measuring their relative strength, unless accounting differences are adjusted for in the computations.
A second problem with including inventories in the current ratio derives from the difference between the inventory's accounting value, however calculated, and its economic value. A simple example is a firm subject to business-cycle fluctuations. For a firm of this sort, inventories will typically build during a downturn. The posted market price for the inventoried product will often not fall very much during this period; nevertheless, the firm finds it cannot sell very much of its inventoried product at the so-called market price. The growing inventory is carried at the posted price, but there really is no way that the firm could liquidate that inventory in order to meet current obligations. Thus, including inventories in current assets will tend to understate the precarious financial position of firms suffering inventory buildup during downturns.
Might we then conclude that the quick ratio is always to be preferred? Probably not. If we ignore inventories, firms with readily marketable inventories, appropriately valued, will be undeservedly penalized. Clearly, some judicious further investigation of the marketability of the inventories would be helpful.
Low values for the current or quick ratios suggest that a firm may have difficulty meeting current obligations. Low values, however, are not always fatal. If an organization has good long-term prospects, it may be able to enter the capital market and borrow against those prospects to meet current obligations. The nature of the business itself might also allow it to operate with a current ratio less than one. For example, in an operation like McDonald's, inventory turns over much more rapidly than the accounts payable become due. This timing difference can also allow a firm to operate with a low current ratio. Finally, to the extent that the current and quick ratios are helpful indexes of a firm's financial health, they act strictly as signals of trouble at extreme rates. Some liquidity is useful for an organization, but a very high current ratio might suggest that the firm is sitting around with a lot of cash because it lacks the managerial acumen to put those resources to work. Very low liquidity, on the other hand, is also problematic.
LEVERAGE
Firms are financed by some combination o£ debt and equity. The right capital structure will depend on tax policy—high corporate rates favor debt, high personal tax rates favor equity—on bankruptcy costs, and on overall corporate risk. In particular, if we are concerned about bankruptcy possibilities, the long-run solvency or leverage of the firm may be important. There are two commonly used measures of leverage, the debt-to-assets ratio and the debt-equity ratio;
Debt-to-asset ratio = total liabilities / total assets
Debt-equity ratio = long-term debt / shareholder's equity
As with liquidity measures, problems in measurement and interpretation also occur in leverage measures. The central problem is that assets and equity are typically measured in terms of the carrying (book) value in the firm's financial statements. This figure, however, often has very little to do with the market value of the firm, or the value that creditors could receive were the firm liquidated.
Debt-to-equity ratios vary considerably across industries, in large measure due to other characteristics of the industry and its environment. A utility, for example, which is a stable business, can comfortably operate with a relatively high debt-equity ratio. A more cyclical business, like manufacturing of recreational vehicles, typically needs a lower D/E—a reminder that cross-industry comparisons of these ratios is typically not very helpful.
Often, analysts look at the debt-equity ratio to determine the ability of an organization to generate new funds from the capital market. An organization with considerable debt is often thought to have little new-financing capacity. Of course, the overall financing capacity of an organization probably has as much to do with the quality of the new product the organization wishes to pursue as with its financial structure. Nevertheless, given the threat of bankruptcy and the attendant costs, a very high debt-equity ratio may make future financing difficult. It has been argued, for example, that railroads in the 1970s found it hard to find funds for new investments in piggybacking, a large technical improvement in railroading, because the threat of bankruptcy from prior poor investments was so high.
RATES OF RETURN
There are two measures of profitability common in the financial community, return on assets (ROA) and return on equity (ROE).
ROA = net income / total average assets
ROE = net income / total stockholders equity
Assets and equity, as used in these two common indexes, are both measured in terms of book value. Thus, if assets were acquired some time ago at a low price, the current performance of the organization may be overstated by the use of historically valued denominators. As a result, the accounting returns for any investment generally do not correlate well with the true economic internal rate of return for that investment.
Difficulties with using either ROA and ROE as a performance measure can be seen in merger transactions. Suppose we have an organization that has been earning a net income of $500 on assets with a book value of $1000, for a hefty ROA of 50 percent. That organization is now acquired by a second firm, which then moves the new assets onto its books at the acquisition price, assuming the acquisition is treated using the purchase method of accounting. Of course, the acquisition price will be considerably above the $1,000 book value of assets, for the potential acquirer will have to pay handsomely for the privilege of earning $500 on a regular basis. Suppose the acquirer pays $2,000 for the assets. After the acquisition, it will appear that the returns of the acquired firm have fallen. The firm continues to earn $500, but the asset base is now $2,000, so the ROA is reduced to 25 percent. Indeed, the ROA may be less as a result of other factors, such as increased depreciation of the newly acquired assets. Yet in fact nothing has happened to the earnings of the firm. All that has changed is its accounting, not its performance.
Another fundamental problem with ROA and ROE measures comes from the tendency of analysts to focus on performance in single years, years that may be idiosyncratic. At a minimum, one should examine these ratios averaging over a number of years to isolate idiosyncratic returns and try to find patterns in the data.
STOCK MARKET RATIOS
Several ratios are calculated not from the income statements and balance sheets of organizations, but from data associated with their stock market performance. The three most common ratios are earnings per share (EPS), the price-earnings ratio (P/E), and the dividend-yield ratio:
EPS = (net income - preferred dividends) /
common shares outstanding
P/E = market price per share / earnings per share
Dividend yield = annual dividends / price per share
EPS is one of the most widely used statistics. Indeed, it is required to be given in the income statements of publicly traded firms. As we can see, the ratio tells us how much the firm has earned per share of stock outstanding. As it turns out, this is not generally a very helpful statistic. It says nothing about how many assets a firm used to generate those earnings, and hence nothing about profitability. Nor does it tell us how much the individual stockholder has paid per share for the rights over that annual earning. Further, accounting practices in the calculation of earnings may distort these ratios. And finally, the treatment of inventories is again problematic.
The P/E is another ratio commonly cited. Indeed, P/Es are reported in daily newspapers. A high P/E tends to indicate that investors believe the future prospects of the firm are better than its current performance. They are in some sense paying more per share than the firm's current earnings warrant. Again, earnings are treated differently in different accounting practices.
Finally, from the perspective of some stockholders at least, dividend policy may be important. The dividend-yield ratio tells us how much of its earnings the firm pays out in dividends versus reinvestment. Rapidly growing firms in new areas tend to have low dividend-yield ratios; more mature firms tend to have higher ratios.
SUMMARY
In this note, we have briefly reviewed a variety of ratios commonly used in strategic planning. All of these ratios are subject to manipulation through opportunistic accounting practices. Nevertheless, taken as a group and used judiciously, they may help to identify firms or business units in particular trouble. Finding profitable new ventures requires rather more work.
Monday, October 26, 2009
Monday, September 14, 2009
HEDGE ACCOUNTING
What Does Hedge Mean?
Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.
An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations.
Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge).
DE-HEDGE
The process of closing out positions that were originally put in place to act as a hedge in one's portfolio. De-hedging involves going back into the marketplace and closing out hedged positions, which were previously taken to limit an investor's risk of price fluctuations in relation to their underlying asset.
De-hedging is done when holders of an underlying asset have a bullish outlook on their investment. Therefore, the investor would prefer to remove their hedged position to gain exposure to the expected upward price fluctuations of their investment.
For example, a hedged investor in gold who feels the price of their asset is about to go up would buy back any gold futures contracts they had sold in the futures market. By doing this, the investor will have positioned themselves to reap the rewards of an increase in the price of gold if their bullish prediction on gold is correct.
HEDGE RATIO
1. A ratio comparing the value of a position protected via a hedge with the size of the entire position itself.
2. A ratio comparing the value of futures contracts purchased or sold to the value of the cash commodity being hedged.
1. Say you are holding $10,000 in foreign equity, which exposes you to currency risk. If you hedge $5,000 worth of the equity with a currency position, your hedge ratio is 0.5 (50 / 100). This means that 50% of your equity position is sheltered from exchange rate risk.
2. The hedge ratio is important for investors in futures contracts, as it will help to identify and minimize basis risk
HEDGE FUND
An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).
Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year.
For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies.
It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.
HEDGE ACCOUNTING-SUMMARY
The accounting treatment of call options prima facie will depend upon the intention with which the options are purchased: for hedging or speculation (nonhedging).
If the position is taken as a hedge against some other position, then the relevant accounting standards will be applicable and there are certain conditions that are to be fulfilled for the same.
Only long calls and long puts are eligible for hedge accounting, as written calls or puts limit the profitability while exposing the investor to unlimited risks and as such are not eligible for hedge accounting.
The standards require that the potential for gains should be at least equal to the potential for losses; this is known as a symmetrical risk-reward situation. For a written option the risk-reward is asymmetrical; hence, written options per se do not qualify for hedge accounting.
However, a combination of written options and certain other derivative instruments that results in a symmetrical risk-reward may qualify for hedge accounting.
To qualify for hedge accounting, either the upside and downside potential of the net position must be symmetrical or the upside potential must be greater than the downside potential.
Written options based on symmetry of the gain and loss potential of the combined hedged position qualify for hedge accounting as per the accounting standard.
If a written option is designated as hedging a recognized asset or liability, the combination of the hedged item and the written option provides at least as much potential for gains (as a result of a favorable change in the fair value of the combined instruments) as it does exposure to losses from an unfavorable change in their combined fair value.
Hedge accounting is not permitted for covered calls. This prohibition is also specifically mentioned in the standard itself.
It is permissible to separate the intrinsic value and time value of an option contract, designate as the hedging instrument only the change in intrinsic value of an option, and exclude change in its time value.
The accounting standards permit an entity to apply hedge accounting for a delta-neutral hedging strategy and other dynamic hedging strategies under which the quantity of the hedging instrument is constantly adjusted in order to maintain a desired hedge ratio.
Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.
An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations.
Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge).
DE-HEDGE
The process of closing out positions that were originally put in place to act as a hedge in one's portfolio. De-hedging involves going back into the marketplace and closing out hedged positions, which were previously taken to limit an investor's risk of price fluctuations in relation to their underlying asset.
De-hedging is done when holders of an underlying asset have a bullish outlook on their investment. Therefore, the investor would prefer to remove their hedged position to gain exposure to the expected upward price fluctuations of their investment.
For example, a hedged investor in gold who feels the price of their asset is about to go up would buy back any gold futures contracts they had sold in the futures market. By doing this, the investor will have positioned themselves to reap the rewards of an increase in the price of gold if their bullish prediction on gold is correct.
HEDGE RATIO
1. A ratio comparing the value of a position protected via a hedge with the size of the entire position itself.
2. A ratio comparing the value of futures contracts purchased or sold to the value of the cash commodity being hedged.
1. Say you are holding $10,000 in foreign equity, which exposes you to currency risk. If you hedge $5,000 worth of the equity with a currency position, your hedge ratio is 0.5 (50 / 100). This means that 50% of your equity position is sheltered from exchange rate risk.
2. The hedge ratio is important for investors in futures contracts, as it will help to identify and minimize basis risk
HEDGE FUND
An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).
Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year.
For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies.
It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.
HEDGE ACCOUNTING-SUMMARY
The accounting treatment of call options prima facie will depend upon the intention with which the options are purchased: for hedging or speculation (nonhedging).
If the position is taken as a hedge against some other position, then the relevant accounting standards will be applicable and there are certain conditions that are to be fulfilled for the same.
Only long calls and long puts are eligible for hedge accounting, as written calls or puts limit the profitability while exposing the investor to unlimited risks and as such are not eligible for hedge accounting.
The standards require that the potential for gains should be at least equal to the potential for losses; this is known as a symmetrical risk-reward situation. For a written option the risk-reward is asymmetrical; hence, written options per se do not qualify for hedge accounting.
However, a combination of written options and certain other derivative instruments that results in a symmetrical risk-reward may qualify for hedge accounting.
To qualify for hedge accounting, either the upside and downside potential of the net position must be symmetrical or the upside potential must be greater than the downside potential.
Written options based on symmetry of the gain and loss potential of the combined hedged position qualify for hedge accounting as per the accounting standard.
If a written option is designated as hedging a recognized asset or liability, the combination of the hedged item and the written option provides at least as much potential for gains (as a result of a favorable change in the fair value of the combined instruments) as it does exposure to losses from an unfavorable change in their combined fair value.
Hedge accounting is not permitted for covered calls. This prohibition is also specifically mentioned in the standard itself.
It is permissible to separate the intrinsic value and time value of an option contract, designate as the hedging instrument only the change in intrinsic value of an option, and exclude change in its time value.
The accounting standards permit an entity to apply hedge accounting for a delta-neutral hedging strategy and other dynamic hedging strategies under which the quantity of the hedging instrument is constantly adjusted in order to maintain a desired hedge ratio.
Tuesday, August 18, 2009
Loanable Funds Theory of Interest
According to the Loanable Funds Theory of Interest, the rate of interest is calculated on the basis of demand and supply of loanable funds present in the capital market. The concept formulated by Knut Wicksell, the well-known Swedish economist, is among the most important economic theories.
Basic Tenet of the Loanable Funds Theory of Interest The Loanable Funds Theory of Interest advocates that both savings and investments are responsible for the determination of the rates of interest in the long run. On the other hand, short-term interest
rates are calculated on the basis of the financial conditions of a particular economy.
The determination of the interest rates in case of the Loanable Funds Theory of the Rate of Interest, depends essentially on the availability of loan amounts. The availability of such loan amounts is based on certain factors like the net increase in currency deposits, the amount of savings made, willingness to enhance cash balances and opportunities for the formation of fresh capitals.
In an attempt to develop the macro-economic theory, John Maynard Keynes studied minutely, The Demand supply interaction of Loanable funds
According to the loanable funds theory of interest the nominal rate of interest is determined by the interaction between the demand and supply of loanable funds. Keeping the same level of supply, an increase in the demand for loanable funds would lead to an increase in the interest rate and the vice versa is true. Conversely an increase in the supply of loanable funds would result in fall in the rate of interest. If both the demand and supply of the loanable funds change, the resultant interest rate would depend much on the magnitude and direction of movement of the demand and supply of the loanable funds.
Now, the demand for loanable funds is basically derived from the demand from the final goods and services. These final goods and services are again generated from the use of capital that is financed by the loanable funds. The demand for loanable funds is also generated from the government.
The Loanable Funds Theory of the Rate of Interest has similarity with the Liquidity-Preference Theory of Interest in the sense that both of them identify the significance of the cash balance preferences and the role played by the banking sector to ensure security of the investment funds.
Basic Tenet of the Loanable Funds Theory of Interest The Loanable Funds Theory of Interest advocates that both savings and investments are responsible for the determination of the rates of interest in the long run. On the other hand, short-term interest
rates are calculated on the basis of the financial conditions of a particular economy.
The determination of the interest rates in case of the Loanable Funds Theory of the Rate of Interest, depends essentially on the availability of loan amounts. The availability of such loan amounts is based on certain factors like the net increase in currency deposits, the amount of savings made, willingness to enhance cash balances and opportunities for the formation of fresh capitals.
In an attempt to develop the macro-economic theory, John Maynard Keynes studied minutely, The Demand supply interaction of Loanable funds
According to the loanable funds theory of interest the nominal rate of interest is determined by the interaction between the demand and supply of loanable funds. Keeping the same level of supply, an increase in the demand for loanable funds would lead to an increase in the interest rate and the vice versa is true. Conversely an increase in the supply of loanable funds would result in fall in the rate of interest. If both the demand and supply of the loanable funds change, the resultant interest rate would depend much on the magnitude and direction of movement of the demand and supply of the loanable funds.
Now, the demand for loanable funds is basically derived from the demand from the final goods and services. These final goods and services are again generated from the use of capital that is financed by the loanable funds. The demand for loanable funds is also generated from the government.
The Loanable Funds Theory of the Rate of Interest has similarity with the Liquidity-Preference Theory of Interest in the sense that both of them identify the significance of the cash balance preferences and the role played by the banking sector to ensure security of the investment funds.
Thursday, July 16, 2009
What is sum of the years digits depreciation?
Sum of the year's digits depreciation is a method of calculating the depreciation of an asset over the years. Sum of the year's digits falls under the category of accelerated depreciation methods, as opposed to straight-line depreciation.
Accelerated depreciation methods are considered to be more conservative calculations of depreciation and also more accurate methods of depreciation calculation. Accelerated depreciation calculation methods assume and rest on the idea that an asset will lose value more quickly at the beginning of its useful life as opposed to losing value at a steady rate throughout its depreciable life. Another method of calculating depreciation that falls under accelerated depreciation is double-declining balance depreciation, or just plain declining balance depreciation.
Here's a simple way to describe how sum of the years digits works.
1. Take the expected life of the asset (make sure that it is in years). Count from the top number back to one. Then add all of the numbers together. So if you purchase a piece of machinery that is expected to last for 12 years, you would do the following:
12 years useful life = 12 + 11 + 10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 Sum of the years = 78
2. To calculate the depreciation of an asset for each year of its useful life, you take the year of its useful life and set it as a percentage of the sum of the years.
This means that in the first year of your machine's life, it would end up being depreciated 12/78 in value. This fraction comes out to 15.38%. So the asset loses 15.38% of its value in the first year. The second year, the machine will be depreciated 11/78, or 14.10% of its value. In the third year, your machine will depreciate 10/78 in value, or 12.82% of its value. And so on and so forth.
3. Let's look at an example. Let's simply use the machine from up above. Let's say that this particular machine cost you $17,000. It has a salvage value of $900. Its useful life is 12 years. We have already calculated the sum of the years for the machine, and it comes out to 78.
We have already calculated that in the first year of use, the machine is going to depreciate by 15.38%. This means that in the first year of use, you will see depreciation expenses of $2467.18 (after subtracting the salvage value from the historical cost). In the second year, the machine has depreciation expenses of 14.10%. This means that you will see depreciation expenses of $2270.10. In the third year, the value will depreciate by 12.82%. Your depreciation expenses will end up being $2064.02.
That was the simple way of describing sum of years digits depreciation. Here's the more technical and complicated way of describing its formula.
Sum of years digits can also be described as a historical depreciation method. Its accelerated is in between straight line depreciation and declining balance depreciation. Here is the formula that is used to determine sum of years digits depreciation.
N = depreciable life of an asset
B = cost basis
S = salvage value
D(t) = depreciation charge for year t
Sum = (N(N + 1))/2
Then
D(t) = (N - t + 1) x ((B - S)/Sum)
Sum of the years digits depreciation is a way of calculating depreciation that will allocate the cost of whatever asset you have over its useful life. A simpler way of describing the formula than that above is to simply say that the numerator of the fraction is the number of years left to be depreciation out of the useful life of the asset. The denominator is the sum of the years digits, determined with the formula: ( N (N + 1) ) / 2 where N is the years of the depreciable life
The sum of the years’ digits, often referred to as SYD, is a form of accelerated depreciation. (A more common form of accelerated depreciation is the declining balance method used in tax depreciation.) The sum of the years’ digits method will result in greater depreciation in the earlier years of an asset’s useful life and less in the later years. However, the total amount of depreciation over an asset’s useful life should be the same regardless of the depreciation method used. The difference is in the timing of the total depreciation.
To illustrate the sum of the years’ digits method of depreciation, let’s assume that a plant asset is purchased at a cost of $160,000. The asset is expected to have a useful life of 5 years and then be sold for $10,000. This means that the asset’s depreciable amount will be $150,000 to be expensed over its useful life of 5 years.
Next the digits in the years of the asset’s useful life are summed: 1 + 2 + 3 + 4 + 5 = 15. In the first year of the asset’s life, 5/15 of the depreciable amount (5/15 of $150,000) or $50,000 will be debited to Depreciation Expense and $50,000 will be credited to Accumulated Depreciation. In the second year of the asset’s life, $40,000 (4/15 of $150,000) will be the depreciation amount. In the third year, $30,000 (3/15 of $150,000) will be the depreciation. The fourth year will be $20,000 (2/15 of $150,000) and the fifth year will be $10,000 (1/15 of $150,000). As indicated earlier, the total depreciation during the asset’s useful life needs to sum to the depreciable cost (in this case $150,000) regardless of the depreciation method used.
Instead of adding the individual digits in the years of the asset’s useful life, the following formula can be used: n(n+1) divided by 2. In this formula, n = the useful life in years. Let’s use the formula to check our calculation above. When the useful life is 5 years, the formula will be 5(5+1)/2 = 5(6)/2 = 30/2 = 15. If the useful life is 10 years, the formula will show 10(10+1)/2 = 10(11)/2 = 110/2 = 55. In the first year of the asset having a 10 year useful life, the depreciation will be 10/55 of the asset’s depreciable cost. The second year will be 9/55 of the asset’s depreciable cost. In the tenth year, the depreciation will be 1/55 of the asset’s depreciable cost.
******************************************************************************
YOU HAVE EXPERIENCED ALL THE INSTITUTES AND
COACHING CENTRES BUT AT THE END YOUR RESULT IS STILL
LAPSE/ FAIL OR REFERRAL.
THE REASONS ARE
Ø NON COMMANDABILITY ON BASIC CONCEPTS OF
STUDENTS.
Ø INSTITUTES DO NOT TAKE PAINS TO TEACH BASIC
CONCEPTS.
Ø STRENGTH OF EVERY CLASS IS ABOVE 30
STUDENTS.
Ø LACK OF INDIVIDUAL ATTENTION.
Ø SHY STUDENTS ALWAYS BECOME THE VICTIM OF
THIS SYSTEM.
IN A NUT SHELL
YOU HAVE TO ULTIMATELY CHANGE YOUR FIELD
BECAUSE OF YOUR INCAPABILITY TO REACH BEYOND
INTERMEDIATE STAGE OR MODULE A OR B OF
ICMAP/ICAP.
W HAT ARE YOU W AITING FOR
JOINKHALID AZIZ AND IMPROVIZE YOUR
BASIC CONCEPTS BECAUSE ITS IMPOSSIBLE TO CLEAR
THE PAPERS OF CA/ICMAP WITHOUT HAVING A SOUND
GRIP OVER BASIC CONCEPTS.
KHALID AZIZ
0322-3385752
R-1173, AL-NOOR SOCIETY BLOCK 19, F.B.AREA,
KARACHI.
Accelerated depreciation methods are considered to be more conservative calculations of depreciation and also more accurate methods of depreciation calculation. Accelerated depreciation calculation methods assume and rest on the idea that an asset will lose value more quickly at the beginning of its useful life as opposed to losing value at a steady rate throughout its depreciable life. Another method of calculating depreciation that falls under accelerated depreciation is double-declining balance depreciation, or just plain declining balance depreciation.
Here's a simple way to describe how sum of the years digits works.
1. Take the expected life of the asset (make sure that it is in years). Count from the top number back to one. Then add all of the numbers together. So if you purchase a piece of machinery that is expected to last for 12 years, you would do the following:
12 years useful life = 12 + 11 + 10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 Sum of the years = 78
2. To calculate the depreciation of an asset for each year of its useful life, you take the year of its useful life and set it as a percentage of the sum of the years.
This means that in the first year of your machine's life, it would end up being depreciated 12/78 in value. This fraction comes out to 15.38%. So the asset loses 15.38% of its value in the first year. The second year, the machine will be depreciated 11/78, or 14.10% of its value. In the third year, your machine will depreciate 10/78 in value, or 12.82% of its value. And so on and so forth.
3. Let's look at an example. Let's simply use the machine from up above. Let's say that this particular machine cost you $17,000. It has a salvage value of $900. Its useful life is 12 years. We have already calculated the sum of the years for the machine, and it comes out to 78.
We have already calculated that in the first year of use, the machine is going to depreciate by 15.38%. This means that in the first year of use, you will see depreciation expenses of $2467.18 (after subtracting the salvage value from the historical cost). In the second year, the machine has depreciation expenses of 14.10%. This means that you will see depreciation expenses of $2270.10. In the third year, the value will depreciate by 12.82%. Your depreciation expenses will end up being $2064.02.
That was the simple way of describing sum of years digits depreciation. Here's the more technical and complicated way of describing its formula.
Sum of years digits can also be described as a historical depreciation method. Its accelerated is in between straight line depreciation and declining balance depreciation. Here is the formula that is used to determine sum of years digits depreciation.
N = depreciable life of an asset
B = cost basis
S = salvage value
D(t) = depreciation charge for year t
Sum = (N(N + 1))/2
Then
D(t) = (N - t + 1) x ((B - S)/Sum)
Sum of the years digits depreciation is a way of calculating depreciation that will allocate the cost of whatever asset you have over its useful life. A simpler way of describing the formula than that above is to simply say that the numerator of the fraction is the number of years left to be depreciation out of the useful life of the asset. The denominator is the sum of the years digits, determined with the formula: ( N (N + 1) ) / 2 where N is the years of the depreciable life
The sum of the years’ digits, often referred to as SYD, is a form of accelerated depreciation. (A more common form of accelerated depreciation is the declining balance method used in tax depreciation.) The sum of the years’ digits method will result in greater depreciation in the earlier years of an asset’s useful life and less in the later years. However, the total amount of depreciation over an asset’s useful life should be the same regardless of the depreciation method used. The difference is in the timing of the total depreciation.
To illustrate the sum of the years’ digits method of depreciation, let’s assume that a plant asset is purchased at a cost of $160,000. The asset is expected to have a useful life of 5 years and then be sold for $10,000. This means that the asset’s depreciable amount will be $150,000 to be expensed over its useful life of 5 years.
Next the digits in the years of the asset’s useful life are summed: 1 + 2 + 3 + 4 + 5 = 15. In the first year of the asset’s life, 5/15 of the depreciable amount (5/15 of $150,000) or $50,000 will be debited to Depreciation Expense and $50,000 will be credited to Accumulated Depreciation. In the second year of the asset’s life, $40,000 (4/15 of $150,000) will be the depreciation amount. In the third year, $30,000 (3/15 of $150,000) will be the depreciation. The fourth year will be $20,000 (2/15 of $150,000) and the fifth year will be $10,000 (1/15 of $150,000). As indicated earlier, the total depreciation during the asset’s useful life needs to sum to the depreciable cost (in this case $150,000) regardless of the depreciation method used.
Instead of adding the individual digits in the years of the asset’s useful life, the following formula can be used: n(n+1) divided by 2. In this formula, n = the useful life in years. Let’s use the formula to check our calculation above. When the useful life is 5 years, the formula will be 5(5+1)/2 = 5(6)/2 = 30/2 = 15. If the useful life is 10 years, the formula will show 10(10+1)/2 = 10(11)/2 = 110/2 = 55. In the first year of the asset having a 10 year useful life, the depreciation will be 10/55 of the asset’s depreciable cost. The second year will be 9/55 of the asset’s depreciable cost. In the tenth year, the depreciation will be 1/55 of the asset’s depreciable cost.
******************************************************************************
YOU HAVE EXPERIENCED ALL THE INSTITUTES AND
COACHING CENTRES BUT AT THE END YOUR RESULT IS STILL
LAPSE/ FAIL OR REFERRAL.
THE REASONS ARE
Ø NON COMMANDABILITY ON BASIC CONCEPTS OF
STUDENTS.
Ø INSTITUTES DO NOT TAKE PAINS TO TEACH BASIC
CONCEPTS.
Ø STRENGTH OF EVERY CLASS IS ABOVE 30
STUDENTS.
Ø LACK OF INDIVIDUAL ATTENTION.
Ø SHY STUDENTS ALWAYS BECOME THE VICTIM OF
THIS SYSTEM.
IN A NUT SHELL
YOU HAVE TO ULTIMATELY CHANGE YOUR FIELD
BECAUSE OF YOUR INCAPABILITY TO REACH BEYOND
INTERMEDIATE STAGE OR MODULE A OR B OF
ICMAP/ICAP.
W HAT ARE YOU W AITING FOR
JOINKHALID AZIZ AND IMPROVIZE YOUR
BASIC CONCEPTS BECAUSE ITS IMPOSSIBLE TO CLEAR
THE PAPERS OF CA/ICMAP WITHOUT HAVING A SOUND
GRIP OVER BASIC CONCEPTS.
KHALID AZIZ
0322-3385752
R-1173, AL-NOOR SOCIETY BLOCK 19, F.B.AREA,
KARACHI.
Tuesday, July 7, 2009
Flexible Budget
budget is a plan for the future. Hence, budgets are planning tools, and they are usually prepared prior to the start of the period being budgeted. However, the comparison of the budget to actual results provides valuable information about performance. Therefore, budgets are both planning tools and performance evaluation tools.
Usually, the single most important input in the budget is some measure of anticipated output. For a factory, this measure of output is the number of units of each product produced. For a retailer, it might be the number of units of each product sold. For a hospital, it is the number of patient days (the number of patient admissions multiplied by the average length of stay).
The static budget is the budget that is based on this projected level of output, prior to the start of the period. In other words, the static budget is the “original” budget. The static budget variance is the difference between any line-item in this original budget and the corresponding line-item from the statement of actual results. Often, the line-item of most interest is the “bottom line”: total cost of production for the factory and other cost centers; net income for profit centers.
The flexible budget is a performance evaluation tool. It cannot be prepared before the end of the period. A flexible budget adjusts the static budget for the actual level of output. The flexible budget asks the question: “If I had known at the beginning of the period what my output volume (units produced or units sold) would be, what would my budget have looked like?” The motivation for the flexible budget is to compare apples to apples. If the factory actually produced 10,000 units, then management should compare actual factory costs for 10,000 units to what the factory should have spent to make 10,000 units, not to what the factory should have spent to make 9,000 units or 11,000 units or any other production level.
The flexible budget variance is the difference between any line-item in the flexible budget and the corresponding line-item from the statement of actual results.
The following steps are used to prepare a flexible budget:
1. Determine the budgeted variable cost per unit of output. Also determine the budgeted sales price per unit of output, if the entity to which the budget applies generates revenue (e.g., the retailer or the hospital).
2. Determine the budgeted level of fixed costs.
3. Determine the actual volume of output achieved (e.g., units produced for a factory, units sold for a retailer, patient days for a hospital).
4. Build the flexible budget based on the budgeted cost information from steps 1 and 2, and the actual volume of output from step 3.
Flexible budgets are prepared at the end of the period, when actual output is known. However, the same steps described above for creating the flexible budget can be used prior to the start of the period to anticipate costs and revenues for any projected level of output, where the projected level of output is incorporated at step 3. If these steps are applied to various anticipated levels of output, the analysis is called pro forma analysis. Pro forma analysis is useful for planning purposes. For example, if next year’s sales are double this year’s sales, what will be the company’s cash, materials, and labor requirements in order to meet production needs?
A flexible budget can help managers to make more valid comparisons. It is designed to show the expected revenue and the allowed expenditure for the actual number of units produced and sold. Comparing this flexible budget with the actual expenditure and revenue it is possible to distinguish genuine efficiencies. The question is: how to prepare a flexible budget? This post provide a simple overview of how a flexible budget is prepared.
Before a flexible budget can be produced, managers must identify which costs are fixed and which are variable. The allowed expenditure on variable costs can then be increased or decreased as the level of activity changes. “Fixed costs” are those costs which will not increase or decrease over a given range of activity. The allowance for these items will therefore remain constant. Let us continue with the example…
Management have identified that the following budgeted costs are fixed:
Direct labor = $8,400
Overheads = $53,000
It is now possible to identify the expected variable cost per unit produced and sold:
Now that managers are aware of the fixed costs and the variable costs per unit it is possible to ‘flex’ the original budget to produce a budget cost allowance for 1,000 units produced and sold.
The budget cost allowance for each item is calculated as follows:
Cost allowance = budgeted fixed cost + (number of units produced and sold x variable cost per unit)
For the costs which are wholly fixed or wholly variable the calculation of the budget cost allowance is fairly straightforward. The remaining costs are semi-variable, which means that they are partly fixed and partly variable.
The budget cost allowance for direct labor is calculated as follows:
Cost allowance for direct labor = $8,400 + (1,000 units x $4) = $12,400
The budgeted sales price per unit is $120,000 / 1,200 = $100 per unit.
If it is assumed that sales revenues follow a linear variable pattern (because the sales price remains constant) the full flexible budget can now be produced.
To make sure that you followed it, let’s do further example.
Following the example of the calculation of the budget cost allowance for direct labor, calculate a revised budget cost allowance for all costs for an activity of 1,000 units and produce a revised variance statement for April.
Firstly, we need to compute the cost allowance for the overhead. Here we go:
Cost allowance for overhead = $53,000 + (1,000 units x $7) = $60,000
Next, we can make “flexible budget comparison” for April as below:
This revised analysis shows that in fact the profit was $7,610 higher than would have been expected from a sales volume of 1,000 units.
The largest variance is a $10,000 favorable variance on sales revenue. This has arisen because a higher price was charged than budgeted.
Could the higher sales price have been the cause of the shortfall in sales volume?
Although the answer to this question is not available from this information, without a flexed budget comparison it was not possible to tell that a different selling price had been charged. This is an example of variances which may be interrelated – a favorable variance on sales price may have caused an adverse variance on sales volume.
The cost variances in the flexible budget comparison are mainly adverse. These overspendings were not revealed when a fixed budget was used and managers may have been under the false impression that costs were being adequately controlled. You may be wondering what has happened to the remainder of the $6,990 adverse profit variance shown in our original budget comparison at the beginning of this example. This could be analyzed as follows:
Difference in budgeted profit -
causedby volume shortfall ($26,200 - $11,600) = ($14,600)
Profit variance from flexible budget comparison = $7,610
Total profit shortfall, per original budget comparison = ($6,990)
This shows clearly that the adverse variance was caused by the volume shortfall, and not by differences in the expected cost and revenues from the sales that were made.
Using Flexible Budgets for Planning
Although flexible budgets can be useful for control purposes they are not particularly useful for planning. The original budget must contain a single target level of activity so that managers can plan such factors as the resource requirements and the product pricing policy. This would not be possible if they were faced with a range of possible activity levels.
Usually, the single most important input in the budget is some measure of anticipated output. For a factory, this measure of output is the number of units of each product produced. For a retailer, it might be the number of units of each product sold. For a hospital, it is the number of patient days (the number of patient admissions multiplied by the average length of stay).
The static budget is the budget that is based on this projected level of output, prior to the start of the period. In other words, the static budget is the “original” budget. The static budget variance is the difference between any line-item in this original budget and the corresponding line-item from the statement of actual results. Often, the line-item of most interest is the “bottom line”: total cost of production for the factory and other cost centers; net income for profit centers.
The flexible budget is a performance evaluation tool. It cannot be prepared before the end of the period. A flexible budget adjusts the static budget for the actual level of output. The flexible budget asks the question: “If I had known at the beginning of the period what my output volume (units produced or units sold) would be, what would my budget have looked like?” The motivation for the flexible budget is to compare apples to apples. If the factory actually produced 10,000 units, then management should compare actual factory costs for 10,000 units to what the factory should have spent to make 10,000 units, not to what the factory should have spent to make 9,000 units or 11,000 units or any other production level.
The flexible budget variance is the difference between any line-item in the flexible budget and the corresponding line-item from the statement of actual results.
The following steps are used to prepare a flexible budget:
1. Determine the budgeted variable cost per unit of output. Also determine the budgeted sales price per unit of output, if the entity to which the budget applies generates revenue (e.g., the retailer or the hospital).
2. Determine the budgeted level of fixed costs.
3. Determine the actual volume of output achieved (e.g., units produced for a factory, units sold for a retailer, patient days for a hospital).
4. Build the flexible budget based on the budgeted cost information from steps 1 and 2, and the actual volume of output from step 3.
Flexible budgets are prepared at the end of the period, when actual output is known. However, the same steps described above for creating the flexible budget can be used prior to the start of the period to anticipate costs and revenues for any projected level of output, where the projected level of output is incorporated at step 3. If these steps are applied to various anticipated levels of output, the analysis is called pro forma analysis. Pro forma analysis is useful for planning purposes. For example, if next year’s sales are double this year’s sales, what will be the company’s cash, materials, and labor requirements in order to meet production needs?
A flexible budget can help managers to make more valid comparisons. It is designed to show the expected revenue and the allowed expenditure for the actual number of units produced and sold. Comparing this flexible budget with the actual expenditure and revenue it is possible to distinguish genuine efficiencies. The question is: how to prepare a flexible budget? This post provide a simple overview of how a flexible budget is prepared.
Before a flexible budget can be produced, managers must identify which costs are fixed and which are variable. The allowed expenditure on variable costs can then be increased or decreased as the level of activity changes. “Fixed costs” are those costs which will not increase or decrease over a given range of activity. The allowance for these items will therefore remain constant. Let us continue with the example…
Management have identified that the following budgeted costs are fixed:
Direct labor = $8,400
Overheads = $53,000
It is now possible to identify the expected variable cost per unit produced and sold:
Now that managers are aware of the fixed costs and the variable costs per unit it is possible to ‘flex’ the original budget to produce a budget cost allowance for 1,000 units produced and sold.
The budget cost allowance for each item is calculated as follows:
Cost allowance = budgeted fixed cost + (number of units produced and sold x variable cost per unit)
For the costs which are wholly fixed or wholly variable the calculation of the budget cost allowance is fairly straightforward. The remaining costs are semi-variable, which means that they are partly fixed and partly variable.
The budget cost allowance for direct labor is calculated as follows:
Cost allowance for direct labor = $8,400 + (1,000 units x $4) = $12,400
The budgeted sales price per unit is $120,000 / 1,200 = $100 per unit.
If it is assumed that sales revenues follow a linear variable pattern (because the sales price remains constant) the full flexible budget can now be produced.
To make sure that you followed it, let’s do further example.
Following the example of the calculation of the budget cost allowance for direct labor, calculate a revised budget cost allowance for all costs for an activity of 1,000 units and produce a revised variance statement for April.
Firstly, we need to compute the cost allowance for the overhead. Here we go:
Cost allowance for overhead = $53,000 + (1,000 units x $7) = $60,000
Next, we can make “flexible budget comparison” for April as below:
This revised analysis shows that in fact the profit was $7,610 higher than would have been expected from a sales volume of 1,000 units.
The largest variance is a $10,000 favorable variance on sales revenue. This has arisen because a higher price was charged than budgeted.
Could the higher sales price have been the cause of the shortfall in sales volume?
Although the answer to this question is not available from this information, without a flexed budget comparison it was not possible to tell that a different selling price had been charged. This is an example of variances which may be interrelated – a favorable variance on sales price may have caused an adverse variance on sales volume.
The cost variances in the flexible budget comparison are mainly adverse. These overspendings were not revealed when a fixed budget was used and managers may have been under the false impression that costs were being adequately controlled. You may be wondering what has happened to the remainder of the $6,990 adverse profit variance shown in our original budget comparison at the beginning of this example. This could be analyzed as follows:
Difference in budgeted profit -
causedby volume shortfall ($26,200 - $11,600) = ($14,600)
Profit variance from flexible budget comparison = $7,610
Total profit shortfall, per original budget comparison = ($6,990)
This shows clearly that the adverse variance was caused by the volume shortfall, and not by differences in the expected cost and revenues from the sales that were made.
Using Flexible Budgets for Planning
Although flexible budgets can be useful for control purposes they are not particularly useful for planning. The original budget must contain a single target level of activity so that managers can plan such factors as the resource requirements and the product pricing policy. This would not be possible if they were faced with a range of possible activity levels.
Tuesday, June 30, 2009
Opportunity cost
Opportunity cost or economic opportunity loss is the value of the next best alternative forgone as the result of making a decision. Opportunity cost analysis is an important part of a company's decision-making processes but is not treated as an actual cost in any financial statement. The next best thing that a person can engage in is referred to as the opportunity cost of doing the best thing and ignoring the next best thing to be done.
Opportunity cost is a key concept in economics because it implies the choice between desirable, yet mutually exclusive results. It is a calculating factor used in mixed markets which favour social change in favour of purely individualistic economics. It has been described as expressing "the basic relationship between scarcity and choice." The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently. Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, swag, pleasure or any other benefit that provides utility should also be considered opportunity costs.
The concept of an opportunity cost was first developed by John Stuart Mill.
A person who invests $10,000 in a stock denies herself or himself the interest that could have accrued by leaving the $10,000 in a bank account instead. The opportunity cost of the decision to invest in stock is the value of the interest.
A person who sells stock for $10,000 denies himself or herself the opportunity to sell the stock for a higher price in the future, inheriting an opportunity cost equal to future price minus sale price.
An organization that invests $1 million in acquiring a new asset instead of spending that money on maintaining its existing asset portfolio incurs the increased risk of failure of its existing assets. The opportunity cost of the decision to acquire a new asset is the financial security that comes from the organization's spending the money on maintaining its existing asset portfolio.
If a city decides to build a hospital on vacant land it owns, the opportunity cost is the value of the benefits forgone of the next best thing that might have been done with the land and construction funds instead. In building the hospital, the city has forgone the opportunity to build a sports center on that land, or a parking lot, or the ability to sell the land to reduce the city's debt, since those uses tend to be mutually exclusive. Also included in the opportunity cost would be what investments or purchases the private sector would have voluntarily made if it had not been taxed to build the hospital. The total opportunity costs of such an action can never be known with certainty, and are sometimes called "hidden costs" or "hidden losses" as what has been prevented from being produced cannot be seen or known. Even the possibility of inaction is a lost opportunity. In this example, to preserve the scenery as-is for neighboring areas, perhaps including areas that it itself owns.
Opportunity cost is assessed in not only monetary or material terms, but also in terms of anything which is of value. For example, a person who desires to watch each of two television programs being broadcast simultaneously, and does not have the means to make a recording of one, can watch only one of the desired programs. Therefore, the opportunity cost of watching Dallas could be enjoying Dynasty. In a restaurant situation, the opportunity cost of eating steak could be trying the salmon. For the diner, the opportunity cost of ordering both meals could be twofold - the extra $20 to buy the second meal, and his reputation with his peers, as he may be thought gluttonous or extravagant for ordering two meals. A family might decide to use a short period of vacation time to visit Disneyland rather than doing household improvements. The opportunity cost of having happy children could therefore be a remodelled bathroom
The consideration of opportunity costs is one of the key differences between the concepts of economic cost and accounting cost. Assessing opportunity costs is fundamental to assessing the true cost of any course of action. In the case where there is no explicit accounting or monetary cost (price) attached to a course of action, or the explicit accounting or monetory cost is low, then, ignoring opportunity costs may produce the illusion that its benefits cost nothing at all. The unseen opportunity costs then become the implicit hidden costs of that course of action.
Note that opportunity cost is not the sum of the available alternatives when those alternatives are, in turn, mutually exclusive to each other. The opportunity cost of the city's decision to build the hospital on its vacant land is the loss of the land for a sporting center, or the inability to use the land for a parking lot, or the money which could have been made from selling the land, as use for any one of those purposes would preclude the possibility to implement any of the others.
However, most opportunities are difficult to compare. Opportunity cost has been seen as the foundation of the marginal theory of value as well as the theory of time and money.
In some cases it may be possible to have more of everything by making different choices; for instance, when an economy is within its production possibility frontier. In microeconomic models this is unusual, because individuals are assumed to maximise utility, but it is a feature of Keynesian macroeconomics. In these circumstances opportunity cost is a less useful concept.
The first step to making good decisions is to think about the trade-offs involved. This primer explains how measuring opportunity cost can help you find the trade-off that lurks within every decision.
Let's begin by analyzing a typical decision carefully, just as a coach might videotape a tennis player's stroke and then study it frame by frame.
Suppose that Jim is about to purchase a CD of his favorite singer. Let's see what goes on in his mind as he makes his decision.
Jim first looks at the songs and thinks about the hours of pleasure he would get listening to them. In economic terms, he determines the benefit he expects to get from the CD. Next, he glances at the price tag to see how much it costs -- $15. Jim determines that the CD's benefit exceeds its cost, so he decides to buy it.
To make his decision, Jim followed a simple rule: Do something if its benefit outweighs its cost. To see if Jim's rule is a good one, let's try it out on another problem. Suppose a woman is walking along down the street when she sees a dime on the sidewalk. Should she pick it up?
Yes, you may be thinking. If she picks up the dime, she gets a benefit of 10 cents. On the other hand, it doesn't cost her anything to pick it up. The benefit clearly outweighs the cost.
But what if the woman is Madonna, and she's hurrying to a recording studio where a symphony orchestra is waiting to perform with her. Do you still think she should stop and pick up the dime?
It's clearly not worth her time. Perhaps Jim's rule needs to be modified, say to this: Do something if its benefit outweighs its cost unless you're a famous singer. Or a movie star, or President of the United States, or a brain surgeon.
But there's a simpler way. We can greatly improve Jim's decision-making rule by adding just one word. Here's the rule for deciding whether it's in your own best interest to do something:
Do something if its benefit outweighs its opportunity cost.
When asked how much something costs, people usually answer by giving its price, or money cost. Economists usually measure cost differently, using what they call opportunity cost, defined as the value of the next best alternative opportunity that is given up in order to do something.
Here's how to calculate it. When considering a choice, ask yourself three questions:
1. What alternative opportunities are there?
2. Which is the best of these alternative opportunities?
3. What would I gain if I selected my best alternative opportunity instead of the choice I'm considering?
The answer to the third question is the opportunity cost of the choice.
To find out the opportunity cost to Madonna of picking up the dime, we need to come up with her alternative opportunities and select the best one. Let's assume that Madonna's best alternative to picking up the dime would be to leave it on the sidewalk and arrive at the recording studio 30 seconds sooner.
The value of those 30 extra seconds at the recording studio is the opportunity cost to her of picking up the dime. She should compare the benefit she'd get from picking up the dime (10 cents) with its opportunity cost (arriving 30 seconds sooner at the recording studio) to decide what to do.
When we compare the opportunity cost of picking up the dime with the benefit, we can see that it doesn't make sense for Madonna to retrieve it. Her time would be better spent at the recording studio. Perhaps a child─whose time isn't worth as much─will come along later and decide to pick up the dime.
Opportunity cost and trade-offs
Let's have Jim decide again whether to buy the CD, this time using opportunity cost instead of money cost. As before, he should first consider the benefit he'd get from the CD, and look at its price tag. But before making a decision, Jim should consider alternative opportunities -- other things that he could do with the $15. Suppose his best alternative is to buy a pair of $15 sunglasses. The value to him of the sunglasses represents the opportunity cost of the CD.
As he decides whether to buy the CD, he should compare its benefit with its opportunity cost -- the sunglasses. If the benefit (the value to Jim of the CD) outweighs the opportunity cost (the value to Jim of the sunglasses), then he should buy the CD. If the benefit is less than the opportunity cost, then he shouldn't buy it.
In other words, thinking about the opportunity cost of buying a CD expresses the problem as a choice between the CD and the sunglasses. This is precisely why opportunity cost is such a powerful decision-making tool. It shows a decision for what it really is -- a trade-off between your two best alternatives.
As another example, consider a government proposal to build a new dam. Here's how a poor decision-maker might view the problem:
"If we build a dam, we'll have better flood control and cheaper electricity. If we don't, then we'll experience occasional flooding, and electricity will be more expensive."
Here the choice seems to be between having a dam and not having a dam. When put that way, it's tempting to choose to build the dam. Cheaper electricity and flood control are better than expensive electricity and floods.
Here's another way of presenting the problem:
"If we build the dam, it will provide us with flood control and cheaper electricity, but it will cost us $100 million."
This decision-maker recognizes that something must be given up to build a dam. There's a trade-off. This is better, but still not the best way to view a decision. When we think of the cost in dollars, the trade-off we're facing is often unclear. It's hard for most people to imagine how much $100 million is, and we don't know whether the money could be put to better use elsewhere.
Here's how an economist would view the problem:
"If we build the dam, we'll have flood control and cheaper electricity. But the $100 million to build the dam could be used instead to build two new high schools."
Here, the benefit of the dam is compared with its opportunity cost: new high schools. Expressed that way, the cost of the dam becomes much more concrete. Besides, it's not really money that we're sacrificing when we build a dam, but rather resources -- workers, machines, cement, and land -- that could be used elsewhere. If money were the only thing we sacrificed, there would be no trade-offs; our government could buy us everything we wanted simply by printing more money, preferably in very large denominations.
Using opportunity cost -- an example
Ernesto is trying to decide whether to attend college and has determined the money cost of attending college for one year.
Money Cost of a Year of College
Tuition: $1,000
Books and school supplies: 2,000
Room and board: 10,000
Transportation: 1,000
Miscellaneous expenses: 3,000
__________________________________
Total money cost: $17,000
This tells Ernesto how much money he'll need to come up with if he decides to go to college.
But in order to decide whether to go to college, Ernesto should figure out its opportunity cost. The first step is for Ernesto to determine the best alternative to going to college. Let's say that it's working full time at the local Drive-In. The opportunity cost of going to college, then, is the value of what he would gain if he worked instead of going to college.
If Ernesto worked, he wouldn’t have to pay for tuition, books, or school supplies. He also would earn $10,000 during the year that she worked. The opportunity cost of a year of college, therefore, is:
Opportunity Cost of a Year of College
Tuition: $ 1,000
Books and school supplies: 2,000
Foregone wages from working: 10,000
_____________________________________
Total opportunity cost: $13,000
This tells Ernesto how much he'd have to spend on other things if he decided not to go to college.
You may be wondering why we didn't include room and board, transportation, entertainment, and miscellaneous expenses in the opportunity cost calculation. Wouldn't Ernesto have these expenses at college?
Yes, he would, but he also would face these costs if he decided to work. Remember, opportunity cost includes only the value of what one would gain under the next best alternative opportunity. Ernesto can't get out of paying for room and board, transportation, and entertainment by working. These expenses, therefore, should not be included in the opportunity cost of going to college.
The opportunity cost of going to college -- $13,000 -- tells Ernesto what he would gain if he chose not to go to college. When deciding whether to go to college, he should weigh that cost against the benefits of college, like higher future earnings, new friends, and a better understanding of our world.
Sunk Costs
Just as Eskimos have lots of words to describe snow, economists have lots of words to describe cost. This section introduces sunk costs.
Sunk costs are costs that must be paid whether or not you do something. They're of special interest to us because we don't want to include them when calculating opportunity cost. Unfortunately, sunk costs are like invasive weeds; it's often hard to yank them out of a problem.
To see why sunk costs should be ignored, let's go back to Sheila, who has had her car for a week now. She has just returned home from school and she's trying to decide whether to go out and see a movie.
To figure out the opportunity cost of seeing a movie, Sheila first determines her best alternative opportunity. Let's assume that it's to stay home and do homework. Next, she lists all the things that she would gain if she stayed home and did homework instead of watching a movie.
Opportunity Cost of Going to a Movie
Time to do homework: 3 hours
Gas and parking: $1.50
Admission to the theater: $2.00
__________________________________________________
Opportunity Cost: 3 hours and $3.50
Notice that Sheila correctly includes gas and parking in her opportunity cost calculations. But what about all the other costs associated with owning a car, like insurance and registration fees? Shouldn't she include them as part of the opportunity cost of going to a movie?
The answer is no. If Sheila stayed home, she'd still have to pay the same insurance and registration fees. She can't reduce these costs by staying home.
Insurance and registration fees are examples of sunk costs. Sunk costs can't be recovered by choosing the best alternative opportunity. That's why economists use the following rule when calculating the opportunity cost of something:
Ignore sunk costs.
Now suppose that Sheila decides to go to the movie and her little brother asks to come along. He will pay for his own admission. What is the opportunity cost to Sheila of bringing him?
The answer is nothing at all. Since Sheila has already decided to go to the movie theater, the expense of driving there has become a sunk cost -- she will incur that expense whether or not her brother comes. She doesn't sacrifice anything by bringing him along, unless, of course, he's obnoxious.
Opportunity cost is a key concept in economics because it implies the choice between desirable, yet mutually exclusive results. It is a calculating factor used in mixed markets which favour social change in favour of purely individualistic economics. It has been described as expressing "the basic relationship between scarcity and choice." The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently. Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, swag, pleasure or any other benefit that provides utility should also be considered opportunity costs.
The concept of an opportunity cost was first developed by John Stuart Mill.
A person who invests $10,000 in a stock denies herself or himself the interest that could have accrued by leaving the $10,000 in a bank account instead. The opportunity cost of the decision to invest in stock is the value of the interest.
A person who sells stock for $10,000 denies himself or herself the opportunity to sell the stock for a higher price in the future, inheriting an opportunity cost equal to future price minus sale price.
An organization that invests $1 million in acquiring a new asset instead of spending that money on maintaining its existing asset portfolio incurs the increased risk of failure of its existing assets. The opportunity cost of the decision to acquire a new asset is the financial security that comes from the organization's spending the money on maintaining its existing asset portfolio.
If a city decides to build a hospital on vacant land it owns, the opportunity cost is the value of the benefits forgone of the next best thing that might have been done with the land and construction funds instead. In building the hospital, the city has forgone the opportunity to build a sports center on that land, or a parking lot, or the ability to sell the land to reduce the city's debt, since those uses tend to be mutually exclusive. Also included in the opportunity cost would be what investments or purchases the private sector would have voluntarily made if it had not been taxed to build the hospital. The total opportunity costs of such an action can never be known with certainty, and are sometimes called "hidden costs" or "hidden losses" as what has been prevented from being produced cannot be seen or known. Even the possibility of inaction is a lost opportunity. In this example, to preserve the scenery as-is for neighboring areas, perhaps including areas that it itself owns.
Opportunity cost is assessed in not only monetary or material terms, but also in terms of anything which is of value. For example, a person who desires to watch each of two television programs being broadcast simultaneously, and does not have the means to make a recording of one, can watch only one of the desired programs. Therefore, the opportunity cost of watching Dallas could be enjoying Dynasty. In a restaurant situation, the opportunity cost of eating steak could be trying the salmon. For the diner, the opportunity cost of ordering both meals could be twofold - the extra $20 to buy the second meal, and his reputation with his peers, as he may be thought gluttonous or extravagant for ordering two meals. A family might decide to use a short period of vacation time to visit Disneyland rather than doing household improvements. The opportunity cost of having happy children could therefore be a remodelled bathroom
The consideration of opportunity costs is one of the key differences between the concepts of economic cost and accounting cost. Assessing opportunity costs is fundamental to assessing the true cost of any course of action. In the case where there is no explicit accounting or monetary cost (price) attached to a course of action, or the explicit accounting or monetory cost is low, then, ignoring opportunity costs may produce the illusion that its benefits cost nothing at all. The unseen opportunity costs then become the implicit hidden costs of that course of action.
Note that opportunity cost is not the sum of the available alternatives when those alternatives are, in turn, mutually exclusive to each other. The opportunity cost of the city's decision to build the hospital on its vacant land is the loss of the land for a sporting center, or the inability to use the land for a parking lot, or the money which could have been made from selling the land, as use for any one of those purposes would preclude the possibility to implement any of the others.
However, most opportunities are difficult to compare. Opportunity cost has been seen as the foundation of the marginal theory of value as well as the theory of time and money.
In some cases it may be possible to have more of everything by making different choices; for instance, when an economy is within its production possibility frontier. In microeconomic models this is unusual, because individuals are assumed to maximise utility, but it is a feature of Keynesian macroeconomics. In these circumstances opportunity cost is a less useful concept.
The first step to making good decisions is to think about the trade-offs involved. This primer explains how measuring opportunity cost can help you find the trade-off that lurks within every decision.
Let's begin by analyzing a typical decision carefully, just as a coach might videotape a tennis player's stroke and then study it frame by frame.
Suppose that Jim is about to purchase a CD of his favorite singer. Let's see what goes on in his mind as he makes his decision.
Jim first looks at the songs and thinks about the hours of pleasure he would get listening to them. In economic terms, he determines the benefit he expects to get from the CD. Next, he glances at the price tag to see how much it costs -- $15. Jim determines that the CD's benefit exceeds its cost, so he decides to buy it.
To make his decision, Jim followed a simple rule: Do something if its benefit outweighs its cost. To see if Jim's rule is a good one, let's try it out on another problem. Suppose a woman is walking along down the street when she sees a dime on the sidewalk. Should she pick it up?
Yes, you may be thinking. If she picks up the dime, she gets a benefit of 10 cents. On the other hand, it doesn't cost her anything to pick it up. The benefit clearly outweighs the cost.
But what if the woman is Madonna, and she's hurrying to a recording studio where a symphony orchestra is waiting to perform with her. Do you still think she should stop and pick up the dime?
It's clearly not worth her time. Perhaps Jim's rule needs to be modified, say to this: Do something if its benefit outweighs its cost unless you're a famous singer. Or a movie star, or President of the United States, or a brain surgeon.
But there's a simpler way. We can greatly improve Jim's decision-making rule by adding just one word. Here's the rule for deciding whether it's in your own best interest to do something:
Do something if its benefit outweighs its opportunity cost.
When asked how much something costs, people usually answer by giving its price, or money cost. Economists usually measure cost differently, using what they call opportunity cost, defined as the value of the next best alternative opportunity that is given up in order to do something.
Here's how to calculate it. When considering a choice, ask yourself three questions:
1. What alternative opportunities are there?
2. Which is the best of these alternative opportunities?
3. What would I gain if I selected my best alternative opportunity instead of the choice I'm considering?
The answer to the third question is the opportunity cost of the choice.
To find out the opportunity cost to Madonna of picking up the dime, we need to come up with her alternative opportunities and select the best one. Let's assume that Madonna's best alternative to picking up the dime would be to leave it on the sidewalk and arrive at the recording studio 30 seconds sooner.
The value of those 30 extra seconds at the recording studio is the opportunity cost to her of picking up the dime. She should compare the benefit she'd get from picking up the dime (10 cents) with its opportunity cost (arriving 30 seconds sooner at the recording studio) to decide what to do.
When we compare the opportunity cost of picking up the dime with the benefit, we can see that it doesn't make sense for Madonna to retrieve it. Her time would be better spent at the recording studio. Perhaps a child─whose time isn't worth as much─will come along later and decide to pick up the dime.
Opportunity cost and trade-offs
Let's have Jim decide again whether to buy the CD, this time using opportunity cost instead of money cost. As before, he should first consider the benefit he'd get from the CD, and look at its price tag. But before making a decision, Jim should consider alternative opportunities -- other things that he could do with the $15. Suppose his best alternative is to buy a pair of $15 sunglasses. The value to him of the sunglasses represents the opportunity cost of the CD.
As he decides whether to buy the CD, he should compare its benefit with its opportunity cost -- the sunglasses. If the benefit (the value to Jim of the CD) outweighs the opportunity cost (the value to Jim of the sunglasses), then he should buy the CD. If the benefit is less than the opportunity cost, then he shouldn't buy it.
In other words, thinking about the opportunity cost of buying a CD expresses the problem as a choice between the CD and the sunglasses. This is precisely why opportunity cost is such a powerful decision-making tool. It shows a decision for what it really is -- a trade-off between your two best alternatives.
As another example, consider a government proposal to build a new dam. Here's how a poor decision-maker might view the problem:
"If we build a dam, we'll have better flood control and cheaper electricity. If we don't, then we'll experience occasional flooding, and electricity will be more expensive."
Here the choice seems to be between having a dam and not having a dam. When put that way, it's tempting to choose to build the dam. Cheaper electricity and flood control are better than expensive electricity and floods.
Here's another way of presenting the problem:
"If we build the dam, it will provide us with flood control and cheaper electricity, but it will cost us $100 million."
This decision-maker recognizes that something must be given up to build a dam. There's a trade-off. This is better, but still not the best way to view a decision. When we think of the cost in dollars, the trade-off we're facing is often unclear. It's hard for most people to imagine how much $100 million is, and we don't know whether the money could be put to better use elsewhere.
Here's how an economist would view the problem:
"If we build the dam, we'll have flood control and cheaper electricity. But the $100 million to build the dam could be used instead to build two new high schools."
Here, the benefit of the dam is compared with its opportunity cost: new high schools. Expressed that way, the cost of the dam becomes much more concrete. Besides, it's not really money that we're sacrificing when we build a dam, but rather resources -- workers, machines, cement, and land -- that could be used elsewhere. If money were the only thing we sacrificed, there would be no trade-offs; our government could buy us everything we wanted simply by printing more money, preferably in very large denominations.
Using opportunity cost -- an example
Ernesto is trying to decide whether to attend college and has determined the money cost of attending college for one year.
Money Cost of a Year of College
Tuition: $1,000
Books and school supplies: 2,000
Room and board: 10,000
Transportation: 1,000
Miscellaneous expenses: 3,000
__________________________________
Total money cost: $17,000
This tells Ernesto how much money he'll need to come up with if he decides to go to college.
But in order to decide whether to go to college, Ernesto should figure out its opportunity cost. The first step is for Ernesto to determine the best alternative to going to college. Let's say that it's working full time at the local Drive-In. The opportunity cost of going to college, then, is the value of what he would gain if he worked instead of going to college.
If Ernesto worked, he wouldn’t have to pay for tuition, books, or school supplies. He also would earn $10,000 during the year that she worked. The opportunity cost of a year of college, therefore, is:
Opportunity Cost of a Year of College
Tuition: $ 1,000
Books and school supplies: 2,000
Foregone wages from working: 10,000
_____________________________________
Total opportunity cost: $13,000
This tells Ernesto how much he'd have to spend on other things if he decided not to go to college.
You may be wondering why we didn't include room and board, transportation, entertainment, and miscellaneous expenses in the opportunity cost calculation. Wouldn't Ernesto have these expenses at college?
Yes, he would, but he also would face these costs if he decided to work. Remember, opportunity cost includes only the value of what one would gain under the next best alternative opportunity. Ernesto can't get out of paying for room and board, transportation, and entertainment by working. These expenses, therefore, should not be included in the opportunity cost of going to college.
The opportunity cost of going to college -- $13,000 -- tells Ernesto what he would gain if he chose not to go to college. When deciding whether to go to college, he should weigh that cost against the benefits of college, like higher future earnings, new friends, and a better understanding of our world.
Sunk Costs
Just as Eskimos have lots of words to describe snow, economists have lots of words to describe cost. This section introduces sunk costs.
Sunk costs are costs that must be paid whether or not you do something. They're of special interest to us because we don't want to include them when calculating opportunity cost. Unfortunately, sunk costs are like invasive weeds; it's often hard to yank them out of a problem.
To see why sunk costs should be ignored, let's go back to Sheila, who has had her car for a week now. She has just returned home from school and she's trying to decide whether to go out and see a movie.
To figure out the opportunity cost of seeing a movie, Sheila first determines her best alternative opportunity. Let's assume that it's to stay home and do homework. Next, she lists all the things that she would gain if she stayed home and did homework instead of watching a movie.
Opportunity Cost of Going to a Movie
Time to do homework: 3 hours
Gas and parking: $1.50
Admission to the theater: $2.00
__________________________________________________
Opportunity Cost: 3 hours and $3.50
Notice that Sheila correctly includes gas and parking in her opportunity cost calculations. But what about all the other costs associated with owning a car, like insurance and registration fees? Shouldn't she include them as part of the opportunity cost of going to a movie?
The answer is no. If Sheila stayed home, she'd still have to pay the same insurance and registration fees. She can't reduce these costs by staying home.
Insurance and registration fees are examples of sunk costs. Sunk costs can't be recovered by choosing the best alternative opportunity. That's why economists use the following rule when calculating the opportunity cost of something:
Ignore sunk costs.
Now suppose that Sheila decides to go to the movie and her little brother asks to come along. He will pay for his own admission. What is the opportunity cost to Sheila of bringing him?
The answer is nothing at all. Since Sheila has already decided to go to the movie theater, the expense of driving there has become a sunk cost -- she will incur that expense whether or not her brother comes. She doesn't sacrifice anything by bringing him along, unless, of course, he's obnoxious.
Monday, June 22, 2009
Single Entry
Single-entry bookkeeping system also known as Single-entry accounting system is a one sided accounting entry to maintain financial information.
Most businesses maintain a record of all transactions based on the double-entry bookkeeping system. However, many small, simple businesses maintain only a single-entry system that records the "bare-essentials." In some cases only records of cash, accounts receivable, accounts payable and taxes paid may be maintained. Records of assets, inventory, expenses, revenues and other elements usually considered essential in an accounting system may not be kept, except in memorandum form. Single-entry systems are usually inadequate except where operations are especially simple and the volume of activity is low.
This type of accounting system with additional information can typically be compiled into an income statement and balance sheet by a professional accountant.
Advantages
Single-entry systems are used in the interest of simplicity. They are usually less expensive to maintain than double-entry systems because they do not require the services of a trained person.
Disadvantages
Data may not be available to management for effectively planning and controlling the business.
Lack of systematic and precise bookkeeping may lead to inefficient administration and reduced control over the affairs of the business.
Single-entry records do not provide a check against clerical error, as does a double-entry system. This is one of the most serious defects of single-entry systems.
Single-entry records seldom make provision for recording all transactions. In addition, many internal transactions, such as adjusting entries are often not recorded.
Because no accounts are provided for many of the items appearing in both the Income Statement and Balance Sheet, omission of important data is possible.
In the absence of detailed records of all assets, lax administration of those assets may occur.
Theft and other losses are less likely to be detected.
Most of financial accounting is based on double-entry bookkeeping. To understand and appreciate the advantages of double entry, it is worthwhile to examine the simpler single-entry bookkeeping system. In its most basic form, a single-entry system is similar to a checkbook register and is characterized by the fact that there is only a single line entered in the journal for each transaction. In a simple checkbook, each transaction is recorded in one column of an account as either a positive or a negative amount in order to represent the receipt or disbursement of cash. This system is demonstrated in the following example for a repair shop business:
Single Column System
Date Description Amount
Jan 1 Beginning Balance 1,000.00
Jan 2 Purchased shop supplies (150.00)
Jan 4 Performed repair service 275.00
Jan 7 Performed repair service 125.00
Jan 15 Paid phone bill (50.00)
Jan 30 Ending balance 1,200.00
While extremely simple, because the above system uses a single column, only the difference between revenues and expenses is totaled - not the individual values of each. Knowing the individual total amounts of revenues and expenses is important to a business, for example, when formulating a budget. The revenues and expenses also are reported in the income statement. In the above example, the individual revenue and expense amounts can be determined only by sorting through the transactions and tabulating the revenue and expense totals. This process can be designed into the system by using a separate column for revenues and expenses:
Separating Revenues and Expenses
Date Description Revenues Expenses
Jan 2 Purchased shop supplies 150.00
Jan 4 Performed repair service 275.00
Jan 7 Performed repair service 125.00
Jan 15 Paid phone bill 50.00
------- -------
January Totals 400. 200.00
While the above example now uses two columns, it still is considered to be a single-entry system since only one line is used to record each transaction in the cash account. This single-entry system often is expanded to provide more useful information. For example, additional columns can be added to classify the revenues as sales and sales tax collected, and the expenses as rent, utilities, supplies, etc. Some single-entry systems may add dozens of columns for different types of revenues and expenses. Many small businesses utilize such a system. However, even with columns to classify the revenues and expenses, single-entry bookkeeping is limited in its ability to provide detailed financial information. Some disadvantages of a single-entry system include:
Does not track asset and liability accounts such as inventory, accounts receivable and accounts payable. These must be tracked separately.
Facilitates the calculation of income but not of financial position. There is no direct linkage between income and the balance sheet.
Errors may go undetected and often are identified only through bank statement reconciliation.
Because of these drawbacks, a single-entry system is not practical for many organizations such as those having many thousands of transactions in a reporting period, significant assets, and external suppliers of capital. The more sophisticated double-entry bookkeeping system addresses the more demanding needs of such businesses.
Most businesses maintain a record of all transactions based on the double-entry bookkeeping system. However, many small, simple businesses maintain only a single-entry system that records the "bare-essentials." In some cases only records of cash, accounts receivable, accounts payable and taxes paid may be maintained. Records of assets, inventory, expenses, revenues and other elements usually considered essential in an accounting system may not be kept, except in memorandum form. Single-entry systems are usually inadequate except where operations are especially simple and the volume of activity is low.
This type of accounting system with additional information can typically be compiled into an income statement and balance sheet by a professional accountant.
Advantages
Single-entry systems are used in the interest of simplicity. They are usually less expensive to maintain than double-entry systems because they do not require the services of a trained person.
Disadvantages
Data may not be available to management for effectively planning and controlling the business.
Lack of systematic and precise bookkeeping may lead to inefficient administration and reduced control over the affairs of the business.
Single-entry records do not provide a check against clerical error, as does a double-entry system. This is one of the most serious defects of single-entry systems.
Single-entry records seldom make provision for recording all transactions. In addition, many internal transactions, such as adjusting entries are often not recorded.
Because no accounts are provided for many of the items appearing in both the Income Statement and Balance Sheet, omission of important data is possible.
In the absence of detailed records of all assets, lax administration of those assets may occur.
Theft and other losses are less likely to be detected.
Most of financial accounting is based on double-entry bookkeeping. To understand and appreciate the advantages of double entry, it is worthwhile to examine the simpler single-entry bookkeeping system. In its most basic form, a single-entry system is similar to a checkbook register and is characterized by the fact that there is only a single line entered in the journal for each transaction. In a simple checkbook, each transaction is recorded in one column of an account as either a positive or a negative amount in order to represent the receipt or disbursement of cash. This system is demonstrated in the following example for a repair shop business:
Single Column System
Date Description Amount
Jan 1 Beginning Balance 1,000.00
Jan 2 Purchased shop supplies (150.00)
Jan 4 Performed repair service 275.00
Jan 7 Performed repair service 125.00
Jan 15 Paid phone bill (50.00)
Jan 30 Ending balance 1,200.00
While extremely simple, because the above system uses a single column, only the difference between revenues and expenses is totaled - not the individual values of each. Knowing the individual total amounts of revenues and expenses is important to a business, for example, when formulating a budget. The revenues and expenses also are reported in the income statement. In the above example, the individual revenue and expense amounts can be determined only by sorting through the transactions and tabulating the revenue and expense totals. This process can be designed into the system by using a separate column for revenues and expenses:
Separating Revenues and Expenses
Date Description Revenues Expenses
Jan 2 Purchased shop supplies 150.00
Jan 4 Performed repair service 275.00
Jan 7 Performed repair service 125.00
Jan 15 Paid phone bill 50.00
------- -------
January Totals 400. 200.00
While the above example now uses two columns, it still is considered to be a single-entry system since only one line is used to record each transaction in the cash account. This single-entry system often is expanded to provide more useful information. For example, additional columns can be added to classify the revenues as sales and sales tax collected, and the expenses as rent, utilities, supplies, etc. Some single-entry systems may add dozens of columns for different types of revenues and expenses. Many small businesses utilize such a system. However, even with columns to classify the revenues and expenses, single-entry bookkeeping is limited in its ability to provide detailed financial information. Some disadvantages of a single-entry system include:
Does not track asset and liability accounts such as inventory, accounts receivable and accounts payable. These must be tracked separately.
Facilitates the calculation of income but not of financial position. There is no direct linkage between income and the balance sheet.
Errors may go undetected and often are identified only through bank statement reconciliation.
Because of these drawbacks, a single-entry system is not practical for many organizations such as those having many thousands of transactions in a reporting period, significant assets, and external suppliers of capital. The more sophisticated double-entry bookkeeping system addresses the more demanding needs of such businesses.
Subscribe to:
Posts (Atom)
Popular Posts
-
B.COM PART 1 AND 2 COACHING CLASSES FOR SUPPLEMENTARY EXAMS. HOME AND COACHING. ACCOUNTING, STATISTICS AND ECONOMICS OF PART 1. ADVANCED... -
University Of Karachi M.A. (Previous) and M.A. (Final) Examination IN ECONOMICS SCHEME OF STUDIES M.A. (Previous) 1. The examination for deg...
-
MA-ECONOMICS PRIVATE KARACHI UNIVERSITY,REGISTRATION DATE EXTENDED. -
B.COM 1 & 2 ACCOUNTING, STATISTICS, ECONOMICS, ADVANCED ACCOUNTING, INCOME TAX LAW JOIN SIR KHALID 0322-3385752 R-1173,AL NOOR SOCIETY, ...
-
What is a Term Finance Certificate (TFC) A corporate debt instrument issued by companies to generate short and medium-term funds. Corporate... -
C.A. is sometimes used to identify the Chief Accountant & Chartered Accountant CAD see CASH AGAINST DOCUMENTS. CAFR see Comprehensive An...
-
In 1943, Dr. Abraham Maslow 's article "A Theory of Human Motivation" appeared in Psychological Review, which were further exp... -
MA ECONOMICS EXTERNAL COACHING CLASSES. MICRO ECONOMICS, STATISTICS & MACRO ECONOMICS. GUESS PAPERS AND NOTES ARE AVAILABLE 0322-338575...
-
MA-ECONOMICS FOR EXTERNAL CANDIDATES CRASH CLASSES PREVIOUS & FINAL MICRO ECONOMICS MACRO ECONOMICS ADVANCED STATISTICS FOR ECONOMICS GU...