Relevant cost is important for decision making and identifying it actually requires some common sense. In general, relevant is always future, incremental cash flow.
Future
Therefore, sunk cost (past cost) should be ignored.
Incremental
The key question is "Is there extra cost making this choice?". When there is more cost to be incurred such as hiring new labour, it is a relevant cost. Fixed cost (like an unavoidable cost) is not relevant but if there is an increment, the increase is relevant.
Cash flow
Therefore, non-cash flow cost such as depreciation and provision should be ignored.
Furthermore, variable cost (avoidable cost) will be relevant for decision making. A committed cost, although is a future cash flow, is not relevant as it must be incurred, cannot be avoided even if the decision is not made. Opportunity cost (the sacrifice from choosing this decision instead of another) is relevant as well.
Relevant cost for material
This requires more common sense.
Example: Company has 100 units of material in inventory and need another 200 units for the job, current purchase price is $10 per unit. Such material will not be replaced. Such material can be used for another job to earn a contribution of $15 per unit and it has a net realisable value (NRV) of $18 per unit.
Solution: The problem is dealing with the 100 units, 200 units will be purchased so relevant cost is $2000 (200 x $10). For the 100 units, since they will not be replaced, if without this job company can actually sell them or use them to generate contribution of $15 per unit. It is obvious that company will sell ($18 is more than $15) if without this job, so by taking this job, the opportunity cost is 100 x $18 = $1800.
Total relevant cost = 2000 + 1800 = $3800.
Relevant cost for labour
Again this needs common sense. When labour is hired the relevant cost is the cost of hiring. If labour has free time to do this job then there is no incremental cost (unless overtime) so relevant cost will be $0. If labour is transferred from other job to do this job, then again opportunity cost arises as contribution from other job is lost because of this job.
Relevant cost for non-current asset
If without this job, non-current asset such as machine might be sold for money or used to generate contribution. By taking this job, opportunity cost occurred again and this time, opportunity cost is the higher of NRV or contribution from using the machine elsewhere because we want to know the maximum that we lost. Alternatively, the machine could be replaced and therefore there is a replacement cost. In such situation, replacement cost can be compared to opportunity cost identified earlier, as we want to save cost, the relevant cost will be the lower of replacement cost and opportunity cost.
With the above idea I hope the relevant cost concept is clearer to you now, as you can see there is nothing to remember. :)
Sunday, October 23, 2011
Wednesday, October 19, 2011
Opportunity cost
This is an important term used in many of the FIA/ACCA papers, however it is sometime not obvious and tend to be ignored in finding the relevant cost.
The definition is the benefit forgone from taking one action instead of another. With this, we can understand the principle underlying opportunity cost, that is "each act of choice involves some sacrifice". Therefore, here is a simple example, let say you have two choices, one is to attend ACCA class for 3 hours and one is to sleep for 3 hours, if you choose to attend the 3 hours class, your opportunity cost is the 3 hours of sleep.
Therefore, you can see that it is not really a difficult thing, you just have to think "if I do this, what I will lose?" then you should be able to find the opportunity cost and include it as part of relevant cost. :)
The definition is the benefit forgone from taking one action instead of another. With this, we can understand the principle underlying opportunity cost, that is "each act of choice involves some sacrifice". Therefore, here is a simple example, let say you have two choices, one is to attend ACCA class for 3 hours and one is to sleep for 3 hours, if you choose to attend the 3 hours class, your opportunity cost is the 3 hours of sleep.
Therefore, you can see that it is not really a difficult thing, you just have to think "if I do this, what I will lose?" then you should be able to find the opportunity cost and include it as part of relevant cost. :)
Tuesday, October 18, 2011
ED Management commentary - ACCA P2
Exposure draft (ED) could be asked in question 4 as a current issue question. Management commentary, also known as Operating and Financial Review (OFR) or Business Review, is an important means used to communicate with capital markets and stakeholders. IASB proposes this ED to recommend a framework for the preparation and presentation of management commentary to accompany financial statements that are prepared under IFRS. It is not mandatory to prepare and publish management commentary, however if an entity would like to prepare one, it should:
1. Not make it available without the financial statements.
2. Clearly distinguish management commentary from other information in the same financial report.
The ED states that the purpose of management commentary is to provide existing and potential capital providers with information that helps them in making decision. A decision-useful management commentary:
1. Discusses and analyses the entity's performance, position and development through the eyes of management.
2. Provides additional explanations of amounts presented in the financial statements and including information that is not presented in financial statements.
3. communicates the direction the entity is taking, include forward-looking information.
IASB proposes that management commentary should contain the following information:
1. The nature of the business.
2. Management's objectives, and strategies for meeting those objectives.
3. Entity's most significant resources, risks and those relationships that might impact the entity's performance and value.
4. Results of operations and prospects.
5. Critical performance measures and indicators that management uses to evaluate the entity's performance against stated objectives.
There should be a mixture of narrative and numerical disclosures.
In conclusion, management commentary should supplement and complement financial statements, including orientation to the future, and fairly present the views of management on the relationship between the financial statements and the company's strategies and objectives.
1. Not make it available without the financial statements.
2. Clearly distinguish management commentary from other information in the same financial report.
The ED states that the purpose of management commentary is to provide existing and potential capital providers with information that helps them in making decision. A decision-useful management commentary:
1. Discusses and analyses the entity's performance, position and development through the eyes of management.
2. Provides additional explanations of amounts presented in the financial statements and including information that is not presented in financial statements.
3. communicates the direction the entity is taking, include forward-looking information.
IASB proposes that management commentary should contain the following information:
1. The nature of the business.
2. Management's objectives, and strategies for meeting those objectives.
3. Entity's most significant resources, risks and those relationships that might impact the entity's performance and value.
4. Results of operations and prospects.
5. Critical performance measures and indicators that management uses to evaluate the entity's performance against stated objectives.
There should be a mixture of narrative and numerical disclosures.
In conclusion, management commentary should supplement and complement financial statements, including orientation to the future, and fairly present the views of management on the relationship between the financial statements and the company's strategies and objectives.
Monday, October 17, 2011
Double entry concept relevant to FA1/FA2/FFA
Double entry concept is a very important concept underpinning financial accounting. The idea is that every financial transaction has dual effect and therefore is recorded twice, one debit and one credit. This concept is sometime difficult to apply in certain transactions, it requires practice.
The followings are some examples:
1. Debit expenses = more expenses are incurred.
2. Debit asset = more asset is controlled.
With the above, you should understand that credit will be the opposite:
1. Credit income = more incomes are earned.
2. Credit liability = more liability is obliged.
3. Credit capital = more capital is injected/created.
Note: Capital provider injects money or other assets to the business, thus created capital. Capital is therefore the amount that business owes to the capital provider and so it is on the credit side, like liability.
Now let's mix them up:
1. Debit income = income is reduced.
2. Credit asset = asset is reduced.
3. Debit liability = liability is reduced.
Therefore, by knowing a little of double entry principles, you can do the rest, this is where common sense applies.
Certain accounts are known as contra asset, for example accumulated depreciation and allowance for receivables (provision for doubtful debt). The word "contra" implies cancel, so you would credit them to the relevant assets, ie. non-current assets and trade receivables. Drawing made by the sole proprietor or partner is a contra capital/equity account so you debit drawing to the capital account.
One more common question asked by student is why profit is credited to the capital account. This is because profit earned from the business belongs to the capital provider, by crediting the capital account, the business is owing more to the capital provider.
Do not underestimate this concept because you will use it throughout your accountancy life, it is still very important even in ACCA P2. Catch the logic and master them now. :)
The followings are some examples:
1. Debit expenses = more expenses are incurred.
2. Debit asset = more asset is controlled.
With the above, you should understand that credit will be the opposite:
1. Credit income = more incomes are earned.
2. Credit liability = more liability is obliged.
3. Credit capital = more capital is injected/created.
Note: Capital provider injects money or other assets to the business, thus created capital. Capital is therefore the amount that business owes to the capital provider and so it is on the credit side, like liability.
Now let's mix them up:
1. Debit income = income is reduced.
2. Credit asset = asset is reduced.
3. Debit liability = liability is reduced.
Therefore, by knowing a little of double entry principles, you can do the rest, this is where common sense applies.
Certain accounts are known as contra asset, for example accumulated depreciation and allowance for receivables (provision for doubtful debt). The word "contra" implies cancel, so you would credit them to the relevant assets, ie. non-current assets and trade receivables. Drawing made by the sole proprietor or partner is a contra capital/equity account so you debit drawing to the capital account.
One more common question asked by student is why profit is credited to the capital account. This is because profit earned from the business belongs to the capital provider, by crediting the capital account, the business is owing more to the capital provider.
Do not underestimate this concept because you will use it throughout your accountancy life, it is still very important even in ACCA P2. Catch the logic and master them now. :)
Thursday, October 13, 2011
IAS 11 Contruction contracts - advanced
Two issues to look at are the unplanned rectification costs and when we are not in the first year of contract.
Unplanned rectification cost
When there is such cost exist, it should be recognised in full in the income statement. This is because the cost is not originally estimated so what we do is to deduct the gross profit to be recognised in the period.
We are not in the first year of contract
You should understand that income statement only shows figures in an accounting period, ie. 12 months while statement of financial position shows the balance to date (therefore the amount is accumulated). Therefore, we have a problem, in the second year of contract for example, you should only show the 12 months revenue, cost of sales and gross profit in the income statement. However, the one who certifies the work will only be able to identify the sale value of work done to date, he can't determine exactly how much of work certified is for the 12 months. What we can do is to follow the steps as normal, then take the revenue/cost of sales/gross profit less the last year balance, with this we can identify the amount for current period (12 months). Do not confuse with the revenue/cost of sales/gross profit in the income statement, here I am referring to those relating to the contract only.
You will need to practice some questions to understand what I have just said here, June 2011 question 5 would be a good question to try.
Unplanned rectification cost
When there is such cost exist, it should be recognised in full in the income statement. This is because the cost is not originally estimated so what we do is to deduct the gross profit to be recognised in the period.
We are not in the first year of contract
You should understand that income statement only shows figures in an accounting period, ie. 12 months while statement of financial position shows the balance to date (therefore the amount is accumulated). Therefore, we have a problem, in the second year of contract for example, you should only show the 12 months revenue, cost of sales and gross profit in the income statement. However, the one who certifies the work will only be able to identify the sale value of work done to date, he can't determine exactly how much of work certified is for the 12 months. What we can do is to follow the steps as normal, then take the revenue/cost of sales/gross profit less the last year balance, with this we can identify the amount for current period (12 months). Do not confuse with the revenue/cost of sales/gross profit in the income statement, here I am referring to those relating to the contract only.
You will need to practice some questions to understand what I have just said here, June 2011 question 5 would be a good question to try.
Wednesday, October 12, 2011
IAS 11 Construction contracts - basic ideas
This standard seems to be complicated, but if you know the concept then it should be easy to handle. It follows accrual basis of accounting so although money is received in progress payments, you should recognise revenue earned in the period.
Recognition of revenue and cost
They are recognised when it is probable that economic benefits attached to the contract will flow to the entity and outcome can be measured reliably.
Stage of completion
This can be calculated either using revenue basis (work certified to date/contract price) or cost basis (cost to date/estimated total cost). If you are using revenue basis, revenue to be recognised in the period is equal to the work certified to date and if you use cost basis, cost of sales to be recognised in the period is equal to the cost incurred to date.
Steps of accounting
1. Determine profit or loss - this can be found by contract price - estimated total cost. Estimated total cost includes any contract cost incurred to date - estimated further cost to complete the contract. If it results in loss, then you don't need to calculate stage of completion of the contract because loss must be recognised in full as a gross loss.
2. Determine stage of completion and profit to recognise - use the stage of completion calculated and multiply by the estimated profit in step 1, that will be the gross profit.
3. Determine amount due from customers (current asset) - this is calculated from cost to date + profit recognised (from step 2) - progress payment. The idea is that cost + profit is the price that customer should pay, then less the progress payment will arrive at the amount that customer is still owing to us. If it is a negative figure, then it should be a current liability (amount due to customer).
4. Prepare income statement and statement of financial position. The trick is that let say you use revenue basis to calculate stage of completion and then profit to be recognised, you know that the revenue to be recognised is equal to work certified to date, therefore with both revenue and gross profit amount, the balance is cost of sales.
More complicated issue is discussed later.
Recognition of revenue and cost
They are recognised when it is probable that economic benefits attached to the contract will flow to the entity and outcome can be measured reliably.
Stage of completion
This can be calculated either using revenue basis (work certified to date/contract price) or cost basis (cost to date/estimated total cost). If you are using revenue basis, revenue to be recognised in the period is equal to the work certified to date and if you use cost basis, cost of sales to be recognised in the period is equal to the cost incurred to date.
Steps of accounting
1. Determine profit or loss - this can be found by contract price - estimated total cost. Estimated total cost includes any contract cost incurred to date - estimated further cost to complete the contract. If it results in loss, then you don't need to calculate stage of completion of the contract because loss must be recognised in full as a gross loss.
2. Determine stage of completion and profit to recognise - use the stage of completion calculated and multiply by the estimated profit in step 1, that will be the gross profit.
3. Determine amount due from customers (current asset) - this is calculated from cost to date + profit recognised (from step 2) - progress payment. The idea is that cost + profit is the price that customer should pay, then less the progress payment will arrive at the amount that customer is still owing to us. If it is a negative figure, then it should be a current liability (amount due to customer).
4. Prepare income statement and statement of financial position. The trick is that let say you use revenue basis to calculate stage of completion and then profit to be recognised, you know that the revenue to be recognised is equal to work certified to date, therefore with both revenue and gross profit amount, the balance is cost of sales.
More complicated issue is discussed later.
Tuesday, October 11, 2011
Inti Social night 2011
The date is at 14th of October 2011, 7.00pm to 10.30pm, Kampungku restaurant near Holiday Villa in Subang. Price is at RM25 and the theme is black and gold. Do register for this event as there are variety of food and we have prepared some games for you all. The price is much subsidised and 50 pax is the maximum. Register NOW!!! :D
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