Question No. 4 - Accounting for Managerial Decisions

Solutions to Assignments 

MCO-05 Accounting for Managerial Decisions

Question 4

(a) What do you mean by accounting reports? What are the different types of reports for internal use? 

An accounting report is a financial report that a business files to show its past and present financial situation. With this report, businesses and financial analysts can also predict their financial situation in the future more easily.

An accounting report might include information from every part of the business, or it might only focus on a small goal, such as determining which department uses the most cash flow. Many businesses that closely follow their finances report accounting at least once per month. They might even do it more often, particularly if they are pursuing company-wide goals related to finances.

An accounting report is typically made up of three types of reports:

• Income statement

• Cash flow statement

• Balance sheet

With these reports, a company can see its financial status over time as well as at one specific snapshot in time. All accounting reports should follow Generally Accepted Accounting Principles (GAAP) as established by the Financial Accounting Standards Board (FASB). These ensure accounting reports follow a set of principles, which include, but are not limited to, consistency, sincerity and good faith.

Consistency means a business is following the same accounting practices from month to month and year to year. Sincerity means the person creating the report (the accountant) is being honest. When people are acting in good faith, it means that everybody involved in every transaction is honest.

When all businesses follow the same principles, it's easier to compare one business to another. This ensures companies do not misrepresent their information so that investors and others outside the company are not misled regarding the company's financial standing.

Types of accounting reports

Accounting reports come in different forms depending on what information a company needs to know. Below are three common types of accounting reports:

Income statement

An income statement is a report that details overall expenses and revenue to determine a company's overall net profit. Sometimes an income statement is called a profit-and-loss report.

To prepare an income statement, accountants use data from ledgers and accounting journals. The statement includes both primary and secondary sources of income to get an accurate number. Similarly, primary and secondary expenses are included in the income statement.

Cash flow statement

A cash flow statement shows where cash is coming from (cash flow sources) and where cash is going (cash flow expenditures). This helps a business see how well they are generating cash. Executives and decision-makers can use this report to see where cash is coming from and then where it is going, which could include:

Business operations

Financing

Investments

A cash flow statement measures the cash flow between two dates. To prepare a cash flow statement, an accountant looks at the cash flow in every account, which may include equity accounts, liability accounts, expense accounts, revenue accounts and asset accounts.

Balance sheet

A balance sheet shows an ending balance at one specific point in time. It often includes balances for assets, liability and equity. The balance sheet gives the business an opportunity to evaluate its financial reserves as well as liquid assets. It also helps potential investors or lenders see the financial state of the company.

Typically, a business sets an accounting cycle, and someone prepares a balance sheet at the end of each cycle. Like an income statement, data for a balance sheet comes from the ledger.

 (b) Explain the significance of Profit-Volume ratio, Margin of Safety and Angle of Incidence?

• Significance of Profit-Volume ratio 

Profit-volume ratio indicates the relationship between contribution and sales and is usually expressed in percentage.

The ratio shows the amount of contribution per rupee of sales. Since, in the short-term, fixed cost does not change, the profit-volume ratio also measures the rate of change of profit due to change in the volume of sales.

The advantages of profit-volume ratio are that it can be used to measure profitability of each product, or group of them, separately so that the necessity for continuance of such production can be examined. It may also be used to measure the profitability of each production centre, process or operation.

One fundamental property of profit-volume ratio is that it remains same at various levels of operation and, thus, break-even point; required selling prices to maintain profits at various levels etc. can be easily calculated by suitable application of this ratio.

The formula to calculate P/V ratio is:

• Significance of Margin of Safety 

The difference between actual sales and sales at break-even point represents the margin of safety. Since the assumption of break-even analysis is that production will correspond to sales, margin of safety may also be considered to be excess production over break-even production. This excess may be expressed in absolute terms as well as in terms of percentage of sales.

The margin of safety is calculated by applying the formula:

The soundness of a business may be gauged by the size of the margin of safety. A high margin of safety indicates the soundness of business i.e., the break-even point is much below the actual sales so that even if there is a fall in sales, there will still be a profit. A small margin, on the other hand, indicates a not-too-sound position.

If a low margin of safety is accompanied by high fixed cost and high contribution margin ratio, action is called for reducing the fixed cost or increasing sales volume. But if the margin of safety as well as the contribution ratio are low (the fixed cost being reasonable) the situation requires that efforts should be made towards reducing the variable cost, or an increase in the selling price should be effected. Margin of safety is also of immense use in making inter-firm comparisons.

• Significance of Angle of incidence 

The Angle of Incidence in accounting occurs when the entire sales line crosses the cost line from below in the break-even chart. Or, it is an angle that gets created due to the sale and cost line. Usually, this angle starts forming at the break-even point, indicating how efficiently the company is making a profit. Further, the angle suggests that the rate at which the company is making profits.

A general rule of thumb is the higher the angle, the more is the profit and vice versa. A large angle of incidence means the company is making profits at a higher rate.  Similarly, a small angle suggests the profit is being earned at a lower rate.

Additionally, it gives one more significant information. If the angle of incidence is small, it means, the company is incurring more variable costs. Thus, for a business, a desirable situation is a large angle of incidence with a high margin of safety. It could further indicate that the business might have a monopoly status in its industry.