Tuesday, 19 March 2013

Product-mix decisions when capacity constraints exist

By Jackie, Researcher
Topic: Education
Area of discussion: Management and Cost Accounting
Chapter: Measuring relevant costs and revenues for decision-making

The primary objective of this posting is to critically describe the key concept that should be applied for presenting information for product-mix decisions when capacity constraints apply. In this discussion, I have taken a past year question from CIMA Cost Accounting 2 and prepared sample solutions with detailed workings to aid illustration purposes. Personally, I like this question because it is very tricky as ‘duo ranking system’ applies due to the nature of allotment and the presence of ‘market commitment’ in this question.  

Suggested answers with workings:

Solution for a(i):

Note: Variable costs are quoted per acre, but selling prices are quoted per tonne. Therefore, it is necessary to calculate the planned sales revenue per acre. 

Solution for a(ii):

Ordinarily, the allocation of scarce resources will strictly follow the ascending order of rankings (in term of contribution amount); starting with the product that gives the highest contribution per limiting factor and then, leaving behind the balance of scarce resources to be taken up by other products that give lesser contribution per limiting factor. However, ‘market commitment’ exists in this case. So, the ‘market commitment’ will be the first one to get allocated. For profit maximization purposes, ‘market commitment’ has to be filled up with the product that gives the lowest contribution per limiting factor and the balancing figure to be taken up by other products that give a higher contribution per limiting factor. Also, due to the ‘market commitment’, the nature of allocation of scarce resource (i.e. land space) has been splitted into two.

Solution for b(i):

‘No market commitment and the land could be cultivated in such a way that any of the above crops could be produced’ simply means that the clause (i.e. the land that is being used for the production of carrots and parsnips can be used for either crop, but not for potatoes or turnips. The land being used for potatoes and turnips can be used for either crop, but not for carrots or parsnips. In order to provide an adequate market service, the gardener must produce each year at least 40 tonnes each of potatoes and turnips and 36 tonnes each of parsnips and carrots.) was not in effect anymore.

Solution for b(ii):

Note: To get 100 acres, sum up all the area occupied (i.e. 25 + 20 + 30 +25); while the contribution of £960/acre is taken from solution for a(i).

Solution for b(iii):

There are two ways to calculate this. The first one is to calculate the BEP in acres by dividing the fixed costs with the contribution per acre, and then used the computed figure to further multiply with its sales revenue per acre. (i.e £54,000 ÷ £960/acre = 56.25 acres, then 56.25 acres x £1,620/acre = £91,125). The second one is shown below by dividing the fixed costs with the contribution/sales ratio. Both methods are well explained in Cost-Volume-Profit analysis’ chapter.

Additional readings, related links and references:

Throughput accounting and TOC, one step beyond limiting factor analysis. The time frame is so short until all operating expenses are treated as fixed including direct labour; only direct materials are treated as variable. http://www.accaglobal.com/content/dam/acca/global/pdf/sa_nov11_throughput2.pdf

Reframing the Product Mix Problem using the Theory of Constraints

Product Mix: Determining My Winners and Losers

Limiting factors analysis

Short-term Decisions Overview and Product Mix Decisions 

Sunday, 10 March 2013

Fair Value Vs Historical Cost

By Jackie, Researcher
Topic: Education
Area of discussion: Financial Accounting and Reporting
Chapter: Accounting Concepts

The objectives of this posting are: to critically compare and contrast the usefulness of fair value and historical cost (in different conditions); as well as to identify, explain, and analyse the benefits and limitations of both fair value and historical cost.

Fair Value
Fair value is also known as “market value” or “current value”; it is a rational and unbiased estimate of the potential market price of a good, service, or asset.

Arguments in support of fair value concept
  1. It is recommended to use fair value concept during inflation period or when the currency is unstable or fluctuate.
  2. It is also suitable to be used when there is an active and observable market; such market usually exists in popular and densely-populated area where there will be a lot of buyers and sellers trading daily.
  3. Depending on the nature of the assets, this valuation method is suitable for assets that undergo appreciation (i.e. value goes up) instead of depreciation (i.e. value goes down). For example: land and buildings, livestock and raw materials. Assets that follow this concept are required to undergo revaluation process after a specific time (if needed) and also test for impairment (if any) before the assets values are to be displayed in the financial statements (inside the annual reports).
  4. It upholds the accounting qualitative characteristic: relevance.
  5. Information about the assets values is updated. Hence, it is useful for decision making purposes (especially for potential buyers) 

Arguments against fair value concept
  1. Valuing assets using current market price is very subjective. It involves a lot of predictions, assumptions and careful analysis in order to get an estimated figure. However, not everyone can agree with that figure as the figure is usually open to dispute or debate as it involves a lot of judgements, thoughts and opinions which can be either personal or professional. Furthermore, the amount has not been “realised” yet (i.e. not incurred yet). Thus, it cannot be fully trusted.    
  2. Unlike historical cost, those estimated figures are usually given in a “range of values” instead of one clear-cut value for each asset.
  3. In reality, active and observable market is highly dependent on location. Therefore, if the assets (usually properties) are situated in an isolated location, it is very hard for the property agents to estimate the price of the properties because there is insufficient data to be used as comparison and analysis purposes.
  4. Some experts believe that as compared to historical cost, fair value concept is easier to be manipulated by unethical corporate directors and managers.
  5. It will be quite troublesome sometimes, because the preparers of financial statements are required to make some changes to the subsequent recording and readjust the depreciation amount. Thus, a lot of paperwork and additional disclosures are involved.

Historical Cost
According to the historical cost concept, assets are shown at the original cost price (i.e. the figures shown during the initial recording of those particular assets at the date of acquisition). 

Arguments in support of historical cost concept
  1. It is suitable to be used when the currency is stable.
  2. Depending on the nature of the assets, historical cost is suitable to be applied to any assets that undergo depreciation instead of appreciation. For example: plant and machinery, motor vehicles and office equipment. Assets that follow this type of valuation method are required to be depreciated accordingly usually per annum by using appropriate depreciation methods such as straight-line, reducing balance or sum-of-digits methods. Assets values that are displayed in financial statements are also known as Net Book Values (NBVs). NBVs are computed by using initial cost less accumulated depreciation.
  3. Valuing assets at their original cost is very objective. Everyone can accept and agree on it because it is based on a factual occurrence. Not only that, it also has a very concrete support in term of nature of evidence such as printed receipts, legal documents and purchase agreements.  
  4. It upholds the accounting qualitative characteristic: reliability.
  5. It gives one clear-cut and precise value for each asset.
  6. It is convenient and easy to use. It does not required active and observable market nor additional disclosure simply because there is no real change. 

Arguments against historical cost concept
  1. Information about the assets values is outdated. Accountants called it as “sunk cost”. Thus, it will not be helpful in decision making processes anymore.
  2. During the period of rising prices, using historical cost accounting might poses adverse effects on financial statements as well as some financial ratios. For example, in the Statement of Comprehensive Income (i.e. the Income Statement), the understated depreciation will cause the profit to be overstated. Meanwhile, in the Statement of Financial Position (i.e. the Balance Sheet), the cost of assets, accumulated depreciation of the assets and net book values of the assets will be all understated. On the other hand, financial ratios like ROCE (Return On Capital Employed) and ROA (Return On Assets) will be overstated. This is because the numerator tends to be overstated and the denominator tends to be understated. Ultimately, it makes the figures to be “unpresentable” and “unreflective” to the current situation. Not only that, it also poses risk and danger to the users of financial statements (especially for the shareholders and potential investors) as the information is misleading.

Additional readings, related links and references:

“Causes and consequences of choosing historical cost versus fair value”; this journal’s discussion is mainly on real estate. (IAS 40 – Investment Property) 

Historical cost vs. market (fair) value. Emphasize more on theories. http://commerceducation.blogspot.com/2011/04/historical-cost-vs-market-fair-value.html

Does fair value accounting for non-financial assets pass the market test? http://faculty.chicagobooth.edu/valeri.nikolaev/PDF/FairvaluePaper_RAST_Conference.pdf

Historical cost vs. fair value. Examples are given with calculations too.

Wednesday, 6 March 2013

Conceptual Framework For Financial Reporting

By Jackie, Researcher
Topic: Education
Area of discussion: Financial Accounting and Reporting
Chapter: Frameworks

The objectives of this research are to find out and critically explain: the brief history of what had happened in the past in financial reporting when the framework is not developed yet; what is a conceptual framework?; the functions of conceptual framework and benefits of having it; the limitations and barriers in establishing a global conceptual framework; and some proposed solutions on how to set up an international conceptual framework.

Research question:
Discuss why there is a need to have an international conceptual framework and the extent to which an international conceptual framework can be used to resolve practical accounting issues.

Research Essay
INTI International College Subang

                Historically, in the late 1960s, a plenty of negative feedback and complaints have been lodged by the unsatisfied companies’ stakeholders against the misleading accounting treatments and approaches which were best described as being unclear, irregular and confusing. For example, at that particular time, all the accountants were not using the similar or standardised methods to compute profits. As a result, the calculated profits tend to vary among each other and subject to manipulation too (Wood & Sangster 2005, p.106). Alexander and Nobes (2010, pp.71-79) state that the factors leading to the variation in international reporting approaches are the manners in which companies are financed by the providers of finance, the nature of national legal system in influencing the financial reporting’s regulations, the correlation between the tax and reporting systems, the competence of the accountancy profession and the development of accounting theories, as well as the globalisation of capital markets around the world. In actual fact, explicit detailed framework is still absent in most of the nations. Hence, financial statements are hardly comparable internationally as accounting is performed differently in different place (Alexander & Nobes 2010, p.36). Fortunately, this has hastened the development of conceptual framework as a solution to handle this situation. For instance, the establishment of IASB Framework in 1989, followed by subsequent changes to the requirements of particular IFRSs, and then recently the collaboration between the IASB and US FASB in running a project which aims to revise and conform their conceptual framework. Ideally, conceptual framework is a statement of generally accepted accounting principles (GAAP) which form the frame for reference for financial reporting; it provides the basis for evaluation of existing practices and the development of new accounting standards as well as forming ground for transactions’ treatment, measuring bases and communication to the respective users (Scott 2011, p.1). It is considered as the most appropriate treatment for certain transactions under the supervision of professional bodies and researches (Thomas & Ward 2012, p.38).

             Generally speaking, it is extremely crucial to have a proper international conceptual framework as it offers numerous benefits and carries out significant purposes. Firstly, it assists the IASB and International Financial Reporting Interpretations Committee (IFRIC) members in the development of future IFRSs and reviews existing standards by setting out the underlying concepts. This can be seen in Ernst & Young 2012’s publication regarding to the IFRS update of standards and interpretations. For example, one of the upcoming changes is effectively starting from 1 January 2013, entities are required to disclose information about rights of set-off and related arrangements like collateral arrangements with the aim of evaluating netting effect of arrangements towards an entity’s financial position under IFRS 7 Disclosures – Offsetting Financial Assets and Financial liabilities – Amendments to IFRS 7.

                Secondly, framework is also utilised to help the board of the IASB in promoting harmonisation of accounting regulations, standards and procedures in financial statements’ presentation by providing a basis in reducing the number of alternative accounting treatments permitted by IFRSs (Thomas & Ward 2012, p.40). Framework provides a sense of direction in resolving accounting questions without the necessity for an increment in specific standards. Similarly, this also means that it can avoid the preparers, auditors and financial statements’ users from exerting unnecessary pressure by requesting for more detailed standards. Besides, unpleasant situation like the need to answer each accounting question at a sudden for a particular purpose can also be prevented (Alfredson et al. 2007, p.63). Consequently, the risk of over-regulation will be mitigated and the issue of ‘overloaded standards’ can be potentially reduced (Riahi-Belkaoui & Jones 2000, p.134).

                Thirdly, framework serves as a ‘point of references’ to the preparers of financial statements by assisting them in applying IFRSs and IASs, including the handling of accounting transactions that have yet to form the subject of an accounting standard (Scott 2011, p.2). Frankly, it is difficult for any accounting standards to give clear-cut and precise answers to all accounting questions; situation will be worsen if the standards or interpretations do not even exist, or have not be formed specifically to deal with those issues yet. Hence, a sound judgement is crucial in answering such technical problems. Luckily, boundaries to apply sensible judgement were established in the framework which ever concern with the preparation of financial statements (Alfredson et al. 2007, p.63). 

             Fourthly, framework aids the users of financial statements in interpreting the content contained in financial reports prepared in conformity with IFRSs by increasing users’ understandability as presentation is done in simpler and summarised manner which is suitable for “layman usage”; technical jargons are minimised plus additional notes and disclosures are inserted to give extra explanations. Riahi-Belkaoui & Jones (2000, p.134) claim that this will indirectly lead to a better communication among all the stakeholders since all parties are using a common set of definition and criteria. Alfredson et al. (2007, p.64) add that it could even enhances the public confidence towards the financial report too.

                In addition, sometimes standards development (especially national standards) is subject to political interference. Experts believe that a framework can decrease political pressures in making accounting judgement as well as potentially reduce the activities of lobbies and interested parties (who may have personal interest’s motivations) in influencing the standard-setting process (Riahi-Belkaoui & Jones 2000, p.134). This is because whenever there is a conflict of interest between user groups in deciding which policies need to be chosen, policies taken from a conceptual framework will often be less open to criticism as it eliminates personal biases and external pressure.  

               Dangerous situations will arise if there is no conceptual framework.

            In the absence of a conceptual framework, standards tend to be produced in a ‘fire-fighting’ approach where serious defects in accounting standards were often produced as an end results. This means that countries or standard setters will only address or respond to problems when a catastrophic corporate scandal or failure arises, rather than being proactive in determining best policy, developing and maintaining a coherent set of rules (Scott 2011, p.2). For example, during the 1980s it became fashionable for organisations to value their brand names and incorporate them into their balance sheets; the ASB’s predecessor body was completely unprepared for this and struggled hardly to develop a standard. Apparently, it is enormously difficult task as there was no universal agreement about such fundamental issues as the reason for preparing financial statements as well as the definition of what constituted an asset (Ciancanelli et al. 2009, p.37).

             Scott (2011, p.2) argues that the lack of conceptual framework will cause proliferation of ‘rules-based’     accounting systems whose primary objective is that the treatment of all accounting transactions are ought to be dealt with by detailed specific rules or requirements; such a system is very prescriptive and rigid, but has the attraction of financial statements being more comparable and consistent. Real life example can be seen in USA where the Financial Accounting Standards Board (FASB) has produced a huge number of highly detailed standards and indirectly created a financial reporting environment governed by specific rules rather than general principles as cohesive set of principles were not in place. 

           Likewise, this also means that fundamental principles can be dealt more than once in different standards (duplication) and consequently, provoking problems especially in relevant to contradictions and inconsistencies in basic concepts. This can be seen in the arguments, disputes, and conflicts in between relevance and reliability, especially in property and real estate industry. For instance, there is always a tension in deciding the most appropriate way to record the value of assets, such as land and buildings in balance sheet. Some accountants suggest that it is better to use current valuation method or market-based price approach as it is more reflective and would gives more relevant information as compared to original cost due to appreciation (an increase in value of assets over time). However, some accountants disagree as they believe original cost or historical cost method could be more reliable, as current valuation method is just an estimation or prediction only, which might not be completely accurate and hence, cannot be fully trusted (Alexander & Nobes 2010, pp.40-43).

             Nevertheless, the capabilities of conceptual framework in solving each practical accounting issue will still   remain a question; Bullen and Crook (2005, p.1) voice out that the existing FASB Concepts Statement and IASB Framework for the Preparation and Presentation of Financial Statements can solve part, but not all of the problems. Even though, framework has succeed in supplying the fundamental principles for making a selection between alternatives as well as provides definitions which have formed the basis of accounting standards’ definitions, it would still be unlikely that it can answers all practical accounting questions. This is because in reality, financial statements are prepared for a variety of purposes and used by different kind of users. For example, banks and suppliers are interested in the company’s liquidity ratio and statement of cash flows to assess whether they will be paid; potential investors are interested in future growth prospect and earning ability such as Earnings Per Share (EPS) and Accounting Rate of Return (ARR); while managers of the firm will use it to measure performance and make financial decisions. Thus, it is uncertain and doubtful whether a single conceptual framework can suit all users. In addition, there is no clear indication or guarantee that conceptual framework will definitely ease the task of preparing and implementing standards than without having a framework.

                All in all, the duo efforts of IASB and US FASB in running a joint project with the intention to adopt one global conceptual framework is utmost important. Although there is still some minors flaws, it is undeniable and proven that the conceptual framework can eventually produce fruitful outcomes in promoting unity, handling controversial issues, and help decision makers to make a selection. Hopefully, they will consistently update, improve, and refine the framework from time to time in order to cope with the frequent changes in business environment, globalisation, and users’ needs.


For more information and details about the collaboration between FASB and IASB, you may visit this website: 
Note: The picture below is a screen shot of that particular website.


Alexander, D & Nobes, C 2010, Financial Accounting – An International Introduction, 4th edn, Prentice Hall, London.

Alfredson, K, Leo, K, Picker, R, Pacter, P, Radford, J & Wise, V 2007, Applying international financial reporting standards, John Wiley & Sons Australia Ltd, Milton.

Bullen, HG & Crook, K 2005, Revisiting the Concepts: A New Conceptual Framework Project, viewed 15 November 2012, <http://www.fasb.org/cs/BlobServer?blobkey=id&blobwhere=1175818825710&blobheader=application%2Fpdf&blobcol=urldata&blobtable=MungoBlobs>

Ciancanelli, P, Dunn, J, Koch, B & Stewart, M 2009, Financial and Management Accounting, University of Strathclyde, e-book, viewed 15 November 2012, <http://www.scribd.com/doc/54424572/7/The-statement-of-principles-for-%EF%AC%81nancial-reporting>

Ernst & Young 2012, IFRS Update of standards and interpretations in issue at 31 March 2012, viewed 12 November 2012, <http://www.ey.com/Publication/vwLUAssets/CTools_InterimUpdate_Apr2012/$FILE/CTools_InterimUpdate_Apr2012.pdf>

Riahi-Belkaoui, A & Jones, S 2000, Accounting Theory, 2nd edn, Nelson Thomson Learning, Southbank Victoria.

Scott, S 2011, The need for and an understanding of a conceptual framework, viewed 14 November 2012, <http://www.accaglobal.com/content/dam/acca/global/PDF-students/2012/sa_oct11_framework.pdf>

Thomas, A &Ward, AM 2012, Introduction to Financial Accounting, 7th edn, McGraw-Hill, Berkshire.

Wood, F & Sangster, A 2005, Business Accounting 1, 10th edn, Prentice Hall, Harlow.