ACTIVITY-BASED COSTING

 Activity-based costing is a two-stage costing method that creates a cost pool for each major activity in an organization (such as setups required, purchase orders issued, and so on). Overhead costs are assigned to products and services on the basis of the number of iterations of each activity involved in manufacturing the product or providing the service.

 Activity-based costing (ABC) is a better, more accurate way of allocating overhead.

The steps to product costing are:

1.  Identify the cost object;

2.  Identify the direct costs associated with the cost object;

3.  Identify overhead costs;

4.  Select the cost allocation base for assigning overhead costs to the cost object;

5.  Develop the overhead rate per unit for allocating overhead to the cost object.

Activity-based costing refines steps #3 and #4 by dividing large heterogeneous cost pools into multiple smaller, homogeneous cost pools. ABC then attempts to select, as the cost allocation base for each overhead cost pool, a cost driver that best captures the cause and effect relationship between the cost object and the incurrence of overhead costs. Often, the best cost driver is a nonfinancial variable.

ABC can become quite elaborate. For example, it is often beneficial to employ a two-stage allocation process whereby overhead costs are allocated to intermediate cost pools in the first stage, and then allocated from these intermediate cost pools to products in the second stage. Why is this intermediate step useful? Because it allows the introduction of multiple cost drivers for a single overhead cost item.

ABC focuses on activities. A key assumption in activity-based costing is that overhead costs are caused by a variety of activities, and that different products utilize these activities in a non-homogeneous fashion. Usually, costing the activity is an intermediate step in the allocation of overhead costs to products, in order to obtain more accurate product cost information. Sometimes, however, the activity itself is the cost object of interest.

Activity base costing system is more useful where the proportion of fixed expenses are higher in total cost of manufacturing.

LONG TERM FINANCE

Ideal capital structure is composing of mixture of debt and equity finance. Debt is a cheaper source of finance as interest cost is tax deductible, while dividend on equity is taxable. However one cannot opt for exclusive debt finance on account of restriction by lenders and availability of sufficient amount of cash flow to service the debt.

Following are the pros and cons of various long term source of finance. For ideal capital structure one need to evaluate all these options before making the final selection.

COMMON SHARES

Advantages:

• Right to vote
• Right to transfer through sale of shares
• Right of earning
• Limited liability

Disadvantages:

• Least priority in profit
• High cost while floating in public
• Dividend is not tax deductible

PREFERENCE SHARES

Preferred shares with redemption privileges are very similar to debt with a fixed payment each year- the accounting for such shares is to treat them as debt and not equity. Preference shares without redemption privilege are treated as equity.

Advantages:

• Diviend can be differed for future years
• Debt equity ratio may improve
• No dilution of control on account of non-voting power
• No charge on assets like bank loan

Dis-advantages:

• In case of liquidity, last priority but before common shares
• Return is limited and fixed
• No voting right
• Dividend is not tax deductible

 BANK LOAN

Advantages:

• Easy form of finance, obtained quickly
• Less costly compare to other finance as interest cost is tax deductible

Disadvantages:

• Have to observe bank convent
• Charge on assets by bank
• Debt to equity ratio may go up

Bonds

Bonds will require regular cash outflows to pay the interest expense but this differs from a loan in that no principal repayments are required before the bond is due. The interest expense is deductible for tax purposes. It will increase debt equity ratio.

Fully Convertible bonds

The fully convertible debentures are comprised of two components: a financial liability with a contractual arrangement to deliver cash at a specified time and an equity instrument where the holder is to convert it into a fixed number of shares at the end of X years. For accounting purposes, it would be required to record the liability and equity components separately. This will impact the debt-to-equity ratio by the amount recorded under each component and could result in a breach of the debt covenant. It will also be required to clearly disclose the specific characteristics of the fully convertible debt in the financial statements.

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IT System and Audit Risk

Audit risk has a direct co-relation with IT system in an organisation.  Whenever organisation is planning and implementing new IT system or upgrading the present one, control risk will increase on account of change in flow of activities. Following are the possible scenario where IT system needs improvement or an implementation of a new or revise version of the present system.

• In case of merger
• In case of expansion by issue of equity shares
• In case of expansion in foreign subsidiaries
• In NFPO( Not For Profit Organisation), where present system is a manual one or needs upgrade  due to problems in the existing system
• In case of old and out dated present IT system

In all above situation, control risk will increase and as such audit risk will decrease. Auditor will require collecting more evidences with substantive testing.

Audit and IT Environment

Due diligence and care is required while performing an audit with IT environment in an organisation. All accounting transactions are processed now a day through computer program and as such it will be difficult for the auditor to track and verify the accuracy. Auditor can do audit around the computer and audit within the computer through certain techniques. He can verify input record and output records, can do analysis, perform reasonability check and or do computation on calculators. He can verify management policies and procedures. He can also check programing by entering sample transaction in his own software to ensure accuracy and reliability of financial data.

Technical Knowledge & Case Writing

Technical knowledge is very important part for PA exam. Many students do not have enough exposure to previous courses on account of long time gap. Also students found migrating from different countries and obtained exemption from courses studied in their countries. PA exam test the knowledge of students on main concepts they learned and passed out earlier. This knowledge is very important to solve MCQ (Multiple Choice Questions) and case analysis.

PA exam are evaluated on the basis of competencies identified by the student. They expect in depth analysis of the response along with professional approach. Points are allotted on the basis of identification, analysis, alternatives and relevant and effective recommendation. Students are required to identify direct and indirect (integrated) competencies in case analysis. Some time students are required to identify hidden competencies as well.

Effective writing is another important skill required to pass PA exam. Answer should be very well drafted, concise, clear and with easy to flow language. This requires lot of practice for physical writing. You need to have the professional skills (technical knowledge) so you are providing the “meat” for the discussion.  A wonderful write-up of a non-relevant issue is of no use to the reader. On the other hand, you need to be able to show your knowledge in a clear, coherent manner that the reader can understand and be able to use in his/her decision-making. A professional response integrates a discussion of the appropriate technical knowledge with a clearly communicated writing style. It is important to apply conceptual knowledge and exercise judgment. You will have to use your knowledge to solve practical problems. This means you will have to know what parts of that knowledge are relevant in a given situation. You also will need to be able to identify the problem from the facts provided.  You will have to consider alternatives, analyze them using your core knowledge and exercise your judgment in choosing one alternative.  Finally you must support your recommendation with a logical argument flowing from your analysis. Write your answer with proper heading and sub-headings; do not write case analysis like a story. There are many competencies that marker need to assess form your response, and therefore well-organized professional write up is the key to get success in the final exam.