3
INFLATION ACCOUNTING
3.1
Introduction Every year the financial financial statements statements are prepared prepared with a view to exhibit the true and fair financia financiall position of the concern. But in the current scenario of heavy inflationary trends in the globe, the position as shown by the financial statements becomes inflated and hence does not exhibit true and fair view. Under Under the condition conditionss of inflation, inflation, the prices prices of all the factors factors and inputs inputs of the production production are on a constant rise. The value of money declines in real term as the same quantity of goods is purchased at higher costs. The values attached to the different assets undergo big change with the changes in price levels and traditional Balance Balance Sheet fails to reflect current economic position. There is distortion of figure figuress disclo disclosed sed by histor historica icall Balanc Balancee Sheet Sheet finall finally y leading leading to the disclos disclosure ure of inapprop inappropriat riatee financial position. Thus, accounting based on historical cost concept inflates profits and results in erosion of capacity by way of dividend payment and tax liability. liabilit y.
3.2 3.2
Weak We akne ness sses es of Hist Histor oric ical al cost costss-ba base sed d Finan Financi cial al Stat Statem emen ents ts (1)Exaggerat Exaggerated ed figures figures of profits profits especial especially ly because because of underchar undercharging ging depreciatio depreciation n and higher value of inventories. (2) Unreliable results shown by financial statements leading to wrong decision making by the users of financial accounting information. information. (3) Payment of heavy dividends and taxes as the profits are inflated and hence depletion of financial resources as the profit is partly fictitious. (4) Insufficient funds for replacement of fixed assets after the end of useful life. (5) It adversely affects working capital position. (6) Comparison of financial figures of different position becomes difficult and misleading. (7) Gains from the appreciation of assets are not accounted for.
3.3 3.3
Mea Meaning ning of Infl Inflat atiion Acco Accoun unti ting ng In order to minimize or eliminate the impact of inflation on maintenance of accounting records and to ensure e nsure appropriate treatment of various assets and a nd liabilities, the inflation accou account nting ing app approa roach ch is is developed. As in the historical cost system of accounting the profits are inflated, assets are undervalued and losses and gains arise on holding of assets and liabilities, the inflation accounting system suggests that the t he assets asse ts and liabilities liabilitie s be maintained maintaine d at the current current prices prices as on the the date date of recording recording and and also also the incomes and expenses. The underlying objective of inflation accounting is to present true and fair view vie w in i n books b ooks of account acc ountss and a nd prevent the erosi erosion on of assets assets and and business business resources. resources.
3.4
Merits of of In Inflation ac accounting Inflation accounting holds the true and fair view of accounts as basic objective and hence it has imbibed some merits which are as under: (1) It enables the correlation of current cost with the current revenue leading to more realistic profitability position of the business. (2)It prevents the payment of dividend from inflated profits as shown by the historic cost system. (3) As in the inflation accounting, the depreciation is charged on current values of the assets, the capital is maintained intact. (4) It facilitates meaningful comparison of the records of the different period. (5)As the true profits (instead of inflated profits) are shown, the tendency of uncontrolled expenses by management and heavy demands by the employees is curbed. (6) Investors and public get to know the true profitability and financial position of the business of organization.
3.5
Demerits of Inflation Accounting Though the inflation accounting aims to ensure the truth in the financial statements organizations, its implementation and follow up has many obstacles in it. Inflation accounting faces many limitations which are as under: (1) It involves frequent critical calculations as to adjusting price level changes which further makes financial statements more complicated. (2) Valuation at current prices takes different views and brings further subjectivity ultimately defeating the true and fair view objective of inflation accounting. (3) Income tax department does not except the accounts prepared and profits shown under the inflation accounting system. (4) During the period of deflation it becomes more difficult to maintain inflation accounting system as it leads to controversial situation. (5) Charging depreciation on current values leads to charging of the depreciation more than the cost of the asset. This is not allowed by standard accounting principles.
3.6
Methods of Maintaining Inflation Accounting Generally, there are two methods of maintaining the books of accounts as per inflation accounting. Current purchasing power method and current cost accounting method are two different methods having different approaches leading to the different ways of calculating current values of various accounting variables. These two methods are explained as under. 3.6.1 Current Purchasing Power (CPP) According to this method, the historical costs are adjusted with the general price index. The items in the financial statement are adjusted and revalued at the general price level. General Price Index is considered as very good measure for conversion of historical costs into equivalent current purchasing power. For e.g. an asset purchased at Rs. 15000 in 1981-82 has to have X value in 2007-08. This X value is found out by dividing purchase price of asset by general index value of the y-ear of purchase and then multiplying it with the general price index value of the current year. General Price index value of 1980 is 100 whereas its value in 2007-08 is 551. So the value of asset in 2007-O8 is 15000/100x551 = 82650. The depreciation will be charged on this current value of asset. 3.6.2
Current Cost Accounting (CCA) The current cost accounting method is more realistic as it reflects more correct impact of inflation by measuring the current cost of individual asset by applying specific index value instead of general index value. It takes into account the individual price index relating to particular asset of a concern. This method attempts to show the assets at current cost instead of showing the changes in general purchasing power of the money. Under this method each item in the financial statement is measured at its current cost. This method has several merits such as the profit revealed is more realistic and it is simple to implement this method.
Thus in the general practice of maintaining of financial accounting records, the inflation accounting methods are not incorporated by any business concern. It is not acceptable to the legal machinery of the country. Inflation is a concurrent problem in any economy and to deal with this problem while showing financial position and profitability of the concern is a challenging task. It require further research for the development of more accurate systems of incorporating inflation accounting and eliminating impact of inflation on the various variables of the financial accounting information.
5 5.1
ENVIRONMENT ACCOUNTING Introduction An industrial enterprise is an integral part of the society. It makes use of resources of the society for production of goods and services. Its activities affect the members of the society and the society at large. It is due to the cooperation of the society that any business enterprise can survive, grow and succeed. The natural resources of any nation like water, climate, minerals, forests, trees, oil fields, geological structures, port facilities, rain, animal world etc. affect the business activities of any enterprise. The geographical and natural forces have significant impact on the location of industries. The industries tend to be located at places where natural resources are in plenty, where land is cheaper, raw materials are easily available, where climate is suitable and where infra-structure and other facilities are available. Such environmental resources which are gifted by nature and not man made are natural resources of the country. They are invaluable and hence there is a need to maintain accounts' of such natural resources. Of course, it is a stupendous task and must be done at the national level, but the corporate responsibility in this respect cannot be denied. During the last five years, an idea has been put forward by some experts that the costs, revenues, depreciation and values of natural resources used must be accounted for in the books of corporate enterprises.
5.2
Meaning Environmental accounting is entirely a new developing concept. It had no place in traditional accounting. Environmental accounting can be defined as follows: I. In simple words, "Environmental accounting is a method of re cording environmental elements in the books of accounts," II. In broad sense, " Environmental accounting includes valuation of n atural resources, measuring income there from, keeping records of cost relating to them, estimating their Values and providing depreciation on them". III. A comprehensive definition can be given as follows : "Environ mental accounting is a method of keeping accounts of natural resources and environmental elements, by which efforts are made to get an idea of nation's economic activity, social welfare and maintenance of natural resources." Thus environmental accounting is a method of keeping records of environmental goods and services. It is such an area of accounting system which includes the activities, methods and techniques of recording in the books on accounts and analysing the financial effects of environment and recording its effects in books of accounts." 5.3
(1) (2) (3) (4) (5) (6) (7) (8) (9)
Scope Though the concept of environmental accounting is not clear at present stage so as to make its scope clear, the following can be included in its scope: Concept of National Income. Cost Concept. Depreciation of Natural Resources. Valuation of Natural Resources. Disclosing its Value in National Balance Sheet. Determining Values. Contribution to Industrial Development. Contribution of Industries to Environment. Social wellbeing. (1)
Concept of National Income: The natural resources are such re sources, ownership of
which rests with the nation. Such resources are utilized by the industrial enterprises and such accounting is useful for computing in come arising out of it.
5.4
(2)
Concept of Costs : Some costs have to be incurred to make use of such resources like cost of extracting minerals, cost incurred to get water, cost of stone quarries, cost of cutting trees to get wood for industrial use, cost of developing and maintaining ports etc. Such costs are classified as (1) Revenue expenses and (2) Capital expenses. For any type of accounting, such classification is needed.
(3)
Depreciation of Natural Resources: The natural resources get depleted with its use e.g. coal mines, oil fields. Such assets are wasting assets and in order to compute the true income, depreciation has to be provided for such use.
(4)
Valuation of Natural Resources : The total quantity contained, in any mine, wells etc. has to be estimated and natural resources are valued on that basis e.g. if any oil field is discovered, the total quantity of oil contained in it is estimated and it is determined whether it is worthwhile to get oil out of it.
(5)
Disclosing Value of Natural Resources in Balance Sheet: As natural resources are considered valuable assets of the nation, they have to be disclosed in the Balance sheet of the Nation as national assets.
(6)
Determining Values: The environmental accounting is a system in which environmental goods and services are included. These goods and services have to be valued in monetary terms, as they are precious. Of course, I environmental goods and services cannot be traded in the market.
(7)
Contribution to Industrial Development: Natural resources are the bases of industrial development. They are very valuable raw materials for the industries. They, therefore, have a significant contribution to industrial development and economic progress of the nation.
(8)
Contribution of Industries to Environment: Not only do the industries make use of natural resources, but they have some favourable effects and some adverse effects also on environment, e.g. air pollution, water pollution, soil erosion, noise, fumes, dirt and wastes, dirty water. Besides, they use the natural resources, which are exhausted and cannot be replaced. They produce some wastes which cannot be properly disposed off. They are, therefore, asked to remove these pollutions and thus fulfill their social responsibilities. They are to develop such production processes which reduce such pollution to the minimum.
(9)
Social Wellbeing: Environment deeply affects the society. The change in the environment and use of natural resources affect the health of the members of the society. Hence both of them are closely connected with social welfare. The environmental accounting must show how social welfare and social interest are protected.
Utility of Environmental Accounting
Pollution control has become a hot favorite topic of discussion now-a-days and the environmental accounting must show the extent to which pollution has been controlled by the companies. Environmental accounting is useful in disclosing how much natural resources are available in the country, what are the incomes arising out of them, what are the expenses incurred to protect the resources, what is its importance from the viewpoint of the nation, what amount of depreciation should be charged, how to evaluate them and at what values should they be shown in the nation's balance sheet etc. Environmental accounting is useful in another sense also, that it gives an idea about industrial development, nation’s economic progress and social welfare and fulfillment of social responsibility. Of course, it is a complicated issue to measure the inter-relationship between environment and development. It is because the present national accounting does not properly consider the value of natural resources. Hence the development strategy which is necessary for standard income depends on the accounting techniques. The problem of environment protection is becoming more and more serious and. the need for considering the value of services of environmental resources also goes on increasing day by day. Even the United Nations has also undertaken some exercises for introducing some amendments to its System of National Accounting (SNA) as regards the accounting of estimates of environmental incomes. The United Nations, International Monetary Fund and World Bank all have stressed the need for development of environmental ac-l counting methods, so that better economic decisions are made possible. Utility of Environmental Accounting can be described as under: (1) To Measure effects of Environment on Profit: The natural resources used by an industrial enterprise and its surrounding environment have definite effect on the business profits. The business performance is measured by profit. Particularly when an environmental project is to be implemented or any product relating to environmental accounting is useful. (2) To Determine the Exact Expenses and Incomes: Some expenses are incurred on maintenance of environment or to obtain protection against it. Of some income is also available out of it. In order to know the exact income and expenses the method is useful. Useful for Valuation of Natural Resources: The natural resources, which are being utilized, (3) must be properly valued in order to know the exact expenses. Of course this is a difficult problem, particularly at national level. Provision for depreciation has to be made on natural resources. For all these, a profit system of environmental accounting is required. (4) For Presenting Natural Resources in National Balance Sheet: It is natural that nation's natural resources must be shown as assets in National Balance sheet. For the purpose it is necessary, though difficult to assess the actual quantities available. Whatever quantities of natural resources are left after being utilized must be shown as nation's asset in the balance sheet and the liability for expenses are also to be shown in it. Taking Corrective Measures to remove the evil effects of Pollution: The problem of pollution (5) has assumed great importance for the last few years. Pollution arises due to use of natural resources by industrial enterprises, e.g. water pollution, air pollution, soil erosion,, dirty and contaminated water, dirt, noise, smoke are some of the evils which affect the health of the people adversely, The industries must try to prevent or reduce such pollution and take corrective measures for which environment accounting serves as a useful guide. (6) Fulfilling Social Responsibility: The business enterprises work among environment and makes use of natural resources. And the serious problems of depleting natural resources and pollution arise. Under such circumstances the business should fulfill its social responsibility. They must try to dispose off polluted water and air control noise etc. so that the society does not become prey to such evils.
For Information about Economic Activities: The environment prevailing has a considerable (7) effect on nation's economy, Even the extent of economic activity depends upon the availability of natural resources. All economic activities of any nation have considerable contribution from environment. And so the environmental accounting is useful in indicating the economic activities going on in a nation. For Economic and Investment Decisions: Any economic decisions for investment purposes are (8) to a great extent guided by environmental accounting. It is useful to government and business units for taking economic decisions and also of use to shareholders and prospective investors in taking investment decision. For Health and Welfare of Society: Healthy environment is conducive to good health of people (9) in society and contributes positively for social welfare. If however, environment is adversely affected and pollution arises, the health of the people is badly affected. Environmental accounting will show to what extent this has been done, which corrective measures have been taken and how consciousness has been created among people in business about maintaining clean environment.
The question of protection of environment is becoming more serious. The need to think about the prices of environmental natural resources is being felt now. The national government does legislate on protection of environment But the contribution of industrial units is significant in controlling the pollution. Even the International Monetary Fund and the World Bank of the UNO has emphasized the need for Environmental Accounting in order to stop the evil effects of use of natural resources and polluting the environment. 5.5
Procedure For Environmental Accounting
The following procedure is adopted for the Environmental Accounting (1) Profit and Loss Account: All revenue expenses required for the protection of environment should be debited to the Profit and Loss Account and all revenue incomes arising out of it must be credited to it. Balance Sheet: The organization should prepare Environmental Balance Sheet. All natural (2) resources which are consumed and exhausted by the organisation should be shown as assets. The expenses for the same are the liabilities of the organisation towards the society. (3) Budgets: The Environmental Budgets should be prepared by the organisation to ascertain the amount to be allocated for environmental activities. The Organisation should check whether such amount is actually spent on the environmental activities. The responsible person should check and verify how far the amount is really spent on environmental activities. (4) External Reporting: The organization should report for the environmental activities, the cost imposed by the organization and environments benefits rendered by the business organization, benefits received from the environment and the costs imposed by environment. The social responsibility will be fulfilled by the reporting. The major burning issues and challenges before the Accountant are as follows: i. How can one assess the impact of a business organization on environment? ii. How to value environmental metamorphosis caused by a business organization? iii. What criteria should be evolved to assign monetary value to the environmental changes? iv. How to depreciate environmental assets? v. How to estimate the remaining natural resources? vi. How the costs, revenues, depreciation and values of natural-resources should be accepted in the books of accounts of the organization? 5.6
Development of Environmental Accounting in Different Countries
Commendable work has been done on Environmental Accounting in some countries of the world. Some countries have developed their national approaches to it, and outstanding among them are Norway, the USA and France. Norway: Norway is the country which is most interested in area of Environmental Accounting which has presented its own approaches to Environmental and Natural Resource Accounting. The objective of Norwegian System is not to make possible adjustments for best measure of true income, but to be helpful to the government in its decisions relating to the management of natural resources. This has great political and economic importance. U.S. In a developed country like the USA limited work has been done on Natural Resource Accounting. Before 1989, the Bureau of Census had undertaken a survey of nearly 20,000 firms in production sector. While, the Bureau of Economics had also undertaken Survey of firms carrying on production activities, and firms not doing any production activities. In this survey, research was done on degradation and depletion of Natural resources by such firms. France: For a long time, the French experts tried to develop Patrimony Accounting. This is a complete system in which accounting is done at seven levels. From the first level of collecting data regarding natural resource till seventh level where attempts have been made to develop welfare indicators. he object was to describe the three basic functions of natural factors like economic, ecological and social analysis. India: India has a vast reservoir of natural resources. India is prosperous from the viewpoint of environment. Most of the industrial units freely make use of vast natural resources. But this has led to a serious problem of pollution, and environment according has become absolutely necessary to control it. Of course, the Government of India and number of Indian companies are conscious of this problem and they are trying to stop pollution or to control it to a considerable extent. Even the judiciary is making orders to keep environment pollution free. But no company has so far given any environmental accounting in its annual reports. Of course, some mention is made in the directors' reports or in chairman's statement. In its Annual Report of 1998-99, the Tata Engineering and Locomotive Co. Ltd. (Telco) has stated under "Concern for Environment" heading the steps taken by it to control pollution and also the implementation of the suggestions made by EPCA (Environmental Protection (Prevention and Control) Authority appointed by the Central Government under orders from the Supreme Court. The Indian Aluminum Co. Ltd. in its Annual Report of 1998-99 has discussed under the heading of "Safety and Environment" in its Chairman's Speech, how it has tried to conserve water and electricity. On page 2 of the laid Report it has presented its "Environmental Policy Statement" which gives the measures taken by the company to satisfy social, economic and environmental demands on it. It has also stated the steps taken by it to communicate this to its employees, customers, people etc. its environment management system, steps taken for protection of environment for health and safety of the people etc. Thus it has adopted some aspect of environmental accounting. Even TISCO has tried to show its consciousness towards Environment in its Annual Report of 1998-99 on title page 3 under the heading of "Environmental Management" in which it has stated how it has implemented the environment friendly scheme of Environment Ministry, steps taken by it to prevent pollution and planting of more than 6 lacs trees by it. 5.7
Conclusion As the Environmental Accounting is of great significance from the national view point, it covers in its scope incomes from environmental and natural resources, costs, depreciation, valuation, maintenance and estimates. It clarifies gradually how to treat them in environmental accounting. Of course, there are some difficulties with respect to estimate of remaining natural resources in the sub-soil, depreciation on them and its valuation aspect. But Environmental Accounting has proved to be very useful in measuring the nation’s economic development, social welfare, industrial development, pollution control and in satisfying the needs of the government. Still, the system is in its infant stage and all countries
have not been able to develop such a system. But with the passage of time, gradually the system will develop, more and more research will be undertaken and it will fulfill the purl poses for which it was originated.
EXERCISE
Q1.
Explain the meaning of Environmental Accounting and discuss its scope
Q2.
What is Environmental Accounting? Explain its Utility.
Q3.
Clearly explain the meaning of Environmental Accounting and describe its procedure.
Q4.
How is Environmental Accounting prepared?
Q5.
Describe the development of Environmental Accounting in various countries.
Q6.
Do you believe that Environmental Accounting is absolutely essential in modern times? Why?
6
RESPONSIBILITY ACCOUNTING
6.1
Introduction When a system of accounting is so developed that revenues and costs are reported so as to relate them to the manager who has the control over such costs and/or revenues, the system is called Responsibility Accounting. Responsibility for costs and revenues are entrusted to various persons. Thus responsibility centres are established and accounting reports are prepared and presented before the managers who are assigned the control and responsibility of that centre. The budgeted figures for that centre are compared with the actual performance in the responsibility accounting reports and the performance of each responsibility centre is evaluated and appraised on that basis. Responsibility accounting is a system of cost control, whereby each item of expenditure is assigned to the manager who can best influence it by his actions. Reports are prepared for evaluation of actual performance for determining whether actual performance is in accordance with the planned figures and if actuals are not according to the plan, then what are the variances, why variances have occurred and what corrective actions are necessary to bring the performance in line with the plan.
6.2
Definitions of Responsibility Accounting In order to understand the concept of responsibility accounting properly, Let us study some of the definitions: According to Shri Kohler, "It is a method of accounting in which costs are identified with persons assigned to their control rather than with products or f unctions."
According to John A. Higgins, "It is a system of accounting which is tailored to an organisation so that costs are accumulated and reported by levels of responsibility within the organisation. Each supervisory area in an organisation is charged only with the cost for which it is responsible and over which it has control." Charles Horngren writes, "Responsibility Accounting is a system of accounting that recognizes various responsibility centres throughout the organization and that reflects the plans and actions of each of these centres by assigning particular revenues and costs to the one having the pertinent responsibility." E. W. Netten has described it as follows, "Responsibility Accounting classifies accounting and statistical information on an enterprise's activities according to the managers responsible for them. So many varied techniques are practised now under the name of responsibility accounting that really it is synonymous with management accounting." The Certified Institute of Management Accountants, London has described it as follows: "Responsibility Accounting is a system of Management Accounting, under which accountability is established according to the responsibility delegated to various levels of management and management information and reporting system instituted to give adequate feedback in terms of delegated responsibility." According to Robert Anthony, "Responsibility accounting is that type of management accounting that collects and reports both planned and actual accounting information in terms of responsibility centres."
From the above definitions, the following features of Responsibility Accounting are made clear: 1. The system focuses on human factor in management. It emphasizes preparation of and reporting of general information and 2. particularly accounting information keeping responsibility centres in view. 3. The responsibility accounting system is prepared, so as to be consistent with the organization structure of the enterprise. 4. It concentrates on cost and other data on the basis of responsibility levels in the organization structure. 5. Accounting reports in respect of expenses and incomes are presented before those managers who can be considered responsible for such expenses and incomes. 6. The reports give comparative figures of actual performance with budgeted figures and also figures of past periods. 7. The information is provided to management at a time when it is needed for planning, decision making and control purposes. 6.3
The Requirements of Responsibility Accounting The responsibility accounting involves following: 1. The determination of responsibility for each activity carried on in an enterprise and the assigning of each item of income, expense and other expenditure accordingly. 2. The definition of the kind and amount of data each manager needs and the reflection of them in the account and statistical classification. 3. The use of management reports to convey the data to those who will use it, at the time- they want it. 4. Planning and budgeting practices made fully compatible with the reports. 5. The setting up of measures of performance to be incorporated in the reports and budgets. 6. Devising accounting and statistical procedures to' gather and process the required data. 7. After the nature of information required is determined, it must be decided as to how often the reports are to be submitted, what details are to be included and the format of the reports. 8. Reports for control purposes may be produced monthly, weekly or daily. Foremen and first line supervisors may need many details and frequent reports. Reports to senior management are not so frequent. They must be in condensed form, summarizing the results of lower levels.
6.4
Essentials of Effective Responsibility Accounting In order that responsibility accounting system can operate efficiently, the following points need to be taken into consideration. 6.4.1 Creating Efficient Organisation Structure The success of responsibility accounting system mainly depends upon the organisation structure. The organisation structure must be clearly defined and there must be clear cut division of authority and responsibility. If there is no corresponding authority coupled with responsibility or no corresponding responsibility alongwith authority, the system of responsibility accounting will fail. The authority should be commensurate with responsibility. If the responsibility is not properly distributed, a manager may not be held responsible for his failure or he will be held responsible for responsibility which was never entrusted to him. The whole organisation should be divided into various cost centres or profit centres. Of course, it is difficult to allocate responsibility. But with carefully following the rules of an ideal organisation structure, it is possible to do so.
6.4.2 Determining Responsibility Centres The Responsibility Centres are the corner stones of the system. There are four types of responsibility centres, namely, cost centres or expense centres, profit centres, investment centres and revenue centres. These centres must be devised keeping in view the main objective of controlling. Every item should be the responsibility of manager of one centre or the other. 6.4.3 Fixing Standards for Measuring Performance To control is to measure performance, and without fixing the standards of performance in advance, such measurement is not possible. An efficient tool of m easuring performance is a budget. There are other tools also besides budget for measuring performance like standard costing, manning tables, sales quota etc. Of course, there are certain matters which cannot be measured. For example, relations with customers, leadership etc. Yet it is possible to develop standards for measuring performance of responsibility centres. Mainly budgeted figures are used therefore. If budget is to be used as criteria for measuring performance, the managers of responsibility centres must be involved in its preparation. 6.4.4 Setting an Effective Budget Procedure It is essential for an efficient responsibility accounting system that accurate and acceptable budgets must be prepared. Targets must be decided for the budget for which the opinions of managers of responsibility centres must be obtained and considered and final budget figures must be determined in the light of these figures. An efficient system of reporting actual performance alongwith these budgeted targets must be developed. 6.4.5 Reports to Management Presentation of reports to management is an important pre-condition of managerial control. Reports must be prepared for each responsibility centre and presented to the manager. The following decisions must be made for an efficient system of reporting. Which items must be included and how much of them should be included. • At what time periods the reports should be presented. • In which formats the reports must be made. • 6.4.6 Support of Top Management No system can be successful without the active support of management. They must realise the importance of responsibility accounting for control purposes and they should therefore endeavour to promote it. The realistic targets must be established which is in most cases the task of top management. Whenever the middle level managers oppose the system, it is the top management who should persuade them to accept it. 6.4.7 Educating Manager Those middle level managers who are responsible for implementing the system must know the usefulness of the system. It is the top management who should educate them in this respect. They must be involved in preparation of budgets. The targets should be such as to motivate them, the human being is at the centre of the system and the system should be implemented keeping in mind the emotional reactions of those implementing it. The performance reports are meant not for punishing those responsible, but to bring to their notice the deficiencies and to motivate them f or better performance. 6.4.8 Measuring Performance In order to evaluate the efficiency of manages of responsibility centres, their performance of centre should be measured and presented to them in proper format and must be
compared with pre-determined figures. A proper system of reporting should be developed for this purpose. 6.4.9 Presenting Variances Presentation of variances indicating difference between budgeted performance and actual performance is essential to know how far the responsibility managers have succeeded in fulfilling their responsibility. If the variances are significant, the attention of top management should be drawn. 6.4.10 Taking Corrective Action The ultimate aim of responsibility accounting is to take corrective actions if something goes wrong in a significant manner. If the targets have not been fulfilled, the causes of variances are analysed and efforts are made to remove them by taking corrective action. 6.5 Advantages of Responsibility Accounting It is an important system of management control and is useful in decentralizing the business enterprise. Besides, it has number of other advantages. 1. It provides a useful tool to the management for control. The efficiency and profitability of large and small departments and sections are available from such reports. 2. It helps in evaluating the performance of divisional managers in an objective manner. Their performances are compared with realistic targets fixed in advance carefully by the top management. 3. In order to appraise the performance, the objectives of business are to be determined and carefully prepared realistic targets are to be fixed. Thus it compels top management to do so. 4. Under responsibility accounting, decision making is delegated to managers of responsibility centres. This helps in decentralization, of business enterprise. Decentralization has become almost inevitable in modern business world. 5. Cost consciousness develops among divisional managers. Whenever they present a proposal, they would always analyze cost benefit aspects of it. 6. It improves over-all efficiency of business, as the performance reports are promptly presented and corrective actions are taken in time before it is too late. 7. It leads to improved efficiency in yet another way. As the performance reports are presented very much in time before the divisional managers, they have enough data before them, on the basis of which they take their decisions. Thus decision-making delegated to him becomes scientific. These decisions are matured. 8. It is a motivating technique for divisional managers. Presenting the performance reports of their division would encourage them to see that their targets are being achieved. 6.6 Limitations of Responsibility Accounting 1. If the top management does not heartily support the system, it will fail. Instead of motivating the divisional managers, it will develop bitter feelings. 2. If the organization structure is not properly organized, there would be imbalance in delegation of responsibility and authority. Thus the base itself would be weak. 3. The targets fixed must be realistic. If the targets are too high, it will discourage divisional personnel and would not achieve its goal of motivating managers. 4. The defective reporting system will have adverse repercussions. So also, not presenting reports in time will discourage the operating managers. They would not be able to take timely corrective measures.
In recent times responsibility accounting has assumed an important place in modern business. But too much should not- be expected from it. After all, it is a system and its success depends upon the manner in which the management utilizes it. It is not a substitute for good management. The lop management should consider even behavioral aspect of the system. Else, it will discourage the managers and would not achieve its objectives. As E. W.
Net ten writes, "Responsibility accounting opens up new ways for the accountant to provide valuable services to his enterprise and lo take his place on management team. Enterprise after enterprise has adopted it and has found that it brought very worthwhile benefits through more realistic planning, greater profit consciousness, clear definition of organizational responsibilities, closer control and better management decisions
6.7 Responsibility Centers The responsibility centre is at the centre of the responsibility accounting. Responsibility centre is that part of an organization that is headed by a manager, who is responsible for its activities. Accounting reports and information are presented to each manager of each responsibility centre in respect of activities which are controllable by him and for which he is responsible. Its output is measured as compared to inputs and on that basis it is decided whether the responsibility centre is efficient and effective or otherwise. The following figure shows the responsibility centre.
Inputs
Output Work
Resources
(Goods or Services)
Each responsibility centre uses inputs which are materials, labour and. other services. It carries on work on these resources with the help of assets. The responsibility centre then produces outputs, which may be physical goods or which may be services like engineering, accounting, administrative services etc. The latter type of outputs are difficult to measure. Thus the whole organization is divided into various departments, divisions, sections etc. for the purpose of efficient operations and control. Each of them is invested with certain activities for which authority is delegated to the head of that section, who is then considered responsible for the activities Of that section. Reports are presented to him in regard to activities under his control. Such a department, division or a section is considered Responsibility Centre. It may be a big department like Sales Department or a small section like Repairs section of production department. Thus there are two criteria for determining the responsibility centre. One, it must be clearly identifiable for management and control and its performance must be measurable. 6.8 Types of Responsibility Centers There are four types of responsibility centres: Expense Centres or Cost Centres, Revenue Centres, Profit Centres and Investment Centres. 6.8.1 EXPENSE CENTERS OR COST CENTERS Expense centres are responsibility centres for which inputs or expenses or costs only are measured in monetary terms, but for which monetary value of its output is not measured. In other words, if the manager of a responsibility centre is held responsible for its costs or expenses only and not for its incomes or revenue, it is called expense or cost centre. The manager of such centre produces goods or services by using resources like materials, labour, machines and equipments etc. for which costs are incurred but he has no authority over incomes or revenue of that department or he is not accountable for it. In order to evaluate the performance of cost centre, its figures of actual expenses or costs are compared with the budgeted figures. The variances of expenses are calculated and any significant variance is investigated. While preparing reports, only those costs which can be directly attributable to that centre or controllable costs of the cost centre should be included. It should not include apportionment of overhead costs.
In a manufacturing concern, the production departments and service departments are expense centres or cost centres. According to Anthony and Reece, expense centres are not the same as cost centres. A cost centre is a device used to collect costs that are subsequently to be charged to cost of production while the objective of expense centre is to control the expenses of a responsibility centre. Secondly, expense centre is a responsibility centre in the sense that it has a manager, whereas some cost centres do not have identifiable managers. There are two general types of expense centres namely, engineered expense centres and discretionary expense centres. Engineered costs are those elements of cost in respect of which proper amount of costs that should be incurred can be estimated with reasonable degree of reliability e.g. cost of direct labour, direct material, supplies are such costs. Discretionary costs or managed costs are those for which no such estimate is possible. The amount to be spent depends upon the management's judgment. Expense centres in which all or most of the costs are engineered costs are engineered expense centres, while expense centres in which most of the costs are discretionary are called discretionary cost centres. The output of discretionary expense centres cannot be measured in monetary terms e.g. accounting, legal, public relations etc. However, an expense centre is not a useful basis of measuring performance of a responsibility centre because it does not take into account the output of the centre. However, where output, is difficult to measure e.g. personnel department, this is the most suitable form of responsibility centre. 6.8.2 REVENUE CENTERS A revenue centre is one where outputs are measured in monetary terms, but no formal attempt is made to measure expenses or costs. The manager of such a responsibility centre has no powers to make any decision regarding investments or regarding expenses to be made. He is responsible only for revenues of his centre. Thus marketing organizations are such revenue centres. They do not have profit responsibility, as it would include control over both expenses and incomes. In order to evaluate the performance of such a centre, the actual revenues are compared with budgeted figures. The expenses relating to sales are also controlled in the same manner. But revenue centres do not have the authority to set selling prices. 6.8.3 PROFIT CENTERS When the manager of a responsibility centre is considered responsible for costs or expenses and also revenues or output of that centre, it is called Profit Centre. In other words if the performance of a responsible centre is measured in terms of both, the revenue it earns and, the expense it incurs, the responsible centre is a profit centre. "When financial performance in a responsible centre is measured in terms of profit, which is the difference between the revenues and expenses, the responsibility centre is called a profit centre." A profit centre may be say a product division, which may be responsible for expenses (costs) of its input and for its output which is revenue. So it is like an independent firm. Such a centre is a natural profit centre, where both input and output can be measured in monetary terms. As against that, there may be constructive profit centres, where input may be measurable but output is not measurable, as it does not sell anything. For example, the computer section. This is actually the expense centre, as it provides services to other departments and does not sell product or services. But the management may consider its constructive profit, which is not the real profit but the cost which it saved by owning the computers, which it would have paid to an outside firm for buying computer services. It must be remembered that the actual profit which is compared with budgeted
profit is profit before tax, as it is a divisional profit and tax is payable on total firm's profit. Advantages of Profit Centres By creating independent profit centres, the following advantages are obtained: 1. The profit centre is like an independent firm and it has its own income statement which shows its revenues, expenses and the profit. This forms the basis of control of divisional performance and also of manager's performance. 2. As the manager's performance is measured by the profit of his division, the manager is motivated to make decision about inputs and outputs which will increase the profit of his division. 3. A profit centre provides a training ground for general management responsibilities to the divisional managers. He is running his division as if it is his own business firm and is trained in managing all the functional areas. It also provides means of evaluating the manager's potential for higher management jobs. 4. When a profit centre is created, it amounts to organizational decentralization; it makes possible the decentralization of organization and delegation of authorities. Top management can safely delegate the authority to divisional managers, because the profit centre reports provide adequate information about how well the operating managers are doing their jobs. 5. The speed of operating decisions increases because they are taken by the divisional manager, who is delegated the authority to do so. The quality of decision also improves, as the manager would take the decision which would improve the profitability of his division. This also leads to relieving the top management of the burden of making day-to-day decisions and they can therefore concentrate on more important matters. 6. It develops profit consciousness among the divisional managers. As they are responsible for the profit, they would be constantly looking for ways to improve the profits. When he decides to spend some money, he would always think of ways to increase the revenues too, so that profit is improved. 7. The measurement of performance is done in a better way, as profit is a more comprehensive measure of performance than only the measure of either revenues or expenses separately. It measures the effects of management actions on both revenues and expenses. Limitations of Profit Centres The following difficulties of creating profit centres must be kept in mind: 1. Creating a profit centre would involve extra record keeping to measure input and output in monetary terms. If the centre receives goods or services from other department, there is a burden of recording the cost of goods received. 2. Sometimes a manager of a responsible centre has little authority to decide on quality or quantity of its output or on the relation of output to costs. In such a case, the profit centre becomes useless as a control device. 3. If the management wants that some department should provide service to other responsible centres of the company, the service should not be charged to other centres, e.g. computer division. In that case the service department cannot work as a profit centre. 4. If a product is fairly homogenous like cement, then it can be measured in terms of non-monetary units like weight. In such a case no substantial benefit is available in making profit centre. Only expense centre would serve the purpose. 5. Making a division, a separate profit centre will result in competition among divisional managers. It may generate conflict between various profit centres, which may damage the interest of the company. Here the need is that there should be close cooperation between various organizational units.
6. There would be too much interest in short run profits to the detriment of long-run profits. The managers must be made to understand the importance of long-run profitability in the interest of the company. If there is no such situation prevailing, it is better not to use profit centres. 7. When decisions are decentralized, top management may lose some control. It must be remembered that relying on control reports only is not as effective as the personal knowledge. 8. There is a problem of measuring certain types of expenses to be considered for computing divisional profit. The over-all expenses of the company are allocated to the division, but the question is whether such expenses should be included for computing divisional profit. Such expenses should not be considered as they are not controllable by the divisional manager. They cannot be traceable to the division. 9. The problem of transfer prices also complicates the calculation of divisional performance. A transfer price is a price used to measure the value of goods or services furnished by a profit centre to other responsi ble centres within a company. 6.8.4 INVESTMENT CENTERS Investment centre is a responsibility centre in which inputs are measured in terms of costs expenses and outputs are measured in terms of revenues and in which assets employed are also measured. When a divisional manager is allowed some powers about the amount of investment undertaken by the division, and the divisional profit is related to the amount of capital invested, then such divisions are investment centres. The performance of such centres are measured by Return on Capital Employed (ROCE) also known as Return on Investment (ROI) or by Residual Income.
As Robert Anthony and Reece write, "An investment centre is a responsibility centre in which the manager is held responsible for the use of assets, as well as for revenues and expenses. In an investment centre, the manager is expected to earn a satisfactory return on the assets employed in his responsibility centre." Generally subsidiary companies are treated as investment centres and within each subsidiary the main divisions are treated as profit centres. The managers, of such subsidiaries are allowed to make decisions about the volume of production and about the prices of the products. The problem in evaluating the performance of investment centre on the basis of return on investment is to determine the assets to be included in the total investment. For example, what cash on hand should be included is a problem. The centre keeps less cash on hand, because cash with the headquarters is always available to it in case of need and so some part of company's cash should also be included in investment of the ce ntre. Investment centres are used generally by relatively large companies for their big divisions which both manufacture and market a line of product. But the limitations of investment centres are similar to those of profit centres. For example, there is an increase in costs of record keeping. Secondly, the managers are interested in short-run profits and so they take decisions which are not consistent with the long-run best interests of the company as a whole. EXERCISE
Q1.
What is Responsibility Accounting? How are responsibility centres determined?
Q2.
Define Profit Centre. What are merits and demerits of Profit Centre?
Q3.
Write Short Notes on the following:
Q4.
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Responsibility Accounting
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Investment Center
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Essentials of Good Responsibility Accounting
What is Responsibility Accounting? State its Advantages and Disadvantages
