BBA108_Financial and Management Accounting(Draft 2)-converted-converted

UNIT-7 ROYALTY ACCOUNTS Structure Learning Objective Introduction Terms used in Royalty agreements distinction between rent and royalty accounting entries in the books of lessee Stoppage of work due Summary Key words Learning Activity Unit -End Questions References LEARNING OBJECTIVE After studying this unit, you will be able to: • Explain royalty account • List distinction between rent and royalty • Describe terms used in royalty agreements INTRODUCTION Royalty is payable by a client to the proprietor of the property or something on which a proprietor has some unique rights. A royalty arrangement is set up between the proprietor and the client of such property or rights. In the event that instalment is made to buy the privilege or property that will be treated as capital expenditure rather than a Royalty. Installment made by the tenant on account of a royalty is normal business expenditure and will be debited to the Royalty account. It is a nominal account and toward the end of the accounting period, balance of Royalty account should be transferred to the normal Trading and Profit and Loss account. Royalty, in light of the creation or yield, will carefully go to the Manufacturing or Production account. On the off chance that, where the Royalty is payable at a sale basis, it will be essential for the selling costs. TERMS USED IN ROYALTY AGREEMENTS Minimum Rent 98 CU IDOL SELF LEARNING MATERIAL (SLM)

As mention, the lessor goes into a contact or an agreement with the lessee for the instalment or payment of royalty. This royalty is resolute on the basis of number of goods produced or quantum of goods sold. Presently, there can be situations when the quantity of goods produced or sold are invalid or moderately low. In such a case, the lessor would get no or little royalty legitimately affecting lessor's royalty income. As such, when there is no or little production or sale, the lessor would be at a loss since no or production or sale would be gotten from the lessee. This is notwithstanding lessee using the asset. To dispose of such a circumstance, the lessor requires a base measure of payment to be paid by the lessee regardless of the quantity of goods produced or sold by the lessee. That is, lessee is needed to pay least minimum to the lessor. This is in spite of the way that the actual royalty amount, which is determined dependent on the things produced or sold, is less than the minimum rent to be paid. Such a guaranteed minimum amount so received by the lessor is called the minimum rent. Minimum rent is fixed at the time when the lessor enters into an agreement with the lessee. It is a term included in the contract in the interest of the landlord as it assures minimum rent even in cases of lower sales or output. Therefore, the lessee pays minimum rent or the actual royalty amount, whichever is higher. Example For example, say the output produced by Mine X is 8,000 tons. The royalty to be paid by the lessee is Rs 200 per ton and the minimum rent in the agreement is Rs 10 Lakhs. As per production, the actual royalty amount to be paid comes at Rs 8 Lakhs. Since the actual royalty amount is less than the minimum rent, the lessee is required to pay minimum rent of Rs 10 Lakhs to the Lessor. Short Workings or Redeemable Dead Rent Short Workings is only the sum by which the minimum rent is more than the actual royalty. All in all, short workings are the distinction between minimum rent and actual royalty. 99 CU IDOL SELF LEARNING MATERIAL (SLM)

In the example above, the Short Workings amount to Rs 2 Lakh (10 Lakh – 8 Lakh). It must be noted that Short Workings comes into picture only when the clause of minimum rent is included in the agreement. Excess Working Excess Working is nothing but the amount by which Actual Royalty is more than the minimum rent. Say for instance, in the example above, the output produced is 12000 tons. Accordingly, excess working comes out to be Rs 4 Lakhs (12 Lakh – 8 Lakh). Recoupment of Short Workings Normally, the arrangement entered by the lessor and the lessee under Royalty Accounting accommodates an arrangement. This arrangement permits to carry forward of short workings so as to change the equivalent in future. In this manner, in the next years Short Workings is changed against the excess royalty amount. Such a cycle of adjusting Short Working capital is known as recoupment of Short Workings. As such, the statement of recoupment in Royalty Agreement gives the privilege to the tenant to recuperate excess payment made by him to the lessor for consenting to the provision of least lease in the earlier years. Moreover, a time span is specified in this agreement. Such a period sets out the quantity of years during which Short Workings can be recovered or recuperated by the lessee. This time- frame can be fixed or fluctuating. In situations where the resident neglects to recuperate the Short Workings inside the specified time, the Short Workings slip by and is debited to the P&L Account for the period in which the recoupment slips. Fixed Right Fixed Right implies that the lessee can recoup short working from the lessor within a specific time span from the date of rent of the asset. For example, according to fixed right, say the lessee can recoup Short Workings inside a long time from the date of rent. On the off chance that he neglects to do as such, the recoupment slips by or closes. 100 CU IDOL SELF LEARNING MATERIAL (SLM)

Fluctuating Right Under Fluctuating Right, the lessee can recuperate Short Workings for any period during the resulting time frame or periods. For example, Short Workings of the earlier year can be recuperated in the resulting year. Strike and Lockout There can be cases where a strike or a lockout takes place during the period of the Royalty Contract. Thus, the Royalty Agreement can provide for a provision that the minimum rent would be reduced proportionately in case a strike or a lockout takes place. DISTINCTION BETWEEN RENT AND ROYALTY The following are some the difference between Royalty and Rent: • The term Royalty refers to the payment made for exclusive use for both tangible and intangible assets whereas Rent refers to the payment made towards use of tangible assets only. • The payment of Royalty is made on the basis of output or sale, whereas Rent is paid for a specific period. • The payment of Royalty varies as per sales or output whereas Rent is always fixed • The parties involved in Royalty are known as lessee, lessor, patent holder, patentee, publisher author etc whereas there are only two parties involved in Rent landlord and tenant. • In case of Royalty agreement there is a clause of making minimum payment whereas in case of Rent there is nothing like minimum rent. The term Minimum Rent is also referred as fixed rent, dead rent, flat rent, contract rent and rock rent. ACCOUNTING ENTRIES IN THE BOOKS OF LESSEE The following are the accounting entries passed in the books of lessee: (1) When the Royalty is Less than Minimum Rent and the Minimum Rent Accountis not Maintained: 101 CU IDOL SELF LEARNING MATERIAL (SLM)

(2) When the Royalty is Less than Minimum Rent and the Minimum Rent Account is Maintained: (3) When Royalties are More than Minimum Rent: 102 CU IDOL SELF LEARNING MATERIAL (SLM)

(4) When Short Working cannot be Recouped in Future: Illustration: 103 CU IDOL SELF LEARNING MATERIAL (SLM)

104 CU IDOL SELF LEARNING MATERIAL (SLM)

N.B. The excess of Minimum Rent over actual Royalty is termed as Short workings. Here, the Lessee has a right to recover the Short workings over the first three years only. Therefore, in the year 2004. Lessee could recover Rs 4,000 out of the Royalty; the balance of Short workings Account amounting to Rs 4,500 (Rs. 6,500 + 2,000 = 8,500 – 4,000 = 4,500) written off to Profit & Loss Account, as the amount is no longer recoverable. 105 CU IDOL SELF LEARNING MATERIAL (SLM)

Entries for 2004 and 2005 are the same, as done. The reason is that in 2004 and 2005 the amounts of Royalties are more than the Minimum Rent. Therefore, Minimum Rent will not be opened. STOPPAGE OF WORK DUE Sometime, there may be stoppage of work due to conditions beyond control like strike, flood, etc. in this case, minimum rent is required to be revised as provided in the agreement. Revision of the minimum rent will be − • Reduction of minimum rent in the proportion of the stoppage of work; • On the basis of fixed percentage; or • By a fixed amount in the year of stoppage. SUMMARY As far as accounting, royalty is the thing that a lessee pays to a lessor for the utilization of any rights, copyrights, establishments or any such resource. It is the arrangement of sharing of incomes between the lessee and the lessor. KEY WORDS • Royalty: A periodic payment, which may be based on a sale or output is called Royalty. Royalty is payable by the lessee of a mine to the lessor, by publisher of the book to the author for the book, by the manufacturer to the patentee, etc. • Landlord: Landlords are the persons who have the legal rights on mine or quarry or patent right or copybook rights. • Tenet: An Author or publisher; lessee or patentor who takes out rights (usually commercial or personal rights) from the owner on lease against the consideration is called tenet... 106 CU IDOL SELF LEARNING MATERIAL (SLM)

• Minimum Rent: According to the lease agreement, minimum rent, fixed rent, or dead rent is a type of guarantee made by the lessee to the lessor, in case of shortage of output or production or sale. It means, lessor will receive a minimum fix rent irrespective of the reason/s of the shortage of production. LEARNING ACTIVITY 1. What are the types of royalties? 2. A Company leased a colliery on 1st January , 2007 at a minimum rent of 40,000 merging into a royalty of rs.3 per ton with power to recoup short workings over the first four years was 18,000 tons , 24,000 tons , 32,000 tons , 40,000 tons respectively Pass the necessary journal entries for each of the four years in the book of the company UNIT END QUESTIONS A. Descriptive Type question • Describe all are the parties involved in royalty accounts at Honeywell? • Analyse recoupment of short working at pharmaceutical industry • A colliery worked coal under a lease which provided for the payment of royalties at Rs 5 per tonne with a minimum rent of Rs 1,70,000 per annum. Each year’s excess of minimum rent over the actual royalties was recoverable during the subsequent three years. The lease, however, stipulated that if in any year the normal rent was not attained due to strike or accident, the minimum rent was to be regarded as having been reduced proportionately having regard to the length of the stoppage. The output was as follows: During the year 2010-11 there was a stoppage due to strike lasting three months. Give the necessary ledger accounts in the books of the colliery for each of the above years. • What is the procedure of recoupment of short-working? Provide the accounting treatment regarding royalty transactions in the books of lessee. 107 CU IDOL SELF LEARNING MATERIAL (SLM)

B. Multiple Choice Questions: 108 1. What is Royalty? a. A payment is made for use of fixed asset. b. A fixed payment for use of fixed Assets. c. A payment paid by owner. d. None of these 2. Mining Royalties is based on --------- a. Production b. Sales c. Purchases d. None of above 3. Patent Royalties is based on -------- a. Production b. Sales c. Purchases d. None of these 4. Copyright Royalties based on-------- a. Sales b. Production c. Purchases d. None of these 5. What is minimum Rent? a. Payment for use of land which is fixed. b. It is payment for use of land on the basis of output. c. A payment paid by owner. d. None of these 6. Minimum Rent is also called? a. Dead Rent b. Rock Rent c. Fixed Rent d. All of these CU IDOL SELF LEARNING MATERIAL (SLM)

Answer 1. a 2. a 3. a 4. a 5. a 6. d REFERENCES • Anthony, R.N. and Reece, J.S. (1988). Accounting Principle. New York: Richard Irwin Inc. • Gupta RK. and Radha swamy, M. (2004). Financial Accounting. New Delhi: Sultan Chand and Sons • Monga J. R, Ahuja Girish, and Sehgal Ashok. (2014). Financial Accounting. Noida: Mayur Paper Back. • Shukla, M.C. Grewal T.S. and Gupta, S.C. (2016). Advanced Accounts. New Delhi: S. Chand & Co. • R.K. Mittal, M.R. Bansal. (2018). Advanced Financial Accounting. New Delhi: VK Publications. 109 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-8 MANAGERIAL ACCOUNTING Structure Learning Objective Introduction Origin Concept Nature and Scope Distinction between Managerial Accounting and Financial Accounting Summary Key words Learning Activity Unit -End Questions 8.10.References LEARNING OBJECTIVE After studying this unit, you will be able to: • State managerial accounting • Describe distinction between managerial accounting and financial accounting • Analyse the concept of managerial accounting INTRODUCTION Managerial accounting (otherwise called cost bookkeeping or the board bookkeeping) is a part of accounting that concerned with the identification, measurement, analysis, and interpretation of accounting information so it very well may be utilized to managers with settling on fundamental decisions to proficiently deal with an organization'stasks. ORIGIN Managerial accounting has its foundations in the modern revolution of the nineteenth century. During this early period, most firms were firmly constrained by a couple of owner-managers who obtained dependent on close to home connections and their own resources. Since there were no outside investors and minimal debt without collateral, there was little requirement for expand budgetary reports. Conversely, managerial accounting was moderately refined and given the fundamental data expected to deal with the large scale production of textile, steel, and other products. After the turn of the century, financial accounting prerequisites expanded due to new weights put on organizations by capital 110 CU IDOL SELF LEARNING MATERIAL (SLM)

business sectors, lenders, administrative bodies, and government tax assessment from pay. Johnson and Kaplan express that \"numerous organizations expected to raise assets from progressively inescapable and confined providers of capital. To tap these huge stores of outside capital, firms' manager needed to gracefully evaluated money related reports. Also, on the grounds that external providers of capital depended on examined fiscal summaries, autonomous bookkeepers had an unmistakable fascination for setting up very much characterized methodology for corporate money related detailing. The stock costing system received by open bookkeepers after the turn of the century profoundly affected management accounting. As an outcome, for a long time, the management accountants progressively centred their endeavours around guaranteeing that money related bookkeeping prerequisites were met and budgetary reports were delivered on schedule. The act of the management accounting deteriorated. In the early piece of the century, as product offering extended activities turned out to be more mind boggling, forward looking organizations saw a restored requirement for the board arranged reports that was discrete from monetary reports. However, in many organizations, the management accounting rehearses up through the mid-1980s were to a great extent unclear from rehearses that were normal before world war I. Lately, notwithstanding, new financial powers have prompted numerous significant developments in the executives bookkeeping. CONCEPT Managerial accounting is the act of distinguishing, estimating, investigating, deciphering, and conveying monetary data to managers for the quest for an association's objectives. It shifts from financial accounting in light of the fact that the planned reason for managerial accounting is to help clients inside to the organization in settling on all around educated business choices. Managerial accounting incorporates numerous features of accounting pointed toward improving the nature of data conveyed to the board about business activity measurements. Managerial accountants use data identifying with the expense and deals income of merchandise and ventures created by the organization. Cost accounting is an enormous subset of managerial accounting that explicitly centres around catching an organization's all out expenses of production by evaluating the variable expenses of each progression of production, just as fixed expenses. It permits organizations to distinguish and decrease pointless spending and boost profits. NATURE AND SCOPE Nature of Management Accounting: 111 CU IDOL SELF LEARNING MATERIAL (SLM)

Despite the fact that Management Accounting is the most recent branch in the accounting field, it could be viewed halfway as a Science and incompletely as an Art. It is the study of 'Evaluating and summing up' and Art of ‘Interpreting’ accounting data. The Management Accounts infers its decisions through collection, processing and objective analysis of data Quantified in figures. Hence, it relies on \"Objectivization and Quantification of progress and issues\". Starting here of view Management accounting might be viewed as a Science. Anyway Management Accounting likewise includes human judgment, motivations, impulses and biases as proven in understanding of information, allowances and ends drawn from examination. 'Subjectivity' is unavoidable in 'inferring the significance of information'. Allowances can't be logical with accuracy. Individual judgment of Management accountant may impact the translations and derivations altogether. Starting here of view, Management Accounting might be viewed as an Art. We may conclude by saying that like all other social sciences, Management Accounting is partly a Science and Partly an Art. 3. Characteristics of Management Accounting: The aim of Management accounting is to record, dissect and present money related information to the Management so that it gets valuable and accommodating in arranging and running business tasks methodically and successfully. Scope of Management Accounting: The fundamental concern of the management accounting is to give essential quantitative and subjective data to the management for arranging and control. For this reason it draws out data from accounting just as non- accounting sources. Consequently, its degree is very huge and it incorporates inside its overlap practically all parts of business activities. Be that as it may, the accompanying zones may properly be called attention to as existing in the extent of the management accounting. i. Financial Accounting: The significant function of the management accounting is the revamp or adjustment of information. Financial accounting gives the very premise to such a function. Subsequently, 112 CU IDOL SELF LEARNING MATERIAL (SLM)

the management accounting can't get full control and coordination of activities without an all- around planned financial accounting system. ii. Cost Accounting: Planning, decision-making and control are the essential managerial functions cities. The cost accounting framework gives vital apparatuses, for example, standard costing, budgetary control, stock control, minor costing, and differential costing and so on, for doing such functions proficiently. Henceforth, cost accounting is viewed as a vital assistant of the management accounting. iii. Revaluation Accounting: Revaluation or substitution value accounting is chiefly concerned about guaranteeing that capital is kept up in genuine terms and benefit is determined on this premise. iv. Statistical Methods: Statistical tools, for example, chart, graphs, outlines and record numbers and so on, make the data more great and exhaustive. Different instruments, for example, time series, regression analysis, sampling techniques etc., are highly useful for planning and forecasting’s. Operations Research: Modern managements are confronted with exceptionally muddled business issues in their dynamic cycles. O P methods like linear programming, queuing theory, decision theory so on, empower the board to discover logical answers for the business issues. vi. Taxation: This incorporates calculation of income tax according to tax laws and guidelines, documenting of profits and making charge instalments. Lately, it additionally incorporates tax planning. vii. Organization and Methods [O&M]: O&M manage organizations diminishing expense and improving the proficiency of accounting, as additionally of office systems, procedures, and operations and so forth viii. Office Services: This incorporates support of appropriate information handling and other office the board management, correspondence and best utilization of most recent mechanical gadgets. ix. Law: 113 CU IDOL SELF LEARNING MATERIAL (SLM)

The greater part of the management decisions must be taken in a legal environment where the necessities of various legal arrangements or guidelines are to be satisfied. A portion of the Acts, which have their impact on the board choices, are as per the following: The Companies Act, MRTP Act, FEMA, SEBI Regulations, and so on x. Internal Audit: This includes the development of a suitable system of internal audit for internal control. xi. Internal Reporting: This incorporates the readiness of quarterly, half yearly, and other interval reports and pay proclamations, income and assets stream explanations, scarp reports, and so forth DISTINCTION BETWEEN MANAGERIAL ACCOUNTING AND FINANCIAL ACCOUNTING A typical inquiry is to clarify the contrasts between financial accounting and managerial accounting, since every one includes an unmistakably unique profession way. When all is said in done, financial accounting alludes to the total of accounting data into financial statements, while managerial accounting alludes to the interior cycles used to represent business transactions. There are various contrasts among financial and managerial accounting, which fall into the accompanying classes: • Aggregation. Financial accounting gives an account of the concerns of a whole business. Managerial accounting quite often reports at a more nitty gritty level, for example, benefits by item, product offering, client, and geographic locale. • Efficiency. Financial accounting covers the benefit (and thusly the proficiency) of a business, while managerial accounting covers explicitly what is making issues and how fix them. • Proven data. Financial accounting necessitates that records be kept with impressive accuracy, which is expected to demonstrate that the financial statements are right. Managerial accounting much of the time manages gauges, instead of demonstrated and evident realities. • Reporting Focus. Financial accounting is situated toward the formation of financial statements, which are dispersed both inside and outside of an organization. Managerial accounting is more worried about operational reports, which are just dispersed inside an organization. 114 CU IDOL SELF LEARNING MATERIAL (SLM)

• Standards. Financial accounting must follow different accounting norms, though managerial accounting doesn't need to conform to any guidelines when data is ordered for inward utilization. • Systems. Financial accounting gives no consideration to the general framework that an organization has for creating a benefit, just its result. Alternately, managerial accounting is keen on the area of bottleneck tasks, and the different approaches to upgrade benefits by settling bottleneck issues. • Time period. Financial accounting is concern about the financial outcomes that a business has just accomplished, so it has a verifiable direction. Managerial accounting may address spending plans and figures, thus can have a future direction. • Timing. Financial accounting necessitates that budget summaries be given after the finish of an accounting period. Managerial accounting may give reports considerably more much of the time, since the data it gives is of most importance of supervisors can see it immediately. • Valuation. Financial accounting tends to the correct valuation of resources and liabilities, as is associated with weaknesses, revaluations, etc. Managerial accounting isn't worried about the estimation of these things, just their efficiency. There is a distinction in the accounting certifications commonly found in every one of these areas. Individuals with the Certified Public Accountant designation have been prepared in financial accounting, while those with the Certified Management Accountant assignment have been prepared in managerial accounting. Pay levels will in general be higher in the zone of financial accounting and fairly lower for managerial accounting, maybe on the grounds that there is a recognition that all the more preparing is needed to be completely familiar with financial accounting. SUMMARY Managerial accountants need to investigate different functions and operational measurements so as to make an interpretation of information into helpful data that can be utilized by the organization's management in their decision-making process. They intend to give nitty gritty data with respect to the organization's tasks by breaking down every individual line of items, working action, office, and so forth 115 CU IDOL SELF LEARNING MATERIAL (SLM)

KEY WORDS • Management accounting: Reporting accounting information within a business, for management use only. • Financial accounting A term usually applied to external reporting by a business where that reporting is presented in financial terms. • Cost of a non-current asset: is the cost of making it ready for use, cost of finished goods is cost of bringing them to the present condition and location. • Cost of goods sold: Materials, labour and other costs directly related to the goods or services provided. • Cost centre: A responsibility centre whose manager is accountable only for controllable costs that have well-defined relationships between the centre’s resources and certain products or services. LEARNING ACTIVITY 1. Financial and administrative accounting aid in decision making. Nonetheless, the common sense of the use of financial and managerial accounting is sketchy for decision making in the organization. What are the purpose behind the trouble in the use of financial and managerial accounting in every day decision making in the organization? What are the solutions to apply financial and managerial accounting for decision making in the organization? 2. What are the distinction between financial and managerial accounting? How do these differences affect the type of information that must be gathered and reported? UNIT END QUESTIONS A. Descriptive Type question 1. Explain the meaning of management accounting 2. What is financial accounting? 3. What is the nature of management accounting? 4. What is the difference between management accounting and financial accounting? 5. What is the importance of management accounting? 116 CU IDOL SELF LEARNING MATERIAL (SLM)

B. Multiple Choice Questions: 117 1. Management accounting assists the management in a. Only in control b. Only in direction c. Only in planning d. In planning, direction and control 2. are tools of management accounting? A) Decision accounting B) Standard costing C) Budgetary controls D) Human Resources Accounting a. A, B and D b. A, C and D c. A, B and C d. A, B , C, D 3. Management accounting is associated with a) the problem of choice making b) recording of transactions c) Cause and effect relationships a. A and B b. B and C c. A and C d. All are false 4. Management accountancy is a structure for a. Costing b. Accounting c. Decision making d. Management CU IDOL SELF LEARNING MATERIAL (SLM)

5. Who coined the concept of management accounting? a. R.N Anthony b. James H. Bliss c. J. Batty d. American Accounting Association 6. Management accounting deals with a. Quantitative information b. Qualitative information c. Both a and b d. None of the above Answer 1. d 2. c 3. c 4. c 5. b 6. c REFERENCES • Anthony, R.N. and Reece, J.S. (1988). Accounting Principle. New York: Richard Irwin Inc. • Gupta RK. and Radha swamy, M. (2004). Financial Accounting. New Delhi: Sultan Chand and Sons • Monga J. R, Ahuja Girish, and Sehgal Ashok. (2014). Financial Accounting. Noida: Mayur Paper Back. • Shukla, M.C. Grewal T.S. and Gupta, S.C. (2016). Advanced Accounts. New Delhi: S. Chand & Co. • R.K. Mittal, M.R. Bansal. (2018). Advanced Financial Accounting. New Delhi: VK Publications. 118 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-9 MANAGERIAL ACCOUNTING Structure Learning Objective Introduction Changing role of managerial accounting in a dynamic business environment Use of accounting information – various stakeholders. External Users of Accounting Summary Key words Learning Activity Unit -End Questions References LEARNING OBJECTIVE After studying this unit, you will be able to: • State the changing role of managerial accounting in a dynamic business environment • Describe the use of accounting information • Analyse the external users of accounting INTRODUCTION Managerial accounting is the practice of identifying, measuring, analysing, interpreting, and communicating financial information to managers for the pursuit of an organization's goals. It varies from financial accounting because the intended purpose of managerial accounting is to assist users internal to the company in making well-informed business decisions. CHANGING ROLE OF MANAGERIAL ACCOUNTING IN A DYNAMIC BUSINESS ENVIRONMENT The role of management accounting in modern business, which is also known as managerial accounting, involves providing accounting information to managers within businesses, and are enabling these managers to manage, make decisions and perform control functions. It is distinguished from cost accounting, which aims to record the costs incurred in a business, and financial accounting, which is concerned with preparing financial statements for decision- makers, as well as internal and external stakeholders, such as stockholders, suppliers, creditors and banks, employees, government agencies and customers. 119 CU IDOL SELF LEARNING MATERIAL (SLM)

In addition, the role of management accounting in modern business also involves providing information that supports strategic, performance, and risk management, as follows: 1. Strategic management: The management accountant is a strategic partner in the organization. 2. Performance management: The management accountant is a partner in developing the practice of business decision-making and managing the performance of the organization. 3. Risk management: The management accountant contributes to frameworks and practices for identifying, measuring, managing and reporting risks to the accomplishment of a businesses' objectives. Management accounting emphasizes the future and, as noted, aims to influence the behaviour of managers and employees in achieving the goals of a business. Management accounting is not particularly constrained by generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS), as are cost accounting and financial accounting. Business models are changing in a way that will fundamentally alter the role of management accountants in future, according to Professors Alnoor Bhimani and Michael Bromwich. There are key challenges facing businesses in the 21st century and management accountants will have to adapt to the changing commercial landscape. The future of business can be summed up in two words - fluid and flexible. Innovation in the form of advanced operational systems and flexible organisational technologies has created a whole new form of business enterprise. As a result, these developments have given companies the nimbleness to meet the pressures of the modern business world from global integration to worldwide competition and complex supply chains. All the signs indicate that companies are seeing the value of developing greater versatility in the future. By their definition, fluid organisations can assume different forms. They can be informal grouping of firms or parts of firms seeking to achieve specific shared objectives. Such groups emerge when the legal, managerial and governance structures of the parent firms are altered to allow more immediate entrepreneurial or innovative activity. Creating new relationships and openness These groups may come together to allow access to skills not possessed by some of the parent firms. The result is the creation a portfolio of skills which enables the group to move into novel areas of activities, risk bearing, financing and the development of large projects or new products that would otherwise be unviable. 120 CU IDOL SELF LEARNING MATERIAL (SLM)

Unlike traditional corporate structures, fluid entities are bound together by shared endeavours and continuously orchestrated interfacing. The emergence of such organisations has been facilitated by major changes in relationships with suppliers. The necessity for trust and the role of the customer The traditional approach of seeking suppliers by formal legal and fully specified tenders has been substituted by more subtle partnerships. The emphasis is now on substantial information exchanges between parties including full knowledge of the cost structures and production activities of all parties. Today, suppliers may participate in the purchasing organisation’s planning and may even contribute to designing the production technology and the product itself. Trust is therefore a key component. The customer relationship is also being transformed by these changes. Fluid and flexible firms founded on a strong digital platform now give customers direct access to collaboration infrastructures. Businesses may co-create their products with the customer or they may go further and allow total product creation. Although enterprises may not pre-design the consumer experience with the product, they still invent the broad product concept and orchestrate the achievement of the product’s potential via the consumer. Who is a Prosumer? Prosumers are growing in the energy space as more Americans generate their own power from distributed energy resources. This is most often accomplished through rooftop solar panels and electric vehicles. Gone are the days when electricity consumption was a one-way street. Today’s electric grid is blurring the lines between power generation and consumption. A consumer who becomes involved with designing or customizing products for their own needs. The rise of the prosumer Increasingly, a variety of industrial, service based and digital products are now created directly via customer input and design. At the forefront of this revolution, consumers have turned into ‘prosumers’ who co-innovate products, services and, most essentially, experiences, with producers. Experience is increasingly becoming part of the consumer package. Apple invented the iPod but users create their own experiences with the product by loading it with independently created 121 CU IDOL SELF LEARNING MATERIAL (SLM)

podcasts, shows, music and the like. Similarly, Facebook has developed a platform for users to stage their own unique experiences. In other sectors, similar engagement is now commonplace. Toy firm LEGO takes part in ‘distributed co-creation’ where customers are invited to suggest new products while car manufacturer Peugeot recently asked for public input for a new vehicle. IBM has adopted the open operating system Linux for some of its computer products and systems and this platform is continuously improved by a wide-ranging community of systems software developers. Different companies may try a variety of approaches but ultimately what facilitates this new attitude to innovation is the rise of the web as a participatory platform. The new costs of doing business This puts a new dynamic on the concept of costing. In the context of the electronic platform, the content of the website is generated by the consumer but it is the advertisements on the interactive platforms between users that form the revenue source. In this situation, pricing and costing issues do not follow a traditional model which may be cost-plus based or market based. Rather, the pricing has to link directly into the strategy of the firm and its revenue-generating model where the product that is costed does not directly align with where sales are generated. Co-creation of products is not a choice but a necessity for many business models. This is because product choices are infinite and cannot be conceptualised or delivered by one ‘producer’. The new mind-set This is coupled with the fact that the product created by the consumer is often not in fact the product that is ultimately generating the firm’s revenues. Management accountants have a new role here in determining the costs and profitability of satisfying the specific consumer preferences. They will need to cost the product attributes developed with, or by, consumers as well as analyse plausible revenue propositions that may be dissociated from the consumer created products. In order to contribute to this new business process generally, management accountants will want to become part of management and operational teams and need to become business partners. To do this, they will need to understand the technology underlying the organisation 122 CU IDOL SELF LEARNING MATERIAL (SLM)

and learn to cope without at least some of the conventional formal management control structures or systems. In supply partnerships, management accountants will focus on designing information systems that allow more ready exchanges of information between parties. They will also need to become comfortable with operating in regimes which may have more informal management and governance structures and which rely more extensively on trust between partners. This has to be done whilst still providing appropriate performance reports. The evolution of change In the mid-1990s, fluid organisations appeared on the horizon. Today, we are seeing a rapidly evolution in their development. The challenge for management accountants is to seek solid grounding in knowledge about the technology available to, and deployed by, businesses. Management accountants, it is anticipated, will aim to become skilled in appraising the benefits, costs and contextual issues of different customer supply networks and supply chains and report appropriately. This is a formidable challenge but it is a fascinating time to be in business as we see technologies that were originally viewed simply as leisure-time activities now becoming essential components of the business process. Accounting is a changing phenomenon. Applied sciences and concepts continuously evolve and redefine accounting. Management accounting is a subfield of accounting that plays a vital role in the enterprise environment. This study highlights the changing role of management accounting in 21st century focusing on purpose, function, and role of information technology on its transformation. The main source of information retrieval has been taken from web and search engines. The framework of the study has outlined into historical need for reforming management accounting system, future direction, new scope, trends, role of information technology in management accounting transformation, and the changing role of management accountants. It will be of remarkable significance to reap a proper understanding of how management accounting works locally and globally. The 21st century has viewed the emergence of information age and the resulting economy driven by knowledge as a source of competitive advantage. Therefore, this era calls for professionals with an appropriate balance between technical skills and breadth of knowledge to be compatible with the ongoing transformation. 123 CU IDOL SELF LEARNING MATERIAL (SLM)

USE OF ACCOUNTING INFORMATION – VARIOUS STAKEHOLDERS. Internal Users of Accounting Internal users are the primary users of accounting. Following are the 3 types of internal users and their information needs: Owners Owners need to assess how well their business is performing. Financial statements provide information to owners about the profitability of the overall business as well as individual products and geographic segments. Owners are also interested in knowing how risky their business is. Accounting information helps owners in assessing the level of stability in business over the years and to what extent have changes in economic factors affected the bottom line of the business. Such information helps owners to decide if they should invest any further in the business or if they should use their financial resources elsewhere in more promising business ventures. Managers Managers need accounting information to plan, monitor and make business decisions. Managers need to allocate the financial, human and capital resources towards competing needs of the business through the budgeting process. Preparing and monitoring budgets effectively requires reliable accounting data relating to the various activities, processes, products, services, segments and departments of the business. Management requires accounting information to monitor the performance of business by comparison against past performance, competitor analysis, key performance indicators and industry benchmarks. Managers rely on accounting data to form their business decisions such as investment, financing and pricing decisions. 124 CU IDOL SELF LEARNING MATERIAL (SLM)

In case of investment decisions for example, managers would require the return on investment calculation of a proposed project supported by reliable estimates of the costs and revenues. Employees For the employees operating in the finance department, using accounting information is usually part of their job description. This includes for example preparing and reviewing various financial reports such as financial statements. Employees are interested in knowing how well a company is performing as it could have implications for their job security and income. Many employees review accounting information in the annual report just to get a better understanding of the company’s business. In recent years, the increase in number of shares and share options schemes for employees particularly in start-ups has fostered a greater level of interest in accounting information by employees. Moreover, potential employees are also interested to learn about the financial health of the organization they aspire to join in the future. EXTERNAL USERS OF ACCOUNTING External users are the secondary users of accounting. Following are the 8 types of external users and their information needs: Investors Investors need to know how well their investment is performing. Investors primarily rely on the financial statements published by companies to assess the profitability, valuation and risk of their investment. Investors use accounting information to determine whether an investment is a good fit for their portfolio and whether they should hold, increase or decrease their investment. Lenders 125 CU IDOL SELF LEARNING MATERIAL (SLM)

Lenders use accounting information of borrowers to assess their credit worthiness, i.e. their ability to pay back any loan. Lenders offer loans and other credit facilities on terms that are based on the assessment of financial health of borrowers. Good financial health is indicated by the borrower’s ability to pay its liabilities on time, high profitability, substantial securable assets and liquidity. Poor liquidity, low profitability, lack of assets that can be secured and an inability to pay liabilities on time demonstrate poor financial health of borrowers. On a lighter note, borrowers can only get a loan from lenders if they can prove that they don’t need the money. Suppliers Just like lenders, suppliers need accounting information to assess the credit-worthiness of its customers before offering goods and services on credit. Some suppliers only have a handful of customers. These customers could be very large businesses themselves. Suppliers need accounting information of its key customers to assess whether their business is in good health which is necessary for sustainable business growth. Customers Most consumers don’t care about the financial information of its suppliers. Industrial consumers however need accounting information about its suppliers in order to assess whether they have the required resources that are necessary for a steady supply of goods or services in the future. Continuity in supply of quality inputs is essential for any business. Tax Authorities Tax authorities determine whether a business declared the correct amount of tax in its tax returns. Occasionally, tax authorities conduct audits of the tax returns filed by businesses in order to verify the information with the underlying accounting records. 126 CU IDOL SELF LEARNING MATERIAL (SLM)

Tax authorities also cross reference accounting information of suppliers and consumers in order to identify potential tax evaders. Government Government ensures that a company's disclosure of accounting information is in accordance with the regulations that are in place to protect the interest of various stakeholders who rely on such information in forming their decisions. Government defines and monitors accounting thresholds such as sales revenue and net profit to determine the size of each business for the purpose of ensuring that it complies with the relevant employee, consumer and safety regulations. Auditors External auditors examine the financial statements and the underlying accounting record of businesses in order to form an audit opinion. Investors and other stakeholders rely on the independent opinion of external auditors on the accuracy of financial statements. Public General public may also be interested in accounting information of a company. These could include journalists, analysts, academics, activists and individuals with an interest in economic developments. SUMMARY Managerial accounting encompasses many facets of accounting aimed at improving the quality of information delivered to management about business operation metrics. Managerial accountants use information relating to the cost and sales revenue of goods and services generated by the company. Cost accounting is a large subset of managerial accounting that specifically focuses on capturing a company's total costs of production by assessing the variable costs of each step of production, as well as fixed costs. It allows businesses to identify and reduce unnecessary spending and maximize profits. KEY WORDS • Cost driver: an activity base that causes a cost pool to increase in amount as the cost driver increases in volume. 127 CU IDOL SELF LEARNING MATERIAL (SLM)

• Cost flow: the association of costs with their assumed flow in the operations of a company. • Financial Accounting Standards Board (FASB): The most important body for developing rules on accounting practice; it issues Statements of Financial Accounting Standards. • Financial performance measurement: an evaluation method that uses all the techniques available to show how important items in financial statements relate to a company's financial objectives. Also called financial statement analysis. • Financial position: the economic resources that belong to a company and the claims (equities) against those resources at a particular time. • Financial statements: the primary means of communicating important accounting information to users. They include the income statement, statement of retained earnings, balance sheet, and statement of cash flows. LEARNING ACTIVITY 1. Explain the role of managerial accounting in changing environment 2. Who all are the external users of accounting information? UNIT END QUESTIONS A. Descriptive Type question 1. Define Management Accounting. What Are Its Objectives at Stationery store? 2. Interpret the Limitations of Management Accounting for SBI bank? 3. Evaluate the Scope Of Management Accounting at Tata Steel? 4. Determine Various Techniques Used To Discharge The Function Of Management Accounting? 5. Present all are the users of accounting information for ICICI Prudential? B. Multiple Choice Questions: 1. The term management accounting was first coined in 128 CU IDOL SELF LEARNING MATERIAL (SLM)

a. 1960 129 b. 1950 c. 1945 d. 1955 2. Management accounting is A) Subjective B) Objective a. Only A b. Only B c. Both A and B d. None of the above 3. The use of management accounting is a. Optional b. Compulsory c. Legally obligatory d. Compulsory to some and optional to others 4. The management accounting can be stated an extension of A) Cost Accounting B) Financial Accounting C) Responsibility Accounting a. Both A and B b. Both A and C c. Both B and C d. A, B, C 5. Which of the following is true about management accounting? A) Management accounting is associated with presentation of accounting data. B) Management accounting is extremely sensitive to investor’s needs. CU IDOL SELF LEARNING MATERIAL (SLM)

a. Only A b. Only B c. Both A and B d. None of the above Answer: 1. b 2. a 3. a 4. a 5. a REFERENCES • Anthony, R.N. and Reece, J.S. (1988). Accounting Principle. New York: Richard Irwin Inc. • Gupta RK. and Radha swamy, M. (2004). Financial Accounting. New Delhi: Sultan Chand and Sons • Monga J. R, Ahuja Girish, and Sehgal Ashok. (2014). Financial Accounting. Noida: Mayur Paper Back. • Shukla, M.C. Grewal T.S. and Gupta, S.C. (2016). Advanced Accounts. New Delhi: S. Chand & Co. • R.K. Mittal, M.R. Bansal. (2018). Advanced Financial Accounting. New Delhi: VK Publications. 130 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-10 METHODS AND PROBLEMS OF TRANSFER PRICING Structure Learning Objective Introduction Methods of transfer pricing Problems of transfer pricing Summary Key words Learning Activity Unit -End Questions References LEARNING OBJECTIVE After studying this unit, you will be able to: • State different methods of transfer pricing • Describe problems of transfer pricing • Discuss transfer pricing INTRODUCTION In tax collection and accounting, transfer pricing means to the rules and techniques for pricing transactions inside and between enterprises under common ownership or control. Transfer price is the cost at which related parties transact with one another, for example, during the exchange of provisions or work between departments. Transfer prices are utilized when singular elements of a bigger multi-element firm are dealt with and estimated as independently run substances. It is regular for multi-element enterprises to be merged on a monetary announcing premise; nonetheless, they may report every substance independently for charge purposes. A transfer price can also be known as a transfer cost. “What is transfer pricing?” Subsequent to perusing this article, you comprehend the idea of transfer pricing. To start with, we characterize move valuing. Next, you will find the potential financial risks you face 131 CU IDOL SELF LEARNING MATERIAL (SLM)

when not making the correct strides. In conclusion, you realize which necessities your firm requirements to meet. Transfer Prices Defined Transfer prices refer to the terms and conditions which so-called “associated enterprises” agree for their “controlled transactions.” Examples of such transactions are the provision of management services, the supply of goods and the provision of loans. According to this widely used OECD definition, enterprises are associated if: (a) an enterprise participates directly or indirectly in the management, control or capital of another enterprise or (b) the same persons participate directly or indirectly in the management, control or capital of two enterprises. METHODS OF TRANSFER PRICING The Management’s goal in setting a transfer price is to empower objective coinciding among the division supervisors engaged with the transfer. A general rule that will ensure goal congruence is given below: The overall principle indicates the transfer price as the amount of two cost parts. The first component is the outlay cost caused by the division that produces the goods or services to be transferred. Outlay costs will incorporate the immediate variable expenses of the product or service and some other outlay costs that are brought about just because of the transfer. The second part in the general transfer-pricing rule is the opportunity cost acquired by the organization all in all in light of the transfer. An opportunity cost is an advantage that is done without because of making a specific move. Comprehensively, there are three bases accessible at deciding transfer prices, however numerous alternatives are likewise accessible inside each base. These methods are: (1) Market Prices 132 CU IDOL SELF LEARNING MATERIAL (SLM)

(2) Cost-Based Prices (3) Negotiated Prices (4) Dual Prices (1) Market-Based Prices: Market price means to a cost in an intermediate market between independent purchasers and sellers. When there is a competitive external market for the transferred product, market prices function admirably as transfer prices. When transferred goods are recorded at market price, divisional performance is bound to speak to the genuine economic contribution of the division to add up to organization benefits. On the off chance that the gods can't be purchased from a division inside the organization, intermediate product would need to be bought at the current market price from the external market. Divisional benefits are consequently prone to be like the benefits that would be determined if the divisions were independent organisations. Consequently, divisional profitability can be compared directly with the profitability of- similar companies operating in the same type of business. Managers of both buying and selling divisions are indifferent between trading with each other or with outsiders. No division can benefit at the expense of another division. In the market price situation, top management will not be tempted to intervene. Market-based prices are based with respect to opportunity costs concepts. The opportunity cost approach flags that the right transfer price is the market price. Since the selling division can sell all that it produces at the market price, transferring internally at a lower cost would exacerbate the division off. Likewise, the purchasing division can generally secure the intermediate goods at the market price, so it is reluctant to pay more for an internally transferred goods. Since the minimum transfer price for the selling division is the market price and the most maximum price for the purchasing division is additionally the market value, the main conceivable transfer price is the market price. The market price can be utilized to determine clashes among the purchasing and selling divisions. From the organization perspective, market price is the ideal inasmuch as the selling division is working at full limit. The market price doesn't permit any additions or misfortunes in productivity of the selling division. It spares administrative costs as the utilization of competitive market prices are liberated from any contest, contention and predisposition. 133 CU IDOL SELF LEARNING MATERIAL (SLM)

Further, transfer prices dependent on market price are reliable with the responsibility accounting concept of profit centres and investment centres. Notwithstanding promising division managers to zero in on divisional productivity, market based transfer prices help to show the commitment of every division to generally organization benefit. However, there are some problems using the market price approach: (i) Appropriate Market Price may not Exist: Initially, finding a competitive market price might be troublesome if such a market doesn't exist. Inventory cost may just enigmatically identify with actual sales prices. Market prices may change frequently. Likewise, inner selling costs might be not exactly would be acquired if the items were offered to outcasts. Further, the way that two responsibility centres are portions of one organization demonstrates that there might be a few preferences from being important for one organization and not being two separate organizations managing each other on the lookout. For instance, there might be more sureness about the interior division's item quality or conveyance dependability. Or then again the selling division may make a specific item for which there are not substitutes on the lookout. Henceforth, it may not be conceivable to utilize market prices. (ii) Excess Production Capacity: Another problem with market prices can occur when a selling division is not operating at full capacity and cannot sell all its products. To illustrate this point, assume that material used by Division A in a company are being purchased from outside market at Rs 200 per unit. The same materials are produced by Division B. If Division B is operating at full capacity, say of 50,000 units and can sell all its products to either Division A or to outside buyers, then the use of transfer price of Rs 200 per unit (market price) has no effect on Division B’s income or total company profit. Division B will earn revenue of Rs 200 per unit on all its production and sales, regardless of who buys its product and Division A will pay Rs 200 per unit, regardless of whether it purchases the materials from Division B or from an outside supplier. In this situation, the use of market price as the transfer price is appropriate. However, if Division B is not operating at full capacity and unused capacity exists in that division, the use of market price may not lead to maximisation of total company profit. To illustrate this point, assume that Division B has unused capacity of 30,000 units and it can continue to sell only 50,000 units to outside buyers. 134 CU IDOL SELF LEARNING MATERIAL (SLM)

In this situation, the transfer price should be set to motivate the manager of Division A to purchase from Division B if the variable cost per unit of product of Division B is less than the market price. If the variable costs are less than Rs 200 per unit but the transfer price is set equal to the market price of Rs 200, then the manager of Division A is indifferent as to whether materials are purchased from Division B or from outside suppliers, since the cost per unit to Division B would be the same, Rs 200. However, Division A’s purchase of 20,000 units of materials from outside suppliers at a cost of Rs 200 per unit would not maximise overall company profit, since this market price per unit is greater than the unit variable cost of Division B, say Rs 100. Hence, the intra-company transfer could save the company the difference between the market price per unit and Division B’s unit variable expenses. This savings of Rs 100 per unit would add Rs 20,00,000 (20,000 units X Rs 100) to overall company profit. Transfer prices based on market prices are consistent with the responsibility accounting con- cept of profit centres and investment centres. In addition to encouraging division managers to focus on divisional profitability, market-based transfer prices help to show the contribution of each division to overall company profit. When aggregate divisional profits are determined for the year, and ROI and RI are computed, the use of a market based transfer price helps to assess the contributions of each division to overall corporate profits. Hilton sums up difficulty associated with general rule of transfer pricing in the following words: (i) Difficulting in Measuring Opportunity Costs: The general transfer-pricing rule will always promote goal-congruent decision making if the rule can be implemented. However, the rule is often difficult or impossible to implement due to the difficulty of measuring opportunity costs. Such a cost-measurement problem can arise for a number of reasons. One reason is that the external market may not be perfectly competitive. Under perfect competition, the market price does not depend on the quantity sold by anyone producer. Under imperfect competition, a single producer or group of producers can affect the market price by varying the amount of product available in the market. In such cases, the external market price depends on the production decisions of the producer. This in turn means that the opportunity cost incurred by the company as a result of internal transfers depends on the quantity sold externally. These interactions may make it impossible to measure accurately the opportunity cost caused by a product transfer. (ii) Nature of Transferred Goods: 135 CU IDOL SELF LEARNING MATERIAL (SLM)

Other reasons for difficulty in measuring the opportunity cost associated with a product transfer include uniqueness of the transferred goods or services, a need for the producing division to invest in special equipment in order to produce the transferred goods, and interdependencies among several transferred products or services. For example, the producing division may provide design services as well as production of the goods for a buying division. What is the opportunity cost associated with each of these related outputs of the producing division? In many such cases it is difficult to sort out the opportunity costs. (iii) Distress Market Prices: Occasionally an industry will experience a period of significant excess capacity and extremely low prices. For example, when gasoline prices soared due to a foreign oil embargo, the market prices for recreational vehicles and power boats fell temporarily to very low levels. Under such extreme conditions, basing transfer prices on market prices can lead to decisions that are not in the best interests of the overall company. Basing transfer prices on artificially low distress market prices could lead the producing division to sell or close the productive resources devoted to producing the product for transfer. Under distress market prices, the producing division manager might prefer to move the division into a more profitable product line. While such a decision might improve the division’s profit in the short run, it could be contrary to the best interests of the company overall. It might be better for the company as a whole to avoid divesting itself of any productive resources and to ride out the period of market distress. To encourage an autonomous division manager to act in this fashion, some companies set the transfer price equal to the long-run average external market price, rather than the current (possibly depressed) market price. (2) Cost Based Prices: When external markets do not exist or are not available to the company or when information about external market prices is not readily available, companies may decide to use some forms of cost-based transfer pricing system. Cost-based transfer prices may be in different forms such as variable cost, actual full cost, full cost plus profit margin, standard full cost. (a) Variable Cost: Variable cost-based pricing approach is useful when the selling division is operating below capacity. The manager of the selling division will generally not like this transfer price 136 CU IDOL SELF LEARNING MATERIAL (SLM)

because it yields no profit to that division. In this pricing system, only variable production costs are transferred. These costs are direct materials, direct labour and variable factory overhead. Variable cost has the major advantage of encouraging maximum profits for the entire firm. By passing only variable costs alone to the next division, production and pricing decisions are based on cost- volume-profit relationships for the firm as a whole. The obvious problem is that selling division is left holding all its fixed costs and operating expenses. That division is now a loss division, nowhere near a profit centre. (b) Actual Full Cost: In actual full cost approach, transfer price is based on the total product cost per unit which will include direct materials, direct labour and factory overhead. When full cost is used for transfer pricing, the selling division cannot realise a profit on the goods transferred. This may be disincentive to the selling division. Further, full cost transfer pricing can provide perverse incentives and distort performance measures. A full cost transfer price would have shut down the chances of any negotiation between divisions about selling at transfer prices. (c) Full Cost-Plus Profit Margin: Full cost plus mark-up (or profit margin) overcomes the weaknesses of full cost basis transfer pricing system. The full cost plus price include the allowed cost of the item plus a mark-up or other profit allowance. With such a system, the selling division obtains a profit contribution on units transferred and hence, benefits if performance is measured on the basis of divisional operating profits. However, the manager of the buying division would naturally object that his costs (and hence reported performance) are adversely affected. The basic question in full cost plus mark-up is ‘what should be the percentage of mark up.’ It can be suggested that the mark up percentage should cover operating expenses and provide a target return on sales or assets. (d) Standard Costs: In actual cost approaches, there is a problem of measuring cost. Actual cost does not provide any incentive to the selling division to control cost. All product costs are transferred to the buying division. While transferring actual costs any variances or inefficiencies in the selling division are passed along to the buying division. The problem of isolating the variances that have been transferred to subsequent buyer division becomes extremely complex. To promote responsibility in the selling division and to 137 CU IDOL SELF LEARNING MATERIAL (SLM)

isolate variances within divisions, standard costs are usually used as a basis for transfer pricing in cost-based systems. Whether transferring at differential costs or full costs, standard costs, where available, are often used as the basis for the transfer. This encourages efficiency in the selling division because inefficiencies are not passed onto the buying division. Otherwise, the selling division can transfer cost inefficiencies to the buying division. Use of standard cost reduces risk to the buyer. The buyer knows that standard costs will be transferred and avoids being charged with suppliers’ cost overruns. (3) Negotiated Prices: Negotiated prices are generally preferred as a middle solution between market prices and cost- based prices. Under negotiated prices, the managers involved act much the same as the managers of independent companies. Negotiation strategies may be similar to those employed when trading with outside markets. If both divisions are free to deal either with each other or in the external market, the negotiated price will likely be close to the external market price. If all of a selling division’s output cannot be sold in the external market (that is, a portion must be sold to the buying division), the negotiated price will likely be less than the market price and the total margin will be shared by the divisions. The conditions under which a negotiated transfer price will be successful include: 1. Some Form of Outside Market for the Intermediate Product: This avoids a bilateral monopoly situation in which the final price could vary over too large a range, depending on the strength and skill of each negotiator. 2. Sharing of all Market Information Among the Negotiators: This should enable the negotiated price to be close to the opportunity cost of one or preferably both divisions. 3. Freedom to Buy or Sell Outside: This provides the necessary discipline to the bargaining process. 4. Support and Occasional Involvement of Top Management: The parties must be urged to settle most disputes by themselves; otherwise the benefits of decentralization will be lost. Top management must be available to mediate the occasional unresolvable dispute or to intervene when it sees that the bargaining process is clearly leading 138 CU IDOL SELF LEARNING MATERIAL (SLM)

to suboptimal decisions. But such involvement must be done with restraint and tact if it is not to undermine the negotiating process. Negotiated price avoids mistrusts, bad feelings and undesirable bargaining interests among divisional managers. Also, it provides an opportunity to achieve the objectives of goal congruence, autonomy and accurate performance evaluation. The overall company is beneficiary if selling and buying divisions can agree upon some mutually transfer prices. Negotiated transfer price is considered as a vital integrating tool among divisions of a company which is necessary to achieve goal congruence. If negotiations help ensure goal congruence, top management has little temptation to intervene between divisions. The agreed prices also can be used for performance measurement without creating any friction. The use of negotiated prices is consistent with the concept of decentralised decision-making in the divisionalised firms. However, negotiated prices have the following disadvantages: (1) A great deal of management effort, time and resources can be consumed in the negotiating process. (2) The final emerging negotiated price may depend more on the divisional manager’s ability and skill to negotiate than on the other factors. Thus, performance measures will be distorted leading to incorrect evaluation of divisional performance. (3) One divisional manager having some private information may take advantage of another divisional manager. (4) It is time-consuming for the managers involved. (5) It leads to conflicts between divisions. (6) It may lead to a suboptimal level of output if the negotiated price is above the opportunity cost of supplying the transferred goods. Garrison and Noreen observe: “The difficulty is that not all managers understand their own businesses and not all managers are cooperative. As a result, negotiations often break down even when it would .be in the manager’s own best interest to come to an agreement. Sometimes that is the fault of the way managers are evaluated. If managers are pitted against each other, rather than against their own past performance or reasonable bench-marks, a non-cooperative atmosphere is almost 139 CU IDOL SELF LEARNING MATERIAL (SLM)

guaranteed. Nevertheless, it must be admitted that even with the best performance evaluation system, some people by nature are not cooperative.” (4) Dual Prices: Under dual prices of transfer pricing, selling division sells the transferred goods at a (i) market or negotiated market price or (ii) cost plus some profit margin. But the transfer price for the buying division is a cost-based amount (preferably the variable costs of the selling division). The difference in transfer prices for the two divisions could be accounted for by special centralised account. This system would preserve cost data for subsequent buyer departments, and would encourage internal transfers by providing a profit on such transfers for the selling divisions. Dual prices give motivation and incentive to selling divisions as goods are transferred at mar- ket price and this arrangement provides a minimal cost to the buying division as well. Market price can be considered as the most appropriate base for the selling division. Thus dual pricing-system has the function of motivating both the selling division and buying division to make decisions that are consistent with the overall goals of decentralisation—goal congruence, accurate performance measurement, autonomy, adequate motivation to divisional manager. Summary View: Transfer pricing policy aims to drive the divisions, who are more inclined to act in their indi- vidual self-interest and consider their own costs, prices and market opportunities, toward behaviour that is best for the organization. Economies of scale, synergies and saving transaction costs motivate divisional managers to conduct transactions within the company rather than using market-based transactions with external supplier and customers. In reality, no particular transfer pricing system can be suggested for all decentralised compa- nies as no one transfer price will be helpful to them in achieving all their goals and objectives. The divisionalized companies should first determine their goals and priorities before selecting a transfer pricing. Therefore, the transfer pricing methods selected by a particular business enterprise must reflect the requirements and characteristics of that enterprise and must ultimately be judged by the decision making behaviour that it motivates. Anderson and SSullenbergerhave presented their evaluation of different transfer pricing approaches as displayed Exhibit12.1. 140 CU IDOL SELF LEARNING MATERIAL (SLM)

Kaplan and Atkinson have given the following recommendations in choosing a transfer pric- ing practice: 1. Where a competitive market exists for the intermediate product, the market price, less selling, distribution, and collection expenses for outside customers, represents an excellent transfer price. 2. Where an outside market exists for the intermediate product but is not perfectly competitive and where a small number of different products are transferred, a negotiated- transfer- price system will probably work best, since the outside market price can serve as an approximation of the opportunity cost. At least occasional transactions with outside suppliers and customers must occur if both divisions are to have credibility in the negotiating process and if reliable quotes from external firms are to be obtained. 3. When no external market exists for the intermediate product, transfers should occur at the long-run marginal cost of production. This cost will facilitate the decision making of the purchasing division by providing the stability needed for long-run planning but at the same time exposing the cost structure so that short-run improvements and adjustments can be made. A periodic fixed fee based on capacity reserved for the buying division is incorporated in the marginal cost calculation. The fixed fee, ideally based on product and facility-sustaining costs from an ABC model, should allocate the capacity-related costs of the facility in proportion to each user’s planned use of the facility’s resources. The fixed fee forces the purchasing division to recognize the full cost of the resources required to produce the intermediate product internally, and it 141 CU IDOL SELF LEARNING MATERIAL (SLM)

provides a motivation for the producing divisions to cooperate in choosing the proper level of productive capacity to acquire. 4. A transfer price based on fully allocated costs per unit (using present, that is, non-ABC, methods of allocation) or full cost-plus mark-up has no discernible desirable properties. Although the full-cost transfer price, has limited economic validity, it remains widely used. The marginal cost calculated from an ABC model does provide the capability for managers to use a full-cost approach that is consistent with economic theory. PROBLEMS OF TRANSFER PRICING The company uses transfer prices to transfer goods and services between divisions while allowing them to retain their autonomy. The transfer price can motivate managers to act in the best interest of the company. To help explain the issues involved with transfer pricing, we will discuss four transfer pricing situations: 1. No outside suppliers are available. 2. Outside suppliers are available, but the selling division is below capacity. 3. Outside suppliers are available, and the selling division is at capacity. 4. Outside suppliers are available, the selling division is below capacity, and alternative facility uses exist. Each example requires a differential revenue/cost analysis. Case I: No Outside Suppliers: If a company evaluates division managers on division profit measures, they will consider transfer price important. The company as a whole, however, will receive the same operating profit regardless of the transfer price, assuming that it cannot purchase the part from another company (externally). For example, assume that HCL Technologies Ltd. has two decentralized divisions, Hardware and Computers. Computers division has always purchased certain units from Hardware division at Rs 50 per unit, but Hardware might raise the price to Rs 70 per unit (the current market price). Hardware has variable costs per unit of Rs 50 and monthly fixed costs of Rs 10,000. 142 CU IDOL SELF LEARNING MATERIAL (SLM)

The Computers division bundles the units with other products and sells there for Rs 100 each. Computers Division incurs no additional variable costs, and monthly fixed costs total Rs 5,000, Computer Division produces 1,500 units per month. Given this information, which transfer price will provide the highest operating profit? As Exhibit 12.2 shows the transfer price will not affect overall company operating profit. Clearly, a change in transfer prices does not change the total company operating profit, but does affect division performance. Hardware division would likely prefer the higher transfer price because its operating profit increases from a loss of Rs 10,000 to a profit of Rs 20,000, especially if the company evaluates the division on its operating profit. Computers division, however, would prefer the lower transfer price. 143 CU IDOL SELF LEARNING MATERIAL (SLM)

Case II: Transfer Pricing when Outside Suppliers are Available (Selling Division below Capacity): Using the same data as in Case 1 for HCL Technologies Ltd. let’s add an additional option for Computers division: purchasing units from an outside supplier for Rs. 60 (the outside supplier offers a good deal to get Computers’ business). If Computers division buys from an outside supplier, the facilities that Hardware division uses to manufacture these units would remain idle. Which option yields the highest total company operating profit for HCL Technologies (transfer from Hardware or purchase from outside supplier)? As Exhibit image shows, purchasing units from an outside supplier will result in a loss in companywide operating profit of Rs 15,000, the additional cost to the company of purchasing the units externally for Rs 60 versus purchasing the units internally for Rs 50 (Rs 15,000 = [Rs 60 – Rs 50] x 1,500 units). The general economic transfer pricing rule when the seller is operating below capacity (with idle capacity) states that the seller should set the transfer price at the variable cost per unit (or the differential cost of production). Thus, in this example, the seller should set the transfer price at its variable cost (Rs 50 per unit) to maximize overall company operating profits and to send the correct signal from the Hardware Division to the Computers Division that the variable cost of producing the item is Rs 50. 144 CU IDOL SELF LEARNING MATERIAL (SLM)

Exhibit image. Profit Calculation with Outside Suppliers Available, Selling Division below Capacity Case III: Transfer pricing when Outside Supplier are Available (Selling Division at Capacity): Using data as in Case II for HCL Technologies Ltd., we change one assumption. Assume that Hardware does not have idle capacity if Computers division buys from an outside supplier. Instead, if Computers buys from an outside supplier, Hardware division can sell all of its units to the outside at the market price of Rs 70 (i.e. Hardware is operating at capacity). Which option yields the highest total company operating profit for HCL Products (transfer from Hardware or purchase from outside supplier)? As Exhibit image shows that purchasing units from an outside supplier results in a gain in companywide operating profit of Rs. 15,000, which is the savings for Computers division of purchasing the units externally for Rs. 60, versus purchasing the units internally for Rs. 10 (Rs. 70 – Rs. 60) x 1,500 units = Rs. 15,000. The general economic transfer pricing rule when the seller is operating at capacity is that the seller should transfer at the market price. Thus, with this example, the seller should set the transfer price at its market price (Rs. 70 per unit) to maximize overall company operating profits. 145 CU IDOL SELF LEARNING MATERIAL (SLM)

Case IV: Transfer Pricing when Outside Suppliers are Available (Selling Division below Capacity with Alternative Facility Utilization): Using the same data as in Case I for HCL Technologies Ltd., we make additional changes in our assumptions. Assume that Hardware division has idle capacity if Computers division buys from an outside supplier for Rs 60 per unit. However, if Computers Division buys from an outside supplier, the firm can use the Hardware idle capacity for other purposes, resulting in cash operating saving of Rs 35,000. Which option yields the highest total company operating profit for HCL Technologies (transfer from Hardware or purchase from outside supplier)? As Exhibit images shows, purchasing units from an outside supplier results in a gain in companywide operating profit of Rs. 20,000 the operating savings (Rs. 35,000) less the additional cost of purchasing the units externally ([Rs. 60 – Rs. 50] x 1,500 units = Rs. 1,500). 146 CU IDOL SELF LEARNING MATERIAL (SLM)

The preceding examples demonstrate the two rules for establishing a transfer price: (1) If the selling division is operating at capacity, the transfer price should be the market price. (2) If the selling division has idle capacity, and the division cannot use the idle facilities for other purposes, the transfer price should be at least the variable costs incurred to produce the goods. SUMMARY A transfer price emerges for accounting purposes when related parties, for example, divisions inside an organization or an organization and its subsidiary, report their own profit. At the point when these connected parties are needed to execute with one another, a transfer price is utilized to decide costs. Move costs for the most part don't vary much from the market cost. 147 CU IDOL SELF LEARNING MATERIAL (SLM)