Accounting Notes ALL @ MBA

8/3/2019 Accounting Notes ALL @ MBA

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1. An Introduction to Accounting and the Accounting Equation

Accounting may be defined as a series of processes and techniques used to identify,

measure and communicate economic information which users find helpful in makingdecisions. Accounting is not an end in itself: it provides information to decision makers. Itconfines itself to economic information and is usually expressed in money values. However,accountants also deal with such things as tons of raw materials used, number of hoursworked, capacity of machinery used, and units of output produced.Accounting information must be relevant for the purposes for which it is designed. Then, ofcourse, the accountant must communicate the information in such a way that the users canunderstand it. Who are the users of a companys accounting information?Internal users: Directors, senior executives, managers, employees, and trade unions

External users: Shareholders, analysts, creditors, tax authorities, the public

Providing information about profitability and liquidity is seen by many to be the goal of theaccounting system. The relationship between resources and the funds provided to acquirethese resources is expressed in accounting like this:

ASSETS = OWNERS EQUITY + LIABILITIES or ASSETS LIABILITIES =OWNERS EQUITY

A profit and loss account shows how a companys profit was made. Profit is the excess insales revenue over cost incurred in generating the revenue. Items of expenditure accountedfor via the profit and loss account are called revenue expenditure.

The balance sheet is a collection of balances after each transaction has been completedand recorded. Accounting entries involve a mixture of cash-driven items and judgment-drivenitems. Items for expenditure accounted for via the balance sheet are called capitalexpenditure.

Fixed assets are of relatively long life and are generally used in the production of goods andservices rather than be held for resale.

Current assets are assets that are either currently in the form of cash or are close to being

converted into cash within a short period of time (usually a year).Current liabilities are those obligations that a company must meet in cash within a shortperiod of time (usually a year).

A cash flow statement portrays only those economic events of a business that affect thecash flow. Why is the cash flow statement so important? It breaks the conventions separatingthe balance sheet and the P&L account and states all events that affect the cash flow.

A sole tradercan start trading at any time with assets at his disposal. He must, however,distinguish between the transactions that pertain to his business and those that are domesticin nature. In law he has unlimited liability. Because his creditors can pursue him beyond thelimit of his business there is no requirement for him to make public his profit and loss accountand balance sheet each year.In a partnership a number of individuals agree to set up business together, bringing to thepartnership assets in varying proportions. As with the sole trader, a partnership need not

make public its annual results because its creditors can pursue the partners beyond the limitof their equity in the partnership.

A company structure avoids the risk of unlimited liability by limiting the liability of the owners(called shareholders) to the amount of equity (called share capital) paid into the company. Inthe event of legal action being taken against the company, shareholders cannot lose anymore money than the sum paid for the shares.

The accounting statements depicted in the previous section report the total picture of the firmfor an accounting period: total sales, total costs, total profits, and total asset structure. Thisinformation is compiled after the accounting period is over and the books of account havebeen closed. This part of accounting is called financial accounting or financial reportingand derives from the legal obligation on directors and managers to report to the owners of thebusiness (the shareholders) how they have used the resources at their disposal during theaccounting period under review (usually annual).

While financial reporting and an analysis of financial accounts are important for managers fora variety of decisions they have to make, the information contained therein is of little value in


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helping them to plan and control the day-to-day activities of the business. The secret of goodmanagement lies in predicting the future, in plotting a course today which will steer thebusiness through the turbulent seas of uncertainty lying ahead. To enable them to do this,management need detailed and relevant information. From the accounting process they needactual and projected costs and prices of individual products, actual and projected costs ofindividual departments and individual processes, projected sources and uses of cash,

proposals for major investment in plant and equipment, and many other details. Thisinformation is called management accounting.

2. The Profit and Loss Account

A glance at the profit and loss account will reveal that profit is the difference between thesales which the enterprise made during the period under review and all the costs which hadbeen incurred to bring the goods sold to the market place ready for sale. These costs include:

the direct costs of manufacture or preparation (the purchases of raw materials used,the wages of the workforce involved in the transformation process, and the costs of using upthe equipment, namely depreciation); and

the indirect costs (advertising and salaries of service support staff).

Profit equals the measurement of accomplishment (sales) minus the measurement of effort(costs).Accomplishment is generally measured at the first point in the operating cycle at which allthe following conditions are satisfied.

1. The principal revenue-producing service has been performed, i.e. the product hasbeen made and delivered against a firm order.2. All costs that are necessary to create the revenue have either been incurred or, if notyet incurred, are either negligible or can be predicted within an acceptable degree ofaccuracy.

3. The amount ultimately collectable in cash can be estimated within an acceptablerange of error.

The justification of the shipping and invoicing measure of accomplishment is that in mostcases it is the first point in the cycle at which all three criteria are met and reflects whatmanagement have achieved by way of sales, not what they think they might achieve. Such ameasure, although the most popular, need not be used if some other recognition basis meetsthe criteria better. Three other possible choices are:

Time of Sales Orders, e.g. sales rep performance measurement Time of Production, e.g. ship building Time of Collection

Accounting is a series of techniques and procedures which have been developed byaccountants over many years and which are called conventions. Two such conventions areadopted in measuring the sales figure:

1. The realisation convention: Only products that have been sold are measured as sales.Products which are completed or partially completed and have not realised value for thebusiness are not included.2. The accruals convention: Cash does not have to be received to create value; anobligation from a creditworthy customer is good enough to be called a sale. The accrualsconvention also covers the situation where a sole trader, or company or any other entity paysan invoice for a product or service which covers a period stretching beyond the date he/shedraws up the financial statements.

Efforts are all the costs involved in producing saleable products, and the costs involved in

actually selling the products which are recognised in the measurement of salesaccomplishment. The measurement of effort is governed by three conventions:


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1. The matching convention: Profit is arrived at by matching the effort (or costs) withthe units shipped and invoiced to the customers (sales) during the period.

2. The allocation convention: The first task is to determine how much of each meansof production, expressed in money terms, was consumed during the accounting period, thatis, the companys total purchases of means of production (e.g. raw materials, power, wagesof production workers) have to be allocated over the accounting period. The second task is to

determine how much of each means of production, again expressed in money terms, shouldbe matched with sales revenue and how much should be added to the closing work-in-progress (inventory of unfinished goods) and to the inventory of finished goods (on theassumption that goods remain unfinished at the end of the accounting period and that thebusiness produces more finished units than it sells). It will be noted that the second task issimilar to the procedures adopted under the matching convention.

3. The cost convention: The means of production is measured and expressed inmoney terms. The general rule is found in the cost convention: accountants use the historical(or acquisition) cost of different means of production, that is, the price paid for them by thebusiness when they were acquired.

The figure for raw materials used, often the largest of all the costs of production, is

determined by deducting the physical quantity of raw materials at the end of the year from thesum of opening inventory of raw materials and purchases during the year. Four valuationpossibilities suggest themselves:

1. Using the last price paid for all the closing inventory;2. Counting back using actual prices;3. Using earliest prices;4. Using the average cost of units.

The difference in stock valuation is significant.

The annual (or monthly, or weekly) payroll is the usual source for the measurement oflaboureffort expended. The information comes from the pay records and is in money terms.

Depreciation charges are based on rule-of-thumb procedures devised by engineers andaccountants which try to reflect the periodic use of plant and machinery. The periodiccharge for depreciation is calculated having regard to three factors:

1. the actual historic (sometimes called acquisition) cost, including installation chargesif any;

2. the estimated net residual amount which the business will receive for the asset ondisposal;

3. the estimated useful life of the asset to the present owner.

Note that two of the three factors are nothing more than estimates.The selection of method influences the amount of cost allocated to each accounting period;

the amount of depreciation allocated in turn influences reported profit.

Method 1 Straight-line Depreciation: The straight-line depreciation method iswidely used because it is simple and reasonable in respect of many kinds of fixed assets. Anequal portion of the original acquisition cost less estimated residual value is allocated to eachaccounting period during the assets service life. Method 2 Reducing Balance Depreciation: This method is based on the notionthat there should be relatively large amounts of depreciation expense reported in earlier yearsof the service life and correspondingly reduced amounts of depreciation expense in the lateryears. The basis for this method is that a fixed asset is more efficient in generating revenue inthe earlier years than in the later years of life, therefore it makes sense to allocate more costagainst earlier years revenue than later years. Also, repair expenditure tends to be low in theearly years and higher in the later years, therefore it makes sense to counterbalance the low

early maintenance with high early depreciation. Method 3 Consumption Method: The consumption method is based on the


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number of running hours of the machine: the assumption is the greater the machine hoursrun, the greater is the wear and tear on the machine.

The next step is to value the closing inventories of finished goods and work-in-progress, thenthese costs must be deducted from the total costs measured before and the balance is set offas a charge in the profit and loss account. The selection of an inventory valuation system is

very important because it will have a major impact on the measurement of effort, andconsequently on reported profit, for any accounting period. In other words:

the higher the ending inventory valuation, the higher the reported profit; alternatively the lower the ending inventory valuation, the lower the reported profit.

The kind of inventory normally held depends on the characteristics of the business. In amanufacturing operation we usually find the following categories.

1. Finished goods inventory: goods manufactured by the business, completed andready for sale.

2. Work-in-progress inventory: goods in the progress of being manufactured but notyet completed as finished goods.

3. Raw materials and supplies inventory: items acquired by purchase to be used inthe manufacturing process.

Inventory, once physically counted, is valued according to a mixture of cost and conservatismconventions in accounting. A choice among the inventory costing methods is necessary onlywhen there are different unit costs in the opening inventory and/or the purchases madeduring the accounting period. Generally accepted accounting principles require that theinventory costing method must be rational and systematic.

First In, First Out (FIFO): The first in, first out method assumes that the oldest unitcosts (the first units purchased) are the first ones sold. This means that the units left in

inventory at the end of the accounting period are deemed to be the latest purchased andtherefore valued at the latest prices. FIFO is favoured by many businesses because it isconsistent with the physical flow of the goods. Also, the balance sheet inventory is carried atcurrent realistic values, provided the stock is turned over quickly. Its greatest drawback,however, is that the reported income is relatively high during periods of rising prices becauseof the oldest and lowest costs which have been set off against sales revenue. High reportedincome leads to high taxes, high dividends and potentially high wage demands. And of courseinventory must be replaced, demanding more cash outlay. When prices are rising, companiesfind it increasingly difficult to replace the physical volume of inventory used and sold. Last In, First Out (LIFO): The last in, first out method assumes that the mostrecently acquired goods are sold first. Irrespective of the physical flow of goods, LIFOassumes that the most recent purchases (and therefore the most recent prices) aretransferred first into production, leaving in the ending inventory the oldest (and lowest priced)units. Thus the LIFO method attains results that are the opposite to FIFO: lower profit isreported in times of rising prices and replacement of inventories is therefore made easier.However, many managers do not want to report the lower profit figure. Average Method: The average method involves computing the weighted averageunit cost of the goods available for sale. The average unit cost is then applied to (a) thenumber of units sold in order to calculate the cost of goods sold, and (b) the number of unitsin the ending inventory to measure the inventory value.

Very often tax minimisation is a primary goal of management: in times of rising prices LIFOwill result in lower-valued inventories, therefore higher costs being passed into cost of salesand hence lower profits.Most managers believe that the best inventory valuation method is the one that best matches

the sales pricing policy of the company. Businesses, it is thought, set selling prices within aLIFO assumption since the inventory used up through sales must be replaced on the shelf atthe latest cost rather than the earlier cost.


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Two of the costs which have been examined in detail in this module, raw materials andlabour, are known as product costs. Such costs can be traced directly to the products beingmanufactured, or to the production process. In addition to the ones just mentioned we canadd various factory overheads such as indirect labour (assume that the labour costsconsidered so far were wages of operatives directly involved in manufacturing) representingwages and salaries earned by supervisors, warehouse staff and maintenance engineers, all

of whom do not work directly on the products but whose services are connected to theproduction process. Other factory overheads would include heat, light and power, suppliesand maintenance, depreciation and asset insurances.There is another category of costs which companies incur and which are set off against salesrevenue in the profit and loss account without any question of including them in the valuationof closing inventory. Such costs are called period costs. Examples of period costs areselling, distribution and marketing costs, general administrative costs and financial charges.These costs are incurred so that a companys products can be sold, and the money can becollected from the customer, but they typically do not add value to the products unsold at theend of the accounting period. They are therefore written off each year.

The way in which a company classifies its costs into period costs and product costs can havea significant effect on the reported profit figure. The more costs a company deems to beproduct costs, the higher the inventory valuation will be at the end of the accounting period.

And the higher the inventory, it will be recalled, the higher the reported profit figure.If a measure of the efficiency of the transformation process is wanted the gross profit figureshould be selected, that is, sales less cost of sales. Net profit, on the other hand, whichreflects the further expenditure identified normally as period costs, enables the reader to judge overall managerial efficiency against both previous accounting periods and othercompanies engaged in similar fields. The most commonly used measure of managerialefficiency is net profit before interest charges and taxes: managements efficiency ofmanufacturing, selling and distributing the companys products should not be affected by thefinancing arrangements made to bring about the trading results. If the reader wants to assessthe companys financial structure the important figures are the interest payment (interest, thatis, on money borrowed from non-shareholders) and the net profit after interest but beforetaxes.

The profit and loss account measures the difference between accomplishment (sales) andeffort (cost of sales and other overheads). Sales are measured by reference to goods andservices shipped and invoiced to the customer and are not dependent on the cash received.Cost of sales are measured by reference to the valuation of inventory of raw materials, work-in-progress and finished goods at the end of the accounting period. This inventory can bevalued in one of a number of ways, each one producing a different cost of sales figure andtherefore a different profit figure. Depreciation is another cost which is subject to a variety ofmethods of calculation. Care must be taken to segregate product costs from period costs.The latter category must be written off in the profit and loss account while the former can beinventoried and carried forward in the valuation of inventory in the balance sheet. Profit canbe calculated at a number of levels, before and after overheads, and before and after interestand taxes. Managers must select the figure which best suits their purpose.

3. The Balance Sheet

Assets can be described as (a) the untransformed means of production like land, buildings,plant and machinery and raw materials; and (b) the transformed means of production likework-in-progress and finished goods which have not yet been released into the profit andloss account.

Fixed assets are those assets that a company keeps for a substantial period of time (likeland and buildings or plant and equipment or motor vehicles), not for resale, but to use in thecourse of business. It is the intention of management as to the use of the asset, not itsphysical characteristics, that determines whether or not it is classified as a fixed asset.Categories of fixed assets are:

Land Buildings Plant and equipment


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Fixed Assets not owned by the company: the asset appears under the heading fixedassets and the future lease payments under creditors.

The distinction should be made between the expense of maintaining and operating the fixedassets and the depreciation which is charged. Maintenance expenditure is an expense whichis charged against profits in the period of outlay. Depreciation, on the other hand, is the

allocation of a previously incurred cost. For the sake of completeness, it should be noted thatassets acquired under an operating lease (one in which ownership remains with the lessor)are not capitalised.. Both the capital and interest elements of the operating lease paymentsare charged in the profit and loss account. In the case of finance leases only the interestelement is charged to the profit and loss account while the capital portion is deducted fromthe lease obligation amount in the balance sheet.

Current assets are assets which are expected to be sold or consumed during the normaloperating cycle of the company (usually one year). Categories of current assets are:

Inventories: the valuation is based n the lower of the cost or current market valuerule; cost is defined as direct manufacturing cost plus a share of manufacturing overhead(period cost such as administration overhead are not included in inventory); inventory

valuation methods can influence the value of the inventory and any changes in valuationmethods has to be properly disclosed Debtors: payment by debtors is expected shortly after the start of the next accountingperiod. Provisions for bad debts are entered at the beginning in the P&L account andsubsequently changes in those provisions and actual bad debts are entered in the P&Laccount. Cash

Current liabilities are liabilities which is plans to meet in the short term by the payment ofcash. Examples are creditors, bank overdraft, taxes payable, dividends payable, accruals,and deferred revenue.The balance sheet is often described as a snapshot of a companys resources on a givendate. Imagine the view from a helicopter sent up to take an aerial photograph of a company.

Plant and equipment, land and buildings, piles of inventory (raw materials, work-in-progressand finished goods) would be picked out by the camera, maybe even the cash drawersstuffed with money. The profit and loss, by contrast, could be regarded as a video of thecompanys activities during the year. A video is a moving picture, not a static snapshot, andwould reflect the constantly fluid operations of accomplishment and effort, the purchasing,manufacturing and selling activities which reflect the companys raison dtre.

4. The Cash Flow Statement

Cash flow statements are needed to unstitch the accounting principles which are applied tocompile balance sheets and profit and loss accounts and to reveal whether the entity hassufficient cash funds to finance its future operations and its future ambitions for dividend

payments to the owners and investments in assets and acquisition of other businesses.Where does cash come from?

Profit from Operations Capital Introduction Increase in Creditors Sale of Fixed Assets Loans Decrease in Inventories Decrease in Debtors

Where does cash go to?

Loss from Operations


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Capital Repayments Decrease in Creditors Purchase of Fixed Assets Repayment of Loans Increase of Inventories Increase in Debtors

Eight major categories of cash flow = Our Really Tall Cat Ate Everyones Meaty Food:

1. Operating activities2. Returns on investments and servicing of finance3. Taxation4. Capital investment5. Acquisitions and disposals6. Equity dividends paid to shareholders7. Management of liquid resources8. Financing

What is needed to draw up the cash flow statement?

The profit and loss account for the period The balance sheet at the start of the period The balance sheet at the end of the period Supplementary notes to the financial statements

Of the three financial statements regularly prepared by companies and other organizationsthe cash flow statement is arguably the most critical. This is because entities need cash tosurvive; cash is the lifeblood that keeps them alive. Cash flow statements allow users offinancial reports to assess a companys liquidity and financial adaptability. Remember:

Market share is VANITY; Profit is SANITY; Cash flow is REALITY.

5. The Framework for Financial Reporting

The material which follows refers to the reporting environment influenced by the work of theInternational Accounting Standards Board (IASB) through its international financial reportingstandards (IFRSs). These are sometimes referred to, inaccurately, as internationalaccounting standards (IASs); in fact IASs were issued by the International AccountingStandards Committee which preceded the IASB whose subsequent standards are known asIFRSs. The term IAS still applies to earlier standards which the IASB has been prepared to

endorse since its inception in 2000.The overall requirement of the law is that the companys profit and loss account and balancesheet shall give a true and fair view of, respectively, the profit or loss for the financial year,and the state of affairs as at the end thereof.

Generally it is interpreted to mean that the financial statements have been drawn upaccording to accepted accounting principles using accurate figures as far as possible, andreasonable estimates otherwise, and that the whole picture is free from deliberate bias,manipulation or concealment of material facts. A companys auditor must certify every yearthat a true and fair view has been given of the companys profits and state of affairs.

The accounting profession, in 1969, took it upon itself to issue standards for accountingprocedures which its members are obliged to follow. The standards, properly termedStatements of Standard Accounting Practice or SSAPs, were issued on behalf of the variousprofessional accounting bodies by the Accounting Standards Committee up to 1990 and fromthis date Financial Reporting Standards, or FRSs, have been issued by the AccountingStandards Board, a body independent of the professional accounting bodies.


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The distinction between the Companies Act and accounting standards should be stressed:the Companies Act lays down that companies must disclose certain information,predominantly of a financial nature, about its affairs during the accounting year under review.Accounting standards, on the other hand, underpin the financial disclosures in that they setcontrols on how the numbers in the financial statements are to be compiled.

In order to promote harmonisation of regulations and procedures throughout the world, the

International Accounting Standards Committee (IASC) was set up in 1973. In an effort toembrace many member countries own standards setting efforts, the requirements of theearly international standards permitted a wide range of options. Finance directors did not findit difficult to comply with IASC standards if, first, they had met the requirements of theirnationally set standards. But the pace quickened in the late 1990s when some companiesabused the relatively liberal regime of both national and international standards and the IASCwas reconstituted the International Accounting Standards Board (IASB) in 2000.

Groups of companies are recognised in law and their combined financial results must bereported in consolidated, or group, financial statements. The responsibility for publishinggroup accounts rests with the holding company, that is the company which owns theshareholdings (over 50 per cent) in the subsidiary companies in the group. The holdingcompany must publish not only the group profit and loss account and group balance sheet,but also its own balance sheet. The subsidiary companies must continue to publish their own

financial statements in the usual way.Experienced readers of annual accounts always start their examination with the enterprisesAccounting Principles and Policies. These brief statements are required by IAS 1Presentation of Financial Statements. Accounting policies are the specific accounting basesselected and consistently followed by a business enterprise as being, in the opinion of themanagement, appropriate to its circumstances and best suited to present fairly its results andfinancial position.

Three lessons can be learned from the foregoing paragraphs in this module.

1. Disclosure requirements are numerous and complex and require detailedinterpretation by company management, accountants and lawyers, and by the auditors (towhose role we shall turn next). MBA students and managers do not need to master the detail.

2. A corporate tradition has been built up of disclosing the absolute minimuminformation required. Very seldom does a company publish information that is not mandatory.3. Despite a rigorous application of disclosure requirements, large gaps in informationcan still be detected by interested readers.

In attempting to understand the annual report and accounts of any company the readershould appreciate the seven fundamental accounting principles that underpin theirpreparation. These are set out in IAS 1.

Fair Presentation: A fair presentation requires management to select and applyaccounting policies (e.g. the depreciation method or the inventory valuation method) whichare relevant to the users and are reliable in that they (a) represent faithfully the results andfinancial position of the enterprise; (b) reflect the economic substance of events and

transactions and not merely the legal form; (c) are neutral, that is free from bias; (d) areprudent; and (e) are complete in all material respects. The Going Concern Principle: If management is aware of material uncertaintiesrelated to events or conditions that may cast significant doubt upon the entitys ability tocontinue as a going concern, these uncertainties should be disclosed. The standard requiresmanagement to review all available evidence relating to at least the period of twelve monthsfrom the balance sheet. Significant doubts about such matters as a collapse in orders,repayment of debt falling due, payment of interest on current debt levels or continuing supportof banks and other providers of debt could trigger the need to draw up the financialstatements prepared on a basis other than going concern. In practice this would lead to amaterial write-down of the carrying value of assets in the balance sheet which, in turn wouldhit the profit and loss account. The Accrual Basis of Accounting: Financial statements drawn up on the accrualbasis inform users not only of past transactions involving payment and receipt of cash butthey also reflect the obligations to pay cash or the prospect of receiving cash in the future.


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The Consistency Principle: In order to provide a reflection of the affairs on an entityit is essential that readers get presented with information which has been prepared on aconsistent basis. This allows the reader to compare this years performance with the previousyears. IAS 1 requires entities to stick to its presentation and classifications from one year toanother unless there are compelling reasons to change them. A significant acquisition ordisposal, or a review of the presentation style, might suggest that a change is required. This

change is only permissible if the changed presentation provides information that is reliableand is more relevant to the users and that the revised structure is likely to continue, so thatusers will be able to compare years performances in the future. Materiality, Aggregation and Offset: Each material class of similar items must bepresented separately; and items of a dissimilar nature of function should be shown separatelyunless they are immaterial. So if a line item is not individually material it should beaggregated with other items either on the face of those statements or in the notes. Profit or Loss for a Period: Every gain or loss, whether it arose from the normaloperations of the business or from the purchase or sale of assets, should be captured in theprofit and loss account. (Cant find a seventh accounting principle in this list in the textbook)

Legislation in most countries requires that all limited companies have their accounts auditedby independent persons who hold an accounting qualification recognised by the government.The auditors are required to make a report to the shareholders on the accounts examined bythem. This report forms part of the published financial statements. The report shall statewhether, in the auditors opinion, a true and fair view is given of the profit (or loss) for the yearand of the financial position at year-end.

To enable them to make a report, the auditors must ensure that the books, records andinternal controls have been satisfactorily maintained during the accounting period. Theprincipal aspects of their work include:

an examination of the system of bookkeeping, accounting and internal control toascertain whether it is appropriate for the business and properly records all transactions. Thisis followed by such tests and enquiries as are considered necessary to ascertain whether the

system is being properly carried out. Both these steps are necessary to form a basis for thepreparation of the accounts; comparison of the balance sheet and profit and loss account and other statementswith the underlying records in order to see that they are in accordance therewith; verification of the title, existence and value of the assets appearing in the balancesheet;

verification of the amount of the liabilities appearing in the balance sheet; verification that the results shown by the profit and loss account are fairly stated; and confirmation that the statutory requirements have been complied with and that therelevant accounting standards have been applied correctly.

Internal control is a term used to describe all the various measures taken by the owners and

managers of a company to direct and control their employees.Managers are constrained by three sets of rules when constructing corporate financialstatements:

1. company legislation passed by the government of the country in which the companyis registered;2. the accounting standards set by the accounting profession or its regulators; and3. the listing requirements of the stock exchange.

Few companies disclose any information not required. Groups of companies consolidate theirresults at the end of the financial year into a group profit and loss account and a groupbalance sheet; in addition the parent company must publish its own balance sheet.

An auditor is required to report to the shareholders of a company on whether or not theaccounts reflect a true and fair view of the companys affairs. To do this he or she undertakesa series of checks and examinations of the companys books and internal controls.


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6. Interpretation of Financial Statements

Percentages, or ratios, permit easy comparison between different corporate entities: divisionswithin the company, companies within the same group, or companies within the sameindustrial sector. The frequently used benchmarks for the purposes of comparison are thedata produced by the various clearing houses for industrial statistics.

In ratio analysis it is important to study the trend of the ratios calculated rather than to attemptto arrive at sound conclusions on one years numbers.

Ratio Analysis:

Liquidity Ratios: Liquidity ratios are designed to measure a companys ability tomeet its maturing short-term obligations. Profitability Ratios: Profitability ratios are designed to measure managementsoverall effectiveness. Capital Structure Ratios: Capital structure ratios are divided into two groups whichare: (a) those that examine the asset structure of the company; and (b) those that analyse thefinancing arrangements of the companys total assets, in particular the extent to which thecompany relies on debt. This group of ratios is generally known as the gearing ratios.

Efficiency Ratios: Efficiency ratios give an indication of how effectively a companyhas been managing its assets.

1. Group 1: Liquidity Ratios

A company is in a good position to meet its current obligations if current assets exceedcurrent liabilities by a comfortable margin.

Current ratio = Current assets/Current liabilities Quick ratio (or acid test) = (Current assets Inventory)/Current liabilities

2. Group 2: Profitability Ratios

Gross profit margin = Gross profit/Revenues Profit margin = Profit from ordinary activities before taxation/Revenues Return on total assets = Profit from ordinary activities before taxation/Total assets Return on inventory = Profit from ordinary activities before taxation/Inventory Return on capital employed = Profit from ordinary activities before taxation/Capitalemployed (Capital employed = Working Capital (Current Assets Current Liabilities) + FixedAssets) Return on owners equity = Profit from ordinary activities attributable toshareholders/Owners equity

3. Group 3: Capital Structure Ratios

Fixed (Non-current) to current asset ratio = Fixed (Non-current) assets/Current assets Debt ratio = Total debt/Total assets (gearing ratio) Times interest earned = Profit before financial result (=Profit from operations)/Interestcharges (gearing ratio)

4. Group 4: Efficiency Ratios

Inventory turnover = Cost of sales/Inventory Average collection period = Trade receivables/Revenues per day Non-current asset turnover = Revenues/Non-current assets

One ratio is deemed by most companies to be ultimately significant, namely Return on TotalAssets (ROTA).


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Furthermore: Basic Stock Market Ratios

Earnings per share (EPS) = Net profit/Number of ordinary shares in issue Price/earnings ratio (EP) = Market price/EPS Dividend yield = Dividend per share/Market value per share Dividend cover = Profit from ordinary activities attributable to common stock/Dividendpayout

Financial statements report absolute figures. But these figures by themselves do not revealmuch about the company; they need to be related one to another so that internal strengthsand weaknesses can be revealed. Ratio analysis only produces insights when it is carried outfor a number of years and when the ratios are compared with industrial averages. The mostprominent ratios can be grouped into four categories.

1. liquidity ratios which are designed to measure a companys ability to meet itsmaturing short-term obligations;2. profitability ratios which strike at the heart of a companys activities, namely whether itcontrols expenses and earns a reasonable return on funds invested;

3. capital structure ratios which examine the percentage of a companys total assetswhich are contributed by shareholders and the effect and risk of such a percentage on theearnings; and4. efficiency ratios which measure the companys asset management.

Stock market ratios are also critical for the management of a quoted company but becausethese are based on the daily share price these ratios tend not to be controllable in the shortterm.

No set of ratios is sacrosanct; the secret of good ratio analysis is to understand theunderlying significance of a small number of ratios and then apply them consistently throughtime and across companies.

7. Emerging and Controversial Issues in International FinancialReporting

The pressure on profits or more specifically earnings per share for that is the ultimateindicator of corporate growth is a phenomenon referred to as shorttermism.

Depending on the terms of business combination, i.e. how a company becomes asubsidiary of a holding company, accounting practice permits two types of group accountswhich produce starkly different numbers. These two practices are known as acquisitionaccounting and merger accounting (sometimes referred to as business combinations).Acquisition accounting (sometimes called purchase method accounting) is used to reflectnormal takeovers where the predator company (called the holding company in this module)acquires more than 50 per cent of the equity share capital of the target (called the subsidiary)for cash, or shares in the holding company, or a combination of cash and shares.

Merger accounting (sometimes called pooling of interests) is based on the concept ofharmony and agreement rather than the hawkish behaviour of predator and prey whichunderpins acquisition accounting. A merger (as opposed to a takeover) presumes agreementbetween the two parties to pool their respective interests rather than for the one to hand overits assets to another. The accounting statements in merger accounting attempt to portray thisharmonious coming together by restating both companies accounts as if the two companieshad always been one.Internally Generated Intangible Assets:

Research and Development: Research expenditure must be written off to the profitand loss account because the company cannot demonstrate that an intangible asset existsthat will generate probable economic benefits. Development expenditure should be

recognised as an internally generated intangible asset only if the company can demonstrateidentifiability, control, and existence of future economic benefits.


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Website Costs: Planning (expenses), application and infrastructure development(intangible asset), graphical design development (intangible asset), content development(expenses), operating stage (expenses).

Share-Based Payments:

The day of grant is the date on which the employee is informed of the award ofoptions. To provide the necessary incentive and motivation the board, or its remunerationcommittee if the company has such a body, will set the price of the option above the price ofthe share on the day of grant. The vesting day is the day on which the vesting conditions (e.g. length of time to beserved or profitability levels to be reached before options become payable) have beensatisfied. If the share price on vesting day is above the price set by the board on the day ofgrant the options are seen to be in the money; on the other hand if the vesting day shareprice is below the day of grant value the options are under water. The period between theday of grant and vesting day is called the vesting period. If the options are claimed on thisday, the day is also known as the exercise day. If the exercise day lies beyond the vestingdate, as so often is the case, the time between vesting day and exercise day is called the

exercise period. The life of the option is the period between the day of the grant and the last day onwhich the grant can be exercised, beyond which the grant expires. Share-based options are valued at the fair value of the equity instrument at the datewhen it was originally granted; should it not be possible to determine fair value reliably,management may use intrinsic value, that is the price of the underlying share less theexercise price, if any, for the award.

Pensions are employee benefits which are payable after the completion of employment.They come in two forms:

Defined contributions where a company pays an agreed contribution each year intoa pension fund on behalf of an employee. This fund is typically managed by a life assurancecompany or other professional investor; at the end of employment the fund will pay out apension the amount of which is heavily dependent on the success of the funds investmentsover the years the employee was working. Should the employee find the pension less thanwas indicated by the pension provider during employment or simply insufficient to meethis/her needs, the company has no further responsibility. From the employers stance wethink the term defined inputs would capture the nature of this type of pension funding. Defined benefits (or in our parlance defined outputs) which guarantees thepensioner a set amount each year based usually on his/her final salary or the average of thelast three (or more) years salary. Note the term guarantee; should the fund to which theemployer and employee has contributed during the pensioners working life not havesufficient assets in it to fund the defined benefits, the company has a responsibility to top itup.

What is a Financial Instrument? IAS 39 defines a financial instrument as any contract thatgives rise to a financial asset of one enterprise and a financial liability or equity instrument ofanother enterprise. So the financial instrument is the contract, not the financial asset orfinancial liability. The four categories for financial assets and/or financial liabilities are:

1. Held for trading: this is an asset which was acquired or incurred principally for thepurpose of generating profit from short-term fluctuations in price or dealers margin.2. Held-to-maturity investments: these are financial assets with fixed or determinablepayments and fixed maturity that a company plans to hold to maturity.3. Loans and receivables originated by the enterprise: these are financial assets thatare created by the company by providing money, goods or services directly to a debtor otherthan those the company plans to factor (which should be categorised as held for trading.

4. Available for sale: these are financial assets that are not captured by the other threecategories.


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These categories are important because IAS 39 lays down two sets of measurement rules.Financial assets held for trading and those available for sale are to be measured at fair value(remember the definition of fair value: the amount for which an asset could be exchanged ora liability settled, between knowledgeable, willing parties in an arms length transaction) andthe other two categories, assets held-to-maturity and loans and receivables are to bemeasured at amortised cost using the effective market rate.

A provision is recognised as a liability (assuming that a reliable estimate can be made)because it is a present obligation and it is probable that an outflow of cash or other resourcewill be required to settle the obligation.

A contingent liability, on the other hand, is not recognised as a liability in the balance sheetbecause it is either only (a) a possible obligation as it has yet to be confirmed whether thecompany has an obligation that could lead to an outflow of cash; or (b) a present obligationwhose probability of cash outflow is low or for which a sufficiently reliable estimate cannot bemade.A contingent asset is defined more simply: it is a possible asset that arises from pastevents and whose existence will be confirmed only by the occurrence or non-occurrence ofone or more uncertain future events not wholly within the control of the company.

8. An Introduction to Cost and Management Accounting

The forward-looking branch of the accounting discipline is called management accounting.Readers should note from the outset that the characteristics of the same global definitionapply to management accounting as to financial accounting and reporting.

The difference between financial accounting and management accounting can be describedas financial accounting reports on management and management accounting reports formanagement.

Management Accounting FinancialAccounting

Structure No formal structure, can be designed to suitmany purposes, each with its own set of

guidelines.

Highly structuredaround the

accountingequation.

Rules No externally imposed rules. Rigid handling ofasset valuations, overhead allocation andrevenue recognition is relaxed.

Hemmed in bygeneral accountingprinciples toenable comparisonacross companies.

Compulsory No, but few succeed without a system, howeverinformal. No value in maintaining one if it is notuseful.

Yes, companiesare obliged by lawto produce

external accounts.Moneyterms

Not exclusively. Yes, financialstatements aredrawn upexclusively inmoney terms.

Time Spans Information tends to be future oriented.Management might compromise precision forspeed.

Records andreports pastevents asaccurately as theunderlying

accountingprinciples permit.


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Whole or parts

By its nature fragmented. Focuses on productlines, departments, processes, etc. Informationcan be reworked in many different ways

Reports the eventsof the company asa whole.

Audit Strictly speaking, no, although the externalauditors may with to test the internal controls by

examining aspects of the managementaccounting system. An internal audit functionmight use the management accounting systemas its basis.

Yes, accountshave to be audited

by a registeredauditor.

Planning and coordination and directing and control are the two groups of tasks formanagers. To assist managers in these they need information that allows them to takedecisions.

Cost accounting is a major and essential part of management accounting. Theclassification, collection and analysis of costs, principal features of cost accounting, arefundamental to management planning and control.

Costing systems are designed to facilitate the allocation or apportionment of expenditure tocost centres (the smallest unit of activity or area of responsibility for which costs are

accumulated) or to products. Costs are allocated to products if the relationship is obvious;these are called direct costs. Other costs such as the heating and lighting in the workshop,depreciation of the machinery, salaries of the administrative staff are called indirect costsand have to be apportioned by some given formula to the products.

Materials first must be quantified and then must be priced. The cost accounting systemusually records the amount of raw material that is drawn from the stores for use in theassembly process. The amount is recorded on a stores requisition slip which shows both thequality and the quantity of the material drawn. This slip is used not only to cost the individualunits but to update the records for raw material inventory which will eventually needreplenishment.

Direct labour is that part of the total labour cost which can be traced to, or otherwiseidentified with, the units of output produced. The higher the volume, the higher the labour

costs. Typically, direct labour comprises those employees who are closest to themanufacturing or assembling process. Again, the direct labour must be measured in terms oftime and price.

Manufacturing overheads is a broad category of cost which includes all costs associatedwith manufacturing other than direct material and direct labour. Examples are indirect labourof those employees associated, but not directly, with production, supplies, factory heating andlighting, power, machine maintenance and depreciation. Non-manufacturing overheads areadministrative costs, selling and distribution costs and financial expenses.

The system described above is known as job costing, appropriate where the units of outputare sufficiently identifiable to pinpoint the direct material and labour applied to each unit.

There are many areas where the items produced are so homogeneous that physicalidentification is impossible; examples are refining, chemical processing and manufacturingactivities where products are continuously produced in an unvarying mix. In these cases, job

costing is impossible to operate and another system called process costing is adopted.Process costing systems collect costs for all the products worked on during an accountingperiod and, by dividing these total costs by the total number of units worked on during thesame period, determine the cost for each unit.Management decisions can be split into two broad categories: routine and special. Routinedecisions are concerned with the day-to-day operations of the enterprise: ensuring that theagreed volume of output is produced in the agreed manner, ironing out problems that arisewith supplies of raw materials or with the production workers, in general encouraging staff toachieve the companys objectives as efficiently as possible. For these tasks the managerneeds much cost information, mostly of a routine nature, which the cost accounting system isdesigned to produce. Special decisions need special cost information which does not fallout easily from the cost accounting system. The management accountant must package therelevant cost information in a manner most appropriate for managers to make their decision.

The overriding criteria for management accounting information are relevance andtimeliness.


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Equation method (calculates revenues or break-even sales): Break-even sales =Fixed costs + Variable costs (Sales = Fixed costs + Variable costs + Profit) Contribution margin method (calculates break-even number of units): Contributionmargin = Sales revenue per unit Variable costs per unit; then BEP = Fixedcosts/Contribution margin

The secret of good management is to identify the limiting factors and calculate thecontribution margin per unit of limiting factor. The higher the contribution margin per limitingfactor, the more the good in question contributes to the bottom line.

Contribution Margin Ratio Method (or Profit/Volume Ratio) = (Sales price Variablecosts)/Sales price; then BEP = Fixed costs/P/V ratio

The profit/volume ratio is used in the break-even decision making and measures the impactof volume on profit.

Assumptions underlying the cost-volume-price analysis:

1. All costs can be identified as either fixed or variable.

2. Variable costs rise linearly, fixed costs are the same for all volumes produced.3. Sales price per unit remains unchanged.4. The sales mix (mix of products) will be maintained precisely as budgeted, as totalvolume moves up or down.5. All production is sold.

These assumptions restrain the usefulness of the break-even analysis in real worldsituations. However, the analysis of cost behaviour is useful in many situations of decision-making.

10. Allocating Costs to Jobs and Processes

Where do costs come from?

Materials Labour Manufacturing overheads Non-manufacturing overheads

Because overheads are not directly attributable to cost units in the same manner as directmaterials and direct labour where the actual usage of resources can be tracked precisely,accountants use a predetermined overhead rate with which to spread overheads acrossthe units of production. This rate is based on the following calculation:

Predetermined overhead allocation rate = Budgeted overhead for accounting

period/Budgeted production unitsDifficulties arise, however, in a business which produces more than one product. If theseproducts have different production characteristics (that is, they consume differing proportionsof the factors of production including overhead costs) the simple fraction above does notwork because the budgeted production units cannot be added together.

Cost accountants search for causal factors or activity bases, the one particular factorwhich prompts the incurrence of most of the headings of cost which comprise overhead.Typical activity bases are direct labour hours, or direct labour cost or machine-hours. A closeexamination of overheads in each business will reveal that one of these activity bases can beseen to cause the majority of the overheads (but by no means all). It is virtually impossible toestimate accurately both the numerator (budgeted overheads) and the denominator(budgeted level of production expressed in terms of an activity base). The difference betweenthe actual figure of overhead incurred and that allocated to the product is accounted

directly to the profit and loss account.To assume the same linkage to the selected activity base for all overhead costs can lead to


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misleading allocations and therefore product costs. Management must design a cost-allocation system which reflects each products actual usage of overheads rather than adhereto the blunt instrument of a plantwide rate. Typical activity bases for service departmentcosts include the following:

personnel/welfare services: number of persons employed; computing: hours run; number of reports issued; machinery: machine-hours; buildings and estate: space occupied; power: machine-hours; metered usage; executive salaries: sales; production scheduling: number of different products.

Cost accountants use many methods which revolve around two principal techniques, thedirect method and the step method. In the direct method, the overhead costs for each of theservice departments are emptied out into the production departments and added to theoverheads already there to calculate two predetermined overhead rates. The secondtechnique, the step method, recognises the interdependency among departments. A

sequence to close down service departments costs must be established. Two of the mostcommon are: (a) select service departments in descending order of magnitude of overheadspend, and (b) select first the department that renders the highest percentage of its totalservices to other service departments and end with the one that renders the lowestpercentage of service to other service departments.In some industries, work is concentrated on the production of one product but other productsare produced which may or may not have significant market potential. The true characteristicof ajoint product is that it must appear during the processes involved in producing the mainproduct. If management has the option of not allowing the second product to emerge from theprocess the two products cannot be deemed to be joint.

Equal Shares Physical Characteristics: The underlying principle in the physical characteristicsmethod is that such characteristics as weight, volume or difficulty to handle cause certaincosts to be incurred. Sales Value at Split-Off: The sales value at split-off is the first method to consider theproducts ability to bear the joint costs, such ability being reflected in money generated byeach product for the business. Ultimate Net Sales Value: The ultimate net sales value method is an extension of thepreceding method, sales value at split-off. It recognises that the business may wish toprocess the two products further after the split-off point in an effort to maximise profit.

By-products are different from joint products only in terms of motive and commercial value.Joint products are planned for and the production process is designed to cater for them. Insuch a situation no attempt would be made to allocate the costs of production between the

two products; instead the revenues generated from the by-product would be deducted fromthe costs of processing before determining the gross margin from operations.

The type of costing, where individual products are deemed to be separate jobs which incurseparate costs, is called job costing. Job costing is operated in enterprises where relativelysmall numbers of high-value tasks are undertaken during the accounting period, for examplein the construction, aerospace, shipbuilding and consultancy industries, or where the outputscan be batched in larger units for costing purposes, for example in the personal computer,motor vehicle and furniture industries. Significant costing problems are encountered byindustries where no uniqueness is identifiable in the products produced and where theprocess is almost continuous, for example the chemical industry or the brewing industrywhere the units of output are indistinguishable from each other. This type of costing is calledprocess costing. The principle underpinning both job costing and process costing is that ofaveraging costs incurred over units produced. With job costing the averaging technique is

largely reserved for indirect overhead although the valuation of direct material and directlabour can also be subject to averaging. The same principle of averaging underpins process


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costing but cost accountants use the notion of equivalent units of production. An equivalentunit of production is an assessment of the degree of completion of a unit under each majorcomponent of cost. Activity-based costing (ABC) is a technique currently being explored bysome companies and organisations which attempts to combat the deficiencies of traditionalcosting techniques. The essence of activity-based costing is its focus on the belief thatactivities (e.g. production planning, quality inspection) rather than products cause costs to be

incurred and products consume activities. Activity-based costing focuses on cost drivers those activities or factors which generate cost.

11. Costs for Decision Making

The form of accounting in which each unit is asked to absorb its share of fixed productionoverhead, a not-unreasonable requirement, is called full or absorption cost accounting.The form of accounting which accounts for fixed costs in a lump sum is called variable ordirect costing.

The net profit under full costing and variable or direct costing is identical and, in suchcircumstances as postulated where actual production equals planned production, and wheresales equals production, the managerial insights gained from one method of costing as

opposed to the other are limited. But we know that actual production hardly ever matchesexactly planned production, and it is rare to find a business where all production is sold bythe end of the accounting period. As soon as commercial reality is introduced into the model,the two costing systems produce different numbers.A denominator volume variance arises when actual production planned production. Bottom-line profit difference arises when sales actual production.Under variable costing, profit is a function of sales, that is, when sales rise, so do profits. Butwith absorption costing, profit is influenced not only by sales but also by production levels. Bystepping up production beyond sales, management can increase profits because more fixedproduction expenses are parked in inventory. But this action must inevitably be reversedbecause of cash flow problems (cash required for production not being restored by sales);when the fixed production expenses come tumbling out of the inventory warehouse underabsorption costing, they hit the profit and loss account.

It is essential that managements construct a framework within which one-off decisions canbe analysed in a thoroughly disciplined manner:

Task One: Define the Problem and List All Feasible Alternatives Task Two: Cost the Alternatives: When alternative courses of action are being costed(from both the revenue and cost angles) management is concerned only with the relevantcosts, not the total costs, of each alternative. Sometimes a relevant cost is called adifferential cost because it is a cost that differs when management changes the scheme ofoperations. It should be stressed, however, that while the emphasis in examining relevantcosts is on variable, or marginal costs, this should not preclude a consideration of fixed costs,too. Task Three: Assess the Qualitative Factors

Task Four: Make the Decision

By taking a decision to implement a specific option, management automatically forgoes theopportunity of embarking on alternative options. It may be possible to identify certain costs ofnot choosing one alternative which may be relevant in the decision making process.Accountants are uncomfortable with opportunity costs because (a) these costs cannot bedetermined from the accounting system and (b) they are highly subjective and uncertain. Butmanagers should make every effort to quantify such costs because they could have aprofound impact on the other relevant costs and therefore on the decision to be taken.Relevant cost analysis must not be confused by mixing costs which have been incurred fromold decisions with costs which will be incurred in the future. Costs which have been incurredare called sunk costs and should be ignored when looking for relevant costs.Relevant costs are:

future costs;


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cash costs; avoidable costs; costs which differ among alternatives.

12. Budgeting

Budgeting has the following attributes:

Coordination Planning Motivation Control

A budget is a plan of action, usually expressed in numbers and amounts, that sets targets forindividuals and for the business over a defined future timeframe. Planning of a businessfuture, that is strategic planning, must precede the budget exercise. Strategic planning is themanagerial exercise that attempts to ensure that a business accomplishes a sufficient

process of innovation and change by allocating scarce resources (cash, managerial skill,technological know-how) by adapting to environmental opportunities and threats and bycoordinating activities so as to reflect the business strength and weaknesses.

Discretionary costs are difficult to budget for and manage because

the output is often difficult to measure, budget holders might not be sure of the companies objectives and therefore unsureabout where their efforts should be focused, and it might not be easy to control it on an annual basis (e.g. in R&D where a year is avery short timeframe).

On technique to ensure that discretionary cost budgets provide sufficient visibility is calledzero-base-budgeting (ZBB). In zero-base-budgeting management invites certain activities tobid for their resources as if they were starting from scratch (or from a zero base) instead ofadopting the normal incremental approach to annual budgeting. This tool can only beadopted in areas of discretionary expenditure where management must decide the level ofexpenditure that is appropriate for the business at the current time; with engineered costs,however, the sole criterion of level of spend is the production output required. ZBB involvesthe analysis of an activity such as R&D or legal services or machine maintenance intopackages of work which can be separated from each other, starting with the mostfundamental activity and building up to the activity which, were the resources to be madeavailable, it would be beneficial to undertake. These packages of discrete activities arecosted and, when placed alongside packages from other discretionary activities, ranked inorder of top management priority. Top management must take a view on whether anotherfully qualified recruit to legal services, to handle the growing problem of intellectual propertyrights, is more desirable for the company in its current position than another maintenanceengineer the addition of whom to the staff of the maintenance department would provide 24-hour cover and thereby prevent costly breakdown of machines on the night shift. Thesedecisions are extremely difficult but the secret of ZBB is that the decisions are made by topmanagement and not by budget holders whose vested interests are inextricably bound upwith their budget proposals. ZBB also requires corporate functions to identify minimum levelsof expenditure below which their activities cannot really operate. New requests for increasedspending must be given a priority against existing commitments.

Good budgeting procedures shorten the lead time between starting the budgeting exerciseand the beginning of the budget period, receive the full backing of top management, andengender a feeling of ownership of the budget numbers among the managers who helped toconstruct them.

13. Standard Costing


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There can be no better benchmark to judge actual performance than the plan, i.e. the budget,for the period. Management needs detailed costs and revenues of individual components ofthe business so that corrective action can be taken at the source of the problem. Standardcosts are used for this control process. Standard costs are budgeted costs for individual costitems. Put another way, a budget is built up from many standard costs. Standard costs arecompared with actual costs and explanations are sought for any differences between the two.

The standards for both variable and fixed overhead depend on three components:

the budgeted cost of each overhead; the allocation key to be used to allocate overhead to product; and the volume expected of each allocation key to be used.

Variable overhead efficiency variance = (Standard cost of budgeted time for unitsproduced) (Standard cost of actual time taken for units produced)

Variable overhead spending variance = (Standard cost of time taken) (Actual costsincurred)

Fixed overhead spending variance = (Budgeted fixed overhead) (Actual fixed overheads)

Fixed overhead denominator variance = (Budgeted fixed overheads) (Overhead applied

tounits produced)Material costs can be more (or less) than standard for only two reasons:

actual production used more (or less) material than planned, and/or the price to purchase the material was more (or less) than planned.

Material and labour variances can be split into price (or rate) variances and quantity(efficiency) variances; variable overhead variances comprise spending and efficiency whilefixed overhead variances can be divided into spending and denominator variances. Thecalculation of variances represents only one step in variance analysis; seeking explanationfor these variances and taking necessary remedial action is the more important function. Only

the most significant variances should be investigated.Material efficiency variance = (Standard quantity Actual quantity) x (Standard price perunit)Material price variance = (Standard price per unit Actual price per unit) x (Actual quantityused)

An adverse variance is one where actual cost is above standard cost; a favourable varianceis one where actual cost is less than standard cost.

Labour cost variances are caused by a combination of the same two reasons:

actual production requiring more (or less) time than planned; and/or the labour rates actually paid were more (or less) than planned.

Labour efficiency variance = (Standard time allowed Actual time taken) (Standard rateper hour)

Labour rate variance = (Standard rate per hour Actual rate per hour) (Actual time taken)

Management needs clear, relevant and up-to-date information to control ongoing operations.Variances from budget, in principle, should be of interest to managers; through exceptionreporting they can learn immediately where there may be problems and take remedialaction.The sales quantity variance describes the difference between budgeted and actual numbersof units sold. Sales variance analysis enables the manager to gain detailed insight into totalcontribution earned from sales and depending on contribution per unit and volume.

Sales contribution variance = (Actual contribution margin per unit Budgeted contributionmargin per unit) Actual sales in units

Sales volume variance = (Actual sales in units Budgeted sales in units) Budgetedcontribution margin per unitSales quantity variance = (Actual sales in units Budgeted sales in units) Budgeted


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indicator such as ROI or RI. Instead they design a matrix of measures which focus on quality,speed of response, customer satisfaction and employee contentment.

Criteria for establishing a transfer price:

Market prices: Market pricing is by far the best method for transferring goods andservices between divisions because it can be objectively tested by both parties to the deal. Cost-based prices: Full costs: When full costs are used, the selling division would calculate the transferprice using variable costs plus a proportion of fixed costs, using the normal absorptionformula of the division. Variable costs: From a company point of view the use of variable costs in transferprices overcomes the shortcomings of using full costs but its use leaves Division A neither upnor down on the deal and it must sit back and watch Division B making all the profit on theultimate sale. Why should Division A be penalised in this way, particularly if there is a buoyantmarket for its goods? At the least, they would argue, let us cover our fixed costs by using fullcosts. Negotiated costs: The term negotiated costs is a delightful euphemism for amanagerial punch-up. Behind the need for negotiation lies the reality that market price and

cost-based prices have not worked and top management has instructed the two managers topropose a solution which will not harm the company. Such a dual pricing procedure cannot beadopted for a lengthy period of time otherwise the motivation of both divisions, and theirconfidence in the system, will deteriorate.

Determining a transfer price which (a) motivates divisional managers, (b) permits anevaluation of their divisions and (c) leaves them to run their own show as autonomousemployees is extremely difficult.

A company very often feels obliged to minimise the amount oftax it pays on profits. This hasa number of beneficial effects including reducing cash outflows and boosting earnings pershare. If transfer pricing can be so geared that the ultimate profit emerges in a tax regimewith low rates on corporate profits, the overall tax bill is reduced. Second is the issue ofrepatriation of profits. Clearly it would be futile for the company in the illustration above to

allow its profits to emerge in a tax regime with low rates on corporate taxes if thatgovernment refused to allow the company to repatriate the funds by way of cash transfer ofdividends. In such a situation transfer prices could be adjusted so that the division located inthe restricting country is asked to pay high transfer prices. In this way the cash emerges fromthe country by way of transfer prices rather than dividends which could be blocked.

15. Investment Decisions

An investment decision is defined as one whose impact extends beyond the immediateoperating period, i.e. the business year. A decision which has its impact within the operatingperiod is defined as an operating decision. In accounting, these terms, particularly forfinancial reporting, have become synonymous with capital and revenue. In reality, there is

often no clear distinction between the two. Investment decisions always require forecastsabout the future explicit or implicit and future profits are directly related to the success orotherwise of investment decisions.

The investment process involves three quite distinct, albeit related, processes:

Search: There is very little that accounting by itself has to offer on the identifying orfinding of suitable investment opportunities. This is a separate managerial function and willarise out of the normal managerial processes through perhaps those specifically employedfor that purpose. Evaluation: The broad framework will be the organisations strategic plan of where itis, what are its strengths and weaknesses and where it wants to go. Such a plan formal orotherwise will take into consideration environmental and industrial factors, medium- andlong-term assessments and financial and operating objectives. This will form the general

background against which investments will be judged. In addition potential investments will bejudged against some other more specific yardstick of which, in all organisations, profit and/or


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cost will be important components. In judging the impact of an investment decision on profitand/or cost the most important concept that is used is that ofpresent value. Control: Once an investment has been undertaken, the financial control of it willfollow the normal budgetary control procedures.

Present value is the sum which would have to be invested today to amount to a given sum at

a rate of interest over a given time period. If n is the numbers of years and i the rate ofinterest then any sum invested for n years at i per cent will amount to that sum multiplied by(1 + i)n ; the result is referred to as the future value. We can use the reciprocal of theequation, i.e. x/(1 + i)n. This concept of present value, that is, the value today of a sumreceivable or payable sometime in the future at a given rate of interest, is one of the mostimportant concepts in all financial calculations which involve different sums over different timeperiods. It forms the basis of what is popularly known as the discounted cash flow approachto the evaluation of investment opportunities. Discounted cash flow means that when weare dealing with an investment that extends over different time periods we discount the cashflows arising out of the investment down to a present or equivalent value so that we cancalculate the profitability and/or cost of it. There are two main techniques which incorporatethis principle:

Net present value (NPV; sometimes called excess present value or simply presentvalue): The net present value approach takes all the cash flows associated with a project andreduces (discounts) them to a common denominator (present value) by using an appropriateinterest rate (sometimes called the cost of capital or the cost of finance). If when all thepresent values have been added together the resultant total is positive, i.e. there is a positivenet present value, then the project is worth undertaking in that it is profitable and has a returnwhich is greater than the interest rate (cost of capital) applied. Discounted cash flow (DCF) rate of return (sometimes called the internal rate ofreturn (IRR) or simply the rate of return): Instead of discounting by the cost of capital we findthe interest rate which reduces all these cash flows to zero, that is, the interest rate (rate ofreturn) at which the project will exactly break even. The calculation of the internal rate ofreturn (DCF yield) is easily done using a trial and error approach based in the knowledge that

the correct rate of return will give a net present (discounted) value of zero.

Both NPV and DCF rate of return are based on the discounted cash flow principle and bothgive a measure of profitability which takes into consideration the time factor and the need toallow for the recovery of the capital investment over the lifetime of the project.Investment appraisal in non-revenue and not-for-profit situations still can use the conceptof NPV to support the reaching of a decision. In this case the NPV is used to comparedifferent options only regarding cost, no cash inflows are expected.

Methods to deal with risk in investment decisions are:

Do not deal with risks in a quantitative way. The investment estimates are simplydeveloped using the most realistic estimate under the circumstances and the evaluation isperformed using the discounted cash flow approach. Apply a high hurdle test, e.g. projects that are regarded to be a high risk projecthave to pass a higher targeted rate of return for approval. The problem with this approach isthat the risk of individual components of the project is not broken out. Payback period isanother example of a high-hurdle test.

The margin of safety is the amount by which a project can deviate from the targetedestimates before a profit is turned into a loss.

The payback period is the time it takes to recover the original investment. The paybackperiod has to be calculated using the properly discounted cash-flows in order to adjust for thetime value of money. The weaknesses of using payback period for investment decisions are:

that it is implied in the assessment of risk that there is a standard payback period

against which the forecast is compared. Although a company might set it (e.g. 5.0 years forlow risk projects, 2.5 years for high risk projects), there is no external reference for guidance.


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payback looks at the break-even position and ignores the profit that will be generatedafter break-even.

Sensitivity analysis is not an evaluation technique, nor does it enter directly into theevaluation calculation. Rather it is a further analysis which is an aid to management in theexercise of judgement. In its simplest and often most useful form, sensitivity analysis consists

of changing the value quantity or price of a key variable to assess the impact which thishas on the final result. While sensitivity analysis is a useful device for highlighting the impactof a change in the forecast value of a variable, it does not give, nor build into the evaluation,any indication of the likelihood of such a variation taking place. Profitability may be highlysensitive to variations in the cost of capital but the probability of a change in this variable maybe very small. The consideration of this probability of change comes under what is called riskanalysis.

Risk analysis is about taking this idea of a range of likely values and applying themathematical techniques of probability analysis to it in order to give a better feel for theriskiness of a project. In the strict mathematical sense, probability, that is, predicting thelikelihood or chance of an event, can only be used if there is a history of the event havingtaken place in identical circumstances on many occasions, or there is the ability to repeat theevent on many occasions in identical circumstances such as throwing dice or tossing a coin.When we look at business decisions we can appreciate that there can be no repetition ofsimilar events in identical circumstances. To make this clear we talk about subjectiveprobability.

Investment appraisal techniques highlight the key investment factors which are central tothe profitability of an investment:

1. Capital investment: The cash flows will consist of the total fixed and working capitalthat will be required for the specific project. As far as the amount is concerned it is importantthat not only the cash outflows associated with the project are included such as the cost ofnew buildings, plant and equipment, but also the inflows which they may generate.

2. Operating cash flows: These will arise out of the inflows from sales and the outflowsfrom operating expenses. The emphasis is on the word cash because non-cash expenses

such as depreciation which are essentially accounting book entries have no part to play inthese calculations. Investment appraisal looks at the profitability of a project over its lifetime,not at the allocation of part of this profit to specific time periods such as the accounting year.It is only concerned with the number of years over which the project is to be evaluated, i.e.the investment life. An important factor affecting cash flows is taxation. This will often reducecash flows, where profits are being made, but equally can often increase cash flows if taxrefunds/incentives are available in any particular period.3. Investment life: Most assets have a finite life and will eventually have to be scrappedor otherwise disposed of. The determinants of this life may be physical, technical or market-related.4. Cost of capital: The cost of capital is a key factor in assessing the profitability of aproject and enters the calculations either directly as with the net present value or indirectly asa comparison between the expected return and the DCF rate of return.

In projecting the average cost of capital, an organisation is regarded as having a centralpool or fund of resources from which all projects are financed. The major sources of long-term finance can be classified under the following headings:

1. Fixed interest loans such as debentures: The cost of these to the business will bethe rate of interest it has to pay on the loans plus an allowance for the cost of raising(servicing) the loan less taxation.

2. Fixed interest (dividend) shares such as preference shares : The cost of these willagain be the net interest (or dividend) plus an allowance for the cost of raising it.

3. Residual equity shares: For example a new issue of ordinary shares, rights issuesand other non-free issues of ordinary shares. Such sources of finance, unlike the othersmentioned above, do not have any predetermined rate of interest or dividend attached tothem. It seems reasonable to assume that, if a new issue of share capital is being made, then


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the lowest return which will be expected will be one equal to what is being earned at present.The overall earnings per share should not be diluted; thus the company should at leastmaintain its present value.

4. Retained earnings (profits): The same principle is required when we consider thecost of funds which the business has generated internally through not distributing all theprofits it earns. While a dividend does not have to be paid on these, if the relative value of the

shareholders interest in the business has to be maintained, these funds should earn at leastthe same as the existing investment.

The investment appraisal techniques at which we have been looking take into considerationthe time value of money. This concept of a time value is independent of, and separate from,the question of if, and by how much, the real value (purchasing power) of money changesover time because of inflation (or deflation). If we wish to build an allowance into ourcalculations for this then it must be done quite specifically.

16. Techniques under Development in Management Accounting

Critics of current management accounting spell out its perceived shortcomings in the light of

the high-technology environment of modern business:

1. Management accounting procedures are still being driven by the requirements offinancial accounting with its emphasis on profit measurement and therefore on inventoryvaluation.2. Direct labour as a percentage of total product cost is shrinking, yet despite this, directlabour remains a popular method of overhead allocation, leading, predictably, to allocationpercentages running into three figures.3. Computerised production control, robotic production lines and other technologicaldevelopments have rendered obsolete some of the traditional assumptions about which costsare variable and which are fixed.4. As well-managed companies see the potential for differentiating themselves on thebasis of quality, customised design and speed of order processing and delivery, a sensibleexpansion of overheads in these activities is to be encouraged whereas most businessesregard overhead as a burden to be squeezed out from the cost profile as far as possible.5. The sheer complexity of business has increased exponentially.6. Global markets accentuate the product difficulties identified above. Competition onprice is intense and the demand for a management accounting system to identify accurateproduct costs becomes more pressing. A cost system based on inventory valuation andfinancial accounting may not deliver to managers the numbers that will allow the business tosharpen its competitive edge.

Target costing has been developed to help companies manage their costs in circumstanceswhen the selling price is known. Equally for an innovator who plans to be the first to market,the target price is set on the basis of the customers perceived value for the product or

service and an informed assessment of how much the competition will charge when theycatch up. Once the target price is known, the desired profit margin can be deducted in orderto determine the target cost beyond which the company would consider it uneconomic toproduce and sell

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Accounting Notes ALL @ MBA