Management Accounting

MBA504
Accounting & Financial Management

FACULTY OF BUSINESS
Study Guide/Readings
201260
*MBA504*
Accounting & Financial Management

MBA504 Study Guide/Readings
Faculty of Business
Written and compiled by

Associate Professor John Williams
Produced by Division of Learning and Teaching Services, Charles Sturt University, Albury Bathurst - Wagga Wagga, New South Wales, Australia.
First published
Revised
Reprinted
Revised
November 2004
August 2005
April 2006, July 2006, April 2007, August 2007
April 2008, July 2008, April 2009, July 2009, May 2010, September 2010,
May 2011, September 2011, May 2012
Printed at Charles Sturt University

Charles Sturt University
Previously published material in this book is copied on behalf of Charles Sturt University pursuant
to Part VB of the Commonwealth Copyright Act 1968.
ii
Contents
Page
Introduction
vii
Topic 1
An introduction to financial accounting
Topic 2
The nature and objectives of financial accounting: Basic

financial statements
1
Topic 3
Analysis and interpretation of accounting reports
Topic 4
Managing working capital - cash and inventory
Topic 5
Internal control and cash
Topic 6
Social and environmental accounting
Topic 7
Introduction to management accounting
Topic 8
Cost-volume-profit analysis
Topic 9
Relevant information and special decisions
Topic 10 Budgeting master budget and flexible budgets
31
27
Topic 11 Capital budgeting
Readings
All these readings except 5.1 are located on CDROM#1. A hard copy of reading
5.1 is provided in your Study Guide.
1.1
Drucker, P. F. (2001).
Be data literate-know what to know.
1.2
Sheckley, R. (1988).
The accountant.
1.3
Perry, C. (1996).
One of the oldest professions?
1.4
Pacioli, L. (1966 reprint).

Double entry book-keeping
iii
iv
1.5
Mann, G. (1994).
The origins of double-entry.
1.6
Weis, W., & Tinius, D. (1992).

Luca Pacioli: Renaissance accountant.
1.7
Chatfield, M. (1977).
Accounting in the ancient world.
1.8
Integrate Excel into Word.
2.1
O'Leary, T. J., & O'Leary, L. I. (2011).

Creating and editing a worksheet
2.2
OLeary T. J., & OLeary, L. I. (2008).

Charting worksheet data.
2.3
Mautz, R. K., & Sharaf, H. A. (1978).

Ethical conduct - an excellent summary including the ideas of
philosophers.
2.4
Northcott, P. H. (1993).
Case 4, Cheating: The pressure on Pasquale Vialletta to succeed.
2.5
Northcott, P. H. (1993).
Ethics and the certified practicing accountant: Case studies Presenters notes.
3.1
Brewer, P. C., Garrison, R. H., & Noreen, E. W. (1995).

How well am I doing?: Financial statement analysis.
3.2
Crossman, J., Bordia, S., & Mills, C. (2011).

Communicating in writing.
3.3
Davies, M. R., Kries, K. E., Nutting, J. B., & Tronc, K. E. (1985).

Business reports - a classic chapter. Consider exchanging web
references on this topic.
3.4
Windschuttle, K., &Windschuttle, E. (1989).

Rational debate and common fallacies - further material will be
distributed at the workshop.
3.5
Downes, S. (1999).
Stephens guide to the logical fallacies
3.6
(1999).
False dilemma
3.7
Wikipedia (2008).
Digital dashboard.
5.1
Horngren, C. T., Harrison, W. T., & Oliver, M. S. (2012).

Internal control and cash. (Not on CD; Hard copy in Study Guide)
6.1
Deegan, C. (2009).
Extended systems of accounting the incorporation of social and
environmental factors within external reporting.
6.2
Ravlic, T. (2004).
Mung bean counters.
9.1
Macintosh, N., & Quattrone, P. (2010).

Management accounting and control systems: An organizational and
sociological approach
This is a very comprehensive reading list! And you are expected, in some areas,
to have current knowledge from the Internet and other sources.
But you have choice. See the Subject Outline and sample exam for assessment
guidelines including the choice of topics available to you in the final examination.
We have provided these readings to you in PDF format. This means you can load
them onto your netbook or iPad.
vi
Introduction
General comments
As stated in the Subject Outline the textbook does not cover the full range of
topics to be studied. It is for this reason that in the Study Guide some topics are
more detailed and refer to relevant Readings.
The commentaries provided in this Study Guide are intended to act as a guide in
directing your attention to concepts, definitions, fundamentals etc. basic to the
topic of study. These are in no way a substitute for the intensive study and
individual summaries that you will prepare for each topic.
At the beginning of each chapter of the textbook, is a list of Learning Objectives.
This list should guide your study as well as act as a means of self assessment. For
those topics that are not included in the textbook, there are a list of objectives
included in this Study Guide.
vii
Spreadsheet advice
The images and text below provide general advice on the spreadsheet component
of assignments in this subject.
Assignment checklist for spreadsheets? Paste two versions in your document;
paste normal views and formula views; show row and column headings; keep data
and report areas completely separate; save all spreadsheets in one workbook; use
IF functions where appropriate and create correct solutions that can be easily
replicated.
The assignment spreadsheet questions have particular requirements which are
demonstrated in the examples that follow. Also read the assignment requirements
in the Subject Outline very carefully. You can use any spreadsheet software as
long as we can read it with Microsoft Excel. Some of you will use Excel 2003
(sometimes called Excel XP), some will use Excel 2007 and some will use Excel
2010. Open Office http://www.openoffice.org/ works well and has the advantage
of being free! Any Excel version is ok but in later versions of Excel it is not
always so easy to paste spreadsheets into a Word doc showing row and column
headings an assignment requirement. In the past students have had a variety of
experiences with this feature. But a separate and free program, snippy.exe works
all the time.
Note that Snippy allows you to copy and paste a freehand or rectangle shape.
http://www.bhelpuri.net/Snippy/
Another simple program is Plixia.
http://download.cnet.com/Plixia/3000-13455_4-10910988.html
If you come across other freeware that does the same job share your discovery on
the forum.
Use any copy and paste technique/software you wish as long as it works.
You can also use ALT PrintScreen to capture and paste. But this method grabs the
spreadsheet menu as well which takes up space. One improvement minimise
viii
the menu before capture. And consider adjusting the size of the window so you
only capture the part of the screen that is relevant.
Students using Mac computer can achieve the same results.
Here is some advice from Natalie who uses Mac.
Oh Hallelujah!!!! I FINALLY figured it out!! Douglas, you put me on the right
track but there's a few wee differences in 2011...
If anyone else is having trouble with Excel 2011 here it is...........
Select the area you wish to copy. Press [control] + [p] Chose print selected area
at the bottom of the screen click on page setup in here you will find a box which
says row and column headings. Make sure this is ticked and then select ok
then select preview. Your spreadsheet will be displayed ready to print. Now you
can select the image and copy and paste into your word document...
I'm on the 29th floor and i swear, my Mac nearly made it to ground level the fast
way this afternoon!!!!
Hurrah.
For PC users.
How to paste a spreadsheet showing row and column headings in Excel 2007 and
Excel 2010.
i)
Highlight the print area, on the PAGE LAYOUT menu, set the PRINT
AREA, and tick the boxes for HEADINGS
ii)
on the HOME menu bar select PASTE, AS PICTURE, COPY AS

PICTURE, AS SHOWN AS PRINTED
iii)
Go to your Word doc and then use Ctrl + V to paste the image into your
document
If we share spreadsheet examples on the forum its a good idea to use the Excel
2003 format. That is, save your files as xls files. Then everyone should be able to
open them irrespective of the version they use.
See examples and advice following. Not every example is directly relevant to your
assignments. But some might make your work easier. If you have questions
please raise them on the forum. Remember there is also lots of advice available on
the Internet just Google your question.
And share your discoveries (and questions) on the forum.
ix
The message? Save all your spreadsheets in one workbook as shown

above. Note the tabs at the bottom of the screen shot.
The following example is copied and pasted as a picture. The row and columns
box was first ticked in Page Setup in Excel. This works fine in Excel 2003 and
works sometimes (?) in Excel 2007. Discussion on the subject forum is good.
Budget
1
2
3
Data Input
The sales budget for the nine months ended September 30 follows
Quarter Ended
Mar-31
Jun-30
Sep-30
Cash sales
20% $
20,000 $
49,000 $
29,000
8 Credit sales
80% $
87,000 $ 102,000 $
76,000
9 Total sales
100% $ 107,000 $ 151,000 $ 105,000
4
5
6
7
Nine-month
Total
$
98,000
$ 265,000
$ 363,000
10
11
In the past, the cost of goods sold has always been

70%
of total sales.
The director of marketing, the production manager, and the vice-president agree that
ending inventory should not go below
$
25,000
plus
30%
14 of cost of goods sold for the following quarter. Expected sales are
$ 120,000
15 during the fourth quarter. January 1 inventory was
$
19,000
12
13
16
17
18
19
20
21
22
23
24
25
Required:
Prepare a budget showing purchases, cost of goods sold and inventory for the nine
months ended 30 September. See template below.
Solution/Report
Cost of goods sold

Desired ending inventory
26
27
28
Beginning inventory
Purchases
$
$
$
$
$
Mar-31
74,900
56,710
131,610
19,000
112,610
Quarter Ended
Jun-30
$ 105,700
$
47,050
$ 152,750
$
56,710
$
96,040
$
$
$
$
$
Sep-30
73,500
50,200
123,700
47,050
76,650
Nine-month
Total
$ 254,100
29
xi
The formula view is gained by toggling the Control + ` key combination (check
Excel Help: Formula View). This is the (grve) key below the ~ (tilde) key on the
top left of your keyboard.
Its an error to
A
Data Input
4
5
6
7
The sales budg
Cash sales
Credit sales
9 Total sales
8
11383
0.2
20000
0.8
87000
=SUM(B7:B8) =SUM(C7:C8)
Quarter Ended
11110
11202
49000
29000
102000
76000
=SUM(D7:D8)
=SUM(E7:E8)
10
11
0.7
In the past, the

The director of
ending invento
14 of cost of good
15 during the fourt
12
13
16
17
18
19
20
21
22
23
24
25
28
25000
Nine-month
Total
=SUM(C7:E7)
=SUM(C8:E8)
=SUM(F7:F8)
of total sales.
plus
0.3
120000
19000
Required:
Prepare a budg
months ended
Solution/Repo
Cost of goods s
Desired ending
26
27
Budget
1
2
Beginning inve
Purchases
=+C5
=+C6
=+E11*C9
=+D13+F13*D24
=SUM(C24:C25)
=+E15
=+C26-C27
=+D6
=+E11*D9
=+D13+F13*E24
=SUM(D24:D25)
=+C25
=+D26-D27
=+F5
=+E6
=+F6
=+E11*E9
=SUM(C24:E24)
=+D13+(F13*E11*F14)
=SUM(E24:E25)
=+D25
=+E26-E27
29
In the formula view it is the formulas themselves that are important so column
widths can be adjusted and text can be truncated as is done here with several
columns.
And we prefer portrait orientation rather than landscape wherever possible.
xii
Or the spreadsheet can be pasted as a screen capture. Use Alt PrtSC (printscreen)
(or free software such as Snippy.exe http://download.cnet.com/Snippy/300013455_4-10910988.html
Capture and paste the rectangular area you need. If needed, take several snapshots.
For example - one snapshot of the data entry area and another of the report area.
Snippy.exe is free and works all the time! Here is an example using Alt
Printscreen. Notice it captures the menu.
BTW its not good presentation to capture and paste a lot of empty cells.
A question may require a graph or chart. See the following example created using
the Excel chart wizard.
xiii
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
xiv
C-V-P Analysis
Data Section:
Production costs:
Direct materials
Direct labour
Factory overhead
Selling expenses:
Sales commissions
Advertising
Miscellaneous selling expense
General expenses:
Office supplies
Administrative salaries
Miscellaneous general expense
Fixed
180,000
Selling price per unit
Variable
4.00
5.00
2.00
78,000
142,000
17,000
0.75
55,000
76,000
12,000
$560,000
0.25
$12.00
$40.00
Target net income
$112,000
Solution
Contribution margin per unit
Contribution margin ratio
Unit sales at break-even point
Dollar sales at break-even point
Unit sales needed to meet target net income
Dollar sales needed to meet target net income
Margin of Safety in dollars
Data for Graph
Units
Sales
10,000
400,000
20,000
800,000
30,000
1,200,000
40,000
1,600,000
Variable Cost
120,000
240,000
360,000
480,000
Fixed Cost
560,000
560,000
560,000
560,000
560,000
$28.00
70.00%
20,000
800,000
24,000
960,000
160,000
Total Cost
560,000
680,000
800,000
920,000
1,040,000
CVP Graph
1,800,000
1,600,000
1,400,000
1,200,000
Dollars
Sales
Variable Cost
1,000,000
Fixed Cost
Total Cost
800,000
600,000
400,000
200,000
0
-
10,000
20,000
Units
30,000
40,000
Same spreadsheet on the next page but captured and pasted in two sections with
Snippy.
xv
xvi
A
1
Income Statement and Balance Sheet
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
Bell Petroleum
Data
Cash & equivalents
Revenues
Notes payable
Long term debt, excluding current portion
Accounts receivable, net
Estimated income tax expense
Other long-term assets
Interest expense
Deferred income tax liability
Retained earnings
Income taxes payable
Cost of sales
Inventories
Prepaid expenses
Common stock
Property plant & equipment, at cost
Accounts payable
Interest income
Goodwill, patents, trademarks
Current portion of long-term debt
Less: accumulated depreciation
Selling and administrative expenses
Additional paid-in capital
254,000
2,200,000
495,000
240,000
160,000
80,000
560,000
45,000
89,000
1,560,000
52,000
1,350,000
78,000
40,000
3,500,000
5,835,738
213,000
65,000
350,000
78,000
170,000
430,000
?
xvii
29
Report
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
Income Statement for the Year ended 31 December 20X0

Revenues
Cost of sales
Gross Profit
Income from operations
$
2,200,000
(1,350,000)
850,000
(430,000)
420,000
Other
Interest income
Interest expense
Total other expenses
65,000
(45,000)
20,000
Income before Tax

Income tax
Net Income
440,000
(80,000)
360,000
Balance Sheet as at 31 December 20X0
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
Current Assets
Cash & equivalents
Inventories
Prepaid expenses
Total Current Assets
Noncurrent Assets
Net book value
Total non-current assets
Total Assets
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
Liabilities and Shareholders Equity

Current Liabilities
Notes payable
Accounts payable
Total Current Liabilities
Non Current Liabilities
Total Noncurrent Liabilities
Shareholders Equity
Common stock
Retained earnings
Total shareholders equity
Total liabilities & shareholders equity
80
81
254,000
160,000
78,000
40,000
532,000
5,835,738
(170,000)
5,665,738
560,000
350,000
6,575,738
7,107,738
495,000
52,000
78,000
213,000
838,000
240,000
89,000
329,000
3,500,000
880,738
1,560,000
5,940,738
7,107,738
OK
Here is the formula view.

Note that there is NO data entered into the report section.
xviii
A
1
Income Statement and Balance Sheet
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
Bell Petroleum
Data
Cash & equivalents
Revenues
Notes payable
Estimated income tax expense
Interest expense
Retained earnings
Cost of sales
Inventories
Prepaid expenses
Common stock
Accounts payable
Interest income
254000
2200000
495000
240000
160000
80000
560000
45000
89000
1560000
52000
1350000
78000
40000
3500000
5835738
213000
65000
350000
78000
170000
430000
?
xix
29
Report
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
Income Statement for the Year ended 31 December 20X0
=+B6
=+B16
Gross Profit
=+B26
Income from operations
$
=C6
=-C16
=SUM(C32:C33)
=-C26
=SUM(C34:C35)
Other
=+B22
=+B12
Total other expenses
=C22
=-C12
=+C40+C39
Income before Tax

Income tax
=IF(C45>0,"Net Income","Net Loss")
=C36+C41
=-C10
=C43+C44
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
Current Assets
=+B5
=+B9
=+B17
=+B18
Total Current Assets
Noncurrent Assets
=+B20
=+B25
Net book value
=+B11
=+B23
Total non-current assets
Total Assets
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
Liabilities and Shareholders Equity

Current Liabilities
=+B7
=+B15
=+B24
=+B21
Total Current Liabilities
Non Current Liabilities
=+B8
=+B13
Total Noncurrent Liabilities
Shareholders Equity
=+B19
=+B14
Total shareholders equity
Total liabilities & shareholders equity
Balance Sheet as at 31 December 20X0
80
81
$
=C5
=C9
=C17
=C18
=SUM(C49:C52)
=C20
=-C25
=SUM(C55:C56)
=+C11
=C23
=+C57+C58+C59
=C60+C53
=C7
=C15
=C24
=C21
=SUM(C65:C68)
=C8
=+C13
=+C72+C71
=+C19
=+C78-C75-C77
=C14
=+C79-C73-C69
=+C61
=IF(C79=C61,"OK","ERROR")
Note the IF function in cell C80

A non accounting graph example follows for those interested in biorhythms.
xx
A
B
1 Biorhythm chart
2
19-May-71
3 birthday
02-Feb-08
4 date
5
offset
day
6
-15
13393
7
-14
13394
8
-13
13395
9
-12
13396
10
-11
13397
11
-10
13398
12
-9
13399
13
-8
13400
14
-7
13401
15
-6
13402
16
-5
13403
17
-4
13404
18
-3
13405
19
-2
13406
20
-1
13407
21
0
13408
22
1
13409
23
2
13410
24
3
13411
25
4
13412
26
5
13413
27
6
13414
28
7
13415
29
8
13416
30
9
13417
31
10
13418
32
11
13419
33
12
13420
34
13
13421
35
14
13422
36
15
13423
37
38
39
40
41
1.50
42
43
44
45
1.00
46
47
48
49
0.50
50
51
52
0.00
53
54
55
56
-0.50
57
58
59
60
-1.00
61
62
63
64
-1.50
65
19
66
67
68
date
19
26
16
physical
0.94
0.82
0.63
0.40
0.14
-0.14
-0.40
-0.63
-0.82
-0.94
-1.00
-0.98
-0.89
-0.73
-0.52
-0.27
0.00
0.27
0.52
0.73
0.89
0.98
1.00
0.94
0.82
0.63
0.40
0.14
-0.14
-0.40
-0.63
emotionalintellectual
0.90
-0.81
0.78
-0.69
0.62
-0.54
0.43
-0.37
0.22
-0.19
0.00
0.00
-0.22
0.19
-0.43
0.37
-0.62
0.54
-0.78
0.69
-0.90
0.81
-0.97
0.91
-1.00
0.97
-0.97
1.00
-0.90
0.99
-0.78
0.95
-0.62
0.87
-0.43
0.76
-0.22
0.62
0.00
0.46
0.22
0.28
0.43
0.10
0.62
-0.10
0.78
-0.28
0.90
-0.46
0.97
-0.62
1.00
-0.76
0.97
-0.87
0.90
-0.95
0.78
-0.99
0.62
-1.00
BIORHYTHM CHART
Physical
26
Intellectual
Emotional
2
16
Day of the Month
xxi
A
B
C
D
E
F
G
H
1
Unique Traders
2 Input Data
Year
20X2
3
rate of increase (%)
Sales units
30,000
8%
p.a. compound
4
Sales volume increase is to a maximum of
40,000
p.a. One product only
5
20X3
20X4
20X5
20X6
20X7
6 Purchase
$
5.10 $
5.36 $
5.68 $
6.02 $
6.50
7 cost per unit
Closing Inventory
15% of next year sales
8
Opening Inventory
3,600
Units
Value
$17,640
9
20X3
20X4
20X5
20X6
20X7
10
30%
30%
30%
35%
35%
11 Markup (%)
General and Administrative Expenses rate (%)
14%
of Sales
12
Tax Rate (%)
40%
Dividend Paid Rate (%)
65%
of after tax profits
13
O/B Retained Earnings
$
3,500
Assume FIFO cost flow
14
15 Required: Prepare budgeted income statement and statement of retained earnings for five years
16 Report
20X3
20X4
20X5
20X6
20X7
17 Sales Budget
Units
32,400
34,992
37,791
40,000
40,000
18
Unit Price
6.630
6.968
7.384
8.127
8.775
19
Sales $
214,812
243,824
279,049
325,080
351,000
20
20X3
20X4
20X5
20X6
20X7
21 Purchases Budget
Sales
32,400
34,992
37,791
40,000
40,000
22
Closing Inventory
5,249
5,669
6,000
6,000
6,000
23
Less:
24
Opening Inventory
3,600
5,249
5,669
6,000
6,000
25
Purchase units
34,049
35,412
38,122
40,000
40,000
26
Purchase $
173,650
189,808
216,533
240,800
260,000
27
Purchases
Unit Price
Sales
Balance
28 Inventory Budget
Year
Unit
Amount
29
20X2
4.90
3,600
17,640
30
20X3
34,049
5.10
32,400
5,249
26,770
31
20X4
35,412
5.36
34,992
5,669
30,386
32
20X5
38,122
5.68
37,791
6,000
34,080
33
20X6
40,000
6.02
40,000
6,000
36,120
34
20X7
40,000
6.50
40,000
6,000
39,000
35
20X3
20X4
20X5
20X6
20X7
36 Budgeted Income Statement
Sales
214,812
243,824
279,049
325,080
351,000
37
Less COGS
38
Opening Inventory
17,640
26,770
30,386
34,080
36,120
39
Purchases
173,650
189,808
216,533
240,800
260,000
40
Goods for Sale
191,290
216,578
246,919
274,880
296,120
41
Closing Inventory
26,770
30,386
34,080
36,120
39,000
42
COGS
164,520
186,192
212,839
238,760
257,120
43
Gross Profit
50,292
57,632
66,210
86,320
93,880
44
G & A Expenses
30,074
34,135
39,067
45,511
49,140
45
Net Income
20,218
23,496
27,143
40,809
44,740
46
Tax
8,087
9,399
10,857
16,324
17,896
47
16,286
24,485
26,844
Net Income after tax
12,131
14,098
48
20X3
20X4
20X5
20X6
20X7
49 Statement of Retained Earnings
Opening balance
3,500
7,746
12,680
18,380
26,950
50
Add Income after tax
12,131
14,098
16,286
24,485
26,844
51
15,631
21,844
28,966
42,865
53,794
52
Dividends
7,885
9,164
10,586
15,915
17,449
53
Closing balance
7,746
12,680
18,380
26,950
36,345
54
This budget example uses the IF and ROUND functions. In what cells, I wonder?
xxii
Variance Analysis - Materials and Labour
2
3
Data
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
The Mac Company produces raincoats. Data follows:

Units produced
Standard amounts per unit
Direct materials
Direct Labour
9,000
5 square metres @
3 hours @
Actual Data
Square metres purchased and used
Price per square metre
60,000
$6.70
$6.00 per metre

$9.00 per hour
Hours of input
Labour price per hour
24,000
$8.40
Solution/Report
Actual Quantity
x Actual Price
Direct
Material
60,000 X
$6.70
$402,000
Actual Quantity
x Standard Price
60,000
Standard Quantity
x Standard Price
$6.00
$360,000
Actual Quantity
x Actual Price
24,000 X
$201,600
$8.40
$6.00
-$90,000 Unfavourable
Actual Quantity
x Standard Price
24,000
$270,000
-$42,000 Unfavourable
Direct
Labour
9,000 X
Standard Quantity
x Standard Price
$9.00
9,000 X
$216,000
$14,400 Favourable
$9.00
$243,000
$27,000 Favourable
This example uses the IF function to show variances as Favourable or

Unfavourable or No Variance. The IF function is very useful. Look for
opportunities to use it.
On the next page is a spreadsheet pasted into word in landscape format. Wherever
possible use portrait format but sometimes landscape looks better and is easier
to read. BTW this spreadsheet uses the IF function in several places to display
net income or net loss, to check that the balances of columns are equal, to
calculate the net income (or net loss) and to correctly create figures in the adjusted
trial balance columns. The net income solution has subtle numerical significance.
What is the hidden significance?
Here are some of the IF functions. Can you work out what each is doing?
=IF(C20=B20,"OK","ERROR")
=IF(H50>-1,"Net Income","Net Loss")
=IF((B26-C26+D26-E26)<0,0,B26-C26+D26-E26)
=IF(I49>H49,I49-H49,0)
xxiii
xxiv
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
Account Titles
Trial Balance
Debit
Credit
8,000
6,000
500
2,000
8,000
5,500
3,000
18,258
400
13,742
2,500
600
700
800
$35,000
$35,000
OK
Net Income
Solution
Heaven Corporation - Worksheet for Month Ended March 31, 20XX
Trial Balance
Debit
Credit
Account Titles
Cash
8,000
Accounts Receivable
6,000
Office Supplies
500
Prepaid Rent
2,000
Computer Equipment
8,000
Office Furniture
5,500
Accounts Payable
3,000
Heaven, Capital
18,258
Heaven, Drawings
400
Service Revenue
13,742
Office Salary Expenses
2,500
Advertising Expense
600
Telephone Expense
700
Utilities Expense
800
$35,000
$35,000
OK
Office Supplies Expense
Rent Expense
Depreciation Expense - Computer Equipment
Accumulated Depreciation - Computer Equipment
Depreciation Expense - Office Furniture
Accumulated Depreciation - Office Furniture
Salaries Payable
Cash
Accounts Receivable
Office Supplies
Prepaid Rent
Computer Equipment
Office Furniture
Accounts Payable
Heaven, Capital
Heaven, Drawings
Service Revenue
Office Salary Expenses
Advertising Expense
Telephone Expense
Utilities Expense
Data
HEAVEN CORPORATION
$1,408
83
400
700
100
125
$1,408
OK
83
125
100
400
700
$35,308
83
400
700
100
$35,308
OK
83
125
100
Adjusted Trial Balance

Debit
Credit
8,000
6,000
100
1,300
8,000
5,500
3,000
18,258
400
13,742
2,625
600
700
800
Adjustments
A: Office supplies on hand
B: Prepaid Rent expired
C:1 Computer Equipment cost
Expected life
Residual value
C:2 Office Furniture cost
Expected Life
Residual value
D: Salaries owing but not yet paid
Adjustments
Debit
Credit
6,008
7,734
$13,742
83
400
700
100
2,625
600
700
800
$13,742
OK
13,742
13,742
Income Statement
Debit
Credit
100
700
8,000
5 years
2,000
5,500
5 years
500
125
$29,300
29,300
83
125
21,566
7,734
$29,300
OK
100
Balance Sheet
Debit
Credit
8,000
6,000
100
1,300
8,000
5,500
3,000
18,258
400
-
xxv
The following Job Cost example is a jigsaw puzzle style of problem where data is
missing and the solution must be reconstructed.
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
D E
Reconstructing accounts: forensic accounting - the case of Oscar Bese

DATA INPUT
O. Bese, the management accountant for a firm, kept efficient records to date in spite of a low
kilojoule diet necessitated by a weight problem. On the morning of 1 September 20X4, however, he went
berserk from hunger, and consumed the accounting records. He was overpowered and rushed to hospital.
Unfortunately his condition depreciated and he was written off at 4 p.m. An autopsy (with a qualified forensic
auditor - Elbert Hubbard CA CPA - in attendance) disclosed the following information:
Ledger balances:
Materials Control 31/8/X4
Work-in-Process 1/8/X4
Finished Goods 1/8/X4
Accounts Payable 1/8/X4
$
31,000
3,000
36,000
17,000
Overhead is allocated by using a predetermined rate that is set at the beginning of each year
by forecasting the year's overhead and using forecast direct labour hours as a cost driver
All factory workers receive the same rate of pay
An interview with the factory foreman revealed the following additional information:
1
2
3
4
5
6
7
8
9
10
11
12
Accounts Payable are for direct materials only. The balance on 31 August was
Payments for Accounts Payable made during August were
A stocktake after O. Bese's autopsy revealed only one unfinished job in the factory
Source documents showed that the one unfinished job had direct labour
The direct labour hours in the unfinished job was
The direct material in the unfinished job was
The finished goods inventory as at 31 August was
The budget for 20X4 called for total direct labour hours of
Budgeted factory overhead is
Jobs sold during August realised
Direct labour hours worked during August totalled
Finished jobs are priced at a percentage mark-up on manufacturing cost.
$9,000
$37,000
$2,000
800 hours
$4,000
$44,000
167,539 hours
$502,617
$180,000
18,800 hours
50%
Required:
The balance of Materials Control account at 1/8/X4.
REPORT/SOLUTION
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
xxvi
General Ledger showing only accounts essential to the solution.

Direct Materials Control
Work-in-Process
Finished Goods
Accounts Payable
Cost of Goods Sold
Some comments
Derive the solution by using the data to complete the jigsaw puzzle
Plug in all balances first
The ending balance of WIP is direct material + direct labour (both given) + direct labour hours X the overhead rate
The overhead rate is the budgeted overhead amount divided by the budgeted hours
The cost of goods sold is the total sales revenue divided by 1 + the mark-up %
WIP transferred to FG is a missing figure
DM in WIP is a missing figure
And the beginning balance of DM is a missing figure!
Here is an example of a manufacturing statement and an income statement. The

solution has subtle numerical significance.
1
Cost of Goods Manufactured Statement and Income Statement
Helen Reddy Corporation

Data Input area
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
For Specific Date
For Year 20X1

(in millions $)
Work in process, Jan 1, 20X1

Direct materials, Dec 31, 20X1
Finished goods, Dec 31, 20X1
Accounts payable, Dec 31, 20X1
Accounts receivable, Jan 1, 20X1
Work in process, Dec 31, 20X1
Finished goods, Jan 1, 20X1
Accounts receivable, Dec 31, 20X1
Accounts payable, Jan 1, 20X1
Direct materials, Jan 1, 20X1
10
4
9
16
32
6
26
39
24
21
(in millions $)
Plant utilities
Indirect manufacturing labour
Depreciation - plant, building & equip
Revenues
Misc. manufacturing overhead
Marketing, Distribution, Customer-Service Costs
Direct materials purchased
Direct manufacturing labour
Plant supplies used
Property taxes on plant
7
23
8
667
11
88
64
75
5
3
Required: Cost of goods manufactured statement and income statement
Report/Solution
Helen Reddy Corporation
Schedule of Cost of Goods Manufactured
For the Year Ended December 31, 20X1 (in millions $)
Direct materials:
Beginning inventory, Jan 1, 20X1
Purchase of direct materials
Cost of Goods available for sale
Ending inventory, Dec 31, 20X1
Direct materials used
21
64
85
4
81
Direct labour
Indirect manufacturing costs:
Plant utilities
Indirect labour
Depreciation - plant, building & equip
Misc. manufacturing overhead
Plant supplies used
Property taxes on plant
Indirect manufacturing costs total
Total manufacturing costs, 20X1
Add beginning work in process, Jan 1, 20X1
Total manufacturing costs to account for:
Deduct ending work in process, Dec 31, 20X1
Cost of Goods Manufactured, 20X1
75
7
23
8
11
5
3
57
213
10
223
6
217
Income Statement
For the Year Ended December 31, 20X1 (in millions $)
Revenues
Cost of Goods Sold
Beginning Finished Goods, Jan 1, 20X1
26
Cost of Goods Manufactured, 20X1
217
Ending Finished Goods, Dec 31, 20X1
9
Total Cost of Goods Sold
Gross Margin
Marketing, Distribution, Customer-Service Costs
Operating Income
667
234
433
88
345
xxvii
This example shows how a spreadsheet can be used to create multiple choice questions.
A
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
Management Accounting - Multiple Choice Questions

Questions
1 Cost of Goods Manufactured
The Hieronymous Bosch Company had the following account balances
Direct materials inventory

Work in process inventory
Finished goods inventory
Purchases of direct materials
Direct labour
Indirect labour
Factory insurance
Depreciation - factory equipment
Repairs - factory
Marketing expenses
General & administrative expenses
End of
20X2
22,000
21,000
18,000
End of
20X3
26,000
20,000
23,000
75,000
25,000
15,000
9,000
11,000
4,000
93,000
29,000
Workings
22,000
75,000
97,000
26,000
71,000
25,000
15,000
9,000
11,000
4,000
What is the cost of goods manufactured?

COGM
39,000
135,000
21,000
156,000
20,000
136,000
A $
135,000
B $
136,000
C $
258,000
D $
71,000
E None of the above
2 Cost of Goods Manufactured
The Michael Connelly Company had the following account balances
Direct materials inventory

Work in process inventory
Finished goods inventory
Purchases of direct materials
Direct labour
Indirect labour
Factory insurance
Depreciation - factory equipment
Repairs - factory
Marketing expenses
General & administrative expenses
End of
20X2
123,456
245,678
23,456
End of
20X3
145,321
345,697
22,134
782,345
567,900
23,654
23,567
98,768
6,754
45,678
36,879
123,456
782,345
905,801
145,321
760,480
567,900
23,654
23,567
98,768
6,754
What is the cost of goods manufactured?

COGM
A $ 1,481,123
B $
760,480
C $ 1,463,661
D $ 1,381,104
E None of the above
Creating well structured spreadsheets is a bit like Lego for adults.

We are looking forward to seeing your creative efforts.
xxviii
152,743
1,481,123
245,678
1,726,801
345,697
1,381,104
Faculty of Business, School of Accounting & Finance

Sample Examination
MB A504
AC C OUNT ING & F INANC IAL MANAG E ME NT
Question Paper MAY NOT be retained by the Candidate

WRITING DURING READING TIME IS PERMITTED ON ALL EXAMINATION
MATERIALS
LECTURER:
John Williams (Wagga Wagga)
WRITING TIME:
3 hours 10 minutes
MATERIALS SUPPLIED BY UNIVERSITY:
1 x 12 page examination answer

booklet
General Purpose Answer Sheet
MATERIALS PERMITTED IN EXAMINATION:
Battery/Solar Calculator (no

printer, non programmable
2B Pencil/Eraser
NUMBER OF QUESTIONS:
Part A: 60 Multiple Choice

Part B: 5 Questions
VALUE:
70%
INSTRUCTIONS TO CANDIDATES:
1.
Enter your name and student number and sign in the space provided at the
bottom of this page. Also enter your name and student number (in pencil)
on the General Purpose Answer Sheet. Shade in the appropriate circles.
2.
No written material, reference books or notes will be permitted into the

examination room.
3.
Part A: Sixty (60) multiple choice questions worth 60 marks.

Part B: Five (5) questions of which two (2) questions are to be attempted
worth 40 marks.
4.
Write your answers to Part A on the answer sheet provided. Write your
answers to Part B in the booklet provided. Students must provide a
signature on the front of each booklet used.
5.
Balance your time appropriately between Part A and Part B.
STUDENT NAME: ... STUDENT NUMBER: ..

STUDENT SIGNATURE:
Calculator model (if used):
xxix
More example Multiple choice questions are available in

the Study Guide and on the textbook website.
1.
Luca Pacioli was important to accounting because:

A.
B.
C.
D.
E.
2.
Honey Sweet Goods is planning to sell 4,500 layer cakes for $8 each and
9,000 pound cakes for $7 each. The production process is such that the
produces the products in this proportion automatically. Variable costs are $5
per unit for the layer cakes and $4 per unit for the pound cakes. Fixed costs
are $45,000. At the break-even point, how many cakes will have been sold?
A.
B.
C.
D.
E.
3.
a 7,000 unit decrease

a 9,000 unit decrease
a 7,000 unit increase
a 9,000 unit increase
none of the above.
Mom's Nursery sells garden shears for $7.00 each. Variable costs are 68% of
sales and the break-even point is $243,750. What are total fixed costs?
A.
B.
C.
D.
E.
xxx
4,000 layer cakes and 8,000 pound cakes

none of the above.
Warrior Inc is considering an investment in a labour-saving machine that

would initially increase fixed costs by $8,000 per year. Variable cost per
lamp would decrease from $15 to $10. The lamps sell for $18 each, and
fixed costs presently total $48,000. If the investment is made, the breakeven
point in units will show:
A.
B.
C.
D.
E.
4.
he was born in Parmalat

he said, 'The typical accountant is a man past middle age, spare,
wrinkled, intelligent, cold, passive, non-committal, with eyes like a
codfish; polite in contact but at the same time unresponsive, calm and
damnably composed as a concrete post or a plaster of Paris cast,' a
petrification with heart of felspar and without charm of the friendly
germ, minus bowels, passion or a sense of humour. Happily they never
reproduce and all of them finally go to Hell.'
he drew the sketch of Vitruvian man for Leonardo da Vinci's book on
Divine Proportions
he won the award for risk manager of the year
he published the first book about double entry accounting in 1494.
$82,000
$78,000
$170,625
$546,000
none of the above.
5.
Which of the following is not an assumption underlying CVP analysis?

A.
B.
C.
D.
E.
6.
If the bank mistakenly recorded a $17 deposit as $71, the error would be
shown on the bank reconciliation as a:
A.
B.
C.
D.
E.
7.
B.
C.
D.
E.
If fixed costs are reduced while contribution margin remains

unchanged, the break-even point will increase
At the break-even point, total sales revenue equals total costs
At the break-even point, total contribution margin equals total fixed
costs
If the sales price increases while variable costs and fixed costs remain
constant, the break-even point will decrease
None of the above.
The '@' or '=' key in spreadsheet software is used to indicate:

A.
B.
C.
D.
E.
9.
$71 addition to the bank balance

$54 addition to the bank balance
$71 deduction from the bank balance
$54 deduction from the bank balance
none of the above.
Which of the following statements about the break-even point is false?

A.
8.
Cost-volume-profit relationships are curvilinear

Expenses can be classified as variable or fixed
Selling price per unit will be unchanged
Sales mix of products will be unchanged
Variable costs are fixed per unit.
that text is centred in a cell

that the numbers immediately above will be summed and the result
shown in the current cell
a mathematical function
an error has occurred
that the spreadsheet has a circular reference.
Zunilda Travel Company budgets total revenues, total expenses, and net
income for the first four months of the year as follows:
Budgeted revenues
Budgeted expenses
Budgeted net income
January
$84,000
February
$60,000
March
$70,000
April
$83,000
55,000
$29,000
34,000
$26,000
35,000
$35,000
50,000
$33,000
In comparing Zunilda's rolling budgeted income statement for the quarter

ended March 31 and the quarter ended April 30, management is expecting
the following change in revenues and net income from the quarter ended
March 31 to the quarter ended April 30:
xxxi
10.
A.
Revenues
Increase $12,000
Net Income
Decrease $3,000
B.
Decrease $1,000
Increase $4,000
C.
Increase $3,000
Decrease $2,000
D.
E.
Increase $13,000
none of the above.
Decrease $2,000
The Estefan Guitar Company has budgeted sales for the months of April and
May of $520,000 and $480,000, respectively. Monthly sales are 80% credit
and 20% cash. 50% of credit sales are collected in the month of sale and
50% are collected in the following month.
What are Estefan's budgeted cash collections from customers for the month
of May?
A.
B.
C.
D.
E.
11.
$496,000
$500,000
$288,000
$400,000
none of the above.
The MacGyver Tool Company has forecast sales of its tools for January,
February and March to be $150,000, $225,000 and $180,000 respectively.
MacGyver's policy is to maintain ending inventory of $850,000 plus 20% of
costs of goods sold in the following month.
Budgeted sales for April are $210,000.
Sales are 50% cash and 50% credit.
All accounts receivable are collected in the month following sale.
Cost of goods sold averages 60% of sales.
12.
If during an accounting period no new capital was introduced, assets

increased by $6,000, liabilities increased by $4,000 and the profit was
$3,000 after deducting from revenue expenses of $2,000, then the proprietor
withdrew for his own use:
A.
B.
C.
D.
E.
13.
The term matching principle refers to the matching up of:

A.
B.
C.
D.
E.
xxxii
$4,000
$7,000
$1,000
$3,000
none of the above.
assets and claims on those assets

net profit and drawings
expenses and revenues
cash inflows and outflows
expenditures and revenues.
14.
The Escort Company has budgeted purchases of inventory for April of

$35,000. Expected Beginning Inventory and Ending Inventory for April are
$40,000 and $43,000, respectively. If cost of goods sold averages 80% of
sales, what are budgeted sales for April?
A.
B.
C.
D.
E.
15.
The Columbo Lighting Company sells its lamps for $50 per unit. The
beginning inventory is 20,000 units, and the desired ending inventory is
12,000 units. If budgeted production is 54,000 units, what is the forecast
sales revenue from the lamps?
A.
B.
C.
D.
E.
16.
$1,530,000
$2,025,000
$310,000
$630,000
None of the above
During June, the Shasta Lake Company's actual sales were $180,000
compared to budgeted sales of $195,000. Actual cost of goods sold was
$135,000 compared to budgeted cost of goods sold of $136,500. Monthly
operating expenses were $25,000, and budgeted operating expenses were
$28,000. The company also earned interest revenue of $2,500, which was
not included in the budget. The performance report would show net income
for June over (under) budget by:
A.
B.
C.
D.
E.
17.
$43,750
$40,000
$94,400
$89,375
none of the above.
$(13,000)
$13,000
$(8,000)
$8,000
none of the above.
Current operations for Daltons Manufacturing show:

Variable cost per unit
Total fixed costs
75
35
120,000
If Daltons can achieve a $20,000 reduction in fixed costs, by how much can
the variable costs increase and still allow the firm to maintain the original
break-even point?
A.
B.
C.
D.
E.
$10.00 per unit

$6.00 per unit
$6.66 per unit
-0none of the above.
xxxiii
18.
The acid test ratio is:

A.
B.
C.
D.
E.
19.
Which inventory method is the most accurate in matching current expenses

with current revenues?
A.
B.
C.
D.
E.
20.
A matching principle
B expense recognition principle
C disclosure principle
D comparability principle
E historical cost principle.
Kristan Antiques has the following assets: Cash, $5,000; Accounts

Receivable, $60,000; Allowance for Uncollectible Accounts, $20,000;
Office Supplies, cost of $300 with scrap value of $50; Equipment: cost,
$60,000, Accumulated Depreciation, $25,000, with a disposal value of
$8,000. Total assets of the going concern are:
A.
B.
C.
D.
E.
xxxiv
understated by $15,000
none of the above.
Amortising the cost of a patent is justified by the:

A.
B.
C.
D.
E.
22.
FIFO
LIFO
standard cost
weighted average
none of the above.
Two separate errors affected the Parmalat Dairy Farms in Year I. The
beginning inventory was understated by $5,000 and the ending inventory
was understated by $20,000. Net income in Year I will be:
A.
B.
C.
D.
E.
21.
the ratio of a current assets to current liabilities

usually less than the quick ratio
the ratio of cash plus short term investment plus net current
receivables to current liabilities
the ratio of current assets less estimated uncollectible to current
liabilities
the ratio of current liabilities to net current assets.
A $80,500
B $53,300
C $80,300
D $53,050
E none of the above.
23.
Which of the following symbols precedes an absolute cell reference?

A. @
B. #
C. &
D. $
E.
none of the above.
Questions 24, 25 and 26 relate to the following data

A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
24.
E
F
Savage Art Gallery
Income Statement Projections
For the first six months of 2OXX
JAN
FEB
MAR
APR
MAY
JUN
TOTAL
Sales
Sculptures
Paintings
Lithographs
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
Total Sales
Cost of Sales
Gross Profit
Expenses
Salaries
Rent
Advertising
Telephone
Utilities
Misc
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
Total Expenses
Net profit
Refer to the spreadsheet above. The formula to calculate Savage's February

painting sales will be entered in cell:
A.
B.
C.
D.
E.
B9
C9
B12
Cl2
none of the above.
xxxv
25.
Refer to the spreadsheet above. To calculate Savage's gross profit in June

the entry would be:
A.
B.
C.
D.
E.
26.
Refer to the spreadsheet above. If the sales of painting increase by 5% a

month, the formula for the February painting sales is:
A.
B.
C.
D.
E.
27.
a label
formula
value
operator
an algebraic function.
Merryn Smith, a lawyer, performs bankruptcy services for a client and bills
full fee of $6,000 on September, 20Xl. Smith is uncertain if she will collect
the entire fee. At December 31, 20Xl, Smith had collected $900. Smith
received an additional $2,000 in 20X2. How much service revenue should
Smith report in 20Xl and 20X2, respectively assuming the use of the cash
basis accounting?
A.
B.
C.
D.
E.
xxxvi
statement, true, false

condition, calculation if true, calculation if false
calculation if false, condition
true statement, statement
condition, calculation if false, calculation if true.
A cell entry that instructs a spreadsheet program to calculate a number is

referred to as
A.
B.
C.
D.
E.
29.
105*B9
B9*.05
B9+1.05*B9
l.05*B9
none of the above.
When the IF function is used in a spreadsheet, what items are listed in

parentheses?
A.
B.
C.
D.
E.
28.
+G8-Gl4
+G12-G14
+GIO-G14
+Gl2+Gl4
none of the above
$900
$2,000
$6,000
$0
$3,000
$3,000
$0
$6,000
none of the above.
30.
Which of the following statements is FALSE?

A.
B.
C.
D.
E.
31.
Which of the following is a command to show the formula view of a

spreadsheet?
A.
B.
C.
D.
E.
32.
Cost is a measure of the value of resources supplied or consumed to

achieve a specific objective.
Variable cost per unit is constant for a given period regardless of
volume.
Fixed cost per unit is constant for a given period regardless of volume.
A cost driver is any factor that causes costs to change.
E Total fixed costs are constant for a given period regardless of
volume.
Control `
Function ~
Control ~
Alt F7
Alt Page Up
The labour rate variance is calculated as:

A.
B.
C.
D.
E.
actual hours x (actual rate standard rate)

standard rate x (actual hours standard hours allowed)
actual rate x (actual hours standard hours allowed)
standard hours allowed x (actual rate standard rate)
none of the above.
Use the following information to answer Questions 33 and 34

Zodiac Industries produce cosmic gismos. One gismo has the following standard
direct material data:
Standard cost for one gismo:
Material A:
Material B:
10 units @ $100 per unit

20 units @ $150 per unit
During November the company had the following results:

Gismos produced 2,000 units
Materials purchased and used:
Material A:
Material B
22,000 units @ $94

38,000 units @ $152
xxxvii
33.
The direct material price variances for A and B respectively were:

A.
B.
C.
D.
E.
34.
$12,000 F
and
$120,000 F
and
$188,000 UF and
$132,000 F
and
none of the above
$4,000 UF
$80,000 UF
$304,000 F
$76,000 UF
The direct material usage variances for A and B respectively were:

A.
B.
C.
D.
E.
$188,000 F
and
$200,000 UF and
$200,000 F
and
$188,000 UF and
none of the above.
$304,000 UF
$300,000 F
$300,000 UF
$304,000 F
Use the following information to answer questions 35 and 36

Fast Foods has established the standard direct labour time of 4 minutes to serve a
typical meal. Labour costs $6.50 per hour. During September Fast Foods sold
30,000 meals and incurred a labour cost of $33,000 for 4,600 hours of labour.
35.
The direct labour rate variance was:

A. $3,100 F
B. $3,100 UF
C. $16,900 UF
D. $16,900 F
E.
none of the above
36.
The direct labour efficiency variance was

A.
B.
C.
D.
E.
$18,652 UF
$13,040 UF
$16,900 F
$16,900 UF
none of the above.
Use the following information to answer Questions 37 and 38

On 1 July Charles Ltd commenced business with a cash balance of $100,000 after
acquiring the necessary assets to carry on business. Sales for the next 6 months
are expected to be:
July
August
September
$50,000
$100,000
$200,000
October
November
December
$300,000
$400,000
$200,000
The gross profit on sales is 60%. Finished goods inventory any month will be
sufficient to cover sales for the next two months. Purchases will be paid for in the
month following purchase. Other expenses are expected to be $50,000 monthly,
including $10,000 depreciation. Expenses will normally paid in the month in
which incurred.
xxxviii
60% of sales are expected to be cash sales. Of the credit sales, 20% are expected
to be collected in the month of sale and 80% in the month following sale.
37.
Cash receipts for August are expected to be:

A.
B.
C.
D.
E.
38.
Cash payments in August are expected to be

A.
B.
C.
D.
E.
39.
$180,000
$90,000
$70,000
$100,000
none of the above.
Suppose Prentice-Hall is considering investing in warehouse management

software that costs $500,000 and should lead to cost savings of $120,000 a
year for its 5 year life. If Prentice-Hall has a 12% required rate of return,
what is the net present value of the investment? The present value of an
annuity of $1 for 5 years at 12% is 3.605. The present value of $1 for 5 years
at 12% is 0.567.
A.
B.
C.
D.
E.
40.
$100,000
$60,000
$68,000
$72,000
none of the above
($67,400)
($88,040)
($56,700)
($340,200)
none of the above
Which of the following Capital Investment methods is a non discounted

cash flow model focusing on profitability:
A.
B.
C.
D.
E.
Accounting Rate of Return

Payback
Internal Rate of Return
Net Present Value
none of the above
xxxix
Part B -Essay question (20%)

There are five essay questions of which you are required to answer two (2).
The five areas which will be examined include:
the history of accounting,

ethics, accounting and corporate failure,
business communication and report writing,
social and environment accounting including Triple Bottom Line, and
panopticism and accounting control systems.
For the essay questions, utilisation of the relevant readings and workshop
handouts will be expected. It is important to present well structured answers that
directly address the question asked. In some areas the Internet can provide correct
information.
It is very important to allocate your time appropriately. Answer all questions.
xl
Sample exam multiple choice questions - solutions

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
E
C
B
B
A
D
A
C
B
A
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
B
C
C
B
E
C
C
C
B
A
21.
22.
23.
24.
25.
26.
27.
28.
29.
30.
A
C
D
B
B
D
B
B
A
C
31.
32.
33.
34.
35.
36.
37.
38.
39.
40.
A
A
D
B
B
D
E
A
A
A
xli
xlii
Topic 1 An introduction to financial accounting
Required reading
Textbook:
Horngren, et al., ch. 15, including appendices.
Reading 1.1:
Drucker, P. F. (2001). Be data literate know what to know.
Reading 1.2:
Sheckley, R. (1988). The accountant.
Reading 1.3:
Perry, C. (1996). One of the oldest professions?
Reading 1.4:
Pacioli, L. (1966 reprint). Double entry book-keeping.
Reading 1.5:
Mann, G. (1994). The origins of double-entry.
Reading 1.6:
Weis, W., & Tinius, D. (1992). Luca Pacioli: Renaissance

accountant.
Reading 1.7:
Chatfield, M. (1977). Accounting in the ancient world.
Reading 1.8:
Integrate Excel into Word.
You can read Chapter 15 now or at the end of these notes. It provides a
comprehensive introduction to financial accounting and may seem overwhelming
at the first reading because of the many new terms and concepts but dont be put
off by this.
There are always issues about where to start when one is trying to understand this
new language accounting. We are not interested, in this subject, in the nitty
gritty of accounting systems; we are not interested in detail such as comprehensive
journals, ledgers etc. But we need to understand how to use accounting
information and in order to do this we need to have an overall understanding of
how the system works.
The purpose of this topic is to provide an introduction and overview of the
financial side of accounting. Familiarity with accounting concepts, techniques and
conventions is necessary if you as a manager are to extract and make use of the
information included in financial statements. This not only means the statements
relating to your organisation but also the statements for other organisations,
whether they form part of your industry or not.
At this point it is recommended that you read the following excerpt and attempt to
answer the questions raised. You are not required to submit your answer for
marking but it is advisable to write down what you consider to be the main points,
problems etc. There is no single correct answer although several alternative
solutions have been included at the end of these notes.
1.1
1.1 The Sheepherders: An accounting game

Part I
In the high mountains of Chatele, two sheepherders, Deyonne and Batonne sit
arguing their relative positions in life, an argument which has been going on for
years. Deyonne says that he has 400 sheep while Batonne has only 360 sheep.
Therefore, Deyonne is much better off. Batonne, on the other hand, argues that he
has 30 acres of land while Deyonne has only 20 acres; then too, Deyonnes land
was inherited while Batonne had given 35 sheep for 20 acres of land 10 years ago,
and this year he gave 40 sheep for 10 acres of land. Batonne also makes the
observation that of Deyonnes sheep 35 belong to another man and he merely
keeps them. Deyonne counters that he has a large one-room cabin that he built
himself. He claims that he has been offered three acres of land for the cabin.
Besides these things, he has a plough, which was a gift from a friend and is worth
a couple of goats; two carts which were given him in trade for a poor acre of land;
and an ox which he had acquired for five sheep.
Batonne goes on to say that his wife has orders for five coats to be made of
homespun wool, and that she will receive 25 goats for them. His wife has 10
goats already, three of which have been received in exchange for one sheep just
last year. She has an ox which she acquired in a trade for three sheep. She also
has one cart which cost her two sheep. The Batonnes two-room cabin, even
though smaller in dimensions than Deyonnes should bring him two choice acres
of land in a trade. Deyonne is reminded by Batonne that he owes Tyrone three
sheep for bringing up his lunch each day last year.
Carlson and Higgins, 1974.
Which sheepherder is the more well-off?
Objective
What solution are you able to offer Deyonne and Batonne? Specify any
assumptions you find it necessary to make. Hint: Use sheep or sheep equivalents
as the basis for valuing the assets and liabilities.
The following points are worth noting in addition to the answer supplied.
1.2
Summary points
The question posed related to which of the sheepherders was the more well-off.
1.
The Entity Concept: If the question posed was relative well-offness do

you or do you not include the assets of Batonnes wife?
2.
Realisation: Should orders received but not yet completed be valued and
completed?
3.
Basis of Valuation: It was suggested you use sheep as the method of

valuing assets and liabilities. Would goats have been another basis for
valuation?
If there are any limitations in using either sheep or goats, would money as a
basis of valuation have overcome these limitations?
4.
Valuation Principle: Did you value land at the actual historical exchange
price or at a more recent basis of valuation? i.e. replacement cost.
5.
Limitations of Financial Statements: The answer explicitly values in

quantitative terms the well-offness of each of the sheepherders. What you
are not able to ascertain from this information are such qualitative
considerations as their ages, state of health, the ability of each to enjoy life,
make use of their assets.
The second part to this introduction relates to an understanding of the
concept of income. Read the Sheepherders Part II and answer the question
asked. Again a solution to this problem is included in the Solutions Manual
accompanying this Study Guide.
1.3
The Sheepherders: An accounting game

Part II
A year has elapsed since you solved Part I of the Sheepherders Game. After
studying your solution to Part I, Deyonne and Batonne grudgingly accepted your
opinion as to their relative wealths at the end of last year. The passage of time has
not diminished their penchant for argument, however. Now theyre arguing about
who had the largest income for the year just ended.
Deyonne points out that the number of sheep which he personally owns at year
end exceeds his personal holdings at the beginning of the year by 80, whereas
Batonnes increase was only 20. Batonne replies that his increase would have
been 60 had he not traded 40 sheep during the year for 10 acres of additional land.
Besides, Batonne points out that he exchanged 18 sheep during the year for food
and clothing items; whereas Deyonne exchanged only seven for such purposes.
The food and clothing has been pretty much used up by the end of the year.
Batonne is happy because his wife made five coats during the year (fulfilling the
orders she had at the beginning of the year) and received 25 goats for them. She
managed to obtain orders for another five coats (again for 25 goats) - orders on
which she has not begun to work. Deyonne points out that he took to making his
own lunches this year; therefore he does not owe Tyrone anything now. Deyonne
was very unhappy one day last year when he discovered that his ox had died of a
mysterious illness. Both men are thankful, however, that none of the other
animals died or was lost.
Except for the matters reported above, each mans holdings at the end of the
current year are the same as his holdings at the end of last year.
Objective
By your calculation which sheepherder had the greater income for the year?
1.4
Discussion points
1.
Carlson and Higgins (1974) have included a comment on the concept of

income. In your analysis of income you may wish to examine it from the
position of:
How much could have been consumed and saved during the period (1 year)
and yet each sheepherder be still as well off (i.e. at the end of the period) as
they were at the beginning of the year?
2.
Well-offness could be equated to a more commonly used term wealth. In

accounting the changes in financial position between periods can be due to
the generation of net income (revenue minus expenses).
3.
There are two solutions to Part II. The first solution measures the changein-net-worth between the beginning and the end of the period and is
consistent with the approach used by the economist J.R. Hicks. This is a
balance sheet approach. The second solution uses the flow concept of
income, the inflow represents revenue and the outflow expenses. The
difference between revenue and expenses is net income.
4.
You have probably valued the cabin, carts and plough in the same number of
sheep at the beginning of the period and the end of the period. This is not a
realistic assumption as each have aged one year and in the case of the carts
and plough have had their useful life reduced by wear and tear. These assets
have been used up to some extent and this process in accounting is called
depreciation. In the flow approach to measuring income it would have been
legitimate to include as an outflow, along with the death of the ox, the sheep
equivalents for the loss in value of the cabin, carts and plough. This has the
effect of reducing net income.
5.
Some of the events recorded in the flow approach (Income Statement) are
regular and normally occurring activities consistent with the businesses
Deyonne and Batonne are engaged in. It is arguable that the death of the ox
is an extraordinary event which should not be included as part of the
normal events from which operating income is derived. As you will see in
later topics in the discussion on the formal accounting statements,
accountants are required to separately disclose events which may be
considered extraordinary to the results from the more normal operations.
For example if Deyonnes sheep had been destroyed in a fire then the
usefulness of the income statement would be enhanced by this separate
disclosure.
1.5
Answers to Sheepherders: An accounting game,

fundamental questions Part I & II
The Sheepherders - An accounting game, Part I
In the high mountains of Chatele, two sheepherders, Deyonne and Batonne sit
arguing their relative positions in life, an argument which has been going on for
years. Deyonne says that he has 400 sheep while Batonne has only 360 sheep.
therefore, Deyonne is much better off. Batonne, on the other hand, argues that he
has 30 acres of land while Deyonne has only 20 acres; then too, Deyonnes land
was inherited while Batonne had given 35 sheep for 20 acres of land 10 years ago,
and this year he gave 40 sheep for 10 acres of land. Batonne also makes the
observation that of Deyonnes sheep 35 belong to another man and he merely
keeps them. Deyonne counters that he has a large one-room cabin that he built
himself. He claims that he has been offered three acres of land for the cabin.
Besides these things, he has a plough, which was a gift from a friend and is worth
a couple of goats; two carts which were given him in trade for a poor acre of land;
and an ox which he had acquired for five sheep.
Batonne goes on to say that his wife has orders for five coats to be made of
homespun wool, and that she will receive 25 goats for them. His wife has 10 goats
already, three of which have been received in exchange for one sheep just last
year. She has an ox which she acquired in a trade for three sheep. She also has one
cart which cost her two sheep. The Batonnes two-room cabin, even though
smaller in dimensions than Deyonnes should bring him two choice acres of land
in a trade. Deyonne is reminded by Batonne that he owes Tyrone three sheep for
bringing up his lunch each day last year.
Objective
By studying the situation carefully, see what solution you may be able to offer
these men. Specify any assumptions which you find it necessary to make.
This game is clearly not one for which a single correct answer can be identified.
The entity concept
When the question at issue concerned the welloffness of each man, why might
some include (exclude) the assets of Battones wife?
Realisation
Why might some include (exclude) the value of orders received but not yet
completed?
Were you concerned with possible changes in the quality of the herd (due to
changes in age, weight, etc.) rather than only with the number of animals?
1.6
Choice of valuing agent

Why might some choose sheep (goats) as the unit of measure? What are the
limitations of sheep (goats) as valuing agents? If money had been the valuing
agent, would all of these problems have been avoided?
Valuation principle
Why might some value land at its actual historical exchange price while others
valued it in terms of its replacement cost (most recent exchange price?)
Limitations of financial statements
What dimensions of welloffness have not been quantified in your solution, e.g.,
age, state of health, capacity for enjoying life, etc.?
The second meeting in the term is devoted to solving Part II and, in the process, to
gaining some understanding of the income concept.
The Sheepherders - An accounting game, Part II
A year has elapsed since you solved Part I of the Sheepherders Game. After
studying your solution to Part I, Deyonne and Batonne grudgingly accepted your
opinion as to their relative wealths at the end of last year. The passage of time has
not diminished their penchant for argument, however. Now theyre arguing about
who had the largest income for the year just ended.
Deyonne points out that the number of sheep which he personally owns at year
end exceeds his personal holdings at the beginning of the year by 80, whereas
Batonnes increase was only 20. Batonne replies that his increase would have been
60 had he not traded 40 sheep during the year for 10 acres of additional land.
Besides, Batonne points out that he exchanged 18 sheep during the year for food
and clothing items; whereas Deyonne exchanged only seven for such purposes.
The food and clothing has been pretty much used up by the end of the year.
Batonne is happy because his wife made five coats during the year (fulfilling the
orders she had at the beginning of the year) and received 25 goats for them. She
managed to obtain orders for another five coats (again for 25 goats) - orders on
which she has not begun to work. Deyonne points out that he took to making his
own lunches this year; therefore he does not owe Tyrone anything now. Deyonne
was very unhappy one day last year when he discovered that his ox had died of a
mysterious illness. Both men are thankful, however, that none of the other animals
died or were lost.
Except for the matters reported above, each mans holdings at the end of the
current year are the same as his holdings at the end of last year.
1.7
Objective
What solution can you offer the two men as to which had the greatest income for
the year?
A Note on the Income Concept
The concept of income refers to how much one has improved his welloffness
(wealth) during a period of time. J.R. Hicks, an economist well known for his
definition of income, has defined income as the amount a man could consume (or
otherwise distribute) during a period of time and still be as well off at the end of
the period as at the beginning.
Two approaches to the solution of Part II are illustrated in the appendix to this
paper.
Alternative views of the income concept.
Income may be viewed either as a change-in-net-worth concept or as a
flow concept (revenues minus expenses). The alternative solutions to Part II
illustrate the validity of both views of income.
Recurring Income vs. Extraordinary Items
The possibility of treating the oxs death as an extraordinary item might be
discussed.
When taken together, Part I and Part II give the student an early glimpse at the
relationship between the income statement and the balance sheet. He then has an
overview of the accounting process before examining its parts in detail.
The use of the game approach generates greater student involvement in the
learning process and better prepares the student for the study of accounting than
do the traditional first lectures in accounting. This approach also gives the student
a much better framework for evaluating later discussions on differences in
accounting methods, and it helps to explain many of the whys of accounting.
1.8
Appendix of tenable solutions

Solution to Part I
Balance Sheets
(All items stated in sheep-equivalents)
Assets
Deyonne
Sheep
Land
Cabin
Carts
Plow
Ox
Goats
400
80
12
4
Total assets
/3
5
0
5012/3
Batonne
360
120
8
2
0
3
31/3
4961/3
Liabilities
Sheep belonging to others
Payable to Tyrone
Total liabilities
Net worth
35
3
38
463
0
496
Solutions to Part II
Part II can be solved in two ways. The first views income as a change in net
worth concept; the other views it as the result of certain flows of resources taking
place during the period. The first method translates Hicks definition of income
into algebraic form. Hicks definition implies that income for an individual is
equal to the change in net worth during the period plus that periods consumption,
or,
Y = NW1 NW0 + C
where Y = Income
NW1 = Net worth at the end of the period
NW0 = Net worth at the beginning of the period
C = Consumption during the period
NW1 is computed below
1.9
Balance Sheets Date of Part II

(All items stated in sheep-equivalents)
Assets
Deyonne
Sheep
Land
Cabin
Carts
Plow
Ox
Goats
480
80
12
4
2
Batonne
/3
0
0
5762/3
Total assets
380
160
8
2
0
3
112/3
5642/3
Liabilities
Sheep belonging to others
Net worth
35
541
____
564
Income for Part II can now be computed.
Income Computation Change In Net Worth Approach

NW1 NW0 + C = Y
Deyonne
5412/3 4632/3 + 7 = 85
Batonne
5642/3 4962/3 + 18 = 86.
The income numbers derived above can also be derived by basing the computation
on the inflows and outflows of resources during the period. Most students will
find that this flow based computation illuminates further the understanding of
income which they acquired from study of the change in net worth method.
1.10
Income Statements Flow Approach

We became better off by
Acquiring animals:
Sheep
Net increase in sheep herd
Plus: Sheep traded during the year
For consumer goods
To pay Tyrone
To buy land
Deyonne
Batonne
80
7
3
0
20
18
0
40
10
58
Gross increase in sheep

(identical with number of sheep born
during the year)
90
78
Goats
Goats received for services
(stated in sheep-equivalents)
Total animals acquired during the year
0
90
81/3
861/3
We became worse off because of animal

deaths:
Death of ox (stated in sheepequivalents)
(5)
Net income
85
86
1.11
Reference
Carlson, M. L., & Higgins, J. W. (1974). A games approach to introducing
accounting. In Accounting education: Problems and prospects
(pp. 365-369). American Accounting Association.
1.2
Accounting and its environment
You should use these study notes in conjunction with your reading of the text.
This section provides a general introduction to some concepts in accounting, to
the accounting profession, and to common accounting financial statements.
The topic is divided into eight sections. They are:
1.
2.
3.
4.
5.
6.
7.
8.
Definition of accounting
Users of accounting information
The development of accounting thought
The accounting profession
Different types of business organisations
Accounting concepts and principles
The accounting equation
Financial statements
Definition of accounting
Accounting is an information system. Its purpose is to provide information to
decision makers, whether the decision makers be inside or outside the accounting
entity.
Definition of Accounting
... the system that measures business activities, processes that information into
reports, and communicates these findings to decision makers.
Horngren & Harrison
Even if the particular persons involved with the business decided they did not
need accounting information, it is required by governments that businesses keep
accounting records for the purposes of calculating income tax. Businesses also
need to know if they are making a profit or not, and how much the business is
worth. These purposes are achieved by using financial statements such as the
Income (Profit and Loss Statement) and the Balance Sheet.
Bookkeeping is not accounting. Bookkeeping is to accounting as arithmetic is to
mathematics. That is, accounting includes bookkeeping. These days most of
bookkeeping activities are performed by computers and computer software
packages. The procedural aspects of accounting are increasingly of less
importance as computers and computer software take over these mundane day-today tasks.
1.12
Users of accounting information

Different textbooks identify different lists of users of accounting information.
Generally, users include list individuals, businesses, investors and creditors,
government regulatory agencies, taxing authorities, non-profit organisations, and
other users. You may care to recall some of the uses of accounting information by
the use of a mnemonic - CROME. The letters of this mnemonic stand for: C =
Creditors; R = Regulatory authorities; O = Owners; M = Management; and E =
Employees. The term owners may include shareholders, partners or a sole
trader.

Accounting has a long history. Archaeologists continue to be interested, for
example, in ancient Mesopotamia, and excavate in order to find clay tablets which
record early examples of writing. Most of these clay tablets contain accounting
records, which lends support to the claim that the invention of writing was due to
the need for accounting records. Early examples of accounting systems can also
be found in other ancient civilisations such as China, Greece, Egypt and South
America. Further early examples can be found in the ancient civilisations of South
America. It is also possible to argue that the pre-eminence of these ancient
civilisations compared to their neighbours was due in part to the well developed
accounting systems which these civilisations utilised.
It is thought that double entry accounting developed in the Italian city states in the
1300s. The Franciscan monk, Luca Pacioli, wrote the first known book on double
entry accounting, published in 1494. It is important to note that he did not invent
double entry accounting. It is also interesting to note that Pacioli was a
mathematician, and further that he was good friends with Leonardo Da Vinci. In
fact this famous artist provided illustrations for some of Paciolis books.
Paciolis book was very important to double entry accounting because his writings
were copied (plagiarised?) throughout Europe over the next few centuries and the
double entry accounting system that we use today still bears traces of the original
system described by Pacioli.
Since Paciolis time, two inventions of mankind have increased the importance of
accounting to modern society. The first of these is the development of the
company or corporation with shared ownership. This invention gives rise to the
need to develop detailed accounting records so that the many owners of the
enterprise can be informed of the efficiency and effectiveness of the management
of the enterprise in which they have invested their money. The other invention
which has increased the importance of accounting is called income tax. All
modern governments charge income tax on the individuals and corporations in
their countries. In order to calculate income tax, obviously some accounting
records are necessary.
Also note that Pacioli and Leonardo da Vinci were good friends and collaborated
on a book by Pacioli on Divine Proportions published in 1509. Pacioli was the
author and Leonardo did some illustrations including the famous Vitruvian Man.
1.13
Pacioli and Leonardo da Vinci had a mutual interest in measurement. A best

selling novel (and movie), The da Vinci Code by Dan Brown uses the Vitruvian
man as part of the plot. Unfortunately, Pacioli doesnt get a mention in the book.
If you are interested in the Pacioli/Leonardo connection try searching the Internet
for more information. Why was the illustration named after Vitruvius, an
architect?
Recently, a third book by Pacioli has been discovered covering among other
things, magic. It is thought that Leonardo helped out with the illustrations again.

The accounting profession in Australia is constructed in a similar manner to the
accounting profession in the United States. Whereas in the United States there is
one professional body called the American Institute of Certified Public
Accountants (AICPA), in Australia there are two professional bodies - CPA
Australia (CPAA) and the Institute of Chartered Accountants in Australia (ICAA).
These two bodies are very important to the conduct of accounting in Australia.
1.14
For example, it is these two bodies which accredit degrees in Australia and grant
professional recognition.
Full members of the CPA Australia are called CPAs. Members of the Institute of
Chartered Accountants in Australia are commonly called Chartered Accountants.
The two Australian professional bodies represent the profession in discussions
with the governments and also promulgate accounting standards. These standards
are contained in the respective handbooks of the two professions.
Note that details of the structure of the American accounting profession are not
assessable in this subject.
Accountants provide many different services including auditing, taxation
accounting, management consulting, management accounting and, of course,
teaching and research. It is also worthwhile to note that many managers of large
companies have an accounting background. This is understandable when one
realises that the person within an organisation who understands the organisation
best is likely to be the accountant. Many of you have or will discover that, in
order to advance further in the organisation for which you work, a knowledge of
accounting is a distinct advantage. Maybe one day they will make you the boss.
Good luck!
Different types of business organisations

There are three main forms of business organisation:
1.
A proprietorship is a business with a single owner. Most proprietorships

are small organisations, mainly because of their limited ability to raise
capital.
2.
A partnership is a business organisation that has two or more owners.

Each of the owners is called a partner and they generally share the profits by
some formal agreement. The accounting system treats the partnership as a
separate entity from the private activities of the owners.
3.
The third kind of business organisation is called a company or corporation.

A company or corporation is owned by persons called shareholders. A
company is a separate legal entity and, for example, can sue or be sued in
the law courts in its own name. Obviously the accounting systems for
companies may be much more complex than for proprietorships or
partnerships.
It is important to note that proprietorships and partnerships, although treated in

accounting as separate accounting entities, are not regarded as separate legal
entities. This means that under income tax law the profit of a partnership or the
profit of a proprietorship is taxable in the hands of the owners.
1.15

This topic introduces several elementary accounting principles. At this
introductory stage of your study, only a few concepts or principles or assumptions
are introduced. They are: the entity concept, the objectivity or reliability
concept, the cost principle, the going-concern concept and the stable money unit
concept. These concepts are essential to your understanding of the basic
accounting model.
The essence of the entity concept is that the accounting system treats the business
as being separate from the owner. In other words, the business is a separate entity
to the owner. This enables us to treat, for example, an investment of money in a
business by an owner as a genuine double entry transaction. Thus from the
businesss point of view, it gains an asset, i.e. the cash which is invested, but on
the other hand it also incurs an obligation for the money which is due to the
owner. An important corollary of this concept is that the private transactions of
the owner have nothing to do with the business.
The reliability or objectivity principle simply means that the accounting system is
based on information which should be as objective or verifiable as possible. For
example, if you own a motor car, can you say how much it is worth? Many
figures are possible, including how much you could sell it for, how much it would
cost to replace, how much it is worth to you intrinsically, and so on. However, the
accounting system, because of the objectivity principle, uses a figure based on the
original transaction cost, i.e. the original cost of the motor vehicle.
The third principle introduced in this section, the cost principle, flows from the
concept of objectivity. Under this principle, assets and services which are
acquired should be recorded at the original transaction cost. This original
transaction cost is often called the historical cost.
The going concern concept or continuity concept assumes that the business will
remain in operation for the foreseeable future. One implication of this concept, is
that business assets should not normally be valued at their disposal value because the intention is to continue to use them in the business, not to sell them.
The stable money unit concept assumes that the medium of exchange in a
country, be it the Hong Kong dollar, the Singapore dollar, the Malaysian ringgit or
the Australian dollar, is relatively stable in value. This concept enables
accountants to add dollars from different time periods. If necessary, accountants
can prepare inflation adjusted accounts which is obviously a departure from this
concept.
Earlier we said that accounting is an information system designed to aid decision
makers. To some extent these three concepts conflict with the stated definition of
accounting. For example, a decision maker needs to know the current costs of the
assets in a business in order to make appropriate and correct decisions. Yet the
traditional accounting system is likely to report assets at the original cost, less
perhaps some adjustment for depreciation.
1.16

The double entry accounting system first described by the Franciscan monk, Luca
Pacioli, is based on the idea that for every transaction there is a dual or twofold
effect. Each and every transaction affects the equation:
Assets = Equities
Assets are the economic resources owned by a business. Equities are the claims
against those assets. There are two main kinds of equities: those which are
internal to the business and those which are external to the business. The internal
equity or economic obligation is called owners equity. The external equities are
called liabilities. Thus we can expand the original equation into:
Assets = Liabilities + Owners Equity
The Owners Equity category can be further subdivided. The owners equity in a
business is increased by the revenues of the business and decreased by the
expenses of the business. Thus we can further expand the equation:
Assets = Liabilities + Original Owners Equity + Revenues - Expenses
Your text has examples. Dont just read them work through them on paper.
This is the only effective way to understand this material.
Financial statements
In this introductory chapter the authors introduce three financial statements: the
Balance Sheet, the Income (Profit and Loss Statement), and the Statement of
Owners Equity. It is important to note that each of these statements is
interrelated. It is common practice for the statement of owners equity to be
included as part of the Balance Sheet. It is important to note that the term Profit
and Loss Statement instead of Income Statement is sometimes used in
Australia. Check the examples used in the textbook carefully by recording
solutions on your own paper.
1.17
Self-test questions
Try yourself out with these questions.
i.
Matching
You are required to match the numbered term with the letter of the most
appropriate description.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
____
____
____
____
____
____
____
____
____
____
A.
The author of the first-known book on double-entry accounting.
B.
CPA Australia.
C.
The accounting concept which treats the owner as separate from the
business.
D.
A form of business organisation which has many owners and is a separate

legal entity.
E.
Certified Practising Accountant.
F.
A kind of accountant that conducts independent examinations of accounting

records.
G.
Institute of Chartered Accountants in Australia.
H.
A kind of business organisation that has several owners but is not a separate
legal entity.
I.
A process in accounting involving the setting of sales and profit goals.
J.
The accounting concept based on the idea that transactions should be

supported by independent evidence.
1.18
CPAA
ICAA
CPA
Company
Partnership
Entity
Objectivity
Auditor
Budgeting
Luca Pacioli
ii.
Multiple choice
For each of the following questions, identify the correct alternative.

1.
Cash is an example of:

A.
B.
C.
D.
E.
2.
Accounts Payable is an example of:

A.
B.
C.
D.
E.
3.
an asset
a liability
owners equity
revenue
none of the above
A bank loan is an example of:

A.
B.
C.
D.
E.
5.
an asset
a liability
owners equity
an expense
none of the above
The owners Capital account is an example of:

A.
B.
C.
D.
E.
4.
revenue
expense
owners equity
an asset
none of the above
an asset
a liability
a revenue
an expense
none of the above
The account Land is an example of:

A.
B.
C.
D.
E.
owners equity
a liability
revenue
an expense
none of the above
1.19
6.
Net income or net profit equals:

A.
B.
C.
D.
E.
7.
If the beginning balance of owners equity was $100, the ending balance
$250, and the net profit for the month $200, and there were no investments
by the owner, how much did the owner withdraw during the month?
A.
B.
C.
D.
E.
8.
$10,000
$12,000
$20,000
$42,000
none of the above
Which of the following equations is incorrect?

A.
B.
C.
D.
E.
1.20
$73,000
$68,000
$29,000
$47,000
none of the above
If, in a business, accounts payable is $12,000, owners equity is $50,000,

cash is $9,000, accounts receivable is $13,000, and land is $20,000, then
office supplies must be:
A.
B.
C.
D.
E.
10.
$100
$200
$250
$50
none of the above
If, in a business, cash is $42,000, accounts receivable is $5,000, office

supplies are $2,000, land is $24,000, accounts payable is $5,000 - then how
much is owners equity?
A.
B.
C.
D.
E.
9.
revenue plus expenses

revenue minus expenses
assets minus liabilities
liabilities plus owners equity
none of the above
A = OE + L
OE = A - L
Net Income = R - E
L = OE - A
none of the above
iii. Completion statements

Complete each of the following statements with the most appropriate word or
words.
1.
The amounts earned by a business are called ______________
2.
The concept which explains the separation of the owner and the business is
called the ______________________________ concept.
3.
_____________________ was the author of the first-known book on double

entry accounting.
4.
The __________________________________________ is the financial

statement which lists Assets, Liabilities and Owners Equity.
5.
The term ____________________________________ is often used in

Australia instead of the term Income Statement.
6.
Luca Paciolis book on double entry accounting was published in
7.
The term CPA in Australia stands for
8.
The two professional accounting bodies in Australia are the

and
the __________________________________________________________
9.
Bookkeeping is to Accounting as arithmetic is to _____________________
10.
________________________ is the accounting service whereby an

accountant external to the business examines the financial records.
1.21
iv. Exercises
1.
Amanda operates a manicure service. During the first month of operation

the following events occurred:
A.
B.
C.
D.
E.
F.
G.
H.
Amanda invested $2000 in the business.

She paid rent of $600.
She purchased $1500 of furniture on account.
She purchased $100 of supplies for cash.
She performed $1500 in services for clients.
She paid $300 on the furniture purchased in C.
She received $50 from a customer on her account.
She sold supplies (which cost $7) to a friend for $7.
Prepare an analysis of transactions showing the effects of each event on the

accounting equation.
OWNER'S
EQUITY
ACCOUNTS + CAPITAL
LIABILITIES +
=
=
ASSETS
CASH + ACCOUNTS + SUPPLIES + FURNITURE
RECEIVABLE
Cash
Accounts
Receivable
PAYABLE
+
Supplies
Furniture
A.
B.
Accounts
Payable
=
C.
=
+
D.
+
+
E.
+
F.
G.
H.
1.22
Capital
2.
Presented below are the balances in the assets, liabilities, revenues, and
expenses for Kens Cleaning on March 31, X9.
Accounts Payable
$10
Accounts Receivable 15
Cash
5
Ken, Capital
?
Equipment
20
Service Revenue
40
Supplies
10
Prepare a balance sheet for Kens Cleaning for March 31, X9.
Kens Cleaning
Balance Sheet
31 March, X9
Assets:
______
Liabilities:
______
Cash
______
Accounts payable
______
Accounts receivable
______
Total liabilities
______
Supplies
______
Owners Equity:
______
Equipment
______
Dan, capital
______
Total assets
______
Total liabilities and

owners equity
______
1.23
3.
The following are the balances in the accounts of Billys Lawn Service on
31 July, X9.
Accounts Receivable
Accounts Payable
Lawn Equipment
Notes Payable
Salaries Payable
Salary Expense
Service Revenue
Supplies
Supplies Expense
Tax Expense
Telephone Expense
Truck Rental Expense
Billys, Capital
$ 500
300
4,000
300
150
2,000
6,500
400
200
150
250
600
150
Prepare an income statement for Billys Lawn Service for the month of July,
X9.
Billys Lawn Service
Profit & Loss Statement
For the Month Ended 31 July, X9
Service revenue
Expenses
Truck rental
Salaries
Supplies
Tax
Telephone
Net profit
1.24
Self-test solutions First part of Topic 1

i.
Matching
1 B; 2 G; 3 E; 4 D; 5 H; 6 C; 7 J; 8 F; 9 I; 10 A.
ii.
Multiple choice
1.
2.
3.
4.
5.
E (an asset)
6.
7.
D (100 + 200 - ? = 250)
8.
B (42 + 5 + 2 + 24 - 5 = 68)
9.
C (9 + 13 + 20 + ? = 50 + 12)
10.

1.
Revenues.
2.
Entity.
3.
Fra Luca Pacioli.
4.
Balance Sheet.
5.
Profit and Loss Statement.
6.
1494.
7.
It used to stand for Certified Practising Accountant. Curiously, now it

doesnt stand for any particular words.
8.
CPA Australian Institute of Chartered Accountants in Australia.
9.
Mathematics.
10.
Auditing.
1.25
iv. Exercises
1.
Cash
Accounts
Receivable
Supplies
Furniture
Accounts
Payable
Capital
A.
$2,000
$2,000
B.
-600
-600
$1,400
$1,400
C.
$1,400
-100
$100
$1,300
$100
D.
E.
$1,500
$1,500
$1,500
$1,500
$1,400
$1,500
$1,500
$1,400
$1,500
$2,900
$1,500
$1,300
F.
$1,500
$100
$1,500
-300
$1,000
G.
-300
+
50
$1,500
$100
$1,500
$1,200
$2,900
$100
$1,500
$1,200
$2,900
$1,500
$1,200
$2,900
-50
$1,050
$1,057
H.
$1,500
$1,450
-7
$1,450
$93
TOTAL
2.
Kens Cleaning
Balance Sheet
31 March, X9
Assets:
Cash
Liabilities:
$
Accounts payable
Accounts receivable
15
Total liabilities
Supplies
10
Owners Equity:
Equipment
20
Ken, capital
Total assets
1.26
$ 50
Total liabilities and owners

equity
$ 10
10
40
$ 50
Billys Lawn Service

Profit & Loss Statement
For the Month Ended 31 July, X9
Service Revenue
$ 6,500
Expenses
Truck rental
$ 600
Salaries
2,000
Supplies
200
Tax
150
Telephone
250
Net profit
3,200
3,300
1.27
1.3 Recording business transactions

This section provides an overview to the double entry accounting system and can
be divided into six parts. They are:
1.
2.
3.
4.
5.
6.
Introduction
Double entry
Journals
Ledger
Trial balance
Chart of accounts
Introduction
This section gives an overview of the mysterious Debit and Credit accounting
system. This Debit and Credit accounting system is in essence the same as that
described by Luca Pacioli in his book published in 1494. The terminology used
dates from Paciolis time. For example, the words Debit and Credit are from the
Latin terms. You have probably already noticed, for example, that the word Debit
is abbreviated to Dr, and the word Credit is abbreviated to Cr. Thousands of
accountants throughout the world use these abbreviations daily. Most of them do
not know why they use those particular abbreviations. For example, where is the
r in the word Debit? The answer is that the word Debit comes from the Latin
word Debere. Thus the word Debit, when abbreviated, becomes Dr. Similarly
Credit is abbreviated to Cr, not because of the second letter in the word but
because it is an abbreviation of the Latin term Credere. If you happen to know a
qualified accountant, you might like to test your new knowledge by asking them
why the word Debit is abbreviated to Dr.
Why is the word Debit abbreviated to Dr?
Section 1.2 used an equation approach to help begin your understanding of

accounting. This equation approach is obviously unwieldy for any firm recording
thousands of transactions on a day-to-day basis. It is in this section that we begin to
see how firms really record transactions. The approach demonstrated in Section 1
would obviously be too time-consuming and inefficient for any business operating
in the real world.
This section introduces many new terms. Make sure you are familiar with these
terms. An account is a place in the ledger which is used to record changes in a
particular kind of asset, or liability, or owners equity, or revenue, or expense.
Accounts are gathered together in a book called the ledger. Thus a ledger is a
collection of accounts. In actual practice each account is recorded on its own
ledger page. Businesses should use some classification or layout system such that
they group assets together and liabilities together and so on. Assets are economic
resources that are expected to benefit the business in the future. Examples include
1.28
Cash, Land, Buildings. Liabilities are obligations by the business to outsiders.

Examples include Accounts Payable, and Mortgages. Owners Equity is the
claim that the owner has on the assets of the business. It includes the amounts
invested by the owners in the business and also includes the difference between
revenues and expenses. Thus:
Revenues and Expenses are temporary subdivisions of Owners Equity
If, in any accounting period, Revenues exceed Expenses, the business has earned a
profit. This profit increases Owners Equity. You may encounter some variations
in terminology from textbook to textbook. For example, Cash is sometimes called
Cash at Bank, or simply Bank. Accounts Receivable is sometimes called Debtors
or Sundry Debtors. Accounts Payable is sometimes called Sundry Creditors or
Creditors. Withdrawals is sometimes called Drawings.
Double entry
Every transaction has a two-fold effect on the records of a business. Thus, when a
business purchases land for cash, two accounts are affected - namely, Cash and
Land. Each transaction can be analysed in terms of its effect on the five main
kinds of accounts. The five main kinds of accounts are: Owners Equity,
Liabilities, Assets, Revenues and Expenses. Thus the purchase of land for cash
must affect the two accounts, Cash and Land. Both of these accounts are assets.
One account is increasing and another account is decreasing. In this example, the
Cash account is decreasing and the Land account is increasing. The Land account
which is increasing is debited and the cash account which is decreasing is
credited. For every debit there is an equal and corresponding credit.
Uses of funds in a business are called debits. Sources of funds in a business are
called credits. Thus the purchase of land is a use of funds and therefore a debit in
the Land account. The source of funds in this example was the Cash account, and
therefore is a credit.
Uses of funds are called debits. Sources of funds are called credits
Let us try another example. The business pays wages. In this example, wages is a
use of funds. Wages is an Expense account and it is increasing and therefore it is
debit. The cash which is used to pay wages is an Asset account and it is
decreasing, so therefore it is credit.
We will now use an acronym which may help you to understand the debit and
credit accounting system. For the sake of the acronym, we will use P for
1.29
Proprietorship instead of Owners Equity. Treat Proprietorship as being exactly

the same as Owners Equity. Thus we have five different kinds of accounts: P =
Proprietorship; A = Asset; L = Liability; E = Expense; R = Revenue. We thus
have an acronym - PALER. We have already seen that an increase in an asset is a
debit and that a decrease in an asset is credit. Similarly, a decrease in
Proprietorship is a debit and an increase in Proprietorship or Owners Equity is a
credit. Continuing, an increase in a Liability is a credit and a decrease in a
Liability is a debit. An increase in an Expense is a debit, being a use of funds, and
a decrease in an Expense is a credit. An increase in a Revenue is a credit, being a
source of funds, and a decrease in a revenue is a debit, being a use of funds. We
can now develop a rule.
DR P A L E R
and
CR P A L E R
The direction of the arrows indicate increase or decrease .

In handwritten accounting systems, accountants often use a summary device called
a T account. In a T account, the lefthand side is debit and the righthand side is
credit. In actual practice, most accounts are kept in computer systems.
Your text gives a number of examples of T accounts. It summarises heavily by
just recording amounts and the number of each of the transactions. We prefer
students to add a bit more detail to the account. A useful piece of information
which should be added to the T account is as follows. Alongside each of the
figures recorded in a T account you should write the name of the other account
concerned. We believe this practice aids an understanding of ledger accounts. It
also helps students to trace the effects of transactions in the ledger system.
Journals
Journals list an entitys transactions in chronological order.
The accounting cycle begins with a transaction. This transaction should then be
recorded in some kind of source document. Then this source document is used to
make an entry into a journal. A journal is a chronological record of an entitys
transactions. In Topic 1.6 we will examine different types of journals. At this
1.30
stage we will assume that there is only one journal. This journal contains
instructions to debit a ledger account and to credit a ledger account. Examples are
given in your textbook.
For each transaction we need to identify the two accounts concerned; then we need
to establish what kinds of accounts each of these two accounts are; third we need
to know if the kinds of accounts are being increased or decreased; fourth, or from
the rule above, we need to determine which is debit and which is credit; fifth, the
transaction can be entered into the journal; and sixth, posted to the ledger.
Ledger
The ledger is a collection of all ledger accounts, including all balance

sheet and revenue and expense accounts.
As we said before, the ledger is a collection of ledger accounts. Transactions are

entered into the journal. Then transactions are posted from the journal to the
ledger. Remember the key words: Enter into journals; post to ledgers.
Let us now use our version of the debit and credit rule and apply it to the
following transactions. We will use the PALER rule and we will ask four
questions for each transaction.
Question 1:
Question 2:
Question 3:
Question 4:
What are the two accounts?

What kinds of accounts are they?
Are they increasing or decreasing?
Are they debit or credit?
Transaction 1: Peter invested $100,000 to begin his accounting practice.

Q1: The two accounts are Cash and Capital.
Q2: Cash is an Asset account; Capital is a Proprietorship or Owners Equity
account.
Q3: The Asset account is increasing; the Proprietorship or Owners Equity
account is also increasing.
Q4: Therefore Cash which is an Asset account and increasing must be debit; and
Capital which is a Proprietorship account and increasing must be credit. We
can answer this last question by using our rule - PALER.
1.31
Let us apply the same analysis to transaction 2: The business paid $20,000 cash
for a computer.
Q1: The two accounts are Computer and Cash.
Q2: Both of these accounts are Assets.
Q3: The Cash asset account is decreasing; the Computer asset account is
increasing.
Q4: The Cash asset account is credit; the Computer asset account is debit.
The PALER rule demonstrated here can be applied to every transaction you may
ever encounter. It is also interesting to note that you really do not have to learn
the complete rule. That is, if you can work out which account should be debited,
then the other account obviously must be credited.
At the end of the accounting period, which may be a week or a month, each of the
ledger accounts is balanced.
Instead of a T account for showing ledger accounts, a four-column account format
may be used. The four column format shows each transaction in a debit or credit
column and then adjusts the debit or credit Balance columns. Normally in this
subject we will not require students to use a four-column ledger account format.
Four-column account formats are wonderful for computers. The computer has no
trouble calculating a new debit or credit balance after each and every transaction.
However, human beings dont like to make this many calculations. A T account
only needs to be balanced once every accounting period. A four-column ledger
account needs to be balanced after each and every transaction. Good for computer
programs but not for human beings. Transaction analysis helps you understand
the underlying rationale in Income Statements and Balance Sheets.
Trial balance
A trial balance is merely a list of all ledger accounts at a particular date. If we
have followed the debit and credit rules consistently, then the trial balance must
balance. If the trial balance does not balance, it means that we have not followed
the debit and credit rules consistently or we have made errors in addition. Note
that, if a trial balance does balance, this does not necessarily prove that we have
not made any errors. For example, if a transaction is omitted completely from an
exercise, then the trial balance will balance, but of course it will be incorrect.
A trial balance is a list of all ledger accounts and their respective

balances at a particular date.
1.32
Chart of accounts
The Chart of Accounts is a classified list of all the ledger accounts in an
organisation. The accounts are usually classified into groups with the headings:
Assets, Liabilities, Owners Equity, Revenues and Expenses. Each account is
usually given a number code within each of these groups. The numbering system
usually permits the addition of new accounts as the need arises. In some countries
in Europe, the numbering systems are so standardised that a particular account
will have the same number in every firm of that kind in the country. This is not
the case in the United States or in Australia. Each firm designs its own chart of
accounts to suit its own particular needs.
This section has introduced the fundamentals of the accounting cycle. By the time
you have finished studying this topic you should understand that every transaction
can be analysed into its two components: the debit and the credit. Then
transactions are entered into journals, posted to the ledger, the ledger accounts are
balanced, and a trial balance is prepared.
Summary
You should have completed the following tasks before proceeding to Topic 2:
1.
Read Chapter 15 of Horngren as an introduction to financial accounting.
2.
Attempt the Sheepherders problem both Parts I and II. Review your
solution against the solution provided in the Solutions Manual. Examine the
discussion points in particular the points relating to Part II. The analysis
distinguished between a balance sheet approach and an income statement
approach to measuring income, the distinction between these two
approaches is fundamental to your later understanding of financial
statements.
3.
Review the questions and solutions from your text which follow.
1.33
Self-test questions Part 2 of Topic 1

How much have you learned?
i.
Matching
You are required to match the numbered term with the letter of the most
appropriate description.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
____
____
____
____
____
____
____
____
____
____
A.
Place where accounts are kept.
B.
The chronological accounting record of an entitys transactions.
C.
The term used to describe the transference of information from the journal to
the ledger.
D.
An alternative name for Accounts Receivable.
E.
The left-hand side of a T account.
F.
Another name for Withdrawals.
G.
A classified list of ledger accounts.
H.
The term used to describe the process of recording transaction information

in journals.
I.
An abbreviation of a Latin term.
J.
A list of ledger account balances whereby the total of the debits should be
equal to the total of the credits.
1.34
Chart of Accounts
Posting
Entering
Dr
Ledger
Journal
Trial Balance
Debtors
Drawings
Debit
ii.
Multiple-choice

1.
The list of ledger accounts, with their account numbers, is called:

A.
B.
C.
D.
E.
2.
Income or Profit and Loss Statements show:

A.
B.
C.
D.
E.
3.
debit to Accounts Payable

credit to Withdrawals
credit to Capital
credit to Cash
none of the above.
A business purchases land for cash. The correct entry for this transaction is:
A.
B.
C.
D.
E.
5.
Revenues and Expenses

Revenues and Drawings
Assets and Owners Equity
Expenses and Assets
None of the above.
When the owner of a business withdraws cash, the journal entry should
include:
A.
B.
C.
D.
E.
4.
Journal
Ledger
Trial Balance
Chart of Accounts
None of the above.
debit Purchases, credit Cash

debit Land, credit Cash
debit Cash, credit Land
debit Land, credit Owners Equity
none of the above.
Accounts Receivable is an example of:

A.
B.
C.
D.
E.
Owners Equity
Assets
Liabilities
Expenses
Revenues.
1.35
6.
Accounts Payable is an example of:

A.
B.
C.
D.
E.
7.
Capital is an example of:

A.
B.
C.
D.
E.
8.
Assets are overstated by $1,000

Expenses are understated by $1,000
the Trial Balance will not balance
Expenses are overstated by $1,000
none of the above.
The Cash account had total debits for the month of $3,400, and total credits
for the month of $2,700. If the beginning balance of Cash was $400, what is
the new balance at the end of the month for the Cash account?
A.
B.
C.
D.
E.
1.36
overstatement of Cash and Service Revenue

understatement of Assets, and overstatement of Revenues
overstatement of Assets and Liabilities
overstatement of Assets and understatement of Revenues
none of the above.
An accountant debited Rent Expense for $1,000, and credited Cash $1,000,
in error. The correct entry should have been: debit Prepaid Rent for $1,000,
and credit Cash for $1,000. As a result of this error:
A.
B.
C.
D.
E.
10.
Owners Equity
Assets
Liabilities
Expenses
Revenues.
When cash was received in payment for services rendered on account, the
accountant debited Cash and credited Service Revenue. As a result, there
was an:
A.
B.
C.
D.
E.
9.
Owners Equity
Assets
Liabilities
Expenses
Revenues.
$3,800
$1,100
$2,700
$300
none of the above.

Complete each of the following statements:
1.
The process of copying information from the journal to the ledger is called
_______________________________________
2.
The term credit refers to the ______________________________ side of

the ledger account.
3.
A classified list of ledger accounts with account numbers is called

a/an__________________
4.
Revenues and ____________ are temporary subdivisions of owners equity.
5.
The _______________ is used to indicate whether total debits equal total

credits in a ledger.
6.
Transactions are first recorded in ______________
7.
Accounts Payable is another name for ______________
8.
Revenue less Expenses equals ______________
9.
A four-column ledger account format is most suitable for a/an

______________________ accounting system.
10.
The term Drawings is an alternative title for the account

______________________________
1.37
MBA504 Self-test solutions

i.
Matching
1 G; 2 C; 3 H; 4 I; 5 A; 6 B; 7 J; 8 D; 9 F; 10 E.
ii.
Multiple-choice
1.
2.
3.
4.
5.
6.
7.
8.
E (an overstatement of Assets and an overstatement of Revenues)
9.
D (and assets are understated)
10.
B (400 + 3,400 - 2,700 = 1,100)

1.
Posting
2.
Right
3.
Chart of Accounts
4.
Expenses
5.
Trial Balance
6.
Source Documents (e.g. Receipt)
7.
Sundry Creditors
8.
Net Profit or Net Income
9.
Computerised
10.
Withdrawals
1.38
Microcomputer systems questions

In this subject you will be using computers and spreadsheets. This material can be
considered background. We shouldnt assume that all students necessarily have
this background knowledge. The answers are provided later in this Study Guide.
1.
In what decade did computers first become available to business?
2.
What is the name given to large, expensive and complicated computers?
3.
What is a computer?
4.
What is hardware?
5.
What is software?
6.
What is the name given to the type of application program which make it
possible to write, edit and format text?
7.
What is the name of the general purpose software (application) which is

used to manipulate numbers?
1.39
8.
What is the name given to the class of software which is used to manage
data such as Payroll, Inventory, Sales, etc.?
9.
What is the name given to software used to develop images?
10.
Human beings generally use a decimal numbering system. What is the

numbering system called which is used by a computer?
11.
A transistor that is on has the value 1; a transistor that is off has the value
0. What is the term used to describe these values?
12.
How many bits in a byte?
13.
How many bytes in a kilobyte?
14.
How many bytes are available in a computer that has 512mb of memory?
15.
Approximately how many bytes in a megabyte (mb)?
16.
How many bytes are there in a gigabyte (gb)?
17.
How many bytes in a terabyte (tb)?
18.
What does CPU stand for?
1.40
19.
A computer may have two types of internal memory. What are they?
20.
In the computer industry, what is a port?
21.
What is ADSL?
22.
Which is faster - parallel ports, serial ports, USB 1.1, USB2 or USB3?
23.
What is the name given to the standard layout of keyboards most commonly
found?
24.
What is another name for the return key?
25.
What does OCR stand for?
1.41
26.
What is a pixel?
27.
What is a light pen?
28.
What is a mouse?
29.
The following two sentences, taken from The Economist, illustrate the
problems still being experienced with what kind of input device to a
computer?
- This new display can recognise speech.
- This nudist play can wreck a nice beach.
30.
What are the two main classes of display screens used with computers?
31.
List two different kinds of printers.
32.
What is a USB drive?
1.42
33.
How much space is available on a USB drive?
34.
Give two other names for a hard disk drive.
35.
What is a CDROM disk?
36.
What is a DVD disk? What does the V stand for?
37.
What is a modem?
38.
What class of software programs are used to demonstrate images?
39.
What is the term used to describe that class of program which combines
various applications such as word processing, database management,
spreadsheets, graphics and communications?
40.
What class of programs make it easy to combine text and graphics?
41.
What is the term used to describe small, generally inexpensive programs

(apps) that perform a single task and which help to make your computer more
efficient?
1.43
42.
What is an ASCII file? What do the letters in the term ASCII stand for?
43.
In computer programs, what is a menu?
44.
What is a printer driver?
45.
How far should a computer operators eyes be from a screen - 6", 20" or 36"?
1.44
Microcomputer systems - Answers

1.
In what decade did computers first become available to business?

In the early 1950s.
2.
What is the name given to large, expensive and complicated computers?

Mainframes.
3.
What is a computer?
A computer is, in essence, a data processing machine.
4.
What is hardware?
Hardware is the physical equipment that you use, parts you can touch, drop
or break. It includes the computer itself, keyboard, display screen, and
printer.
5.
What is software?
Software is a set of instructions, often called a program, that is distributed
on magnetic disk.
6.
What is the name given to the type of application program which make it
possible to write, edit and format text?
Word processing software.
7.
What is the name of the general purpose software which is used to

manipulate numbers?
Spreadsheets.
8.
What is the name given to the class of software which is used to keep track
of data such as Payroll, Inventory, Sales, etc.?
Database management software.
9.
What is the name given to software used to develop images?

Graphics application programs.
10.
Human beings generally use a decimal numbering system. What is the

numbering system called which is used by a computer?
A binary system.
11.
A transistor that is on has the value 1; a transistor that is off has the value
0. What is the term used to describe these values?
Bits.
12.
How many bits in a byte?

8.
13.
How many bytes in a kilobyte?

1,024.
1.45
14.
How many bytes are available in a computer that has 512mb of memory?
Approximately 512 million.
15.
Approximately how many bytes in a megabyte (mb)?

1 million.
16.
How many bytes are there in a gigabyte (gb)?

1 billion.
17.
How many bytes in a terabyte (tb)?

1 trillion.
18.
What does CPU stand for?

Central Processing Unit.
19.
A computer may have two types of internal memory. What are they?
ROM (Read Only Memory) and RAM (Random Access Memory).
20.
In the computer industry, what is a port?

In the computer industry, a port is a socket, usually located at the back of a
computer, which connects the computer to peripherals such as the monitor
and the printer.
21.
What is ADSL?
Asymmetric Digital Subscriber Line a method for connecting to the
Internet.
22.
Which is faster - parallel ports, serial ports, USB1.1, USB2 or USB3?

Currently, the fastest is USB3 10 times faster than USB2.
23.
What is the name given to the standard layout of keyboards most commonly
found?
QWERTY, named after the first six keys on the top row of letter keys.
24.
What is another name for the return key?

The enter key.
25.
What does OCR stand for?

Optical Character Recognition.
26.
What is a pixel?
Pixels are the small dots on computer screens which make up text and
graphics.
27.
What is a light pen?

A light pen is used to draw images directly on a computer screen.
28.
What is a mouse?
A mouse is either a furry rodent or a device containing a laser sensor which
is connected by its tail to the computer or operated wirelessly.
1.46
29.
The following two sentences, taken from The Economist, illustrate the
problems still being experienced with what kind of input device to a
computer?
- This new display can recognise speech.
- This nudist play can wreck a nice beach.
Voice input.
30.
What are the two main classes of display screens used with computers?
Flat panel displays such LCD, or gas plasma screens.
31.
List two different kinds of printers.

Ink-jet and laser.
32.
What is a USB drive?

A solid state device to hold data. Universal Serial Bus.
33.
How much space is available on a USB drive?

Its increasing rapidly 2gb, 4gb, 8gb, 16gb, 32gb and more.
34.
Give two other names for a hard disk drive.

Fixed disk or Winchester disk drive.
35.
What is a CDROM disk?

A CDROM disk is a laser disk that can store large amounts of data
commonly 700mb.
36.
What is a DVD disk? What does the V stand for?

Digital Versatile Disk. Capacity 4.7mb or 9mb (dual layer) or 18mb on
double sided dual layer disks.
37.
What is a modem?
A modem is a device which enables a computer to communicate to another
computer via telephone lines. The modem is derived from the words
modulate demodulate.
38.
What class of software programs are used to demonstrate images?

Graphics programs.
39.
What is the term used to describe that class of program which combines
various applications such as word processing, database management,
spreadsheets, graphics and communications?
Integrated programs.
40.
What class of programs make it easy to combine text and graphics?

Desktop publishing programs.
41.
What is the term used to describe small, generally inexpensive programs

that perform a single task and which help to make your computer more
efficient?
Utility programs (apps).
1.47
42.
What is an ASCII file? What do the letters in the term ASCII stand for?
ASCII files are files saved in a standard format which is recognised by all
computers and all programs. ASCII stands for American Standard Code for
Information Interchange.
43.
In computer programs, what is a menu?

The term menu refers to a screen whereby the user can choose from
several choices in order to execute commands in a program.
44.
What is a printer driver?

A printer driver is a small program which accompanies another program
such as word processing software which translates the programs
instructions to a specific printer.
45.
How far should a computer operators eyes be from a screen - 6", 20" or
36"?
About 20". Depends on screen size and quality.
1.48
Topic 1 Questions and solutions

Selected from Horngren, C. T., Sundem, G., & Stratton, W. O. (2004).
Introduction to management accounting (13th ed.). Pearson Prentice Hall.
Study questions
Source: Horngren, C. T., Sundem, G., & Stratton, W. O. (2004). Introduction to management accounting
(13th ed., pp. 695-696). Pearson Prentice-Hall.
1.49
1.50
1.51
1.52
Solutions to study questions

15-A2
1.
(40-55 min.)
See Exhibit 15-A2 on the following page.
2.
SRINIVAS COMPANY
Income Statement
For the Month Ended April 30, 20X1
Sales (revenue)
$100,000
Deduct expenses:
Cost of goods sold
$40,000
Wages, salaries and commissions
43,000
Rent, 2,000 + 10,000
12,000
Depreciation
1,000
Total expenses
Net income
96,000
$
4,000
1.53
Exhibit 15-A2
1.54
SRINIVAS COMPANY
Balance Sheet
April 30, 20X1
Assets
Liabilities and Stockholders' Equity

Liabilities:
Cash
$ 41,000
Note payable
$ 24,000
Accounts receivable
55,000
Accounts payable
7,000
Merchandise inventory
20,000
Total liabilities
$ 31,000
4,000
Stockholders' equity:
Prepaid rent
Paid-in capital
Equipment and fixtures
35,000
$120,000
Retained earnings
4,000
Total stockholders equity

Total assets
3.
$155,000
Total liabilities and stockholders equity
124,000
$155,000
Most businesses tend to have net losses during their infant months, so
Srinivas's ability to show a net income for April is good. Indeed, the rate of
return on beginning investment is $4,000 $120,000 = 3.33% per month, or
40% per year. Many points can be raised, including the problem of
maintaining an optimum cash balance so that creditors can be paid neither
too quickly nor too slowly. See the next solution also.
1.55
15B2 Exhibit 15 B2
1.56
2.
PACCAR
Statement of Earnings
For the Month Ended January 31, 2003
(in millions)
Sales
Deduct expenses:
Cost of goods sold
Rent and insurance expense
Depreciation
Total expenses
Net earnings
$655
$390
100
90
20
600
$ 55
PACCAR
Balance Sheet
January 31, 2003
(in millions)
Assets
Cash
Accounts receivable
Inventories
Prepaid expenses & other assets
Property, plant, and equipment
Total
15-28

$ 428
5,264
421
1,138
1,557
$8,808
Accounts payable
Other liabilities
Stockholders equity
$1,325
4,827
2,656
Total
$8,808
(15-20 min.)
Dec. 31:
Jan. 1:
Change:
Assets
B125,000
B100,000
B 25,000
- Liabilities
- B55,000
- B40,000
- B15,000
= Stockholders' equity
= B70,000
= B60,000
= B10,000
1.
As above, B60,000. This is the easiest computation.
2.
Change in stockholders' equity + Cash dividends = Net income

B10,000 + B16,000 = B26,000
3.
Let X = Cost of goods sold

Sales - Cost of goods sold - Operating expenses = Net income
B265,000 - X - B50,000 = B26,000
-X = B26,000 - B265,000 + B50,000
X = B189,000
1.57
15-30
1.
(45-75 min.)
See Exhibit 15-30 on the following page.
2.
UNIVERSITY WIRELESS
Statement of Income
For the Month Ended October 31, 20X1
Sales
$60,000
Cost of goods sold
30,000
Gross profit
$30,000
Operating expenses:
Rent
Depreciation
Advertising
Wages and salaries
Miscellaneous
Operating income
Interest expense
Net income
1.58
$ 500
50
9,000
11,000
1,510
22,060
$ 7,940
40
$ 7,900
Exhibit 15-30
1.59
UNIVERSITY WIRELESS
Balance Sheet
October 31, 20X1
Assets
Equities
Liabilities:
Cash
$ 5,490
Accounts payable
Accounts receivable
50,000
Notes payable
Inventory
10,000
Accrued wages and
Prepaid rent
500
Fixtures and equipment
5,950
$23,000
5,000
salaries payable
6,000
Accrued interest payable
40
Total Liabilities
$34,040
Paid-in capital
$36,000
Retained earnings
Total assets
$71,940
1,900
Total equities
37,900
$71,940
UNIVERSITY WIRELESS
Statement of Retained Earnings
For the Month Ended October 31, 20X1
Retained earnings, October 1, 20X1
Add: Net income for October
Total
Deduct: Cash dividends
Retained earnings, October 31, 20X1
3.
0
7,900
$7,900
6,000
$1,900
The picture in this set of financial statements is not unusual for new
businesses. Some of the liabilities are very current: accounts payable,
$23,000 and accrued wages, $6,000. Yet there is a small amount of cash.
Unless much of the accounts receivable can either be collected or discounted
(sold to a bank or other lender) the company may be unable to meet its
payroll and pay its bills on time. Moreover, the inventory badly needs
replenishment if sales are to continue at their current pace. Payment of a
$4,000 dividend may not have been wise.
Many new businesses can show a respectable net income but nevertheless be
at the brink of financial disaster because they are "under-capitalized." That
is, there is insufficient long-term investment capital to sustain a smooth
growth. Too often, creditors and employees need cash far in advance of
when customers provide the cash to the business. This may be such a case,
unless customers pay promptly.
1.60
15-32
(10 min.)
The following statements are true: 4, 5, 8, 9.

Explanations for the false statements follow:
1.
The first sentence is correct. However, credit entries always must be on the
right.
2.
Amounts borrowed are debited to Cash and credited to Notes Payable.
3.
Decreases in assets are shown on the credit side, but decreases in liabilities
and stockholders equity are shown on the debit side.
6.
All credits are on the right.
7.
Payments on mortgages are credited to cash and debited to Mortgage

Payable.
10.
Purchases of inventory should be debited to Inventory and credited to

Accounts Payable.
11.
Decreases in liability accounts should be on the left (or decreases in asset

accounts should be on the right).
1.61
1.62
Reading
1.1
Drucker, P. F. (2001). Be data literate know what to know. In S. M. Young
(Ed.), Readings in management accounting (pp. 2-3). NJ: Prentice Hall.
Accounting information has value from its use in decision-making. The vast
amount of data available in the modern age, especially given computing
developments, means that it is paramount that the user of data is able to discern
relevant information for necessary decisions.
This reading can be found on CDROM#1.
1.63
Reading
1.2
Sheckley, R. (1988). The accountant. In E. L. Ferman (Ed.), The best fantasy
stories from the magazine of science and fiction (pp. 125-133). Octopus
Books Ltd.
You will realise that this reading is not examinable but provides a different
perspective on accountants.
1.64
Reading
1.3
Perry, C. (1996). One of the oldest professions? Management Accounting, April,
20-21.
What is the worlds oldest profession?

1.65
Reading
1.4
Pacioli, L. (1966 reprint). Double entry book-keeping (pp. 4-7, 11 & 12). The
Institute of Book-Keepers.
An extract from the first book on double entry accounting published in 1494.
1.66
Reading
1.5
Mann, G. (1994). The origins of double-entry. Australian Accountant, July,
17-21.
A summary of the history of double entry accounting.

1.67
Reading
1.6
Weis, W., & Tinius, D. (1992). Luca Pacioli: Renaissance accountant. Australian
Accountant, October, 12-15.
It is interesting to note that in the novel and movie The Da Vinci Code an
illustration by Da Vinci called The Vitruvian Man figures prominently. This
illustration was drawn by Leonardo for a book by Pacioli, the author of the first
book on double entry accounting.
1.68
Reading
1.7
Chatfield, M. (1977). Accounting in the ancient world. In A history of accounting
thought (rev. ed., pp. 3-18). Huntington, NY: Robert E. Krieger Publishing
Company.
A classic and insightful analysis of accounting in the ancient world.

1.69
Reading
1.8
Integrate Excel into Word. Accessed August 2011
http://www.computorcompanion.com/LPMArticle.asp?ID=33
This reading may assist you with the assignments in this subject. Part of your
assignment is to include two copies of each spreadsheet in a Word Document.
There are several ways to do this: Some are covered in this online article. But
there are other ways as well. For example a screen dump. If you are using
Excel 2007 you can still paste spreadsheets into word documents but results are
variable, particularly when pasting showing row and column headings, as is
required for your assignments. In Excel 2010 it is somewhat easier. It is easier to
take a picture of the spreadsheet and paste it into Word. Free software works
quite well. See the spreadsheet examples provided at the beginning of the Study
Guide. Discuss with your fellows students and exchange other advice about
spreadsheets. Free software can make the task easier. One example is Snippy.exe.
1.70
Topic 2 The nature and objectives of financial

accounting: Basic financial statements
Required reading
Textbook:
Horngren, et al., ch. 16 & Appendix 16A.
Reading 2.1:
O'Leary, T. J., & O'Leary, L. I. (2011). Creating and editing a

worksheet.
Reading 2.2:
OLeary T. J., & OLeary, L. I. (2008). Charting worksheet data.
Reading 2.3:
Mautz, R. K., & Sharaf, H. A. (1978). Ethical conduct.
Reading 2.4:
Northcott, P. H. (1993). Case 4, Cheating: The pressure on

Pasquale Vialletta to succeed.
Reading 2.5:
Northcott, P. H. (1993). Ethics and the certified practicing

accountant: Case studies Presenters notes.
Learning objectives
On completion of this topic you should be able to:
define financial accounting;
identify the uses of financial accounting information and understand how the
information may be used;
use the accounting equation to describe an organisation and to analyse

business transactions;
distinguish between the accrual method of accounting and the cash method
of accounting;
analyse the effect of business transactions on the balance sheet and income
statement;
identify the more significant Generally Accepted Accounting Principles

(GAAP) and conventions that form the basis for external financial reports.
Note that you are expected to know about cash flow statements but not the details
of creating them.
Australia adopted International Financial Reporting Standards (IFRS) (formerly
known as International Accounting Standards) in January 2005. The adoption of
IFRS involves the introduction of new standards and amendments to many current
Australian Accounting Standards. The US is moving towards IFRS - slowly.
2.1
The increasingly global nature of business necessitates access to complete and

accurate financial information to stakeholders both within (e.g. management,
owners) and outside the firm (e.g. government, creditors, unions).
Greater harmonisation of standards will improve the usefulness of accounting
information. The profession may then be better regarded.
You should now read the following Supplementary Notes to reinforce your
understanding of Chapter 16.
Background to bookkeeping
A necessary part of any business or organisation is the maintenance of some form of
record keeping. The earliest forms of bookkeeping can be traced back to Babylonia
in 3600 BC. Here scribes would make notes of a merchants sales and purchases of
goods on either slabs of stone or clay tablets. Today we have technology at our
disposal to improve the efficiency and storage ability of bookkeeping.
Financial accounting is concerned with the recording, classifying and summarising
of business transactions. Most societies use money as the symbol of exchange,
and hence, business transactions are recorded in monetary terms. Owners and
managers of businesses need to know the profitability and financial position of
their organisations in order to make important decisions about the operation of
these businesses, and financial accounting provides this information.
Predl (1981, p. 1) outlines the main objectives of accounting:
a.
to systematically record, classify and summarise all the business transactions

in financial terms;
b.
to provide evidence of transactions having been conducted;
c.
to provide a means of control over the financial activities of the business;
d.
to provide information to individuals/groups who have an interest in the

financial affairs of the business;
e.
to maintain financial records to meet any internal or external requirements

that influence the business.
Forms of business ownership

Profit motivated
The sole trader
A business that is owned by one person is a sole trader or sole proprietor. The
owner has sole rights to all profits and makes all business decisions
himself/herself. Likewise, the owner must bear all losses alone, and is personally
liable for all debts of the business, even to the extent of seizure of his/her private
2.2
property if the business is in financial difficulty. The level of finance to start the
business is limited to the amount the owner can personally raise.
The Partnership
Where two or more owners contribute resources to and operate a business for the
purpose of making a profit, the business is a partnership. The Corporations Law
limits the number of partners to twenty, with the exception of one hundred plus
for professions such as lawyers, accountants and medical practitioners. Each
partner is fully liable for the debts of the business, to the extent of his/her personal
estate. Profits of the partnership will usually be distributed under a predetermined
sharing arrangement, which is often based on the amount of capital contributed
by each owner (although this is not the only basis). If a written agreement is not
made the Partnership Act will determine the regulation of the business. Upon the
death or retirement of a partner, the partnership is dissolved and a new partnership
must be established to continue the business.
The Company
Organisations that raise their finance by means of issuing shares to the public or to
a selected group of the public through invitation are companies (named a public
or proprietory company respectively). In this way large amounts of capital can
be raised to commence the business or to expand. The liability of the owners for
the debts of the company is limited to the amount unpaid on their shares.
Therefore, if a shareholder has bought 1000 shares in XYZ Co. Ltd. at $2.00 per
share, and has paid $1.50 on each of these shares, then the liability to the company
in the event of failure is limited to 50 cents x 1000 shares = $500.
The management of company is undertaken by a Board of Directors, members of
which are voted in by the shareholders, and the guidelines of the Corporations
Law must be strictly followed.
The Trust
A trust is not recognised as a separate legal entity. Four key attributes are needed
for the existence of a trust:
1.
2.
3.
4.
trust property;
trustee;
beneficiary; and
the requirement that the trustee deals with the trust property for the benefit
of the beneficiaries per terms of the trust.
This structure is commonly used in family businesses in combination with other

structures (e.g. a company as a trustee) due to its flexibility. Common types
include fixed trusts, discretionary trusts and unit trusts.
2.3
The Co-operative
A group of people with a common interest may form a venture, either as a
company or as a private organisation, with the purpose of providing a service to
the community. Examples of co-operatives are farmers, dairy or local residents
co-operatives. Profits are usually reinvested in the business or shared between
owners under some agreed arrangement.
Non-profit organisations
Government and semi-government bodies
Government departments operate with the purpose of providing a service to the
public, such as railways, health, education, taxation collection. They are
established by public funds, which are used to provide these services. It is not
their main object to generate a profit to return to owners, as the owners are the
Australian taxpayers who benefit from the service provided by the departments.
Private clubs and societies
Operations created by persons with a mutual interest in order to benefit these
members rather that earn a profit are non-trading bodies. Examples include
service clubs (RSL, Leagues), church groups, sporting clubs, Lions, Rotary and
Apex clubs. Income to support their activities is generated by raffles, donations,
subscriptions by members, social functions, etc.
The administrative process

The set of administrative activities of a business is made up of five phases:
a.
b.
c.
d.
e.
decision-making
planning
communicating
controlling
reappraising
Decision making involves the:

i.
ii.
iii.
iv.
diagnosis of a problem
search for alternative solutions
quantification and evaluation of alternative solutions
selection of a solution.
Planning consists of developing detailed plans from the master strategy decided
upon. Plans for each level of operations must be made.
Communicating is the process of informing the right people of the plans (top
down communication). The method of communication must take into
consideration personal friction, likely misinterpretation of terms, delays, status
differences and so on.
2.4
Controlling is the process of ensuring that programs and plans are proceeding
satisfactorily; that standards are established; that actual performance is compared
with planned performance and any deviations reported - both favourable and
unfavourable; and finally, the desired action is then taken.
Reappraising is the act of evaluating the original plans in light of external factors that
affect the firm and may cause deviations from the firms plans. Both these plans and
the controlling process may be reappraised and altered if deemed necessary.
How can we tie accounting into this administrative process?
The accounting department is a service department of an organisation which
provides information for the administrative processes. It is concerned with the
identification of financial information, expressing this in quantitative terms and
communicating the information to those who should have the information to make
economic decisions. as well as to other interested parties.
In a well developed accounting system the accountant is concerned with:
a.
planning for the future, estimating what is going to happen;
b.
recording and reporting what has happened;
c.
considering the implications of what has happened (evaluation);
d.
investigating whether any corrective action is needed in light of the results

obtained.
This sequence of events is illustrated by the following diagram:

PLANNING
RECORDING AND
REPORTING
REMEDIAL ACTION
INTERPRETATION
AND EVALUATION
The Recording and Reporting phase is the phase we are concerned with in this
subject. In it the organisation communicates to those interested in its activities,
the financial position and performance of the organisation.
2.5
Financial Statements are the means by which this information is communicated.

Financial Statements are formal reports prepared by the firms accountant,
showing the net result of the activities of the business - net profit/loss and the
value of the businesss resources and owners interest in the firm at a particular
point in time.
The ultimate purpose of accounting is to provide useful financial information to
the users of that information, so that they can make informed decisions.
Financial reports attempt to provide that information. A discussion of the users
of financial statements follows.
The three main financial statements are:
The profit and loss statement (Account)

The balance sheet
The cash flow statement.
Companies are required by law to produce Annual Reports which the public and
shareholders can access. The Tax Commissioner also requires sole traders,
partnerships and companies to submit annual reports showing their asset and
equity values at the end of the year.
Users of financial statements

There are may people and groups interested in the reported information of a
business. These can be broken into two groups - those parties within the
organisation (internal) and those outside the organisation (external).
Internal users
Owners
Owners of the business include shareholders, proprietors, members. They are
interested in knowing the return on their investment i.e. profit; the growth in
assets and liabilities of the business; cash liquidity; shareholding. Potential
investors will also be interested in the trend of dividend payout and financial
stability of the firm.
Management
Very frequent reporting of the activities of the business are essential for management
to make decisions about the method of production, the use of credit facilities for
sales and purchases or use only a cash system, how much stock to buy and when,
whether more investment or financing is needed, and so on. Management will use
the reports as a means of controlling, evaluating and appraising the master strategy
of the business, and in the development of short term plans.
2.6
Employees
Another internal party interested in the financial statements of a business
enterprise is the employees. They will be keen to know that the firm is operating
profitably and able to maintain the present level of employment, if not improve it.
External users
Government bodies, Commissioner of Taxation
Bodies such as the Australian Securities and Investments Commission (ASIC), the
Australian Prudential Regulation Authority (APRA), and others are concerned
with adherence to the Corporations Law, the Partnership Act, The Bankruptcy
Act, by the business.
Taxation laws must also be adhered to both at Federal Income Tax level and State
Tax level (e.g. Stamp duty, land tax) as well as other charges such as rates to local
councils.
Competitors
Since public companies must disclose their financial results in a published Annual
Report assessable by the public, competitors are able to appraise the sales levels
and market position of the business. This, hopefully, makes for improved
competition in the market.
Unions
Unions are concerned with the ability of the firm to pay award wages and the
situation of possible above award wage claims. Improved profit is usually
followed by union claims for higher wages.
Creditors/Lenders
Parties that lend money to the business to finance its operations are interested in
the ability of the firm to repay its loans; and meet its credit purchases on time.
The business entity

Accounting convention; Separate accounting entity
Regardless of the form of business ownership and organisation, one important
accounting convention or principle must be understood and obeyed. In the course
of its activities, the business is treated as a Separate Accounting Entity to its
owners. The affairs of the owners, whether they be a sole proprietor or thousands
of shareholders, are always kept separately from the operations of the business.
That is, if the owner had to pay a mortgage on his/her private home to the bank,
this money transfer is not a part of the businesss outlays. Following on from this,
if the owner could not make the payment from personal funds and needed to draw
on the money of the business, this act is said to be a drawing of the business
2.7
reducing the owners capital contribution and share in the profits. The owner may
be expected to return the withdrawn funds and reinstate his/her capital holding to
the level it was before the withdrawal.
Business transactions
In accounting, the term transaction refers to events that affect the business. In the
activities of acquiring resources, organising and transforming them into goods and
services, and finally selling these goods, the business is involved in hundreds of
transactions. Hence, in accounting, all business activities are reduced to the
perception of transactions as they occur.
Transactions take on two forms:
a.
External transactions are those taking place between two independent

businesses, such as purchasing raw materials for production, or selling the
output to the market.
b.
Internal transactions are those that take place solely within the one organisation,
such as converting crude oil (raw material) into petroleum (the output).
It is those external transactions that financial accounting is concerned with, whilst

managerial accounting (the main focus of this subject) is concerned with internal
transactions.
The business cycle
The complete set of business transactions are in the form of a cycle. This cycle is
made up of the same decision making processes regardless of the type of business
enterprise. Basically, these processes consist of three phases Input, Processing
and Output.
Within these three phases lie the many transactions of the business. In
diagrammatic form the business activities can look like the following:
INPUT
Acquire resources
from suppliers
PROCESSING
production into final
goods and services
OUTPUT
Selling and
distribution
Acquiring resources
The resources of the enterprise are called Assets. They are things of value to the
firm and will be used to produce future income. These assets can be acquired
using either cash or credit, such as loans or bank overdraft.
The assets that are injected into the business by the owners to commence
operations make up the Owners Equity or capital. Remember that these assets are
now part of the business, which is a separate accounting entity to the owners. The
value of these injected resources is then, the owners claims on the assets of the
business. For instance, with a partnership, one partner may invest $20 000 and
2.8
another partner $15 000 plus a truck worth $12 000. The assets of the business to
start operations are worth $47 000. The owners claim, together, on those assets,
(owners equity) is also $47 000.
If the assets of the business were acquired through a bank loan or other means of
credit, then these liabilities or things the business owes, are known as external
equities. This is because the providers of the credit have a stake or claim in the
business and expect to be repaid some time in the future.
Therefore, in accounting terms, the relationship between assets and equities is
clear. The Basic Accounting Equation reads as:
ASSETS = EQUITIES
This is something that will be referred to many times over and it is imperative that
you understand the concept of a separate accounting entity.
Selling the output
In a profit motivated business the most important aspect of its activities is to sell
its products or services and make a profit on these. One of the business decisions
made by managers is to determine the selling price for their products. This
involves taking into consideration the cost of raw materials, the cost of conversion
into final product and the cost of selling and distributing the products. This is the
area of concern for managerial accountants.
Another decision to be made in connection with sales is whether the business is
strictly a cash-only business or will allow credit sales to approved customers.
Allowing credit may increase the sales volume but it often brings with it an
increase in debts that are not paid by customers as well as a lengthening of the
time for cash flows to come into the business. Often short term outside credit
finance is needed to continue the cycle of buying more resources to generate more
sales. The recording of these important cash flows is discussed in the next
section.
Cash flows - The heartbeat of business

Cash flows simply refer to the timing of the patterns of cash receipts and payments
of a business. Managers, lenders and investors are always very interested in cash
flows. Many external economic factors influence the timing and quantity of cash
flows. These factors include seasonal market fluctuations, cyclical demand and
supply, government charges and taxes and union wage contracts to mention a few.
The recording of cash flows consists of the necessity to keep receipts or cheque
butts for all payments and keep copies of receipts for sales of products to
customers and receipts for shareholder capital contributions. Basically then, a
cash accounting system requires the recording of Cash Receipts and Cash
Payments in a systematic and logical manner. No payment or receipt should be
overlooked or omitted from recording.
2.9
Types of cash flows

There are two types of cash flows that affect a business:
a.
b.
cash flows of raising and investing ownership funds;

cash flows affecting profit.
Raising and investing capital

Referring back to the business cycle and business transactions section of this
topic, we discovered that the business must have ownership funds to commence
operations and that these funds are equal to the resources that can be acquired by
these funds. Likewise, any funds provided by lenders must be recognised as
equities of the business. Therefore, the cash flows of raising and investing capital
consist of:
receipts from shareholders and owners of the business and receipts from loans
obtained from external sources
LESS
cash spent on acquiring resources (assets).
For example, a company raises $450,000 through shareholder funds and $250,000
from bank loans. $620,000 of this capital is then spent on acquiring buildings and
land, machinery and equipment to operate the companys manufacturing business.
The net increase in cash is then ($450,000 + $250,000) - $620,000 = $80,000.
The assets of this company are recorded as $620,000 in long-term assets and
$80,000 in cash, whilst owners equity and loan liabilities are $450,000 +
$250,000. Therefore, the accounting equation:
ASSETS = EQUITIES
consists of
$620,000 + $80,000 = $450,000 + $250,000
Cash flows affecting profit
Cash received from sales, both those on credit and cash are the main source of
cash flows affecting profit. However, in order to generate these sales certain
payments must be made, such as wages and salaries of employees, cost of
purchases of goods to sell, electricity, rates and rent of business premises, interest
payments on the loan finance and income tax payments. The net increase or
decrease in cash flows depends on whether the sales receipts exceed the expenses
of operating the business.
What cash flows do not reveal

Cash accounting can only reveal the net increase or decrease in the asset, cash.
Relying on the evidence of a receipt from a sale or the actual payment of cash for
2.10
expenses could mean a great disparity between what the business actually earned
during the year and what it actually received from customers. With a large
amount of credit sales, the firm may find that customers do not pay very promptly;
the receipts from a November sale, say, may not occur until January. However,
managers and owners want to know regularly what the company has earned in
sales revenue. If the bookkeeper only had records for the cash received from sales
(regardless when the sale took place) then this so-called sales revenue would be
an inaccurate reflection of the real earnings of the firm during the month or year.
Likewise, the recording of payments as they are made will cause a great disparity
between what the firm has incurred in expenses and what it has actually paid out.
For instance if wages are paid at the end of the month and the manager wants to
know the amount of expenses incurred in generating revenue, the bookkeeper
would only be able to tell the manager the amount of cash that has been spent on
wages. Wages still owing to employees for their services are not recorded in a
cash accounting system.
Another example of disagreement with cash payments and expenses incurred
occurs with the stock of goods not sold to customers. Under a cash system, the
amount of purchases on stock that is deducted from sales revenue when
calculating profit, would be overstated, as some of this stock would be left unsold
at the end of the year.
Cash flows also do not tell us the correct amount of assets and liabilities of the
business at the end of the year. In many cases payments of rates and rent are made
ahead of time, so that cash would be understated at the end of the year or month,
and an extra asset for these prepaid expenses is not recognised under a cash-basis
system. Similarly, with expenses that are still owing (such as the wages) the cash
system omits the existence of the liability to pay this debt.
Therefore, the cash flows accounting system fails to provide us with information
about the firms:
a.
b.
profit for the year

financial position at the end of the year.
Accrual accounting/The accounting equation

The system of accounting adopted by business enterprises is known as Accrual
Accounting. It overcomes the downfalls of the cash-flow system by facilitating
the calculation of profit and financial position, using a few underlying
assumptions as its basis.
Underlying accounting assumptions
Here the business entity is assumed to have an unlimited life span, continuing
operations and usage of resources indefinitely. Only evidence of foreseeable
bankruptcy or liquidation can affect this assumption.
2.11
Going concern, time, period/periodic reporting

Because of the assumption of continued life of an entity, financial information must
be reported to the interested parties on a regular basis. Such regular reporting will
enable these users to make their economic decisions about the entity. Following on
from this, this assumption divides the life of the entity into shorter time periods, so
that the reporting phase of the business cycle can take place.
The matching principle
Accrual accounting reports revenues and expenses in relation to the transactions
that involved any change of the firms resources (such as goods for credit revenue
or cash inflow). Revenues generated by a business are matched against the
expenses incurred in generating this revenue during an accounting time period.
That is, the accountant does not wait until actual cash outlays are made or cash
receipts taken to recognise expenses and revenues of the business.
Monetary measurement
Financial statements can only be expressed in monetary terms. That means, all
business transactions must be reflected in dollar terms. Also, the purchasing
power of this dollar is assumed to be stable, i.e. there is no inflation or deflation.
Cost principle
Using the stable dollar as the measure of value in the economy, the resources of
the business are recorded at their acquisition cost, also known as their historical
cost. This recorded amount is not altered even if the resources value in the
market increases or decreases.
Objectivity
It is essential that the accountant preparing the business financial reports is
objective, or non-biased in determining values. There are times however, when
estimations and judgements need to be made in order to comply with the matching
principle of accrual accounting.
Bookkeeping and accounting

Bookkeeping is not accounting. Bookkeeping is to accounting as arithmetic is to
mathematics. That is, accounting includes bookkeeping. These days most of the
bookkeeping activities are performed by computers and computer software
packages. The procedural aspects of accounting are increasingly of less
importance as computers and computer software take over these mundane day-today tasks.
2.12

Accounting has a long history. Archaeologists continue to be interested, for
example, in ancient Mesopotamia, and therefore excavate in order to find clay
tablets which record early examples of writing. Most of these clay tablets contain
accounting records, which lends support to the claim that the invention of writing
was due to the need for accounting records. Early examples of accounting
systems can also be found in other ancient civilisations such as China, Greece and
Egypt. Further early examples can be found in the ancient civilisations of South
America. It is also possible to argue that the pre-eminence of these ancient
civilisations compared to their neighbours was due in part to the well developed
accounting systems which these civilisations utilised.
It is thought that double entry accounting developed in the Italian city states in the
1300s. The Franciscan monk, Luca Pacioli, wrote the first known book on double
entry accounting, which was published in 1494. It is important to note that he did
not invent double entry accounting. It is also interesting to note that Pacioli was a
mathematician, and further that he was good friends with Leonardo Da Vinci. In
fact this famous artist provided illustrations for some of Paciolis books. See
readings included in this Module.
Paciolis book was very important to double entry accounting because his writings
were copied throughout Europe over the next few centuries and the double entry
accounting system that we use today still bears traces of the original system
described by Pacioli.
Since Paciolis time, two inventions of mankind have increased the importance of
accounting to modern society. The first of these is the development of the
company or corporation with shared ownership. This invention gives rise to the
need to develop detailed accounting records so that the many owners of the
enterprise can be informed of the efficiency and effectiveness of the management
of the enterprise in which they have invested their money. The other invention
which has increased the importance of accounting is called income tax. All
modern governments charge income tax on the individuals and corporations in
their countries. In order to calculate income tax, obviously some accounting
records are necessary.

The accounting profession in Australia is constructed in a similar manner to the
accounting profession in the United States. Whereas in the United States there is
one professional body called the American Institute of Certified Public
Accountants (AICPA), in Australia there are two professional bodies - CPA
Australia (CPAA) and the Institute of Chartered Accountants in Australia (ICAA).
These two bodies are very important to the conduct of accounting in Australia.
For example, it is these two bodies which accredit degrees in Australia and grant
professional recognition.
Entry into these two professional bodies in Australia requires that persons must
hold a degree from a recognised tertiary institution and must have passed a certain
2.13
range of subjects in accounting, economics and law. Full members of the CPA
Australia are called CPAs. Members of the Institute of Chartered Accountants in
Australia are commonly called Chartered Accountants. The two Australian
professional bodies represent the profession in discussions with the governments
and also promulgate accounting standards. These standards are contained in the
respective handbooks of the two professions. Consider utilising the websites of
these Australian professional accounting bodies.
Note that details of the structure of the American accounting profession are not
examinable in this subject.
Accountants provide many different services including auditing, taxation
accounting, management consulting, management accounting and, of course,
teaching and research. It is also worthwhile to note that many managers of large
companies have an accounting background. This is understandable when one
realises that the person within an organisation who understands the organisation
best is likely to be the accountant. Many of you have or will discover that, in
order to advance further in the organisation for which you work, a knowledge of
accounting is a distinct advantage. Maybe one day they will make you the boss.
Good luck!

These notes introduce several elementary accounting principles. At this
introductory stage of your study in accounting, only a few concepts or principles
or assumptions are introduced. They are: the entity concept, the objectivity or
reliability concept, the cost principle, the going-concern concept and the stable
money unit concept. These concepts are essential to your understanding of the
basic accounting model.
The essence of the entity concept is that the accounting system treats the business
as being separate from the owner. In other words, the business is a separate entity
to the owner. This enables us to treat, for example, an investment of money in a
business by an owner as a genuine double entry transaction. Thus from the
businesss point of view, it gains an asset, i.e. the cash which is invested, but on
the other hand it also incurs an obligation for the money which is due to the
owner. An important corollary of this concept is that the private transactions of
the owner have nothing to do with the business.
The reliability or objectivity principle simply means that the accounting system is
based on information which should be as objective or verifiable as possible. For
example, if you own a motor car, can you say how much it is worth? Many
figures are possible, including how much you could sell it for, how much it would
cost to replace, how much it is worth to you intrinsically, and so on. However, the
accounting system, because of the objectivity principle, uses a figure based on the
original transaction cost, i.e. the original cost of the motor vehicle.
The third principle introduced in this topic, the cost principle, flows from the
concept of objectivity. Under this principle, assets and services which are
2.14
acquired should be recorded at the original transaction cost. This original

transaction cost is often called the historical cost.
The going concern concept or continuity concept assumes that the business will
remain in operation for the foreseeable future. One implication of this concept, is
that business assets should not normally be valued at their disposal value - because
the intention is to continue to use them in the business, not to sell them.
The stable money unit concept assumes that the medium of exchange in a
country, be it the Hong Kong dollar, the Singapore dollar, the Malaysian ringgit or
the Australian dollar, is relatively stable in value. This concept enables
accountants to add dollars from different time periods. If necessary, accountants
can prepare inflation adjusted accounts which is obviously a departure from this
concept.
Earlier we said that accounting is an information system designed to aid decision
makers. To some extent these three concepts conflict with the stated definition of
accounting. For example, a decision maker needs to know the current costs of the
assets in a business in order to make appropriate and correct decisions. Yet the
traditional accounting system is likely to report assets at the original cost, less
perhaps some adjustment for depreciation.

The double entry accounting system first described by the Franciscan monk, Luca
Pacioli, is based on the idea that for every transaction there is a dual or twofold
effect. Each and every transaction affects the equation:
Assets = Equities
Assets are the economic resources owned by a business. Equities are the claims
against those assets. There are two main kinds of equities: those which are
internal to the business and those which are external to the business. The internal
equity or economic obligation is called owners equity. The external equities are
called liabilities. Thus we can expand the original equation into:
Assets = Liabilities + Owners Equity
The Owners Equity category can be further subdivided. The owners equity in a
business is increased by the revenues of the business and decreased by the
expenses of the business. Thus we can further expand the equation:
Assets = Liabilities + Original Owners Equity + Revenues - Expenses
You are studying this subject in an MBA program. The subject is not designed to
train you as an accountant but to understand the accounting function and to
successfully interact with accountants. If you are a manager dealing with
accountants you need to understand their advice, their way of thinking and be able
2.15
to ask sensible, informed questions. You can make jokes about debts and credits
but you should have some idea about the working of the double entry system.
Spreadsheet applications
Businesses do not purchase microcomputers for their staff to play games. There
are two main reasons why businesses buy computers. The first is to replace the
typewriter. Most businesses these days use microcomputers as modern electronic
typewriters. Businesses generally regard microcomputers as executive toys until a
software package called a spreadsheet was invented. It is usually agreed that the
first usable spreadsheet software package was VisiCalc. VisCalc revolutionised
the use of microcomputers in business. Spreadsheets are incredibly flexible tools
which have gained tremendous popularity in business and in particular with
accountants. It has made the boring repetitive tasks in accounting much easier. It
has made the use of sophisticated mathematics fun.
The most common spreadsheet in business applications is Microsoft Excel. Most
spreadsheets perform three functions. The three functions are: spreadsheet,
database, and graphs. The database capabilities of spreadsheets are very useful,
but are much more limited than the features available in dedicated database
packages such as Microsoft Access.
2.16
Spreadsheet applications - Questions

Some of you know about spreadsheets; some dont. They are very useful in
corporate and government environments.
1.
What is a spreadsheet template?
2.
What is a label?
3.
What is the purpose of function key F5?
4.
Which keys enable you to move up or down in a spreadsheet, one page at a

time?
5.
Which key causes the cursor to move to cell A1 in the spreadsheet?
6.
Which key causes you to move to the right in a spreadsheet one full screen
at a time?
7.
How do you move to the left in a spreadsheet one full screen at a time?
8.
Which function key provides help in a spreadsheet?
9.
If you are preparing a spreadsheet and across the first row you want to show
the years for ten years starting with 2000, then 2001, and so on, which
spreadsheet command would you use to perform this quickly?
2.17
10.
If in doubt about the order in which a spreadsheet program will calculate

formulas, what should you do?
11.
What symbols in a spreadsheet are used to indicate exponentiation,

multiplication, division, less than, not equal to?
12.
If using a function in a formula in a spreadsheet, what symbol must precede

the function?
13.
What is the purpose of the following functions: =FV, =IRR, =NPV,

=DATE?
14.
Assume, in a spreadsheet, that you wish to add a column of figures.

Describe three different ways of performing this operation.
15.
What symbol is used to change a relative cell reference into an absolute cell
reference?
16.
What is a circular reference?
2.18
17.
If you suspect that you have forward references or circular references, what
can you do?
18.
What does the look up function do?
19.
What is a data table?
20.
What is the purpose of the =TODAY function?
21.
What is the effect of protecting a cell?
2.19
22.
What are macros? What is the purpose of macros?
23.
What is a data base?
24.
List four data base statistical functions.
Answers are provided below.
2.20
Spreadsheet applications - Answers

1.
What is a spreadsheet template?

A spreadsheet template is a model which consists of formulas, labels and
functions, but which does not contain any numbers. In other words, it is a
blank spreadsheet.
2.
What is a label?
In a spreadsheet, a label is nothing more than a string of text characters, i.e.
a word or words.
3.
What is the purpose of function key F5?

Function key 5 is the go to key. This key enables you to go to any
particular cell in the spreadsheet.
4.
Which keys enable you to move up or down in a spreadsheet, one page at a

time?
The Pg Dn; or Pg Up keys.
5.
Which key causes the cursor to move to cell A1 in the spreadsheet?

The Home key.
6.
Which key causes you to move to the right in a spreadsheet one full screen
at a time?
The Tab key.
7.
How do you move to the left in a spreadsheet one full screen at a time?
By pressing the Shift and Tab key simultaneously.
8.
Which function key provides help in a spreadsheet?

The F1 function key.
9.
If you are preparing a spreadsheet and across the first row you want to
show the years for ten years starting with 2000, then 2001, and so on, which
spreadsheet command would you use to perform this quickly?
The DATA FILL command.
10.
If in doubt about the order in which a spreadsheet program will calculate

formulas, what should you do?
Use brackets (parentheses).
11.
What symbols in a spreadsheet are used to indicate exponentiation,

multiplication, division, less than, not equal to?
Exponentiation ^, multiplication *, division/, less than <, not equal to < >.
2.21
12.
If using a function in a formula in a spreadsheet, what symbol must precede

the function?
The symbol which must precede the function is the = symbol.
13.
What is the purpose of the following functions: =FV, =IRR, =NPV, =DATE?
=FV calculates the Future Value of an Annuity, =IRR calculates the Internal
Rate of Return, =NPV calculates the Net Present Value, =DATE calculates a
unique number for that date.
14.
Assume, in a spreadsheet, that you wish to add a column of figures.

Describe three different ways of performing this operation.
One way would be to type in, as a formula, a cell, plus another cell, plus another
cell, and so on. A second way would be to add a series of cells by pointing with
the cursor and inserting the + sign between each pointing operation. A third
way would be to use the =SUM function and specify the range.
15.
What symbol is used to change a relative cell reference into an absolute cell
reference?
The symbol is used to change a relative cell reference into an absolute cell
reference is the $ symbol.
16.
What is a circular reference?

A circular reference occurs when a formula refers either directly or
indirectly to itself. In spreadsheet design, you should, if possible, avoid
forward references or circular references.
17.
If you suspect that you have forward references or circular references, what
can you do?
Press the F9 key several times to observe if there are any changes in your
results.
18.
What does the look up function do?

A look up function firstly looks for a specified value on a row or column
of the table and secondly selects a corresponding value in an adjoining row
or column.
19.
What is a data table?

The data table commands will return a series of values for formulas having
variables, where you would want to know the value each formula would return
for a series of different inputs. An input is a value given to the variable in the
formula. Data tables speed up the process of exploring what-ifs.
20.
What is the purpose of the =TODAY function?

The =TODAY function displays a current date or time if it was entered
into the computers system clock when the computer was started up.
2.22
21.
What is the effect of protecting a cell?

When a cell is protected, this means that the information in that cell cannot
be changed until the cell is unprotected.
22.
What are macros? What is the purpose of macros?

Macros are a way to store key strokes so that they can be played back with
one or two keys later. The purpose of macros is to save the computer
operator from keying in a number of repetitive key strokes. Macros can also
be used to create new menus. This can make it easy for persons who are not
familiar with spreadsheets to actually use spreadsheets and they can contain
viruses.
23.
What is a data base?

A data base is a collection of information organised into records and fields.
The data base functions included in spreadsheets facilitate the collection,
sorting and analysing of information.
24.
List four data base statistical functions.

Data base statistical functions include: =DAVERAGE - this function
averages the values in the selected field that match a specified criteria;
=DCOUNT- counts all non-blank cells of records in the selected field that
matches the specified criteria; =DMAX - selects the largest value in the
selected field that matches the specified criteria; =STDEV - finds the
standard deviation of the selected field that matches the specified criteria.
2.23

Study questions
2.24
2.25
(13th ed., p. 755). Pearson Prentice-Hall.
2.26
2.27

16-B2
(25 min.)
This is a good exercise in recognizing items that fit in a Statement of Cash Flows
and placing them in the proper section of the statement. Three items listed in the
problem do not appear in a Statement of Cash Flows: net sales, retained earnings,
and total assets.
WALGREEN COMPANY
Statement of Cash Flows
For the Year Ended August 31, 2002
(in millions)
Cash flows from operating activities:
Net earnings
$ 1,019.2
Adjustments to reconcile net earning to net cash provided by operating activities:

Depreciation and amortization
307.3
Deferred income taxes
22.9
Other non-cash expenses
48.2
Changes in current assets and liabilities:

Inventories
(162.8)
Trade accounts payable
289.6
Accrued expenses and other liabilities
75.0
Accounts receivable
(170.6)
Other current assets
30.7
14.3
Net cash provided by operating activities
1,473.8
Cash (Used for) Provided by Investing Activities:

Additions to property and equipment
(934.4)
Disposition of property and equipment
368.1
Proceeds from the surrender of corporate owned life insurance
14.4
Net cash used for investment activities
(551.9)
Cash (Used for) Provided by Financing Activities:

Cash dividends paid
(147.0)
Repayments of short-term borrowings
(440.7)
Net proceeds from employee stock plans
111.1
Other cash used for financing activities
(12.3)
Net cash used for financing activities
(488.9)
Changes in Cash and Cash Equivalents:

Net increase in cash and cash equivalents
433.0
Cash and cash equivalents at beginning of year

Cash and cash equivalents at end of year
2.28
16.9
$
449.9
16-42
(25-30 min.)
This problem is similar to 16-A1 but is more difficult because items not shown in
exhibits 16-1 and 16-5 are included and terminology is varied slightly.
HOKKAIDO Company
Balance Sheet
May 31, 20X1
(in millions)
ASSETS:
Current assets:
Cash and equivalents
31,000
Receivables
22,000
Inventories
29,000
Other current assets
6,000
Total current assets
88,000
Noncurrent assets:
Fixed assets, net
Capital construction fund
28,000
Intangible assets
21,000
Long-term investments
15,000*
Total noncurrent assets
281,000
Total assets
*
217,000
369,000
To compute the amount for long-term investments, recognize that total

assets must be 369,000 (equal to total liabilities and stockholders' equity).
Then:
Total noncurrent assets = Total assets - Total current assets
= 369,000 - 88,000
= 281,000
Long-term investments = Noncurrent assets - Fixed assets, net - Capital
construction fund Intangible assets
= 281,000 - 217,000 - 28,000 - 21,000
= 15,000
2.29
LIABILITIES AND STOCKHOLDERS' EQUITY:

Current liabilities:
Accounts payable
19,000
Accrued expenses payable
16,000
Other current liabilities
9,000
Total current liabilities
44,000
Noncurrent liabilities:
Mortgage bonds
84,000
Debentures
77,000
12,000
Total noncurrent liabilities
173,000
Redeemable preferred stock
15,000
Common stock, at par
5,000
Paid-in capital in excess of par
102,000
Retained income, appropriated

for self-insurance
16,000
Retained income, unrestricted
27,000
Less: Treasury stock
(13,000)
Total stockholders' equity
152,000
Total liabilities and stockholders' equity
369,000
HOKKAIDO Company
Income Statement
For the Year Ended May 31, 20X1
(in millions except net income per share)
Net sales
410,000
Cost of goods sold
(190,000)
Gross margin
220,000
Operating expenses:
Administrative and general expenses
(65,000)
Research and development expenses
(42,000)
Selling and distribution expenses
(41,000)
Total operating expenses
148,000
Operating income
72,000
Other income (expenses), net
(12,000)
Income before income taxes
60,000
Income taxes
2.30
(51,000)
Net income
Net income per share*
180,000
9,000,000,000 50,000 = 180,000
9,000
16-52
(20-30 min.)
1.
JUNEAU COMPANY
Statement of Cash Flows
For the Year Ended December 31, 20X2
(in millions)
Cash flows from operating activities:
Net income
$ 60
Adjustments to reconcile net income to net cash provided by

operating activities:
Depreciation
20
Increase in receivables
(35)
Increase in inventories
(50)
Increase in current liabilities
75
Net cash provided by operating activities
$ 70
Cash flows from investing activities:

Purchase of fixed assets
(190)*
Cash flows from financing activities:

Issue of long-term debt
Dividends paid
$120*
(6)
Cash provided by financing activities

Net decrease in cash
114
$ (6)
Cash balance, December 31, 20X1

Cash balance, December 31, 20X2
31
$
25
This assumes that the debt was issued for cash and the cash used to buy the
fixed assets. If the debt were issued directly to the seller of the fixed assets,
the cash outflow for purchase of fixed assets would be $70 million, there
would be no cash from issuance of long-term debt, and a supporting
schedule would have a investment and financing activity of $120 million for
acquiring the fixed assets.
2.
Dear Ms. Tallman:

Severe shortages of cash commonly accompany rapid corporate growth.
Profitable operations usually produce heavy supplies of cash. But the
insatiable demand for cash to expand receivables, inventories, and fixed
assets may deplete the cash on hand despite profitable operations. This is
why so many so-called growth companies usually pay little or no dividends.
Note also that the ratio of current assets to current liabilities is 3.7 to 1 on
December 31, 20X1 but only 1.8 to 1 on December 31, 20X2. It appears
that the need for cash to support increases in receivables and inventory has
come primarily from increases in current liabilities.
2.31
16-54
1.
(15 min.)
a. FIFO Method:
Inventory shows:
Costs:
600 tons on hand

300 tons @ $10.00
250 tons @ $ 9.00
50 tons @ $ 8.00
July 31 inventory valuation

b. LIFO Method:
Inventory shows:
Costs:
600 tons on hand

500 tons @ $7.00
100 tons @ $8.00
July 31 inventory valuation
$3,000
2,250
400
$5,650
$3,500
800
$4,300
T accounts (not required) are:

Inventory (FIFO)
Balance
3,500
Purchases:
8,000
To cost of goods sold
11,100
2,250
3,000
Available
Balance
16,750
5,650
Inventory (LIFO)
Balance
3,500
Purchases:
8,000
To cost of goods sold
2,250
3,000
Available
Balance
2.
Revenue
Cost of goods sold
Gross profit
2.32
16,750
4,300
FIFO
$16,000
11,100
$ 4,900
LIFO
$16,000
12,450
$ 3,550
12,450
16-56
(20 min.)
1.
Sales
Cost of goods sold:
Inventory, December 31, 20X0
Purchases
Cost of goods available for sale
Inventory, December 31, 20X1
Cost of goods sold
Gross margin or gross profit
Units
LIFO
FIFO
30,000
$360,000
$360,000
15,000
52,000
67,000
37,000
30,000
90,000
396,000
486,000
246,000 *
240,000
$120,000
90,000
396,000
486,000
291,000 **
195,000
$165,000
*15,000 @ $6 = $ 90,000
20,000 @ $7 = 140,000
2,000 @ $8 =
16,000
$246,000
**32,000 @ $8 = $256,000
5,000 @ $7 = 35,000
$291,000
2.
Gross margin is higher under FIFO. However, cash will be higher under
LIFO by .40($165,000 - $120,000) = .40 x $45,000 = $18,000.
2.33
2.34
Reading
2.1
O'Leary, T. J., & O'Leary, L. I. (2011). Creating and editing a worksheet. In
Microsoft Office 2010. (Ex. 1.1-Ex. 1.87). McGraw-Hill.
This reading may help to get you started on Microsoft Excel. If you need
assistance, then use the help function built into Microsoft Excel.
These days the Internet has lots of advice on how to do spreadsheets - and on
occasions you can discover spreadsheet templates.
This reading can be found on CDROM#1
2.35
Reading
2.2
OLeary T. J., & OLeary, L. I. (2008). Charting worksheet data. In Microsoft
Office 2007 (Ex2.1 Ex2.86). McGraw-Hill.
Comment
This reading will assist you with preparing graphs (charts) in Excel.
Fortunately most spreadsheet software is similar. Excel 2007 has similar functions
to other spreadsheets but has a new ribbon menu system. Excel 2010 continues the
ribbon feature. Use any spreadsheet software you like as long as we can read it
with Excel.
The Internet has many resources/blogs on Excel. If you get stuck try posting a
question through Google chances are you will find an answer.
But be careful you can easily suffer from information overload. In this subject
we are only using some basic features of spreadsheet software. Check the
assignment requirements in the subject outline and the examples in the
Introduction section at the beginning of the Study Guide.
Some Excel Internet Resources
http://en.wikipedia.org/wiki/Microsoft_Excel
http://office.microsoft.com/en-us/excel/default.aspx
YouTube has many, many videos explaining Excel
Here are a few
http://video.google.com/videoplay?docid=432862483444888312&ei=65dKS_nEHYGQwgPSyrnqDA&q=Excel+7#
http://www.dailymotion.com/video/x5nh6t_excel-2007-demo-use-simpleformulas_tech
If you find a useful resource please share it on the forum.
2.36
Reading
2.3
Mautz, R. K., & Sharaf, H. A. (1978). Ethical conduct. In S. E. Loeb (Ed.), Ethics
in the accounting profession (pp. 29-37). John Wiley.
An interesting and insightful discussion of ethics and accounting drawing on the

work of philosophers such as Socrates, Hume, Kant and Locke.
2.37
Reading
2.4
Northcott, P. H. (1993). Case 4, Cheating: The pressure on Pasquale Vialletta to
succeed. In Ethics and the accountant: Case studies, student edition
(pp. 17-18). Sydney: Prentice-Hall.
A case study on ethics.

2.38
Reading
2.5
Northcott, P. H. (1993). Ethics and the certified practicing accountant: Case
studies Presenters notes. Australian Society of Certified Practicing
Accountants, (now CPA Australia) (pp. 30-32). Deakin University.
Some advice on the previous case study.

2.39
2.40
Topic 3 Analysis and interpretation of accounting

reports
Required reading
Textbook:
Horngren, Sundem & Stratton, ch. 17, Part Two only.
Reading 3.1
Brewer, P. C., Garrison, R. H., & Noreen, E. W. (1995). How

well am I doing?: Financial statement analysis.
Reading 3.2:
Crossman, J., Bordia, S., & Mills, C. (2011). Communicating in

writing.
Reading 3.3:
Davies, M. R., Kries, K. E., Nutting, J. B., & Tronc, K. E.

(1985). Business reports.
Reading 3.4:
Windschuttle, K., &Windschuttle, E. (1989). Rational debate

and common fallacies.
Reading 3.5:
Downes, S. (1999). Stephens guide to the logical fallacies [Online]
Reading 3.6:
(1999). False dilemma [Online]
You should now study the Brewer et. al Reading as well as Chapter 17, Part Two,
of your textbook.
There are a myriad of accounting and finance texts which address the topic of
analysis and interpretation of accounting reports. It is recommended you study
Reading 3.1 and your text because they provide a sound treatment of the more
commonly used ratios and techniques in analysing financial statements. If you
read more widely on this subject you will find that there are many different ratios
which can be extracted from published financial statements. In most cases these
ratios are very similar to or are only variations of the more frequently used ratios,
used by other authors for interpreting results or predicting future outcomes.
The overall objective of the financial analyst is to extract information from the
financial statements for use in assessing profitability, financial stability and
operating efficiency of an entity.
3.1
Learning objectives
Besides equipping you with the techniques for guessing/anticipating the future
results of companies listed on the stock exchange and their share price you should
be able to:
apply analytical techniques in the analysis of financial statements
vertical analysis;
horizontal analysis (absolute dollar change as well as percentage change);
identify improvements or deteriorations in the performance of firms and

highlight trends;
use base year analysis and be aware of the criteria for selecting the base
year;
use vertical analysis in comparing financial statements;
be able to calculate the three common measures of operating performance
return on assets;
return on shareholders equity;
return on sales;
understand and calculate the four methods frequently used by an analyst in

relation to net income and dividends paid
earnings per share;

price earnings ratio;
dividend yield;
dividend payout;
be familiar with the terms trading on the equity and leverage;
calculate and comment on the ratios and averages used in the analysis of
financial strength
equity ratio;
(bond) interest coverage;
preference dividend coverage;
current ratio;
quick ratio;
use short-term credit analysis i.e. assess the companys working capital
position;
calculate inventory turnover and average collection period for accounts

receivable;
recognise the limitations of all these ratios, percentages and relationships as

being the product of specific analytical techniques, which singly, do not
necessarily indicate strengths or weaknesses, but identify areas which should
be subject to further investigation;
3.2
appreciate that the published accounting data may have limited usefulness
because of the difficulty in comparing results between firms even in the
same industry (size, range of products, method of operation)
business may not adopt uniform accounting methods (depreciation,

inventory valuation, conservation etc.);
external reports are based on historical costs and each business is very
protective of sensitive commercial information.
Note: A number of terms used in the financial statements may be unfamiliar to

you as you will have had only limited exposure to financial accounting. Access
any of the financial and accounting dictionaries that are available or an
introductory financial accounting textbook to explain more fully these terms.
Alternatively, search for definitions on the internet.
Before proceeding to later topics ensure you have a thorough understanding of the
important ratios used in the analysis and interpretation of financial statements.
These are summarised in Brewer et. al and Chapter 17, Part Two of your text. At
this point you should attempt the Topic review questions which are included in
your Readings.
Finally, do not learn these ratios without understanding the value of the result
interpreting the result is a measure of your skill in interpreting financial reports.
3.3

Study questions
3.4
3.5

17-B4
(10-20 min.)
1.
Total asset turnover: 8.9% 4% = 2.225 times*
2.
Net income: 8.9% x $27.3 billion = $2.4297 billion
3.
Total revenues: $2.4297 billion 4% = $60.7425 billion (or 2.225 x $27.3

billion = $60.7425 billion)
4.
Average stockholders' equity: $2.4297 billion 18.9% = $12.8556 billion
5.
Gallons sold: $2.4297 billion 3.6 cents = 67.492 billion gallons
Alternatively, the total asset turnover can be computed after determining net
income and total revenues: $60.7425 billion $27.3 billion = 2.225 times
17-36
(40-50 min.)
Amounts are in millions of Norwegian kroner.

1.
a.
Current ratio:
20X1: ( 5 + 70 + 85) 55 = 2.9 to 1
20X2: (30 + 85 + 120) 70 = 3.4 to 1
b.
Rate of return on sales:

(Sales: 20X1: 380+620 = 1,000; 20X2: 520+980 = 1,500)
20X1: 60 1,000 = 6.0%
20X2: 95 1,500 = 6.3%
c.
Rate of return on stockholders' equity:

20X1: 60 1/2(205 + 10 + 205 + 55) = 25.3%
20X2: 95 1/2(205 + 55 + 205 + 120) = 32.5%
d.
Ratio of total debt to stockholders' equity:

20X1: (65 + 55) (205 + 55) = 46.2%
20X2: (80 + 70) (205 + 120) = 46.2%
e.
Ratio of current debt to stockholders' equity:

20X1: 55 (205 + 55) = 21.2%
20X2: 70 (205 + 120) = 21.5%
f.
Gross profit rate:

20X1: 380 1,000 = 38%
20X2: 520 1,500 = 34.7%
g.
Average collection period for accounts receivable:

20X1: [(1/2) x (40 + 70) x 365] 1,000 = 20.1 days
20X2: [(1/2) x (70 + 85) x 365] 1,500 = 18.9 days
3.6
h.
Price-earnings ratio (Earnings per share are 60 10 = 6 for 20X1 and

95 10 = 9.5 for 20X2):
20X1: 30 6 = 5
20X2: 40 9.5 = 4.2
i.
Dividend-payout percentage (Dividends per share are 15 10 = 1.50

for 20X1 and 30 10 = 3.00 for 20X2):
20X1: 1.50 6 = 25%
20X2: 3.00 9.5 = 31.6%
j.
Dividend yield:
20X1: 1.50 30 = 5.0%
20X2: 3.00 40 = 7.5%
2.
3.
a.
No, f
b.
No, b
c.
Yes, c
d.
No, g
e.
Yes, i, j
f.
No, d, e
g.
Yes, h
h.
Yes, b, c
i.
No, a
j.
No, j
k.
Yes, g
The company has grown rapidly and profitably (ratios b. and c.). Sales have
tripled; earnings have nearly quadrupled; dividends have increased 500%;
and total assets have increased 64%. Moreover, the large increase in
retained income indicates that the expansion has been financed largely by
internally generated funds. The expansion has been accompanied by
increased liquidity of current assets (ratio a.). The stock is priced
attractively (h.), and the dividend policy seems conservative (i. and j.).
3.7
3.8
Reading
3.1
Brewer, P. C., Garrison, R. H., & Noreen, E. W. (1995). How well am I doing?:
Financial statement analysis. In Introduction to managerial accounting
(2nd ed., ch. 14, pp. 584-629). NY: McGraw Hill.
A conventional treatment of financial statement analysis which may supplement

the prescribed text.
3.9
Reading
3.2
Crossman, J., Bordia, S., & Mills, C. (2011). Communicating in writing. In
Business communication for the global age (pp. 288-317). North Ryde,
NSW: McGraw-Hill.
These pages provide a broader view of written business communication including

some ethical issues.
3.10
Reading
3.3
Davies, M. R., Kries, K. E., Nutting, J. B., & Tronc, K. E. (1985). Business
reports. In The business of communicating (ch. 8, pp. 212-231).
McGraw-Hill.
An old reading, but still provides a useful summary of business reports.

3.11
Reading
3.4
Windschuttle, K., &Windschuttle, E. (1989). Rational debate and common
fallacies. In Writing, researching and communicating (ch. 9, pp. 74-81).
McGraw-Hill.
A graduate from CSU who used this reading said later post graduation that
these concepts strongly influenced his thinking and attitude to life.
3.12
Reading
3.5
Downes, S. Stephens guide to the logical fallacies, [Online], viewed
30 March 1999,
<http://assiniboinec.mb.ca/user/downess/fallacy/fall.htm>
Try using a search engine such as Google.com to find more examples e.g. search
on Stephens fallacies or false dilemma and so on.
3.13
Reading
3.6
False dilemma, [Online], viewed 30 March 1999,
<http://www.assiniboinec.mb.ca/user/downes/fallacy/distract/fd.htm>
viewed 29 March 1999,
<http://www.assiniboinec.mb.ca/user/downes/fallacy/posthoc.htm>
viewed 8 December 1998,
<http://arachne.sjsu.edu/depts/itl/graphics/adhom/dilemma.html.
3.14
Reading
3.7
Wikipedia (2008). Digital dashboard. Accessed February 2008.
Digital dashboards are increasingly used to provide information about

corporations in a pictorial manner. They are often based on spreadsheet software.
But is the financial information (and other information) audited? They are
certainly useful for internal reporting purposes.
3.15
3.16
Topic 4 Managing working capital - cash and

inventory
Required reading
Study these study guide notes. If you think you need further information then
consider using the Internet. However, for the purposes of this subject these notes
are sufficient. Also examine the spreadsheet examples at the beginning of the
study guide in the spreadsheet advice section AND the spreadsheet example at the
end of this section.
Working capital including cash and inventory are vitally important in the efficient
management of organisations.
Working capital and cash
Working capital: Working capital is composed of cash and other liquid

assets such as marketable securities, accounts receivables and inventories those that can be transformed into cash within a relatively short period - less
accounts payable and other liabilities that would be expected to consume
cash within the same short period.
Working capital = Current assets - Current liabilities.
Cash: Cash is what is needed by a business to satisfy its obligations as

they come due, to meet day-to-day expenses, and to make distribution of
assets to stockholders eager for a return on investment.
The chief sources: The chief sources of working capital are, operations,
additional investments by owners, long-term borrowing and the sale of
assets.
Uses: The uses of working capital emphasise the inter-relationship of the

sources (inflows) and uses (outflows) of working capital.
Over the long run a business will acquire plant and make other investments
in assets, retire long-term debt and distribute dividends to its shareholders
largely from the working capital generated by revenue-producing activities
with service to customers. (Granof, 1987)
Working capital management
Working capital management is the management of current assets and current

liabilities. Anything that affects either current assets or liabilities affects the
working capital. In managing working capital there are 3 major tasks:
Making sure that the level of current assets maximises the firms
profitability;
4.1
Making sure that there is the best possible balance between long-term and
short-term debt, to keep the average cost of capital as low as possible;
Making sure that funds are not squandered by keeping assets that are not
productive.
In order to achieve these a firm must have the right composition of assets.
Smooth outflow and inflow of working capital is a result of managerial

decisions, keeping track of working capital does not only speak of the
financial well-being of the company but also sheds light on the effectiveness
of the financial policies of its management.
It helps to better understand the transactions involving the financial and

investing activities: the exchanges with outside parties in which enterprises
are engaged during an accounting period.
General rules for working capital management
Keep stocks as low as possible without running the risk of stock-outs.
Keep debtors as low as possible without offending them by over-aggressive

collection.
Dont keep larger cash balances than you need but have significant available
for emergencies.
Try to keep the operating cycle as short as possible.
Topic 3 examined the use of financial ratios; this topic extends the discussion on
the items which comprise working capital.
Recall that working capital is defined as current assets minus current

liabilities and the following items are included in its calculation.
Cash
Debtors or accounts receivable
Inventory
Prepaid expenses
Work-in-process
Raw materials
Finished goods
Short term investments
Bank overdraft
Creditors or accounts payable
Accrued expenses
Short term loans
4.2
Current Asset (CA)

CA
CA
CA
CA
CA
CA
CA
Current Liabilities (CL)
CL
CL
CL
Inventory not only includes stock on hand for resale in the case of retailer,
but for manufacturing businesses it can also include: the raw materials
which are converted or have value added in the processing/manufacturing
system, partly completed goods which havent been subject to the full
application of materials and labour i.e. work-in-progress (W-I-P) and,
finished goods which are stock on hand awaiting sale.
Managing inventory
Inventory is a significant component of working capital. Inventory comprises:
raw materials
work-in-progress
finished goods
Objective
To turn stock over as quickly as possible. (Maintain a store of saleable inventory,
avoid obsolete stock or stock that may deteriorate). Important considerations:
erratic customer demand may require a higher level of stock
imports require a higher level of stock because of their variation in supply
the level of raw materials depends upon production schedules and reliability
of suppliers.
Inventory control
The major objective in inventory planning is to maintain the optimum level of
inventory. See EOQ analysis later in this topic.
Advantages of keeping inventory low:
a.
requires little storage space and reduces storage costs (insurance,

warehousing);
b.
reduced risk of obsolescence, pilferage and deterioration with a small

inventory which turns over rapidly;
c.
a smaller capital investment, reduced financing costs.
Advantages of a larger inventory:

a.
reduced risk of running out of stock (retailers and manufacturers), serious

consequences if you run out of stock e.g. lost orders and customers;
b.
few re-orders with larger inventories ... saving in administrative costs and
paperwork;
c.
larger orders can mean bigger discounts.
All these factors must be considered when planning inventory levels.
4.3
4 steps in determining optimum inventory levels

1.
Which inventory items are worth the cost in time and effort in planning?
small volume, relatively inexpensive, non-perishable;
2.
If planning is deemed necessary for an item calculate the safety stock or

minimum acceptable stock level;
3.
Determine the economic order quantity for those items which will be subject
to planning;
4.
Where planning for items is not considered necessary develop rules or

policy re the level of stock and re order position (simplify procedures).
Problems will vary between industries. Motor vehicle manufacture: average car
10,000 parts; some will be unique and others common to a number of models;
some large, others small; some expensive, others inexpensive.
Special problems
Fashion goods, storage requirements, cost of item.
Use a cost benefit approach in deciding whether or not to use a planning approach.
Inventory planning can be an expensive procedure.
Detailed planning requirement
Involves the calculation of:
1.
2.
3.
4.
5.
lead time;
sales rate;
safety stocks;
average inventory levels;
order quantities.
Lead time
Time taken to receive an order after it has been placed; local v. overseas supplier.
4.4
Sales rate
Annual sales (budget data) expressed as a daily sales rate, sales may not have an
even distribution throughout the year.
If sales rate even and lead time certain, re-ordering would be a simple
matter.
Average inventory level
This is the mid-point between the highest level and lowest level of inventory. A
high is reached when the new order arrives and the low point is immediately
before the order arrives.
if the inventory level is never allowed to fall below 200 units and each order
is for 800 units, then the average inventory level is:
=
200 + [800 + 200]

600units
Safety stock
A level of stock required because of the uncertainty associated with receipt of
stock to replenish inventory
transport problems, industrial disputes, supplier stock problems.
This cushion (buffer) or margin for safety can be calculated in two ways:
1.
where daily usage is uncertain: (maximum daily usage - average daily

usage) lead time
2.
where the lead time is uncertain: (maximum lead time - usual lead
time) average daily usage
Order quantities or re-order point

re-order point = safety stock + (lead time average daily usage or sales)
The business would re-order when the inventory on hand plus inventory in transit
equals the re-order point.
There are costs associated with the re-ordering of inventory and costs incurred for
carrying inventory on hand.
4.5
Ordering costs
Administrative expenses associated with ordering, receiving, inspection and
quality control.
Carrying costs
Financing, warehousing, handling, insurance, allowances for loss, damage and
obsolescence; calculated on a per unit per annum basis.
Total ordering costs are lower the less times stock is ordered i.e. re-order in larger
quantities.
By re-ordering in larger quantities the total carrying costs will be increased.
Total costs associated with inventory will be at their lowest where
Total ordering costs = total carrying costs.
The following notes are adapted from Fatseas, V. A., & Williams, J. F. (2008).
Management accounting decisions. McGraw-Hill.
Inventory control
The concern in this part of the topic is with the timing of the placement of orders, or
the set-up of manufacturing runs, and the optimum quantities involved.
Inventory control involves decisions about the level of inventory of different products
to hold. Such decisions traditionally involve a consideration of two countervailing
factors. On the one hand, there is the desire to hold sufficient stocks to meet demand
and retain customer goodwill. On the other hand, there are costs involved in holding
inventories, for example, cost of funds invested, warehousing costs and the costs of
deterioration or obsolescence. In manufacturing settings it can be argued that there are
further costs of holding inventories because they can mask inefficient work practices
and poor quality control. Decisions about the level of inventories to maintain must be
made by wholesalers, retailers and manufacturers.
Purpose of inventory
Wholesalers and retailers hold finished goods inventories (merchandise) to enable
them to supply goods immediately to satisfy customer demand. By reducing the level
of inventories they can reduce the costs of carrying (holding) inventory, but they will
increase the frequency of ordering. This increases acquisition (ordering) costs
because it costs money to prepare purchase orders and place them with suppliers and
then receive the goods and check that the order was properly filled. Lower inventory
levels also increase the likelihood of being unable to meet customer demand
immediately and possibly losing potential sales. For some items, however, it may be
optimal not to hold stocks, particularly when items have a high cost, a low turnover,
or can be obtained very quickly from a supplier. If reliable suppliers can be
established firms can operate a just in time (JIT) inventory system, thus allowing
them to hold little or no inventory.
4.6
Inventory management is usually more complex for a manufacturer. A manufacturer

holds inventories of finished goods for sale as well as sufficient stocks of raw materials
and work-in-process to ensure smooth production runs. The holding of work-inprocess is usually unavoidable because the production process is not instantaneous; the
level of work-in-process inventories is a function of the volume of production, the time
taken to produce finished goods, and the need for work-in-process as a buffer between
work centres and to provide flexibility in operations. Raw material inventories are held
as a safeguard against variability in raw material delivery time and to prevent the
consequences of delays to the production process. It should be noted, however, that
these conventional explanations for holding raw material and work-in-process
inventories have been somewhat overturned by Japanese manufacturers who carry
practically no inventories, relying on instantaneous delivery at the required time - the
just in time inventory system which is gradually spreading throughout the world.
Manufacturers may also hold finished goods inventories to meet variations in product
demand, to ensure a stable level of operations (particularly where demand is seasonal)
and to permit lower cost operation through economic production runs.
Control objectives
The objective of inventory control is to minimise the total costs associated with
inventories by finding the optimum quantity to order (raw materials or
merchandise), or the optimum sized production run (manufactured products).
There are three main classes of inventory costs, ordering costs, carrying (or
holding) costs, and stockout costs.
Ordering costs are incurred in ordering and receiving inventories. These include
costs associated with the preparation and approval of purchase requisitions and
purchase orders, the costs of receiving goods into store, and the costs of settling
accounts. It is often difficult to estimate such costs because of the problem of
allocating common costs. At the very least one should try to identify those costs
which vary with the number of orders placed. By ordering larger quantities (or
having larger production runs) each time, fewer orders (or production runs) are
required per time period, usually a year, and thus this policy results in lower
ordering (or set-up) costs, but higher carrying costs for holding larger inventories.
Conversely, by ordering smaller quantities (or having smaller production runs)
each time, there are more frequent orders (or production runs) resulting in higher
ordering (set-up) costs, but lower carrying costs because there are fewer units on
hand.
Carrying costs are the costs of holding inventories until they are sold (or used).
They include warehousing costs (storemen's wages, rental or rental foregone, light
and power, heat, refrigeration etc.), insurance, interest on borrowed funds or
foregone on own funds invested in purchase of inventory held, and the costs of
spoilage, deterioration or obsolescence. Again some of these costs may be
difficult to estimate. For example, how do you apportion a storeman's wages over
a large number of inventory lines? Further, many of these may be opportunity
costs (e.g. interest or rental foregone) which are not routinely generated by an
accounting system. Nevertheless, as we shall see later, it is better to try to
estimate these costs because large errors in estimates are not necessarily fatal.
4.7
Stockout costs are incurred when firms are out of stock of finished goods, or
when manufacturing operations are disrupted through shortages of raw materials.
These costs include loss of profit on sales lost, and foregone on possible future
sales from customers who have been lost through stockouts, or increased
manufacturing costs and possible lost sales because of shortages of finished
goods.
Various models are available for determining the optimum quantity to order (or
the optimum sized production run), the re-order point signalling the need to place
a new order (to set up a new production run), the effects of quantity discounts, and
the optimum level of safety stocks to carry as a buffer against uncertainty in
demand or lead time. The following analysis concerns any one line of inventory.
Firms with a large range of products would not carry out such analysis for every
line, but only for the more valuable items. Frequently less than 20% of items
account for about 80% of the value of inventory.
A simple model - economic order quantity
The optimum purchase or production batch size is known as the economic order
quantity (EOQ). In the simplest model it is assumed that:
1.
demand for an item is known and constant;
2.
lead time between placement and receipt of an order (or set-up time)is
known and constant;
3.
batches arrive (are finished) just as the old stock is exhausted, and hence
there are no stockouts;
4.
there are no quantity discounts.
In Figure 11-1 if Q is the order size (or production run size), the lot is reduced at a
constant rate until, just as it is exhausted, a new order is received (or batch is
produced). Hence the average inventory level is half the number of units in the lot
size, that is Q/2.
Let
4.8
D = annual demand (requirements)

P = unit purchase price (or manufacturing cost)
O = ordering costs per order (or set-up costs per run)
K = carrying cost per unit per annum
I = inventory carrying costs as a percentage of value of average inventory
K = PI
Q = economic order quantity
TAIC = total annual inventory costs.
Quantity of
Inventory
Average
Inventory
Q/2
0
t0
t1
t2
t3
Figure 11-1: The Sawtooth Model
The objective is to minimise total annual inventory costs. These are represented
by:
TAIC
ordering costs
+
(or set up costs)
DO
Q
carrying costs +
KQ
2
purchase outlay
(or variable manufacturing costs)
DP
(11-1)
The ordering costs are equal to the number of orders per year (D/Q) multiplied by
the ordering costs per order (O). Carrying costs are the product of carrying cost
per unit per annum (K or PI) and the average inventory on hand (Q/2).
We can find the optimum value for Q (the EOQ) by finding the minimum value
for TAIC (given that all other variables are known). Using calculus, we
differentiate TAIC with respect to Q, set the first derivative equal to zero, and
solve for Q:
K
d (TAIC )
DO
=
+
=0
2
2
Q
d (Q)
Q2 K = 2DO
Q =
2DO
K
(11-2)
(Note: the second derivative is positive, indicating minimum cost)

It may be noted that when taking the first derivative the purchase outlay (DP)
drops out [because it does not contain Q], meaning that it is irrelevant to the
decision (given a fixed price).
4.9
Example 11-1: A Retailer

A retailer requires 20 000 units of an item per year. He buys them for $1
per unit. Ordering costs are $5 per order. Inventory carrying costs are
20% of the value of average inventory.
Required: Determine the economic order quantity.
Substitute into the EOQ formula:
EOQ =
2DO
=
PI
2 20 000 5
= 1000 units
1 0.2
Thus the retailer should order in lots of 1000 units, giving minimum total annual
inventory costs of:
TAIC =
=
DO
Q
20 000 5
+
1000
= 100
PI (Q)
2
0.2 1000
2
100
DP
+ (20 000 1)
+
20 000
= $20 200
It may be noticed that both the ordering costs and the carrying costs are $100 per
year. This is no accident. At the EOQ they are always equal, and this is a test of
the accuracy of your calculations. Using Example 11-1 data, we plot the cost
curves showing minimum total cost (excluding purchase outlay which is
irrelevant) occurring directly above the intersection of the curves representing
ordering and carrying costs, in Figure 11-2.
4.10
K
0
500
1000
1500
2000
2500
tc
0
50
200
250
100
100
200
150 66.66667 216.6667
200
50
250
250
40
290
Figure 11-2
Example 11-2: A Manufacturer

A manufacturer uses the same plant to produce a number of different
motor vehicle spare parts. The demand for a particular part is estimated
to be 10 000 units in the coming year.
The cost of setting up machines each time is $50, and the annual cost of
carrying one unit in inventory is $1.
Required: What is the optimum size production run?
The only difference in this second example is that we use set-up cost in place of
ordering cost:
EOQ =
2DO
=
K
2 10 000 50
= 1000 units
1
Re-order point: When to place an order

The re-order point is governed by two considerations. First, the length of time
taken by the supplier from the time the order is placed until delivery, known as the
lead time. Clearly, the longer the lead time the earlier new orders should be
placed. Second, the quantity demanded by customers over the lead time is critical.
The higher the demand over the lead time, the earlier orders should be placed, so
that stockouts do not occur.
4.11
The re-order point (ROP) is established in terms of the number of units of

inventory on hand. When inventory falls to the critical level it is time to re-order.
This critical level, the ROP, depends upon the quantity demanded over the lead
time:
ROP = daily usage x lead time (in days)
(11-3)
Given the assumptions in the basic model, both lead time and demand are know
with certainty and are constant.
Example 11-3: Re-order Point
Referring to Example 11-2, suppose there are 200 working days per year.
The lead time between receiving notice from the finished goods store of
the need for a new batch and the scheduling, set-up and completion of a
new production batch is 5 days.
When should the finished goods store place a new order with the
production department?
We need to calculate the daily usage of the motor vehicle part. The annual
demand is 10 000 units, and there are 200 working days. Therefore the daily
usage (based on working days) is
10 000/200 = 50 per day.
Thus, ROP = daily usage x lead time
= 50 x 5 = 250.
Therefore the finished goods store should reorder when the stock level for this part
falls to 250 units.
Model sensitivity
Here we are concerned with how sensitive the EOQ model is to errors in
estimation of the key variables and consequently whether total annual inventory
costs vary significantly with small errors in the EOQ. The two variables which are
most likely to be subject to errors in estimation are ordering costs (or setup costs)
(O) and carrying costs per unit (K). Because of the square root sign in the formula
Q=
4.12
2DO
K
a given percentage error in either O or K will produce a smaller percentage error

in Q. Using the figures from Example 11-1, suppose O is wrongly estimated to be
$6.25 instead of $5, a 25% over-estimate. Then the calculated EOQ would be
Q=
2DO
=
PI
2 20 000 6.25
= 1118,
0.2
an error of 11.8% above the correct EOQ. If instead, O were wrongly

underestimated by 25% at $3.75, Q would be 866, an error of 13.4% under the
correct EOQ.
More importantly, given the error in Q, what effect does the incorrect EOQ have
on annual inventory costs? For Q = 1000, the optimum order quantity, annual
ordering plus carrying costs are equal to $100 + $100 (see above) = $200. In the
case of the 25% over-estimate in O giving Q = 1118, annual ordering plus carrying
costs would be
20 000 5 0.2 1118
DO KQ
+
=
+
11118
2
2
Q
= 89.43 + 111.8
= $201.23
Thus an error of 25% in ordering costs results in an opportunity loss of $1.23
($201.23 - $200), or a total ordering plus carrying cost which is within 1% of the
minimum. Note that in calculating ordering plus carrying costs to find the result
of an error in O the true value of O, $5, is used. The initial error in O is reflected
in the wrong value for Q.
The error as a result of underestimating ordering costs results in a lower Q and a
larger opportunity loss. Therefore it is safer to err on the high side rather than on
the low side. It is sometimes maintained that to be within the range Q 25% is
accurate enough, but as shown, it is usually better to err on the high side.
For errors in carrying costs, K, similar results occur. The reader is invited to try a
25% error and follow it through. If the same percentage error occurs in both O and
K, the errors cancel out because one is in the numerator and one in the denominator.
Summary
Inventory control involves decisions about the level of inventory of different
materials or products to hold. The simple EOQ model was examined to determine
the optimum order quantity. Reorder points were also calculated, taking account
of safety stocks where appropriate.
4.13
4.14
Self-test questions
I.
Matching
Match the numbered term with the letter of the most appropriate description.
1.
_____
Economic order quantity
2.
_____
Stockout cost
3.
_____
Reorder point
4.
_____
Lead time
5.
_____
Safety stock
6.
_____
Ordering cost
7.
_____
Carrying cost
8.
_____
JIT (Just in Time) inventory system
A.
The optimum batch size to purchase or produce, so as to minimise costs.
B.
Incurred by holding and storing inventory.
C.
Additional inventory held as a buffer against possible stockouts during the

lead time.
D.
Opportunity cost associated with running out of raw materials or finished

goods.
E.
Incurred at each reorder point.
F.
Elapsed time between placing and receipt of an order.
G.
Practice of purchasing or producing inventory items only when necessary so

that no inventories are held for any length of time.
H.
The critical number of units on hand at which it becomes necessary to put in

motion procedures for replenishing stocks.
II.
Completion statements
Complete each of the following statements with the appropriate word or words.
1.
Two key inventory decisions are _______________________ and

_____________________________.
2.
For a typical retailer the largest cost item is

__________________________.
3.
Two key merchandise ordering decisions faced by retailers are

__________________________ and ________________________.
4.
_________________________ production reduces the role of cost

accounting because the focus is on non-financial performance measures such
as production lead time and percentage of defective units.
5.
Three costs that can be affected by quantity discounts are

________________, _______________ and _________________.
4.15
III. Multiple choice

Identify the correct alternative in each question.
1.
The overall objective of inventory management is

A.
B.
C.
D.
E.
2.
to ensure that no stockouts occur.

to provide the correct balance between the cost of placing purchase
orders and the cost of carrying inventory.
to provide the optimum trade-off between the cost of carrying
inventory and the cost of not carrying enough inventory.
to ensure that each time a purchase order is placed, the economic order
quantity is ordered.
to minimise the cost arising from stock obsolescence.
Given:
Inventory unit cost - $32

Annual demand - 28,125 units
Cost of placing an order - $5
Inventory carrying cost - $2 per unit per annum
What is the economic order quantity?

A.
B.
C.
D.
E.
3.
66 units
490 units
275 units
375 units
None of the above
What is the total inventory system cost at the economic order point for
Penthouse Ltd., given:
Cost of placing an order - $2
Inventory carrying cost - $4 per unit per annum
Annual demand - 4,008,004 units?
(ignore purchase outlay cost)
A.
B.
C.
D.
E.
$8008
$2002
$4004
$1001
$9009
Use the following data to answer Questions 4 and 5:

Annual demand is 51,200 units at a unit selling price of $10, giving a total
sales volume of $512,000. Cost of placing and processing each order is $20.
Cost of carrying inventory is $5 per unit per annum.
4.16
4.
What is the economic order quantity?

A.
B.
C.
D.
E.
5.
2,024
640
3,200
160
None of the above
The annual cost of maintaining a safety stock level of 100 units would be
A.
B.
C.
D.
E.
$500
$250
$2000
$1000
none of the above
6.
Which of the following is incorrect?

From the point of intersection marked O on the above graph it is possible to
read off directly from one or other of the axes for the optimal inventory
policy:
A.
B.
C.
D.
E.
the annual purchase order cost.

the annual inventory carrying cost.
half the total annual inventory cost, excluding purchase outlay.
the total annual inventory cost, excluding purchase outlay.
the economic order quantity.
4.17
7.
Given:
Economic order quantity - 2000 units
Unit selling price - $10
Unit purchase cost - $8
Safety stock level - 300 units
Average cost of capital - 15%
The annual cost of funds invested in this inventory line is
A.
B.
C.
D.
E.
8.
$2,760
$1,560
$1,380
$3,225
$1,950
Given:
250 business days per year
Order lead time - 6 business days
Annual demand - 125,000 units
Safety stock level - 800 units
Unit selling price - $40
Unit purchase cost - $26
Economic order quantity - 10,000 units
The reorder point in units is
A.
B.
C.
D.
E.
9.
2,300
3,800
3,400
2,200
none of the above
Which of the following is incorrect?

The economic order quantity model is frequently described as an insensitive
model, and because of this lack of sensitivity
A.
B.
C.
D.
E.
4.18
total annual inventory cost will be relatively little affected by a

reasonable error in estimation of the cost of a purchase order.
the calculated order quantity will be a useful approximation,
notwithstanding reasonable errors in estimation of all input variables.
total annual inventory cost will be relatively little affected by a
reasonable error in estimation of the cost of carrying inventory.
the low point of the total inventory cost curve will always be vertically
above the point of intersection of the ordering cost curve and the
carrying cost curve.
the total cost curve will tend to have a relatively flat section in the
region of the economic order quantity.
10.
Given:
Daily demand and order lead time are random variables described by the
following frequency distributions:
Daily Demand
Units
Frequency
12
9
13
14
14
31
15
26
20
16
100
Order Lead Time

Days
Frequency
4
50
5
30
20
6
100
Then in order to ensure that a stockout would never occur it would be

necessary to use a reorder point of
A.
B.
C.
D.
E.
70
67.4
467.4
400
96
4.19
Self-test solutions
I.
Matching
1 A; 2. D; 3. H; 4. F; 5. C; 6. E; 7. B; 8. G.
II.
Completion statements
1.
how much to order (or make); when to order.
2.
cost of goods sold.
3.
how much to order; when to order.
4.
just in time.
5.
ordering costs, carrying costs, purchase outlay costs.
III. Multiple choice
4.20
1.
2.
Q = [(2281255)/2] = 375
3.
Q = [(240080042)/4] = 2002
TAIC = (4008004/2002)2 + (2002/2)4 = 8008
4.
Q = [(25120020)/5] = 640
5.
100 UNITS $5 = $500
6.
7.
[(2000/2) + 300] $8 0.15 = $1560
8.
[(25,000/250)6] + 800 = 3,800
9.
The statement D is correct but does not relate to sensitivity
10.
Maximum demand maximum lead time: 166=96

Selected from Fatseas, V. A., & Williams, J. F. (2008). Management accounting
decisions (ch. 10). McGraw-Hill.
Study questions
P10-6
Quantity discounts
Javid Dones Ltd buys men's shirts from Whitworth Shirts. The number
required annually is 100 000. Each order placed costs $50 and it has
been estimated that inventory carrying costs are 25% of the value of
average inventory. The price of the shirts is $15 each if the order is for
less than 3000, with a progressive reduction of $1 per shirt for each
additional 1000 ($14 for 3000-3999, $13 for 4000-4999 etc.). There is,
however, a minimum price of $10 per shirt.
How many shirts should Javid Dones order at a time?
P10-9
Comprehensive inventory ordering problem (difficult)

Rollergame Ltd is planning the manufacture of a new roller bearing, part
number NL86325. Company plans are formulated on the basis of 250
working days per year. For inventory management purposes the
following estimates relative to the new product have been prepared:
i.
Daily sales in units

40
50
60
70
Probability
0.5
0.3
0.1
0.1
ii.
Annual carrying cost per unit $0.40.
iii.
Set-up time to manufacture the part is 6 hours for each of the five
machines involved in the process, and the operators of these
machines who are paid at an hourly rate of $5.89 effect all
necessary adjustments. Manufacturing overhead for the department
is charged at the rate of $8.00 per machine hour, for every hour that
a machine is committed to a particular job irrespective of whether
the machine is actually running or not. Other costs associated with
a stock replenishment order for the part are not significant and may
be ignored.
4.21
iv.
Depending on the work load of the department at the time a

requisition for replenishment of the stock of part number NL86325
is issued from the finished goods store, the elapsed time until the
new stock is received could be as low as 15 days or as high as 20
days with the following probability estimates:
Days to fill order
Probability
15
0.30
16
0.15
17
0.15
l8
0.15
l9
0.15
20
0.10
v.
Estimated unit cost for part number NL86325, exclusive of set-up

costs, is $3.00.
vi.
The part can be manufactured at the rate of 1000 per day by the
production department.
Required:
a.
Calculate the economic size for each production run.
b.
When should the requisition for replenishment of stock of the part

be issued from the finished goods store (based on expected values)?
c.
How would your answer to (b) change to take account of the

following comments by the chief executive?:
I am prepared to accept stock-out situations that arise because
sales during the time taken to meet a requisition order are higher
than usual, but if sales do occur at the expected level, you people
should be able to order in such a way that at least 9 times out of 10
the new batch will be on the shelves before a stock-out occurs. At
the same time, you know we dont want to be holding larger stocks
than necessary.
4.22
d.
What is the extra annual cost of using the re-order point calculated
in (c) in preference to that calculated in (b)? Explain.
e.
If the re-order point calculated in (c) were used, what rate of stock
turnover would be achieved for this part?
f.
Assuming that all estimates and probabilities are accurate, what

level of safety stock would need to be carried to ensure a service
level of 100%?
g.
Having regard to your earlier calculation what is the full estimated

unit cost for the part?
h.
The rollers for manufacture of this new bearing are purchased from
outside sources and it is certain that supplies can always be
received within eight working days from issue of a purchase order.
Fourteen rollers are used in each bearing, and these particular
rollers are not used in any other product made by the company.
Suggest a procedure for purchase of the rollers.
P10-12 Relevant costs and EOQ

The Finetread Tyre Company imports steel-belted radial car tyres from
overseas and resells them at its discount tyre shops. In the past it has had no
special inventory policy other than some vague notion that inventory should
turn over about four times per year and hence each order should be
approximately equal to one-quarter of the expected annual demand.
In order to examine the possible advantages of a more scientific approach,
Finetread engage you to prepare an analysis for one tyre size, 165 SR 13,
which fits certain popular small cars. You ascertain the following
information.
The invoice price FOB Taiwan is $A20.00 per tyre. Freight charges and
import duties are 40% of the purchase price. Annual demand is uncertain but
the following probability distribution is believed to reflect the possibilities:
Demand (tyres)
Probability
10 000
0.2
14 000
0.5
20 000
0.3
The purchasing department processes approximately 200 purchase orders
a month. Direct labour cost associated with processing of each purchase
order is $l7.50. The cost of forms, supplies and other variable inputs is
$100 per month.
Payments are processed in the accounting department. Work sampling
studies indicate that the labour cost averages $6 an order. The bureau
charge for data processing is $1.60 per order and electricity and other
variable costs of data processing amount to 20 cents an order. All
purchased items are inspected in the receiving department at a cost of $12
per order for this class of goods. Annual insurance amounts to 7% of the
cost of the average quantity of inventory on hand.
The company rents one warehouse on a 20-year lease at an average
annual cost of $8.50 per square metre. Comparable warehouse space in
the area now rents for $11.20 per square metre. Tyres can be stacked 10
high, and after allowing for aisle space, each stack requires a square
metre of floor space. Space must be available for twice the anticipated
average inventory quantity. Warehouse labour costs average 10% of the
average inventory value in an average year. Investment proposals are
expected to produce a return of at least 20% before taxes.
a.
With a view to implementing the EOQ model, calculate:

i.
The annual demand figure to be inserted into the EOQ

formula.
ii.
The order cost per order.
iii.
The cost of holding one tyre for one year.
b.
Calculate the economic order quantity.
c.
Calculate the annual inventory cost for this order size (excluding
purchase outlay).
d.
Compare this with the annual inventory cost of the crude policy of
ordering four times a year.
4.23

P10-6 7000 shirts
D = 100 000
Q1-2999 =
O = $50
2DO
=
PI
I = 0.25
P = $15.00 (1-2999)
$14.00 (3000-3999)
$13.00 (4000-4999)
$12.00 (5000-5999)
$11.00 (6000-6999)
$10.00 (7000+)
2x100 000x50
= 1633 units (in range)
15x0.25
Check TAIC for EOQ of 1633, 3000, 4000, 5000, 6000, 7000:
DO PIQ
+
+ DP
Q
2
100 000 50 15x0.25 1633
=
+
+ 100 000 15
1633
2
= 3062 + 3062 + 1 500 000
= $1 506 124
TAIC1633 =
DO PIQ
+
+ DP
Q
2
100 000 50 14x0.25 3000
=
+
+ 100 000 14
3000
2
= 1667 + 5250 + 1 400 000
= $1 406 917
TAIC3000 =
DO PIQ
+
+ DP
Q
2
100 000 50 13x0.25 4000
=
+
+ 100 000 13
4000
2
= 1250 + 6500 + 1 300 000
= $1 307 750
TAIC4000 =
DO PIQ
+
+ DP
Q
2
100 000 50 12 0.25 5000
=
+
+ 100 000 12
5000
2
= 1000 + 7500 + 1 200 000
= $1 208 500
TAIC5000 =
4.24
DO PIQ
+
+ DP
Q
2
100 000 50 11 0.25 6000
=
+
+ 100 000 11.00
6000
2
= 833 + 8250 + 1100 000
= $1109 083
TAIC6000 =
DO PIQ
+
+ DP
Q
2
100 000x50 10x0.25x7000
=
+
+ 100 000x10
7000
2
= 714 + 8750 + 1 000 000
= $1 009 464 *
TAIC7000 =
Thus the EOQ is 7000 units.

(It is obvious that the reduction in purchase outlay swamps the effects of
the changes in ordering and carrying costs, and hence there is no real
need to check TAIC for every price break, but it has been done for
completeness.)
P10-9 a.
5000 units
D = Expected daily sales 250
E(daily sales) = 40(0.5) + 50(0.3) + 60(0.1) + 70(0.1) = 48
D = 48250 = 12 000 units
O = set up costs (other replenishment costs not significant)
= 6 hours 5 men $5.89 + 6 hours 5 machines $8
= 30 $13.89
= $416.70
K = $0.40 (given)
Q=
b.
2DO
=
K
2 12 000 416.70
= 5000 units
0.4
816 units
ROP = expected daily sales x expected lead time (days)
E(lead time) = 15(.3) + 16(.15) + 17(.15) + 18(.15) + 19(.15) + 20(.1)
= 17 days
ROP = 48 x 17 = 816 units
c.
912 units
ROP = 48 x 19
= 912 units
[p(lead time 19) = 0.9]
4.25
d.
$38.40
TAIC = DO/Q + KQ/2 (+ purchase outlay not relevant)
Whilst Q/2 might be a reasonable expression of the average holding
of stock using the reorder point of 816, the more conservative
policy regarding stockouts amounts to holding a safety stock of
912-816 or 96 units. The average holding would be better
represented by Q/2 + 96. Therefore the extra annual cost is 96K =
96(0.4) = $38.40.
e.
4.62 times pa
As stated in (d) the average holding of stock using 912 as the
reorder point is Q/2 + 96 = 5000/2 + 96 = 2596
Expected annual sales = 12 000
Rate of stock turnover = 12 000/2596 = 4.62 times/year
f.
584 units
To ensure that a stockout never occurs a lead time of 20 days in
conjunction with a daily sales of 70 units must be considered.
Total possible sales during 20 days lead time = 20 x 70 = 1400
units
Normal ROP as in (b) = 816
Therefore safety stock = 1400-816 = 584 units
g.
$3.08 approx
Set-up costs calculated in (a) = $416.70
Allocating to batch size of 5000 gives $416.70/5000 = $0.08
(approx)
Unit cost exclusive of set-up costs = $3.00 (given in v)
Full cost = $3.00+$0.08 = $3.08 (approx)
h.
4.26
1000 bearings per day can be made. The lot size of 5000 units
takes 5 days + 1 day for set-up = 6 days. If rollers can be obtained
in 8 days or less the requisition for purchase of rollers could be
initiated immediately a requisition for bearings is received and no
stocks need be carried. This, however, might reduce flexibility in
production scheduling. It would be better to trigger order of rollers
perhaps 8 days before a requisition is due for bearings. If using 816
as reorder point for bearings, it would assist production scheduling
if an order for rollers were triggered when bearing stocks fall to 816
+ (8x48) = 1200. At that time 70 000 (14x5000) rollers (plus extra
quantity based on expected waste or faulty rollers minus any on
hand) should be ordered.
P10-12 a.
i.
15 000 units
Expected annual demand = 10 000(0.2)+14 000(0.5)+20 000(0.3)

= 15 000 units
ii. $37.80
Per Order
Direct labour
$17.50
Forms and supplies ($100/200)
0.50
Accounting - Labour
6.00
- EDP
1.60
- Electricity
0.20
Receiving
12.00
37.80
iii. $12.60
Cost of 1 tyre = $20 + $8 = $28
Rental of warehouse: $11.20/10 $1.12
Twice anticipated av. inv.
2.24
Percent of cost of av. inv. = $2.24/$28 =
Rental
Insurance
Warehouse labour
Investment
8%
8%
7%
10%
20%
45%
Holding cost = 45% x $28 = $12.60

b.
300 tyres
Q=
c.
2DO
=
PI
2 15 000 37.80
= 300 tyres
12.60
$3780
DO PIQ
+
Q
2
15 000 37.80 12.60 300
=
+
300
2
= 1890 + 1890
= $3780
TAIC =
4.27
d.
$19 996.20 cheaper

DO PIQ
+
Q
2
12.60 15 000/4
= 4x37.80 +
2
= 151.20 + 23 625
= $23 776.20
TAIC =
Advantage in using EOQ formula = $23 776.20 - $3780 =

$19 996.20 per year
4.28
Topic 5 Internal control and cash
Required reading
Reading 5.1:
Horngren, C. T., & Harrison, W. T. (2009). Internal control and

cash.
Managers should be aware that there are certain attributes of accounting systems
which will allow them to perform their responsibilities more efficiently and
effectively. Horngren & Harrison identify a number of administrative and
accounting controls which, aided by a system of internal controls, promote
efficiency and effectiveness and satisfaction of the organisations goals.
Controlling the business includes:
1.
stewardship of the assets;
2.
the preparation of accurate and reliable accounting records;
3.
maximising the wealth of the owners through the efficient use of the
companys scarce resources;
4.
pursuing other corporate objectives; environmentally safe, community

participation etc.
The features and design of an effective accounting system are outside the scope of
this subject. One form of internal control which should be adopted by all
organisations is a bank reconciliation. This recommendation applies equally to
charitable or profit oriented organisations both large and small.
Cash is an asset which is subject to a high degree of risk. In addition to the
separation of duties and proper supervision of staff who handle cash or make the
adjustments to the accounting records, the Bank Reconciliation will provide
evidence of the reconciliation between the internal records of the organisation
(Cash at Bank Account) and the external records of the bank (a Bank Statement).
The internal accounting records of the business relating to cash follow these rules:
If cash is available the account is in debit balance, and would be regarded as a
normal balance.
Account overdrawn: the Cash Account is in credit balance.
5.1
Note: These are the opposite to the records of the bank. If your bank account has
money available then the banks record of your account or the Bank Statement
will show a credit balance. If your account is overdrawn then the bank statement
will show a debit balance.
You should now read Reading 5.1
Learning objectives
On completion of this topic you should be able to:
understand and be able to perform the steps in preparing a bank

reconciliation;
test your knowledge by attempting the following review questions.
Review question 1
Dot Smith regularly has her accountant perform a reconciliation between the
balance of her Cash at Bank account and the balance of her bank account as
shown on the bank statement. This month her accountant is on holidays and you
have been asked to perform the reconciliation.
The following details are provided for the month of May;
1.
The Cash at Bank balance in D. Smiths books on 1 May was $1,088.42

debit, and the bank statement for May showed a credit balance of $3,321.16.
2.
The total of cash receipts for May was $56,374.33 and the total of cash
payments for May was $54,376.28. These amounts have not been posted to
the Cash at Bank ledger account.
3.
Unpresented cheques were $435.24.
4.
The following debit entries were recorded in the bank statement:
bank charges for May, $50

a cheque received from a customer and deposited by Dot in the bank was
returned because of insufficient funds - $203.75.
5.
A credit entry in the bank statement revealed that a direct deposit of $760
had been made to Dots account. This had not been recorded in the books of
the business.
6.
A deposit of $742.80 was in transit on 31 May.
7.
An error has been detected in the accounting records; cheque no. 501 for
$159.20 being payment for rent was incorrectly recorded as $195.20 in the
Cash Payments journal.
Check answer
Adjusted balance in the reconciliation should be $3,628.72.
5.2
Solution to review question 1

Step 1
Adjust cash receipts
Balance
ADD: Direct deposit
Adjusted balance
Step 2
56,374.33
760.00
57,134.33
Adjust cash payments
Balance
ADD: Bank fees
Returned Chq
54,376.28
50.00
203.75
54,630.03
LESS: Adjustment for chq No. 501
36.00
54,594.03
Step 3
Reconstruct cash at bank account in general ledger

Cash at bank
May 1 balance
Cash receipts May
1088.42
57,134.33
58,222.75
31 May Balanced b/d
3,628.72
Step 4
Cash payments May

Balance 31 May c/d
54,594.03
3,628.72
58,222.75
Prepare reconciliation statement
Balance as per Bank Statement

ADD: Deposit in transit
LESS: Unpresented cheques
3,321.16 Cr
742.80
4,063.96
435.24
Balance per cash at Bank Account
3,628.72
5.3

Study questions
(See Reading 5.1)
Selected from Horngren, et al. (2008). Accounting (7th ed., ch. 8, pp. 436-437,
438, 439, 441, 442, 447 & 448). Pearson Prentice Hall.
5.4
Quick check questions
5.5
5.6
5.7
5.8

Quick Check
Answers:
1.
2.
c
d
3.
4.
c
d
5.
6.
c
d
7.
8.
c
b
9. b
10. d
Explanations:
Adjusted cash balance is $650 ($770 Service charge
$20 NSF check $100)
8. b.
S 8-8
The cash in the cash drawer will be $500 lower than the total amount recorded by
the cash register.
E 8-14
a.
Weakness. The control environment will not be as effective as it would be if

top management led in establishing internal controls.
b.
Weakness. The accounting department should not be allowed to order

merchandise. An accountant could have goods sent to his / her home and
then approve payment for the goods.
c.
Weakness. The sales clerk should not have access to the total recorded by the
machine. The clerk could steal cash and delete a cash receipt from the
machine record.
d.
Weakness. The officer should examine the payment packet to ensure that the
payment is for the correct amount.
5.9
E 8-17
D.J. Hunter
Bank Reconciliation
September 30, 20XX
BANK:
Balance, September 30
Add: Deposit in transit
Less: Outstanding checks:
Check No.
626
627
Adjusted bank balance
BOOKS:
Balance, September 30
Less:
Correction of book error
Recorded $68 check as $58
Cost of checks
Service charge
Adjusted book balance
$ 431
1,209
$ (75)
(275)
(350)
$1,290
$1,330
$ (10)
(18)
(12)
(40)
$1,290
Hunter has cash of $1,290 on September 30.

E 8-21
TO: Store Manager
There is a weakness in internal control over cash receipts. The cash register keeps
no internal record of sales. With no record of sales, you cant determine how much
cash should be in the cash drawer. This makes it easy for the cashier to steal cash
and not get caught.
To improve internal control over cash, we should use cash registers that record
each sale inside the machine. The manager can prove the amount of cash in the
cash drawer against this recorded amount.
5.10
P 8-32B
TO:
Adam Klaus
FROM:
Consultant
RE:
Internal Control
Every business needs a system of internal controls. Internal control is the

organizational plan and all the related measures adopted by an entity to (1)
safeguard assets, (2) encourage employees to follow company policy, (3) promote
operational efficiency, and (4) ensure accurate and reliable accounting records.
Adam, you must set the tone at the top to let everyone know we have a reasonable
control environment.
A company with an effective system of internal control needs competent and
reliable personnel. The business may have to increase employee pay in order to
attract and retain high-quality employees.
You need to assign responsibilities to employees so that everyone knows his or
her duties. This avoids confusion and helps ensure that all jobs are performed.
Certain duties should be separated between two or more employees to limit the
opportunity for fraud. For example, the custody of cash should be separated from
the accounting for cash.
The business may need to have an audit by a CPA. Auditors can evaluate our
system of internal control and suggest ways to improve efficiency. Auditors also
gauge the reliability of accounting records, which provide the information for our
decisions.
Documents are needed to keep track of sales and cash receipts, expenses, and
payments. These records will help us track transactions and manage the business
better.
Electronic and other controls can safeguard assets. Encryption and firewalls can
protect our data files. We need burglar alarms to protect buildings, and we should
store important documents in fireproof vaults. You should rotate employees from
job to job. This will keep them honest.
Responses may vary.
5.11
P 8-34B
Dunlap Dollar Stores
Bank Reconciliation
April 30, 2008
BANK:
Balance, April 30
Add:
$18,080
Deposits in transit ($1,060 + $330)
1,390
19,470
Less: Outstanding checks:

Check No.
3119
$ 630
3120
1,670
3121
100
3122
2,410
Adjusted bank balance, April 30
(4,810)
$14,660
BOOKS:
Balance, April 30
Add:
$13,640
EFT collection of rent

Bank collection of note receivable
300
1,300
Book error$1,390 check

recorded as $1,930
540
2,140
15,780
Less: EFT payment of insurance

NSF check
Service charge
Adjusted book balance, April 30
5.12
$ 200
900
20
(1,120)
$14,660
Reading
5.1
Horngren, C. T., Harrison, W. T., & Oliver, M. S. (2012). Internal control and
cash. In Accounting (9th ed., ch. 7, pp. 355-403). Sydney: Prentice-Hall.
Cash is the most liquid of assets and good management and adequate controls are
vital. The bank reconciliation is a technique that should be regularly performed
and allows for prompt identification and correction of errors and accurate records.
Note that this chapter is from a text with online support. Earlier editions have
more accessible resources for students.
5.13
5.14
Topic 6 Social and environmental accounting
Required reading
Reading 6.1:
Deegan, C. (2009). Extended systems of accounting the

incorporation of social and environmental factors within external
reporting.
A major source of information on social and environmental accounting is the

Internet. Keep in mind we are interested in accounting aspects.
Reading 6.2:
Ravlic, T. (2004). Mung bean counters.
Learning objectives
Upon completion of this topic, students should:
understand the potential for MBA graduates to promote understanding of the

relationship between the environment and business and have increased
awareness of the role they can play.
be aware of corporate social and environmental responsibilities.
be aware of initiatives in social and environmental accounting.
understand the potential role of the manager, the financial accountant and
the management accountant.
understand both old and new approaches to best practice social and
environmental management.
6.1
Introduction
Corporations can achieve good operating results by ignoring the damage being
done by the enterprise to society and the environment. In the systems of reporting
currently in use by most enterprises, there is no attempt to measure the harm done
by the release of poisonous by-products into waterways or by the scarring of the
land by open-cut mining. Neither is credit given for social and environmental
benefits provided by businesses. Social and social and environmental accounting
is about considering the impact of a corporations activities on the environment
(e.g. pollution), on the community, on occupational health and safety issues (e.g.
asbestos) and on energy use.
It has been suggested that society should no longer neglect to account for favourable
and unfavourable social and social and environmental actions. Public activist groups
and agencies of government are expressing concern for the impact of business
enterprises on the environment. Corporations can no longer look to income
determination as the sole measure of effectiveness. Increasingly, business in Western
societies is operating in a New World where society expects improvement in the
environment and sanctions for those businesses harming the environment.
Enterprises with a sense of social and social and environmental responsibility are
incurring costs beyond those of their competitors and are unwilling for these
penalties to be continued.
On the other hand, when an enterprise ignores its responsibilities to society and
deliberately persists in polluting the environment, it is able to report favourable
results because the costs of rectification are not being incurred.
The present position

You may need to refer to the Internet for current discussion and anticipated tools.
Note that the focus here is on general principles and implications for measurement
processes.
Most business enterprises choosing to disclose their social and environmental
activities do so in the directors report or in some other descriptive section of the
annual report. The details provided tend to be vague and naturally paint a
favourable picture of the enterprise. Unfavourable activities are of course omitted.
Thus social and social and environmentally responsible behaviour is largely a
public relations exercise.
Where it is not in a companys interest to act independently in a social and
environmentally desirable manner, there are two possible ways of ensuring that
they do act responsibly. One approach is for businesses to act in concert but it is
doubtful whether this would prove popular among competing enterprises.
Alternately, governments could impose penalties on those who fail to act in a
socially responsible manner. In a free enterprise society it is difficult for
businesses to justify socially responsible actions which are not undertaken by their
competitors.
6.2
Role of accountants
Accountants have been reluctant to widen their role to embrace measurement of
social and social and environmental issues, claiming that the objective of a
business is the maximisation of income, and that any attempt by business to
become socially responsible may divert attention from the profit motive and cause
harm to the economy. It has been suggested that social and social and
environmental activities are a function of government and that businesses should
conduct their activities within the laws imposed upon them by the government to
protect society. Agreement on this matter is unlikely in the near future.
A company engaged in social and social and environmentally desirable projects
require information to enable the effectiveness of such projects to be gauged. Four
approaches to accounting and reporting on projects have been suggested:
Inventory approach
This involves the reporting of a comprehensive list of social and environmentally
responsible actions. It would be ideal if a list of irresponsible actions were also
furnished. This method has the obvious drawback that intercompany comparisons
are impossible, but it is the approach, which is at, present the most popular.
Cost approach
This approach involves an addition of the cost of each social and social and
environmental responsible action. Although this approach is superior to the
previous one, the data published must be interpreted with caution. High benefits
do not necessarily result from large expenditures. The effectiveness of
expenditures is ignored.
Program management approach
Under this approach disclosure is made of the extent to which the objectives of a
companys actions have been attained. There is no indication of the amount of
social benefit derived from the attainment of the objectives.
Cost-benefit approach
Under this approach socially responsible activities are disclosed as well as
expenditures on them and the resulting benefits to society. The major difficulty is
the definition and measurement of benefits. It is difficult to place a dollar value on
the protection of a wilderness area so that the survival of a species of frog is
ensured.
6.3
Social and social and environmental Contributions some

elements
Air
Timely meeting of the law and going beyond the law in avoiding the creation of,
alleviating, or eliminating pollutants in these areas.
Water
Sound
Solid waste
Disposal of solid waste in such a manner as to minimise contamination, reduce its
bulk, etc., and the design of processes and products which will minimise the
creation of solid waste.
Use of scarce resources
The conservation of existing energy sources, the development of new energy
sources, and the conservation of scarce materials.
Aesthetics
The design and location of facilities in conformance with surroundings and with
pleasing architecture and landscaping.
6.4
Social and social and environmental audit or attestation
Source:
Microsoft Office images.
The term social and social and environmental audit is frequently encountered in the
literature. Although occasionally used to mean the examination and certification of
the social and social and environmental report by an independent party, it is generally
used to refer to reports on the environment, which are not attested. An examination of
social reports presently published discloses that unfavourable item are rarely revealed.
It has been suggested that those included were probably known to the public at large
at the time of publication. An interesting development in the United States was the
inclusion by the Phillips Screw Company of a pollution audit in its annual Report.
The independently prepared audit indicates instances where pollution standards have
been exceeded and the costs involved, in obtaining compliance. The question has
been asked, Does this signal the emergence of pollution auditors? Will there be
other specialised auditors concerned with internal human resources, employment
practices, industrial safety, charitable contributions, and product safety? Only time
will tell.
The growing emphasis on social and social and environmental issues is not
going to subside;
To ensure their long-term survival, businesses need to improve their social

and social and environmental awareness and responsibility;
Social and social and environmental legislation/regulation combined with

community and competitive pressures will increasingly impact on organisations,
particularly in social and social and environmentally sensitive industries;
There is a lack of knowledge in many organisations as to how to address the

issues; and
Management accountants have a major role to play in the effective and

responsible management of social and social and environmental resources.
6.5
The Interactive forces of the environment

The growing emphasis on social and social and environmental issues is not going
to subside. World conferences on the environment confirm that there is increasing
consensus on the need to speed up efforts to improve social and social and
environmental awareness. It is not business that has led the way; rather,
governments and pressure groups with broad public support have placed social
and social and environmental issues on business agendas internationally.
The focus on the environment as an issue in Australia and around the world is the
result of four interactive forces that emphasise social and social and environmental
concerns and stimulate increased social and social and environmental awareness.
The interactive, forces are: the community, including customers and the public
generally government policy and legislation developments in resources and
technology companies and competition.
Community pressures
The modern community no longer accepts that there is an inevitable link between
economic development and pollution. It recognises that the impact of human
activity, industrial practices and consumer disregard has detrimentally affected the
environment and that, unless a more serious approach to the problem is adopted,
the world will suffer irreparable damage. This, in turn, will limit the ability of the
planet to support human and other species into the future. This conviction has led
to the broad acceptance of the concept of Sustainable Development, a definition of
which was advanced by the World Commission on Social and Environmental
Development in 1987:
Humanity has the ability to make development sustainable - to ensure that it meets
the needs of the present without compromising the ability of future generations to
meet their own needs.
(p. 8)
In Australia, the community tends to perceive corporations, particularly in the

mining and industrial sectors, as having shown little regard for the environment in
the past, indeed to have exploited it either directly or indirectly. There appears to
be continuing uncertainty about the social and environmental responsibility of
business today. There have, for example, been instances of individuals and/or
community groups actively opposing, on social and environmental grounds, the
siting of new facilities, industries or factories in their backyards; of concern
about wilderness and rainforest preservation, and fauna protection; of fears about
pollution and potential resultant health effects.
On the other hand, business questions the validity of some community concerns
and, in certain instances, the motivation underlying the objections. In the interview
process undertaken for this study, one respondent claimed that some protests had
no scientific validity. Another expressed doubt that community objections to the
erection of state-of-the-art smoke-stack plants in the neighbourhood were social
and environmentally related, citing the prospect of increasing property values if
the industrial development was thwarted as a more probable reason. In this
6.6
instance, land had been purchased and homes built with full knowledge that the
adjoining land was zoned for industrial development.
Despite these conflicting views, it is not an adequate response, nor even a practical
response, for industry to ignore community concerns. To do so is likely to
engender political, legislative or customer reactions that could be very detrimental.
A more sensible approach may be to recognise the adverse social and
environmental effects of their activities and processes, to rectify past damage and
to establish policies and procedures to eliminate or minimise future damage.
Customers, as members of the community, are demanding social and
environmentally responsible products, which minimise or eliminate waste and
pollution. These demands are, in part, idealistic but, in part, highly practical. The
user pays principle, for example, applied to domestic energy and water usage has
emphasised the need for individual households to conserve resources, which are
limited or can be expanded only at considerable cost. In turn, customers expect
firms producing the items they buy to be similarly responsible. Increasingly, too,
corporations are expected to ensure that their products do not place usage and
disposal problems and costs on the customer.
Government policy and legislation
Community concerns are reflected in governmental actions. For example, social
and environmental protection agencies have been established in the various states,
along with the passing of a number of social and environmental laws affecting
business. The major thrusts of legislation have been:
the extension of liability and personal responsibility provisions for

companies and their management;
more stringent enforcement of, and lower thresholds for, emissions; and
the introduction of the polluter pays principle which links market forces
and social and environmental protection.
Around the world, there has been a shift from standard setting and enforcement as
the basis of social and environmental legislation. Some governments and
regulators now see these methods as having adverse effects on international
competitiveness in addition to being expensive to enforce and, at times,
counterproductive as they emphasise a pollution control, rather than a pollution
prevention, ethos. Co-regulation with industry, the use of economic instruments
(e.g. recycling credits, taxes) and the encouragement of self-regulation by industry
are techniques being added to sanctions as a basis of social and environmental
regulation. These changes in approach are now occurring in Australia.
6.7
Developments in resources and technology

New knowledge, new substitutable materials, new techniques for resource use and
improved production technologies have facilitated process and product development
which use energy and material more efficiently and produce fewer pollutants than
before. At the same time, regulators have developed an enhanced ability to detect and
source small quantities of hazardous substances, and thus are more able to impose
penalties for illegal disposal. The combination of these two factors is likely to result in
an increased willingness on the part of firms to investigate new resource and
technology developments and incorporate their use where feasible.
Companies and competition
The impact on a business of community pressures and social and environmental
legislation can be substantial, particularly if there is a significant cost for damage
control or rectification. What the effect will be in dollars and cents in many
organisations is frequently unknown. It is not a subject that has received a lot of
attention from corporate management. However, it is an area which management
needs to address if it is to understand this additional cost of doing business. Only by
doing this will it recognise the true economic value of the business and from this
develop a strategy, which includes social and environmental considerations and
ensures its survival in the future.
There appears little doubt that compliance with regulation is the primary motivator for
companies in Australia at present. But competition is becoming a powerful influence.
Businesses are finding that marketing strategies can be built around green products;
that gains can be made in customer acceptability and that being social and
environmentally responsible can give a competitive advantage. Ever increasing
international competition will, over time, pressure Australian companies to embrace
best practice social and environmental management principles currently in use in the
United States and Europe. These principles influence strategies, organisational
structure and functioning, and attitudes to the community as shown below:
Best practice social and environmental management

Old
Management
strategy
End of pipe focus

Meet required standard
None or few social and
environmental indicators
Management
style
Low level of responsibility within

company
Command and control internal
processes
Weak or no links between
Organisational Health and Safety,
Social and environmental Controls
and Production Management
Closed door
Organisational
structure
Community
access
6.8
New
Pollution prevention
Continuous Improvement - audits,
financial incentives
Sophisticated set of social and
environmental indicators
High level of responsibility within
company CEO, CFO
Participative control and solution
making
Strong, integrated relationship
between Organisational Health and
Safety, Social and environmental
Controls and Production Management
Open door, accept right to know
Some Australian companies have recognised that social and environmental

responsibility provides windows of opportunity (e.g. cost reduction through waste
reduction and more efficient processes, marketing opportunities, recycling) and
have already adopted suitable strategies and technologies as a part of the constant
search for competitive advantage. Others have gone further and pro-actively
developed social and environmentally based objectives and strategies, beyond
those required by law, which are fundamental to their consideration of strategic
plans, capital investment decisions, product development and processing
technology choices. Some, too, have recognised the advantage to be gained from
an involvement with, and the opportunity to influence, the regulatory process.
There is, indeed, a growing recognition that being social and environmentally
aware is good business. Not only does it provide the image of a good corporate
citizen but there are financial and non-financial rewards, which justify the
commitment of resources to this endeavour. Many, though, have not yet started on
the path to social and environmental responsibility and it is primarily to these
businesses that this document is directed. It will hopefully answer some questions
and provide a guide for management and, in particular, management accountants
to help resolve many of the social and environmental issues they may confront as
they face the need to tackle the issue of accounting for the environment.
FAQs (Frequently Asked Questions)

What is meant by the environment?
The term the environment means different things to different people and, indeed,
different things to the same person in different contexts. For example, the
conservationist, using the term, may mean the natural surroundings but not the
urban or built environment. On the other hand, to a planner, the environment is
the physical, human-made structures and surroundings in which people live and
work. A social worker may be referring to the social environment while
employers and employees may be concerned with the work environment.
For the purposes of this topic, the definition contained in s3 of the Commonwealth
Environment Protection Act 1974 is adopted. The environment
includes all aspects of the surroundings of human beings, whether affecting human
beings as individuals or in social groupings.
This definition, while hardly complete, is broad enough to embrace the physical,
biological, social and economic aspects of our world.
6.9
Who are the stakeholders in an organisation with regard to social

and environmental responsibility?
The stakeholders are all parties who have an interest in the operations of the
business. These may vary from firm to firm but would generally include:
legislative and executive branches of federal, state and local governments

and their commissions and regulatory agencies;
investors/owners;
lenders;
past and present employees suppliers;
customers;
corporate management.
Depending on the social and environmental sensitivity of an organisations

activities, stakeholders may also include social and environmental activists, public
interest groups and neighbourhood groups.
Future generations are also stakeholders in the sustainable development view of
social and environmental responsibility.
What is social and environmental policy?
The social and environmental policy provides guidance, direction and leadership
in social and environmental management within an organisation. A policy
statement is normally brief but sets the framework within which objectives are
defined and the social and environmental plan is designed. It thus influences
numerous corporate decisions, e.g. concerning sites, products, processes,
investments.
What constitutes an social and environmental management system?
An effective social and environmental management system includes:
a social and environmental policy and objectives, and a plan for achieving
them;
an organisational structure that cascades responsibility for social and

environmental performance through the organisation;
procedures covering all routine activities that relate to the environment,

including regular reporting;
procedures for responding to abnormal or emergency situations;
processes for assessing and auditing social and environmental performance;
a mechanism for regular review of all elements of the system.
6.10
What is the purpose of a social and environmental plan?

The social and environmental plan of a firm determines how the various social and
environmental issues will be handled to satisfy group objectives and conform to
corporate policy. The plan will also establish priorities for the tackling of social
and environmental problems.
What are the common social and environmental issues for business?
Common social and environmental issues include:
site rehabilitation, e.g. after mining, after contamination as a result of past

practices;
the storage, use and disposal of hazardous materials;
waste reduction;
waste disposal;
pollution through, for example, emissions to atmosphere, to

sewer/stormwater, seepage, dust or noise;
product labelling;
product packaging;
energy use;
social and environmental risk.
What is a social and environmental audit?

There are four types of social and environmental audits:
A statutory audit is instigated by a statutory authority, such as the Social and
environmental Protection Authority, and requires a registered social and
environmental auditor to conduct an investigation and prepare a report. The report
must include, among other things, an evaluation of any site believed to be a social
and environmental risk, an assessment of whether any clean-up is required; and, if
so, a recommendation relating to the carrying out of the clean-up.
A compliance audit is voluntarily undertaken by many firms as a result of
regulations and legislation, which place responsibility (and potential liability) on
directors and other managers to ensure compliance with social and environmental
regulations. It may be conducted by external auditors or by internal staff, often
assisted by external consultants. As the name suggests, a compliance audit seeks
to assess the degree to which the firm is complying with all social and
environmental laws and regulations affecting it.
6.11
A management audit is one instigated by the firm as part of its social and
environmental management plan. The aim is to identify risks and opportunities,
currently existing or potential, in addition to compliance. The output of a
management audit is desirably a social and environmental plan, which would
preferably be audited at regular intervals as part of the continuing auditing
program.
A diagnostic audit is a high-level review of a corporations response to social and
environmental issues and is undertaken as part of the financial audit or as a
separate audit aimed at board members.
There is an argument that social and environmental considerations should not be
distinguished as a somewhat peripheral appendage to organisational activities but
be an integral part of all the firms strategic decisions, product planning and
processes. More advanced firms have reached this stage. Businesses, however,
which have not to date consciously taken into account the effect of their activities
on the environment can find an audit an appropriate place to start.
What are social and environmental costs?
Social and environmental costs are those costs incurred in compliance with, or
prevention of breach of, social and environmental laws, regulations and company
policy. They may be grouped under a number of headings:
General and administrative costs
Costs incurred in connection with compliance, and the monitoring of compliance,
with existing social and environmental regulations (e.g. costs of permits,
inspections, legal and consulting fees).
Fines and penalties
Government regulatory agencies are empowered to impose fines and penalties on
companies not in compliance with social and environmental regulations. These
can be substantial and are intended, not as a revenue raising exercise, but as a
powerful incentive for firms to comply.
Disposal of waste
In Australia, permits are granted to firms to dispose of hazardous wastes at certain
specified sites. The amount charged varies with the amount and type of waste. In
addition to these fees, there are costs associated with transportation of waste, often
over considerable distances, and control procedures to ensure that waste has been
correctly disposed.
In some cases, hazardous waste is difficult to dispose of and is, consequently,
stored on site. Costs in these instances include the provision of safe storage,
maintenance costs and supervisory costs.
6.12
In other instances, laws and regulations may require a company to install or upgrade
devices to remove hazardous materials from liquid and solid waste before disposal.
Remediation costs
Remediation of polluted sites may be affected by the nature, location and volume
of waste; the hazardous nature of the waste; the remediation regulations; and the
process selected. Remediation may, for example, involve the removal and
treatment of source material, treatment of ground and water contamination,
disposal or destruction of waste material, containment of contamination, etc.
Costs associated with remediation include the actual remediation process and all
the associated soft costs, e.g. the cost of outside legal, consulting and
remediation project management fees, incremental in-house costs, site closure
costs and post-remediation monitoring costs.
There are many firms which have engaged in practices and processes which have
contaminated their sites. Unless legislation requires clean-up immediately, these
firms are inclined to let the issue rest until it is intended to dispose of the site.
Clean-up is completed prior to disposal as the property, if designated as
contaminated, will lose much of its value. More than one company, too, has
unwittingly purchased a site which proved afterwards to be polluted. Remediation
is generally required before, for example, the building of facilities.
Capital costs
Costs incurred in upgrading facilities in order to comply with regulations, e.g.
waste water collection and treatment on site, new technology to reduce emissions,
noise-reducing measures, the provision of afterburners to destroy odour, etc.
Social and environmentally related costs may also be incurred, not in the cause of
compliance, but in the pursuit of increased efficiency and competitive advantage,
e.g. on process change, R&D. These are voluntary costs which are unlikely to be
incurred unless the prospective benefits (which may include difficult-to-quantity
benefits such as an enhanced good citizen profile) are expected to exceed the
expenditures.
Are social and environmental benefits available to firms? How can
these be obtained?
There are undeniable benefits to be obtained from an social and environmental
consciousness on the part of firms. Our discussions with firms have indicated that
the need to comply or the desire to reduce social and environmental costs have
been the inspiration for:
changing processes to reduce waste;
installing facilities which recycle waste;
finding markets for waste;
6.13
a raised awareness of energy usage, resulting in cost savings;
an increased awareness of employee health and safety issues, resulting in

fewer accidents and a reduction in accident-related costs;
a reinforcing of quality principles;
a more co-operative and involved workforce.
Other benefits which can be obtained by social and environmentally responsible

firms are:
gains in customer acceptability;

competitive advantage.
What is social and environmental performance evaluation?

Effective social and environmental performance evaluation refers to a continuous
cycle involving social and environmental policy objectives, the social, political,
legal and economic climate, the systems designed to collect and report financial
and non-financial social and environmental information and the ongoing
monitoring process.
What is social and environmental risk?
Social and environmental risk is conceptually no different to many other risks of
economic loss (e.g. product failure, physical loss or damage, technological
obsolescence, increased government controls) faced by organisations. It is,
however, potentially extremely damaging. For example:
laws and regulations may require the commitment of substantial funds in

site remediation or in the installation of new devices, technologies, etc.;
more stringent social and environmental laws and regulations in the future
may have a deleterious effect on the profitability of the business or sections
of it;
a firm may have exposure to legal claims for personal injury as a result of,
for example, spills, explosions or health-damaging products and, in addition
to financial consequences, suffer long-term damage to its reputation;
companies and their officers may face substantial fines and penalties for
failing to exercise due diligence.
How can social and environmental risk be managed?

First, identify the risks by systematic and continuous evaluation of potential
sources of penalty or loss.
Second, analyse each risk. How often could the loss occur? How substantial could
the loss be? How would this loss threaten the business?
6.14
Third, control the risk. Can the risk be eliminated, avoided or reduced? Where
possible, implement a program of control.
Fourth, finance the risk. What proportion of the risk can be sustained? Can the
remainder of the risk be transferred contractually, e.g. to another business or to an
insurer?
Fifth, monitor and review. How effective is the risk control program? Should it be
reviewed?
What is the relationship between Total Quality Management (TQM)
and social and environmental management?
The four guiding principles of TQM are:
customer satisfaction;
the elimination of waste;
empowerment of employees;
continuous improvement.
An effective social and environmental management plan will incorporate all these
principles.
Attaining best practice in social and environmental

management
The International Institute for Sustainable Development (IISD) has suggested a
framework for working towards social and environmental responsibility. It
contains six steps:
perform stakeholder analysis;

set social and environmental policies and plans;
design and execute an implementation plan;
develop supportive corporate culture;
develop standards and measures of performance;
prepare reports to enhance internal monitoring process.
Stakeholder analysis
This involves the identification of all parties who have an interest in the operations
of the business. These are listed in the previous chapter. The organisation must
address the concerns and information needs of all stakeholders and develop (a)
systems to collect the required data and (b) reports suitable to various groups.
Setting social and environmental policies and plans
The aim is to articulate the basic values of the firm in relation to social and
environmental issues and to clearly state these values as organisational policies
and objectives. The policies and objectives must guide the organisations planning
6.15
and set out values that management, employees and other groups, such as
suppliers, are expected to strive to achieve. Of necessity, the board of directors or
other governing body must demonstrate leadership and a strong commitment to
social and environmental policies. Senior management should also be involved.
Designing and executing an implementation plan
Translating policies into strategies and thence to operational plans is a major task.
It requires:
a review of existing organisational structures to determine who should bear

specific responsibilities for the social and environmental objectives;
a modification of strategic and planning processes to incorporate social and

environmental priorities;
the possible modification of organisation systems and processes;
the enhancement of management information systems to ensure that

management and employees receive the appropriate information to plan and
control their performance against established objectives.
Developing a supportive corporate culture

This requires the incorporation of social and environmental policies and objectives
in the fabric of organisational thinking and decision-making - not an easy task as it
requires a broader view of organisational responsibility than is customary in many
Australian companies.
It is, however, possible through training and employee involvement to achieve a
corporate culture that is supportive of social and environmental responsibility.
One firm mentioned its concern with employee safety. Supervisors speak to each
production employee weekly, seeking suggestions and reactions to safety
procedures and standards. Suggestions are always considered and, where
appropriate, acted upon. The safety record has improved dramatically. In this firm,
suggestions and reactions to social and environmental matters are not sought but
doing so may well have similar results. In some other firms interviewed, an social
and environmental consciousness is encouraged at all levels.
Developing standards and measures of performance
This is another way to encourage the co-operation of all staff members in thinking
and acting responsibly with regard to the environment. The standards developed
should be operationally based and derived from the social and environmental
policies and objectives of the firm. If the objective is, for example, to achieve
100% compliance with social and environmental laws and regulations, the target
may be defined as the elimination of penalties imposed by regulatory authorities
and performance measured against this target. Other firms, with objectives related
to good neighbour or good corporate citizen or cost reduction, may set targets
related to a reduced number of complaints, waste reduction, reduced waste
disposal costs or process improvements.
6.16
It is often said that what is measured, is managed. The setting of targets and the
measuring of performance against those targets is an important part of the process
of achieving best practice social and environmental management.
The preparation of reports for external users the role of the
financial accountant
It is important when developing reporting systems for social and environmental
matters that the various users and their needs are clearly identified. The federal
government, for example, carries responsibility for all Australians and is subject to
a variety of political pressures. The ministry concerned needs to be well informed
and will obtain a wide range of social and environmental information and seek a
variety of opinions regarding social and environmental matters of concern to the
electorate. State governments have the responsibility for social and environmental
legislation within their own areas and will be seeking advice and opinion on a
state-wide basis in order to determine the desirability of legislative action. A
glance through Australian legislation indicates, however, that not all legislation
applies to whole states: several Acts relate only to very specific areas within a
state. State governments, then, will often narrow their focus to specific areas,
problems affecting specific sections of the public, or quite specific aspects of the
operations of an individual organisation. Similar conflicts in legislation are likely
to prevail in any country that has different levels of government.
In contrast, participants such as employees will be more interested in an indication
of the companys overall social performance (e.g. in organisational health and safety
in addition to the environment). Suppliers may legitimately be concerned about the
end-use of inputs to manufacture by another firm. Investors will be concerned with
the overall profile of the company in which they invest and in the existence of social
and environmental risk which may, in the near or distant future, affect the
profitability of their equity share. Lenders, too, would wish to ensure that the
security of their finance will not be threatened by potential (perhaps undisclosed)
liabilities resulting from social and environmentally undesirable practices.
Many of these interested parties can obtain the information they require directly
from individual firms. Others, however, must rely on general purpose reports.
What, then, should general purpose reports include?
A description of the business entity, its activities and the period covered by
the report.
The enterprises sustainable development policy.
The sustainable development objectives established to guide the

implementation of the policy.
A comparison of actual performance against each of the sustainable

development objectives using financial, operational, scientific and other
relevant statistics and data.
6.17
A description of the sources and processes used by management in

generating the information on performance used for monitoring progress and
preparing the report (including the purpose of, and results from, social and
environmental audits).
A statement as to whether the enterprise has, in all material respects,

complied with relevant laws and regulations.
An overall assessment of the achievement of the sustainable development

policy, including a description of managements planned course of action in
each area where the sustainable development objectives were not achieved.
Identification of who takes responsibility for the report (e.g. board of

directors, CEO, environment manager).
In Australia there is, as yet, little of substance concerning the environment in

corporate annual reports. Larger companies often include sections on their
social and environmental policies and actions within the directors report or
elsewhere in the document but these usually contain little substantial
information.
Enhancing internal monitoring processes

Internal monitoring processes normally take three forms:
Breaches of compliance and potential issues
Once policy is established, corporate management will want to monitor policy
adherence. There are, consequently, often extensive reporting requirements with
regard to breaches of legislation, penalties imposed and corrective actions taken.
In addition, potential issues need to be raised and dealt with before they become
problems.
Performance against objectives
The policy setting process involves the establishment of objectives and specific
targets. These targets should be measurable and reporting systems must be capable
of monitoring progress. A useful tool for setting targets is benchmarking, which
involves establishing where the organisation is against a desired state (for
example, best practice in the industry).
Value added potential
Value added reporting involves highlighting those areas where changes can be
made to yield improved results. Once again, benchmarking can be a useful tool to
identify areas that need attention.
Effective data collection and analysis will highlight areas where continuous
improvement or competitive advantage may be realised through pollution
prevention, streamlined waste management operations and other green practices.
6.18
The role of the management accountant

Historically, the management accounting function comprised the use of two
techniques: cost accounting and budgeting. By the mid 1960s, these techniques had
become quite sophisticated and other techniques drawn from management science,
information systems and organisational science were utilised by management
accountants in providing financial and operating information to management.
By the mid 1980s, the organisations in which management accountants work were
changing. Increased competition created new focuses: on customers and
competitors, on time (quick and continuous product innovation, time to market,
real time information), on flexibility (in response to customers requirements, in
production), and on continuous improvement (in efficiency, productivity, quality).
In response the shape of organisations changed, becoming flatter, utilising crossfunctional work teams and widely empowering the work force. Meanwhile, new
information technology reduced the importance of accountants as number
crunchers. Their role now is as a knowledgeable analyst, participating in and
contributing to:
strategy formation to ensure sustained competitive advantage, achieved by

providing customer and shareholder value;
resourcing decisions to ensure the availability of social and environmental

resources, finance, technology, people, knowledge, processes and products
to achieve the determined strategies;
the management of change in a world of uncertainty, complexity and speed.
Today, the management accountant has left his or her office and is a fully fledged
participant in the determination of resource use and a value-adding contributor to
team-based management.
The environment is a resource, like any other used by the firm. As with human
resources, technology and, indeed, finance, it has to be managed. Management
accountants have a key role to play in ensuring that social and environmental
resources are used for the benefit of the firm and in accordance with the principle
of Sustainable Development. Yet there is anecdotal evidence that management
accountants in industry and commerce are unsure of the contribution they can
make. The list below is suggestive.
Participation in strategy formation
Incorporate social and environmental policies and objectives in strategy

development.
Specifically consider social and environmental opportunities, threats, costs,

and benefits in the assessment of available strategies.
Sponsor an understanding of the importance of a co-ordinated, integrated

approach to strategic resource management, i.e. of increasing the
productivity of asset utilisation and reducing resource consumption.
6.19
Specifically include potential social and environmental opportunities,

threats, costs, and benefits when projecting the performance and profitability
of divisions, sites, products, customers, etc.
Identify the environment-related expectations of all stakeholders.
Devise systems to improve product decisions by tracing waste and other

social and environmental costs to individual products.
Identify value-adding social and environmental strategies.
Investment/project appraisal
Ensure the inclusion of costs associated with present and potential laws and
regulations.
Assess the social and environmental risk dimensions of projects/new

products, etc.
Determine the value to the business of any voluntary expenditure incurred to

achieve social and environmental goals.
Be directly involved in harnessing and conserving the use of organisational

resources.
Business planning processes
Undertake financial modelling to reflect, for example,
changes in product revenues associated with exploiting green

opportunities
the use of substitute materials or recycling
the impact of changes in process technology
the potential cost of future legislation.
Include social and environmental considerations in value chain analysis.
Include social and environmental considerations in outsourcing decisions, in

supplier selection and, in certain sensitive industries, in customer selection.
Include the cash flow and financial effects of environment-related decisions

in all operational and capital budgets.
Directly support continuous improvement in operations. Directly support

cost reduction.
Investigate the potential for profiting from waste, e.g. by sale of waste.
6.20
Managing change
Sponsor TQM thinking throughout the organisation.
Directly support endeavours; related to quality, time, flexibility and

innovation.
Sponsor social and environmental consciousness in all employees, e.g.

through training and communication.
Monitor external developments, e.g. new standards on emissions, increased

monitoring of emissions by agencies or increased penalties for breaches of
requirements, the availability of new, more social and environmentally
benign equipment or substitute materials, developments in
technology/processes occurring overseas or locally.
Organisation design
Encourage employee empowerment.
Promote the development of adequate social and environmental knowledge,

skills and awareness within the organisation.
Identify social and environmental best practice in all the firms

processes/activities.
Benchmark against world best practice.
Performance measures and control systems
Develop key social and environmental performance indicators (KEPIs).
Ensure that KEPIs are easily measurable factors which describe the principal
relationships between the company and the environment.
Incorporate KEPIs into the budgeting and forecasting process and monitor at
least monthly.
The specific nature of KEPIs will depend on the type of business but would
normally include:
capital and operating expenditures on social and environmental matters,

e.g. expenditures on social and environmental R&D, waste disposal
costs, site remediation costs;
the volume and types of material processed by internal and external waste
recycling programs;
the volume and types of waste generated;
measures of efficiency, energy conservation, input-output conversion
factors and rates of spoilage for products and production processes;
air emission rates;
volume of hazardous materials used in production processes;
6.21
number and volume of hazardous or toxic chemical spills;

number and types of other incidents;
number and type of environment-related complaints from stakeholders;
penalties paid;
volume index of social and environmentally friendly products within the
total volume portfolio.
Devise systems to collect environment-related data (financial and nonfinancial).
Devise control systems which are effective in monitoring progress against

organisational objectives.
Communicate social and environmental performance throughout the

company in a meaningful way.
Managing the management accounting function

Develop management information systems that ensure the provision of all
necessary information to enable employees to plan and control their performance
in line with company policy and objectives.
Encourage social and environmental responsibility, e.g. maximum recycling,
minimum energy consumption, with the management accounting area.
Conclusion
In the third millennium we are at last becoming, albeit slowly, aware of the fact that
human activity, including business operations, can have a deleterious effect on
future quality of life on this planet. Accountants and managers have a role to play in
measuring and controlling the impact of human activity on the environment.
6.22
Self-test questions
Using the information contained in this study guide attempt the following
questions:
i.
Matching
You are required to match each term to its definition by placing the letter of the
most appropriate description in the space provided.
1.
Descriptive report
2.
Inventory approach
3.
Cost-benefit approach
4.
Closed door
5.
Environment
6.
Stakeholders
7.
EIA
8.
Due diligence
9.
Remediation cost
10.
Compliance audit
a.
Includes all aspects of the surroundings of human beings, whether affecting

human beings as individuals.
b.
Is undertaken voluntarily by many firms as a result of regulations and

legislation which place responsibility and potential liability on directors or
other managers.
c.
The most difficult approach to reporting social and environmental activities.
d.
Exercising reasonable foresight and care.
e.
Social and environmental impact assessment.
f.
Most business choose to disclose their social and environmental activities in

this manner.
g.
All parties who have an interest in the operations of a business.
h.
Old practice regarding community access to social and environmental

management in a corporation.
i.
A comprehensive list of social and environmentally responsible actions.
j.
An example of this cost is the removal and treatment of waste material.
6.23
ii.
Multiple choice

1.
Which of the following is NOT a suggested approach to accounting and

reporting on social and environmental activities?
A.
B.
C.
D.
E.
2.
Which of the following terms means the design and location of facilities is
conformance with surroundings and with pleasing architecture and
landscaping?
A.
B.
C.
D.
E.
3.
6.24
inventory approach
liability approach
cost approach
program management approach
cost-benefit approach.
aesthetics
resource allocation
eugenics
program management
none of the above
The focus on the environment is a result of four interactive forces that

emphasise social and environmental awareness. Which of the following is a
list of those forces?
I.
II
III
IV
V
VI
VII
VIII
stringent enforcement
public consumer
companies competitors
scarce resources
user pays principle
professional pressure groups
resources technology
policy legislation
A.
B.
C.
D.
E.
I, II, III, IV
III, II, VII, IV
VI, II, III, VII
II, III, VII, VIII
None of the above
4.
Participative control and decision making in relation to social and

environmental issues is an example of:
A.
B.
C.
D.
E.
5.
Which of the following groups is NOT a potential stakeholder in social and

environmental issues?
A.
B.
C.
D.
E.
6.
government
social and environmental activities
customers
investors
none of the above
Which of the following terms is a cost incurred in upgrading facilities in

order to comply with regulations?
A.
B.
C.
D.
E.
7.
new management strategy

old management strategy
new management style
new organisational structure
none of the above.
statutory cost
remediation cost
waste disposal cost
capital cost
none of the above
The International Institute for Sustainable Development has suggested six

sequential steps for working towards social and environmental
responsibility. In sequence they are:
I
II
III
IV
V
VI
prepare reports
perform stakeholder analyses
develop supportive corporate culture
set social and environmental policies and plans
develop standards and measures of performance
design and execute an implementation plan
A.
B.
C.
D.
E.
IV, VI, II, V, III, I

VI, IV, II, V, III, I
II, IV, VI, III, V, I
II, VI, IV, III, V, I
none of the above
6.25
8.
Which of the following is NOT part of the social and environmental

investment/project appraisal process?
A.
B.
C.
D.
E.
9.
KEPIs are:
A.
B.
C.
D.
E.
10.
Consider the social and environmental expectations of all

stakeholders.
Ensure the inclusion of costs associated with compliance with laws
and regulations.
Assess social and environmental risk dimensions.
Be directly involved in harnessing and conserving the use of
organisational resources.
None of the above.
knowledge and environment performance indicators

key social and environmental performance indicators
knowledge, enthusiasm, profit, indicators
key, executives and personnel indicators
none of the above.
Which of the following is NOT a social and environmental issue?

A.
B.
C.
D.
E.
green house gases

global warming
disposal of radio active waste
visual pollution caused by overhead cables
none of the above.
iii. Exercises
1.
List and briefly describe six current social and environmental issues. Choose
two of these and discuss how accounting measurement processes might
assist in dealing with the problem.
2.
Write a report on a current social and environmental issue discussed in the

media. Define the issue, present arguments for and against, and give reasons
why or why not you believe the government should regulate or enforce
regulation.
3.
Conduct a web search for social and environmental accounting and related
terms. Summarise your research findings in 500 words and attach hard
copies of web pages as an appendix.
6.26
Self-test solutions
i.
Matching
1. F; 2. I; 3. C; 4. H; 5. A; 6. G; 7. E; 8. D; 9. J; 10. B.
ii.
Multiple choice
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
iii. Exercises
Answers will vary. The important thing is to focus on accounting and
measurement issues, rather than being caught up in emotional debate. CPA
Australia and the Institute of Chartered Accountants in Australia have relevant
resources.
6.27
6.28
Reading
6.1
Deegan, C. (2009). Extended systems of accounting the incorporation of social
and environmental factors within external reporting. In Financial
accounting theory (3rd ed., ch. 9, pp. 378-457). Australia: McGraw-Hill.
6.29
Reading
6.2
Ravlic, T. (2004). Mung bean counters. Australian CPA, September, 33-35.
Tom Ravlic writes on triple bottom line reporting. TBL can be relevant to social
and environmental accounting - as can Balanced Scorecard. Google (Bing ?) TBL
and Balanced Scorecard. Wikipedia provides a succinct discussion. Interestingly,
Tom who writes prolifically for accounting publications in Australia, is an
accounting graduate of CSU.
6.30
Topic 7 Introduction to management accounting
Required reading
Textbook:
Horngren, et al., ch. 1.
This topic looks at the role of the accountant within an organisation - as a

scorekeeper, attention director and problem solver.
Considerable emphasis is placed on the use of accounting data for decision
making, and the difference between financial and managerial accounting:
a single accounting system may be developed for both management

accounting and financial accounting requirements because in many instances
the data requirements and concepts are the same i.e. overlapping.
Managerial accounting involves reporting accounting data which focuses on the

allocation of resources within the organisation and is used by management in
deciding how to plan and control operations.
Financial accounting is reporting directed towards external decision makers such
as owners (shareholders), prospective owners, creditors and government
(Australian Taxation Office, Australian Securities and Investments Commission).
The planning and controlling function is an important part of the management
process. The overall function of management is to choose between alternative
courses of action to achieve a specific goal or objective.
Internal decision makers are managers at all levels:
Group Manager
Marketing Manager
Division Manager
Area Manager
Plant Manager
Process Manager/Assembly Line Manager
Foreman.
7.31
Decisions relating to the internal operation of the organisation could include:
Long term strategic plan

What combination of product to manufacture
Should the product be made or bought from another firm
Should equipment be scrapped or maintained
The quantity of product held as stock
Which process to use
Should overtime be worked.
The performance of managers can be evaluated by using quantitative financial

criteria. Formal plans may be expressed in accounting terms which represent
budgets. A performance report is a form of control which compares actual results
with the planned or budgeted outcome. The differences or deviations from the
plans are referred to as variances.
you should have now realised that managerial accounting data in the form of
a budget is more useful to management for internal decision making.
Contrast this with financial accounting data which provides an historical
evaluation; this year versus last year.
The chapter also explores the role of the accountant in organisations. The titles of
some positions e.g. President is used in the American context. This is equivalent
to positions titled General Manager or Managing Director in Australia.
The importance of ethics to the profession and as a basis for business cannot be
overemphasised. The global nature of business means that the ramifications of
unethical behaviour reverberate through the world economy. This was evident in
collapses such as Enron. It is crucial to understand the central nature of ethical
behaviour to survival in the long term. Please refer to Reading 7.1.
Cost-benefit analysis
This is a theme which runs through this subject and the textbook. All decisions
involve a choice between alternatives. In choosing between accounting systems
and accounting methods a cost benefit approach would be adopted. The selection
will be based upon the decision makers perception of the expected incremental
benefits in relation to the incremental costs.
incremental means additional; as a consumer, student, participant in the

workforce etc. cost benefit analysis is used in decision making although it
may not be formalised in quantitative terms
information has not only a benefit but also a cost and this economic
consideration should not be overlooked.
7.32
Behavioural aspects
An important consideration in the development of a management accounting
system is its impact upon the individuals within the organisation, and in particular,
the likely effect on their performance. The chapter briefly addresses the function
of budgeting and how this forces management to plan. Evaluation of performance
and information in the form of feedback are necessary if individuals are to be
motivated positively.
in the development of an internal reporting system there should be recognition

of the diversity of individuals within an organisation and that each may
perceive goals or objectives which are inconsistent with that of the firm
the evaluation process may have negative consequences and motivate

employees in an undesirable manner.
7.33

Selected from Horngren, C. T., et al. (2004). Introduction to management
accounting (13th ed., ch. 1). Pearson Prentice Hall.
Study questions
Source:
Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., p. 31). Pearson
Prentice Hall.
Source:
Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., p. 38). Pearson
Prentice Hall.
7.34
Source:
Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., p. 38-39).
Pearson Prentice Hall.
7.35

1-A1
Because the accountant's duties are often not sharply defined, some of these
answers could be challenged:
1.
Attention directing and problem solving. Budgeting involves making

decisions about planned activities hence, aiding problem solving. Budgets
also direct attention to areas of opportunity or concern hence, directing
attention. Reporting against the budget also has a scorekeeping dimension.
2.
Problem solving. Helps a manager assess the impact of a decision.
3.
Scorekeeping. Reports on the results of an operation. Could also be attention

direction if scrap is an area that might require management decisions.
4.
Attention directing. Focuses attention on areas that need attention.
5.
Attention directing. Helps managers learn about the information contained

in a performance report.
6.
Scorekeeping. The statement merely reports what has happened.
7.
Problem solving. The cost comparison is apparently useful because the

manager wishes to decide between two alternatives. Thus, it aids problem
solving.
8.
Attention directing. Variances point out areas where results differ from
expectations. Interpreting them directs attention to possible causes of the
differences.
9.
Problem solving. Aids a decision about where the parts should be made.
10.
Scorekeeping. Determining a depreciation schedule is simply an exercise in

preparing financial statements to report the results of activities.
1-46
1.
Because of the standard of confidentiality, the information in the geologist's

report should not be revealed.
2.
The standard of integrity would require one to reject the invitation.
3.
This is a difficult ethical problem, one that deserves discussion. Two ethical
standards apparently conflict. Confidentiality would lead to nondisclosure,
provided there was no legal requirement to do so. But objectivity would
indicate that the information about the additional losses should be used in
making the earnings prediction. The authors think that objectivity should
take precedence here, but others might disagree.
4.
The standard of competence, and to some extent the standard of integrity, would
lead one to research the tax law before deciding whether to deduct the item.
7.36
1-48
1.
Line authority is held by those managers directly responsible for the

production and sales of goods or services. Staff authority is held by persons
who have an indirect responsibility for the production and sale of goods and
services. Staff members provide expertise, advice and support for line
positions; line managers are directly responsible for achieving the basic
objectives of the organization.
Conflicts between line and staff can arise for many reasons, ranging from
the types of people that are generally attracted to each type of position to
their responsibilities in the organization. Among the reasons are:
Staff personnel tend to be younger, better educated, more
professionally established.
Line managers see staff managers as threats to their authority.
Line managers are uncomfortable when they must rely on the
knowledge and expertise of staff.
Line managers often think staff managers overstep their authority and
have a narrow view of the world.
Staff managers often think line managers ignore their advice and resist
their ideas.
2.
Chen has a staff position, providing advice to the controller. His main
conflicts will probably arise with the chief accountant and the managers
under him. He reports to the chief accountants superior, but he prepares
reports that affect the operations in the chief accountants area of
responsibility.
Paperman is in a staff position because accounting is not directly involved
with sales or delivery of leasing services. He provides counsel and advice to
all the line managers and most of the staff managers in the company.
Conflicts may arise if he tries to exert authority instead of just giving advice
or if the other managers ignore his advice.
Hodge is in a line position because she is an integral part of the companys
main line of business, leasing equipment. Her main conflicts are likely to
arise in areas such as requisitioning of equipment and billing of customers
where she must rely on other departments over which she has no authority.
Burgstahler is in a staff position and offers advice to most other managers in
the company. Conflicts might arise if managers perceive her advertising of
positions or screening of candidates as not fulfilling their needs, or if she tries
to exert her preferences instead of the hiring departments preferences into the
advertising and screening activities. Conflicts can also arise in the
performance evaluation functions, where she may be enforcing an unpopular
policy.
7.37
7.38
Topic 8 Cost-volume-profit analysis
Required reading
Textbook:
Horngren, et al., ch. 2 (including Appendix 2A).
Cost-volume-profit (CVP) analysis or breakeven analysis

Cost-volume-profit analysis is used by managers to assist in making operating
decisions such as:
how many units of production should be sold to achieve a specific level of

profit;
below what level of production and sales will a loss be incurred;
how to classify particular costs as either variable, fixed or semivariable.
To be able to classify costs as either fixed, variable or semivariable one has to

understand how a particular cost fluctuates in relation to changes in output, e.g. if the
normal daily output of beer from a brewery is 20,000 kegs what would be the effect
on the usage of yeast, hops, factory rent and executive salaries if output increased to
22,000 kegs. Intuitively you would expect the usage of hops and yeast to increase by
10% but no change in rent or executive salaries. Hops and yeast, typical raw
materials in beer production represent variable costs while factory rent and executive
salaries are fixed costs; they have not changed despite a 10% increase in output.
Unit costs
In the text there is a comparison of variable and fixed costs. To reinforce your
understanding of the relationship between total costs and changes in the volume of
activity, work through this example.
Volume of Production (Units)
10,000
15,000
5,000
Type of Cost
Total
Cost $
Average
Cost Per
Unit $
Total
Cost $
Average
Cost Per
Unit $
Total
Cost $
Average
Cost Per
Unit $
Fixed Costs
10,000
1.00
10,000
0.67
10,000
2.00
Variable Costs
14,000
1.40
21,000
1.40
7,000
1.40
8.1
The important points to observe are:

1.
there is no change in the total amount of fixed costs ($10,000);
2.
the total for variable costs varies in direct proportion to changes in the
volume of production;
3.
the average cost per unit for the fixed component decreases or increases with
changes in activity;
4.
variable costs are constant per unit ($1.40).
Semivariable (mixed) cost

This is a cost that changes when the volume of activity changes, but not in direct
proportion. A semivariable cost has both fixed and variable cost properties.
Examples of these costs are maintenance and telephones. There are fixed
components to both these costs, but as production and sales increase there would
be increasing demands placed on maintenance and telephone usage.
The text introduces the concept of relevant range. It is important that you
understand this term and its application to fixed costs. A cost may be classified
fixed subject to the constraints of a budget period and given range of activity, but
over a long enough time span and outside this range all costs may change.
Although the chapter recognises that some fixed costs may vary over time and that
variable costs may behave in a non-linear way, the assumption is made, for ease of
explanation, that all costs can be classified as either variable or fixed and:
1.
a given variable cost is associated with only one measure of volume
2.
that relationship is linear i.e., a straight line.
Breakeven analysis
The term breakeven can be a little misleading. Firms seek to make profits not just
breakeven. This analysis is used in the planning process, in making operating
decisions and is an indicator of risk.
Breakeven analysis is based on the following assumptions:
1.
linearity for variable costs
2.
the volume of output is within the relevant range i.e. fixed costs do not alter
within this range.
8.2
C-V-P or breakeven analysis

The textbook explains two analytical techniques and a graphical technique. You
may wish to work through the graphical technique first, followed by the two
analytical techniques (contribution margin techniques and the equation technique).
Work through the summary problem.
This chapter uses the term contribution margin which is simply defined as the
selling price minus variable costs. Each unit of output generates a contribution
margin which goes towards meeting the fixed costs and thereafter towards profit.
An incremental approach is used where a specific level of profit or net income is
desired.
CVP Analysis
In many decisions concerned with product and profit planning there is a need to
carefully analyse the behaviour of costs, revenues and profits in response to changes
in sales volume. The selling prices of a firm's products are usually known, or else
based on cost plus a markup. It is the sales volume which tends to involve the
greatest uncertainty, and, of course, the number of units sold affects profit levels.
Cost-volume-profit (CVP) analysis is a technique for assessing the effects of changes
in volume on expected profits. CVP analysis is strictly a short-run analytical
technique because in the longer term cost structures change, as well as prices.
CVP relationships are very useful, and are often used implicitly by small business
traders who have had no formal training in their use, and who may never have
heard of the expression CVP analysis. Nevertheless, they realise that they must
generate a certain level of sales dollars to cover expenses before they begin to
make a profit in any given period. A small businessman who marks up goods by,
say, 100% on cost, can readily determine the success of a period's trading using
CVP techniques.
Single Product CVP Analysis
Basic Model
Assume a firm produces and sells a single product, for a price p, which is given.
We assume that the firm is a price-taker, and cannot significantly influence p.
Each unit produced and sold has a variable cost (or cost of resources supplied as
used), b, which covers all variable production and distribution costs. Assume also
that there is a fixed cost (or cost of resources supplied in advance of usage), a, for
the period, covering the capacity cost to produce, store and sell the product. For
simplicity, assume also that the quantity produced is equal to the quantity sold (no
change in inventories).
8.3
Hence the total cost of producing and selling x units (TCX) in a given time period
is represented by
TCX = a + bX
(9-1)
The total revenue from selling x units (TRX) is the product of price per unit and
units sold:
TRx = px
(9-2)
The profit from producing and selling x units (X) is equal to total revenue (TR)
minus total costs (TC):
X = TR - TC
= TR - FC - VC
= px - a - bx
= (p-b)x - a
(9-3)
The expression (p-b), that is unit selling price minus unit variable cost, is known
as the contribution margin per unit. It is called contribution margin because
each unit sold contributes (p-b) towards the recovery of fixed costs and earning of
profits.
Example 9-1
Data for month of January:
Required:
Unit selling price

Unit variable cost
January fixed costs
p = $10
b = $6
a = $8000
What is the profit equation?
Substituting the data from Example 9-1 in equation (9-3) gives:

X
= (p-b)x - a
= (10-6)x - 8000
= 4x - 8000
Note that the unit contribution margin (p-b) is $4. X = 4X-8000 represents the
firm's profit equation and clearly, the value of X depends on the unit sales
volume, x.
Breakeven Point
A particular volume level which is of interest is the point where the firm breaks
even - earns zero profit, neither a profit nor a loss. Most firms (except for nonprofit institutions) wish to do better than break even, but the breakeven point is of
interest because it is an important milestone on the way to profits.
8.4
The breakeven volume (x) can be found by setting X = 0 in equation (9-3):

X = (p-b)x - a
0 = (p-b)x - a
(p - b)x = a
Thusx =
a
p-b
(9-4)
From equation (9-4) we see that the breakeven point (BEP) in sales units is equal
to the fixed costs divided by the unit contribution margin, and is often memorised
in the form:
BEP =
FC
CM
Using the data from Example 9-1, we can calculate the breakeven sales volume:
BEP =
FC 8000
=
= 2000 units
CM
4
meaning that 2000 units have to be produced and sold during January just to break
even. Any sales volume in excess of 2000 units during January will earn positive
profits.
PV Chart
A graph of the equation X = 4x - 8000 is known as a Profit-Volume Chart, and is
shown in Figure 9-1. The y-intercept represents the period fixed costs ($8000)
and the x-intercept (2000 units) is the breakeven point in units. The slope of the
line is equal to the contribution margin (4). From this chart the profit resulting
from any particular sales volume can be read off directly.
8.5
Profit
8000
6000
4000
Profit
2000
0
-2000
1000
2000
3000
4000
-4000
-6000
-8000
x
Figure 9-1: PV Chart
Target level of profit

Rather than just breaking even, management is more likely to be interested in
earning some target level of profit. From the basic equation (9-3), if X is the
target level of profit, we can solve for x to obtain the required volume to earn $:
= (p-b)x - a
(p-b)x = a +
x=
a+
p-b
(9-5)
That is,
Required Volume =
=
Fixed Cost + Profits

Contribution Margin
FC +
CM
Using the data from Example 9-1, how many units must be produced and sold to
earn a net profit of $2000?
Required Volume =
FC +
CM
8000+2000
4
10 000
4
= 2500 units
8.6
So 2500 units must be produced and sold to earn a net profit of $2000. This can be
verified in another way. Breakeven point is 2000 units. Therefore the contribution
margin on all units in excess of 2000 is all profit. 2500 units is 500 in excess of
BEP. A contribution margin of $4 on each of 500 units gives $4 x 500 = $2000
profit. The excess of 500 units above BEP is known as the margin of safety.
Breakeven point and target level of profit in sales dollars
Often there is interest in the breakeven point in terms of sales dollars rather than
sales units. For example, a shopkeeper is more likely to know the sales receipts
(cash plus credit sales vouchers plus cheques) than the unit sales. There are two
approaches to this problem. We could calculate BEP in units, and then multiply
the units by the selling price. Using Example 9-1 data, the BEP was 2000 units.
In terms of dollar sales, the BEP would be
2000 units x $10 = $20 000.
The second, more direct approach, is to modify the unit breakeven equation (9-5)
by multiplying both sides by price, p:
BEP (units): x =
BEP ($): px = p
FC
a
or
CM
p-b
FC
a
or
CM ratio
(p-b)/p
(9-6)
The denominator in equation (9-6), (p-b)/p, is called the contribution margin

ratio. Using the data from Example 9-1,
p-b 10-6
=
= 0.4
10
p
Thus,
BEP($) =
FC
8000
=
= $20000
CM ratio
0.4
Similarly, the required sales dollars to earn a target level of profit is

Required Volume ($) =
FC+
CM ratio
Thus the required sales dollars to earn a net profit of $2000 is

Required Volume ($) =
8000+2000
0.4
This excess of sales dollars over breakeven sales dollars ($25 000-$20 000) is
known as the margin of safety. The margin of safety can be expressed in terms of
sales units or sales dollars.
8.7
The contribution margin ratio can also be calculated from aggregate data instead of
unit data. For example, a direct (or variable) costing income statement would show
Sales and Total Contribution Margin (or Variable Profit). The contribution margin
ratio would simply be Contribution Margin (or Variable Profit) divided by Sales.
Profit from selling given volume
In relation to Example 9-1, a typical question might be, What profit would be
earned from selling 3000 units?
The answer to this question can be approached in two ways. First, we could
substitute 3000 for x in the profit equation:
X = 4x-8000
= 4(3000)-8000
= $4000.
Alternatively, we could reason that BEP is 2000 units. Sales of 3000 units is 1000
units in excess of BEP. Therefore the profit is the contribution margin of $4 times
the 1000 units = $4000.
Effects of income tax
Income taxes do not affect the breakeven point because no tax is paid on zero
profit. However, income taxes can affect target profit calculations. Suppose a
firm is interested in the number of units required to be sold to earn a certain net
profit after tax. The before-tax profit equation is
= (p-b)x-a
To earn $ after tax requires a higher profit before tax. Therefore we multiply the
right hand side by (1-t) where t is the tax rate:
(After tax) = (1-t)[(p-b)x-a]
1-t
= (p-b)x-a
a+
x=
1 t
p b
FC+
or Required Volume =
8.8
1-t
CM
To illustrate, using Example 9-1 data, how many units must be sold to earn a net
profit after tax of $6000, given a tax rate of 40c in $?
6000
1-0.4
4
8000+
Required Volume =
=
8000+10 000
4
= 4500 units
Breakeven charts and financial risk
In addition to product risk firms are exposed to financial risk associated with
various strategic options. There are various types of financial risk. The source of
funding is one type. Equity funds provide the lowest possible financial risk from
the users point of view. Borrowed money, that is debt, represents much higher
financial risk. If an organisation finances the launch of a new product with debt
this would represent a combination of two types of risk: a high business risk
combined with high financial risk.
The cost structure of the business represents another source of financial risk.
Firms with high fixed costs, eg from automation or robotics, are exposed to high
risk. Because variable costs tend to be low, and hence contribution margin high,
high profits are earned above breakeven point, but high losses are incurred below
breakeven activity level.
40000
35000
Sales
Sales/Costs
30000
Profits
25000
20000
Total cost
15000
Losses
10000
Low variable cost
5000
0
0
500
1000 1500 2000 2500 3000 3500

Activity level
Figure 9-2: High fixed cost/high contribution strategy
8.9
25000
Sales
Sales/Costs
20000
Profits
15000
10000
Total cost
High variable cost
5000
Losses
0
0
500 1000 1500 2000 2500 3000 3500

Activity level
Figure 9-3: Low fixed cost/low contribution strategy
The breakeven chart shown in Figure 9-2 illustrates the situation. The breakeven
point is 1500 units. Below breakeven losses are the vertical distance between the
sales revenue line and the total cost line, while profits are made above breakeven
point. Clearly high profits will be made when activity levels are above breakeven,
but high losses will be incurred below breakeven. Returns will be very volatile
and this would be a high risk strategy.
Alternatively, fixed costs may be kept lower but variable costs are higher, eg from
outsourcing. This strategy results in the same breakeven point of 1500 units, as
seen in Figure 9-3. Variable costs tend to be high, and hence contribution margin
low, resulting in significantly lower levels of profits or losses for the same
variation in sales activity. The risk of high losses has been reduced at the cost of
the opportunity for high profits. Some of the risk has been transferred to the
supplier who demands a higher return for bearing this risk.
Multi-product CVP analysis
Our analysis now turns to the more usual case where a firm produces and sells
more than one product. To illustrate the problem we will consider the twoproduct case, which can be generalised to any number of products.
Example 9-2
Assume that two products are produced using common production
facilities, with period fixed costs of $20 000 which are common to the
two products. Other data are:
Product
P1
P2
8.10
pi
$10
15
bi
$6
10
Thus the contribution margins for the two products are $10-$6 = $4 for product P1
and $15-$10 = $5 for product P2. The profit equation for the firm is
= [(pibi)xi] a
= 4xi +5x2 20 000
where xi = number of units of product Pi. For breakeven, = 0, so
4x1 + 5x2 - 20 000 = 0,
i.e. 4x1 + 5x2 = 20 000
(9-6)
Equation (9-6) is the equation of a straight line which can be graphed as shown in
Figure 9-4. With x1 on the horizontal axis and x2 on the vertical axis, we can plot
two points on the line and join them. If x2 = 0, then 4x1 = 20 000, and hence x1 =
5000. This gives us the point (5000,0). Alternatively, if x1 = 0, then 5x2 = 20 000,
and thus x2 = 4000. This gives the point (0,4000). We then join the two points,
ignoring the extensions into the second and fourth quadrants because either x1 or
x2 would be negative, and negative production or sales is not meaningful.
What the graph shows is that there is no unique breakeven point. The two
extremities are both possible breakeven points:
(5000,0): = 4(5000)+5(0)-20 000 = 0
(0,4000): = 4(0)+5(4000)-20 000 = 0
5000
x2
4000
4x1+5x2=20,000
3000
2000
1000
0
0
2000
4000
6000
x1
Figure 9-4: Breakeven Graph
But any other point on the line is also a breakeven point, meaning that there are
multiple breakeven points. Such other points are linear combinations of the two
extremities, and can be calculated using the expression
g(S1)+(1-g)(S2)
where S1 is solution 1: x1 = 5000, x2 = 0,
S2 is solution 2: x1 = 0, x2 = 4000,
and g can take any positive value in the range 0g1.
8.11
So we can find other breakeven points by selecting different values for g between
zero and one. For example, suppose we let g = 1/5. Then we have another BEP:
1/5(5000,0)+4/5(0,4000)
The new x1 value = 1/5 of the x1 value from S1 plus 4/5 of the x1 value from S2,:
x1 = 1/5(5000)+4/5(0) = 1000.
Similarly, the new x2 value = 1/5 of the x2 value from S1 plus 4/5 of the x2 value
from S2:
x2 = 1/5(0)+4/5(4000) = 3200
Hence we have discovered another breakeven point (1000,3200). To verify:
= 4(1000)+5(3200)-20 000 = 0.
Not only is there no unique breakeven point, but there are multiple solutions for
the required volume to earn a target level of profit. Suppose we are interested in
earning a net profit of $5000. Then all points on the line
4x1+5x2 = 20 000+5000
= 25 000
are possible solutions. For example, (6250,0) or (0,5000) or any point along the
line between them is a solution. The graph of this line would be parallel to, but
above the breakeven line.
Of course, this graphical technique is restricted to the case of two products, but the
general principle of multiple solutions holds for more than 2 products.
A given mix
A unique solution can be obtained, however, if the multiple products are produced
and sold in fixed proportions (that is there is a given product mix). For example,
suppose that products P1 and P2 are sold in the ratio x1:x2 = 5:1, meaning that for
every 1 unit of P2, 5 units of P1 are produced and sold. How many units of each
product are required to break even?
We calculate a weighted average contribution margin, based on the given mix, to
use in the breakeven formula. With a ratio of 5:1, P1 will constitute 5/(5+1), or
5/6 of sales, while P2 will constitute 1/(5+1), or 1/6 of sales. Hence,
Average CM = 5/6($4)+1/6($5)
= (20+5)/6
= 25/6
8.12
Then,
BEP =
FC
20 000 120 000
=
=
= 4800 units
Av.CM
25/6
25
These 4800 units represent a mix of P1 and P2, and the individual components
are:
x1 = 5/6(4800) = 4000
x2 = 1/6(4800) = 800
It can be easily proved that (4000,800) is a breakeven point:
= 4(4000)+5(800)-20 000 = 16 000+4000-20 000 = 0.
Similarly, given the mix x1:x2 = 5:1 we could calculate the required volume to
earn a given net profit, say $5000:
Required Volume =
That is,
FC+
20 000+5000 25000 6
=
=
= 6000 units
Av. CM
25/6
25
x1 = 5/6(6000) = 5000 units

and x2 = 1/6(6000) = 1000 units.
This type of analysis, given the sales mix, can be used for any number of products.
Limitations of CVP analysis
Although CVP analysis can be very useful, and can answer many questions, it is
not a maximising technique. That is to say, CVP analysis does not answer such
questions as, How many units of each product do I need to produce and sell in
order to maximise profits? Linear programming, the topic of the next chapter,
was designed to answer such questions.
Peanuts and cost accounting

This adaptation has appeared in many forms over the years in Accounting and
Management journals as well as on the Web and has become a classic. In
discussing the cost allocation to various types of operations, the analogy was
drawn of the restaurant which adds a rack of peanuts to the counter intending to
pick up a little additional profit in the usual course of business. However, the
accuracy of the analogy is evident when one considers the actual problem faced by
the Restaurateur (Joe) as revealed by his zealous cost accountant, (Harry). One
issue is the general problem of cost allocation; another is the matter of overhead
cost alteration and whether or not it makes logical sense.
8.13
Harry
Joe, you said you put in these peanuts because some people ask for
them, but do you realize what this rack of peanuts is costing you?
Joe
It aint gonna cost. Sgonna be a profit. Sure, I hadda pay $25 for a
fancy rack to holda bags, but the peanuts cost 6 cents and I sell em for
10 cents. Figger I sell 50 bags a week to start. Itll take 12 weeks to
cover the cost of the rack. After that, I gotta clear profit of 4 cents a
bag. The more I sell, the more I make.
Harry
That is an antiquated and completely unrealistic approach, Joe.

Fortunately, modern cost accounting procedures permit a more
accurate picture which reveals the complexities involved.
Joe
Huh?
Harry
To be precise, those peanuts must be integrated into your entire

operation and be allocated their appropriate share of business
overhead. They must share a proportionate part of your expenditures
for rent, heat, light, equipment depreciation, decorating, salaries for
your waitresses, cook,...
Joe
The cook? Whatsa he gotta do wita peanuts? He don even know I

gotem!
Harry
Look, Joe, the cook is in the kitchen, the kitchen prepares the food, the
food is what brings people in here, and the people ask to buy peanuts.
Thats why you must charge a portion of the cooks wages, as well as
a part of your own salary to peanut sales. This spreadsheet contains a
carefully calculated cost analysis which indicates the peanut operation
should pay exactly $1,278 per year toward these general overhead
costs.
Joe
The peanuts? $1,278 a year for overhead? Thats nuts.
Harry
Its really a little more than that. You also spend money each week to
have the windows washed, to have the place swept out in the
mornings, and to keep soap in the washroom. That raises the total to
$1,313 per year.
Joe
(Thoughtfully) But the peanut salesman said Id make money

putem on the end of the counter, he said and get 4 cents a bag
profit.
Harry
(With a sniff) Hes not an accountant. Do you actually know what the
portion of the counter occupied by the peanut rack is worth to you?
Joe
Aint worth nothing - no stool there - just a dead spot at the end.
8.14
Harry
The modern cost picture permits no dead spots. Your counter contains
60 square feet and your counter business grosses $15,000 a year.
Consequently, the square foot of space occupied by the present rack is
worth $250 a year. Since you have taken that area away from general
counter use, you must charge the value of the space to the occupant.
Joe
You mean I gotta add $250 a year more to the peanuts?
Harry
Right. That raises their share of the general operating costs to a grand
total of $1,563 per year. Now then, if you sell 50 bags of peanuts per
week, these allocated costs will amount to 60 cents per bag.
Joe
What?
Harry
Obviously, to that must be added your purchase price of 6 cents per

bag, which brings the total to 66 cents. So you see, by selling peanuts
at 10 cents per bag, you are losing 56 cents on every sale.
Joe
Somethings crazy.
Harry
Not at all. Here are the figures. They prove your peanut operation
cannot stand on its own feet.
Joe
(Brightening) Suppose I sell lotsa peanuts thousand bags a week

stead a fifty?
Harry
(Tolerantly) Joe, you dont understand the problem. If the volume of

peanut sales increases, your operating costs will go up. Youll have to
handle more bags, with more time, more depreciation, more
everything. The basic principle of accounting is firm on that subject:
The Bigger the Operation, the More General Overhead Costs that
Must be Allocated. No, increasing the volume of sales wont help.
Joe
Okay, youre so smart, you tell me what I gotta do.
Harry
(Condescendingly) Well you could first reduce the operating

expenses.
Joe
How?
Harry
Move to a building with cheaper rent. Cut salaries. Wash the windows
bi-weekly. Have the floor swept only on Thursday. Remove the soap
from the washrooms. Decrease the square foot value of your counter.
For example, if you can cut your expenses 50%, that will reduce the
amount allocated to peanuts from $1,563 down to $781.50 per year,
reducing the cost to 35 cents per bag.
Joe
(Slowly) Thats better.
8.15
Harry
Much, much better. However, even then you would lose 26 cents per
bag if you charge only 10 cents. Therefore, you must also raise your
selling price. If you want a net profit of 4 cents per bag, you would
have to charge 40 cents.
Joe
(Flabbergasted) You mean after I cut operating costs 50%, I still gotta
charge 40 cents for a 10 cent bag of peanuts? Nobodys that nuts about
nuts. Whod buy em?
Harry
Thats a secondary consideration. The point is at 40 cents, youd be

selling at a price based upon a true and proper evaluation of your then
reduced costs.
Joe
(Eagerly) Look! I got a better idea. Why dont I just throw the nuts out
put em in a trash can?
Harry
Can you afford it?
Joe
Sure. All I got is about 50 bags of peanuts cost about three bucks
so I lose $25 on the rack, but Im outa this nutsy business and no
more grief.
Harry
(Shaking head) Joe, it isnt quite that simple. You are in the peanut
business! The minute you throw those peanuts out, you are adding
$1,563 of annual overhead to the rest of your operation. Joe, be
realistic can you afford to do that?
Joe
(Completely crushed) Itsa unbelievable! Last week, I was gonna make

money. Now, Im in a trouble justa because I think peanuts on a
counter is a gonna bring me some extra profit justa because I
believe 50 bags of peanuts a week is a easy.
Harry
(With raised eyebrow) That is the object of modern management

accounting for costs and control, Joe, to dispel false illusions.
Summary
Cost-volume-profit analysis is a technique for assessing the effects of changes in
volume on expected profits. We can calculate the breakeven point for a product in
units and dollars, as well as the required volume in units or dollars to earn a target
level of profit. Profit from selling a given volume can also be calculated.
Breakeven charts are useful for illustrating and analysing financial risk.
CVP analysis can also be applied to multiple products. There is no unique
breakeven point unless the product mix is specified.
8.16

Adapted from Fatseas, V. A., & Williams, J. F. (2008). Management accounting
decisions. McGraw-Hill.
Study questions
P8-3 Single product CVP analysis: comprehensive set of questions
BE Ltd manufactures and sells a single product for $10 per unit. Variable
costs are $5 per unit to manufacture and $2 per unit to distribute. Fixed
costs are $30 000 per month.
Calculate:
a.
Unit contribution margin.
b.
Contribution margin ratio.
c.
Monthly breakeven point in sales units.
d.
Monthly breakeven point in sales dollars.
e.
Monthly profit if 14 000 units are sold.
f.
Sales units required to earn a monthly net profit of $15 000.
g.
Monthly sales in dollars required to earn an after-tax monthly profit of

$10 000 given a company tax rate of 45c in the dollar.
h.
The effect on the breakeven point calculated in (c) if there is a 20%

decrease in variable manufacturing costs as a result of new production
methods which increase monthly fixed costs by $5000.
P8-7 Cost structure and financial risk

ABC Company is contemplating launching a new product to sell at $100 per
unit. It is considering two strategies:
1.
Buy Machine A to make the product. Fixed costs would be $800 000
per year, but variable operating costs would be only $20 per unit.
2.
Buy Machine B. Fixed costs would be $200 000 per year and variable
operating costs would be $80 per unit.
Required:
a.
Calculate the breakeven points using (i) Machine A, and (ii) Machine
B.
b.
Suppose that production and sales in the first year are 1000 units.
Calculate the profit before tax using (i) Machine A, and (ii) Machine
B.
c.
Suppose that production and sales in the second year are forecast to be
15 000 units. Calculate the profit before tax using (i) Machine A, and
(ii) Machine B.
d.
Which machine represents the riskier strategy? Why?
8.17
P8-9 Multi-product CVP: 3 products

SKN Bearings Ltd manufactures a wide range of bearings. One particular
product line consists of three grades of skateboard bearings which are
produced using separate facilities with annual fixed costs of $9000. Unit
selling prices and variable costs are as follows:
Selling Price
$1.00
1.50
2.00
Low grade
Medium grade
High grade
Variable Cost
$0.60
0.70
1.00
Required:
a.
Suppose SKN decides to produce only Low and Medium grade

bearings this year. Calculate three possible breakeven volumes, one
involving only Low grade, one involving only Medium grade, and a
linear combination of these two using a value of 1/3 for g.
b.
SKN decides against the policy mentioned in (a) and intends to

produce and sell the following mix this year:
Low : Medium : High = 1 : 2 : 1.
i.
Given this sales mix, how many of each grade should be sold to
break even on skateboard bearings?
ii.
Given this sales mix, how many units of each grade should be
sold to earn an after-tax profit of $10 000 on skateboard
bearings, given a company tax rate of 40c in the doll

P8-3 a.
p-b $10-($5+$2) $3
=
=
= 0.3
p
$10
$10
b.
CM ratio =
c.
BEP =
d.
Can be calculated in 2 ways:
e.
8.18
CM = p-b = $10-($5+$2) = $3
FC $30 000
=
= 10 000 units
CM
$3
1.
or
BEP$ = 10 000 units x $10 = $100 000
2.
BEP$ =
FC
$30 000
=
= $100 000
CM ratio
0.3
14 000 units = 4000 units above BEP

Therefore profit = 4000 x $3 = $12 000
or
Profit equation is = 3x-30 000
= 3(14 000)-30 000
= 42 000-30 000
= $12 000
f.
Required volume =
FC+ $30 000+$15 000 $45 000

=
=
= 15 000 units
CM
$3
$3
$10 000
$30 000+
1-t =
1-0.45 = $160 606 (rounded)
Required sales =
CM ratio
0.3
FC+
g
h.
b = 0.8 x $5 = $4 a = $30 000+$5000 = $35 000

CM = $10-($4+$2) = $4
BEP = FC/CM = $35 000/$4 = 8750 units
which is 1250 units lower than in (c)
P8-7 a.
Same BEP for both machines: 10 000 units

i.
ii.
b.
i. Loss of $720 000

i.
ii.
P8-9 a.
ii. Loss of $180 000
= $80(1000)-$800 000 = -$720 000 (ie loss)

= $20(1000)-$200 000 = -$180 000 (ie loss)
i. $400 000
i.
ii.
d.
BEP = FC/CM = $800 000/($100-$20) = 10 000 units

BEP = FC/CM = $200 000/($100-$80) = 10 000 units
ii. $100 000
= $80(15 000)-$800 000 = $400 000

= $20(15 000)-$200 000 = $100 000
Machine A represents the riskier strategy. The breakeven point is the

same for both machines. However, because Machine A has high fixed
costs/high contribution margin it will earn greater profits for a given
volume above breakeven but sustain larger losses for a given volume
below breakeven than Machine B. The answers to (b) and (c)
demonstrate this.
(1) (22 500,0), (0,11 250), (7500,7500)
CM(Low Grade)
= $1.00-$0.60 = $0.40
CM(Medium Grade) = $1.50-$0.70 = $0.80
CM(High Grade) = $2.00-$1.00 = $1.00
Breakeven equation: 0.4L+0.8M = 9000
(where L and M represents units of Low and Medium grades respectively)
Breakeven points:
1. L = 22 500 M =
0
2. L =
0 M = 11 250
3. L = 1/3(22 500)+2/3(0) = 7500
M = 1/3(0)+2/3(11 250) = 7500
8.19
b.
i.
L=3000, M=6000, H=3000

Average CM = 1/4($0.40)+2/4($0.80)+1/4($1.00)
= $0.10+$0.40+$0.25
= $0.75
BEP = FC/Av CM = 9000/0.75 = 12 000 units
i.e., L = 1/4(12 000) = 3000 units
M = 2/4(12 000) = 6000 units
H = 1/4(12 000) = 3000 units
ii.
L=8556, M=17 112, H=8556

Required volume = [FC + /(1-t)]/Av CM
= [9000+10 000/(1-0.4)]/0.75
= [9000+16667]/0.75
= 34 222 .22
= 34 223 (rounded up)
L = 8556, M = 17 112, H = 8556 (all approx.)
8.20
Sample spreadsheet for CVP analysis and Solution
8.21
Solution
8.22

Study questions
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., p. 68). Pearson
Prentice Hall.
Prentice Hall.
8.23
Prentice Hall.
Prentice Hall.
8.24

2-A1
(20-25 min.)
1.
Let N
Sales
$1.00 N
$.20 N
N
Let S
S
.20 S
S
= number of units
= Fixed expenses + Variable expenses + Net income
= $6,000 + $.80 N + 0
= $6,000
= 30,000 units
= sales in dollars
= $6,000 + .80 S + 0
= $6,000
= $30,000
Alternatively, the 30,000 units may be multiplied by the $1.00 to obtain

$30,000.
In formula form:
In units
($6,000 +0)
Fixed costs + Net income
=
= 30,000
$0.20
In dollars
($6,000+0)
Fixed costs + Net income
=
= $30,000
$0.20
Contribution margin percent
2.
The quick way: (40,000 - 30,000) x $.20 = $2,000
Compare income statements:

Break-even Point
Increment
Total
30,000
10,000
40,000
$30,000
$10,000
$40,000
24,000
8,000
32,000
6,000
6,000
Total expenses
$30,000
$8,000
$38,000
Effect on net income
2,000
$ 2,000
Volume in units
Sales
Deduct expenses:
Variable
Fixed
8.25
3.
Total fixed expenses would be $6,000 + $1,552 = $7,552

$7,552
$7,552
= 37,760 units;
= $37,760 sales
$0.20/unit
0.20
or 37,760 x $1.00
4.
= $37,760 sales
New contribution margin is $.18 per unit; $6,000 $.18 = 33,333 units
33,333 units x $1.00 = $33,333 in sales
5.
2-34
1.
The quick way: (40,000 - 30,000) x $.16 = $1,600. On a graph, the slope of the
total cost line would have a kink upward, beginning at the break-even point.
(15 min.)
$23. To compute this, let X be the variable cost that generates $1 million in
profits:
($48 - X ) x 800,000 - $19,000,000
= $1,000,000
($48 - X) = ($1,000,000 + $19,000,000) 800,000
$48 - X = $200 8 = $25
X = $48 - $25 = $23
2.
Loss of $600,000:
($48 - $25) x 800,000 - $19,000,000
= ($23 x 800,000) - $19,000,000
= $18,400,000 - $19,000,000
= ($600,000)
2-42
1.
(15 min.)
Let X = amount of additional fixed costs for advertising
(1,100,000 x 13) +300,000 -.30(1,100,000 x 13) - (7,000,000 + X) = 0
14,300,000 + 300,000 - 4,290,000 - 7,000,000 - X = 0
X = 14,600,000 - 11,290,000
X = 3,310,000
2.
Let Y = number of seats sold

13Y + 300,000 - .30(13)Y - 9,000,000 = 500,000
9.10Y = 9,200,000
Y = 1,010,989 seats
8.26
2-50
1.
(40 min.)
Let N = the number of people to be admitted for the season
Revenue:
Rights for concession
Admissions
Percentage of bets
$60,000
$1.00N
10% of $25N = $2.50N
Total revenue = $60,000 + $3.50N

Expense:
Fixed costs:
Wages of cashiers
Commissioner's salary
Maintenance
Utilities
Other expense
Purses
Total fixed costs
$ 150,000
20,000
20,000
40,000
100,000
810,000
$1,140,000
Variable costs:
Parking is $4.80 per car or $.80 per person
(6 persons attend for each car, so $4.80 6 = $.80)
Total expense = $1,140,000 + $.80N
a.
Break-even point:
$60,000 + $3.50N - $1,140,000 - $.80N = 0
$2.70N = $1,080,000
N = 400,000 people
b.
Desired operating profit $270,000:
$60,000 + $3.50N - $1,140,000 - $.80N = $270,000
$2.70N = $1,350,000
N = 500,000 people
2.
Previous level of attendance 600,000 people

20% increase in attendance 720,000 people
Total bets: 720,000 x $25 $18,000,000
Revenue:
Concession
Admission
Percentage of bets (10% x $18,000,000)
Total revenue
Expense:
Fixed
Variable ($.80 x 720,000)
Operating profit
$1,140,000
576,000
60,000
None
1,800,000
$1,860,000
$1,716,000
$ 144,000
8.27
3.
The purses are doubled:

Previous fixed expense
Additional purse money
New fixed expense
$1,140,000
810,000
$1,950,000
Variable expense, $.80 per person

Revenue, $60,000
+ $3.50N
$60,000 +$3.50N - $1,950,000 - $.80N = 0
$2.70N = $1,890,000
N = 700,000 people
8.28
Topic 9 Relevant information and special decisions
Required reading
Textbook:
Horngren, et al., chs 5 & 6.
Learning objectives
On completion of this topic you should understand:
relevant costing;
absorption versus variable (contribution) costing;
the application of relevant costing to managerial decision-making and

pricing in particular; and
Panopticism and management accounting control systems.
Before studying this chapter you should ensure that you understand the
following basic manufacturing terms:
direct materials
direct labour
factory overhead
indirect costs.
This topic examines the concept of relevant costing; accountants are expected to
collect and report data to decision makers,
the data must be pertinent to the decision to be made i.e. relevant

information;
be aware that qualitative factors may also be relevant to the decision. These
are aspects which will have a bearing on the decision but for which it is
difficult or imprecise to measure in dollars and cents i.e. quantitatively e.g.
the decision to undertake a tertiary course may be based upon the anticipated
future stream of income following graduation plus other benefits which are
not quantifiable - status, quality of life, satisfaction etc.
9.1
Special decisions
Can be distinguished from the regular or typical operating decisions. Special
decisions are atypical or unusual and generally occur less frequently than those
associated with normal operations. Examples of special decisions would be
whether to accept a special order, buy-in or manufacture a component, repair or
replace an item of capital equipment.
Relevant information is the expected future data that will differ among
alternatives. Note: The emphasis is placed upon future rather than historical
(financial accounting) costs, and that there is a difference between the alternatives.
Work through the Cordell Company problem in your text. Recognise how the
contribution approach for constructing the income statement assists in analysing
the data because it distinguishes between variable and fixed costs. In the Cordell
example fixed expenses do not change between the alternatives being considered.
Absorption costing
Is the generally accepted method of costing which assigns all types of
manufacturing costs (direct materials and labour, as well as variable and fixed
overhead) to units produced. Sometimes called full costing.
Variable (direct) costing
Is a method of cost allocation that assigns only variable manufacturing costs to
product and treats fixed manufacturing costs as period costs (not product costs).
The text does not provide a clear explanation of the differences between product
and period costs. Product costs (also referred to as inventoriable costs) are those
costs which are included in the cost of the product produced by the firm. The
reason the term inventoriable is used, is that if the product is not sold but carried
forward to the next period then the manufacturing costs associated with the
production carried forward must also be carried forward. You will recall from the
balance sheet studied in financial accounting that there is a valuation shown for
the current asset, inventory; this is how that valuation is derived. Period Costs are
those costs which are expensed in the period in which they are incurred. These are
normally classified as non manufacturing costs except for fixed manufacturing
costs under the variable costing system which are classified as period costs.
9.2
The following table should provide further clarification.

Cost
Period
No
No
Manufacturing Costs
Direct Material
Direct Labour
Product
Yes
Yes
Variable Factory Overhead

Fixed Factory Overhead
Yes
*
No
**
Non-Manufacturing Costs
Variable Selling & Admin.
Fixed Selling & Admin.
No
No
Yes
Yes
*
**
A product cost under Absorption costing.

A period cost under Variable (direct) costing.
Note
When the product is sold either in the current or subsequent periods the cost of the
product is recognised as an expense e.g. Cost of Goods Sold.
Consider the section headed Incorrect Analysis in your text. Ensure that
you understand how this has occurred to make sure that in a similar situation
you do not treat the fixed component of a manufacturing cost as though it
behaved in a variable manner.
You will recall previously we distinguished between unit costs and total
costs when we initially studied variable and fixed costs; re-read this section
of the text to reinforce your understanding of the differences.
In the text you are introduced to the terms avoidable costs and unavoidable
costs. Firms are often required to make special decisions, for example, as to
whether a particular department or branch should continue operating.
Avoidable costs are those that will not continue if certain action is taken
whereas unavoidable costs are common costs which will continue despite
the decision to change operations.
9.3
Panopticism and Management Accounting Control Systems

Jeremy Bentham developed a design for a prison in the 18th century. See
diagrams. Later, Michel Foucault took this idea and made it a metaphor for
modem control systems.
Macintosh describes the importance of the panoptic concept Macintosh
(Macintosh, N. B. (1994). Management accounting and control systems (p. 228).
Wiley):
Panopticism
Panopticism refers to the unique architecture of Sir Samuel Benthams (1757-1831)
famous panoptic prison. The geometry of the prison called for a central tower in the
middle of a peripheral ringed building which was divided into solitary cells each one
facing the tower. Every cell had two large windows, one at the rear to light up the
cell from the outside, and one in front, facing the tower. Thus, the prisoner stood out
against the backlighting of the peripheral ring while the side walls prevented any
visual contact with fellow prisoners. The cells acted as tiny theatres, putting each
inmate on the stage, alone and individualized, but constantly visible from the central
tower. Unlike the dungeon, which hid prisoners in a dark hole, the panopticon
brought them out into the light.
Panopticism also called for a constantly visible but unverifiable gaze. The cental tower,
always clearly in sight from each cell, was designed so the occupant could never tell
whether or not someone in the tower was gazing in. This was accomplished by
installing venetian blinds on the windows of the tower and by arranging its interior into
intersection partitions and zigzag openings so that any small noise, movement, or ray of
light in the tower seemed to indicate the watchers present. A petty clerk, a janitor, an
inspector, a visitor, or even a tourist moving in the tower was enough to instil on the
occupants mind the feeling of being constantly watched. Under the power of an allknowing, all-seeing gaze, the prisoners anxiety rose, making him or her amenable to
any normalizing prescriptions.
The panopticon design had further advantages. Various treatments of correction could
be administered to the prisoner and their effects readily observed. Criminologists could
discreetly experiment with different punishments, work regimes, and drugs. Moreover,
wardens and administrators could easily monitor the guards and watch correction
workers with an eye to devising more efficient methods. The panopticon, in its ideal
form, was a highly efficient and effective laboratory of power. It could be put into place
in schools and military encampments and, importantly, in factories and business
enterprises.
If you read more widely in this area you may discover different stories about who
originated the Panoptic concept - Jeremy Bentham or his brother Samuel.
Macintosh credits Samuel; others credit Jeremy. It is usually the more famous
brother Jeremy who is given credit. But Samuel came up with the architectural
plan first - in Russia.
Samuel conceived of a work place/building (factory) whereby a supervisor could
monitor many workers. It was Jeremy who took this idea back to England and
named it the Panopticon and presented the concept as an ideal structure for a
prison. That was back in the 18th century.
9.4
In the last twenty years or so there has been a re-examination of the Panoptic
concept and has resulted in an extensive literature in management control and also
in electronic surveillance.
Susan Bryant (p. 2) describes this re-examination of workplace monitoring.
I must stress that I am not in any way suggesting that workplace monitoring is in itself a
new practice; in fact, work has always been monitored to some degree in the capitalist
workplace (and with heightened success in this century through the application of
Scientific Management). The key issue here is that the nature of at least some
computerized surveillance technologies permits a more extensive, and importantly,
intensive (i.e., directed to a single area or subject) degree of information gathering. In
the past, employers gathered data about the quantity and quality of products produced
by a whole department or unit. New information technologies enable employers to
gather and analyze highly detailed performance-related data, not just a bout the work,
but about each individual worker - in many cases on a minute-by- minute basis and
often without the employee necessarily being able to detect the watching.
<http://www.wlu.ca/~wwwpress/jrls/cjc/BackIssues/20.4/bryant.html>
For our purposes, the last sentence is most important. Modem management
accounting performance and control systems comprise a modem panoptic
surveillance and control system.
Figure 1: This is the original design for Benthams Panopticon prison

Source: <http://www.notfrisco.com/prisonhistory/origins/origins02a.html>
9.5
Figure 2: This is how a Panoptican prison would look from the inside
Source: <http://www.ric.edu/rpotter/panorama.html>
Figure 3: This is Jeremy Bentham - or rather his skeleton with a wax head
on top. It has been suggested a web cam should be pointed at this
auto-icon to emphasise his panopticon concept.
Source: <http://doric.bart.ucl.ac.uklweb/Nina/JBentham.html>
9.6
Figure 4: This is the actual plan of a prison in Pennsylvania

constructed using Benthams principles.
Source: <http://.notfrisco.com/prisonhistory/origins/origins02b.html>
Figure 5
9.7
Who owns the Panopticon idea? Well Jeremy Bentham invented the prison
architecture while Michel Foucault used the Panopticon as a metaphor for control.
The relevance in this topic is that Management Accounting Control Systems
serves a similar control function as the panopticon prison.
The Panopticon from Bentham to Foucault

<http://www.rochester.edu/College/FS/Publications/Lyon.html> retrieved
February 2002.
Extract
This is an extract from the text of chapter four of Lyon, D. (1994). The electronic eye:
The rise of surveillance society (pp. 57-80). Minneapolis: University of Minnesota Press.
The Panopticon has been used for analysing surveillance in a number of different
settings; the workplace, government administration, and consumer contexts. We
shall examine some of these below. It should be remembered that the Panopticon
does not come to us directly from Bentham but recently mediated through the work
of Michel Foucault and critics who have debated it. Though many historians of ideas
or of systems of punishment have recognized the importance of the Panopticon, it is
really only since Foucault that interest in it has become widespread.
Foucault illuminates the connections between the Panopticon and modernity by
showing that it forms the watershed between punitive and reforming disciplinary
practices. Enlightenment reason, concerned with empirical observation and
classification, and related to the rational reproducing of social order, is neatly
expressed here. The theme of exploiting uncertainty as a means of controlling
subordinates reappears here as well, having obvious resonance with the
unobtrusive monitoring of which new electronic technologies are capable.
However, this in turn propels us into the debate over postmodernity. A hallmark of
modern thought is the way individuals are placed centre-stage in history. But
postmodern discourse pushes such actors into the wings, and this seems to echo
what happens with electronic surveillance. If the supposedly personal details of
intimate everyday life circulate beyond our control within remote databases, where
now is the human centred self?
Jeremy Bentham, the British philosopher and social reformer, published his plan for the
Panopticon penitentiary in 1791. Essentially, it was for a building on a semi-circular
pattern with an inspection lodge at the centre and cells around the perimeter. Prisoners,
who in the original plan would be in individual cells, were open to the gaze of the
guards, or inspectors, but the same was not true of the view the other way. By a
carefully contrived system of lighting and the use of wooden blinds, officials would be
invisible to the inmates. Control was to be maintained by the constant sense that
prisoners were watched by unseen eyes. There was nowhere to hide, nowhere to be
private. Not knowing whether or not they were watched, but obliged to assume that they
were, obedience was the prisoners only rational option. Hence Benthams Greek-based
neologism; the Panopticon, or all-seeing place.
9.8
The Panopticon was to be a model prison, a new departure, a watershed in the

control of deviance and a novel means of social discipline. Bentham invested
more time and energy in this than any other project - and mourned its failure
more passionately. He saw in it a great and new invented instrument of
government and believed the panoptic principle held promise of the only
effective instrument of reformative management. In a closing eulogy he made the
famous claim, Morals reformed - health preserved - industry invigorated instruction diffused - public burdens lightened - Economy seated, as it were, upon
a rock - the Gordian knot of the Poor Laws not cut, but untied - all by a simple
idea in Architecture!
Benthams apparently utopian enthusiasm for the Panopticon had personal,
political, and cultural origins. Personally, he hoped to reap financial benefit from
an entrepreneurial stake in the project, and to raise his status profile through being
its first director. Indeed, when shown the plans, Edmund Burke saw straight
through them; Theres the spider in the web! he exclaimed. Politically, the
Panopticon promised local, non-religious prison reform over against the
Evangelical and transportation-to-Australia alternatives currently on offer. And
culturally, the Panopticon epitomised the kind of social physics so popular with
the philosophes of his day. It neatly translated the clockwork image of being
human seen in La Mettries LHomme Machine into an architectural reality.
Ironically, while it appears that no prison was ever built exactly along the lines
Bentham had in mind, and he certainly failed to persuade the British government
to invest in it, the principles embodied in the Panopticon were to have a
widespread influence. The key principle was inspection, through inspection of a
specific kind. Benthams Panopticon represented a secular parody of divine
omniscience, and the observer was also, like God, invisible. Thus the more
constantly the persons to be inspected are under the eyes of the persons who
should inspect them, the more perfectly will the purpose of the establishment be
attained. And if such constant supervision proves impossible, prisoners should be
given the impression that the gaze is unwavering.
Benthams innovation, then, was not just to inspect, or even to ensure that the
gaze is asymmetrical, but to use uncertainty as a means of subordination. The
asymmetrical gaze created uncertainty which in turn produced surrender.
Asymmetrical surveillance became part of the whole modern project of destroying
the certainties of alternative powers, the supposed hangovers from traditional
societies, wherever they still lurked. This is why the Panopticon principles were so
significant.
The inspection principle suited other purposes than prisons, according to
Bentham. Of courses they did! Indeed, he got the original idea of the Panopticon
from his brothers workshop in Russia. And he advertised the virtues of the
panoptic as being appropriate for any context in which supervision was required;
for punishing the incorrigible, guarding the insane, reforming the vicious,
confining the suspected, employing the idle, maintaining the helpless, curing the
sick, instructing the willing in any branch of industry, or training the rising race in
the path of education. Foucault argues that panoptic control has indeed become
significant in many of these spheres.
9.9
Two other principles attached to the panoptic in the specific context of the
penitentiary. One was the solitude or isolation of inmates, the other was to allow
the prison to be run as a private enterprise by outside contractors. Solitude would
extend even to having private toilets for prisoners, and to holding chapel services
from a central position above the inspection lodge, without prisoners moving from
their cells. Inmates were to be atomised, secluded. As for running the prison by
contract, this would possible enable profit to be made and prison governors to be
held in unaccustomed esteem.
Bentham cheerfully defended his Panopticon from any misplaced liberal attack.
Might it be thought despotic, or might the result of this high-wrought
contrivance be constructing a set of machines under the similitude of men? Let
people think so if they wish. Such criticisms miss the point, namely, would
happiness be most likely to be increased or decreased by this discipline? Here is
control, and clean control at that. Much better, he commented, than something like
Addisons bizarre sounding proposal to try virginity with lions. There you saw
blood and uncertainty: here you see certainty without blood. Of course,
uncertainty still exists for those subjected to the Panopticon regime. Indeed, the
machine depends on it. Certainty resides in the system, and, one might add, with
the inspector, the one in the know.
This kind of certainty, sought by Bentham in the Panopticon, epitomises for Foucault
the social disciplines of modernity. Whereas in earlier times the failure of social
control would result in punishment that was public and brutal, modernity introduced
clean and rational forms of social control and punishment. The unruly crowd is
rendered manageable; no plots of escape from prison, no danger of contagion if they
are sick, no mutual violence if they are mad, no chatter if schoolchildren, and no
disorders or coalitions if workers. The crowd is replaced by a collection of separated
individualities. As Foucault says, Bentham made visibility a trap.
In the following important quotation Foucault summarises his understanding of
the major effect of the Panopticon:
to induce in the inmate a state of conscious and permanent visibility that assures the
automatic functioning of power. So to arrange things that the surveillance is
permanent in its effects, even f it is discontinuous in its action; that the perfection of
power should tend to render its actual exercise unnecessary; that this architectural
apparatus should be a machine for creating and sustaining a power relation
independent of the person who exercises it; in short, that the inmates should be
caught up in a power situation of which they themselves are the bearers.
In the Panopticon, discipline crossed what Foucault calls a disciplinary threshold

in which the formation of knowledge and the increased of power regularly
reinforce each other in a circular process. Older, more costly, and more violent
forms of power fell into disuse and were superseded by a subtle, calculated
technology of subjection.
Recall for a moment our previous discussion of Nineteen eighty-four. Though the
older forms of power are still present there, the later concern with power for
powers sake and the subtle, calculated subjection clearly predominates in
Orwells mind. On the other hand, Orwell places less emphasis on subjects being
the bearers of their own surveillance and of the power relation connected with it.
9.10
Sociology is indebted to Foucault for his theory of surveillance, touching as it

does on both aspects of its power; the accumulation of information, and the direct
supervision of subordinates. The former is found in the detailed files held on each
Panopticon inmate, the latter in the architectural potential of the building itself.
Acknowledging Foucaults contribution, Giddens observes that in modern times
disciplinary power is characterised by new modes of regularizing activities in
time-space. Observation is central to these modes, and thus the Panopticon
epitomises such disciplinary power.
However, Foucault also insists that such power is typically present throughout the
institutions of modernity, in all kinds of administrative contexts. Is it surprising,
asks Foucault rhetorically, that the cellular prison, with its regular chronologies,
forced labour, its authorities of surveillance and registration, its experts in
normality... should have become the modern instrument of penality? But not only
that; he goes on, Is it surprising that prisons resemble factories, schools, barracks,
hospitals, which all resemble prisons? What for Bentham was an aspiration is for
Foucault a social reality the panoptic principle diffusing different institutions.
This assumption, often questioned within the sociology of administrative power,
must be re addressed in the context of electronic surveillance.
The perverse irony is that Foucault himself seems to have made no comments
about the relevance of panoptic discipline to the ways that administrative power
has been enlarged and enhanced by computers, especially since the 1960s. Yet
surely we see here nothing less than the near-perfection of the principle of
discipline by invisible inspection via information-gathering.
9.11

Study questions
Prentice Hall.
Source: Horngren, C. T., et al. (2004). Introduction to management accounting (13th ed., pp. 230-231).
9.12
Prentice Hall.
Prentice Hall.
9.13
9.14
Prentice Hall.
9.15
9.16
9.17

5-A2
1.
(10 min.)
Contribution margins:
Plain = $66 - $50 = $16
Professional = $100 - $70 = $30
Contribution margin ratios:
Plain = $16 $66 = 24%
Professional = $30 $100 = 30%
2.
a.
b.
3.
5-A4
1.
Units per hour

Contribution margin per hour
Total contribution for 20,000 hours
Plain
2
$16
$32
$640,000
Professional
1
$30
$30
$600,000
For a given capacity, the criterion for maximizing profits is to obtain the
greatest possible contribution to profit for each unit of the limiting or scarce
factor. Moreover, fixed costs are irrelevant unless their total is affected by
the choice of products.
(15-20 minutes)
Revenue ($360 x 70,000)
Total cost over product life
Estimated contribution to profit
Desired (target) contribution to profit 40% $25,200,000
Deficiency in profit
$25,200,000
16,600,000
$ 8,600,000
$10,080,000
$ 1,480,000
The product should not be released to production.

2.
Previous total estimated cost

Cost savings from suppliers .20 .70 $8,000,000
Revised total estimated cost
Revised total contribution to profit:
$25,200,000 - $15,480,000
Desired (target) contribution to profit
Deficiency in profit
The product should not be released to production.
9.18
$16,600,000
1,120,000
$15,480,000
$ 9,720,000
$10,080,000
$
360,000
3.
Previous revised total estimated cost from requirement 2

Process improvement savings:
.25 .30 $8,000,000
$600,000
Less cost of new technology
220,000
Revised total estimated cost
Revised total contribution to profit:
$25,200,000 - $15,100,000
Desired (target) contribution to profit
Excess contribution to profit
$15,480,000
380,000
15,100,000
$10,100,000
$10,080,000
$
20,000
The product should be released to production.
5-36
1.
(20 min.)
These warehouse stores attempt to maximize profits by cutting prices and
increasing turnover. Since profit is the product of contribution margin and
total sales, it can be affected by changing either. Total profit can be increased
if the added turnover brought about by a lowering of price brings in more
contribution margin than was lost by the price cut. They also try to minimize
fixed costs by limiting their investment in buildings and equipment.
Characteristics: (a) choose product lines and sizes that move quickly and
avoid stocking slow-moving items and sizes; (b) stock lower cost, lower
quality items; (c) rely heavily on self service; and (d) attempt to cut costs by
providing fewer services, and (e) build low-cost buildings in a place where
property costs are not too high.
2.
Such a criterion by itself gives no indication what total contribution margin

(TCM) can be expected. Sales turnover or sales volume must be used also.
The rate of return on assets is determined by
TCM = Unit contribution margin Total sales
If sales turnover can be assumed to be fairly constant among items, then
such a figure as a 20% average target gross profit might be meaningful.
5-40
1.
(15 min.)
Assuming that total fixed costs are the same at production levels of 6,000
and 10,000 units, the analysis can focus on contribution margins:
CM@ $12:
CM@ $10:
6,000 units ($12-$6) = $36,000

10,000 units ($10 - $6) = $40,000
Profits will be $40,000 - $36,000 = $4,000 higher at the $10 price.
9.19
2.
5-48
Subjective factors include image in the marketplace (higher price may give
image of quality), market penetration (satisfied customers may become
repeat customers), and effects on the sales force.
(15-20 min.)
1.
Year to
Grand Date
Totals
Tuition revenues
Costs of courses
Contribution margin
General administrative
expenses
Operating income
2.
Final Course
Enrollment
30
10 More
$2,000,000
800,000
1,200,000
$6,000
4,000
2,000
$1,000
600
400
$2,007,000
804,600
1,202,400
400,000
$ 800,000
0
$2,000
0
$ 400
400,000
$ 802,400
The same general considerations influence pricing decisions in profitseeking and nonprofit organizations. The exception is price-setting by many
government-owned entities, which often is heavily affected by legislative
bodies. The familiar three Cscustomers, costs, and competitiondo
influence price setting.
Executive education is highly competitive; the rates for top-flight teachers
are relatively high; and customers often do without or conduct their own inhouse training. The offering of discounts is often risky. It may alienate fullpaying customers, may lead to widespread price-cutting, and may encourage
the particular customers to bargain hard regarding course after course.
The setting of tuition in private universities is similar to setting prices in
private industry. Customers may go to the competition to other private or
public universities. Costs must be recovered if the institution is to survive.
Of course, tuition is only one part of a universitys revenue. Private
institutions are especially dependent on endowment income and on
donations from friends and alumni.
6-34
(20-25 min.)
Nantucket Nectars should make the bottles.

Make
Total
Purchase cost
Direct materials
Direct labor
Variable overhead
Avoidable fixed overhead
Total relevant costs
Difference in favour of making
9.20
$85,000
30,000
60,000
60,000
$235,000
$15,000
Per Bottle
$.085
.030
.060
.060
$.235
$.015
Buy
Total
Per Bottle
$250,000
$.250
________
$250,000
_____
$.250
6-48
(15-20 min.)
The data are placed in the format of the income statement, and the unknowns are
computed as shown:
Sales
Variable expenses
Direct materials
Direct labor
Variable factory overhead
Variable manufacturing cost of goods sold
Variable selling and administrative expenses
Total variable expenses (970 - 200)
Contribution margin
Fixed expenses
Fixed factory overhead
Fixed selling and administrative expenses
Operating income
1
2
3
6-52
$970
$210
170
110
490 1
280 2
770
200
90 3
100
190
$ 10
210 + 170 + 110 = 490

970 - 200 = 770; 770 - 490 = 280
Total fixed expenses = 200 - 10 = 190
Fixed factory overhead = 190 - 100 = 90
(35-50 min.)
Note: Requirement 2 of this problem usually gives trouble to students; because

Requirement 2 takes considerable class time for a clear explanation, you
may prefer to assign Requirement 1 only.
1.
There are several ways to approach this problem. The easiest is probably to
concentrate on the difference in the total contribution margin. The total
fixed costs of $780,000, before considering the increase in advertising, will
be unaffected and may be ignored. Production and sales will decline by
10%, from 60,000 to 54,000 units:
Sales at $90 and $98, respectively

Variable costs at $70*
Contribution margin
*
60,000
Units
$5,400,000
4,200,000
$1,200,000
54,000
Units
$5,292,000
3,780,000
$1,512,000
Difference
$312,000
$35 + $12 + $8 + $15

Advertising may be increased by $312,000 without affecting the current
operating income level of $420,000 (contribution margin of $1,200,000
minus fixed expenses of $780,000).
9.21
2.
If the total fixed costs do not change, the company will need a total
contribution margin of $1,200,000 from the two products together. How
many units of the new product can be sold? The clue to the production
capacity of the plant is in how fixed factory overhead was unitized:
$300,000 $6 per unit = 50,000 units of expected sales.
New product budget @ 50,000 Units:
Sales at $40
Variable costs at $30*
Contribution margin, new product
*
Direct material
Direct labor
Variable factory overhead
Variable selling expense, 10% $40
Total variable costs per unit
$2,000,000
1,500,000
$ 500,000
$ 6
12
8
4
$30
Therefore, the needed contribution margin on the old product is

$1,200,000 - $500,000, or $700,000.
Sales, 60,000 units at $90
Contribution margin needed
Total variable costs that can be sustained
Variable selling costs at $9*
Maximum that may be paid to the supplier
*
$5,400,000
700,000
$4,700,000
540,000
$4,160,000
$15 less 40% = $9 or 60% ($15 x 60,000) = $540,000
Maximum unit purchase price, $4,160,000 60,000 = $69.33.

If students do not accept the above analysis, the following proof may be
helpful (in thousands):
Sales
Variable costs
Contribution margin
Fixed manufacturing costs
Fixed selling costs
Total fixed costs
Operating income
9.22
Old
$5,400
4,200
$1,200
300
480
$ 780
$ 420
Difference
$2,000
2,000
$
$
$
-
New
Product 1 Product 2
$5,400
$2,000
*
4,700
1,500
$ 700
$ 500
300
380**
100**
$ 380
$ 400
$ 320
$ 100
An alternate approach to this whole solution is to use the above format

and solve toward the unknown purchases figure. The $4,700,000 is
the maximum allowable variable cost. Because $540,000 of the
$4,700,000 represents selling expense, the remainder, $4,160,000
must be the maximum that may be paid to the supplier.
**
This allocation uses the $2.00 unit cost figure for the new product and
assigns the remaining fixed costs to the old product. Note, however,
that how the total fixed selling costs are allocated is irrelevant because
total fixed costs are unaffected by allocation methods or by how such
costs are assigned to products.
6-64
1.
(30-40 min.)
Minnetonka Corporation should make the bindings.
Cost saved by purchasing bindings:
Material, 20% $30
Labor, 10% $35
Overhead, 10% $5*
Total
Cost to buy per pair
*
$ 6.00
3.50
.50
$10.00
$10.50
Total overhead is $15 per pair

Allocated overhead is $100,000 10,000 = $10 per pair
Therefore, variable overhead is $15 - $10 = $5 per pair.
2.
Minnetonka Corporation would not pay more than $10 each because that is
the cost to make the product internally.
3.
At a volume of 12,500 pair, Minnetonka should buy the bindings. The cost
of buying 12,500 pair is $131,250. The cost of making 12,500 pair is:
12,500 $10
Added fixed costs
Total
Buying the bindings will save
$125,000
10,000
$135,000
$ 3,750
Making the bindings saves variable costs of $.50 per pair. If sales exceed
$10,000 $.50/pair = 20,000 pair, it is cheaper to make the bindings.
4.
Minnetonka Corporation needs 12,500 pair of bindings. The cost to buy

12,500 pair is $131,250. The cost to make 10,000 and buy 2,500 is:
Cost to make 10,000 pair
Cost to buy 2,500 pair
Total
$100,000
26,250
$126,250
Therefore, Minnetonka should choose this latter course of action, which

saves $5,000.
5.
There are many nonquantifiable factors that Minnetonka should consider in

addition to the economic factors calculated above. Among such factors are:
a.
b.
c.
d.
e.
f.
The quality of the purchased bindings as compared to Minnetonkaproduced bindings.

The reliability of delivery to meet production schedules.
The financial stability of the supplier.
Development of an alternate source of supply.
Alternate uses of binding manufacturing capacity.
The long-run character and size of the market.
9.23
9.24
Reading
9.1
Macintosh, N., & Quattrone, P. (2010). Management accounting and control
systems: An organizational and sociological approach (pp. 3-5, 18-22,
286-289). Chichester, West Sussex: John Wiley.
1.1
Why are MACS so important? (pp. 3-4).
1.2
What are MACS? (p. 5).
2.3
Wedgwood potteries (pp. 18-22).
10.2.1 "If I cannot see it, I cannot manage it!" - MACS and the Panopticon.
(pp. 286-289).
9. 25
9.26
Topic 10 Budgeting master budget and

flexible budgets
Required reading
Textbook:
Horngren, et al., ch. 7 & ch. 8, pp. 340-360.
Learning objectives for master budgeting

The principal objective of this and the following topic is to demonstrate a process
of effective planning using budgets,
a budget being a financial plan that is used to estimate future results and
assist in controlling future operations.
You should be familiar with these budgets facets:
advantages;
types;
the components of, and how to construct a master budget.
The cash budget is important in terms of decision making; taking advantage of

discounts, cashflow, credit policy etc.
cash flow predicaments are the cause of many small business failures.
The construction of the master budget is one of the most important planning
functions within an organisation The worked example in the text is good in that it
clearly identifies the likes between the various schedules and components of the
master budget.
One of the principal reasons for business failure is poor cash management. The
preparation of a cash budget will at least alert management to the need for
arranging debt finance or reviewing internal policy re-credit to customers.
In covering this topic you should become familiar with the method for compiling a
master or static budget. The steps are clearly defined and to an extent procedural.
The text acknowledges the behaviour ramifications for budgets but only in a
limited way. You may be aware of the dysfunctional aspects of budgets,
particularly where they are based on unattainable standards or goals and have been
developed without consultation with the participants or employees concerned.
10.27
To balance the topic from a behavioural perspective Reading 10.1 has been
included.
Learning objectives for flexible budgets

The objective of this topic is to introduce flexible budgeting and the procedure for
identifying and calculating variances.
in the previous section all the budgets were static or inflexible in that they
were prepared for one level of activity say 50,000 units.
This section also discusses Standard Costs and Variance Analysis and demonstrates
uses of the analysis in terms of responsibility, control, feedback and trade-offs.
Chapter 8 is structured so that you can study this topic in two parts:
Flexible Budgets, and
Flexible Budget Variances.
The following aspects of budgeting are provided to complement your study of this
topic:
consider the advantages of a flexible budgeting system to that of a stable

budget i.e. the flexible budget projects receipts and expenditures as a
function of activity levels
variance is the difference between actual and standard costs or between

budgeted and actual expenditures
variances for labour and material can be analysed in respect of its two
components:
1.
2.
price
quantity (the term efficiency is used the text).
the sales volume variance measures effectiveness whereas the flexible

budget variance reflects both price changes and efficiency.
a standard cost is an anticipated cost of producing a unit of output; a

predetermined cost to be assigned to products produced; distinguish between
perfection and currently attainable standards, and their applications.
the diagram shown as Exhibit 8-6 provides a general approach for the
analysis of direct material and direct-labour variances; refer to this if you
have difficulty in following the discussion.
be aware that in investigating the cause of a certain variance cost-benefit

considerations may be relevant.
10.28
This topic involves working through problems and performing a number of

calculations. The textbook approach to calculating direct-material and directlabour variances is recommended until you fully understand the relationships of
the variances.
Budgets are initially prepared as part of the planning function, but are also used to
control activities. It is not just the calculation of variances that is important, but it
is also the interpretation of the results. What are the causes of the variance? Who
is responsible? How can these problems be avoided in the future? Has a
favourable price variance lead to an unfavourable efficiency variance? e.g. did the
purchase of second quality material at a cheaper price result in higher wastage in
the cutting room?
Try to draw some conclusions or provide an explanation for the variances as this
will aid your understandings of this topic.
This topic and the following topic (Capital Budgeting), contain the most difficult
quantitative calculations in this subject.
These calculations arent too difficult but involve a number of formulae which
you will be required to apply to particular problems. The following is a summary
of the key points which you are required to know. Use this as a checklist of your
understanding of this topic.
You will be required to be familiar with:
how to construct a flexible budget and its relationship to the static budget
a performance report and how these are prepared
the calculation of:
static budget variances

sales volume variances
flexible budget variances
price variances
efficiency variances
overhead variances
how to use standard costs
perfection standards
currently attainable standards
the difference between effectiveness and efficiency in flexible budgeting
mutual price and efficiency effects
how to analyse and interpret the results so that the aspects of responsibility
and controllability are considered.
11.29
10.30
11.31
10.32
11.33
10.34

Study questions
11.35
Prentice Hall.
Prentice Hall.
10.36
11.37
Prentice Hall.
Prentice Hall.
10.38

7-B1
(60-120 min.)
$ refers to New Zealand dollars.

1.
See Exhibits I, II, and III and supporting schedules a, b, c, d.
2.
The cash budget and balance sheet clearly show the benefits of moving to
just-in-time purchasing (though the transition would rarely be accomplished
as easily as this example suggests). However, the company would be no
better off if it left so much of its capital tied up in cash it has merely
substituted one asset for another. At a minimum, the excess cash should be
in an interest bearing account the interest earned or forgone is one of the
costs of inventory.
January
February
March
Schedule a: Sales Budget

Total sales (100% on credit)
$62,000
$75,000
$38,000
Schedule b: Cash Collections

60% of current month's sales
30% of previous month's sales
10% of second previous month's sales
Total collections
$37,200
7,500
2,500
$47,200
$45,000
18,600
2,500
$66,100
$22,800
22,500
6,200
$51,500
December
January
February
March
$39,050
12,500
$51,550
16,000
$35,550
$ 6,000
31,000
$37,000
39,050
$
-
$ 6,000
37,500
$43,500
8,050
$35,450
$ 6,000
19,000
$25,000
6,000
$19,000
$35,550
$35,450
$19,000
Schedule c: Purchases Budget

Desired ending inventory
Cost of goods sold
Total needed
Beginning inventory
Purchases
Schedule d: Disbursements for Purchases
100% of previous month's purchases
March 31 accounts payable
11.39
Exhibit I
VICTORIA KITE
Budgeted Statement of Cash Receipts and Disbursements
For the Three Months Ending March 31, 2005
Cash balance, beginning
Minimum cash balance desired
(a) Available cash balance
Cash receipts and disbursements:
Collections from customers
(Schedule b)
Payments for merchandise
(Schedule c)
Rent
Wages and salaries
Miscellaneous expenses
Dividends
Purchase of fixtures
(b) Net cash receipts & disbursements
Excess (deficiency) of cash before
financing (a + b)
Financing:
Borrowing, at beginning of period
Repayment, at end of period
Interest, 10% per annum
(c) Total cash increase (decrease) from financing
(d) Cash balance, end (beginning balance + c + b)
January
February
March
$ 5,000
5,000
0
$ 5,100
5,000
100
$37,692
5,000
32,692
47,200
66,100
51,500
(35,550)
(8,050)
(15,000)
(2,500)
(1,500)
$ (15,400)
(250)
(15,000)
(2,500)
$ 48,350
(35,450)
(250)
(15,000)
(2,500)
$(15,400)
$ 48,450
$27,992
$ 15,500
$ 15,500
$ 5,100
$
(15,500)
(258)
$(15,758)
$ 37,692
Exhibit II
VICTORIA KITE
Budgeted Income Statement
For the Three Months Ending March 31, 2005
Sales (Schedule a)
Cost of goods sold
(Schedule c)
Gross margin
Operating expenses:
Rent*
Wages and salaries
Depreciation.
Insurance
Miscellaneous
Net income from operations
Interest expense
Net income
* (January-March sales less $10,000) x .10 plus 3 x $250
10.40
$175,000
87,500
$ 87,500
$17,250
45,000
750
375
7,500
70,875
$ 16,625
258
$ 16,367
(3,000)
$(4,700)
$
$32,992
Exhibit III
VICTORIA KITE
Budgeted Balance Sheet
March 31, 2005
Assets
Current assets:
Cash (Exhibit I)
Accounts receivable*
Merchandise inventory (Schedule c)
Unexpired insurance
Fixed assets, net: $12,500 + $3,000 $750
Total assets
$32,992
22,700
6,000
1,125
$62,817
14,750
$77,567

Liabilities:
Accounts payable (Schedule d)
Rent payable.
Dividends payable
Stockholders' equity**
Total liabilities and stockholders' equity.
$19,000
16,500
1,500
$37,000
40,567
$77,567
*February sales (.10 x $75,000) plus March sales (.40 x $38,000) = $22,700
**Balance, December 31, 2004
$25,700
Add: Net income.
16,367
Total
$42,067
Less: Dividends declared.
1,500
Balance, March 31, 2005
$40,567
7-32
(10-15 min.)
Collections from:
January sales:
February sales:
March sales:
Total cash collections
$300,000 12%
$400,000 10% 99%
$400,000 25%
$450,000 50% 99%
$ 36,000
39,600
100,000
222,750
$398,350
11.41
7-34
(20-25 min.)
This is straightforward. Except for requirement 1, it follows the illustration in the

chapter very closely. All amounts are in euros.
1.
2.
200,000 - [15,000 + .9(.6 300,000)] = 200,000 - [15,000 + .9(180,000)]

= 200,000 - 177,000
= 23,000
BARCELONA S.A.
Purchases and Disbursements Budgets
June
July
August
Purchases budget
Ending inventory*
Cost of goods sold, 60% of sales
Total needed
Beginning inventory
Purchases
166,200
180,000
346,200
200,000
146,200
198,600
168,000
366,600
166,200
200,400
231,000
204,000
435,000
198,600
236,400
Disbursements for purchases

80% of last month's purchases
20% of this month's purchases
Disbursements for purchases
120,000
29,240
149,240
116,960
40,080
157,040
160,320
47,280
207,600
*Inventory targets, end of month:

June:
15,000 + .9(0.6 x 280,000) = 15,000 + .9(168,000) = 166,200
July:
15,000 + .9(0.6 x 340,000) = 15,000 + .9(204,000) = 198,600
August:
15,000 + .9(0.6 x 400,000) = 15,000 + .9(240,000) = 231,000
10.42
7-42
(50-90 min.)
These spreadsheets contain data from the problem in the top of the spreadsheet
space. Computations of operating expenses are accomplished with formulas that
reference the table. Comparing the summary calculations of operating expenses
(labelled Total operating expense) allows the user to assess the effects of
alternate scenarios.
1. Table of budget data
Cost behavior
Cost
17 Displays
15 Displays
Indirect
Packaging
Shipping
Total operating expense
Sales forecasts
Fixed
$40,000
$8,000
$8,000
$19,206,000
Variable
$100
$40
$16/component
$4 / display
$2 / display
17 Displays 15 Displays
Sales mix
Sales growth
3,200
2,400
5,600
3,200
3,200
2,400
2,400
2,800
1
1
3,200
2,400
5,600
3,200
3,200
2,400
2,400
2,800
1.25
1
4,000
3,000
7,000
4,000
4,000
3,000
3,000
3,500
Operating expenses
Month
Components
1 October
$2,400,000
2 November
1,800,000
3 December
4,200,000
4 January
2,400,000
5 February
2,400,000
6 March
1,800,000
Totals
$15,000,000
Indirect
$616,000
472,000
1,048,000
616,000
616,000
472,000
$3,840,000
Packaging
$36,800
29,600
58,400
36,800
36,800
29,600
$228,000
Month
1 October
2 November
3 December
4 January
5 February
6 March
7 April
8 May
Quantity / display
5
5
Shipping
$22,400
18,800
33,200
22,400
22,400
18,800
$138,000
Total
$3,075,200
2,320,400
5,339,600
3,075,200
3,075,200
2,320,400
$19,206,000
11.43

Cost behavior
Cost
17 Displays
15 Displays
Indirect
Packaging
Shipping
Fixed
$40,000
$8,000
$8,000
$16,639,680
Sales forecasts
Sales mix
Month
1 November
2 December
3 January
4 February
5 March
6 April
7 May
Sales growth
2,400
5,600
3,200
3,200
2,400
2,400
2,800
Operating expenses
Month
Components
1 November
$1,620,000
2 December
3,780,000
3 January
2,160,000
4 February
2,160,000
5 March
1,620,000
6 April
1,620,000
Totals
$12,960,000
Indirect
$428,800
947,200
558,400
558,400
428,800
428,800
$3,350,400
10.44
Variable
$100
$40
$16 / component
$4 / display
$2 / display
Quantity / display
5
5
17 Displays
1
0.9
2,160
5,040
2,880
2,880
2,160
2,160
2,520
15 Displays
1.25
0.9
2,700
6,300
3,600
3,600
2,700
2,700
3,150
Packaging
$27,440
53,360
33,920
33,920
27,440
27,440
$203,520
Shipping
Total
$17,720 $2,093,960
30,680
4,811,240
20,960
2,773,280
20,960
2,773,280
17,720
2,093,960
17,720
2,093,960
$125,760 $16,639,680

Cost behavior
Cost
17 Displays
15 Displays
Indirect
Packaging
Shipping
Sales forecasts
Sales mix
Month
1 December
2 January
3 February
4 March
5 April
6 May
7
8
Operating expenses
Month
Components
1 December
$4,032,000
2 January
2,304,000
3 February
2,304,000
4 March
1,728,000
5 April
1,728,000
6 May
2,016,000
Totals
$14,112,000
Fixed
$40,000
$8,000
$8,000
$18,240,600
Sales growth
5,600
3,200
3,200
2,400
2,400
2,800
0
0
Indirect
$1,048,000
616,000
616,000
472,000
472,000
544,000
$3,768,000
Variable
$100
$40
$16 / component
$4 / display
$2 / display
Quantity / display
5
5
17 Displays
1
0.9
5,040
2,880
2,880
2,160
2,160
2,520
0
0
15 Displays
1.5
0.9
7,560
4,320
4,320
3,240
3,240
3,780
0
0
Packaging
$58,400
36,800
36,800
29,600
29,600
33,200
$224,400
Shipping
$33,200
22,400
22,400
18,800
18,800
20,600
$136,200
Total
$5,171,600
2,979,200
2,979,200
2,248,400
2,248,400
2,613,800
$18,240,600
11.45
8-A3
(20 - 30 min.)
1.
Direct materials:
Direct labor:
Total
5 lb. x $10.00 = $ 50.00

5 hrs. x $25.00 = 125.00
$175.00
2.
The standard costs expected are based on actual output achieved, not
scheduled or budgeted output.
A
Actual Cost
Incurred:
Actual Inputs
Actual Prices
In general:
Direct
Materials
10.46
B
Flexible Budget
Based on
Actual Inputs
Expected Prices
C
Flexible Budget
Based on
Expected Inputs
for Actual
Outputs Achieved
Expected Prices
$xxx
$xxx
$xxx
Price variance
Usage variance
(A - B)
(B - C)
Flexible-budget variance (A - C)
2,700 lbs x $8.50

2,700 lbs x
525 units x 5 x
= $22,950
$10.00 = $27,000 $10.00 = $26,250
Price variance
Usage variance
(A - B) =
(B - C)
$22,950 $27,000 - $26,250
$27,000 =
=
$4,050 F
$750 U
Flexible-budget variance (A - C)
$22,950 - $26,250 =
$3,300 F
Direct
Labor
3.
8-30
1.
A
B
C
2,850 hr $26.00 =
2,850 hr $25.00 =
525 units 5 hr
$74,100
$71,250
$25.00 = $65,625
Price variance
Usage variance
(A - B) =
(B - C) =
$74,100 - $71,250 =
$71,250 - $65,625 =
$2,850 U
$5,625 U
Flexible-budget
variance (A - C)
$74,100 - $65,625 =
$8,475 U
Among the possible explanations for the performance are:

a.
Were substandard materials used because they were cheaper, resulting

in higher waste than usual? (Note the tradeoff resulted in a net
favourable materials variance.)
b.
Net savings in material costs may be undesirable if they cause

inefficient use of direct labor, too.
c.
Direct labor is expensive. A wage rate that is 4% above the standard

rate can be significant in total amount.
(15-20 min.)
Price variance per hr.
= Total price variance/ Actual hrs.

= $1,015 1,750
= $.58, unfavorable
Actual labor rate (price) = Standard price + Price variance

= $14.00 + $.58
= $14.58
2.
Flexible-budget labor variance

= Price variance + Usage variance
$1,855 = $-1,015 + X
X = $2,870, favorable
Usage variance
$2,870
Difference in hours
= Standard price x Difference in hours

= $14.00 x Difference in hours
= $2,870 $14.00
= 205
Because the variance is favorable, the standard hours allowed must be

1,750 + 205 = 1,955.
11.47
The analytical framework follows. All given items are designated by an

asterisk (*).
Actual Hours
Actual Price
Actual Hours
Expected Price
Standard Hours
Expected Price
1,750 hrs.*
1,750 hrs.*
1,955 hrs.
$14.58
$14.00*
$14.00*
= $25,515
= $24,500
= $27,370
1,750* $.58
205 $14.00*
= Price variance, $1,015U* = Usage variance, $2,870F
Flexible-budget variance, $1,855F*
8-43
(25-30 min.)
Direct
materials
Direct
labor
Variable
overhead
Flexible Budget
Based on
Standard Inputs
Cost Incurred:
Flexible Budget
Allowed for Actual
Actual Inputs
Based on Actual Inputs
Outputs Achieved
Actual Prices
Expected Prices
Expected Prices
3,300 lbs $.96
3,300 lbs $1.00
3,000 lbs $1.00
= $3,168
= $3,300
= $3,000
3,300 ($.96 - $1.00) = (3,300 - 3,000) $1.00
=
Price variance $132F
Usage variance $300U
Flexible-budget variance, $168U
5,500 hrs $7.60
5,500 hrs $8.00
5,000 hrs $8.00
= $41,800
= $44,000
= $40,000
5,500 ($7.60 - $8.00) = (5,500-5,000) $8.00 =
Price variance $2,200F Usage variance, $4,000U
Flexible-budget variance, $1,800U
5,500 hrs $.86 *
5,500 hrs. $.80
5,000 hrs. $.80
= $4,730
= $4,400
= $4,000
5,500 ($.86 - $.80)
(5,500-5,000) $.80
= Spending variance,
= Efficiency variance,
$330U
$400U
Flexible-budget variance, $730U
U = Unfavorable, F = Favorable
*
10.48
The average variable overhead price is unnecessary to comply with the requirements of the
problem. It was computed by dividing $4,730 by 5,500 hours.
Topic 11 Capital budgeting
Required reading
Textbook:
Horngren, et al., ch. 11, and Appendix B (Fundamentals of

Compound Interest and the use of Present Value Tables).
Learning objectives
This topic introduces procedures which you can apply to your personal
circumstances (financial position) as well as to selecting investment projects for
an enterprise. The techniques with which you will become familiar are:
discounted cash flow (DCF);

net-present-value (NPV);
internal rate of return (IRR);
payback model;
accounting rate of return.
Capital budgeting is the process of selecting investment projects for an enterprise

by considering the present value of cash flows and deciding whether to accept the
investment opportunity because it projects a rate of return consistent with the
criteria or reject it because it fails to meet the required rate of return.
An example of an investment decision is the decision to replace an existing
assembly line with a new line which is technically superior and capable of
generating increased cash flows in the future.
other examples could include a government decision to build a new

telephone system or highway network.
The financing decision or how to finance the investment is an entirely separate

issue.
11.1
The discounted cash flow model is a type of capital budgeting model and in this
model the time value of money is especially recognised.
in simple terms, as a recipient of cash would you rather receive $100 now or
$100 in a year hence? Of course you would require more than $100 in a
years time to compensate for the loss of purchasing power.
The DCF model is in widespread use in the commercial world. The two main
variations of this model which are examined in this chapter are:
net present value

internal rate of return.
These two techniques are discussed in the text and the worked example is set out
in exhibits 11-1 and 11-2 respectively.
you may need to work through several of the review questions to ensure a
thorough understanding of these concepts and gain familiarity with the use
of the financial tables.
Net Present Value is the discounted or present value of all cash inflows and
outflows of a project or from an investment at a given discount rate.
The Internal Rate of Return is the discount rate that equates the net present value
of a stream of cash inflows and outflows to zero.
if an item of equipment has a scrap or salvage value be sure to include this

cash inflow in your analysis.
The recommended approach to studying this topic is as follows:

1.
Study Appendix B of the text. Work through the examples described in the
appendix and make sure you understand how to use the present value tables
(both Table 1 and Table 2). Make sure you understand the concept of an
annuity.
2.
Attempt the questions listed in the Study schedule. These exercises are
good revision for using the tables and the answers are provided at the end of
the Chapter.
3.
Study the chapter in paying particular attention to the assumptions relating

to the DCF model.
4.
The learning objectives of the text provide a useful guide to the expected
outcomes for this topic. The use of a diagram in depicting the flow of cash
over time is often a good starting point as this approach will assist you in
identifying all cash flows.
11.2
The IRR, NPV, accounting rate of return and payback models each have particular
advantages and disadvantages depending upon the investments being evaluated
and the criteria for selection.
Generally speaking the DCF is the preferred approach because of its explicit
recognition of the time value of money.
You should also appreciate that the capital budget is an integral part of the master
budget which was studied in an earlier topic. Failure to make provision for the
cash flows resulting from investment decisions can have a major influence on the
cash budget. The chapter also discusses the use of sensitivity analysis; there are
many entrepreneurs in Australia at the present time who now understand the
significance of this technique and if applied in investment appraisals may have
resulted in different decisions or less optimistic predictions re cash flows and
interest rates.
Capital investment decisions

The implementation of competitive strategies often involves the acquisition of
new capital assets in the form of plant and equipment, or the acquisition of other
companies or businesses. The outlays involved in such activities are referred to as
capital expenditures or capital investments. Capital investment decisions
involve the acquisition of capital assets which, typically, are retained in an
organisation for a considerable number of years. Further, capital expenditures
usually involve large outlays of funds. Sometimes additional commitment by way
of increased working capital is required to finance additional inventories and
debtors. On the other hand, investments in new technology may reduce
throughput time and increase flexibility which, coupled with JIT production
techniques, may actually reduce working capital by reducing inventory levels and
associated costs. A capital investment decision commits an organisation to a
particular form of operations, or a particular level of operations, from which it
cannot readily diverge without incurring losses. The process of evaluating capital
investment proposals and allocating scarce funds to projects is also known as
capital budgeting.
Good capital investment decisions are vital, as well as difficult to make. They
involve risk taking, in that the organisation commits a known present outlay in
exchange for uncertain future benefits. These uncertain future benefits can
become even more uncertain through unforeseen changes in demand,
technological change and new competition.
11.3
Few organisations have sufficient capital funds to simultaneously undertake all the
capital projects they would like to. Hence there is a need for capital rationing, by
ranking proposals in order of merit, and choosing only the most attractive, or else
raising additional funds, or both. Thus an evaluation of capital expenditure
proposals involves a consideration of profitability (the rate of return on funds
invested) as well as liquidity (the timing of large cash outlays and future cash
inflows generated by projects).
There is a number of methods for evaluating the desirability and financial
consequences of capital investment decisions. The more simple techniques do not
have regard for the time value of money, while other techniques specifically do
so through the use of discounting techniques. Five techniques will be considered
here: the accounting rate of return, the payback period, the net present value, the
internal rate of return, and the payback reciprocal. Firstly, it is assumed that there
are no taxes on profits. Subsequently this assumption is relaxed.
No income taxes
Accounting rate of return
The accounting rate of return (ra) is a profitability measure which calculates return
on investment, based on accounting concepts of income and investment. In
general, the accounting rate of return is equal to the increase in annual net profit as
a result of the capital investment decision, expressed as a percentage of the capital
expenditure incurred. There are, however, slight variations in its calculation. The
two most common measures are:
1.
ra =
average annual profit (income) from the investment

initial investment
ra =
average annual profit (income) from the investment

average investment
and
2.
The decision rule is:
accept project if ra k
reject project if ra < k
where k is the required rate of return for a project of that risk. This rule is used for
(i) accept/reject decisions, and (ii) ranking mutually exclusive proposals. To
illustrate the calculation we use the data from example 8-1.
Illustrative example 8-1
Cost of new machine
$120 000
Useful life
4 years
Residual value after 4 years
$20 000
Increase in annual net profit
(after charging $25 000 depreciation) $12 000
Cost of capital, or required ROI
10%
11.4
Using the first measure, based on initial investment, we get:

ra =
12 000
= 0.1 or 10%
120 000
The second measure uses average investment as the denominator:

ra =
12 000
12 000
=
= 0.171 or 17.1%
70 000
0.5(120 000 + 20 000
Using the first measure the project is just acceptable (k = 10%), while it
comfortably passes the test of acceptability using the second measure. Clearly,
using average investment as the base increases the rate of return. In fact, if there
were no residual (or salvage) value for the machine, the accounting rate of return
would be exactly doubled when average investment is used in preference to initial
investment [ra = 12 000/0.5(120 000+0)=0.2].
Note that in this example the net profit each year was constant. If the net profit
varies from year to year we would have to calculate the average annual net profit
for the numerator.
The major criticism of the accounting rate of return is that it ignores the size and
timing of cash flows. Accounting profit will differ from net cash flow because of
accounting accruals of revenues and expenses

depreciation
changes in the level of inventories
tax effect accounting procedures
Furthermore, there remains the possibility of a variety of measures of return on

investment because of different ways of measuring accounting profit (e.g. by using
different depreciation techniques or rates and different revenue and expense
recognition criteria) as well as different investment values (e.g. where average
investment is largely influenced by assumptions about depreciation).
Payback period
The payback period measures the number of years required for an investment
outlay to be recouped from the cash flows generated by the investment. It is solely
concerned with liquidity and completely ignores profitability. The method is
useful when the organisation faces possible liquidity problems and/or when cash
flows after the payback period are uncertain. The payback period is analogous to
the breakeven point calculation in CVP analysis, and may be regarded as the time
required to break even on an investment (ignoring the time value of money).
11.5
Where annual net cash inflows from a project are equal, the payback period (in
years) is calculated as follows:
C
Payback period =
R
where C = initial cash outlay
R = annual net cash inflow
If the annual net cash inflows are not equal the payback period may be calculated
by adding the net cash inflows in consecutive years until the amount of the initial
outlay is recovered. It is assumed that the cash flow occurs uniformly throughout
the year to facilitate the calculation when the payback period is not a whole
number of years.
Using the data from example 8-1 we can calculate the payback period. First, we
need to calculate the annual cash inflow by adding back the non-cash depreciation
expense to net income:
Annual cash inflow = net income + depreciation
= $12 000 + $25 000
= $37 000.
Payback period =
120 000
= 3.24 years
37 000
As well as being a direct test of liquidity, the payback period is a guide to risk, there
being less risk involved with projects which promise a short payback period. In fact,
if there is risk of early obsolescence of the capital asset being considered, a short
payback period is very desirable. Although the payback period ignores differences
in expected project life, and profitability, it is a useful screening device use the
payback period as a first test, then examine profitability. The payback period also
ignores the time value of money, although it is possible to calculate the discounted
payback period using the present value of the cash inflows.
The time value of money
One of the criticisms of the accounting rate of return and the payback period
calculations is that both of them ignore the time value of money. The next two
techniques to be considered (net present value and internal rate of return) are, it is
argued, theoretically superior approaches to investment appraisal because they
specifically consider the time value of money. Before looking at these two techniques
we digress briefly to discuss the time value of money and discounting techniques.
The time value of money rests on the ability of money to earn interest. $1000 cash
held now is preferable to an expectation of $1000 cash in the future, because the
$1000 now can be invested and earn interest, thus accumulating to more than
$1000 in the future. Conversely, $1000 to be recovered in the future is worth less
than $1000 in the hand now.
11.6
The time value of money is not synonymous with the concept of inflation. The
time value of money derives from economic utility theory, specifying that people
have a preference for money now rather than money in the future, irrespective of
inflation. While inflation can impact on capital investment decisions, as we shall
see in later sections of this chapter, it is not to be confused with the time value of
money.
To illustrate, suppose an investor invests $1000 now at an interest rate of 10% per
annum (compound). At the end of years 1, 2 and 3 the investor would have
future sums of:
End of year 1: $1000 x 1.1 = $1100
End of year 2: $1100 x 1.1 = $1210
End of year 3: $1210 x 1.1 = $1331.
In general, the future sum in n years time, Sn of P dollars invested now at an
interest rate of i percent is given by the formula:
=
S n P (1 + i ) n
(8-1)
Thus, the future sum of $1000 invested at 10% for, say, 3 years is
S3 = 1000(1 + 0.1)3
= 1000(1.1)3
= 1000(1.331) = $1331.
It is argued that, given a risk free interest rate of 10%, an investor is indifferent
between $1000 now and $1331 in three years time.
Alternatively, we can find the present value of a future sum. Dividing both sides
of equation (8-1) by (1 + i)n gives
P=
Sn
(1 + i ) n
(8-2)
So, for example, the present value of $1000 to be received 3 years from now at an
interest rate of 10% is
P=
1000 1000
=
= $751.31
1.13
1.331
This means that an investor who could invest risk free at 10% pa. would be
indifferent between receiving $751.31 now or $1000 in 3 years time because
$751.31 invested now at 10% would have a future value of $1000 in 3 years time.
In other words, the present value of $1000 in 3 years time is $751.31, which is
quite a deal less than $1000. We say that the $1000 has been discounted to
reflect the time value of money.
11.7
Using this discounting technique it is possible to calculate the present value of

future cash flows generated by different investments, facilitating a comparison of
the investments because their cash flows would be expressed in common (current)
dollars.
If we prefer, instead of actually dividing each years cash flow by (1+i)n we can
use discount tables which show the present value of $1 at various interest rates
and for differing periods. One simply looks up the table to find the appropriate
discount factor and multiplies the years cash flow by the discount factor. For
example, Table D in the appendix gives the present value of $1. Under the 10%
column (.10) in the rows for 1, 2 and 3 periods, we find the factors .9091, .8264
and .7513. Therefore the present value of $1000 in 1, 2 and 3 years time
respectively at 10% is:
In 1 years time : 1000 x .9091 = $909.10
In 2 years time : 1000 x .8264 = $826.40
In 3 years time : 1000 x .7513 = $751.30
with possible slight rounding errors because the factors are only to 4 decimal
places.
Alternatively, we could use the NPV formula from Excel:
=NPV(rate,value1,value2,..)
where rate is the interest rate as a decimal, value 1 is the first
payment received, value 2 is the second and so on, where the
payments are equally spaced.
Thus =NPV(0.1,1000) returns $909.09, =NPV(0.1,0,1000) would
give the PV of $1000 at the end of the second year, Excel returning
the value $826.45 and =NPV(0.1,0,0,1000) returns $751.31.
Suppose that we wanted to calculate the present value of $1000 to be received at
the end of each of the next 3 years (i.e. an annuity). We could add the present
value of each of the payments, giving $2486.80:
P.V. of $1000 in 1 year : 1000 x .9091 = $909.10
P.V. of $1000 in 2 years: 1000 x .8264 = $826.40
P.V. of $1000 in 3 years: 1000 x .7513 = $751.30
P.V. of $1000/year for 3 years
= $2486.80
Clearly it might be faster to add the three discount factors and multiply $1000 by
their sum. This is equivalent to using the factor for the present value of an
annuity. When the same sum of cash is received in consecutive years, we call it
an annuity. The present value of an annuity for n years, An, is calculated as
follows:
11.8
An =
S
S
S
S
+
+
+ +
2
3
(1 + i ) n
1 + i (1 + i )
(1 + i )
(8-3)
This is a geometric progression whose sum to n terms is normally calculated from

Sn =
Thus,
a (1 r n )
1
, where r in (8-3) would be
.
1+ i
1 r
S
1 n
[1 (
) ]
1 + i = S [1 1 ]
=
An 1 + i
1
i
(1 + i ) n
1
1+ i
(8-4)
So the present value of an annuity of $1000 each year for 3 years at 10% is
=
A3
1000
1
[1 3 ] = 10 000 - (10 000/1.331) = $2486.85
0.1
1.1
There are also discount tables available showing the present value of an annuity of
$1 (see Table E in the appendix). Under the 0.10 column of Table E in the row
corresponding to 3 periods we find the factor, F, of 2.4869. Therefore the present
value of an annuity of $1000 for 3 years at 10% = 1000 2.4869 = $2486.90
(rounding error because discount factor is rounded to 4 decimal places).
Using Excel
=PV(rate,nper,pmt)
where rate is the interest rate as a decimal, nper is the number of
periods, and pmt is the periodic payment. Here we must specify
pmt as a negative.
Thus, =PV(0.1,3,-1000) returns the value $2,486.85
Net Present Value (NPV)

Using the concept of the time value of money, the net present value of a project is
calculated by finding the excess of the present value of the expected future cash
flows, generated by the investment, over the initial cash outlay. The discount rate
used, k, is the cost of capital, or the required rate of return, or the cut-off rate, or
the hurdle rate. Thus,
NPV=
R1
R2
Rn
+
+ ... +
C
n
2
1 + k (1 + k )
(1 + k )
(8-5)
where Rj = annual net cash inflow for period j

C
= initial cash outlay of the project
11.9
In the case of an annuity (R1 = R2 = ... = Rn), so that the NPV for an annuity is:
R
R
k
C
NPV =
k (1 + k ) n
The decision rule is:
(8-6)
accept project if NPV 0

reject project if NPV < 0
This rule can be used for accepting/rejecting a single investment project.

Mutually exclusive investment proposals can also be ranked according to the size
of their NPV, the most preferred proposal having the highest NPV.
Using the data from example 8-1, we calculate the NPV as follows:
NPV = 37 000(3.1699) + 20 000(.6830) - 120 000
= 117 286.3 + 13 660 - 120 000
= $10 946.30.
Since the NPV is positive the project would be acceptable. Note that the $37 000
cash flow each year is treated as an annuity by multiplying by the annuity factor of
3.1699, while the residual value received at the end of year 4, $20 000, is
discounted using the present value of $1 factor for year 4 (0.683). The initial
outlay, $120 000, is not discounted of course because it is outlaid now.
Using Excel:
=NPV(0.1,37000,37000,37000,57000)-120000 returns $10,945.29
In the remainder of this chapter it is assumed that all cash flows occur at the end
of the year to which they relate. This is a simplifying assumption, but does not
significantly affect results.
Internal Rate of Return (r)
The internal rate of return, r, is the discount rate which equates the present value
of the net cash inflows with the initial investment outlay. That is, r is the discount
rate which would give a NPV of zero.
In the case of unequal cash flows the internal rate of return is calculated by solving
for r in equation (8-7) below:
C=
11.10
R1
R2
R3
Rn
+
+
+ +
2
3
1 + r (1 + r ) (1 + r )
(1 + r ) n
(8-7)
where C
Rj
r
n
= initial investment
= predicted annual cash flow in year j
= the internal rate of return
= life of the investment (years)
In the case of equal annual cash flows, solve for r in

1
1
=
C R [ (1
)]
(1 + r ) n
r
(8-8)
Having determined r, we then compare it with the cost of capital, k, using the
decision rule:
accept project if r k
reject project if r < k.
In example 8-1, although the annual cash flows are equal for the first three years,
in the final year there is also a recovery of the residual value of $20 000.
Therefore it does not represent a straight annuity. Internal rate of return
computations can be complex if done by hand, using a trial and error basis. We
start by taking a guess at r. Because there was a positive NPV using a discount
rate of 10%, we know that r must be greater than 10%. Lets guess at 12%. Then,
using the discount tables (Tables D and E) the present value (P.V.) of the cash
flows is calculated:
Year
1-4
4
Cash Flow 12% Discount Factor

$37,000
3.0374
$20,000
0.6355
P.V.
$112,383.80
12,710.00
$125,093.80
This gives a present value of $125 093.80 which is greater than the initial
investment of $120 000 (i.e. there is a positive NPV of $5093.80). Therefore our
guess was too low, because r needs to be larger still. We try 14%:
Year
1-4
4
Cash Flow 14% Discount Factor

$37,000
2.9137
$20,000
0.5921
P.V.
$107,806.90
11,842.00
$119,648.90
This gives a present value of $119 648.90 which is just a little less than the initial
investment of $120 000 (i.e. there is a negative NPV of $351.10). Therefore 14% is a
trifle too high, but near enough for our purposes. We compare this 14%
(approximately) with the cost of capital of 10%, and find the project acceptable (r>k).
11.11
Using Excel the cash flows are tabulated in the range B2:B6, beginning with Year
0 as now when the investment of $120 000 is made and Years 1 to 4 as the four
years of returns.
A
Year
0
1
2
3
4
1
2
3
4
5
6
B
Cash Flow
-120,000
37,000
37,000
37,000
57,000
We then use the IRR function:

=IRR(values,guess)
where values is an array or reference to cells. The array must contain
at least one positive value and one negative value. Guess may be
inserted or omitted. If omitted 10% is assumed as the guess.
Thus, =IRR(B2:B6) returns 14%
Calculating the internal rate of return is more straightforward manually if the cash
flows are all equal. For an NPV of zero, with equal cash flows, R, we use
RF=C
where F is the discount factor for an annuity. Thus, F = C/R. Using the F value,
we search an annuity table for the corresponding rate of return. To illustrate,
suppose there were no residual value for the machine in example 8-1. We
determine F from
F=
C 120 000
=
= 3.2432
R 37 000
which the observant reader will recall is the payback period calculation. We now
enter the annuity table (Table E) in the row corresponding to n (i.e. 4 years) and
read across until we find the closest factor. The closest is 3.3121, corresponding
to 8%. Thus r would be approximately 8%, so the project would be rejected (less
than required 10%).
Apart from the tedious manual calculations when there are different cash flows
each year (in practice spreadsheets or other computer routines are used) the
internal rate of return also has the disadvantage that it can produce multiple rates
of return (when there are sign changes to cash flows from year to year - from
inflows to outflows or vice-versa).
11.12
Payback reciprocal
R
C
If there are equal annual cash inflows and the project has a useful life of at least
twice the payback period, then the payback reciprocal is a close approximation to
the internal rate of return.
The payback reciprocal is:
In example 8-1, again ignoring the residual value, the payback reciprocal is
R 37 000
= = 0.31 or 31%
C 120 000
which is over twice the internal rate of return. In this case it is a poor estimate of r
because its life is too short vis-a-vis the payback period.
With income taxes
Where income taxes exist the analysis should be performed on an after-tax basis. Thus
both the cost of capital and the cash flows must be expressed on an after-tax basis.
The cost of capital, or required rate of return, k, must be on an after-tax basis. If k
is expressed as a before-tax return it may be converted to an after-tax form:
k (after tax) = k (before tax) (1 - tax rate).
For example, if the required rate of return is 20% before tax and the tax rate is 45
cents in the dollar, then
k (after tax) = 0.2(1 - 0.45) = 0.11 (or 11%).
Cash flows should include taxation payments, or reductions therein. Thus it is necessary
to calculate taxable income attributed to a project so that the tax payment (cash outflow)
can be determined. Calculating taxable income often involves considering expenses
which do not involve outlays of cash. The most common of these is depreciation, which
is a non-cash expense, but nevertheless, it reduces tax payable. The depreciation rate
used, of course, must be the rate allowed for tax purposes. Further, depreciation for tax
purposes should be based on original cost with no regard for predicted salvage value.
This is different from the accountants calculation of depreciation which deducts salvage
value from cost to determine the annual depreciation. There are two common methods
of calculating the taxation payments. To illustrate, assume a net annual cash inflow
from operations before tax of $10 000, annual depreciation expense for tax purposes of
$3000, and a tax rate of 40 cents in the dollar:
1.
Accounting method
Cash inflow before tax
Less Depreciation
Taxable income
Tax at 40c in $
Net income after tax
Add back Depreciation
Cash inflow after tax
$10 000
3 000
7 000
2 800
4 200
3 000
$7 200
11.13
Note that depreciation is deducted to determine taxable income (profit), so that tax
can be calculated. Tax is a cash outflow and reduces net cash inflow. After
determining net income after tax, we add back the non-cash item depreciation, to
get the net cash inflow. Depreciation is added back because it was deducted in the
first place simply to calculate tax payable it must then be added back to cancel
its deduction because it is not a cash flow.
Method 1. is a safe method which is least likely to lead to errors. Many people,
however, prefer to use the second method which is far quicker:
2.
Depreciation tax shield method

Adjust for tax effect [x(1-t)]
Add Depreciation Tax Shield [depn t]
Cash inflow after tax
$10 000
6 000
1 200
$7 200
[10 000(1-0.4)]
[3000(0.4)]
As you can see we get the same answer, $7200, with fewer calculations. The first
step assumes that no depreciation exists, and that the cash inflow equals net profit.
Thus we multiply by (1 - tax rate) to get the net cash flow after tax. This understates
the net cash flow, however, because we do have depreciation which is an expense
allowable for taxation and must adjust for it. In effect, the depreciation expense
reduces tax payable by 40 cents (the tax rate) for every $1, because each $1 of
depreciation reduces taxable income by $1. Thus the so-called depreciation tax
shield [depreciation x tax rate = 3000 0.4] is added to give $7200.
While this second method is quick, students sometimes become confused as to
whether they should be multiplying by t or (1-t), and whether they should add or
subtract. Further, the second line produces a figure of $6000 which defies
description - it is meaningless. Finally, it can lead to errors if there is insufficient
income before tax in any year to sustain a full deduction for depreciation. And
since the method does not calculate net income before tax the aforementioned
problem is not obvious. Consequently, unless the reader feels particularly
confident of using method (2) (s)he should stick to method (1).
On termination of projects, or when old capital assets are sold, disposal values can
lead to gains or losses on disposal which increase or reduce taxes, thus affecting
the cash flow associated with disposal. For example, an asset with a book value
of $1000 is sold for $1500. There is a taxable gain on disposal of $500, so that
the net cash inflow is $1500 (cash received) minus the tax on the gain on disposal
of $500 (cash to be paid to the taxation authorities).
It is generally assumed that tax payments or savings occur at the same time as
corresponding cash flows. In practice, however, if tax payments lag behind the
cash flows to which they relate then the primary cash flows and the consequent tax
payments will need to be calculated separately.
11.14

Ocean Dumping Pty Ltd is considering an investment proposal to
purchase a barge and contract to dump waste at sea. Details follow:
Purchase of a used motorised barge
Immediate capital expenditure to modify the barge
$180 000
$20 000
Completion of a contract to dump waste at sea for 8 years. The

following revenue and expense estimates are available:
Years 1 to 3
Years 4 to 8
Revenue
$120 000
$210 000
Cash operating costs

$80 000
$130 000
For tax purposes the barge would be depreciated on a straight line

basis over 20 years. At the end of 8 years the estimated sales value of
the barge is $150 000. Assume tax is payable in the year in which
profits are earned at a rate of 40%.
Required:
Calculate the net present value for the project assuming a cost of
capital of 16% after tax.
The solution to this example appears in Table 8-1. Year 0 represents the present
when the investment outlay occurs. The present value factors appear near the
bottom, after the cash flows have been completed.
Note that in the solution we have grouped like years together. Thus years 1-3 can
be grouped because all figures are the same. In year 4 the revenues increase, so
that years 4-8 are grouped. An extra column for year 8 shows transactions only
for Year 8 (the disposal of the asset). We have then used discount tables to
calculate present values. If we wanted to use the NPV formula from Excel we
would have to set out a column for every one of the 8 years.
11.15
Evaluating two mutually exclusive projects

Incremental versus total project approach
Some capital investment decisions involve a comparison of two investment
proposals which are mutually exclusive. A common example is whether to
purchase a new asset or keep an old one - e.g. buy a new machine or keep the old
one for a few more years. This type of decision usually involves two sets of costs
- the new machine usually features lower operating costs. There are two methods
of approaching the solution. Separate analyses of each alternative (e.g. Keep or
Replace) can be performed, with the PV of each being calculated to find which is
more favourable. This is called the total project approach. Alternatively, the
difference between the two proposals can be calculated, known as the incremental
(or differential) approach. The incremental approach is usually quicker but
requires care not to omit a relevant item. Furthermore, if there are more than two
proposals being considered the only feasible method is the total project approach.
Example 8-3 illustrates both approaches.
Table 8-1
Ocean Dumping Pty Ltd Solution
Purchase barge
Modification
Revenues
Cash operating costs
Net cash inflow before tax
1
Less depreciation
Pre-tax profit
Tax (40%)
After-tax profit
Add back depreciation
Net cash inflows after tax
Sale of barge at end of 8 years
2
Tax on gain on disposal
3
PV Factors
Present values
Net present value
Accept project
Year 0
-180,000
-20,000
-200,000
1
-200,000
Years 1-3
Years 4-8
120,000
-80,000
40,000
-10,000
30,000
-12,000
18,000
10,000
28,000
210,000
-130,000
80,000
-10,000
70,000
-28,000
42,000
10,000
52,000
28,000
2.2459
62,885
52,000
2.0977
109,080
Year 8
150,000
-12,000
138,000
0.3050
42,090
14,056
Notes
1
Depreciation = (180,000+20,000)/20 = 10,000
2
Cash proceeds before tax
150,000
WDV [200,000 - 8(10,000)]
120,000
Gain on sale
30,000
Tax on gain (0.4 * 30,000)
12,000
3
PV factor for an annuity for years 4-8 = PV factor of annuity for 8 years minus PV factor
of annuity for 3 years: 4.3436-2.2459=2.0977
11.16

ABC Company is considering replacing a machine. The existing
machine cost $45 000 and now has a book value for tax purposes of
$15 000. Its estimated remaining life is 3 years and at the end of that
time its estimated salvage value would be $3000. Its current salvage
value is $9000.
The new machine would cost $35 000 and would have an estimated
useful life of 3 years, with no residual value at the end of that period.
In addition, a capitalised cost of $4000 to rearrange the production line
would be incurred.
Estimated operating costs per year are as follows:
Direct labour
Indirect labour
Materials
Depreciation
Power
Old Machine
$34 000
7 000
12 000
5 000
7 000
New Machine
$14 000
7 000
9 500
13 000
10 000
The tax rate is 40% and the company requires a rate of return of 18%
after tax on investments.
In using a total project approach for example 8-3 we have a situation in which all
the cash flows (except for disposal of old machine) are outflows. These outflows
are reduced by the tax they save as deductions for expenses. A comparison of the
two negative PVs leads to selection of the smaller of the two, the difference
representing the NPV of the preferred action. Tables 8-2 (keep existing machine)
and 8-3 (replace existing machine) show the calculations.
11.17
a.
Total project approach
Table 8-2
ABC Company - Solution using Total Project Approach
KEEP EXISTING MACHINE
Years 1-3
$
Direct labour
-34,000
Indirect labour
-7,000
Materials
-12,000
Power
-7,000
Net cash operating outflow before tax
-60,000
Depreciation
-5,000
Total expenses before tax
-65,000
Tax effects (reduction) 40% x 65,000
26,000
Total expenses after tax
-39,000
5,000
Net cash operating outflow after tax
-34,000
Sale of machine end year 3
Tax on gain on sale 40%($3000-$0)
-34,000
PV factors
2.1743
Present value
-72,830.72 -73,926.2
Year 3
$
3,000
-1,200
1,800
0.6086
1,095.48
Table 8-3
ABC Company - Solution using Total Project Approach
REPLACE EXISTING MACHINE
Year 0 Years 1-3

$
$
Purchase new machine
-35,000
Rearrange production line
-4,000
Sale of old machine
9,000
Tax reduction on loss on sale [40%(15,000-9,000]
2,400
Direct labour
-14,000
Indirect labour
-7,000
Materials
-9,500
Power
-10,000
Net cash operating outflow before tax
-40,500
Depreciation
-13,000
Total expenses before tax
-53,500
Tax effects (reduction) 40% x 53,500
21,400
Total expenses after tax
-32,100
13,000
Net cash operating outflow after tax
-19,100
-27,600
-19,100
PV factors
1
2.1743
Present value
-69,129.13 -27,600.00 -41,529.13
There is an advantage in favour of replacement of $3 701.59 [(72,830.72) (69,129.13)]. That is, the NPV of the action replace is $3 701.59.
11.18
b.
Incremental approach
Under the incremental (or differential) approach only the difference between the
two alternatives for each item is entered. For example, if the machine is to be
replaced we would enter the costs of purchasing the new machine and proceeds
from the sale of the old machine. The difference in costs or revenues would be
entered: e.g. the reduction in the cost of direct labour with the new machine.
When there is no difference between the two alternatives the item is not even
entered: e.g. indirect labour is the same under both alternatives so is omitted.
Finally, because the old machine would be disposed of now (under the replace
alternative) rather than at the end of Year 3 if it were not replaced, we must
include this forgone source of revenue in Year 3 as a cost, together with the tax on
the gain on sale avoided as a revenue. The calculations are shown in Table 8-4.
Table 8-4
ABC Company - Solution using Incremental Approach
REPLACE MACHINE
Year 0
Years 1-3
-35,000
Rearrange production line
-4,000
Sale of old machine
9,000
Tax reduction - loss on sale
2,400
1
Savings in direct labour
20,000
1
Savings in materials
2,500
2
Increase in power
-3,000
Reduction in pre-tax cash outflow
19,500
Less increase in depreciation
-8,000
Reduction in pre-tax expenses
11,500
Increase in tax [40%(11,500)]
-4,600
Reduction in after-tax expenses
6,900
Add back increase in depreciation
8,000
Reduction in after-tax cash flow
14,900
Salvage in Year 3 on old machine forgone
Tax on gain on sale avoided
-27,600
14,900
PV factors
1
2.1743
Present values
-27,600.00 32,397.07
NPV
$3,701.59
Replace machine because NPV is positive.
Year 3
-3,000
1,200
-1,800
0.6086
-1,095.48
Notes
1
Reduction in costs with new machine. e.g. DL:$34,000-$14,000=$20,000
2
Increase in costs with new machine: $7,000-$10,000=-$3,000
11.19
Effects of Inflation
Inflation is the process of rising prices in the economy. This has an impact on
capital investment decisions because they involve estimates of future cash flows
and interest rates, typically over several years. There are two established ways of
dealing with inflation in capital budgeting:
Use nominal (i.e. actual, incorporating inflation) cashflows and interest

rates, or
Use real (i.e. assuming no inflation) cashflows and interest rates.
The return on investments, e.g. in financial markets, incorporates two

components: (1) a return to compensate investors for risk, and (2) a return to
compensate for inflation. Thus these rates are nominal rates. Real rates of return
compensate only for investment risk. When there is zero inflation the nominal
interest rate is equal to the real interest rate.
The relationship between real and nominal rates of return is given by the formula
1 + N = (1 + R) x (1 + I)
where N = nominal rate, R = real rate and I = inflation rate.
This can be rearranged in terms of either N or R:
N =(1 + R )(1 + I ) 1
or
=
R
1+ N
1
1+ I
To illustrate, suppose that the nominal rate is 26% and the inflation rate is 5%.
Then the real rate is
=
R
1 + 0.26
1.26
=
1
=
1 0.20 = 20%
1 + 0.05
1.05
Alternatively, given that the real rate is 20% and the inflation rate is 5%, then the
nominal rate is
N = (1 + 0.20)(1 + 0.05) 1 = 0.26 = 26%
The reader will observe that the nominal rate (26%) is higher than simply the sum
of the real rate (20%) and the inflation rate (5%). This is because the nominal rate
also takes account of the decrease in purchasing power of the real rate:
Real rate of return
Inflation rate
Inflationary effect on real rate
Nominal rate of return
11.20
0.20
0.05
0.01
0.26
[0.05 x 0.20]
When evaluating capital investment proposals we should use either all nominal
rates (i.e. for cash flows and discount rates) or all real rates. Never mix the two,
say by estimating future nominal cash flows but using a discount rate reflecting
real interest rates.
Using nominal rates, we would estimate future cash flows that we actually expect
to receive, i.e. incorporating expectations about inflation. These should then be
discounted by the nominal required rate of return.
If we use real rates, we estimate future cash flows in real terms (deflated for
inflation) and discount them by the real rate of return. One way to do this is to
simply deflate the nominal after-tax cash flows by dividing by (1+I)n , and then
use the real rate of return in the discounting process. This is probably unrealistic
because if we knew the nominal cash flows we might as well work with them.
We would be more likely to use real cash flows if we estimated future cash flows
in todays dollars.
The solutions to example 8-4 demonstrates these differences. The solution using
nominal rates is completed in the usual way, as shown in Tables 8-5(a) and 8-5(b).
The solution using real rates can be obtained by simply converting the nominal
after-tax cash flows to real after-tax cash flows by deflating them by the inflation
rate as described in note 1 of Table 8-6(a), i.e. dividing by (1+I)n. Then the real
discount rate is calculated as explained in note 2 of Table 8-6(a), using the
formula R = [(1+N)/(1+I)]-1. Finally the real after-tax cash flows are discounted
using the real discount rate. This should result in the same present values for each
year and the same NPV, as shown in Table 8-6.
Cost of new machine
Useful life
Residual value
Increase in annual net profit
before depreciation
Annual depreciation
Nominal rate of return
Inflation rate
Taxation rate
$50 000
4 years
zero
$20 000 in todays dollars
25% on cost
10% pa after tax
3% per annum
40%
Required: Evaluate proposal using (1) nominal rates, and (2) real rates
11.21
Table 8-5(a): Accounting Method

Using nominal rates
1
Profit before depreciation
Less depreciation
Taxable profit
Tax at 40%
After-tax profit
After-tax cash flows
PV @ 10%
NPV
Buy machine
1
Year 0
-50,000
-50,000
-50,000
Year 1
Year 2
Year 3
Year 4
20,600
-12,500
8,100
-3,240
4,860
12,500
17,360
15,782
21,218
-12,500
8,718
-3,487
5,231
12,500
17,731
14,654
21,855
-12,500
9,355
-3,742
5,613
12,500
18,113
13,608
22,510
-12,500
10,010
-4,004
6,006
12,500
18,506
12,640
6,684
Assuming profits will increase at the general rate of inflation the profit before depreciation is
n
given by 20,000(1.03)
Table 8-5(b): Depreciation Tax Shield Method

Using nominal rates
Year 0
-50,000

1
Cash inflow after tax [*(1-t)]
Depreciation tax shield
After-tax cash flows
-50,000
PV @ 10%
-50,000
NPV
Buy machine
1
Year 1
Year 2
Year 3
Year 4
20,600
12,360
5,000
17,360
15,782
21,218
12,731
5,000
17,731
14,654
21,855
13,113
5,000
18,113
13,608
22,510
13,506
5,000
18,506
12,640
6,684
Assuming profits will increase at the general rate of inflation the cash inflow before tax is
n
given by 20,000(1.03)
Using the depreciation tax shield method, Table 8-6(a) demonstrates that we can
simply deflate the nominal after-tax cash flows to get real cash flows and then
discount these by the real rate. The first 5 lines of Table 8-6(a) are identical to the
first 5 lines of Table 8-5(b).
In Table 8-6(a) it will be noted that the deflation of the after-tax nominal cash
flows means that even the depreciation tax shield is deflated. This is the key to
working with real cash flows as shown in Table 8-6(b). Because depreciation is
based on the cost of the capital asset now, the depreciation tax shield in future
years has to be deflated to express the tax savings in real dollars.
11.22
Table 8-6(a): Deflating nominal after-tax cash flows

Using real rates
Year 0
-50,000

After-tax cash flows (nominal)
1
Real after-tax cash flows
2
PV @ 6.796%
-50,000
-50,000
-50,000
NPV
Buy machine
1
2
Year 1
Year 2
Year 3
Year 4
20,600
12,360
5,000
17,360
16,854
15,782
21,218
12,731
5,000
17,731
16,713
14,654
21,855
13,113
5,000
18,113
16,576
13,608
22,510
13,506
5,000
18,506
16,442
12,640
6,684
Deflate by dividing nominal cash flows by (1+I) . e.g. Year 2 = 17,731/(1.03)

Real rate = (1.10/1.03)-1 = 0.067961
Table 8-6(b): Using real cash flows

Using real rates
1
Real after-tax cash flows
2
PV @ 6.796%
NPV
Buy machine
1
2
Year 0
-50,000
-50,000
-50,000
Year 1
Year 2
Year 3
Year 4
20,000
12,000
4,854
16,854
15,782
20,000
12,000
4,713
16,713
14,654
20,000
12,000
4,576
16,576
13,608
20,000
12,000
4,442
16,442
12,640
6,684
Depreciation has to be deflated by the inflation rate to reflect loss of purchasing power in tax
savings.
Real rate = (1.10/1.03)-1 = 0.067961
Uncertainty
Emphasis has been placed on quantitative techniques for evaluation of long-term
investment proposals. Such emphasis assumes that organisational decision
making follows the rational model of choice. The making of good long-term
investment decisions is not, however, quite so straightforward as a study of the
quantitative models might suggest.
Varying degrees of uncertainty will be associated with the inputs to the decisions uncertainty as to (i.) the economic life of the project; (ii.) the future cash flows,
particularly for the more remote time periods; (iii.) incremental cash flows; and
(iv.) the appropriate discount rate. Each of these uncertainties will affect the
results obtained from the different models. Sensitivity analysis (varying different
inputs and seeing the effect on the output) might be useful in coping with some of
the possible sources of uncertainty. The use of probability estimates would enable
simulation tests (see Chapter 4) on results. Increasing the hurdle rate is a common
approach to uncertainty, as well as requiring a shorter payback period.
11.23
Feasibility
The techniques presented provide a quantitative approach to evaluating projects in
terms of their desirability, having regard to the objective of obtaining maximum
return on funds employed. Desirability, however, is not the only test. Feasibility
also must be considered. The investment cash outflows and net cash inflows must
be estimated period by period and incorporated into the periodic cash flow
forecasts for the whole organisation. This would reveal any need for additional
financing, and possible sources of such finance could be explored. In addition,
profit and loss and balance sheet effects of the project should be estimated for
each period and again, consolidated into forecasts for the organisation as a whole,
to ensure that future reported figures are likely to be acceptable for each period.
The feasibility study should also examine technical aspects of the project,
availability of management skills and other personnel requirements for successful
execution of the project.
Isolation of incremental cash flows
Even for a project which is largely independent of other activities of the
organisation there will be some uncertainty associated with the estimation of
incremental cash flows. In cases where the proposed investment will have indirect
effects on existing programs, isolation of incremental effects will be even more
difficult. A division of a company might plan to expand its activities into two
remaining States to give it complete national coverage. Estimates for the activities
in the two extra States could be made. A strategic aspect of the decision,
however, may be that ability to provide complete national coverage would enable
the division to win the accounts of some large national customers, thus affecting
cash flows in existing state branches. There could also be a flow on of some
beneficial effects to the other divisions, and some general enhancement of
company image. Such effects may be very difficult to quantify.
Qualitative aspects
Qualitative aspects of a decision refers to those aspects which, though relevant,
cannot be quantified or expressed in financial terms with any meaningful degree of
accuracy. Consider, for example, a proposed large expenditure for installation of
safety equipment and safety training in a plant with a bad record of industrial
accidents. Here moral values enter into the decision. Is it a worthwhile objective in
itself to reduce the number of employees who may suffer death or disabling injuries?
To what extent will this desirable aim be achieved? How should the benefit be
measured or quantified? How should this alternative be compared with other
financially beneficial alternatives? Clearly qualitative factors are important, but
equally clearly it is no easy task to combine qualitative and quantitative benefits.
11.24
Behavioural dimensions
Besides the quantitative techniques examined above for evaluating projects,
writers often refer to urgency and persuasion as criteria which are used to
justify projects. The use of persuasion smacks of political interference which
often is a fact. The safety officer in a large organisation would seek to emphasise
the moral aspects of creating a safer work place. Yet the fact that large
expenditures for this purpose might increase the importance and status of his own
position would not be absent from his mind. Similarly, divisional managers are
motivated to act in the best interests of their own divisions. The future career
prospects of a division manager are likely to be contingent on the size and
performance of his own division. He may be motivated to advocate acceptance of
his own divisions investment proposals, without being too much concerned that
marginally better investments are being proposed by other divisions.
The effects of persuasion are important because:
the objectives and motivations of individuals may not be in complete

harmony with the objectives or best interests of the organisation as a whole;
qualitative factors may cloud the issue of selection of the projects which are
best for the company; and
uncertainty causes quantitative information to be subjective, and it may be

heavily biased to serve the ends of those best able to prepare the
information.
Capital budgeting and modern manufacturing technology

A number of criticisms have been levelled at the use and interpretation of net
present value and internal rate of return figures, especially where strategic
decisions lead to proposed investments in modern production technology. These
criticisms include:
there is inappropriate adjustment for risk

discount rates are excessively high
proposed investments are compared with the status quo
there is a bias towards incremental change
investment outlays are understated
benefits are understated
11.25
Inappropriate adjustment for risk

Some companies require that investments in new production technology pay back
their investment outlays within a very short period of time, perhaps in only two or
three years. This is justified on the grounds that such investments are relatively risky.
But revised production process technology may provide flexibility to accommodate
new and revised products which may be introduced many years into the future certainly beyond an arbitrarily prescribed payback period. The use of excessively
short payback periods, to compensate for perceived risk, may result in investments in
modern production technology being rejected despite the long run benefits.
Excessively high discount rates
The use of excessively high discount rates penalises alternatives which promise cash
flows over a relatively long life. This is likely to be the case for proposed investments
in modern production technology because it may take some time for substantial cash
inflows to occur as the benefits in relation to new and revised products are realised.
Such benefits are likely to flow over a relatively long time period. Excessively high
discount rates may be used to incorporate a premium for risk into the analysis. In the
case of changed production process technology, the uncertainty may attach to the
investment outlay required to make the new technology operational and to bring on
stream the new and revised products which exploit that technology. It is preferable to
recognise such uncertainties explicitly (e.g. by probability analysis) rather than to
somewhat simplistically increase the discount rate.
Comparison with status quo
The proposed investment must be evaluated against some alternative, such as
retaining old technology. Such an evaluation may understate the benefits from
investing in new production technology unless care is taken to correctly consider the
future cash flow consequences of retaining the existing technology. Future cash
flows from the status quo may decline, perhaps substantially, from their present
level as adaptive competitors adopt new production technologies and steal business.
The assumption that the company can maintain future cash flows at their present
level, despite the rejection of new technology, is likely to prove quite erroneous.
Bias towards incremental projects
Rather than invest in new technology some organisations may focus on developing
investment proposals which represent small incremental changes to existing
production processes, promising operating cost savings or relief of production
bottlenecks. Such strategies may tend to reinforce the commitment to existing
technology which may become increasingly obsolete and hence damage long run
capacity, efficiency and profitability. A more comprehensive and global approach
is required to ensure that the adoption of new technology is not unduly delayed. It
can certainly be difficult to determine appropriate costs and benefits of proposals
involving the modification, improvement and refurbishment of existing
production technology versus the adoption of new production technology.
11.26
Investment outlays are understated

While the acquisition and installation costs of new equipment may be relatively
easy to estimate, there may be some costs which are overlooked or seriously
understated. The commissioning of new equipment may be costly and time
consuming, especially where such equipment is at the forefront of technological
development. In the case of computer integrated manufacturing systems (CIMs)
the development of suitable computer software may be omitted from the analysis.
The costs of retraining and educating managers, supervisors and operators may
prove elusive to estimate. Initially output and productivity may decline when new
technology is introduced and it may take considerable time and managerial effort
to achieve previous and forecast levels.
Benefits are understated
In addition to the obvious anticipated savings in operating cash expenses or
increase in net cash inflows, there may be other benefits which are not so easy to
identify and measure. For example, there may be reduced investment in
inventory, reduced factory space required, improved quality, increased flexibility
and reduced throughput time and lead time. In all these areas it may be difficult to
identify and estimate the benefits. It is clear, however, that to ignore such benefits
is to exert a downward bias on the results of any discounted cash flow analysis. It
may be that rather than endeavouring to attach a dollar value to such benefits
managers should reverse the process and ask how substantial these benefits need
to be in order to justify the proposed investment in new technology.
Summary
Capital investment decisions involve the acquisition of capital assets which
involve large outlays of money and are typically retained for a considerable
number of years.
Capital investment proposals can be evaluated by simple methods such as accounting
rate of return and payback period. Both of these ignore the time value of money.
Discounted cash flow techniques explicitly incorporate an allowance for the time
value of money. The two common methods are the net present value method and
the internal rate of return method.
Because of the long time period over which capital assets are held, inflation will
impact on the forecast cash flows over the life of the asses. The effects of
inflation can be dealt with either by using nominal cashflows and interest rates
(i.e. actually incorporating inflation) or real cashflows and interest rates).
Care has to be taken in evaluating proposals for investment in modern technology.
Conventional NPV or IRR figures must be treated with caution.
11.27
Self-test questions
i.
Matching
Match the numbered term with the letter of the most appropriate description.
1.
_____
payback
2.
_____
accounting rate of return
3.
_____
NPV model
4.
_____
IRR
5.
_____
nominal cash flows
6.
_____
total project approach
7.
_____
payback reciprocal
8.
_____
capital rationing
9.
_____
qualitative aspects
10.
_____
incremental approach
A.
Annual cash inflow divided by initial cash investment, given uniform annual
cash inflows.
B.
Uses a required rate of return to discount cash outflows and inflows to give
their net difference.
C.
Factors which cannot be expressed accurately in financial terms but which

are pertinent to capital expenditure proposals.
D.
Expressed in future dollars which incorporate the effects of inflation.
E.
Calculates the difference between the present value of the cash flows of each
of two projects.
F.
Equates the sum invested at a given date with the present value of the
expected cash inflows from an investment.
G.
Calculates the annual differences in cash flows between two proposals and
then evaluates those differences.
H.
Selecting only those investments which can be undertaken because of an

overall budget limit.
I.
Increase in future annual net income divided by initial investment.
J.
Number of years required to recoup an investment.
11.28
ii.
True/false
For each of the following statements write T or F.

1.
A project has a net loss whenever it has a negative NPV.
2.
A project with a negative NPV could have a positive IRR.
3.
When the NPV of a project is negative the IRR would be lower than the
discount rate used to compute the NPV.
4.
When two similar projects are compared, the one with the shorter payback
period would tend to have the lower IRR.
5.
The IRR of a project is the discount rate that would produce a zero NPV.
6.
The net cash effect of $80,000 depreciation per year, assuming a 30% tax
rate, is a $56,000 cash inflow per year.
7.
When there is zero inflation the nominal interest rate is equal to the real
interest rate.
8.
The nominal rate of return is equal to the sum of the real rate of return and
the inflation rate.
9.
Residual value is the present value of a business beyond the forecast period.
10.
The shareholder value created by a strategy is equal to the total shareholder

value of a business with the new strategy.
iii. Multiple choice

Identify the correct alternative in each question.
1.
A project whose useful life is 12 years requires an initial investment of

$200,000 with an estimated residual value of $20,000. The annual savings in
cash operating expenses are $30,000. The accounting rate of return on
average investment is
A
B
C
D
E
15.0%
13.6%
6.8%
16.7%
7.5%
Use the following information to answer Question 2:

Initial investment
$12,000
Life
8 years
Salvage value
$2,000
Production and sales volume
1000 units/year
Selling price
$7/unit
Variable costs
$4/unit
Annual cash fixed expenses
$1,000
Straight line depreciation over 8 years
11.29
2.
In the absence of taxes the accounting rate of return on initial investment is

A
B
C
D
E
3.
0.20
0.10
0.075
0.0625
none of the above
Wagga Company has depreciation expense of $800,000 in one year. Given a

tax rate of 60%, the after-tax effect is a decreased net cash
A
B
C
D
E
outflow of $320,000
inflow of $320,000
outflow of $480,000
inflow of $480,000
none of the above
Use the following information to answer Questions 4 and 5:

XYZ Co. sold for $44,000 cash an old piece of equipment. It was purchased 8
years ago for $130,000 and was being depreciated on a straight line basis over 10
years. The same depreciation was used for accounting and tax purposes. The
expected terminal scrap value was $10,000.
4.
What was the gain or loss on sale before tax?

A
B
C
D
E
5.
Given a tax rate of 40%, the net after-tax cash flow from the sale of
equipment was
A
B
C
D
E
11.30
$20,000 gain
$18,000 loss
$10,000 gain
$10,000 loss
$18,000 gain
$32,400
$36,800
$37,200
$51,200
$54,800
6.
If the real rate of return is 10% and the inflation rate is 4% then the nominal
rate of return is (to one decimal place)
A
B
C
D
E
7.
5.8%
6.0%
14.0%
14.4%
none of the above
If the nominal rate of return is 30% and the inflation rate is 10% then the
real rate of return is (to one decimal place)
A
B
C
D
E
18.2%
20.0%
40.0%
43.0%
none of the above
Use the following information to answer Questions 8 and 9:

Sales in 19X0
Sales growth rate
Operating profit margin
Cash income tax rate
Incremental fixed capital investment rate
Incremental working capital investment rate
Cost of capital
8.
Cash flow from operations in 19X1 would be

A
B
C
D
E
9.
$1000
10% per year
20%
40%
15%
12%
18%
($38)
$132
$193
$220
none of the above
What is the residual value (to the nearest dollar) at the end of 19X1?
A
B
C
D
E
$583
$733
$1,222
$5,555
None of the above
11.31
Use the following information to answer Question 10:

Initial investment
$12,000
Life
8 years
Salvage value
$2,000
Production and sales volume
1000 units/year
Selling price
$7/unit
Variable costs
$4/unit
Annual cash fixed expenses
$1,000
Straight line depreciation over 8 years
10.
Given a tax rate of 50%, the payback period is

A
B
C
D
E
2.5 years
4.0 years
7.38 years
6.67 years
6.86 years
Self-test solutions
i.
Matching
1. J;
ii.
2. I;
3. B;
4. F;
5. D;
6. E;
7. A;
8. H;
9. C;
10. G.
4. F;
5. T;
6. T;
7. T;
8. F;
9. T;
10. F.
True/false
1. F;
2. T;
3. T;
iii. Multiple choice

1.
B.
NP =
=
ARR =
$30,000 - Depn = 30,000 - [(200,000-20,000)/12]

$15,000
15,000 / 0.5(200,000 + 20,000) = 0.136
2.
D.
NP =
=
ARR =
cash flow - depn = 2000 - [(12,000-2000)/8]

750
750 / 12,000 = 0.0625
3.
C.
i.e., a reduction in taxes of 0.6(800,000)
4.
E.
Annual depreciation = 10% * 130,000 = 13,000

Book value = 130,000 - (13,000 * 8 yrs) = 26,000
Gain on sale = 44,000 - 26,000 = 18,000
11.32
5.
B.
Cash sale value = 44,000

Tax on gain on sale = 0.4 18,000 = 7,200
Net cash flow after tax = 44,000 - 7,200 = 36,800
6.
D.
N=(1+R)(1+I)-1 =
=
7.
A.
R=[(1+N)/(1+I)] -1 = [1+0.3)/(1+0.1)]-1 = 1.3/1.1 - 1 = 0.1818 (18.2%)
8.
E.
Sales in 19X1 = 1000(1.1) = 1100

Operating profit (20%) = 1100(0.2) = 220
Less tax (40%) = 0.4(220) =
88
Operating profit after taxes
132
(1+0.1)(1+0.04)-1
(1.1)(1.04)-1 = 1.144-1 = 0.144 (14.4%)
Incremental F capital inv (1100-1000)(0.15) =

Incremental WC inv (1100-1000)(0.12) =
Total investment
Cash flow from operations
15
12
27
105
9.
B.
Residual value
= Cash flow before new investment/Cost of capital

= Operating profit after taxes/Cost of K
= 132/0.18 = $733
10.
E.
For tax purposes must base depreciation on original cost of $12,000.

An 8 year life - 12.5% p.a.
Depn = 0.125 * 12,000 = 1500
Annual cash flow after tax = (1-0.5)2000 + 0.51500 = 1750
Payback period = 12,000 / 1750 = 6.857 years
11.33

Adapted from Fatseas, V. A., & Williams, J. F. (2008). Management accounting
decisions. McGraw-Hill.
Study questions
8-15 Personal investment: government loan versus rental property
An individual who has a personal taxable income in excess of $40 000 per
year has $50 000 available for investment. He is considering investing that
sum in a government guaranteed loan with a 10 year term and interest
payable annually at a rate of 14% per annum.
It has been suggested to him that the following investment should be more
attractive:
Purchase a rental home unit for $50 000.
Weekly rental would be $80 which, allowing for an average 2 weeks

vacancy factor per year, would give a gross rental of $4000 per year.
Annual cash expenses including agent's commission, rates, water rates

and repairs and maintenance are estimated at $800 per year.
Estimated resale value of the property after 10 years is $90 000.
The personal income tax rate is 60 cents on each $1 in excess of $35 000 per
year. There are no capital gains taxes.
Required:
Using a net present value approach, compare the two investments.
8-25 Competing investment proposals: investment in working capital and
gain/loss on disposal
Pacioli Ltd has developed a unique product which it intends to market world
wide. Two proposals for the necessary manufacturing equipment have been
prepared. One, Plan X, entails the use of general-purpose equipment. This
equipment could easily be sold on the active used equipment market if the new
product is not a success. Plan Y envisages using highly specialised equipment,
which would have to be scrapped if the new product is not a success.
Costs for each plan (assuming an output of 40 000 units per year) are as follows:
Initial capital outlay for equipment

Unit variable costs Labour
Materials
Other
Annual non-variable costs involving cash outlays Supervision
Insurance, repairs & maintenance and other overhead
11.34
Plan X
$
2 300 000
Plan Y
$
5 300 000
67
49
24
l9
32
l9
700 000
299 000
800 000
600 000
Additional Information:a.
It is anticipated that raw material inventories under the respective

proposals will average one-fifth of the total annual raw material costs.
In addition, replacement parts to the value of $25 000 will be carried for
the general purpose or $100 000 for the special purpose equipment.
Any replacement parts used during the life of the two proposals would
be replaced immediately. Trade creditors are expected to average onetwelfth of annual raw material purchases.
b.
When the equipment is sold, under either plan, any additional working
capital required, with the exception of the inventory of replacement
parts, will be recovered. It is expected that the replacement parts for the
general purpose equipment can be scrapped for 80% of their outlay cost
but that replacement parts for the special purpose equipment can be
expected to realise zero value when scrapped. Replacement parts
should be amortised in the accounting records, but written off as used
for taxation purposes (included in other cash overheads).
c.
For tax purposes only, the general-purpose equipment (Plan X) will be

depreciated over ten years and the special purpose equipment (Plan Y)
over five years. The straight-line method of calculating depreciation
will be used based upon the initial capital outlay. Ignore prospective
salvage value at the end of the period for the purpose of calculating
depreciation for tax purposes.
d.
Predicted salvage values if the machinery is sold are as follows:At end of year
1
2
3
4
5
6
7
8
9
10
Plan X
$
1 800 000
1 400 000
1 000 000
1 000 000
800 000
800 000
600 000
400 000
400 000
200 000
Plan Y
$
300 000
300 000
250 000
200 000
200 000
175 000
150 000
100 000
100 000
100 000
e.
A new, wholly owned subsidiary will be formed to purchase the

equipment and manufacture the new product. The subsidiary will sell
the product to the parent company at $220 each.
f.
Income tax rates are expected to be 40% of income. (For the purpose of
this analysis, assume, that tax is paid in the years in which the income is
earned).
g.
The new product will be manufactured for 5 years only.
11.35
Required:
Perform a Net Present Value analysis to show which plan is financially more
attractive, assuming that 40 000 units are sold each year, that the product
will be manufactured for five years only, that all gains and losses on
disposal have a tax effect and that the minimum desired rate of return is
18% after taxes. Clearly include the following (for each project) in your
analysis:
1.
Initial outlays for equipment, raw materials, replacement parts, and

trade creditors.
2.
Contribution Margin (Variable Income)
3.
Fixed Costs
4.
Depreciation for tax purposes
5.
Annual Operating Cash Flows
6.
Cash Flows at project termination
7.
Net Present Values.
8-26 Renovation versus investment in new technology

PART A
Norleans Corporation has an existing manufacturing plant which has been in
use for about 8 years and is fully depreciated for taxation purposes. It has
zero net salvage value at present and is in need of major renovation and
refurbishment in order to meet production specifications.
It is expected that the cost of this renovation would be $5 million. This is
expected to result in a useful life of 10 years before any major overhaul or
replacement would be required. At the end of this period it is expected the
renovated plant would have zero net salvage value. For taxation purposes
the cost of the renovation is to be depreciated on a straight line basis over 5
years. Because a wide variety of products pass through this plant it is
difficult to estimate what the net cash inflow is expected to be. Based on
historical perceptions of the firm's management the following estimates
have been prepared:
Working weeks per annum - 48
Available hours per week - 80 (based on 2 shifts per day and a 5 day
working week)
Operating usage factor - 60 per cent. The remaining time is spent on

repair and maintenance, and setting up for production runs. The out of
pocket costs associated with this time (R & M and setups) is estimated
to be $100 000 per annum.
Based on the firm's existing product range and mix, the net cash flow
per operating hour is expected to be $500.
The firm requires an after-tax internal rate of return of 12% per annum on
investments of similar risk characteristics. The tax rate applicable to the
firm's income is 40 per cent.
11.36
Required:
Prepare a schedule showing the net cash flow per annum for this proposal,
and calculate its net present value.
PART B
The production engineering department has become aware of a computer
integrated manufacturing (CIM) facility which represents much more up to
date manufacturing technology than the renovation and refurbishment
discussed above. It has a number of apparently favourable and unfavourable
features.
Perhaps the most notable favourable feature is the much higher investment
outlay required. It is estimated that the CIM facility will cost $10 million
for purchase and installation ready for use. It is expected to have a useful
life of 10 years, and while it may have some net salvage value at the end of
this period it is difficult to estimate because of the uncertainty attaching to
the new production technology. For taxation purposes the cost of the CIM
facility is to be depreciated on a straight line basis over 5 years.
Among the advantages of the CIM facility are the ability to produce more
reliably to product specifications, faster throughput rates, reduced labour and
operating costs, reduced setup times, and the ability to introduce variations of
existing products and even new products more easily and quickly.
Since there is little relevant historical information available the production
engineers in conjunction with the management accounting department have
prepared the following estimates:
Working weeks per annum - 48
Available hours per week - 80 (based on 2 shifts per day and a 5 day
working week)
Operating usage factor - 40 per cent. The remaining time, other than
idle time, is spent on repair and maintenance, and setting up for
production runs. The out of pocket costs associated with this time
(R & M and setups) is estimated to be $400 000 per annum.
Based on the firm's existing product range and mix, the net cash flow
per operating hour is expected to be $1200.
Initially a relatively large amount of idle time is anticipated until additional

custom is won or new products are introduced. Because management views
this as 'blue sky' and is not convinced that the benefits of increased activity
will be realised, no explicit recognition of such prospective advantages is to
be included in the financial analysis.
11.37
Required:
a.
Prepare a schedule showing the net cash flow per annum for the CIM
proposal and calculate its net present value.
b.
Based on the financial calculations which you have made, should the
firm invest in the first alternative (renovation and refurbishment) or the
second alternative (CIM facility)?
c.
Assume that while the estimates of the cash flows for the first
alternative are believed to be reasonably reliable, those of the second
alternative are much less so. What level of annual net operating cash
flows before tax for the second alternative would be required to produce
the same net present value as the first alternative?

8-15 Home unit appears better with NPV of $11,794 although there is more
uncertainty attached to the home unit proposal and hence it is more risky.
LOAN
The government guaranteed loan is returning 14% (risk free) before tax,
which is equal to 0.14(1-0.6) = 0.056, or 5.6% after tax. That is, if the cash
flows associated with the loan were discounted using a discount rate of 5.6%
we would get an NPV of zero.
HOME UNIT
The following evaluation uses Excel so that the exact PVs can be calculated
at a discount rate of 5.6%. Otherwise, using discount tables students would
probably have to use 6% which would give an NPV of $9677.
Purchase unit
Annual gross rental
Annual cash expenses
Net cash flow before tax
Tax at 60%
Sale of unit
PV @ 5.6%
NPV
Year 0
-50,000
Yrs 1-10
Year 10
4,000
-800
3,200
-1,920
-50,000
-50,000
11,794
1,280
9,602
90,000
90,000
52,192
The home unit appears to be a much better proposal, with the following
reservations:
i. The 5.6% after tax return on the loan is risk free, whereas the home unit
cash flows are estimates and far from risk free. For example, on what
basis do we estimate the resale value of the unit in 10 years' time?
ii. Further risk is involved in the tax treatment of the $40,000 capital gain
expected on the unit. What if a capital gains tax is brought in? [Note:
This question was designed before capital gains tax was introduced in
Australia]
11.38
8-25 PACIOLI LTD

1.
Initial outlays
Capital outlay
Raw materials inventory
(0.2*40,000*[49,32])
Replacement parts
Suppliers credit (1/12*40,000*[49.32]
Plan X
-2,300,000
-392,000
Plan Y
-5,300,000
-256,000
-25,000
163,333
-2,553,667
-100,000
106,667
-5,549,333
Plan X
220
140
Plan Y
220
70
80
3,200,000
150
6,000,000
3.
Cash Fixed Costs
Supervision
Insurance, r & m, and other overhead
Total cash fixed costs
Plan X
-700,000
-299,000
-999,000
Plan Y
-800,000
-600,000
-1,400,000
4.
Depreciation for tax purposes
Depreciation [0.1*2.3m, 0.2*5.3m]
Plan X
-230,000
Plan Y
-1,060,000
5.
Annual Operating Cash flows
Variable profit
Less fixed costs
Less depreciation
Pretax profit
Tax 40%
After tax profit
Annual operating cash flows
Plan X
3,200,000
-999,000
-230,000
1,971,000
-788400
1,182,600
230,000
1,412,600
Plan Y
6,000,000
-1,400,000
-1,060,000
3,540,000
-1416000
2,124,000
1,060,000
3,184,000
2.
Variable Profit
Unit variable cost [67+49+24],
[19+32+19]
Unit contribution margin
Variable profit [x 40,000]
11.39
6.
Cash Flows on Termination
Salvage
Tax on gain or loss:
[800,000-(2,300,000-5*230,000)]*0.4
[200,000-0]80.4]
Recovery of raw material inventory
Reduction in suppliers credit
Sale replacement parts [0.8*25,000], [0]
Tax on loss on disposal of parts:
[0.4*(25,000-20,000)], [0.4*100,000]
7.
X: $2,384,226
Y: $4,542,792
Plan X
800,000
Plan Y
200,000
140,000
392,000
-163,333
20,000
-80,000
256,000
-106,667
0
2,000
1,190,667
40,000
309,333
($2,384,257 using discount tables)

($4,542,881 using discount tables)
Plan X
Cash flows
PV Factors (18%)
Present Values
NPV
Year 0
-2,553,667
1
-2,553,667
2,384,226
Yrs 1-5
1,412,600
3.1272
4,417,442
Year 5
1,190,667
0.4371
520,451
Plan Y
Cash flows
PV Factors (18%)
Present Values
NPV
Year 0
-5,549,333
1
-5,549,333
4,542,792
Yrs 1-5
3,184,000
3.1272
9,956,913
Year 5
309,333
0.4371
135,212
Plan Y is more attractive, having the higher NPV.

8-26 NORLEANS CORPORATION
PART A NPV = $8,331 (Using discount tables $8,326)
Renovation
Year 0
Yrs 1-5
Renovation
-5,000,000
Net cash flow from operations
1,152,000
[48*80*0.6*$500]
Repairs and maintenance
-100,000
Depreciation [0.2*$5,000,000]
-1,000,000
Profit before tax
52,000
Tax 40%
-20,800
Profit after tax
31,200
1,000,000
Net cash flow after tax
-5,000,000
1,031,200
PV Factors (12%)
1
3.6048
Present Values
-5,000,000
3,717,245
NPV
8,331
11.40
Yrs 6-10
1,152,000
-100,000
0
1,052,000
-420,800
631,200
0
631,200
2.0454
1,291,086
PART B
a.
NPV = -$2,223,538
CIM Facility
Purchase CIM
Net cash flow from operations
[48*80*0.4*$1200]
Repairs and maintenance
Depreciation [0.2*$10,000,000]
Profit before tax
Tax 40%
Profit after tax
Net cash flow after tax
PV Factors (12%)
Present Values
NPV
Year 0
Yrs 1-5
-10,000,000
Yrs 6-10
1,843,200
-400,000
-2,000,000
-556,800
222,720
-334,080
2,000,000
-10,000,000 1,665,920
1
3.6048
-10,000,000 6,005,269
-2,223,538
1,843,200
-400,000
0
1,443,200
-577,280
865,920
0
865,920
2.0454
1,771,193
b.
First alternative - has positive NPV of $8326 whereas second

alternative has negative NPV of $2,223,538.
c.
$2,101,542
NPV Renovation
NPV CIM Facility
Difference in NPV
Annual difference in cash flow after tax
Annual difference in cash flow before tax
8,331
-2,223,538
2,231,869
395,005
[2,231,869/5.6502]
[395,005/(1-0.4)]
658,342
Second alternative requires annual net operating cash flows before tax of:
1,843,200-400,000+658,342 = $2,101,542
11.41

Introduction to management accounting (13th ed.). Pearson Prentice-Hall.
Study questions
11.42
11.43
11.44

11-34 (20-25 min.)
This basic exercise develops comfort with the tables and the NPV method.
Number of years
Amount of annual cash inflow
Required initial investment
Minimum desired rate of return
Net present value
a
8
$10,000
$40,776a
14%
$ 5,613
18
$13,749b
$80,000
20%
($13,835)
20
$ 9,000
$65,000
12%c
$2,225
28
$ 8,000
$30,000
25%
$ 1,938d
(4.6389 x $10,000) - $5,613 = $46,389 - $5,613 = $40,776
(4.8122 x CF) - $80,000 = ($13,835); CF = ($80,000 - $13,835) 4.8122 = $13,749
(F x $9,000) - $65,000 = 2,225; F = $67,225 $9,000 = 7.4694
On the 20 year row, the factor 7.4694 is a 12% rate

d
PV Factor for 25% on 28-year row is 3.9923

$8,000 3.9923
= $31,938
NPV =$31,938 - $30,000 = $1,938
11-36
1.
(10-15 min.)
The quickest solution is to net the flows for each year:

1.
2.
3.
4.
5.
$200,000 - $150,000 = $ 50,000

250,000 - 200,000 =
50,000 an annuity of 3 payments (a)
300,000 - 250,000 =
50,000
400,000 - 300,000 = 100,000 an annuity of 2 payments
450,000 - 350,000 = 100,000 deferred three years (b)
a.
b.
$50,000 2.3216
$100,000 1.6467 .6750
Total
Less initial investment
Net Present Value (NPV)
$116,080
111,152
$227,232
215,000
$ 12,232
Various other approaches would reach the same answer, but they would
involve more computations.
2.
The NPV is positive because at a 12% rate, the present value of the net
inflows will be higher than at 14%, so NPV will increase.
11.45
11-38 (30-45 min.)

This problem deals essentially with sensitivity analysis, which asks how the basic
forecasted results will be affected by changes in the critical factors (useful life,
cash flows) that influence rate of return.
1.
2.
3.
4.
5.
$25,000 $5,000 = 5 years

NPV= ($5,000 6.8137) - $25,000 = $9,069
a) NPV = ($5,000 3.7908) $25,000 = ($6,046)
b) NPV = ($5,000 8.5136) $25,000 = $17,568
NPV = ($3,500 6.8137) $25,000 = ($1,152)
NPV = ($4,000 5.3349) $25,000 = ($3,660)
11-44 (10-15 min.)

Annual addition to profit = 40% x $25,000 = $10,000.
1.
Payback period is $30,000 $10,000 = 3 years. It is not a good measure of

profitability because it ignores returns beyond the payback period and it does
not account for the time value of money.
2.
NPV = $11,114. Accept the proposal because the NPV is positive.

Computation: NPV = ($10,000 x 4.1114) - $30,000
= $41,114 - $30,000 = $11,114
3.
ARR =
increase in average cash flow - increase in depreciation

initial investment
=($10,000 - $5,000) $30,000 = 16.7%

11-45 (15 min.)
1.
$12,000 $3,000 = 4 years
2.
$3,000 x 5.7466 = $17,240. The company should buy because the net
present value is a positive $17,240 - $12,000 = $5,240.
3.
ARR =
11.46
$3,000 - ($12,000 8 years)

$1,500
=
= 12.5%
$12,000
$12,000
11-50 (30 min.)

The initial purchase cost of the golf course and the operating receipts and
disbursements for the first season of ownership are irrelevant to the present
decision. The relevant annual costs which Ms. Bogey should take into
consideration are:
Electricity, (300 1 kw) (130 5 hrs.) $.08 per kw hr.
Labor cost, 130 $75
Light bulb cost
Repairs and maintenance of lighting system, .04 $94,000
Property taxes, .017 $94,000
Total additional operating expenses
$15,600
9,750
1,500
3,760
1,598
$32,208
Annual revenue from night operations:

Years 1 and 2:
130 $450
Years 3, 4, and 5: 130 $300
$58,500
$39,000
One-time cash flows:

Present value of initial investment
Salvage value, year 5
$94,000
$35,000
Example of Cash Flow Analysis
Revenue
Expenses
Year 1
$58,500
- $32,208
Year 2
58,500
- 32,208
Year 3
39,000
- 32,208
Year 4
39,000
- 32,208
Year 5
74,000
- 32,208
Present value of cash flows
=
=
=
=
=
Net Flow
$26,292
26,292
6,792
6,792
41,792
PV
PV of
Factor Cash Flows
.9091
$23,902
.8264
21,728
.7513
5,103
.6830
4,639
.6209
25,949
$81,321
Since the present value of the annual cash flows is $12,679 less than the initial
investment of $94,000, the proposed lighting system should not be installed. If
significant increases in revenue were predictable, the plan might become attractive
to Ms. Bogey.
11.47
11-67 (50-75 min.)

This is a complex problem because it requires comparing three alternatives. It
reviews Chapter 6 as well as covering several of the topics of Chapter 11. The
following answer uses the total project approach. The total net future cash
outflows are shown for each alternative.
1.
Alternative A: Continue to manufacture the parts with the current tools.

Annual cash outlays
Variable cost, $9.20 8,000
Fixed cost, 1/3 $4.50 8,000 .6
Tax savings, .4 ($73,600 + $7,200)
After-tax annual cost
Present value, 3.6048 $48,480
PV of remaining tax savings on MACRS:
11.52% $200,000 .4 .8929
5.76% $200,000 .4 .7972
Total present value of costs, Alternative A
$(73,600)
(7,200)
32,320
$(48,480)
$(174,761)
8,229
3,673
$(162,859)
Alternative B: Purchase from outside supplier

Annual cash outlays
Purchase cost, $11.00 8,000
Tax savings, $88,000 .4
Present value, $52,800 3.6048
Sale of old equipment:
Sales price
Book value
[(11.52% + 5.76%) $200,000]
Gain
Taxes @ 40%
Total after-tax effect ($40,000 - $2,176)
Total present value of costs, Alternative B
11.48
$(88,000)
35,200
$(52,800)
$(190,333)
$40,000
34,560
$ 5,440
(2,176)
37,824
$(152,509)
Alternative C: Purchase new equipment

Investment
Annual cash outlays
Variable cost, $7.30 8,000
Fixed cost, (same as A)
Tax savings, .4 ($58,400 + $7,200)
Present value, $39,360 3.6048
Tax savings on new equipment*
Effect of disposal of new equipment
Sales price
Book value
Gain
Taxes @ 40%
Total after-tax effect
Present value, $30,000 .5674
Effect of disposal of old equipment
(see Alternative B)
Total present value of costs, Alternative C
*
$(58,400)
(7,200)
26,240
$(39,360)
(141,885)
57,922
$50,000
0
$50,000
20,000
$30,000
17,022
37,824
$(209,117)
Using the MACRS schedule for tax depreciation, the depreciation rate
for each year of a 3-year asset's life is shown in Exhibit 11-6:
Depreciation
Year
Rate
1
2
3
4
$(180,000)
33.33%
44.45%
14.81%
7.41%
Tax
Savings
PV
Factor
.3333 $180,000 .40 = $23,998

.4445 180,000 .40 = 32,004
.1481 180,000 .40 = 10,663
.0741 180,000 .40 = 5,335
.8929
.7972
.7118
.6355
Total present value of tax savings
Present
Value
$21,428
25,514
7,590
3,390
$57,922
Using Exhibit 11-7, we get .8044 $180,000 .4 = $57,917, which differs

from $57,922 by a $5 rounding error.
The alternative with the lowest present value of cost is Alternative B,
purchasing from the outside supplier.
2.
Among the major factors are (1.) the range of expected volume (both large
increases and decreases in volume make the purchase of the parts relatively
less desirable), (2.) the reliability of the outside supplier, (3.) possible changes
in material, labour, and overhead prices, (4.) the possibility that the outside
supplier can raise prices before the end of five years, (5.) obsolescence of the
products and equipment, and (6.) alternate uses of available capacity
(alternative uses make Alternative B relatively more desirable).
11.49
11.50

Management Accounting

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MBA504

Accounting & Financial Management

Accounting & Financial Management

Written and compiled by

Printed at Charles Sturt University

An introduction to financial accounting

The nature and objectives of financial accounting: Basic

Analysis and interpretation of accounting reports

Managing working capital - cash and inventory

Internal control and cash

Social and environmental accounting

Introduction to management accounting

Relevant information and special decisions

Topic 10 Budgeting master budget and flexible budgets

Topic 11 Capital budgeting

Pacioli, L. (1966 reprint).

Weis, W., & Tinius, D. (1992).

Integrate Excel into Word.

O'Leary, T. J., & O'Leary, L. I. (2011).

OLeary T. J., & OLeary, L. I. (2008).

Mautz, R. K., & Sharaf, H. A. (1978).

Brewer, P. C., Garrison, R. H., & Noreen, E. W. (1995).

Crossman, J., Bordia, S., & Mills, C. (2011).

Davies, M. R., Kries, K. E., Nutting, J. B., & Tronc, K. E. (1985).

Windschuttle, K., &Windschuttle, E. (1989).

Horngren, C. T., Harrison, W. T., & Oliver, M. S. (2012).

Macintosh, N., & Quattrone, P. (2010).

on the HOME menu bar select PASTE, AS PICTURE, COPY AS

The message? Save all your spreadsheets in one workbook as shown

In the past, the cost of goods sold has always been

Cost of goods sold

The sales budg

In the past, the

Selling price per unit

Target net income

Income Statement and Balance Sheet

Income Statement for the Year ended 31 December 20X0

Income before Tax

Balance Sheet as at 31 December 20X0

Liabilities and Shareholders Equity

Here is the formula view.

Income Statement and Balance Sheet

Income Statement for the Year ended 31 December 20X0

Income before Tax

Liabilities and Shareholders Equity

Balance Sheet as at 31 December 20X0

Note the IF function in cell C80

Day of the Month

Variance Analysis - Materials and Labour

The Mac Company produces raincoats. Data follows:

$6.00 per metre

This example uses the IF function to show variances as Favourable or

Adjusted Trial Balance

Reconstructing accounts: forensic accounting - the case of Oscar Bese

General Ledger showing only accounts essential to the solution.

Cost of Goods Sold

Here is an example of a manufacturing statement and an income statement. The

Cost of Goods Manufactured Statement and Income Statement

Helen Reddy Corporation

For Specific Date

For Year 20X1

Work in process, Jan 1, 20X1

Required: Cost of goods manufactured statement and income statement

Management Accounting - Multiple Choice Questions