Study Guide

BUSINESS ACCOUNTING
Content This module deals primarily with the study of the two main branches of business accounting which are financial accounting and management accounting. The first part of the course covers the basics of financial accounting. Topics included here are double entry bookkeeping and the preparation of basic financial statements and financial analysis. The second part of the course covers management accounting techniques for planning, control and decision-making.

Module Aims The aims of this module are to: 1. Introduce the accounting cycle and how accounting data impacts on business decisions. Give an understanding to participants on the preparation and analysis of financial statements. Develop participants abilities to use accounting methods within specific enterprises for the purposes of managerial control and decision making.

2.

3.

Learning Outcomes On completion of this module, a participant will typically be able to: 1. i) ii) iii) iv) v) vi) vii) Show a detailed knowledge and understanding of: The accounting equation and accounting rules. The classification of accounts. Bookkeeping and the accounting cycle. The relation between the principal financial statements. The interpretation of financial statements, the analysis of profitability, of solvency and gearing. Cost behavior and product costs under competing assumptions. The construction and use of budgets inside enterprises.

2. i) ii) iii)

Demonstrate module specific skills with respect to: Preparing a simple balance sheet from financial information. Forecasting financial statements for simple cases and adjusting financial statements for transactions. Citing, explaining, selecting, and applying formats/models to solve numerical problems in such areas as: analysis of financial statements; cost assignment and allocation; pricing and production decisions; and developing budgets.

3. i)

Show cognitive skills with respect to: Integrating and synthesizing between module topics to discuss coherent approaches to the key issues faced in planning and controlling a business from the accounting perspective. Developing familiarity and confidence with accounting / financial arithmetic. Applying accounting models in a real world context.

ii) iii)

4. i) ii) iii) iv) v) vi)

Demonstrate transferable skills in: Information retrieval and numerical analysis. Analytical reasoning. Communication and presentation. Accounting in context. Problem formulation and decision making. Working with others.

Delivery of Module and Lesson Plan Session Topics Prescribed Text, At the completion of this session, Readings participants will be able to: and/or Activities Session Learning Outcomes

1.

Introduction to Accounting

1. Explain the nature and role of accounting and finance. 2. Explain the role of accounting in planning and controlling a business. 3. Distinguish between financial and management accounting. 4. Explain the accounting equation and accounting rules. 1. Explain the major groups of accounts (invested capital, retained earnings, revenue, expenses, owners withdrawal). 2. Complete the accounting cycle: journalize entries, post to general ledger, check accuracy by use of a trial balance, adjust accounts, and close of accounts. 3. Explain the nature and purpose of the three financial reports. 4. Discuss the accounting conventions underpinning the balance sheet. 5. Discuss the limitations of the balance sheet in portraying financial position.

McLaney and Atrill,Chapter 1

2.

Bookkeeping and the Accounting Cycle

McLaney and Atrill, Chapter 2

3.

Measuring and Reporting Financial Performance

1. Discuss the nature and purpose of McLaney and the profit and loss account. Atrill, Chapter 2. Prepare a profit and loss account 3 from relevant financial information and interpret the results. 3. Discuss the main measurement issues that must be considered when preparing the profit and loss account. 4. Explain the main accounting conventions underpinning the

profit and loss account. 4. Accounting for Limited Companies 1. Discuss the nature of a limited company. 2. Explain the role of directors of limited companies. 3. Describe the main features of owners claim of limited companies. 4. Draw up a set of financial statements for a simple limited company. 5. Explain how the income statement and balance sheet of a limited company differ from that of sole proprietorships and partnerships. 1. Describe the responsibilities of directors and auditors concerning the annual financial statements provided to shareholders and others. 2. Outline the statutory regulations surrounding accounting for limited companies. 3. Outline the non-statutory regulations surrounding accounting for limited companies. 4. Prepare an income statement, balance sheet and statement of changes in equity for a limited company in accordance with International Financial Reporting Standards. 1. Explain the role that cash plays in enterprise. 2. Explain the nature of the statement of cash flows and how it can help in identifying cash flow problems. 3. Draw up a simple cash flow statement. 4. Interpret a statement of cash flows. 1. Establish the usefulness of financial reports to various interest groups. 2. Identify the major categories of ratios which may be used for McLaney and Atrill, Chapter 4

5.

Reporting for Limited Companies

McLaney and Atrill, Chapter 5

6.

Measuring and Reporting Cash Flows

McLaney and Atrill, Chapter 6

7.

Analysis of Financial Statements

McLaney and Atrill, Chapter 7

analysis. 3. Calculate a range of accounting ratios and explain their significance and limitations. 4. Explain the importance of gearing to an enterprise and its owners. 8. Budgeting 1. Define a budget and show how budgets, corporate objectives and long-term plans are related. 2. Explain the interlinking of the various budgets within a business. 3. Indicate the uses of budgeting and construct various budgets, including the cash budget. 4. Discuss the criticisms that are made of budgeting. 1. Discuss the role and limitations of budgets for performance evaluation and control. 2. Undertake variance analysis and discuss possible reasons for the variances calculated. 3. Discuss the issues that should be taken into account when designing an effective system of budgetary control. 4. Explain the nature, role and limitations of standard costing. 1. Deduce the full (absorption) cost of a unit of output in a single product environment. 2. Deduce the full (absorption) cost of a unit of output in a multiproduct environment. 3. Discuss the problems of deducing full (absorption) costs in practice. 4. Distinguish between full (absorption) and variable costing. 5. Discuss the usefulness of full (absorption) cost information (versus variable costing) to managers. 1. Bearing in mind the distinction between fixed costs and variable costs, explain the relationship between costs, volume and profit. McLaney and Atrill, Chapter 12

9.

Accounting for Control

McLaney and Atrill, Chapter 13

10.

Full Costing and Marginal Costing

McLaney and Atrill, Chapter 10

11.

Cost-profit-volume Analysis

McLaney and Atrill, Chapter 9

2. Use cost-volume-profit analysis to establish the break-even point for some activity. 3. Discuss the weaknesses of breakeven analysis. 4. Demonstrate the way in which marginal analysis can be used when making short-term decisions. 12. Costing and Pricing in a Competitive Environment McLaney and 1. Discuss the nature and practicalities of activity-based Atrill, costing. Chapter 11 2. Explain how new developments such as total life-cycle costing and target costing can be used to control costs. 3. Discuss the importance of nonfinancial measures of performance in managing a business and the use of the Balanced Scorecard to integrate financial and nonfinancial measures. 4. Explain the term shareholder value and describe the role of EVA in measuring and delivering shareholder value. 5. Explain the theoretical underpinning of pricing and discuss the issues in reaching a pricing decision in real-world situations.

Teaching and Learning Methods Participants will learn through a combination of lectures and practice exercises. Participants will be expected to learn independently by carrying out reading and directed study beyond that available within taught classes.

Indicative Readings Textbooks required McLaney E and Atrill, P (2008), Accounting, An Introduction, FT Prentice Hall, Harlow. Gowthorpe, C. (2005), Business Accounting and Finance for Non-Specialists, Mason, Ohio: Thomson Learning. Ross, S.A., Westerfield, R.W. and Jordan B.D. (2008),

Supplementary reading

Fundamentals of Corporate Finance, Columbus, Ohio: McGraw-Hill Irwin. Online Journals Use of online databases like EBSCO and references to: Financial Management, the Journal of Chartered Institute of Management Accountants, Journal of Accounting, Accountancy, Journal of the Institute of Chartered Accountants in England and Wales, Accounting Review and Harvard Business Review.

Assessment/Coursework All assessments must comply with the SIM Rules and Regulations. To satisfy module requirements, students must: 1) Satisfactorily complete and present on due dates their completed assignment. A penalty of 20% of the total marks will be imposed for late submission. More than one calendar will get zero marks. 2) Complete all assignments and the final examination in a satisfactory manner. 3) Must reference all their work and observe SIMs policy on plagiarism. Students found guilty of plagiarism will be dealt with severely. 4) Adopt either the Harvard or APA (American Psychological Association) Referencing Styles. 5) Spend at least 100 hours (including class attendance and assignments) on the module in order to fare reasonably. Specific for this module are the following requirements: Weighting between components A and B - A: 70% B: 30% Element Description Component A (Controlled Conditions) Examination (180 minutes) Component B (Assignments) 1. Class test. 2. Exercises/scenarios in financial accounting. Total Element Type % of Assessment

Summative Summative Summative

70% 15% Session 7 15% Due: Session 10 100%

ACKNOWLEDGEMENTS The following notes (from session 1 to session 12) are abridged, adapted and customized from the textbook and its accompanying instructors manual: Eddie McLaney and Peter Atrill (2008), Accounting: An Introduction, NJ: Pearson Education.

Session 1 Introduction to Accounting and Finance At the end of the session, students should be able to: 1. Explain the nature and role of accounting and finance. 2. Distinguish accounting users and characteristics of accounting information. 3. Distinguish between financial and management accounting. 4. Explain different business structures _____________________________________________________________________

1.1

WHAT IS ACCOUNTING AND FINANCE? Accounting is concerned with collecting, analyzing and communication financial information. The information is useful for businesses to make decisions and to plan. The accounting information system has features that are common to all valid information systems. These are: a) b) c) d) identify and capturing relevant information recording the information collected analyze and interpret the information collected report the information in a manner suitable for the targeted users

For every firm, there are those who are within the company and those who are outside the companies. Both will need accounting information for decision making. Those who are in the company will need the accounting information to make decisions on: a) developing new products or services b) prices changes on their products or services c) financing planning d) expansion of business Those who are outside of the company will need this information to decide whether to: a) invest or disinvest in the company b) lend money to the company c) offer credit facilities to the company d) enter into business contracts Finance like accounting is also for decision making. It focuses on the way in which funds for a business are raised and invested. Businesses raise funds from investors (owners and lenders) and then use these funds to make investments (i.e. buy equipments, machines and inventories) to generate income or wealth for the investors. Finance is concerned with: a) the forms of finance available

b) the costs and benefits of each form of finance c) the risks associated with each form of finance d) the role the financial markets in supplying finance 1.2 ACCOUNTING USERS AND ACCOUNTING INFORMATION The users of accounting information can be internal or external to the company. The following are possible users you can consider. a) b) c) d) e) f) g) Owners Managers Employees Customers Suppliers Competitors Government

Are you able to think of reasons why each of the above is keen to have the accounting information? Good accounting information must have some characteristics or key qualities to be of value to the users. The 4 main key characteristics are: a) Relevance means the ability to influence decision making. This implies the information must be available and sufficiently critical to change a decision e.g. to invest or not to invest in a company. For information to be relevant, it has to be timely as well. b) Reliability means that the information should be free from significant errors or bias. However, a reliable information may not be relevant for decision making and a relevant information may be unreliable c) Comparability this is a quality that enables a user to identify changes in the business over a time frame. Making accounting procedures used to measure and present information the same each year will allow easy comparison d) Understandability Accounting reports should be expressed as clearly as possible and should be understood by the users of the information. While good information should have the above characteristics, it must also satisfy two other criteria for information recording. The first is materiality whether omission or misrepresentation of the information would lead to a change in decision making. The second is the cost-benefit ratio this considers the benefit gained by the effort in gathering the data. If the cost is greater than the benefit, it is not reasonable to be accurate with no benefit to the users.

1.3

DIFFERENCE BETWEEN MANAGERIAL ACCOUNTING

FINANCIAL

ACCOUNTING

AND

Financial accounting seeks to meet the needs of all the users (both internal and external) already identified above and to assist them in their decision making. Managerial accounting is targeted at internal users such as the managers who will need the information for business decision making. The following summarized the differences: Managerial Accounting Internal users Future emphasis Emphasis on relevance Emphasis on timeliness Focus on segments of a company Need not follow GAAP Not Mandatory

Financial Accounting 1 2 3 4 5 6 7 1.4 Users Time focus Verifiability versus relevance Precision versus timeliness Subject GAAP Requirements External users Historical perspective Emphasis on verifiability Emphasis on precision Focus on the whole organization Must follow GAAP Mandatory

Types of business ownership The form of business ownership is important for accounting and it is useful to know the main forms of ownership that exists. The three basic arrangements are: a) Sole proprietorship b) Partnership c) Limited company Characteristics of a sole-proprietorship Single owner Limited capital requirements Small scale of operations Combined ownership and management Legal or professional restrictions (must operate as sole trader or partnership) Professional responsibility (in terms of unlimited liability) Minimal regulation and minimal external record keeping requirements Taxation advantages Unrestricted ability to sell

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Characteristics of a partnership Access to additional capital Complementary skills and services Flexible management Economies of scale Limited scale of operations Legal or professional restrictions (must operate as sole trader or partnership) Professional responsibility (in terms of having unlimited liability) Tax sharing advantages Moderate regulation Minimal external record keeping requirements Characteristics of Limited Company: Access to significant capital (type and amount) Separation of ownership and management Continuity of operations Limited liability Possible taxation advantages Unlimited level of activity While one can memorized the above as characteristics for each of the business entity, it will be worth your learning process to view the information as advantages or disadvantages for each business structure

Review Questions Source: Atrill , McLaney, Harvey, Jenner (2006): Accounting : An Introduction, NJ: Pearson Education. 1) 2) What is the purpose of producing accounting information? Relevance and reliability are two key characteristics of accounting information. Explain what they mean and are they in conflict? Distinguish between financial accounting and management accounting. A sole proprietor converts to a limited liability company. What are the potential advantage to the owner and the potential disadvantage to the suppliers of the company? Discuss the advantage and disadvantages of companies compared to other entity structures.

3) 4)

5)

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Session 2 Bookkeeping and the Accounting Cycle At the end of the session, students should be able to: 1. Explain the nature and purpose of major financial statements. 2. Prepare a simple balance sheet 3. Understand accounting conventions _____________________________________________________________________

2.1

THE MAJOR FINANCIAL STATEMENTS The major financial statements aim to provide an overall picture of the health of a company. They present the financial position and financial performance of a business. The three major statements are a) the Balance Sheet (also known as Financial Position Statement), b) the Income Statement (also known as the Profit and Loss Statement or Financial Performance Statement and the c) the Cash Flow Statement. The Balance Sheet shows the financial position of a company at a point in time. It presents what the business possess as assets, the amount it owes to outside lenders and the value of the business belonging to the owners of the business The Profit and Loss Statement presents the annual (or semi-annual, quarterly or monthly) performance of the company in generating profits for the business. The Cash Flow Statement explains the where the cash comes from and how it is used during the year. At this point, understand that the profit earned is not equal to the cash for the year.

2.2

PREPARING A SIMPLE BALANCE SHEET The balance sheet is made up of three major items. They are the Assets, the Liabilities and the Equity (also referred to as Capital) These 3 items form what we call the Accounting Equation. Assets = Liabilities + Equity (Capital) The Balance Sheet can be presented in the Horizontal Format or Vertical Format.

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The Horizontal Format

Liabilities Assets Equity (Capital) A=L+E The Vertical Format

Assets

Total Assets

Liabilities

Equity (Capital) Total Liabilities + Equity Now let us focus on each category. It is important that you know the definition of each category because this will enable you to place items into their respective group for presentation.

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Assets These are essentially a resources held by the company. To be an asset, the following characteristics should exist; a) A probable future economic benefit implies it is expected to generate some future monetary value b) Business has exclusive right or control over the benefit implies that while the business may not fully own the asset, it can use it to generate future monetary benefit for itself c) Economic benefit must arise from past event or transaction implies that a transaction or event must have occurred to allow the business to enjoy the benefit. d) It must be capable of being measured in monetary terms implies the possibility of placing a value to it. Note that assets can be either short term or long term. Accountants use one year (12 months) as the general accepted time frame for classifying assets as either short term (we call them Current Assets) or long term (Non-Current Assets) Current assets are basically assets that meet any of the following conditions: a) held for sale or consumption in the normal course of business operating cycle b) expected to be sold within the next year c) are held primarily for trading d) are cash or near cash items such as marketable short term investments Examples of current assets are cash, accounts receivables, inventory, prepayments etc. Non-Current Assets (also called Fixed Assets) are those that do not meet the conditions of a current asset. Generally speaking, they are held for long term operations. Examples of non-current assets are machinery, building, property, vehicles, fixtures etc. Most non-current assets have physical substance. This means that one can see and touch the assets. However, some assets do not have physical substance and we term them as Intangible Non-current assets. Examples of such assets are copyrights, goodwill, trademarks etc.

Liabilities and Equity (Capital) While the company has control of the assets (whether current or non-current), the financing came from the liabilities and equity (capital). Liabilities and Equity (Capital) are sources of financing provided by parties outside the business entity. These are the Claims by outside parties on the company. So a claim is an obligation on the part of the business to provide cash or some other form of benefit to these outside parties.

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Equity or Capital are the claims by the business owners. Why? The business owners are the ones who contributed either cash (most common) or personal assets into the company to start the business operations. Besides the owners, the business also has claims by third parties other than the business owners. We called them Liabilities. Liabilities must arise from past transactions or events such as supplying goods or lending money to the business. Once a liability is settled, it will normally be through an outflow of assets (usually cash) Like assets, liabilities are also classified as short term (current liabilities) or long term (non-current liabilities). Short term liabilities should meet any of the following criteria: a) they are expected to be settled within the normal course of the business operating cycle b) they are due to be settled within 12 months following the date of the balance sheet on which they appear c) they are held primarily for trading purposes d) there is no right to defer settlement beyond 12 months following the date of the balance sheet on which they appear Non-current liabilities represent amounts due to third parties but doe not meet the definition of current liabilities. Examples of current liabilities are account payables, unearned revenue (income), bank overdraft. Examples of non-current liabilities are long term loans, mortgage etc. A sample of a balance sheet in horizontal format Balance sheet as at 31 December 2009 $ Non-current assets Vehicles Premises Plant - cost 50,000 Less acc. depreciation (8,000) Current assets Inventories Trade receivables Cash at bank 30,000 46,000 42,000 Non-current liabilities Borrowings from Commercial Loan Company Current liabilities Trade payables 173,000 Capital Balance at 31 December 2009 $ 102,000

23,000 21,000 11,000

45,000

26,000 173,000

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Note: One can also present the current asset above the non-current assets, the liabilities above the capital. 2.3 ACCOUNTING CONVENTIONS AND THE BALANCE SHEET Accounting has a number of rules or conventions and we will focus on the following few listed below. Business Entity Convention this convention implies there is a legal separation between businesses and the owners. For limited companies, there is a clear legal distinction between the owners (investors) and the company. However, for sole proprietorship and partnerships, the law does not make any distinction. Historical Cost Convention indicates that the value of assets shown on the balance sheet should be based on their acquisition cost (that is, historical costs). Prudence Convention this convention holds that caution should be exercised when making accounting judgments. Example: Income is considered earned only when they actually occur and not when discussions are held. This convention allows reporting to be fairly presented for users. Going Concern Convention this convention indicates that the financial statements should be prepared on the assumption that the business will continue operations into the foreseeable future, unless this is known to be untrue. Dual Aspect Convention This convention asserts that every transaction will have two aspects and both will affect the balance sheet. Thus a purchase of a vehicle with cash payments will result in an increase in the non-current asset (a vehicle) but a decrease in the current asset (cash outflow). A settlement of a loan will result in a decrease in an asset (cash outflow) and a decrease in a liability (loan is settled and now owe the third party less). While accounting conventions exist, there will be circumstances where a firm may deviate slightly in order to present the financial statements in a manner for the investors can understand the firm better.

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Review Questions 1) Discuss the main characteristics of assets? What do we mean by current in the classification? The balance sheet indicates that there are two types of claims on the assets of a firm. What are the two types of claims and how are they different? Discuss two accounting conventions discussed in this session. Using a vertical format, prepare a balance sheet with the following information. Inventory Property Accounts Receivables Accounts Payables Vehicles Bank Loan Bank Overdraft Heavy Equipment $208,000 $350,000 $135,000 $180,000 $110,000 $200,000 $120,000 $150,000

2)

3) 4)

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Session 3 Measuring and Reporting Financial Performance At the end of the session, students should be able to: 1. Explain the nature and purpose of the profit and loss statement 2. Prepare a simple profit and loss statement 3. Understand the recognition and measurement of income 4. Understand main accounting convention for the income statement _____________________________________________________________________

3.1

THE NATURE AND PURPOSE OF THE PROFIT AND LOSS STATEMENT OR THE INCOME STATEMENT The purpose of the profit and loss statement is to measure and report how much wealth (in terms of profit) the business has generated over a period. We term this period as the accounting period and while is usually reported using a year, it can also be monthly, quarterly or semi-annually. What is accounting profit? Profit is the difference between revenue and total expenses for the accounting period under consideration. In short, the income statement is made up of the following 3 major items. Revenue Less Expenses Profit or Loss Revenue is the measure of the inflow of economic benefits arising from ordinary activities of the firm and Expenses are essentially the opposite of revenue. They measure the economic outflow of benefits arising from ordinary business activities. If the revenue is larger than expenses, the result is PROFIT which will increase the wealth of the owners and this amount will enhance (increase) the equity (capital) in the balance sheet. If the revenue is lesser than expenses, it will result in a loss which will reduce the total value of the equity in the balance sheet. Examples of revenues are sale of goods by a manufacturer, providing a service by a lawyer, subscriptions collected by a club or earning interests from an investment or bank deposit. Expenses can be further detailed into several groups. The first group is the Cost of Sales (sometimes referred to as Cost of Goods Sold). This will exist mainly for manufacturers or retailers. Then we have the Operating Expenses which are incurred to run the business. Examples of operating expenses are salary, rental, insurance, utilities, telephone and postage, printing and stationery. The following section shows the appropriate presentation.

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3.2

PREPARING A PROFIT AND LOSS STATEMENT The format of the statement takes the following form and it is important that you remember the format well. Revenue (Sales) Cost of Goods Sold Gross Profit Operating Expenses (e.g. salary, rental) Marketing Expenses (e.g. commission, advertisement) Administrative Expenses (e.g. postage, utility) Financial Expenses (e.g. interests expense) Operating Profit (Net Profit before Tax) Other Income (e.g. interests earned) Profit for the year

Less Less Less Less Less Add

From the format above, gross profit is the net earnings from sales after deducting the costs of the items sold. Profit for the year is the Operating income together with other income through activities which are not the normal day to day operations. For the sole proprietor or the partnership, the profit for the year is taxed at their marginal tax rate and thus taxes will not appear in the statement. The profits are then their residual earnings. This will increase the wealth of the owners. If the owners did not do any withdrawals from the earnings (i.e. not distributed back to the owners), the earnings amount will increase the equity (capital) values in the balance sheet. Cost of Sales (or cost of goods sold): If the cost of sales is not given, we can derive the cost of sales from other information provided. Illustration: On the 1st Jan 2009, the company has $30,000 worth of inventory which was purchased the year before. They are acquired for the purpose of trading to make a profit. During different months in 2009, the company purchased additional $75,000 worth of inventory. During the year, the accountant recorded each sale as it occurred. Inventories were exchanged for the sales. At the end of the year, a stock-count was conducted and the amount left in the warehouse is $29,000. What is the cost of goods sold? If the total revenue is $120,000, what is the gross profit? Thought process: The company has $30,000 worth of inventory at the beginning and it bought $75,000 more. This means that the company has a total of $30,000 + $75,000 = $105,000 worth of stocks on hand to sell during the year. Note that while the sales are recorded, the cost of the items sold were not. Firms usually do a stock-take at year end (can also be monthly or quarterly) which determines what is left in the warehouse. Those in the warehouse remains your assets and those that are not are assumed SOLD. Thus, the COGS is ($105,000 - $29,000) = $76,000. So the COGS = Beginning Inventory + Purchases Ending Inventory (Note: Beg Inventory + Purchases = Amount Available for Sale)

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Presentation of a Profit and Loss Statement Total Revenue (Sales) Beg Inv $ 30,000 Purchases $ 75,000 Less End Inv ($29,000) COGS Gross Profit 3.3 $120,000

$ 76,000 $ 44,000

RECOGNITION AND MEASUREMENT OF PROFIT In the profit and loss, the key issue is the measurement of profit and so it is important to the point where revenue is considered earned and when expenses are considered incurred. Recognizing Revenue There are three points where associated revenue could be recognized: a) at the time that the order is placed by the customer b) at the time the purchased item is collected by the customer (or services enjoyed by the customer) c) at the time the customer pays for the purchased item or services. While these points can be far apart, the main criteria for recognizing revenue are that: a) the amount of revenue can be measured reliably b) it is probable that the economic benefits will be received. c) Ownership and control of the items is passed to the buyer It is important to know that revenue is considered earned (realized) and must be recorded in the profit and loss statement when the above criteria are met. This means that even if cash is not paid yet, the revenue is earned as the items are collected by the buyer or the services are already provided. An example is a Credit Sale which is a completed sale but the client is allowed to pay at a later date. Recognizing Expenses The matching convention in accounting provides guidance concerning the recognition of expenses. This convention states that the expenses should be matched to the revenue that they help to generate.

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Example: A company incurred $50,000 of salesmen salary and commission in January to generate sales. Based on the matching convention, the salary must be deducted as expenses against the revenue generated when computing the profits earned. Note that we recognize the full amount as January expenses even if a portion of the salary or commissions are paid the following month. The above example will result in the expenses recorded in the profit/loss statement is more than the cash paid during the period. Accountants termed it as Accrued Expenses (Accrued payables). If the company pays $45,000 of the $50,000 in January, it would have owed the remaining $5,000. The records will show a $50,000 expense with a $45,000 outflow of cash payment and a $5,000 liability (accrued expense) in the balance sheet. Example: A company pays $12,000 for insurance premiums for the full year of 2009. This means that monthly insurance expense is $1,000. Based on the transaction, the cash outflow is $12,000. But the company cannot recognize the full $12,000 as January insurance expense immediately because it is for the full year and not January only. As the amount was paid in advance before the expenses are incurred, accountants termed these types of transactions as Prepaid Expenses (prepayments). For January, we will record $1,000 as insurance expense, $11,000 as Prepaid Expenses (Current Asset) and an outflow of $12,000 cash payments. 3.4 ACCOUNTING CONVENTION FOR PROFIT/LOSS STATEMENT There are several accounting convention required to calculate expenses that affect the performance statements. These affect the non-current asset like machinery and the current assets such as the inventory and the account receivables. We will consider them now. Depreciation Expenses Non-current assets like machinery, vehicles etc will last a long period while generating revenue for the firm. As they are used to generate the revenue, their values will decline due to usage, age, wear and tear. Accounting termed this decline in values for the non-current assets as depreciation expenses. Depreciation is defined as the rational allocation of cost over the period where the asset is used to generate revenue. Calculating Depreciation Expenses To calculate a depreciation charge for a period, four factors are considered: The cost (or fair value) of the asset includes the purchased price plus all costs incurred to make the asset ready for use. This includes delivery, installation, testing, legal costs etc. The useful life of the asset A non-current asset has physical and economic life. Physical life will be exhausted through the effects of wear and tear but economic life is decided by the effects of technology.

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The residual value of the asset this is the disposal value when the asset is no more required. Past sale value of similar assets can be a guide to estimating the residual value. The depreciation method we will discuss two methods listed below.

Depreciation Methods: Straight Line Method and Reducing Balance Method. The Straight Line method allocates the cost of the asset equally over the time it is used to generate revenue. It is based on the following formula: Depreciation Exp Per Year = (Cost of Asset Residual Value) / Useful life The Reducing Balance method uses a fixed percentage to calculate the yearly depreciation expense based on the reduced asset value at the beginning of each year. Example: An asset costs $40,000 and is expected to have a useful life of 4 year. The estimated residual value is $1,024. A fixed percentage of 60% is used for the reducing balance method. Calculate the depreciation expense per year under both methods. Using Straight Line, the depreciation expense per year will be ($40,000 -$1,024) / 5 = $9,744 per year So, the depreciation expense from years 2 to 4 will also be $9,744 per year. Using Reducing Balance method To use this method, one must determine the Net Book Value (NBV) of the asset at the beginning of each accounting period. The depreciation expense for each year is calculated by using the (NBV x fixed percentage). The NBV is the computed using (Cost Accumulated Depreciation) and Accumulated Depreciation is the total of depreciation expense incurred to date. NBV at Beg 40,000 16,000 6,400 2,560 Dep Exp (40,000 x 0.6) = 24,000 (16,000 x 0.6) = 9,600 (6,400 x 0.6) = 3,840 (2,560 x 0.6) = 1,536 Acc Dep 24,000 33,600 37,440 38,976

Year 1 Year 2 Year 3 Year 4

The final net book value (residual value) will be ($40,000 $38,976) = $1,024

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Costing Inventory It is important to know that different methods of costing inventory will result in different cost of goods sold and thus will affect the final profit or loss for the year. There are three cost flow assumptions used in computing cost of inventory. The first is First in, First Out (FIFO) assumption. This assumes that the earliest inventories are the first to be used. Note the concept here is focusing on the cost of the item and not the physical distribution of items to clients. The next is the Last In, First Out (LIFO) assumption. This assumes that the latest inventories bought or held are the first to be used first. This method, however, may not be accepted in practice. The last approach is the Weighted Average Cost (AVCO) method which used the averaging method to calculate the cost of each unit of inventory. Example: A business has the following stock information and sold 9,000 units during the year. Beginning Inventory First purchase Second purchase 1,000 units at $10 per unit 5,000 units at $11 per unit 8,000 units at $12 per unit

With 9,000 units sold, the ending inventory will be (Beg Inv + Purchases Units Sold) = End Inventory So the ending inventory will be 5,000 units. What is the cost of the 9,000 units sold? It depends on the inventory assumptions used. a) First In First Out Cost Flow Assumption Units sold first will be Beginning Inventory 1,000 x $10 = $10,000 Then the first purchase 5,000 x $11 = $55,000 Then 3,000 units of the last purchase 3,000 x $12 = $36,000 Total Cost of Goods Sold (FIFO) 9,000 units = $101,000 The ending inventory is from the last purchase that is not sold yet and is 5,000 x $12 = $60,000 b) Last In First Out Cost Flow Assumption Units sold first will be second purchase Then 1,000 units of the first purchase Total Cost of Goods Sold (FIFO) 8,000 x $12 = $96,000 1,000 x $11 = $11,000 9,000 units = $107,000

The ending inventory is 4,000 units from the first purchase and 1,000 in the beginning inventory. So the ending inventory cost is (4,000 x $11) + (1,000 x$10) = $ 54,000

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c) Weighted Average Cost (AVCO) First, find the average cost per unit. The total inventory cost = $161,000 The total number of units = 14,000 units So the average cost is $11.50 per unit Thus, the cost of goods sold is 9,000 x $11.50 = $103,500 And the ending inventory is 5,000 x $11.50 = $ 57,500 Trade receivables issues Businesses usually sell their products or provide services on credit. With this arrangement, there will be a volume of accounts receivables outstanding at each accounting year end. With the outstanding receivables, there are risks that customers may not settle the amounts due. When it becomes reasonable certain that the client will never pay, the debt owed is considered bad and must be written off in the income statement as bad debts expense. Since the accounts receivables cannot be collected anymore, it will have to be reduced in the balance sheet. Example: Current Accounts Receivables outstanding is $135,000. A client who owes $6,000 is determined a bankrupt. The accountant will record the $6,000 as bad debt expense (affect PL statement) and reduce the AR by $6,000 giving a final AR outstanding of $129,000. There is also the Allowance Method which estimates an amount of uncollectible in the coming year. The estimate can be based on outstanding AR or Sales. Example: Current AR outstanding is $135,000 at year end. The company estimates that 4% of the AR may be uncollectible in the coming year. Compute the bad debts and show the balance sheet presentation. Using 4%, the estimated bad debts is ($135,000 x 0.04) = $5,400 As in the above, the profit and loss will show $5,400 of bad debt expense. The balance sheet will be presented as follows: Accounts Receivables Allowance for trade receivables Net Account Receivables $135,000 ($ 5,400) $129,600

Note : Under the Allowance Method, the provision of $5,400 is shown as it is only an estimated amount and not a definite uncollectible. The AR is not directly reduced.

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Review Questions 1) What does the word income means in acccounting ? Discuss the condition of recognition. Explain the meaning of costs and differentiate it with the word expense in accounting. An equipment was purchased at the beginning of the year at a cost of $160,000. Straight line method is used and the equipment is expected to have a useful life of 15 years and residual value of $17,500. a) b) What is the depreciation for the first year? If the equipment is sold for $90,000 at the end of the sixth year, determine the profit or loss on the sale of the equipment.

2)

3)

4)

Ex 3.4 of recommended text.

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Session 4 Accounting for Limited Company At the end of the session, students should be able to: 1. Discuss the nature of the limited company 2. Explain the role of directors of limited companies 3. Describe the main features of the owners claim in a limited company 4. Explain how the income statement and the balance sheet of a limited company differ from other business structure _____________________________________________________________________

4.1 DISCUSS THE NATURE OF THE LIMITED COMPANY A limited company has features that do not exist in sole proprietorship or partnership. The following section will examine and discuss each feature of a limited company. Legal Nature: A limited company can be deemed to be an artificial person that has been created by law. This means that it has as many rights and obligations as a person and therefore can sue others or be sued by others, can enter into contracts in its own name. The owners of the limited company are considered as the shareholders (investors) and own the shares of the company. There are generally two types of shares ordinary shares and preferred shares. Perpetual Life: A business entity is considered to be an on-going concern unless proven otherwise. But unlike a sole proprietorship or a partnership that ends when the owner or a partner dies, a limited company is granted perpetual existence and will continue as an entity when a shareholder dies. This is possible as the shares of the deceased can be transferred to his/her beneficiaries. The ownership can also be transferred through buying and selling of the shares and these transactions will not affect the company status. Limited Liability: A sole proprietor or partners are personally responsible for the liabilities and claims on the business. The limited company as a legal person in its own right is also responsible for the third party claims. As it is legally separated from the owners of the shares, the liabilities do not extend to the personal assets of the shareholders. Once the shareholders agree to pay for the shares, their obligation to the company or its creditors are limited to the amount paid. While limited liability is a good feature for the shareholders, it is a disadvantage to those who may have claims on the company. Supplies for example would have to carefully consider the amount of credit extended to the limited companies as there will not be payments if the company pays only what is available within the organization. This is why some suppliers insist on cash payments or limit the credit limits. To limit their risks, lenders to the firms (suppliers or banks) can place restrictions on the ability of shareholders to withdraw their investment from the company. Example

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is to limit the amount of dividends paid to shareholders. Another procedure is to require limited company to present their annual statements and make them publicly available. This allows anyone interested to deal with the organization an opportunity to assess the firm before entering into any business relationships. Taxation: As a limited company, it will be accountable to the tax authorities for the taxes on their profits and gains. The profits earned are not tax to the shareholders at their personal marginal tax rates. 4.2 EXPLAIN THE ROLES OF DIRECTORS A limited company is a legal entity but it is not a human being capable of making decisions and running the operations on a daily basis. There is then the need to have individuals to undertake the management duties and planning. The most senior level of management is the Board of Directors. Who elect the board of directors? The shareholders will elect the board to manage the company on a daily basis on their behalf. Depending on the size of the limited company, the board can be one director to several directors elected. It is not necessary for the directors to be shareholders. Why the need for a board of directors? The owners (investors) of the firms owns the shares but are not personally involve in the running of the business or actively contributing to the strategic planning of the firm. As the control of the business activities are managed by senior management or managers, there is the need to have the board of directors to ensure the best interests of the owners are protected. While the objective is for the Board to protect the investors, this main objective may not be met in practice as the Board may pursue their own interests through high salaries or benefits in the form of perks. What are the guidelines to monitor directors? The guidelines and rules to monitor the directors are based on the following principles. a) Principle of Disclosures this is the heart of good corporate governance. Proper disclosures by board of directors on the firm and providing adequate and timely information about corporate performance will allow investors to make inform buy-sell decisions and help the market to value the firm under the current management. Thus, investing in made a little more transparent. b) Principle of Accountability This requires the directors to act in the best interest of the shareholders. They are not to use their position and knowledge of the firm to benefit themselves at the expense of the shareholders. They are also required to have the financial statements audited and report the performance of the entity in a true and fair manner. c) Principle of Fairness As the board of directors, they have privileged information on the firm. We deemed their status as insiders and having insider information, they can reap abnormal benefits at the expense of the shareholders.

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To ensure this does not happen, restrictions are placed on the board of directors ability to sell or buy the firms shares.

4.3 DESCRIBE THE MAIN FEATURES OF THE OWNERS CLAIM Similar to the balance sheet of a sole proprietor or a partnership, the EQUITY section represents the value owned by the shareholders. In the equity section of a limited company, the likely items shown are the Share Capital, the Reserves (or Retained Earnings). Let us focus on each of this independently. Share Capital: shares are the basic units of ownership of a business. Ordinary shares (OS) are usually issued and are known as equity. The number of ordinary shares issued will depend on a per-share value and the total amount of financing raised through ordinary shares. If a firm wants to raise $10,000 through ordinary shares, it will be to issue 10,000 shares if each share is $1/share, or issue 20,000 shares if each share is $0.50/share or just 1 share if the only share issued is $10,000 per share. Besides ordinary shares, some companies have preferred shares (PS) which are guaranteed a dividend payment when dividends are declared. They have priority claims above ordinary shares. This means that if the company liquidates, the preferred shares must be paid first before the ordinary shareholders are paid. Thus, the ordinary shareholders have higher risks in their ownership of the firm. The following show how the equity section of the balance sheet is presented. Equity Share capital: 100,000 shares at $1 each Share premium Revaluation Reserve Retained Earnings Total Equity

$100,000 $ 30,000 $ 40,000 $ 60,000 $230,000

Share Premium: While the share basic or par value is $1 each, the issued price can be higher resulting in a premium collected. Based on the above illustration, the premium per share is $0.30 ($30,000 / 100,000 shares) Reserves: The first type of reserves is the Retained Earnings which are the profits and gains that the company has made since its inception. As they are not distributed to the shareholders as dividends, they remain in the balance sheet. The reserves are the claims of the shareholders since the profits earned are for them. Do note that while reserves (retained earnings) can be reduced through dividend payments, it can also be

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reduced because the firm has losses instead of profits during the year. Earning related reserves are also classified as Revenue Reserves. A second type of reserve is known as Capital Reserve. It arises out of issuing shares at above their nominal or par value or a revaluation upwards of non-current assets. Revaluation Reserve occurs when the firm revalues the non-current assets upwards. This usually applies to property held by the firm. A share with a nominal value of $0.50 cents can be issued to the public at $0.70. If 10,000 shares are issued, the equity section with a revenue reserve of $2,000 will look as follows: Share capital 10,000 shares at 0.50 each Capital Reserve Revenue Reserve Total Equity Other issues related to share capital Stock split a stock split is basically breaking each share into smaller numbers. Example: a $1 share is split 5 for 1 implies that if I own 1 share before the split, I will be holding an equivalent of 5 shares at $0.20 per share. Note that the total value I own still remains at $1.00 Cash Dividends firms usually pays cash dividends on a yearly basis and this is the normal inducement to attract investors. To distribute cash dividends, the firm must have strong cash flows to initiate the payment. Cash dividends, however, can only be paid out of revenue reserve (thus reducing the amount) and not from the capital reserves in the balance sheet. Bonus shares firms usually pays cash dividends to their shareholders. However, some firms can give bonus shares instead of cash as dividends. In this case, the number of shares in the market will increase. Like cash dividends that reduces the revenue reserves, bonus shares also affect the revenue reserve in the same way.

$5,000 $1,000 $2,000 $8,000

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4.4 HOW THE INCOME STATEMENT AND BALANCE SHEET DIFFER FROM OTHER BUSINESS STRUCTURES Generally, the financial statements are of limited companies are based on the same principles as those of the sole proprietor or partnership. There are some differences which we will highlight below. The Income Statement: The income statement has three measures of profit displayed after the gross profit. They are the operating profit, the net profit before tax and the net profit after tax (or net profit for the year) There is also the audit fee and the corporation tax on the profits for the year Example of presentation: Revenue Cost of sales Gross Profit Administration expenses Distribution expenses Net Profit before tax Taxation Net Profit after tax Attributed to: Equity holder of the parent Minority interest $123,000 ($56,000) $ 57,000 ($28,000) ($ 9,000) $ 30,000 ($ 12,000) $ 18,000

$ 16,000 $ 2,000

The net profit after tax is split between the parent company and minority interest (if it exists). The Balance Sheet: While the assets and liabilities are similar to the sole proprietorship and partnerships, the equity section has more detailed items. Instead of just capital, the share capital, the revenue reserves and the capital reserves are shown. Unlike the sole proprietorship and partnership, payment of dividends will not appear as drawings in the equity section for the limited company. This is because it is summarized in the Statement of Changes in Equity. Statement of Changes in Equity. Beginning Retained Earnings 1/1/2010 Net Profit after tax for the year ended 31/12/2010 Dividends declared Ending Retained Earnings 31/12/2010 $100,000 $ 50,000 ($ 20,000) $ 30,000

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Review Questions 1) 2) 3) Limited liability is the key feature of a limited company. Is it necessary an advantage? Discuss the guidelines and rules that govern the actions of directors. A firm has 50,000 shares at $1.00 each. During the initial issue, a premium of $0.20 per share is collected. For the first year, the gross profit is $80,000 which is 40% of sales. The operating expenses are 35,000. The tax rate is 20%. In the middle of the year, there is a stock split of 1:2. A property the firm owns was revalued upward by $30,000. At year end, there is a dividend of $0.30 per share declared and paid. Present the Income Statement and the Equity Section of the firm 4) Differentiate between bonus shares and cash dividends. Explain how the balance sheet will be affected.

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Session 5 Reporting for Limited Company At the end of the session, students should be able to: 1. Describe the responsibilities of directors and auditors concerning the annual financial statements provided to shareholders and others. 2. Outline the statutory regulations surrounding accounting for limited companies. 3. Outline the non-statutory regulations surrounding accounting for limited companies. 4. Prepare an income statement, balance sheet and statement of changes in equity for a limited company in accordance with International Financial Reporting Standards _____________________________________________________________________ 5.1 DESCRIBE THE RESPONSIBILITIES OF AUDITORS AND DIRECTORS Shareholders while owning the firm through their shares do not get involve with the day to day operations of the companies. The appointed directors are to act in the interests of the shareholders. The separation of ownership and control requires this appointment. Stewardship is the prime responsibilities of the directors. The law requires the directors to (a) maintain appropriate accounting records and (b) prepare annual financial statements with a directors report and (c) make these reports available to the shareholders and the public. To maintain accounting records, the need for a framework of rules regarding how statements should be prepared is required. While accounting framework assists in making statements comparable and understood by users, directors can adopt policies and practices that present an unrealistic position of the company. Regulations cannot possibly eradicate all manipulations or concealment of truths but can, at least, reduce the possibility. To enhance understanding and to help investors appreciate accounting reports of different companies across different countries, the trend towards international harmonization on reporting prevails. These rules, known as International Accounting Standards or International Financial Reporting Standards, deal with the following key issues: what information should be disclosed how information should be presented how assets should be valued how profit should be measured The responsibility of the auditors is to report whether in their opinion, the financial statements presents a true and fair view of the firm according to the relevant accounting rules and policies.

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To make such an opinion, auditors are to scrutinize the statements and the evidence upon which they are based. Their opinion and statement must be in the financial statements presented to the shareholders and the Registrar of Companies. While the directors are elected by the shareholders to give account of the company, the auditors are elected by the directors to give an independent view of the firm to the shareholders. 5.2 STATUTORY REGULATIONS FOR LIMITED COMPANIES The auditors report provides and opinion by an independent auditor concerning whether the financial statements provide a true and fair view of the financial health of the business. They are to present an independent view of the firm to the shareholders. The directors report contains information of both financial and non-financial nature which goes beyond that contained in the financial statements. Some information may be details of the directors, their financial interests in the firm, employment policies or donations etc. The auditors do not audit the directors report.

5.3

NON-STATUTORY REGULATIONS FOR LIMITED COMPANIES Segmental reports disaggregate information on the financial statements to help users better understand the information contained in the statements. Segment reports can be classified according to products or services and according to geographical regions. IASB requires listed companies to disclose segment information according to each business unit and to each geographical region. Why is the business segmentation of the reports important? This is important to users as it is a part of the business that can be separately identified and which provides a certain product or services or a group of product or services. Why is geographical region important? Like business segment, a geographical region also is a separately identified area where a particular product or service is provided under certain economic environment. Region can be a country or a group of countries. Basis of reporting: To report a business segment or a region, it must be of a significant size. A 10 percent or more of the businesss revenue, operating income or total revenue is used to determine whether a segment is considered significant. Directors are to decide whether the report is to be presented based on the products or services offered or based on the geographical region. The one that has greater impact is the primary segment. This shows the risks transparently and the users can assess the company accordingly.

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Segmental Disclosures: The standards require the following items to be presented: Revenue separate revenue from external customers and revenue from other segments Total Assets Capital Expenditure for the period Depreciation, impairment losses and other non-cash items Segment operating results Total Liabilities 5.4 PREPARING THE INCOME STATEMENT, THE BALANCE SHEET AND THE CHANGES IN EQUITY FOR A LIMITED COMPANY According to the International Accounting Standard IAS 1, Presentation of Financial Statements, the financial statements consists of (a) an income statement, (b) a balance sheet, (c) a statement of changes in equity (d) a cash flow statement and (e) notes on accounting policies and other explanatory notes. To do all the above, the overriding requirement is for the financial statements to provide a true and fair view of the companys financial performance, position and cash flows. The IAS presumes this will be achieved if statements are drawn based on the IAS standards issued. Only under unusual circumstances, the standards do not result in a fair presentation of the company. Besides the true and fair view, there are other contrasting considerations in preparing financial reports. These include the concept of relevance, the feature of timeliness of information, the degree of details required and the quality of understandability of financial data. The financial report preparation process largely depends on who are the users and why the report is being prepared. Thus, some trade offs will inevitably be required to meet the needs of the users. The Income Statement: The IAS sets out the minimum that must be reported on the face of the income statement. The items include: Revenue, Finance costs, gains or losses on sale of assets, settlements of liabilities arising from discontinued operations, tax expenses and profit or loss. There are two recommended ways to present expenses. They can be presented according to their natures e.g. interests, salaries, depreciation or their function e.g. marketing costs, financial costs, selling costs, administrative costs etc. The standards also require separate disclosure of material items. Material items are those will affect the decision of an investor. They do not have to be on the face of the income statement and can appear as notes to the financial statements. Examples of material information that require separate disclosures are: write-down of inventories to net realizable value
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write-down or disposal of property, plant or equipment disposal of investments restructuring costs discontinued operations litigation settlements

The Balance Sheet The IAS does not have a prescribed format for the Balance Sheet but state the minimum information required. This includes the following: Property, Plant and Equipment Investment Property Intangible assets Financial assets Inventories Trade and other receivables Cash and cash equivalents Trade and trade payables Provisions Financial liabilities not included in the above Tax liabilities Issued share capital and reserves

Assets and liabilities normally are presented in their Current and Non-current format in the balance sheet. However, the firm is also permitted to present the assets and liabilities according to liquidity if it considers that this format presents a more reliable and relevant position of the firm. The Statement of Changes in Equity This statement is useful for users to understand the changes in share capital and the reserves that took place during the accounting period. As capital and reserves can be increased or decreased, this statement reconciles the beginning balance to the closing balance of the year. While the income statement shows the realized gains and losses, there are unrealized gains and losses that do not go through the operating income. Example of unrealized gains and losses are currency exchange effects. A firm can revalue the assets, e.g. a property, upwards or downwards and asset revaluation reserve is affected in the equity. You are encouraged to access the audit report of a listed company on the stock exchange and understand how the equity section of the balance sheet is presented for investors. The Cash Flow Statement The IAS 7 states the requirements for presenting the cash flow statement. This statement explains how the firm generates or access funds and how it uses the cash

35

during the accounting period. Thus, it helps the users to access the liquidity of the firm. The details workings of the statements will be covered in detail during the next lecture. Besides the above, explanatory notes also help users to understand the financial statements. Explanatory notes normally contain the following information: a statement that the financial statements comply with the relevant IFRS summary of the measurement bases and accounting policies used. Supporting information to the three major statements Other disclosures e.g. future contractual obligations not recognized yet or managements objectives and policies

Review Questions
Source : Eddie McLaney and Peter Atrill (2008), Accounting : An Introduction, NJ: Pearson Education.

1)

The size of annual financial reports published by listed companies has increased steadily over the years. What are likely reasons that cause this apart from the increasing volume of accounting regulations? What problems are likely to be encountered when preparing summary financial statements for shareholders? Prepare an income statement according to the requirement of IAS. Interest payable Cost of sales Distribution costs Revenue Administrative costs Other expenses 40,000,000 460,000,000 110,000,000 943,000,000 212,000,000 25,000,000

2)

3)

The corporate tax is 25% of the profits available to the shareholders. 4) Visit www.sgx.com and select a company that has segment reporting. Present a brief summary of the company. Explain the purpose of the auditors report and the directors report in the financial statements

5)

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Session 6 Measuring and Reporting Cash Flows At the end of the session, students should be able to: 1. Explain the role of cash in an enterprise 2. Explain the nature of the cash flow statement and its usefulness 3. Prepare a simple Cash Flow Statement 4. Interpreting a Statement of Cash Flows _____________________________________________________________________ 6.1 THE ROLE OF CASH IN AN ENTERPRISE While cash is a current asset and is like any other assets the company has, it is critically important as it allows the company to function well. With all purchases, cash is required for payments. Suppliers who are unfamiliar with the firm will require cash for transactions. Even it credit is given, the time frame will be short and cash will still be needed to meet obligations. Thus, the use of cash is transactional. When unexpected opportunities occur, the firm can only take advantage of them if cash is required for payment and the firm has sufficient funds at that point. Cash allows the firm to be sustainable and most businesses failed because of cash flow problems. 6.2 THE NATURE OF THE CASH FLOW STATEMENT AND ITS USEFULNESS The cash flow statement summarizes the cash receipts and payments over the period concern. It explains the firms sources of cash and how they are used during the year. The net cash flow which is the total receipts less the payments explains the change in the cash position for the year. This figure is the reconciling amount between the beginning cash and the ending cash in the balance sheet. This will be illustrated later. The accounting standards define cash as notes and coins on hand and deposits in banks. Cash equivalents are short-term, highly liquid investments that can be easily converted to cash without significant changes in values. Cash equivalents are held for the purpose of meeting short term obligations and not for long term investments. The cash flow statement focuses on the receipts of cash from sales and other income and payments of cash to creditors and for operational expenses. It is different from the principle of accrual where revenues are recorded when earned and expenses are recorded when incurred. 6.3 A SIMPLE CASH FLOW STATEMENT The standard cash flow statement consists of three main sections. They are Cash Flow from Operating Activities, Cash Flow from Investing Activities and the Cash Flow from Financing Activities. The individual subtotal of each of the sections may be positive or negative depending on the flow of cash.

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The total of the three sections shows the net increase or decrease in cash and cash equivalents over the period.

Cash Flow from Operating Activities: Operating activities are the transactions that attempt to increase the profits of the company. Therefore, revenue and expenses which result in receiving cash or payment of cash will be included in this section of the cash flow statement. Note that this section records the amount of cash received from sales or accounts receivables and not the actual sales recorded. Likewise, the cash paid for operational costs is determined here. As operating activities will affect the current asset or current liability, the balance sheet is out source of working out the cash flow. This section is generally presented in the following format: Net Profit before tax Add back non cash expenses (e.g. depreciation, bad debts) Add back loss on sale of NCA Minus gain on sale of NCA XXX XXX XXX (XXX)

Changes in Current Assets (e.g. AR, Inventory, Prepayments) If CA increases from last year to this year (XXX) If CA decreases from last year to this year XXX Changes in Current Liabilities (e.g. AP, Accrued Expenses) If CL increases from last year to this year XXX If CL decreases from last year to this year (XXX) . Net cash flow from Operating Activities XXXXX

Cash Flow from Investing Activities: This section focus on cash used to pay for acquiring non-current assets and cash received from the sale of non-current assets. So, if the company purchases a $10,000 machine, we will be recording the $10,000 as a cash outflow. If an equipment costing $35,000 and net book value of $7,000 was sold for $5,000, the cash received from the sale i.e. $5,000 will be recorded as cash inflow. The $2,000 loss on the sale ($5,000 - $7,000) is not cash and will not be considered in the cash flow statement here. Cash Flow from Financing Activities: Financing activities focus on how the firm raise funds or settle their long term obligations. Firms can raise funds through noncurrent liabilities (e.g. long term loans) or issue new shares (where investors pay cash for the shares). These are inflow of cash.

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Repayment of loan results in cash outflows. Similarly paying dividends is another cash outflow and it is considered as a financing activity since it is a return of cash to the investors. Note that while a $10,000 dividend may be declared, the cash paid may be different if $2,000 is recorded as dividend payable. In this case, the actual cash paid for dividends is only $8,000

Example: Preparing a simple cash flow statement 31 Dec 2010 $ 91,000 90,000 62,000 12,000 90,000 320,000 (92,000) 573,000 38,000 200,000 240,000 95,000 573,000 31 Dec 2009 $ 20,000 65,000 58,000 10,000 80,000 280,000 (60,000) 453,000 35,000 160,000 210,000 48,000 453,000

Cash Accounts receivable Inventory Prepaid Expense Premises Plant and machinery Accumulated Depreciation

Accounts Payable Mortgage loan Share Capital Retained Earnings

Additional information: There was no disposal of premises during the year. A machine costing $50,000 with accumulated depreciation of $20,000 was sold for $25,000. Net Profit for the year after interest and tax was $117,000. Mortgage loan of $25,000 was settled through issue of shares. A dividend of $70,000 was paid during the year.

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Solution: ABC Ltd Statement of Cash Flows For the year ended December 31, 2010 $ Cash flows from operating activities: Net income 117,000 Adjustments to reconcile net income to net cash flow from operating activities: Depreciation 52,000 Loss on sale of machine 5,000 Changes in current operating assets and liabilities Increase in accounts receivables (25,000) Increase in inventories (4,000) Increase in prepaid expense (2,000) Increase in accounts payable 3,000 Net cash flow from operating activities Cash flow from investing activities: Cash paid for purchase of premises Cash received from sales of machine Cash paid for purchase of machine Net cash flow used for investing activities Cash flows from financing activities: Cash received from sale of common shares Cash paid for dividends Cash received from mortgage loan Net cash flow provided by financing activities Increase in cash Cash at the beginning of the year Cash at the end of the year (10,000) 25,000 (90,000) (75,000) $

146,000

5,000 (70,000) 65,000 0 71,000 20,000 91,000

6.4 INTERPRETING A CASH FLOW STATEMENT The cash flow statement tells us how the business has generated cash during the period and where the cash has gone. Thus, the statement tells us the lifeblood of the company. Understanding and interpreting the cash flows allow one to make judgments about the future behavior of the firm.

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Using the above example, we can see the following: The cash flow from operating activities of $146,000 is strong. This indicates that while there are increases in accounts receivables and inventories, the firm is still collecting most of the sales and managing the payment of operational expenses very well. The cash flow from investing activities of ($75,000) should not be a large concern as the information shows that company is renewing their non-current assets for future growth. While there is no indication of business expansion, renewal of assets is a positive sign. The cash flow from financing activities with zero effect shows an increase in funding through loans and most of the amounts were used to fund the dividend payments. Overall, the company is healthy with an overall net increase of $71,000 Review Questions 1) 2) In accounting, there are non-cash transactions. Give examples. A business owner cannot understand the low amount of cash balance at the end of accounting period when there are high revenues and profits reported in the income statement. Explain the apparent discrepancies Which segment of the cash flow statement is affected by the following transactions? a) b) c) d) e) f) g) h) 4) Depreciation expense for the year Purchasing of a new equipment Issue dividends through bonus shares The bank extends another $100,000 loan to the firm Selling an old asset at a gain of $5,000. The selling price is $50,000 Accounts receivables decrease by $10,000 The firm issue new shares in exchange for a piece of land Decrease in accounts payable by $7,000

3)

Aquatech Pte Ltd is a supplier of water purification equipment for home and commercial use. The company is in an aggressive expansion program and will continue to expand if adequate financing can be obtained from its bank. The companys balance sheets for the last 2 years are as follows:

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Balance sheets December 31, 2009 and 2010 Assets Current Assets Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Plant and equipment Less accumulated depreciation Net plant and equipment Goodwill Total Assets Liabilities and Stockholders Equity Current Liabilities Accounts payable Accrued Liabilities Total current liabilities Long term debt Shareholders equity Common stock Retained earnings Total stockholders equity Total Liabilities and stockholders equity 2010 (9,000) 140,000 300,000 7,000 438,000 700,000 180,000 520,000 42,000 1,000,000 2009 21,000 100,000 250,000 9,000 380,000 620,000 150,000 470,000 50,000 900,000

190,000 10,000 200,000 100,000

163,000 17,000 180,000 90,000

300,000 400,000 700,000 1,000,000

285,000 345,000 630,000 900,000

The companys income statement for the year ended 2010 is given below: Sales $1,500,000 Cost of goods sold 900,000 Gross margin 600,000 Operating expenses 510,000 Net income $ 90,000 The following additional information is available for 2010. Equipment that had cost $60,000 new and on which there was accumulated depreciation of $42,000 was sold for its book value of $18,000. The goodwill is being amortized against earnings. The company declared and paid $35,000 in cash dividends. After seeing the negative position in Aquatechs cash account, the companys bank asked for a cash flow statement in order to determine why cash dropped so sharply during the year. You are to prepare the statement for the bank.

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Session 7 Analysis of Financial Statements At the end of the session, students should be able to: 1. Establish the usefulness of financial ratios to various interest groups 2. Identify the major categories of ratios 3. Calculating ratios and explaining their significance 4. Explain the importance of gearing to an enterprise and owners 5. Limitations of ratios _____________________________________________________________________ 7.1 ESTABLISH THE USEFULNESS OF FINANCIAL RATIOS While different users may have different needs, financial ratios can be used to examine various aspects of the performance and position of companies and are widely used in planning and control purposes. Ratios provide a quick and simple way to assess the health status of firms. This allows users to use them without requiring too much of in-depth knowledge. Ratios also allow users to compare companies of different industries as well as size of establishments. It uses a common denominator for comparison. Example, the revenue in dollar may vary a lot but using percentages make all amounts relatively comparable. Ratios can be presented in different form percentages, ratio or number of times relative to a key figure. The only requirement is consistency in usage so that reasonable comparison can be achieved. 7.2 THE MAJOR CATEGORIES OF RATIOS Ratios are grouped into categories with each relating to a particular aspect of financial performance or position. There are five broad categories as follows: Profitability Ratios since businesses exist for profits, these ratios provide insights the firms success in achieving its primary goal. The expressed profits in terms of other key figures in the financial statements Efficiency Ratios as assets are invested to achieve the primary goal of profit making, these ratios analyze how efficient is the firm in using the assets or resources within the organization. They are also referred to as activity ratios. Liquidity Ratios firms collapse when they become illiquid. The liquidity ratios examine the ability of the firm to pay their obligations when they are due and show the relationship of liquid assets to liabilities. Financial Gearing Ratios a firm gets its financing source from shareholders (owners of business) and outside parties in the form of loans. This result in the

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relationship between liability and equity term as leverage or gearing. The level of gearing shows the extent the firm borrows and with higher leverage, there are higher risks. Investment Ratios these are concern with assessing the returns and performance of shares in a particular business.

Different users will have different needs and thus the analyst need to be clear who are the target users and why they need the information. We will consider the computation of the ratios in the next section. 7.3 CALCULATING RATIOS AND THEIR SIGNIFICANCE To understand the ratios, their computations and the interpretations, we will use the following statements as illustration. All figures are from the statements.

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Balance Sheet of Amazing Action Pte Ltd As at 31 December (amounts in thousands) 31-Dec-08 Current Assets Cash Accounts Receivables Inventories Prepayments Total Current Assets Non-Current Assets Land and Building Machinery Equipment Total Non-Current Assets Total Assets Current Liabilities Accounts Payables Accruals Total Current Liabilities Non Current Liabilities Long Term Loan due 2013 Total Liabilities Equity Share Capital ($1 par) Retained Profits Total Equity Total Liabilities and Equity 31-Dec-09

18 32 24 28 102

12 32 60 4 108

290 70 100 460 562

290 82 100 472 580

35 7 42

17 3 20

160 202

160 180

200 160 360 562

200 200 400 580

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Profit and Loss Statement of Amazing Action Pte Ltd For the years ended 31 December (amounts in thousands) 31-Dec-08 Revenue less Cost of Goods Sold Gross Profit Selling Expenses Administrative Expenses Operating Profit Interest Cost Profit before tax less tax Net Profit Dividends declared Other information Market Price per share Average Credit Purchases Number of employee Cash flow from operations 380 227 153 68 31 54 18 36 5 31 16 31-Dec-09 415 235 180 66 30 84 14 70 10 60 20

$1.60 255 1250 100

$1.85 280 1350 125

Profitability Ratios: The 4 basic profitability ratios are return on shareholders funds, return on capital employed, gross profit margin and operating profit margin. Return on shareholders funds Profit for the year less preference dividend (if any) x 100 Average [ Ordinary share capital + Reserves ] = $60 / ($ 360 + $ 400) = 15.6% This ratio implies that for each dollar invested, the return is $0.156 cents per dollar. Return on capital employed Operating profit x 100 . Average [Share capital + Reserves + Non-current liabilities]

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= $60 / ($ 562 + $ 580) = 10.5% The computed ratio of 10.5% means that for each dollar invested, the firm is able to generate $ 0.105 cents of operating profit. Gross profit margin Operating profit x 100 Sales revenue = $84 / $415 = 20.2 % For a firm, one would naturally prefer this number to be large. At 20.2%, the firm is having a $0.202 cents return for every dollar sale generated. Operating profit margin Gross profit x 100 Sales revenue = $180 / $415 = 43.3 % The gross profit is computed by deducting the cost of goods sold. So a high 43.3% implies that for each dollar of sale, the net after cost of sale is $0.433 cents per dollar. The higher the figure is naturally better for the firm. Efficiency Ratios the efficiency ratios measures how well the resources are used and thus the basic efficiency ratios are average inventory turnover period, average trade receivables turnover period, average trade payables turnover period, sales revenue to capital employed and sales revenue per employee. Average Inventories turnover period Average inventories held x 365 Cost of sales = ($24 + $60) / $235 x 365 days = 65.23 days This ratio measures how long the firm is keeping its raw material, work in process or finished goods before selling them. The longer the time frame implies slow moving stocks. Average settlement period for trade receivables Average Trade receivables Credit sales revenue x 365

= ($32 + $32 ) / $415 x 365 days = 28.14 days This ratio computes the number of days before an accounts receivable is collected. The firm will prefer shorter time frame as it means they are collecting

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faster from the customers, have better cash flow and avoid possibility of bad debts. Average trade payables turnover period Average Trade payables x 365 Credit purchases = ($35 + $17) / $280 x 365 days = 33.89 days Cash flow is affected by how fast the firm pays others too. While we prefer to collect our accounts receivables fast, paying suppliers is managed for cash flow purposes. Having a very long payable turnover period can be bad for the firms reputation too. Sales revenue to capital employed Sales revenue Share capital + Reserves + Non-current liabilities = $ 415 / $580 = 71.6 % The firm gets its funds from long term liabilities and shareholders equity. This ratio measures how much sale for each dollar of financing raised by the firm. In the above computation, every dollar of financing can generate $0.716 cents of revenue. Sales revenue per employee Sales revenue Number of employees = $ 415 / 1350 employees = 0.307 per employee The sales revenue per employee ratio measures efficiency of staff in generating sales for the firm. Liquidity Ratios the 3 fundamental liquidity ratios are the current ratio, the quick ratio and the operating cash flows to maturing obligations. Current ratio Current assets Current liabilities = $ 102 / $ 108 = 0.94

The current ratio measure the ability of the firm to pay off its short term liabilities when they become due. In the above computed ratio, the firm has only 0.94 cents

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of current asset to back each dollar of liability. We prefer the figure to be greater than 1. Quick ratio Current assets (excluding inventories and prepayments) Current liabilities = ($ 18 + $ 32) / $108 = 0.463

The quick ratio is very similar to the current ratio in the purpose of measure. However, it only considers the liquid current assets. Thus, the less liquid current assets like inventories and prepayments are ignored.

Operating cash flows to maturing obligations Cash generated from operations Current liabilities = $ 125 / $108 = 1.19 This ratio compares the amount of cash generated from operations to the current obligations. Since the firm will need cash to pay off the liabilities, the cash generated from operations is the basic source of funds. Financial Gearing Ratios Gearing ratios measures the contribution of long term lends to the long term capital structure of the business. With gearing, there are interest costs. Thus, the two basic ratios are gearing ratio and the interest cover ratio. Gearing ratio Long-term (non-current) liabilities x 100 Share capital + Reserves + Long-term (non-current) liabilities = $160 / $580 = 0.276 The firm needs to be constantly aware of the sources of funding. Having too much long term debt would be over leveraging and risky for the firm. This ratio shows the relationship of long term debt to total funding. One would prefer this figure to be less than 50%.

Interest cover ratio Operating profit Interest payable = $ 60 / $14 = 4.29

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Interest cover ratio shows the ability of the firm to pay off the interest incurred in the borrowing process. Based on the figure computed, it implies that the firm has 4.29 years of operating income to pay off the interest incurred. Investment Ratios these for investors to assess the return on their investments. The basic ratios are dividend payout ratio, dividend yield ratio, earnings per share, price earnings per share and operating cash flow per share. Dividend payout ratio Dividends announced for the year Earnings for the year available for dividends = $20 / $60 x100 = 33% All shareholders look forward to dividends. The payout ratio indicated what percentage of each years earnings is distributed to the shareholders. Dividend yield ratio Net Dividend per share/(1 tax rate) x 100 Market value per share = 0.10 per share / $1.85 x 100 = 5.4 % This ratio calculates the yield for holding the shares. It is similar to the return of investment measurement. Where gross dividend per share = $20 / 200 shares = 0.10 per share. Note that the numerator is to convert net dividend to gross dividend. As the dividend is applied at gross value, there is no need to further divide it by (1 tax rate) again. Earnings per share Earnings available to ordinary shareholders Number of ordinary shares in issue = $60 / 200 shares = $ 0.30 per share The earnings per share measures the net earnings available to each share after paying the operating expenses, the interests, the taxes and the preferred share dividends. This shows the residual value belonging to the equity owners. Price earnings per share Market value per share Earnings per share x 100

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= $1.85 per share / $ 0.30 per share = 6.16 This ratio shows the relationship between the current market share price to the earnings per share. A high PE indicates potential future growth prospects of the firm. Operating cash flow per share Cash generated from operations less preference Number of ordinary shares in issue $125 / 200 shares = $0.625 per share dividend (if any)

While not often used, this ratio shows the cash flow generated from the business operations on a per share basis. 7.4 IMPORTANCE OF GEARING TO AN ENTERPRISE AND OWNERS A firm gets its sources of funds from either the owners or from other lenders. A firms level of gearing is the extent to which the firm is required to pay a fixed return to the lender. This is an important factor to consider in assessing its risk. The fixed payment is the interest on the borrowing and if cash-flow if not properly managed, the firm will enter into liquidity problems. With the risks, why do firms still want to borrow? First, it could be because the firm lacks funds and need to borrow from others to adequately finance the firm. Second, gearing can provide returns to the owners when the cost of funds is lower than the return generated. The following example shows three firms with different levels of gearing. every firm, despite different gearing, makes $60,000 net operating profit on the same $400,000 asset means return of assets are the same at 15%. However, the return on equity is larger for firm (b) and (c) as the gearing increases. When the return is greater than the interest costs, the returns to equity becomes larger and benefit the owners.

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Equity Debt Total Assets Debt/Equity ratio Net operating Income Interest (at 10%) Net Income Return on Assets
Return on Equity EPS

(a) All equity $ 400,000

(b) 50% debt 50% equity 200,000 200,000

(c) 75% debt 25 % equity 100,000 300,000 400,000 3:1 60,000 30,000 30,000 15% 30%
EPS =0.30

400,000 0 60,000

400,000 1:1 60,000 20,000

60,000 15% 15%

EPS =0.15

40,000 15% 20%

EPS =0.20

7.5 LIMITATIONS OF RATIOS While ratios are easy to understand or use, users must be aware of their limitations and constraints. a) Quality of underlying statements: The quality of the ratios largely depends on the quality of the statements upon which they are relying on for comparison. Thus, a misleading statement will not lead to useful financial ratios for decision making purposes. b) Effects of inflation: The financial statements are based on historical basis. Inflation will cause assets to be of less value and expenses will be relatively understated when comparing one year with another. c) Restricted vision of ratios: Ratios are discrete in the computation and interpretation. It is thus important for users to recognize the importance of using several ratios to assess the firm. d) Basis of comparison: Ratios do not take into account the differences in companies. No two firms are alike in size, in number of years in operation or the variety of products/ services. This will make the basis of comparison questionable. There is also the differences in accounting policies e.g. depreciation, inventory methods. e) Snapshot of a firm: Ratios that uses the balance sheet only present the position of the firm on that date but it will not reflect the firm throughout the year or the coming year. Firms with seasonable business are likely to have end the financial

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year with lower activity. Thus, their trade receivables or inventories are likely to be low showing little liquidity.

Review Questions 1) 2) What are the advantages of debt financing for a firm? A newbie to accounting who just learnt ratio is applying them to a financial report. What will you caution this person on the limitations of ratios? What do profitability ratios explain? Do Ex 7.3 from the recommended text. Select a listed company on the stock exchange and read its report. Provide an analysis of the ratios you have covered in this session.

3) 4) 5)

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Session 8 Budgeting At the end of the session, students should be able to: 1. Define a budget and show how budgets and corporate objectives are related 2. Explain how various budgets within a business interlink 3. Appreciate the uses of budgets and constructing various types of budgets 4. Discuss the criticisms of budgets _____________________________________________________________________ 8.1 BUDGETS AND CORPORATE OBJECTIVES A budget is a business plan for the short term typically one year. It is likely to be expressed in financial terms and the role is to convert the strategic plans into actions for the immediate future. Since budgets are plans the business wants to achieve, the managers who are involved are aware of the direction and will be more likely involve themselves to achieve the corporate goals. The development of plans involves the following key steps: Establish mission and objectives a mission statement states the broad objective of the business Undertake a positive analysis this assess the current position, where the firms wants to be based on the mission and objectives Identify and assess the strategic options this defines the ways the firm wants to move from where it is now to where it wants to be in the future Select the strategic option this involves selecting the best action plan and formulating a strategic plan. The process will include all the different budgets the firm has to co-ordinate closely for success Perform, review and control feedback via comparing actual outcome from budgets (goals) will allow managers and top management to assess what has gone wrong, what was done right and have greater control for future successes. Budgets can be prepared on a periodic or continual basis. Periodic budget is prepared for a particular period e.g. once a year. This is done once a year and managers allow the budgets to run its course. It may be necessary to revise the periodic budget occasionally. Continual budgets (also known as rolling budgets) are continually updated. A company can plan a 12 month budget and as each month passed, a new month is planned to replace the month that has just passed. This ensures that the firm is constantly looking at a 12-month target plan at all times. Management may review the budgets when necessary.

Since budgets are critical to a firms success, it is usually approached in a methodical and formal manner. The budget setting process involves the following steps:
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Step 1: Establish who will take responsibility Step 2: Ensure communication of budget guidelines to managers Step 3: Identify the key or limiting factors Step 4: Prepare the budget for the area of the limiting factor Step 5: Prepare the draft budget for all other areas Step 6: Review and co-ordinate budgets Step 7: Prepare the master budget Step 8: Communicate the budgets to all interested parties Step 9: Monitor actual performance and compare with budget 8.2 THE DIFFERENT TYPES OF BUDGETS IN A FIRM A firm will prepare more than one budget for a particular period. Each budget relates to a specific area of the business the sales manager will prepare the sales budget while production manager will plan the production budget to meet the sales requirement. The HR manager will plan the human resource requirements while approval for capital investments are done by top management. It is recommended that the managers of each department propose their respective budgets as they know their area best. All the budgets and their contents are summarized into the Master Budget which usually consists of the planned income statement and the balance sheet. Note that all the budgets are interlinked as they affect each other in the planning process. The sales budget is usually the first to be prepared as this determines the overall business activity for the coming period. The sales budget will then affect the production budget which requires support for the raw materials budget, the labor and overheads budget. If additional investment is required to meet the production, the capital expenditure budget needs to be proposed. While purchases are made for raw materials and labor, sales are expected to be generated during the year. Cash flow is important here as there is the need to pay for the materials (trade payable budget) and the operational expenses (labor and overheads). The cash used has to come from the sales through the collection budget or other planned sources of funding. The accountant is usually the one in charge of the cash budget which detail the inflows and outflows of cash. The results of all the budgets combined will project the targeted income statement and the balance sheet for the firm.

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Trade receivables budget

Cash budget

Trade payables budget

Sales budget

Overheads budget

Capital expenditure budget

Direct labour budget

Raw materials purchases budget

Finished inventories budget

Production budget

Raw materials inventories budget

8.3 THE USEFULNESS OF BUDGETS Budgets are generally useful in the following areas Promote forward thinking and identify potential problems allows managers to think ahead for their areas of responsibility. With the plan, it is possible to identify potential problems and manage them before they affect the company. For example, a production manager will see the inventory level declining and react before production stops. The accountant may see cash flow problems months ahead and look into managing cash early. Help to co-ordinate between the various sections of the business allows one department to act in tandem with another for effective operations. For example, the purchasing department plans the purchase and arrival of material to be in time for the production needs. This reduces down time. Motivate managers to have better performance well defined goals can motivate managers and staff in their performance. As they understand the overall effect of the plan to the organization, there is greater focus to work towards a common result. Provides a basis of control Controls are essential for events to conform to original plans. With the budgets, management can then compare actual performance to expected and determine the reasons behind non-performance for improvements.

Provide a system of authorization this relates to the limit a manager can spend on a particular activity. For example, the senior management may allocated a fixed amount of funds for research and development and the person authorized to managed this area should work within the guidelines.

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8.4 PREPARING DIFFERENT BUDGETS There are several types of budgets to prepare. Using the information from the sales budget, one can prepare the inventory budget to determine how many units need to be purchased or make. The sales on cash or credit will require collection of cash. This is the collection budget. The purchases and operational costs such as salaries, rental etc. must be paid and this result in the payment budget. The following section shows the process with an example. Example: Jan Sales in units 5,000 Sales at $10/unit 50,000 Operating Expenses 10,000 Feb 7,000 70,000 12,000 Mar 10,000 100,000 14,000 Apr 12,000 120,000 15,000

The firm begins its business on 1st January with $5,000 cash balance. It has no beginning inventory and requires ending inventory to be 20% of the following months sales and the cost of goods is 40% of sales. Assuming no bad debts, all sales are collected 40% in the month of sale and the remainder the following month. 50% of the purchases are made in the month of purchase and the remainder the following month. a) Preparing the inventory budget and payment budget for Jan to Mar. The inventory budget is based on the same concept when we the cost of goods sold. Jan Feb Mar Beg Inv 0 1,400 2,000 Purchases 6,400 7,600 10,400 Unit sold (5,000) (7,000) (10,000) Ending Inv 1,400 2,000 2,400 From the information, the cost per unit is $4 (40% of sales price $10) So, the purchases in dollars will be Payment Budget Jan Feb Mar Purchases in $ 25,600 30,400 41,600 $ paid on purchase 12,800 $ paid 1 month after 0 Monthly Payment 12,800 Collection Budget from sales Sales at $10/unit 40% collected on sale 60% collected 1 month after Cash collections 15,200 12,800 28,000 Jan 50,000 20,000 0 20,000 20,800 15,200 36,000 Feb 70,000 28,000 30,000 58,000 Mar 100,000 40,000 42,000 82,000

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The Cash Budget The cash budget shows the net cash flow and the ending cash flow for the month. Jan Feb Mar Beg Cash Balance 5,000 2,200 20,200 Cash Receipts * 20,000 58,000 82,000 Cash Payment for purchases** (12,800) (28,000) (36,000) Cash payment for expenses (10,000) (12,000) (14,000) Ending Cash Balance 2,200 20,200 52,200

8.5 CRITICISMS OF BUDGETS While budgets are good tools for effective management, they have their limitations and constraints. Some criticisms against budgets include the following. a) Budgets cannot deal with fast changing environment and they are often out of date before the start of the accounting period b) Budgets focus on managements short term financial goals but managers should focus on creating value for the business. For example, building brand loyalty, innovation etc. c) Budgets when implemented through a top-down approach create command and control by management and prevent junior executives from exercising autonomy. d) Enormous of time is incurred to prepare budgets. The same amount of time can be used to improve the company through proactive activities. e) Budgets focus on department functions. The actual focus should be looking into processes that cut across boundaries and meet the needs of the customers. f) Budgets are usually based on previous years performance for planning. Thus, managers cannot think out of the box for new ideas or strategies that may be necessary in the new economy. g) Budgets protect costs rather than reduce costs. Most managers fear that the amount allocated to them will be taken away the following year if it is not spent. Thus, their response will be to spend the full amount instead of attempting to reduce it. h) Budgets create slacks in the planning processes. To meet the target set, managers will try to negotiate lower sales and higher allocation for expenses. This allows them to build slacks in the budget so that the meetings become easier to conclude.

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Review Questions 1) 2) 3) Define a budget. Explain how budgets are used in planning. How important are the behavioral aspects of a budgetary control system? ABC Private Limited produces food products for cats. The expected forecast is as follows: Unit Sales Dollar Sales January 100,000 $50,000 February 120,000 $60,000 March 110,000 $55,000 April 100,000 $50,000 The firm has inventory policy that requires the ending inventory for each month is to be 20% of next months sales. The beginning inventory for the year is 20,000 cans. a) Prepare the production budget for the first quarter. b) If sales each month is based on 40% cash sales and credit sales are given 30 days credit, prepare the collection schedule from January to March. c) Each can of cat food require 5 oz of material and each oz cost $0.02 cents. The firm has ending material requirement of 15% of next months production. The firm requires a quarterly inventory balance is 100,000 oz. Compute the quantity purchased and its related costs. 4) Prepare the cash budget using the following information. Cash balance on January 2010 is $1,000 Actual cash sales for November and December 2009 are $10,000 and $15,000 respectively. The credit sales are $25,000 for November and $35,000 for December. The firm collection experience shows that 50% of the credit sales are collected in the month of sale, with 30% in the following month and 15% in the third month. The remaining sales are uncollectible. Inventory purchases average 60% of a months total sales. The firm pays 40% cash in the month of purchase and settles all payables by the following month. Salaries and wages amount to $8,000 a month and rental is $1,000 a month. Taxes for 2009 payable in February is $5,000 The projected January cash sales is $20,000 and credit sales is $40,000.

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Session 9 Accounting for Control At the end of the session, students should be able to: 1. Discuss the role and limitations of budgets for performance evaluation and control 2. Understand variance analysis and possible reasons for the variances 3. Explain the issues in designing effective budgetary control systems 4. Explain the nature, role and limitations of standard costing _____________________________________________________________________ 9.1 ROLE AND LIMITATIONS OF BUDGETS Budgets are useful tools for evaluation and exercising control over a business. What is evaluation in this case? As the budgets are the planned goals, the actual performance is likely to be different from them. The measurement of variances i.e. the difference between the actual and planned goals is the process of evaluation. What is control in this case? Control is the act of making events conform to the plan and if variances occur, there is a need to manage them. The manager can either improve on the processes or review the plan to determine if it is achievable and practical. There are two types of control. The first is feedback control where steps are taken to get operations back on track immediately upon a signal that procedures have gone wrong. The second type is feedforward control where predictions are made as to what can go wrong and steps are taken to avoid the undesirable outcomes. Thus, feedforward controls are anticipative and forward looking. Thus, they are more preferred. 9.2 VARIANCE ANALYSIS AND EXPLANATIONS Variances occur when actual performance is different from budgeted plans. Static Budget Actual Result Output 1,000 units 900 units Sales revenue Raw materials Labour Fixed Overheads Operating Profit $100,000 (40,000) (40,000 metres) (20,000) (2,500 hours) (20,000) 20,000 $92,000 (36,900) (37,000 metres) (17,500) (2,150 hours) (20,700) 16,900

Based on the above, it is inappropriate to compare the costs and revenues expected for 1,000 units production with the costs of 900 units. To ensure comparability, it will be necessary to equate the costs and revenue of the budget to the number of units actually produced i.e. 900 units

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Creating the Flexible Budget Output Sales revenue Raw materials Labour Fixed Overheads* Operating Profit Static Budget 1,000 units $100,000 (40,000) (40,000 metres) (20,000) (2,500 hours) (20,000) 20,000 Flexible Budget 900 units $90,000 (36,000) (36,000 metres) (18,000) (2,250 hours) (20,000) 16,000

* Fixed costs do not change with volume.

Now that both the flexible budget and actual performance are based on the same 900 units, we can make reasonable analysis on the variances. Flexible Budget 900 units $90,000 (36,000) (36,000 metres) (18,000) (2,250 hours) (20,000) 20,000 Actual Result 900 units $92,000 (36,900) (37,000 metres) (17,500) (2,150 hours) (20,700) 16,900

Output Sales revenue Raw materials Labour Fixed Overheads Operating Profit

Analyzing Variances Sales Volume Variance is the difference between the profits in the static budget and the flexible budget. The sales volume variance for the above is $4,000 as the firm sold 100 units less than planned. Since the effect is negative, it is an adverse or unfavorable variance. A positive effect will be known as favorable variance. Sales Price Variance is $2,000 and is the difference in revenue between flexible and actual sales. A favorable variance is the result of a higher selling price than originally budgeted. The original budget planned a sales price of $100 per unit but the actual sale price per unit is $102.22 ($92,000 divide by 900 units) Total Material Variances is the difference between flexible and actual material used. The above example has an unfavorable total material variance of $900. The production used more material and also spent more on purchasing them. This implies that material variance is made up of two possible components: The material usage variance and the material price variance. The firm has an unfavorable material usage variance of 1,000 metres x $1 per meter i.e. $1,000 unfavorable. For price variance, the firm pays $100 less ($37,000 -$36,900) than expected for the 37,000 metres. This results in a favorable variance of $100.

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Total Labor Variances is the difference between flexible and actual labor used. The above example has a favorable total labor variance of $500. The firm actually incurs lesser hours and lower labor costs to achieve the 900 units. Like material variance, labor variance is also made up of two possible components: The labor efficiency variance which measures the difference between the actual direct labor hours worked and numbers of labor hours in the flexible budget. The firm has a favorable efficiency variance of 100 hours. With per hour rate of $8, this will result in a favorable labor efficiency variance of $800. The labor rate variance measures the cost per hour incurred between actual and budgeted. For the 2,150 hours used, the budgeted labor cost should have been $17,200 (2,150 hours x $8 per hour). However, the firm spends $17,500 resulting in a unfavorable labor rate variance of $300.

Fixed overhead variance is the difference between the actual fixed overhead costs incurred and the budgeted fixed overhead. Noting that fixed overhead costs should not change with volume, the firm is expected to incur $20,000. As there is a $20,700 fixed overhead incurred, this result in a unfavorable $700 variance.

9.3

ISSUE IN EFFECTIVE BUDGETARY CONTROL SYSTEMS Effective budgetary control systems should contain certain features. These include: All levels of management must be committed to the budgets proposed. A good budgetary control requires establishing systems and routines. There is a clear distinction between the individual managers areas of responsibilities. Routines should include the frequency and relevant variance reporting as well as establishing senior management commitment. Budgets should be challenging and yet achievable. Unachievable targets are counter productive and produce de-motivating effects. The budget reports should be focus and aimed at individual managers instead of general reporting which waste more of the managers time to search for what is relevant to them. Ensure effective data collection and analysis process and these should be part of the periodic reporting procedures. This will save time as they are automatically produced each month. Variance reporting should be provided to the managers shortly after the month ended and not long after. Early reporting allows the managers to response to the variances and implement changes immediately.

9.4

NATURE, ROLE AND LIMITATIONS OF STANDARD COSTING Standard costing used in measuring either the quantity or costs are the basic building blocks for budgets. The basic objective or role of standard costing is to have a means of measuring the actual performance with the budgeted costing standards.

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It is important to note that there are two basic types of standards: the ideal standards and the practical standards. As the term implies, ideal standard assumes perfect operating conditions and inefficiency does not exists. Its role is to encourage employees to meet the standard of excellence. The practical standards considers down time of machines or labor and other challenges of operations management. While lowering the expected performance slightly, the objective is still to set a high and achievable goal for the employees. The practical standard is preferred by most as one would consider it difficult to measure performance under perfect condition. It also may discourage managers as goals are perceived as unattainable, thus, becomes counter productive. While standard costing is a good tool, there are obvious limitations. These are listed as follows: a) Large companies and businesses do not have a clear direct relationship between inputs and outputs. There are expenses of discretionary nature. Examples are advertising and training. b) The fast changing pace of the environment and competition may very quickly make initial standards set by management out of date. Thus, constant monitoring of the standards set is required. c) While management can set the costing standards, there are many factors or variables that are not within the control of the manager. Yet, he may be responsible for any negative variances. d) Standards do not consider the contribution by different managers who work together for the common goal. The line of responsibility between the managers becomes unclear.

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Review Questions 1) 2) 3) 4) How would you explain the meaning of standard costs to a non-accounting person. What is the difference between the static budget and the flexible budget Suggest some possible causes of unfavorable labor efficiency variance. Wonderful Comfort produces footwear. The firm uses as standard cost system and has set the following standard for materials and labor for one pair of boots. Leather (3 units at $10) Direct labor (2 hours at $12) $30 $24

During the year, the firm produces 2,000 pairs of leather boots, The actual leather purchased was 6,200 units at $9.96. There were no beginning and ending inventories of leather. Actual direct labor was 4,200 hours @ $12.50 You are to prepare the following: (a) Compute the costs of leather and direct labor that should have been incurred for the production of the 2,000 pairs of leather boots. (b) Compute the total budget variances for leather and labor (c) Break the material variance into price variance and usage variance (d) Break the labor variance into rate variance and efficiency variance. Describe the fundamentals for budgeting process.

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Session 10 Full Costing and Marginal Costing At the end of the session, students should be able to: 1. Determine the full cost (absorption) of a single product environment 2. Determine the full cost (absorption) of a multiple product environment 3. Understand the problems with full costs (absorption) in practice 4. Distinguish between full (absorption) and variable costing 5. Discuss the usefulness of full (absorption) cost information to managers _____________________________________________________________________ 10.1 WHAT IS FULL COSTING (ABSORPTION COSTING)? Until this point, the cost of goods sold is either given or computed from available information so that we can present the profit and loss statement. A product is made of different inputs that cost the firm resources to produce it. We have not covered the process of accumulating these costs incurred to a unit of product. Full cost is the total amount of all resources measured in monetary terms sacrificed to produce a unit of product or services. For example, materials are used in production and rental is incurred for the factory. These are element of costs of each unit of output. The following sections focus on how we apply full costing to single-product companies and multiple product companies. All products are made up of two categories of costs: the Direct Costs and the Indirect Costs. The direct costs are costs that make up a great portion of the cost of the products and their values are easily calculated or traceable to the products. Direct costs are the direct material and direct labor. In producing a table, wood is an obvious direct material as it is clearly a major part of the product and the accounting records for purchases is used to value it. Similarly, the carpenters salary is a major part of the production costs for without them, the tables will not be made. The payroll records determine the direct labor costs. So the two main elements of direct costs are direct material and direct labor. To produce tables, there is indirect cost as well. Indirect costs are the incurred expenses that are not easily traced to the products. Example of indirect costs in making tables are the glue used, the nails used or cooling liquids for the machinery. We termed these indirect costs as overheads (OH). All products have three important elements: Material, Labor and Overheads (OH). The first two are direct costs and the last element is indirect costs.

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10.2 FULL (ABSORPTION) ENVIRONMENT

COSTING

OF

SINGLE

PRODUCT

In a single product company, the products are usually identical or near identical units of outputs or services. We call them homogenous in nature and one cannot differential one product from another. Examples of homogenous products are producing bag of rice or flour. This costing process for homogenous products is known as Process Costing. To compute the full cost of a single product company, we add all the production costs (e.g. incurred during the period and divide it by the total number of units produced. Example: Fancy Food Services only supply one type of soup noodles. In January, the firm sold a total of 8,500 bowls and generated $25,500 revenues. The total costs incurred during the month are as follows: Ingredient (noodles and fishballs) Chefs salaries Rental for the store Utilities and other support costs Depreciation of fixed assets Full cost per unit is $4,000 $7,500 $5,000 $1,500 $1,125

= (Total production costs) / units produced. = ($19,125) / 8,500 bowls = $2.25 per bowl

10.3 FULL (ABSORTPION) ENVIRONMENT

COSTING

OF

MULTIPLE

PRODUCT

Most companies supply multiple products. A carpentry firm is likely to supply chairs, tables, beds, wardrobes and other products. These products are totally different and the amount of time and material to produce a chair is different from producing a table. Therefore, to assign cost equally across obviously different products will distort the costing process and makes setting of selling price difficult. As the products are uniquely different, the process of costing is term Job Order Costing. This would require each job (say for chairs) will have its own records for materials, labor and fair share of overheads incurred. In a multiple product business, the firm has no problem allocating the cost of direct material and direct labor to each product type since accounting records determine the values incurred. The difficulty or problem lies in allocating or apportioning overheads to the different products.

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10.4 PROBLEMS WITH FULL COSTING IN PRACTISE A) Multiple products with single department Example: A firm ABC that produces tables and chairs estimates the following costs for the coming year. Overhead costs Direct labor hours Machine hours $600,000 140,000 60,000

When the year ended, 20,000 tables and 60,000 chairs are produced. The direct costs incurred are as follows Tables $100,000 $ 80,000 75,000 35,000 Chairs 180,000 70,000 60,000 20,000

Direct material costs Direct labor cost Direct labor hours used Machine hours used

What is the full cost per unit for each table and chair? Solution Process Step 1 is to determine an overhead cost driver. To do this, the manager must determine what activity will drive or push overhead costs up. It can be units produced, number of labor hours, number of machine hours etc. Some products are labor intensive, so direct labor hours would be a good overhead cost driver. If production is machine intensive, then machine hours would be a good choice. The manager has to decide on the cost driver. For the purpose of this example, let us assume the manager determines that machine hour is the cost driver. Step 2 is to compute an overhead recovery rate. The computation format is: Overhead recovery rate = Estimated Overheads Estimated cost driver

For this example, the OH recovery rate = ($600,000 / 60,000 ) machine hour = $10 / machine hour Step 3 is to allocate or apply overhead cost to each product The Applied OH = OH recovery rate x cost driver used For this example, the Applied OH for tables is = $10/machine hour x 35,000 machine hours

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= $350,000 And the Applied OH for chairs is = $10/machine hour x 20,000 machine hours = $200,000 To determine the cost per unit for each table and chair, we add all the direct and allocated overhead costs i.e. the sum of direct materials, direct labor and the allocated overhead costs. Total costs of tables = $100,000 + 80,000 + $350,000 = $430,000 Total cost for chairs = $180,000 + $70,000 + $200,000 = $450,000 Cost per table = $430,000 / 20,000 tables = $21.50 per table Cost per chair = $450,000 / 60,000 chairs = $7.50 per chair

B) Multiple products with multiple departments Another firm XYZ produces tables and chairs estimates the following costs for the coming year. Each product will go through two different departments: the Assembly and Painting Department. Overhead costs Direct labor hours Machine hours Assembly $400,000 80,000 40,000 Painting $200,000 60,000 20,000 Total 600,000 140,000 60,000

When the year ended, 20,000 tables and 60,000 chairs are produced. The direct costs incurred are as follows Tables $100,000 $ 80,000 35,000 38,000 Chairs 180,000 70,000 15,000 10,000

Direct material costs Direct labor cost Direct labor hours used Machine hours used

Assume the manager already determines that labor hour and machine hour are the cost drivers for the assembly department and painting department respectively. What is the applied overhead cost for tables and chairs? Solution Process Assembly a) Overhead Recovery rate = $400,000 80,000 $5/labor hour Painting $200,000 20,000 = $10/machine hour

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b) Apply overhead for tables: Assembly ($5/labour hr x 35,000 labor hours) + $165,000 + $150,000 $315,000 Assembly ($5/labour hr x 38,000 labor hours) + $190,000 + $100,000 $290,000 Painting ($10/machine hour x 15,000 machine hours)

Overhead for tables = =

Overhead for chairs = =

Painting ($10/machine hour x 10,000 machine hours)

What would be the cost per unit for each table and chair? Are you able to calculate it? B) Multiple products with product cost centre and service cost center With most manufacturing environment, there are the product cost centres (or departments) or service cost centres (or departments). Product cost centres are departments where the direct labor and materials are added to manufacture the products. The service centres are support departments and their costs must be charged to the product costs and become part of the products overhead costs. The process of allocating overheads between departments falls into two categories. The first one is Cost Allocation where specific costs are allocated to a particular department. Rent, electricity, salaries of workers are specifically linked and related to a specific department. The second category is Cost Apportionment. This applies to general overheads that relate to more than one department. For example, utilities are not separately metered will need to be apportioned to each product based on the benefit derived. Rental can be apportioned according to square metres. The steps to apportion the overheads are as follows: a) Allocate specific department overheads to the relevant department b) Apportion general overheads among department c) Total the allocated and apportioned overheads to determine the total for each department d) Apportion service department costs to product cost centres e) Total or sum up the product department overheads f) Calculate a departmental overhead absorption rate for each department g) Cost units absorb overheads as they pass through product centres or departments.

1.0.5 FULL COSTING AND VARIABLE COSTING We have covered full costing which includes all costs (direct material, direct labor and overheads) incurred in the product. These forms the product costs in our inventory. When the unit is sold, these costs are then expensed in the profit and loss statement as cost of goods sold. Full costing does not consider the behaviors of the costs.

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Variable costing that will be covered in the next lesson breaks costs into their behaviors i.e. variable costs and fixed costs. In variable costing, all variable costs (direct material, direct labor and variable overheads) are linked to the product and will be expensed only when the product is sold. All fixed costs (i.e. fixed overheads) are expensed in the period in which they are incurred. Supporters of full costing argue that the method allocates costs to each sale and gives a complete picture of the income generated. Variable costing supporters state that the method is more relevant to decision making and is useful for managers.

Review Questions 1) 2) 3) 4) Explain the difference between process costing and job order costing. What is the meaning of full costing? All products have both direct and indirect costs. How do we differentiate them? Faber Technologist has the following information for the year 2010. Budgeted Overhead Budgeted Direct Labour Hours Budgeted Direct Machine Hours Actual Direct Labour Hours Used Actual Direct Machine Hours Used Actual Overheads costs Incurred Equipment Rental costs Depreciation on factory Indirect Labour Utilities for factory Other factory overheads $180,000 15,000 20,000 15,400 22,000 $ 5,000 $ 20,000 $100,000 $ 15,000 $ 45,000

The company has identified that direct labour hour is the main cost driver for overheads costs. During the year, JOB No: K 001 is completed with the following costs information. Actual direct material costs used Actual direct labor costs incurred Average wage per hour per worker $2,340 $3,600 $10 per hour

REQUIRED: (a) Calculate the overhead rate for the year. (b) (c) Calculate the total costs for JOB K001 using application rate. Why might a company use a plant wide overhead rate instead of a departmental overhead rate?

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5) Donald Aeronautics Co. uses a budgeted overhead rate in applying overhead to individual job orders on a machine-hour basis for Department A and on a direct-labor-hour basis for Department B. At the beginning of 19X8, the companys management made the following budget predictions: Department A $1,500,000 $2,170,000 90,000 350,000 Department B $1,200,000 $1,000,000 125,000 20,000

Direct-labor cost Factory overhead Direct-labor hours Machine-hours

Cost records of recent months show the following accumulations for Job Order No. M89: Department A $12,000 $10,800 900 3,500 Department B $32,000 $10,000 1,250 150

Material placed in production Direct-labor cost Direct-labor hours Machine-hours

REQUIRED: (a) What is the budgeted overhead rate that should be applied in Department A? and in Department B? (b) (c) What is the total overhead cost of Job Order No. M89? If Job Order No. M89 consists of 200 units of product, what is the unit cost of this job?

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Session 11 Cost-Volume-Profit (CVP) Analysis At the end of the session, students should be able to: 1. Understand cost behaviors 2. Calculating break-even point with C-V-P Analysis 3. Understand the weaknesses in the C-V-P Analysis 4. Using Marginal Analysis for short-term decisions. _____________________________________________________________________ 11.1 UNDERSTAND COST BEHAVIORS The profit and loss statement shows a list of expenses incurred to generate the income for the year. For greater detail, the accountant can classify the expenses by function i.e. production, sales, marketing, administration and finance. However, the listing of expenses is not sufficient for a manager to make business decisions. It is important to understand how expense and costs behave so that he can manage them. Costs can be broken down into fixed costs or variable costs behavior. Fixed costs can be shown graphically.

As the volume of activity increases, the fixed costs stay the same

Based on the diagram, fixed costs remain the same within the relevant range of production. An example will be rental which remains constant regardless of the production quantity. Other examples are fixed staff salary, insurance for the year or road tax for vehicles. Some fixed costs are regarded as stepped fixed costs (see diagram below). This indicates that at lower volume of production, an initial fixed cost is incurred. However, with expansion or larger volume required, another unit of fixed cost is necessary to meet the production needs. For example, a machinery can produce 50,000 per month will have a fixed depreciation cost. If the firms need to produce

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80,000 units, it will require another machine which results in extra depreciation expense. Step Fixed cost can be presented as follows:

Variable costs are costs that vary with the volume of activity. This implies that with greater volume, the firm will need more of this cost. An example for a manufacturing firm will be the raw materials used in production. While the cost of material may remain constant on a per unit basis, the total variable costs will increase with larger production volume. Variable costs are presented diagrammatically as follows.

As the volume of activity increases, the total variable costs increases the same

It is likely that business have costs that have some element of both fixed and variable cost. These are known as the semi-fixed (semi-variable) costs. The diagram below shows how a certain amount is fixed and as volume increases, an additional amount is charged on a per unit basis. An example will be the sales person having a fixed salary per month but is also paid commission on the sales he generates for the firm.

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11.2 CALCULATING BREAK-EVEN POINT Knowing how costs behave allows a manager to use the information to determine the break even point for the business. The information can also be used to make business decisions such as special order sales, make-or-buy decisions, keep or drop decisions and limited resources constraints. Break even point is where the firm makes zero profit and thus, it concludes that the total revenue is equal to total cost (both fixed and variable costs) So Total Sales Total Sales = = Total Costs Total Fixed Costs + Total Variable Costs

If B represents the units of output, SP is the selling price while VC is the variable cost per unit, the above formula will be B x SP per unit = Total FC + B(VC per unit) B = Total FC / (SP per unit VC per unit)

Note that (SP per unit VC per unit) is also known as the contribution margin per unit. Contribution Margin is the excess of the selling price after deducting the variable costs and this amount will be used to reduce the total fixed costs for determining the profit. Example: Fun Parties Pte Ltd has projected the profit for 2011. Sales ($10/unit) Variable Expenses Contribution Margin Fixed Expenses Profit What is the break even point? $180,000 $108,000 $ 72,000 $ 40,000 $ 32,000

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Solution Process: Based on the above, the firm plans to sell ($180,000 /$10/unit) = 18,000 units The variable cost per unit = $108,000 / 1,800 units = $6/unit Therefore the contribution margin per unit = $10 - $6 = $4 per unit (Alternate way is to use total contribution / units sold) The break even point = ( Fixed cost + zero profit ) Contribution margin per unit = $40,000 / $4 per unit = 10,000 units So, 10,000 units must be sold to break even i.e. cover all variable and fixed costs with no profit. Other concepts related to the break even point analysis are the Margin of safety and the concept of Gearing. The margin of safety is the difference between the planned volume of output or sales and the break even point in output or sales. Based on the above example, the break even point is 10,000 units and $100,000 (10,000 units x $10/unit) of total sales. The planned volume is 18,000 units and $180,000 sales. So the margin of safety in units is 8,000 (18,000 -10,000) and the margin of safety in sales is $80,000 ($180,000 $100,000). What does the $8,000 units in the margin of safety implies? Since the business knows its break-even point at 10,000 units, the 8,000 units is what the firm may fall short in achieving its target and still break even. Any volume larger than 8,000 units will result in a loss. The concept of operating or operational gearing shows the relationship between contribution and the fixed costs. An activity with relatively high fixed costs relative to variable costs is said to have high operating gearing. A higher level of operating gearing makes profit more sensitive to changes in the volume of activity. Illustration: Consider a company with the following cost information. Units 300 600 1,200 Sales ($10 per unit) 3,000 6,000 12,000 Less Variables costs 1,200 2,400 4,800 Contribution Margin 1,800 3,600 7,200 Less Fixed Costs 1,000 1,000 1,000 Profit 800 2,600 6,200 Increase in profit 2.25x 1.38x Assuming a machine with additional fixed cost of $500 can reduced the variable cost by 50%, the new statements will be as follows. Units Sales ($10 per unit) Less Variables costs 300 3,000 600 600 6,000 1,200 1,200 12,000 2,400

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Contribution Margin Less Fixed Costs Profit Increase in profit

2,400 1,500 900

4,800 1,500 3,300 2.67x

9,600 1,500 8,100 1.48x

The comparison shows that doubling the unit sales results in faster growth in the profit when the additional machine with the additional fixed costs is used in the firm.

11.3 WEAKNESSES IN THE C-V-P ANALYSIS While the C-V-P analysis helps the managers to determine the relationships between fixed costs, variable costs and volume of activity, it still have weaknesses that require our attention. The first weakness is that the analysis assumes a linear relationship between sales revenue, variables costs and volume. In the real business environment, these costs are non-linear in nature. The second weakness is that fixed costs are assumed fixed over all volumes of activities. In practice, they tend to be stepped in nature. The third weakness is that the C-V-P analysis is based on a single product environment. Most businesses have multiple products. This raises the question on how an additional product will affect the sale on existing ones or the effects of fixed cost behavior across the business.

11.4 USING MARGINAL ANALYSIS FOR SHORT-TERM DECISIONS With marginal analysis concept, managers can make short term decisions such as the Accept/reject special order, Make/buy decisions, Keep/Drop a business unit and efficient use of scarce resources. We will illustrate these with examples. Accept/reject special contracts this is a situation where an external party requests to buy from the firm its products at a lower price than existing clients. Example: A firm XYZ with the detailed statement is approached by a potential overseas client to sell them 10,000 units at $4 per unit. Should firm XYZ agree to the proposal? Profit and Loss of XYZ Sales (10,000units) Less all variable costs Less all fixed costs Profit for the year

$70,000 $25,000 $20,000 $25,000

Based on the above, the current selling price per unit is $7 ($70,000/10,000 units). The cost of per unit is $4.50 ($25,000+20,000)/10,000 units. One would think the firm will lose $0.50 per unit ($4.00 - $4.50) if the proposal is accepted.

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Note that while the fixed cost of $20,000 is incurred, remember that fixed cost does not change with volume. By accepting the 10,000 units will not increase the fixed costs. So the only cost the 10,000 units have is the variable cost per unit of $2.50 So, if the firm accepts the offer, it will make $15,000 in additional profits since the selling price $4 per unit is higher than the $2.50 per unit cost of production. Closing or continuation of business (Keep/Drop) This type of decision usually occurs when a manager faces a department or product that is showing a loss each month. To decide if the department or product should be drop from the business, the manager has to consider the effects of fixed costs on the operations. Example: Selling Variable cost Contribution margin Less fixed cost Profit and Loss Product A $ 25,000 $ 12,000 $ 13,000 $ 5,000 $ 8,000 Product B $ 10,000 $ 6,000 $ 4,000 $ 5,000 $ (1,000)

The firm has a common fixed cost of $4,000 that is equally shared between the two products. The firm profit and loss is $7,000 Based on the above, it is likely a manager will choose to drop product B believing that without the $1,000 loss, the firm will improve its profit. This thinking process is flawed as the manager overlooked the nature of fixed costs. Note that fixed costs can be directly related to the product these are direct fixed costs which will be saved (avoidable) if the product is dropped. There is also common fixed cost these are costs such as rental, CEO salary that will not change if the product is dropped. Thus, in making such decision, ONLY marginal costs are to be considered. The decision process is to consider only direct fixed costs. Product A Product B Selling $ 25,000 $ 10,000 Variable cost $ 12,000 $ 6,000 Contribution margin $ 13,000 $ 4,000 Less direct fixed cost $ 3,000 $ 3,000 Product Profit and Loss $ 10,000 $ 1,000 Product B is actually making a profit and thus contributing to covering part of the common fixed cost. So it should not be dropped. Another way is to consider the overall profit from product A alone if product B is dropped Product A

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Selling Variable cost Contribution margin Less direct and common fixed cost Product Profit and Loss Make-or-buy decisions

$ 25,000 $ 12,000 $ 13,000 $ 7,000* $ 6,000

* Original fixed cost of $5,000 plus $2,000 of common costs transferred from B

A make or buy decision occurs when a firm is making a product but a supplier proposes to supply the firm the same products at a certain price. Once again, a manager is likely to compare the current cost against the supplier price but he has to consider the fixed costs effect again. Example: A firm with the following cost information needs to determine if it is better to produce 10,000 units of a component in-house or buy from a supplier at $2.40 per unit. Total Cost $ 9,000 $ 8,000 $ 4,000 $ 7,000 $28,000

Direct material Direct labor Variable overhead Fixed overhead Total Cost

Total cost per unit $2.80

To accept the offer by comparing the offer price of $2.40 and the production costs of $2.80 thinking there is a saving of $0.40 is a flaw. First, the manager has to consider if the fixed overheads are avoidable or unavoidable. Avoidable fixed overheads means the costs is entirely not required if the decision is to buy from the supplier. Unavoidable costs remain regardless of the decision. If the fixed cost is unavoidable (i.e. $7,000 has to be paid regardless of decision), the comparison is made on the avoidable costs only Total Cost $ 9,000 $ 8,000 $ 4,000 $21,000

Direct material Direct labor Variable overhead Total Cost

Avoidable cost per unit $2.10

So it is cheaper to make the product in-house and the offer should be rejected.

If a portion of the fixed cost is avoidable (e.g. $3,000 of rental can be saved because we do not need the space), the decision will be as follows. Total Cost $ 9,000 $ 8,000

Direct material Direct labor

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Variable overhead Fixed overhead Total Cost

$ 4,000 $ 4,000 $25,000

Avoidable cost per unit $2.50

Now it is cheaper to buy from the supplier at $2.40 per unit. Efficient use of scare resource A company usually focuses on sales or contribution margin per product to make production decision. However, it overlooked the firms resource constraint. If time (e.g. machine hour) is a constraint, the firm should attempt to make the most profit on a per hour basis instead of per unit of product. Example: Selling Price Variable cost Contribution margin Hours required per unit Product A $ 25 $ 12 $ 13 2 Product B $ 10 $ 6 $ 4 0.5

Clearly, product A makes higher contribution margin. However, as the number of hours is a constraint, we need to calculate the maximum we can make per hour. Contribution margin per hour $6.50 $8

Based on the above, the firm should use the resource to produce product B first until all demands are made before allocating resources to product A. This will achieve maximum contribution margin for the firm.

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Review Questions 1) Your non-accounting friend says that fixed costs will decline as volume increases. Explain whether you agree or disagree with this statement.

2)

Contribution Margin is the excess of sales over fixed costs. Explain if you agree or disagree with this statement.

3)

You plan to own a hair salon with 5 barbers. Each barber is paid $3.00 per hour and is required to work 40 hours a week for 50 weeks per year regardless of the number of haircuts. For each service provided, they are paid additional $4.00. The rental is expected to be $2,500 per month. The target price per haircut is $12. a) What is the contribution margin per haircut? b) Determine the number of haircuts to break even. c) If the firm can provide 10,000 haircuts per year, what will be the operating income? d) What will be the margin of safety?

4)

Your company provides the following performance budget when it sold 2,000 units of its products. Sales Manufacturing cost of goods sold Gross Profit Less selling and admin expenses Net profit $10,000 $ 6,000 $ 4,000 $ 3,300 $ 700

Other information: Fixed manufacturing costs are $2,400 and fixed selling administrative expenses are $2,500. a) What is the break even point for the company? b) Assume the company has idle capacity and a foreign firm requests for 500 units at a selling price of $3 per unit. Should your company accept the special order? c) If a supplier offer to sell you the same product at a cost of $2.50 per unit, will you take up the offer to buy from him if all your fixed costs will be incurred regardless of your decision. 5) Your firm manufactures and sells two products: A123 and B456. The selling prices for both products are $6.00 and $4.00 respectively while their variable costs are $3.00 and $1.40. Product A123 requires 0.5 machine hour to produce each unit and B456 requires 0.33 machine hour per unit.

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a) If the company has only 1,000 machine hours per week, which product should be produced first? b) If the company has only 1,000 machine hours per week and each product has a weekly demand of 2,100 units, how would you allocate the machine hours and how many units of each product can you produce? 6) A firm has the following three departments. You are to make a decision as to whether the Kids department should be dropped. Amounts in thousands Sales Variable Costs Fixed Costs Mens $400 $200 $ 50 Ladies $5,000 $3,500 $ 750 Kids Department $600 $390 $310

Other information If the Kids department is dropped, $100,000 of the fixed costs is eliminated as the service staff are no longer required. a) Show computation to explain your decision on keeping or dropping the Kids department. b) Now assume that the space vacated by the Kids department can be used by the Ladies Department. Your estimated that a salary of $25,000 per year is required for an assistant manager and the sales is expected to increase by $300,000. Should you still drop the Kids Department?

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Session 12 Costing and Pricing in a Competitive Environment At the end of the session, students should be able to: 1. Discuss the nature of activity-based costing (ABC) 2. Understand total life cycle costing and target costing 3. Discuss the importance of non-financial performance measurements 4. Understand shareholder value and EVA for the income statement 5. Explain the theoretical underpinning of pricing and issues with pricing decision _____________________________________________________________________ 12.1 NATURE OF ACTIVITY BASED COSTING (ABC) We have covered the traditional method of calculating overheads based on a specific cost driver. While the methodology makes sense, we can over or under estimate the applied overhead as the chosen cost driver may not be a true representation of the link between the costs and the event where the cost driver appears. Accountants recognize that overhead cost do not just occur but are incurred due to the activities of production. The Activity Based Costing as the terminology implies states that it is the various activities that drive overhead costs up. Thus, the more time an activity occurs, more overhead cost should be applied to the product. Setting up is an activity in making a product. A production process that requires more set ups for manufacturing will be allocated more overheads. Under the ABC, an overhead cost pool is first determined. This is where each activity and its related overhead costs are placed together to form the cost pool. The manager looks at the operations and observes the types of activities that occur and the frequency of the activities. An example of a cost pool is shown as follows: Estimated Overhead Costs Set up costs Lifting costs Invoicing cost Quality costs Cost driver Number of set-ups Number of times forklifts are used Number of invoices Number of quality checks

$100,000 $ 50,000 $ 70,000 $ 80,000

Every method has its own supported and critics. Those who oppose the ABC method argues that the process of identifying the activities that increases the overhead costs is too time consuming. While the process may make the costing more accurate, they argue that the cost benefit ratio is not justified. The critics also argue that process does not provide relevant information for decision making.

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12.2 TOTAL LIFE CYCLE COSTING AND TARGET COSTING Besides Activity based costing, other approaches are developed to meet new competitive environment. New concepts include Life Cycle Costing and Target costing. What is life cycle costing? The term implies costing the product over the three specific phases of production. The first is the pre-production phase where research and development and market research are conducted. The phase will end with the final setting up of the production facilities, the delivery facilities and the initial advertising and promotion activities to create product awareness. The second phase is the production phases. Here the actual making and selling of the product or service occurs. The final phase is the post production phase where any cost required to correct faults are incurred. This is where after sales service costs are measured. The life cycle costing considers all aspects of production from development to after sales service. Example: A firm can consider the following are part of the product life cycle Design: Creation of the product Manufacturing: Use material, labour and overhead in production Marketing: Creating awareness of firm and product Distribution: Transfer of product from warehouse to clients Total estimated costs $ 100,000 $ 500,000 $ 300,000 $ 400,000 $1,300,000

Another method to the traditional costing is target costing. The traditional costing approach is the cost plus approach. This method computes the cost incurred on the product and using the cost as the base measurement, a percentage of profit is added to it to determine the selling price. Target costing meets the objective from the opposite direction. The first step is to determine a market acceptable selling price. This is done through market survey or research. Using the selling price as the benchmark, a percentage of profit is deducted to determine the costs for making the product or service. This is known as the cost gap and now the focus of design and production is to work around these costs to ensure efficient means of providing the product or service to the market. Note that target costing is related to life cycle costing because savings are sought during the initial phase of production. This is the point where focus on efficiency and cost reduction begins.

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12.3 IMPORTANCE OF NON-FINANCIAL MEASUREMENTS All firms are measured in monetary terms because the numbers give investors a sense of financial performance and positional strength of the company. Although numerical measurement is critical, the trend is to also focus on non-financial measurements. The value of a firm is also created by non-financial drivers. Examples are employee satisfaction, customer satisfaction and loyalty, high level of product innovation, good after sales service, high quality of the product and social responsibility. The modern era recognizes that happy employees are more productive and good service or products keep customers and retain their loyalty. Thus, these non-financial measurements are leading indicators of how the firm is performing and creating wealth for the shareholders. The Balance Scorecard The balance scorecard developed by Robert Kaplan and David Norton attempts to integrate both financial and non-financial measurements. The objective is to create a system that both measures as well as manage the firm. The Balance Scorecard set the objectives into the following four areas: a) Financial this measures the returns for shareholders and therefore, financial ratios like return on capital employed, net profit margin, total asset turnover etc. are useful indicators. b) Customer this focus on the type of customers the firm wishes to serve. It also establishes measurement for customer satisfaction and growth levels of customer base. c) Internal business process successful business need to focus on processes to keep up with the change economic environment and competition. Thus, areas like innovation, after sales service, response time, product life cycle are important business processes that need continual observation. d) Learning and growth this area focus on long term growth and the specific areas are the people, the system and the procedures. Measurements like employee motivation, satisfaction, loyalty together with their skills and profiles are important growth ingredients for the firm. 12.4 SHAREHOLDER VALUES AND EVA The key objective of a business is to increase the shareholders value or wealth. This implies that management must act in the interest of the shareholders and their management decisions focus on this fundamental objective. With all objectives, one would need to set up some basic processes. The following list the processes for value creation. The four stage process for creating shareholder value: a) Set objectives that recognize the supremacy of shareholders intent of this is to create a clear focus for management.

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b) Select an appropriate measure of shareholder return the traditional measurement using profits or ratios using profits are measurement are usually used. However, they raised other problems of concern. Profits are usually measured over a relatively short period such as a year. To enhance shareholders wealth, improvements are achieved over the long run. Thus, a manager may focus on short term gains while sacrificing longer term and larger rewards for the shareholders. Examples are cutting back on research expenses or maintenance which improve current profits and did not consider longer term negative effects. Risk is ignored. In finance, we recognized that risk and reward have a direct relationship. This implies that the higher the risks, the higher the returns expected. Management may take on projects that will increase the profits for the shareholders. However, such strategy can reduce the shareholders wealth if the increase in profits is not commensurate with the increase in the level of risks. Accounting profit does not take into account all the cost of capital invested by the business. Shareholders fund has opportunity costs and there should be an equivalent measure of interests charged. While the accounting process less the interest expense from borrowings, it does not minus off the cost of lending by shareholders. In other words, there may not be profits earned if all costs of lending, whether long term liabilities or shareholders funds are paid interest. Accounting profits are affected by accounting policies. With different accounting policies, the profit measurement is not consistent across companies. Aggressive depreciation policies will result in lower profits and different method of depreciation create different value of measurement.

c) Generate shareholder returns through focused management this process focus on management of the firm. This require the firm to have focus mission statement, set high demanding and yet achievable targets for employees, resource management to achieve maximum result and good incentive system to maintain loyal staff. d) Measure shareholder returns to see whether the objectives are being achieved. This final stage is the feedback period to constantly review and check if the objectives are met through the management processes. This review will then focused on enhancing and improving the systems already in place for maximizing the shareholders value. Economic Value Added (EVA) The economic value added measurement is based on economic profit and not accounting profit. The aim is to generate returns that exceed the required rate of returns of investors. The EVA formula is presented as Where EVA = NOPAT (R x C)

NOPAT is the net operating profit after tax R is the required returns of investors C is the capital invested (also mean the net assets of the firm)

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The higher the EVA, the greater is the increase in the shareholder wealth and this means that the EVA has to be positive. Problems with the EVA and adjustments required The EVA computation depends on the financial statements to compute the wealth created for the shareholders. So the reliability of the profit and loss statements and the Balance Sheet are critical to the process. Since EVA starts with the net operating profit after tax from the income statement, advocates suggested that the income together with the capital invested are understated due to accounting biases and policies. Therefore, some adjustments should be made to present a clearer position of wealth creation. In computing profits, some expenses are based on managerial judgment and are deducted as expenses within the accounting period. This results in understating the profits used in measuring EVA. Examples of such expenses are goodwill written off, research and development expenses, provision for doubtful debts. Therefore, these should be added back to profit after tax amount before EVA is computed. With capital, some assets are presented at lesser than invested amounts because of depreciation. This resulted in understatement of invested capital. Examples are the restructuring costs and marketable securities. In accounting, restructuring costs are expensed but advocates of EVA argue that these amounts should be considered as investment as they placed the firm into better position for future challenges and growth. Similarly, marketable securities (shares and bonds investments) are not part of invested capital because the income from these investments are added in the income statement after operating profit is calculated. 12.5 PRICING THEORY AND ISSUES IN DECISION MAKING In economics, the price of a product is dependent on the supply and demand of the product. Depending on the market structure, firm that are monopoly are price makers and competitive markets are price takers. While economics use the supply and demand to determine the equilibrium price of a product, accountants uses different pricing methods for costing product. The following section discusses the different methods which are also covered in earlier sections a) Full cost (cost plus) pricing As discussed in earlier chapters, full costing consider the cost of production in direct material, direct labor and overheads. With a target profit to achieve, the firm works out the target selling price.

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Consider a firm with production cost per unit of $20 and incurred direct and indirect cost of $100,000. The firm wants to have a target profit of $40,000. How is the selling price computed? If the $40,000 profit is to be earned, the ratio of profit to cost is calculated as ($40,000 / $100,000) = $0.40 per one dollar of cost. Since the per unit cost is $20, the prorated profit will be (0.40 x $20) = $8 per unit. Therefore the selling price is $20 + $8 = $28 per unit b) Cost Plus Method This method is useful for price takers within a competitive market where buyers dictate the price they are willing to pay. So the manufacturer has to consider effective ways to reduce costs in order to sell at the market price and still make a profit. Assume the market is willing to pay $70 for a service provided by firm XYZ. As a price taker, the firm is unable to increase the selling price. Therefore, the firm decides on the profit it wants to make. Assume the firm is targeting a profit of $20 per service, it concludes that the cost of production or providing the service must be at the highest of $50 (Selling price less profit). Now that the firm has determined the cost, it works towards cost saving techniques to achieve this in order to make the target profit. c) Marginal Cost Pricing (Variable Cost Approach) As discussed in earlier chapters, marginal cost approach focus on the contribution margin per unit or service provided. As contribution margin is sales less variable costs, the firm would want to maintain the contribution to cover the fixed costs. With the basic assumption that fixed costs remain constant regardless of volume, the firm manages the sales volume to cover operational costs. The airline industry uses this method to sell unsold seats before the flight takes off. While fixed cost remains constant, any unsold seat would not generate any income to the firm. So the company offer these seats are promotional prices or during off peak season to cover the variable costs and the remaining to cover the fixed costs or increase their profits. The hotel industry does the same with the room rates during off peak season as well. d) Other pricing strategies Penetration pricing and price skimming are other strategies used by firms to enter the markets. While market forces determine the price of a product, the firm can lower the selling price to make it relatively cheaper to other complement products. This allows the firm to gain a larger percentage of the market share. Making the selling price low

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also dissuade competitors from entering the similar market. This is penetration pricing and firms use this method to gain in the long run. Price skimming is the opposite of penetration pricing. Firms that use this strategy believe that the market segments who want their products are broken into different stratum. The firm initially sets the selling price high to capture those buyers within the group of buyers in the highest stratum who are unconcerned about high prices. Once this group of buyers is saturated, the firm adjusts the selling price slowly downward to capture the next group of buyers. New products are cost in this manner to cover the cost of research and development and manage the demand as production capacity improves. New technology gadgets are good examples of this type of pricing. Review Questions 1) Explain how the traditional costing approach and the activity based costing approach differ.

2)

While activity based costing (ABC) is a good concept, what are some possible limitations in this method?

3)

Explain the main focus of the Balance Scorecard. What are the basic objective areas?

4)

A firm has revenue of $190,000. The total operating expenses is $70,000. The fir tax rate is 20%. The total net assets shown on the balance sheet is $80,000. The management has decided that the required rate of return is 8%. Based on this information, calculate the economic value added measurement.

5)

Illustrate with an example how cost plus pricing works and how is it different from target pricing.

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