QUESTION 1

Compare and contrast management accounting with business accounting as they are currently applied to
organisations in the construction, land-based and associated industries.
Introduction:
Financial accounting is classification and recording of the monetary transactions of an entity in accordance
with established concepts, principles, accounting standards and legal requirement and their presentation,
by means of profit and loss statements, balance sheets and cash flow statements during and at the end of
an accounting period.
Financial accounting is the application of the principles of accounting and financial management to create,
protect, preserve and increase value for the stakeholder of forprofit and not-for-profit enterprises in the
public and private sectors. (CIMA, Office Terminology, 2005)
Similarities
Some important similarities between financial and management accounting do exist. Most elements of
financial accounting are also found in management accounting. There are two reasons for this; first the
same considerations that make GAAP sensible for purposes of financial accounting are likely to be relevant
for purposes of management accounting. Second, summaries of the document or computer records of
operating results, such as of orders placed, filled and shipped, customers billing, warranties made,
customer payments received, invoices received, cheques written, labour used, amounts borrowed, and
payments due and made on borrowings, provide much of the raw material used in both financial reporting
and management accounting.
Perhaps the most important similarity between financial and management accounting information is the
both are used in decision making. Financial accounting information assists investors in evaluating
companys prospects so that decision can be made about supplying debt or equity funds to these
companies. Management accounting information is used in a wider array of decisions made by managers
including decision about product pricing, raw material sourcing, personnel staffing, investing on long-lived
assets and evaluating performance of individual entities and managers
Differences:
Management accounting similar and differs in several ways from financial accounting. The important
differences between management accounting and financial accounting are summarised below:
a) Objective:
Financial accounting and management accounting also differ in relation to their ultimate objective.
Financial accounting is prepared to supply information in form of profit and loss account, balance sheet and
cash flow statements to external parties like shareholders, creditors, banks and government. From the
management point of view, the purpose of financial accounting is accomplished when it is reflected in the
above mentioned three financial statements. On the other hand, management accounting is prepared to
serve as an aid to managerial decision making process such planning, controlling and directing functions. In
planning, the management decides what action should be taken to help organization achieve its goal. In
directing, the management look ahead the operation of day to day activities and in controlling function,
step are taken to ensure the all departments, projects and sections are operating with allocated budget.
Thus, financial accounting is primarily an external reporting process while management accounting is an
internal reporting process.
b) Sources of Principles:
A related aspect is the impact of the GAAPs(Generally Accepted Accounting Principles) on the preparation
of the two types of accounting. Financial accounting is prepared in accordance with GAAPs. Accounting is
the language of business as it is the principal means by which information about a business is
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communicated to those interested in it. Therefore, the information is to be communicated effectively and
understood properly, it should be prepared in accordance with a mutually understood set of rules that
rules referred to as GAAPs. In others words, GAAPs provide a specified framework for the preparation of
financial accounts which have evolved over the years and are based on experience, reason, usage,
convention and necessity. Thus, GAAPs ensure that financial accounts are prepared in accordance with
certain norms and standards for better comprehension and reliability. On the other hand, management
accounting is for the exclusive use of the management of firm. Outsiders do not need such accounts and
have no access to them. Therefore, there is scope for flexibility in their preparation. They can be tailored to
the specified needs of the management. The criteria for inclusion of any information in management
accounting are utility. In short, financial accounting, which essentially caters to the need of outsiders, is
prepared according to the norms set by the GAAPs, where as management accounting, as an aid to
managerial decision-making, is dependent on and largely influenced by, the internal requirement of the
management.
c) Monetary and non-monetary content:
Financial accounting capture only such economic events which can be described in money term and
financial accounting reports summarise the effects of these events in primarily monetary form. However,
the management is equally interested in non-monetary economic events such as technical innovation,
human resources and changes in interest rate and exchange rate. Management accounting reports
summarise both monetary and non-monetary information that is useful for decision-makers. They show
quantities of material as well as monetary cost, number of employees and hours worked as well as labour
costs, units of products sold as well as the amounts of revenue, defect rates as well as scrap costs, and so
on. Some of the information is strictly non-monetary such as new project completion times, progress yields
of each project, number of project completed on time, numbers of customer complaints received, and
competitors estimated market shares.
d) Report Frequency:
Corporate issue detailed financial statement only annually and less detailed interim reports quarterly. By
contrast, fairly detailed management accounting reports are issued monthly is larger organization, and
reports on certain activities may be prepared weekly, daily, or even more frequently. Some management
accounting information must even be constantly updated and made available to managers on an instant
access (real-time) basis.
e) Time Orientation:
The end-products of financial accounting are the three financial statements, namely, the balance sheet,
profit and loss account, and cash flow statement. These are essentially records of what has happened in the
past. Therefore, these are aptly called historical accounts. On the other hand, management account does
not record financial history of the organization. Though past data is included in management accounting, a
major part of its contents is related to the future plans. It is, therefore, future-oriented. It aims at providing
data for budgeting, planning and so on. Thus, management accounting lays more emphasis on the future.
f) Analyzing performance:
Financial accounting relates to the business as a whole. The financial statement like loss and profit
statement and balance sheet report on overall performance of business. In contract, management
accounting focuses on parts of the business. In management accounting, the business is divided into
different division, departments and report about the profitability and performance of each of them.
Financial accounting deals with the aggregate and therefore, cannot reveal what part of the management
action is going wrong and why, in contract management accounting provides detailed analytical data for
these purposes. Thus we can say financial accounting is objective while management accounting is more
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subjective and this is because management accounting is fundamentally based on judgement rather than
on measurement.
g) Non-mandatory:
Another difference between financial accounting and management accounting relates to the need for
preparing such accounts. The preparation of financial accounts is a statutory obligation. In fact, the
corporate laws and regulations that govern the functioning of corporate organization not only make it
mandatory to prepare such accounts but also lay the format in which such accounts are to be prepared.
Corporate law also prescribe independent audit by professional auditors to endure that the accounts
reflect a true and fair view of the firms affairs. Apart from this, tax regulation also requires the
maintenance of records by business establishment. In sharp contrast, management accounting is entirely
optional. It is prepared only if it is deemed useful to the management. There are no external compulsions
for its preparation. The format, as also the items to be included, is exclusive dependent on the
managements discretion.
Conclusion:
The above point of difference between financial accounting and management accounting prove that
management accounting has flexible approach as compared to rigid approach in financial accounting. In
brief, financial accounting shows how the business has moved in past while management accounting shows
how the business has to move in the future.
References:
CEM (2010) Paper 8046 , Business accounting , Reading: College of Estate Management.
J.R.Dyson,(2005), 6th edition "Accounting for non-accounting students ", financial times-Prentice Hall,
London
Atrill, P. & McLaney, E. (2006), 5th edition Accounting and Finance for Non-Specialists., Prentice Hall,
London
"CIMA "Management Accounting Official Terminology, Second Edition (2005), Prentice Hall, London
A short but concise website offering Top Ten Essay Writing Tips is, Available at:
www.studentnow.com/features/essayswritingtips.html [Accessed 18 May 2013]
Financial Accounting and Management Accounting, Available at:
http://www.wadsworthantheneum.org/111-financial-accounting-and-management-accounting-an-
overview [Accessed 10 May 2013]
Managerial Accounting and Cost Concepts, Available at:
www.lec.edu/.../ADM%20301%20Accounting%20for%20Managers.pdf [Accessed 10 May 2013]
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Managing Products and Finance_F108MAN
Assignment No: 02
Capital Investment Appraisal
A report on capital investment appraisal of four manufacturing equipment options
For:
Strathgammon Estates Ltd.
May 20, 2013
By:
Naveed Iqbal
Assistant Secretary
PNJ Ltd
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Table of Contents
1 Introduction............................................................................................................................................. 3
2 Investment appraisal techniques ........................................................................................................ 3
2.1 Accounting rate of return (ARR)....................................................................................................... 3
2.1.1 Risk issues: ................................................................................................................................ 3
2.2 Payback Period (PP) .......................................................................................................................... 3
2.2.1 Risk issues: ................................................................................................................................ 3
2.3 Net Present Value (NPV)................................................................................................................... 3
2.3.1 Risk issues: ................................................................................................................................ 3
2.4 Internal Rate of Return (IRR) ............................................................................................................ 4
2.4.1 Risk issues.................................................................................................................................. 4
3 Results of investment analysis ................................................................................................................. 4
4 Analysis of results: .................................................................................................................................... 5
5 Recommendations: ................................................................................................................................... 5
Appendix 1: ....................................................................................................................................................... 6
6 References:................................................................................................................................................ 8
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1 Introduction
The board of directors at PNJ Ltd decided to replace the manufacturing equipment in their production
units13 of the Caxham Industrial Estate. They received four estimates of new equipment to replace old
equipment in Unit 13.This report analyses the financial feasibility of estimates of four machines by using a
number of investment appraisal techniques. The report makes a recommendation on the final selection of
machines by evaluating the results of four investment appraisal techniques. The four investment appraisal
techniques used in this report are the Accounting Rate of Return (ARR), payback period, Net Present Value
(NPV) and Internal Rate of Return (IRR). The results of the four investment appraisal techniques may not be
similar because of differences in their approaches and calculations. Hence, it is beneficial to use more than
one investment appraisal method and understand the benefits and limitations of each method before
making a final decision.
2 Investment appraisal techniques
Atrill & McLaney (2006, p.351) describes that there are basically four techniques used in practice by
businesses and these four investment appraisal techniques can be classified into two main groups. The
Accounting rate of return (ARR) and payback period are non-discounting techniques whereas the Net
present value (NPV) and Internal rate of return (IRR) are discounting techniques.
2.1 Accounting rate of return (ARR)
The accounting rate of return (ARR) method takes the average accounting profit that the investment will
generate and expresses it as a percentage of the average investment made over the life of the project.
2.1.1 Risk issues
ARR suffers from some defects as means of assessing investment opportunities, also while using ARR it
does not take into consideration the time factor for return on investment. For example, if three projects
have an equal investment and projected return a fixed period of time, they will all have the same ARR.
2.2 Payback Period (PP)
The payback period (PP) is the length of time it takes for an initial investment to be repaid out of the net
cash inflows from a project. Since it takes time into account, the PP method seems to go some way to
overcoming the timing problem of ARR.
2.2.1 Risk issues
The major problem with this method is that it does not consider the amount of cash flow in the period it
takes to repay the investment. In payback period technique, it is difficult to calculate the net cash flows and
the period in which they will be received.
2.3 Net Present Value (NPV)
The Net present value (NPV) method allows us to make a decision based on all of the costs and benefits as
well as the exact timings in which they occur (Atrill & McLaney , 2006, p.340).The NPV method calculates
the net value of equipment by discounting the cash flows at a rate which reflects the risks of those cash
flows.
2.3.1 Risk issues
The drawback of the NPV method is that it assumes constant gearing to maintain same cost of capital. This
rarely happens as cash inflows over the period change the gearing. A company will have to issue debt
regularly to maintain same gearing (Atrill & McLaney, 2006, p.343). This is difficult to do due to
administrative issues and costs. It is also not easy to calculate cost of capital that is used for discounting
cash flows. Finally, the NPV method is not useful on its own when a company faces capital rationing.
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2.4 Internal Rate of Return (IRR)
This method is closely tied with NPV .Internal rate of return (IRR) method discounts the future cash flows
and gives the cost of capital at which the NPV would be zero. This gives an idea about the margin of safety
that is available in terms of possible decline in the rate of return before it equals cost of capital.
2.4.1 Risk issues
The risk lies in IRR method is that it can give two IRRs for same set of cash flows if the pattern of cash
inflows and outflows reverses more than once during the life of equipment. It also assumes that cash
inflows during the life of equipment will be reinvested at the IRR which may not be true as the firm may not
have similar opportunities to invest in.
The investment appraisal techniques have their pros and cons and it is useful to use more than one method
to get a better picture.
3 Results of investment analysis
Option 1 (Wades equipment)
The first option is the Wades equipment with 1,000,000 capital cost and having 20,000 residual value.
The calculations and results of the investment appraisal methods of Wades equipment are shown below.
The equipment will be sold back to Wade at the end of project (5 years). It implies that the average
investment ((1,000,000+20,000)/2) over the period will be 60,000.
ARR = Average Net cash flow / Average investment = 19,600 / 60,000 = 32.67%
The cumulative cash flows turn positive for the first time in year 4.
Payback period = 3 + (80,000-67,000/15,000) = 3 years 10 months.
NPV = 100,000 +
,
( %)
+
,
( %)
+
,
( %)
+
,
( %)
,
( %)
= 11,468
IRR
Now We calculate the point at which NPV shifts from negative to positive by searching for the value of r,
called the internal rate of return (IRR) in the following equation, which makes the NPV=0
100,000 +
,
( %)
+
,
( %)
+
,
( %)
+
,
( %)
,
( %)
= 0.00
The IRR can, in general, only be derived by trial and error. Putting our values for the cash flow into
equation we find the IRR= 5.552%
By applying above mentioned techniques we derived results for other three options in the following
appendix.
Appendix: Investment appraisal table
Company
Capital investment appraisal techniques result
ARR Payback Period NPV IRR PI
Wade 32.67% 3 years 10 months -11,468
5.552% 0.115
Murray 41.29% 3 years 9 months -18,463
4.013% 0.123
Perry 42.11% 4 years 0 months -20,014
6.124% 0.114
Austin 43.81% 3 years 4 months -11,675 7.369% 0.584
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The total present value of cash flows from the equipment investment is less than the total purchase price
of the equipment. That is, the net present value is negative.
4 Analysis of results
We start our analysis in light of business decision rule that if the rate of return from the project is greater
than the return from an alternative investment, the NPV will be positive. On the other hand, if the rate of
return is lower, the NPV will be negative. A positive NPV indicates that an investment should be accepted
while a negative value indicates that it should be rejected. In our case all investment NPV are in negative so
we have to consider the less negative value in order to reduce the loss impact on PNJ Ltd.
Based on our calculation in appendix 1, figures show that Wade and Austin are close competitors as
compare to Murray and Perry therefore we sort these two competitors and make comparison between
them. The ARR, Payback and IRR methods favor Austin as the ARR value is 43.81% and payback period of
cumulative cash flow turn in positive for first time in 3.33 years and NPV -11,675 with IRR 7.369% as
compare to Wade whose ARR value is 32.67%, payback period is 3.83 years and NPV -11,468 with IRR
5.552%. All these values are in favor of Austin except NPV.
If we graph the projects NPV we can see that the IRR is the point where the NPV curve crosses the x-axis
and Austin NPV curve is higher than all of other three options.
In case of Austin, Austins NPV curve crosses the x-axis very close to 8% which is Austin IRR 7.369%. In
addition to above analysis, while deciding about investment some other point should also take into
consideration such as profitability index. Profitability Index (PI) allows a comparison of the cost and benefits
of different projects to be assessed and thus allow decision making to be carried out. A project with a
greater PI should be accepted. In our case, Austins PI value is 0.584 which is higher than any other
alternative.
5 Recommendations
The conclusion of this report has found the project to be unacceptable using the NPV, IRR, ROA and
Payback techniques. The NPV generated a negative figure indicating that proposed equipments are not
acceptable and would not result in greater wealth for the stakeholders. Suppose if JPN Ltd want to choose
(30,000)
(20,000)
(10,000)
-
10,000
20,000
30,000
40,000
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12%
N
P
V
Discount Rate
NPV CURVES
Wade Murray Perry Austin
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one of the options then go with Austin as is more favorable as compare to other three options as it is less
risky in terms of ARR, Payback period and IRR.
Appendix 1: calculation of capital Budgeting Techniques:
1. Payback Period technique:
Wade Year Cash flow
Cumulative
Cash flow
Net investment
0 (100,000.00) (80,000.00)
year 1 recovered 1 25,000 25,000 -55,000
year 2 recovered 2 22,000 47,000 -33,000
year 3 recovered 3 20,000 67,000 -13,000
year 4 recovered 4 15,000 82,000 2,000
year 5 recovered 5 16,000 98,000 18,000
= 3 +
80,000 67,000
15,000
= 3 10
Murray Year Cash flow
Cumulative
Cash flow
Net investment
0 (150,000.00) (145,000.00)
year 1 recovered 1 50,000 50,000 -95,000
year 2 recovered 2 40,000 40,000 -55,000
year 3 recovered 3 40,000 40,000 -15,000
year 4 recovered 4 20,000 20,000 5,000
year 5 recovered 5 10,000 10,000 15,000
= 3 +
145,000 130,000
20,000
= 3 9
Perry Year Cash flow
Cumulative
Cash flow
Net investment
0 (175,000.00) (160,000.00)
year 1 recovered 1 20,000 20,000 -140,000
year 2 recovered 2 30,000 30,000 -110,000
year 3 recovered 3 40,000 40,000 -70,000
year 4 recovered 4 70,000 70,000 0.00
year 5 recovered 5 40,000 40,000 40,000
= 3 +
160,000 90,000
70,000
= 4
Austin Year Cash flow
Cumulative
Cash flow
Net investment
0 (200,000.00) (190,000.00)
1 60,000 60,000 -130,000
2 60,000 60,000 -70,000
3 60,000 60,000 -10,000
4 30,000 30,000 20,000.00
5 20,000 20,000 40,000
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= 3 +
, ,
,
= 3 4 s
2. Accounting rate of return (ARR)
Company
Year Wade Murray Perry Austin
Capital cost 0 (100,000) (150,000) (175,000) (200,000)
Net cash flow 1 25,000 50,000 20,000 60,000
2 22,000 40,000 30,000 60,000
3 20,000 40,000 40,000 60,000
4 15,000 20,000 70,000 30,000
5 16,000 10,000 40,000 20,000
Residual Value 20,000 5,000 15,000 10,000
Avg. Investment 60,000 77,500 95,000 105,000
Total Cash flow 98,000 160,000 200,000 105,000.00
Avg. Cash flow 19,600 32,000 40,000 46,000
ARR =
.
.
100
ARR
32.67% 41.29% 42.11%
43.81%
3. Net Present Value (NPV)
Wade Year 1 Year 2 Year 3 Year 4 Year 5
Net Cash flow 25,000.00 22,000 20,000 15,000 36,000
Disc Factor 0.9091 0.8264 0.7513 0.6830 0.6209
PV of cash flow 22,728 18,181 15,026 10,245 22,352
Total PV of Cash 88,531.70
Initial Investment 100,000.00
NPV -11,468.30
Murray Year 1 Year 2 Year 3 Year 4 Year 5
net Cash flow 50,000.00 40,000 40,000 20,000 15,000
Disc Factor 0.9091 0.8264 0.7513 0.6830 0.6209
PV of cash flow 45,455 33,056 30,052 13,660 9,314
Total PV of Cash 131,536.50
initial Investment
150,000.00
NPV -18,463.50
Perry Year 1 Year 2 Year 3 Year 4 Year 5
net Cash flow 20,000.00 30,000 40,000 70,000 55,000
Disc Factor 0.9091 0.8264 0.7513 0.6830 0.6209
PV of cash flow 18,182 24,792 30,052 47,810 34,150
Total PV of Cash 154,985.50
initial
Investment
175,000.00
NPV -20,014.50
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Austin Year 1 Year 2 Year 3 Year 4 Year 5
net Cash flow 60,000.00 60,000 60,000 30,000 30,000
Disc Factor 0.9091 0.8264 0.7513 0.6830 0.6209
PV of cash flow 54,546 49,584 45,078 20,490 18,627
Total PV of Cash 188,325.00
initial Investment 200,000.00
NPV -11,675.00
4. Internal Rate of Return (IRR)
IRR = +
( )
( )
Wade IRR = 5%+
,
( , , )
(10%5%) = 5.552%
Murray IRR = 4%+
( , )
(10%4%) = 4.013%
Perry IRR = 6%+
( , )
(10%6%) = 6.124%
Austin IRR = 7%+
,
( , , )
(10%7%) = 7.369%
6 References:
J.R.Dyson,(2005), 6th edition "Accounting for non-accounting students ", financial times-Prentice Hall,
London
Atrill, P. & McLaney, E. (2006), 5th edition Accounting and Finance for Non-Specialists., Prentice Hall,
London
CEM (2010) Paper 1968, Strathgammon Estate Group Ltd, Reading: College of Estate Management.
CEM (2010) Paper 0265, Making financial decision, Reading: College of Estate Management.
CEM (2010) Paper 0527, Long-term decision making, Reading: College of Estate Management.
Capital Budgeting: The Capital Budgeting Process At Work Available at:
http://www.investopedia.com/university/capital-budgeting/process-at-work.asp [Accessed 15 May 2013]
Capital Budgeting Decisions Available at:
http://smallbusiness.chron.com/three-primary-methods-used-make-capital-budgeting-decisions-
11570.html [Accessed 10 May 2013]
Value Based Management" Net Present Value Method Available at:
http://www.valuebasedmanagement.net/methods_npv.html [Accessed 30 April 2011].
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