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Accounting
Module 1 – Intro to Accounting
Accounting may be defined as a series of processes and techniques used to identify, measure and communicate economic information which users find helpful in making decisions
Accounting is a service function. It provides information to decision makers
Accounting deals with economic information it confines itself to economic information as is usually expressed monetary. However it can deal in tons of raw materials, # of hours worked capacity of machinery, etc.
Economic activity must be identified then measured CIO hearts attack vs. sales rep company car tires. – The latter only can be measure and identified so it was considered
Accounting is a communication device – information must be relevant for the purposed for which it is designed. The accountant must communicate the information in a way y that the user can understand.
Users of accounting information Internal, Directors, Executives, Managers, and employees
External – shareholders, analysts, creditors, tax authorities and the public
The accounting equation All economic resources acquired by an entity must be funded from somewhere
Assets = owners equity + liabilities
Or Assets – liabilities = owners equity
Owner’s equity of a company is represented by the net assets (fixed plus net current = Assets – Liabilities = owner equity)
Assets of the company can be split into fixed (long life) and current (easier to convert to cash)
Current liabilities are those obligations which a company must meet in cash in a short time usually less than a year
Profit Loss statement
Profit is the excess sales revenue over the costs incurred in generating the revenue. Expenses accounted via the profit/loss statement are revenue expenditure vs. expenses via the balance sheet are capital expenditure
Depreciation is a deduction from sales revenue before profit is determined but has no effect on cash
Cash flow statement – shows only those events of a business which affect cash flows.
First sources of cash should always be the operations of the business
The profit is the most useful starting point for determining the amount of cash generated by operations.
An increase of creditors is a source of cash
An increases in debtors is potentially not – if they don’t pay
The cash flow statement breaks down the accounting conventions of each event into either the balance sheet of the profit and loss accounts
Types of businesses
Sole Trader Unlimited liability Business and personal assets are at risk No requirement for him to make public his profit and loss account
Partnership
Normally a partnership agreement is written upPartnership need not make public its annual results because Business and personal assets are at risk
Company A company structure avoids unlimited liability by limiting the liability of the owners – shareholders to the amount of equity paid into the company. Shareholders cannot lose any more money than the sum paid for the share
For this privilege companies must make pubic there annual accounts which must be audited by a registered auditors.
Financial accounting – the past – repots to the owners of the business how they have used resources during the accounting period. Usually annually
Management accounting - the current/future – actual and projected costs of departments, products, processes and projection on cash, investments etc.
Module 2
Profit and loss Account
Profit is the difference between the sales and all the costs incurred to bring the goods to market.
Two types of costs
Direct costs – raw materials, wages of workers in transformation the goods, and depreciation
Indirect costs – advertising salaries of service support staff
Profit is the difference of the measure of accomplishment (sales) less the measure of effort (what the sales cost)
Accomplishment is measure at the first point in the operating cycle which all the following conditions are met
1. Principal revenue product./service has been performed – product made and delivered against a firm order
2. All costs that are necessary to create the revenue are incurred or if not yet incurred are negligible or can be accurately predicted
3 – Amount collectible in cash that can be estimated with an acceptable range of error.
Justification of shipping and invoicing measure of accomplishment is the first point in the cycle at which all three criteria are met
Three other possible choices
Time of sales orders – can be challenging when there is a delay between order and shipment in which customer can change mind or change the specifications.
Time of Production – sales may not materialize in one period due to no orders in that period. I.e. shipbuilding, construction.
Time of collection. -- Installment plans for goods.Provisions on an installment plan – small down payment requiredThe payment period is long and requires payments of principal and interestThe seller has conditional title to the goods
High risk of reclaims of the product because of non payment...
Revenue is recognized as cash is collected.
Costs of merchandise sold on installment are carried in inventory in the balance sheet.
Profit loss is transferred after payment has been received
Accounting Conventions - Conventions underlying measurement of sales accomplishment
Realization convention – Only sold goods are recognized as Sales
Accruals convention – Cash does not have to be received to create value
An obligation of a creditworthy customer is good enough for a sale
Measurement of EffortProfit equals the measurement of sales minus measurement of effort – costs – What sales had cost
Three conventions
Matching convention – arrived by matching the effort (costs) with the units shipped and invoiced to customers (sales) for the period: both cost of products and selling and admin
Allocation convention – two tasks
How much of each means of products express in money was used during that period
Second task to determine how much means of production in money should be matched with sales revenue and how much to work in progress inventory and finished goods inventory
Cost convention – accountants used historical cost the price paid for them when they were bought.
Determining the means of Production
Labor, Raw materials, Depreciation of Fixed Assets
Labor – annual, monthly, weekly payroll
Deprecation of Fixed assets
Deprecation is based on rule of thumb devised by engineers and accountants to affect the use of plant and machinery.
Three common types
Actual historical (acquisition cost including installationThe estimated net residual amount once disposed.
Estimated useful like of the asset to the present however,
1 – Straight line – equal portion of the acquit ions cost less estimated residual value allocated to the accounting period. During the asserts life
2 – Reducing Balance Deprecation
Large amounts of deprecation in earlier years then tapered off. Basis is fixed asset is more efficient in generating revenue early years and repair expenditure is low in early years.
3 – Consumption Method – running hours of the machine – more hours more wear and tear
Comparison of the three
Depreciation is the allocation of the costs of assets purchased in one period over the account periods in which they are usedDeprecation is a cost of production like raw materials and labor costsDependant on method used then the amount of deprecation allocated effects profit
Deprecation does not provide cash for a replacement of the fixed asset. This cost reduces reported profit and the less cash potentionally lowers tax and diveneds
Determining the value of existing work in progress and inventory
Types of inventoryRaw material’s ns supplies inventory – bought by purchase to use in the manufacturing processesWork in progress – goods being made into the final saleable products – finished goodsFinished goods – goods manufactured, completed and ready for sale
Inventory valuation methods
The higher the Inventory value, the higher the reported profit.Once counted is valued either by the Cost or Conservatism convention.
Cost - sum of expenditure either directly or indirectly incurred
Conservatism - if the goods are not sold and a reduced price is to be realized, the sale price less the cost of the sale gives the value for the inventory.
FIFO – First in First Out
The older unit costs (first purchased) are first ones sold. Inventory at the end of the period are the latest purchased
Negatives – reported income is high during periods of rising prices because the older and lower costs which have been set off against sales.
AS prices rise, companies find it difficult to replace physical volume of inventory used
LIFO – Last in First out
Most recent materials processed and sold
Opposite of FIFO – lower profit in times of rising prices and replacement inventory is easier
Average Method.
Weighted average unit cost – all costs incurred during the entire period/ divided by the number of goods rather than at the beginning or end costs like FIFO and LIFO
Valuation of Work in Process and finished goods
Products costs – costs traced directly to the products being manufactured – raw materials, labor,
Indirect costs – wages of supervisors, ware house staff, those whom do directly work on the production of goods. Could include factory overheads – heat light, depreciation
Three types of inventory
Raw materials – cost of raw materials
Work in process – product costs accumulated for those products started but not completed at the end of the period
Finished Goods – goods ready for sale
Period costs are selling, distribution and marketing costs, general adm costs – TTS, PFME
The more costs a company puts into product costs the more the inventory is worth. The higher the inventory the higher reported profit
Interpreting Profit
Gross Profit- Sales less Cost of sales measures efficiency of the transformation process.
Net Profit before Taxes and Interest - Gross profit less Product costs measures overall managerial efficiency.
Net Profit after Interest - measures the financial efficiency of the company
Net Profit after taxes and interest - tells very little.
Summary
The Profit and Loss account or Income statement therefore measures the Sales less the Cost of Sales.
Module 3 – The balance sheet
Assets are eitherUntransformed means of production – Land, buildings, plant machinery, raw materialsTransformed – work in progress and finished goods which are not released to profit. /loss
The BALANCE SHEET
Fixed assets – Are those that a company will keep for several periods – land buildings, plants or equipment.
Expenditures to Fixed Assets – Maintenance expenses are those charged against profits in the period of outlay
Depreciation is the allocation of the outlay for the asset, operating and is deducted from the Balance Sheet over the life of the asset. Expenses for maintaining the asset are deducted from the profit in the P&L as account. Both have the same impact on the profit and loss account
Land - is not usually depreciated as it has infinite life and does not normally diminish. Capitalizing - Acquisition costs together with legal fees are included in the land value. Writing off – costs written against profit and loss statement
Accountants take conservative position and write off expenditures unless it is clearly related to acquisitions of the asset. – needed to get the asset
BuildingsIt can be depreciated.
Plant and equipment – a slower depreciation rate reduces the impact of deprecation on profits.
Fixed assets not company owned.Finance Lease - Assets leased under the terms of a finance lease (ownership reverts to the lessee at end of lease) are put on the balance sheet as a fixed asset and on the opposite side the future lease payments under creditorsOperating Lease- ownership remains with the finance company. The leased item does not have to appear, as an asset nor do the payments have to appear as a liability, though these costs are charged to the P&L account.
Advantages are - Avoids large outflow of cash for purchase
Spreads cash flow over a period Replacement of the asset without sale and purchase Maintenance cost are normally covered in the lease Payments are charged to the P&L account and therefore deductible before tax is incurred
Current AssetsAssets expected to be sold/consumed during a normal op cycle – i.e. one yearIncludes raw materials, WIP inventories, finished goods, debtors (accounts receivable)
Inventories Value of inventory based on lower of cost or market value Cost is direct manufacturing cost plus share of manufacture overhead. Admin overheads are not normally in this Reported profit can be changed by the type of valuation of inventory. If valuation method is switched you must tell shareholders and users of financial stament’s so a proper analysis can be made.
DebtorsCustomers at the end of the period have been billed by company but have not yet paid.To take care of potential bad debts and the matching convention not being realized A provision for bad debts is made.Size of provision is made by considering Risks attached to each customer Severity with which the company will go after debtors Economic environment – interest rate changes
Cash – must ensure that company has cash to meet operating needs and investment plans. However, idle cash produces no revenue
Current LiabilitiesConsidered to be those debts owed by the company which expects to pay in the next 12 months.Ex - Creditors, bank overdraft, taxes payable on profits.Deferred revenue – advanced revenue is placed in the balance sheet as a current liability because the company has not fulfilled the service yet
Net Current Assets and Net AssetsNet current assets (net current liabilities) = current assets less current liabilities
Financing Net Assets – Internally generated assets – original equity and operations that produce profit and not distributed to the owner. The sum of these is the ownership equity.
External sources - long tern loans – usually have long term fixed interest, or bonds payable on a given date Secured – lenders have a guarantee that if company cannot pay loan or company is liquid dated before loan is paid. Then certain assets belong to the lenders to pay the debt. Lenders of long term loans have the right to annual fixed rate interest. Amount of interest charged as expense against profits before shareholders get dividends. The higher the gearing (higher amount of total equity is by loan); the higher the amounts for equity payments will be when profits are high. When profits are low, highly geared companies have a lower return as more money is paid in interest.
Module 4
Cash flow statements show companies if they have sufficient cash funds to finance its operations and future ambitions for dividend payments to the owners and investments in assets and acquisitions
Remember profit doesn’t equal cash
Cash is cash balances bank balances and cash equivalents i.e. temp investments of cash not needed write now but will be readily available
Where does cash come from?
Profit from the operation - this does not include depreciation which is added back in the Cash Flow statement. Equally it does not include provision for bad debt. This is recorded as a charge against profits in the P&L account.
Capital Introduction Increase in Creditors Sales of fixed Assets – amount released less the costs associated with disposal are included
Loans – banks or other lenders for a specified period Decrease in Inventories – reduction in inventories is a source of cash Decrease in debtors
Where does cash go Loss from operations Capital repayments – company uses cash to buy back its own shares thus reducing capital base Decrease in Creditors – very negative effect on cash Purchase of a fixed asset Repayment of Loans Increase in inventories – companies are looking to have just in time inventories, thus freeing up cash Increase in Debtors
Eight major categories of Cash flow
1 – Cash flow from operating activities – a company that fails to produce cash from operations will fail because suppliers of loans and credit will not give more cash to run the company2 – Cash flows from returns on investments and servicing of financeinvestments in other entities and cash paid out to non equity shareholders and minority interest and interest on borrowed money3 – Taxation – tax paid over the government. – Tax is paid on year often relates to profits of previous years.4 – Capital investment – receipts from sales or disposals, or payments to acquire property, plant and equipment5 – Acquisitions and disposals 6- Equity dividends paid to shareholders7 – Management of liquid resources’8 – Financing
To do a cash flow you need four things1. Profit and loss account for the period2. Balance sheet at the beginning of the period3. Balance sheet at the end of the period4. Supplementary info – on financials
MODULE 5
THE FRAMEWORK FOR FINANCIAL ACCOUNTING
Disclosure - protects investors (creditors and share holders) in Limited companies from unscrupulous traders in that it requires that certain information be reported in a certain manner at certain times of the year.
A limited company is liable for the amount of the initial investment at the par value of each share. A sole trader is liable for everything to the shirt on his back and the tools of his trade. Companies do not want to disclose for fear of providing competitors and predators with useful information and for fear of interference from out with.
Sources of DisclosureThee main sources of rules governing disclosure practices
Government legislation i.e. Companies acts in 85 and 98 Accounting profession rules of procedure contained in international Accounting standards Requirements of stock exchange for companies whose ordinary shares are listed on exchange
Companies’ acts – company profit and loss and balance sheet give a true and fair view of information and state of affairs. Accounting standards – they set controls on the numbers in the financial statements are to be compiled. I.e. switch from FIFO to LIFO non only must be disclosed but the effect on profit as well
Stock exchange agreement – company wants a price on the exchange it must give detailed info about the management and finances of the company. For every year.I.e. geographical analysis of sales turnover, details of share holders more than 20 %, dividends waived by directors or shareholders.
Group of companies – responsibility for publish group accounts rests with the holding company (owns over 50%). They must provide group results and subsidueary results
Accounting Policies
True and fair view – financials must reflect a true and fair view of the state of affairs of the company. External auditors – external auditors must approve the selection of accounting policies. Consistency – management must consistently apply the policies from year to year. Unless economic conditions have altered dramatically
Review of the consolidated balance sheet Called up share capital - companies are authorized to raise a sum of money through selling shares. Number of shares is capped by government. Company then must petition courts to raise its legal limit on share capital. Share premium accounts – company selects a price around the stock market price. Price is likely to be far in exce3ss of share face value Companies finances are totally unaffected by daily movements in share price.
Fundamental Accounting Concepts
The going Concern concept A company will continue to trade for the future. Any occurrence that would jeopardize the company must be reflected immediately in the accounts where the impact will be
The accruals concept – company does not wait for cash before accounting for revenue and costs. Revenue is recognized when e sale made and shipped, invoiced, even though the
customer has not yet paid. Costs incurred in fulfilling the sales even though no cash may have been paid
Consistency concept Assumed that treatment of the like items between years is the same
Prudence Concept Revenue/profits are not recon zed until all effect expended and the customer is likely to pay. All costs and losses actual and expected are recognized immediately. Prevents reporting profits before earned
Non Aggregation concept – amount of each individual asset or liability that was not taken in to accounts shall be determined separately. I.e. show Net current assets – all parts must be show separately.
External Auditor
Role – all limited companies have accounts audited by and independent accountant
Auditor will make report to shareholders on accounts that were examined. Report will say in auditors opinion, a true and fair view is given of profit for the year and the financial position
Audit Methodology
Auditors must ensure that the books have been maintainedKey aspects of there work
Examination of the system of booking, accounting and internal control is appropriate Comparison of the balance sheet, profit loss and other statements are in order Verifications of title, existence and value of assets Verification of the amount of liabilities appearing in the balance sheet Verification of results show in the profit loss accoui9ing Confirmation that all requirements have been used and standards have been applied.
Internal control – various measures taken by owners and mangers to direct and control their employees. Procedures established to make them accountable for behavior.
Auditor will show any shortcomings in internal control to the attention of management in the end of audit letter. Also goes to board of directors.
Materiality – limit usually in money, which auditors will not examine in depth. The auditor sets the limit
The audit report – shows that accounts give the information required for the companies act Balance sheet gives a true and fair view of the sate of the company’s affairs Profit loss is fair and true Holding company has group and subsidiaries that are fair and true
Also must haveIf auditors are unable to satisfy themselves in Obtained all info and explanations required Books of account have been kept Returns adequate for the purpose of their audits have been received to subsidiaries. Accounts are in agreement with books.
Report is unqualified if auditor aggress with the above Unqualified is they do not and must state reason why and extent of why
Module 6
A financial ratio is a relationship between two numbers on companies’ financial statements that is derived by dividing one quantity by another.Purpose is to reduce the amount of data to a workable form and make it more meaningful
Liquidity ratios – to measure a company’s ability to meet its short term obligations
Current Ratio – current assets by current liabilities. Rule of thumb is that 2 times current ratio is a sound financial situation
Quick Ratio – aka Acid Test – Rule of thumb of 1 times ( no matter how great the losses incurred on a sale the company still has enough to pay its obligations
Profitability RatiosTo measure managements overall effectiveness
Gross Profit Margin
Profit margin - typically profit before taxes
Return on Total Assets – shows how a company has been working its assets
Return on specific assets
Return on Capital Employed – the total assets of a company minus the current liabilities or option of owner’s eq plus long term loans and provisions. This figure is an indicator of the magnitude of the resources locked up in the business and working for the shareholders and the providers of loans/debt
Return on Owners equity
Capital Structure RatiosExamines the asset structure of the companyAnalyze financing arrangement of the companies’ total assets and how much the company relies on debt
Fixed to Current Asset Ratio –e x for every $1 invested in current assets, this company has invested around 1.31 in fixed assets
Debt Ratio – proportion of assets that are financed by debt
Every $1 that the company has invested in assets, 39.78 has been contributed by persons other that shareholders
A low geared company protects its shareholders in times of economic hardship but by the same token fails to allow them to cash in on good years.
Times interest earned – measure the gearing position and margin of safety in relation to earnings, measures the level to which earnings can decline without the company being able to meeting annual interest costs.
Efficiency Ratios – how effective a company has been managing its assets?
Inventory Turnover – try to identify the raw material and labour components in the cost which are deducted from turnover to calculate operating profit
. This is a historic figure given on the year end figure of inventory and must be checked in management terms against the year to see if it is the common length for keeping stock. Inventory can act as a buffer for a sudden demand and it may be cyclical that this occurs at the year end/beginning of next and this is the reason if the figure is high. Equally ’just in time’ inventory and the rapidly changing market for electronic goods makes large inventory a danger for some companies.
Average collection period – day’s sales outstanding – is calculated by dividing debits by the daily average of sales
Fixed asset turnover – related the fixed asset to the level of sales generated from them
Window Dressing – Managers may be tempted to enter artificial arrangements with the sole purpose of make there accounting and the ratios calculated look better
The DuPont ChartOne of the most important ratiosReturn – profit and sales and Total Assets – Sales/investment in assets
Inventories + Debtors + Investments + Cash + Fixed Assets = Total Assets are divided by Sales to give Total Asset Turnover.
Cost of Sales + Distribution Costs + R&D + Administration Costs = Operating Costs are then subtracted from Sales to give Trading Profit which is divided by Sales to give Return.
Total asset Turnover and Return are multiplied to give the ROTA.
One Hundred percent
The one hundred per cent statement – where sales are set at 100 percent and each item of cost is calculated as a percentage of sales
Basic market ratiosEarnings per share (EPS)
Price Earnings RatioMarket Price / EPS. This figure represents the purchase of the number of years profit to achieve it. It could be taken as an indicator of whether or not to invest in the company.
Dividend yieldThis tells the investor what the return is on the share based on the market value of the share not the ordinary share price.
As tax is paid before the dividend is paid, companies add the tax paid onto the Dividend figure before dividing it. These figures allow investors to compare companies to see who give the best return on their shares.
Taxes at 20%
Dividend Cover. This figure allows an investor to see if profits are being paid from profit or from reserves
Module 7 Emerging Issues and Managerial Options in Financial Reporting
Managers are under pressure to increase profits and growth for the company. This will increase the value of shares and the desire for people to invest in the company to grow and so on. Analysts advise investors where to put their monies and they rely on predictions for profits at the end of each reporting cycle. If the management meets the predicted profit, share price will stay the same as it went to at the time the prediction was published. If it is higher, share price may increase. If it is lower the price will undoubtedly fall.
It is in this environment that manager’s look to improve their returns though not always by improving their operating profit.
Research and Development (R &D) Expenditures made by a company each year to ensure a steady flow of new products and services for future years. Because much of R&D is uncertain in value, need to be conservative, to write off all the expenditures as incurred, rather than capitalize a series of annual costs which may turn out to be worthless
Development expenditure may be captialized provided that it
Is a clearly defined project Related expenditure is separate from all other R&D Outcome has been assessed with recognizable certainty too Its technical feasibilityo Commercial viability in light of market conditions, public opinion and consumer demand and environment legislation
That future sales and revenue will exceed all costs ( deferred development, production, selling.admin) And adequate resources exist, or can be made available to get the project done and provide increases in working capital.
Off Balance Sheet Transactions
Stock Market regards high gearing as negative and regards to situation as an indicator to more issues of shares to enable a company to lower its gearing ratio to a more stable level. When a share issue is anticipated, right or wrong, typically share price is marked down
To cover borrowings that will give the appearance of being highly geared, companies may attempt the following Off Balance Sheet Transactions -
Quasi Subsidiaries A subsidiary is a company whose equity share cap was owned by another of 50 percent or more
1.An investment company can make it so share capital and voting rights attached to the other company is done so it avoids owning more than 50 percent but has control of management decisions It holds all the ordinary shares in the sub but is not a legal sub because another category of shares held by a friendly 3rd party qualifies as equity capital and amounts to more than 50 percent.
2. In this example, the parent company set up another company and sells it some of its assets. The other company is funded by loans from and by purchasing from the parent company, and is putting money back into it. The parent company then manages the assets for the subsidiary and if the subsidiary sells the assets, it pays the money back to the parent company through some management charge.
3. Where a parent company sets up in a joint venture and leases back its assets from the subsidiary that has purchased the asset, this is shown as an investment in an associated company. If, The parent company is the lead partner and exerts a dominant role, or Can take back its asset under beneficial terms (not full market value), or There is an unequal share of profits, losses, dividends and or loan guarantees, Then the parent company must register the company as a subsidiary under FRS 5 because in all the scenarios, the parent company has control.
Consignment Inventories – car dealers
Manufactures send to dealers the inventory for sales but no payment is required at this time. Manufactures has legal title until inventory is sold.
IN FRS 5 the accounting profession has two types of agreements that may exist between dealer and manufactures
Dealer may return the unsold goods with no significant penalty, does not bear risk of inventory carrying and the items (including financing) are not on the balance sheet
If dealer is obliged to pay for goods, whether of not sold. Risk is on the dealer and the inventory is deemed an asset
Sale and Repurchase Agreements - here the company sells part of its assets that never leaves its control and buys them back at a later date plus interest. This is a loan and should be shown as such in the balance sheet with the accrued interest being entered in the P&L account. (Whiskey Company, whisky still at distiller)
Debt Factoring
Companies who wait for their money from debtors may have to borrow to fund their working capital until payment is received
They can sell debts to a finance house to collect the debts on their behalf. The house will buy the debts at a discount and hope to collect full value. If the finance house has no right of recourse to the company, if the debts go bad then the transaction is fine Company would reduce asset Debtors and increase cash and write off difference through p/l Problem is factoring deal - finance house has recourse to the company when debts go bad. FRS5 required to company to keep a proportion of the sold debts on balance sheet with matching liability to the house. When debts have been recovered then they can be removed from the balance sheet.
Acquisition accounting – reflects normal takeovers where the predator (holding company) acquires more than 50% of the equity share capital of the target (subsidiary) for cash or shares or a combination. The difference between the par value and the share price goes into the Share Premium Account. Anything paid over the Net Asset value for the company is Goodwill and will show on the consolidated balance sheetMerger accounting – based on concept of agreement rather than attack and take over Presumes agreement between both parties to pool interests and resources.
Managers can have access to more free reserves than under acquisition where legal structures are in place on the share premium accounting.
Merger accounting however, must follow FRS 6 – Acquisitions and Mergers, conditions
None of the parties is acquirer or acquired, both equal No party dominates the management of the combined company Sizes of the combined companies are no skewed so that one company dominates the combined entity because of its size. Each party receives primary equity shares No equity shareholders of the combined company have material interest in only the combined company.
Goodwill
The excess over book value that a company is prepared to pay for anther companies assets.Good will is an intangible asset – value locked up in one company which another is prepared to pay for because it gives them future economic benefits. Two schools of thought on how to account for1 – Write off the good will at the moment of acquisition against reserves2 – Capitalize the amount paid as an asset and depreciate the asset over its life
Assets should be capitalized and placed on the balance sheet. But must be written off year by year in a manner that reflects its reduction in value.
Shorter the period for write off the greater the impact of profits. Speed of write off does not have to be constant. The period of amortization must be subject to an impairment test. This is a detailed consideration of the inherent value of the goodwill. If there is no value then it must be written off.
Brands
On the balance sheet potential as an intangible asset Brands are the names of consumer products can bee seen as having value because they are so well known by the consumer.
The construction of brands value on the balance sheet can have the following effects for a company
With acquisitions and mergers, companies can be left alone by predators or have bid price raised on the value of the assets. By putting a value on their brands on the balance sheet Aggressive predators that use issued shares in their company in exchange for a target company will put brands on the balance sheet to drive up sheer price before the acquisitionBrands increase value of total assets Restores a over geared situation since OE is increase by the brand amount Increase balance sheet size could mean no shareholder approval required for future acquisitions If brands are a component of purchased goodwill. Then an amount for the brands purchased as part of the acquisition can be stripped out of the goodwill figure and capitalized separated on the balance sheet. Lessens impact on reserves of subseque4nt profit.
Brands are valued at historic cost or Earnings MethodHistoric Cost - all the money spent on developing and maintaining the brand are capitalized. R&D and marketing costs which have previously been written off are written back into the value of the brand.Earnings Method - Management attributes the actual earnings of the company to specific brands and then applies a multiplier which reflects the brand strength. This guess upon guess method.
Operating and Financial ReviewReview is meant to provide companies to product a clear, balance analytical discussion of the companies’ performance. Of the past year and future opps and challenges that face the company
Operating Review could include Changes in market conditions New products and services introduced or planned Changes in market share
New activities, discontinuations, acquisitions, disposals Scarcity of raw materials and/or labor Training Financial contributions
Financial Review – could have Capital structure of the business Capital funding and treasury policies Cash gerneate3d from operations and other cash inflows during the period Restrictions on the ability to transfer funds from one part of the group to another Debts that could restrict the use of credit options. Strenghts and resources of the business who value is not refe3lctd in the balance sheet i.e. R&D not capitalized.
Environmental reporting
Review on benchmarked performance on safety at work, health of employees, protection of customer’s and public from risky products, and recycling programs.
Impairment of Fixed assets and Goodwill
UK FRS has added rigor to the process and goodwill and fixed asset amortization on
An impairment review is conducted when A company has goodwill on the balance sheet and is not amortizing over 20 years or less The second is where indications of impairment say that companies’ assets may not be fully recoverable – Factors include Continually operating losses or negative operation cash flows Significant fall in asset market value Asset physically damaged or becoming obsolete Adverse change in competitive or regulatory environment Significant re org Major loss of key employees Significant increase in market interest rates or other rates of return.
Impartment review principle – fixed assets should not be carried in the balance sheet more than their recoverable amount. Or higher of the NRV - net realizable value and value in use ( VIU)
If recoverable amount is higher than NRV and VIU then have to show that one of these is not less than carrying value then NRV is simple value at which asset could be disposed of Where NRV of an asset can be shown to be at least or greater than carrying value, nothing needs to be done
1st adjust Carry value if VIU is lower than carrying value then adjust good will a\s the cv and VIU must match at least
Provisions and contingencies
Module 8 – Intro to Cost and Management AccountingA refresher –
Accounting is a service function an not an end in itself
Accounting deals with economic information and avoids the occurrence of events and happenings which cannot be quantified Accounting is a communication device.
Management accounting looks forward - as apposed to corporate financial accounts which is historic
How accounting fits into a company
First group of tasks – managers must plan for the future; they must consider the support services the need to assist them. Co ordination is a key role in the managers planning activties i.e. sale manager may plan 50 Percent increase in units of A but production manager has limited supply of materials for A
Differences between Management accounting and financial accounting
Management accounting and cost accounting – cost accounting is a major and essential part of management accounting. Classification, collection and analysis of costs are fundamental to management planning and control.
Management accounting serves management in the following ways:1. It is the primary source of information to assist management in planning2. Provides skilled staff to assist management in interpreting the accounting and non-accounting numbers produced3. Management accounting information pervades the whole company and therefore acts as a good communicator. It does this by involving many people in the planning process and
then by informing them of actual operating performance by means of feedback and control reports.
Module 9 - Cost Characteristics and Behavior
Variable and Fixed Costs
Variable Costs are those who can directly related with the volume produced i.e. if a company manufactures no product then they will have no variable costs
Fixed costs are those that remain constant regardless of output i.e. managerial salaries, rent rates etc.
Beware of the possible calculation error that when fixed costs have been unitized, that is associated with each unit for production for a certain number of units. Example: Fixed costs/unit=$2 (when 100 units are produced), variable cost/unit=$2, for a total unit cost of $4. When production is raised to 200 units, the fixed cost per unit does not stay the same; it is now $1/unit as it is now spread across 200 units. When looking at per unit cost, it is not always clear whether fixed costs have been unitized or not.
Direct Costs - Those which can be seen to be incurred simply because the item is manufactured
Indirect Costs – all other not captured above. Indirect costs are seen by the accountants as being costs incurred in support of the fundamental activities of manufacturing, buying, and selling; they are not attributable to a single product or range of products
Traceable costs - costs that can be traced into the cost itemCommon costs are indirect costs incurred by a business to support all production
Product costs are costs which can be attached to the cost items without very much difficulty.
Period costs are costs although incurred ultimate in support of product are best controlled in time periods.
Controllable and Non controllable costs Controllable refers to the person – manager or foreman who is held accountable for the costs measured – foreman (overtime) CFO - Insurance costs. These are usually time framed as well. Non-Controllable costs can not be controlled by that manager or can not be controlled by the manager in a certain way
Standard and actual costs - budgeted costs for one cost item based on studies and recent experienceActual costs – are what happenNote – standard costs have both variable costs of cost unit and share of fixed costs.
Engineered and Discretionary Costs – Engineered – direct and critical items of manufacturing that were engineered into the product - such as the raw material and the labor it takes to produce the item),Discretionary costs – managers responsible can reduce spend if business needs. I.e. R&C and Maintenance
The break even chart – Break even point – business sold all the units made, the total costs (variable and fixed) would be met by revenue from sales). Anything above breakeven is called margin of safety
In Break-even analysis the fixed costs are taken as a given and the focus the attention on the rate at which profit is earned. This “profit” is usually referred to as contribution.
Equation method
Contribution Margin Method
Contribution and Limiting Factors The secret of good management is to identify the limiting factors and calculate the contribution margin per unit of limiting factor. The higher the contribution margin per limiting factor, the more the good in question contributes to the bottom line.
Assumptions underlying the cost-volume-price analysis:1. All costs can be identified as either fixed or variable2. Variable costs rise linearly, fixed costs are the same for all volumes produced3. Sales price per unit remains unchanged4. The sales mix (mix of products) will be maintained precisely as budgeted, as total volume moves up or down5. All production is sold
Module 10 Allocating Costs
Where do costs come from?
Materials
Cost item – is an unit of production
Materials are perhaps the easiest cost to trace to a cost most of the time because of there physical nature
Standard price is usually set for a pre determined time for ease of calculation
Any differences which arise between the issued price and the actual price hits the profit and loss account as a price variance at the end of the period
Just in time inventory helps reduce inventories of raw materials to almost zero freeing up cash which can be used for revenue building
Labor
Labor cost is a multiple of time spend times rate of pay earned by each operative
Rate can be difficult to determine with different amounts being given by employee.
Standard wage rate is given; this will be more than just wage and may have out of poke costs like social security, pension incentives
Overheads – Manufacturing and Non manufacturing
Both types of costs are indirect – no close relationship tied to outputs of production
Manufacturing overheads are supplies of low value high use components – screws, glue adhesive, power, and production supervision depreciati9on
Non Manufacturing Overheads – includes administr5aiotn, selling, and distribution financial costs including bank interest
Overheads need to be under constant review because costs can escalate.
Overheads costs should be put into cost centre’s – pockets of activity for which The difference between actual individual managers are responsible for – sales manager – fleet costs
Principal cost manager can sub divide to other mangers to make accountable
Predetermined overhead for accounting period divided by budgeted production units
Difference between actual figures of overhead incurred and t6hat allocated to the product hits the profit loss account
Plant wide vs. Departmental Rates Typical activity bases for service department costs included
Personnel. Welfare services Computing Machinery buildings Power Executive salaries Production scheduling
Direct methodOverhead costs for service departments are emptied out in to the production departments and added to the overheads already there to calculate two predetermined overhead rates.
Direct method of overhead cost allocation is straight forward approach to clear out service department overheads
Step method - recognizes that departments certain costs to service each other.
Two methods of calculation
Select service departments in descending order of magnitudes of overhead spendOrSelect first the department that renders the highest percentage of the total services to other departments and end with the one that renders the lower percentage of service to the service departments.
Example of A below
Rule of thumb – overheads should fall on the products which have caused them
Joint products and by products
Joint product – product that must appear during the process involved in production the main product. Management has the option of not allowing second product to emerge from the processEqual shares costing– equal shares based on production are allocated to t6he products
Physical Characteristics – underlying principle in the physical characteristics method is that things like weight volume or difficult to handle causes certain costs to be incurred
Sales value at split – sales value determines amount of costs
Ultimate net sales value – like above but business will process products further after split off point for things like
Product management – marketing design, development costs Or for inventory valuation – i.e. end of year external accountings for shareholders –
business to attribute a value to costs of goods sold and unsold.
By products are different from joint products - Joint products are planned for a product process caters to them
By product is one which emerges from a production process Product and manager effort is devoted to the main product but another product emerges at the same time which has low sales value relative to the main product.
The revenue generated from the by product would be deducted form the costs of processing before determining the gross margin from operations.
Only revenue generated from actual by product used can be deducted form cost of sales balance carried in inventory at zero cost.
Process CostingJob costing, the cost items are physically separable to such an extend that cost can be traced to each one; the items are deemed individual jobs which incur separate costs. Process costing is used when no uniqueness is identifiable in the products produced and where the process is almost continuous.
Averaging costs incurred is used in both job costing and process costing With job costing averaging technique is usually reserved for indirect over4ation For process costing accountings use the equaling units of prdo8ct Equivalent unit of production is an assessment of the degree of completion of a unit
under each major cost component.
Example:A company starts the year with 2 million liters of paint in production that are 50% complete. During the year it produces 12 million liters of paint as output. At the close of the year is has 4 million liters in production that are 25% completed.
Material Labor/ConversionOpening work-in-progress - 1 millionUnits started and completed 12 million 12 millionClosing work-in-progress 4 million 1 millionEquivalent units of production 14
million12 million
In order to determine the cost of material per unit, the total material cost has to be divided by 14 million. In order to determine the cost of labor per unit, the total labor cost has to be divided by 12 million.
Cost per equivalent unit Costs to be accounted for in any production activity comes in two parts Those attached to open work in process at the beginning of the period but were
incurred in the previous period and Two - costs incurred during this accounting period in order to finish the opening work
in process, make units started and finished din the period and start work on the units left in process at the end of the period as closing W.I.P.
The FIFO method for production costing calculates a period’s cost precisely as incurred and without averaging out the cost. The weighted average cost method can be used when cost fluctuations around a predictable level occur and management does not need to be altered of the regular fluctuation in unit cost.
Activity Based costing
Focus on activities (product planning quality inspection) rather than products, cause cost to be incurred and products consume activities (costs’)ABC claim shortcomings of costing listed above are allocated by this technique
1 – ABC causes the cost of products to become the principal goal not to be subservient to inventory valuation
Different activities have different cost drivers. Business with complete production will have multiple cost drivers to load overhead across products. Costs fall wherever they are consumed
ABC embraces call costs including R&D, quality control production and marketing. Does not restrict to production overhead only.
ABC reflects complexity of production, and marketing, and costs are loaded into the price, Simple products with few requirements receive a light burden of overhead.
ABC gives strategic insight by providing accurate product costs
ABC is most helpful in industries that produce customized products in low volumes and where product diversity, speed to market, quality and reliability are the factors that keep a company competitive.
Module 11
The Dilemma of the Denominator
Here the problem of the numerator and denominator is what figure to use to calculate the cost of the product is it the budgeted or actual manufacturing (or non manufacturing) overhead that is divided by the budgeted or actual output to give the cost of the product.
The numerator - the cost of overhead can be determined more easily as prices tend not to fluctuate over short periods and can be predicted if costs are subject to contract (the price you buy in your goods at).
The denominator can fluctuate from month to month as you cannot guarantee to produce the same amount every month or sell the goods produced. Downtime can result in shortfalls of production.
Absorption and Variable Cost AccountingUnder full or absorption cost accounting the full amount of the cost of sales (variable and fixed, direct production related and direct production overhead) are charged against the sales
revenue to arrive at the gross profit. Under variable or direct cost accounting the fixed costs of production are accounted for as a lump sum.
The extra products are put into the inventory. Each is valued at the full cost of production
If, in the next period production is less to account for the over production and the goods produced plus the goods in inventory are sold, the variance is added back to the expenses in the P&L account thus reducing the profit.
Variable Costing Fixed production costs are not added to the individual product but deducted from the
gross profit in the P&L account after sales at the end of the period under review. The goods sold after the variable cost of sales is deducted, are said to leave a Contribution Margin (to fixed and other costs).
From the Contribution Margin, fixed and other expenses are deducted to leave a
profit.
If there is an over production, these goods are put into inventory at the cost of production without a share of fixed production costs.
If in the next period there is an under production and the goods are removed from inventory for sale, then the total sales less Variable costs gives the contribution to fixed and other costs which is again deducted to give the profit.
Managerial implications of absorption vs. Variable costing
Management may not have a decision in which method Many tax authorities insist of absorption costing because inventory valuations are
normally higher and therefore taxable profits are higher Sole criterion for choice must be which method shows the clearest set of signals.
Absorption costing gives managers the potential to influence bottom line profit Absorption costing – profit is influenced not only by sales but also by production
levels. Upping production beyond sales management can increase profits because more fixed production expenses are parked in inventory.
Under variable costing profit is a function of sales, when sales rise so do profits. Variable costing recognizes the all fixed production expense in every accounting
period. Absorption buckets them into inventory to eventually release in next period.
Cost information for management decisions Routine are those decisions manager takes in normal course of events
o Sorting out production disruptions, dealing with customers on issues, Cost information can be extracted routine cost systems
Non routine usually require less personal, direct negotiation on the part of the manager. They require logical analysis of the facts and alternatives
Cost data tends to play a significant part in non routine decisions. Examples could be whether to shut down a product or department, invest in a new R&D project, or continue with a current or a different supplier.
Developing an analytical framework. Task one – Define the problem and list feasible Alternatives Task two- cost the alternatives – relevant costs in every situation requiring a decision
are those that differ for alternatives under review Task three – Asses qualitative factors – relationship to workforce not just costs Task Four – make the decision Decisions are made even if they are wrong
Finding the relevant costs – is cost that change as a result of the decision being contemplated.
Full costing – the pitfalls Full costing which allocate all costs, direct and indirect to units of output to be sold. Danger in this is once allocated, fixed costs assume the characteristics of variable
costs. I.e. more volume produced the higher the costs.
Opportunity costs – what is the cost of making a decision on an option if it doesn’t taken another option.
Accountings don’t like these as costs, cannot be determined with the accounting system, and are highly subjective
Department vs. Company
Cost decisions must take into account the effect on the company as a whole not just the department concerned.
Sunk costs – costs which have been incurred are ignored when looking for relevant costs
Relevant costs are future costs, and involve cash spend or saved.
Management decisions in action – examples of relevant costs
Future costs – old costs not to influence future decisions.
Cash costs – relevant costs are all future costs; these involve cash flows. Need to be concerned with real money implications of decision not accounting implications like depreciation
Avoidable costs – if cost is avoidable , even future cash cost, its not relevant for the decision under review, it will happen anyway
Those which differ among alternatives - is another way of looking at avoidable costs. If the same cost is incurred in all options, ignore it as it causes confusion.
The following three scenarios are common non-routine management decisions: Closing down a unit
o How long should operations keep going, if products contribute towards fixed costs then should product continue
o Fixed costs may be reduced if opera rations were shut down
The special sales order: Management needs to decide if it wants to offer better conditions to a large potential customer than it usually does.
Should we process further: Management needs to decide whether it is worth to process a by-product of a process further?
Module 12 - Budgeting
Budgeting has the following attributes Co ordination – coordinates activities within the same organization. Aspirations of
sales team can be realized by production department
Planning – It encourages planning. A detailed plan sets out the targets for the entire organization to aim for. Sales plan will dovetail with production etc.
Motivation – Promotes motivation – budget is broken down into its dept parts and dept heads have a clear picture of the route ahead for the next period
Control It provides a control benchmark against which actual performance is measured A budget is a plan of action usually expressed in numbers which sets targets for
individuals and the business over a time frame.
Why Budgeting gets a bad name
Time taken – demoralizing in length of time taken for managers not knowing how the current year is panning out before being asked for assessment of next year. The budget process should start as late as possible in the current year consistent with getting agreement by the start of the New Year.
Lack of Top management commitment
Budget holders (managers in operating divisions) resent effort and self control required to keep within budget. Only to see out of control spending by senior exec.
Only if the whole management team shares the idea of constant improvement of operating performance will commitment of lower staff be ensured
Form of Punishment Budgets are seen to be for control purposes only, to keep things to absolute minimum
of resources required to do an okay job Budgets are the principal vehicle for planning and control in a company. Requires
consultation and co ordination with all levels. Managers will feel they own part of the budget if they are part of the construction
Responsibilities are blurred Budgets are a means that all costs and revenues are planned for the next accounting
period. Manager don’t like to be responsibility for costs out of there control i.e. marketing
executive salaries. Corporate expenditure should be allocated to a budget holder responsible. The budget holder should have responsibility only over controllable costs.
Moving Goalposts – Numbers are not updated in light of changing environment – collapse of customers.
They feel budget should be adjusted.
Challenge is the effort originally used to get to original budget should not be misplaced
Companies can fix in one of two ways
Adopt rigid view of original budget. No matter what happens, budget is benchmarked against performance that will be measured. In reporting variances of actual and budget would be striped out by accounting before highlighting variances which the manager should be responsible for.
They can implement a rolling budget, as current month expires; another month is added to the budget – rolling 12
Budgeting rewards inefficiency
Blanket approach – 10% more what could you do??? Departments or divisions which have slack in their proceeds will be given additional
percentage uplift on the element of slackness. When reductions may occur, slack departments can give it up easier than efficient ones.
Top management should be tougher and more rigorous than blanket approach There should be competition for surplus resources within the org,
Discretionary expenditure and Zero Base Budgeting
Discretionary costs are those that do not need to be incurred, at least in the short termo R&D, marketing, legal
Discretionary costs are difficult to budget for and manage as it’s hard to determine measure of output.
Budget holders are not sure of corporate objectives and are unsure of what their efforts should be focused on
Major issue concerning discretionary is that not easy to control on a n annual basis I.e. R&D runs across several years.
ZBB -Zero based budgeting can help
IN ZBB Management invites certain activities to bid for resources as if they are starting from scratch (zero base) Tool can only be adopted in areas of discretionary where management must decide the level of expenditures that is appropriate for the business at the current time
ZBB involves analysis of an activity like R&D into packages of work that can be separated from each other. Starting with the most fundamental activity and building up to those if resources are made available it would be beneficial to undertake.
Packages of activities are costed and placed alongside other ones and ranked in order for top management priority decision making
ZBB also requires corporations to identify minimum levels of expenditure below which there proposed activities cannot really operate. New requests for increase spending must be given a priority against existing commitments
Zero-base-budgeting has two significant drawbacks: Dividing activities in to packages is often problematic and requires a lot of effort (and
cost).
The definition of the packages is left to the management of the function under review. This might leave questions open on the potential vested interest in the definition of the packages.
Top management might need external expert opinion to review the packages
Module 13
Standard costs are budgeted costs for individual cost items or a budget is built up from many standards costs. Standard costs are compared with actual costs and explanations are sought for the differences if any
Normal or operations standards are those which could be expected to be achieved by a productive operations operating carefully and efficiently but also reflects the normal problems which surround a process where things can go wrong.
Material usage standards: An engineering study will help to determine the following two standards:
a) The ideal or engineering standards are the standards achievable (e.g. amount of material needed) if every aspect of production works to maximum efficiency.
b) The normal or operating standards are those that can be expected to be achieved by a productive operation operating carefully and efficiently, but which also reflects the normal perils.
Materials price standard – based on expected purchase pattern, suppliers estimates of price movements, quantity discounts negotiated and the quality of raw material required. Businesses that have raw materials are such that they flux in price (commodities) should reduced budget period to weeks or months.
Labor usage and price standardsLabor usage is measure in units of timeStandard price or rate of pay for direct labor is calculated by regard to current rates and any uplift during the budget period due to cost of living, time served, or bonus payments
Overhead standards – overhead comprise those costs which a business incurs in support of production but not necessarily directly related to production
Standards for variable and fixed overhead depend on three things Budgeted cost of each overhead Allocation key to be used to allocated overhead to product i.e. machine hours and; The volume expected of each allocated key to be used.
A flexed budget is a budget that has been adjusted to account for the variances in cost due to a difference between budgeted and actual production numbers.Variances
Material variances can be more or less than standard for only two reasons1. Actual production used more or less material than planned and/or2. The price to purchase the material was more or less than planned
An adverse variance is one where actual cost is above standard cost, a favorable variance is one where actual cost is less than standard cost
Labor cost variances care caused by combo of the same two reasons1. Actual production requiring more or less time than planned; and/or2. The labor rates actually pad were more or less than planned
Why is the standard rate/price used? The variances defined above provide insight into the financial impact of the deviation
from the budgeted and planned costs. By holding all rates/prices as standard the efficiency of production can be examined.
Were one to use the actual price/rate, two variables would change at the same time (quantity and price) and thus the number would be meaningless. In the price/rate variance the actual quantity/time is used because if the budgeted quantity/time would be used the variance would have no resemblance to the reality and e.g. a purchasing manager might be held accountable for a material price variance that is actually smaller (if less was purchased) than the material price variance when using the actual quantity purchased.
Exception reporting where managers receive information only on items which appear out of control.
Sales variances.
The sales mix variance proceeds to value the increase or drop in units sold per line and the difference between actual contribution margin per line and the budgeted weighted average contribution line
Sales quantity variances indicated that a decline in overall sales volume has caused a decline in total contribution margin, the sales mix variance tells him that the fewer low contribution items he sells the better
Module 14 – Accounting for Divisions
Advantages for divisions Specialization – Specialized knowledge and management kept in divisions Size – Detailed knowledge can be used immediately on local problems Motivation – Employees working away from the HQ can be demotivated and demoralized
by having decisions made about their activities by remote management in HQ – Feeling of ownership and pride by making own decisions
Sharper decisions – Managers on the ground see problems emerge long before HQ would detect potential trouble
Career mobility – success at one level will lead to more challenging appointments and so on. When people are picked for HQ-- skills have already been tested and learning curve is less. Divisions can be testing grounds for management talent
Disadvantages
Lack of control – division set up and management team given task of running its own ship. HQ has lost an amount of control. Territorial directors can be set up to have various divisions under their control. or quarterly review meetings with division heads report can overcome this perceived advantgtage
Cost – divisions may require support services such as personnel, training, computer and r/d. that are duplicates of HQ
Internal rivalries’ if divisions are set up with a performance management system which highlights superior performance, spirit of competition may emerge which can be dysfunctional.
Types of divisions Cost centers – divisions are held responsible only for the incurrence of cost and have
nothing to do with the generation of revenues. – i.e. government research facility
Revenue centers – divisions that have the task of generating funds without any reference to underlying costs. – i.e. reservation division of an airline
Profit centers – where costs and revenues are matched and divisional performances is assessed on bottom line profits
Investment centers – where divisions net assets are taken into account when evaluation profit performance. . Allows corporate headquarters to assess not only profitability of each division but also the efficiency with which assets are employed in the divisions.
Asset Base valuation Net book value – the value is the difference between original purchase price and
accumulated deprecation. – all things being equal division’s net book value of asset base will fall year by year. Thereby increase in ROI
Current replacement cost – division determines the most current cost for assets either by reference to suppliers’ price lists or industrial indices of specific price movements.
The subjectiveness involved in the process determining replacement cost together with the amount of time required may prevent companies in doing this
Residual Income – the ROI alternative
Using ROI as an indicator might lead to dysfunctional behavior in the following way. Assuming a company’s cost of capital; is 10% but a divisions ROI is 20%, the division might not undertake a project that would bring in 17% ROI because it might ‘water down’ the ROI of the division although it still would be in the best interest for the company.
RI – (Residual income) each division is charged interest on its invested capital, charged interest being at the rate of the companies cost capital and management’s goal should be to accept investment opps that exceed the imputed interest charge.
Residual income is expressed in absolute money terms, ROI is expressed in percentages.
Two problems must be overcome before companies can use RI Instead of using the companies cost of capital, management might assess the
commercial risk associated with each division, thereby imputing different rates of interest across divisions.
The selection of the imputed interest does matter to the calculation of RI due to the effect that gearing has. Low interest rates favor divisions with high investment in net assets, when interest rates are higher, the high investments made in assets make themselves felt in the high imputed interest rate charge levied on the division.
Transfer pricing If managers in a divisional structure can set their own prices and there is no
agreement between these divisions. The buying division should be free to go outside the group for the product or service they need. Although this could be a little dysfunctional the well being of the whole company might be harmed
Market prices – best method for transferring goods/services between divisions. It can objectively tested by both divisions. Suppliers price lists, market observations can be used to determine price. At what the deal should be. However, so called market price must be truly competitive market for similar products of similar quality i.e. china dumping products for market share.
Cost based prices – Where easily comparable market prices are not available.
Full costs – the selling division would calculate the transfer prices using variable costs plus a proportion of fixed costs using adsorption formal costs of the division. It might be appropriate to let the buying division’s accountant audit the selling division’s
cost to make sure that they have no slack build in to their cost structure. For the buying division the price paid to the selling division becomes a variable cost to
which it would add its own variable cost. If the buying division would then price its products with an eye on the contribution margin, the ‘variable’ cost would contain a proportion of the fixed cost of the selling division.
Under market pressures when the buying division might have to use pricing based on variable cost only, it would have a higher variable cost than the company variable cost due to the proportion of fixed cost contained in the variable cost. In this case full cost pricing might lead to loss of sales.
Variable costs – company view in using variable only in transfer prices overcomes some of the problems above.
Negotiated cost pricing is used when market based pricing and cost based pricing has not worked and headquarter management has instructed the two divisions to come up with a solution. Top management might want to participate in the negotiation process to make sure that
the interests of the whole company are considered. In special situation headquarter might allow a dual pricing scheme where the buying division pays a lower price than the paying division receives, with the difference absorbed by a headquarter contingency account.
However, such a scheme would result in loss of confidence in the system and motivation between the management of the two divisions.
When considering transfer pricing between international divisions, the following additional items have to be considered:
Taxation: if the transfer pricing can be geared so that the ultimate profit emerges in a tax regime with low corporate profit taxes, the overall tax bill of the company is reduced.
Repatriation of profits: if a country would not allow the repatriation of profits by a way of cash transfers of dividends, transfer prices could be adjusted so that the division located in the restricted country is asked to pay a high transfer price.
Determining a transfer price that a) motivates divisional managers,b) permits an evaluation of their division, and c) leaves them to ‘run their show’
is extremely difficult.
Module 15 – Investment decisions
Investment decision is one whose impact extends beyond the immediate accounting period. A decision which has impact within the operating period is called an operating decision
Investment process
Search – Identifying or finding suitable investment ops. It is the responsibility of every manager to search for worth while opportunities.
Control – once investment undertaken, financial control of it will allow normal budgetary control procedures. Control will be based on feedback through monitory actual income and expenditures and compares it against budget or plan. Reporting any significant deviation from it in terms of both amount and time
Control is not only that actual expenditures that can be related to planned but also that they take place when forecasted ( time is money)
Evaluation - Evaluation: between search and control of an investment lies in evaluation to ascertain if it is economically worth while.
Present value – Money at different time periods has different value. The principle of present value is using an interest rate to give an equivalent VALUE TO MOINIES PAYABLE or receivable at different points of time. The value today of a sum receivable or payment sometime in the future at a given rate of
interest. Discounted cash flow approach With investments that extend over time periods we discount cash flows of the investment
to present value so we can calculate profitability and cost of this.
NPV – net present value approach – takes all cash flows associated with project and reduces(discounts) to common (present value) by using appropriate interest rate ( like cost of capital)
If present values added together are positive then the project is worth it.
When should an investment opportunity be undertaken? If the NPV>0 the rate of return of the investment opportunity is higher than the cost of
capital and should therefore be undertaken. If the NPV<0 the rate of return is lower than the cost of capital and should not be
undertaken. Net Present Value
NPV =CF0+∑
i=1
n CF i
(1+r )i=CF0+CF1
(1+r )+
CF 2
(1+r )2+. . .
NPV: Present Value of a future cash flow CF: Future Cash Flow in time period i (cash outflows are negative)
CF0: Initial Cash Flow r: cost of finance, or cost of capital
n: number of time periods
In order to compare return of investment for different projects one should consider the NPV/Initial Investment in order to compare small and large projects equally.
Discounted cash flow rate of return. Instead of discounting by the cost of capital, we find the interest rate which reduces all
these cash flows to zero. This is interest rate that business could handle and not see a loss
DCF rate of return is a measure of return or profitability which is more familiar to the market place
These techniques can also be used for non revenue and non for profit situations – lowest cost is best
Risk and uncertainty - choices
Do nothing – estimates are prepared on most realistic estimate and evaluation is done using discounted cash flow approach. Management looks at figures and makes decision on this info and any other factors that are felt to be relevant.
High hurdle test – projects with higher risk have to pass more rigorous test of acceptability. – Projects are grouped into categories i.e. high, med, and low
Most common is high hurdle to require a higher rate of return the more risky the project.
Margin of safety is the amount by which the business can be wrong in its estimates before a profit is turned into a loss.
Payback period – time taken to recover original investment – when will we get our money back.
Payback is the time taken for the positive cash flows to recoup the original investment
Method is common, does not use the opportunity cost of the capital invested. I.e. the interest given up on capital that could have been used elsewhere. .
Another way to calculate discounted payback is to add i8ntest to the outstanding capital and then deduct the undiscounted cash flows until the capital plus interest has been eliminated.
Payback ignores profit. Payback is a break even position and thus profit only occurs after payback.
Sensitivity analysis
Consists of change the value – quantity or price of a key variable to assess the impact which this has on the final result
Selling prices and sales quantities are population factors. Risk analysis – is about taking the ideal of a range of likely values and applying the
mathematical techniques of probability analysis in order to get a better feel for the risk of the project.
Key investment factors Investment appraisal techniques highly the key factors which are central to profibility of
the investment
Capital investment – consists of the total fixed and working capital that will be required for the project. Amount and timing is important. Outflows and inflows are included
Cash flows will be allocated to the appropriate time period. Timing is important
Operating cash flows. Operating cash flow: operating cash flows are the cash flows that occur in the operating
period. The will arise out of inflows from sales and outflows from operating expenses. When making an investment decision many businesses need to see the impact that the investment will have on the financial statements. In some cases taxation/subsidies need to be considered just as other cash items when the IRR after corporate taxation is assessed.
Investment life Most assets have a finite life Physical - wear and tear, metal fatigue, Technical – obsolete because a new machine is available which is technically and
economically superior Market – product or service which the asset provides may have no more demand in the
market
Investment life for appraisal purposes will be the estimate of which of the three above is likely to occur fist.
Cost of capital – Cost of capital: The IRR of the project will have to exceed (or match) the company’s cost of capital in order for the company to approve the investment project.
Alternatively the NPV of the investment has to be positive using the company’s set cost of capital in order for the project to make economic sense. Companies may set different rates for the cost of capital for different projects.
Projected and Average cost of capital
Company has pool of resources for which all projects are financed. The cost of capital is therefore regarared as the average of off the various sources below.
Fixed interest loans – cost to the businesses will be the rate of interest on the loans plus an allowance for the cost of servicing the loan less taxation.
Fixed interest (dividend) shares – cost of the3s earned net interest plus an allowance or service fee. No tax shield.
Residual equity share – new issues of shares. These do not necessarily have a predetermined rate of interest or dividend. Rate that will be paid is determined by business to be paid out oaf earnings. There should be an imputed return, assumed that the new issues then the lower return from preiovus would be expected
Retained earnings – profits – While a dividend does not have to be paid on the retained earnings, the relative value of the shareholders’ interest in the business has to be maintained; the funds for the investment should earn at least the same as the existing investment.
Average cost of capital When the projected average cost of capital for each of the sources of finance has been
calculated, the weighted average cost of capital can be calculated.
Opportunity cost, risk and cost of capital
Opportunity cost concept 0 when management decides that regardless of what it will cost to raise funds, they should only be used internally if the return achieved is as good or better of that that could be invested outside the company
Target rate of return – introduced both general and specific allowances for risk and uncertainly.
A general uncertainty is that not all projects will reach the targeted rate of return and therefore a generally higher target is set so that the actual rate achieved in (hopefully) in line with the original target.
Specific uncertainties can be incorporated e.g. through the definition of risk categories and association of higher IRR targets with riskier projects.
Inflation is important when evaluating cash flows over longer periods of time. It is a separate from the ‘time value of money’ concept and has to be accounted for
separately. Care should also be taken in looking at the different impact that inflation has on different
variables (e.g. wages vs. computer equipment).
Module 16 – New developments in management accounting
Critics of current management accounting and their perceived shortcomings Management accounting procedures are still being driven by the requirements of
financial accounting with emphasis on profit measurement and inventory valuation Direct labor remains a popular method of overhead allocation “computerized production control have rendered obsolete some of the assumptions
about which costs are variable and which are fixed Well managed companies see potential for differentiation themselves. A sensible
expansion of overheads in these activities is to be encouraged where as most business regard overhead a s a burden to be squeezed out from the cost profile as much as possible
Sheer complexity of business has increased exponentially, Global markets accentuate the product difficulties identified above – Competition on
price is intense and demand for management accounting systems to identify accurate product costs becomes more pressing
Target costing
Target costing has been developed to help company’s manage their costs in circumstances when the selling price is known. I.e. cars, consumer electronics, Used in industries that are fast moving technologically innovated, cut throat comp and customers who are largely influenced by price.
Target price is set on basis of customer perceived value of product or service, and an assessment of what the comp will charge when they catch up.
Once target price is known, desired profit margin can be determined in order to determine the target cost.
Target costs differ from standard costs. Standard costs are set up for products and services only at the point when output is stable and is in the production or delivery stage and thus the detailed specs are known and not likely to change over planning period.
Target costs different are they start as global figures (target selling less target profit margin) and are set for an entirely new model or process.
The target cost is simply the difference between market price and the desired profit margin. A company using target costing will not launch a product until it can be designed produced and distributed or the target cost.
Value engineering is a complete re appraisal of every aspect of the process of manufacture and distribution to try and reach the target costing. Target costing has a market focuses, not only does market determine price of a product but ask the question before product is introduced. Are we sure this is what the customer wants.
Life cycle costing The annual periods that financial accounting is forced to use for regulatory reasons is
unnatural because production and sales does not simply stop at the end of the year but is a continuous activity. The annual budget cycle is another reason that management tends to think largely in annual cycles.
Focuses on the time that starts with the initial conception of the product or service (e.g. in R&D or by the service provider) and ends when the product or service is withdrawn and all associated customer service is also ended.
Lifecycle costing gathers all revenue and costs associated with a product or service over its whole lifecycle time span so that it’s ultimate profitability can be measured and management decision taken thereon.
It breaks down two barriers erected by normal accounting processes – the differentiation between capital and revenue is removed and the annual focus of accounting is obliterated as the lifetime revenues are matched to life time costs.
Throughput AccountingWhen taking the ‘throughput’, that is the rate at which money is earned, certain situations might tend to use different management accounting principles than traditionally used.
1. Depreciation and other, in the short term fixed, costs, such as anything that does not move with production (e.g. labor) should be grouped together as one cost into total factory cost. Only material costs should be excluded as they can be influenced in the (very) short term.
2. Value is created in a business only when it sells a product. As such inventory does not create value but only incurs costs and is something that should be driven down and out of the business. This way management can concentrate on maximizing throughput from the suppliers through manufacturing and to the customer.
3. Product profitability can be considered the rate at which the product earns money, not the method by which they share costs. Thus management will be able to concentrate attention on reducing bottlenecks in the production of different products or by moving resources from a product that is inhibited by a bottleneck to one that is not.
Throughput accounting stresses that fact that products do not earn money, but businesses earn money by selling products.
Return per factory hour = [Sales price – Material cost] / [Time spent at the bottleneck per product]
Cost per factory hour = Total factory cost / Total time available at bottleneck
Throughput accounting ratio = Return per factory hour / Cost per factory hour
If the throughput accounting ratio for a product is less than 1 the business is spending more money on the production of the product than it is able to receive money through sales. The throughput ratio allows management to focus on the current production constraints and distribute shared scarce resources between products to maximize throughput.
Costing for Competitive Advantage Accounting is increasingly involved in strategic decisions. Strategy is defined as a course of action, including the specification of the resources
required, to achieve a specific objective. Strategic management accounting is the provision and analysis of management
accounting data relating to a business strategy; particularly the relative levels and trends in real costs and prices, volumes, market share, cash flow, and the demands on a company’s total resources.
In planning a production strategy a company would consider a number of issues like1. Production Facilities - capacity and ability to meet specification2. Labor skills3. Sourcing of Supplies4. Introduction of TQM, JIT5. Outsourcing6. Suppliers limitations