Accounting

The Accounting programme is written by Niall Lothian, Professor at Edinburgh Business School, Heriot-Watt University, and John Small, Professor Emeritus at Heriot-Watt University. Both have previously occupied chairs in the University’s Department of Accountancy & Finance. Professor Lothian has taught at IMEDE (now IMD) in Lausanne and is currently a member of the visiting faculty of INSEAD, Fontainebleau. He has conducted seminars and managerial briefings in Europe, Africa and China, the latter under the auspices of the United Nations Industrial Development Organisation. Professor Lothian has been consultant to British government agencies such as the Ministry of Defence and the Cabinet Office and to a number of international companies including IBM, Nokia, Philips, Roland Berger, Swire and ScottishPower. His current research and consulting interests include the study of managerial controls over R&D expenditure, a field in which he has published widely, and the accounting implications of flexible manufacturing systems. A chartered accountant by professional training, he is a Past President of the Institute of Chartered Accountants of Scotland. Professor Small is a member of the board of Scottish Homes. He was from 1982 to 1991 Chairman of the Accounts Commission in Scotland. The Accounts Commission is responsible for arranging the audit of local government in Scotland and ensuring the proper steps are taken to achieve economy, efficiency and effectiveness. He is a member of the Council of the Chartered Association of Certified Accountants and was its President in 1982/83. He has been Chairman of the Education Committee of the International Federation of Accountants and a member of the executive Board ´ of the Union Europeenne des Experts Comptables, Economiques et Financiers. He is an honorary member of the Arab Society of Certified Accountants. He has also held visiting professorships and external examinerships at various universities and business schools. His special interest is in the use of financial information in decision making for planning and control. In this area he is a consultant to a number of organisations and has advised companies and government agencies in the UK and abroad. Professor Small was made a Commander of the Order of the British Empire in the Queen’s Birthday Honours, 1991.

Release AC-A1.2

ISBN 0 273 60916 5

HERIOT-WATT UNIVERSITY

Accounting
Niall Lothian
Professor, Edinburgh Business School

John Small
Professor Emeritus, Heriot-Watt University

Edinburgh Gate, Harlow, Essex CM20 2JE, United Kingdom Tel: +44 (0) 1279 623112 Fax: +44 (0) 1279 623223 Pearson Education website: A Pearson company www.pearsoned-ema.com

First published in Great Britain in 2003 c Niall Lothian and John Small 1991, 1998, 2001, 2003 The right of Niall Lothian and John Small to be identified as Authors of this Work has been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. ISBN 0 273 60916 5 British Library Cataloguing in Publication Data A CIP catalogue record for this book can be obtained from the British Library. Release AC-A1.2 All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without the prior written permission of the Publishers. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published, without the prior consent of the Publishers. Typesetting and SGML/XML source management by CAPDM Ltd. Printed and bound in Great Britain. (www.capdm.com)

The publisher’s policy is to use paper manufactured from sustainable forests.

Contents
PART ONE
Module 1

FINANCIAL ACCOUNTING FOR MANAGERS
An Introduction to Accounting and the Accounting Equation
1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11 Approaching Accounting The Reality of Accounting What Accounting Is Focus on Profit-Seeking Businesses Who Are the Users of a Company’s Accounting Information? For what Sort of Decisions Do these Users Value Accounting Information? Common Information Requirements among Users The Accounting Equation The Accounting Statements Sole Trader versus MBA Accounting: The External and Internal Functions 1/1 1/2 1/2 1/3 1/5 1/6 1/6 1/8 1/8 1/11 1/19 1/20 2/1 2/2 2/3 2/4 2/8 2/9 2/10 2/12 2/16 2/17 2/18 2/20 2/22 2/23 3/1 3/2 3/3 3/3 3/8 3/9 3/10 3/13 3/15 4/1 4/1

Module 2

The Profit and Loss Account
2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 2.12 2.13 Introduction What Is Profit? The Measurement of Accomplishment Another Reason for Opting for ‘Ship and Invoice’ Conventions Underlying Measurement of Sales Accomplishment The Measurement of Effort Task One: Determining the Consumption of the Means of Production Task Two: Determining the Value of Closing Work-in-Progress and Inventories Types of Inventory in a Manufacturing Company Inventory Valuation Methods Valuation of Work-in-Progress and Finished Goods Interpreting Profit Summary

Module 3

The Balance Sheet
3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 Introduction The Anatomy of the Balance Sheet Fixed Assets Current Assets Current Liabilities Net Current Assets and Net Assets Why Does a Balance Sheet always Balance? Summary

Module 4

The Cash Flow Statement
4.1 Introduction

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Contents

4.2 4.3 4.4 4.5 4.6 4.7 4.8

Why Are Cash Flow Statements Needed? What Is ‘Cash’ in a Cash Flow Statement? Cash: Where Does it Come from? Where Does it Go to? Eight Major Categories of Cash Flow Worked Example with Commentary Do-it-Yourself Example Summary

4/2 4/3 4/3 4/6 4/7 4/10 4/14 5/1 5/2 5/3 5/4 5/4 5/5 5/6 5/6 5/6 5/9 5/9 5/11 5/13 5/15 5/16 5/18 5/20 5/20 5/21 5/25 6/1 6/2 6/4 6/5 6/6 6/8 6/12 6/14 6/15 6/16 6/18 6/18 6/20 7/1 7/2 7/3 7/6

Module 5

The Framework for Financial Reporting
5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 5.10 5.11 5.12 5.13 5.14 5.15 5.16 5.17 5.18 5.19 Introduction The Concept of Disclosure Sources of Disclosure Requirements The Companies Acts 1985 and 1989 Accounting Standards The Stock Exchange Listing Agreement Financial Reporting in Action An Introductory Note on Groups of Companies Abstract of Annual Reports: MBA plc and Award Ltd The Accounting Policies The Consolidated Profit and Loss Account The Consolidated Balance Sheet (and Parent Company’s Balance Sheet) A Concluding Note on MBA’s Balance Sheet Statement of Group Cash Flow Detailed Disclosure Requirements for Selected Items The Lessons to Be Learned Fundamental Accounting Concepts The External Auditor Summary

Module 6

Interpretation of Financial Statements
6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 6.10 6.11 6.12 Introduction Ratio Analysis Group 1: Liquidity Ratios Group 2: Profitability Ratios Group 3: Capital Structure Ratios Group 4: Efficiency Ratios Other Possible Ratios Window Dressing Putting it all Together: The Dupont Chart A One Hundred Per Cent Statement Basic Stock Market Ratios Summary

Module 7

Emerging Issues and Managerial Options in Financial Reporting
7.1 7.2 7.3 Introduction Research and Development (R&D) Off-Balance-Sheet Transactions

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7.4 7.5 7.6 7.7 7.8 7.9 7.10 7.11 7.12

Accounting for Acquisitions and Mergers Goodwill Brands Operating and Financial Review Environmental Reporting Impairment of Fixed Assets and Goodwill Provisions and Contingencies International Harmonisation of Accounting Standards Summary

7/11 7/13 7/16 7/19 7/20 7/21 7/22 7/23 7/24

PART TWO
Module 8

MANAGEMENT ACCOUNTING FOR DECISION MAKING
An Introduction to Cost and Management Accounting
8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8 8.9 8.10 8.11 8.12 8.13 What Accounting Is: A Refresher Management Accounting Looks Forward Where Accounting Fits into a Company A Brief Note on what a Manager Does The Role of Accounting Information Management Accounting in MBA plc Differences between Management Accounting and Financial Accounting Management Accounting and Cost Accounting Where Costs Come from and an Overview of the Modules to Follow Process Costing Costs Relevant to Management Decisions Other Topics in the Management Accounting Course Summary 8/1 8/2 8/3 8/4 8/4 8/7 8/7 8/11 8/12 8/14 8/15 8/16 8/17 8/18 9/1 9/2 9/3 9/3 9/6 9/9 9/10 9/10 9/11 9/12 9/12 9/12 9/15 9/16 9/17 9/20 9/22 9/23 9/26

Module 9

Cost Characteristics and Behaviour
9.1 9.2 9.3 9.4 9.5 9.6 9.7 9.8 9.9 9.10 9.11 9.12 9.13 9.14 9.15 9.16 9.17 9.18 Introduction Cost: A Deceptively Simple Word Variable and Fixed Costs Beware the Unitising of Fixed Costs! Direct and Indirect Costs Traceable and Common Costs Product Costs and Period Costs Controllable and Non-Controllable Costs Standard and Actual Costs Engineered and Discretionary Costs Another Look at Variable and Fixed Costs: The Break-Even Chart Profit from Different Cost Structures The Break-Even Chart: An Alternative Display Other Ways of Calculating Break-Even Points Break-Even Analysis and the Multi-Product Firm Contribution and Limiting Factors of Production Assumptions Underpinning Cost-Volume-Profit Analysis Summary

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Contents

Module 10

Allocating Costs to Jobs and Processes
10.1 10.2 10.3 10.4 10.5 10.6 10.7 10.8 10.9 10.10 10.11 Introduction Cost Gathering Where Do these Costs Come from? Plantwide versus Departmental Rates Joint Products and By-Products Process Costing Process Costing and the Equivalent Unit Cost per Equivalent Unit Activity-Based Costing Traditional Costing versus ABC Summary

10/1 10/2 10/3 10/3 10/8 10/12 10/17 10/17 10/19 10/24 10/24 10/32 11/1 11/2 11/2 11/7 11/8 11/9 11/9 11/13 11/13 11/14 11/14 11/15 11/16 11/17 11/19 11/20 11/22 12/1 12/2 12/2 12/4 12/8 12/20 12/23 13/1 13/2 13/2 13/5 13/5 13/7 13/9 13/12 13/18

Module 11

Costs for Decision Making
11.1 11.2 11.3 11.4 11.5 11.6 11.7 11.8 11.9 11.10 11.11 11.12 11.13 11.14 11.15 11.16 Introduction The Dilemma of the Denominator Managerial Implications of Absorption versus Variable Costing Cost Information for Management Decisions Routine and Non-Routine Decisions Developing an Analytical Framework Finding the Relevant Costs The Pitfalls of Full Costing Opportunity Costs Department versus Company Sunk Costs Management Decisions in Action Closing Down a Unit The Special Sales Order Should we Process Further? Summary

Module 12

Budgeting
12.1 12.2 12.3 12.4 12.5 12.6 Introduction Why Bother with Budgets? Why Budgeting Gets a Bad Name Budgeting in Action: The Go-Straight Trolley Company Discretionary Expenditure and Zero-Base Budgeting Summary

Module 13

Standard Costing
13.1 13.2 13.3 13.4 13.5 13.6 13.7 13.8 Introduction Setting Standards A Word about Motivation Flexible Budgets The Anatomy of Variances: Materials and Labour Responsibility for Variances Variable and Fixed Overhead Analysis Investigation of Variances

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13.9 Sales Variances 13.10 Summary

13/19 13/22 14/1 14/2 14/3 14/5 14/6 14/9 14/10 14/11 14/16 14/17 14/17 14/20 14/23 15/1 15/2 15/3 15/4 15/6 15/6 15/9 15/11 15/12 15/14 15/14 15/15 15/18 15/20 15/22 15/25 15/26 15/27 15/29 15/30 15/31 16/1 16/1 16/3 16/11 16/15 16/18 16/23 16/31

Module 14

Accounting for Divisions
14.1 14.2 14.3 14.4 14.5 14.6 14.7 14.8 14.9 14.10 14.11 14.12 Introduction Why Divisionalise? Types of Divisions Defining Profits and Investments Asset Base Valuation Residual Income: An Alternative to ROI The Imputed Rate of Interest Does Matter! A Cautionary Note about Performance Measures Transfer Pricing Criteria for Establishing a Transfer Price The International Dimension Summary

Module 15

Investment Decisions
15.1 15.2 15.3 15.4 15.5 15.6 15.7 15.8 15.9 15.10 15.11 15.12 15.13 15.14 15.15 15.16 15.17 15.18 15.19 Introduction The Investment Process Concept of Present Value Discounted Cash Flow Approach Net Present Value (NPV) Discounted Cash Flow (DCF) Rate of Return Comparison of Net Present Value and DCF Rate of Return Investment Appraisal in Non-Revenue and Not-for-Profit Situations Risk and Uncertainty and Inflation Risk and Uncertainty Payoff or Payback Period Sensitivity Analysis Risk Analysis The Key Investment Factors Projected Average Cost of Capital Average Cost of Capital Opportunity Cost, Risk and the Cost of Capital Investment Appraisal and Inflation Post-Assessment/Continuous Post-Audit of Capital Expenditure Projects 15.20 Conclusion

Module 16

New Developments in Management Accounting
16.1 16.2 16.3 16.4 16.5 16.6 16.7 Introduction Target Costing Life Cycle Costing Throughput Accounting Costing for Competitive Advantage The Balanced Scorecard Summary

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Contents

Appendix 1 Appendix 2 Appendix 3 Index

Answers to Review Questions and Worked Solutions to Case Studies Practice Final Examinations and Worked Solutions Glossary

A1/1 A2/1 A3/1 I/1

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PART ONE

Financial Accounting for Managers
Module 1 Module 2 Module 3 Module 4 Module 5 Module 6 Module 7 An Introduction to Accounting and the Accounting Equation The Profit and Loss Account The Balance Sheet The Cash Flow Statement The Framework for Financial Reporting Interpretation of Financial Statements Emerging Issues and Managerial Options in Financial Reporting

Accounting

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Module 1

An Introduction to Accounting and the Accounting Equation
Contents
1.1 1.2 1.3 1.3.1 1.3.2 1.3.3 1.3.4 1.4 1.5 1.6 1.7 1.8 1.9 1.9.1 1.9.2 1.10 1.10.1 1.10.2 1.10.3 1.11 Approaching Accounting The Reality of Accounting What Accounting Is Accounting Is a Service Function Accounting Deals with Economic Information Economic Activity Must Be Identified, then Measured Accounting Is a Communication Device Focus on Profit-Seeking Businesses Who Are the Users of a Company’s Accounting Information? For what Sort of Decisions Do these Users Value Accounting Information? Common Information Requirements among Users The Accounting Equation The Accounting Statements Do-it-Yourself Example Worked Solution Sole Trader versus MBA Sole Trader Partnership Company Accounting: The External and Internal Functions 1/2 1/2 1/3 1/4 1/4 1/4 1/5 1/5 1/6 1/6 1/8 1/8 1/11 1/14 1/16 1/19 1/19 1/19 1/20 1/20 1/21 1/25

Review Questions Case Study 1.1

Learning Objectives
By the end of this module you should understand: • • • the value to various groups in society of a knowledge of accounting; the role of accounting in management; the need for, and use of, accounting information in decision making within any organisation;
1/1

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Module 1 / An Introduction to Accounting and the Accounting Equation

• • •

the accounting equation; the basic layout of the profit and loss account (sometimes called the income statement), the balance sheet and the cash flow statement; the distinction between financial accounting and management accounting.

1.1

Approaching Accounting
Few subjects in a Master’s degree course in Business Administration are approached by students with a greater sense of awe than accounting. Put another way, of all the subjects typically on offer in an MBA programme, accounting is the one which students would most prefer to avoid! Why should this be? Here are some reasons which may reflect the reader’s thinking as he or she embarks on this course. • Unlike many other MBA disciplines, such as marketing, economics and organisational behaviour, which are viewed as being intuitive, that is the reader has a fairly good idea of what the subject is about without prior study, accounting is non-intuitive, requiring the mastery of rules from the outset. Accounting is seen to deal exclusively with numbers; many people prefer to deal with words and ideas. Because of its concentration on numbers, accounting is considered to be concerned with precision and accuracy, both of which require a highly developed mathematical mind. Readers know friends and relatives who have studied for a degree or professional qualification in accounting; since these people spent many years studying, how can an MBA course deal with complexities so quickly? Accounting and accountants are treated by society as being dull and boring! The image, bolstered by the perceived obsession with numbers and accuracy, is picked up by TV scriptwriters and producers who stereotype the accountant as being humourless, repetitive, pedantic, unimaginative and incapable of forming close personal relationships!

• •

In an effort to put the reader’s mind at ease at the outset of the course, two points should be made. 1 2 Virtually everyone (whether studying for an MBA or not) who is not a trained accountant views accounting and accountants as set out above. They are all wrong!

1.2

The Reality of Accounting
All business disciplines, including marketing, economics and organisational behaviour, are based on fundamental concepts and relationships which must be appreciated from an early stage. The fact that a novice believes he knows what is involved in these subjects does not remove the need to study the underlying principles in as rigorous a manner as he would require to do in accounting.

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Module 1 / An Introduction to Accounting and the Accounting Equation

Accounting is indeed concerned with numbers but it is concerned with many more aspects besides; the presentation and communication of financial information is just as important as the numbers themselves. More attention is being paid today to the use of accounting numbers in the decision making process than ever before. Major companies currently issue to shareholders an abbreviated set of annual accounts (perhaps only a few pages) instead of the full set; companies’ web sites often display shortened versions of their annual reports. Indeed some US companies have stopped circulating automatically their annual reports to shareholders; instead shareholders are supplied the web address at which they can access the main features of the year’s results. They are doing this not to save money but in recognition of the fact that the important accounting numbers, such as turnover, profit for the year and dividends payable, are not easily discernible in the full set. Shareholders need this information so that they can assess the performance of the company in which they have a stake. A simple presentation and the medium of communication are as important to accounts as the financial message. Accounting numbers attempt to reflect economic activity in an organisation. But there is no one given view of this activity; two people can form different views. It follows that there can be no one given set of accounting numbers which must be used. Choice, judgement and the reconciliation of vested interest prevent the accountant from ever becoming dull and boring.

Example
A company purchased a residential house in 1991 in the Georgian New Town of Edinburgh for use by its senior executives when on company business in Scotland. It cost £100 000. In 2001 the company’s property advisers consider the house would sell for £1 000 000. The company’s insurers require buildings insurance to be based on its replacement value of £1 750 000. Which value should the company’s accountant select for recording the asset in the 2001 accounts?

Precision, accuracy and the need for a mathematical turn of mind may be desirable but not essential. So often these attributes are confused with numeracy, the skills of reading and handling numbers and applying to them the basic arithmetical rules of addition and subtraction. A modestly priced calculator will prove to be invaluable! This course is written not only for those studying for a degree by distance learning but also for managers and others who need to use accounting numbers in their work. The underlying methodology of accounting will be explained only where it is essential to the reader’s understanding of the concepts and his or her appreciation of how to apply the techniques in the world of business.

1.3

What Accounting Is
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.

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But this information is only one factor in the committee’s decision making process. What are the constituent pieces of the definition? 1. or towards meeting goals other than profits like a political party.3 Economic Activity Must Be Identified. and the impact on power and maintenance costs as compared with the existing organ. each guess produces a different cost figure which. accountants also deal with such things as tons of raw materials used. a club or a church. the suppliers’ requirements for capital equipment to build the production models. e. a car. the cost of old organ removal and preparatory site works. a partnership or a sole trader. Example The government’s defence procurement establishment is weighing up the potential of placing a long-term contract with one of three civilian suppliers of laser equipment.3. 1. Alongside the results of the military’s experiences with the prototypes under simulated battlefield conditions.2 Accounting Deals with Economic Information Within organisations there exists a bewildering range of information on all sorts of subjects. capacity of machinery used. like a company. The organ committee has asked the treasurer for the following financial information: the range of competitive tenders in money terms. ultimately the decision will also take into account musical and liturgical issues. 1. Whether an entity is oriented towards making profits.3. Example A cathedral is planning to replace its organ. Accounting confines itself to economic information and is usually expressed in money values. However. like the sale of a unit of production.1 Accounting Is a Service Function Accounting is not an end in itself: it provides information to decision makers. Others are easy to identify but are difficult to measure: the robotic equipment used in the car-assembly process depreciates through use and the passage of time but accountants can only guess at how quickly this cost should be recognised.3. produces a different profit figure. in turn. and units of output produced. the range of guesses is curtailed by the exercise of commercial judgement and professional 1/4 Edinburgh Business School Accounting . number of hours worked. the accountants will lay their estimates of costs of production. are relatively easy to identify and to measure. the rate at which equipment will depreciate and the pricing formulae being used by the suppliers.g. a charity.Module 1 / An Introduction to Accounting and the Accounting Equation A definition is like a completed jigsaw: the whole picture is readily visible but it is not nearly as interesting as the process of fitting all the pieces together. Of course. the potential impact of exchange rates on overseas organ builders’ tenders. then Measured Some economic events. accounting information is universally employed by decision makers.

Module 1 / An Introduction to Accounting and the Accounting Equation precedent. To this extent. say.3. It would not be unfair to say that accountants have a lot of work still to do to improve their communications skills: too often accountants forget that users cannot understand accounting numbers as easily as they can. But the detailed procedures and rules governing. accounting is a universally applicable management tool employing universally applicable principles. It follows that accountants must know what sort of economic information decision makers want: accounting information must be relevant for the purposes for which it is designed. a brewery and a government Accounting Edinburgh Business School 1/5 . Example The charismatic founder and chief executive of a recently Stock Exchange quoted company suffered a near-fatal coronary thrombosis while golfing two weeks before the end of the financial year-end. 1. the Inland Revenue. it is accounted for. The financial controller compiles financial information in pie-chart format which reveals that all but a small percentage of income is spent directly on the charity’s objectives. the accountant must communicate the information in such a way that the users can understand it. while the former event. of course. Some events may have an economic impact on the organisation which are so difficult to identify and measure that they escape the accountant’s attention. On the same day one of the company’s sales reps replaced the two rear tyres on his company car.4 Focus on Profit-Seeking Businesses What have the following persons in common? • • • • • • the chairman of a football club a chief executive in the local brewery the Chancellor of the Exchequer a financial controller of a university the senior partner of a law firm the medical director of a hospice. escapes recording. require accounting numbers to be presented in a totally different manner.4 Accounting Is a Communication Device Accounting information can help decision makers reach their objectives. Example A national charity is about to launch a fund-raising campaign. one which could have a long-term negative effect on the performance of the company. 1. Then. Because the accountant can identify and measure the economic impact of the latter event. Answer They are all concerned with the raising and spending of money and the control of scarce resources through budgets. on the other hand the information required by the government’s tax authorities.

they are likely to find that their expectations are not fulfilled. and specifically manufacturing industry within this sector. The thrust of governments’ financial management in many countries today is towards ‘privatisation’. We believe that a manufacturing industry setting enables students to grasp the principles and procedures of accounting more easily than any other. It has a presence in every continent and its activities span every aspect of technology and systems. Once these principles are understood they can be applied in other commercial and social settings. adopting the techniques and performance measures of the private sector. If they make decisions without adequate information (which happens all too often). Who are the users of the MBA’s accounting information? They can be grouped as internal users and external users. Reference will be made to other settings where appropriate. 1/6 Edinburgh Business School Accounting . 2 3 1. We do this for three reasons. We have selected the profit-seeking private sector.Module 1 / An Introduction to Accounting and the Accounting Equation department are so diverse that it would be wise to focus on only one sector during this course. We will use the fictitious financial statements of MBA plc throughout the text for analytical use and for illustration. 1 Managers and other readers who work for the not-for-profit sector very often have personal investments in profit-seeking private sector companies and are interested in tracking the performance of their investments. MBA plc is based on one of the world’s largest engineering and communications companies.5 Who Are the Users of a Company’s Accounting Information? Take MBA plc as an example of a manufacturing company.6 For what Sort of Decisions Do these Users Value Accounting Information? All the users of company accounting information are faced with the choices among alternative courses of action. i. Internal users • Directors • Senior executives • Managers • Employees (and trade unions) External users • Shareholders • Analysts • Creditors • Tax authorities • The public 1.e.

are we confident that a subsidiary company in Australia is not borrowing money at 20 per cent to fund an expansion when the subsidiary in Japan is building up a cash balance in the bank earning 12 per cent interest?’ ‘Is our manager remuneration scheme sufficiently rigorous to promote effort and commitment while at the same time being competitive with other multinationals?’ ‘Would it be cheaper to make a component ourselves or buy it in from an outside supplier?’ ‘Are all our lines profitable?’ ‘How much should we claim in the next wage round?’ ‘What are the security and prospects of employment in this company?’ ‘Should we buy (or sell or hold) shares in this company?’ ‘How much dividend has been paid last year compared with profits earned?’ MBA provides a breakdown of its shareholders in 20x2 as follows. but note that the 335 shareholders (institutional investors like pension funds) who own over one million shares each combine to own just under 77 per cent of the entire share capital while the 4770 shareholders who each own less than 100 shares possess insufficient to be measured on this scale! Analysts ‘Should we advise shareholders and potential shareholders to buy or sell or hold shares in the company?’ Accounting Edinburgh Business School 1/7 .8 3. Size of holding Number of ordinary shareholders’ accounts 4 770 41 386 69 002 475 275 187 335 116 430 Number of shares (millions) 1 25 285 76 100 133 2 057 2 677 Percentage of issued share capital – 0.9 100 1–100 101–1000 1001–100 000 100 001–250 000 250 001–500 000 500 001–1 000 000 Over 1 000 000 All holdings The law recognises all shareholders as being equal. how much is being spent on improving the flawed processes?’ ‘Are we managing our money efficiently? For example.e. have all our industrial processes been friendly to the environment? If not. i.0 76.7 2.Module 1 / An Introduction to Accounting and the Accounting Equation Directors Senior executives Managers Employees Shareholders ‘Has the company been employing its resources in the most effective way to maximise the profit earned for our shareholders? Is it maximising shareholder value?’ ‘Has the company been a good corporate citizen.9 10.7 5.

Providing information about profitability and liquidity (the professional jargon for cash position) is seen by many to be the goal of the accounting system. Such parties ask a variety of questions. including ones directed at a company’s profitability. Although the emphasis in this course will be on the informational requirements of managers. The course is designed to assist the manager in interpreting and understanding accounting information. for instance. not to instruct him in how to prepare it. He should be as concerned with shareholder value as the shareholders. minimising environmental pollution. each manager should be familiar with the basic mechanics of the accounting process before he tries to gain an appreciation of what the accounting numbers mean. as aware of the company’s debt-paying abilities as the creditors and as sensitive to environmental matters as either the directors or the external consumer lobby. 1. a good manager should be concerned with all the questions posed by all the interest groups set out above. 1/8 Edinburgh Business School Accounting . efficiency. we will examine the accounting recording system which produces information on profits and cash. However. or by abiding by international guidelines for trading in Third World countries?’ Sound answers to these questions require accounting information. 1. sometimes of a most sophisticated kind.Module 1 / An Introduction to Accounting and the Accounting Equation Creditors Tax authorities The Public ‘Is the performance of the company this year superior to its competitors?’ ‘Should we advise a switch of holding to a company with a more promising prospect?’ ‘Should we extend our credit to this company. ‘The public’ is a loose phrase which includes inter alia environmental pressure groups and consumer groups. ‘Is the company fulfilling its obligations to society by.8 The Accounting Equation Before proceeding to a more detailed analysis of the concepts and objectives of accounting.7 Common Information Requirements among Users Answers to all the questions above require knowledge of a company’s profits and cash position. or should we press to recover our debts?’ ‘In the longer term will the company be able to supply us with business?’ ‘How much tax can we expect to receive from the company?’ Note that a multinational company will file tax returns in every country in which it operates. contributions to political organisations and transactions with overseas governments.

Module 1 / An Introduction to Accounting and the Accounting Equation The accounting recording system is based on the simple. Entities do not simply acquire resources out of thin air: resources must be provided by someone (usually the owner) in the first instance. not to say selfevident. At the conclusion of this action. = Owner’s equity £20 000 + Cash £8000 + Plant £12 000 + Raw material inventories Creditors £6000 £6000 Action 3 Here we see an acquisition of another asset. A simple example will show how this equation works by examining a series of actions through a period of time. notion that all economic resources acquired by an entity must be funded from somewhere. Action 4 £500 worth of inventory is processed through the machines at a labour cost of £20 to form finished goods inventory. Only one side of the equation needs adjustment: Cash £8000 + Plant £12 000 = Owner’s equity £20 000 Inventories of raw materials are purchased on credit for £6000. The accounting equation of the business would record: Assets (Cash) £20 000 = Owner’s equity £20 000 The amount of owner’s equity signifies the owner’s claim over the assets of the enterprise. other people such as creditors or banks may put up money to provide further resources for the company. But exactly the same accounting equation would be used to record the activities of MBA or any company or partnership as the ones we will employ below. financed by the suppliers of the inventories. Later. How much is the owner now worth? Still £20 000. the individual’s stake in the business is worth £20 000. Eventually the business will have to pay this amount in cash. represented by cash of £20 000. we use the economic events associated with an individual starting up in business rather than using the more complex world of companies like MBA. inventories. Action 1 An individual commences his business on 1 January with £20 000 cash. represented by assets totalling £26 000 less £6000 owed to his creditors. Cash £7980 + Plant £12 000 = Owner’s equity £20 000 + + Raw material inventory Creditors £6000 £5500 + Finished goods inventory £520 1/9 Accounting Edinburgh Business School . For illustration. Action 2 Out of these cash resources he purchases plant and equipment for £12 000. the creditors remain a liability. until it does. The relationship between resources and the funds provided to acquire these resources is expressed in accounting like this: ASSETS = OWNER’S EQUITY + LIABILITIES or ASSETS − LIABILITIES = OWNER’S EQUITY This accounting equation underpins the entire accounting recording system.

(This method of calculating depreciation is known as the consumption method. This overhead is a charge against profits which have not yet been earned. On its own the above transaction looks like this: Change in finished goods inventories (−£520) + Change in debtors (+£750) = Change in owners’ equity (+£230) Action 7 £3000 of the amount due to suppliers is paid along with an advertising bill of £10.Module 1 / An Introduction to Accounting and the Accounting Equation Here.50. it will be added to the owner’s equity. An asset called ‘debtors’ is created because cash has not yet been received for the sales. a process known as depreciation. there are others. When profit is made. Action 5 The accountant. for every hour used the machine will cost £0. the £20 cash spent on labour is assumed to add value to the raw material inventory of £500 all of which the business would hope to recover in the eventual selling price. so it is deducted from the original capital in the interim. Action 6 The entire finished goods inventory is sold for £750 on credit. an employee of the business. yet another expense of operations. Since the effective working life was 24 000 hours and the equipment cost £12 000. The use of machinery implies that the machine wears out. Cash £7970 + Plant £12 000 = Owner’s equity £20 220 + + Raw material inventories Creditors £6000 £5500 + Debtors £750 The finished goods inventory has been reduced to zero.) For 100 hours the depreciation charge is £50: the value of the plant is reduced by £50 and the owner’s equity 1/10 Edinburgh Business School Accounting . is paid his wage of £10 in cash. The company has made £230 profit on this transaction. = Owner’s equity £20 160 + Cash £4960 + Plant £11 950 + Raw material inventories Creditors £3000 £5500 + Debtors £750 The payments to suppliers are a straightforward matter. just like the accountant’s fee. which increases the owner’s equity. At the end of this action the individual’s stake in his business has been reduced by £10 to £19 990. At this point the machine which has an effective working life of 24 000 hours has been used for 100 hours. reducing cash and creditors by the amount £3000 paid over. The advertising bill is paid in cash too and must reduce the owner’s equity – this is an expense of being in business. Cash £7970 + Plant £12 000 = Owner’s equity £19 990 + + Raw material inventories Creditors £6000 £5500 + Finished goods inventories £520 It is important to distinguish between the wages paid to production workers in Action 4 (which increase the value of the inventory to be sold) and those of an administrative nature (which do not increase the value of assets and which do not vary with output).

Accounting Edinburgh Business School 1/11 . Note that the accounting entries involve a mixture of cash-driven items and judgement-driven items. The accounting equation is a collection of balances after each transaction has been completed and recorded. if it has decreased he has made a loss. Note that no cash outlay is involved with the depreciation charge. or any earlier one for that matter. If it has increased the owner has made a profit. it is possible to determine the profit made by comparing the owner’s equity at the beginning of the period under review with the balance on the owner’s equity at the end of the period. At this stage.9 The Accounting Statements Balance sheet at the end of Action 7 Assets £ Cash 4 960 Plant and equipment 11 950 Inventories 5 500 Debtors 750 £23 160 Owner’s equity £20 160 Creditors 3 000 £23 160 The layout of this balance sheet could be improved to give a clearer picture of the financial position of the company at the end of Action 7. This equation can also be laid out in a more meaningful fashion called a balance sheet. 1. Fixed assets Plant and equipment at cost Less: Depreciation Current assets Inventories Debtors Cash Less: Current liabilities Creditors Net assets of the company Represented by: Capital introduced Profits earned Owner’s equity £ 12 000 50 £ 11 950 5 500 750 4 960 11 210 3 000 8 210 20 160 20 000 160 £20 160 This layout highlights some fundamental points that should be noted. In the example the profit is £160 (£20 160 less £20 000).Module 1 / An Introduction to Accounting and the Accounting Equation is reduced by £50. Depreciation is examined in Module 2.

and current assets. i. this procedure can become very complex in a multi-product. how many sales were recorded. profit is simply the excess of sales revenue over costs incurred in generating the revenue. multiplant company engaging in thousands of transactions daily. The straight comparison of owner’s equity figures provides an arithmetically accurate figure of profit but it does not tell how that profit was made. the original cash introduced by the owners is consumed in the purchase of assets and in the trading activities for which the company was set up. items of expenditure accounted for via the balance sheet we call capital expenditure.e. again usually one year. Current liabilities are those obligations which a company must meet. The detailed items which affected owner’s equity were: Action 5 6 7 7 Net increase Accountant’s wage Profit on sale of finished goods Advertising bill Depreciation charge on plant in equity £ −10 +230 −10 −50 +160 An accounting statement which is more meaningful than the accounting equation is constructed. what the cost of these sales was. which are of relatively long life and are generally used in the production of goods and services rather than being held for resale. (NB: Net current assets are defined as current assets less current liabilities. Items of expenditure accounted for via the profit and loss account we call revenue expenditure. In the example the profit and loss account has been created from the preceding data relatively easily.Module 1 / An Introduction to Accounting and the Accounting Equation 1 2 The owner’s equity of a company is represented by the net assets (fixed assets + net current assets) of the company. However. usually a year. which are either currently in the form of cash or are close to being converted into cash within a short period of time. This accounting statement is called the profit and loss account (or the income statement) for an accounting period: Profit and loss account for the period Actions 1–7 Sales Less: Cost of sales Materials Labour Depreciation Gross profit Less: Selling and administrative costs Advertising Salaries Net profit £ 500 20 50 £ 750 570 180 10 10 20 £160 As can be seen. within a short time. or what expenses were incurred on the accounting period. Accountants have 1/12 Edinburgh Business School Accounting . in cash.) Assets of the company can be split into fixed assets.

For the example above the cash flow statement would be as follows: Cash flow statement for the period to Action 7 Sources of cash Profit from operations Adjusted for non-cash items: depreciation Capital introduction Increase in creditors Uses of cash Purchase of plant Increase in debtors Increase in inventories Closing balance of cash £ 160 50 20 000 3 000 £ 210 23 000 23 210 12 000 750 5 500 18 250 £4 960 Accounting Edinburgh Business School 1/13 . These detailed procedures of bookkeeping are the accountant’s job. portrays only those economic events of a business which affect cash flows. the cash flow statement. not the manager’s. it is an accounting convention that recognises this figure as if the money has been received when calculating profit. So far the two accounting statements have produced information on: (a) the profitability of the company for the seven actions listed. A third accounting statement. The business has not received payment for the sales at the time the profit and loss account is drawn up. Neither statement. and (b) the financial position of the business at the end of Action 7. reveals anything about the cash position which is important to many users of financial information: Directors Senior executives Managers Employees Shareholders Creditors Tax authorities Money spent on major process improvements Cross-national money switching Cash saved in buying in components Wage increases Dividends Payment of debts Payment of taxes Profit is not the same as cash. depreciation is a deduction from sales revenue before profit is determined but has no effect on cash. Also. But. There are many reasons for this: one such reason can be readily understood by considering the nature of the sales figure of £750 which gives rise to the reported profit. however. provided the owner believes the debtors will pay the amount shortly.Module 1 / An Introduction to Accounting and the Accounting Equation therefore devised a continuous recording system – based on the double-entry procedure encountered in the previous section – which eliminates the need to calculate the effect on profit and owner’s equity after every transaction but which will continue to provide the useful information in profit and loss account format whenever it is required.

(If it is not so then sooner rather than later the business will go bust!) In a start-up situation. Items which were charged in the profit and loss account and which did not affect cash. For the short period the business is owing the money. His cousin informs Forth that he is not looking for interest or early repayment. Readers will be guided through more realistic layouts of the three financial statements in the next three modules. profit and loss account and cash flow statement adopting the layouts given in the text. 3 An increase of creditors is a source of cash. Cash is cash whether the event affects the balance sheet or the profit and loss account. Note that the layout of the cash flow statement above.1 Do-it-Yourself Example In the space provided below each action for Forth Enterprises you should construct the accounting equation which reflects the transaction(s). depreciation.e. Therefore the business’s creditors can be seen to provide cash to the business. 1 The first source of cash should always be the operations of the business. In another situation a company can report healthy profits in the profit and loss account but the cash flow statement can reveal a rapidly deteriorating liquidity position. 2 The profit figure is the most useful starting point for determining the amount of cash generated by operations.Module 1 / An Introduction to Accounting and the Accounting Equation Note the following points. 5 The significance of the cash flow statement is that it breaks down the accounting conventions which separate economic events into either the balance sheet or the profit and loss account. many managers and analysts consider the cash flow statement to be equally informative. i. Action 1 Fred Forth commences business with £40 000 from his own savings and a further £10 000 cash from his cousin. the main source of cash is usually by way of original capital injection or by bank borrowings. are added back to this figure. 6 Despite the emphasis on the profit and loss account and balance sheet. When customers don’t pay cash for goods and services this weakens the financial state of the business for a short period. and the profit and loss account and balance sheet before it. 4 The reverse is true with the increase in debtors.9. 1/14 Edinburgh Business School Accounting . The business is therefore paying out cash to support its credit customers’ businesses for a short period of time. are skeletal and simplistic. such as in the example. it is able to use the money for other business purposes. At the end of Action 12 draw up a balance sheet. 1.

Action 7 The delivery van breaks down and requires £100 of repairs which Forth pays for in cash. and raw materials £8000 (half by cash. half by credit). factory and warehouse £25 000 cash. Action 3 Before the equipment can function properly. Action 8 At Christmas. He pays for both items using his credit card. Forth pays for this in cash. Accounting Edinburgh Business School 1/15 . Action 4 Forth pays his creditors in full and sells half of the finished goods (recorded at cost of £2200) for £4000 credit. Forth buys his wife a foodmixer costing £100 and his secretary a fur jacket costing £1200. Raw materials worth £4000 are then processed into finished goods through the equipment at a labour cost of £400. it requires a post-installation lubrication costing £200. Action 5 Forth buys a second-hand delivery van for £3000 on credit and a typewriter for his secretary for £200 cash. Action 6 Forth sells the remainder of the finished goods (recorded at a cost of £2200) for £3900 cash. and receives payment of £3900 from his debtors.Module 1 / An Introduction to Accounting and the Accounting Equation Action 2 Forth buys the following assets: plant and equipment £5000 cash. He buys further raw materials for £6000 cash and processes the remainder of his first batch of raw materials (which had cost £4000) at a cash cost for labour of £300.

e. receiving half of the money in cash and giving credit for the other half.Module 1 / An Introduction to Accounting and the Accounting Equation Action 9 He sells his second batch of finished goods (which are recorded at a cost of £4300) for £6000. They also recommend that he provides for depreciation on plant and equipment at a rate of 10 per cent and on motor vehicles at 25 per cent. He pays off his creditors. Note that the post-installation lubrication has been ‘capitalised’. Any further maintenance on this equipment would be ‘expensed’. Action 12 Forth considers that one-fifth of his factory and warehouse space is excessive for his needs. He withdraws £2000 in cash for personal needs. he sells that part for £7000 in cash. his labour force incurring £1000 wages in so doing. he also has all of his raw materials (cost £6000) processed. in their opinion this debt is now irrecoverable. Action 11 His auditors advise him that he should write off the debt of £100 which has been outstanding since Action 4. Action 3 P&E £5200 + F&W £25 000 + RMI £4000 + Finished goods inventory (FGI) £4400 + Cash £15 400 = OE £40 000 + LTL £10 000 + Creditors £4000. i.2 Worked Solution Action 1 Cash £50 000 = Owner’s equity (OE) £40 000 + Long-term loan (LTL) £10 000. We can gather from the action that the equipment would not work without this lubrication and so we can add this cost to the original purchase price. 1/16 Edinburgh Business School Accounting . written off against Owner’s equity. 1. Action 10 Forth pays £400 cash for advertising and £200 cash for audit fees. Action 2 Plant and equipment (P&E) £5000 + Factory and warehouse (F&W) £25 000 + Raw material inventory (RMI) £8000 + Cash £16 000 = OE £40 000 + LTL £10 000 + Creditors £4000.9.

Accounting Edinburgh Business School 1/17 . Action 11 P&E £4860 + F&W £25 000 + MV £2250 + FGI £7000 + Debtors £3000 + Cash £11 000 = OE £43 110 + LTL £10 000. Action 8 No change from Action 7. This action represents personal expenditure and does not affect Fred’s business records. Action 7 P&E £5400 + F&W £25 000 + MV £3000 + RMI £6000 + FGI £4300 + Debtors £100 + Cash £12 600 = OE £43 400 + LTL £10 000 + Creditors £3000. Action 10 P&E £5400 + F&W £25 000 + MV £3000 + RMI £0 + FGI £7000 + Debtors £3 100 + Cash £11 000 = OE £44 500 + LTL £10 000. Action 5 P&E £5400 + F&W £25 000 + Motor vehicles (MV) £3000 + RMI £4000 + FGI £2200 + Debtors £4000 + Cash £11 200 = OE £41 800 + LTL £10 000 + Creditors £3000.Module 1 / An Introduction to Accounting and the Accounting Equation Action 4 P&E £5200 + F&W £25 000 + RMI £4000 + FGI £2200 + Debtors £4000 + Cash £11 400 = OE £41 800 + LTL £10 000 + Creditors £0. Action 12 P&E £4860 + F&W £20 000 + MV £2250 + FGI £7000 + Debtors £3000 + Cash £16 000 = OE £43 110 + LTL £10 000. Action 6 P&E £5400 + F&W £25 000 + MV £3000 + RMI £4000 + FGI £0 + Debtors £100 + Cash £19 000 = OE £43 500 + LTL £10 000 + Creditors £3000. Action 9 P&E £5400 + F&W £25 000 + MV £3000 + RMI £6000 + FGI £0 + Debtors £3100 + Cash £12 600 = OE £45 100 + LTL £10 000 + Creditors £0.

Such gains (or losses) are not part of the normal profits from operations and should be shown separately in the profit and loss account. that is. purchase price less depreciation charged to date. Balance sheet at the end of Action 12 Fixed assets Factory and warehouse Plant and equipment Motor vehicles Current assets Finished goods Debtors Cash Less: Current liabilities Net assets of the company Represented by: Capital introduced Profit Less: Drawings Owner’s equity Long-term loan £ £ 20 000 4 860 2 250 £ 27 110 7 000 3 000 16 000 26 000 – 26 000 £53 110 £ £ 40 000 5 110 45 110 2 000 43 110 10 000 £53 110 1/18 Edinburgh Business School Accounting .Module 1 / An Introduction to Accounting and the Accounting Equation Profit and loss account for the period to Action 12 £ Sales Less: Cost of sales Raw materials Labour Depreciation on plant and equipment 8 000 700 540 100 400 750 100 200 9 240 4 660 £ 13 900 Motor repairs Advertising Depreciation on motor vehicles Bad debt Audit Net profit from operations Extraordinary profit from sales of factory (see note) Net profit Gross profit General expenses 1 550 3 110 2 000 £5 110 Note: The sale of a fixed asset produces a gain (or loss) when the proceeds received by the business exceed (or are less than) net book value.

For example he would record as business expenditure petrol for his delivery van but his weekly groceries would not go through his books of account. make an annual tax return to the tax authorities and be taxed on his yearly profit. The link between the two would be the drawings or salary he paid himself out of the business profits. Here a number of individuals agree to set up business together.10. 1. Because his creditors can pursue him beyond the limit of his business there is no requirement for him to make public his profit and loss account and balance sheet each year. however.10.2 Partnership A partnership is very similar to the situation of a sole trader. He will. not only are his business assets at risk but so too are his personal assets such as his home and domestic possessions. 1. Each is different but all use the same accounting equation.10 Sole Trader versus MBA Businesses can be set up in a number of forms. In law he has unlimited liability. distinguish between the transactions that pertain to his business and those that are domestic in nature. bringing to the partnership Accounting Edinburgh Business School 1/19 . He must.Module 1 / An Introduction to Accounting and the Accounting Equation Cash flow statement for the period to Action 12 £ Sources of cash Profit from operations Adjusted for non-cash items − depreciation Capital introduction Long-term loan Sale of factory and warehouse Uses of cash Purchase of assets 3 110 1 290 40 000 10 000 £ 4 400 50 000 7 000 61 400 Factory and warehouse Plant and equipment Motor vehicles Increase in inventories − Finished goods Increase in debtors Drawings Closing balance of cash 25 000 5 400 3 000 7 000 3 000 33 400 10 000 2 000 45 400 £16 000 1. of course. This means that if a customer or supplier or other person connected with his business sues him for poor workmanship or providing goods which are dangerous.1 Sole Trader A sole trader like the individual in the example (Actions 1 to 7) can start trading at any time with assets at his disposal.

Most of the needs of the users described earlier are largely satisfied by the information contained in financial accounts. Various defences are currently being mounted by the Big Six including pressing governments to permit proportional liability and limited liability partnerships. total profits. a partnership need not make public its annual results because its creditors can pursue the partners beyond the limit of their equity in the partnership. The secret of good management lies in predicting the future. The company still has access to the original paid-in capital. in plotting a course today which will steer the business 1/20 Edinburgh Business School Accounting .11 Accounting: The External and Internal Functions The accounting statements depicted in the previous section report the total picture of the firm for an accounting period: total sales. This is an expensive procedure and forces disclosure of business activities which sole traders and partnerships do not experience. or nominal value (MBA’s nominal value is 5 pence). 1. Some worldwide accounting partnerships are facing legal actions from clients which. In the event of legal action being taken against the company. £1. called the par value. and total asset structure. To protect creditors and others against abuse of this legal privilege companies must make public their annual accounts which must be audited by a registered firm of auditors. total costs. 1. As with the sole trader. While financial reporting and an analysis of financial accounts are important for managers for a variety of decisions they have to make. This information is compiled after the accounting period is over and the books of account have been closed.Module 1 / An Introduction to Accounting and the Accounting Equation assets in varying proportions. shareholders cannot lose any more money than the sum paid for the shares (provided the full face value of the shares has been called up by the company). even though the price struck between buyer and seller is considerably in excess of par value. A company’s ‘owner’s equity’ is termed ‘share capital’ and is split into individual shares usually expressed in small units of.10. inter alia. One major exception is management’s needs. how they will share the annual profit.3 Company A company structure avoids the risk of unlimited liability described above by limiting the liability of the owners (called shareholders) to the amount of equity (called share capital) paid into the company. This small amount is the face value of the share. may put in jeopardy the continuance of the partnerships. When a company grows in size and number of shareholders. its accounting equation is unaffected by any market transaction in its shares. the information contained therein is of little value in helping them to plan and control the day-to-day activities of the business. say. Before they start trading they will normally draw up a partnership agreement which sets out. if successful. This part of accounting is called financial accounting or financial reporting and derives from the legal obligation on directors and managers to report to the owners of the business (the shareholders) how they have used the resources at their disposal during the accounting period under review (usually annual).

(iv) Accounting requires only the mastery of a strict set of rules. managers concerned with the profitability of product lines.3 Which of the following reflects the effects on the accounting equation of a payment to creditors? (a) (c) Assets decrease. This information is called management accounting. (iv) analysts concerned with the company’s environmental record. (b) Assets decrease. (iii) Accounting handles only economic information. actual and projected costs of individual departments and individual processes. 1. Which of the following is correct? (a) (c) (i) and (ii) only. (ii) and (iii) only. Review Questions 1. liabilities decrease. To enable them to do this. The first seven modules of this course are devoted to financial accounting for managers. (d) Assets decrease. From the accounting process they need actual and projected costs and prices of individual products.2 Accounting information is used by different groups of people for different primary purposes. They are: (i) (ii) shareholders concerned with the level of employee remuneration. owners’ equity increases.Module 1 / An Introduction to Accounting and the Accounting Equation through the turbulent seas of uncertainty lying ahead. (d) (iii) and (iv) only. Which of the following is correct? (a) (c) (i) and (ii) only. owners’ equity decreases. (b) (i) and (iii) only. proposals for major investment in plant and equipment. (i) (ii) Accounting provides information for decision makers. the following nine modules address management accounting for decision making. (ii) and (iv) only. Assets increase. (iii) creditors concerned with the company’s ability to settle debts on time. (b) (i) and (iv) only. Accounting Edinburgh Business School 1/21 .1 There are several views of the role of accounting. management need detailed and relevant information. 1. (d) (ii) and (iv) only. and many other details. liabilities decrease. Accounting demands a high degree of mathematical precision. projected sources and uses of cash.

for cash. Action 1 T. (b) Assets unchanged. owners’ equity unchanged. from debtors.8 Which of the following economic actions increases the amount of current assets? (a) (c) A receipt of cash from debtors. A receipt of a loan from the owner’s brother. (d) A payment to creditors. on credit. he then acquires £8000 of raw materials inventory. 1. (b) A purchase of plant. on credit. A purchase of plant. His first actions are to purchase a van. (d) A payment for production wages. Assets increase. (d) A receipt of cash. 1.6 Which of the following economic actions reduces the amount of owners’ equity? (a) (c) A payment of administration wages. on credit. comprising the initial owners’ equity. costing £5000. for cash. (d) A payment to creditors. (b) A sale of finished goods.4 Which of the following reflects the effect on the accounting equation of a sale of finished goods inventory. on credit. for cash? (a) (c) Assets increase. Assets decrease. A purchase of raw material inventory. owners’ equity increases. on credit.5 Which of the following reflects the effect on the accounting equation of a purchase of an item of plant. owners’ equity increases. The following information applies to Questions 1. 1/22 Edinburgh Business School Accounting . 1. owners’ equity decreases. 1. (b) A receipt of cash from debtors. (b) Assets decrease. 1. for cash.22.9 Which of the following economic actions decreases the amount of current assets? (a) (c) A payment for production wages. A payment for a motor vehicle. (d) Assets unchanged. owners’ equity decreases. on credit? (a) (c) Assets decrease. (d) Assets increase. owners’ equity unchanged.Module 1 / An Introduction to Accounting and the Accounting Equation 1. owners’ equity unchanged. has commenced business with a start-up cash balance of £15 000.10 to 1. Harding & Co. owners’ equity increases. (b) A purchase of raw material inventory.7 Which of the following economic actions increases the amount of owners’ equity? (a) (c) A purchase of raw material inventory.

Module 1 / An Introduction to Accounting and the Accounting Equation 1. (b) £16 800.15 What is the amount of finished goods inventory after Action 3? (a) (c) £3700. 1. (b) £4100. £9000. 1.14 What is the amount of owners’ equity after Action 2? (a) (c) £17 900. (d) £24 000. Action 3 Payment of £5000 is made to creditors. The van breaks down. paid for in cash. (b) £8000. 1. Action 2 Plant is purchased at a cost of £4000.12 What is the amount of cash after Action 2? (a) (c) £8800. £15 000. (d) £28 000. on credit. (b) £22 000. Accounting Edinburgh Business School 1/23 . (d) £4850. £27 000. (b) £5000. half of which is sold for cash of £7000. £4500. (d) £18 000.10 What is the amount of current assets after Action 1? (a) (c) £5000. £23 000. 1. incurring repair costs of £350.11 What is the amount of owners’ equity after Action 1? (a) (c) £10 000. 1.13 What is the amount of fixed assets after Action 2? (a) (c) £4000. (d) £24 800. Depreciation of £400 on plant is to be taken into account. (d) £29 900. £21 800. and £200 is paid in wages to the production staff for the conversion of the raw materials into finished goods inventory. (b) £15 000.

(b) £8200. (d) £22 450. what should be the amount of sales? (a) (c) £7000. (b) £4400. £5000.20 What is the amount of current assets after Action 4? (a) (c) £17 050. £18 650. (d) £8600.21 What is the amount of creditors after Action 4? (a) (c) £1000.18 What is the amount of cash after Action 4? (a) (c) £8950. (b) £9350. 1. £8500. £19 050. £5350. 1/24 Edinburgh Business School Accounting .17 What is the amount of owners’ equity after Action 3? (a) (c) £12 150. (d) £7900. 1. (d) £23 650. 1. (d) £18 000. (b) £16 550. 1.22 If a profit and loss account were to be prepared at the end of Action 4. £17 050. 1. (b) £3000. (b) £17 450. on credit. (d) £21 050.19 What is the amount of owners’ equity after Action 4? (a) (c) £14 500. (d) £15 500.16 What is the amount of fixed assets after Action 3? (a) (c) £3650.Module 1 / An Introduction to Accounting and the Accounting Equation 1. £17 650. Action 4 The remaining finished goods inventory is sold for £8500. (b) £17 150. 1. Payments of administration wages of £500 are made. together with a further £2000 to creditors.

A company. (b) Sales less Material costs.Module 1 / An Introduction to Accounting and the Accounting Equation 1. During his first six months of trading. (d) A sole trader. Paid £2000 in manufacturing wages in converting 75 per cent of the materials into finished goods.1 Peter Brown opened his business for trading on 1 January with £25 000 cash from his own resources. (d) Sales less Administrative costs. Accounting Edinburgh Business School 1/25 . (b) Fixed assets + Current assets. 1. (b) A partnership. Sales less Cost of sales. the following economic actions occurred. (d) Introduction of capital.25 Which of the following should be the primary source of cash in the preparation of a cash flow statement? (a) (c) Profit from operations.26 In which of the following is owners’ equity divided into individual shares with a nominal value? (a) (c) A university. and the estate car requires to be depreciated over three years.24 Which of the following defines gross profit in a manufacturing company? (a) (c) Sales less Selling costs. Paid £600 for office staff wages and £300 for petrol. (d) Fixed assets + Net current assets. half of which was paid in June. Further information The equipment is estimated to have a useful life of five years. Purchased equipment for £10 000 and an estate car for £6000. (b) Decrease in debtors. on credit.23 Which of the following is equal to owners’ equity? (a) (c) Current assets + Current liabilities. Acquired £8000 of manufacturing materials. Fixed assets + Current liabilities. of which only £7500 was received in cash. 1. Sold 60 per cent of the finished products for £12 000. Case Study 1. Increase in creditors. 1 2 3 4 5 6 Paid six months rent of £2000 for the premises. 1.

2 Prepare a profit and loss account for the six months to 30 June and a balance sheet as at that date. 1/26 Edinburgh Business School Accounting . include depreciation with Action 6.Module 1 / An Introduction to Accounting and the Accounting Equation Required 1 Prepare the accounting equations after each of these economic actions.

4 2.13 Introduction What Is Profit? The Measurement of Accomplishment Time of Sales Orders Time of Production Time of Collection Another Reason for Opting for ‘Ship and Invoice’ Conventions Underlying Measurement of Sales Accomplishment The The The The Measurement of Effort Matching Convention Allocation Convention Cost Convention 2/2 2/3 2/4 2/6 2/6 2/7 2/8 2/9 2/10 2/10 2/11 2/11 2/12 2/12 2/13 2/13 2/14 2/14 2/15 2/16 2/17 2/18 2/18 2/19 2/19 2/20 2/20 2/22 2/23 2/23 2/27 2/32 Task One: Determining the Consumption of the Means of Production Use of Raw Materials Labour Depreciation of Fixed Assets Method 1: Straight-line Depreciation Method 2: Reducing Balance Depreciation Method 3: Consumption Method Task Two: Determining the Value of Closing Work-in-Progress and Inventories Types of Inventory in a Manufacturing Company Inventory Valuation Methods First In.6.6.12 2.10.7 2.2 2. First Out (LIFO) Average Method Which Method Should Be Chosen? Valuation of Work-in-Progress and Finished Goods Interpreting Profit Summary Appendix 2.1: The Impact of Changing Money Values Review Questions Case Study 2.7.1 2.1 2.2 2.10.3.4 2.1 2.2 2.7.1 2.6 2.3 2.2 2.Module 2 The Profit and Loss Account Contents 2.11 2.1 Accounting Edinburgh Business School 2/1 .7.3 2.6.3.2 2.3 2.9 2.4 2. First Out (FIFO) Last In.8 2.10.1 2.6 2.5 2.10 2.7.3.3 2.7.10.7.3 2.5 2.

the timing of revenue and expense and the role of accounting conventions. three financial statements were drawn up at the end of the sole trader’s Action 7. profit and loss account and cash flow statement. the impact on profit of different stock valuation methods and depreciation methods. the principal features of depreciation. A word of warning: although the material has been split up over two modules.Module 2 / The Profit and Loss Account Case Study 2. and the various techniques used to measure aspects of business activity. 2. the implications of ‘gross profit’ and ‘net profit’.2 Case Study 2. Over the next two modules we shall be examining these statements in greater depth so that readers are aware of: • • • where the underlying information in these statements comes from. the distinction between product costs and period costs. readers should not think that the techniques of measuring profit (the subject of this module) can be divorced from those surrounding the valuation of assets and liabilities (the subject of Module 3). the conventions employed by accountants in constructing the statements. For ease of reference the profit and loss account and balance sheet of the sole trader encountered in Module 1 are reproduced below: 2/2 Edinburgh Business School Accounting .1 Introduction In Module 1. The two issues are closely related (remember: the profit and loss account is a more detailed picture of all activities which affect owner’s equity in the balance sheet) and there will be considerable overlap between the two modules. his balance sheet.3 2/32 2/33 Learning Objectives By the end of this module you should understand: • • • • • • the role of the profit and loss account in the measurement of corporate accomplishment and effort.

These costs include: (a) the direct costs of manufacture or preparation (the purchases of raw materials used.2 What Is Profit? A glance at the profit and loss account will reveal that profit is the difference between the sales which the enterprise made during the period under review and all the costs which had been incurred to bring the goods sold to the market place ready for sale.Module 2 / The Profit and Loss Account Profit and loss account for the period to Action 7 Sales Less: £750 Cost of sales Materials Labour Depreciation £500 20 50 Gross profit Less: Selling and administrative costs Advertising Salaries Net profit 570 £180 £10 10 20 £160 Balance sheet at the end of Action 7 Fixed assets Plant and equipment at cost Less: Depreciation Current assets Stocks Debtors Cash 50 £12 000 £11 950 £5 500 750 4 960 £11 210 3 000 8 210 £20 160 Less: Current liabilities Creditors Net assets of the company Represented by: Capital introduced Profits earned Owner’s equity £20 000 160 £20 160 2. the wages of the workforce involved in the transformation process. and (b) the indirect costs (advertising and salaries of service support staff). Accounting Edinburgh Business School 2/3 . namely depreciation). and the costs of using up the equipment.

such a process being defined as the functions which are necessary to convert raw materials into a saleable product. The problems faced by accountants and managers in measuring the components of profit need to be examined closely. The difference between the two measures is the units of products which have been produced but not yet sold at the end of the period: these units of product would be stored in the warehouse.1 Accomplishments less Efforts The result (profit) of the entire transformation process over a given period can be viewed as the difference between: (a) a measure of accomplishment (what has been achieved in sales). 2/4 Edinburgh Business School Accounting . 2. and (b) a measure of effort (what these sales have cost).1.Module 2 / The Profit and Loss Account For many managers of companies and other profit-seeking organisations.3 The Measurement of Accomplishment What can be considered as a measure of accomplishment in the transformation process in an accounting period? A simple example can be used to consider this question. The chain of functions could be described as shown in Figure 2. Number of Product ABC shipped and invoiced to customers: 250 units. Example • • Total production for one accounting period of Product ABC: 300 units. profit serves as the prime indicator of overall effectiveness. Sale Storage Transformation Accomplishment: Revenue less Efforts: Costs Storage equals Purchase Profit Figure 2. The main purpose of the profit and loss account is to show the results of the transformation process over a given period.

The vagaries of weather make an earlier recognition of accomplishment unwise! 2 Accomplishment is generally measured at the first point in the operating cycle at which all the following conditions are satisfied. although the most popular. The amount ultimately collectable in cash can be estimated within an acceptable range of error. While the measure of accomplishment described above can be applied by all companies. and not before. And even if there is no doubt about the sale in the future. 3 The justification of the shipping and invoicing measure of accomplishment is simple: in most cases it is the first point in the cycle at which all three criteria are met and reflects what management have achieved by way of sales. the business can be reasonably certain that the customers have accepted the products and thus are liable to pay for them. Three other possible choices need to be examined briefly. depending on the specific circumstances in which operations take place. need not be used if some other recognition basis meets the criteria better. not what they think they might achieve. For an ice cream seller. different measures are used in practice. 1 The measurement of accomplishment in a South African gold mine is often viewed as occurring at the point the gold is extracted from the rock simply because the world demand for gold is so buoyant that the mining company can be assured of selling it within a predictable price range. as we saw in the case of the sole trader in Module 1. a sale occurs when the customer hands over his money in return for an ice cream cone. The events of shipping and invoicing the products are viewed as being critical in measuring accomplishment because at this time.Module 2 / The Profit and Loss Account In the profit and loss account. i. Such a measure. if not yet incurred. accomplishment for the accounting period is measured by the number of products shipped and invoiced to customers during the period. the product has been made and delivered against a firm order. The 50 units of finished product left in the warehouse may be monochrome monitors for a personal computer the latest version of which boasts a colour graphic screen. Accounting Edinburgh Business School 2/5 . The main reason for not taking total production as a measure of accomplishment is based on the consideration that normally the company cannot be sure that finished products in the warehouse will be accepted by customers in the future. the cash does not necessarily have to be received. Remember that. are either negligible or can be predicted within an acceptable degree of accuracy. often the selling price which can be obtained is not known with certainty. 1 2 The principal revenue-producing service has been performed. If the 50 units were to sell in the future – surely an unlikely event – the sales price would require to be reduced. All costs that are necessary to create the revenue have either been incurred or.e.

in some industries like shipbuilding.1 Time of Sales Orders Ask a sales rep when a sale occurs and the answer will be. 2. Example XY Construction plc is in the process of building a bridge linking two Scottish Hebridean islands. A firm order? Yes. In period 2 these costs are moved into the profit and loss account of period 2 as cost of sales to be set off against the revenue generated from sales. 2/6 Edinburgh Business School Accounting . the better job he has done. However. that is. when the amount of collection is reasonably certain and when the timing of shipping is more uncertain than the timing of production.3. one-third of the contract of £12 million had been completed. But in some businesses there exists a delay between order and shipment (perhaps due to the manufacturing process) during which time the customer can change his mind or change the specification. which is the same date as the company’s financial year-end. namely.3. In the next period the position is reversed. The job will take two years. Orders would only be recognised as a measure of accomplishment if: (a) the goods which are ordered are in inventory when the order is received. the inventory of finished goods) in the balance sheet for period 1.’ This reflects not only an intuitive understanding of a measure of his accomplishment but the method by which his performance is assessed by his superiors – the more orders he books. It is a more accurate reflection of economic reality that the business records the costs in storage for period 1 (i. The danger of recognising accomplishment in period 1 is clear – the sales may never materialize. A customer who will pay? Yes. ‘When I receive an order.Module 2 / The Profit and Loss Account 2. and (c) the number and timing of cancelled orders are known not to vary significantly. And the business incurs costs which are not predictable at the time the order was received. civil engineering and construction. the time of production is used for recognising accomplishment when no significant amount of services is required following the production effort. At the end of the first year. it does no manufacturing but sells the entire inventory that had been built up in the preceding accounting period. Certain production costs? No. Example A knitwear company received an order to supply high-quality sweaters to the Britain/Europe Ryder Cup golf team for their next match against the USA. building up inventories but making no sales. These conditions are likely to hold only when the interval between order receipt and shipment is so short that the distinction is of no practical importance.2 Time of Production Consider a business that devotes its entire attention to manufacturing in one accounting period. (b) all major costs have already been incurred.e. The world price of cashmere is volatile and may change significantly between order and delivery. although the client had paid only one-sixth.

namely £4 million. How many sales and profits should XY recognise at the end of Year 1? Observe that: 1 2 One-third of the contract.Module 2 / The Profit and Loss Account £2 million. XY’s sales would be £8 million and cost of sales £6 million. could be deemed to be sales in Year 1 provided this proportion could be confirmed by an independent surveyor. it would be acceptable to record sales as £4 million and cost of sales as £3 million at the end of Year 1. would be recorded in XY’s balance sheet as a debtor. video and hi-fi equipment) on instalment plans. so the critical point becomes the time of collection. the costs of the merchandise sold on instalment contracts are carried in inventory in the balance sheet and transferred to cost of sales in the profit and loss account in proportion to the amount of the payments received. and (c) the seller retains conditional title to the goods. The company expected to make £3 million profit on the bridge and at the end of Year 1 costs were being incurred on a predictably even basis. (b) the payment period is long and requires monthly or weekly payments of principal and interest. many companies sell large items of merchandise (such as cars. one-third of £9 million is £3 million. 2. The usual provisions of an instalment plan are: (a) a relatively small down payment is required. TV sets.e. Accounting Edinburgh Business School 2/7 . In such circumstances revenue is recognised as the cash is collected. i.3. Answer Provided the payment to account of £2 million is not indicative of a difficulty in paying on the part of the client. profit £1 million. The effect of these provisions is that there is a relatively high risk of reclaims of the merchandise because of non-payment. For example. £2 million. Using the timing of production method of measuring accomplishment allows XY plc to record profit in both years of the contract rather than to wait for its completion in Year 2.3 Time of Collection Even when goods are shipped and invoiced there are occasions when the market is such that the likelihood of receiving payment cannot be predicted accurately. giving a Year 2 profit of £2 million. In Year 2. Because only £2 million had been received by the year-end the balance of sales revenue. Total costs anticipated by the company are £9 million. it is important to appreciate that it is applied only when the company is producing to an order. Although readers need not concern themselves with the various rules accountants have developed to implement the production basis for measuring accomplishment. not in the hope of getting one.

On the understanding that the trader is confident that all customers would pay for the goods within the agreed credit period (e.2 A typical manufacturing cycle 2.4 Another Reason for Opting for ‘Ship and Invoice’ Consider the example given in Module 1: • The sole trader recorded sales during the period of £750. 2. Also. 5. Figure 2. Inventory of finished goods Too early – unsold goods may never sell. and would thereby fail to measure accomplishment correctly in either of the two periods.g. 4. Problem A manufacturer of sports bags supplies major retail sports outlets. that is the outcome of the economic effort which has been expended during the period. 30 days after sale). 6. Invoice About right – goods are normally invoiced at the time of shipment. then the measurement of accomplishment in the second period would be a mixture of: (a) sales made in the second period and paid for in the second period. Ship 3. the business recognises the full figure of £750 as the measurement of accomplishment at the end of Action 7. Order Too early – costs too uncertain. The relevant figures for production and sales for one year are as follows: Orders received during the year by the manufacturer’s sales force Sports bags manufactured Sports bags shipped and invoiced Faulty bags returned and not yet repaired How many sports bags were sold during the year? 2/8 Edinburgh Business School Accounting 15 000 10 000 12 000 1 000 . • All sales were on credit. Were the business to delay recognition of sales to the next period when the cash would have been received. customer may walk away before delivery. he received no cash for them at the time of sale. that is. Cash received Unnecessarily late unless there is evidence that customer won't pay for goods. and (b) cash of £750 received for sales made in the first period. the ultimate sales price may be unknown. Enquiry Too early – order may not emerge. • By the time the accounts were drawn up at the end of Action 7 no customers had paid for the goods.Module 2 / The Profit and Loss Account When Is a Sale a Sale? 1.

2/9 2 Accounting Edinburgh Business School . which is that 2000 bags have been drawn from inventory (last year’s unsold production) to satisfy the orders actually shipped. Two such conventions are adopted in measuring the sales figure: 1 The realisation convention: Only products that have been sold are measured as sales. he would pretend he had paid it so that his profit and loss account for the year to 31 December 20x1 would reflect the time consumption of resource in the 12 months of the accounts and the balance sheet would show this ten months’ unpaid tax as a current liability called ‘Accruals’. Products which are completed or partially completed and have not realised value for the business are not included. it cannot be used to measure accomplishment. Similarly. and to gauge the backlog build-up between orders and production output. The accruals convention: Cash does not have to be received to create value. That is. or company or any other entity pays an invoice for a product or service which covers a period stretching beyond the date he/she draws up the financial statements. the customers could walk away at any time (change of mind or change of supplier) if their orders are not satisfied on time.5 Conventions Underlying Measurement of Sales Accomplishment Accounting is a series of techniques and procedures which have been developed by accountants over many years. But because 1000 bags have been returned as faulty – the retail sports outlets will not have paid the manufacturer for these goods – the figure of 12 000 must be reduced by 1000. Don’t forget.Module 2 / The Profit and Loss Account Comment and Answer 1 Orders are buoyant but have not yet been satisfied. if he pays his annual insurance premium on his assets on 1 October 20x1 for the following 12 months and draws up accounts on 31 December 20x1. where the sole trader pays his property tax in arrears annually on 1 March 20x2. Sales will be recorded for the year at 11 000 bags. and the balance sheet would record the nine months’ balance of premium not recognised in the profit and loss account as a current asset called ‘Prepayments’. Therefore the best measure of accomplishment for the year is 12 000. For example. the profit and loss account for the year would include only three months’ worth of this premium (and presumably nine months’ worth of the premium paid on 1 October 20x0). an obligation from a creditworthy customer is good enough to be called a sale. The 1000 faulty bags will be returned to inventory or written off. he would accrue two months’ worth of the expected payment at 31 December 20x1. 2 3 2. each valued at the selling price charged by the manufacturer to the retailer. The accruals convention also covers the situation where a sole trader. and we don’t know what the loss would be. We call them conventions. Although the figure of 15 000 can be used to measure the sales force’s performance during the year. The figure of 10 000 bags manufactured again fails to portray economic reality.

the efforts of the period are not equal to the efforts linked to sales. 2.Module 2 / The Profit and Loss Account 2. Consider the following examples. or when it is smaller than sales volume. In these situations the inventory of work-in-progress and/or finished goods is added to. When production volume exceeds sales volume. The measurement of effort is governed by three conventions. the allocation convention and the cost convention. made 12 000): Sales for year Cost of sales: (a) Costs of manufacturing Less: (b) Costs attaching to bags put into finished goods inventory Bags 10 000 12 000 2 000 10 000 2/10 Edinburgh Business School Accounting . Identifying the costs of the units sold is not so easy as it sounds because the volume of units manufactured in any accounting period seldom equals the volume of units sold.6 The Measurement of Effort Profit equals the measurement of accomplishment (sales) minus the measurement of effort (costs). sold 10 000. Example (a) When sales volume exceeds the volume of units produced for a period (as in the sports bag example but ignoring faulty goods): Sales for year Cost of sales: (a) Costs of manufacturing Plus: (b) Costs attaching to bags taken from finished goods inventory Bags 12 000 10 000 2 000 12 000 (b) When production volume exceeds the units sold (reverse the numbers of the sports bag example. i.1 The Matching Convention Profit is arrived at by matching the effort (or costs) with the units shipped and invoiced to the customers (sales) during the period. namely the matching convention.e. or dipped into.6.

again expressed in money terms. Typical costs of selling and administration: • advertising and promotion • packaging and distribution • staff salaries • non-production overhead expenditure • research and development. was consumed during the accounting period. raw materials. Some typical costs of production: • raw materials • labour • depreciation of production plant and machinery • overheads directly related to the production cycle.2 The Allocation Convention The first task is to determine how much of each means of production. What is meant by ‘efforts’? Efforts are all the costs involved in producing saleable products. expressed in money terms. and the costs involved in actually selling the products which are recognised in the measurement of sales accomplishment. that is. 2. 2. power.g. It will be noted that the second task is similar to the procedures adopted under the matching convention. the company’s total purchases of means of production (e.6. the price paid for them by the business when they were acquired. We shall now have a closer look at the two tasks of the allocation convention.6.Module 2 / The Profit and Loss Account Without the matching convention the effort of producing 12 000 bags would be set against the accomplishment of selling 10 000. should be matched with sales revenue and how much should be added to the closing work-in-progress (inventory of unfinished goods) and to the inventory of finished goods (on the assumption that goods remain unfinished at the end of the accounting period and that the business produces more finished units than it sells). (This process is known as cost determination and recognises that not all purchases made during the period are consumed by production. Accounting Edinburgh Business School 2/11 . The general rule is found in the cost convention: accountants use the historical (or acquisition) cost of different means of production.3 The Cost Convention It was stated above that the means of production is measured and expressed ‘in money terms’.) The second task is to determine how much of each means of production. It will be seen that this rule creates problems when purchase prices fluctuate during the accounting period. wages of production workers) have to be allocated over the accounting period. that is.

50 £3. Assume that the 1200 units were purchased in a period of rising raw material prices at two-monthly intervals as follows: February April June August October December 200 200 200 200 200 200 1 200 units units units units units units units @ @ @ @ @ @ £1.00 each (using earliest prices).00 each. Four valuation possibilities suggest themselves: 1 2 300 units @ £3.00 £1. the question to be asked is. Similarly. ‘What is the value of the closing inventory?’ By valuing closing inventory and deducting the value from £2800 we can determine the value of purchases consumed by production during the year. When approaching the issue of valuing the 1000 units consumed. the valuation selected will have a direct impact on the portion remaining. Therefore the total costs to be allocated amount to £2800. During the year the company purchased 1200 units. 2/12 Edinburgh Business School Accounting . Physical units can normally be counted relatively easily and the inventories can be calculated at the beginning and at the end of the year from the purchase invoices.7 Task One: Determining the Consumption of the Means of Production Not all goods which are purchased in an accounting period are used up in that period – some are left over in inventory.50 each (using the last price paid for all the closing inventory). 200 units @ £3.50 each (counting back using actual prices).1 Use of Raw Materials The figure for raw materials used.50 each each each each each each £200 300 400 500 600 700 £2 700 The opening inventory of 100 units was valued at £1 per unit.7. and 100 units @ £3. The closing valuation of 300 units is not always the most obvious valuation.50 £2. 2.Module 2 / The Profit and Loss Account 2. The consumption of raw materials was therefore 1000 units. often the largest of all the costs of production. is determined by deducting the physical quantity of raw materials at the end of the year from the sum of opening inventory of raw materials and purchases during the year. Greater problems arise when we start to value the amount consumed.00 £2. Example XY Ltd commenced the year with 100 units of raw materials. 3 300 units @ £1. some are drawn from the inventory left over from the previous accounting period. At the end of the year 300 units were left in the raw material inventory. namely the 1000 units consumed.00 £3.

including installation charges if any. (c) the estimated useful life of the asset to the present owner. (b) the estimated net residual amount which the business will receive for the asset on disposal. or weekly) payroll is the usual source for the measurement of labour effort expended. So therefore is the difference in cost of units consumed.Module 2 / The Profit and Loss Account 4 300 units @ £2. of fixed assets is as valid an expense as the consumption of raw materials and labour services.7.7.3 Depreciation of Fixed Assets The cost of the depreciation of fixed assets must be included in the measurement of effort: the consumption.15 (using the average cost of units £2800 ÷ 1300). The periodic charge for depreciation is calculated having regard to three factors: (a) the actual historic (sometimes called acquisition) cost. 2. Valuation method 1 2 3 4 Closing stock valuation £1 050 1 000 300 645 Valuation of units consumed £1 750 1 800 2 500 2 155 Total £2 800 2 800 2 800 2 800 Note the following points: 1 2 The range of values for consumption of raw materials spreads between £1750 and £2500. Task Two (allocating costs to closing inventory of finished goods) was undertaken before Task One could be completed. (This is not necessarily scrap value: a company may have a policy of disposing of one-third of its car fleet each year. Accounting Edinburgh Business School 2/13 . In such a situation the company could expect a good second-hand value). The question to be asked is ‘How much should be recognised as a cost of a particular accounting period?’ There is no universally acceptable answer to this question: depreciation charges are based on rule-of-thumb procedures devised by engineers and accountants which try to reflect the periodic use of plant and machinery. or decline in value. The information comes from the pay records and is in money terms.2 Labour The annual (or monthly. 3 2. The difference in stock valuation is significant. These values are determined by the value that was selected for closing stock. The valuation of closing stock affects (a) value of units consumed (which has been shown) and therefore (b) profit (which will be considered in a later section). This shows that we cannot keep the two tasks in the allocation process separate.

The basis for this method is that a fixed asset is more efficient in generating revenue in the earlier years than in the later years of life.4 Method 1: Straight-line Depreciation The straight-line depreciation method is widely used because it is simple and reasonable in respect of many kinds of fixed assets. therefore it makes sense to counterbalance the low early maintenance with high early depreciation. The common set of data is as follows: Machine X Acquisition cost Estimated net residual value Estimated service life Estimated pattern of running hours: £1250 £50 3 5000 8000 2000 Year 1 Year 2 Year 3 years hours hours hours 2. repair expenditure tends to be low in the early years and higher in the later years. 2/14 Edinburgh Business School Accounting . therefore it makes sense to allocate more cost against earlier years’ revenue than later years’.Module 2 / The Profit and Loss Account Note that two of the three factors are nothing more than estimates. Bear in mind there are many others. 2. The annual charge would be: £1250 − £50 3 = £400 The depreciation schedule covering the life of Machine X would be as follows: Year At acquisition 1 2 3 Depreciation expense £400 400 400 £1 200 End of year Balance in accumulated depreciation £400 800 1 200 Book value £1 250 850 450 50 This method has the virtue of simplicity: it is especially appropriate where the use of the asset is essentially the same each year and is coupled with an approximately equal decline in the economic usefulness of the asset each period. Three methods of depreciation will be illustrated.7.5 Method 2: Reducing Balance Depreciation This method is based on the notion that there should be relatively large amounts of depreciation expense reported in earlier years of the service life and correspondingly reduced amounts of depreciation expense in the later years.7. Also. An equal portion of the original acquisition cost less estimated residual value is allocated to each accounting period during the asset’s service life.

the greater is the wear and tear on the machine.6 Method 3: Consumption Method The consumption method is based on the number of running hours of the machine: the assumption is the greater the machine hours run.Module 2 / The Profit and Loss Account The annual charge is based on the formula: 1− n Scrap value Cost where n = the estimated service life of the asset.7. This formula results in a figure of roughly 66 per cent depreciation rate per annum in this example. The annual charge in this example would be: Annual running hours Total number of running hours × Net cost Year 1 Year 2 Year 3 5 000/15 000 × £1 200 = £400 8 000/15 000 × £1 200 = £640 2 000/15 000 × £1 200 = £160 End of year Balance in Book value accumulated depreciation £1 250 £400 850 1 040 210 1 200 50 Year Depreciation expense At acquisition 1 2 3 £400 640 160 £1 200 Accounting Edinburgh Business School 2/15 . The depreciation schedule covering the life of Machine X would be as follows: Year At acquisition 1 2 3 Depreciation expense £825 280 95 £1 200 End of year Balance in accumulated depreciation £825 1 105 1 200 Book value £1 250 425 145 50 2.

these are statutorily determined rates of depreciation for different classes of assets). but it is by a roundabout way! Businesses are therefore better placed to replace their assets if they charge depreciation than if they did not. the various means of production consumed during the accounting period must first be measured.Module 2 / The Profit and Loss Account Comparison of methods Year 1 2 3 Straight line £400 400 400 £1 200 Depreciation expense Reducing balance £833 278 93 (say) Consumption method £400 640 160 £1 200 The principal features of depreciation should be clearly understood.8 Task Two: Determining the Value of Closing Work-inProgress and Inventories It will be remembered that. This is easy to understand: of all the costs incurred in an accounting period. But the act of allocating this cost to an accounting period serves to reduce reported profit. the amount of depreciation allocated in turn influences reported profit. 4 2. wage expectations in succeeding periods. by itself. Depreciation. for any accounting period. The next step is to decide how many of these costs should be allocated to products unsold or unfinished at the end of the period. Thus charging depreciation has a positive effect on the cash position of a business. (In many fiscal jurisdictions such as the UK depreciation per se is not allowed as a charge against profits for the purposes of calculating tax simply because businesses have a wide choice of depreciation rates and could therefore manipulate the level of taxable profit. then these costs must be deducted from the total costs measured in Task One: the balance is set off as a charge in the profit and loss account. and consequently on reported profit. does not provide cash for the replacement of the assets. 1 2 3 Depreciation is the allocation of the cost of assets purchased in one accounting period over the accounting periods in which they are used. In other words. the closing inventories of finished goods and work-in-progress must be valued. The selection of method influences the amount of cost allocated to each accounting period. Depreciation is a cost of production like raw materials and labour costs. this in turn dampens down the loss of cash from the business by lowering the tax and dividend payments and. The selection of an inventory valuation system is very important because it will have a major impact on the measurement of effort. these can be allocated either against 2/16 Edinburgh Business School Accounting . Fiscal authorities substitute capital allowances for depreciation. in order to measure the efforts or costs involved in producing saleable products. perhaps.

In a manufacturing operation we usually find the following categories.9 Types of Inventory in a Manufacturing Company The kind of inventory normally held depends on the characteristics of the business. each one different. Let us imagine the 1000 units sold realised £5 each. when worked upon. Sales (measurement of accomplishment) would therefore amount to £5000. completed and ready for sale. (1) £5 000 1 750 £3 250 £1 050 (2) £5 000 1 800 £3 200 £1 000 (3) £5 000 2 500 £2 500 £300 (4) £5 000 2 155 £2 845 £645 2. 1 2 Finished goods inventory: goods manufactured by the business. Here we saw four inventory valuations being put forward. Work-in-progress inventory: goods in the progress of being manufactured but not yet completed as finished goods. the less the cost of units sold is going to be in the profit and loss account. 3 Accounting Edinburgh Business School 2/17 .1. Raw materials inventory.7. the variation in profit can be significant. We can express this relationship like this: Beginning inventory + Purchases − Ending inventory = Cost of goods sold charged in P/L Account In other words: (a) the higher the ending inventory valuation. the lower the reported profit. the higher the reported profit. becomes work-in-progress.Module 2 / The Profit and Loss Account sales revenue or to unsold and unfinished products. Raw materials and supplies inventory: items acquired by purchase to be used in the manufacturing process. Consider the four profit and loss accounts that would emerge using four inventory valuation methods: Sales Cost of sales Profit Closing inventory Note that: (a) the addition of cost of sales and inventory amounts to £2800 in each case. Because inventory is often a very significant asset owned by a manufacturing company. Work-in-progress inventory. The more costs we allocate to unsold and unfinished products. Example Refer back to the example in Task One on raw materials in Section 2. when completed it becomes finished goods inventory until sale. alternatively (b) the lower the ending inventory valuation. and (b) the higher the ending inventory (method (1)) the higher the profit. when completed. becomes finished goods inventory until sale.

Now the profit and loss would read: Sale Cost of sales (1800 + 900) Profit Closing inventory (1000 − 900) £ 5000 2700 2300 100 This is an example of the conservatism convention overriding the cost convention. A choice among the inventory costing methods is necessary only when there are different unit costs in the opening inventory and/or the purchases made during the accounting period. we see that 1000 units sold for £5000. 300 units of which 200 were valued at £3.1 and select valuation method 2. Let us assume that a technological advance announced towards the end of the period rendered the closing inventory obsolete and the business considered that only £100 would be raised from its sale as scrap.00. first out method assumes that the oldest unit costs (the first units purchased) are the first ones sold. that is. it would be wrong to value the inventory at cost because this would lead to understating cost of sales and overstating income: the loss of sale would then have to be recognised in a later accounting period. because of changes in technology. a company will find that some inventory will not sell for even the cost price and that it has to reduce its selling price below cost to get rid of it on the market. Under normal circumstances. the three principal ones will be expanded below. But sometimes.10 Inventory Valuation Methods Inventory. ‘Recognise losses and reductions in value whenever they come to light’. cost will be lower than net realisable value. 2. There are many methods. once physically counted.Module 2 / The Profit and Loss Account 2. consumer tastes and the like. First Out (FIFO) The first in. cost of sales were £1800. Conservatism says. being the sum of the applicable expenditures and charges directly or indirectly incurred in bringing the article to its existing condition and location. This valuation of £1000 is based on the cost convention. Generally accepted accounting principles require that the inventory costing method must be rational and systematic. is valued according to a mixture of cost and conservatism conventions in accounting. profit was £3200 and closing inventory was £1000. goods in inventory are valued in terms of cost. Generally.50 and 100 at £3. Example Refer back again to the example in Task One in Section 2. If the adjustment were not to be made in this period. In such circumstances. This means that the units left in inventory at the end of the accounting period are deemed to be the latest purchased and 2/18 Edinburgh Business School Accounting . Accountants therefore adopt a more conservative rule: inventory is valued at the lower of cost or net realisable value. the £900 additional costs would require to be written off in the next period.7.1 First In.10.

lowest costs while those allocated to the closing inventory in the balance sheet are the newest. and (b) the number of units in the ending inventory to measure the inventory value. the balance sheet inventory is carried at current realistic values. first out method assumes that the most recently acquired goods are sold first. producing a closing stock valuation of £300 and a cost of sales figure of £2500 for stock consumed. not 300. In the example valuation method 4 is on the Average method and gives a weighted average cost of £2.) Accounting Edinburgh Business School 2/19 .1 is not a recognised valuation method because it does not reflect the facts of the business. Also. Its greatest drawback. LIFO assumes that the most recent purchases (and therefore the most recent prices) are transferred first into production.1. only 200 units were purchased at £3. leaving in the ending inventory the oldest (and lowest priced) units. (For the sake of completeness it should be noted that valuation method 1 described in Section 2. 2.15 per unit which in turn gives a closing stock figure of £645 and a cost of sales figure of £2155 for stock consumed.50. If the prices have been moving up during the period the costs which are allocated to cost of sales in the profit and loss account are the oldest. valuation method 2 is on the FIFO basis. However. FIFO is favoured by many businesses because it is consistent with the physical flow of the goods.7. many managers do not want to report the lower profit figure.Module 2 / The Profit and Loss Account therefore valued at the latest prices.2 Last In. When prices are rising.10.7. Irrespective of the physical flow of goods. And of course inventory must be replaced. high dividends and potentially high wage demands. companies find it increasingly difficult to replace the physical volume of inventory used and sold. with a high closing valuation of £1000 and a low cost of sales figure of £1800 for inventory consumed. however. The average unit cost is then applied to (a) the number of units sold in order to calculate the cost of goods sold. High reported income leads to high taxes. is that the reported income is relatively high during periods of rising prices because of the oldest and lowest costs which have been set off against sales revenue. In the example in Task One in Section 2.10. Thus the LIFO method attains results that are the opposite to FIFO: lower profit is reported in times of rising prices and replacement of inventories is therefore made easier. provided the stock is turned over quickly. demanding more cash outlay. First Out (LIFO) The last in. 2. that is. In the example valuation method 3 is on the LIFO basis. The unit cost is representative of all the costs incurred during the entire period rather than concentrating on the costs at either the beginning or the end of the period as FIFO and LIFO do.3 Average Method The averagemethod involves computing the weighted average unit cost of the goods available for sale. highest costs.

4 Which Method Should Be Chosen? Each of the three methods discussed is in accordance with generally accepted accounting practice even though each one produces very different cost of goods figures and asset valuations. all of whom do not work directly on the products but whose services are connected to the production process. In addition to the ones just mentioned we can add various factory overheads such as indirect labour (assume that the labour costs considered so far were wages of operatives directly involved in manufacturing) representing wages and salaries earned by supervisors. therefore higher costs being passed into cost of sales and hence lower profits. (b) work-in-progress: the product costs accumulated for those products on which production has been started but not yet completed at the end of the accounting period.10. Management should choose the system which suits their long-term goals. Very often tax minimisation is a primary goal of management: in times of rising prices LIFO will result in lowervalued inventories. or to the production process.Module 2 / The Profit and Loss Account 2. warehouse staff and maintenance engineers.3. together with all the other supporting costs incurred by a company in the pursuit of profit. light and power. must now be examined. and 2/20 Edinburgh Business School Accounting .11 Valuation of Work-in-Progress and Finished Goods So far the valuation discussion has been largely concerned with units of raw material. The allocation of product costs between the cost of products sold (reflected in the profit and loss account) and the closing inventory (which is recorded as an asset in the end-of-year balance sheet) has already been discussed at length and may be viewed in Figure 2. it is thought. depreciation and asset insurances. To understand the issues involved in this important area of inventory valuation the types of costs involved in converting raw materials into saleable goods must be considered. Businesses. Most managers believe that the best inventory valuation method is the one that best matches the sales pricing policy of the company. This discussion must now be widened to take account of three types of inventory: (a) raw materials: the cost of raw materials in the storeroom. 2. namely workin-progress and finished goods. No one system can be considered ‘best’. Few tax authorities would countenance managerial switches from LIFO to FIFO (and perhaps back again) just to avoid tax. Two of the costs which have been examined in detail in this module. The other two categories of inventories identified above. supplies and maintenance. Such costs can be traced directly to the products being manufactured. are known as product costs. raw materials and labour. Other factory overheads would include heat. set selling prices within a LIFO assumption since the inventory used up through sales must be replaced on the shelf at the latest cost rather than the earlier cost.

Such costs are called period costs.3 Allocation of product costs (c) finished goods: the product costs of goods that have been completed but not yet sold. The more costs Accounting Edinburgh Business School 2/21 . There is another category of costs which companies incur and which are set off against sales revenue in the profit and loss account without any question of including them in the valuation of closing inventory. Examples of period costs are selling. distribution and marketing costs. For instance some accountants argue that a portion of administrative costs should be deemed a product cost. These costs are incurred so that a company’s products can be sold. and the money can be collected from the customer. however. general administrative costs and financial charges.Module 2 / The Profit and Loss Account Figure 2. but they typically do not add value to the products unsold at the end of the accounting period.4. that selling costs are never included as product costs.4 Allocation of product and period costs Accountants do not agree where the line should be drawn between product costs and period costs. Few would disagree. labour and factory overhead) which are not allocated to any of the three categories of inventory described above are charged against sales revenue in the profit and loss account as cost of sales. They are therefore written off each year. The total costs in the profit and loss account would look like Figure 2. Those product costs (materials. The way in which a company classifies its costs into period costs and product costs can have a significant effect on the reported profit figure. Figure 2.

If the reader wants to assess the company’s financial structure the important figures are the interest payment (interest. which reflects the further expenditure identified normally as period costs. And the higher the inventory. selling and distributing the company’s products should not be affected by the financing arrangements made to bring about the trading results. net profit comes in different shapes and sizes! The most commonly used measure of managerial efficiency is net profit before interest charges and taxes (2): management’s efficiency of manufacturing. that is. sales less cost of sales. on the other hand. it will be recalled. A consistent treatment of. But again. the higher the inventory valuation will be at the end of the accounting period. Profit and loss account for Sole Trader for the period ended Action 7 (extended to include interest and tax) Sales Less: Cost of sales: Materials Labour Depreciation Gross profit Advertising Salaries Net profit before interest and taxes Interest charges Net profit after interest but before taxes Tax Net profit after interest and taxes 750 500 20 50 10 10 570 180 20 160 10 150 50 £100 (1) (2) (3) (4) It should be clear for what purpose the profit figure is intended. Taxes are also an irrelevant consideration when 2/22 Edinburgh Business School Accounting . It makes sense therefore for profit to be measured in a consistent manner from one accounting period to another.Module 2 / The Profit and Loss Account a company deems to be product costs. enables the reader to judge overall managerial efficiency against both previous accounting periods and other companies engaged in similar fields. on money borrowed from non-shareholders) and the net profit after interest but before taxes (3). the higher the reported profit figure.12 Interpreting Profit Great care must be taken in interpreting the profit or loss figure which results from matching the measure of accomplishment with the measurement of effort. that is. 2. It has been seen that both accomplishment (sales) and effort (costs) can be measured in so many different ways. Is it required to measure the efficiency of the entire company and its management or to measure the efficiency of the manufacturing (transformation) sector only? If a measure of the efficiency of the transformation process is wanted the gross profit (1) figure should be selected. say. Net profit. inventory valuation or depreciation prevents management from switching between methods solely to influence reported profits.

And management have little influence on the method of determining the level of tax paid. 2.Module 2 / The Profit and Loss Account judging managerial performance because the taxes shown as being payable in an accounting period seldom bear much resemblance to the taxes actually paid. The modules on management accounting will provide this type of detail. each one producing a different cost of sales figure and therefore a different profit figure. departments. Sales are measured by reference to goods and services shipped and invoiced to the customer and are not dependent on the cash received. tells the reader very little about the company’s efficiency. products and so on). It should also be recognised that the profit figure for a whole company (or sometimes even a group of companies) which is disclosed in a set of financial accounts does not yield sufficient information for a judgement to be made on managerial efficiency. Depreciation is another cost which is subject to a variety of methods of calculation. Cost of sales are measured by reference to the valuation of inventory of raw materials. Different countries adopt different techniques to overcome these shortcomings of historic cost accounting. The profit measurement rules under the Historic cost convention do not allow companies to reflect the damaging consequences of inflation on the economic fabric of their resources. This inventory can be valued in one of a number of ways. before and after overheads. Profit can be calculated at a number of levels. that is. Depreciation We saw in this module that depreciation is Accounting Edinburgh Business School 2/23 . Set out below are typical adjustments that are used to reflect the impact of changing money values on Depreciation and Cost of sales.1: The Impact of Changing Money Values Many countries suffer high rates of inflation. and before and after interest and taxes. The latter category must be written off in the profit and loss account while the former can be ‘inventoried’ and carried forward in the valuation of inventory in the balance sheet. From the above discussion it can be seen that the ‘bottom line’ profit (4). work-in-progress and finished goods at the end of the accounting period. Care must be taken to segregate product costs from period costs. Much more detail is required (on company sectors. Managers must select the figure which best suits their purpose. Appendix 2.13 Summary The profit and loss account measures the difference between accomplishment (sales) and effort (cost of sales and other overheads). the net profit after deductions. This is due to various statutory timing differences which throw tax liability and tax payment out of phase.

This is due to the fact that the previous year’s replacement-based depreciation has not been updated to the current year’s replacement-based depreciation charge. and that the residual value rose by the same amount each year. Example Consider Machine X again. even in an inflationary environment.) The calculation of depreciation by any of the three methods shown in the module will set aside only the original cost of the asset being replaced. technological developments may serve to reduce the replacement cost. such as in the microelectronics industry. Assume that during the asset’s life the replacement cost of this asset rose by 20 per cent per year. Replacement of assets is fundamental to the ongoing nature of the business: businesses must replace worn out assets with new ones. with its acquisition cost of £1250.Module 2 / The Profit and Loss Account (a) an allocation of cost. (1) End of year 1 2 3 (2) Replacement value £1 500 1 800 2 160 (3) Residual value £60 72 86 (4) Depreciable amount (2) − (3) £1 440 1 728 2 074 Depreciation charged at one-third per annum £480 576 691 £1 747 Total Compare the depreciation cost charged to profit and loss account under replacement cost accounting with that charged under historic cost. The calculations that follow are based on the straight-line method of depreciation. End of year 1 2 Replacement value £1 500 1 800 Depreciation charge 480 576 Top-up Cumulative depreciation depreciation – £480 96 1 152 (to top up Year 1 576−480) 230 2 073 (to top up Years 1 and 2 2 × 691−1152) Book value £1 020 648 3 2 160 691 87 2/24 Edinburgh Business School Accounting . being full replacement cost of £2160 less replacement residual value £86. and (b) one of the means whereby a company can ease the cash burden on itself brought about by replacing its assets. (Occasionally. estimated service life of three years and estimated net residual value of £50. The total charge has increased from £1200 to £1747. But notice that sufficient depreciation has still not been provided to cover the net replacement cost of £2074. But inflation and changing money values conspire to make the replacement usually more expensive than the original cost.

50 each for units purchased in December. Note that the cost convention has been overturned by the use of replacement costs. the top-up depreciation of £230 arising in Year 3 reflects shortfalls in Years 1 and 2 and should be provided for from reserves. the £96 required in Year 2 to bring the cumulative depreciation up to a level which reflects the two-thirds of the replacement value less residual value refers to a shortfall in Year 1’s depreciation. The cost of each parcel of units is rising throughout the year. This could cause difficulties for the company if it had parted with cash to pay tax and dividends based on a high profit. Cost of Sales Refer to the data in Section 2. which is relatively easy to operate. If the company adopts valuation method 2. Accounting Edinburgh Business School 2/25 . from the trend in purchase prices.8) would look like this: £ Sales 1000 units @ £5 Opening inventory 100 units @ £1 Purchases 1200 units @ varying prices Closing inventory 300 units 200 @ £3. There are many ways the adjustment can be calculated: one method favoured by many companies is the averaging method.00 Cost of goods sold Profit Less: 100 2 700 2 800 £ 5 000 1 000 1 800 3 200 This profit would attract tax and shareholders would expect a dividend to be paid to them from such a healthy figure. the profit and loss account (given in brief form in Section 2. from £1 each for units held in inventory at the beginning of the year to £3.Module 2 / The Profit and Loss Account The question which is posed now is. In an attempt to reflect the upward movement in costs.50 100 @ £3. a method commonly used by enterprises. No firm answer is possible to the question but it would appear unfair to penalise Year 2’s profit with a cost which refers to Year 1. Similarly. But it is clear that. the company is faced with replacing the units sold at a higher price than that paid for them at the original purchase.1 concerning the purchase of raw materials.7. ‘Should the top-up amounts be charged as additional depreciation in the profit and loss account of the accounting periods following the ones they refer to?’ For instance. Accountants would generally favour taking this top-up £96 from the reserves (undistributed previous years’ profits) so as to reflect the real profit each year. The current cost of sales may be computed by revising the historical cost of opening and closing inventory to the average current cost for the year. accountants have designed a cost of sales adjustment which has the effect of removing the holding gains (‘profit’ from holding inventory while it rises in value) from reported profit.

Module 2 / The Profit and Loss Account and the cost of sales adjustment will be the difference between the current cost of inventory at the date of sale and the amount charged in computing the historical cost. seldom can an organisation track its individual purchase price movements with such precision! The cost of sales adjustment is calculated as follows. 1 Index relating to the specific raw materials and supplies: 1 January 31 December Average for year 2 Revision of inventory balances: Opening inventory Closing inventory 3 £100 × 225/100 = £225 £1000 × 225/350 = £643 100 350 225 Current cost of goods sold: £ 225 2 700 2 925 643 2 282 Opening stock Purchases Less: closing stock Current cost of goods sold 4 Cost of sales adjustment: Historic cost of goods sold Current cost of goods sold Cost of sales adjustment 5 Restated profit and loss account £1 800 2 282 482 £ Sales Opening inventory Purchases Less: closing stock Historic cost of goods sold Cost of sales adjustment Current cost of goods sold Profit 100 2 700 2 800 1 000 1 800 482 £ 5 000 2 282 2 718 2/26 Edinburgh Business School Accounting .1. even though specific price rises can be identified.7. We will now apply the averaging method to the data in Section 2.

2. Matching. which of the following accounting conventions is adopted in measuring the sales figure in the profit and loss account? (a) (c) Conservatism.1 In the profit and loss account. (d) Cost. Review Questions 2. 2. The adjusted profit figure of £2718 is a better reflection of operational and managerial effectiveness than £3200. which of the following accounting conventions is applied in the measurement of effort in the profit and loss account? (a) (c) Matching. (d) Total cash receipts from debtors.Module 2 / The Profit and Loss Account The adjusted profit is £482 less than the original historic cost profit and this represents the gain made by the company simply from holding inventory as it rose in price. (b) Accruals. Accounting Edinburgh Business School 2/27 . (b) Product research and development. It must be stressed that each country affected by high inflation has its own way of accounting for changing money values.5 Which of the following is a typical cost of production? (a) (c) Salaries of office staff. Total shipped and invoiced sales. (b) Total sales orders received. Repairs to plant and machinery. (d) Packing and distribution.4 Which of the following is a typical cost of selling and administration? (a) (c) Depreciation of plant and machinery. (d) Going concern. (b) Realisation. 2. 2. Raw materials.3 In the profit and loss account. which of the following is regarded as the measure of accomplishment? (a) (c) Total manufacturing output. (b) Wages of production staff. Accruals. This appendix describes only one method for depreciation and one method for cost of sales. Note that if a company decided to implement both of these inflation adjustments its reported profits could drop dramatically.2 In the profit and loss account. It also attracts less tax and lower dividends and therefore allows the company to retain more cash to help replace the inventory which is rising dramatically in price. (d) Expenditure on brochures.

each of which had cost £100. 2. 2. (d) £122.6 What is the amount of purchases during the year? (a) (c) £2500. During the next year. (b) £4740. 2. (d) £9940.7 What is the total cost to be allocated between closing inventory and cost of sales? (a) (c) £2240. (b) £114. amounting to £9350. At 31 December.70. what is the amount of cost of sales? (a) (c) £1740. 2. (b) £2500.9 If the first-in. (b) £4759.00. first-out (FIFO) method of inventory valuation is used. £2500. first-out (FIFO) method of inventory valuation is used.10 If the average cost method of inventory valuation is used. £120. (d) £5500.6–2.60. Month March May June September November Sets purchased 5 10 8 6 12 Unit price £100 £110 £115 £120 £125 Annual sales totalled 52 sets. £7240. £5500.12. 2/28 Edinburgh Business School Accounting . (d) £7240.50.Module 2 / The Profit and Loss Account The following information applies to Questions 2. £6850. what is the cost per set in closing inventory? (a) (c) £109. (d) £7240. what is the amount of closing inventory? (a) (c) £1740. 2. (b) £1750.8 If the first-in. counting 25 colour television sets. further purchases were made as follows. James White & Co carried out its annual physical stocktaking.

what is the annual depreciation charge in Year 2? (a) (c) £3400. £1540. 2. (d) £29 900.14–2. (b) £4335. (d) Acquisition cost. (d) £6000. Average cost for period purchases. £4000. (d) £4600. 2.13 Which of the following factors in depreciation computations is based on an actual figure? (a) (c) Residual value. at which point it is anticipated that it will be capable of resale for £6000. Accounting Edinburgh Business School 2/29 . requiring an annual depreciation rate of 15 per cent. what is the amount of closing inventory? (a) (c) £1400. (d) £1680. first-out (LIFO).14 If the straight-line method of depreciation is used. JK Builders Co purchases a new excavator. (d) First-in.11 If the last-in. costing £40 000.17.15 If the straight-line method of depreciation is used. 2. what is the annual depreciation charge? (a) (c) £2800. 2. (b) £1470. Replacement value. first-out (LIFO) method of inventory valuation is used. what is the book value of the excavator at the end of four years? (a) (c) £20 400.Module 2 / The Profit and Loss Account 2. £5100. 2. The following information applies to Questions 2. Its expected useful lifetime is 10 years. (b) £3400.16 If the reducing balance method of depreciation is used. (b) £22 800. (b) Last-in. £26 400. (b) Useful life of asset. first-out (FIFO).12 Which of the following methods of inventory valuation will result in the highest cost of sales? (a) (c) Weighted-average cost.

(d) £24 565. light and power. (d) Bank charges. 2. (d) (ii) and (iv) only. (b) £18 905. (b) (i) and (iii) only. (b) Financial charges. (d) Depreciation of plant. (iii) is a part of the cost of financial charges. which of the following accounting conventions is of prime importance? (a) (c) Conservatism.22 Which of the following profit measures is appropriate to use in assessing management’s efficiency in manufacturing.20 Which of the following is a period cost? (a) (c) Maintenance engineers’ wages.18 In considering its features.19 In valuing closing inventory at net realisable value. 2. Which of the following is correct? (a) (c) (i) and (ii) only. 2.Module 2 / The Profit and Loss Account 2. (ii) and (iii) only. Heat. (b) Realisation.17 If the reducing balance method of depreciation is used. is an allocation of the cost of fixed assets over their period of use. but before taxes. Net profit after interest. (d) Gross profit. 2/30 Edinburgh Business School Accounting . it is important to appreciate that depreciation: (i) (ii) produces cash for fixed asset replacements. (iv) is a measure of the value of the consumption of a fixed asset. Matching. (b) Insurance on sales vehicles. 2.21 Which of the following is a factory overhead? (a) (c) Accountants’ salaries. (b) Net profit after interest and taxes. (d) Cost. Foremen’s wages. £22 400. what is the book value of the excavator at the end of three years? (a) (c) £16 000. 2. selling and distributing its products? (a) (c) Net profit before interest and taxes.

for the year ending 31 December 20x5. is £11 000. The replacement cost of the fixed assets has increased by 10 per cent per annum since their purchase on 31 December 20x3.25 Using the averaging method. what is the revised opening inventory? (a) (c) £522. on a historic cost basis. (b) £1200. £1210.24. (d) £780. The annual depreciation charge.Module 2 / The Profit and Loss Account The following information applies to Questions 2.27. £ Sales Less: Cost of sales Opening inventory Purchases Closing inventory Gross profit £ 6 250 600 3 250 3 850 790 3 060 3 190 The trade index relating to materials supplied to Hare and Howndes is: 1 January 20x5: 100 31 December 20x5: 130 2.24 What is the amount of ‘top-up’ depreciation at the end of 20x5 for a replacement cost-based depreciation charge? (a) (c) £1100. In Tweed Limited’s Balance Sheet at 31 December 20x5.23–2. (b) £1320. The following information applies to Questions 2. (b) £600. (d) £2310.23 What is the total amount of extra depreciation at the end of 20x4 to introduce a replacement cost-based depreciation charge? (a) (c) £1100. 2. (d) £3300. Hare and Howndes Limited has prepared its profit and loss account. Accounting Edinburgh Business School 2/31 . fixed assets are stated at a net book value of £88 000. comprising the original acquisition cost of £110 000 less cumulative depreciation of £22 000. £2200. under historic cost accounting.25–2. 2. £690.

£329. Its policy is to depreciate all machinery on a 25 per cent reducing balance method.2 At 1 April. their annual operating performances are identical. costing £8100. the company’s policy is to depreciate on a straight-line basis. with an estimated final trade-in value of £1700.27 What is the cost of sales adjustment? (a) (c) £181. 2/32 Edinburgh Business School Accounting . the Scottish division values its inventory on a FIFO basis. and a new delivery van. (b) £271. (d) £3940. 25 000 10 000 15 000 4 000 5 000 Unit price £ 70 35 45 50 25 Case Study 2. Case Study 2. Appletree Yarns Ltd acquired a new weaving machine. With similar market sizes to address. (d) £362. However.1 Orange Computer Printers Limited operates two selling and distribution divisions – one in Scotland and one in Canada. The delivery van is expected to have four years of useful life. whereas the Canadian division applies a LIFO approach. costing £64 000.26 What is the current cost of goods sold? (a) (c) £3073. 2. On motor vehicles. £3331. (b) £3241. The following information is available for each division: Units Sales Purchases April June September Opening inventory Selling and distribution costs = £575 000 Required Prepare the profit and loss accounts for each division and explain the reason for any difference in performance.Module 2 / The Profit and Loss Account 2.

The issue was fully paid up and its proceeds were lodged in the company’s bank account at Midwest Bank plc.Module 2 / The Profit and Loss Account Required For the weaving machine and the delivery van.11. (b) book values at the end of each of the first three years of use.x0 21.12. what is the effect on the profits of Year 2? Case Study 2. Accounting Edinburgh Business School 2/33 . on credit Paid wages of £3500 for November.10. the following economic actions occurred: Date 04.10.x0 15. for £8600.11. on credit Sold finished goods inventory for £13 000 cash Paid £6000 to creditors Purchased raw materials costing £7000.x0 12.12.x0 30. costing £4500.10. additional information has to be taken into consideration.12. costing £250 Paid for raw materials.x0 06.x0 31.x0 15.10.11.x0 15. costing £5300.x0 24.x0 01.x0 06.11.12. on credit Paid £5400 for raw materials Paid £1000 for advertising Received £500 credit note from suppliers in respect of the return of defective raw materials Paid wages of £2800 to convert £4200 of raw materials into finished goods Received £2500 from debtors Before final accounts can be prepared for the quarter to 31 December 20x0.x0 31.12. costing £4000 Paid wages of £3000 for October. compute: 1 (a) annual depreciation charge for each of the first three years of use. 2 If the delivery van is sold at the end of the second year for £5200.x0 Paid £4000 for six months’ advance rent Paid for plant.10. on credit Paid for van repairs.x0 08.3 On 1 October 20x0.x0 16. converting half of raw materials inventory into finished goods Purchased office equipment. Lowland Products Limited commenced trading with the issue of 80 000 Ordinary Shares of 50 pence each.12. costing £8000.x0 05.x0 18.12. During the company’s first quarter of trading.10. on credit Sold the remainder of finished goods inventory for £7700. costing £10 000 and van costing £7000 Purchased raw materials.11.x0 10. converting a further £5000 of raw material inventory into finished goods Sold finished goods inventory.

3 Prepare the balance sheet as at 31 December 20x0.Module 2 / The Profit and Loss Account 1 2 3 The company has decided to apply the following depreciation policy: (a) Plant 15 per cent per annum. (b) Van 25 per cent and office equipment − 25 per cent per annum. straightline methods. with no prospect of any recovery. One of Lowland’s customers has gone into liquidation in early 20x1. 2/34 Edinburgh Business School Accounting . At 31 December 20x0. reducing-balance method. Required 1 Prepare the accounting equation as at 30 November 20x0. owing £1100. 2 Prepare the profit and loss account for the quarter to 31 December 20x0. there is an unpaid electricity bill of £480.

6 3. the relationship between asset valuation and the measurement of profit.2 3.1 Case Study 3. Accounting Edinburgh Business School 3/1 . and construction.5 3. why a balance sheet must always balance. inventories and debtors.4.5.1 3.4 3.1 3.3.4.3.2 Learning Objectives By the end of this module you should understand: • • • • • the detailed structure of the balance sheet and the valuation problems surrounding fixed assets.6.1 3.4.2 3. the impact of gearing on profits available for distribution to shareholders.3.4 3.8 Introduction The Anatomy of the Balance Sheet Fixed Assets Land (not included in the illustration) Buildings Plant and Equipment Fixed Assets not Owned by the Company Current Assets Inventories Debtors Cash Current Liabilities Example of Deferred Revenue Net Current Assets and Net Assets Financing Net Assets Why Does a Balance Sheet always Balance? Summary 3/2 3/3 3/3 3/4 3/5 3/6 3/6 3/8 3/8 3/8 3/9 3/9 3/10 3/10 3/11 3/13 3/15 3/15 3/20 3/21 Review Questions Case Study 3. the significance.7 3.1 3. of the statement of cash flows.3 3.1 3.3.2 3.3 3.Module 3 The Balance Sheet Contents 3.3 3.

1 Introduction In Module 2. But assets do not last for ever. The complementary aspects of assets. and finished goods. The cost of £1000 is therefore deemed to be an asset and would be placed in the balance sheet as a fixed asset. must be recognised each year. During the first year it pays £100 to the local power utility company for energy consumed by these fittings. Problem A new business purchases light fittings for its offices and warehouse for £1000. These will be explored in this module. and (b) the transformed means of production like work-in-progress and finished goods which have not yet been released into the profit and loss account. no further benefit is anticipated from these costs. namely the financing of them by equity (the owner’s contribution). it was seen that the measurement of a company’s profit (or loss) for an accounting period depended to a very large extent on the valuation of certain assets on hand at the end of the period. Therefore a portion of the £1000 original cost must be written off as an expense. buildings. an accounting statement which is designed to take a cross-sectional perspective of both the profit and loss account and balance sheet.Module 3 / The Balance Sheet 3. plant and machinery and raw materials. all of which have valuation problems which make an impact on the profit and loss account. The light fittings have been purchased with a view to providing future benefit to the business for a number of years. This expense is in addition to the energy costs paid for annually to power the light fittings. Inventories of raw materials. When they are released. called depreciation. Their loss in value. it has no future benefit and is therefore written off as an expense in the profit and loss account. therefore. The review of the accounting model will be concluded by an analysis of the cash flow statement. devoted to an analysis of the profit and loss account. loans and credit will also be examined. or lower future benefit. Assets. What are the accounting treatments for these transactions? Comment and Answer 1 The £100 energy consumption is an expense of the business. together with depreciable fixed assets were two whose valuation had a significant impact on profits. in the profit and loss account. we call these costs ‘expenses’. 2 3 There are of course many other assets. 3/2 Edinburgh Business School Accounting . work-in-progress. can be described as: (a) the untransformed means of production like land.

between the expense of maintaining and operating the fixed assets and the depreciation which is charged. Balance sheet as at Action 7 Fixed assets Plant and equipment at cost Less: Depreciation Current assets Inventories Debtors Cash Less: Current liabilities Creditors Net assets of the company Represented by: Owner’s equity Profit earned and not distributed £12 000 50 £11 950 £5 500 750 4 960 £11 210 3 000 8 210 £20 160 £20 000 160 £20 160 3.2 The Anatomy of the Balance Sheet For ease of reference. on the other hand. on the other hand. Maintenance expenditure is an expense which is charged against profits in the period of outlay. the balance sheet constructed in Module 1 is set out again. that determines whether or not it is classified as a fixed asset. If a fixed asset is viewed as a bundle of services acquired in one period for use in succeeding periods.3 Fixed Assets Fixed assets are those assets that a company keeps for a substantial period of time (like land and buildings or plant and equipment or motor vehicles). the plant and equipment is employed in transforming the raw material into finished manufactured products.Module 3 / The Balance Sheet 3. It is the intention of management as to the use of the asset. Depreciation. The degree of efficiency in using these assets will influence the earnings of the business over time. A car dealer. Accounting Edinburgh Business School 3/3 . Further items will of course be introduced in this module in an effort to add commercial realism and to permit a comprehensive discussion of balance sheets. a current asset. motor vehicles are used in the shipping of finished goods to the point of sale. The distinction should be made. For example. not for resale. Depreciation and maintenance expense have a similar impact in the profit and loss account but they are quite different in nature. however. is the allocation of a previously incurred cost. depreciation is simply the recognition of the use of these services period by period. but to use in the course of business. as will the expense of maintaining and operating them. not its physical characteristics. would account for motor vehicles as inventory.

handbills and local media advertising will cost another £250 000. which is reserved. Although it is clear that the expenditure has been undertaken as a result of the acquisition of the new site. including land. Although this increase/decrease in value is a gain/loss in wealth.Module 3 / The Balance Sheet Let us examine the major fixed asset categories and consider some of the accounting issues surrounding them. Accountants tend to take a conservative position and therefore write off expenditure unless it is clearly related to the acquisition of the asset and the asset could not be made operational without incurring the cost. Two alternative treatments are possible: (a) to continue to record acquisition cost and to publish market value in parenthesis. This uncertainty leads accountants to recognise the cost as an expense in the profit and loss account immediately. The promotional expenditure should be written off to profit and loss account. The accounting profession is unhappy with the cost convention in relation to some assets. No rule can be set down about which expenditure should be capitalised (and recorded as an asset in the balance sheet) and which should be written off (and charged in the profit and loss account). it should not be recorded as profit/loss. as far as possible. How much of this expenditure should be treated as a fixed asset? Comment and Answer 1 2 3 The land is clearly a fixed asset. 3/4 Edinburgh Business School Accounting . The land cost £3. Accountants record the asset at its acquisition cost together with legal fees and the cost of preparing the land. This accounting action is called capitalising the fees and preparation expenditure: contrast this action with writing off the cost against profits in the period of incurrence.1 Land (not included in the illustration) Land is an asset that is not usually depreciated since it has an infinite life and thus does not normally diminish in value. legal and survey fees cost £250 000 and a promotional programme announcing the impending development involving billboards. Problem A retail grocery company purchased an urban site on which it proposes to locate a new supermarket within the next six months. 3. or (b) to revalue the land from time to time.5 million. The acquisition cost bears little resemblance to the current market value which is usually much greater than cost. for operating transactions. nevertheless the future benefits which may flow from the campaign are very uncertain.3. The legal and survey fees are an essential expenditure in acquiring land and should be capitalised as part of land. amend the book value (acquisition cost less depreciation to date) accordingly and add/subtract the incremental change to the shareholders’ equity in the company.

especially if management plan for long-term ownership. Accounting Edinburgh Business School 3/5 . the practice is becoming more accepted because accountants agree that land value gains will continue to be positive and that companies do not have to wait until the sale of the land to recognise these gains. Note that the increase of £15 000 in shareholders’ equity does not derive from the operations of the company and is therefore kept out of the profit and loss account. The profits of the company are unaffected by this revaluation. But of course land values can go down as well as up.3. many accountants are loath to use this method because the actual gain of £15 000 has not yet been realised and because there is no intention to sell the land in the foreseeable future. 3. Treatment 1: Balance sheet extract Fixed asset Land (market value £20 000) Represented by: Shareholders’ equity Owner’s contribution Treatment 2: Balance sheet extract Fixed asset Land Represented by: Shareholders’ equity Owner’s contribution Revaluation reserve £5 000 £X £20 000 £X £15 000 While Treatment 2 seems to be the obvious method for recording this increase in value. However.2 Buildings Often the asset of buildings is combined with land and is shown as one amount in the balance sheet.Module 3 / The Balance Sheet Example A company’s land was revalued at the balance sheet date at £20 000. The rate of cost write-off will normally be quite slow. The land was purchased five years ago for £5000 and has not been revalued until now. It is perfectly possible that some of the rise in value recorded above has to be reversed in subsequent years if market values fall. But many companies now consider buildings to be a depreciating asset because they have a finite life and show both the original acquisition cost and the depreciation which has been written off to date.

Note the interrelationship of depreciation and book value: because the profit and loss account charge for depreciation is simply an allocation of an earlier incurred cost.3 Plant and Equipment The accounting treatment for plant and machinery was considered in the previous module and reference should be made to the various methods of calculating depreciation. the faster the depreciation rate selected. Many accountants are unhappy with this treatment: they claim that a long-term lease contract is in effect a purchase transaction and should be recorded in the balance sheet. A company may choose to lease a portion of its assets. The effect of not recording the leased asset in the balance sheet can be seen from the following example. they argue. there is no legal obligation on it to record the ‘acquisition’ as an asset (and the commitment to pay the lease payments as a liability).3. The company can replace the leased asset with an up-to-date model without having to record a loss/gain on sale of the old model.3. 1 2 3 4 5 Leasing avoids a substantial outflow of cash which would be required in an outright purchase. the lower both the profit figure and the book value (acquisition cost less depreciation charged to date) in the balance sheet become. the company spreads the cash outflows into relatively small ones over the years of the asset’s life. the asset appears under the heading ‘fixed assets’ and the future lease payments under ‘creditors’.4 Fixed Assets not Owned by the Company Many companies operate fixed assets which they do not legally own. The asset’s maintenance costs are usually covered by the lease agreement and this saves the lessee company further cash outflows. Dee Ltd and Don Ltd have identical balance sheets: 3/6 Edinburgh Business School Accounting . (The discussion so far has taken for granted that the company owns the assets being accounted for. Without such a balance sheet entry. lease payments are an allowable charge against profits before the calculation of taxation. The selection of a slower depreciation rate reduces the impact of depreciation on profits. As a consequence. for example a fleet of vehicles or a mainframe computer. Since the company does not own the asset. 3. In such a situation the annual lease payment would be treated as an expense which is charged in the profit and loss account. Example Two shipping firms.Module 3 / The Balance Sheet 3. or assets purchased under hire-purchase agreements. it is not possible to relate a company’s earnings in an accounting period with the underlying assets which gave rise to the earnings. for example leased or rented assets. For the lessee. for a number of reasons. The accounting profession now puts assets leased under the terms of a finance lease (one in which ownership will revert to the lessee at the end of the lease) on the balance sheet.) This section considers briefly the accounting problem created by leased assets.

Dee Ltd will purchase its tanker with a loan from the bank and Don Ltd will lease its tanker. If Don Ltd were to adopt the accounting profession’s recommendations on leased assets acquired under finance leases the balance sheet would be similar to that of Dee Ltd’s: Don Ltd Owner’s equity Loans Creditors: lease obligations £m 5 5 10 20 Assets Leased assets £m 10 10 20 This balance sheet then permits a comparison of the relative trading performance of Dee and Don in as much as both managements have operational control over the same amount of assets. the lease payments are charged annually in the profit and loss account. In the case of finance leases only the interest element is charged while the capital portion is deducted from the lease obligation amount in the balance sheet. Accounting Edinburgh Business School 3/7 . Both the capital and interest elements of the operating lease payments are charged in the profit and loss account. The respective balance sheets will look like this after the acquisition: Dee Ltd Owner’s equity Loans £m 5 15 20 Total assets £m 20 20 Don Ltd Owner’s equity Loans £m 5 5 10 Total assets £m 10 10 Both companies are using the same amount of fixed assets in trading but the balance sheets show a different picture.Module 3 / The Balance Sheet Owner’s equity Loans £m 5 5 10 Total assets £m 10 10 Each firm decides to acquire a new tanker costing £10m. it should be noted that assets acquired under an operating lease (one in which ownership remains with the lessor) are not capitalised. For the sake of completeness.

In such an event the debt has to be written off against profits in the accounting period in which the debt is considered irrecoverable. it must be brought to the attention of shareholders and other users of financial statements so that a sensible analysis of the company’s financial performance can be made. In succeeding periods. It is anticipated that shortly after the beginning of the next accounting period. the debtors will pay cash and their debts will be extinguished.4. and finished goods).4. bad debts) should be matched against the associated revenue. work-in-progress. Period costs such as administrative overheads are not normally allocated to inventory. Accountants like to recognise the very real possibility that some debtors will not pay their debts. The most significant points are repeated here: 1 2 The valuation of inventories is based on the ‘lower of cost or market value’ rule. The profit and loss account is charged with an initial provision (a general allowance based on past experience) for bad debts as if it represented real bad debts in the accounting period in which the provision is set up.Module 3 / The Balance Sheet 3. only the incremental adjustment in provision is entered in the profit and loss account. When a switch is made. have been billed by the company but who have not paid. There is only one snag about the amount to record in the balance sheet for debtors. Management decides on the size of provision by considering a number of factors including: 3/8 Edinburgh Business School Accounting . accountants make a provision for bad debts each period.1 Inventories The valuation of the three categories of inventories was discussed at length in Module 2. Typically inventories (raw materials.4 Current Assets Current assets are those assets which are expected to be sold or consumed during the normal operating cycle of the company. The level of reported profit can be influenced by changing the basis of valuation for inventories. usually one year. at the end of the accounting period. the accounting convention of consistency prevents management from making switches which cannot be warranted by the underlying economic conditions. 3. and this is related to the convention of conservatism. ‘Cost’ is usually defined as direct manufacturing cost plus a share of manufacturing overhead. 3 3. debtors (increasingly known by its American term accounts receivable) and cash are regarded as being current assets. But this time-lag between the debt arising (in the accounting period of sale) and the debt being written off (in perhaps a succeeding period) breaches the matching convention which holds that expenses (in this case. The account consists of those customers who. To abide by both conventions. However.2 Debtors A quick glance at the worked example in Module 1 will show how the asset of debtors comes about.

or departmental floats. or in the bank. can be counted. the general economic environment. Current liabilities are considered to be those debts owed by the company which it expects to pay within the next 12 months. the asset of cash is subject to least adjustment. interest rate changes.4.Module 3 / The Balance Sheet • • • the risks attaching to each particular customer. whether it be located in the cash till. the severity with which the company will pursue recalcitrant debtors. 3. e. Year 1 Debtors (given) Policy: general provision for bad debts to be set at 5% £100 000 Year 2 Debtors (given) Same policy on general provision Specific bad debt arising in Year 2 to be written off £122 000 £2 000 Entry in profit and loss account Charge for bad debts provision £5 000 Entry in profit and loss account Bad debt written off Top-up provision to 5% of £120 000 Required £6 000 less existing £5 000 £2 000 £1 000 Entry in balance sheet Debtors less provision £95 000 Entry in balance sheet Debtors £120 000 Less: Provision £6 000 £114 000 Again note the articulation between balance sheet and profit and loss account. bank overdraft. 3.5 Current Liabilities Just as a company possesses current assets which are expected to be transformed into cash shortly. so a company has liabilities which it expects to meet in the short term by the payment of cash.g. Cash. The managerial issue surrounding this asset is to ensure that the company has sufficient cash to meet its operating needs and investment plans without hoarding it. Idle cash produces no revenue.3 Cash Of all the assets discussed so far. Under this heading are found such items as creditors. taxes payable Accounting Edinburgh Business School 3/9 . a reduction in an asset (debtors) leads directly to a reduction in profits (through a provision for bad debts).

Clearly it would be wrong to recognise all of this receipt as revenue in the profit and loss account of the period in which the payment has been received: the advanced revenue is placed in the balance sheet as a current liability (while the cash received would increase current assets). 3. accruals. To take advantage of its reputation the company offered a three-year subscription starting in 20x2 for £210. In 20x2 the company received 3000 one-year subscriptions and 2000 three-year subscriptions. because the company has still to fulfil the service of allowing access to the factory space in question. During its first two years of publication it enjoyed a considerable success rate in terms of the performance of shares selected and was voted ‘Insider of the Year’ in 20x1. The entire amount of £210 had to be paid before the customer was placed on the mailing list.6 Net Current Assets and Net Assets It is conventional to deduct a company’s current liabilities from its current assets and to show a figure for what is called net current assets (or net current liabilities if that be the case). 3.Module 3 / The Balance Sheet on previously reported profits. this payment referring to part of the next accounting period. the financial statements for 20x2. 20x3 and 20x4 would appear as follows: Balance sheets Cash Owner’s equity Deferred revenue Profit and loss account Subscription revenue: One year Three years 20x2 £645 000 £X 280 000 20x3 – £X 140 000 20x4 – £X – £225 000 140 000 £365 000 – £140 000 £140 000 – £140 000 £140 000 Notice that the revenue is recognised in the profit and loss account in the year that the service is provided. The company therefore expected an increase in subscriptions for 20x2. dividends payable on previously reported profits. and deferred revenue (being revenue received by the company in advance of providing the goods or services): for example a company which rents out factory space and receives from the tenant the rental in advance.1 Example of Deferred Revenue In 20x0 the Aberdeen Investment Services Company launched a subscription newsletter which was intended to predict ‘hot tips’ on the UK Stock Exchange. The advanced revenue received is a liability because the company has still to provide the service. The annual subscription remained at £75. Finance textbooks – and sheer commercial judgement – will say that companies should possess net current assets since this indicates a 3/10 Edinburgh Business School Accounting . Isolating this event.5.

either by their original cash input or from their decision not to withdraw all profit accruing. some very successful companies whose inventory and cash control is rigorous find themselves with net current liabilities. and (b) the operations which produced a profit which was not distributed to the owner. from the owners of the firm.1 Financing Net Assets In the example in Module 1. In the balance sheet presented at the beginning of the module. This is an external source of funds for the company’s net assets. perhaps through the acquisition of other businesses. Imagine also that the profit and distributions to the owner are known for each of the next three years. The build-up in owner’s equity can be calculated as follows: Year 1 2 3 4 Profits £160 250 370 490 Distribution to owners – 50 70 150 Transfer to reserves £160 200 300 340 1 000 20 000 £21 000 Original capital introduction Owner’s equity at end of Year 4 The other major source (not revealed in the example in Module 1) is from suppliers of long-term loans which can vary in amount. These loans usually arise from the need to purchase fixed assets or major expansions of the operations.6. 3.Module 3 / The Balance Sheet basic ability to meet liquid commitments from liquid resources. Example Imagine that Actions 1–7 in the example in Module 1 represent one year. in effect. However. we saw the acquisition of net assets over one accounting period from two sources: (a) the original equity introduced by the owner. Another convention in accounts presentation is to add the fixed assets to the net current assets to arrive at the net assets of the enterprise. They usually involve long-term. net current assets amount to £8210 but have not been defined as such. duration and legal rights and obligations. fixed interest. notes payable or bonds payable. There is no particular significance in this figure except in looking at the trend of the magnitude of net assets over a number of accounting periods. These sources are called internally generated because they both come. The combined sum of these internally generated funds is called ownership equity. In the balance sheet presented at the beginning of the module. net assets are shown at £20 160. A successful business would expect to see this figure build up year by year through profits earned but not all distributed to the owners. repayable on a given date in the Accounting Edinburgh Business School 3/11 .

The effect of gearing on the return on owner’s equity can be seen: Year 1 £ 1 000 Year 2 £ 600 Year 3 £ 1 500 Profit before interest Company A Interest on debt Available to equity Return on equity: Company A (highly geared) Company B Interest on debt Available to equity Return on equity: Company B (lowly geared) 600 400 1 000 10% 600 – 600 – 600 900 1 500 22. etc.Module 3 / The Balance Sheet future. 3/12 Edinburgh Business School Accounting . Unlike ordinary shareholders who have no statutory right to dividends. Often the loans are secured. that is lenders are given a guarantee that if the company is unable to pay the interest on the loan or if it is liquidated before their loan is repaid. notes. in difficult years shareholders have to forgo dividends altogether while the fixed interest will continue to be paid out. debentures.25% Workings: these percentages are derived by dividing the profit before interest available to equity by the original equity in the respective companies. For example. In profitable years shareholders can expect a higher return on their investment than lenders of long-term loans.) have an enforceable right to annual fixed rate interest. The relationship between shareholder funding (owner’s equity) and loans is called gearing or leverage.5% 200 800 1 000 10% 200 400 600 5% 200 1 300 1 500 16. a certain asset (or group of assets) is deemed to belong to them and its realised value will be paid over to them as repayment for the loan. lenders of long-term loans (bonds. This amount of interest must be charged as an expense against profits before shareholders become entitled to any dividends. Example Two companies each have assets totalling £10 000 funded as follows: Company A £4 000 6 000 £10 000 Company B £8 000 2 000 £10 000 Owner’s equity 10% long-term debt Gearing Long-term debt Total assets 60% 20% Each company records the same level of profits for three years.

which leads to a relatively high reported profit (in the profit and loss account). leads to a relatively low charge for cost of goods sold (in the profit and loss account).Module 3 / The Balance Sheet in Company A in Year 3. Consider the situation of a management facing the decision to switch their inventory valuation from LIFO to FIFO. creditors. But the knock-on effects of such a switch are clear too: • • • • a relatively high closing inventory valuation (in the balance sheet). But when profits dip. and highest. the balance sheet valuation for inventory would rise. Debtors may be reduced by whatever amount management considers to be prudent for a provision against bad debts. long-term loans and so on. reflecting the most recent. 3. Inventories can be valued by many methods and may include varying proportions of factory overheads. Example The figures of the illustration in Module 2 are given below.7 Why Does a Balance Sheet always Balance? The foregoing discussion reveals that many items on the asset side are susceptible to multiple valuation: 1 2 3 Fixed assets can be depreciated at many rates and by many methods. shareholders will achieve a better return on their money in a high-geared company. Other items on the balance sheet are absolutely fixed and unalterable: cash. Altogether 1200 units were purchased in a period of rising raw material prices at two-monthly intervals as follows: Accounting Edinburgh Business School 3/13 . the economic environment is inflationary and unit prices of the inventory items are rising. the return on equity of 22. as in Year 2. If management made the switch. given this array of possible valuations? The secret lies in understanding the role of the profit and loss account and how it relates to the balance sheet. which leads to a relatively high ‘profit retained’ figure in the balance sheet. How is it then that the balance sheet always balances. as in Year 3.5 per cent is derived by the following calculation: Available to equity £900 Equity £4000 × 100 In years of healthy profits. the heavy burden of debt has a more dramatic effect on their return than in a low-geared company. unit prices trapped in inventory at the end of the accounting period.

50 £2.00 = 200 units @ £3.50 = Assuming no tax or distribution to shareholders: Balance sheet under LIFO Owner’s equity increased by Balance sheet under FIFO Owner’s equity increased by (an increase over LIFO of £650) £1550 Inventory valuation £350 £2200 Inventory valuation £1000 (an increase over LIFO of £650) It can be seen that the profit and loss account acts as a kind of trampoline into which are dropped changes in asset valuation and out of which will bounce a matching impact on profits. The total costs to allocate are £2800. The balance sheet will always balance because of this role played by the profit and loss account.50 = 200 units @ £1.00 £1.00 Opening stock Purchases: 1200 units @ varying prices Less: Closing stock 300 units Cost of goods sold Gross profit Valuation of closing stock 300 units 100 units @ £1.Module 3 / The Balance Sheet February April June August October December 200 200 200 200 200 200 1 200 units units units units units units units @ @ @ @ @ @ £1.00 £3. 3/14 Edinburgh Business School Accounting . The profit and loss account would appear as follows: Under LIFO Sales: 1000 units @ say £4. Assume the alternative facing management is to value inventory on either a LIFO or a FIFO basis.50 £3.50 each each each each each each £200 300 400 500 600 700 £2 700 The opening inventory of 100 units was valued at £1 per unit.00 £2. Therefore the total costs to be allocated amount to £2800.00 = £4 000 £ 100 2 700 £2 800 350 2 450 £1 550 LIFO £150 £200 £350 £ 100 2 700 £2 800 1 000 1 800 £2 200 FIFO £300 £700 £1 000 Under FIFO £4 000 100 units @ £3.

not a static snapshot. as current assets. maybe even the cash drawers stuffed with money! In other words. A video is a moving picture. the assets would be fairly clearly visible and the reader would have to imagine how these assets have been funded (unless the camera spotted a queue of bankers and creditors at the factory gates shouting for their money). (b) (i) and (iv) only. or future income streams which the asset will generate discounted back to today. so complex. (d) (i). by contrast. and would reflect the constantly fluid operations of accomplishment and effort. to resell at a profit in the future. could be regarded as a video of the company’s activities during the year. (ii) and (iii) only. Readers of this text should be aware that the relevance of historic cost is under constant review but until the accounting profession can agree on what is to replace it. e Balance sheets contain assets measured by reference to historic cost. Imagine the view from a helicopter sent up to take an aerial photograph of a company. (iv) Creditors. they should master the techniques. Accounting Edinburgh Business School 3/15 . work-in-progress and finished goods) would be picked out by the camera. manufacturing and selling activities which reflect the company’s raison d’ˆtre.8 Summary The balance sheet is often described as a snapshot of a company’s resources on a given date.1 The following items appear in balance sheets. Plant and equipment. Review Questions 3. and understand the philosophy. including: (i) (ii) to act as a hedge against inflation. that members of the accounting profession cannot agree among themselves which method is superior or how to go about the valuation profession. as current assets. (iii) Plant. in fact. The profit and loss. land and buildings. These are complex matters.2 Companies acquire fixed assets for a variety of reasons. the purchasing. (ii) and (iv) only. Which of the following is correct? (a) (c) (i) and (ii) only. piles of inventory (raw materials. But does it really matter what a company paid for an asset years ago? Wouldn’t it be better to attempt to reflect the value to the company of the asset today? This would involve either assessing how much the company would receive if the asset were sold today. 3. (i) (ii) Cash. as current liabilities. Inventories.Module 3 / The Balance Sheet 3. (i). Historic costs are a favourite among accountants and auditors because they can be easily verified and not influenced by too much subjective assessment. as fixed assets. of historic cost accounting.

7 There are several benefits for companies in choosing to lease fixed assets. (d) £1.9 million. 3. (iii) improved operational efficiency of assets. 3. (b) £400 000. (d) £2.4–3.0 million. 3/16 Edinburgh Business School Accounting . 3. how much might then be transferred to a revaluation reserve? (a) £0. rather than purchase them outright. (ii) overstatement of profits.3 To accountants. The company plans a massive advertising drive to promote the factory and to recruit skilled personnel. including: (i) beneficial cash flow impact of smaller payments. (c) (ii) and (iii) only.8 million.5 million.5 What is the cost of the land in the company’s balance sheet? (a) £1. (b) (i) and (ii) only.6 million. 3.6.5 million and there were professional fees of £100 000. An initial package of £400 000 has been agreed with their advertising agents for this purpose. 3. A major electronics company has acquired a greenfield site to build a new factory.4 How much of this expenditure will be written off in the profit and loss account? (a) £100 000. (b) (i) and (iv) only.3 million. (iv) replacement of assets without generating gains or losses. capitalising expenditure and writing off expenditure have identical impacts on the profit and loss account. True or false? The following information applies to Questions 3. Which of the following correctly reflects their primary reason(s)? (a) (i) only.6 If. after a two-year property boom. (c) £1. (b) £1. (c) £500 000. (d) (ii) and (iv) only. The land cost £1.Module 3 / The Balance Sheet (iii) to avoid cash surpluses. (c) £2. the land was revalued at £2.9 million.1 million. (iv) to use in the course of the business. (d) (iv) only. (b) £0. (d) £900 000. The site requires remedial work costing £500 000 on old mineshafts before any building can commence.4 million. (c) (iii) and (iv) only. Which of the following is correct? (a) (i) and (ii) only.

understating both assets and liabilities. for a compressor. 3.14.11–3. (d) Short-term hire. for a vehicle.9 The exclusion of leased assets from a balance sheet has the effect of: (a) (c) overstating both assets and liabilities. (d) £60 000. (b) Rental. (d) £190 000. £130 000. for a photocopier. understating liabilities. (b) Inventories. but overstating liabilities.Module 3 / The Balance Sheet 3. (d) overstating assets. 3.12 What is the amount of total fixed assets? (a) (c) £75 000. The following information applies to Questions 3. (b) £40 000. Vehicles. 3.10 Which of the following is NOT a current asset? (a) (c) Cash. In which of the following contractual agreements do these guidelines apply? (a) (c) Contract hire. £50 000. (b) £150 000. (d) £255 000. (b) £105 000. (b) understating assets. Finance lease. Thames Limited has listed the following amounts in its balance sheet: Cash Buildings Creditors Taxes payable £10 000 £75 000 £25 000 £15 000 Debtors Plant Inventories Dividends payable £55 000 £30 000 £60 000 £20 000 3. 3.8 The accounting profession has developed guidelines to deal with leased assets.11 What is the amount of total current assets? (a) (c) £125 000. £180 000. (d) Debtors.13 What is the amount of total current liabilities? (a) (c) £35 000. Accounting Edinburgh Business School 3/17 . for a van.

The following information applies to Questions 3. all 400 members were fully paid up. but 20 had paid their subscriptions in advance for the year to 31 March 20x2. (c) £205 000. At 31 March 20x0.17. At 31 March 20x1. Gleneagles Golf Club Limited has a financial year which runs to 31 March each year.18–3.14 What is the amount of net current assets? (a) £40 000. (c) £13 200. (b) £45 000. The annual subscription has been fixed at £500 for the years to 31 March 20x0.17 What is the amount of debtors less provision for bad debts at the end of 20x2? (a) £192 400.Module 3 / The Balance Sheet 3.15–3. (c) £195 900. (d) £210 000. (b) £200 000. 3. (d) £95 000.19. 3. (c) £65 000.18 What is the subscription revenue for the year to 31 March 20x1? (a) £195 000. The following information applies to Questions 3. 20x1 and 20x2. 3.15 What is the amount of the provision for bad debts at the end of 20x1? (a) £7 200. Specific bad debts have already been written off during each year. (b) £194 400. (b) £6900. (c) £7200. (d) £201 600. ten members had paid their annual subscriptions in advance. (b) £10 700. (d) £8400. (d) £16 799.16 What is the amount charged for bad debts in the profit and loss account in 20x2? (a) £5700. 3. Humber Limited has extracted the following information for its financial year-ends 20x0–20x2: Debtors 20x0 20x1 20x2 £150 000 £180 000 £210 000 Specific bad debts written off Nil £3 500 £5 700 Its policy towards bad debts is to make a general provision of 4 per cent of debtors. 3/18 Edinburgh Business School Accounting .

ordinary shareholders can expect a higher return on their investment than lenders of long-term loans. which of the following is the correct treatment for deferred revenue? (a) As a current asset in the balance sheet. (c) £52 000. (d) £49 000. 2 The loan stock is repayable in four equal annual instalments. 3. The following balances have been extracted from the accounting records of Mersey Limited at 31 January 20x0. (b) £46 000.21.22 In preparing year-end financial statements.19 What is the amount of deferred revenue at 31 March 20x1? (a) £Nil.21 What is the amount of total long-term liabilities at 31 January 20x0? (a) £36 000. 3. (d) £56 000. (d) £15 000. Accounting Edinburgh Business School 3/19 . (c) Selling and distribution overhead. 3. (b) £5 000. The following information applies to Questions 3. (b) Variable manufacturing overhead. Creditors Taxes payable Loan stock Debtors £20 000 £10 000 £40 000 £45 000 Prepayments Accruals Bank overdraft Leasing creditor £2 000 £4 500 £8 500 £9 000 Additional information is available: 1 The leasing creditor comprises a further three years of lease payments of £3000 per annum. (d) As an expense in the profit and loss account.20–3. (c) As a long-term liability in the balance sheet. (b) As a current liability in the balance sheet. True or false? 3.20 What is the amount of total current liabilities at 31 January 20x0? (a) £43 000. (d) Fixed manufacturing overhead.24 Which of the following costs will normally be excluded from the valuation of inventories? (a) Direct materials.Module 3 / The Balance Sheet 3. (c) £46 000. (c) £10 000. (b) £39 000. the first of which is due on 31 January 20x1. 3.23 In more profitable years.

00 4. (b) £230 000.1 Clydemouth Chemicals Limited has purchased 1500 kg of material Y over a six-month period. how much long-term loan stock would result in a return on owner’s equity of 25 per cent? (a) £110 000. how much long-term loan stock would result in a gearing ratio of 37. (b) £60 000.25 4. (c) £300 000.25–3. Case Study 3. Required Prepare profit and loss accounts for the six months. (d) £160 000. Sales revenue for the six months to 30 September amounted to £8000. (c) £137 500.20 4.25 In Year 2. in respect of 1000 kg sold. 3/20 Edinburgh Business School Accounting .5 per cent? (a) £37 500. (d) £350 000. adopting: (a) LIFO inventory basis. 3. costing £336.26.00 3. as follows: Quantity kg 300 400 250 150 400 1 500 Unit cost £ 3.Module 3 / The Balance Sheet The following information applies to Questions 3.26 In Year 3. Solway Limited has the following three-year record of profits before interest: Year 1 2 3 £ 55 000 36 000 48 000 Assume that owner’s equity is fixed at £100 000 for each of the three years. (b) FIFO inventory basis Outline the balance sheet implications of each basis.50 Total cost £ 900 1 300 1 000 630 1 800 5 630 April May July August September At 1 April. the company had a stockholding of 120 kg. 3. The company has been offered long-term loan stock at 10 per cent per annum.

£ 10 000 6 000 15 000 Accounting Edinburgh Business School 3/21 . both companies have earned the same operating profits (before interest): Year 1 Year 2 Year 3 Required Compute the gearing ratios for each company and assess the impact of the gearing on the return on equity for each company in each year. the funding of the assets differs. For three years.2 Longhorn Whisky Ltd and Inverness Distillers Ltd employ equal amounts of assets in their respective businesses. However. as follows: Longhorn Whisky Ltd £ 40 000 60 000 100 000 Inverness Distillers Ltd £ 80 000 20 000 100 000 Owner’s equity Long-term debt The long-term debt in each company attracts an interest charge of 8 per cent per annum.Module 3 / The Balance Sheet Case Study 3.

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1 4.5 4.2 4.9.8 Introduction Why Are Cash Flow Statements Needed? What Is ‘Cash’ in a Cash Flow Statement? Cash: Where Does it Come from? Where Does it Go to? Where Does Cash Come from? Where Does Cash Go to? Eight Major Categories of Cash Flow Worked Example with Commentary Do-it-Yourself Example Summary 4/1 4/2 4/3 4/3 4/3 4/5 4/6 4/7 4/10 4/14 4/15 4/19 4/20 Review Questions Case Study 4.4. that profit is not the same as cash.3 4.1 Introduction The third financial statement derived from the Accounting Equation Actions in Module 1 is the cash flow statement which portrays only those economic events of a business which affect cash flows.2 4. Section 1.1 Case Study 4. in particular the critical importance of cash flow from operations. and reconsider how we derived the numbers for the cash flow statement drawn up after Action 7 and re-read the six notes that interpreted these numbers. Readers are advised to return to Module 1.7 4.4. how to interpret a cash flow statement.1 4. Accounting Edinburgh Business School 4/1 .6 4. 4.2 Learning Objectives By the end of this module you should understand: • • • • the need for a cash flow statement in addition to a profit and loss account and balance sheet.4 4. the major sources and uses of cash and how these are compiled into a cash flow statement.Module 4 The Cash Flow Statement Contents 4.

In order to provide users of financial statements with a more complete picture of resource flows over an accounting period. Section 1. The goods were sold on credit in Action 6. Consider also ‘Depreciation £50’. usually the end of the financial year. including managers. between them. ‘Why is a third statement needed? Can’t the profit and loss account and the balance sheet. has been abandoned by many countries’ financial reporting regulators. entries are derived from both the balance sheet and the profit and loss account. usually the financial year. or to report a worrying loss but have plenty of cash. the expression ‘sales’ implies that customers have paid £750 for goods and services provided by the firm at some point(s) throughout the accounting period.2 Why Are Cash Flow Statements Needed? After mastering the intricacies of compiling a profit and loss account and a balance sheet. This is not so. the difficulty in interpreting what ‘funds’ meant. 4/2 Edinburgh Business School Accounting . Depreciation is simply a mechanism by which the accountant spreads the cost of the purchase of an asset over the accounting periods which benefit from the use of the asset. inter alia. tell you what’s going on in an organisation?’ The answer to these related questions is an emphatic ‘NO!’ A balance sheet reports on inventory of resources (fixed assets and current assets) and claims against these resources (liabilities and equity) at a given moment.9). But because of various accounting principles embedded in the measurement of accomplishment and the measurement of effort (described in Module 2) the flows of resources are not measured in terms of cash. this reconciliation is provided by the cash flow statement. (Readers should be aware that an earlier version of this Statement was called a Funds statement or a statement of sources and application of funds. the depreciation thereon does not. readers may ask the questions. It is therefore possible for an organisation: either to report a healthy profit but be running out of cash.9) which reflects the movement of cash during the first seven actions. A profit and loss account reflects a flow of resources throughout a given period. Section 1.) Cash flow statements are needed to ‘unstitch’ the accounting principles which are applied to compile balance sheets and profit and loss accounts and to reveal whether the entity has sufficient cash funds to finance its future operations and its future ambitions for dividend payments to the owners and investments in assets and acquisition of other businesses.Module 4 / The Cash Flow Statement 4. in other words. As can be seen from the cash flow statement (Module 1. Users of financial statements. need a reconciliation between profits and cash. companies are obliged to include a Cash flow statement. The original purchase of the asset affects cash flow. no cash changed hands even though the transaction was sufficiently complete for the accountant to recognise it as an accomplishment. Take the profit and loss account drawn up at the end of Action 7 (Module 1. This statement is crucially different from cash flow and because of.

4. Detailed accounting rules expound at length on the definition of cash. have the dividends paid this year based on this year’s profits been paid out of cash generated from operations or from money borrowed? Where did the money for asset acquisition come from? From operations or from borrowings? Is the company solvent? That is. These investments are usually readily convertible into cash or. Here we see some of the possible sources and uses of cash. it is sufficient to appreciate that ‘cash’ equals cash balances. For example. ‘cash’ means the money we’ve got in our pockets and what’s in our bank account. comprising temporary investments of cash not required at this moment by the business. Similarly.3 What Is ‘Cash’ in a Cash Flow Statement? For us. It is not quite as straightforward in the business world. would mature within three months into cash. Therefore how can we place this item at the top of the list? The reason is that profit is the best starting point for determining cash from trading or operating activities but we must make adjustments to it for items that may have been charged as an expense against Sales but which do not effect cash. if left alone.Module 4 / The Cash Flow Statement Managers and other users of company financial statements want answers to the following range of questions: • • Do the normal trading operations generate sufficient funds to enable the company to continue paying dividends? Or put another way. depreciation reduces profits but has no impact on cash.4 Cash: Where Does it Come from? Where Does it Go to? Refer once again to Module 1. 4. with a bad debts provision: in this case a company charges against its profits an amount relating to customers who have taken goods on credit but Accounting Edinburgh Business School 4/3 . Cash flow statement. / • • • 4.1 Where Does Cash Come from? Profit from Operation Profit does not equal cash. This should be added back to the profit figure to get a better picture of cash generated by operations. bank balances and what is termed ‘cash equivalents’. has it sufficient liquid assets to meet its short-term obligations? Why does the company seem to borrow so much when it’s making so much profit? Remember: PROFIT = CASH. We will list these and add to them. At this stage in the course. as in our Actions 1–7 statement. 4.9. Section 1.

this can cause serious cash shortages with the suppliers. of course. Increase in Creditors In the company depicted in Actions 1–7. If depreciation was a source of cash. 4/4 Edinburgh Business School Accounting . Capital Introduction All organisations start with an injection of cash from their owners but this injection of capital is unlikely to be repeated for some years. the sale of an asset could bring about a gain if the company realised more for it in the market than the carrying value in the balance sheet. This gain would increase profits but it has no impact of cash. For example. at the expense of small suppliers. Therefore we deduct the ‘gain on sale of asset’ from profit for cash flow purposes. Illustration Let us assume both companies operate identical businesses except for depreciation rates. This is. unless the organisation is growing so rapidly that it cannot generate cash from other sources to acquire assets or other businesses. the cash flow outcome will be the same. The increase is viewed as a source of cash because the business is owing this money to its suppliers and for a short period is able to use the money for other business purposes. Company 1 writes off its assets over ten years and company 2 over four years. This item is properly recorded as a charge against profits but has no impact on cash (the cash left the company a long time ago when the goods were made and sold) and should be added back to profit in calculating cash flow from operations. companies may record gains which do not affect cash.Module 4 / The Cash Flow Statement who may not pay their debt. Extract P&L Profit before depreciation Depreciation Profit after depreciation Company 1 £1 000 100 £ 900 Company 2 £1 000 250 £ 750 Extract cash flow calculation: cash from operations Profit after depreciation £ 900 Add back depreciation 100 Cash from operations £1 000 £ 750 250 £1 000 It does not matter how much depreciation is charged. nonsense. and will appear on our list below. companies would charge a high depreciation figure. The total receipt of the cash from the party who purchased the asset is a source of cash. A cautionary word on depreciation: sometimes cash flow statements list depreciation as a source of cash. This may rebound on the major company if a supplier goes out of business. the creditors at the beginning of the period were zero and rose to £3000 by the end of the period. Conversely. Where a major company uses this source to generate cash over a long period of time.

Loans (not shown in Section 1. They must therefore look to banks and other lenders for loans. thereby parting with cash. the resulting figure. 4. Decrease in Inventories (not shown in Section 1. Once the adjustments such as depreciation.9) In a start-up situation.9) When a company lowers its pile of inventories (raw materials.Module 4 / The Cash Flow Statement Sale of Fixed Assets (not shown in Section 1. A reduction in debtors can only be achieved by debtors paying their bills. regular asset sales would be expected. Decrease in Creditors Creditors are those parties to whom the business owes money. we would not expect a company to sell assets but in an ongoing concern. a company may decide to use some of its spare cash to buy its own shares. once introduced. if still negative. Loss from Operations We know that profit from operations does not equal cash but is used as the starting point for a cash flow statement. work-in-progress and finished goods) it releases cash tied up in these items.9) The movement of a decrease in debtors has the same effect as an increase in creditors. Capital Repayments Repayment of cash would be a most unusual item in most businesses because capital. However. Accounting Edinburgh Business School 4/5 . The total amount realised less the costs associated with disposal would be included in the cash flow statement. thereby reducing its capital base. bad debts and profit on sale of assets are made to the loss figure at the foot of the profit and loss account. A loss from operations plays a similar but opposite role. usually for a specified period and perhaps secured over specified assets. Decrease in Debtors (not shown in Section 1.9) Sometimes companies have investment and growth ambitions which exceed the shareholders’ capital introduction and cash generated from operations.2 Where Does Cash Go to? Most of the items listed below are the opposites to those listed in the previous section. remains tied up in the company in the form of assets and working capital.4. The only way this balance can be reduced is for the business to pay them. to help in the funding process. is deemed to be cash consumed by operations. hence this is viewed as a source of cash. A reduction in inventories is viewed therefore as a source of cash.

If a company consistently fails to produce cash from operations. it will fail because suppliers of loans and other credit will become nervous and will give no more cash to the company. But seldom is a company faced with this action on an unplanned basis. An increase in debtors normally follows an increase in sales but so often it can signal a weakness in cash collection procedures or a tactic used by a company to gain market share (‘Buy from us and we’ll give you ten days more credit than our nearest competitor’). The revolving nature of loans can be a major preoccupation of finance directors. However. the repayment of loans has a very negative affect on cash flow. Therefore increasing this indebtedness is viewed as a use of cash. however. Edinburgh Business School Accounting 4/6 . a company can allow cash from operations to slip in the knowledge that shareholders or banks or the selling of unwanted assets will make good the shortfall. This policy frees up cash.Module 4 / The Cash Flow Statement Purchase of Fixed Assets (shown in Section 1. One way for companies to lessen the impact of asset expansion/replacement is for them to lease or rent assets. Increase of Inventories Raising the piles of raw materials.5 Eight Major Categories of Cash Flow The various sources and uses of cash set out above can be regrouped into eight categories and follow the requirement of Financial Reporting Standard No 1 Cash Flow Statements (FRS 1 1996 Revised): 1 Cash flow from operating activities Cash flow from operating activities should be the primary source of cash in the long run. This reduces dramatically the cash flow and even allows the companies to replace the assets more rapidly then they otherwise could.9) The purchase of fixed assets can be a major use of cash for a growing business or for one which is confronting rapid technological change. Increase in Debtors Debtors owe cash. a company which is expanding production or lengthening the chain between itself and its suppliers must increase inventories to ensure that a stock-out does not occur thereby damaging customer relations. companies know when loans are due to be repaid and so often arrange for a replacement loan to be taken out so that the old one can be repaid on schedule. Repayment of Loans Understandably. finished goods are produced just-in-time to be sold to the customer. work-in-progress and finished goods consumes cash and should be avoided. But sometimes. the trend in inventory management is towards a severe reduction in inventory so that the philosophy of just-in-time may be practised. 4. namely raw materials are purchased just-in-time to be put into production. In the short term.

6 Worked Example with Commentary In order to draw up a cash flow statement you need four pieces of data: • the profit and loss account for the period. • the balance sheet at the beginning of the period. the focus changes to the other side of the balance sheet. 4. Discussions about the exact amount of tax due take time so the tax paid in one year often relates to profits of previous years. Financing cash flows include movements in debt (except overdrafts) and shareholders’ funds. Accounting Edinburgh Business School 4/7 . Taxation The taxation figure represents the tax paid over to the fiscal authorities during the accounting period. • supplementary notes (which are often difficult to extricate from a set of published financial statements). This makes sense because all three items (collectively known as working capital) move as a direct consequence of operational activities. Capital investment Cash flows under the heading of capital investment include receipts from sales or disposals – or payments to acquire – property.Module 4 / The Cash Flow Statement 2 3 4 5 6 7 8 Note that increases and decreases in inventories. Equity dividends paid to shareholders Management of liquid resources Liquid resources are current asset investments such as government securities held as readily disposable stores of value which can be disposed of quickly in an active market without disrupting the business. joint ventures and similar investments. Cash flow from returns on investments and servicing of finance Items under the heading of cash flow from returns on investments and servicing of finance largely reflect the cash received by the company from its investments in other entities and cash paid out in dividends to nonequity shareholders and minority interest and interest on borrowed money. of course. debtors and creditors are included as part of cash flow from operating activities. Note that a profit and loss account would include items in both categories 1 and 2 but because their purpose is fundamentally different (operational and financial) the cash flow statement attempts to separate them. plant and equipment. Acquisitions and disposals The heading acquisitions and disposals covers cash flows arising from purchases and sales of subsidiaries. Financing Under the heading financing. associated companies. • the balance sheet at the end of the period. This. involves the receipt and the repayment of such funds.

Also included in profit on ordinary activities is the loss on sale of plant and machinery for £500. at 31 March 20x1 £ £ Fixed assets Plant & machinery Less: Depreciation Current assets Inventories Debtors 10 100 Less: Provision for bad debts 400 Bank and Cash Current liabilities Creditors 5 675 Taxation 9 950 Proposed dividends 10 000 Net current assets Total assets less current liabilities Long-term loan Shareholders’ equity Issued share capital Retained profits 40 625 15 175 22 925 15 775 9 700 20 050 52 675 725 15 050 4 700 49 850 £ at 31 March 20x2 £ £ 35 225 13 275 30 100 £ 25 450 21 950 3 600 5 175 25 625 27 050 52 500 (7 500) 45 000 25 000 20 000 45 000 33 750 26 275 60 025 3 000 11 775 38 075 60 025 – 60 025 4/8 Edinburgh Business School Accounting . a depreciation charge of £2600 has been made. which had originally cost £5400 and which had been depreciated at the time of sale by £4500.Module 4 / The Cash Flow Statement Profit and loss account for the year ended 31 March 20x2 (in abbreviated form) Profit on ordinary activities before tax Tax on ordinary activities Proposed dividend Retained profits £ 14 450 5 175 9 275 3 000 6 275 Supplementary Notes In calculating profit on ordinary activities.

Dividends paid to equity shareholders included below) Taxation Capital expenditure Disposal of tangible fixed assets Acquisitions and disposals (No entry under this heading) Equity dividends paid Management of liquid resources (No entry under this heading) Financing Issue of shares Repayment of loan Decrease in cash £ 2 850 – (9 950) 500 – (10 000) – 8 750 (7 500) 1 250 (15 350) Accounting Edinburgh Business School 4/9 .Module 4 / The Cash Flow Statement Calculations required for cash flow statement Adjustments to profit from operations: Profit on ordinary activities before tax Add back items that do not affect cash: Depreciation Increase in bad debts provision Loss on sale of plant & machinery (1) Adjustments to working capital: Increase in inventories Increase in debtors (2) Decrease in creditors Cash flow from operating activities Note 1: Loss on sale of plant and machinery Original cost Depreciation Book value at time of sale Loss on sale Sale proceeds £ £ 14 450 2 600 325 400 3 325 17 775 (7 175) (5 675) (2 075) £ 5 400 4 500 900 400 500 (14 925) 2 850 Note 2: Increase in debtors: note that the difference between the actual debtors figures in the balance sheet is recorded. Note 3: Brackets are used in cash flow statements to signify outflows of cash. Provision for bad debts has nothing to do with cash flow and should be ignored. Cash flow statement for year ended 31 March 20x2 £ Net cash flow from operating activities Returns on investment and servicing of finance (No entry under this heading.

namely £3000. it has a very poor cash flow position. The layout of the profit and loss and balance sheet is slightly different from the example of the company above but you should set out your cash flow statement in exactly the same way. each one dragging down the cash level. Profit and loss account for year ended 30 June 20x2 £ Gross profit Add: Profit on sale of plant & equipment Less: Expenses Maintenance Depreciation on plant & equipment Wages and salaries Bad debts Increase in provision for bad debts General expenses Net profit £ 44 439 855 45 294 2 385 1 635 13 185 510 180 3 216 21 111 24 183 4/10 Edinburgh Business School Accounting . as this company has done. Having reported a profit on ordinary activities of £14 450. In this company. The final figure of (£15 350) being a net cash and cash equivalent outflow can be reconciled with the fall in cash level between the opening and closing balance sheets. Issuing fresh shares. it would be likely that the loan which was repaid this year would be replaced by a fresh loan or deferred repayment for a later period. assists cash flow but is not a frequent event. the cash from operations of £2850 for the year ended 31 March 20x2 was wholly inadequate to meet the cash required to pay last year’s dividend. the cash flow problems facing this company are even worse than indicated by a further £8750. A company declares a dividend out of one year’s profits but pays out the cash to shareholders during the next year. Given the cash flow condition of this company. The dividend declared on this year’s profits. If this item were to be ignored for the moment.Module 4 / The Cash Flow Statement Commentary on Cash Flow statement This company has a serious cash flow problem. Questions must be asked about the need for these negative movements: have they come about by a dramatic upturn in sales and production or by a downturn in economic conditions causing the company to build its inventory of finished goods and its customers to delay payments of debts outstanding? The dividend of £10 000 refers to last year’s dividend. will be paid during the year to 31 March 20x3.7 Do-it-Yourself Example This example is concerned with the financial affairs of a sole trader. Consider first the negative influences on cash flow of working capital movements: the company has increased inventories and debtors and decreased creditors. 4. not a company.

Your Solution Make sure you don’t look at the worked solution before attempting to fill in the pro-forma solution.Module 4 / The Cash Flow Statement Balance sheets for years ended 30 June 20x1 and 30 June 20x2 30 June 20x1 £ £ Fixed assets Plant & equipment at cost Less: Depreciation Current assets Inventories Debtors less provision for bad debts Bank and cash Current liabilities Creditors Net current assets Total assets less current liabilities Long-term loan Owner’s equity Opening balance Net profit for year 16 800 6 240 15 443 7 785 2 352 25 580 4 155 21 425 31 985 9 000 22 985 18 365 21 120 39 485 16 500 22 985 22 985 24 183 47 168 18 750 28 418 30 June 20x2 £ £ 10 800 4 470 25 725 5 070 3 173 33 968 4 380 29 588 35 918 7 500 28 418 10 560 6 330 Less: Drawings Notes 1 Debtors less provision for bad debts: Year to 30 June 20x1 £8235 − Provision £450 = £7785 Year to 30 June 20x2 £5700 − Provision £630 = £5070 2 The item of plant and equipment was sold for £3450 during the year to 30 June 20x2. Use pencil so that you can attempt the exercise more than once! Accounting Edinburgh Business School 4/11 .

Module 4 / The Cash Flow Statement Calculations required for cash flow statement Adjustments to profit from operations: Profit on ordinary activities before tax Add back/deduct items that do not affect cash: Depreciation Increase in bad debts provision Profit on sale of plant and equipment Adjustments to working capital: Increase in inventories Decrease in debtors Increase in creditors Cash flow from operating activities Cash flow statement for year ended 30 June 20x2 £ Net cash flow from operating activities Returns on investment and servicing of finance Taxation Capital expenditure Acquisitions and mergers Equity dividend paid Management of liquid resources Financing £ £ £ 4/12 Edinburgh Business School Accounting .

These represent the amount of cash taken out of the business for personal use. the sole proprietor has released cash by decreasing his debtors outstanding and increasing the balance he owes to his creditors. It is important that the attention of the proprietor is drawn to this impact through the cash flow statement. Accounting Edinburgh Business School 4/13 . As before. The more the proprietor takes out. As in the company example.Module 4 / The Cash Flow Statement Worked Solution Calculations required for cash flow statement Adjustments to profit from operations: Net profit Add back/deduct items that do not affect cash: Depreciation Increase in bad debts provision Profit on sale of plant and equipment Adjustments to working capital: Increase in inventories Decrease in debtors Increase in creditors Cash flow from operating activities Cash flow statement for year ended 30 June 20x2 Net cash flow from operating activities Returns on investments and servicing of finance Taxation Capital expenditure Disposal of plant and equipment Acquisitions and mergers Equity dividend paid Drawings taken by proprietor Management of liquid resources Financing Long-term loan repaid Increase in cash 17 621 – – – 3 450 – – (18 750) – (1 500) 821 £ £ 24 183 1 635 180 (855) 960 25 143 (10 282) 2 535 225 (7 522) 17 621 Notes and Comments on the Do-it-Yourself Example The approach taken in this example is identical to the one taken in the cash flow statement of the company. the movement in debtors is taken from the gross balances outstanding. The proprietor’s drawings need some explanation. The corporate equivalent of this item would be equity dividends paid to shareholders. Note that the proprietor is withdrawing more cash than operating activities are producing. note the cash-greedy build-up of inventories but in contrast to the company. and for the same reasons. an imbalance which cannot continue indefinitely. the less cash is available for business purposes.

More and more prominence is being given to the cash flow statement. • cash flow is REALITY. the stock market tends to focus on earnings per share (that is bottom line profits divided by the number of shares in issue) but cash flow is what keeps the company floating above the water line.97) Cost £16 800 6 000 Depreciation £6 240 3 405 £2 835 1 635 £4 470 £10 800 4. • profit is SANITY. Corporate chairmen and chief executives are keen to stress the turnover or market share of their companies. that the original purchase price of this equipment was £6000 (£16 800 less £10 800). There was only one movement on Fixed assets during the year – a sale of plant and equipment. not out of profits. We can assume. Accounting conventions can have an unfortunate tendency of portraying a company’s financial position and economic viability in a rather better light then they deserve. simply because it cuts through the conventions underpinning the profit and loss account and balance sheet to capture the vital juices which flow through the company during the period. 4/14 Edinburgh Business School Accounting . Remember: • market share is VANITY. If the firm sold the piece for £3450 and made a profit of £855. We have seen in this module how a company can report a healthy profit on ordinary activities of £14 450 but find that its cash balances drop by £15 350.6. This is because entities need cash to survive. cash is the lifeblood that keeps them alive. we can calculate that the written-down value of the piece of equipment sold was £2595 (£3450 less £855).6.96) Plant sold Charged for year Closing balance (30. Cash flow statements allow users of financial reports to assess a company’s liquidity and financial adaptability. A company pays its bills out of cash.Module 4 / The Cash Flow Statement Readers may care to reconcile the opening and closing balances of the Fixed assets accounts in the balance sheet. therefore. Therefore. the depreciation already charged on the plant at date of sale was £3405 (£6000 less £2595): Opening balance (30.8 Summary Of the three financial statements regularly prepared by companies and other organisations the cash flow statement is arguably the most critical.

1 Which of the following is correct? (a) A balance sheet reports the flow of resources through an accounting period. (d) Loss on disposal of fixed assets. £22 500. Cash and bank balances only. as applied in a cash flow statement? (a) (c) Cash balances only. The following information applies to Questions 4. (b) A profit and loss account reports an inventory of resources at the end of an accounting period. (d) A cash flow statement provides a reconciliation between profits and cash. (b) £12 500. (d) £62 500. (b) Cash and bank balances plus temporary investments of cash.2 Which of the following items in a profit and loss account involves a direct movement of cash within an accounting period? (a) (c) Depreciation.Module 4 / The Cash Flow Statement Review Questions 4.4–4.4 What is the cash flow from operations for Company A? (a) (c) £2 500. Accounting Edinburgh Business School 4/15 .5 What is the cash flow from operations for Company B? (a) (c) £4 500. 4. (b) £11 000.3 Which of the following defines ‘Cash’. (c) A cash flow statement reports on the claims against a company’s resources at the end of an accounting period. 4. (d) £20 000. £15 500. (b) Decrease in provision for bad debts. 4. Taxation. (d) Bank balances plus temporary investments of cash. The following information has been obtained from the accounting records of Company A and Company B for the year ended on 30 June: Company A £ 12 500 50 000 20% pa Company B £ 15 500 45 000 10% pa Profit (after depreciation) Fixed assets Depreciation policy 4.5.

(b) Increase in creditors. Dividends received from associated companies. (d) Losses from operations. Sale of a subsidiary company. (d) Sale of fixed assets.6 Which of the following is a source of cash? (a) (c) Increase in authorised share capital. (d) Sale of fixed assets. (b) Disposal of fixed assets. 4/16 Edinburgh Business School Accounting . (b) Profit from operations.11 In a cash flow statement. Purchase of fixed assets. which of the following is included in the category ‘Capital investment’? (a) (c) Investment in a joint venture company.10 In a cash flow statement.8 Which of the following is a use of cash? (a) (c) Decrease in inventories. (b) Increase in inventories. Purchase of fixed assets. Increase in debtors.Module 4 / The Cash Flow Statement 4. (b) Subscription for share capital. (b) Decrease in creditors. (d) Increase in debtors. which of the following is included in the category ‘Cash flow from returns on investment and servicing of finance’? (a) (c) Overdraft interest. 4. 4. (d) Investment in an associated company. 4. (d) Proceeds from issue of loan stock. which of the following is included in the category ‘Cash flow from operating activities’? (a) (c) Payment of dividends. Decrease in debtors. Increase in debtors.12 In a cash flow statement.9 Which of the following is not a use of cash? (a) (c) Repayment of loan stock. 4. 4. (b) Profit on ordinary activities before taxation. 4.7 Which of the following is not a source of cash? (a) (c) Purchase of fixed assets. (d) Purchase of a subsidiary company.

(b) Depreciation. (d) +£32 000.Module 4 / The Cash Flow Statement 4. The following information applies to Questions 4. which of the following is included in the category ‘Financing’? (a) (c) Increase in overdraft balances.16 If the company’s profit for the year was £27 000. (c) +£24 000. (d) Investment in an associated company. 4. (b) −£32 000.16. (b) Purchase of fixed assets. (iii) Depreciation amounted to £3000 for the year. Repayment of loan stock. 4. £27 000. what was the total amount of net cash flow from operations? (a) (c) £23 000. (d) Loan interest paid. 4.15–4.15 If a cash flow statement is prepared for 20x1. (b) £25 000. The following amounts were extracted from a company’s balance sheet at year-ends: 20x0 £ 54 000 36 000 26 000 – 4 000 10 000 20x1 £ 36 000 48 000 18 000 28 000 – 12 000 Inventories Debtors Creditors Cash at bank Bank overdraft Plant 4. (d) £29 000. Further information is also available: (i) (ii) The company’s bad debt provision had already been reviewed and reduced by £500 at the year-end. Accounting Edinburgh Business School 4/17 . ZB Products Limited had earned a profit on ordinary activities (before taxation) of £10 000. Repayment of loan stock. which of the following is included in the category ‘Acquisitions and disposals’? (a) (c) Disposal of fixed assets. There had been a gain of £700 on the sale of a motor vehicle.17 For its financial year to 31 March.13 In a cash flow statement. what will be the movement in the cash balance? (a) −£4 000.14 In a cash flow statement.

(i). 4/18 Edinburgh Business School Accounting . Fixed assets with a net book value of £3000 were sold during the year. Which of the following will result in an increase in cash inflows? (a) (c) (i) and (ii) only. (d) (ii).20 A company is considering various options to improve its cash inflows. £31 000. An increase of £6000. what is the effect of the total amount of the ‘Adjustments to working capital’ on the cash flow from operating activities? (a) (c) A decrease of £2000. (d) £14 200. From a company’s balance sheets for 20x0 and 20x1.18–4. (iii) and (iv) only. The following information applies to Questions 4. what is the total of profit before tax plus items added back? (a) (c) £11 800.Module 4 / The Cash Flow Statement In a cash flow statement. (iii) increase inventories. 4. (b) £28 000. the following data have been extracted: 20x1 £ 80 000 75 000 89 000 10 000 73 000 20x0 £ 65 000 42 000 72 000 2 000 21 000 Fixed assets Inventories Debtors Cash at bank Creditors The depreciation charge for 20x1 amounted to £16 000.19. (d) A decrease of £36 000. including actions to: (i) (ii) reduce debtors. 4. (b) £12 800.19 What is the total amount of purchases of fixed assets during 20x1? (a) (c) £25 000.18 In a cash flow statement. £13 200. (b) An increase of £2000. 4. (d) £34 000. increase creditors. (iii) and (iv) only. (iv) increase capital expenditure. (b) (i) and (iii) only.

21 The operating profits generated by a business over an accounting period will always equal the change in cash balances between the start and the end of the period. Accounting Edinburgh Business School 4/19 . yet profits were earned instead of the losses of 20x0. There are several factors puzzling him. The balance sheets are as follows: 20x0 £ Fixed assets Current assets Inventories Debtors Cash at bank Current liabilities Creditors Bank overdraft Net current assets £ 9 606 £ 20x1 £ 15 300 4 680 3 920 2 720 11 320 5 920 – 5 920 5 400 15 006 7 500 7 506 15 006 7 920 7 640 – 15 560 3 326 1 240 4 566 10 994 26 294 9 500 16 794 26 294 Ordinary share capital Profit and loss account Additional Information The profit for the year was £9288 (20x0 – loss £3500) after charging depreciation of £3706.Module 4 / The Cash Flow Statement 4. True or false? Case Study 4. True or false? 4. His creditors are lower than ever before and the shareholders had even subscribed for a further £2000 of ordinary shares. The bank balance has deteriorated over the year.1 The Managing Director of LMP Products Limited has been reviewing the balance sheets for 20x0 and 20x1.22 A loss from operations will always result in a reduction in cash balances. Required You have been asked to explain to the Managing Director the reasons for the deterioration in the cash position by preparing a cash flow statement for 20x1.

Module 4 / The Cash Flow Statement Case Study 4. They are intrigued with the apparently strange combination of circumstances which have seen the company incur significant losses in the year to April 20x1 and also move from an overdraft at April 20x0 to positive cash balances at April 20x1.2 The directors of Exmouth Trading Limited have been reviewing the company’s balance sheet for the year just ended at 30 April 20x1. The summary profit and loss accounts for 20x1 (and 20x0) are as follows: 20x1 £000 250 220 30 (70) (96) (136) 20x0 £000 270 120 150 (85) (60) 5 Sales Cost of sales Gross profit Selling and distribution costs Administrative expenses Operating (Loss)/Profit The balance sheets for 20x1 and 20x0 are as follows: 20x1 £000 50 46 55 20 121 75 – 75 46 96 100 (4) 96 20x0 £000 100 100 72 – 172 45 25 70 102 202 70 132 202 Fixed assets Current assets Inventories Debtors Cash at bank Current liabilities Creditors Bank overdraft Net current assets Total assets less Current liabilities Capital and reserves Ordinary share capital Profit and loss account 4/20 Edinburgh Business School Accounting .

Module 4 / The Cash Flow Statement Further information is also available: 1 The loss for the year included a depreciation charge of £10 000. Accounting Edinburgh Business School 4/21 . Required Prepare a cash flow statement for the year to 30 April 20x1 and comment on any significant movements in cash over the year. 2 There were no purchases of fixed assets during the year to 30 April 20x1. 4 There were no taxation charges or dividend payments in the year. 3 There were no gains or losses on disposal of fixed assets during the year.

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18.11 5.18 5.14 5.1 5.5 5.13 5.19 Introduction The Concept of Disclosure Sources of Disclosure Requirements The Companies Acts 1985 and 1989 Accounting Standards The Stock Exchange Listing Agreement Financial Reporting in Action An Introductory Note on Groups of Companies Abstract of Annual Reports: MBA plc and Award Ltd The Accounting Policies The Consolidated Profit and Loss Account The Consolidated Balance Sheet (and Parent Company’s Balance Sheet) Called-up Share Capital Share Premium Account Revaluations A Concluding Note on MBA’s Balance Sheet Statement of Group Cash Flow Detailed Disclosure Requirements for Selected Items Fixed Assets and Depreciation Stocks and Work-in-Progress The Lessons to Be Learned Fundamental Accounting Concepts The External Auditor The Role of the Auditor Audit Methodology Internal Control Internal Control Surrounding Additions to Fixed Assets Materiality The Audit Report Summary 5/2 5/3 5/4 5/4 5/5 5/6 5/6 5/6 5/9 5/9 5/11 5/13 5/14 5/14 5/14 5/15 5/16 5/18 5/18 5/19 5/20 5/20 5/21 5/22 5/22 5/22 5/23 5/24 5/24 5/25 Accounting Edinburgh Business School 5/1 .6 5.2 5.12.18.18.15 5.8 5.4 5.9 5.18.7 5.12.10 5.2 5.18.2 5.16 5.4 5.18.1 5.Module 5 The Framework for Financial Reporting Contents 5.3 5.2 5.3 5.15.1 5.1 5.12 5.5 5.3 5.17 5.6 5.15.12.

the Statements of Standard Accounting Practice including the International Standards. the role of the auditor and the report which he makes to the company.1 Introduction The first three modules have highlighted the fact that the valuation of a company’s assets and. the temptation to draw up financial statements which exaggerate the efficiency of their performance can often prove overwhelming for some managers! The material in this module will describe the framework within which companies must operate in financial reporting.Module 5 / The Framework for Financial Reporting Appendix 5. the determination of its periodic profit.1 (Additional Questions) 5/26 5/61 5/86 5/93 Learning Objectives By the end of this module you should understand: • • the legal and quasi-legal framework within which companies draw up their financial statements. The typical issues confronting managers with respect to their companies’ financial accounting and reporting can be expressed in the following questions: ‘What inventory valuation method should we use: LIFO or FIFO or average?’ ‘What portion of overheads should be allocated to inventory.1: Extract from MBA Annual Report 20x2 Appendix 5. • • • 5. is not the end product of the application of a scientific formula but rather requires the exercise of considerable judgement. it will also describe briefly the additional information which companies must disclose 5/2 Edinburgh Business School Accounting . how to read a published set of corporate financial statements. the credibility.2: Extract from Award Annual Report 20x2 Review Questions Case Study 5. and the Financial Reporting Standards. It should be equally clear that if managers are to be left with unfettered discretion in these matters. reliability and usefulness of financial statements are severely jeopardised. and what portion should be written off against this year’s profit?’ ‘How should we depreciate our fixed assets? What is the useful life of the assets?’ ‘When should we recognise revenue – on payment or at time of invoice?’ It should be clear to the reader by this stage that the company’s reported profit will be directly affected depending on how the manager decides to answer these questions. the principal features of the disclosure requirements contained in the UK Companies Acts 1985 and 1989. and the Stock Exchange Listing Agreement. consequently. the principles and basic mechanics of group accounting.

Indeed creditors may enforce the realisation of everything belonging to a sole trader or a partner. such as their homes and their contents. why should it be reluctant to disclose to the public what is going on? What has it got to hide? The first of these questions is the easiest to answer and is related to the limited liability status of companies. except the ‘shirt on his back and the tools of his trade’! Such are the wide recovery powers of persons doing business with a sole trader or a partnership that the law recognises that there need not be obligations on such entities to disclose a statement of their affairs on a periodic basis. balance sheet and funds flow statement. and cars. that this unit will introduce the reader to the legal and quasi-legal framework. they have a personal interest in how the company is employing their funds. partners. By forcing companies to publish certain information. it is not to be considered as a comprehensive checklist of disclosure requirements. It should be stressed. In other words. If a sole trader or partnership decides to incorporate himself/themselves. This is not the case with companies.Module 5 / The Framework for Financial Reporting other than that contained in the profit and loss account. Because creditors are less able to recover money when dealing with companies in financial trouble than with sole traders or partnerships. a shareholder cannot lose more money than that which he put into the company. A comparison of the financial statements of MBA (registered in the UK) with those of any company registered in a country whose financial reporting are rooted in the work of IASC will reveal how similar they are in structure and layout. Although the material will refer to the reporting environment of a UK company. Shareholders become divorced from management: like creditors. the law affords them a measure of protection by forcing companies to publish each year certain information which should assist the creditors in forming an opinion of the creditworthiness of their corporate customers.2 The Concept of Disclosure The word ‘disclosure’ implies a degree of resistance on the part of a company to make public certain aspects of its affairs. As companies become larger. Sole traders and partnerships are liable at law for the full extent of the debts which they may incur. Creditors may pursue sole traders and partners beyond the extent of their capital accounts into their personal possessions. no matter how large the debts of the company become. or others invited to contribute capital become) is limited to the extent of their shareholdings. Even with the rigorous disclosure requirements that exist today it must be admitted that Accounting Edinburgh Business School 5/3 . it should be appreciated that many countries adopt largely similar concepts and procedures encapsulated in statements from the International Accounting Standards Committee. however. Why should a company be made to disclose information? On the other hand. the liability of the shareholders (for that is what the sole trader. the law protects shareholders in the same way that it protects creditors. the demand for capital increases and the number of shareholders tends to increase. 5.

and (c) the requirements of the Stock Exchange Listing Agreement for companies whose ordinary shares are listed on the Stock Exchange. the 5/4 Edinburgh Business School Accounting . the Act being preceded by a Royal Commission which made recommendations based on the inadequacies of the existing legislation. Major industrial companies today are subject to demands for information from many quarters: Module 1 described some of these demands which could be collectively described as seeking protection from managerial manipulation and exploitation. however. the Companies Act 1985. These are: (a) government legislation in the form of the Companies Acts 1985 and 1989.Module 5 / The Framework for Financial Reporting creditors and shareholders can still lose money if their company is managed by unscrupulous or imprudent persons. The result has been to confront companies and their professional advisers with a complex array of requirements. none of which has had the benefit of the reasoned judgement of a Royal Commission. At the moment. The latest major act. Prior to 1973 the trend was towards a Companies Act being placed on the Statute Book every twenty years or so. and repeals.4 The Companies Acts 1985 and 1989 The major controlling influence on the content of UK company financial statements over the years has been the numerous Companies Acts passed by Parliament. some examples of specific requirements are then examined in a set of published accounts. the emphasis within the legal and quasi-legal framework is on the provision of information to shareholders and creditors. consolidated and refined all previous legislation and the 1989 Act added to and amended the 1985 Act so that both Acts have to be read together. 5. A very brief description of each source follows. Each year Parliament adds to. (b) the accounting profession’s rules of procedure contained in Accounting Standards and International Accounting Standards.3 Sources of Disclosure Requirements There are three main sources of rules which govern the disclosure practices of UK companies. Since 1973 the pace has quickened: an increasing political awareness of the notion of disclosure coupled with sharp practice by a few companies have led Parliament to pass several Companies Acts. 5. some of the later ones repealing earlier ones. The overall requirement of the law is that the company’s profit and loss account and balance sheet shall give a true and fair view of. but most being simply an extension of what already existed. some parts of this legislation. The desire to operate with a low level of external interference and to prevent competitors from getting sensitive commercial information has led increasingly to company managements’ disclosing the minimum information required by the various regulations. respectively. Very few companies disclose additional information voluntarily.

This has the positive effect of keeping the financial statements uncluttered. A company’s auditor must certify every year that a true and fair view has been given of the company’s profits and state of affairs. reporting financial performance and related party transactions. Accounting standards. leases and hire-purchase contracts. manipulation or concealment of material facts. despite their short history. A company must disclose its accounting policies. were issued on behalf of the various professional accounting bodies by the Accounting Standards Committee up to 1990 and from this date ‘Financial Reporting Standards’. The standards. The distinction between the Companies Act and Accounting Standards should be stressed: the Companies Act lays down that companies must disclose certain information. about its affairs during the accounting year under review. pension costs. and is now sponsored by over 50 countries. Its standards permit a wide range of options so that compliance with UK SSAPs and FRSs tends to ensure compliance with IASC standards. took it upon itself to issue standards for accounting procedures which its members are obliged to follow. the International Accounting Standards Committee (IASC) was set up in 1973. 5. for example a switch from FIFO stock valuation to LIFO. It is true to say that. in 1969. Changes in accounting policies. Much of the information is given by way of notes which are keyed into summarised figures on the accounts. not only must be disclosed but should also be quantified in terms of its effect on reported profits. What is meant by a ‘true and fair view’? Generally it is interpreted to mean that the financial statements have been drawn up according to accepted accounting principles using accurate figures as far as possible. group accounts. accounting standards have made a more profound impact on financial reporting than company legislation because of the limits they place on managerial freedom in the matter of Accounting Edinburgh Business School 5/5 . or FRSs. on the other hand. In an effort to promote harmonisation of regulations and procedures throughout the world. underpin the financial disclosures in that they set controls on how the numbers in the financial statements are to be compiled. and because some companies abused these long-established conventions. how it applied the accounting standards to its specific business and environment. a body independent of the professional accounting bodies.Module 5 / The Framework for Financial Reporting profit or loss for the financial year. properly termed ‘Statements of Statements of Standard Accounting Practice’ or SSAPs. that is. and that the whole picture is free from deliberate bias. and the state of affairs as at the end thereof. Accounting standards have been issued on such diverse topics as stocks and work-in-progress. have been issued by the Accounting Standards Board.5 Accounting Standards Largely because successive Companies Acts dealt primarily only with what should be disclosed and stopped short of requiring companies to apply specific accounting conventions in a specific manner. and reasonable estimates otherwise. predominantly of a financial nature. depreciation. and the negative effect of making the process of reading or understanding a set of accounts a very difficult task. the accounting profession.

through its Review Panel. companies over a certain size are obliged to state ‘whether the accounts have been prepared in accordance with applicable standards and particulars of any material departure from those standards and the reasons for it shall be given’.7 Financial Reporting in Action This module presents an extract from MBA’s published accounts for 20x2. Quoted companies must also prepare half-yearly profit reports for shareholders. other 5/6 Edinburgh Business School Accounting . A more rigorous. or directors’ interests in company contracts. statutory recognition has been given to the existence of accounting standards. Apart from the requirement to draw this non-compliance to the attention of shareholders. They make no attempt to prescribe accounting conventions for companies to adopt.6 The Stock Exchange Listing Agreement When a company seeks a quotation on a recognised stock exchange it must supply the exchange with detailed information about the management and financial structure of the company. It can be seen that the listing requirements of the Stock Exchange extend the requirements of the Companies Acts rather than the Accounting Standards. and details of dividends waived by directors or shareholders. a statement giving details of directors’ shareholdings in the company. leaving this to the Accounting Standards Board to deal with. or are taken over by. For instance. Now. The new Accounting Standards Board not only has the power to issue standards without seeking approval from no fewer than six professional accounting bodies but. 5. since the Companies Act 1989. But of course companies merge with. 5. together with some of the relevant notes and disclosure requirements. Attention will be drawn to the most significant aspects. Each year thereafter the quoted company must provide certain information in its annual report and accounts. when taken together. details of shareholdings of more than 20 per cent in other companies.Module 5 / The Framework for Financial Reporting selecting accounting practices and procedures which. less flexible. a geographical analysis of sales turnover. 5. can produce a profit figure which best fits management’s aspirations. with particular emphasis on the operation of accounting standards. the modules so far have concentrated on the financial accounting and reporting of the activities of a single company. which must be disclosed in the press. The profound weakness of the UK accounting standards programme up to 1990 lay in the fact that companies could choose not to abide by specific standards.8 An Introductory Note on Groups of Companies In an effort to aid the reader’s understanding. companies escaped any penalty or punishment. regime of corporate reporting in the UK is taking shape. for example. can force companies to make adjustments in their accounts to show a true and fair view. a UK company must give a statement giving reasons for any departures from accounting standards.

that is the company which owns the shareholdings (over 50 per cent) in the subsidiary companies in the group. Before the acquisition. Ltd to form the Ben Nevis Group of Companies. While it is not the intention of this course to instruct the reader in detailed accounting mechanics. Ltd acquired 70 per cent of the ordinary share capital of Ben Lomond Co. it is useful to consider the basic principles of group accounting. Ben Nevis’s balance sheet was as follows: £ Fixed assets Current assets (mostly cash) Current liabilities Net current assets Total assets less current liabilities Owner’s equity After the acquisition Ben Nevis’s balance sheet looked like this: Fixed assets Investment in subsidiary Current assets Current liabilities Net current assets Total assets less current liabilities Owner’s equity On acquisition. Ben Lomond’s balance sheet was as follows: £ Fixed assets Current assets Current liabilities Net current assets Total assets less current liabilities Owner’s equity 50 50 – 50 50 £ 50 £ 100 40 60 100 £ 140 100 100 – 100 100 £ 100 (40) 100 100 Accounting Edinburgh Business School 5/7 . The subsidiary companies must continue to publish their own financial statements in the usual way. but also its own balance sheet. Example Ben Nevis Co. It acquired the holding in Ben Lomond by paying cash of £40 to its shareholder. financial statements. The resultant group of companies is recognised in law and its combined financial results must be reported in consolidated. The responsibility for publishing group accounts rests with the holding company.Module 5 / The Framework for Financial Reporting companies for a variety of reasons (which are of no concern to this course). The holding company must publish not only the group profit and loss account and group balance sheet. or group.

it does not refer to the valuation of its own goodwill which is never recorded in the accounts – although some managers believe it should. the ‘plus factor’ which an acquirer is willing to pay for net assets which he believes possess a higher intrinsic value than that appearing in the balance sheet. too. 2 Minority interest is calculated thus: 30% × Ben Lomond’s Owner’s equity £50 = £15 3 4 The group’s net assets amount to £265 less £150 or £115. The asset ‘goodwill’ in a company’s balance sheet refers to the purchased goodwill on the acquisition of a subsidiary. the balance belonging to the minority interest. The principle of group accounts is that they should reflect a true and fair view of the state of affairs of the group of companies from the point of view of the shareholders of the holding company. Note. that Ben Nevis acquired only 70 per cent of Ben Lomond’s equity. therefore.Module 5 / The Framework for Financial Reporting 1 2 3 4 5 It should be noted that Ben Lomond’s financial statements would show no sign of Ben Nevis’s acquisition other than a brief note in the accompanying notes to the accounts. In subsequent consolidated profit and loss accounts. 5/8 Edinburgh Business School Accounting . (Net assets = Total assets £100 less Current liabilities £50. Thus the Ben Nevis Group balance sheet would appear on acquisition as follows: £ Fixed assets Intangible asset (goodwill) Current assets Current liabilities Net current assets Total assets less current liabilities Owner’s equity Minority interest £ 150 5 110 150 (40) 115 100 15 115 Note that: 1 The account ‘Investments in subsidiary’ in Ben Nevis’s balance sheet is replaced by the underlying net assets of the subsidiary in question. thereby reflecting the holding company management’s operating control on all of the net assets of the subsidiary (not just 70 per cent) and show that the 30 per cent minority interest of Ben Lomond has a stake in the total net assets of the group as well. Ben Lomond Ltd The excess of the amount paid by Ben Nevis over the book value of Ben Lomond is goodwill. 30 per cent of Ben Lomond’s annual profit will be deducted from total group profit and added to the minority interest stake in the group’s net assets. The book value of such a holding is 70% × Net assets £50 = £35. It is. good accounting practice to add together the net assets of the holding company and the subsidiary. The difference of £5 is known as goodwill.) But Ben Nevis paid £40. Ben Nevis’s shareholders own £100 worth.

Accounts may therefore appear to be out of date. many bases are in operation: LIFO. Readers are recommended to make such a request from a major company in their region in order to compare it with MBA and Award.9 Abstract of Annual Reports: MBA plc and Award Ltd We reproduce sizeable extracts from the Annual Report and Accounts of MBA plc for the year to 31 March 20x2 and Award Limited for the 53 weeks ended 1 January 20x2 (see Appendix 5. the accounts of Award will be used largely as a basis for questions but we would urge readers to compare the accounting treatments of the two companies. Readers should appreciate the wording of at least four policies at this stage in their studies. in the opinion of the management. Not all accounting treatments need to be explained: the ASB requires explanation of only those items for which several alternative accounting bases are in common use (for example. These brief statements are required by the Accounting Standards Committee’s Statement of Standard Accounting Practice Number 2 ‘Disclosure of Accounting Policies’. Readers should be aware that any major public company will issue its annual report and accounts on request to the Company Secretary. We would make two points: 1 The principles on which the text of the modules will be focusing are basic and have a ‘shelf life’ well beyond the precise wording of the accounting standards and relevant legislation extant at the time of publication of this text. see p. Most major companies now post a summary set of financial statements on their web site. some time may elapse between editions. Average.1 and Appendix 5.Module 5 / The Framework for Financial Reporting 5. To master all of this would require a professional qualification in accounting! We shall restrict our study to the broad issues with which managers and MBA students should be conversant.10 The Accounting Policies Experienced readers of annual accounts always start their examination with the Accounting Policies (MBA’s report. with inventory valuation. 5/29). FIFO. and which are often of such size that the choice of one base or another can have a material effect on reported profits and financial position.). Accounting policies are the specific accounting bases selected and consistently followed by a business enterprise as being. etc. Accounting Edinburgh Business School 5/9 .2). 2 A glance at the two sets of accounts in the Appendices will reveal the complexity involved. A word about up-to-date accounts: despite the best intentions of authors and publishers to keep the text of a course like this up to date. The text of this module and the next will refer mostly to the accounts of MBA. and level of detail required. in published documents such as these. 5. appropriate to its circumstances and best suited to present fairly its results and financial position.

If they do not. Apart from some revaluation of fixed assets (see Note 12.Module 5 / The Framework for Financial Reporting 1 2 3 4 The rubric to the entire set of policies concerns the use of the historical cost convention. This means that management is free to select a method which is suitable for their industry but which may be frowned upon by most others provided that. Note that the company uses the straight line basis for depreciation and that management makes an estimate of the useful lives of the various asset groups (discussed in Module 2). External auditors Second. pp. This estimate will be based on past experience and current knowledge of technology but will seldom accord exactly with the actual usage. Goodwill. So the more a company pays for an acquisition. MBA treats this amount as an asset and amortises (the word used for depreciating intangible assets) it over varying periods not exceeding 20 years. Stocks and contracts in progress (discussed in Module 2) is valued in a prudent manner so that profit is not recognised until it has been properly earned. A failure to operate this accounting policy rigorously leads to many corporate scandals and/or collapses when the reality of a loss making contract eventually becomes known. will reveal no reference to disapproval of their client’s failure to comply with Financial Reporting Standards or Accounting Standards. • 5/10 Edinburgh Business School Accounting . 5/41–5/43). 5/28. a subject to be discussed in later modules. The depreciation policy is stated under the heading ‘Tangible Fixed Assets’. the financial statements show a true and fair view. see p. they must make reference to their disapproval in their report to shareholders. this loss must be provided for this year. is the excess of purchase price paid for an acquired company over the fair market values of the assets acquired. the company’s external auditors must approve the selection of accounting policies. The role of auditors will be examined at the end of this module. in management’s opinion. if they consider a loss will eventually be incurred on any contract.1). like virtually every other company. • True and fair view First. Note that management must make an assessment of the profitability or otherwise of long-term contracts. Appendix 2. Management enjoys only a limited freedom in the selection of accounting policies. the more the future years’ profit and loss accounts will be charged with this amortisation. ignores the current cost accounting convention (described briefly in Module 2. MBA. A quick look at the report of MBA’s auditors. An adjustment to the net asset values will therefore have to be made when the assets are ultimately disposed of. the choice of base must be selected by management so that the financial statements reflect a true and fair view of the state of affairs of their company.

in other areas standards limit management’s freedom within tightly defined limits. Note that MBA has not made any acquisitions or disposals on 20x2 and so the numbers are slightly easier to understand. Compared to the profit and loss accounts which have been set out in these modules so far. An exceptional item is one which is material in amount but which derives from events or transactions that fall within the ordinary activities of the company: (a) profits or losses on the sale or termination of an operation. But the Companies Act 1985 requires certain information to be disclosed by way of note. Some comments on MBA’s consolidated profit and loss account and Notes 1–13 may be useful to help readers understand what lies behind the principal numbers: 1 Financial Reporting Standard No. At the end of Note 1 the geographical split of turnover and profit and net assets is also provided. (b) costs of a fundamental re-organisation or re-structuring having a material effect on the nature and focus of the company’s operations. the items shown in Notes 1–3 on pp. namely. and.11 The Consolidated Profit and Loss Account The typical published profit and loss account (see MBA’s on p. the published version is skeletal and is. Note 1 to the accounts breaks down the turnover. 5/31). slightly more than half its profits and requires a very small asset base in comparison with other segments. The impact of accounting standards on managerial discretion will be considered when individual items in MBA’s financial statement are examined. Electronic systems produces slightly less than half MBA’s turnover for 20x2. less informative than the ones described earlier. therefore. 5/11 2 3 Accounting Edinburgh Business School . 5. In many of the crucial areas accounting standards sometimes prescribe what methods must be selected. 5/35–5/38: these help the reader to reconstruct the trading account. published in accordance with the law. profit and net assets figures into the various segments of MBA’s business. The initial selection of methods is not necessarily an open one facing management. Exceptional items need to be disclosed separately. and quantify the effect of the change on reported profits and financial position. In such an event the company would disclose the nature of the change in accounting policy. 3 (FRS 3) ‘Reporting Financial Performance’ requires companies to disclose profits between continuing operations (subdivided into acquisitions and others) and discontinued operations down to the level of operating profit. does not tell us very much. once the selection has been made management must consistently apply the policies from year to year unless the underlying economic conditions have materially altered so that a consistent application would prevent a true and fair view of the state of affairs of the company from being shown.Module 5 / The Framework for Financial Reporting • Consistency Third.

that is the undistributed profits from previous years. when the company has experienced poor trading conditions which are expected to be overcome.20 pence per share in 20x2 and are due a further 8. 2 Taxation on profits is the next charge. In such a circumstance. MBA has £775m of net exceptional gains in 20x2 which are analysed in Note 3 on p. By separating these items from the results of ordinary activities. From Note 7 we read that for each share held. or where a particular event like a corporate restructuring has adversely affected profits. notice that while MBA pays £57 million interest in 20x2 it receives £111 million interest from various deposits and investments. Perhaps the most critical of all numbers in the entire accounts is earnings per share or EPS. 3 Minority interests claim £17 million of Profit on ordinary activities after taxation. Boards of directors declare a dividend from profits but in some years. the dividend would be charged against reserves. the payment of £433 million is analysed in Note 5 on p. Note that the operating costs of £6082 million (disclosed in Note 2 on p. It is surprising that there is no obligation on companies to provide an analysis of these very large items. A company is ‘owned’ when over 50 per cent of the voting share capital belongs to one party. The only indicator of performance in 20x2 is to compare each number with that for 20x1. The stock market likes to see this number growing quarter Edinburgh Business School Accounting 5/12 . They must be protected in law and be given a proportionate share of the profits of their subsidiary. Dividend policy is a complex subject and is covered in the MBA Finance course. 5/38 provides a breakdown of this amount. A further £19 million interest received from joint ventures produces a net interest income of £73 million. Dividends are profits paid to shareholders as a return on their investment in the company. What are minority interests? Minority shareholders are those remaining in the subsidiaries acquired by MBA. a quick look back at Note 1 will reveal that MBA’s profits are earned mostly in the UK. 5/38. 5/37) comprise four major items. When MBA made a bid for certain of its subsidiaries some shareholders did not accept the bid and remained as a minority in the original company.8 pence per share on the profits of 20x2 which will be paid in cash early in 20x3. 5/38. MBA allows the reader to form a view of how the core businesses have performed during the year without the effect of exceptional events masking the numbers. Notice that the UK tax amounts to a large proportion of total tax paid. Readers will see that the biggest contributor to this figure was the flotation of HWU which netted £745m. From the entry ‘Exceptional items etc’ the remainder of the published profit and loss account describes how the profit is distributed among the interested parties: 1 First charge is interest paid to banks and other providers of borrowings. the directors are entitled to declare a dividend which exceed available profits. Note 4 on p.Module 5 / The Framework for Financial Reporting 4 5 (c) profits or losses on the disposal of fixed assets. MBA shareholders were paid 4.

The group must also publish last year’s consolidated figures.1 pence but when the impact of its exceptional events make themselves felt this rises to 38. Consider the capital and reserves of MBA. 5. It can be appreciated that an annual amortisation of goodwill negatively impacts reported profits. many companies prefer to keep the statement of major headings only and disclose the details by way of note. Accounting for goodwill is a topic that does not lend itself to quick explanation but suffice to say that there are two schools of thought. that is treated like an asset on the balance sheet and each year’s reduction in value charged against that year’s profit. The second point to note is that assets not so owned by the holding company are entered in the consolidated balance sheet as Minority interests (the last item in MBA’s consolidated balance sheet). In MBA’s group balance sheet. the principal ones of which would be listed in the annual report but are not reproduced here. year by year. This latter method is the one used by MBA because it is the method mandated by accounting standards.Module 5 / The Framework for Financial Reporting by quarter. Three items should be particularly noted in MBA’s balance sheets. Ben Nevis acquired 70 per cent of Ben Lomond for £40. Note 9 on p.12 The Consolidated Balance Sheet (and Parent Company’s Balance Sheet) In comparison with many other published balance sheets. Note that in 20x2 MBA’s profits suffered a charge of £189 million in respect of loss in value of goodwill. but 70 per cent of Ben Lomond’s net assets amounted to £35.9 pence per share. Management often feel pressure to deliver yet another record EPS. Note that a group of companies has to publish its consolidated profit and loss account but it is not required to publish the profit and loss account of the holding company separately. the single largest asset. The transaction produced an asset called goodwill on the group balance sheet amounting to £5. 5/39 describes this method clearly and also describes the restatement of the previous year’s figures. goodwill amounts to £3281 million. Three items are worthy of explanation. The first is the item Investments: Shares in Group Companies (ordinary shares purchased) acquired by the holding company in the subsidiaries owned by MBA. all of which refer to the nature of consolidated accounts. A group can either write-off each year’s purchased goodwill against reserves (old retained profits) in the balance sheet which would not affect the profit and loss account or it can be capitalised. those of MBA are full of detail on the face of the statement. Accounting Edinburgh Business School 5/13 . a massive increase from the previous year. The third item worthy of note is Goodwill. In 20x2 MBA’s EPS on normal business amounted to 27. In the group accounting example given earlier in the module. When the balance sheets of the whole group are consolidated this item disappears and is replaced by the complete assets and liabilities underpinning the investments.

it is adequate to round up each amount to the nearest hundreds.12. or thousands.12. of pounds provided the truth and fairness of the accounts is not affected by such rounding. or sometimes millions. Note that in published accounts there is no requirement to enter amounts to the last pound or penny. 5/48 we read that MBA has issued (‘called up’) £133.12. 5. a 5/14 Edinburgh Business School Accounting . Were MBA to issue shares at this time. p. From Note 19 on p. but the Companies Act requires that the share premium account be shown separately (see separate section in Note 19.05) as share premium. This indicates that the board of MBA has considered it appropriate to revalue (increase!) some assets held at the end of the year. Take. namely to finance the expansion of the business. A very important point: a company’s finances are totally unaffected by the daily movements of its share price on the Stock Exchange. This price is likely to be far in excess of the share’s face value (or nominal price). This amount is used for the same purposes as the face value of shares issued. MBA’s fixed assets amounting to £5734 million: its accounts would not be clarified.8 million of its authorised limit of £175 million. This amount is normally fixed at a sum far greater than the sum of money required for current operations so that the company has the legal authority to sell more shares to finance expansion should that be deemed appropriate. there is no impact on the resources of the company. On each occasion it prices the shares to be sold in accordance with market conditions. for example.3 Revaluations The Accounting Policies stated at the outset that MBA has adopted the historical cost convention in drawing up its accounts.72p which may appear in the books. Although managers retain a close interest in the daily share price (an indicator of market confidence). Conversely.2 Share Premium Account During a company’s lifespan it may issue shares on numerous occasions. However. Look at Note 12 Fixed asset investments–joint ventures. listed investments have been revalued by exactly £847 million. The directors must be confident that this increase in value is fairly permanent and one that is not liable to reverse. 5/48). When the amount issued reaches the authorised limit the company will petition the courts to raise its legal limit on authorised share capital. a close look at Note 19 Equity shareholders’ interest will reveal a revaluation reserve amounting to £847 million.1 Called-up Share Capital Under the provisions of the Companies Act companies are authorised to raise a certain sum of money through selling ordinary shares.Module 5 / The Framework for Financial Reporting 5. if it is a company whose shares are quoted on the Stock Exchange it would select a price around the stock market price. it would select an issue price of around £12 (or slightly less because it would want to tempt existing shareholders to subscribe for the new shares) and treat the difference between the two amounts (£12 less £0. 5. nor would they be more informative if they entered the exact amount of £5 734 276 214. In MBA’s case each share’s face value is 5 pence while the current market value is around £12. associates and other.

13 A Concluding Note on MBA’s Balance Sheet In the space of five modules the reader has been taken from the profit and loss account and balance sheet of a sole trader (Actions 1 to 7 in Module 1) to the financial statements of one of the largest companies in the world.98p might not show a true and fair view by rounding up to £500: the difference is material. The sheer complexity of the accounts and notes thereon of MBA may encourage the reader to believe that the two entities are so different that their financial statements bear no resemblance to each other in structure. the amount would have a significant effect on the overall disclosed financial position of the company. that is.Module 5 / The Framework for Financial Reporting small company whose fixed assets amounted to £478. We set out below the balance sheets of the two enterprises to reveal how similar they are: Sole Trader: Balance sheet as at end of Action 7 Fixed assets Plant and equipment Less: Depreciation Current assets Inventories Debtors Cash Less: Current liabilities Creditors Represented by: Capital introduced Profit for the year £ 12 000 50 5 500 750 4 960 11 210 3 000 8 210 20 160 £ 11 950 20 000 160 20 160 Accounting Edinburgh Business School 5/15 . 5. depending on the rounding policy selected for the other amounts in the financial statements. so it would round to £480. This is not so.

5/33): 1 Only a few numbers in cash flow statements can be traced from the preceding financial statements and succeeding notes to the accounts. Cash left the company when the assets were purchased. MBA provides specific notes on how certain numbers are made up. Depreciation is added back to the profit in an attempt to evaluate the cash amount being thrown off MBA’s operations. Note 20 (p.) This accounting profit is now adjusted for seven items described below to convert it into a cash inflow: (a) Depreciation is a charge against profits to reflect the value of fixed assets consumed during the year. (This sum can be traced to the group profit and loss account. 5/49) is the crucial one. if you like. 5. Over subsequent years this amount requires to be written off Edinburgh Business School Accounting 5/16 .14 Statement of Group Cash Flow Readers should consider the following points from MBA’s Cash Flow Statement (see p. and its profit and loss account is part of a detailed explanation of how the owner’s equity has moved up from £4695 million at the beginning of 20x2 to £5989 million by the end. it does not affect cash. the company’s last accounting equation for the year. The figure is a book entry. Goodwill is paid for in cash when an acquisition is made. (b) Goodwill amortisation is handled in the same way as depreciation and for the same reason. not when they are used. There it can be seen that the peg on which everything else is hung is group operating profit of £574 million.Module 5 / The Framework for Financial Reporting MBA plc: Balance sheet as at 31 December 20x2 Fixed assets Total assets less depreciation Current assets Stocks (inventories) Debtors Investments Cash Less: Current liabilities Creditors and short-term borrowings Represented by: Long-term loans Provisions and deferred income Minority interest Owner’s equity £ £ 5 734 1 052 1 953 224 1 135 4 364 3 216 1 148 6 882 266 535 801 92 5 989 6 882 MBA’s balance sheet on 31 December 20x2 is.

the details of which are contained in Note 21). (c) Stocks increase indicates a consumption of cash caused by raising the holding of stocks. plucking out only those entries which prompted a cash inflow or a cash outflow and leaving alone the accounting entries. using your customers’ cash to fund your work-inprogress is very sensible. adjustments and conventions which underpin these two statements. (e) Creditors increase is a source of cash in as much as the company has increased its indebtedness to suppliers during the year. warranties. etc. It is pure coincidence that the increase in creditors is exactly matched by an increase in debtors. To the £775 million cash generated from operating activities £438 million was added from dividends and management fees received from joint ventures and associates. Other investments yielded £25 million in cash. MBA is left with an overspend of cash of £260 million. MBA’s investments in capital expenditure and financial investments consumed £286 million while net acquisitions (buying new companies less the proceeds from selling existing companies) used £636 million (not much less than MBA’s cash from operating activities). The figure is not reconcilable with those provided in the balance sheet. (g) Making provisions for future uncertainties (bad debts. Companies must keep a sharp eye on this figure to avoid the figure becoming too high (and therefore costly).Module 5 / The Framework for Financial Reporting 2 3 4 in the profit and loss account. litigation environmental issues. Accounting Edinburgh Business School 5/17 . How is this overspend covered? The answer lies in borrowing slightly more from the money markets than it invested (£138 million more. After paying out dividends amounting to £218 million. It is possible to reconcile the figure given of £111 million with the increase of stocks between 20x1 and 20x2 of £112 million shown in the balance sheet. But in the current year the cash impact of this provision is zero. (d) Debtors increase represents a use of cash of £133 million caused by allowing more customers to delay payment of invoices. These increases should therefore be added back to profit to determine net cash flow from operations. The last display in Note 21 indicates a massive increase in bank borrowings (net £516 million) and MBA spent £310 million buying back its own shares. Readers will now be aware that the cash flow statement in effect cuts diagonally through the profit and loss account and balance sheet.) allows management to reduce the current year’s profits if they consider the risk of paying out cash in the foreseeable future to be reasonably high. This item is added to the Group operating profit in the Cash Flow Statement because it would have been ignored in drawing up MBA’s profit and loss account. (f) Increase in payments received in advance of £60 million is excellent for MBA’s cash flow. But each year’s write-off does not affect cash so for cash flow purposes it should be added back.

Module 5 / The Framework for Financial Reporting 5. 5/18 Edinburgh Business School Accounting . plant and equipment. the cost or revaluation of land and buildings. an airline would include a category ‘Aircraft. 5.15. and the aggregate amount provided or written off since the date of acquisition or valuation for depreciation or diminution in value of each major class of fixed assets owned by the company. requiring detailed preparation by skilled accountants. 5/37. There is no obligation to state the proceeds of sale. Exchange adjustments arise when a group has overseas subsidiaries and translates the amount of overseas fixed assets into sterling. goes some way towards laying down detailed accounting methods. The Companies Act 1985 requires a company to show the cost or. fittings. if they stand in the books at a valuation. Accounting for Depreciation. that is. a further distinction must be made between those whose unexpired term is not less than 50 years (long lease) and those on a short lease (less than 50 years). ‘Plant and machinery’. is disclosed in Note 10 to the balance sheet.15 Detailed Disclosure Requirements for Selected Items It would be inappropriate and unnecessary to discuss in detail every item that appears in MBA’s accounts. the Companies Acts requirements are very broad in nature and do not give detailed instructions to management on which assets should be depreciated and which rates of depreciation should be used. The figure of £207 million is embedded in the ‘Depreciation and amortisation’ figure of £396 million in Note 2 on p. £207 million. As the exchange rates move so too will the valuation of overseas assets as expressed in sterling terms. The depreciation charged for the year in question. Statements of SSAP 12. This information is also supplied in Note 10 to MBA’s accounts (see p. The aggregate amount of the assets acquired during the year. Specialised companies tend to add a category which refers to their area of specialism. although if the company made a significant profit (or loss) on these transactions. Some items are self-evident. 5/40). 20x2.1 Fixed Assets and Depreciation The detailed figures for tangible fixed assets are given in Note 10 to the balance sheet. and stocks (inventories) and work-in-progress. tools and equipment’ and ‘Assets under construction’ are fairly typical of major industrial companies. the amount thereof (gross book value). Such movements must be disclosed. Leasehold property’. and the aggregate cost together with the aggregate depreciation charged on the assets sold or disposed of during the year must also be disclosed. for example. The figure of £982 million which appears in the balance sheet is the net book value. it would disclose such an amount as an exceptional item in the profit and loss account. As can be seen. We shall focus on two groups of items: fixed assets and depreciation. others are most complex. For leasehold properties. owned and leased’. ‘Fixtures. MBA reports an exceptional profit of £775m on ‘disposal of subsidiaries and other fixed assets’ in its profit and loss account. MBA’s categories of ‘Freehold property. fixtures and fittings and assets under construction less the aggregate depreciation to date.

MBA discloses its method in its statement of accounting policies and its rates at the foot at Note 10. it requires companies to disclose the depreciation methods and rates used for each major class of depreciable asset. Accounting Edinburgh Business School 5/19 . SSAP 9 endeavours to fill in some of these gaps. or whether it includes an allowance for manufacturing or other overheads – all crucially important points when one is considering a company’s performance from year to year. SSAP 9 also gives guidance on how much overhead should be apportioned to stocks and work-in-progress. the combined requirements of the Companies Acts and SSAP 9. it requires that the amount at which stocks and work-in-progress are stated should be the total of the lower of cost and net realisable value of the separate items of stock and work-in-progress or of groups of similar items. . . It also requires that stocks and work-in-progress should be sub-classified in balance sheets or in the notes to the accounts in a manner which is appropriate to the business and so as to indicate the amounts held in each of the main categories. For instance. A change from one method of providing depreciation to another is permissible only on the grounds that the new method will give a fairer presentation of the results and of the financial position . Stocks and Work-in-progress are not onerous on companies so far as disclosure is concerned. that these methods and rates require annual review because the allocation of depreciation to accounting periods involves the exercise of judgement by management in the light of technical. SSAP 12 gives some guidance on the selection of method. An increase in the value of land or buildings does not remove the necessity for charging depreciation on the buildings. The management of a business has a duty to allocate depreciation as fairly as possible to the periods expected to benefit from the use of the asset and should select the method regarded as most appropriate to the type of asset and its use in the business. The law requires that the company should state the manner in which the amount for stocks and work-in-progress has been computed (which tends to be very brief). It is permissible to include production overheads. In order to give an adequate explanation of the affairs of the company the accounting policies followed in arriving at the amount at which stocks and work-in-progress are stated in the accounts should be set out in a note (Note 13 in MBA’s accounts). Under the provisions of SSAP 12 depreciation must be charged on buildings because they have a limited life which may be materially affected by technological and environmental changes.2 Stocks and Work-in-Progress Given the crucial importance of the valuation of stocks and work-in-progress in the calculation of profit and financial position.15. FIFO or average basis. commercial and accounting considerations. the effect should be disclosed in the year of change. Where differing bases have been adopted for different types of stocks and work-in-progress the amount included in the accounts in respect of each type should be stated. however. It recognises. if material.Module 5 / The Framework for Financial Reporting Although SSAP 12 does not set out fixed depreciation rates. 5. There is no obligation to state whether the ‘cost’ figure for stock is calculated on a LIFO.

large gaps in information can still be detected by interested readers. The failure to apply them. 1 Disclosure requirements are numerous and complex and require detailed interpretation by company management. to predict that inventory will be disposed of through the usual sales channels and to plan for creditors being paid in the 5/20 Edinburgh Business School Accounting . If a company is engaged in long-term contract work SSAP 9 lays down the principle which is to be applied in valuing this work-in-progress at the balance sheet date. a contracting company is obliged to recognise profits (or losses) year by year rather than waiting to account for the total profit (or loss) at the completion of the contract. Disclosure of Accounting Policies and a fifth was introduced by the Companies Act 1985. based on the normal levels of activity. less any foreseeable losses and progress payments received and receivable’. 3 Despite a rigorous application of disclosure requirements. a company will continue to trade for the foreseeable future. Very seldom does a company publish information that is not mandatory. labour and services for production.Module 5 / The Framework for Financial Reporting defined as those overheads incurred in respect of materials. attributable in particular circumstances of the business to bringing the product or service to its present location and condition may also be deemed to form part of the ‘cost’ of converted stocks of workin-progress. 5.17 Fundamental Accounting Concepts In attempting to understand the annual report and accounts of any company the reader should appreciate the five fundamental accounting concepts that underpin their preparation. Four concepts are articulated by SSAP 2. and by the auditors (to whose role we shall turn next). it is surprising that no disclosure of composition is required. would it not be useful to know the breakdown of MBA’s raw materials and consumables figure of £2584 million (given in Note 2)? When one considers the magnitude of this number compared with all other costs. 2 A corporate tradition has been built up of disclosing the absolute minimum information required. For instance. The amount should be ‘cost plus any attributable profit (that part of the total profit currently estimated to arise over the duration of the contract which fairly reflects the profit attributable to that part of the work performed at the accounting date). and the reasons for non-application. The Going Concern Concept Subject to evidence to the contrary. Such an assumption allows management to write down the company’s assets in an orderly manner. if any. 5. therefore. must be disclosed. In this way.16 The Lessons to Be Learned Three lessons can be learned from the foregoing paragraphs in this module. taking one year with another. MBA provides the required information in its Accounting Policies (stock and contracts in progress). accountants and lawyers. Other overheads.

The Accruals Concept We have already examined the operation of this concept in the recognition of revenue (Module 2). significant. Accounting Edinburgh Business School 5/21 . The remainder of this module describes briefly the role of external auditors. The application of this concept prevents management from reporting profits before they have been earned. Any known. all costs and losses. the customer even though the customer has not yet paid. 5. The Consistency Concept Unless there are pressing reasons to change accounting techniques and methods (such changes being disclosed) it is assumed that the treatment of like items between one year and another is the same. The Prudence Concept We have already mentioned the conservative approach of accountants to profit measurement.18 The External Auditor It can be seen from the brief description of disclosure requirements for fixed assets and inventories in a company’s financial statements that management’s freedom to select accounting methods and to portray results and financial position is strictly limited. and invoicing. The non-aggregation concept requires the constituent parts to be disclosed separately. For instance a company may be tempted to disclose a figure for Net current assets (being the difference between Current assets and Current liabilities).Module 5 / The Framework for Financial Reporting normal manner. Revenues and profits are not recognised until virtually all effort has been expended and the customer is likely to pay. costs are those incurred in fulfilling the sales even though the company may not have paid out cash to the suppliers of the goods and services consumed in the manufacture of the units sold. Revenue is recognised when the sale has been made by shipping to. likely occurrence which may jeopardise the company’s future must be reflected immediately in the accounts which will usually lead to an accelerated write-down of assets and a consequent reduction in profits. A company (or any organisation) does not necessarily wait for cash to change hands before accounting for revenues and costs. are recognised immediately. The Non-Aggregation Concept In determining the aggregate amount of any item the amount of each individual asset or liability that falls to be taken into account shall be determined separately. actual and expected. the methods they employ and the report which they submit. Another major force which controls the actions of management is the annual external audit.

The auditors are required to make a report to the shareholders on the accounts examined by them. a true and fair view is given of the profit (or loss) for the year and of the financial position at yearend. There are safeguards which protect the auditors from being dismissed by an unscrupulous or vindictive management. 5/28 of its accounts and their responsibilities are set out on the previous page. Provided they have ensured that the system of internal control is secure. existence and value of the assets appearing in the balance sheet. 5. This report forms part of the published financial statements. MBA’s auditors’ report is reproduced on p. (d) verification of the amount of the liabilities appearing in the balance sheet. The principal aspects of their work include: (a) an examination of the system of bookkeeping.1 The Role of the Auditor The Companies Act requires that all limited companies have their accounts audited by independent persons who hold an accounting qualification recognised by the Department of Trade and Industry. records and internal controls have been satisfactorily maintained during the accounting period.18. The report shall state whether.3 Internal Control Note that the auditors are not required to satisfy themselves about every single transaction of the company during the accounting period.Module 5 / The Framework for Financial Reporting 5. they are appointed by the shareholders in general meeting and are eligible to be reappointed each year. in the auditors’ opinion. 5. Auditors are spending an increasing proportion of their time today examining 5/22 Edinburgh Business School Accounting . Both these steps are necessary to form a basis for the preparation of the accounts. they can rely on that system to produce adequate records from which the financial statements will be drawn. (c) verification of the title.18. the auditors must ensure that the books. The auditors are normally drawn from firms engaged in public practice.2 Audit Methodology To enable them to make a report. (b) comparison of the balance sheet and profit and loss account and other statements with the underlying records in order to see that they are in accordance therewith.18. accounting and internal control to ascertain whether it is appropriate for the business and properly records all transactions. (e) verification that the results shown by the profit and loss account are fairly stated. and (f) confirmation that the statutory requirements have been complied with and that the relevant accounting standards have been applied correctly. This is followed by such tests and enquiries as are considered necessary to ascertain whether the system is being properly carried out.

or. Such flow charts will highlight weaknesses in the system where. the power vested in him or her by the company. sales. A simple but effective method of examining internal control is for the auditor to draw a flow chart of each major system in the company. purchases. where the amounts involved do not warrant a board minute. The items selected for test should be properly authorised. might be or become dishonest. cash responsibilities. Internal control is a term used to describe all the various measures taken by the owners and managers of a company to direct and control their employees. audit tests. 5. which they see as a fundamental basis for later.18. too much authority and executive action resides in one official. If capital expenditure is extensive. The auditor would look at the following points during assessment of the system of internal control. whether such expenditure consists of purchases from third parties or the company’s own labour and materials. inventory control. careless or lazy. 1 All capital expenditure should be authorised. and more widespread. architects’ certificates. and rules should be laid down for the regular reporting of actual expenditure against authorisations. or manager for that matter. The authorisation should normally be given by means of board minutes. but this test should include all items over a stated amount. (This point is of special importance where 5/23 2 3 4 5 6 Accounting Edinburgh Business School . incompetent.4 Internal Control Surrounding Additions to Fixed Assets The nature of internal control can best be grasped by an example drawn from the audit tests surrounding the additions to a company’s fixed assets. either deliberately or accidentally. plus the company’s expenditure on direct materials and labour. only a percentage of additions need be verified. Expenditure capitalised should be for additional assets and not for replacements (unless the asset or part replaced has been written off) and should be limited to the cost of work done or supplied by outside contractors. either by the board or by a responsible official. In the case of large capital projects the system should provide for progressing the project and authorising the necessary payments up to completion. The auditors will then concentrate their attention and tests on this person’s activities ensuring that the official has not abused. by a senior official of the company. and so on. it is necessary to establish procedures designed to make them directly accountable for their behaviour and to encourage them to avoid such irregularities and shortcomings. The percentage added for overheads should be checked and it should be seen that these are restricted to shop or factory overheads as are appropriate. suppliers’ invoices and other documentary evidence in respect of purchases from third parties or by an examination of stores requisitions and wages sheets as regards the company’s own materials and labour. The auditor will also bring this type of shortcoming in internal control to the attention of management in the end-of-audit letter which the auditor sends to the board of directors. The items selected should be verified by inspecting agreements. Because any employee. for example.Module 5 / The Framework for Financial Reporting and testing internal control.

5/24 Edinburgh Business School Accounting . capitalised expenditure boosts the fixed assets and therefore is not a charge to this year’s profit and loss account). the auditor examines these decisions. he will set a limit of materiality of. the magnitude of the mistake is not going to make a material difference to the reported results of the company.6 The Audit Report The aim of the audit is to enable the auditor to report to the shareholders of the company on the following matters: (a) whether the accounts give the information required by the Companies Act 1985 in the manner required by this Act. He will examine individual items of expenditure above the amount and if he is broadly in agreement with the managerial decisions taken on these. they can place reliance on the system of internal control surrounding the additions of fixed assets and. authorisation and treatment of the small number of transactions tested. therefore. If auditors are satisfied with the accuracy.18. Mistakes occur. 5.5 Materiality An auditor’s task is made more difficult by the volume of transactions entered into by a company during the course of a year. is called the level of materiality. But since the £25 million comprises many thousands of individual programmes of repairs and refurbishments.Module 5 / The Framework for Financial Reporting 7 any of the directors or senior executives are remunerated by commission on profits. below which they will not examine in depth. shortcuts are taken. This limit. They therefore set a limit. on the figures produced for them by the company. The decision on whether each individual item of expenditure should be capitalised or written off is one which is taken by the company. they will not insist on these being put right before signing their audit report. (b) whether the balance sheet gives a true and fair view of the state of the company’s affairs as at the end of year. he will assume the smaller items are also correct. as the figure upon which commission is calculated will be inflated if revenue expenditure properly accounted for in the profit and loss account is incorrectly allocated to capital in the balance sheet. should mistakes emerge in the low-value transactions. and concentrate their attention on other sensitive areas of the company’s accounting system. usually expressed in monetary terms. £50 000. say. And even if they are wrong. 5.) Any substantial capital additions which have been made during the year under audit should be inspected to satisfy the auditor that expenditure which has been capitalised is properly represented by some tangible asset. which they alone set.18. Equally. But. Clearly auditors cannot check every transaction nor can they expect every one to be exactly in accordance with stated procedures. Example A brewery company spends about £25 million per annum on repairs and refurbishments of its pubs. because the decision affects the level of reported profits (that is.

For example. . If the auditor qualifies a report it is important that the qualification should state specifically and positively the reason why. not to arouse enquiry. they may be unhappy about the provision for bad and doubtful debts. The absence of any comment in the audit report is equivalent to a positive statement by the auditors that they have satisfied themselves on the above matters. Accounting Edinburgh Business School 5/25 . (d) in the case of a holding company submitting group accounts. (d) that the accounts are in agreement with the books. The report would read as follows: In our opinion. the provision which has been made by the company for losses in respect of bad and doubtful is insufficient by £6 million. . wherever possible. (b) the accounting standards set by the accounting profession or its regulators. There are many possible causes for auditors to qualify their reports. The MBA audit report is unqualified. meaning that they have found nothing in the audit to detract from the opinion that the accounts show a true and fair view of the state of affairs of the company. With this reservation in our opinion the accounts set out on pages X to Y give a true and fair view. auditors must state in their reports if they are unable to satisfy themselves as to the following matters: (a) that they have obtained all the information and explanations which they require. (b) that proper books of account have been kept.19 Summary Managers are constrained by three sets of rules when constructing corporate financial statements: (a) company legislation passed by the government of the country in which the company is registered. It should also state the effect on the accounts and. the auditor is not satisfied. The objective of the auditor should be to convey information.Module 5 / The Framework for Financial Reporting (c) whether the profit and loss account gives a true and fair view of the profit or loss for the year. The auditors’ report is usually unqualified. In addition. whether the group accounts have been properly prepared so as to give a true and fair view of the state of affairs and profit and loss of the company and its subsidiaries so far as concerns members of the company. the amounts involved. (c) that proper returns adequate for the purpose of their audits have been received from branches or subsidiaries not visited. 5. believing that the company should have provided more than it did in the profit and loss account. and the extent to which. and (c) the listing requirements of the Stock Exchange.

1: Extract from MBA Annual Report 20x2 5/26 Edinburgh Business School Accounting . in addition the parent company must publish its own balance sheet.Module 5 / The Framework for Financial Reporting Few companies disclose any information not required by the above set of rules. These financial statements are subject to audit. To do this he or she undertakes a series of checks and examinations of the company’s books and internal controls. An auditor is required to report to the shareholders of a company on whether or not the accounts reflect a true and fair view of the company’s affairs. Appendix 5. Groups of companies consolidate their results at the end of the financial year into a group profit and loss account and a group balance sheet.

Quarterly performance reviews are held with each sector management team. using the same policies adopted in the annual accounts. The Audit Committee has reviewed the effectiveness of the Group’s internal financial control system. but not absolute. After reviewing the Group’s budget and projected cash flows and taking into account the Group’s net cash balances at 31st March. Central review and approval procedures operate in major risk areas such as acquisitions and disposals. The sector managing directors are responsible for completing Letters of Assurance which certify that they are not aware of any weaknesses in internal controls which have resulted in the risk of material loss. Forecasts are updated monthly. taxation and environmental issues. the Directors consider that the Company and the Group have adequate resources to continue as a going concern for the foreseeable future and accordingly adopt that basis in preparing the accounts. Executive Directors agree a strategic plan. All controlled business groups have cascaded this risk control reporting system throughout their operations to ensure unit level responsibility and maximum transparency of any issues to the sector management and the MBA Directors. Internal Audit co-ordinates its work with external audit and reports regularly to the executive Directors and periodically to the Audit Committee. The Directors are responsible for ensuring that the Company keeps accounting records which disclose with reasonable accuracy the financial position of the Company and which enable them to ensure that the financial statements comply with the Companies Act 1985. and the management replies. Accounting Edinburgh Business School 5/27 . contract tenders. litigation. associated companies and major investments are safeguarded by regular attendance of MBA representatives at meetings of Directors. The external auditors report on any weaknesses in internal financial control identified during their audit. Directors’ Responsibilities for the Financial Statements The Directors are required by the Companies Act 1985 to prepare financial statements for each financial year which give a true and fair view of the state of affairs of the Company and of the Group and of the profit or loss of the Group for the financial year. MBA’s out-sourced Internal Audit function reviews and monitors the Group’s internal control processes. capital expenditure. assurance against material misstatement or loss. regular discussions with management and consultation on material corporate transactions. are reported monthly and variances against budget and last year are prepared for executive review. treasury management. reasonable and prudent judgements and estimates have been made and applicable accounting standards have been followed. 20x2. The Directors approve the agreed Group budget. Actual results. The Directors consider that the financial statements on pages 5/29 to 5/58 have been prepared on a going concern basis. who are accountable for the conduct and performance of their businesses within agreed business strategy.Module 5 / The Framework for Financial Reporting Directors’ Statement on Internal Financial Control The Directors have overall responsibility for MBA’s system of internal financial control which aims to safeguard the Group’s assets and to ensure that proper accounting records have been maintained and that financial information is reliable. a comprehensive phased budget and a set of objectives with the management of each business group on an annual basis. Group results are prepared monthly and reviewed by the Directors at their regular meetings. The Group’s investments in joint ventures. appropriate accounting policies have been used and applied consistently. The Directors have a general responsibility for taking such steps as are reasonably open to them to safeguard the assets of the Company and the Group and to prevent and detect fraud and other irregularities. are reviewed by the Audit Committee. The Group’s overall strategy is reviewed regularly by the Directors. giving details of remedial actions taken. This review included consideration of both the reports of the external and internal auditors and the Letters of Assurance provided by the managing directors of each sector and of the budgeting and monthly reporting process. industrial relations. The framework of key financial controls is as follows: A management structure with clearly defined levels of delegated authority gives major decision-making responsibility to the business group managing directors. These reports. Any system of internal control can only provide reasonable.

We have audited the financial statements on pages 5/29 to 5/58. and of whether the accounting policies are appropriate to the circumstances of the Company and the Group. We planned and performed our audit so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the financial statements are free from material misstatement. Respective responsibilities of Directors and auditors The Directors are responsible for preparing the Annual Report. We consider the implications for our report if we become aware of any apparent misstatements or material inconsistencies with the financial statements. Opinion In our opinion the financial statements give a true and fair view of the state of affairs of the Company and the Group as at 31st March. of evidence relevant to the amounts and disclosures in the financial statements. including as described on page 5/26 the financial statements.Module 5 / The Framework for Financial Reporting Auditors’ Report To the Members of MBA p. We report to you our opinion as to whether the financial statements give a true and fair view and are properly prepared in accordance with the Companies Act 1985. consistently applied and adequately disclosed. Our responsibilities. and we report if it does not. the Directors’ Report is not consistent with the financial statements. if we have not received all the information and explanations we require for our audit. Basis of audit opinion We conducted our audit in accordance with Auditing Standards issued by the Auditing Practices Board. In forming our opinion we also evaluated the overall presentation of information in the financial statements. 20x2 and of the profit of the Group for the year then ended and have been properly prepared in accordance with the Companies Act 1985. which have been prepared under the accounting policies set out on pages 5/29-30. the listing Rules of the London Stock Exchange and by our profession’s ethical guidance. X Y and Z Chartered Accountants and Registered Auditors 12th June. as independent auditors. whether caused by fraud or other irregularity or error.c. We are not required to form an opinion on the effectiveness of the corporate governance procedures or the Group’s internal controls. An audit includes examination. We read the other information contained in the Annual Report. We also report to you if. if the Company has not kept proper accounting records. and consider whether it is consistent with the audited financial statements. including the corporate governance statement. We review whether the statement [not reproduced here] reflects the compliance with those provisions of the Combined Code specified for our review by the Stock Exchange.l. or if information specified by law or the Listing Rules regarding Directors’ Remuneration and transactions with the Company and other members of the Group is not disclosed. on a test basis. are established by statute. in our opinion. 20x2 5/28 Edinburgh Business School Accounting . the Auditing Practices Board. It also includes an assessment of the significant estimates and judgements made by the Directors in the preparation of the financial statements.

plant. There is no trading activity in financial instruments Foreign exchange transaction exposures The Group hedges actual foreign exchange exposures as soon as there is a firm contractual commitment. joint ventures and associates and cash flows of overseas subsidiaries are translated at the average rates of exchange during the year.66 French Franc 9. All accounts are made up to 31st March. Non-sterling net assets are translated at year-end rates of exchange.Module 5 / The Framework for Financial Reporting Accounting Policies The financial statements have been prepared in accordance with applicable accounting standards.81 2 895 1. 3. as modified by the valuation of listed fixed asset investments. 8 and 9. Balance sheet translation exposures A large proportion of the Group’s net assets are denominated in overseas currencies. Freehold land does not bear depreciation where the original cost of purchase was separately identified.79 2 866 1. Key rates used are as follows: Average rates 20x2 20x1 Year-end rates 20x2 20x1 Financial instruments The Group uses financial instruments. Leased assets US Dollar 1. Currency translation Profits and losses of overseas subsidiaries. Where appropriate. including interest rate and currency swaps. fixtures. tools and equipment are recorded at cost and depreciated on a straight line basis over their estimated useful lives.61 9. Reserves are adjusted to include the differences arising from the restatement to year-end rates of exchange of profits and losses and the translation of the net assets of overseas subsidiaries. Tangible fixed assets Property. Exchange gains or losses arising on the notional principal of these currency swaps during their life and at termination or maturity are dealt with as a movement in reserves. Amounts are included in the accounts at the forward exchange contract rate.71 Italian lira 2 861 Euro 1. The effects of these changes are shown in Notes to the Accounts 1. Turnover Turnover. the Group hedges these balance sheet translation exposures by borrowing in relevant currencies and markets.48 1. solely for the purpose of raising finance for its operations and to manage interest and currency risks associated with the Group’s underlying business activities.50 1. and the Group’s percentage interest in sales of joint ventures. comprises sales to outside customers. Interest rate risk exposure The Group hedges its exposure to movements in interest rates associated with its borrowing primarily by means of interest rate swaps and forward rate agreements. excluding VAT. The more important MBA Group accounting policies are summarised below to facilitate the interpretation of the financial statements and are in addition to the policies explained in the notes to the accounts. and all of its subsidiary undertakings (‘Group companies’ or ‘subsidiaries’). Currency swaps are used only as balance sheet hedging instruments. Comparative figures have been restated to reflect changes in presentation arising from the adoption of FRS 10 Goodwill and Intangible Assets.l. Forward contracts are used to hedge the exposure. and the Group does not hedge the currency translation of its profit and loss account. If the contract ceases to be a hedge any subsequent gains or losses are recognised through the profit and loss account.47 1. Contingent Liabilities and Contingent Assets and FRS 14 Earnings per share. fittings. joint ventures and associates at the beginning of the year.38 3 053 1.c. All other exchange gains and losses are included in profit on ordinary activities before taxation.65 9.56 Assets held under finance leases are included in tangible fixed assets and the present values of lease commitments are included under creditors. and by the use of currency swaps. machinery. Accounting Edinburgh Business School 5/29 . Accounting convention The financial statements are prepared under the historical cost convention. Operating lease payments are charged to the profit and loss account as incurred. Basis of consolidation The financial statements consolidate the accounts of MBA p. and the reclassification of HWU. FRS 12 Provisions. The Group records transactions as sales when the delivery of products or performance of services takes place in accordance with the terms of sale.67 10.

is charged to the profit and loss account so as to spread the cost over the expected average remaining service lives of current employees. The sector analysis of turnover. Research and development Expenditure incurred in the year is charged against profit unless specifically chargeable to and recoverable from customers under agreed contract terms. Other unlisted fixed asset investments and the Company’s investment in shares in Group companies are stated at cost less provision for permanent diminution in value. listed fixed asset investments are stated at market value. provided that the outcome of the contract can be assessed with reasonable certainty. profit and net assets includes the Group’s share of the results and net assets of joint ventures. Advance payments received from customers are shown as creditors until there is a right of set-off against the value of work under-taken. Current asset investments are stated at the lower of cost and net realisable value except dated listed securities which are stated at market value. Taxation Taxation on profit on ordinary activities is that which has been paid or becomes payable in respect of the profits of the year. Pensions and other post retirement benefits The expected cost of providing pensions and other post retirement benefits. Profit before taxation includes the Group’s share of joint ventures and associates. Investments Joint ventures comprise long-term investments where control is shared under a contractual arrangement. not exceeding 20 years (see Note 9). Associates consist of long-term investments in which the Group holds a participating interest of not less than 20 per cent and over which it exercises significant influence. inclusive of appropriate overheads.Module 5 / The Framework for Financial Reporting Goodwill Purchased goodwill on acquisitions is capitalised and amortised over its useful economic life. Profit on long-term contracts in progress is taken when a sale is recorded on partdelivery of products or part-performance of services. Progress payments received are deducted from the value of work carried out. any excess being included with payments received in advance. Deferred taxation is provided on all timing differences which are expected to reverse in the future at the rate of tax anticipated to apply in the year of assessment. 5/30 Edinburgh Business School Accounting . Stocks and contracts in progress Stocks and contracts in progress are valued at the lower of cost. as calculated periodically by independent actuaries. and estimated net realisable value. Provisions are made for any losses incurred or expected to be incurred on uncompleted contracts. Investments in unlisted joint ventures and associates are stated at the amount of the Group’s share of net assets including goodwill at 31st March derived from audited or management accounts made up to that date.

1p 38.2p 23. gains less losses on disposals of subsidiaries and other fixed assets Income from loans.8p 18.9p 27. less interest payable Group Share of joint ventures HWU Profit on ordinary activities before taxation Tax on profit on ordinary activities Profit on ordinary activities after taxation Minority interests Profits on ordinary activities attributable to the shareholders Dividends Retained profit for the financial year Earnings per share Earnings per share before exceptional items and goodwill amortisation Diluted earnings per share 3 3 1&4 1 5 6 7 8 8 8 Accounting Edinburgh Business School 5/31 .5p 654 (130) 524 9 69 (7) 595 783 159 (12) 17 759 – 20 64 10 26 100 879 (311) 568 (59) 509 (311) 198 18. deposits and investments.1p 2 Disposals 2 Share of joint ventures after £10 million (20x1 nil) exceptional charges 12 – before goodwill amortisation – goodwill amortisation Group and joint venture operating profit before exceptional items and goodwill amortisation HWU – before goodwill amortisation – goodwill amortisation Other associates Separation costs Exceptional items. 20x2 20x2 Note £ million 20x1 Restated £ million Turnover Group turnover Share of joint ventures – retained businesses – disposals 2 2 12 1 6 590 – 1 035 7 625 5 875 394 896 7 165 Operating profit Group operating profit – retained businesses after £86 million (20x1 £51 million) exceptional charges before goodwill amortisation – goodwill amortisation 763 (189) 574 – 81 (8) 647 940 58 (16) 17 706 (50) 775 54 13 6 73 1 504 (433) 1 071 (17) 1 054 (348) 706 38.Module 5 / The Framework for Financial Reporting Consolidated Profit and Loss Account For the year ended 31st March.

Signed on behalf of the Board of Directors. Heriot H. 20x2 Group 20x2 Note £ million 20x1 Restated £ million Company 20x2 20x1 £ million £ million Fixed assets Goodwill Tangible assets Investments: Shares in Group companies Joint ventures Share of gross assets Share of gross liabilities Share of net assets HWU Other associates Other 9 10 11 3 281 982 1 781 871 – 24 4 069 365 – 23 3 445 365 12 Current assets Stocks and contracts in progress Debtors Outside the Group Group companies Investments Cash at bank and in hand 1 439 (995) 444 943 32 52 1 471 5 734 1 052 1 953 224 1 135 4 364 (3 216) 1 148 6 882 (266) (535) 6 081 134 208 9 847 4 791 5 989 92 6 081 821 (498) 323 725 98 20 1 166 3 818 940 1 726 331 1 097 4 094 (2 131) 1 963 5 781 (231) (635) 4 915 136 182 6 – 4 371 4 695 220 4 915 943 1 49 1 358 5 451 – 27 1 472 10 482 1 991 (1 215) (1 506) (730) 4 721 – (72) 4 649 134 208 9 708 3 590 4 649 4 649 520 58 17 960 4 428 – 79 624 12 308 1 023 (341) (1 816) (1 134) 3 294 – (105) 3 189 136 182 6 – 2 865 3 189 3 189 13 14 15 15 Creditors: amounts falling due within one year Outside the Group 16 Group companies Net current assets/(liabilities) Total assets less current liabilities Creditors: amounts falling due after more than one year Outside the Group 16 Provisions for liabilities and charges 17 Capital and reserves Called up share capital Share premium account Capital redemption reserve Revaluation reserve Profit and loss account Equity shareholders’ interest Minority interests 19 These accounts were approved by the Board of Directors on 12th June. W. 20x2. Watt } Directors 5/32 Edinburgh Business School Accounting .Module 5 / The Framework for Financial Reporting Balance Sheets 31st March.

20x2 20x2 £ million 20x1 £ million Increase/(decrease) in cash Cash inflow/(outflow) from investment in liquid resources Cash inflow/(outflow) from decrease in debt and lease financing Change in net monetary funds resulting from cash flows Net debt acquired with subsidiaries Finance leases of subsidiaries sold Effect of foreign exchange rate changes Movement in net monetary funds in the period Net monetary funds at 1st April Net monetary funds at 31st March 84 (138) (489) (543) (172) – 15 (700) 1 184 484 (24) 85 54 115 (5) 10 (22) 98 1 086 1 184 Net monetary funds comprise cash and liquid resources less bank borrowings. debentures and other loans including obligations under finance leases. 20x2 20x2 Note £ million 20x1 Restated £ million Net cash inflow from operating activities Dividends and management fees received from joint ventures and associates Net cash inflow from returns on investments and servicing of finance Tax paid Net cash outflow from capital expenditure and financial investment Net cash inflow/(outflow) from acquisitions and disposals Equity dividends paids to shareholders Cash inflow/(outflow) before use of liquid resources and financing Net cash inflow/(outflow) from management of liquid resources Net cash inflow/(outflow) from financing: Purchases of ordinary shares Other Increase/(decrease) in cash and net bank balances repayable on demand 20 21 21 21 21 775 438 25 (358) (286) (636) (218) (260) 138 (310) 516 84 853 125 32 (269) (242) 229 (339) 389 (85) (301) (27) (24) 21 21 Reconciliation of Net Cash Flow to Movement in Net Monetary Funds (Note 22) For the year ended 31st March. Accounting Edinburgh Business School 5/33 .Module 5 / The Framework for Financial Reporting Cash Flow Statement For the year ended 31st March.

20x2 20x2 Note £ million 20x1 Restated £ million Total recognised gains and losses Dividends Scrip dividend Issues of ordinary shares for cash Purchases of ordinary shares for cash Total movement in the year Shareholders’ funds at 1st April (restated) Shareholders’ funds at 31st March 7 1 925 (348) – 27 (310) 1 294 4 695 5 989 378 (311) 29 27 (301) (178) 4 873 4 695 Published shareholders’ funds at 1st April. these have been restated by £2 167 million for the reinstatement of purchased goodwill (Note 9) and by £19 million for the after-tax effect of the FRS 12 adjustment (Note 1). 5/34 Edinburgh Business School Accounting . 20x0 were £2 687 million. Reconciliation of Movements in Shareholders’ Funds For the year ended 31st March. 20x1 for the reinstatement of purchased goodwill amount to £2 101 million. 20x2 20x2 £ million 20x1 Restated £ million Profit on ordinary activities attributable to the shareholders Group Share of joint ventures Share of associates Surplus on valuation of listed fixed asset investments Exchange differences on translation Group Share of joint ventures Share of associates Total recognised gains and losses 947 67 40 1 054 847 36 3 (15) 24 1 925 318 46 145 509 – (75) (6) (50) (131) 378 Prior period adjustments since 1st April.Module 5 / The Framework for Financial Reporting Statement of Total Recognised Gains and Losses For the year ended 31st March.

it is appropriate to state the investment at its market value at the balance sheet date.7 pence to 23. gains less losses on disposals of subsidiaries and other fixed assets 775 Interest bearing assets and liabilities 67 Share of HWU interest 6 Unallocated net liabilities 1 504 20x1 Restated £ million 252 130 87 (30) 439 335 9 (137) 646 (51) 595 159 (12) 17 759 – Turnover 20x2 £ million 1 858 1 501 772 (41) 4 090 3 535 – 7 625 20x1 Restated £ million 1 715 1 277 826 (50) 3 768 3 003 394 7 165 Net assets at 31st March 20x2 20x1 Restated £ million £ million 503 449 192 30 1 174 320 – 3 538 5 032 397 345 207 28 977 188 8 1 883 3 056 943 32 725 98 20 74 26 879 610 (536) 6 081 1 381 (345) 4 915 Comparative figures have been restated to include the results of businesses which were sold in this and the previous financial year under the heading ‘Disposals’. represent continuing operations as defined in Financial Reporting Standard 3. Average numbers of employees.8 pence. including businesses sold. For the year to 31st March. accordingly. 20x1 the Group’s shareholding was 24 per cent. markets and net assets employed Analysis of results and net assets by classes of business Average number of employees 20x2 20x1 Restated 000s 000s 17 10 13 1 41 43 – 84 17 10 12 2 41 36 4 81 Profit 20x2 £ million Communications 295 Systems 151 Capital 78 Other (including intra-activity sales) (16) 508 Electronic Systems 432 Disposals – Goodwill (197) 743 Exceptional items continuing operations (Note 3) (96) 647 HW – before goodwill amortisation 58 – goodwill amortisation (16) Other associates 17 Operating profit 706 Separation costs (50) Exceptional items. 20x1 was £1 603 million (20x1 full year £3 618 million).Module 5 / The Framework for Financial Reporting Notes to the Accounts 1 Principal activities. profit contributions. The Directors have decided that. The contribution of subsidiaries acquired in the year ended 31st March. 20x2 was £610 million to turnover and £55 million to operating profit before exceptional items and goodwill amortisation. The adoption of FRS 12 has resulted in a charge of £27 million in exceptional items . All turnover and profit. 20x1 from 24. 20x1 the Company does not now believe that it exercises significant influence and. Accounting Edinburgh Business School 5/35 . turnover and net assets include the MBA share of joint ventures. An analysis of the amounts of profit. turnover and net assets included is given in Note 12. 20x1. profit. For the 6 months to 30th September. From the date of flotation to 30th September. 20x1 the results of HWU reflect the Group’s 50 per cent shareholding. 20x1 HWU is included as an associate and comparative figures have been restated accordingly. Sales of Group companies to joint ventures and associates amounted to £102 million (20x1 £162 million). 20x1 to its flotation on 28th June. This necessary reclassification results in a restatement of earnings per share before exceptional items and goodwill amortisation for the year ended 31st March.continuing operations in the year ended 31st March. The share of HWU turnover for the six months to 30th September. due to the treatment of exceptional items recorded by HWU last year. 20x2 and for the period from 1st April. Reporting Financial Performance. in order to reflect the value of this investment to the Company. Purchases from joint ventures and associates amounted to £54 million (20x1£85 million). After careful review of the Company’s actual involvement in HWU since 30th September. has treated HWU as a fixed asset investment from that date.

Asia and Australasia Goodwill 527 92 282 39 (197) 743 457 112 193 21 (137) 646 3 678 1 219 2 362 366 7 625 3 981 1 000 1 687 497 7 165 578 289 550 77 3 538 5 032 464 231 423 55 1 883 3 056 5/36 Edinburgh Business School Accounting . profit contributions. turnover and net assets by territory origin Profit 20x2 £ million 20x1 Restated £ million Turnover 20x2 £ million 20x1 Restated £ million Net assets at 31st March 20x2 20x1 Restated £ million £ million United Kingdom Rest of Europe The Americas Africa.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 1 Principal activities. markets and net assets employed continued Analysis of turnover by classees of business To customers in the United Kingdom 20x2 20x1 Restated £ million £ million To customers overseas 20x2 20x1 Restated £ million £ million Communications Systems Capital Electronic Systems Business disposals Other (including intra-activity sales) 795 49 495 1 269 – (59) 2 549 694 42 516 1 196 57 (96) 2 409 1 063 1 452 277 2 266 – 18 5 076 1 021 1 235 310 1 807 337 46 4 756 Analysis of turnover by territory of destination 20x2 £ million 20x1 Restated £ million United Kingdom Rest of Europe The Americas Africa. Asia and Australasia 2 549 1 777 2 399 900 7 625 2 409 1 656 1 733 1 367 7 165 Analysis of profit before exceptional items.

continuing operations 6 590 9 57 6 656 (284) 2 584 2 066 396 20 1 298 2 6 082 574 – 574 574 – 574 6 269 9 90 6 368 (5) 2 420 1 864 355 16 1 156 3 5 809 559 (26) 533 524 9 533 20x2 £ million 20x1 Restated £ million Restructuring and reorganisation costs For businesses acquired in the year Group Joint ventures Other businesses Group (restated to comply with FRS 12) Joint ventures Special costs Group Joint ventures Analysed between Communication Systems Capital Electronic Systems Other United Kingdom Rest of Europe The Americas Africa. Asia and Australasia 40 – 5 9 41 1 96 28 7 16 47 (2) 96 62 10 22 2 96 9 – 27 – 15 – 51 1 10 1 33 6 51 46 2 2 1 51 (b) Separation costs The costs of separating Electronic Systems include fees to professional advisors and the consequent cost of reorganisation of new MBA businesses.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 2 Group operating profit 20x2 £ million 20x1 Restated £ million Sales to customers outside the Group Own work capitalised Other operating income Increase in stocks of finished goods and work in progress Raw materials and consumables Staff costs (Note 27) Depreciation and amortisation Cost of hire of plant Other external and operating charges Auditors’ remuneration Operating profit arising in the Group Less management fees receivable from joint venture Retained businesses Disposals 3 (a) Exceptional items . Accounting Edinburgh Business School 5/37 .

deposits and investments. less interest payable 20x2 £ million 20x1 £ million Income from fixed asset investments Listed investments Unlisted investments Income receivable from current asset investments and cash Loans and deposits Listed investments Interest payable Bank loans and overdrafts Loan capital Other Finance leases 1 1 102 7 111 (42) (3) (12) – (57) 54 19 73 1 1 84 7 93 (18) (3) (7) (1) (29) 64 36 100 Share of net interest income receivable of joint ventures 5 Tax on profit on ordinary activities 20x2 £ million 20x1 Restated £ million United Kingdom taxation Corporation tax 31% (20x1 31%) Double tax relief Deferred taxation 30% (20x1 31%) Joint ventures and associates Overseas taxation Current Deferred taxation Joint ventures and associates Over provisions of previous years 463 (193) 15 10 295 127 – 35 162 (24) 433 155 (40) (17) 21 119 122 (4) 78 196 (4) 311 Tax on profit includes a charge of £135 million for profits on sale of subsidiaries and other fixed asset investments (20x1 credit £13 million).Module 5 / The Framework for Financial Reporting 3 Exceptional items . and a credit of £39 million for exceptional items – continuing operations and separation costs (20x1 credit £11 million). 5/38 Edinburgh Business School Accounting .continuing operations continued (c) Gains less losses on disposals of subsidiaries and other fixed assets 20x2 £ million 20x1 £ million Flotation of HWU Goodwill written off on disposal Other 944 (199) 745 30 775 – – – 20 20 4 Income from loans.

Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 6 Minority interests Minority interests represent the share of the profits less losses on ordinary activities after taxation attributable to the interests of equity shareholders in subsidiaries which are not wholly-owned by the Company or its subsidiaries. Previously reported operating profit for the year ended 31st March.1 509 51 (20) – (24) 149 665 18.6 million ordinary shares (20x1 restated 2 793.9 3.5 (28. This new policy has been applied retrospectively and prior year figures have been restated accordingly.9 27.8p per share (20x1 8. 20x1 Acquisitions Charged to profit and loss account At 31st March. 9 Goodwill Cost £ million Amortisation £ million Net book value £ million At 1st April. 20x1 as required by FRS 14.8 (0. as follows: 20x2 Earnings Earnings per share £ million pence 20x1 Earnings £ million Earnings per share pence Earnings and earnings per share 1 054 Exceptional items: Continuing operations 96 (Gains) less losses on disposals of subsidiaries and other fixed assets (775) Separation costs 50 Taxation arising on exceptional items (Note 5) 96 Goodwill amortisation 213 Earnings.3 million ordinary shares) in issue during the year. excluding exceptional items and goodwill amortisation. The restatement represents the identifiable goodwill previously written off including joint ventures and associates net of accumulated amortisation of £800 million and impairment of £55 million as at 1st April.4 23. calculated in accordance with FRS 14. and adjusted earnings per share 734 38.43p) Final proposed 8. 20x1 has been reduced by £149 million for the amortisation charge.8 Diluted earnings per share are calculated by reference to a weighted average of 2 738. Accounting Edinburgh Business School 5/39 .7 million ordinary shares (20x1 2 810. Therefore an adjusted earnings per share is presented. Previously all goodwill was written off to reserves on acquisition.9) 5. which have been adjusted following the exercise of the put warrants on 6th October. 20x2 2 690 1 689 – 4 379 (909) – (189) (1 098) 1 781 1 689 (189) 3 281 In accordance with FRS 10.5 7. purchased goodwill is now capitalised and amortised over its estimated useful life.7) – (0. non-operating exceptional gains and losses and goodwill amortisation do not relate to the profitability of the Group on an ongoing basis. 7 Dividends 20x2 £ million 20x1 £ million Interim 4. This includes the weighted average number of ordinary shares which would be issued on exercise of share options.5) 1. Exceptional costs charged against operating profit.00p) 112 236 348 93 218 311 8 Earnings per share Earnings per share are calculated by reference to a weighted average of 2 711. This has given rise to a restatement of the accumulated balance on retained profits of £2 167 million.8 3.20p per share (20x1 3. 20x0.4 million ordinary shares) in issue during the year.2 1.

20x1 Charged to profit and loss account Disposals Depreciation at 31st March. 20x2 138 Net book value at 31st March. 20x1 Additions Disposals Cost at 31st March. 20x2 Net book value at 31st March. 20x1 303 Company Cost at 1st April. on which the depreciation charge for the year was £2 million (20x1 £3 million). 5/40 Edinburgh Business School Accounting . tools and equipment – on average. fittings.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 10 Tangible fixed assets Fixtures fittings tools and equipment £ million Payments on account and assets under construction £ million Group Cost at 1st April. Depreciation rates: Freehold buildings – 2 per cent to 4 per cent per annum Leasehold property – over period of lease or 50 years for long leases Plant. 20x2 330 Net book value at 31st March. in excess of 10 per cent per annum. 20x1 135 Exchange rate adjustment 1 Charged to profit and loss account 17 Disposals (15) Businesses sold/transferred to joint ventures – Depreciation at 31st March. 20x2 468 Depreciation at 1st April. 20x2 Net book value at 31st March. machinery. fixtures. 20x1 Exchange rate adjustment Additions Businesses acquired Disposals Freehold property £ million Leasehold property Long Short £ million £ million Plant and machinery £ million Total £ million 438 5 30 26 (30) Businesses sold/transferred to joint ventures (1) Cost at 31st March. 20x1 25 – – 25 6 1 – 7 18 19 102 – – – – – 102 36 – 2 – – 38 64 66 41 1 9 15 (1) (16) 49 20 1 4 (1) (1) 23 26 21 993 6 118 30 (103) (120) 924 717 6 109 (103) (89) 640 284 276 640 7 117 9 (74) (26) 673 473 6 75 (68) (19) 467 206 167 38 1 33 3 – (3) 72 – – – – – – 72 38 2 252 20 307 83 (208) (166) 2 288 1 381 14 207 (187) (109) 1 306 982 871 – – – – – – – – – – 2 – – 2 – – – – 2 2 2 1 – 3 2 – – 2 1 – 5 2 (1) 6 3 1 (1) 3 3 2 – – – – – – – – – – 34 3 (1) 36 11 2 (1) 12 24 23 The net book value of tangible fixed assets of the Group includes an amount of £11 million (20x1 £21 million) in respect of assets held under finance leases. 20x2 Depreciation at 1st April.

20x1 Additions Disposals At 31st March. Company At 1st April. 20x1 Exchange rate and other adjustments Additions Disposals and repayments Reclassification Profits less losses retained Surplus on valuation of listed investments At 31st March. 20x2 Joint ventures and associates Other investments Shares Shares Cost Provisions Cost Provisions £ million £ million £ million £ million Total £ million 944 (310) (267) – 367 (1) – – – (1) 55 (37) 267 708 993 (38) 37 – – (1) 960 (310) – 708 1 358 Accounting Edinburgh Business School 5/41 . 20x2 Provisions £ million £ million 865 – 58 (442) (217) – – 264 279 (12) – 161 89 (332) – 185 2 – 25 – – – – 27 59 – – (37) 128 – 847 997 (39) – – 37 – – – (2) 1 166 (12) 83 (281) – (332) 847 1 471 The investment in joint ventures and associates includes capitalised goodwill of £257 million (20x1 £114 million).Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 11 Fixed assets investments – shares in Group companies At cost £ million Provisions £ million Net book value £ million At 1st April. 20x1 Disposals and repayments Reclassification Surplus on valuation of listed investments At 31st March. 20x2 3 456 1 189 (565) 4 080 (11) – – (11) 3 445 1 189 (565) 4 069 12 Fixed assets investments – joint ventures. associates and other Joint ventures and associates Shares Share Loans Cost less of post amounts acquisition written-off reserves £ million £ million £ million Other investments Cost or valuation £ million Total Group At 1st April.

as follows: 20x2 £ million HWU – listed overseas Other investments – listed overseas 943 49 No provision has been made for taxation of £95 million which could arise if these investments were realised at the values stated. Share of summarised balance sheets of joint ventures (20x2 and 20x1) and HWU (20x1). profits less losses and goodwill attributable to the Group’s interest retained by joint ventures and associates.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 12 Fixed assets investments – joint ventures. 20x2 Joint ventures £ million 20x1 Joint ventures £ million HWU £ million Goodwill Other fixed assets Current assets Stocks and contracts in progress Debtors Current asset investments and cash Liabilities falling due within one year Payments received in advance Creditors Bank and other loans Liabilities falling due after more than one year Accrued contract costs and provisions Bank and other loans Minority interests Shareholders’ funds 257 156 362 482 182 (315) (442) (108) (130) – – 444 103 119 166 246 187 (147) (288) (5) (52) (6) – 323 206 767 1 455 2 612 539 (2 287) (1 349) (85) (1 046) (58) (29) 725 5/42 Edinburgh Business School Accounting . associates and other continued Turnover. 20x2 £ million HWU £ million 20x1 Other £ million Total £ million Turnover Profit on ordinary activities before tax Operating profit after exceptional items and goodwill amortisation Non-operating exceptional items Net interest income receivable Management fees payable to shareholders Taxation Profit on ordinary activities after tax Paid in dividends [nil from listed companies (20x1 £114 000)] Joint ventures Associates 1 293 3 618 1 214 4 832 90 – 13 – 103 (25) 78 (30) (3) 45 147 28 26 (26) 175 (67) 108 79 – 10 – 89 (32) 57 226 28 36 (26) 264 (99) 165 (96) (3) 66 Market values Listed fixed asset investments are stated at market value.

Asia and Australasia Goodwill 25 66 (8) 83 (10) 13 – 86 43 47 – 1 (8) 83 33 36 (7) 62 – 10 – 72 40 28 – 1 (7) 62 301 734 1 035 328 568 896 73 17 257 347 74 23 444 62 (16) 103 149 176 (2) 323 24 21 1 – 103 149 539 470 2 24 1 035 559 319 – 18 896 89 – – 1 257 347 13 Stocks and contracts in progress Group 20x2 £ million 20x1 £ million Company 20x2 20x1 £ million £ million Raw materials and bought-out components Work in progress Payments on account Long-term contract work in progress Payments on account Finished goods 212 257 (57) 1 496 (1 082) 226 1 052 167 270 (78) 1 127 (777) 231 940 – – – – – – – – – – – – – – Accounting Edinburgh Business School 5/43 . associates and other continued Information on the Group interest in joint ventures included in Note 1 is as follows: Profit 20x2 £ million 20x1 £ million Turnover 20x2 £ million 20x1 £ million Net assets at 31st March 20x2 20x1 £ million £ million By classes of business Capital Electronic Systems Goodwill Exceptional items – continuing operations Interest bearing assets and liabilities Unallocated net assets/(liabilities) By territory of origin United Kingdom Rest of Europe The Americas Africa.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 12 Fixed assets investments – joint ventures.

Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 14 Debtors Group 20x2 £ million 20x1 £ million Company 20x2 20x1 £ million £ million Amounts falling due within one year Trade debtors Amounts recoverable on contracts Corporation tax recoverable Amounts owed by joint ventures and associates Other debtors Prepayments and accrued income 1 434 111 65 52 92 81 1 835 1 183 95 51 68 68 74 1 539 2 – – 1 4 9 16 2 – – 1 5 11 19 Amounts falling due after more than one year Trade debtors Amounts recoverable on contracts Advance corporation tax recoverable Other debtors Prepayments and accrued income Deferred taxation (Note 18) 20 1 – 38 5 54 118 1 953 21 19 55 4 2 86 187 1 726 – – – – – 11 11 27 – – 55 – – 5 60 79 15 Current asset investments and cash at bank and in hand Group 20x2 £ million 20x1 £ million Company 20x2 20x1 £ million £ million Dated securities at market value Listed overseas – cost £106 million (20x1 £112 million) 110 Other securities 104 Other investments at lower of cost and market value Listed in the United Kingdom – market value £10 million (20x1 £12 million) 10 Investments 224 Cash at bank and in hand 1 135 1 359 Divided between Cash and bank deposits repayable on demand (Note 32) 265 Liquid resources (Note 32) 1 094 1 359 117 202 12 331 1 097 1 428 218 1 210 1 428 – – 10 10 482 492 37 455 492 – – 12 12 308 320 4 316 320 5/44 Edinburgh Business School Accounting .

Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 16 Creditors Group 20x2 £ million 20x1 £ million Company 20x2 20x1 £ million £ million Amounts falling due within one year Bank loans and overdrafts Repayable on demand Other Debenture loans Obligations under finance leases Payments received in advanced Trade creditors Owed to joint ventures and associates Taxation on profit Advance corporation tax on accrued dividend Other taxation and social security Other creditors Accruals and deferred income Proposed dividend Amounts falling due after more than one year Bank loans Debenture loans Obligations under finance leases Payments received in advance Trade creditors Other creditors 40 761 15 – 816 408 728 106 33 – 91 215 471 348 3 216 – 56 3 59 102 2 103 266 81 94 10 4 189 338 698 22 34 55 78 133 366 218 2 131 5 50 – 55 105 2 69 231 – 644 4 – 648 – 3 78 24 – – 105 9 348 1 215 – – – – – – – – 1 – 4 – 5 – 2 9 27 55 1 13 11 218 341 – – – – – – – – Accounting Edinburgh Business School 5/45 .

8 per cent) Total amount Instalments due after five years 801 38 33 3 875 (816) 59 180 32 28 4 244 (189) 55 644 – 4 – 648 (648) – 1 – 4 – 5 (5) – – 8 34 17 59 45 5 5 26 19 55 27 – – – – – 4 – – – – – 4 26 17 33 19 – – – – Maturiry of financial liabilities The maturity of the Group’s financial liabilities at 31st March. an analysis of which is shown in Note 32. or on demand 816 In more than one year but not more than two years 54 In more than two years but not more than five years 81 In more than five years 28 979 Borrowing facilities The Group has various undrawn committed borrowing facilities. was as follows: In one year or less. The undrawn facilities available at 31st March. 20x2 were: Expiring in one year or less 1 020 Expiring in more than one year but not more than two years – Expiring in more than two years but not more than five years 2 396 3 416 5/46 Edinburgh Business School Accounting . 20x2.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 16 Creditors continued Group 20x2 £ million 20x1 £ million Company 20x2 20x1 £ million £ million Bank loans and overdrafts Unsecured Debenture loans Secured against assets Unsecured Obligations under finance leases (Note 32) Less amounts falling due within one year Amounts falling due after more than one year Analysis of repayments of loans and debentures Bank loans Between one and two years Debenture and other loans Between one and two years Between two and five years In more than five years Debenture loans Repayable at par wholly within five years (average rate 4.5 per cent) Repayable at par partly or wholly after five years mainly by instalments (average rate 3.

20x1 Business acquired//transferred to joint ventures Credited/(charged) to profit and loss account At 31st March. 20x2 126 – 12 (1) 42 (29) (53) 97 509 1 61 (29) 178 (125) (157) 438 635 1 73 (30) 220 (154) (210) 535 105 – – – 1 – (34) 72 Other provisions of the Group and total provisions of the Company mainly comprise expected cost of maintenance under guarantees. Accounting Edinburgh Business School 5/47 . 18 Deferred taxation assets Group £ million Company £ million At 1st April. other work in respect of products delivered. losses on contract work in progress. pensions and other post retirement benefits. 20x1 Exchange rate adjustment Additions Disposals/transferred to joint ventures Charged Released Spent against existing provisions At 31st March.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 17 Provisions for liabilities and charges Restructuring £ million Other £ million Group total £ million Company total £ million At 1st April. 20x2 86 (14) (18) 54 5 – 6 11 Note a Deferred tax asset balances are included in debtors – Note 14. b Deferred taxation assets/(liabilities) Group 20x2 £ million 20x1 £ million Company 20x2 20x1 £ million £ million Tax effect of timing differences on: Provisions and accruals for liabilities and income Accelerated capital allowances 50 4 54 83 3 86 11 – 11 5 – 5 c No provision is made for any taxation which might arise if reserves of overseas subsidiaries were distributed as such distributions are not expected to occur in the foreseeable future.

20x1 Shares allotted under the MBA Employee 1992 Savings-related Share Option Scheme Shares allotted under the MBA Managers’ 1984 Share Option Scheme Shares allotted under the MBA 1997 Executive Share Option Scheme Less: Shares purchased for cancellation Shares allotted at 31st March. 20x2. 20x1 Cancellation of shares purchased At 31st March. The Directors’ interests as defined by the Companies Act 1985 (which include trustee holdings and family interests incorporating holdings of infant children) in shares of the Company and its subsidiaries are as set out in the Report to the Shareholders by the board on Directors’ Remuneration [not reproduced here]. 20x2 Revaluation Reserve Group £ million Company £ million Number of shares £ 2 721 204 288 5 600 540 4 665 250 163 648 (54 328 160) 2 677 305 566 136 060 214 280 027 233 263 8 182 (2 716 408) 133 865 278 41 134 722 175 000 000 £ million 182 26 208 £ million 6 3 9 Added in the year At 31st March. 20x1 Added in the year At 31st March. The profit of the Company for the financial year amounted to £1 380 million (20x1 £281 million). 20x2 options had been granted and were still outstanding in respect of the Company’s ordinary shares of 5p under the Company’s options schemes: Number of shares Amount of shares £ million Subscription price Date normally exercisable The MBA Employee 1992 Savings-related Share Option Scheme The MBA Managers’ 1984 Share Option Scheme The MBA 1997 Executive Share Option Scheme 38 711 006 7 332 800 33 578 692 1.4 1. 20x2 Unissued ordinary shares Authorised Share premium account At 1st April.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 19 Equity shareholders’ interest Share capital Fully paid ordinary shares of 5p each Shares allotted at 1st April. Pursuant to Section 230 of the Companies Act 1985 the Company is not presenting its own profit and loss account in addition to the consolidated profit and loss account on page 5/31. being the Group’s share of reserves held by joint ventures and associates. 20x2 Profit and loss account Group 20x2 £ million 20x1 £ million 847 847 708 708 Company 20x2 20x1 £ million £ million At 1st April 4 371 4 576 2 865 3 168 Added/(deducted) in the year 420 (205) 725 (303) At 31st March 4 791 4 371 3 590 2 865 Note At 31st March. 20x2 Capital redemption reserve At 1st April.7 222 – 337p 182 – 328p 404 – 553p 20x2 – 20x6 20x2 – 20x7 20x3 – 20x9 £185 million (20x1 £279 million) of the Group’s balance on profit and loss account is not available for distribution at 31st March. 5/48 Edinburgh Business School Accounting .9 0.

deposits and investments Interest paid Dividends paid to minority shareholders in subsidiaries Net cash inflow from returns on investments and servicing of finance Tax paid UK corporation tax paid Overseas tax paid Tax paid Capital expenditure and financial investment Purchases of tangible fixed assets Purchases less sales of fixed asset investments Sales of tangible fixed assets Net cash outflow from capital expenditure and financial investment Acquisitions and disposals Investments in subsidiary companies (Note 23) Net cash/(overdrafts) acquired with subsidiaries Investments in joint ventures and associates (Note 24) Net overdrafts transferred to joint ventures and associates Sales of interests in subsidiaries and associates (Note 25) Net (cash)/overdrafts disposed of with subsidiaries Net cash inflow/(outflow) from acquisitions and disposals Management of liquid resource – comprising term deposits generally of less than one year and other readily disposable current asset investments Deposits made with banks and similar financial institutions Deposits withdrawn from banks and similar financial institutions Purchases of Government and similar securities Sales of Government and similar securities Purchases of securities issued by banks and other corporate bodies Sales of securities issued by banks and other corporate bodies Net cash inflow/(outflow) from management of liquid resources Financing – other Issues of ordinary shares Increases/(decreases) in bank loans Increases/(decreases) in debenture loans Capital element of finance lease repayments Net cash inflow/(outflow) from financing – other 113 (59) (29) 25 (264) (94) (358) (307) – 21 (286) (1 707) 4 – 17 1 050 – (636) 93 (33) (28) 32 (138) (131) (269) (290) (1) 49 (242) (64) 8 (1) – 305 (19) 229 (5 455) 5 547 (13) 23 (145) 181 138 27 657 (164) (4) 516 (5 451) 5 369 (16) 61 (195) 147 (85) 27 (41) (3) (10) (27) Accounting Edinburgh Business School 5/49 .Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 20 Net cash inflow from operating activities 20x2 £ million 20x1 Restated £ million Group operating profit Depreciation charge Goodwill amortisation (Increase)/decrease in stocks (Increase)/decrease in debtors Increase in creditors Increase/(decrease) in payments received in advance (Decrease)/increase in provisions 574 207 189 (111) (133) 133 60 (144) 775 533 225 130 40 (61) 146 (80) (80) 853 21 Analysis of cash flows shown net in the cash flow statement 20x2 £ million 20x1 £ million Returns on investments and servicing of finance Income received from loans.

Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 22 Analysis of net monetary funds Acquisitions/ disposals (excluding cash and overdrafts) £ million At 1st April 20x1 £ million Cash flow £ million Exchange rate adjustment £ million At 31st March 20x2 £ million Cash at bank and in hand Overdrafts 218 (81) 42 42 84 (138) 3 5 (1) 265 (40) Liquid resources Amounts falling due within one year Bank loans Debenture loans Finance leases Amounts falling due after more than one year Bank loans Debenture loans Finance leases 1 210 19 1 094 (94) (10) (4) (5) (50) – 1 184 (662) 3 3 5 161 1 (489) (543) – (8) – – (165) (2) (172) (5) – 1 – (2) (2) 15 (761) (15) – – (56) (3) 484 23 Investments in subsidiary companies 20x2 £ million 20x1 £ million Net assets acquired Tangible fixed assets Investments Inventory Debtors Cash at bank and in hand Liquid resources Bank overdrafts Creditors and provisions Taxation Loan capital Minority interests Goodwill. including minority share Purchase consideration Accounted for by Cash subscribed (Note 21) Deferred consideration Investments in joint ventures and associates reclassified 83 1 115 202 16 3 (12) (307) (9) (175) 113 30 1 689 1 719 1 707 6 6 1 719 20 – 21 25 8 – – (61) – (5) (7) 1 66 67 64 (6) 9 67 5/50 Edinburgh Business School Accounting .

Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 24 Investments in joint ventures and associates 20x2 £ million 20x1 £ million Net assets acquired Tangible fixed assets Inventory Debtors Cash at bank and in hand Bank overdrafts Creditors and provisions Cash subscribed (Note 21) Share of equity acquired Accruals at 1st April Accruals at 31st March Purchase consideration 52 128 61 50 (67) (166) 58 – 58 (6) 6 58 – – – – – – – 1 – (6) 6 1 25 Sales of interests in subsidiaries and associates 20x2 £ million 20x1 £ million Net assets disposed of Tangible fixed assets Investment in associates Other fixed asset investments Inventory Debtors Cash at bank and in hand Bank overdrafts Creditors and provisions Finance leases Goodwill Profit/(loss) Consideration Creditors and provisions at 1st April Creditors and provisions at 31st March 5 69 – 2 2 – – (2) – 199 275 775 1 050 (25) 25 1 050 193 8 5 86 91 23 (4) (104) (10) 17 305 (8) 297 (17) 25 305 Accounting Edinburgh Business School 5/51 .

acquisitions were made and accounted for using the acquisition method. Certain fair value adjustments at 31st March.3 11. The results of Co.7 26. 20x0 was US$101.9 million. A Fair value Book value adjustments Fair value £ million £ million £ million 1 719 30 1 689 58 (104) 162 1 777 (74) 1 851 At book and fair value Co.7 5/52 Edinburgh Business School Accounting . There were no other material adjustments to book values of subsidiaries acquired. B £ million Other £ million Total £ million Tangible fixed assets Investments Inventory Debtors Cash at bank and in hand/(overdrafts) Liquid resources Creditors and provisions Loan capital Taxation Minority interests 74 7 92 133 (3) – (103) (166) 15 – 49 (6) (6) (7) (4) – – (151) – (19) – (193) 68 1 85 129 (3) – (254) (166) (4) – (144) – – – – – – – – – 111 111 15 – 30 73 7 3 (53) (9) (5) 2 63 83 1 115 202 4 3 (307) (175) (9) 113 30 The fair value adjustments on Co. income tax and extraordinary items Net income Net income for the year ended 31st December. A mainly relate to revenue recognition on long-term contracts. contract loss provisions and accrued costs. 20x1 were as follows: US$ million Net sales Earnings before interest. Subsidiaries £ million Joint ventures and associates £ million Total £ million Purchase considerations Fair value of net tangible assets acquired Goodwill arising in the Group Analysis of tangible assets of subsidiaries acquired Acquisition of Co. A on a US GAAP basis for the three months from 1st January. 290. 20x1 to 31st March. 20x2 were provisional. deferred tax debit balances.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 26 Goodwill Goodwill arising on acquisitions: During the year.

Three Directors were members of defined contribution schemes and other benefits include the payment of a non-pensionable earnings supplement in relation to their membership of these schemes. 20x2. bonuses and other remuneration payable to Directors include £1 085 000 (20x1 £904 000) in respect of the highest paid Director.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 27 Directors and employees 20x2 20x1 a Average number of employees working in the United Kingdom Gross remuneration State social security costs Other pension costs b Average number of employees working overseas Gross remuneration State social security costs Other pension costs c Average total number of employees Gross remuneration State social security costs Other pension costs 38 872 £938 million £89 million £41 million 35 381 £880 million £99 million £19 million 74 253 million million million million 44 323 £976 million £91 million £42 million 27 640 £653 million £86 million £16 million 71 963 £1 629 million £177 million £58 million £1 864 million £1 818 £188 £60 £2 066 d Summary of Directors’ remuneration 20x2 20x1 Salaries and fees Other benefits Bonuses Gains made on exercise of share options Pension contributions. £000 2 823 511 1 237 4 571 121 735 – 5 427 £000 2 861 392 804 4 057 137 510 390 5 094 During the year. Pension contributions include £182 000 (20x1 £183 000) for the highest paid Director. Accounting Edinburgh Business School 5/53 . 6 Directors (20x1 7 Directors) were accruing benefits under the MBA 1972 Plan and 2 Directors (20x1 4 Directors) were members of the Selected Benefit Scheme. of which £642 000 (20x1 £330 000) relate to defined contribution schemes Compensation for loss of office Total Salaries and fees include £193 000 (20x1 £133 000) in respect of fees. other benefits. At 31st March. The total salaries. the highest paid Director was entitled to an accrued pension of £4000 per annum (20x1 £2000) and an accrued lump sum of £1 495 000 (20x1 £1 185 000) on retirement.

The provision in the balance sheet which resulted from the difference between the pension cost charge and contributions amounted to £26 million (20x1 £29 million). the MBA 1972 Plan (‘the Plan’) covers nearly 86 per cent of employees who are members of pension plans in the UK and 49 per cent of worldwide scheme members. using the ‘projected unit’ method. 20x1. health care costs after retirement charged to the provision amounted to £5 million (20x1 £5 million) and the retranslation for exchange movements increased the provision by £1 million (20x1 £2 million decrease). including a charge of £23 million in non-operating exceptional items).75 per cent per annum and State pensions by 4. The liability was increased in 20x2 by £6 million for a business acquired.0 per cent per annum. The principal pension scheme. the Company’s contribution rate could be reduced from the long-term annual rate of 7.6 per cent of pensionable earnings with effect from 6th April.1 per cent to 6. The Plan was last valued by the Scheme Actuary as at 5th April 20x0. Total pension costs for other pension plans. As a result. The schemes are unfunded. the provision at 31st March. The main financial assumptions for the future were that the return on investments would be 8. representing surpluses in overseas funds. 6004 employees (20x1 5650 employees) and 4233 retired employees (20x1 3215 retired employees) of companies in the United States of America and Canada were entitled to health care benefits after retirement.25 per cent per annum. amounted to £6 million (£8 million) and provisions for unfunded liabilities amounted to £24 million (20x1 £19 million). Benefits are primarily of the ‘defined benefit’ type. that present and future pensions would increase at the rate of 3. 30 Contingent liabilities Group 20x2 £ million 20x1 £ million Company 20x2 20x1 £ million £ million At 31st March 25 15 10 – Contingent liabilities relate mainly to the cost of legal proceedings. charged to the profit and loss account amounted to £19 million (20x1 £20 million). mainly overseas.0 per cent per annum.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 28 Pensions Pension plan assets are held in trustee-administered funds independent of the Group’s finances. During the year. that equity dividends would increase in the long-term by 4. 20x2 amounted to £41 million (20x1 £38 million). taking account of members’ contributions of 3 per cent and the residual surplus. which in the opinion of the Directors. The actuary advised that. The market value of the assets was £4 715 million at the valuation date. prepayments. 29 Post retirement benefits other than pensions At 31st March. The accumulated assets of the Plan were sufficient to finance 101 per cent of the past service liabilities including provision for future inflation. the benefits cost charge was £2 million (20x1 £17 million. included in debtors.5 per cent per annum. The pension cost charge to the profit and loss account for the Plan for the year ended 31st March. that increases in pensionable earnings due to inflation would average 6. are not expected to have a materially adverse effect on the Group. The benefit cost charges and provisions for the liability included in the accounts are determined by a qualified independent actuary. 5/54 Edinburgh Business School Accounting . 20x2 was £81 million (20x1 £77 million). 20x2.

8 million for professional advice on acquisitions. disposals and capital restructuring.8 million (20x1 £1. Accounting Edinburgh Business School 5/55 .Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 31 Other information Group 20x2 £ million 20x1 £ million Company 20x2 20x1 £ million £ million Capital expenditure commitments contracted at 31st March Operating lease charges in the year Land and buildings Other items 69 47 22 9 31 – 2 – 2 – 1 – 1 34 12 46 Amounts payable under operating leases which fall due in the next financial year Land and buildings.1 million) including £2. leases expiring: Within one year 2 Between two and five years 13 After five years 2 69 6 8 9 1 7 1 32 2 – – – – – 2 2 – – – – – 2 Non audit fees worldwide to the Group auditors amounted to £7. leases expiring: Within one year 7 Between two and five years 25 After five years 20 Other items.

9 3.4 Financial liabilities After taking into account interest rate swaps and forward currency contracts. the interest rate profile of the Group’s financial assets at 31st March. 20x2 is shown in Note 16.8 – 9.0 8.7 1.0 1.5 2.3 * 1. the interest rate profile of the Group’s financial liabilities at 31st March.5 2. 5/56 Edinburgh Business School Accounting .8 3.4 1.4 2.5 2.2 2.3 0.4 2.4 0. * As stated on page 28 (not reproduced).0 5.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 32 Financial instruments Treasury policy and the Group’s use of financial instruments are dealt with in the Finance Director’s Review [not reproduced here]. 20x1 are not disclosed since it is impracticable to do so.0 3.1 5.7 5. a Currency and interest rate risk profile of financial assets and financial liabilities Financial assets After taking into account interest rate swaps and forward currency contracts.5 2.0 Floating rate borrowings and assets bear interest based on relevant national LIBOR equivalents.5 0. The maturity profile of the Group’s financial liabilities at 31st March.3 3. 20x2 was: Fixed rated Non-interest Non-interest Average Weighted bearing Total Floating rate Fixed rate bearing interest rate period weighted average £ million £ million £ million £ million % years period – years Sterling US Dollars Euro Other Total Borrowings (Note 16) Long-term trade creditors 96 681 153 49 979 875 104 979 6 53 101 34 194 194 – 194 – 623 45 13 681 681 – 681 90 5 7 2 104 – 104 104 – 5. comparative figures for the year ended 31st March.8 5. As permitted by FRS 13. 20x2 was: Fixed rated Non-interest Non-interest Average Weighted bearing Total Floating rate Fixed rate bearing interest rate period weighted average £ million £ million £ million £ million % years period – years Sterling US Dollars Euro Other Total Liquid resources (Note 15) Cash at bank and in hand (Note 15) Long-term trade debtors and amounts recoverable on contracts 764 261 227 128 1 380 1 094 265 21 1 380 78 89 149 54 370 197 173 – 370 683 158 75 73 989 897 92 – 989 3 14 3 1 21 – – 21 21 5. interest rate swaps in a principal amount of US$1000 million have been used to manage the Group’s exposure to fluctuations in interest rates on US dollar borrowings.9 6.0 1.

20x2 were: Book value £ million Fair value £ million Short-term financial liabilities and current portion of long-term borrowings Long-term borrowings Financial assets Interest rate swaps Forward foreign currency contracts Currency swaps (816) (163) 1 380 (10) – – (816) (155) 1 378 (10) 1 – The fair values of the interest rate swaps and forward foreign currency contracts have been determined by reference to prices available from the markets on which the instruments involved are traded. were: Net foreign currency monetary assets/(liabilities) Sterling US Dollars Euro Other Total £ million £ million £ million £ million £ million Functional currency of Group operation Sterling US Dollars Euro Other Total – 53 53 180 286 44 – (29) 27 42 50 – – 1 51 (23) – (1) – (24) 71 53 23 208 355 The Group’s net monetary funds and net assets by currency at 31st March. 20x2. after taking into account the effects of currency swaps and forward foreign exchange contracts. 20x2 were: Net assets before net monetary funds £ million Net monetary funds £ million Net assets £ million Sterling US Dollars Euro Other 4 034 773 599 191 5 597 (79) 199 50 314 484 3 955 972 649 505 6 081 c Fair values of financial assets and financial liabilities The book values and fair values of the Group’s financial assets and liabilities at 31st March.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 32 Financial instruments continued b Currency exposures At 31st March. Accounting Edinburgh Business School 5/57 . Other fair values have been calculated by discounting cash flows at prevailing interest rates. the Group’s currency exposures excluding borrowings treated as hedges.

33 Post Balance Sheet events In April.2 billion.1 billion and agreement for the acquisition of D Systems. £6 million of the gains and £4 million of the losses are expected to be recognised in the profit and loss account for the year ending 31st March. net of cash. the Group completed a further committed credit facility of Euro 2. 20x2. including assumed debt. It is impracticable to disclose the amount of the net gains or losses not recognised at 31st March.20x2. unrecognised cumulative aggregate gains and losses on financial assets and liabilities for which hedge accounting has been used amounted to £11 million for gains and £10 million for losses. 20x2 the Group announced the acquisition of C Corporation for a total consideration. It also uses interest rate swaps to manage its interest rate profile. On 4th June. of US$4. At 31st March. of US$2. 5/58 Edinburgh Business School Accounting .5 billion with a syndicate of relationship bankers. for a consideration.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 32 Financial instruments continued d Gains and losses on hedges The Group enters into forward foreign exchange contracts to eliminate the currency exposures arising on sales and purchases denominated in foreign currencies as soon as there is a firm contractual commitment. 20x1 which were dealt with in the profit and loss account for the year ended 31st March. Inc. 20x3.

60p 9. earnings per share and goodwill for 20x1 have been restated in accordance with FRS 10 to reflect historical purchased goodwill on the Balance Sheet and to amortise it through the profit and loss account.4p 348 311 365 345 312 296 281 260 250 249 13.8p 19.51p 11.7p 19. less bank borrowings.8p 19.6p 20.37p 10.1p 23.0p 11.9p 20.6p 22.7p 18. debentures and other loans including obligations under finance leases.4p 25.43p 13.25p 706 198 62 278 252 244 255 277 247 433 3 281 1 781 – – – – – – – – 982 871 1 049 1 122 913 919 926 953 999 1080 1 471 1 166 870 988 977 980 970 802 769 718 1 052 940 1 114 1 197 1 175 1 149 1 195 1 223 1 362 1 504 1 953 1 726 1 744 1 910 1 752 1 681 1 572 1 507 1 663 1 847 484 1 184 1 086 1 152 1 323 1 352 1 216 801 377 396 9 223 7 668 5 863 6 369 6 140 6 081 5 879 5 286 5 170 5 545 (3 142) (2 753) (2 988) (3 048) (2 546) (2 495) (2 510) (2 303) (2 442) (2 981) 6 081 4 915 2 875 3 321 3 594 3 586 3 369 2 983 2 728 2 564 5 989 92 6 081 4 695 220 4 915 2 687 188 2 875 3 112 209 3 321 3 348 246 3 594 3 328 258 3 586 3 101 268 3 369 2 712 271 2 983 2 484 244 2 728 2 328 236 2 564 * Net cash in the Group consists of cash.6p 20. bank balances and short-term investments.2p 38. Accounting Edinburgh Business School 5/59 .82p 10.15p 12.6p 19.30p 9.6p 19.25p 9.2p 15.9p 18.4p 22. Profit before taxation for 20x0 and 20x1 has been restated in accordance with FRS 12 for provisions originally charged in 19x9/20x0 and restated to 20x0/20x1. described as ‘net monetary funds’ in the accounts.6p 18.9p 18.8p 23.Module 5 / The Framework for Financial Reporting Statistical Information 19x3/20x2 20x2 £m Sales – subsidiaries and share of joint ventures Profit before taxation Excluding exceptional items and goodwill amortisation Total Earnings per share Excluding exceptional items and goodwill amortisation Total Ordinary dividends per share Profit retained Goodwill Fixed assets Investments Inventories Debtors Net cash in the Group* Liabilities Financed by Shareholders’ interest Minority interests 7 625 20x1 £m 7 165 20x0 £m 7 430 19x9 £m 7 040 19x8 £m 6 552 19x7 £m 6 513 19x6 £m 6 284 19x5 £m 6 403 19x4 £m 6 569 19x3 £m 5 807 1 088 1 504 1 059 879 1 010 734 1 004 981 907 891 866 866 863 863 829 863 818 812 872 1 036 27. Profit before taxation. Note Earnings per share figures for 20x1 have been restated in accordance with FRS 14 for the impact of the free put warrant issue in 20x2.

20x2 Record date for the final dividend. 12th July.4 0.0 76. 5/60 Edinburgh Business School Accounting .3 90. 6th August. 20x2 Annual General Meeting. 20x2 Annual Report and Accounts or Summary Financial Statement and letter from the Chairman to shareholders.4 3.7 1.3 100.0 * at 31st March.5 59. 16th July. 20th August. 20x2 Preliminary Statement published including proposed final dividend for the year ended 31st March. 20x2 6th July.0 203 650 187 8 687 749 2 429 034 531 35 933 099 2 677 305 566 7.9 10.2 0.4 100.7 2.9 100.2 0. 20x2 Ordinary shares first quoted ‘ex-dividend’.2 0.7 5.1 35.3 0.Module 5 / The Framework for Financial Reporting Information to Shareholders Shareholder Analysis Number of holders Percentage of total holders Number of shares Percentage of issued capital Classification of shareholders* 30 473 416 116 430 (Nominee holdings have been included under Institutions/Companies) Individuals United Kingdom Foreign Institutions/Companies United Kingdom Foreign 82 012 3 529 70.8 3.6 0.0 184 679 25 269 134 285 314 498 76 107 963 100 334 204 132 584 392 2 057 510 696 2 677 305 566 – 0. 20x2 Financial Calendar 10th June.4 100.0 26.0 Shareholder Range 1– 101 – 1 001 – 100 001 – 250 001 – 500 001 – 1 000 001 – 100 1 000 100 000 250 000 500 000 1 000 000 and over 4 770 41 386 69 002 475 275 187 335 116 430 4. 20x2 Payment of final dividend.

2: Extract from Award Annual Report 20x2 Accounting Edinburgh Business School 5/61 .Module 5 / The Framework for Financial Reporting Appendix 5.

RS&T Chartered Accountants and Registered Auditors Edinburgh 22 March 20x2 5/62 Edinburgh Business School Accounting . We read the other information contained in the Annual Report and consider whether it is consistent with the audited accounts. An audit includes examination. Our responsibilities. Auditors’ report to the members of The Award Group PLC We have audited the accounts on pages 5/63 to 5/84 which have been prepared under the historical cost convention as modified by the revaluation of certain fixed assets and on the basis of the accounting policies set out on pages 5/63 and 5/64 . In preparing those accounts. They are also responsible for safeguarding the assets of the company and hence for taking any reasonable steps for the prevention and detection of fraud and other irregularities. and of whether the accounting policies are appropriate to the group’s circumstances. We review whether the statement [not reproduced here] reflects the company’s compliance with those provisions of the Combined Code specified for our review by the Stock Exchange. We also report to you if. of evidence relevant to the amounts and disclosures in the accounts. are established by statute.Module 5 / The Framework for Financial Reporting Directors’ responsibilities Company law requires the directors to prepare accounts for each financial period which give a true and fair view of the state of affairs of the company and of the group and of the profit or loss of the group for the period. if the company has not kept proper accounting records. on a test basis. make judgements and estimates that are reasonable and prudent. as independent auditors. and we report if it does not. in our opinion. the Auditing Practices Board. We planned and performed our audit so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the accounts are free from material misstatement. or if the information specified by law or the Listing Rules regarding directors’ remuneration and transactions with the company is not disclosed. the accounts. We consider the implications for our report if we become aware of any apparent misstatements or material inconsistencies with the accounts. It also includes an assessment of the significant estimates and judgements made by the directors in the preparation of the accounts. and state whether or not applicable accounting standards have been followed. Basis of audit opinion We conducted our audit in accordance with Auditing Standards issued by the Auditing Practices Board. The directors are responsible for keeping proper accounting records which disclose with reasonable accuracy at any time the financial position of the group and which enable them to ensure that the accounts comply with the Companies Act 1985. consistently applied and adequately disclosed. In forming our opinion we also evaluated the overall adequacy of the presentation of information in the accounts. the directors’ report is not consistent with the accounts. Opinion In our opinion the accounts give a true and fair view of the state of affairs of the company and of the group as at 1st January 20x2 and of the profit of the group for the 53 weeks then ended and have been properly prepared in accordance with the Companies Act 1985. the directors are required to select suftable accounting policies and then apply them consistently. if we have not received all the information and explanations we require for our audit. whether caused by fraud or other irregularity or error. We report to you our opinion as to whether the accounts give a true and fair view and are properly prepared in accordance with the Companies Act. as described above. the Listing Rules of the London Stock Exchange and by our profession’s ethical guidance. We are not required to form an opinion on the effectiveness of either the company’s corporate governance procedures or its internal controls. Respective responsibilities of directors and auditors The directors are responsible for preparing the Annual Report and Accounts including.

Grants of a revenue nature are credited to income in the period to which they relate. c) Tangible Assets Freehold land and buildings are stated at valuation with subsequent additions at cost. Turnover recorded on long term contracts is the value of work done and this is calculated to be cost together with a proportion of profit appropriate to the stage of completion of each contract. d) Government Grants Grants related to expenditure on tangible assets are credited to profit at the same rate as the depreciation on the assets to which the grants relate. Claims for progress payments are deducted from amounts recoverable on long term contracts. are disclosed as payments receivable on account. Except for land. Provision is made for all foreseeable losses and due allowance is made for obsolete and slow moving items. other than subsidiaries or joint ventures. or to the extent that they exceed this value.Module 5 / The Framework for Financial Reporting Accounting policies a) Group Accounts The group accounts consolidate the accounts of the company and subsidiary undertakings made up to a date coterminous with the financial year of the company. or to the extent that they exceed this value. in which the group has a participating interest and over whose operating and financial policies the group exercises a significant influence are treated as associates. The accounts are prepared in accordance with applicable accounting standards. the cost or valuation of tangible assets is depreciated over the estimated useful life by equal annual instalments at rates of 2. first-out basis and direct labour plus attributable production overheads based on a normal level of activity. Net realisable value is based on estimated selling price less anticipated costs to disposal. associates are accounted for using the equity method. If a subsidiary. References to ‘associates’ are to be taken as references to associated undertakings unless otherwise stated. Cost comprises direct materials on a first-in. Accounting Edinburgh Business School 5/63 . are disclosed as payments receivable on account. The amounts shown in the balance sheet in respect of grants consist of the total grants receivable to date. Claims for progress payments are deducted from the value of work in progress. Entities in which the group holds an interest on a long term basis and are jointly controlled by the group and one or more other venturers under a contractual arrangement are treated as joint ventures. Positive goodwill arising on acquisitions since 27th December 20x0 is capitalised. Other tangible assets are stated at cost. associates or businesses prior to 26th December 20x0 was deducted directly from reserves and has not been reinstated on implementation of FRS 10. It is reviewed for impairment at the end of the first full financial year following the acquisition and in other periods if events or changes in circumstances indicate that the carrying value may not be recoverable. Provision is made for all foreseeable losses. The surplus arising on revaluation of buildings included in the revaluation reserve is amortised over the estimated useful lives of these buildings by transfer to the profit and loss account reserve in equal annual instalments.5% for buildings and 5% to 33. In the group accounts. References to ‘subsidiaries’ are to be taken as references to subsidiary undertakings unless otherwise stated. e) Stocks Stocks are stated at the lower of cost and net realisable value. any goodwill arising on acquisition that was deducted directly from reserves or that has not been amortised through the profit and loss account is taken into account in determining the profit or loss on sale or closure. joint ventures are accounted for using the gross equity method as defined in FRS 9. b) Goodwill Goodwill on acquisition of subsidiaries. In the group accounts. less the amounts so far credited to profit. Entities. The amounts are derived from the latest audited or reliable unaudited accounts made up to the company’s reporting date. classified as an asset on the balance sheet and amortised on a straight line basis over its useful economic life up to a presumed maximum of 20 years.33% for plant and equipment. The results of subsidiaries acquired during the year are consolidated from the date of acquisition and the results of subsidiaries disposed of are consolidated up to the date of sale. f) Long Term Contracts A long term contract is defined as the supply of a single substantial entity where the supply extends into different accounting periods. associate or business is subsequently sold or closed.

h) Deferred Tax Deferred tax is provided on all timing differences which are expected to reverse in the future. The accounts of subsidiaries where hyperinflationary conditions exist have been prepared using a stable currency before translation into sterling. The interest element of the rental obligations is charged to profit and loss account over the period of the lease and represents a constant proportion of the balance of capital repayments outstanding. Advance corporation tax is written off except where recovery is assured beyond reasonable doubt. 5/64 Edinburgh Business School Accounting . Deferred tax assets are only recognised if recovery without replacement by equivalent debit balances is reasonably certain. The accounts of overseas subsidiaries and associates. monetary assets and liabilities in foreign currencies and the Group’s interest in the equity of overseas associates. Exchange differences on consolidation. after adjusting for differences on foreign currency net borrowings. Full provision is made for unfunded unapproved pension promises. calculated at the rate at which ft is estimated that tax will be payable.Module 5 / The Framework for Financial Reporting Accounting policies (continued) g) Research and Development Expenditure Research and development expenditure is written off in the year in which it is incurred. Pension costs are charged to profit and loss account over the service lives of the employees in the scheme and are assessed in accordance with the advice of the actuary. are treated as adjustments to reserves and other exchange differences are dealt with through the profit and loss account as they arise other than those on contracts which are incorporated into the contract assessment. are translated at the rates ruling at the balance sheet date. k) Leasing Assets obtained under finance leases are capitalised in the balance sheet and are depreciated over their useful lives. contribution payments are made to the schemes to ensure that the schemes’ assets are sufficient to cover future liabilities. On the advice of an independent qualified actuary. This accounting policy is in accordance with UITF Abstract 9 ‘Accounting for operations in hyper-inflationary economies’. Rentals paid under operating leases are charged to income on a straight line basis over the term of the lease. i) Foreign Currencies Transactions in foreign currencies are converted at the rate ruling at the date of the transaction. j) Pensions The company and its major subsidiaries operate defined benefit pension schemes which are set up under separate trusts or through insurance companies. The excess of contributions paid over accumulated pension costs or vice versa is shown as either a prepayment or a pension provision in the balance sheet respectively.

Module 5 / The Framework for Financial Reporting Consolidated profit and loss account for the 53 weeks ended 31st January 20x2 Group Note 20x1 £’000 20x0 £’000 Turnover Group – Continuing operations Ongoing operations Acquisitions – Discontinued operation Share of – Joint venture – Associates 1 600 199 23 643 656 624 418 4 621 95 897 724 936 2a 48 648 2 569 40 (415) 50 842 1 992 8 334 61 168 20c 2b 2c 3 7 935 2 461 71 564 18 640 52 924 94 18 4 17 52 830 19 790 33 040 46 733 – 1 950 – 48 683 1 873 9 389 59 945 – 190 60 135 16 618 43 517 90 43 427 18 276 25 151 619 693 – 17 136 636 829 4 594 115 505 756 928 Operating profit Group – Continuing operations Ongoing operations Acquisitions – Discontinued operation – Goodwill amortisation Share of – Joint venture – Associates Exceptional item Profit on disposal of discontinued operation Interest and other income Profit on ordinary activities before tax Taxation on profit on ordinary activities Profit on ordinary activities after tax Minority interest Profit attributable to the Award Group PLC Dividends Transfer to reserves Earnings per share Earnings per share excluding goodwill amortisation and exceptional item Diluted earnings per share 5 5 5 26.2p 26.5p 21.1p 23.3p Accounting Edinburgh Business School 5/65 .0p 21.5p 21.

Learning.Module 5 / The Framework for Financial Reporting Balance sheets at 1st January 20x2 Group Notes 20x1 £’000 20x0 £’000 Company 20x1 20x0 £’000 £’000 Fixed assets Intangible assets – goodwill Tangible assets Investments Joint venture – share of gross assets – share of gross liabilities Associates Other 7 8 9 19 931 104 076 7 510 2 864 4 646 14 870 218 19 734 143 741 – 97 240 5 661 1 847 3 814 12 255 209 16 278 113 518 – 106 – – – 14 792 259 398 274 190 274 296 – 41 – – – 12 187 232 642 244 829 244 870 Total fixed assets Current assets Stocks Debtors Cash at bank and in hand Creditors falling due within one year Borrowings Other creditors Net current assets Total assets less current liabilities Less Creditors falling due after more than one year Loan capital Obligations under finance leases Provisions for liabilities and charges Deferred tax Pension costs Other provisions Deferred income Grants not yet credited to profit Minority interest Capital and reserves Called up share capital Share premium account Capital redemption reserve Revaluation reserve Special reserves Profit and loss account 10 11 96 181 58 335 14 191 206 129 094 446 201 741 485 952 437 304 94 190 49 334 10 191 202 132 234 910 210 354 943 165 108 246 – 10 247 19 898 30 145 6 889 16 401 23 290 6 855 281 151 – 9 808 28 238 38 046 4 182 18 106 22 288 15 758 260 628 12 13 273 045 245 764 14 15 3 9 13 415 910 5 523 2 047 – 611 395 250 144 17 327 664 790 390 – 722 367 225 504 25 408 7 943 – 85 2 297 189 771 225 504 22 600 – 1 436 547 6 424 – – 250 144 28 616 – – 390 6 118 – – 225 504 16 17 17 17 17 17 24 908 8 449 531 – 1 882 214 374 250 144 24 908 25 408 8 449 7 943 531 – (13 600) (42 500) 1 840 134 386 228 016 100 267 250 144 225 504 Approved by the Board of Directors on 22nd March 20x2 L. Director 5/66 Edinburgh Business School Accounting . Distance. Director D.

(3 278) 7 525 6 876 11 123 (1 896) – (413) (961) 1 437 9 290 19 117 28 407 15 564 (18 986) 22 649 19 227 – 430 (102) (97) 1 333 20 791 (1 674) 19 117 Accounting Edinburgh Business School 5/67 .Module 5 / The Framework for Financial Reporting Cash flow statement for the 53 weeks ended 1st January 20x2 Group Notes 20x1 £’000 20x1 £’000 20x0 £’000 20x0 £’000 Cash inflow from operating activities – funds generated by operations – decrease in working capital Dividends received from Joint Venture Dividends received from Associates Returns on investments and servicing in finance Taxation Capital expenditure and financial investment Acquisitions and disposal – acquisitions – disposal Equity dividends paid Cash inflow before liquid resources and financing Management of liquid resources Financing – issue of shares – purchase of shares – (debt repaid)new loans – foreign exchange hedging (Decrease)increase in cash 19a 63 630 4 356 67 986 550 3 625 1 858 (11 722) (15 850) (20 847) 11 141 (9 (18 18 (6 495 (7 633) (7 525) 200 (14 463) (3 278) 706) 680) 061 876) 1 487 – 18 986 127 20 600 15 564 (12 029) – (12 (14 17 (22 029) 125) 613 649) 60 530 5 637 66 167 600 5 233 714 (11 809) (17 138) 19b 19b 19b 20d 19b 19b 19b 19b 19b Reconciliation of net cash flow to movement in net funds (debt) Group Notes 20x1 £’000 20x1 £’000 20x0 £’000 20x0 £’000 (Decrease)increase in cash Cash flow from debt repaid (new loans) Cash flow from management of liquid resources Change in net funds (debt) resulting from cash flows Short term debt – acquired Cash deposit – acquired Leases – inceptions – acquired Exchange Movement in net funds (debt) during the year Net funds (debt) at 27th December 20x0 Net funds at 1st January 20x2 The analysis of net funds (debt) is included in note 19c.

Module 5 / The Framework for Financial Reporting Additional statements for the 53 weeks ended 31st January 20x2 Statement of total recognised gains and losses Group 20x1 £’000 20x0 £’000 Profit excluding share of profits of joint venture and associates Share of joint venture’s profit Share of associates’ profit Profit attributable to the Award Group PLC Exchange differences on foreigh currency net investments Tax thereon Total recognised gains 45 653 1 414 5 763 52 830 (1 579) 304 51 555 35 870 1 345 6 212 43 427 (2 170) (938) 40 319 Reconciliation of movement in shareholders’ funds Group 20x1 £’000 20x0 £’000 Total recognised gains Dividends Other movements Scrip dividends New share capital subscribed Cost of issuing shares Share purchase Goodwill deducted directly from reserves Adjustment to prior years’ goodwill Net addition to shareholders’ funds Opening shareholders’ funds Closing shareholders’ funds 51 555 (19 790) – 537 (29) (7 633) – – 24 640 225 504 250 144 40 319 (18 276) 2 489 1 891 (287) – (7 070) 934 20 000 205 504 225 504 Shareholders’ funds are entirely attributable to equity interests 5/68 Edinburgh Business School Accounting .

The analysis of group turnover and group operating profit before unallocated costs. it represents the value of work done during the year. Accounting Edinburgh Business School 5/69 . Turnover and profit on ordinary activities before tax Turnover represents the amount invoiced to third parties in respect of goods sold and services provided excluding value added tax. Turnover and profit on ordinary activities before tax were contributed as follows: Group 20x1 Turnover £’000 20x0 Turnover £’000 20x1 Profit £’000 20x0 Profit £’000 Engineering Products: Group – ongoing – acquisitions – continuing – discontinued Share of Associates 455 577 23 643 479 220 656 546 480 422 478 586 – 478 586 15 370 475 494 431 37 569 2 569 40 138 40 23 40 201 36 992 – 36 992 1 766 31 38 789 Engineering Services: Group – continuing Share of Joint Venture Share of Associates 144 542 4 621 95 351 244 514 134 394 4 594 115 030 254 018 11 890 1 992 8 311 22 193 10 436 1 873 9 358 21 667 Segment totals Group Joint Venture and Associates Goodwill amortisation – Engineering Products Unallocated costs * Exchange adjustment – Group Exceptional item – Engineering Products Interest and other income 624 418 100 518 – – – 724 936 – – 724 936 628 350 120 099 – – 8 479 756 928 – – 756 928 52 068 10 326 (415) (811) – 61 168 7 935 2 461 71 564 49 194 11 262 – (889) 378 59 945 – 190 60 135 * for comparative purposes 20x0 figures have been restated at the 20x1 closing exchange rates. goodwill amortisation and share of joint venture and associates by geographical area of origin is as follows: Group 20x1 Turnover £’000 20x0 Turnover £’000 20x1 Profit £’000 20x0 Profit £’000 United Kingdom Rest of Europe Americas Middle East and Africa Asia Australia Continuing operations Discontinued operation 342 53 188 16 844 601 679 424 518 21 696 623 762 656 624 418 321 39 201 18 007 902 593 786 242 31 450 612 980 15 370 628 350 27 363 7 549 16 436 206 118 356 52 028 40 52 068 20 431 4 962 19 978 1 705 1 351 47 428 1 766 49 194 Acquisitions made during 20x1 are included principally withing the ‘United Kingdom’ and the ‘Rest of Europe’.Module 5 / The Framework for Financial Reporting Notes to the accounts 1. In the case of long term contracts.

Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 1. administrative expenses £4 328 000 (excluding goodwill amortisation) and other operating income £128 000. cost of sales £16 116 000. Turnover and profit on ordinary activities before tax – continued The analysis of group turnover by geographical area of destination is as follows: Group 20x1 £’000 20x0 £’000 United Kingdom Rest of Europe Americas Middle East and Africa Asia Australia Continuing operations Discontinued operation 200 759 74 575 193 649 57 282 71 910 25 587 623 762 656 624 418 181 204 67 353 203 290 65 758 59 881 35 494 612 980 15 370 628 350 An analysis of net assets by class of business and geographical origin has not been disclosed. 2. The directors are of the opinion that to disclose such information would be seriously prejudicial to the interests of the Group. The total figures for continuing operations in 20x1 include the following amounts relating to the acquisitions made during the year: turnover £23 643 000. 5/70 Edinburgh Business School Accounting . Profit on ordinary activities before tax Group 20x1 20x1 Continuing Discontinued £’000 £’000 20x1 Total £’000 Group 20x0 20x0 Continuing Discontinued £’000 £’000 20x0 Total £’000 (a) Movement between turnover and operating profit: Turnover Cost of sales Gross profit Distribution costs Administrative expenses Other operating income Operating profit: – Group – Share of joint venture – Share of associates Total operating profit 623 762 (480 188) 143 574 (49 584) (45 980) 2 792 656 (532) 124 (49) (35) – 624 418 (480 720) 143 698 (49 633) (46 015) 2 792 619 693 (490 768) 128 925 (46 585) (38 208) 2 601 17 136 (13 824) 3 312 (834) (528) – 636 829 (504 592) 132 237 (47 419) (38 736) 2 601 50 802 1 992 8 334 61 128 40 – – 40 50 842 1 992 8 334 61 168 46 733 1 873 9 389 57 995 1 950 – – 1 950 48 683 1 873 9 389 59 945 The goodwill amortisation of £415 000 (20x0 Nil) is included under the heading ‘Administrative expenses’ above. distribution costs £758 000.

Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 2. auditor’s remuneration and expenses for other services relating to acquisitions amounted to £81 000. Operating lease rentals: Land and buildings Plant and machinery Gross research and development Reimbursable from third parties Net cost 3 234 3 898 7 132 3 370 (283) 3 087 3 294 3 700 6 994 3 122 (347) 2 775 Accounting Edinburgh Business School 5/71 . Profit on ordinary activities before tax – continued Group 20x1 £’000 20x0 £’000 (b) Interest and other income: Interest receivable on cash at bank Income from unlisted investments Interest payable: On bank loans and overdrafts On other loans Finance charges payable under finance leases Group interest and other income Share of – Joint venture – Associates 4 491 890 (2 587) (3) (150) 2 641 21 (201) 2 461 1 930 846 (1 925) (14) (187) 650 17 (477) 190 (c) Profit on ordinary activities before tax is after charging(crediting): Depreciation Goodwill amortisation Government grant credits Auditor’s remuneration and expenses for audit services: Company Subsidiaries Auditor’s remuneration and expenses for other services: United Kingdom Overseas 15 390 415 (111) 15 040 – (152) 80 666 61 599 318 88 268 258 In addition to the above.

Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 3. Tax Group 20x1 £’000 20x0 £’000 (a) Profit and Loss Account – Tax charge: Corporation tax at 31% (20x0 31.5%) Double tax relief Overseas tax UK deferred tax Overseas deferred tax Tax on franked investment income Adjustments to prior years Share of joint venture’s tax Share of associates’ tax Tax on exceptional item Tax on profit on ordinary activities 11 083 (3 149) 4 123 1 868 280 122 (157) 14 170 599 2 370 17 139 1 501 18 640 5 638 (969) 5 219 2 888 892 121 (326) 13 373 545 2 700 16 618 – 16 618 Group 20x1 £’000 20x0 £’000 Company 20x1 20x0 £’000 £’000 (b) Balance Sheet – Deferred tax: Accelerated capital allowances Other timing differences Unutilised tax losses Advanced corporation tax Deferred tax payable (recoverable) 4 280 1 435 (192) – 5 523 3 539 512 (129) (3 132) 790 – 1 436 – – 1 436 – (122) – – (122) 4.46p) 5 541 14 249 19 790 5 142 13 134 18 276 5/72 Edinburgh Business School Accounting . Dividends Group 20x1 £’000 On ordinary shares: 20x0 £’000 Interim 2.15p per share (20x0 6.54p) Proposed final 7.75p per share (20x0 2.

The earnings per share excluding goodwill amortisation and the exceptional item is based on earnings of £46 811 000 (20x0 £43 427 000) being profit attributable to The Award Group PLC of £52 830 000 (20x0 £43 427 000) as adjusted to exclude goodwill amortisation of £415 000 (20x0 Nil) and the exceptional item profit after tax of £6 434 000 (20x0 Nil) and on the weighted average of 202 108 704 shares in issue (20x0 202 207 347). 6. The effect of excluding the goodwill amortisation and the exceptional item is 2. Earnings per share The earnings per share calculation is based on earnings of £52 830 000 being profits attributable to The Award Group PLC (20x0 £43 427 000) and on the weighted average of 202 108 704 shares in issue (20x0 202 207 347). The weighted average shares in issue is based on the basic weighted average of 202 108 704 shares in issue (20x0 202 207 347) together with the dilutive potential ordinary shares of 717 156 (20x0 1 402 315) in respect of employee share options.9p per share (20x0 Nil). The figure for earnings per share excluding goodwill amortisation and the exceptional item has been presented as the directors consider that this figure gives a more meaningful measurement of earnings.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 5. Directors and employees Group 20x1 £’000 20x0 £’000 Average number of persons employed by the company and its subsidiaries: Engineering Products Engineering Services 6 801 1 706 8 507 6 685 1 639 8 324 Group 20x1 £’000 20x0 £’000 Staff costs: Wages and salaries Social security costs Other pension costs (see note following) 178 908 17 905 4 857 201 670 167 748 16 582 5 054 189 384 Pension costs are analysed as follows: Group UK scheme Regular cost Interest on pension costs provision Amortisation of surplus Other UK schemes Overseas schemes 6 523 – (5 708) 815 1 068 2 974 4 857 5 900 150 (5 019) 1 031 764 3 259 5 054 Discharged by: Cash contributions Pension costs provision decrease Cash flow effect of funding rate Interest 7 088 (2 231) – 4 857 7 065 (2 161) 150 5 054 Accounting Edinburgh Business School 5/73 . The diluted earnings per share calculation is based on earnings of £52 830 000 being profits attributable to The Award Group PLC (20x0 £43 427 000) and on the weighted average of 202 825 860 shares in issue (20x0 203 609 662).

higher than increases in contribution salaries.. Intangible assets – goodwill Group £’000 Cost: At 27th December 20x0 Acquisitions At 1st January 20x2 Amortisation: At 27th December 20x0 Provided during the year At 1st January 20x2 Net book value at 1st January 20x2 – 20 346 20 346 – 415 415 19 931 Goodwill arising on the acquisitions during the year is being amortised over the directors’ estimate of useful economic life which is 20 years in each case. The principal assumptions used are dividend growth of 5% p. The actuarial method adopted was the projected unit method.. investment returns of 2.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 6. The latest actuarial assessment of this scheme was as at 6th April 20x0. 7.a.a. and an allowance for increases to pensions in payment of 4% p. 5/74 Edinburgh Business School Accounting . At the valuation date. It is intended that the next actuarial assessment of the Group UK scheme will take place as at 6th April 20x3. Directors and employees – continued The company and its major subsidiaries operate a number of pension schemes throughout the world of which the Group UK scheme is predominant. The actuarial surplus is being spread over a period of 14 years being the average remaining service lives of the scheme members as a level percentage of contribution salary.25% p.a. the market value of the assets of the Group UK scheme was £302m and the level of funding based on projected contribution salaries was 127%. On the advice of the Actuary the company has continued to pay a level of contributions of 6% of total contribution salaries.

Accounting Edinburgh Business School 5/75 . At 1st January 20x2 the net book value of tangible assets acquired under finance leases included in Group plant and machinery amounted to £2 783 000 (20x0 £2 971 000) and in Company plant and machinery £Nil (20x0 £Nil). freehold land and buildings would have been included at a cost of £45 453 000 (20x0 £41 613 000) less a cumulative provision for depreciation of £10 796 000 (20x0 £10 282 000). Depreciation charged for the year on these assets amounted to £781 000 (20x0 £931 000) and £Nil (20x0 £Nil) respectively. On a historical cost basis. Tangible assets Group Freehold Land and Buildings £’000 Plant and Machinery £’000 Freehold Land and Buildings £’000 Company Plant and Machinery £’000 Total £’000 Total £’000 At 27th December 20x0 Cost Valuation 19W1 Valuation 19W4 Additions Acquisitions Disposals Exchange At 1st January 20x2 Whereof: Cost Valuation 19W1 Valuation 19W4 38 780 9 627 2 303 2 079 3 567 (2 094) (425) 53 837 143 232 – – 17 317 2 353 (4 130) (625) 158 147 182 012 9 627 2 303 19 396 5 920 (6 224) (1 050) 211 984 49 – – – – – – 49 73 – – 86 – (1) – 158 122 – – 86 – (1) – 207 43 119 9 274 1 444 53 837 158 147 – – 158 147 201 266 9 274 1 444 211 984 49 – – 49 158 – – 158 207 – – 207 Aggregate depreciation At 27th December 20x0 Charge for year Disposals Exchange At 1st January 20x2 Net book value 11 479 1 510 (452) (77) 12 460 41 377 85 223 13 880 (3 319) (336) 95 448 62 699 96 702 15 390 (3 771) (413) 107 908 104 076 19 2 – – 21 28 62 19 (1) – 80 78 81 21 (1) – 101 106 The value of freehold land included in freehold land and buildings amounted to £7 157 000 at cost and £923 000 at valuation (20x0 £7 838 000 at cost and £946 000 at valuation). No provision has been made for the liability to tax from capital gains amounting to £137 000 (20x0 £149 000) which would arise if land and buildings were to be sold at their book amounts.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 8.

Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 9. Fixed asset investments Group Joint Venture £’000 Other Associates Investments £’000 £’000 Total £’000 At 27th December 20x0 Cost Equity basis Additions Acquisitions Disposals Increase in net assets At 1st January 20x2 Whereof: Cost Equity basis – 3 814 – – – 832 4 646 – 12 255 – – – 2 615 14 870 209 – 139 20 (150) – 218 209 16 069 139 20 (150) 3 447 19 734 – 4 646 4 646 – 14 870 14 870 218 – 218 218 19 516 19 734 Group Associates 20x1 20x0 £’000 £’000 The aggregate of the Group’s share in the net assets of the associates is analysed as follows: Fixed Assets Current Assets Share of gross assets Liabilities due within one year Liabilities due after more than one year Share of gross liabilities Share of net assets 13 682 28 466 42 148 24 104 3 174 27 278 14 870 14 645 34 636 49 281 28 821 8 205 37 026 12 255 Company Subsidiaries Shares Loans £’000 £’000 Other Associates Investments £’000 £’000 Total £’000 At 27th December 20x0 Cost Valuation Acquisitions/advances Income accrued Repayments Increase in net assets Exchange At 1st January 20x2 Whereof: Cost Valuation – 157 938 41 839 4 209 – 20 403 349 224 738 – 74 680 6 585 – (52 944) 5 724 591 34 636 – 12 187 – – – 2 605 – 14 792 24 – – – – – – 24 24 244 805 48 424 4 209 (52 944) 28 732 940 274 190 – 224 738 224 738 – 34 636 34 636 – 14 792 14 792 24 – 24 24 274 166 274 190 5/76 Edinburgh Business School Accounting .

10. Borrowings Group 20x1 £’000 20x0 £’000 Company 20x1 20x0 £’000 £’000 Bank overdrafts and short term debt Loan capital current portion Bank loans Other borrowings 9 515 4 970 – 14 485 5 790 4 969 184 10 943 6 889 – – 6 889 3 998 – 184 4 182 Bank advances of £2 305 000 (20x0 £4 824 000) utilised by subdidiaries were secured over local assets. Accounting Edinburgh Business School 5/77 . On a historical basis the invesments in the associates would have been included at a cost of £7 174 000 (20x0 £7 174 000). As at 1st January 20x2 a provision of £6 424 000 (20x0 £6 118 000) has been made against the deficiency of underlying net assets in certain subsidiaries.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 9. On a historical cost basis the investment in the subsidiaries would have been included at a cost of £297 471 000 (20x0 £296 843 000) less a provision for diminution in value of £16 879 000 (20x0 £16 712 000). Debtors Group 20x1 £’000 20x0 £’000 Company 20x1 20x0 £’000 £’000 Amounts recoverable within one year: Amounts recoverable on contracts Trade debtors Amounts owed by subsidiaries Amounts owed by joint venture and associates Tax recoverable Advance corporation tax recoverable VAT recoverable Other debtors Prepayments and accrued income Amounts recoverable after one year: Advance corporation tax recoverable Deferred tax recoverable (note 3) Pension costs 34 983 129 014 – 1 218 609 1 398 707 4 689 5 855 – – 2 973 181 446 28 410 148 122 – 802 234 1 398 717 5 708 4 783 151 – 585 190 910 – – 6 696 – – 2 609 – 761 141 – – 40 10 247 – – 5 712 – – – – 607 64 3 283 122 20 9 808 12. Stocks Group 20x1 £’000 20x0 £’000 Raw materials Work in progress Finished goods Less: progress payments received and receivable 35 033 43 468 31 125 109 626 13 532 96 094 32 940 48 861 28 210 110 011 15 777 94 234 11. Fixed asset investments – continued Investments in subsidiaries and associates are held at valuation representing the amount of attributable underlying net assets at the balance sheet date.

Other creditors Group 20x1 £’000 20x0 £’000 Company 20x1 20x0 £’000 £’000 Payments receivable on account Obligations under finance leases (note 15) Trade creditors Amounts owed to subsidiaries Amounts owed to associates Corporate tax Other taxes and social security costs Other creditors Accruals and deferred income Proposed dividends 29 794 984 67 676 – 43 7 903 6 027 25 998 39 278 14 249 191 952 32 514 1 159 66 305 – 32 9 396 6 977 18 927 42 721 13 134 191 165 – – – 211 – 839 266 – 836 14 249 16 401 – – – 193 – 3 740 238 – 801 13 134 18 106 14. Loan capital Group 20x1 £’000 20x0 £’000 Company 20x1 20x0 £’000 £’000 Amounts due are repayable as follows: between two and five years – bank loans – loans from subsidiaries between one and two years – bank loans Loan capital current portion (included in borrowings – see note 12) – bank loans – other borrowings 8 146 – 5 269 13 415 4 970 – 18 385 12 796 – 4 531 17 327 4 969 184 22 480 – 22 600 – 22 600 – – 22 600 – 28 616 – 28 616 – 184 28 800 Bank loans amounting to £629 000 (20x0 £323 000) are secured over local assets. 5/78 Edinburgh Business School Accounting .Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 13.

Leasing commitments Group 20x1 £’000 20x0 £’000 Company 20x1 20x0 £’000 £’000 (a) Finance leases: As at 1st January 20x2 the net obligations under finance leases amounted to of which payable during 20x2 20x3 to 20x6 after 20x6 1 894 984 669 241 1 894 1 823 1 159 664 – 1 823 – – – – – – – – – – (b) Operating leases: As at 1st January 20x2 committed payments under operating leases for 20x2 amounted to Land and buildings Other of which payable in respect of operating leases ending in 20x2 20x3 to 20x6 after 20x6 2 757 3 498 6 255 1 446 3 146 1 663 6 255 2 639 3 657 6 296 1 247 3 689 1 360 6 296 – 55 55 10 45 – 55 – 50 50 21 29 – 50 16. Share capital 20x1 £’000 20x0 £’000 Authorised share capital: Ordinary shares of 12.5p each Aggregate Nominal Value £’000 36 000 24 908 36 000 25 408 Shares Allotted Number ConsiderShare ation Premium Received £’000 £’000 Exercise of share options 245 514 31 506 537 Shares Cancelled Number Aggregate ConsiderNominal ation Value Paid £’000 £’000 Shares purchased 4 250 000 531 7 633 Accounting Edinburgh Business School 5/79 .Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 15. called up and fully paid: Ordinary shares of 12.5p each Allotted.

0000p 258.5210p 311.0000p 242.0000p 1 116 068 924 745 2 088 769 375 364 1 123 647 388 140 1 196 684 865 836 246.5000p 857 378 276 150 161 924 84 600 37 113 531 592 288 453 71 547 249.6268p 285.0000p 218.5000p 239.0000p 283. Share capital – continued Share options: Price per Share Number of Shares At 1st January 20x2 shares in the company subject to options under the company’s share option schemes were as follows: Executive Share Option Scheme 19W7 First normal exercise date: 19x8 19x9 20x0 20x0 20x0 Savings Related Share Option Scheme 19x4 First normal exercise date: 20x2 20x2 20x3 20x3 20x4 20x4 20x5 20x6 Executive Share Option Scheme 19x7 First normal exercise date: 20x1 20x2 20x2 20x2 20x3 20x3 20x4 20x4 234.0000p 260.0000p 208.0000p 188.4152p 261.0000p 250.0000p 218.0000p 164 812 190 605 186 426 82 406 400 000 The exercise of options granted under the 19x7 Executive Share Option Scheme is normally subject to the growth of the Company’s earnings per share over a three year period either exceeding by six per cent the growth in the retail price index of the United Kingdom over that three year period or exceeding the weighted average growth during that three year period of the earnings per share of those companies categorised as ‘engineering companies’ in The Stock Exchange List.0000p 246.0978p 298.4956p 223.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 16.0000p 250. 5/80 Edinburgh Business School Accounting .5000p 293.

The Company made a contribution to the ESOT equal to the difference between the market price at date of issue and the option price at a cost to the Company of £29 148 net of tax. 18. 19x5 and 19x7 have now been settled. No provision has been made for any taxation which might arise on the distribution to the UK of retained overseas earnings of £57 142 000 (20x0 £40 239 000). Profit attributable to The Award Group PLC The profit dealt with in the accounts of The Award Group PLC was £22 655 000 (20x0 £18 688 000). Reserves Profit and Loss Account £’000 Special Reserves £’000 Revaluation Reserve £’000 Capital Redemption Reserve £’000 Share Premium Account £’000 Total £’000 Group At 27th December 20x0 189 771 Premium on share issues – Cost of issuing shares through ESOT. Accounting Edinburgh Business School 5/81 . net of tax (29) Revaluation surplus amortised 54 Profit retained in year 33 040 Share purchase (7 633) Exchange differences (1 548) Tax on exchange 304 Goodwill amortisation 415 At 1st January 20x2 214 374 2 297 – – – – – – – (415) 1 882 85 – – (54) – – (31) – – – – – – – – 531 – – – 531 7 943 506 – – – – – – – 8 449 200 096 506 (29) – 33 040 (7 102) (1 579) 304 – 225 236 Company At 27th December 20x0 100 267 Transfer 132 546 Premium on share issues – Cost of issuing shares through ESOT. the balances credited to special reserves on these dates totalling £132 546 000 are now distributable and accordingly these balances are now transferred to the profit and loss account reserve. net of tax (29) Surplus on revaluation of investments – Surplus for year 2 865 Share purchase (7 633) At 1st January 20x2 228 016 134 386 (132 546) – – – – – 1 840 (42 500) – – – 28 900 – – (13 600) – – – – – – 531 531 7 943 – 506 – – – – 8 449 200 096 – 506 (29) 28 900 2 865 (7 102) 225 236 As all creditors of the company at the dates of the cancellation of the share premium account in 19x3.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 17. In accordance with the concession granted under section 230 of the Companies Act 1985 the profit and loss account of The Award Group PLC has not been separately presented in these accounts. The cumulative amount of goodwill deducted directly from Group reserves net of goodwill relating to businesses disposed of as at 1st January 20x2 is £150 253 000 (20x0 £150 253 000). During the year the company issued 79 847 ordinary shares to an employee share ownership trust (ESOT) in respect of the exercise of options under the Savings Related Share Option Scheme 19x4.

Cash flow statement Group 20x1 £’000 20x0 £’000 (a) Reconciliation of group operating profit to net cash inflow from operating activities: Operating profit Depreciation.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 19. goodwill amortisation and grant credits Surplus on disposal of tangible assets and investments Funding of pension costs Funds generated by operations Decrease(increase) in stocks Decrease in debtors (Decrease)increase in creditors Decrease in working capital Net cash inflow from operating activities (b) Analysis of cash flows for headings netted in the cash flow statement: Return on investments and servicing of finance: Interest received Interest paid Interest element of finance lease rentals Other dividends received Minority interest dividend paid 50 842 15 694 (675) (2 231) 63 630 4 459 16 194 (16 297) 4 356 67 986 48 683 14 888 (880) (2 161) 60 530 (6 098) 10 952 783 5 637 66 167 4 252 (2 476) (150) 281 (49) 1 858 2 328 (1 669) (184) 239 – 714 Capital expenditure and financial investment: Purchase of tangible fixed assets Sale of tangible fixed assets Purchase of investments Sale of investments Capital grants received (18 892) 2 981 (139) 200 – (15 850) (20 068) 2 848 – 2 80 (17 138) Acquisitions: Purchase of investment in associates Purchase of businesses and subsidiaries (see note 20(b)) – (20 847) (20 847) (1 362) (10 667) (12 029) Management of liquid resources: Cash placed on deposit Financing: Issue of shares Cost of issuing shares Purchase of shares New loan capital Loan capital repaid Short term bank loans Lease obligations repaid Foreign exchange hedging (6 876) (22 649) 537 (42) (7 633) – (6 152) (108) (1 265) 200 (14 463) 1 891 (404) – 23 248 (2 356) (888) (1 018) 127 20 600 5/82 Edinburgh Business School Accounting .

Properties acquired have been revalued to reflect current market value.] All acquisitions have been accounted for using the acquisition method. The contribution of businesses acquired to the turnover and profit before interest of the year is shown in Note 1. assets obtained under finance leases have been capitalised and lump sum retirement indemnity liabilities have been incorporated.12. The acquisitions made during the year together with the respective acquisition dates are as follows: [names of companies not listed here. Other fair value adjustments have been made to align the net assets acquired with Award Group accounting policies. Cash flow statement – continued (c) Analysis of net funds: At 27. Acquisition and disposal (a) Current year acquisitions: Group Net Assets Acquired £’000 Fair Value Adjustments Revaluation Other £’000 £’000 Fair Value £’000 Net assets acquired at fair value Intangible assets Tangible assets Investments Working Capital Stock Debtors Creditors Overdrafts Loan capital Deferred tax Pension costs provision Goodwill arising on acquisition Acquisition cost 1 147 4 472 20 8 662 9 572 (14 688) (1 181) (1 896) 302 (1 500) 18 393 23 303 – 486 – (1 046) – – – – 154 – 406 – (1 147) 962 – – – (1 572) – – 210 – 1 547 – – 5 920 20 7 616 9 572 (16 260) (1 181) (1 896) 666 (1 500) 20 346 23 303 Full settlement of the acquisition consideration is payable in cash.x0 £’000 Cash Flow £’000 Lease Inception £’000 Acquisitions Exchange £’000 £’000 At 1.Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 19. Intangible assets have been written off. Accounting Edinburgh Business School 5/83 .1. and stock has been revalued to the lower of cost and net realisable value. Consequential adjustments have been made to deferred tax.x2 £’000 Cash on call at bank and in hand Overdrafts Cash on deposit at bank Short term debt Loan capital Finance leases 22 088 (5 689) 16 399 27 122 (101) (22 480) (1 823) 19 117 (3 278) 6 876 108 6 152 1 265 11 123 – – – – (413) (413) – – – (1 896) (961) (2 857) 1 431 136 (7) (161) 38 1 437 24 067 (9 515) 14 552 34 134 – (18 385) (1 894) 28 407 20.

Capital commitments Group 20x1 £’000 20x0 £’000 Company 20x1 20x0 £’000 £’000 Outstanding capital commitments contracted but not provided 521 2 751 – – 22. including counter indemnities for performance and tendering bonds of certain subsidiaries. Contingent liabilities and guarantees Group 20x1 £’000 20x0 £’000 Company 20x1 20x0 £’000 £’000 Maximum guarantee obligations relating to bank and other borrowings of subsidiaries and associates 658 655 4 138 4 290 The company and certain subsidiaries had other continent liabilities in the normal course of business. Acquisition and disposal – continued (b) Cash outflow on acquisitions: Group 20x1 £’000 20x0 £’000 Overdrafts (cash) transferred Acquisition cost – current year acquisitions (note 20(a)) – prior years’ acquisitions Deferred consideration – current year acquisitions – prior years’ acquisitions 1 181 23 303 – (3 637) – 20 847 (2 010) 10 887 (934) (180) 2 904 10 667 (c) Current year disposal of business: Group £’000 Net assets disposed of Tangible assets Stocks Debtors Creditors Cash Gain on disposal Proceeds (d) Cash inflow on disposal: 77 280 5 108 (2 259) 4 3 210 7 935 11 145 Group £’000 Cash transferred Proceeds (4) 11 145 11 141 21. 5/84 Edinburgh Business School Accounting .Module 5 / The Framework for Financial Reporting Notes to the Accounts continued 20.

00p 21.Module 5 / The Framework for Financial Reporting Group five year summary 19x7 £’000 19x8 £’000 19x9 £’000 20x0 £’000 20x1 £’000 Turnover Operating profit before exceptional items Interest and other income Profit before exceptional items and tax Exceptional items Profit on ordinary activities before tax Tax Profit on ordinary activities after tax Minority interest Profit attributable to The Award Group PLC Earnings per share excl.00p 624 418 61 168 2 461 63 629 7 935 71 564 18 640 52 924 (94) 52 830 23.50p 619 50 (1 49 900 636 829 493 59 485 453) 650 040 60 135 – – 49 040 60 135 14 256 16 618 34 784 43 517 32 (90) 34 816 43 427 17. goodwill amortisation and exceptional items Ordinary dividends per share 475 523 37 550 802 38 352 (7 803) 30 549 8 512 22 037 – 22 037 16.6p 7.90p £’000 £’000 £’000 £’000 £’000 Total Assets Less Current Liabilities Intangible assets Tangible assets Investments Net current assets – 99 108 7 746 76 638 183 492 – 98 234 4 916 102 023 205 173 – 95 224 12 564 103 899 211 687 – 97 240 16 278 132 246 245 764 19 931 104 076 19 734 129 304 273 045 Financed by: Shareholders’ capital Creditors falling due after more than one year Deferred tax Pension costs provision Deferred income Minority interest 172 310 4 781 – 5 191 1 210 – 183 492 195 436 4 254 509 3 559 1 020 395 205 173 205 504 3 231 – 1 816 794 342 211 687 225 504 17 991 790 390 722 367 245 764 250 144 14 325 5 523 2 047 611 395 273 045 The figures for 19x7 to 20x0 have not been restated to reflect the changes introduced by Financial Reporting Standard No 9 ‘Associates and Joint Ventures’.2p 9.4p 8.1p 6. Accounting Edinburgh Business School 5/85 .5p 9.96p 622 006 47 102 (1 598) 45 504 – 45 504 12 497 33 007 (81) 32 926 16.

(ii) and (iv) only. (iii) prefer to limit any interference from outside. (d) (iii) and (iv) only. 5. 5. (d) The current market value of the shares held. the strict application of rigid accounting formulae. the general public. The shareholder’s entire personal wealth.4 Legal disclosure requirements on limited companies act primarily to safeguard the interests of: (i) (ii) employees. Which of the following is correct? (a) (c) (i). (iii) the choice of inventory valuation method. because they: (i) (ii) dislike being the subject of criticism. (iv) creditors. 5/86 Edinburgh Business School Accounting .Module 5 / The Framework for Financial Reporting Review Questions 5. (iii) shareholders. (ii) and (iii) only.1 Reported profits are directly affected by a number of different factors. (b) Sole trader. (d) (iii) and (iv) only.2 Which of the following entities is most influenced by the impact of disclosure requirements? (a) (c) Partnership. 5. (iv) the selection of external auditors. regard it as commercially useful to competitors. (ii) and (iii) only.5 The management of limited companies seek to minimise the amount of financial information disclosed. (d) Charity organisation. including: (i) (ii) the depreciation rates applied to fixed assets. (b) (i) and (iv) only. (b) The acquisition price of the shares held. 5.3 What is the maximum amount that a shareholder can lose in an investment in shares in a limited company? (a) (c) The nominal value of the shares held. Limited company. (ii) and (iv) only. Which of the following is correct? (a) (c) (i) and (iii) only. (b) (i).

(ii) utilising as accurate figures as possible. (d) (ii) and (iv) only. (iii) and (iv) only. (ii) and (iii) only. (c) (i). (d) (ii) and (iv) only. (c) (ii) and (iii) only. (b) (i) and (iii) only. (ii) Stock Exchange Listing Agreement requirements. 5. (d) (ii). (b) (i) and (iii) only.8 All UK limited companies must adhere rigidly to every aspect of all of the Statements of Standard Accounting Practice (SSAPs) and Financial Reporting Standards (FRS) introduced by the accounting profession. (ii) and (iii) only. Which of the following is correct? (a) (i) and (ii) only. 5.6 In the UK. (iv) government legislation. specifically the Companies Act 1985. (b) (i).9 By being listed on a recognised stock exchange. UK companies ensure that the disclosure requirements applicable to them are: (i) extended beyond the Companies Act limits. the level of disclosure in financial statements is influenced by a combination of: (i) accounting standards. Which of the following is correct? (a) (i) only. (b) (i). 5. (iv) extended in terms of accounting standards. (d) (iii) and (iv) only. (iii) by the application of methodical bias.7 The auditors’ ‘true and fair view’ certification of the annual financial statements provides confirmation that these statements have been prepared: (i) concealing material factors.Module 5 / The Framework for Financial Reporting (iv) are unscrupulous people. Accounting Edinburgh Business School 5/87 . Which of the following is correct? (a) (i) and (ii) only. (c) (ii) and (iii) only. (ii) reduced below the Companies Act limits. (c) (ii) and (iii) only. (ii) and (iv) only. (iii) unchanged in terms of accounting standards. (iv) using accepted accounting principles. Which of the following is correct? (a) (i) and (iii) only. (iii) employers’ desires to give additional information to their employees. True or false? 5.

goodwill is defined as being: (i) (ii) the management’s valuation of a company. (b) £10 000. (iv) the amount paid by a purchaser in excess of a company’s net assets. representing 40 000 £1 ordinary shares in Medical Lasers Limited for £80 000. Instrument Systems Limited has purchased an 80 per cent interest. (d) £40 000.12 In the consolidated balance sheet.Module 5 / The Framework for Financial Reporting 5. Which of the following is correct? (a) (c) (i) only. £20 000. is: Fixed assets Investment in subsidiary Net current assets Ordinary share capital Retained profits £ 55 000 80 000 65 000 200 000 150 000 50 000 200 000 At acquisition. (ii) and (iii) only. Medical Laser Limited’s balance sheet.11–5. the excess of a quoted company’s market capitalisation over its net assets. 5/88 Edinburgh Business School Accounting . £18 000. is: Fixed assets Net current assets Ordinary share capital Retained profits £ 60 000 30 000 90 000 50 000 40 000 90 000 5. The following information applies to Questions 5.10 In financial statements. (iii) the value of a company’s brand names.13. Following this acquisition. 5. what is the amount of goodwill? (a) (c) £8 000. (d) £58 000. in summary form.11 In the consolidated balance sheet. (b) £12 000. Instrument Systems’ balance sheet. what is the amount of minority interest? (a) (c) £8 000. (d) (iv) only. (b) (i) and (iii) only. in summary form.

whereas Award writes off payments for finance leases directly to the profit and loss account. (b) Ordinary share capital = £200 000. (ii) and (iii) only.17 The parameters in management’s choice of accounting policies are set by a combination of: (i) (ii) the requirement to adhere to the consistency convention. the shareholders’ desire for rising dividends. (b) (i) and (iv) only.14 Which of the following describes Award’s accounting policy on the depreciation of buildings ? (a) (c) Straight-line. as payments are made. (d) Capitalised without amortisation. over 40 years. (c) Both MBA and Award write off payments for finance leases directly to the profit and loss account. whereas MBA writes off payments for finance leases directly to the profit and loss account. Which of the following is correct? (a) (c) (i) and (ii) only. but amortised over several years. 5. 5. Written off immediately against reserves.13 In the consolidated balance sheet. (iii) analysts’ concerns over the company’s performance. (b) Award capitalises assets used under finance leases. 5. (b) Distributed among assets acquired. as payments are made. which of the following is correct? (a) (c) Fixed assets + Net current assets = £210 000.Module 5 / The Framework for Financial Reporting 5. Reducing balance. (d) Both MBA and Award capitalise assets used under finance leases. (d) Net current assets = £76 000. over 20 years. over 20 years. (d) Reducing balance. 5. (iv) the need to obtain the approval of the external auditors. as payments are made. (d) (iii) and (iv) only. which of the following is correct? (a) MBA capitalises assets used under finance leases. Accounting Edinburgh Business School 5/89 .15 Which of the following describes MBA’s accounting policy on goodwill prior to 26 December 20X0? (a) (c) Capitalised. (b) Straight-line. over 40 years. Fixed assets + Net current assets = £272 000.16 In comparing the accounting policies of MBA and Award in respect of finance leases.

5. True or false? 5. what is the amount charged for depreciation? (a) (c) £415 000. 5/90 Edinburgh Business School Accounting . 5.18 In Award’s consolidated profit and loss account for 20X1. (d) £25 408 000. 5. what is the nominal value of unissued share capital? (a) (c) £10 592 000. (b) £909m. £9 389 000. (b) £94 000. £1098m. 5. How much operating profit is generated from these sources in 20X0 ? (a) (c) £1 873 000. (b) £8 334 000. (d) £15 805 000. (b) £11 092 000.21 In Award’s consolidated profit and loss account for 20X1. £15 390 000. £24 908 000. (d) £2 461 000. £846 000. what is the amount of goodwill amortised in the profit and loss account for 20X2? (a) (c) £189m. (b) £650 000.23 In MBA’s financial statements.19 In Award’s consolidated profit and loss account for 20X0. (d) £1689m. (b) £15 040 000. (d) £890 000. 5.22 The intangible assets of goodwill appear in both the group balance sheet and the company balance sheet.24 In Award’s balance sheet. £1 992 000.20 Award has interests in companies which are not its subsidiaries. what is the amount of interest received from unlisted investments? (a) (c) £190 000. what is the amount set aside for other shareholders in Award’s subsidiaries? (a) (c) £90 000.Module 5 / The Framework for Financial Reporting 5. (d) £11 262 000.

(d) £2 981 000. (d) £20 068 000.9%. 5.29 In the consolidated accounts of Award.4%. (d) £15 694 000. (b) £13 880 000. 5. Award applied significant amounts of funds in its financing activities. (b) £14 463 000.31 In performing the annual audit.3%.30 In the consolidated accounts of Award. 5. (d) Sale of fixed assets.26 In Award’s consolidated cash flow statement for 20X0. (b) Share premium. the external auditor is required to ensure that: (i) (ii) the client’s accounting systems are operating properly. £15 390 000. what is the movement in stocks of raw materials during 20X1? (a) (c) A decrease of 0. £19 396 000. £2 848 000.27 During 20X1.25 The appearance of which of the following items in consolidated accounts indicates a partial departure from the strict application of historic cost accounting? (a) (c) Long-term loans. what is the total amount of tangible fixed assets acquired during 20X0? (a) (c) £17 317 000.3%. what is the amount of the depreciation charge on plant and machinery in 20X1? (a) (c) £19 000. (b) £18 892 000. (iii) the management is aware of its social and environmental responsibilities. (d) £20 847 000. 5. Accounting Edinburgh Business School 5/91 . £15 850 000. An increase of 6. (d) An increase of 10.Module 5 / The Framework for Financial Reporting 5. 5. (b) An increase of 5.28 In the consolidated accounts of Award. (b) £880 000. Revaluation reserve. 5. what is the total of the proceeds from the sale of tangible fixed assets? (a) (c) £675 000. the company is functioning efficiently. What was the total expended on financing in 20X1? (a) (c) £537 000.

(d) (iii) and (iv) only. 5/92 Edinburgh Business School Accounting . 5. Which of the following is correct? (a) (i) and (ii) only. (ii) the auditor has checked every figure in the financial statements to a high degree of accuracy. Which of the following is correct? (a) (i) and (ii) only. Which of the following is correct? (a) (i) and (ii) only. (c) (ii) and (iii) only. (b) (i) and (iii) only. (iv) the auditor has received sufficient explanation and information on all of his queries. (d) (ii) and (iv) only. the external auditors’ tests will be directed towards: (i) checking appropriate Board authority for major purchases and sales of fixed assets. (iii) effective in ensuring that employees do not shirk their duties. (iv) ensuring that there are no potential bad debts. 5. (iii) and (iv) only.33 In examining a company’s system of internal control on fixed assets. (c) (ii). 5. (b) (ii) and (iii) only. (iii) attending a physical count of all inventories. (iv) safeguarded from abuse by senior executives.34 The inclusion of an unqualified audit report in the financial statements conveys to the reader that: (i) the auditor signing it has yet to qualify as an accountant. (d) (ii) and (iv) only.32 In assessing a company’s system of internal control. (c) (ii) and (iii) only. (b) (i) and (iii) only. Which of the following is correct? (a) (i) and (ii) only. (ii) inspecting major acquisitions. (ii) generating accurate information on which to base the annual financial statements.Module 5 / The Framework for Financial Reporting (iv) the appropriate accounting standards have been used correctly. (c) (ii) and (iii) only. (iii) the auditor is satisfied that proper accounting records have been maintained. the external auditor is primarily concerned that its accounting systems are: (i) simple to understand. (d) (ii) and (iv) only. (b) (i) and (iv) only.

1 (Additional Questions) The nature of Module 5 is such that the usual case study approach is not appropriate. what percentage of profit before exceptional items (and ignoring goodwill) derives from the Americas? Compare the performance in 20X2.Module 5 / The Framework for Financial Reporting Case Study 5. goodwill amortisation and share of joint venture and associates) was generated by the Rest of Europe in 20X1? 14 What is the amount of depreciation charge in 20X1 on assets acquired under finance leases? 15 What percentage of total borrowings at the end of 20X1 is repayable before the end of 20X2? 16 What are the proceeds from the disposal of businesses in 20X1? Accounting Edinburgh Business School 5/93 . what is the profit on sale of interests in subsidiaries and associates? 7 What was the amount of directors’ bonuses payable for 20X1? 8 What was the amount of Minority Interests in 19X8? 9 What is the amount of payments on account against long-term contract work-in-progress at 20X2? 10 What percentage of total turnover derived from Electronic Systems in 20X1? Award Accounts 11 How much cash was generated by the group in 20X0? How does this compare with the cash flow performance in 20X1? 12 What is the amount of turnover from discontinued businesses in 20X0? 13 What percentage of group operating profit (prior to unallocated costs. what proportion of the group’s total current asset investments and cash at bank and in hand is in ‘liquid resources’? 6 In 20X2. In view of the learning objective set out at the start of the Module – for the student to be able to read a published set of financial statements – it is considered that it is more beneficial to allocate further time in increased familiarisation with the accounts of both MBA and Award. 3 What was MBA’s total group liability in respect of advance payments from customers at the end of 20X2? 4 What is the amount of the company’s tangible fixed assets at the end of 20X2? 5 At the end of 20X1. MBA Accounts 1 How many people did MBA employ in UK in 20X2? By how much did the average UK salary in the group increase between 20X1 and 20X2? 2 In 20x1.

Module 5 / The Framework for Financial Reporting 17 What was the charge for Corporation tax in 20X0? 18 What is the total share of Minority Interests at the end of 20X0? 19 How much income did the group receive on its balances of cash at bank during 20X1? 20 How much did the company revaluation reserve change during 20X1? 5/94 Edinburgh Business School Accounting .

9 6.1 6.6 6.4.1 6.3 6.6.3 6.4.10 6.2 6.11 6.11.4 6.4.5.11.6.Module 6 Interpretation of Financial Statements Contents 6.11.2 Accounting Edinburgh Business School 6/1 .5.1 6.1 6.2 6.3 6.2 6.4.4 6.6 6.3 6.1 6.5 6.8 6.2 6.4.4 6.1 Case Study 6.7 6.12 Introduction Ratio Analysis Group 1: Liquidity Ratios Current Ratio Quick Ratio (sometimes called the Acid Test) Group 2: Profitability Ratios Gross Profit Margin Profit Margin Return on Total Assets Return on Specific Assets Return on Capital Employed Return on Owner’s Equity Group 3: Capital Structure Ratios Fixed to Current Asset Ratio Debt Ratio Times Interest Earned Group 4: Efficiency Ratios Inventory Turnover Average Collection Period Fixed Assets Turnover Other Possible Ratios Window Dressing Putting it all Together: The Dupont Chart A One Hundred Per Cent Statement Basic Stock Market Ratios Earnings per Share (EPS) Price/Earnings Ratio (PE) Dividend Yield Dividend Cover Summary 6/2 6/4 6/5 6/5 6/5 6/6 6/6 6/6 6/7 6/7 6/7 6/8 6/8 6/9 6/9 6/11 6/12 6/12 6/13 6/14 6/14 6/15 6/16 6/18 6/18 6/19 6/19 6/19 6/20 6/20 6/21 6/27 6/28 Review Questions Case Study 6.2 6.3.2 6.1 6.5 6.11.5.3 6.6.4.3.

Interpreting financial statements is the logical extension to constructing and reading them. For example. of the principal financial statements prepared by a company. is Financial Accounting for Managers. its balance sheet and its cash flow statement. the basic stock market ratios.Module 6 / Interpretation of Financial Statements Learning Objectives By the end of this module you should understand: • • • • • the need for ratio analysis of external financial statements. These relationships among separate items are expressed as percentages. 6. how to expand the external analysis to an integrated chart analysis focusing on return on investment. its profit and loss account. Some Introductory Points 1 Absolute figures as reported in financial statements do not tell the reader very much. say. The emphasis in the previous modules is on the meaning. and (d) detect areas of weaknesses to which managers can direct their managerial efforts. MBA’s profits before tax to sales ratio is 19. to be told that MBA made £1504 million profit before taxation is not a useful piece of information by itself. and basic construction. This fact must be related to. all seen from the perspective of a manager who must understand what accounting numbers tell him. the strengths and weaknesses of ratio analysis. the major ratios commonly used: liquidity ratios. (c) compare the performance of the company with what the directors expected. or to the capital employed of £6081 million (the net assets in the group balance sheet). he or she is in a position to: (a) compare the performance of the company this period with last. capital structure ratios. the sales of £7625 million which produced the profit. This module completes the broad picture: in it the manager is instructed in how to dismantle the financial statements in such a way that when matching one piece with another.1 Introduction The title of Part One of this MBA course. and efficiency ratios. (b) compare the performance of the company with that of its competitors. profitability ratios.72 per cent. 6/2 Edinburgh Business School Accounting . comprising the first seven modules.

this allows individual companies to position themselves more accurately than is possible with the overall average percentage or ratio. where necessary. say. Some of these organisations are operated for profit in the private sector. others are run by government departments. In such a situation. In this situation ratios disguise the real picture. dominate the industrial sector. and receive in return the computed average percentage and ratios for key performance indicators taken from the information supplied by many of MBA’s competitors in the same industrial sector. Consolidated. These percentages and ratios allow MBA to gauge its own performance against the industrial sector as a whole. ‘profit’ or ‘capital employed’ or ‘debt’. Note. The organisations which publish inter-firm comparisons usually define in detail the key headings to allow subscribing companies to adjust. a company could report. an interperiod comparison would be invalidated. average figures should be used for ratios. a 300 per cent growth in turnover which gives the impression of success and progress. by themselves. In ratio analysis it is important to study the trend of the ratios calculated rather than to attempt to arrive at sound conclusions on one year’s numbers. on a strictly confidential basis. or group. Accounting Edinburgh Business School 6/3 . For example. however. or ratios. The frequently used benchmarks for the purposes of comparison are the data produced by the various ‘clearing houses’ for industrial statistics. However. companies within the same group. a company like MBA would contribute its own financial and production statistics to organisations of inter-firm comparisons. Using year-end figures may not reflect the typical financial position of the business throughout the year. so too one finds wide diversity in approaches to financial analysis. say. They do agree. that they must apply their definitions consistently for the same company for many accounting periods. Just as no two sets of company financial statements are the same in style and layout. Analysts do not argue over their individual definitions of. the basis for such a calculation could be a sales figure of £100 when competitors using the same amount of capital and labour inputs are enjoying sales of £1000. or ratios should be calculated at different points during the year. or companies within the same industrial sector. Unless its operations. financial statements should be used wherever possible for the purposes of ratio analysis. permit easy comparison between different corporate entities: divisions within the company. too. Otherwise. their own figures and percentages.Module 6 / Interpretation of Financial Statements 2 3 4 5 6 7 Percentages. A word of warning about ratios: they can be used to suppress poor absolute figures. that most organisations for inter-firm comparisons supply upper and lower quartile figures in each key area. the average figures (which include MBA’s statistics) will be a reasonable guide to MBA’s management as to how their company has performed over the period covered by the industrial averages (normally half-yearly). Typically. they recognise that agreement would be impossible because no two companies measure these items in the same way.

defence. ratios lead the manager to ask the right questions and sometimes give clues as to possible areas of corporate strength or weakness.Module 6 / Interpretation of Financial Statements 6. so diverse are the sectors covered by MBA – electrical engineering. which is derived by dividing one quantity by another. electronics. The purpose of using ratios is to reduce the amount of data to a workable form and to make it more meaningful. and (b) those that analyse the financing arrangements of the company’s total assets. information technology and systems being the major ones – it is impossible to find publicly available industrial ratios from which to draw sensible benchmark averages. For the purposes of this module. systems. Efficiency Ratios Efficiency ratios give an indication of how effectively a company has been managing its assets. in particular the extent to which the company relies on debt. A manager must learn which combination of ratios is most appropriate in a specific situation. 6/4 Edinburgh Business School Accounting . A financial ratio is a relationship between two quantities on a company’s financial statements.2 Ratio Analysis The financial statements of MBA as produced as Appendix 5. We shall use year-end figures for our analysis. There are hundreds of ratios which could be calculated. Profitability Ratios Profitability ratios are designed to measure management’s overall effectiveness: does the company control expenses and earn a reasonable return on funds committed? Capital Structure Ratios Capital structure ratios are divided into two groups which are: (a) those that examine the asset structure of the company. therefore. the following group of ratios will be explained and discussed: Liquidity Ratios Liquidity ratios are designed to measure a company’s ability to meet its maturing short-term obligations. In normal circumstances it would have been appropriate to use benchmark averages for each ratio calculated drawn from the industrial sector in which MBA is located. have created their own ‘industrial averages’ from data collated from each of the sectors in which MBA is active. remembering that ratios seldom provide conclusive answers. This goal is defeated if too many ratios are calculated.1 in Module 5 will be used again for this module. This group of ratios is generally known as the gearing ratios. However. The authors of this text.

thus providing a more rigorous test of the company’s ability to pay its maturing obligations.03 times MBA has a liquid position that is superior to the average of all the other companies in the same industrial sector. the company could improve this ratio to 4 times (inventory £2000. The quick ratio therefore removes inventory from the calculation. Unfortunately.3. this rule can be misleading: one should not conclude that a company can necessarily pay its bills because it has a current ratio greater than 2 times. Since nothing is known about the marketability of inventory it might be that the liquidity position of 1.95 times The industrial average is slightly less than the widely accepted rule of thumb of 1 times (meaning that no matter how great the losses incurred on the sale Accounting Edinburgh Business School 6/5 . Is the company able to meet its short-term maturing obligations? 6. 6. It is often stated as a rule of thumb that a 2 times current ratio indicates a sound financial situation.03 times 3216 Industry sector = 0.Module 6 / Interpretation of Financial Statements 6. a company is in a good position to meet its current obligations if current assets exceed current liabilities by a comfortable margin.35 times 3216 Industry sector = 1. Quick ratio = Current assets − Inventory Current liabilities 4364 − 1052 MBA = = 1. creditors £500).3 Group 1: Liquidity Ratios The first concern of managers is ensuring the short-run survival of the company.3. In the next accounting period. by paying off many of its creditors in cash. Current ratio = MBA = 4364 Current assets Current liabilities = 1.6 times. giving a current ratio of 1. Their attention inevitably is drawn to liquidity. a company may have current assets of £4000 (cash £2000 + inventory £2000) and current liabilities of £2500 (all creditors).6 times is healthier than 4 times in this example. For example. Since current assets are cash or assets expected to be turned into cash within the next 12 months. Nor should one conclude that a ratio of less than 2 times indicates that a company cannot pay its bills. and current liabilities are those that should be paid within the next 12 months.1 Current Ratio The current ratio is computed by dividing current assets by current liabilities.2 Quick Ratio (sometimes called the Acid Test) Analysts recognise that current assets include inventory which is sometimes slow moving and not so readily realisable into cash as is implied by the current ratio.

4. However. then profitability gives them an insight into long-term survival.2 Profit Margin Some analysts use profit after taxes divided by sales to determine profit margin.4% 6/6 Edinburgh Business School Accounting .4 Group 2: Profitability Ratios If liquidity is management’s first concern for short-term survival.4. However. it is sometimes difficult to get a satisfactory measure of gross profit from published accounts. the company would still have enough left to pay its obligations) but the same caution should be heeded about this rule of thumb as was noted with the current ratio. the tax charge in company accounts is distorted by a variety of fiscal provisions and often reflects tax liabilities incurred in earlier accounting periods. Profitability ratios give some answers as to how effective this managerial action has been. An examination of the order book and production plans should reveal whether such an inventory pile is justified. Profitability is the result of many managerial policies and decisions. 6.Module 6 / Interpretation of Financial Statements of inventories. 6. Profit margin = MBA = 1504 Profit on ordinary activities before taxation Sales × 100 = 19. We will use MBA’s operating profit as a surrogate for gross profit: Gross profit margin = MBA = 940 Operating profit Sales × 100 = 12. and of course does not take into account the ability to raise cash quickly from other sources.72% 7625 Industry sector = 8. The position of MBA is again healthy: the ratio reveals that the group of companies has enough cash to meet its obligations if called upon quickly to do so – an unlikely event one would imagine.32% 7625 Industry sector = not possible to calculate 6. Some analysts therefore are beginning to move towards profit before taxes as the numerator of the fraction. This module will use the before taxes figure. management should consider the level of inventory being carried.1 Gross Profit Margin The gross profit margin is the first critical measure of profit an analyst or manager examines since a company must earn significant gross margin if it is going to bear the burden of other corporate overhead. If a company finds itself with a quick ratio inferior to the industrial average but its current ratio matches the average.

but in this industrial sector the average is calculated on total assets.3% Note that the whole balance sheet figure for total assets (fixed assets plus current assets) has been selected for the fraction: a case can be made for using just the productive assets.89% 10 098 Industry sector = 10.4. Alternatively. that MBA’s profit margin is significantly higher than the industry average. management could start to put things right by shedding unproductive assets. the overall industry average indicates that in this business companies tend to hold substantial inventories. omitting such items as goodwill (if any) and investments. one can add together the owner’s equity Accounting Edinburgh Business School 6/7 . A company which operates with low inventories would expect to see a return on inventory of several hundred percent. 6.5 Return on Capital Employed Capital employed is usually defined as the total assets of a company minus the current liabilities. therefore. by itself.4 Return on Specific Assets It is possible to relate profit to any particular asset if management considers that that asset is crucial to the results of the company: we select inventory.4.3 Return on Total Assets Profit is not only a function of sales. 6. It follows. it is also closely related to the assets employed by the company to produce the profit. If a company finds itself with a low return on total assets ratio. It can be seen that MBA is apparently ‘working its assets’ harder than its competitors which. Return on total assets = MBA = 1504 Profit on ordinary activities before taxation Total assets × 100 = 14.Module 6 / Interpretation of Financial Statements MBA’s profit margin is significantly higher than its gross profit margin because the latter calculation includes only operational activities whereas the former takes into account the huge exceptional gains MBA has made in disposing of parts of its business.97% 1052 Industry sector = 85% While MBA’s return of 142% is unusually high due to the exceptional items contained in the numerator of the fraction. 6.4. is desirable although MBA’s profit figure has been favourably distorted by exceptional items. Return on inventory = MBA = 1504 Profit on ordinary activities before taxation Inventory × 100 = 142.

therefore. It could in fact signal danger if the firm relies too heavily on debt. This figure for capital employed in the business is an indicator of the magnitude of resources locked up in the business and working for the benefit of the two categories of capital providers. the differential is not significant given the substantial exceptional items which have been included in MBA’s numerator.6 Return on Owner’s Equity Perhaps the most important profitability ratio is the one that relates the profit earned to the capital (contributed and accumulated) of the ordinary shareholders of the company.Module 6 / Interpretation of Financial Statements and the long-term loans and provisions. 6. we therefore deduct the share of profits attributable to the minority interest from the profit figure used in earlier ratios. This suggests. But. that MBA is carrying too many assets and should work to reduce the funds tied up in capital employed.59% 5989 Industry sector = 14. Return on owner’s equity = × 100 = 17.8% MBA = 1504 Here we see that although MBA’s return is superior to the industrial average. This matter is analysed in Module 3 and will be revised later in this module.7% MBA = 1054 Profit on ordinary activities attributable to shareholders Owner’s equity Note that the profit attributable to MBA shareholders is the numerator of this fraction because we are gauging the return the owners are earning on their contribution to the company.5 Group 3: Capital Structure Ratios The first group of capital structure ratios examines the asset structure of the company: for example. further analysis could indicate whether a disproportionate increase in debt over equity caused the improvement in this ratio.4. thereby prejudicing the company’s chances of securing additional capital or loans on beneficial terms. Another point to note: one normally considers an increase in this ratio to be a good sign. Readers should remember that investors are more concerned with relating their returns with the current market price of their shares than with the ‘book value’ of their investment. again. has the company the optimum proportion of fixed assets 6/8 Edinburgh Business School Accounting .85% 6882 Industry sector = 17. the shareholders and the providers of loan and debt. Return on capital employed = Profit on ordinary activities before taxation Capital employed × 100 = 21. 6. If the company fails to earn a decent return for its shareholders. the share price will fall. together with the tax due.

if assets earn 14 per cent and debt costs 11 per cent. highly geared companies are very exposed in hard times (due to a high fixed interest charge on reducing profits) but enjoy high profits in boom times. The industry seems to be able to work with a lower level of fixed assets. the risks of the enterprise are borne mainly by the creditors. Gearing ratios (sometimes known as leverage) measure the contributions from shareholders with the financing provided by the company’s creditors and other providers of loan capital. 6. variations can be developed around the principal relationships.Module 6 / Interpretation of Financial Statements to total assets? As in all ratio analysis. If the owners have provided only a small proportion of total financing. Accounting Edinburgh Business School 6/9 . For the purposes of this module we shall adopt the all-inclusive concept of using all non-equity financing with the exception of minority interest which. Companies with low gearing ratios have less risk of loss when their market.5. Others are content to use all non-equity financing on the grounds that it is usually impossible to determine from a set of published accounts which items are interest-bearing and which are not. if the return on the assets falls to 9 per cent. Conversely. For example. In such a situation. the differential of 3 per cent accrues directly to the shareholders. the owners gain the benefits of maintaining control of the firm with a limited investment of their own. or the economy.1 Fixed to Current Asset Ratio Fixed to current asset ratio = Fixed assets Current assets × 100 = 131% 4364 Industry sector = 102% MBA = 5734 This ratio highlights the fact that for every £1 invested in current assets. We reiterate one of our general observations made at the beginning of this module: the definition of individual ratios does not really matter.31 in fixed assets. MBA has invested around £1. by raising funds through debt. go into recession.5. the return to the shareholders is magnified. or owner-supplied funds. The main ratio is fixed to current assets. therefore. 6. the negative differential of 2 per cent between earnings and interest charges must be paid out of profits attributable to shareholders. On the other hand. to provide a margin of safety. However. Creditors look to the owner’s equity. what matters is the consistency with which the definitions are used by the individual analyst. but they also have lower returns when the economy takes off again.2 Debt Ratio The debt ratio measures the proportion of assets that are financed by debt. if the company earns more on the borrowed funds than it pays in interest. But what constitutes debt? Some analysts argue that only debt on which the company bears interest should be included in this ratio. This interrelationship is explained in Module 3. The second group of ratios analyses how the company’s assets have been financed.

which for MBA in 20x2 would read: Total debt × 100 Total equity 3216 + 266 + 535 MBA = × 100 = 67.07% 5989 Which is the better ratio? There is no answer to this question. none is subject to a wider variety of interpretation than the debt ratio. Owner’s equity = £5989 million.78 pence has been contributed by persons other than shareholders. 1 2 3 4 Profits before interest for 20x2 = £1561 million. shareholders have contributed 60. (£1504 million plus £57 million interest paid (note 4) added back) Interest charge for 20x2 = £57 million. Let us further imagine that for both 20x2 and 20x3 the gearing percentage is doubled to 79. and annual interest would be doubled to £114 million. One frequent version is Debt/Equity. This would have two effects: owner’s equity would be reduced from £5989 million to £1972 million (the difference being double the current level of debt). The following table sets out the three profit scenarios assuming two levels of gearing (A) the current relatively low level of 39 per cent and (B) an imaginary high level of 79 per cent: 6/10 Edinburgh Business School Accounting . For illustrative purposes let us imagine two starkly different scenarios for 20x3: (a) profits are roughly one-twentyseventh of 20x2 levels due to a catastrophic downturn in every market in which MBA is currently a world leader. Conversely.78%.78% = 10 098 Industry sector = 32% What does the figure of 39.Module 6 / Interpretation of Financial Statements being the non-MBA shareholders remaining in the subsidiaries acquired. (from note 4) Gearing percentage = 39. analysts tend to use ratios that they are familiar with and for which there are industrial averages available. and (b) profits double in 20x3. let us play with MBA’s numbers from the data given in the 20x2 accounts.22 pence to every £1 of assets employed by MBA. has no legal right to financial reward. To illustrate further the impact of gearing (see Module 3 for an introduction and simple worked example).78 per cent mean? Simply that of every £1 MBA has invested in its assets.56 per cent. Debt ratio = MBA = Total debt Total assets All creditors and provisions Total assets 3216 + 266 + 535 = 39. 39. Of all the ratios so far explained.

53% Workings: the return on equity percentages are calculated by dividing the profit available to equity by the equity in the respective companies.37% £m 3 122 114 3 008 1 972 152. the low-geared company (B) protects its shareholders in times of economic hardship but by the same token fails to allow them to cash in on bumper rewards when business turns up. This accounts for the fact that as companies seek more debt to finance growth rather than equity. as can be seen from the foregoing example. lenders may insist on either a higher interest rate to compensate for the increased risk or a balance to be struck between increased debt and increased equity.5.17 per cent in Company A under ‘Utopia’ is calculated: Available to equity £3065 Equity £5989 × 100 = 51. The extremes of reward are experienced in a highly geared company. Without qualification. and (b) to repay the loan when due. gearing has different connotations. A lender is interested in the company’s ability (a) to pay interest on his debt. a lender is less exposed in a low-geared company. Viewed from the position of a lender.Module 6 / Interpretation of Financial Statements A Profits before interest Interest charge Available to equity Owner’s equity Low-geared return on equity Doomsday! Onetwentyseventh profits £m 57 57 – 5 989 NIL Current position £m 1 561 57 1 504 5 989 25. It measures the extent to which earnings can Accounting Edinburgh Business School 6/11 .17 per cent As we saw in Module 3.3 Times Interest Earned To reflect the concerns of lenders the times interest earned ratio switches to the profit and loss account in order to measure the gearing position and margin of safety in relation to earnings. the return on equity of 51. 6. For example.11% Utopia! Double profits £m 3 122 57 3 065 5 989 51.17% B Profits before interest Interest charge Available to equity Owner’s equity High-geared return on equity £m 57 114 (57) 1 972 negative £m 1 561 114 1 447 1 972 73.

It comprises Raw materials and consumables and Staff costs.Module 6 / Interpretation of Financial Statements decline without the company finding itself unable to meet the annual interest costs. students should try to identify the raw material and labour components in the costs which are deducted from Turnover to calculate Operating Profit. 6.42 times 1052 Industry sector = 6. Unless the item ‘Cost of sales’ is individually identified in either the profit and loss account or in the notes to the accounts. Inventory is an asset which companies require to invest in to act as a buffer between uncertain demand for the finished products on the one hand and uncertain supply of raw materials and the vagaries of the production cycle on the other. Should the company default on these payments.6 Group 4: Efficiency Ratios The efficiency ratios (sometimes referred to as activity or turnover ratios) are designed to assist managers. Times interest earned = MBA = 1504 + 57 Profit on ordinary activities before tax + Interest charges Interest charges = 27.1 Inventory Turnover Inventory turnover = MBA = 4650 Cost of sales Inventory = 4. debtors and fixed assets which help to generate sales.38 times 57 Industry sector = not given MBA’s current interest charges are covered over twenty-seven times by current profits. then creditors can bring legal action against the company. in judging how effectively a company manages its assets.42 times per annum equates with an average holding of inventory of just under three months compared with just over two months for the competitors. and outsiders. 6.6. A figure of 4. It could clearly weather a downturn in profits and an increase in interest rates without risking default on interest payments. This is a healthy position and is consistent with its relatively low gearing.1 times The figure of Cost of sales is obtained from Note 2 to the accounts ‘Group Operating Profit’. All the ratios involve comparisons between the figure of sales and the investment in various assets. It is not possible to be dogmatic about which costs should be included in the Cost of sales simply because no two companies define costs in the same way and no two companies disclose these costs in the same way. they assume that management strives to keep a sensible balance between sales and such items as inventory. But do companies have to carry as much as two months’ supply? Many companies are working with suppliers on just-intime programmes of raw material deliveries where the receiving company can 6/12 Edinburgh Business School Accounting .

The latter groups can survive in a fiendishly competitive market because they manage their inventory level. We assume here a 365-working-day year. PC manufacturers can find themselves caught with high inventory of finished products as prices of memory chips tumble. this can of course be reduced if used consistently. Reports from Japanese car manufacturers quantify inventories of raw materials in terms of hours! At the other end of the supply chain. The pain experienced in keeping high levels of inventory can be illustrated in the market for personal computers.6. some adjustment should be made to this inventory figure if sufficient information is available. It could be that MBA’s pattern of trade dictates a stocking-up at the end of the year. the outcome of such a review so often leads to a reduction in inventory holding. A careful review of past history will allow a realistic view to be taken of the probability of sudden demand. if this seasonal pattern is universal in this industry then no adjustment is required in order to compare MBA’s stocking level with its competitors. MBA has a distinctly inferior ratio compared with the industrial average. Other manufacturers build PCs to order. retail shops are very rapid. The ratio represents the average length of time that a company must wait after making a sale before receiving the cash. whereas the inventory figure is taken from the closing balance sheet. These suppliers are not able to pass on to the customer the high component costs and consequently they record a loss on each sale. thereby dragging down the market price for the PC.2 Average Collection Period Sometimes called days sales outstanding. even though volume demand keeps growing. the average collection period ratio is calculated by dividing debtors by the daily average of sales. Average collection period = MBA = 1953 Debtors Sales per day = 93 days 7625 ÷ 365 Industry sector = 70 days Accounting Edinburgh Business School 6/13 . finished goods are held to guard against a sudden surge in demand. Two additional points should be noted: 1 Sales occur over the entire year. The market is prone to price swings as new chips command premium prices when they are first launched because of their technological lead over existing products. prices fall. 6. The market for memory chips for PCs is highly cyclical. indicating that they need low inventories to service their sales levels.Module 6 / Interpretation of Financial Statements be assured that the correct quantity of materials at the correct quality will be delivered at the correct time. have only two or three weeks of inventory of chips and finished product on hand and can therefore pass on to their customers almost immediately the declining prices of memory chips. However. But as production increases. Heavy engineering tends to be slow because of the length of the production process. 2 Different industries have significantly different inventory turnovers.

6. Another reason. necessary though they may be. The effect of debtors in any business.07 times As in return on total assets. Sometimes. while the above ratio analysis does not provide conclusive answers. 6. It should be repeated that. Given the worldwide basis of MBA’s activities. they require less assets to produce the same level of sales as others. capital employed and remuneration with the number of employees in the company. Fixed asset turnover = MBA = Sales Fixed assets 7625 = 1. it does indicate to management. such calculations would yield fairly meaningless results. notably land and buildings. If MBA’s competitors have more up-to-date land valuations in their ratio. managers should feel free to develop any ratio which they consider gives them insight into their businesses. as in all ratio analysis. the selling company has to borrow money in the short term to finance its customers’ working capital! The figure of 93 days for MBA is apparently unimpressive (but remember the many-sided nature of MBA’s business). The 15 ratios calculated have revealed some possible strengths and weaknesses about MBA’s financial position. which 6/14 Edinburgh Business School Accounting . however. that is. a popular series of ratios relates sales. MBA is seen as having a ratio superior to that of its competitors. the resultant figure is only meaningful when compared with both previously calculated ratios for the same company and the average ratio for the rest of the industrial sector. One reason could be that MBA’s management is more efficient at ‘working its assets’ than other companies. if the credit management gets out of control. and outside analysts. could be that the competition makes a more realistic valuation of some of its fixed assets. Again. The high level of inventory gives cause for concern but the relatively low gearing of the financial structure (relative to industry in general as opposed to the specific industry in particular) is a cause for comfort.7 Other Possible Ratios Companies use many other ratios which are not described here. For example.Module 6 / Interpretation of Financial Statements MBA’s sales outstanding are very much greater than those of its competitors and might represent prima facie slack credit management. is that the company which is owed the money is financing the debtors’ working capital.6. Provided they are used consistently so as to reveal long-term trends. however. then they will inevitably report lower turnover rates. profits.33 times 5734 Industry sector = 1.3 Fixed Assets Turnover Fixed assets are acquired by a company to produce saleable products: it is therefore not unreasonable to relate the investment in fixed assets to the level of sales generated therefrom.

Consider the working capital position of a company which is more or less static throughout the year. say. Current assets Inventory Debtors Cash £ 400 200 100 700 Current liabilities Creditors Net current assets 700 500 500 200 Current ratio = = 1. and ratios. Management may be tempted to enter artificial arrangements with the sole purpose of making their accounts. The company could arrange to ‘sell’.6 times Imagine that management does not wish to be subjected to adverse comment on its liquidity. would look like this: Current assets Inventory Debtors Cash £ 200 400 100 700 Current liabilities Creditors Net current assets 700 500 500 200 Current ratio = = 1.8 Window Dressing Corporate financial statements are drawn up on a given day each year. The weaknesses of ratio analysis are not so much the fault of the ratios but of the managers and analysts who misuse them. look better. thereby restoring the status quo. £200 of finished goods inventory to compliant customers who would agree to return the goods shortly after the beginning of the next financial year. and the ratios calculated thereon.Module 6 / Interpretation of Financial Statements areas require further investigation and provide some clues as to what the problems might be. On the day the balance sheet is drawn up the working capital situation.4 times Accounting Edinburgh Business School 6/15 .4 times Quick ratio = (700 − 400) 500 = 0. This is called window dressing. 6.

alternatively a desire to minimise investment in surplus assets may stimulate calculations of efficiency ratios. Importance varies in accordance with need. But one ratio is deemed by most companies to be ultimately significant. namely Return on Total Assets (ROTA). the numbers used for the ‘Return’ part of the chart have all been drawn from Note 2 on p. If a company is experiencing pressure on its prices. In the interest of traceability. 6. Dupont employed the layout shown in Figure 6. management may be able to submit a plausible story to their auditors so that an unqualified audit opinion is given.9 Putting it all Together: The Dupont Chart So often managers ask: ‘Of all these ratios. We have slotted in the relevant MBA numbers. and managers within these divisions. In that company the performance of individual divisions. ROTA answers the most fundamental managerial question of all in relation to a company’s performance: ‘How much are we making from our investment in total assets?’ ROTA can be broken into its two components: Return Defined as Profit/Sales × 100 Total Assets Sales/Investment in total assets Multiply one by the other Profit/Total assets × 100 = ROTA The chemical company Dupont was one of the first companies to make public (several decades ago) how it viewed the importance of ROTA. On the other hand.0 times This form of sharp practice would no doubt be detected by the company’s external auditor who may take the view that the company’s end-of-year balance sheet does not show a true and fair view. could be evaluated by calculating ROTA per division and improvements sought in areas of perceived weakness. If window dressing is suspected. 6/16 Edinburgh Business School Accounting .Module 6 / Interpretation of Financial Statements Quick ratio = (700 − 200) 500 = 1. managers should focus attention on profitability ratios in order to gauge the impact of market pressures. ratio analysis should be carried out at a number of points throughout the year. 5/37 of the Profit and Loss Account. now universally called the Dupont Chart.1 so that components of the ratio could be identified. which one is the most important?’ There is no single answer to this question.

Check these calculations for yourselves! 4 Readers will note that the return on total assets in the Dupont Chart is 5. This difference is caused by using a different number for profit in the numerator of the two fractions. and (b) inventories are halved overnight to £526 million. In the earlier ratio.22 per cent. But in our view.62% Total asset turnover 0.62% x 0. the operating return on investment since we have used only the operating profit earned in 20x2. in effect. managers are less able to influence these latter items than the costs that comprise operating costs. 3 An improvement in ROTA can be achieved by an improvement in profitability or in asset management or in a combination of both.17 per cent and total asset turnover would move to 0.66 times 5. Managerial attention must be focused on the top line of this chart. 2 The ROTA figure calculated for MBA is. Management will usually have access to much more information.69 per cent and the same ratio calculated in 6. giving a new ROTA of 13. and added to. neither of which is commercially desirable or possible: (a) Staff costs are reduced by one third.4.Module 6 / Interpretation of Financial Statements Return Raw materials 2300 Staff costs 2066 Depreciation 396 Others 1320 Inventories 1052 Total assets Debtors Investments 224 1953 Cash 1135 Operating costs 6082 Sales 6656 Current assets 4364 Fixed assets 5734 Sales 6656 Operating profit 574 Sales 6656 Total assets 10 098 Profit/Sales 8.69 times. trading profit to determine ‘Profit on ordinary activities before taxation’. we were not concerned about the detailed components of profit and selected the figure for profit on ordinary Accounting Edinburgh Business School 6/17 .66 times Return on total assets 8.69% Figure 6. A glance at the profit and loss account will reveal many more items which have been subtracted from.1 The Dupont Chart for MBA’s 20x2 performance Comments on MBA’s chart: 1 Lack of published detail prevents a more rigorous analysis of profit and loss items.3 per cent. Profit/sales would jump to 19.3 is 10. For example. let us recalculate MBA’s numbers making two assumptions.

92 29. 6/18 Edinburgh Business School Accounting .04 5. MBA plc 20x2 £ Sales Raw materials Staff costs Depreciation Other costs Operating costs Operating profit before other operating income 2 300 2 066 396 1 320 6 082 £ 6 656 % 100 34.83 91.10 A One Hundred Per Cent Statement A concluding note on profitability: managements have access to more detailed figures than are made available to shareholders in an annual report. They are also concerned with how the outside world views the company’s future prospects.57 18.27 5. This is not an important distinction.92% to 34. we are required to go into greater detail as to what constitutes operating costs and we selected only those items we believed individual managers had control over. In relation to profitability and cost control a favourite technique used is the One hundred per cent statement where sales are set at 100 per cent and each item of cost is calculated as a percentage of sales. In the case of a quoted company like MBA. 6.22 20x1 £ 6 368 £ 2 415 1 864 355 1 175 5 809 574 8.11 Basic Stock Market Ratios Managers and investors are not only interested in the ratios of past internal performance.55 31. this section defines several stock market ratios so that readers may understand better the financial pages of the daily press.45 91. 6. these should be investigated further.63 8. In the Dupont Chart. Even with published information such analysis is possible.95 19.55% indicating either a change in product mix or a smarter purchasing policy. They are therefore capable of calculating more detailed ratios than those defined in this module.37 % 100 37.78 559 A very slight deterioration in operating profit masks three significant movements in individual items: (a) raw materials have declined dramatically from 37.Module 6 / Interpretation of Financial Statements activities before taxation from the face of the profit and loss account. The accompanying MBA Finance course discusses stock market prices in depth. the daily Stock Exchange quotation is the best surrogate for market opinion about future prospects. and (b) an increase in staff costs and other costs.

6.3 Dividend Yield A company declares a dividend based on its ability to pay out versus its requirements for resources to grow the business. as opposed to a PE of say 12. In MBA’s case (see Note 7 on p.1 Earnings per Share (EPS) The calculation of earnings per share (EPS) is relatively straightforward: Profit on ordinary activities attributable to shareholders Number of ordinary shares in issue In MBA’s accounts this calculation is shown in Note 8 (p.11. Investors would then weigh up whether this represents a ‘risky bet’. 5/39) and is set out at the foot of the profit and loss account at 38. This disclosure is required by FRS 3. 6. then PE is: 690p 38. namely 690p. The figure of 18 informs investors (who probably have no idea of MBA’s EPS for 20x2) that the share price of 690p represents the purchase of 18 years’ profits. say 18.9p = 17. calculated as follows: Dividend per share Market value per share 13p 690p × 100 MBA = × 100 = 1.Module 6 / Interpretation of Financial Statements 6. The investor wants to know the dividend return to be enjoyed based on the market value to be paid for shares today. 5/39) this amounts to 13 pence per share. Again this information must be weighed against market and sector averages.1p when exceptional items are added to the results from normal business (see p.11. a company is obliged to pay the government a tax credit on the dividend before it pays the shareholder. or whether it perhaps indicates a market perception of MBA which predicts much better performance in years to come.88% In the UK and many other countries with similar fiscal regimes. 5/31).73.2 Price/Earnings Ratio (PE) The combination of EPS and market quotation gives a ratio known as price/ earnings or PE: Market price EPS Let’s assume the market price of MBA’s ordinary shares is 690p.9 pence from normal business and 27. Therefore.11. it is common practice to ‘gross-up’ the dividend received by the shareholder by the rate of tax paid by the company in order to gain a Accounting Edinburgh Business School 6/19 . this is known as dividend yield.

12 Summary Financial statements report absolute figures.4 Dividend Cover Some companies which are experiencing downward pressure on profits feel obliged to continue to pay shareholders the level of dividends they have come to expect. in their opinion. a company does not need to earn profits to pay a dividend but if it does not it will erode reserves and this action cannot go on indefinitely. namely whether it controls expenses and earns a reasonable return on funds invested. The most prominent ratios can be grouped into four categories.25p = × 100 = 2. (c) capital structure ratios which examine the percentage of a company’s total assets which are contributed by shareholders and the effect and risk of such a percentage on the earnings. The dividend cover ratio is simple to calculate and is designed to draw attention to overgenerous management decisions to pay out too much. But these figures by themselves do not reveal much about the company. They do this for a number of reasons which are associated with attempting to keep up the share price – which would otherwise be negatively affected by disenchanted shareholders selling their holding on receiving a miserable dividend payout.03 times cover As has already been mentioned. Therefore the adjusted calculation would be as follows: Gross dividend yield = (Dividend per share × 100/80) Market value per share 16. Ratio analysis only produces insights when it is carried out for a number of years and when the ratios are compared with industrial averages. In the UK at present the tax credit is 20 per cent. Profit on ordinary activities attributable to shareholders Dividend payout MBA = 1054 348 = 3. (b) profitability ratios which strike at the heart of a company’s activities.11. and (d) efficiency ratios which measure the company’s asset management.35% 690p × 100 Yields can be compared and investors can opt for the one which. 6. they need to be related one to another so that internal strengths and weaknesses can be revealed. will provide best value for money.Module 6 / Interpretation of Financial Statements view of the gross dividend yield. (a) liquidity ratios which are designed to measure a company’s ability to meet its maturing short-term obligations. 6. 6/20 Edinburgh Business School Accounting .

(ii) and (iii) only. quick decreases. 6. (iii) and (iv) only. (d) (iii) and (iv) only. (b) Current unchanged. (iv) Liquidity ratios analyse the financing arrangements behind a company’s assets. (d) Current decreases.1 In using ratio analysis to assist in the interpretation of financial statements. not (ii). Review Questions 6. (iii) the comparison of ratios with those of similar companies in the same industrial sector.2 Accounting ratios have different prime objectives. Efficiency ratios indicate management’s overall effectiveness. (iii) Profitability ratios indicate how effectively a company has been managing its assets.Module 6 / Interpretation of Financial Statements Stock market ratios are also critical for the management of a quoted company but because these are based on the daily share price these ratios tend not to be controllable in the short term. (d) Not (i). not (iv). quick decreases.3 What effect does the purchase of fixed assets. have on the current and the quick ratio? (a) (c) Current increases. (iv) the application of consistency in computing ratios. (b) (i). it is important that the user of the ratios pays particular attention to: (i) (ii) the trend of ratios over several accounting periods. Accounting Edinburgh Business School 6/21 . the absolute amount of ratios. Current decreases. quick increases. (iii) and (iv) only. for cash. (i). quick decreases. Which of the following is correct? (a) (c) (i) and (ii) only. (i) (ii) Capital structure ratios are designed to assess a company’s ability to meet its short-term obligations. 6. (ii) and (iii) only. Which of the following is correct? (a) (c) (i) and (ii) only. No set of ratios is sacrosanct. (b) (i). not (iii). the secret of good ratio analysis is to understand the underlying significance of a small number of ratios and then apply them consistently through time and across companies.

From the year-end balance sheet of Bell Products Limited.50 times.12 times. The following information applies to Questions 6. (b) An increase in the manufacture of finished goods.68 times. the following items have been extracted: Creditors Debtors Inventories Bank overdraft 6. 6.4 Which of the following should be included in a computation of the current ratio? (a) (c) Share capital.88 times.88 times.00 times.00 times. A slowing down of payments to suppliers.5 What effect does the receipt of cash from a debtor have on the current and the quick ratios? (a) (c) Current unchanged. (d) 1. quick increases. (d) The introduction of stricter credit control procedures. (d) Current increases. the repayment of which is not due for two years. the bank overdraft is converted into a term loan. £ 25 000 42 000 33 000 12 500 6/22 Edinburgh Business School Accounting . Current increases.9.9 Following discussions with the bank.Module 6 / Interpretation of Financial Statements 6. quick unchanged. quick decreases. (b) Creditors of more than one year. (d) Debtors.0 times. 3. 6. 1. 6.7 What is the current ratio? (a) (c) 0.52 times. (b) 0. (b) 2. What are the revised current and quick ratios? (a) Current 2.7–6. Motor vehicles. quick unchanged. quick 0.6 Which of the following represents the most immediate method of effecting an improvement in a poor quick ratio? (a) (c) A decrease in purchases for inventory.8 What is the quick ratio? (a) (c) 0.60 times. 6. (d) 8. (b) Current decreases.

(b) 8.30%. 6.65 times. (c) 42.35%. (d) 1.6%. (c) 23.5 times.10 What is the current ratio in Award’s consolidated balance sheet at 20X0? (a) 0.65 times. Accounting Edinburgh Business School 6/23 . 6. (b) 1. (c) 91. (d) 209. 6.46%. (c) 1. (b) 33.60 times.0 times.65 times.7%.54%. what is the profit margin ratio? (a) 7. (b) 0. (d) 28. (d) 294.95%.63 times.43%. (c) Current 3.12 In Award’s consolidated accounts for 20x1.68 times. (c) 14.67%.53%.93%. (b) 14.15 In Award’s consolidated accounts for 20X0.16 In Award’s consolidated balance sheet.1%. (b) 21. what is the return on owners’ equity? (a) 19.11%.13 In Award’s consolidated accounts for 20X1.48%.04%.8%. quick 1.14 In Award’s consolidated accounts for 20X0.61%. (c) 9.11 What is the quick ratio in Award’s consolidated balance sheet at 20X1? (a) 0. (d) 1.28 times.5 times.42%. 6. what is the return on total assets ratio? (a) 11. quick 1. (b) 49. 6. quick 1.Module 6 / Interpretation of Financial Statements (b) Current 2. (d) 11. what is its fixed to current asset ratio? (a) 25. (d) 26.16 times.81%. what is has its debt ratio in 20X1? (a) 47. (c) 1.34 times. (d) Current 3. 6.40 times.41%. 6.68 times.

(d) 29. a lowly geared company exposes its shareholders to a higher return on equity.6 times.7 Award’s fixed asset turnover ratio in 20X0? times. (ii) has a lengthy production cycle. a highly geared company permits its shareholders an increased return on equity. 6. (c) 28. Which of the following is correct? (a) (i) and (iii) only.Module 6 / Interpretation of Financial Statements 6.3 times.21 What is Award’s average collection period in 20X1? (a) 92 days.22 What is (a) 5.18 In Award’s consolidated profit and loss account in 20X0. 6. (d) If profits are high. what is Award’s inventory turnover ratio? (a) 6.4 (d) 6. (iii) needs to hold extra inventory in anticipation of unexpected surges of demand.3 times. 6.5 times.3 (c) 6. (c) 106 days. (d) 15.19 In 20X1. times.5 times. 6. what is the times interest earned ratio? (a) Nil. (b) (i) and (iv) only. (b) If profits are high. a lowly geared company permits its shareholders an increased return on equity. 6.0 (b) 5. (d) (iv) only.20 A high inventory turnover ratio (10 or higher) indicates that a company: (i) has large amounts of slow-moving inventory. (c) 7. (c) If profits are low.17 Which of the following is correct? (a) If profits are low. (b) 6. (iv) operates in the retail sector where inventory requirements are low relative to annual sales. times. (b) 97 days. (d) 109 days. times.1 times. a highly geared company protects its shareholders’ return on equity.1 times. (c) (ii) and (iii) only. 6/24 Edinburgh Business School Accounting . (b) 24.

10. (d) 56. (b) Increase in share capital. (b) 6.25 What is the dividend yield ratio (ignoring taxation)? (a) (c) 4.5 pence. (d) 25.24 Which one of the following would result in an increase in return on investment? (a) (c) Sale of surplus fixed assets above book value. (b) 14. 7. The following information has been extracted from the annual accounts of Sunmed Holidays plc. (d) Increase in distribution costs.5 Profit on ordinary activities after taxation Exceptional items Profit for the year Ordinary dividend Retained profit for the year Ordinary share capital comprises 700 000 £1 ordinary shares.5.0%.Module 6 / Interpretation of Financial Statements 6. Receipt of cash from debtors. (d) 9.9.0%.27 What is the price/earnings ratio? (a) (c) 1.057%.23 What proportion of Award’s turnover (exclusive of the contributions of joint ventures and associates) is taken up by administrative expenses in 20X1? (a) (c) 6.0 397.5 98.28. (b) 42. (d) 15. £’000 367. The following information applies to Questions 6.0%.8 pence.37%. 6. 6.0. 24. Accounting Edinburgh Business School 6/25 .26 What is the earnings per share (ignoring exceptional items)? (a) (c) 14.8 pence. 6. The current market price of Sunmed ordinary shares is £3. 6.35%.0 pence. 52.50 each.6%.16%.0 299. (b) 6.25–6.7.5 30.

2%.1 pence.50 each.8.29 times.31 If Award’s ordinary shares have a market value of £1.28 What is the dividend cover ratio? (a) (c) 3.6. 6/26 Edinburgh Business School Accounting .3 pence. 6. (b) 7.1 pence.91 times. (d) 20.38 times. what would be the revised earnings per share in 20X1? (a) (c) 14.4. (d) 26.32 If Award’s ordinary shares have a market value of £2. (b) 2. (d) 3.89 times.25 each.9%. 10. 3. 6. 6. what is the dividend cover in Award’s consolidated accounts? (a) (c) 2. (d) 4. (b) 16. (b) 3.06 times. 6.3.Module 6 / Interpretation of Financial Statements 6.2%.7 pence.29 If all unissued ordinary shares in Award are issued. what is the price/earnings ratio (using the undiluted earnings per share? (a) (c) 9.75 times.27 times.30 In 20X0. (d) 25.9%. 17. 3. 18.06 times. what is the dividend yield ratio for 20X1? (a) (c) 7. (b) 10.

As the company’s financial adviser.1 Leven Books Limited is considering the acquisition of a bookbinding company to expand its publishing interests.Module 6 / Interpretation of Financial Statements Case Study 6. you have been asked for your assessment Accounting Edinburgh Business School 6/27 . since it earned higher profits and generated higher sales in the past financial year. The following information has been obtained for their most recent financial years: Crail Binding Profit & loss Sales Cost of sales Gross profit margin Selling & distribution costs Administration costs Profit before tax Taxation Profit after tax Balance sheet Fixed assets Current assets Inventory Debtors Cash Current liabilities Creditors Overdraft Net current assets £ £ 68 000 30 000 38 000 Tayport Publishing £ £ 61 500 38 000 23 500 10 000 6 500 16 500 7 000 1 750 5 250 16 000 10 000 26 000 12 000 3 000 9 000 10 600 18 000 28 000 – 46 000 26 000 5 000 31 000 15 000 25 600 8 000 10 000 2 000 20 000 6 000 – 6 000 8 300 14 000 22 300 Capital and reserves Ordinary share capital Retained profits Long-term loan 10 000 5 600 15 600 10 000 25 600 12 000 10 300 22 300 – 22 300 The Chief Executive favours Crail Binding ahead of Tayport Publishing. Crail Binding Limited and Tayport Publishing Services Limited. Its chief executive has highlighted two possible targets.

85 10.80 12. you have been closely reviewing the operating performance of one of your principal competitors.80 44.45 378.70 20.24 8.63 4.15 The 20x3 published accounts are now available to you.60 24. Case Study 6.30 2. You also have available the average ratios for the brewing industry for 20x3. from the particular viewpoints of: (i) (ii) (iii) (iv) liquidity.70 10. United Breweries plc Profit and loss account Sales Cost of sales Gross profit Operating costs Profit on ordinary activities before taxation Taxation Profit on ordinary activities after taxation Dividends Profit retained for the year 20x3 £m 1 514 760 754 571 183 (49) 134 (73) 61 20x2 £m 1 487 813 674 465 209 (62) 147 (69) 78 6/28 Edinburgh Business School Accounting .60 1. you have computed the following range of ratios for United Breweries plc.46 20x2 0.50 52. efficiency. capital structure.60 14.25 11.58 12.10 0. profitability.20 25.80 1.12 20x1 1.72 12.05 0.95 12.15 365.60 11.97 0.60 65.17 5.30 71 18.80 1. Over the past few years.20 70 18.16 225.2 In your role as director of Whittington Beers plc.Module 6 / Interpretation of Financial Statements of the two companies.20 55.78 20x3 Average 1.75 11.10 12. United Breweries plc. providing an opportunity to update the ratios for both 20x2 and 20x3.15 8.20 70 18.35 0.75 7.10 63 17.08 350.50 22. Ratio Current (times) Quick (times) Profit margin (%) Return on total assets (%) Return on owner’s equity (%) Fixed to Current assets (%) Debt (%) Times interest earned Average collection period (days) Inventory turnover (times) Earnings per share (pence) Dividend yield (%) 20x0 1.

Assess United Breweries’ performance in comparison with the industry average for 20x3.Module 6 / Interpretation of Financial Statements Balance sheet Fixed assets Current assets Stocks Debtors Cash at Bank 1 952 1 749 103 237 100 440 (638) (198) 1 754 (331) 1 423 376 26 1 021 1 423 90 231 124 445 (543) (98) 1 651 (320) 1 331 371 – 960 1 331 Creditors due within one year Net current liabilities Total assets less current liabilities Creditors due in excess of one year Capital and reserves Share capital Share premium Retained profits Additional information is also available from the published accounts: 1 Operating costs includes £26m of interest payable in 20x3 (20x2: £23m). giving rise to a share premium balance of £26m. Early in 20x3. Accounting Edinburgh Business School 6/29 . 3 The market price of United Breweries’ share was 350 pence at the end of the financial year 20x3 (20x2: 400 pence). Required Update the ratios for 20x2 and 20x3. Your colleagues on the Board of Directors (of Whittington Beers plc) believe that United Breweries plc may be prepared to engage in talks to discuss a possible agreed takeover bid by Whittington Beers plc. a further 10m Ordinary Shares were issued at a price of 310 pence per share. highlighting any causes for concern and positive indicators for the future. 2 Share capital comprises wholly Ordinary Shares of 50 pence each in nominal value.

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3 7.6 7. (c) acquisitions and mergers.3. 7/1 Accounting Edinburgh Business School .12 Introduction Research and Development (R&D) Off-Balance-Sheet Transactions Quasi-Subsidiaries Consignment Inventories Sale and Repurchase Agreements Debt Factoring Accounting for Acquisitions and Mergers Goodwill Brands Valuation of Brands Operating and Financial Review Environmental Reporting Impairment of Fixed Assets and Goodwill Provisions and Contingencies International Harmonisation of Accounting Standards Summary 7/2 7/3 7/6 7/7 7/8 7/9 7/9 7/11 7/13 7/16 7/18 7/19 7/20 7/21 7/22 7/23 7/24 7/25 7/31 Review Questions Case Study 7.11 7.2 7.2 7.1 Learning Objectives By the end of this module you should understand: • • the pressures experienced by corporate management to report superior short-term results.3. (b) off-balance-sheet transactions.3.Module 7 Emerging Issues and Managerial Options in Financial Reporting Contents 7.10 7.6.3 7.4 7. Specific areas discussed are: (a) research and development.8 7.1 7. the choices of accounting principles open to management and their impact on reporting earnings.5 7.1 7.4 7.3.7 7.1 7.9 7.

In fact. more assets. but every year. the vagaries of consumer preference. We call these the generally accepted accounting principles. the main drivers behind new disclosure requirements such as the operating and financial review and environmental reporting. (e) brands. The temptations are overwhelming therefore for the management of a company to adopt the set of generally accepted accounting principles which portrays the company in the best possible light. all generated from within) or by acquisition (taking over other companies). The rules. We considered the role of the auditor whose task it is to see that the rules are obeyed and that a ‘true and fair view’ of the company’s state of affairs is portrayed.Module 7 / Emerging Issues and Managerial Options in Financial Reporting • (d) goodwill. e. for example. Indeed. 7. This pressure on profits or more specifically earnings per share – for that is the ultimate indicator of corporate growth – is a phenomenon referred to as short-termism. not just occasionally. statutory and quasi-statutory. or manager. Despite its denials.1 Introduction The modules studied so far have described a system of financial accounting and corporate reporting which may give the impression of being relatively static. is operating. The entire economy and the capital markets underpinning it are geared towards growth. the actions of competitors all create a turbulence through which it is difficult to steer a company towards more and more growth. every half year or quarter year. both of which are slow moving in reflecting the practices and procedures of the day. Companies are expected to grow. 7/2 Edinburgh Business School Accounting . set out only a framework within which individual managements are free to determine their detailed reporting procedures. for it ignores the large element of managerial judgement that enters into the picture of asset valuation and profit measurement. even within the same industrial sector. we can detect different accounting principles being adopted which would lead the cynic to observe that there are aspects of financial reporting which are closer to anarchy than to accounting! Before reaching such a conclusion we must understand the pressure under which the modern company director. and accounting standards. the uncertainties of the market condition. more profit. which has been unchanged since its formulation by the merchants of the Italian City States during the early part of the Renaissance. and for those whose shares are quoted on a recognised stock exchange.g. But neither type of growth is easy to achieve. One set of principles. We read that disclosure requirements in companies are governed by Acts of Parliament dating back fifty years and more. Analysts advise investors and potential investors. may be generally accepted by one industrial sector but not by another. this interpretation would be mistakenly restrictive. the bedrock of accounting being the accounting equation. We saw. the investment analyst community is largely responsible for this outlook. inventory valuation or depreciation rates. With growth comes prosperity measured in terms either of affluence or of the relief of poverty and deprivation. Corporate growth comes either organically (more sales.

The following sections of this last module in the seven-module Part One. In addition to the understandable desire of management to select accounting principles which benefit the company’s reported earnings figure. The major plank of the analysis and advice is a prediction of future earnings levels. On the basis of their advice investors buy. Without the output from R&D a company would surely go out of business as its current product offerings were superseded by the technology and innovation of competitors. for its part. by so arranging their financial affairs that higher profits are reported sooner rather than later. like the analysts.e. companies. between now and then. Herein lies the pressure. 7.Module 7 / Emerging Issues and Managerial Options in Financial Reporting most of whom have neither time nor knowledge to study corporate performance. Management. There are national credits for companies in today’s capital markets in promising shareholders superior profits performance in five years time if. Such a published prediction about earnings. stands by and watches the company’s share price being ‘talked up’ by the analyst community in advance of published accounts. In order to meet the profit prediction. As such this expenditure should be accounted for as an asset in a company’s balance sheet because it contains ‘future service potential’.2 Research and Development (R&D) Consider for a moment the nature of R&D. If this externally imposed target on companies is not easily achievable through normal trading activities. If it meets the prediction the best the company can usually hope for is price stability. the yearly earnings are to be depressed. far less informed prediction. perhaps after a visit to the company concerned and a talk to management. the accounting profession is also faced with new financial instruments which companies can use to finance their business and fend off takeovers. A combination of these devices makes financial accounting and corporate reporting a dynamic discipline which today is moving into unchartered waters. influences the share price which moves at the slightest hint of rumour. particularly if there is consensus among analysts. that quality which separated the expenditure on electric light fitments from the electricity used to power them in our example in Module 3. management can take steps either to trim expenditure which is not absolutely necessary or to adopt accounting principles which give the appearance of an upward trend in performance. The latter was written off immediately through the profit and loss account while the fitments were seen to have future service potential and were capitalised in the balance Accounting Edinburgh Business School 7/3 . It is expenditure made by a company each year to ensure a steady flow of new products and services in future years. This is based on studying past form and in making reasonable assumptions about the future. so often take the short-term view. i. R&D is therefore a corporate investment in the present to secure a better future. for if the company fails to achieve the predicted profit level the share price will be marked down instantly. in Financial Accounting for Managers give readers a flavour of these developments so that not only can they understand some of the techniques involved and their impact on corporate financial statements but they will be able to follow the ongoing debate on these matters in the business press. sell or hold shares.

(c) the outcome of such a project has been assessed with reasonable certainty as to: (i) its technical feasibility. And it is merely following the accounting principle adopted by virtually every company which spends resources on R&D. which separates research from development. R&D. and related production. The annual reduction in this future service potential was charged as depreciation in the profit and loss account. is a risky activity. ‘Expenditure incurred in the year is charged against profit unless specifically chargeable to and recoverable from customers under agreed contract terms. But not all companies enjoy the financial strength 7/4 Edinburgh Business School Accounting . Of course a company believes that its R&D will generate new products and processes for its future prosperity but it has no guarantee how much of each year’s expenditure will bear fruit.’ In other words MBA is treating R&D as it would the electric power rather than the electric fitments in our earlier example. to write off all the expenditure as it is incurred rather than capitalise a series of annual outlays which may turn out to be worthless. being an investment like the light fitments. instead of trying to do so they. consumer and environment legislation. Research scientists and engineers may work for years in perfecting a new compound or process. (b) the related expenditure is separately identifiable. and (e) adequate resources exist. simply write off all outlays.Module 7 / Emerging Issues and Managerial Options in Financial Reporting sheet. In so doing they may have spent many thousands of pounds on experiments which prove to be worthless until they stumble upon the formula or design that has eluded them for years. Why should R&D be written off and not capitalised? The answer lies in the technical and commercial risks attached to R&D. One can appreciate. how difficult it is for a company to justify capitalisation of development expenditure. companies take the view that it is prudent. and further development costs. is clear and unambiguous. like MBA. articulated in its accounts . or conservative. Does this policy of write-off prevent any capitalisation? Consider the wording of SSAP 13. public opinion. (d) the aggregate of the deferred development costs. and (ii) its ultimate commercial viability considered in the light of factors such as likely market conditions (including competing products). by definition. then. or are reasonably expected to be available. Because much R&D is of uncertain value. R&D. to enable the project to be completed and to provide any consequential increases in working capital. While all research expenditure must be written off (because no one year can be seen to benefit from this ongoing activity). should be an asset in a company’s balance sheet – or so one would think! MBA’s accounting policy on R&D. development expenditure may be capitalised provided that: (a) there is a clearly defined project. In this latter situation the company’s profit and loss account would ‘take a hit’ in the year of write-off. selling and administration costs is reasonably expected to be exceeded by related future sales or other revenues.

Consider the risks attached to this accounting treatment. A computer software house could indeed have separately defined projects with identifiable expenditure. Many small companies are involved in R&D but have not the profits against which to write off the annual R&D expenditure.’ Accounting Edinburgh Business School 7/5 . They must listen to the case being put forward by management for capitalising certain development expenditure and weigh up the evidence in the light of the client’s past track record of product launches. the auditors would qualify their audit report. some of which were capitalised with the approval of its auditors: Yr 1 £m 2 1 2 £m 3 2 3 £m 4 2 4 £m 5 R&D spent Of which the following sums were capitalised: In Year 4 the auditors learned that some of the technical difficulties in Project XYZ which had bedevilled the company in Year 3 remained unresolved and that the senior project programmer had resigned to join a competitor. These difficulties must then be put right and this. puts pressure on working capital requirements identified in criterion (e) above. This too can have a devastating effect on market confidence. particularly within the time-frame set by the company for product launch. reflecting market disappointment at the non-appearance of Product XYZ. This action could have a negative effect on the share price because the reported earnings figure will be discounted in the minds of investors.Module 7 / Emerging Issues and Managerial Options in Financial Reporting of MBA. but its ultimate commercial viability may be open to question. In such cases the management may argue that some development expenditure does indeed meet the criteria above only to avoid the lower-than-usual earnings per share being reported to the stock market. The auditors insisted on a write-off of all R&D in Year 4 together with the deferred amount in the balance sheet since they doubted that it has ‘future service potential. Example A software company spent the following amounts of R&D. In addition profits had dipped. To release all R&D into the profit and loss account each year may in fact turn bottom-line profit into loss. Auditors are not obliged to maintain one view. In the light of new evidence they may be of the opinion that previously capitalised expenditure needs to be written off in this year. Even the most reputable software houses make future product announcements which are subsequently withdrawn in the light of technical difficulties encountered in the programs. Computer software companies tend to capitalise some of their R&D because of the imbalance that often exists between annual R&D costs (very high) and ongoing sales (modest). The auditors must of course take a view on the suitability of this form of accounting. If the auditors take the view that all expenditure should be written off and management refuses to change its stance. in turn.

Accounting regulators are now beginning to address off-balance-sheet transactions which we would describe as financing schemes deliberately designed to persuade the reader of a company’s accounts that the company’s financial 7/6 Edinburgh Business School Accounting . When a rights issue is anticipated. rightly or wrongly. Indeed. that is. directed towards the creation and maintenance of the intelligence and knowledge of the workforce (software could be described as a contribution to a company’s artificial intelligence). (Readers will remember from their study of Module 3 that with high gearing goes high risk if the company’s fortunes turn down. But we can equally be certain that some exponents of this form of accounting will ‘get it wrong’ and be forced to write off deferred expenditure in lump sums.) Most UK companies tend to prefer a relatively low gearing percentage so as to minimise risk. typically the share price is marked down. perhaps. There is therefore a natural inclination for a company already exposed in the way described above to drive any further borrowings off the balance sheet in such a way that the existence of this additional funding does not become public knowledge. As more and more corporate expenditure is ‘knowledge based’. viability. share price and.3 Off-Balance-Sheet Transactions Companies’ financial structures often reach a stage which attract comment. with predictably painful consequences on earnings. in the case of companies whose share prices have already been marked down in anticipation of non-existent rights issues. we are going to witness more examples of capitalisation in an attempt to reflect an asset with future service potential. for instance a high gearing percentage where the debt comprises either long-term debt or short-term loans is viewed as a risky scenario. there is a case for them to eliminate existing borrowings from their financial statements. 7. Another negative aspect of high gearing is that the stock market often regards this situation as an indication of a forthcoming rights issue of shares to enable the company to restore the gearing ratio to a more stable level.Module 7 / Emerging Issues and Managerial Options in Financial Reporting The profit and loss accounts for the years would read: Yr 1 £m 6 1 5 2 £m 7 1 6 3 £m 8 2 6 4 £m 7 10 (3) Total £m 28 14 14 Profits before R&D R&D write-off Profits after R&D The alternative profit and loss accounts based on full annual write-off would have been: Profits before R&D R&D Profits after R&D 6 2 4 7 3 4 8 4 4 7 5 2 28 14 14 In retrospect the management of this company would probably regret adopting the policy of capitalisation because of the substantial loss created by the policy in Year 4.

Such a percentage gave the holding company control of the company in terms of board appointments. The substance of the transaction is that B owns S and FRS 5 would insist that B regards S as a quasi-subsidiary and that the assets (pubs) and liabilities (bank loans) of S be consolidated by B. dividend policy and all other major decisions. its assets and debts are added to those of the holding company for disclosure purposes. How then can one company control another company but not own a sufficient percentage of ordinary shares to account for it as a subsidiary? In brief. an investing company can so engineer the share capital and voting rights attaching thereto of another company that it avoids owning more than 50 per cent but retains control of managerial decisions. In the following paragraphs.3. gains less losses would be paid over to B through an adjustment to the management charge. The company is a 50:50 joint venture between Accounting Edinburgh Business School 7/7 . 7. Take another example: a brewery company B sells some of its licensed premises (sometimes called public houses or pubs) to a company S specially set up for the purpose. A subsidiary must be consolidated into the group profit and loss account and balance sheet. Consider the transfer of a number of petrol stations by an oil company to a company specially set up for the purpose. the investing company owning the ordinary shares may be able to control the activities of the ‘subsidiary’ provided the ordinary shares have superior voting rights to these shares held by the third party. It can hold all the ordinary shares in the ‘subsidiary’ yet that company is not a legal subsidiary because another category of shares held by a friendly third party such as the investing company’s bank or investment advisers qualifies as equity capital and amounts to more than 50 per cent of the ‘subsidiary’s’ equity shares. Should S decide to sell any of the pubs. corporate strategy.1 Quasi-Subsidiaries In our discussion on group accounting we noted that the definition of a subsidiary was a company whose equity share capital was owned by another to the extent of more than 50 per cent. B and S enter into a contract in which B undertakes to manage the pubs and is paid to do this by S at a rate which more or less absorbs all of the profits of S after paying off the bank’s interest. The result is that the investing company controls a company that is apparently not a subsidiary. Joint ventures may also get caught up in the wide net of FRS 5.Module 7 / Emerging Issues and Managerial Options in Financial Reporting structure is something other than it is. It is fairly clear from this scenario that the bank’s legal ownership of S is not relevant. Company S is financed by loans from a bank at market interest rates. All transactions during the year between the two companies will be eliminated and B’s consolidated profit and loss account will show the full operational results of the pubs and the interest paid on the loans. B controls S and benefits from its economic success. we describe a few of the more popular forms of off-balance-sheet transactions and show how the UK’s Financial Reporting Standard (FRS) 5 entitled Reporting the Substance of Transactions published in 1994 applies to a number of situations. On the assumption that the friendly third party does not control the composition of the board (an unlikely position given the artificial nature of the scheme in the first instance).

dividends and/or loan guarantees unequally. an example of off-balance-sheet financing of a major portion of the dealer’s assets.2 Consignment Inventories In certain industries. But three circumstances would arise which would lead to the oil company being compelled under FRS 5 to consolidate the financial affairs of the joint venture: (a) where. FRS 5 requires quasi-subsidiaries to be consolidated and not left ‘off-balancesheet’. 7/8 Edinburgh Business School Accounting . the oil company’s balance sheet would reveal ‘investment in associated company’ as a line item. with no other strings attached to the deal. The key component of FRS 5’s definition of a quasi-subsidiary is control. (c) the oil company and the entrepreneur share profits and losses. he does not bear risk of inventory carrying and can avoid putting the asset (and the finance attaching) on the balance sheet. and (b) where the dealer is obliged ultimately to pay for the goods whether or not he has sold them. From the dealer’s balance sheet neither the inventory of vehicles nor the finance required to fund them appears.Module 7 / Emerging Issues and Managerial Options in Financial Reporting the oil company and a retailing entrepreneur. (b) there is a mechanism whereby the oil company can take back the petrol stations under beneficial terms. In this way the manufacturer retains legal title to the vehicles until sold. They are: (a) where the dealer may return the unsold goods without incurring a significant penalty. which is the ability of the parent company to direct its financial and operating activities with a view to gaining economic benefit from its activities. such as motor manufacturers/dealerships. it is common practice for manufacturers to send to dealers vehicles for sale but not request payment for these vehicles until the dealer has sold them. in effect. The petrol stations and loans taken out by the joint venture to finance the deal would not appear. the oil company is the lead partner and ‘exercises’ a dominant role. influence and management must be evenly balanced. This involves risk on the part of the dealer and such inventories should be accounted for. In FRS 5 the accounting profession makes the distinction between two types of agreement which may exist between manufacturer and dealer. To prevent consolidation the risks and rewards of ownership must be fully transferred to the joint venture and the oil company cannot buy back its assets at anything other than full market value.3. To prevent consolidation. The oil company leases back the petrol stations under the terms of an operating lease. 7. In such a straightforward situation.

1 million interest (which would be accrued in the balance sheet during the year) is entered in the profit and loss account. 7.1m interest).3 Sale and Repurchase Agreements Consider the following transaction entered into by Glenrianna Distillery. If the finance house has no right of recourse to the company in the event of bad debts Accounting Edinburgh Business School 7/9 . One way round this problem is for a company to ‘sell’ or factor its debts to a finance house to collect the debts on its behalf. a charge of £0. The balance sheet after borrowing the money would look like this: Current assets Inventories Cash Current liabilities Short-term loans £2m £2m £2m And when the loan is repaid.Module 7 / Emerging Issues and Managerial Options in Financial Reporting 7. To release some cash to build a visitor centre. The whisky does not leave the distillery.4 Debt Factoring In our study of financial statements and the analysis of these by the use of ratios. In common with other distilleries. FRS 5 would ask about the substance of the sales. the balance sheet consequences of which would be: Balance sheet before ‘sale’ Current assets Inventories Cash Balance sheet after ‘sale’ Current assets Inventories Cash £2m 0 0 £2m This is off-balance-sheet financing at its most blatant. it contracts with its bank to sell the bank whisky valued at £2 million and to buy it back in 12 months’ time at £2. The finance house would ‘buy’ the debts at a discount and hope to collect full value from the company’s customers.1 million which is not recorded. This can prove to be costly. and raise the gearing ratio of debt to equity. The distillery has borrowed £2 million and has a liability to the bank for £2. a wellknown Scottish malt whisky producer. Is this really an arm’s length sale or a financing deal? The risks and reward of owning the whisky have not transferred to the bank.1 million (which includes £0. The distillery has simply borrowed money on the security of the whisky. we saw that debtors (customers of a company who do not pay cash at the time of sale) cost money. Glenrianna has many millions of pounds tied up in maturing whisky inventory. Before FRS 5 the management of the distillery might have been tempted to treat the deal as a sale. Companies who wait for their money from debtors may have to borrow from banks to fund their working capital until payment is received.3.3.

and that required by FRS 5. thereby concealing the extent of the company’s potential obligation on non-recovery of the debts. prove to be irrecoverable. The prudent approach would be to set up in effect a loan of £800 in the balance sheet on the security of the debtors. The factor may pursue the company for any of the debts which prove to be irrecoverable. the finance house which buys the debts has recourse to the company when any of the debts go ‘bad’. Only when those debts have in fact been recovered by the factor should the company eliminate both from the balance sheet. Such is the ingenuity and creativity of schemes for financing corporate activities that we suspect that the regulatory authorities (Parliament via the Companies Act and the accounting profession via accounting standards) will always lag behind. Balance sheet before factoring Current assets Debtors Cash Current liabilities Short-term loans Balance sheet after factoring Current assets Debtors Cash Current liabilities Short-term loan Balance sheet after full recovery of debts by factor Current assets Debtors Cash Current liabilities Short-term loans Profit and loss account after full recovery of debts by factor Discount suffered on debt factoring £ 1 000 0 0 £ 1 000 800 800 0 800 0 £ 200 An off-balance-sheet approach would adopt the ‘after full recovery’ layout from the outset of the transaction. Example A company factors its total debtors of £1000 for £800 to a local finance house.Module 7 / Emerging Issues and Managerial Options in Financial Reporting the factoring deal is a straightforward commercial transaction and requires no specific disclosure. and write off the difference through the profit and loss account. requires the originating company to keep a proportion of the ‘sold’ debts on the balance sheet together with a matching liability to the finance house. The company would reduce the current asset called ‘Debtors’. i. 7/10 Edinburgh Business School Accounting . increase the current asset called ‘Cash’.e. as part of the factoring deal. Problems arise however when. The prudent approach.

accounting practice permits two types of group accounts which produce starkly different numbers. acquisition accounting would produce a balance sheet for Forth Group Ltd as follows: Accounting Edinburgh Business School 7/11 . which was accepted by all shareholders in Clyde. Before the offer. 7. Acquisition accounting is used to reflect normal takeovers where the predator company (called the holding company in this module) acquires more than 50 per cent of the equity share capital of the target (called the subsidiary) for cash. the summarised balance sheets of the two companies are as follows: Forth Ltd £m 6 1 5 6 Clyde Ltd £m 4 1 3 4 Net assets Represented by: Share capital (£1 ordinary) Distributable reserves Using the same mechanics as in the Ben Nevis example. sometimes a sizeable minority of original shareholders remains in the subsidiary. Depending on the terms of business combination. The offer therefore values Clyde at £5 million.Module 7 / Emerging Issues and Managerial Options in Financial Reporting Developments in corporate financial reporting will always be frustrated by schemes deliberately designed to conceal important transactions. We saw in Module 5 that the Ben Nevis Group balance sheet contained the assets and liabilities of Ben Lomond Ltd. i. Such takeovers do not necessarily persuade every shareholder in the subsidiary to sell up to the holding company.e. We now introduce another example of a takeover using acquisition accounting. Readers should revise the mechanics of Ben Nevis’s 70 per cent acquisition of Ben Lomond in Module 5. Example Forth Ltd offers to acquire the entire share capital of Clyde Ltd The terms are: one Forth share worth £5 for each of Clyde’s one million ordinary shares. Clyde has net assets shown in its balance sheet of £4 million.4 Accounting for Acquisitions and Mergers Groups of companies are obliged by law to prepare and publish consolidated financial statements. or shares in the holding company. or a combination of cash and shares. how a company becomes a subsidiary of a holding company. These two practices are known as acquisition accounting and merger accounting (sometimes referred to as business combinations). a 70 per cent owned subsidiary.

7/12 Edinburgh Business School Accounting . tangible and intangible. The accounting statements in merger accounting attempt to portray this harmonious coming together by restating both companies’ accounts as if the two companies had always been one. The share premium account forms part of the group reserves and cannot be distributed to shareholders in Forth under normal circumstances.Module 7 / Emerging Issues and Managerial Options in Financial Reporting Net assets Goodwill Represented by: Share capital (£1 ordinary) Share premium Distributable reserves Forth Group Ltd £m 10 1 11 2 4 5 11 Notes on consolidated balance sheet 1 2 Forth’s share capital is doubled as a result of the share issue to Clyde’s shareholders. The difference is the hidden value of Clyde’s assets. Forth. 3 4 Merger accounting is based on the concept of harmony and agreement rather than the hawkish behaviour of predator and prey which underpins acquisition accounting. which Forth is prepared to pay. Share premium arises because Forth issued one million £1 ordinary shares for an acquisition valued at £5 million. Goodwill arises as a result of Forth paying £5 million for Clyde’s assets which appeared in its balance sheet at £4 million. Neither goodwill nor share premium appears on the balance sheet. The distributable reserves of the group are those of the holding company. For our example the combined balance sheet would read: Forth-Clyde Group £m 10 2 8 10 Net assets Represented by: Share capital (£1 ordinary) Distributable reserves Notes on group balance sheet 1 2 3 Share capital comprises £1m original plus £1m newly issued. Distributable reserves of the two companies are added together. A merger (as opposed to a takeover) presumes agreement between the two parties to pool their respective interests rather than for the one to hand over its assets to another.

Far better for the company to avoid the problem in the first place by using merger accounting! An additional feature of merger accounting worthy of managerial attention is the combined nature of distributable reserves. these should be an immaterial proportion to the fair value of the consideration received by the shareholders of that party.5 Goodwill So far in these modules we have defined goodwill as the excess over book value that a company is prepared to pay for another company’s net assets. Writing off goodwill systematically has a negative impact on profits. 7. (e) no equity shareholders of any of the combining entities retain any material interest in the future performance of only part of the combined entity. acquisition and merger.Module 7 / Emerging Issues and Managerial Options in Financial Reporting The managerial issues are clear when the two balance sheets. However. writing it off through the reserves of the company may reduce them dramatically as well. requires companies to adopt merger accounting where all of the following conditions are met. Management would have access to considerably more free reserves than under acquisition accounting where legal strictures are also placed on share premium account. suffice it to say at the moment that the accounting profession recommends that goodwill should not be carried as an asset on the balance sheet beyond its perceived useful life. They are where: (a) none of the parties sees itself as either acquirer or acquired. In the next section of this module we shall examine the nature of goodwill. Merger accounting is not. (d) each of the parties to the combination receives primarily equity shares. however. we shall witness imaginative schemes of share swaps in business combinations which will give maximum flexibility to management in deciding which system to use. if the history of acquisition and merger accounting is a guide to the future. For example. Thus merger accounting is not to be used for the business combination. or if equity shares carrying substantially reduced voting or distribution rights are received. (b) none of the parties dominates the management of the combined entity. open to every management on every business combination. Again merger accounting gives the management of the group more flexibility than under acquisition. in the last section we saw that Forth was prepared to pay £5 million Accounting Edinburgh Business School 7/13 . that it is anticipated that merger accounting will seldom be used. are compared. Acquisitions and Mergers. The one abiding criterion which will be applied by management will undoubtedly be the impact on earnings per share in the year of combination and the years to come. (c) the relative sizes of the combining entities are not so disparate that one company dominates the combined entity by virtue of its relative size. So stringent are the conditions set out above. The UK accounting profession’s FRS 6. If non-equity consideration is received. Under acquisition accounting the figure for goodwill arising on acquisition requires attention. Failure to meet any of the five criteria is to be regarded as meaning that the definition of a merger has not been met.

But once acquired. the immediate write-off option. or technical know-how. or level of workforce training. Goodwill is an intangible asset – value locked up in one company which another company is prepared to pay for because it will yield future economic benefits. a beneficial acquisition has a negative effect on the shareholders’ stake in the combined group! Surely then. A detailed technical adjustment should be noted at this stage. But this annual diminution is not easy to assess.5 million. And in some acquisitions the value placed on goodwill is significant compared with the book value of the net assets acquired. leads to companies showing reduced net worth (share capital plus reserves) even though earnings are not only unaffected but probably improving because of the synergistic effects of the combined undertaking.Module 7 / Emerging Issues and Managerial Options in Financial Reporting for Clyde’s assets. managers take the decision on accounting treatment after weighing up a number of considerations. Should it be over three years or five years or 20 years? The current professional pronouncement 7/14 Edinburgh Business School Accounting . selected by many companies. but it is illogical. or customer awareness. Any one of these attributes. FRS 7.5 million. a fair value exercise may lead to Clyde’s net assets being uplifted to £4. Needless to say. This is simple and straightforward. quality and so on. Assets should be capitalised and placed on the balance sheet. or a combination of them. or marketing and distribution skills. This is an attempt to account fairly for the acquisition transaction by asking what the acquirer has spent. In our example above. requires the acquirer to bring these net assets into the consolidated accounts at their fair value rather than their book value. Goodwill must therefore be written off year by year in a manner that reflects its diminution in value. which were valued at £4 million. or (b) to capitalise the amount paid as an asset and amortise (depreciate) the asset over its useful economic life. first. It may be superior management skills and experience. But assets lose value through either use or the passage of time. Consider. This produced a goodwill figure of £1 million. including impact on earnings per share. it has no impact on future earnings. how should this asset be accounted for? There are two schools of thought: (a) to write off the purchased goodwill at the moment of acquisition against the group reserves. What is goodwill and how should it be accounted for? Goodwill comprises ‘that extra something’ that acquirers see hidden in the business activities of acquirees which has value to them. When a company takes over another company’s assets and liabilities. these are usually recorded in the target’s balance sheet at depreciated historic cost. This option. is worth paying for when acquiring a company. and what it has got for its money. the second option makes more sense? Indeed it does until the impact on the profit and loss account is considered! The acquiring company is paying for future economic benefits in the form of contacts. or reputation for quality. That is. thereby reducing the goodwill to be accounted for to £0. experience. These book values seldom bear any resemblance to the value which the acquirer accords to them. Fair Values in Acquisition Accounting. or established business connections.

If in the year of acquisition the impairment test shows that there is no value attached to the goodwill. At all times. But of course the shorter the period selected for write-off. If UK companies carry goodwill in their balance sheets without subjecting it to amortisation. management is required to subject the figure for goodwill to ‘an impairment test’. where significant goodwill is present and is expected to be maintained indefinitely and is readily measurable. but not easily resolved: would management prefer to reflect the economic substance of the acquisition by capitalising goodwill but suffer the annual reduction in profits by so doing. At the other end of the spectrum. In all cases goodwill should be written off over a period which does not exceed forty years from its date of acquisition’. an annual impairment test would be required to confirm the carrying value. management will try to avoid choosing the four-year write-off period even though the diminution in value of purchased goodwill may be almost completed in that time-frame. So the dilemma for management can be easily stated. a detailed consideration of the inherent value underlying the number. and avoid any impact on profits in the years to come? Example A company acquires another for a figure which produces £40 million goodwill to account for. the greater the negative impact on profits for the amortisation charge must be taken through the current year’s profit and loss account as opposed to the balance sheet reserves. The group’s trading profit is £80 million. then it must be written off. this fact must be brought to the attention of shareholders by the auditors because the law requires goodwill to be amortised systematically over a limited period. an action which runs counter to commercial logic. Three possibilities of goodwill write-off are given below: Write-off to reserves £m 80 – 80 Capitalisation 4 years write-off £m 80 10 70 Capitalisation 20 years write-off £m 80 2 78 Profits Goodwill write-off No. The speed of write-off does not have to be constant: the company management should review the balance sheet value for goodwill annually and reassess its remaining useful life. of shares in issue: 10 million Earnings per share 800p 700p 780p If earnings per share are already under pressure. or would they rather eliminate a proportion of shareholders’ equity at the moment of acquisition.Module 7 / Emerging Issues and Managerial Options in Financial Reporting recommends that the write-off period should be the lower of its useful economic life and 20 years ‘except in rare circumstances where it can be demonstrated that a period in excess of twenty years would be more appropriate. Accounting Edinburgh Business School 7/15 .

Companies have enjoyed high market awareness for certain of their brands for many years: why is the subject of accounting for brands only now beginning to be raised? Several reasons can be put forward: 1 In the current climate of acquisitions and mergers. This has two beneficial effects for companies: first. second. This lessens the impact on either the reserves or the subsequent profit Edinburgh Business School Accounting 2 3 4 7/16 . reflecting the increase in value of the owner’s share in their company.6 Brands Question: how can a company report total assets of £400 million in one year. Managers should be aware of the principles in question so that they can (a) consider the implication of brand accounting for their own companies. the increased size of the balance sheet may prevent the company seeking prior shareholder approval for future acquisitions. for example in vacuum cleaners and mineral water. £1000 million in the next year. for example the recipe for an item of confectionery or the water content in malt whisky. Some other companies have followed and the accounting profession is currently wrestling with the issue. So recognisable are these brand names that not only do they attract consumers to purchase the product in preference to all other competitors but in some situations. and purchase no new assets during the year? Answer: by constructing a figure for its brands and placing them on the balance sheet as an intangible asset. because they are so well known. such approval being required if certain set size tests are not met by the company. Brands are the names of consumer products which. This has the effect. aggressive predators who wished to issue shares in themselves in exchange for those of the target company might put brands on their balance sheets in an effort to drive up their share price before they set out on the acquisition trail. companies which wish to be left alone by predators. put a value of their brands on the balance sheet. as in the case of RHM. can be seen as having value to the companies which own them. and (b) follow the debate as it unfolds in the financial press. ‘I want to look at your Hoovers please. or which wish to have the bid price based on a realistic valuation of assets. it restores a perhaps over-geared situation by virtue of the fact that owner’s equity is increased by the same amount as the brand valuation. Brands increase the value of total assets. Turning the acquisition around. A household electrical goods store will report that a consumer who is considering the purchase of a vacuum cleaner will say. On the assumption that brands are a component of purchased goodwill then a figure for brands purchased as part of an acquisition can be stripped out of the goodwill figure and capitalised separately on the balance sheet of the group. of raising the total value of the balance sheet.Module 7 / Emerging Issues and Managerial Options in Financial Reporting 7. the brand names are used by the consumer as a generic term for the product range even though he or she may buy another model. how much are your Electrolux models?’ Brands also include the technical know-how which is used to make the product. This action was taken by the UK foods group Rank Hovis McDougall plc (RHM) when its 1988 balance sheet was published containing a figure of £678 million for brands.

Many companies which have already put brands on the balance sheet have yet to persuade their auditors and 2 3 4 Accounting Edinburgh Business School 7/17 . Unless the company can prove that the value has not changed year by year (an argument which will be difficult unless supported by evidence of promotional and marketing expenditure). On the other hand if Edinburgh Rock plc were preparing to make acquisitions itself. Its balance sheets before and after ‘branding’ are set out below: Edinburgh Rock plc: Before brands balance sheet £ Fixed assets Current assets Current liabilities Net current assets Total assets less current liabilities Owner’s equity After brands balance sheet £ Fixed assets Intangible assets (brands) Current assets Current liabilities Net current assets Total assets less current liabilities Owner’s equity Revaluation on reserve Total equity and reserves 1 £ 100 50 50 100 (50) 50 50 £ 100 50 100 (50) 100 50 50 100 Should Edinburgh Rock plc feel vulnerable to takeover. the increase in its net assets from £50 million to £100 million will give a signal to potential predators that the opening bid price will need to reflect the new asset valuation. However such a view is only tenable if the company can argue that the brand does not depreciate. otherwise there is no advantage in this splitting up of the total goodwill figure. The problem arises as to how to account for the asset of £50 million once it is on the balance sheet. Example Edinburgh Rock plc decides to put a value of £50 million on its world-famous brand of confectionery. This could allow the company to raise even more debt on the basis of a stronger balance sheet.Module 7 / Emerging Issues and Managerial Options in Financial Reporting figures as net goodwill is written off. this increase in assets could have a beneficial effect on share price and allow the company a share swap with its targets on better terms. the £50 million will have to be depreciated over its remaining useful life. Gearing drops from 66 per cent to 50 per cent as a result of ‘branding’.

we describe below only two methods. The major valuation problem surrounds the homegrown brands which grow in value over many years. it is almost impossible to be confident about the source of a company’s profit figure. First. although it may prove difficult to allocate a specific sum to one intangible asset from the price paid to acquire the entire company. Second. the allocation of costs must inevitably be an arbitrary exercise. that the costs capitalised can be verified from the company records) is partially negated by the subjectivity and managerial judgement surrounding the costs and period of years to be selected for the valuation exercise. Earnings Method In contrast to the historic cost method which looks back. the use of the multiplier is entirely subjective and represents management’s view of the market position of each brand. ‘Your stake in the company is worth more than was shown in last year’s balance sheet because the management now takes the view that previously incurred costs which reduced previously reported profits were in fact expended to build up our brands which help to increase the assets of your company’. Because this action does not affect the current year’s profit and loss account the adjustment is made through the reserves. its market position. the historic cost method requires that all costs spent in developing and maintaining the brand be capitalised. In effect the company is telling its shareholders. 7. those that it purchases from other companies (by separate purchase or through acquisition of the company owning the brands) and those that it develops internally (‘home grown’). Several ways have been suggested. future stability.e. Note the subjectivity in this method. Even if the sales revenue can be attributed to a particular brand. The valuation procedures differ radically. The historic cost method gives a clear insight into how brand accounting works: previously written-off costs such as marketing. advertising. Brands that were acquired through purchase can be valued at their purchase price.6. Therefore the advantage of objectivity claimed for this method (i. But these costs may have been incurred many years earlier. 7/18 Edinburgh Business School Accounting .Module 7 / Emerging Issues and Managerial Options in Financial Reporting shareholders that brands have an indefinite life (and thereby avoid depleting their profits via a depreciation charge). long before the company recognised that the brand in question had value. the earnings method looks forward.e. Under this method management must attempt to attribute the actual earnings of the company to specific brands and then apply a multiplier to this figure which reflects the brand strength (i. development and growth) over the foreseeable future. Historic Cost As its name implies.1 Valuation of Brands A company may argue that it has two kinds of brand. and R&D associated with a brand are ‘written back’ into the financial statements. A cynical view of the earnings method would describe it as a guess upon a guess.

accountants. like goodwill. The UK’s Accounting Standards Board has acknowledged the substance of this complaint by recommending (but not requiring!) that best practice among companies would include an Operating and Financial Review. experience of key personnel and investment in training and education. Brands. e. over time. 7. environmental protection costs and potential environmental liabilities. this chorus of complaint has been more strident. Intangibles. just because they are difficult to value. 7/19 Accounting Edinburgh Business School . it is meant to provide an opportunity to the board of directors to produce a clear. changes in market share. new products and services introduced or announced. as being a genuine attempt to reflect the economic reality of their underlying businesses then many more intangibles could be added to the list. Apart from giving the financial director scope to highlight difficulties that his/her company has had in abiding by a particular standard. may lead to the view that a material misstatement of underlying value has been perpetrated in traditional accounts. As the standards have become more numerous.g. But if these companies’ actions are seen. and lately more rigorous. it has been a frequently heard complaint from finance directors that such mandatory reporting requirements. new activities. financial contributions from the different business units.7 Operating and Financial Review Since accounting standards were first applied to the reporting practices of UK companies in the early 1970s. All these ‘assets’ play an increasingly important part in business life and a failure to recognise them in financial statements. scarcity of raw materials and labour skills. The • • • • • • • • Operating Review could include a discussion on such matters as: changes in market conditions. when managers attempt to account for them in the same way as fixed assets or inventory. auditors and the financial community become nervous. discontinued activities and other acquisitions and disposals. if followed to the letter. balanced and analytical discussion of the company’s performance over the past year and a view of the future opportunities and difficulties that face the company. databases. training programmes. by definition. The Board intended this review to be persuasive rather than mandatory and it is not enshrined in a standard. cannot be inspected or counted and the unspoken accusation against companies which have attempted to account for brands is that they are engaging in creative accounting. are intuitively reasonable assets which companies possess but.Module 7 / Emerging Issues and Managerial Options in Financial Reporting The subject of brands has served to open up a debate which could lead to dramatically different corporate financial statements in the future. would prevent them from portraying the results of their companies in the manner that best displayed their underlying economic performance.

Despite being in front of company boards of directors since 1993. currency and interest rates). In general companies wish to inform shareholders and other readers of their annual report that their environmental performance meets contemporary requirements and that its operations are run in a manner acceptable to local communities. if environmental protection is as much a part of the operations of a business as any other function such as production or marketing. companies are not obliged to feature activities where their environmental record is less than exemplary.1 ) concluded that within the annual reports of the FTSE-100 companies only 16 could be said to have produced a high quality document complying with the spirit of the ASB’s proposals and thus providing readers with a significant addition to the understanding of the annual report. because there is no requirement so to do. the protection of customers and the public from risky products and the recycling of toxic components within products which have reached the end of their useful life. And because of this. • the cash generated from operations and other cash inflows during the period. commenting on any special factors that influenced these. the OFR has had a mixed ‘take up’. 7. • the strengths and resources of the business whose value is not fully reflected in the balance sheet. But few companies issue such a detailed review. ‘Why.Module 7 / Emerging Issues and Managerial Options in Financial Reporting • any subjective judgements to which the financial statements are particularly sensitive. and where a breach of covenant has occurred or is expected to occur. Included in such review are comments and benchmarked performance on issues such as safety at work. health of employees. • any restrictions on the ability to transfer funds from one part of the group to meet the obligations of another part of the group. is it difficult to identify that part of the company’s annual spending which is devoted to the environment?’ Much work is being carried out in the accounting profession on how environmental expenditure and liabilities can be reported most 7/20 Edinburgh Business School Accounting . • the capital funding and treasury policies and objectives including such sensitive matters as the use of financial instruments for hedging purposes. The Financial Review could include discussion on such matters as: • the capital structure of the business (maturity profile of debt. • debt covenants which could have the effect of restricting the use of credit facilities. A research publication by the Institute of Chartered Accountants of Scotland in 1995 (Weetman et al. The question must be asked. the OFR should give details of the measures taken or proposed to remedy the situation.8 Environmental Reporting A few companies issue to shareholders an environmental performance report at the same time as the annual report and accounts are distributed. type of capital instruments used. An example of this undisclosed value would be the amount spent on R&D which has not been capitalised.

a significant fall in an asset’s market value. We can expect to see regulatory activity in the field of environmental reporting in the next few years.Module 7 / Emerging Issues and Managerial Options in Financial Reporting informatively. The second is where there are indicators of impairment that suggest that the company’s assets may not be fully recoverable. the provisions required for the costs of remedial work or the liabilities that may arise. an asset being physically damaged. An impairment review has to be conducted in two main sets of circumstances. a significant reorganisation. Since the recoverable amount is to be the higher of NRV and VIU. or becoming obsolete. These factors include: • • • • • • • persistent operating losses or negative operating cash flows. Net realisable value is straightforward: the value at which the asset could be disposed of. it is only necessary to show that one of these is not less than the carrying value in order to avoid a write-down. Value in use introduces a concept to be covered in Module 15 of this MBA programme. including those resulting from its ultimate disposal. One is when the company is carrying goodwill as an asset in the balance sheet and is not amortising it over 20 years or less. a significant increase in market interest rates or other market rates of return. The biggest obstacle is trying to estimate.9 Impairment of Fixed Assets and Goodwill Throughout this module there has been a presumption that depreciation and amortisation rates for fixed assets and goodwill is a matter for managerial discretion: ‘Shall we use five or seven years as the write-off period? What will be the residual value when we come to sell it?’ Predictably this has led to wildly fluctuating rates of depreciation used by different companies for similar assets. a major loss of key employees. Accordingly. nothing needs to be done. within a reasonable range of possible outcomes. which is defined in the standard to mean the higher of net realisable value (NRV) and value in use (VIU). The principle behind the impairment review is that fixed assets should not be carried in the balance sheet at more than their recoverable amount. namely discounted cash flows: value in use is the present value of the future cash flows obtainable as a result of an asset’s continued use. a significant adverse change in the company’s competitive or regulatory environment. where the NRV of an asset can be shown to be at least as much as the carrying value in the balance sheet. Accounting Edinburgh Business School 7/21 . This is a complex standard and so the following paragraphs distill the contents to its fundamentals. 7. The UK’s Accounting Standards Board has added rigour to this process by issuing FRS 11 Impairment of Fixed Assets and Goodwill. either as a result of legal obligations or decisions by management to undertake remedial work. Otherwise VIU needs to be determined. less selling costs.

warranties. These should be derived from the company’s budgets and perhaps years beyond those covered by budgets and then discounted using the weighted average cost of capital. the company is faced with two impairment losses. it is almost impossible to determine discrete cash flows from individual assets so FRS 11 recommends a higher level of aggregation ‘income generating units’ (IGUs). This would reduce the total carrying value of the company’s assets to £1110 million. However. These are segments of business whose income streams are largely independent of each other. the new carrying value of all assets would be £1080 million. the total value in use is £1080 and therefore a second impairment loss would require to be taken on the goodwill figure. Then the net assets of the whole business have to be allocated across these IGUs. will have to write down their assets. International Accounting Standard (IAS) 36 Impairment of Assets is very similar in nature to FRS 11 except it is generally applicable to all assets. as follows: Income generating unit Carrying value Tom Dick Harry Goodwill Total £240m £360m £360m £120m £1080m This standard introduces a fundamental implication for financial reporting. environmental damage. and restructuring) to set aside in this year’s profit and loss account. Then the future cash flows need to be determined for each unit.10 Provisions and Contingencies In the earlier discussion on financial statements it was suggested that management has the discretion to choose the level of provisions (for example for bad debts. In total. Companies earning a poor rate of return. Each IGU contains an intangible asset which has not been amortised. First. namely that assets must be stated in a balance sheet at amounts that are expected to earn at least a satisfactory rate of return.Module 7 / Emerging Issues and Managerial Options in Financial Reporting First. Such amounts would then be 7/22 Edinburgh Business School Accounting . Ignoring the technical difficulties of carrying out the calculations. 7. litigation. (This process will be explained fully in Module 15). the impairment loss of £60 million must be recorded in respect of the decline in value of the assets of IGU Harry. reducing its carrying value to £120 million. Central assets and goodwill must be apportioned across all the units. even if still profitable. let us consider the impact of such a review: A company acquires a new business comprising three income generating units (IGUs). After three years the carrying amounts of the net assets in the three IGUs and the purchased goodwill compares with the value in use (as determined by discounting future cash flows) as follows: Income generating unit Carrying value Value in use Tom £240m £300m Dick £360m £420m Harry £420m £360m Goodwill £150m Total £1170m £1080m Having carried out the impairment test.

The standard restricts the recognition of provisions further by allowing only obligations that exist regardless of a company’s future actions to be recognised as provisions. to fit smoke filters in a factory. then no provision can be recognised. where the outcome is uncertain. Contingent Liabilities and Contingent Assets. and the finer points of interpretation it produces. A provision is defined as a liability of uncertain timing or amount. namely to stop management dreaming up potential provisions against potential future events and risks which may not happen and which bear little resemblance to reality and charging these amounts against this profits in the current year. it is not the purpose of this note to provide the reader with a detailed analysis of this standard. But the company can avoid the expenditure by its future actions. and a reliable estimate can be made of the amount of the obligation. when the realisation of the profit is virtually certain then the related asset ceases to be a contingent asset and its recognition is appropriate. The potential for managerial abuse is clear: in good years of profit management can set up provisions just in case they may be needed in the future. However. for example by changing its method of operation. Contingent assets usually arise from unplanned or other unexpected events that give rise to the possibility of an inflow of economic benefits to the company. it is probable that a transfer of economic benefits will be required to settle the obligation. 7. should not mask the goal of the ASB. so there is no present obligation for the future expenditure. The complexities of the standard. we made reference to the work of the International Accounting Standards Committee. once the provision is set up. It should be recognised only when a company has a present obligation as a result of a past event. why not hit the profit and loss account with a really big provision and hold some aside for future years? After all the shareholders will be disappointed with any level of provision. alternatively if provisions are truly required this year to such a level that will depress profits. This means that if a company can avoid expenditure by future actions such as changing the way it goes about its business. Why did we not choose to analyse sets of accounts which use Accounting Edinburgh Business School 7/23 . Contingent assets are not recognised in financial statements because it could result in the recognition of profit that may never be realised. so you may as well make it a big one! The issue of so-called ‘big bath’ provisioning has been addressed in FRS 12 Provisions. no further charges need to be made to future profit and loss accounts until the relevant provision has been used up. a body set up in 1973 and sponsored by over 50 countries and which promotes the harmonisation of regulations and procedures throughout the world. rather it describes the thinking behind the ASB’s actions. A word about contingent assets which appears in the title of the standard. because of commercial pressures or legal requirements. An example given in the standard is a claim that a company is pursuing through legal processes. Again. The standard provides an example: a company is required.11 International Harmonisation of Accounting Standards In Module 5.Module 7 / Emerging Issues and Managerial Options in Financial Reporting kept in the liabilities in the balance sheet and used to meet actual payments in future years as and when these fell due. Of course.

This is a tough task because the US Securities and Exchange Commission. that sounded by IASC. The US view cannot be ignored. But this is set to change. When this profit was converted to US principles. In the six months’ results prior to the listing. it disappeared down a black hole and emerged as a loss of DM949 million. so IASC has been negotiating with the International Organisation of Securities Commission (IOSCO) for it to agree that international standards can be used worldwide for cross-border share offerings and listings as an alternative to the use of national accounting standards. remains distrustful of non-US standards. 7. The US view is that European standards allow the build-up of secret reserves and the recording of excessive depreciation and selective consolidation of group subsidiaries. The only way to solve this problem is for all companies to march to the same drum beat. sought a New York Stock Exchange Listing. These practices. IASC. This pressure stems from the stock market’s obsession with earnings 7/24 Edinburgh Business School Accounting . as providing a reporting framework for countries without the resources to devote to constructing their own standards. amongst others. in 1991. recognised some years ago that it would need to work closely with those who have the power to enforce better accounting standards. Historically. rather than UK companies using UK standards? The answer is that there are few companies who adopt IASC standards. The work of the IASC was viewed.Module 7 / Emerging Issues and Managerial Options in Financial Reporting the standards issued by IASC. the most potent force in financial regulation. national standards were developed to meet the reporting requirements and economic conditions in that country. Those countries which developed their own believed that theirs were ‘leading edge’ and that IASC’s standards were the lowest common denominator of these leading-edge contributions. Take the celebrated (perhaps ‘infamous’ would be a more suitable adjective) case of Daimler-Benz which.12 Summary Management is under continual pressure to report superior earnings performances. so the need for one set of standards became apparent. This agreement was put in place in 1995 and IASC is currently active in constructing a common core of standards which will be acceptable to all the major players in world financial reporting. Often this means securities regulators. But pragmatic considerations will make this process inevitable. Much national pride will have to be swallowed before international standards take precedence over the standards of the country in which the company is domiciled. perhaps wrongly. particularly European standards influenced as they are by German standards. for its part. the company reported a profit of DM168 million measured under German accounting principles. But as multinationals’ capital requirements began to cross national boundaries. not only do its capital markets pack a powerful punch globally but the economic significance of USbased multinational companies and the pervasive influence of the US-dominated international auditing firms have a disproportionate effect on how the rest of the world views the choice among competing accounting standards. allow off-balance sheet financing to go undetected.

They are: (a) goodwill – the difference between the fair value of net assets acquired in a corporate acquisition and the price paid for these assets. The Operating and Financial Review represents an imaginative way in which companies can describe aspects of their activities not properly captured by the financial statements. It is far from clear what the best accounting policy is for this amount and companies currently select a variety of treatments. Some companies have been keen to put brands on their balance sheets but financial commentators await with interest how they will account for the brands’ diminution in value. senior executives are under considerable pressure to ensure against the occurrence of the following. Accounting Edinburgh Business School 7/25 . a company can avoid recording transactions in its profit and loss account and balance sheet. using only the notes to the accounts to draw shareholders’ attention to the transactions. resulting in no change in the quoted share price. A further two areas of controversy at present are the subject of vigorous debate within the accounting profession and readers are recommended to follow the discussion in the financial press. depending on the legal structure of certain commercial deals. Review Questions 7. Some accounting policies are sufficiently flexible to allow management to make a choice among several alternatives. (i) (ii) Reported profits are poorer than predicted. Three particularly rich areas for alternative accounting treatments are: (a) research and development where management may be able to capitalise part of the company’s annual spend. As the deals and transactions in the market place become more complex and imaginative we can anticipate traditional accounting concepts being examined more closely than ever before for relevance and applicability.1 In quoted companies. resulting in a significant markdown of the quoted share price. Reported profits are poorer than predicted. each one of which has a different impact on earnings. each alternative can produce a different earnings figure.Module 7 / Emerging Issues and Managerial Options in Financial Reporting per share. and (c) acquisitions and mergers where the price paid for an acquisition and the goodwill purchased as part of the deal can be hidden from view provided certain conditions apply. The adoption of International Standards will aid the process of accounts of global companies become more relevant and more comparable. and (b) brands – one specific component of goodwill associated with the image and market potential of certain products. (b) off-balance-sheet transactions where. Recent standards on Impairment of fixed assets and goodwill and Provisions are examples of how the regulators are tightening up on managerial discretion. Financial accounting and reporting must reflect the underlying economic activity of an enterprise.

5. (b) Writing off all R&D expenditure to profit and loss in the year of incurrence. (d) (iii) and (iv) only.3–7. (b) (i) and (iv) only. The following information applies to Questions 7.3 How much were Hi-tech’s Year 2 profits improved by adherence to the R&D capitalisation policy? (a) (c) £15 000.Module 7 / Emerging Issues and Managerial Options in Financial Reporting (iii) Reported profits are exactly as predicted. 7.2 What is the accounting principle adopted by virtually every company which spends resources on research and development? (a) (c) Capitalisation of all R&D expenditure. (b) £22 000. with only 100 units sold in comparison to the target 2000 units for the first full year of availability of the completed product. (d) £117 000. 7/26 Edinburgh Business School Accounting . resulting in no change in the quoted share price. Hi-tech Products Limited has had a history of capitalising R&D expenditure on specific. resulting in a significant markdown in the quoted share price. (ii) and (iv) only. Capitalisation of most R&D expenditure and writing off only a small proportion of R&D to profit and loss in the year of incurrence. £37 000. Investigations reveal that competitors have brought out a product with comparable performance for 20 per cent of the price. Which of the following is correct? (a) (c) (i) only. (iv) Reported profits are better than predicted. Hi-tech cannot respond and enters a price war since its direct manufacturing costs exceed the competitor’s selling price. justifiable projects. Year 1 2 3 4 5 Reported profits £ 75 000 95 000 110 000 135 000 153 000 R&D capitalised £ 15 000 22 000 31 000 25 000 – In Year 5. sales of the new product are very disappointing. A project to develop a new CO2 gas detector for environmental applications has taken four years to complete. 7. (d) Capitalisation of a small proportion of R&D expenditure and writing off most of R&D to profit and loss account in the year of incurrence.

4 With the advent of the competitor’s new product and the poor sales performance. (iii) the concealment of high-risk activities outside the mainstream core business.7 There are several possible ways to make use of off-balance-sheet financing to the benefit of a company’s financial structure. (ii) and (iii) only. (iii) advance payments by customers. £78 000. (b) (i) and (iii) only. (d) (ii) and (iv) only. (b) £57 000. but also controls the composition of Company B’s board. including: (i) (ii) a desire to improve their gearing structure. 7. (b) (i). These may include: (i) where company A owns less than 50 per cent of the share capital of company B.6 Quoted companies may wish to make use of off-balance-sheet finance for a number of reasons. (iv) a wish to disclose a higher amount of current assets in the Notes to the Accounts. 7. 7. (d) £110 000. Accounting Edinburgh Business School 7/27 . how much will Year 5 profits be reduced by an enforced change in accounting policy on R&D expenditure? (a) (c) Nil. (d) (ii) and (iv) only. (b) £37 000. what would have been its revised profits in Year 3? (a) (c) £42 000. (d) £93 000. Which of the following is correct? (a) (c) (i) and (ii) only. (ii) and (iv) only. (iv) quasi-subsidiaries. These include: (i) (ii) debt factoring with right of recourse.8 The range and nature of inter-company shareholdings can vary substantially. 7. (i). a need to control important fixed assets. Which of the following is correct? (a) (c) (i) and (ii) only.5 If Hi-tech had altered its accounting policy in Year 3. £79 000. consignment inventories.Module 7 / Emerging Issues and Managerial Options in Financial Reporting 7. (ii) and (iii) only.

which amounts would appear in its balance sheet? (a) Debtors £1200. (c) Cash £10 800. which amount would appear in its balance sheet under ‘Current assets’? (a) Cash £1200. increase in creditors. 7. 7. 7. but retaining the right to pursue Kinross for any irrecoverable bad debts. 7/28 Edinburgh Business School Accounting . (d) Debtors £12 000. The following information applies to Questions 7. The debt factoring arm of the Fife Bank has agreed to take on the responsibility for collection of the debts.10–7. together with significant collection problems. 7. Kinross Engineers Limited has trade debtors of £12 000. short-term loan £10 800. increase in cash at bank.Module 7 / Emerging Issues and Managerial Options in Financial Reporting (ii) where company M holds 51 per cent of the share capital of company N. paying Kinross Engineers 90 per cent of the ledger value. (b) Debtors £10 800. (d) Debtors £12 000. (iv) where company T holds 30 per cent of the non-voting share capital of company W. short-term loan £10 800. (c) Debtors £10 800.12 If Kinross chose to account fully for the factoring transaction. short-term loan £10 800.10 If Kinross decided to apply an off-balance-sheet approach. (b) Bad debts £1200.12. decrease in cash at bank. (d) (iii) and (iv) only. (b) Debtors £1200.11 If Kinross decided to apply an off-balance-sheet approach. (b) (i) and (iii) only.9 Which of the following describes the correct accounting treatment for the transactions included in an agreement for the cash sale of current inventories with an accompanying obligation to repurchase from the customer within one year from the date of sale? (a) Decrease in inventories. (c) Debt factors’ discount £10 800. (c) (ii) and (iv) only. company Q sells some of its assets to company R but enters into a management contract which has the effect of stripping company R of all of its profits and returning them to company Q. which amount would appear in its profit and loss account? (a) Debt factors’ discount of £1200. (iii) where. (d) Cash received £12 000. (d) Inventories unchanged. (b) Increase in cash at bank. short-term loan £1200. Which of the following will be regarded as quasi-subsidiaries? (a) (i) and (ii) only. increase in inventories. (c) Inventories unchanged.

(iii) its combination of distributable reserves. (iv) a desire to blend all assets and liabilities into one business entity. 7.16–7. but write off over three years.15 Current accounting guidelines provide for the option of capitalising goodwill on acquisition and transferring its diminution in value to the profit and loss account via depreciation or amortisation over a period of: (i) (ii) a maximum of two years. Its current year profits are £3. (i) and (iv) only. (ii) and (iii) only. (iii) a maximum of 40 years.1m to reserves. (iii) capitalise. (iv) a minimum of ten years. The Directors of Badger Construction Limited have considered the various methods of accounting for goodwill and narrowed the options down to: (i) write off £2.Module 7 / Emerging Issues and Managerial Options in Financial Reporting 7. (b) It means that a beneficial acquisition reduces shareholders’ reserves in the combined group.5m and it has 700 000 ordinary shares.1m. giving rise to goodwill on acquisition of £2. Which of the following is correct? (a) (c) (i) only. (d) (iii) and (iv) only. but write off over 15 years. including: (i) (ii) the need to adopt a friendly approach in acquisition situations.18. (d) There is no improvement in combined earnings. (ii) capitalise.13 Management may prefer to adopt merger accounting instead of acquisition accounting for a number of reasons. Accounting Edinburgh Business School 7/29 . (b) (ii) only. a minimum of its useful economic life. which of the following is most likely to inhibit an immediate write-off of goodwill against reserves? (a) It is a complicated accounting adjustment.14 In accounting for goodwill on acquisition. (d) (ii) and (iii) only. The following information applies to Questions 7. 7. Badger Construction Limited has acquired Deeside Homes Limited for £10m. (c) Net worth is increased. its avoidance of difficulties in treating goodwill. Which of the following is correct? (a) (c) (i) and (ii) only. (b) (i) and (ii) only.

00.80. (iv) identify a specific part of goodwill. what is the earnings per share in the current year? (a) (c) £5. increase revaluation reserve. £5.Module 7 / Emerging Issues and Managerial Options in Financial Reporting 7.00. £4. 7.16 If the directors choose option (ii). The resulting improvement in gearing allows the company to raise its borrowings level.20 If a company decides to include brands in its balance sheet.18 If the directors choose option (i). (d) (iii) and (iv) only.00. Increase fixed assets.00.00.00. decrease revaluation reserve.80. (b) £2. decrease current liabilities. what is the earnings per share in the current year? (a) (c) £1. Which of the following is correct? (a) (c) (i) and (iii) only.19 The recent accounting trend to put a valuation for brands on the balance sheet stems from companies’ desire to: (i) (ii) increase the value of total assets. (iii) participate in a public relations exercise. (b) (i) and (iv) only. (b) £4. (d) £4. 7. what is the earnings per share in the current year? (a) (c) £2. 7. (b) Increase intangible assets. £7. These may include the following: (i) (ii) A higher asset value permits the possibility of more attractive acquisitions by share exchange. 7. (d) £6. (d) £8. advertise their products to the financial markets.00. increase retained profits.21 There are some clear advantages in capitalising brands with particular regard to the stock market’s view of a company.50.00. (d) Decrease fixed assets. 7. (ii) and (iii) only.00. which one of the following reflects the necessary accounting adjustments? (a) (c) Increase intangible assets. 7/30 Edinburgh Business School Accounting .17 If the directors choose option (iii). (b) £6.

(ii) and (iii) only. (d) Scarcity of raw materials and labour skills. (iv) A higher asset value acts as indicator of a minimum price for any potential bidder.22 In assessing the valuation of companies’ ‘home-grown’ brands.23 Which of the following matters would be included within an Operating Review? (a) (c) Debt covenants. 7. (iv) an application of some managerial judgement in determining the costs to be included. a retrospective attempt at identifying past costs on specific brands. (b) (i) and (ii) only. (d) New products and services. Which of the following is correct? (a) (c) (i) only.1 The Directors of Findhorn Distilleries plc have some decisions to take before their annual profits are announced. (d) (ii) and (iv) only. Treasury policy. several sensitive areas have been identified where judgements are required which will influence the level of reported profits. (d) (iii) and (iv) only. 7. Which of the following is correct? (a) (c) (i) and (ii) only. (i). Case Study 7.24 Which of the following matters would be included within a Financial Review? (a) (c) Maturity profile of debt. (b) Training programmes. Accounting Edinburgh Business School 7/31 . In discussions with their external auditors. (ii) and (iii) only. the application of the historic cost approach requires: (i) (ii) a forecast of future earnings potential of each brand. (ii) and (iv) only. 7. (iii) an adjustment to current year’s profits in respect of previously incurred costs. (b) Uncapitalised research and development expenditure.Module 7 / Emerging Issues and Managerial Options in Financial Reporting (iii) Sales of products to stockbrokers will increase. (b) (i). Changes in market share.

8 4 Nairn is expected to play an important role in Findhorn’s bottling activities for at least ten years.8m in cash.8 1.Module 7 / Emerging Issues and Managerial Options in Financial Reporting 1 2 3 During the year.0 1.3 2. how would you approach each of the sensitive areas? Detail the adjustments. Findhorn has also been investing in substantial expenditure on the research and development of an entirely new range of whisky products with an estimated ten-year lifetime. which includes the write-off of £3m in R&D expenditure. At the date of acquisition. Nairn’s summary balance comprised: Fixed assets Net current assets Share capital Reserves £m 1.0 6. you have been entrusted by the Board with the task of maximising the value of the company and its earnings per share. With these objectives in mind. At present. to preliminary profits and prepare the resulting balance sheet.0 14. The development is complete. but the products have not yet been launched on to the market. since it does not have to pay for it until it is sold. Required As Chief Executive. At the end of the financial year.5m on the company’s brands with an indefinite lifetime. 7/32 Edinburgh Business School Accounting . Findhorn’s balance sheet (summary form.5m.0m in respect of this development. prior to 1–4 above) Fixed assets Net current assets Share capital (20m shares) Reserves £m 18. Already written off in this year’s profit and loss account is £3. Findhorn acts as distributor in the UK for Montego Bay Rum Co. including the Wild Heather and Flying Hawk exclusive malt whisky products. held £2m in inventory of bottles of rum.5 24.5 1.5 Findhorn’s preliminary profits for the year are £6. Findhorn engaged a consultancy firm to assess a valuation of its world-famous brand names. if any. this inventory is excluded from Findhorn’s balance sheet.5 24. The consultants placed a value of £2. and at the balance sheet date. Findhorn acquired the whole of the ordinary share capital of Nairn Bottling Co. Limited for £3.5 10.8 2.

Accounting Edinburgh Business School 7/33 . Elizabeth Davie and Ann MacNeill (1995). ‘Operating and Financial Review: A Survey of Compliance with the Spirit of the ASB’s Guidance’. The Institute of Chartered Accountants of Scotland. Bill Collins.Module 7 / Emerging Issues and Managerial Options in Financial Reporting Reference 1 Pauline Weetman.

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PART TWO Management Accounting for Decision Making Module 8 Module 9 An Introduction to Cost and Management Accounting Cost Characteristics and Behaviour Module 10 Allocating Costs to Jobs and Processes Module 11 Costs for Decision Making Module 12 Budgeting Module 13 Standard Costing Module 14 Accounting for Divisions Module 15 Investment Decisions Module 16 New Developments in Management Accounting Accounting Edinburgh Business School .

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6.4.2 8.9.Module 8 An Introduction to Cost and Management Accounting Contents 8.2 8.9.8 8.3 8.9.1 8.13 What Accounting Is: A Refresher Management Accounting Looks Forward Where Accounting Fits into a Company A Brief Note on what a Manager Does First Group of Tasks: Planning and Co-ordination Second Group of Tasks: Directing and Control The Role of Accounting Information Management Accounting in MBA plc Turnover (A) Operating Profit (B) Profit on Ordinary Activities Before Taxation (C) Dividends (D) Differences between Management Accounting and Financial Accounting Management Accounting and Cost Accounting Where Costs Come from and an Overview of the Modules to Follow Materials Labour Manufacturing Overheads Process Costing Costs Relevant to Management Decisions Other Topics in the Management Accounting Course Summary 8/2 8/3 8/4 8/4 8/5 8/6 8/7 8/7 8/9 8/9 8/10 8/11 8/11 8/12 8/14 8/14 8/15 8/15 8/15 8/16 8/17 8/18 8/19 Review Questions Learning Objectives By the end of this module you should understand: • Accounting the differences between management accounting and financial accounting.3 8.7 8.1 8.1 8.9 8.4 8.6.3 8. 8/1 Edinburgh Business School .6.2 8.12 8.6 8.11 8.10 8.5 8.2 8.4.6.4 8.1 8.

But we think such a refresher exercise is useful for two reasons. 8. Accountants’ reluctance to embrace these developments stems from the subjectivity surrounding measurement of items for which there is no ready market-based valuation. the source of costs and how individual costs can be added together to determine the total cost of a product. 2 In Module 1 we defined accounting as ‘a series of processes and techniques used to identify. 1 As students delve deeper and deeper into a subject it is too easy for them to lose sight of the basic principles. This annual publication. is the only communication a company has with its shareholders Edinburgh Business School Accounting 2 3 8/2 . Accounting deals with economic information and avoids the occurrence of events and happenings which cannot be quantified We saw that the field of corporate reporting is currently being extended to include intangible assets such as goodwill and brand names. We highlighted several features of this definition for expansion and illustration. that different costs and revenues are used for different management decisions. management accounting systems must be sufficiently flexible to allow managers to use the information for a variety of purposes. this module represents an intellectual watershed in ideas and techniques. Accounting is a communication device In Part One of this course we studied the accounts of MBA. 1 Accounting is a service function and not an end in itself In Part One we saw how corporate reports and accounts are designed to portray underlying economic strengths and weaknesses. Because the focus of our attention for the remainder of the course (nine modules in total in Part Two) is on Management Accounting for Decision Making. measure and communicate economic information which users find helpful in making decisions’. are sub-sets of the same discipline. management accounting’s role in planning and control. financial accounting and management accounting.1 What Accounting Is: A Refresher After the seven modules of Part One devoted to Financial Accounting for Managers it may seem unnecessary to revisit the fundamentals of the subject and to consider what accounting information attempts to provide. but we wish to reinforce the point made earlier in the course that both subjects. thereby allowing shareholders and others to take share-ownership decisions. It should therefore be a rewarding exercise to stand back from time to time and position the ever-increasing detail within the broader canvas of the discipline. the typical detailed internal decisions lying behind a set of published financial statements. which is accompanied by the Chairman’s Statement and Directors’ Report.Module 8 / An Introduction to Cost and Management Accounting • • • • • the planning and control features of a manager’s job.

the story of performance and achievement is one worth telling. perhaps the oldest and most developed part of any information system. readers will agree that understanding a set of accounts represents a significant challenge to the financially untutored person and the accounting profession needs to devote much more effort to its communicative role in society. it reflects the trading activities of the organisation for the accounting period just finished and displays the financial resources (assets less liabilities) employed both at the beginning of the period and on the last day of the period.2 Management Accounting Looks Forward Directors and managers must however have access to an information system which can predict the path the company will take and will track its performance so closely that remedial action can be taken to put things right. MBA’s accounts were issued some eleven weeks after the end of its financial year. Internal Directors Senior executives Managers Employees (and trade unions) External Shareholders Analysts Creditors Tax authorities The public In the first seven modules we focused on the needs of external users. Accounting and accountants must therefore be capable of looking forward as well as back. must therefore be capable of producing for managers details of corporate activities which assist the directors and managers in steering their way through the turbulent commercial environment so that. Despite efforts to simplify the message. The accounting information contained in a set of corporate financial accounts is historic.Module 8 / An Introduction to Cost and Management Accounting in the course of a normal year. 8. The forward-looking branch of the discipline is called management accounting. Big companies take several weeks to prepare their accounts after the end of their financial year and the auditors require time to undertake their statutory duties. And because the performance of a company’s directors and managers was largely being evaluated through the messages contained in these financial statements they had a vested interest in choosing accounting principles which reflected the company’s results in the best possible light. Module 1 stressed that accounting information served a variety of users both inside and outside the organisation. But readers should note from the outset that the same characteristics of the same Accounting Edinburgh Business School 8/3 . a commendably short time. But note that the company was already three months into the current financial year by the time the external users gained an insight into last year’s activities. Managers dare not await the publication of their company’s results year by year to take decisions affecting the future! Accounting. A historic document indeed. at the end of the year. that is. with particular reference to the annual accounts as being the principal medium employed by a company to satisfy these needs.

management accounting reports for management.1. 8/4 Edinburgh Business School Accounting . he himself usually helps construct these plans. To do this he must know what is expected. (Note that no two companies have the same organisation chart. the production manager needs to order the raw material from the purchasing department which in turn needs to ensure that the quality of goods received is in accordance with specification.) 8. he must know the company’s plans for the area for which he is responsible. who are perhaps equally dissatisfied with the information supplied in financial accounts. we see them both positioned under the control of the financial director. a main board appointment. not open to shareholders. managers can have the system redesigned. readers should depict their own organisation’s hierarchy to compare with the chart in Figure 8. 8. that is. number of shifts worked feature in management accounting systems as commonly as money amounts. hours per machine. The common database for communication is management accounting. 2 3 We could describe the difference between financial accounting and management accounting as follows: • • financial accounting reports on management. If the system fails to provide the information required. 1 Accounting is a service function and not an end in itself In management accounting the system serves managers and all other decision makers within an organisation. This power is.Module 8 / An Introduction to Cost and Management Accounting global definition apply to management accounting as to financial accounting and reporting. sadly.3 Where Accounting Fits into a Company As if to reinforce the common language between financial and management accounting. Hence tons of material.4 A Brief Note on what a Manager Does A company’s objective is to maximise shareholder value and a manager’s prime responsibility is to ensure that things get done efficiently and on time so that this objective is met. Accounting is a communication device Management accounting can be described as the cement which holds together the disparate parts of an organisation. Accounting deals with economic information and avoids the occurrence of events and happenings which cannot be quantified Management accounting also deals with economic information and events which can be quantified but is not so obsessed with translating these quantities into money terms. The sales director needs to inform the production manager of his plans.

The manager’s planning processes are complicated if he or she is only one part of a bigger corporate planning exercise. a few of which they can control but most of which will be beyond their influence. Co-ordination is therefore a key role in the manager’s planning activities. Then the problem is to ensure that the individual managers’ plans add together to make a realistic and practical proposition. they must work out the raw material. will conspire to blow them off course. True. they must translate these sales aspirations into a production plan. and at what price.Module 8 / An Introduction to Cost and Management Accounting Organisation chart: main board Chairman Non-executive Directors Chief Executive Production Director R&D Director Human Resources Director Sales Director Financial Director Organisation chart: finance department Financial Director Group Treasurer Internal Audit Group Controller Banking Corporate Finance Tax Internal Audit Chief Management Accountant Chief Financial Accountant Cost Records Budgets Task Force General Ledger Debtors Creditors Regulatory Figure 8. labour and cash they will need to produce the volume of output they hope to sell.1 Organisation charts 8. but without this predetermined plan they will be like mariners without either compass or chart. that is.4. many events. They must consider the support services they will need to assist them. a sales manager may plan for a 50 per cent increase in units of Product A but the production manager knows that raw materials for Product A are in very short supply and will be either unobtainable or more Accounting Edinburgh Business School 8/5 . For example.1 First Group of Tasks: Planning and Co-ordination All managers must plan for the future. they will have no idea where they are heading. They must consider what products they can sell. the advertising and marketing expertise. the sales representatives. the accounting and financial advice. Their time horizons may vary but they would almost certainly have a detailed plan for the next 12 months and a rough plan for the succeeding year or two.

These tasks are neatly described in Figure 8. Good co-ordination will help to overcome this type of obvious.4. On investigation he discovered that the special drying agent used in the paint formula was being purchased from a French supplier rather than a local one. nor do they do the job themselves. Feedback loop 1 reflects the need to adjust operations immediately on receipt of control information indicating that part of the operations is not running to plan. a part which the experienced and skilful manager is hardly aware of fulfilling. Figure 8.Module 8 / An Introduction to Cost and Management Accounting expensive in the forthcoming year. They are assisted in their tasks of direction by receiving information on current performance which allow them to trim the sails as necessary so that the targets of the company as set out in the plan are met as closely as possible. but all too common.2. problem. This forms the day-to-day part of the manager’s life. The boxes in Figure 8.2 The planning and control loop Example A paint manufacturer believed he had perfected a gloss paint which would dry in one hour after application to woodwork. 8. His first six months’ production figures told him that material costs far exceeded the budget. They must allocate specific tasks to individuals and ensure that their instructions are carried out.2 Second Group of Tasks: Directing and Control Managers cannot sit back and wait for their staff and workers to follow the plan.2 do not need expansion but the feedback loops do. 8/6 Edinburgh Business School Accounting . Steps were therefore put in hand to re-source the supply on the expiry of the current contract.

8. Possibly the most difficult notion for managers to come to terms with is the almost limitless freedom they have in asking for. Management accounting is not hemmed in by statutory and professional regulations which abound in financial accounting: it is informal and flexible. But the information must be useful: it must allow them to take decisions. and so on. It is not concerned with the countless other sources of information they may have access to: newspapers and journals. A chemical analysis of the returned tins of paint revealed that certain climatic conditions caused the special drying agent to work when the tin was first opened. But managers must become familiar with the strengths and limitations of the management accounting information before they are in a position to use it purposefully in decision making. conversations. economic and technological advice. The reason for this rests on the nature of disclosure discussed in Module 5. 8. Accounting Edinburgh Business School 8/7 . information from their accounting systems. some problems require more rigorous analysis as a result of a problem emerging which could have an impact on the entire planning process (feedback loop 2). The second part of this course (Modules 8–16) is concerned with types of information which can be generated by the accounting system to help them make correct decisions. and receiving. is historic in nature and published in a company’s annual report and accounts. making it impossible for the user to dip in his brush! Such results caused him to reassess the viability of this special agent and after further tests in the R&D laboratory. Using the alphabetical key we can surmise the kinds of issues lying behind the disclosed numbers which have been addressed by a variety of MBA managers worldwide and suggest the types of management accounting information used by them in their work.Module 8 / An Introduction to Cost and Management Accounting On the other hand. This information. But for the purposes of illustration we can make some informed guesses at the type of accounting information used by MBA managers from a study of their published accounts. Example The same paint manufacturer recognised after a period of several months’ sales that the level of complaints and returns were running at five times the normal level.6 Management Accounting in MBA plc The exact role of management accounting information in any organisation is not made available publicly. as we have discussed. namely that companies only disclose the information they are obliged to by statute or the Stock Exchange or the accounting profession. lots of it. This of course is not to denigrate this non-accounting information.5 The Role of Accounting Information To assist managers in their two groups of tasks they need information. media stories. it is merely to erect a fence around the accounting material which will be explored here. he decided to abandon the line.

gains less losses on disposals of subsidiaries and other fixed assets 3 Income from loans.8p 18.Module 8 / An Introduction to Cost and Management Accounting Consolidated Profit and Loss Account For the year ended 31st March.5p 654 (130) Disposals Share of joint ventures after £10 million (20x1 nil) exceptional charges 524 9 – before goodwill amortisation – goodwill amortisation 647 Group and joint venture operating profit before exceptional items and goodwill amortisation HWU – before goodwill amortisation – goodwill amortisation Other associates Separation costs 3 Exceptional items. deposits and investments.1p 38.1p 8/8 Edinburgh Business School Accounting . less interest payable Group Share of joint ventures HWU 1&4 (C) Profit on ordinary activities before taxation 1 Tax on profit on ordinary activities 5 Profit on ordinary activities after taxation Minority interests 6 Profits on ordinary activities attributable to the shareholders (D) Dividends 7 Retained profit for the financial year Earnings per share 8 Earnings per share before exceptional items and goodwill amortisation 8 Diluted earnings per share 8 69 (7) 783 159 (12) 17 759 – 20 64 10 26 100 879 (311) 568 (59) 509 (311) 198 18.9p 27.2p 23. 20x2 20x2 Note £ million 20x1 Restated £ million (A) Turnover Group turnover Share of joint ventures – retained businesses – disposals 2 2 12 1 6 590 – 1 035 7 625 5 875 394 896 7 165 (B) Operating profit Group operating profit – retained businesses after £86 million (20x1 £51 million) exceptional charges before goodwill amortisation – goodwill amortisation 2 2 12 763 (189) 574 – 81 (8) 595 940 58 (16) 17 706 (50) 775 54 13 6 73 1 504 (433) 1 071 (17) 1 054 (348) 706 38.

detailed cost of production for each product. collection period and volume purchased by that customer over past quarters. – total production overhead costs. sales targets by lines for next year at least. cost. Take the position of the sales director of MBA’s Electronic Systems in Europe: what figures will help him drive his business? • • • • • • • market share of MBA Electronic Systems in Europe versus principal competitors. including: – raw material cost per product. change in market share quarter by quarter in 20x2 and plan for next two years. – labour cost per product. market opportunities in Eastern Europe. management information systems employed by major organisations make little distinction between accounting and non-accounting information. 8/9 Accounting Edinburgh Business School . market penetration.1 Turnover (A) Breakdown by product group and geographical region is supplied in the company’s annual report. sales force requirements: head count.Module 8 / An Introduction to Cost and Management Accounting 8. the customer. in practice. profit impact. – share of corporate overhead costs. above information broken down for top four (and bottom four) products in Electronic Systems division. discounts given. Note that much of this information is ostensibly non-accounting because it is not concerned with money amounts but. product by product.2 Operating Profit (B) Details of the major costs deducted from Turnover are given in Note 2 of the accounts and include the following items for 20x2: Raw materials and consumables Staff costs Depreciation and amortisation Other external and operating charges £ million 2 584 2 066 396 1 298 Consider the information needs of the production director of MBA’s Communications in the UK whose costs will be contained in all four numbers above: • • • total production costs. The level of detail that may be called for will enable identification of virtually every item sold over the past 12 months. area switching. for the next 12 months. training needs. for past two years. quarter by quarter. new product launch plans: timing. see p. 8. 5/36.6.6. proposed marketing and promotional expenditure.

Specifically. we see a miscellany of information needs. with both examples (the divisional production director and the corporate R&D director). 8.e. how territorial overhead (i. for example. he will want assurance that no country or product is bearing more than its fair share in such a way that the local customers are reluctant to buy seemingly over-priced items. – likely market share when launched. assessment for each ongoing and completed programme. but he cannot be expected to deal with the level of detail seen above this line. – consumables used on the programmes. pricing strategies either to launch new products or dispose of old products..Module 8 / An Introduction to Cost and Management Accounting • • cost reduction programmes for next 12 months with associated capital investment proposals. costs charged by other regions of MBA when supplying Asia Pacific with components or partially finished goods for completion and sale. Instead he wants to know how all of these activities combine to produce profit for the company. actual costs of production for past month compared with budgeted costs. But take.3 Profit on Ordinary Activities Before Taxation (C) This profit line is a crucial line in any organisation’s financial affairs. needs assessment for new staff. • Again. costs incurred on behalf of the Asia Pacific region in support of its activities) is spread over countries and products. production and R&D in his geographical region. including: – likely time to product launch. True. This technique is called transfer pricing and will be examined in Module 14. cost of each major R&D programme. profit margins in each country in his territory. He will want information on: • • • • profit margins in each product range. including: – salaries of directly attributable scientific staff. the majority of which could be expected to be supplied by the management accounting system. – incremental knowledge about underlying science and technology gained as a result of programme and impact on staff recruitment. – reasonable estimate of laboratory and support overhead per programme. and reasons for differences between the two. • 8/10 Edinburgh Business School Accounting . the information needs of the managing director of MBA Asia Pacific. Consider now the information requirements of the corporate R&D director whose costs will also be imbedded in the above figures: • • • breakdown of scientific and engineering personnel comprising the R&D function. he is responsible for sales.6.

Rigid handling of asset valuation. current share price and an in-house assessment of effect on share price of different levels of payout. otherwise outsiders would not be able to evaluate information among companies. however informal. each with its own set of guidelines. Accounting Edinburgh Business School 8/11 . Can be designed to suit many purposes. The ultimate decision on dividend payout rests with the board of directors who will need detailed information on: • the estimated ‘profit on ordinary activities attributable to the shareholders’ figure. Companies are obliged by law to produce external accounts. No externally imposed rules. overhead allocation and revenue recognition is relaxed in a management accounting system. the impact on the stock market of offering new ordinary shares in lieu of cash dividends. Rules? Hemmed in by generally accepted accounting principles.4 Dividends (D) Dividends are a return to shareholders of part of the profits earned during the year. Shareholders come to expect a rising trend of dividend payout while management prefer to hold back as much profit as possible for reinvestment in the business. the cash resources of the company from which the dividend will be paid. analysts’ forecasts of dividends. Structure? Management accounting No formal structure. But there is no value in maintaining one if it is not used properly. payout ratios from competitors and similar multinational groups. but few enterprises succeed or develop without a system. This section sets them all out in an easily digestible format.6. There are others. Yes. together with an assessment from the auditors that no material alteration to the reported profit figure will need to be made as a result of their work. • • • • • 8. Financial accounting Highly structured around the accounting equation.Module 8 / An Introduction to Cost and Management Accounting 8. Compulsory? No.7 Differences between Management Accounting and Financial Accounting The previous paragraphs have touched on some of the differences between internal and external accounting.

estimates. Although management wants reliable and accurate information it is willing to sacrifice precision for speed. Information tends to be future oriented. Forecasts. processes and other areas of responsibility. Instead there tend to exist in most companies many different types of information each used for a different purpose. The main thrust is on costs of product lines. Time-span? Records and reports past events as accurately as the underlying accounting principles permit. Whole or parts? Financial accounting reports the economic events of the company as a whole. departments. As a result there is less emphasis on precision in the data than there is in financial accounting. The secret of good management and accountancy is to select the correct information for the purpose in hand. units of energy consumed. The classification. others state that there is no difference at all between the two types of accounting! In our view neither interpretation is correct. 8. Audit? Yes. Management accounting is by nature fragmented. although the external auditors may wish to test the internal controls by examining aspects of the management accounting system. collection and analysis of costs. just as companies are obliged to produce accounts so they are required to have them audited by a registered auditor.8 Management Accounting and Cost Accounting Many textbooks on accounting suggest that management accounting is quite different from cost accounting. Yes.Module 8 / An Introduction to Cost and Management Accounting Money terms? Not exclusively. unified corporate management accounting system. Cost accounting is a major and essential part of management accounting. Strictly speaking. principal features of cost accounting. there is no such thing as a single. Management accounting systems embrace information in non-monetary terms such as labour hours. It is important therefore 8/12 Edinburgh Business School Accounting . are fundamental to management planning and control. tons of materials used. the management accounting system would form the basis of much of its work. and then make the correct decision. financial statements are drawn up exclusively in money terms. In summary. no. and projections are all part of the structure. If the company has an internal audit function. But the data can be reworked for many different purposes.

Module 8 / An Introduction to Cost and Management Accounting to understand some of the basic concepts of cost before embarking on a study of their managerial implications. Accounting Edinburgh Business School 8/13 .

5 hours @ £5 per hour Prime cost Manufacturing overhead Manufacturing cost Share of non-manufacturing overhead Total cost £ 10. in this case the hi-fi unit. Other costs such as the heating and lighting in the workshop.50 2. The cost accounting system usually records the amount of raw material that is drawn from the stores 8/14 Edinburgh Business School Accounting . Lubricating oils. The concern of this section is: how are the costs accumulated into such an orderly presentation? 8.00 This type of cost structure will be examined closely in Module 9. which are changed in form by skilled workers. nails. that is. Production involves the use of materials (chipboard. Costing systems are designed to facilitate the allocation or apportionment of expenditure to cost centres (the smallest unit of activity or area of responsibility for which costs are accumulated) or to products. salaries of the administrative staff are called indirect costs and have to be apportioned by some given formula to the products.Module 8 / An Introduction to Cost and Management Accounting 8. Payments have to be made to obtain these production factors and are classified according to the nature of the item or service received such as ‘material cost’.00 5. consumes a certain number of screws and hinges. one unit consumes a certain amount of chipboard. Use is also made of buildings.1 Materials Direct material is material that actually becomes part of the specified finished product. veneer and metal trim. Materials first must be quantified and then must be priced.50 25. depreciation of the machinery.00 15.50 22.9. takes a certain number of hours to assemble by a certain grade of worker. It should be distinguished from supplies which are materials used in the workshop but not directly on each unit produced. Costs are allocated to products if the relationship is obvious.9 Where Costs Come from and an Overview of the Modules to Follow As an introduction to the later modules. veneer and metal edging). screws. The cost of one shelved hi-fi unit would be stated thus: One timber-shelved hi-fi unit Direct material Chipboard Veneer Metal trim Direct labour 1. As a background for the discussion it is assumed that the business manufactures timber-shelved stacking units for hi-fi equipment. this section will consider the characteristics of the most usual types of costs incurred by a typical manufacturing company and how the information about such costs is gathered.00 3. ‘labour cost’ and ‘overhead expense’. These are called direct costs.00 7.00 2. machinery and equipment.00 30. glue are examples of supplies.

These costs are recorded in the manner described in the accounting equation (see Module 1) and apportioned to individual units of output by one of a variety of methods to be discussed in Module 9. The price per unit of raw material withdrawn can be determined in various ways.2 Labour Direct labour is that part of the total labour cost which can be traced to. This slip is used not only to cost the individual units but to update the records for raw material inventory which will eventually need replenishment. Ships. 8. or otherwise identified with. FIFO or the average cost method. the units of output produced. the higher the labour costs.Module 8 / An Introduction to Cost and Management Accounting for use in the assembly process. factory heating and lighting. selling and distribution costs and financial expenses are accumulated and allocated in the same manner.3 Manufacturing Overheads Manufacturing overheads is a broad category of cost which includes all costs associated with manufacturing other than direct material and direct labour. turbines. Examples are indirect labour of those employees associated. they use a simple average. The amount is recorded on a stores requisition slip which shows both the quality and the quantity of the material drawn. The higher the volume. 8. Typically. The number of hours and minutes spent on a particular task can be recorded relatively easily: a time card is maintained for each direct labour employee. direct labour comprises those employees who are closest to the manufacturing or assembling process. items of furniture are among the many areas which lend themselves to job costing systems. it may be determined by the stock valuation methods considered in Module 3. power. detailing the time spent by him or her on each unit worked on. chemical processing Accounting Edinburgh Business School 8/15 . 8. supplies.9. Again.9. It is a simple process to calculate the total time spent working on each unit. But there are many areas where the items produced are so homogeneous that physical identification is impossible. namely LIFO. the direct labour must be measured in terms of time and price. or by a standard cost to be discussed in Module 13. with production. examples are refining. By multiplying each hour worked by the rate of pay for the respective employee. appropriate where the units of output are sufficiently identifiable to pinpoint the direct material and labour applied to each unit. some companies do not bother with identifying multiple rates of pay. civil engineering projects. this time information can be converted into money terms. It may be the cost of the individual item if that item is sufficiently distinctive. If not. but not directly.10 Process Costing The system described above is known as job costing. Variations do exist: for example. machine maintenance and depreciation. Non-manufacturing overheads such as administrative costs.

8.Module 8 / An Introduction to Cost and Management Accounting and manufacturing activities where products are continuously produced in an unvarying mix. For these tasks the manager needs much cost information. It is possible. The management accountant must package the relevant cost information in a manner most appropriate for managers to make their decision. The skill of the management accountant. together with the various alternatives that confront management. ironing out problems that arise with supplies of raw materials or with the production workers. that they may have to be ‘reshuffled’ from the format in which they are initially produced by the cost accounting system. There is no limit to the types of special decisions that have to be made in the course of business. Process costing systems collect costs for all the products worked on during an accounting period and. In these cases. mostly of a routine nature. This system of costing will be described in Module 10. comes in presenting to management the costs relevant to the decision under consideration. and that managers who do not fully understand how costs behave may be misled into making the wrong decision. As an example of misinterpretation (and of the 8/16 Edinburgh Business School Accounting . which the cost accounting system is designed to produce. in general encouraging staff to achieve the company’s objectives as efficiently as possible. however. but expensive. model? Should we change our product mix and phase out product XY? How far can we afford to drop our prices in order to capture more market share? It is not possible to be dogmatic about which costs will be relevant (and which will not be relevant) for any particular decision without knowing precisely the circumstances of the situation. Managers are constantly making decisions. to state that costs must be interpreted very carefully. Routine decisions are concerned with the day-to-day operations of the enterprise: ensuring that the agreed volume of output is produced in the agreed manner. job costing is impossible to operate and another system called process costing is adopted. as opposed to the cost accountant. determine the cost for each unit. by dividing these total costs by the total number of units worked on during the same period. Special decisions need special cost information which does not fall out easily from the cost accounting system. but cheaper. product? Should we buy in a particular component and cease manufacturing it ourselves? Should we replace a piece of equipment by a more efficient. In many of their decisions they need financial information on costs and revenues. Management decisions can be split into two broad categories: routine and special. Here are a few: • • • • • Should we change our supplier and purchase a slightly inferior.11 Costs Relevant to Management Decisions Decision making is the essence of management.

50.50. That £1. Perhaps the management is right in refusing this offer (for example. decision in the future. Consider the cost information given above on each hi-fi unit. do not vary at all with volume. These techniques are the subject of Module 15. Unless managers understand the notion of contribution and variable and fixed costs they may take the wrong decision. 8. The balance of cost. otherwise they will have no benchmark against which to measure actual performance. management must construct a budget of costs and revenues.50 would contribute towards meeting the burden of overheads already being incurred. Another special decision facing management is the purchase of capital equipment (fixed assets) to assist in the production process.50 (£24 less £22. managers may be very happy to accept £24 in order to realise the modest contribution for each unit sold – but only if they understand the nature of overheads. If this is not pointed out to the management. corporate management must be able to assess the performance Accounting Edinburgh Business School 8/17 . comprises costs which would largely be incurred regardless of whether one individual unit was made. and damaging. namely £7. Indeed some of the overheads. it may lead the managers to take a wrong. It is therefore misleading for managers to think that each unit costs more than £22. Example The management of the workshop believes that the cost of manufacturing one timber-shelved hi-fi unit is £30. Budgeting is the subject of Module 12.Module 8 / An Introduction to Cost and Management Accounting deeper discussion on this subject that will follow in Module 11) consider the following situation facing the management of the hi-fi cabinet workshop. such as factory rent and depreciation on plant. that is.12 Other Topics in the Management Accounting Course Before any decisions are implemented in an organisation. The manager employs a variety of techniques in this assessment which are known as investment appraisal.50). the company could accept the offer of £24 and be better off by £1. They are deemed to be fixed costs and would be incurred whether the workshop produced any units or not. In complex organisations like MBA plc where the operations are split up into divisions. These costs are overheads which are not directly associated with each unit of production and would not vary in any significant way if production volume increased or decreased by a few units. By not selling for £24 the company has lost this contribution. the cost of making each individual unit. Such equipment is very costly and requires an investment today which will yield income over future years. Each unit’s variable cost. A major home electronics chain offers to buy in bulk for £24 per unit. Provided the bulk order would not stretch production capacity beyond the present limit. For instance when the market drops away and inventory builds up. the units may be selling well for more than £30 so why should they be sold at £24?) but has used the wrong reason. and provided no full price orders would be displaced. is £22.50. The management rejects the offer on the grounds that a loss of £6 per unit would be incurred on such a deal.

8. Management must be provided with the information it wants at the time it wants it. some companies are experimenting with new forms of management accounting because of perceived weaknesses with the old. The cost accounting system is a databank with a vast quantity of details about past performance essential for constructing forecasts for the future. Finally. 3 Management accounting information pervades the whole company and therefore acts as a good communicator. For example. Contrast these criteria with the criterion of verifiability which operates in financial accounting. The evidence surrounding these weaknesses is still slight but readers should be made aware of the current debate. because the roles of divisions differ (some may be producing divisions while others are selling divisions).Module 8 / An Introduction to Cost and Management Accounting of individual divisions and their managers. It does this by involving many people in the planning process and then by informing them of actual operating performance by means of feedback control reports. and non-accounting. irrelevant information not only is useless but also could be damaging. Internal users must also understand the flexibility of accounting data: the information produced by the cost system can be reworked for a multiplicity of uses. The contrast can be understood when one compares the internal and external roles of the two accounting systems. They can go only so far in eliminating uncertainty. 2 It provides management with skilled staff to assist them in interpreting the accounting. the amount of overheads allocated to each timber-shelved hi-fi unit is only an approximation and must be interpreted as such. 1 It is a primary source of information to assist management in planning. But very often. 8/18 Edinburgh Business School Accounting . it must therefore be capable of being verified by experts and be free from deliberate bias.13 Summary Management accounting serves management in a number of ways. the same performance measurement criteria cannot be used. The overriding criteria for management accounting information are relevance and timeliness. Managers cannot expect to get all the information they want to make correct decisions. The limitations of management accounting data must be recognised. Internal information is not similarly constrained. It takes time to prepare and publish. numbers produced. This topic is explored in Module 14. Outsiders rely on the financial accounting information issued by a company. Module 16 looks at these new developments. Late information is almost useless. Accounting information helps in this process but it is subject to approximations and varying degrees of accuracy.

(d) Sources and applications of funds statement. True or false? 8.Module 8 / An Introduction to Cost and Management Accounting Review Questions 8. (iii) the composition of its shareholders. (i) and (iii) only.1 Management accounting is an area of accounting where the principal concern is with the accuracy of historic cost information. Which of the following is correct? (a) (c) (i) only.5 Management information systems are designed to collate. extract and review items of accounting and non-accounting information which are key to a company’s performance. (iii) using available physical measures of activity to enhance the quality of management control. Accounting Edinburgh Business School 8/19 . (d) (i). including: (i) (ii) changes in market share for products. 8. (iv) collating information in the format required by the tax authorities. (iii) and (iv) only. (ii) and (iv) only. (b) (i) and (ii) only.3 The form and shape of management accounting is not controlled by either legal parameters or professional guidelines. Gearing ratio. (d) (ii).6 Which of the following is correct? Management accounting: (a) takes no account of different information needs. (iv) budgeted as compared with actual costs of production. 8. True or false? 8. 8. Which of the following is correct? (a) (c) (i) and (ii) only. objective discipline.2 In the organisation and control of a business. (b) Labour cost per unit of production. (ii) and (iii) only. (b) is a well-defined. profit margins in each product range. providing shareholders with detailed information on the company’s products. (i). management accounting plays an important role in: (i) (ii) linking and co-ordinating the different parts of the business.4 Which of the following information requirements will be fulfilled by a management accounting system? (a) (c) Computation of earnings per share. (b) (i) and (iii) only.

Both financial and management accountants fulfil the same function. (d) takes no account of different information needs. Administrative wages are direct product costs. Management accounts must be audited by a registered auditor. (b) Financial accounting is not compulsory. (b) The management accountant is responsible only for external reporting.12 If materials are drawn out of stores for use in the manufacturing process. 8. increase in finished goods. 8. (d) Direct material + Direct labour + Manufacturing overhead. increase in work-in-progress. which one of the following is the correct accounting adjustment? (a) (c) Increase in stores. objective discipline. 8. but few companies succeed without a system. nor is a well-defined. but is a well-defined.Module 8 / An Introduction to Cost and Management Accounting (c) neither takes account of different information needs. (b) Decrease in stores. which of the following is correct? (a) (c) Depreciation of machinery is a direct product cost. being designed to suit specific purposes. decrease in work-in-progress. (c) Management accounting has no rigid rule enforcement on asset valuation and revenue recognition. 8. (b) Financial accounting focuses on product lines. 8. (b) Direct material + Manufacturing overhead. (b) Wages of skilled craftsmen are direct product costs. profits and costs. 8. Direct labour + Manufacturing overhead.7 Which of the following is correct? (a) Management accounting is highly structured around the accounting equation.10 In considering the operation of a costing system.11 Which of the following defines prime cost? (a) (c) Direct material + Direct labour. increase in work-in-progress. (d) Materials used in manufacture are indirect product costs. (d) Increase in stores. (d) Financial accounting covers information expressed in non-monetary terms.8 Which two of the following are correct? (a) (c) Management accounting deals in future-based information and projections. Decrease in stores. (d) Inventory valuation means that the management accountant fulfils a role in both external and internal reporting. 8/20 Edinburgh Business School Accounting . (d) Management accounting systems differ from company to company. objective discipline.9 Which is the true statement? (a) (c) The management accountant is responsible only for internal reporting.

Module 8 / An Introduction to Cost and Management Accounting

8.13 Which of the following statements is correct? (a) (c) Non-manufacturing overheads are allocated directly to product costs. Manufacturing overheads are allocated directly to product costs. (b) Manufacturing overheads are apportioned to product costs. (d) Non-manufacturing overheads are apportioned to product costs. 8.14 Which of the following will be the appropriate classification for the wages of production supervisors? (a) (c) Non-manufacturing overheads. Direct labour. (b) Manufacturing overheads. (d) Administrative expenses. 8.15 The nature of the final product is an important determining factor in the selection of the most appropriate product costing system. This explains why: (i) (ii) process costing is used for large construction projects; job costing is used by printers and legal firms;

(iii) process costing is used by food-processing companies; (iv) job costing is used by oil refineries. Which of the following is correct? (a) (c) (i) and (ii) only. (ii) and (iii) only. (b) (i) and (iii) only. (d) (iii) and (iv) only. 8.16 The activities of the different departments of any organisation need to co-ordinated effectively. If a sales manager is encountering falling sales one product and decides to stop offering it to his customers, which one the following items of internal management information might cause him re-examine his decision? (a) be of of to

The production manager indicates that the product has a poor yield and suffers quality problems.

(b) The personnel manager advises that there is a scarcity of the skilled operatives required to manufacture the product. (c) The purchasing manager confirms that the key material needed for the product is in short supply.

(d) The stores controller advises that, at the current rate of sales, there are three years’ supplies of finished goods in stores. 8.17 Cost accounting systems produce the type of cost information which can be used, without any amendment, to assist management in making special decisions. True or false? 8.18 If a management accountant describes a cost as relevant in one decision situation, then it is relevant in every decision situation. True or false?

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8.19 For managers to appreciate the available options in decision situations, it is imperative that they understand the concept of contribution and the difference between variable and fixed costs. True or false? 8.20 The role of management accounting in assisting management decisions through the supply of internal accounting information is dependent on: (i) (ii) its verifiability by external scrutiny; its relevance to specific decisions;

(iii) its flexibility in meeting changing demands; (iv) its timely availability. Which of the following is correct? (a) (c) (i) only. (ii) and (iii) only. (b) (i), (ii) and (iii) only. (d) (ii), (iii) and (iv) only.

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Module 9

Cost Characteristics and Behaviour
Contents
9.1 9.2 9.3 9.4 9.5 9.6 9.7 9.8 9.9 9.10 9.11 9.12 9.13 9.14 9.14.1 9.14.2 9.14.3 9.15 9.16 9.17 9.18 Introduction Cost: A Deceptively Simple Word Variable and Fixed Costs Beware the Unitising of Fixed Costs! Direct and Indirect Costs Traceable and Common Costs Product Costs and Period Costs Controllable and Non-Controllable Costs Standard and Actual Costs Engineered and Discretionary Costs Another Look at Variable and Fixed Costs: The Break-Even Chart Profit from Different Cost Structures The Break-Even Chart: An Alternative Display Other Ways of Calculating Break-Even Points The Equation Method The Contribution Margin Method The Contribution Margin Ratio Method (or Profit/Volume Ratio) Break-Even Analysis and the Multi-Product Firm Contribution and Limiting Factors of Production Assumptions Underpinning Cost-Volume-Profit Analysis Summary 9/2 9/3 9/3 9/6 9/9 9/10 9/10 9/11 9/12 9/12 9/12 9/15 9/16 9/17 9/17 9/18 9/19 9/20 9/22 9/23 9/26 9/26 9/33 9/33

Review Questions Case Study 9.1 Case Study 9.2

Learning Objectives
By the end of this module you should understand: • • why cost information is important; the distinction between different categories of cost and how these costs behave:
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Module 9 / Cost Characteristics and Behaviour

• • • •

– variable and fixed costs; – product and period costs; – direct and indirect costs; – standard and actual costs; – controllable and non-controllable costs; – engineered and discretionary costs; – traceable and common costs; the dangers surrounding unitising fixed costs; the construction, and underlying assumptions, of the break-even chart; how to calculate the break-even point, and the contribution margin ratio in single-product and multi-product businesses; the managerial significance of these techniques.

9.1

Introduction
Regardless of type of organisation (profit-seeking or non-profit-seeking), size of organisation (sole trader or MBA), or location of organisation (a whaling station in Antarctica or a home for the destitute of Calcutta), one requirement from management information systems is common to all, namely the cost of particular goods or services provided over a period of time. These might be: • • • • the the the the cost cost cost cost of one power generation plant manufactured by MBA plc; of a passenger-mile on a public suburban bus service; per tonne of processing a whale carcass; or per patient-day in a residential home or hospital.

The need to determine cost is a universal one; the difficulties surrounding the determination of cost are considerable. This module addresses first the cost collection process, that is, the ingathering of costs, and second the cost allocation process, that is, the spreading of these costs over the goods and services produced by the organisation. Why is cost information so important? Cost is one of the most fundamental control mechanisms in a management information system. With a knowledge of cost, managers can: • • • control actual performance against planned performance and take corrective action if necessary; plan next year’s costs carefully, making due allowance for inefficiencies and unforeseen events which distorted last year’s performance; determine a desirable selling price (whether in terms of ticket price in the market or subsidy sought from local or central government), even though that price may not be achievable; track the consumption of the organisation’s resources to ensure that all employees are carrying out their duties efficiently and honestly; choose among alternative courses of action (while recognising, of course, that decisions are made on many more criteria than cost).

• •

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9.2

Cost: A Deceptively Simple Word
Whether the context is domestic or job related all of us use the word ‘cost’ frequently. The domestic consumer complains about the cost of the weekly grocery bill; the politician draws attention to the cost to the environment of acid rain pollution; the small business person begrudges the cost of filling in government returns. Before being able to predict future cost levels and to control day-by-day operations which consume cost we must rid ourselves of the notion that there is such a simple phenomenon as ‘cost’. Costs behave in many different ways depending on context; what we must do is to define these many contexts so that we can understand how costs move. We must try to avoid using the word ‘cost’ without a defining adjective before it. To enable us to be more accurate in our usage of words we need to specify what we are costing: the cost item (a passenger-mile or a tin of paint) must be described unambiguously, otherwise the accountant’s task of calculating the associated costs is made even more difficult. For example, what does the politician mean when he refers to the environment? Is he referring to the low crop yield on affected agricultural soil, the health hazards encountered by the sectors of population most exposed to the pollution, or the deforestation of parts of the world on which the acid rain falls? Each particular aspect could be isolated and costed as a cost item (difficult though the exercise may prove to be) as opposed to the rather nebulous concept of ‘the environment’. As in the previous modules in this course we shall focus on the profit-seeking manufacturing sector unless otherwise stated. To shape our discussion we shall use matched pairs of words, usually opposites.

9.3

Variable and Fixed Costs
Consider the context of the manufacturing process involved in the production of a timber-shelved hi-fi unit (discussed in Module 8). Many costs are involved: chipboard, veneer, metal trim, labour and overhead (manufacturing and nonmanufacturing). This last group of costs needs examination. Overhead typically comprise those costs incurred by a business in support of the cost items being made but not easily identified in the product as materials and labour. Manufacturing Overhead Examples of manufacturing overhead are depreciation on saws, lathes, turners, and power screwdrivers; lubricants and energy costs for the above equipment; rent and rates and other space costs associated with the workshop; salaries of foremen, supervisors, quality inspectors and production management team. Non-Manufacturing Overhead Examples of non-manufacturing overhead are depreciation on office equipment, computers and motor vehicles; rent, rates and other space costs associated with office and showroom; salaries of office staff and general management.

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A close examination of all of these costs, from chipboard to general management salaries, will indicate that some increase with production levels while others do not. Take chipboard: each unit may require two square metres of timber at a cost of £5 per square metre, a total cost of £10 per cost item. If the firm manufactures 10 units the material cost for chipboard will be £100; if 20 units then £200. This cost varies directly with the volume produced; we call such costs variable costs whose behaviour can be depicted in graphical form as in Figure 9.1.

£

Variable cost

@ £10 per unit 0 Volume of output

Figure 9.1

The slope of the variable cost curve is at the rate of £10 per unit; if the business manufactures zero units the chipboard costs will be zero. Other obvious variable costs in the hi-fi unit are veneer, metal trim and labour. Labour costs need explanation in this context. Employment legislation prevents companies from firing labour at random and without warning so to this extent labour may be thought of as being a non-variable cost. But this is only the case in the short term. Over the long haul of a business cycle labour is a variable cost in that companies can recruit and dispose of operatives to reflect production plans. As production increases the demand for labour increases; as production falls away so too do labour costs. An examination of both sets of overhead reveals that only one cost varies with production – energy costs for productive machinery. All the others are largely indifferent to production level. We call them fixed costs and depict them as in Figure 9.2. Take managerial salaries as an example: such costs are paid regardless of volume level. Even if production fell to zero (e.g. during a strike) managers would still expect to receive their salaries. At the other end of the production scale, the same salary would be paid when output reached maximum capacity. How do cost accountants treat depreciation? It may be argued that machinery depreciates more quickly if the usage is greater than were it not used at all. This makes sense but the scenario of zero use is so artificial that it can be
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£

Fixed cost 0

Volume of output

Figure 9.2

dismissed. More likely by far is the situation where machines are used on a relatively predictable pattern and the criterion most prominent for causing the depreciation in value is the passage of time which brings with it technological obsolescence. Consider the obsolescence of computer-based equipment which today represents a significant proportion of assets purchased. We have heard a production manager complain that his computer supplier announced an updated version of the one recently delivered to him before his staff had even unpacked the kit! We can therefore treat depreciation as a fixed cost which does not vary with production levels.

£

Semi-variable cost

0

Volume of output

Figure 9.3

The categories of variable and fixed costs cater for most costs incurred by most organisations, but some costs such as the telephone or some energy supplies or certain suppliers of photocopying facilities have features of both variable and fixed costs. Take the telephone: most telecommunications suppliers charge
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Total costs £

Variable costs

Fixed costs 0

Volume of output

Figure 9.4

a fixed amount per annum for the use of the service together with a variable charge depending on the number and duration of calls made. Such a mixed, or semi-variable, cost would be depicted as in Figure 9.3. This indicates a fixed charge even when no calls are made and the slope of the line is at the rate charged per call. Because of the low number of cost headings involved, and the scale of expenditure involved when compared with variable and fixed costs, accountants tend to disregard semi-variable costs and work with only the two principal categories. The total costs for a period of time can be depicted as in Figure 9.4. Managers can therefore read off the chart the total costs involved at any given production level.

9.4

Beware the Unitising of Fixed Costs!
The foregoing analysis of variable and fixed costs is based on the concept of total business costs. For example, the total chipboard costs move from £100 to £200 as production is increased from 10 units to 20 units; total depreciation for the period remains fixed regardless of production levels. What happens when total variable costs and total fixed costs are split into individual products? Consider the following scenario.

Example
The management of a business is considering the level of production to select for the next quarter-year. Sales are buoyant and any of the production levels set out below can be sold.

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Alternative levels Costs in total Variable Fixed

100 £ 100 600

200 £ 200 600

300 £ 300 600

Note that the behaviour of the above costs perfectly reflects the descriptive adjectives ‘variable’ and ‘fixed’. When management calls for the unit costs the following numbers are presented: Alternative levels Costs per unit Variable Fixed 100 £ 1 6 200 £ 1 3 300 £ 1 2

Note now how the variable costs seem fixed in behaviour while the fixed costs vary! The above simple example is easy to explain, in that each unit of product contains the same amount of materials and labour regardless of production level, while the fixed burden of overhead is shared out more and more as the production level is pushed up. But the managerial trap opens when the decision on production level has been made and the foregoing analysis is discarded. Suppose management selects the upper level of 300 for the next quarter; the unit cost per item at this level would be £3 (£1 variable cost + £2 fixed cost). Now let us suppose that the business wants to push up production to 400 for the succeeding quarter-year. How easy it would be – and how common to encounter – for managers to multiply 400 by £3 to determine total cost for the next quarter, i.e. £1200. This of course is wrong, for the fixed costs of £600 would have to be spread even more thinly over 400 units (£1.50 per unit) and the total costs would therefore be 400 × £2.50 = £1000. In this illustration the principles are clear to see. But in practice it is not always obvious when fixed costs have been ‘unitised’; bad decisions can follow if managers are not kept fully briefed about the individual components of cost.

Case
You have been approached by a friend who works for a local company manufacturing metal housing boxes for heavy duty electric meters. Over the past two months he has been in charge of a department that makes four styles of casing on one assembly line for use by another department. He was appointed acting manager while the full-time manager recovered from illness. The chief executive, in giving him his first managerial responsibility, charged him with ‘keeping costs to the lowest possible level’. He tells you that shortly after taking over responsibility he was presented with a product cost statement revealing the numbers below. Coincidentally he received a competitor’s price list which revealed that product X would be cheaper to buy in.

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Module 9 / Cost Characteristics and Behaviour

Product Costs per unit Materials + labour Manufacturing overhead Competitor’s price

W £ 7 4 11 12

X £ 11 3 14 12

Y £ 12 2 14 16

Z £ 6 1 7 9

Anxious to follow his chief executive’s instructions, and thereby to make a good impression, your friend signed a 12 months’ contract for Product X with the competitor and closed down the X line immediately. ‘As you can see,’ he explains to you, ‘I have saved the company £2 for every casing ordered.’ But he was concerned with the latest print-out of costs received a few days later. Product W now looked expensive to make against the competitor’s prices which had not moved. ‘The problem is that the manager of the department is returning to work next week and I’m slightly concerned that if I get rid of W I’ll show up my colleague to be naive in trying to make all four casings. I don’t want to do this but I would like to save the company even more money.’ Product Costs per unit Materials + labour Manufacturing overhead Competitor’s price W £ 7.00 5.71 12.71 12 X £ Y £ 12.00 2.86 14.86 16 Z £ 6.00 1.43 7.43 9

12

Comments and Analysis
Your friend may have difficulty in finding another position in his company! He has made the mistake of believing that when Product X dropped out all of X’s costs would drop out too. Not so. The fixed costs of £3 per unit would have to be borne by the other three products because one assembly line catered for all four products. Instead of your friend’s decision saving the company £2 per casing ordered it cost the company £1, being the difference between the price paid to the competitor, £12, and the variable costs of manufacturing, £11. Further investigation will enable you to show your friend the error he made. You determine that manufacturing overhead (assumed all fixed costs) amounts to £1000 for each month. Overhead is spread over products using machine hours. When your friend assumed command, 1000 machine hours were used per month, i.e., £1 manufacturing overhead per machine hour. All products No. of products made No. of machine hours Overhead allocated W 100 4 £400 X 100 3 £300 Y 100 2 £200 Z 100 1 £100 Total

£1000

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Dropping X No. of products made No. of machine hours Overhead allocated Overhead per unit W 100 4 £571.42 £5.71 X Y 100 2 £285.71 £2.86 Z 100 1 £142.87 £1.43 Total

£1000

Were he to drop Product W he would be compounding his earlier mistake and it would not be long before the entire department would be closed.

9.5

Direct and Indirect Costs
Another way of separating costs is to consider their relationship with the cost item. Those costs which can be seen to be incurred simply because the item is manufactured are termed direct costs; all others are indirect. The cost profile of the timber-shelved hi-fi cabinet in Module 8 actually defined these costs for us. The direct costs were material and labour, that is, those costs which could be physically traced to each cost item; materials are physically counted out of stores and placed into each cabinet while labour, although not observable in each unit, can be timed and valued for every hour spent in the construction process. The indirect costs were listed as manufacturing overhead (sandpaper for the veneer, screws for the hinges, power and lubricants for the lathes) and non-manufacturing overhead (all other company costs which comprise administration, selling, distribution and financial costs such as bank interest on money borrowed, audit fee and so on). As with all attempts to categorise, no sooner has one created two apparently well-defined boxes into which all costs can be placed than one comes across costs which defy easy categorisation. If one considers that a business is set up for the purpose of manufacturing hi-fi units (or transporting passengers, or providing beds for the destitute) then every conceivable cost incurred by that business should be deemed to be direct. For instance, the cost of management executive education programmes undertaken by large companies is incurred for the sole purpose of ensuring that managers and senior executives have the skills required to guide the business through the economic turbulence of the future. The cost of this education is therefore directly related to the fundamental objective of the business, manufacturing and selling products of quality for which there is a ready market. Why, then, do we deem such a cost indirect? Indirect costs are seen by accountants – again, one of the conventions which tend to drive all costing systems – as being costs incurred in support of the fundamental activities of manufacturing and selling. These indirect costs support every product and range of products made by the business and it is almost impossible for MBA, for example, to relate its worldwide audit fee (£2 million for 20x2) to switching gear manufactured in the UK or to a telecoms network made in Japan. Such support costs are indirectly related to production and are kept separate. Consider the composition of costs in the hi-fi cabinet: both sets of direct costs (which we call prime cost) added up to £22.50 and two sets of indirect costs

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added up to £7.50, giving a total cost of £30.00. Of total costs, 75 per cent were deemed to be direct costs; 25 per cent were therefore indirect and represent the accountants’ best estimate of how much support costs were incurred by the hi-fi unit. Significant problems begin to emerge when such a percentage split reverses to 25 per cent direct and 75 per cent indirect, or to an even more pronounced imbalance such as in the cost profile of a package of software. In general terms the direct materials involved in software are very small in relation to the overall costs; a small amount of magnetic film, some labour associated with machinemanning, and the costs of printing the accompanying manual. The indirect costs of such a product are massive, comprising research and development of the software over a period of years and the processes surrounding the pressing and printing of each diskette. As the balance of total costs swings towards indirect cost, the accountant’s job becomes more difficult. When describing MBA’s task of allocating its global audit fee we used the words ‘almost impossible’. We did so advisedly; we meant that to be accurate in the conduct of such an exercise is indeed impossible. But because the determination of total cost is so important for a number of purposes, the exercise must be attempted. Elaborate tools for allocating costs are available and will be explored in the next module. Are direct and indirect costs the same as variable and fixed costs? The answer is, not necessarily, but there is a significant measure of overlap. In the hi-fi cabinet example, the direct costs were those physically identifiable (or virtually identifiable) with the output. Such identification was assisted by the fact that if production of cabinets was stepped up or reduced these direct costs would increase or decrease in a manner that befits variable costs. There is therefore a close correspondence between direct and variable costs. But from time to time this closeness is broken by, say, a special purchase of a fixed asset (fixed cost) to be directly associated with the production of a specific product. Let us assume that the hi-fi cabinet factory produced a number of lines of foldaway flatpack furniture. The production machinery was used in the construction of every line item. But the hi-fi unit required a special tool to mount the castors. This tool is a fixed cost (in terms of depreciation) but is a cost directly attributable to the production of hi-fi cabinets.

9.6

Traceable and Common Costs
A more descriptive, but less widely used, category of costs is traceable and common costs. Traceable costs are, by definition, those costs that can be traced into the cost item, common costs are the indirect costs incurred by a business to support all production. Without qualification we believe traceable costs are the same as direct costs and common costs are the same as indirect costs. Note that, if a business produces only one product line, it will not have any common costs because every cost can be directly traced to the cost items produced.

9.7

Product Costs and Period Costs
Product costs are costs which can be attached to the cost items without undue difficulty; period costs are those costs which, although incurred ultimately in

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support of the product, are best controlled in time periods. Module 2 (The Profit and Loss Account) presented in diagrammatic form the split between these costs; product costs (raw materials, direct labour, depreciation, factory overhead) were added up for each accounting period and allocated across the cost of goods sold or closing inventory while period costs (selling, administration, financial) were written off to the profit and loss account without any prior allocation. Note that product costs contain a blend of variable and fixed costs, direct and indirect costs (and therefore traceable and common costs). So do period costs. The significance of this cost category is in valuing inventory for financial reporting purposes. It is not a useful tool for managerial planning and control.

9.8

Controllable and Non-Controllable Costs
The cost category of controllable and non-controllable costs most certainly has managerial importance. Here the focus moves away from the cost item, e.g. the hi-fi cabinet, and moves to the individuals in an organisation who incur and control costs. Ultimately if an organisation does not exercise controls on costs it will go out of business. The history of corporate liquidations is littered with companies which, in times of boom and growth, encouraged an atmosphere of flexibility and laissez-faire in relation to spending. But when the economic tables turned and austerity and rigorous control were critical for survival the corporate culture could not change rapidly enough. Rigorous control is required at all times. From our previous descriptions readers could be excused for equating controllable costs with variable costs and non-controllable costs with fixed costs. This, however, is not correct. The word ‘controllable’ refers to the person, the manager or foreman or supervisor, who can be held accountable for the costs being measured. For example, the incurrence of overtime on a particular job is a controllable cost for the shift supervisor (since that person can decide whether overtime needs to be served) but the insurance cost of the factory is not controllable by the shift supervisor. Such an administrative cost is controllable by a senior manager in a corporate position such as the chief accountant or financial director. The concept of control is also influenced by the time-scale involved. In the time-frame of daily shifts the production manager cannot be held responsible for a sudden machine breakdown but over a 12-month period, the maintenance budget is most certainly one of his controllable costs. Similarly with the insurance premium on the factory buildings and plants; even over a period of a year the financial director cannot control such an expense. Considerable planning and advice would be needed before a reduction in this type of cost could be effected. Hence it is sometimes said, ‘In the short term virtually no cost is controllable by anyone!’ In Module 12 on budgeting we shall discuss the importance of measuring the performance of individual managers by reference to their controllable costs only. To ask them to bear responsibility for costs that have nothing to do with them is not only inequitable; it is counter-productive.

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9.9

Standard and Actual Costs
Before a business can assess its performance, in totality or in individual segments, it must know the benchmarks against which its achievements can be measured. In terms of detailed costs and revenues for individual products and services, a business usually sets up standard costs, the budgeted costs for one cost item, which are based not only on engineering studies but on recent experience. Against this norm, the actual costs are measured period by period. Management would want to receive explanations for significant variances between the two sets of figures. Note that a standard cost would comprise both variable costs of the cost unit and a share of fixed costs.

9.10 Engineered and Discretionary Costs
Some costs must be incurred; others must not. This may seem a strange statement until put into the context of time horizons. A business set up to manufacture and sell furniture, such as a hi-fi cabinet, must incur the costs associated with the manufacturing and selling of the existing product range. For instance, there is no way that the enterprise could avoid incurring the cost of chipboard veneer, metal trim and direct labour or certain critical items of manufacturing overhead all of which are engineered into the product. But other costs, such as machine maintenance, administrative support and R&D, need not be incurred every accounting period at the levels that managers have come to expect. We call these discretionary costs because individual managers who are responsible for these activities can reduce the level of spend relatively quickly if their businesses are faced with an economic decline. Of course there will always come a time when the business regrets such a decline in discretionary expenditure – when the machinery seizes up through lack of maintenance or when the new products fail to come on stream because R&D has been cut back. But because these costs are capable of being influenced by managerial decision we call them discretionary.

9.11 Another Look at Variable and Fixed Costs: The Break-Even

Chart
Of all the distinctions we have made so far among costs, easily the most useful in terms of quick managerial insight into a business is that between variable and fixed costs. This insight can be gained by an understanding of the break-even chart which develops the relationships between cost and output described earlier in the module. To the fixed and total cost curves already explained we can add the sales revenue line as in Figure 9.5. The sales revenue line climbs from zero (no sales: no revenue) at the rate of the revenue earned for each unit of output sold. The point of particular interest is where the sales revenue crosses the total cost curve. This is called the break-even point, the point in the operations where, if the business sold all the units made, the total costs (variable and fixed costs) would be exactly met by
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Sales revenue £ Total costs

Break-even point

Fixed costs 0

Volume of output

Figure 9.5

the revenue from sales. At the break-even point the business makes neither a profit nor a loss. The break-even point can be read off the chart in terms of either units or money (see Figure 9.6).
£ PROFIT

Sales revenue Total costs

Break-even point

LOSS

Fixed costs

0

Break-even point

Volume of output

Figure 9.6

The wedges on either side of the break-even point require examination: should a company fail to operate at its break-even point the total costs exceed sales revenue and a loss is incurred. Note that the maximum loss will be incurred when the company has zero sales and the total costs equal the fixed costs. On the other hand, as the company pushes production and sales beyond the break-even point the wedge of profit becomes bigger and bigger as the sales revenue line pulls away from the total costs. The difference between the break-even point and the actual level of output achieved, if greater than break-even, is called the margin of safety.
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7 The break-even point can be read off the graph as 25 000 units or £250 000 sales revenue. What profit would be made if the business made and sold 35 000 components? Profit on this chart is the gap between sales revenue and total costs. (b) at 30 000 units. total costs would be £100 000 + (10 000 × £6) = £160 000. Plot the sales revenue curve using two sample levels of operations: (a) at 10 000 units. £ Sales revenue 400 000 Total cost 300 000 Profit at 35 000 unit activity 200 000 100 000 Fixed costs 0 5 10 15 20 25 30 35 40 45 Thousands of units Figure 9. 1 2 Plot the fixed costs curve at the £100 000 level. yielding a profit of £40 000. revenue would be (30 000 × £10) = £300 000. 9/14 Edinburgh Business School Accounting . (b) at 30 000 units. Plot the total cost curve using two sample levels of operations: (a) 3 at 10 000 units. variable costs are £6 per unit and fixed costs are £100 000 per year.7). total costs would be £100 000 + (30 000 × £6) = £280 000.Module 9 / Cost Characteristics and Behaviour Example A business manufactures and sells a component for use in the assembly of disk drives. What is the break-even point in terms of volume of units sold and money received? The graph can be set up by adopting the following procedure (see Figure 9. revenue would be (10 000 × £10) = £100 000. The selling price is £10 per unit. At the 35 000 output level we read from the chart that revenue would be £350 000 and costs would be £310 000.

Module 9 / Cost Characteristics and Behaviour 9. This will have an effect on the break-even point and may inspire managers to take greater or lesser risk. total costs would be £150 000 + (30 000 × £5) = £300 000. total costs would be £150 000 + (10 000 × £5) = £200 000. Example Assume that for next year the management of this business is faced with the possibility of investing in substantial new production equipment which would have the effect of driving up fixed costs (i. (b) at 30 000 units. Plot the sales revenue curve as before. depreciation and maintenance) by £50 000 but would also reduce variable costs by £1 to £5 per unit (i.8 Accounting Edinburgh Business School 9/15 . Consider the break-even chart for this cost profile (see Figure 9.12 Profit from Different Cost Structures Managers may have a choice between the cost structures within which they may operate. less skilled labour required in final assembly).e. Plot the total cost curve using two sample levels of operations: (a) 3 at 10 000 units. Sales revenue £ 400 000 Total cost Profit at 40 000 unit activity 300 000 200 000 Fixed costs 100 000 0 5 10 15 20 25 30 35 40 45 Thousands of units Figure 9. 1 2 Plot the fixed cost curve at the £150 000 level.8).e.

a concept to which we will return shortly.5 A P/V ratio of 0. P/V ratio = = Cost structure 1 P/V = £4 Profit Sales price Sales price − Variable costs Sales price £10 = 0. fixed and variable. Products under Cost Structure 2 earn a higher contribution. Another method of representing these facts graphically is to feature only profit and volume (see Figure 9.Module 9 / Cost Characteristics and Behaviour Note that the break-even point has moved up from 25 000 units to 30 000 units but if the business pushes up volume by another 10 000 the profit is £50 000 (sales revenue £400 000 less total costs £350 000). Profit is normally defined as the residual after deducting all costs. products under Cost Structure 1 earn a contribution of £0. volume of output and profit (or loss) earned. the difference between sales revenue and variable costs) is earned. although they have to sell more to break even.9). Managers who either are confident of selling well beyond their break-even volume. would select the second cost structure because. 9.40. from sales revenue. In break-even analysis we treat the fixed costs as given and focus our attention on the rate at which ‘profit’ (that is. A word about the definition of ‘profit’ used above in the P/V ratio.4 indicates that for every £1 of sales. This can be quantified by using the profit/volume ratio which measures the impact of volume on profit. 9/16 Edinburgh Business School Accounting . the rate at which they earn profit beyond the break-even point is quicker. In the start-up phase of an operation when the sales forecasts are relatively uncertain. or are willing to take a risk. cautious managers would normally select Cost Structure 1 because they would reach break-even point 5000 units earlier.13 The Break-Even Chart: An Alternative Display The chart we have developed so far focuses on costs. The vertical axis is profit and loss and the horizontal axis is volume of output. This concept of ‘profit’ is usually referred to as ‘contribution’. We sometimes call this cost-volume-profit analysis.4 Cost structure 2 P/V = £5 £10 = 0.

We can juggle with the various factors comprising break-even analysis in a number of ways. It is also helpful in putting across the message of break-even at meetings or seminars within an organisation where other attendees may not be well versed in cost behaviour.4 = £250 000 Accounting Edinburgh Business School 9/17 .14.6S 0.1 The Equation Method One method of calculating the break-even point is the equation method: Sales = Fixed costs + Variable costs + Profit Break-even sales = Fixed costs + Variable costs In our example above: S = £100 000 + 0. However the time taken to construct graphs and one’s reliance on visual accuracy in reading them combine to make the method cumbersome for individual use. Note the steeper rate of climb of Cost Structure 2.9 The profit line climbs at the rate at which the business earns contribution on each unit (sales revenue per item less variable costs per item) and when the profit line cuts the horizontal axis the business is operating at break-even.4S = £100 000 S= £100 000 0. 9. 9.Module 9 / Cost Characteristics and Behaviour Cost structure 2 150 000 100 000 PROFIT Cost structure 1 20 0 5 10 15 25 30 35 40 45 50 55 60 LOSS Thousands of units 100 000 150 000 Figure 9.14 Other Ways of Calculating Break-Even Points The graphical representation of cost is useful because the various relationships between costs and volume can be clearly understood.

14.Module 9 / Cost Characteristics and Behaviour 9. Contribution margin = Sales revenue − Variable costs In the example above sales revenue was £10.2 The Contribution Margin Method In the contribution margin method the focus is on the amount of ‘profit’ earned by each unit of product given that fixed costs will be incurred anyway. If each unit earns £4 contribution (towards fixed costs) how many units must be sold to reach the break-even point (BEP)? BEP = = Fixed costs Contribution margin £100 000 £4 = 25 000 units Picture the fixed costs of a business as a black cloud hovering over the business.) £100 000 + £200 000 £4 Cost structure 1 Sales required = = Fixed costs + Target profit Contribution margin (£100 000 + £200 000) £4 = 75 000 units Cost structure 2 Sales required = = Fixed costs + Target profit Contribution margin (£150 000 + £200 000) £5 = 70 000 units Note the impact of a higher fixed-cost threshold combined with a larger contribution margin – Cost Structure 2 gets there more quickly! 9/18 Edinburgh Business School Accounting . variable costs £6 and contribution £4. Example In the above example (together with the amended cost structure) how many units must be sold if management wishes to make £200 000 profit? (Hint: treat the target profit as being similar in nature to fixed costs. contribution per unit sold helps to penetrate this cloud and when the break-even point has been reached the blue skies of profit shine through.

02. Therefore the black cloud of fixed costs hanging over the petrol station is £40 000 per annum. Each litre makes a contribution of £0.49 per litre. It has made the following calculations: Cost of operations per annum: Salaries of staff Depreciation of equipment Rental of site Cost of litre of petrol Selling price per litre 1 2 £ 30 000 5 000 5 000 0. retailing at £0.Module 9 / Cost Characteristics and Behaviour 9. the more expensive pumps would require a further depreciation of £3000.52 per litre and costing £0.48 0.4 and 0. What effect would such a scenario have on the break-even point calculated in Requirement 1? Comments and Answers 1 All the operational costs are fixed costs apart from the cost per litre.4 how many sales must be achieved to break even? BEP = = Fixed costs Contribution margin ratio £100 000 0.3 The Contribution Margin Ratio Method (or Profit/Volume Ratio) The profit/volume ratio has already been defined as: Ratio = Contribution margin per unit Sales revenue For the two cost structures so far dealt with we calculated the ratio to be 0. This ratio can be used in an earlier identity to calculate the break-even point in sales revenue. if each unit has a contribution margin ratio of 0.02 = 2 000 000 litres Accounting Edinburgh Business School 9/19 .5 respectively. that is. how much could the company afford to spend on this exercise to break even? Were the company to sell higher-grade petrol. BEP = = Fixed costs Contribution margin £40 000 £0.50 3 How many litres must be sold to break even? If an investment in promotional advertising would produce an increase in litres sold of 250 000 litres.4 = £250 000 Case on Break-Even Analysis An oil company is considering the siting of a new petrol filling station beside a city bypass.14.

If not then the company will be forced to look for a cheaper site or put money into an effective advertising campaign (see Requirement 2).Module 9 / Cost Characteristics and Behaviour 2 This figure gives management its first yardstick against which to assess the feasibility of this potential site.02 0.15 Break-Even Analysis and the Multi-Product Firm So far the analysis of break-even points and contribution margins has concentrated on single-product businesses.03 = 1 433 334 litres 3 This figure may prove to be a more realistic target for a new filling station but of course it comprises higher-grade petrol which may. Market research and previous experience will indicate whether or not this is an achievable figure. However the sales team are budgeting for equal sales of Big and Small.02) additional contribution. Some further calculations: Contribution margin ratio for the original scenario: = £0.50 = 0. BEP = £43 000 £0. Therefore the company could afford to spend £5000 on a promotional campaign.04 = £1 000 000 (check: 2 000 000 litres @ £0.04 BEP in sales revenue in the original scenario: = £40 000 0. Example A business manufactures and sells two products which have the following revenue and cost profiles: Sales price Variable costs Contribution margin Total fixed costs Estimated sales for year Big £10 8 £2 £50 000 20 000 20 000 Small £6 3 £3 Note that Small has a higher contribution margin per unit and the business would prefer to sell more of product Small than product Big. by itself. How can the technique be applied to a business making and selling more than one product? The answer is: with difficulty! Consider the following example. An extra 250 000 litres sold would yield £5000 (250 000 × £0.50) 9. 9/20 Edinburgh Business School Accounting . dampen demand.

3125 £50 000 / 0.3125. in turn.2794 = £178 955 0.Module 9 / Cost Characteristics and Behaviour The budgeted profit figure and the break-even point can be calculated easily: Sales units Sales revenue Variable costs Contribution Fixed cost Budgeted profit Contribution margin ratio Break-even point in sales revenue Big 20 000 £ 200 000 160 000 40 000 Small 20 000 £ 120 000 60 000 60 000 Total 40 000 £ 320 000 220 000 100 000 50 000 50 000 0.2 The product switch in the market away from Small to Big has caused the weighted average contribution margin ratio to fall which. the likelihood is that one product will always outpace another for reasons which were unforeseen at the planning stage.5 0. pushes up the break-even point in sales revenue despite the fact that the total number of sales units has remained the same at 40 000.3125 = £160 000 0.5 0.2 Note the weighted average nature of this figure because neither product has a contribution margin ratio of 0. Big’s is substantially less and Small’s is substantially greater. Consider how the above numbers change when 25 000 Big units and 15 000 Small units are sold: Sales units Sales revenue Variable costs Contribution Fixed cost Budgeted profit Contribution margin ratio Break-even point in sales revenue Big 25 000 £ 250 000 200 000 50 000 Small 15 000 £ 90 000 45 000 45 000 Total 40 000 £ 340 000 245 000 95 000 50 000 45 000 0.2794 £50 000 / 0. But the figure of £160 000 represents the break-even point of this business provided the sales of Big and Small match each other unit for unit. However this is an unrealistic proposition. A similar calculation can be made using contribution margin per unit as opposed to contribution margin ratio: Accounting Edinburgh Business School 9/21 .

But the real advantage comes not so much from a slavish adherence to the figures once calculated but from an awareness of what sales mix caused a change in bottom-line profit or break-even point and how best to capitalise on the revenue-generating potential of individual products. management in the business used in the example should endeavour to maximise sales of Small at the expense of Big (because Small earns a greater contribution than Big) even if this may drive up fixed costs in total. 9.16 Contribution and Limiting Factors of Production To ‘maximise contribution’ is a not-unreasonable objective for a company to follow. managers must use accounting numbers as signals to direct their managerial efforts and not allow them to act as blinkers which narrow managerial focus and action. The limiting factor is the ultimate bottleneck through which production flows and which constrains management from producing unlimited quantities even though the market demand is buoyant.50 = 20 000 Thus. On the face of it Small earns £1 more contribution than Big. Such an objective would lead the management of the business above to concentrate all efforts on product Small because of its superior contribution in earning capacity. But this conclusion is simplistic because it ignores the numerous constraints or factors which limit operations.50 £50 000 / £2. Certainly a manager needs to have a rough idea of the break-even point – in our example £160 000 – and what sales mix is needed to hit that point. the budgeted sales mix must be held constant. In other words. 9/22 Edinburgh Business School Accounting . These may be the availability of space (in a supermarket) or machine hours (car assembly) or skilled labour (silicon wafer fabrication). What managerial information do these techniques produce when the slightest variation in sales mix will throw out the budgeted profit and break-even point? We would argue that the absolute numbers (units or revenue) generated are not so important to a manager as the process of fact finding and planning which lies behind the calculation.Module 9 / Cost Characteristics and Behaviour Sales units Sales revenue Variable costs Contribution Fixed cost Budgeted profit Contribution margin Break-even point in units Big 20 000 £ 200 000 160 000 40 000 Small 20 000 £ 120 000 60 000 60 000 £2 Total 40 000 £ 320 000 220 000 100 000 50 000 50 000 £3 £2. that is. as in the following example. The secret of good management is to identify the limiting factor and calculate contribution margin per unit of limiting factor. For example. the break-even point will be at the 20 000 level. provided the business sells 10 000 units of Big and 10 000 units of Small.

managerial action is not so flexible as the term ‘variable cost’ implies. and ignoring market demand for either product. Assumptions 1 All costs can be identified as variable or fixed. businesses discover that a greater proportion of costs assume the character of fixed costs.50 At the extreme. the company could produce and sell either: Big: 60 000 units × 1 hour per unit × £2 contribution per hour = £120 000 contribution Small: 30 000 units × 2 hours per unit × £1. However if the limiting factor of this business is machine hours. This is not as easy as has been suggested in the text.Module 9 / Cost Characteristics and Behaviour Example Consider again the business producing products Big and Small: Sales revenue Variable cost Contribution Big £10 8 £2 Small £6 3 £3 The management of this business would be well advised on the basis of this information alone to focus all manufacturing and selling effort on Small because of its superior contribution margin per unit. 9. the picture changes: Contribution margin per unit Machine hours per unit Total machine hours available 60 000 Contribution margin per limiting factor Big £2 1 £2 Small £3 2 £1. Apart from the complications surrounding semi-variable costs.50 contribution per hour = £90 000 contribution Subject to the demands of the market place. the management of this business should concentrate on product Big because of its superior contribution margin per limiting factor of production. The objective is to maximise contribution per unit of limiting factor.17 Assumptions Underpinning Cost-Volume-Profit Analysis Now that the reader is familiar with some of the managerial applications that are possible with the break-even chart it would be prudent to conclude with the assumptions that must be made in order to use the information flowing from the analyses. particularly as the time horizon shortens. Accounting Edinburgh Business School 9/23 .

additional maintenance would be necessary. space would have to be increased. the production is working smoothly and the company could be benefiting from volume discounts in raw materials. 9/24 Edinburgh Business School Accounting .12 and Figure 9.11 In reality the costs do not behave as smoothly as the charts imply.Module 9 / Cost Characteristics and Behaviour 2 All costs behave as depicted in the early charts along the whole cost curve (see Figure 9. £ Variable cost Volume Figure 9. Such realities could be reflected as in Figure 9. In terms of fixed costs the curve would take a step up as maximum capacity is approached: another machine would be required.10 £ Fixed cost Volume Figure 9. As the volume is pushed up towards capacity.10 and Figure 9.13. Variable costs would be steeper at the beginning of the production cycle because machines would not be calibrated correctly and workers would be tentative and unsure of their roles.11).

This assumption is required so that all costs are moved to the market place and not retained in inventory. (Remember: profit cannot be earned on unsold inventory. volume orders and long-term customer commitment. It would be anticipated that a company would alter its sales price per unit to reflect changing market conditions.Module 9 / Cost Characteristics and Behaviour £ Variable costs Volume Figure 9. as total volume moves up and down.14).) Accounting Edinburgh Business School 9/25 . All production is sold.13 3 4 5 Putting these diagrams together reveals that there is a range in the middle where the fixed and variable costs behave as their defining adjectives describe. We call this the relevant range within which our assumptions and conclusions are valid (see Figure 9.12 £ Fixed costs Volume Figure 9. Sales mix will be maintained precisely as budgeted. Sales price per unit remains unchanged. We have already discussed this restriction in the previous section.

Such analysis also introduces contribution and the profit/volume ratio. including: (i) (ii) the fixing of selling prices. standard and actual. volume of production and sales and profit. engineered and discretionary. product and period. The break-even chart is a useful managerial tool for revealing the relationships among costs. Review Questions 9. But readers should also be familiar with the assumptions which underpin break-even analysis.18 Summary To use the word ‘cost’ without a defining adjective is to risk misleading the user of the information over the constituents of the number presented. the recruitment of suitable staff. It is particularly useful at this stage in the course to master the distinction between variable and fixed costs. (i) and (iv) only.1 The availability of cost information can assist management in a number of areas.Module 9 / Cost Characteristics and Behaviour £ Total costs Fixed costs Relevant range Volume Figure 9.14 9. (iii) the choice of appropriate company logos. direct and indirect. 9/26 Edinburgh Business School Accounting . traceable and common. controllable and non-controllable. (d) (iii) and (iv) only. (b) (i) and (iii) only. Readers should be aware not only of how the following matched pairs of costs differ within themselves but of how the pairs differ from each other: variable and fixed. (iv) the control of actual performance against planned performance. Which of the following is correct? (a) (c) (i) and (ii) only.

Materials directly used in manufacturing products.12 The management accountant of Sam Hogan Golf Limited has produced costs for different levels of output of sets of golf clubs.3 For (a) (b) (c) (d) management purposes. Materials directly used in manufacturing products. (c) Unit fixed costs are fixed at all levels of output. (c) Commission paid to overseas agents on sales.8–9.Module 9 / Cost Characteristics and Behaviour 9.5 Which of the following is correct? (a) Total variable costs are fixed at all levels of output.4 In a manufacturing company. True or false? 9. 9. (b) Unit variable cost is fixed at all levels of output. (c) £50. which of the following is treated as a fixed cost? Factory rent. (d) Total fixed costs are variable at all levels of output.7 Which of the following is an example of a semi-variable cost? (a) Factory rates. The following information applies to Questions 9. (b) £45. what is the amount of fixed cost per set? (a) £30. Accounting Edinburgh Business School 9/27 . (b) Production operatives’ wages. (b) Total costs = Unit fixed costs + Total variable costs.8 If 1500 sets are produced. (d) Depreciation of motor vehicles. the three principal elements of product cost are direct labour. Depreciation of office equipment. Energy costs for productive machinery. Production operatives’ wages.2 For (a) (b) (c) (d) 9.6 Which of the following is correct? (a) Total costs = Total fixed costs + Unit variable costs. inclusive of an annual retainer fee. indirect labour and non-manufacturing overhead. 9. (c) Total costs = Total fixed costs. Quantity/Sets 500 1 000 1 500 Total variable cost £ 25 000 50 000 75 000 Total fixed costs £ 45 000 45 000 45 000 Total costs £ 70 000 95 000 120 000 9. management purposes. (d) Total costs = Total fixed costs + Total variable costs. Factory insurance. (d) £90. 9. which of the following is treated as a variable cost? Salary of chief accountant.

(ii) only. what is the amount of fixed cost per set? (a) (c) £18. producing a higher fixed cost per product unit. £95. what is the amount of total cost per set? (a) (c) £50.13 If fixed costs are allocated to several products on a unit basis. (b) £90.g. 9. (b) (i) and (ii) only. £35. £80. as being direct costs of manufacturing products. sponsorship of sports events. (iii) a reallocation of fixed costs to the remaining products. what is the amount of total costs? (a) (c) £145 000. (d) (iii) and (iv) only. (d) £140. e.10 If 500 sets are produced. 9. (d) £215 000. (d) £45.14 Direct labour is labour that can be physically traced and valued in the manufacturing of products. producing a lower fixed cost per product unit. (b) £30. (b) £50. (iv) an increase in total fixed costs. then the dropping of one product line will result in: (i) (ii) a reduction in total fixed costs. what is the amount of variable cost per set? (a) (c) £45. 9.11 If output may be increased to 2500 sets by using some excess capacity. (d) £95. True or false? 9.Module 9 / Cost Characteristics and Behaviour 9. (b) £165 000.12 If output may be increased to 2500 sets by using some excess capacity. 9.9 If 1000 sets are produced. 9. True or false? 9/28 Edinburgh Business School Accounting . Which of the following is correct? (a) (c) (i) only. a reallocation of fixed costs to the remaining products.15 Accountants view any support costs of the business. £170 000.

(c) (iii) only. (b) Standard costs are budgeted costs. Which of the following is correct? (a) (i) only. (b) Sales revenue exceeds total costs. (c) (iii) only.21 Which of the following describes the interrelationship of sales revenue and costs at the break-even point? (a) Sales revenue equals total costs. (ii) direct costs are usually also fixed costs. (c) Total costs exceed sales revenue.20 Which of the following is an example of a discretionary cost? (a) Direct labour. Accounting Edinburgh Business School 9/29 . 9. (b) (ii) only. (b) (i) and (ii) only. (iii) direct costs are usually also variable costs. (d) Insurance for motor vehicles. (ii) are using a different descriptive term to substitute for ‘fixed’. (iv) indirect costs are usually also fixed costs.17 Traceable costs are identical to direct costs and common costs are identical to indirect costs. In particular: (i) indirect costs are usually also variable costs. 9. True or false? 9. 9. (iii) are concerned primarily with the identification of managers who are responsible for these specific costs. (b) Depreciation of machinery.Module 9 / Cost Characteristics and Behaviour 9. (c) Research and development expenditure. (d) Actual costs are identical to standard costs.19 Which of the following is correct? (a) The level of engineered costs can be reduced quickly in the event of a downturn in business.16 There is much common ground between variable/fixed costs and direct/indirect costs. (d) (iii) and (iv) only. (d) Sales revenue equals variable costs. based on actual past experience and detailed engineering studies. Which of the following is correct? (a) (i) only. (d) (iii) and (iv) only. 9. accountants: (i) are using a different descriptive term to substitute for ‘variable’. (iv) are anxious to minimise the number of costs labelled as non-controllable. (c) Discretionary costs must be incurred in the manufacturing process.18 In classifying costs as controllable.

9. 9. 2500. (b) Contribution = Sales price − Total costs. True or false? 9. (d) A decrease in unit contribution margin.Module 9 / Cost Characteristics and Behaviour 9. Bristol Enterprises Limited sells one product for £30 per unit. The following information applies to Questions 9.30. 9. which of the following identifies the consequence of sales volume (units) rising. (d) (ii). The unit manufacturing costs include materials of £8 and labour of £10. (i).26 In applying break-even analysis to decision situations. which of the following is correct? (a) (c) Total fixed costs are also increasing. (d) 5000.23 In the break-even model.27–9. (b) 1500. Fixed costs are forecast at £30 000 for a sales level of 15 000 units. which of the following is correct? (a) (c) Contribution = Sales price − Fixed costs. (d) Contribution = Sales price − Variable costs. including: (i) (ii) the contribution margin method.22 In break-even analysis. 9. (ii) and (iii) only. there are several possible approaches. (b) The volume of output is increasing. (iii) the profit margin method. (b) An increase in total contribution margin. (iv) the equation method. The volume of output is decreasing. (d) Unit fixed costs are also increasing.25 If total variable costs are increasing. (b) (i). (ii) and (iv) only. 9/30 Edinburgh Business School Accounting . the graphical method.27 What is the break-even point in unit sales? (a) (c) 1363.24 The break-even approach is applicable only for single-product manufacturing companies and has no relevance to the problems of non-manufacturing companies or other organisations. Which of the following is correct? (a) (c) (i) and (ii) only. while all other parameters are unaltered? (a) (c) A decrease in the break-even point. Contribution = Sales price + Variable costs. (iii) and (iv) only. An increase in the break-even point.

50. 9. How many units must be sold to earn a profit of £9600? (a) (c) 3300.20.30 If Bristol’s principal competitor withdraws from this business area.20. (d) £30 000. (b) £0. (d) £1.80.00.20 0.34. enabling the selling price to be increased by 10 per cent.31 What is Newtech’s contribution margin per unit? (a) (c) £0.32 If the selling price is increased to £2. 9. (b) 4100. £42 000. The management accountant has collected the following data: Per unit £ 2. 9. (d) £60 000.28 If 3000 units are sold. Accounting Edinburgh Business School 9/31 . (b) £6000. (d) £1.30.31–9.00 0.Module 9 / Cost Characteristics and Behaviour 9. The following information applies to Questions 9. Newtech Limited manufactures a single product.50.30 0. 5800. £1. what is Newtech’s contribution margin? (a) (c) £0. (b) £1. what is the profit on sales of 6000 units? (a) (c) £15 000.29 The directors have insisted on a level of minimum profit. (d) 6600. what is the profit? (a) (c) Nil.50 0.00.20.50 Selling price Direct materials Direct labour Variable factory overhead Fixed factory overhead Expected sales are 20 000 units 9. £1. £18 000. (b) £36 000.

(ii). by how much must sales change from the original expected volume to achieve a profit of £24 200? (a) (c) An increase of 50 per cent. (iii) and (iv) only. with no change in selling price.34 If all costs increase by 10 per cent and the selling price rises to £2. 9. 9. 9.Module 9 / Cost Characteristics and Behaviour 9. (b) (i). (b) An increase of 60 per cent.33 If fixed factory overhead increases by £10 000.36 The break-even model is dependent on certain key assumptions. (ii) and (iv) only. (d) (iii) and (iv) only. £40 000 revenue. (iii) no change in break-even points. (b) The need to allocate fixed costs to products. 9. The existence of different variable costs for each product. (d) Total fixed costs will not change as output decreases.37 Which of the following is true of cost behaviour within the relevant range? (a) (c) Variable costs per unit will increase as output increases. including: (i) (ii) no changes in unit selling prices. (d) 30 000 units. (d) Constant changes in sales mix. A decrease of 15 per cent.20.35 Although break-even analysis can be applied to multi-product companies. 9/32 Edinburgh Business School Accounting . the ability to categorise costs into variable and fixed. (b) 10 000 units. (b) Total fixed costs will increase as output decreases. Total variable costs will decrease as output increases. (iv) strictly linear relationships between both variable and fixed costs and levels of output. Which of the following is correct? (a) (c) (i) and (ii) only. what is the break-even point? (a) (c) £20 000 revenue. (d) A decrease of 60 per cent. which of the following factors restricts its scope? (a) (c) The confusion of multiple break-even points.

Further information is: Selling price £ 4 800 5 700 6 900 10 000 Variable cost £ 3 200 4 200 5 000 6 500 Maximum monthly demand Units 250 170 100 80 Man-hours per model 25 30 40 50 9/33 Castle Rock Salisbury Morningside Accounting Edinburgh Business School . the following separate proposals will be considered. Increase sales through extra advertising of £400 000. The monthly total capacity is 15 350 man-hours. at the next directors’ meeting. In addition. A B C Pay salesmen a commission of 10 per cent of sales and hence increase sales to reach break-even point. £ Sales (100 000 sinks) Direct materials Direct labour Fixed production overhead Variable production overhead Selling and administration overhead Loss 600 500 400 100 600 2 200 (200) £000 2 000 The directors are anxious to take remedial action to improve the company’s trading position and. Salisbury and Morningside. Rock. to reach a profit target of 10 per cent of sales.Module 9 / Cost Characteristics and Behaviour Case Study 9.2 Lothian Motor Co. productive capacity is constrained by the available manhours. which is estimated to increase sales volume by 45 per cent. Case Study 9. produces four models of high-quality saloon cars – Castle. together with a rise of 20 per cent in selling price. Cut selling price by 15 per cent. a cost-cutting review of fixed overheads could result in annual savings of £150 000. you have been requested by the Chairman to evaluate each of these alternative proposals and comment briefly on each.1 Waterloo Sinks plc has just prepared its summarised profit and loss account for its last financial year. Required As Management Accountant. and the fixed costs are £700 000 per month. Despite the fact that the company operates a three-shift system.

Module 9 / Cost Characteristics and Behaviour Required 1 What would be the best product and sales combination to maximise the monthly net profit? (Assume that there is no opening or closing stock.) 2 Market research has indicated that the monthly sales of the Morningside saloon would rise by 50 per cent if additional special advertising expenditure of £50 000 per month were incurred. Would you recommend to management that this step be taken? 9/34 Edinburgh Business School Accounting .

1 10.5.2 10.3 Learning Objectives By the end of this module you should understand: • the sources for costs of direct material. direct labour and overhead in the cost-gathering process.2 10.2 Case Study 10.5 10.4.5.3.3 10.3.4.1 Case Study 10.10 10.5.1 10.2 10.4 10.2 10.3 10.3 10.7 10.11 Introduction Cost Gathering Where Do these Costs Come from? Materials Labour Overheads: Manufacturing and Non-Manufacturing Plantwide versus Departmental Rates The Direct Method The Step Method Joint Products and By-Products Equal Shares Physical Characteristics Sales Value at Split-Off Ultimate Net Sales Value Process Costing Process Costing and the Equivalent Unit Cost per Equivalent Unit Activity-Based Costing Traditional Costing versus ABC Summary 10/2 10/3 10/3 10/3 10/5 10/5 10/8 10/9 10/11 10/12 10/13 10/14 10/14 10/14 10/17 10/17 10/19 10/24 10/24 10/32 10/33 10/43 10/44 10/44 Review Questions Case Study 10.4 10.9 10.8 10. 10/1 Accounting Edinburgh Business School .1 10.1 10.6 10.5.Module 10 Allocating Costs to Jobs and Processes Contents 10.3.

the costing issues involved in joint products and by-products. Further strains are put on costing systems because of the various requirements made of them. a variable cost could just as easily be called a direct or traceable cost which is part of the engineered component in a cost unit. These systems must constantly be reviewed. controllable and noncontrollable. These categories are ‘broad brush’. the need to question the appropriateness of traditional cost drivers and the basic mechanisms of activity-based costing. the application of activity bases to spread overhead to products. that no two companies select identical principles. new production technologies conspire to put strain on established costing systems. Financial Accounting for Managers (Modules 1–7). so too do businesses develop costing systems which are unique to them and which attempt to reflect their particular production characteristics. 10. process costing.1 Introduction In Module 9 various categories of costs were described: variable and fixed. Note that two of these roles (controlling and tracking) are backward looking while the other two (planning and choosing) are forward looking. It is only through understanding the details of cost gathering and allocation that managers can review alternative systems which may be more in tune with their objectives. Just as we saw in Part One. direct and indirect. its use of equivalent units and its two principal methods.Module 10 / Allocating Costs to Jobs and Processes • • • • • • the use of cost centres to gather overhead costs. standard and actual. These categories are merely a convenient way of understanding how costs behave in relation to managerial decision making and are not mutually exclusive in definition. tracking the consumption of resources. dealing as they do with total blocks of costs. traceable and common. But these characteristics constantly change: new products. The material in this module outlines the basic principles on which all costing systems are based and within which alternative methods may be designed. but an early understanding of their characteristics allows the reader to gain a broad overview of costing and its potential impact on managerial behaviour. planning next year’s costs. the distinction between plantwide and departmental predetermined overhead rates. engineered and discretionary. conventions or modes of presentation. choosing among alternative courses of action. In this module we take the analysis several steps deeper in order to gain an understanding of where individual costs come from and how they are spread over the output of a business. new product mixes. but we 10/2 Edinburgh Business School Accounting . To ask one costing system to cater for all information requirements is unreasonable. In the previous module we described four such roles: (a) (b) (c) (d) controlling actual performance against planned performance. product and period.

3 Where Do these Costs Come from? 10.Module 10 / Allocating Costs to Jobs and Processes fear that many managers do indeed expect their systems to produce answers to every requirement they have. we reproduce the simple cost statement for a timber-shelved hi-fi unit used in Module 8: One timber-shelved hi-fi unit £ Direct material: Chipboard Veneer Metal trim Direct labour 1.50 22. Only when managers are aware of how these requirements are satisfied will they be in a position to assess their informational needs for planning and choosing. This module will concentrate on the tracking and controlling functions of cost systems.00 7.50 25.00 3.5 hours @ £5 per hour Prime cost Manufacturing overhead Manufacturing cost Share of non-manufacturing overhead Total cost 10.00 2. Item of furniture % 50 25 25 100 Personal computer % 25 25 50 100 Software package % 2 8 90 100 Materials Labour Overhead The heavy overhead component in the software package reflects the massive investment in research and development required by a software house to design and test a commercial package which will withstand every conceivable user Accounting Edinburgh Business School 10/3 .00 10. 10.3.2 Cost Gathering To focus our discussion on the complex world of cost gathering (sometimes known as cost accumulation).50 2.00 30.1 Materials In this cost item (this is the costing jargon used for a unit of production) direct materials comprise 50 per cent of the total cost. This percentage varies considerably from item to item depending on labour input and overhead cost.00 5.00 15.

May 3 16 21 30 5 90 10 25 metres metres metres metres @ @ @ @ £0. however. Any differences which arise between actual purchase price and production issuing price are accounted for in the profit and loss account as a price variance at the end of the given period. Usually the price does not appear on the slip. (Remember that inventories tie up a company’s cash which could be used for revenue-earning purposes. In this way the storekeeping staff would be saved from having to make frequent price adjustments. physical nature. On this slip will be recorded the quantity of materials drawn. LIFO or average methods of price calculation. Such a procedure has the positive effect of reducing inventories of raw materials to almost zero. What price should be charged? Answer A number of possibilities suggest themselves.) More likely.06 per per per per metre metre metre metre. Cost accountants can touch the materials and see for themselves the extent of their use in the manufactured item. perhaps.89 £1. This investment must therefore be recovered in future sales.96 £0. Manufacturing companies today are so streamlining their material-requisition systems that individual departments are being encouraged to order their parts direct from the supplier just in time for using in the production cycle. 10/4 Edinburgh Business School Accounting . Example The metal trim required in the construction of the hi-fi units was purchased in five-metre lengths from a local steel stockholder. a standard price would be used which would be set for. Materials are perhaps the easiest cost to trace to a cost item because of their visible. Assume that the metal storekeeper issued 7 metres of metal to production each working day of the month. The business could use FIFO.) The just-in-time procedure would still create a nightmare for the individual departments if they were asked to account for these regular purchases using actual prices. Materials are drawn from inventory and this action triggers the raising of a stores requisition slip. This is due to the fact that in a busy store which is buying and issuing raw material continuously it is impossible to be certain how much a particular component issued to production actually cost. Varying quantities were purchased during the month of May at various prices. For a given period of time similar products are charged similar prices for the consumption of similar materials. (Revise Module 2 if you are unsure of the detailed mechanics of these methods. a three-month period and which would attempt to predict the day-by-day price fluctuations in the market.Module 10 / Allocating Costs to Jobs and Processes demand made upon it. the quality of these materials. the date drawn and the initials of the storekeeper and the requisitioner.90 £0.

60 per hour. The wage or salary received by an employee represents only one part of a company’s out-ofpocket costs. hinges. The compilation of the standard wage rate deserves some attention. that is.10 and £5. Alternatively each operative may maintain a daily time sheet on which to record the jobs worked on and the time per job so that the cost accountants can allocate time to each product. Labour cost is a multiple of time spent on a job and rate of pay earned by the operatives involved.00 per hour. The other major components are the business’s contributions towards social security. machine maintenance and depreciation. space costs of factory and warehouse. one of these persons earned £4. glue and adhesives. 10. financial costs such as bank interest on borrowed money and audit fee. It seems sensible therefore to treat all employee costs in like manner which would result in a standard rate per hour in excess of what individual workers received in their pay packets.Module 10 / Allocating Costs to Jobs and Processes 10. For each identifiable cost item a time record would be attached on which each operative working directly on the job would enter the time spent (broken down into units of.taxes and pension contributions. is not easy to determine.3. as for materials. Each is paid by the company on behalf of the employee in addition to the employee’s own contributions. there is no close relationship that can be traced between the outputs from production and the various headings of cost which comprise overheads. heating Accounting Edinburgh Business School 10/5 . 15 minutes). two other operatives. particularly if the persons involved can be seen to be directly involved in the construction of the cost item. Is it fair to charge different rates of pay to identical products? It is not. Examples of Non-Manufacturing Overheads Non-manufacturing overheads include administration. say. because of differing skill levels or years of service.3 Overheads: Manufacturing and Non-Manufacturing Notice that the describing adjective ‘direct’ does not appear before either of the line items. hence the use of a standard wage rate. Examples of Manufacturing Overheads Manufacturing overheads include supplies of low-value high-use components such as screws.2 Labour Labour is also a relatively easy cost to identify and measure. This implies that both items of cost are indirect. the other £5. like the price of materials. spent 45 minutes constructing another unit. selling and distribution. factory heating and lighting. production supervision. ‘Manufacturing overheads’ and ‘Share of non-manufacturing overheads’. earn different rates of pay.3. power for productive machinery. Simultaneously. Operatives. Rate per hour. earning £5. Example One timber-shelved unit may be worked on by two operatives for 45 minutes each.15 per hour respectively.

) Heating and lighting costs will be the responsibility of the facilities director. By definition they are not directly linked to output. Each principal cost centre manager may decide to split his or her centre into sub-units of responsibility and control. Overhead costs should be gathered initially into cost centres. Car fleet costs. how were the amounts of £2. accountants use a predetermined overhead rate with which to spread overheads across the units of production. This rate is based on the following calculation: Predetermined overhead allocation rate = Budgeted overhead for accounting period Budgeted production units 10/6 Edinburgh Business School Accounting . will be allocated by the cost accounting department. Therefore it is not easy to determine the most appropriate level of expenditure for each heading. verified by either an invoice submitted by the supplier or. But the gathering of overhead costs is a straightforward task when compared with the task of allocating these costs to units of production.50 figure for manufacturing overhead? How much of the £5. how much should a company spend on R&D? Or how many administrative staff should be employed? Such decisions should be kept under constant review because these costs have a tendency to escalate beyond a level which can be justified by either the business’s production or profit. that is. Incurred costs. These costs are very often viewed as being non-controllable but this view is potentially dangerous.00 non-manufacturing overhead represented managerial salaries? Because these overheads are not directly attributable to cost units in the same manner as direct materials and direct labour where the actual usage of resources can be tracked precisely. an agreement on annual write-off rates and assumed second-hand values. including depreciation. or if separately metered.50 and £5. by the factory manager and office manager.00 per hi-fi cabinet calculated for. (In a large business with a substantial requirement for transportation. Someone. Before spreading the overheads to units of production these costs must first be gathered. managerial salaries. in such circumstances a target level of expenditure will be set for each subunit beyond which managers must not go without prior approval. somewhere in the organisation can control the level of this expenditure even if one has to go to the chief executive level to trace the ultimate degree of control. respectively. space costs of offices. For example. manufacturing overhead and non-manufacturing overhead? How much depreciation of production machinery was included in the £2.Module 10 / Allocating Costs to Jobs and Processes and lighting of offices. In our example. R&D laboratory. pockets of activity for which individual managers may be held responsible. these costs may be controlled by the transport director. depreciation on car fleet. will be the responsibility of the sales director or his senior manager. Overheads are notoriously difficult to control. in the case of depreciation.

or direct labour cost or machine-hours. Example In the above example assume that direct labour hours is to be used in the predetermined overhead allocation rate calculation. the one particular factor which prompts the incurrence of most of the headings of cost which comprise overhead. If these products have different production characteristics (that is. if the above business made 9000 units of the existing product and 2000 units of a related. The resulting predetermined rate is applied to the individual products using these products’ consumption of the causal factor. it would be ridiculous to use the figure of 11 000 for the denominator of the fraction. Predetermined overhead allocation rate = £100 000 25 000 Direct labour hours = £4 per Direct labour hour Accounting Edinburgh Business School 10/7 . Typical activity bases are direct labour hours.Module 10 / Allocating Costs to Jobs and Processes Example A business manufactures and sells one product which contains £5 direct material and £10 direct labour. that the business plans to spend 25 000 direct labour hours on production next year and that this product (one of several) takes 2 hours to construct by direct labour staff. where automation has replaced people. product. they consume differing proportions of the factors of production including overhead costs) the simple fraction above does not work because the budgeted production units cannot be added together. in a business which produces more than one product. Cost accountants search for causal factors or activity bases. A close examination of overheads in each business will reveal that one of these activity bases can be seen to cause the majority of the overheads (but by no means all). the overhead is incurred because of the services required to support a large workforce. but different. In a labour-intensive business. most of the overhead can be seen to be people related. For instance. that is. machine-hours is a useful causal factor. On the other hand. however. The predetermined overhead allocation rate would be: £100 000 10 000 = £10 per unit This rate would then be slotted into the cost profile of the product on which pricing and marketing decisions would be taken: Direct material Direct labour Share of overhead Total cost Cost profile for product £5 10 10 £25 Difficulties arise. Over the forthcoming year management plans to manufacture 10 000 units of the product and the estimate of total overhead amounts to £100 000. The business must use some other criterion to spread cost.

4 Plantwide versus Departmental Rates The single plantwide predetermined overhead rate described above. output is more or less than planned. Nevertheless it is virtually impossible to estimate accurately both the numerator (budgeted overheads) and the denominator (budgeted level of production expressed in terms of an activity base). It is unrealistic to assume that one activity base can explain more than a handful of overhead costs. The difference between the actual figure of overhead incurred and that allocated to the product is accounted directly to the profit and loss account. is overly simplistic. Inevitably errors are made in either the predictions or the reality of the year as it unfolds. Production was equivalent to 26 000 direct labour hours. overheads are either greater or less than predicted.Module 10 / Allocating Costs to Jobs and Processes Direct material Direct labour Share of overhead (2 hours × £4) Cost profile for product £5 10 8 £23 The estimates which comprise the above fraction are made by a close examination of last year’s performance and also will include a consideration of management’s expectations to reduce or increase specific overhead outlays in the light of planned production levels. 10. far less a majority of them. formulated for either a one-product firm or a more-than-one-product firm using only one activity base. 10/8 Edinburgh Business School Accounting . Of course direct labour hours or machine-hours can be traced as being a causal factor for some overheads. But to assume the same linkage to the selected activity base for all overhead costs can lead to misleading allocations and therefore product costs. Overhead applied to products = 26 000 × £4 Actual overhead Underapplication £104 000 £105 000 £1 000 This underapplied amount would be charged directly to the profit and loss account as an increase to the figure for the cost of goods sold. The cost accountants would investigate the cause of this overspend and overproduction so that their figures for next year would be even more accurate. for example. supervision and cafeteria costs (direct labour hours) and machine power and maintenance (machine-hours). Example At the end of the year the business above incurred £105 000 on overhead costs. Management must design a cost-allocation system which reflects each product’s actual usage of overheads rather than adhere to the blunt instrument of a plantwide rate.

by allocating overheads to individual departments. 3000). metered usage.4. and second. the direct method and the step method. by identifying the activity base most appropriate for each department. Computing: service hours (Forging. Each service department is taken in turn using a suitable activity base (the numbers in brackets are drawn from the above table): • • • Personnel: number of employees (Forging. power: machine-hours. Departmental overhead rates attempt to avoid the problem of the differing activity bases. 10. production scheduling: number of different products. 75). 4500. first. Site maintenance: square metres occupied (Forging. After a detailed examination of costs and activities the company’s management consultants produced the following estimates for next year. buildings and estate: space occupied.1 The Direct Method In the direct method. 450.Module 10 / Allocating Costs to Jobs and Processes Typical activity bases for service department costs include the following: • • • • • • • personnel/welfare services: number of persons employed. Welding. the first step in the allocation process must be to transfer service department overheads to the production departments so that they can be ‘attached’ to the products as they go through. of employees 50 100 30 20 10 210 Service hours 450 75 225 4 500 1 500 6 750 The aim of overhead cost allocation is to apply costs to the products of the business. Cost accountants use many methods which revolve around two principal techniques. number of reports issued. the overhead costs for each of the three service departments are emptied out into the production departments and added to the overheads already there to calculate two predetermined overhead rates. Welding. Since products flow through production departments and not service departments. Overhead £ Forging Welding Personnel Computing Site maintenance 252 500 113 750 218 000 100 750 73 500 758 500 Square metres occupied 4 500 3 000 1 800 12 000 16 500 37 800 No. computing: hours run. 50. executive salaries: sales. 100). Example A company uses two production departments and three service departments to manufacture heavy lifting gear for the offshore oil industry. 10/9 Accounting Edinburgh Business School . Welding. machinery: machine-hours.

10/10 Edinburgh Business School Accounting . For example. We adopt sequence (a). The second technique. the step method.125 overhead for each machine-hour spent on the order in Forging. recognises this interdependency among departments. in the company described above. overhead of £3. Forging Predetermined = overhead rates = £455 624 45 000 Welding (machine hours) £302 876 hours) 100 000 (direct labour £10. A sequence to close down service departments’ costs must be established.029 will be allocated for every direct labour hour spent on the order. The direct method of overhead cost allocation is a straightforward approach to emptying out service department overhead costs. But some companies prefer to recognise the interdepartmental services provided by each service department before the ultimate allocation to production department. and (b) select first the department that renders the highest percentage of its total services to other service departments and end with the one that renders the lowest percentage of service to other service departments.029 per direct labour hour Every order which goes through Forging will be allocated £10. Two of the most common are: (a) select service departments in descending order of magnitude of overhead spend.125 per machine hour £3.Module 10 / Allocating Costs to Jobs and Processes Forging Initial allocation Personnel (Note 1) Computing (Note 2) Site maintenance (Note 3) £252 500 72 667 86 357 44 100 £455 624 Welding Personnel £113 750 145 333 14 393 29 400 £302 876 £218 000 (218 000) Computing Site maintenance £100 750 £73 500 Total £758 500 0 (100 750) (73 500) £0 0 0 £758 500 £0 £0 Notes 1 Forging’s share of Personnel = 50/150 × £218 000 = £72 667 Welding’s share of Personnel = 100/150 × £218 000 = £145 333 2 Forging’s share of Computing = 450/525 × £100 750 = £86 357 Welding’s share of Computing = 75/525 × £100 750 = £14 393 3 Forging’s share of Site maintenance = 4500/7500 × £73 500 = £44 100 Welding’s share of Site maintenance = 3000/7500 × £73 500 = £29 400 The consultants also studied the activities in Forging and Welding and recommended a machine-hours activity rate for Forging and a direct labour hours rate for Welding. Computing and Site maintenance similarly give a service to their sister service departments. Personnel renders a service not only to Forging and Welding but also to Computing and Site maintenance. when the order moves to Welding.

Personnel) no further service department’s allocations are given to it. Forging Predetermined = (machine hours) 45 000 overhead rates = £9. Use square metres occupied by Forging and Welding respectively. not 210 persons. Thus the total activity base for allocating personnel overhead is 180 persons.Module 10 / Allocating Costs to Jobs and Processes 10. When allocating any service department’s costs.2 The Step Method Forging Welding £113 750 Personnel £218 000 Computing £100 750 Site maintenance £73 500 Total £758 500 Initial allocation Personnel (Note 1) Computing (Note 2) Site maintenance (Note 3) £252 500 60 556 121 111 (218 000) 24 222 124 972 (124 972) 12 111 0 27 772 4 628 92 572 £178 183 (178 183) 0 0 106 910 £447 738 71 273 £310 762 0 0 0 £758 500 Notes 1 Personnel.4. This produces an overhead allocation of £1211. always ignore its consumption of its own resources. The total overhead to be allocated is £124 972. Once a service department has been closed down (in our example.11 per person.108 per direct labour hour Consider two jobs going through both production departments: Job 101 Job 247 Forging 50 machine-hours 150 machine-hours Welding 150 direct labour hours 50 direct labour hours Accounting Edinburgh Business School 10/11 . 3 Site maintenance. being Computing’s original allocation of £100 750 plus £24 222 stemming from Personnel.949 per machine hour £447 738 Welding £310 762 hours) 100 000 (direct labour £3. Therefore the number of service hours used to allocate Computing overhead is 2025 (6750 less those consumed by Computing and Personnel). 2 Computing.

75 Welding 150 × £3. a bus company calculating the cost of a city centre commuter route versus long distance tourist journeys. But the principle of detailed overhead analysis and allocation must remain a sound one.5 Joint Products and By-Products The previous section of this module described the problem of allocating costs among separately identifiable products. If management can install cost systems which are capable of regular review and which can be updated for resource usage among products it will avoid burdening some products with overheads which should clearly fall on others and which could lead to damaging pricing and marketing decisions.60 £1 670. In such a circumstance only indirect costs cause a problem of allocation. work is concentrated on the production of one product but other products are produced which may or may not have significant market potential: 10/12 Edinburgh Business School Accounting .108 £466.65 £1 647.029 £454. a hospital costing a bed in the intensive care ward and one in the long-stay geriatric wing.75 Note that the difference between the two methods is very small and it would therefore be unlikely that the company would resort to the step method. Allocating indirect costs is a problem which is universally experienced across all sectors of the economy: a defence research establishment determining the cost of an electronic device developed for a battlefield communications system.949 £497.Module 10 / Allocating Costs to Jobs and Processes Using the direct method for allocating overhead the jobs would receive the following amounts: Job 101 Job 247 Forging 50 × £10. 10.125 £1 518.20 Using the step method for allocating overhead the jobs would receive the following amounts: Job 101 Job 247 Forging 50 × £9.949 £1 492. As businesses acquire more expensive resources to service their operations (computers. Job 101 was a totally different product from Job 247.35 50 × £3. research and the like) this cost allocation problem will become even more complex.40 Total £963.45 150 × £9.35 Welding 150 × £3. Virtually all cost systems base their allocations on the principles described above. because each job’s direct costs can be identified and measured.20 50 × £3.125 £506.45 Total £960.25 150 × £10.108 £155.029 £151. a university endeavouring to establish the cost of producing a medical graduate as opposed to an accounting graduate. Overheads should fall on the products which have caused them. In some industries.

1. Chemical A £80 000 50 000 £30 000 Chemical B £50 000 50 000 – Total £130 000 100 000 £30 000 Sales value Joint production costs Accounting Edinburgh Business School 10/13 . The true characteristic of a joint product is that it must appear during the processes involved in producing the main product.1 Equal Shares Simplicity of operation and a desire to reflect the relative ease with which both products emerged from the production process are the driving forces behind the equal shares method. The amounts and values can be read off from Figure 10.Module 10 / Allocating Costs to Jobs and Processes Industry Oil Dairy Chemicals Quarrying Main product Aircraft fuel Top quality beef Plastic Granite Additional products Various qualities of petrol. Components for detergents. which form the basis of many variations depending on the industrial setting. fertilizers. The costing problems of joint products are more straightforward to articulate than they are to resolve: how should the production costs be split over the two or more products which appear from the production process? Example A chemical process produces Chemical A and Chemical B. We set out below four of the most common methods. cheese. raw chemicals. Poorer cuts of beef. sand. Chemical A 10 000 tonnes: Sales value £8 per tonne Total costs of process £100 000 Chemical B 5000 tonnes: Sales value £10 per tonne Split-off point Figure 10.1 As in the overhead cost-allocation discussion above. road stone. 10. paints. Slate. Both can be sold at the point they emerge from production. hide. many joint cost-allocation methods exist in practice. milk. If management has the option of not allowing the second product to emerge from the process the two products cannot be deemed to be joint.5.

such ability being reflected in money generated by each product for the business.4 Ultimate Net Sales Value The ultimate net sales value method is an extension of the preceding method. It recognises that the business may wish to process the two products further after the split-off point in an effort to maximise profit.2 Physical Characteristics The underlying principle in the physical characteristics method is that such characteristics as weight. We use weight: Chemical A £80 000 66 667 £13 333 Chemical B £50 000 33 333 £16 667 Total £130 000 100 000 £30 000 Sales value Joint production costs 10. For example. Consider the new information in Figure 10. This method assumes simple linearity in the relationship between cost and characteristic. sales value at split-off.2. New costs £20 000: new sales value £12 per tonne Total costs of process £100 000 Chemical B. Chemical A.3 Sales Value at Split-Off The sales value at split-off is the first method to consider the products’ ability to bear the joint costs. a tonne of a chemical incurs more cost to handle than half a tonne. volume or difficulty to handle cause certain costs to be incurred.5.5. New costs £5000: new sales value £12 per tonne Split-off point Figure 10.2 10/14 Edinburgh Business School Accounting . Chemical A £80 000 61 538 £18 462 Chemical B £50 000 38 462 £11 538 Total £130 000 100 000 £30 000 Sales value Joint production costs 10.5.Module 10 / Allocating Costs to Jobs and Processes 10.

We will see in the next module.2 we see that further processing costs of £20 000 can increase the sales price per tonne of chemical A by £4 (£12 less £8) and with chemical B an increase of £2 per tonne is possible by a further expenditure of £5000. This reason may be viewed as the tail wagging the dog! Why construct a complex ongoing allocation procedure which gives signals (perhaps the wrong ones) to management only to satisfy the requirements of financial accounting? 3 For price-setting purposes under cost-plus pricing. Unsold production leads to costs being held back in inventory which are therefore not written off as cost of goods sold in the profit and loss account. businesses are allowed to charge a fixed mark-up on proven cost of production. If the product in question is a joint product some attempts must be made to determine the cost of production.) Answer The answer is the physical characteristics method because Chemical A is allocated more cost under this method (namely £66 667) than under the others. the business must attribute a value to the cost of goods sold and the cost of goods unsold. why should a business bother with such a complex and arbitrary procedure? Several reasons can be put forward: 1 For product management. 10/15 Accounting Edinburgh Business School . This value has a direct influence on the reported profit for the year. design and development of individual products. The ultimate net sales value method deducts the new processing costs from the ultimate sales value and allocates the joint costs on the net amount: Chemical A £120 000 20 000 £100 000 64 516 £35 484 Chemical B £60 000 5 000 £55 000 35 484 £19 516 Total £180 000 25 000 £155 000 100 000 £55 000 Ultimate sales value New costs Ultimate net sales value Joint production costs Given that the total revenue from sales of both products and the total costs of production remain unchanged regardless of the allocation method selected. Readers who did not get this right should refer to Section 2.9. Some indication of initial cost provides a benchmark of internal resources already consumed by the product. that such information must not be misused.Module 10 / Allocating Costs to Jobs and Processes From Figure 10. In order to construct the end-of-year external accounts for shareholders and other users. In certain commercial negotiations with government departments. Decisions need to be made constantly on such matters as resources devoted to marketing. however. 2 Test your Understanding of Inventory Valuation Assume that the business could sell half the production of Chemical A and all of the production of Chemical B at the split-off point. Which joint cost-allocation method would produce the highest reported profit? (Use the original data. For inventory valuation purposes.

subsidiary. In such a situation the by-product may be elevated to the status of a joint product. Both are desirable products for the business and both have significant economic value. is £30. wood with knots and trimmings inevitably emerge from the sawing process. From the sawing operations 72 metres in length of floorboarding and fencing wood is produced with a retail value of £72 in total. Modest trimming costs could enhance the sales value of the ends and trimmings. these can be viewed as by-products. including the purchase price of the tree. 10/16 Edinburgh Business School Accounting . an abattoir/meat packing company is geared up as much to handle the hide from carcasses processed as to process the meat.Module 10 / Allocating Costs to Jobs and Processes By-products are different from joint products only in terms of motive and commercial value. Awkward lengths of tree trunk.3 reveals that the cost of the timber operations. Sales revenue Cost of sales: Production costs Less: Revenue from by-product Gross margin £ 72 £30 10 20 52 The status of by-products can change over time. product emerges at the same time which has a low sales value relative to the main product. depending on the relative sales values. the timber yard manager could receive an order from a local craft centre for timber trimmed ready for carving into tourist items. In such a situation no attempt would be made to allocate the costs of production between the two products. For instance. In addition the awkward lengths and trimming can fetch £10 per tree processed. Production and managerial effort is devoted to the main product but another. Figure 10. A by-product on the other hand is one which emerges from a production process that is designed to produce another product. Joint products are planned for and the production process is designed to cater for them. instead the revenues generated from the ends and trimmings would be deducted from the costs of processing before determining the gross margin from operations. Consider a timber operation designed to produce planks for floorboards and fencing purposes. For instance.3 Figure 10.

The same principle of averaging underpins process costing but now an additional problem emerges: how many units have been produced in an accounting period? Very often in continuous processes the production line never shuts down. another batch could be 300 units with colour monitor. Although each PC is an individual item. aerospace. 10. Even in the examples which have not specified the products being made. the clear implication has been that they are physically separable to such an extent that costs can be traced to each one. only the revenue generated from actual trimmings sold could be deducted from the cost of sales. motor vehicle and furniture industries. This type of costing is called job costing. If this were not the case. 100 PCs with hard disk. To overcome these practical difficulties encountered in measuring production. the focus has been on the problems associated with individual. Management Accounting for Decision Making. where individual products are deemed to be separate jobs which incur separate costs. With job costing the averaging technique is largely reserved for indirect overhead although the valuation of direct material and direct labour can also be subject to averaging. In the example above the assumption has been made that all the ends and trimmings have been sold in the same accounting period as the 72 metres of planks. from the revenue generated from the by-product.6 Process Costing Throughout this series of modules in Part Two.7 Process Costing and the Equivalent Unit The principle underpinning both job costing and process costing is that of averaging costs incurred over units produced. Job costing is operated in enterprises where relatively small numbers of high-value tasks are undertaken during the accounting period. cost accountants use the notion of equivalent units of production. or where the outputs can be batched in larger units for costing purposes. certainly not at such convenient times as the end of calendar months or financial years. for example the chemical industry or the brewing industry where the units of output are indistinguishable from each other.Module 10 / Allocating Costs to Jobs and Processes Or the by-product method of accounting may continue to be used when. This type of costing is called process costing. for example in the construction. An equivalent unit of production is an assessment of the degree of completion of a unit under each major component of cost. Significant costing problems are encountered by industries where no uniqueness is identifiable in the products produced and where the process is almost continuous. 10. readily identifiable products such as hi-fi cabinets. for example in the personal computer. Accounting Edinburgh Business School 10/17 . the additional costs of processing are deducted before reducing the total production costs by the net amount of revenue raised from the by-product. costs would be gathered by the batch: for example. shipbuilding and consultancy industries. the balance being carried in inventory at zero cost. Costing one pint of beer or a litre of paint must rely on techniques different from those used for costing individual jobs. Care must be taken with unsold by-products. Work-in-process at the beginning and end of the process may be in different states of completion.

the material costs will be divided by 16 million and the labour and other conversion costs will be divided by 13 million. Units started and completed Closing work-in-process Equivalent units of production Material 12 million 4 million 16 million Labour/conversion 12 million 1 million 13 million These numbers indicate that the material input is complete even for the closing work-in-process but that labour and conversion is only one-quarter complete. imagine that all the chemicals required in the process of making paint were introduced at the start of the process and that direct labour and other conversion effort were applied evenly throughout the process. 2 Assume the same facts as above except that of the 12 million litres completed during the year. How many equivalent units were produced during the year? 2 million 2 + 10 million started and completed + 4 million 4 = 12 million The thinking behind this calculation is not complex: if 12 million litres were completed during the year but 2 million of these were started in the previous year then only 10 million were started and completed in the year. finishing 2 million litres which were already half-completed is equivalent to starting and completing 1 million litres. reverting to the second scenario. When we attempt to calculate the cost of producing one litre of paint during this financial year. On the last day the production director assessed that 4 million litres were in production but that they were one-quarter finished.Module 10 / Allocating Costs to Jobs and Processes Examples 1 At the end of the financial year a business had completed the production of 12 million litres of paint. imagine that opening work-inprocess had all the material input added in the previous year and that only labour and conversion effort have to be made during the early days of this accounting period. each litre being half-finished. Additionally. The equivalent unit calculation now has to be broken into two parts: material and labour/conversion. 3 Reverting to the first scenario. 4 Finally. The equivalent units of production amount to: 12 million + 4 million 4 = 13 million equivalent units This figure would then be used to divide into the total costs of production to determine the cost per equivalent unit. the production director reckoned that 2 million litres were in the opening work-in-process at the beginning of the year. Edinburgh Business School Accounting 10/18 . and starting 4 million litres to the extent of one-quarter completion is equivalent to starting and completing a further 1 million units.

This information is required not only for planning and control purposes but for valuing end-of-period inventory for financial accounting and reporting.Module 10 / Allocating Costs to Jobs and Processes Opening work-in-process Units started and completed Closing work-in-process Equivalent units of production Material – 10 million 4 million 14 million Labour/conversion 1 million 10 million 1 million 12 million An equivalent unit is an assessment of the degree of completion of a unit under each major component of cost. like job costing. At the beginning of the month its own work-in-process was assessed at 2000 units (one-quarter finished in terms of material. this cost has been applied to three blocks of production: (a) the completion of the 2 million litres of half-finished opening work-in-process. Process costing. Before calculating the cost per unit we must identify the number of units that have been produced. and Accounting Edinburgh Business School 10/19 . The costs to be accounted for by a production activity in any accounting period comprise two parts: (1) those attaching to opening work-in-process at the beginning of the period but which were incurred in the previous period. and (c) the commencement of work on the 4 million litres lying in production at the end of the financial year. each litre of which was one-quarter finished in terms of labour and conversion. calculates the cost of a unit of production. Self-Test on Equivalent Units Try the following example and check your answer at the end of the text of this module: A department in a multi-process factory received during June 10 000 units from the department which precedes it in the production process. this section considers the application of cost to these units. Calculate the equivalent units of production for the two major headings of production cost. in processes which manufacture homogeneous units like litres of paint where inputs of factors of production such as material and labour are spread over the production process. 10. make units started and completed in the period. one-quarter in terms of labour/conversion). By the end of the month 3000 units remained in production as closing work-in-process (one-half finished in terms of material.8 Cost per Equivalent Unit Let us remind ourselves what we are trying to do under process costing. three-quarters finished in terms of labour/conversion). (b) the 10 million litres started and completed during the year. and (2) those costs incurred during this accounting period in order to finish the opening work-in-process. The previous section dealt with the calculation of equivalent units. the calculation of units produced must resort to a mechanism which converts partially completed units into equivalent whole units. Take the cost (as yet unknown) of labour and conversion effort during the accounting period. under job costing this is a straightforward matter but in continuous production.

Material £m 0.0 20.8 7.0 12.0 £0.Module 10 / Allocating Costs to Jobs and Processes start work on the units left in the process at the end of the period as closing work-in-process.9 12.0 12.7 Value of opening work-in-process Incurred during the year Total costs to account for The cost per equivalent unit (Head of cost £/Equivalent units) is calculated as follows: Material Costs for current period (from above) Equivalent units of production (from above) Cost per equivalent unit Total cost per equivalent unit £7.7 19. Example We use Scenario No.0 14. conversion being assumed to be all direct and indirect overhead incurred by the production process.50 £1. The equivalent unit statement would be calculated as follows: Material (millions of litres) – 10 4 14 Labour/conversion (millions of litres) 1 10 1 12 Opening work-in-process Units started and completed Closing work-in-process Equivalent units of production The costs for the year (given here for the first time) can also be listed under the two headings of material and labour/conversion. 4 from the previous section and repeat the background for ease of reference: a business manufacturing paint started the year with 2 million litres partially finished opening work-in-process (complete as to materials.8 Labour/ conversion £m 0.0 7. half-complete as to labour and conversion effort).50 Labour/ conversion £12.0 10/20 Edinburgh Business School Accounting .9 Total £m 1. During the year it started and completed 10 million litres and a further 4 million litres were in production at the year-end (complete as to materials and one-quarter complete in terms of labour and conversion effort).0 £1.

With such an assumption we ignore the effort expended on production in the previous period and focus only on the effort required to finish the units during the current year.7 1. This business has transferred 12 million litres of paint out of production into finished goods inventory (much of which has probably been sold).0 2.00 for labour and other conversion costs. The critical unit costs calculated above are £1. The cost of the earlier work must of course be passed on to finished goods when the opening work-in-process is completed and transferred out. therefore it is often desirable to Accounting Edinburgh Business School 10/21 . say a four-week production cycle.0 Labour/ conversion £m 1. allocating money values to the equivalent units statement using costs per equivalent unit) is calculated as follows: Material £m – 5. namely £1.0 19. 2 The procedure above is known as First In First Out (FIFO) process costing because it assumes that the opening work-in-process is worked on first during the current period and transferred out to finished goods before work is started on this period’s production.0 1.0 10.0 7.0 3.7 Working Notes 1 The business must account for £20.0 Total £m 1.50 per equivalent unit of production and the two components of this figure.0 12.0 15. But since the equivalent unit statement considers only the effort expended in the current period so then are only the costs of the current period used to calculate the cost per equivalent unit of production.0 20. namely £0.7 million valuation of opening work-in-process and £19 million incurred during the year.7 3. For this business reviewing its production performance over an entire year such figures are significant and can be used to assess managerial competence.0 15.0 Opening work-in-process Units started and completed Closing work-in-process The valuation of units shipped out and closing inventory is calculated as follows: Units shipped out Previously incurred cost of opening work-in-process Costs to complete opening work-in-process Units started and completed Units left in closing work-in-process Total costs accounted for £m 1. and beyond the control of management.Module 10 / Allocating Costs to Jobs and Processes The allocation of costs to production (i. Costs and efficiencies fluctuate sometimes.0 17..e. But consider a cost analysis for a much shorter period.50 for material and £1. This shipment is valued at (a) the cost of work required to complete the opening work-in-process and the units started and completed and (b) the cost attaching to the opening work-in-process from the previous year.7 million for the year.

7 million was expended in the current year. Costs to be accounted for Material £m 0.9 13 £0.7 Value of opening work-in-progress Incurred during the year This time we assume the entire sum of £20.7 19. However.0 20.8 7.4875 £1.4798 Labour/ conversion (millions) £12.9923 Costs of production Equivalent units of production Cost per equivalent unit Total cost per equivalent unit 10/22 Edinburgh Business School Accounting . Cost per equivalent unit Material (millions) £7.9 12.8 16 £0.8 Labour/ conversion £m 0. if costs are to be averaged so too must be the production effort.9 Total £m 1.0 12.0 7.Module 10 / Allocating Costs to Jobs and Processes view the shorter period as part of a continuum in which the costs attached to the opening work-in-process are added to the costs of the current period and a weighted average cost is calculated. Example of Weighted Average Process Costing Equivalent Units Statement Material (millions of litres) 2 10 4 16 Labour/ conversion (millions of litres) 2 10 1 13 Opening work-in-process Units started and completed Closing work-in-process Equivalent units of production Here we ignore the production effort expended in the previous period and assume that it was carried out this period.

7576 2.9924 12. The FIFO method which calculates a period’s costs precisely as incurred and without averaging in the previous period’s displays respective unit costs as £0. Despite the need to avoid reporting sudden.9424 20.9500 7. and perhaps uncharacteristic.7000 20.Module 10 / Allocating Costs to Jobs and Processes The allocation of costs to production (i. swings in costs per units of production – and hence the use of the weighted average method – the example used above displays some worrying signals which only the FIFO method picks up.8750 1. These costs represent jumps of 25 per cent and 11.7000 17. allocating money values to the equivalent units statement using costs per equivalent unit) is calculated as follows: Material £m 0. But if the history of cost fluctuations reveals constant rises and falls around a predictable level. Accounting Edinburgh Business School 10/23 .90 for labour and conversion.7576 Cost of closing work in process £m 3.9424 Total £m 2.4798 Cost of units shipped out £m 17.50 and £1. and only FIFO spells out the blunt message. The signals should be so clear that managers’ attention is arrested and prompt remedial action is taken if necessary.e..11 per cent respectively in the two sets of production costs.7980 2.9596 14. the weighted average method would avoid flagging up signals which may prompt unnecessary reactionary responses by management.40 for material and £0.7000 Management accounting information consists of a series of signals to management.7000 Opening work-in-process Units started and completed Closing work-in-process Value of units shipped out and closing inventory Units shipped out Opening work-in-process Units started and completed Units left in closing inventory Total costs accounted for Comparison of FIFO and weighted average method of process costing Cost per equivalent unit £ 1.9846 9. If these rises represent anything more than a seasonal jump then management must be made aware of the situation.5000 1.0000 2.8000 Labour/ conversion £m 1.7980 17.7000 FlFO Weighted average £m 20.9750 4.9596 14.00. A simple calculation will reveal that the costs per equivalent unit of the closing work-in-process last period were £0.9000 Total £m 2.9230 0.9424 20.

Simple products with few specific requirements receive only a light burden of overhead. 2 3 4 5 10. cause costs to be incurred and products consume activities (and thereby costs). ABC permits a strategic insight into the business by providing accurate product costs. and does not restrict itself to the overhead surrounding the production process.g. year after year. should we drop the product from our range and concentrate on more profitable ones?’).) is an attempt to achieve a measure of accuracy within the overall constraints of speed and ease of calculation. costs fall where they are consumed. The ABC pundits claim that the shortcomings of costing listed above are well catered for by this technique. Product costs determined in this way influence not only pricing decisions (‘How much do we need to charge in the market in order to recover costs and make some margin?’) but strategic decisions (‘Since the market can’t bear the prices we would have to charge to recover costs. may cause hard decisions to be taken. rate per hour. production and marketing facilitation. such costs may lead to strategic shifts in products and/or markets which in the long run may improve the profitability of the business. when factored into the profitability analysis. In this way. ABC embraces all overhead cost such as R&D.9 Activity-Based Costing Activity-based costing (ABC) is a technique currently being explored by some companies and organisations which attempts to combat the deficiencies of traditional costing techniques. This is important because some products may require massive sales and marketing support which. Any mistake in the 10/24 Edinburgh Business School Accounting . By using multiple cost drivers ABC reflects the complexity of production and marketing and this permits those products (and the customers who ordered the products in the first place) to be loaded up with those costs they incurred. The essence of activity-based costing is its focus on the belief that activities (e. number of shipments) to load the overhead across products. Once an enterprise settles on one particular allocation base for a given overhead cost. quality inspection). etc. 1 There is a decoupling of costing from financial accounting. which is not the situation if a business blindly adheres to direct labour as the single method of allocating overhead. the chances are high that no change will be made month after month. rather than products. number of production runs.10 Traditional Costing versus ABC The rationale behind the techniques of cost allocation described in this Module (the direct method or the step method) or the methods employed to absorb overhead to individual product lines (percentage of direct cost. production planning.g. We can therefore expect a business with complex production facilities to employ multiple cost drivers (e. Different activities have different cost drivers (ABC’s jargon for causal factors).Module 10 / Allocating Costs to Jobs and Processes 10. quality control. By focusing on activities ABC causes the cost of products to become the principal goal and not to be subservient to inventory valuation. it is claimed.

or over-aggregation of product lines. Activity-based costing focuses on cost drivers – those activities or factors which generate cost. Specifically. It can be argued that there are no such costs as fixed costs. only short-term and long-term variable costs. quality and reliability are the factors which keep a company competitive. rather they are seen as creating value for the business. Spey and Tweed using the same plant and equipment and similar production processes. Forth. In the sophisticated manufacturing environment when customised products are produced in low volumes and where product diversity. could lead to flawed managerial decisions. for instance the number of suppliers. in turn. It is important therefore to identify the drivers which provoke the costs. rather their increase can be traced directly to the decision to introduce product diversity. in this case measurable activity which reflects product diversity. Product Forth Tay Spey Tweed Quantity manufactured 10 100 1 000 10 000 Units of material 8 6 4 2 Direct labour hours per unit 1 2 3 4 Machine-hours per unit 10 6 4 1 Accounting Edinburgh Business School 10/25 . A traditional cost accounting system would treat these costs as part of manufacturing and/or administrative overhead and allocate them to the product using one of many allocation bases. Advances in computer technology and data processing and retrieval have led certain high technology companies to examine closely the cost of each corporate activity and the precise usage which each product makes of the activities. Failure to identify the correct cost drivers can lead to a distorted picture of product costs which. Traditional cost accounting systems tend to differentiate between costs which vary with production volume (variable costs) and costs which remain relatively constant over the normal range of production (fixed costs). activitybased information has been found to be more helpful than traditional allocated accounting data to determine product costs and to take the strategic decisions which flow therefrom. the number of machine set-ups. But these new costs have been caused neither by direct labour nor by machine-hours.Module 10 / Allocating Costs to Jobs and Processes calculation of product costs due to weak historical data on resource usage. The products differ dramatically in volume and production characteristics as follows. or the hours of associated computer runs. Tay. speed to market. could lead to bad strategic decisions. Example Scottish River plc manufactures four products. where the latter vary with measures of activity other than volume. Non-financial information may be called for to identify the activities which add value to the final output. Take product diversity as an example: a company which wishes to increase the diversity of its products will inevitably increase the machine set-up costs and associated information technology costs. such as direct labour hours. direct labour cost or machine-hours. overhead costs are not viewed in the traditional accounting sense as a measure of resource use.

machine-hours. product Forth is low volume but demanding in terms of quality control (70 per cent of the total activity) and the computing centre (40 per cent of the total activity). These activities are not necessarily related to volume of production. the inspection and other quality control procedures involved from the purchase of bought-in parts to final delivery to the customer. quality control. 10/26 Edinburgh Business School Accounting . Tweed.055 4. But if the individual items comprising overhead – machine-hours.055 4 × £2.220 Note that the highest-volume product. quality control. for example. Total overhead to be allocated Allocation base: direct labour hours (DLH) Overhead allocation per DLH Product Forth Tay Spey Tweed DLH × Allocation rate 1 × £2. direct labour. The cost patterns using activity-based costing would be as follows. direct labour hours in the following manner.110 6.Module 10 / Allocating Costs to Jobs and Processes The four products use corporate resources such as direct material. computing centre and training in greatly varying proportions. the use made by the overall production facilities of the computing centre.055 £88 800 43 210 2. The financial values and actual product usage for each product for one month are given below. is asked to bear four times the overhead of Forth because it consumes four times the amount of direct labour. perhaps. and the training requirements of all personnel associated with the four products. Units of material Direct labour hours 10 200 3 000 40 000 43 210 Machinehours Quality control % 70 10 10 10 100% £10 000 Computing centre % 40 30 20 10 100% £10 000 Training Forth Tay Spey Tweed 80 600 4 000 20 000 24 680 100 600 4 000 10 000 14 700 £58 800 % 10 10 10 70 100% £10 000 Value of Resource Traditional costing systems might aggregate all overhead costs into one cost pool and allocate them to the four products using. namely the time spent on the production machines. computing centre and training – are not ‘driven’ by production volume these allocations will distort the ultimate product costs. An activity-based costing approach to this problem would be to identify the activities which contribute towards the delivery of the final products.055 3 × £2.165 8.055 2 × £2.055 Overhead per unit £2.

or a decision to increase the sales price of high-volume products in a mistaken effort to recover higher overhead could inflict damage to the company from which recovery may be difficult.220 Activity-based £1240 74 20 4. For instance. Even then the competition thinks we’re overpricing and cutting our own throat. Tweed). Forth) and overstates high-volume products (e. On the one hand we’re selling one range of paperweights like hot cakes for a handsome price but our competitors accuse us of dumping below cost.90 Forth Tay Spey Tweed The conventional costing system consistently understates low-volume products (e. On the other hand another range isn’t selling well even though we’ve shaved our prices as far as we dare go.165 8. Since I took over from my father we’ve relied on the cost accountant who is due to retire next year but I suspect he’s hopelessly out of date.Module 10 / Allocating Costs to Jobs and Processes Product Machinehours £400 2 400 16 000 40 000 £58 800 Quality control £7 000 1 000 1 000 1 000 £10 000 Computing centre £4 000 3 000 2 000 1 000 £10 000 Training Total Forth Tay Spey Tweed £1 000 1 000 1 000 7 000 £10 000 = = = = = = £12 400 7 400 20 000 49 000 £88 800 Forth Tay Spey Tweed Total overhead per product £12 400 7 400 20 000 49 000 ÷ Units of production 10 100 1 000 10 000 Overhead per unit £1 240 74 20 4. a decision based on traditional costing allocations to introduce further low-volume products in the mistaken belief that they are cheap to produce.110 6. Traditional per DLH £2.g. Case The managing director of a local company that manufactures and sells highquality paperweights speaks to you one day at the golf club: ‘You ask how things are going! I haven’t a clue.g.’ Accounting Edinburgh Business School 10/27 . I should be grateful if you would come in to look at our cost system. The distortion in product costs (admittedly extreme in this illustration) caused by cross-subsidisation could lead to strategic decisions which could harm the long-term interests of the enterprise.055 4.90 A comparison between the two costing systems reveals a dramatic difference in the overhead portion of unit product costs.

Products Monthly output (units) Direct material cost per unit Direct material usage per unit Direct labour cost per unit Direct labour hours per unit Islay 10 000 £18 3 £6 2 Mull 8 000 £15 3 £8 3 Skye 3 000 £8 8 £5 1 Total £324 000 47 000 The monthly overheads. Although the designers are producing ideas and sketches every day. 10/28 Edinburgh Business School Accounting .’ Design Director: ‘I’m not sure what our main cost driver is. If only our salespeople could tidy up their act and gather their business in a more uniform manner.) Maintenance engineer: ‘My costs are almost exclusively driven by machinehours as you would expect. you get a variety of answers. But it is the number of orders we receive and schedule that drives our costs. listed below. ‘What is the one key feature of your activities that drives overhead costs?’. but I suspect that’s impossible in these highly competitive times.’ (Details below on machine runs.’ Packing and shipping foreman: ‘As you would expect it is the number of shipments made that drive our costs. none of which includes direct labour hours! Engineer-in-charge of production and machine switching and machine runs: ‘Each switch from one line to another costs a packet. Currently we have about 20 machine runs a month in no particular order. Machine set-up Machine energy and maintenance Production scheduling Packing and shipping Design and development £ 20 000 182 000 125 000 61 000 80 000 £468 000 A plant tour enables you to watch the production process in detail and to speak to foremen and supervisors in each of the overhead departments. Packing and shipping one paperweight to a lady round the corner costs about the same in time and effort as processing a bulk order of all three product ranges to a chain store in Hong Kong.’ Chief production scheduler: ‘It’s sometimes thought that scheduling costs go up and down with output.Module 10 / Allocating Costs to Jobs and Processes On your first visit you elicit the following information for the previous month from the cost accountant. are currently allocated to the three products on the basis of direct labour hours. To your question. Just-in-time inventory management allows us to call on raw materials from suppliers just as we need them. We’re always responding to urgent requests from scheduling. If we could cut down the number of switches my costs would fall. He’s never set foot in this office and every time I speak to him he tells me he’s done his costings the same way for forty years and has no intention of changing now. I can’t imagine why our cost accountant consistently uses labour hours as a way of spreading overhead burden. At the end of the day I suppose it must be the number of patterns/designs accepted into production.

I learn from your sales director that you seek to fix prices at a 50 per cent mark-up across all three ranges. Products Islay Mull Skye No. Skye 1 × £9.96. Each accepted design merely tinkers with one of the three principal designs. Total* 27 37 000* 25 19 171 On the basis of information received prepare a report for the managing director outlining the costs per unit of product range under the current scheme and suggest an alternative having regard to the actual cost drivers. of production runs 3 6 18 Machine-hours per unit 2 1 3 No.00 6. Mull 3 × £9.96 22.96 per DLH Cost per product line Direct material Direct labour Share of overhead* Islay £ 18. is based on spreading overhead to products on the basis of direct labour hours.00 19.88 52. ** Direct material usage per unit × No. Let me illustrate: Existing system.88 Skye £ 8. of goods inwards orders** 9 18 144 * Comprising (2 hours × 10 000) + (1 × 8000) + (3 × 3000). This would imply that prices would be set at: Accounting Edinburgh Business School 10/29 . Your current system.96 * Islay 2 × £9.96.00 5.’ The information gleaned from your plant tour can be summarised as follows.92 43. of shipments 6 2 17 No. of production runs.96.00 29. at least as elderly as your cost accountant and one that even your grandfather used.00 8.00 9. of accepted designs 6 3 10 No.Module 10 / Allocating Costs to Jobs and Processes the big costs start to run when the selection committee say “Yes”. On the previous month’s costs (and I’m led to believe that last month’s activities were typical of all other months in every regard) this procedure produces the following results: Overhead rate = = £468 000 47 000 Total overhead Total direct labour hours = £9. Analysis of Case Report to Managing Director of Paperweight plc Need for activity-based costing Having examined your costing system I am not surprised that you find a mismatch between your perception of your own costs and what the competition thinks is going on with your prices.92 Mull £ 15.

of shipments £182 000 37 000 = = £20 000 27 = £740.32 £55 Skye £34.44 £35 And he also informed me that the two products you spoke to me about on the golf course were Mull (shaved prices to the lowest tolerable level but still the competition are wiping the floor with you in the market with much lower prices) and Skye (selling like hot cakes but the competitors accuse the company of dumping well below cost). Calculation of Cost of Overhead per Cost Driver Machine set-up costs = £20 000 No. On an activity-based costing approach each overhead is examined separately for the key ‘driver’ which causes costs to be incurred.74 costs Machine energy and maintenance £4.84 Mull × 6/8 000 = £0.44 ×3 = £14. none of which is labour hours. of goods inwards orders £61 000 No.92 Skye × 18/3 000 = £4. of accepted designs = £80 000 19 = £4210 per design Overhead per unit calculation Machine set-up £740.76 10/30 Edinburgh Business School Accounting . This should not surprise you when you consider the low percentage of direct labour in the current cost profiles of the three products and the fact that so many other functions such as design and development and packing and shipping add value to the product with a very low labour base. The resulting cost profiles are very different from those above. of production runs £182 000 Machine-hours £125 000 No.Module 10 / Allocating Costs to Jobs and Processes Target sales price Actual sales price Islay £65.92 Islay × 3/10 000 = £0.92 per machine-hour £125 000 171 = £731 per order Packing and shipping = = £61 000 25 = £2440 per shipment Design and development = £80 000 No. Overheads vary with a wide variety of factors. The use of direct labour hours is a blunt instrument.56 ×1 = £4. I also notice that there is a marked quarterly decline in Skye sales and the sales director doubts that the success of the range can be taken for granted.88 £65 Mull £79.74 per run Machine energy and maintenance Production scheduling = = = = £4.22 ×2 = £9.

1 Accounting Edinburgh Business School 10/31 .46 × 6/10 000 = £2. The old method of cost allocation is volume related.00 0.61 × 3/8 000 = £1.64 × 2/8 000 = £0. Volume-related overhead bases such as direct labour hours will be reliable only when overhead varies directly with production output but recent US research suggests that in the high-technology manufacturing environment overhead is driven by transactions undertaken by departments in supporting roles.84 0.03 95.00 8.44 14. a low-volume range.64 0. This can be confirmed by comparing the total costs under the traditional method.66 1.56 4. Support overheads will therefore grow and the products which cause overhead should be allocated with their fair share.15 Skye £ 22.09 13.92 1.66 × 6/10 000 = £1.58 Mull £ 15.00 4.15 £2 440 £4 210 Direct material Direct labour Share of overhead Machine set-up Machine energy Production scheduling Packing and shipping Design and development Comparison of unit costs Direct labour hours Activity-based costing ABC shows the company the basis of the comments being received from the competition.83 14.31 Mull £ 52. carries a relatively low burden.00 0.96 95.61 1.46 2. that is.71 × 18/8 000 = £1. the high-volume product range.53 Islay £ 18.00 5. the more resource greedy it is. is asked to carry a relatively high proportion of overhead and Skye.58 32. Paperweight’s ‘true’ costs on Skye far exceed the current selling price of £35. similarly the cost of manufacturing Mull falls well below current estimates and therefore management should contemplate a further price reduction to compete with other suppliers of similar quality. The more specialised and customised the product becomes.76 35.00 6.03 Skye £ 8. In short the ABC form of costing confirms the fears of management and gives substance to the accusations of the marketplace.22 9.09 × 17/3 000 = £13. But this does not accord well with the facts of manufacturing effort.31 × 144/3 000 = £35. Islay.71 Islay £ 43.83 × 10/3 000 = £14.53 38.88 32.Module 10 / Allocating Costs to Jobs and Processes Production scheduling Packing and shipping Design and development ABC cost profile £731 × 9/10 000 = £0.92 38.

00 3.90 Note that while the costs of Mull and Skye are now moving towards their real ABC level they still are very far short of the numbers calculated under ABC.94 18. A careful use of. using the direct method or the step method.09 27. The major reason for this cross-subsidisation is the use of one cost pool and one cost driver. The word ‘allocation’ implies that the costs concerned are not easily traceable to the products and that some subjective judgement is required with these non-direct costs.27 per machine-hour 37 000 Production scheduling = Two-cost centre cost profile Direct material Direct labour Share of overhead Production scheduling Other Islay £ 18.58% of direct material cost £324 000 £468 000 − £125 000 Other overhead = = £9. The cost accounting system has to be designed to reflect the diversity otherwise the products with the low resource consumption will be asked to bear higher overhead costs than they deserve. £125 000 = 38. But a business need not resort to such detail in its efforts to escape from the problems caused by traditional costing.54 49. Accountants call this crosssubsidisation. 10.00 5. Cross-subsidisation is being addressed but has some distance to go.48 Mull £ 15. two cost drivers could still produce a better picture of cost per unit than the use of one. costing joint and by-products.00 6.27 38.79 9. If a business fails to examine the factors which drive the costs of discrete activities then the averages which emerge from the use of one rate will cause cross-subsidisation. and Islay has moved in the wrong direction.00 8. In the case above.00 5. All the techniques described in this module – allocating overheads via plantwide or departmental rates. and the costing of homogeneous products from 10/32 Edinburgh Business School Accounting . Islay and Mull were subsidising Skye. Below we revert to the case and select machine-hours for the majority of the overhead but use the value of direct materials as a base for spreading production scheduling overhead. or over-aggregation of data. and vice versa. say. A full ABC costing system will overcome the problem of product diversity and allow overhead to be allocated in a manner that reflects resource consumption.Module 10 / Allocating Costs to Jobs and Processes ABC – A Concluding Note When the manufacturing resources consumed by two different products are different at the same location these products can be viewed as being diverse in nature.81 43.11 Summary The title of this module is ‘Allocating Costs to Jobs and Processes’. Product diversity causes problems for traditional costing systems.06 Skye £ 8.00 6.

1500 equivalent completed units can be included.Module 10 / Allocating Costs to Jobs and Processes continuous production processes using either the FIFO or the weighted average method – all possess rigour and certainty which may appear somewhat awesome to the reader coming upon these for the first time. (iii) the replacement cost method. These themes will repay careful study but readers must be alert to opportunities to apply them in different ways which reflect ‘local’ commercial conditions. Subjective judgements underpin them all and each business employs its own variations of the themes described in the text. 10. Answer to Self-Test on Equivalent Units Opening work-in-process Units started and completed Closing work-in-process Equivalent units of production 1 Materials 1 500 7 000 1 500 10 000 Labour/conversion 500 7 000 750 8 250 2 3 Opening work-in-process at the beginning of June has to be finished. But much less (one-quarter) conversion effort is required to finish these units during June. 3000 remained unfinished. which of the following costs is readily traceable to a cost item? (a) (c) Sales travel expenses. the average method. including: (i) (ii) the FIFO method. Which of the following is correct? Accounting Edinburgh Business School 10/33 . Therefore 7000 units were started and completed during June. But what must be remembered at all times is that the techniques are merely creations of the fertile minds of accountants and managers over many years and many industrial applications. since labour was only one-quarter completed at the end of the month this is deemed to be equivalent to 750 complete units. Manufacturing overhead. Since the 3000 units closing work-in-process were only half-finished in terms of material. equivalent to 1500 completed units of effort.1 In a cost-gathering system. it is possible to use different approaches. (b) Direct labour. Of the 10 000 units delivered during June from the previous department. Review Questions 10. (iv) the standard price method. (d) Factory rent.2 In pricing issues of materials from stores. therefore 2000 units require three-quarters input for materials.

3 The purpose of ‘just-in-time’ materials control systems is to ensure that cash tied up in inventories is maximised. (b) Actual overhead divided by budgeted units of production. 10. (i).4 Which of the following source documents is typically used by cost accountants to attach labour costs to specific jobs? (a) (c) Weekly wages records.7 Which of the following is an example of a non-manufacturing overhead? (a) (c) Factory heating and lighting. 10. Which of the following is correct? (a) (c) (i) only. (d) (iii) and (iv) only. Research and development expenditure. (b) (i). cost accountants aggregate: (i) (ii) gross wages or salaries. Employees’ clockcards. (d) Actual overhead divided by actual units of production. (iv) employers’ social security costs. (iii) and (iv) only. 10.9 In allocating overheads to cost units. (b) (i) and (ii) only. True or false? 10. (ii) and (iv) only. 10. direct machine-hours. Typically. (d) (i). 10.6 Manufacturing overhead includes cost items which have a direct and close relationship with the output from the manufacturing activity. cost accountants seek to identify activity bases. these include: (i) (ii) direct labour costs. (d) Maintenance of machinery. (ii) and (iii) only.8 Which of the following defines a predetermined overhead allocation rate? (a) (c) Budgeted overhead divided by budgeted units of production. (b) Depreciation of plant. employees’ social security costs. True or false? 10. Budgeted overhead divided by actual units of production. (b) Monthly salary records. (ii) and (iii) only. 10/34 Edinburgh Business School Accounting . which are causal forces in the incurrence of manufacturing overhead. (i).5 In compiling a wage rate for use in cost gathering.Module 10 / Allocating Costs to Jobs and Processes (a) (c) (i) and (ii) only. (iii) employers’ pension contributions. (d) Daily time sheets.

(b) Applied overheads exceed budgeted overheads. (d) £400 000. Which of the following statements is correct? (a) (c) The under-application of overhead was £6400.14 Hunter and Howndes Limited has been operating with an overhead rate of £7. (ii) and (iv) only. (d) An increase in work-in-progress. (b) Measurement of interdepartmental performance. (i).15 In preferring departmental overhead rates to plantwide overhead rates. Which of the following is correct? (a) (c) (i) and (ii) only.11 Which of the following is the normal accounting treatment for an underapplication of overheads? (a) (c) A reduction in work-in-progress. (b) An addition to cost of goods sold.10 Which of the following describes an over-application of overheads? (a) (c) Actual overheads exceed budgeted overheads. actual overheads totalled £315 000 and 41 000 direct labour hours were worked. management is able to generate more accurate product costs by selecting different activity bases for different departments.12 Which of the following is the primary purpose of overhead allocation rates? (a) (c) Reallocation of service centre costs to manufacturing departments. 10.13 If manufacturing overhead is over-applied by £42 000 and applied overhead is £358 000. (d) Comparison of actual overheads with budgeted overheads. 10. The over-application of overhead was £7500. Actual overheads exceed applied overheads. (iv) direct labour hours. £358 000. 10. (d) Applied overheads exceed actual overheads. (b) (i). True or false? Accounting Edinburgh Business School 10/35 . During the year. (b) £316 000.50 per direct labour hour. 10. 10. (b) The over-application of overhead was £6400. what is the amount of actual overhead? (a) (c) £42 000. 10. A reduction in cost of goods sold. (d) (iii) and (iv) only. (ii) and (iii) only. (d) The under-application of overhead was £7500. Application of manufacturing overheads into cost units.Module 10 / Allocating Costs to Jobs and Processes (iii) direct machine costs.

17–10.Module 10 / Allocating Costs to Jobs and Processes 10. Which of the following is correct? (a) (i) and (ii) only. (c) £28 125. 10/36 Edinburgh Business School Accounting . 10. Personnel and Stores. cost accountants use different approaches. and two service departments.18 What is the total amount of overhead allocated to the Machining Department from the Stores Department? (a) £5 000. The following information applies to Questions 10. which empties service department costs straight into production departments. the following estimates have been prepared: Overhead £ 400 000 325 000 50 000 25 000 800 000 Number of materials issues 80 000 20 000 – – 100 000 Number of employees 45 35 7 3 90 Moulding Machining Personnel Stores Management plans to use the direct method of overhead allocation. (c) £20 000. Moulding and Machining. (b) £10 000. In the Machining Department. (b) £25 000. planned output requires 45 000 machine-hours. In the Moulding Department. (b) (i) and (iii) only. including: (i) the direct method. which recognises interdepartmental services provided by service departments. (d) £40 000. using the most suitable activity base. (iii) the step method.20. which recognises interdepartmental services provided by service departments.17 What is the total amount of overhead allocated to the Moulding Department from the Personnel Department? (a) £21 875. For next year. which empties service department costs straight into production departments. (d) £40 000. NB Foundry plc has two manufacturing departments. 10. (iv) the direct method.16 In transferring the costs of service departments to production departments. planned output represents 65 000 direct labour hours. (c) (ii) and (iv) only. (ii) the step method. (d) (iii) and (iv) only.

£7.Module 10 / Allocating Costs to Jobs and Processes 10.55.82. (b) £6. (b) £6.21–10. (d) £7. The following information applies to Questions 10.20 What is the overhead allocation rate per machine-hour for the Machining Department? (a) (c) £5.50. 467? (a) (c) £956. The following information applies to Questions 10.08. 467 in the Binding Department? (a) (c) £390. (d) £1076.89.25. Additional information is available: Printing £375 £75 20 5 Binding £235 £110 10 30 Materials used Direct labour Machine hours Direct labour hours The Printing Department has an overhead allocation rate of £5.96.22.50 and £0. Weekly output comprises 10 000 loaves and 40 000 bread rolls. labour and overhead.00. £1072. for £0.15.89.00. Job No. unwrapped. (b) £969. £7. Aberdon Bakeries plc uses its oven to produce simultaneously loaves and bread rolls from a baking process which costs £5400 per week in materials.00 (d) £562.21 What is the accumulated cost of Job No. 10.80 per machinehour.23–10.00 £510.00 (b) £430.50 10. 467 has accumulated costs in both Printing and Binding departments of the factory. 10. and the Binding Department has an overhead allocation rate of 150 per cent on direct labour cost.19 What is the overhead allocation rate per direct labour hour for the Moulding Department? (a) (c) £6. (d) £9.00. which are sold. Accounting Edinburgh Business School 10/37 .10 respectively.41.22 What is the total cost of Job No.

23 If the sales value approach to joint cost allocation is used. (iii) a desire to improve reported profits. (iv) the need to enhance product quality.Module 10 / Allocating Costs to Jobs and Processes 10.02 for each roll.24 If the physical measures approach to joint cost allocation is used. what is the amount of profit from loaves? (a) (c) £1400. (d) Batch costing.10 for each loaf and £0. (ii) and (iii) only. If the ultimate net sales value approach is used for joint cost allocation. what is the amount of joint production cost allocated to bread rolls? (a) (c) £2400.28 Which of the following describes a system of job costing where groups of individual products are manufactured in large quantities for costing purposes? (a) (c) Contract costing. (d) £4167.26 Given the somewhat arbitrary nature of different methods of joint cost allocation. 10. (b) £2000. True or false? 10. there are additional wrapping costs of £0. each with significant economic values. (d) £4500. (d) (iii) and (iv) only.25 If the company installs a wrapping machine. 10/38 Edinburgh Business School Accounting . it may appear surprising that management insists upon this complicated exercise. what is the amount of cost allocated to bread rolls? (a) (c) £900. (ii) and (iii) only. (d) £3920. (b) Process costing. (b) (i). £2920. 10. £3000. (b) £2400. 10. year-end inventory valuation.27 Joint products and by-products are planned and desirable products of the business. (b) £2778. 10. The reasons include: (i) (ii) price setting for cost-plus pricing. £3200. Variable costing. Which of the following is correct? (a) (c) (i) and (ii) only.

31–10.29 There are certain manufacturing environments in which process costing is the obvious choice for a product costing system. Accounting Edinburgh Business School 10/39 . (iv) the uniformity of all products. 16 000 units. 18 000 units. During the month. 10. there are 4000 units in work-in-process. 10.32 What is the amount of equivalent units of production for labour/conversion costs? (a) (c) 14 000 units. (b) Both job and process costing are forms of product costing which are interchangeable for any type of product. Department S has 5000 units in work-in-process at the beginning of the month. Which of the following is correct? (a) (c) (i) and (ii) only.30 Which of the following is correct? (a) A shipbuilding company is more likely to use a process costing system than a job costing system. (b) (i) and (iv) only. (d) 17 000 units.Module 10 / Allocating Costs to Jobs and Processes 10. (c) A printing company is more likely to use a job costing system than a process costing system. (ii) and (iii) only. The major features of such environments are: (i) (ii) a continuous manufacturing operation. The following information applies to Questions 10. (d) A brick manufacturing company is more likely to use a job costing system than a process costing system. (d) 18 750 units. At the end of the month.32. each 25 per cent finished in terms of materials and 60 per cent finished in terms of labour/conversion costs. (iii) a small number of high-value orders. a further 15 000 units are received from Department R. (b) 16 750 units. the uniqueness of each product. 10.31 What is the amount of equivalent units of production for materials cost? (a) (c) 14 750 units. each 50 per cent finished in terms of materials and 75 per cent finished in terms of labour/conversion costs. (b) 15 000 units. (d) (iii) and (iv) only.

£11 790.Module 10 / Allocating Costs to Jobs and Processes The following information applies to Questions 10.36 The major feature of activity-based costing (ABC) is its reliance on the inventory valuation role of product costing systems. The costs attached to opening work-in-process were: Materials Labour/conversion £7 800 £10 200 During March 12 000 kg were transferred to finished goods. (d) 13 080 kg. (b) 11 130 kg. (d) £22 750. which was 100 per cent complete in materials (since materials are added at the beginning of the manufacturing process) and 75 per cent complete in terms of labour/conversion costs. 60 per cent complete in terms of labour/conversion costs. (b) £9 810.35 What is the cost of output transferred to finished goods in March? (a) (c) £82 250. 12 720 kg.35. True or false? 10.37 If a manufacturing company implements an ABC system. (d) £116 790. (b) £98 790. including: (i) (ii) the provision of more accurate product costs. 10. the weighting of high volume products with equivalently large proportions of total overhead. (iii) the concentration on direct labour as the sole method of allocating overhead. it should expect to derive considerable benefits to management.33–10. (iv) the identification of different cost drivers for different activities within the company. A system of weighted average process costing is being applied.33 What were the equivalent units of production in March for labour/ conversion costs? (a) (c) 9 400 kg. Material costs for March amounted to £37 050. leaving 1800 kg in work-in-process. Pentland Chemicals Limited produces high-quality resin for the plastics industry. £105 000. 10. At the start of March its work-in-process comprises 2600 kg. 10. 10/40 Edinburgh Business School Accounting . with labour/conversion costs of £61 740. 10.34 What is the cost of work-in-process at the end of March? (a) (c) £5 940.

which of the following is a cost driver? (a) (c) Direct labour cost. 10.Module 10 / Allocating Costs to Jobs and Processes Which of the following is correct? (a) (c) (i) and (ii) only. (d) (iii) and (iv) only. ABC is limited to manufacturing overhead only.42–10. (ii) and (iii) only. 10.39 In comparing an ABC system with a traditional costing system. The following data are available in respect of last quarter’s production: Product Monitors Printers Plotters Units manufactured 3 200 475 155 Machine-hours per unit 20 8 3 Direct labour hours per unit 6 4 2 Accounting Edinburgh Business School 10/41 .38 In using traditional product costing systems over a number of years.48. 10. (b) (i) and (ii) only. (b) (i) and (iv) only. (d) The product cost structure is altered continuously over the years. The product cost structure is reviewed rarely over the years. (d) (ii) and (iv) only. (iii) Only traditional costing systems permit the identification of a variety of cost drivers. only short-term and long-term variable costs.41 The basic principle of ABC is that overhead costs should be allocated to products on the basis of multiple cost drivers and not just on the basis of over-simplistic apportionment bases like direct machine-hours. which of the following describes the most typical approach to reviewing the structure of the system? (a) (c) The product cost structure is neither altered nor reviewed over the years. (iv) ABC depends exclusively upon direct labour hours and direct machine-hours as cost drivers. Which of the following is correct? (a) (c) (i) only. which include the following: (i) (ii) ABC has no fixed costs. (b) The product cost structure is reviewed regularly over the years. (b) Manufacturing overheads related to activities. 10.40 In an ABC system. True or false? The following information applies to Questions 10. printers and plotters. Orangeside Peripherals Limited manufactures three ranges of computer peripherals – monitors. there are several crucial differences. (ii) and (iii) only. An activity which consumes resources and incurs overhead costs. (d) A product.

68.76.Module 10 / Allocating Costs to Jobs and Processes Further information is available in respect of the distribution of product support activities: Monitors Quality control Warranty Product design Sales and marketing Machine operating costs 50% 30% 20% 45% £40 000 Printers 20% 60% 45% 35% £35 000 Plotters 30% 10% 35% 20% £40 000 Costs £ 35 000 60 000 130 000 250 000 115 000 10. (d) £16. 10.64.80. (b) £55.04.45 If the company allocates overheads on the basis of direct machine-hours.00.56.91.46 If the company switches to an ABC system. £69.19. £22.88.69. £66.12.92.43 If the company allocates overheads on the basis of machine-hours. (b) £8. 10/42 Edinburgh Business School Accounting .56.12. (d) £70. (d) £82. what is the overhead cost allocated to each plotter? (a) (c) £5. 10. what is the overhead allocation rate per direct labour hour? (a) (c) £8. £88.68. (d) £110. what is the overhead allocation rate per machine-hour? (a) (c) £1.44 If the company allocates overheads on the basis of direct labour hours. 10.24. £8.19.64. (b) £65.42 If the company allocates overheads on the basis of direct labour hours. (d) £27.31. (b) £25. what is the overhead cost allocated to each printer? (a) (c) £34. what is the overhead cost allocated to each monitor? (a) (c) £6. (b) £8. 10.

is introducing a system of allocating overheads to its output through the use of predetermined overhead rates.65. 10. £736.50 The introduction of a full ABC costing system will provide a solution to the problems of product diversity and permit overheads to be allocated in a manner which mirrors the consumption of resources. which of the following is correct? (a) ABC overhead cost content exceeds the traditional overhead cost content by £287. (b) ABC overhead cost content exceeds the traditional overhead cost content by £361.Module 10 / Allocating Costs to Jobs and Processes 10. (d) £980.34. True or false? 10. there are some indirect costs not yet allocated: Rent and rates Power (machines) Depreciation Heat and light Accounting Edinburgh Business School £ 24 000 18 000 15 000 12 000 10/43 .84.49 Traditional costing methods ensure that the overhead cost allocating process results in low-volume products carrying a high burden of overheads whereas high-volume products carry a low burden of overheads. The management accountant has prepared the following estimates of budgeted expenditure for next year. what is the overhead cost allocated to each plotter? (a) (c) £98. (b) £658.48 If a comparison is carried out between the overhead cost of each printer under traditional costing (using direct labour hours) and the ABC approach. 10.1 Leith Engineering Co.47 If the company switches to an ABC system.65.65. (d) Traditional overhead cost content exceeds the ABC overhead cost content by £287. Department Personnel Maintenance Catering Fabrication Welding Allocated indirect costs £ 100 000 75 000 60 000 300 000 200 000 Machine-hours – – – 50 000 40 000 In addition.06.07. (c) Traditional overhead cost content exceeds the ABC overhead cost content by £361. True or false? Case Study 10.34.

60 per cent complete in terms of labour/conversion costs. incurring material costs of £24 000 and labour/conversion costs of £39 936. (b) units started and completed. 10/44 Edinburgh Business School Accounting .2 Jagger Products Limited manufactures toy dolls in a moulding process. Required 1 2 After treating unallocated costs. During the month. doors and kitchen cabinets. Completed dolls totalled 42 000 in the month. (c) completion of opening work-in-process. a further 40 000 dolls have been input to the process. manufactures high-quality wooden products for the housebuilding sector.Module 10 / Allocating Costs to Jobs and Processes Further information is available: Department Number of employees 5 10 10 50 30 Plant value £ 4 000 9 000 8 000 75 000 54 000 Area (square metres) 5 000 5 000 15 000 20 000 15 000 Personnel Maintenance Catering Fabrication Welding The company has decided to opt for the step method of overhead allocation. apply the step method of reallocation to compute the overhead rates for the manufacturing departments. For many years. leaving 6000 in work-in-process. The management accountant has been taken ill and you have been requested to assist in identifying the usual monthly adjustments to measure output and cost of output. Opening work-in-process is 50 per cent complete in terms of labour/conversion costs. The company operates a FIFO approach to accounting for stock movements. Required Prepare the necessary computations to support the costs attached to: (a) closing work-in-process. specialising in window-frames. Case Study 10. what are its implications for product costing? Case Study 10. Opening work-in-process amounted to 8000 dolls. Materials are added at the beginning of the moulding process.3 Precision Joinery Co. If a plantwide rate is used. the company’s costing system has relied on the assumption that direct labour hours were the critical factor in the incurrence of overheads. with costs attached of materials £3984 and labour/conversion of £3840.

) 5 12 3 15 4 6 Cabinets (No. has become increasingly disillusioned with the current product costing system.Module 10 / Allocating Costs to Jobs and Processes Accordingly. House-building companies have become more rigorous in their demands in terms of both product design and service support after delivery. The company’s relationship with its customers has changed in recent years. some of which the Managing Director considers useful in a possible redefinition of the costing system. Overheads comprise: Materials handling costs Batch set-up costs Product design Machining costs Service support Purchasing Department £ 20 000 12 000 30 000 45 000 20 000 28 000 155 000 The Management Accountant’s study has revealed the following product information: Windowframes (No. overheads were allocated to products on the basis of the direct labour hours taken to manufacture each product.) 15 6 4 5 8 4 Doors (No. the Management Accountant has carried out a further examination of available costing information.) 10 6 14 10 3 8 Total Customer orders Production batches Purchase orders Receipts of material Service visits Machine-hours (per unit) 30 24 21 30 15 18 All units manufactured in May were sold. which he believes to be producing costs which do not reflect the change in the market environment initiated by the company’s customers. For May. the following information has been extracted from the current production costing system: Window-frames Sales (units) 2 000 Variable costs (per unit) labour £20 materials £30 Labour hours (per unit) 4 Overheads for May = £155 000 Doors 3 000 £35 £40 7 Cabinets 1 000 £25 £50 5 Under duress. The Managing Director of Precision Joinery Co. Accounting Edinburgh Business School 10/45 .

E. Breaking the Barriers: Measuring Performance for World Class Operations. (1985). September–October. 1 2 3 Using the information available: Select suitable cost drivers for overheads.Module 10 / Allocating Costs to Jobs and Processes Required The Management Accountant is unfamiliar with recent developments in product costing. Boston University’s Manufacturing Roundtable. and Vollman T. Nanni A.. and Dixon J.J. ‘The Hidden Factory’. (1989). what will be the effect of the introduction of ABC approach on the assessment of product profitability? Reference 1 Miller J. 10/46 Edinburgh Business School Accounting . Compute the ABC product cost and compare it with the output of the traditional product costing system If current selling prices are based on a 25 per cent mark-up of product cost. Harvard Business Review. and Vollman T.E.G. He is vaguely aware of ABC costing and calls you in to progress its implementation in Precision Joinery Co.R.

concept of relevant cost for special decisions. 11/1 Edinburgh Business School .1 11.7 11.4 11.6.6 11.11 11.2 Learning Objectives By the end of this module you should understand: • • • • Accounting the the the the distinction between full and variable costing.10 11.3 11.1 Case Study 11.9 11.5 11.3 11.1 11. analytical framework surrounding relevant costs.16 Introduction The Dilemma of the Denominator Managerial Implications of Absorption versus Variable Costing Cost Information for Management Decisions Routine and Non-Routine Decisions Developing an Analytical Framework Task One: Define the Problem and List All Feasible Alternatives Task Two: Cost the Alternatives Task Three: Assess the Qualitative Factors Task Four: Make the Decision Finding the Relevant Costs The Pitfalls of Full Costing Opportunity Costs Department versus Company Sunk Costs Management Decisions in Action Closing Down a Unit The Special Sales Order Should we Process Further? Summary 11/2 11/2 11/7 11/8 11/9 11/9 11/10 11/11 11/12 11/12 11/13 11/13 11/14 11/14 11/15 11/16 11/17 11/19 11/20 11/22 11/23 11/30 11/31 Review Questions Case Study 11.2 11.4 11.2 11.6. impact on reported profit between the two cost systems.13 11.6.8 11.Module 11 Costs for Decision Making Contents 11.12 11.15 11.6.14 11.

Additionally. further processing.50 per cabinet and the share of non-manufacturing overhead. This means that the block of fixed costs must be shared out over each unit produced. the module considers a variety of managerial decisions which lie outside normal. This module explores the implications of combining the desirable features of both of these topics. But management has a need to determine the cost per unit of production or service. These allocations would have been made from a straightforward calculation: Budgeted manufacturing (or non-manufacturing) overhead Budgeted volume of output (units or hours) 11/2 Edinburgh Business School Accounting . opportunity cost.1 Introduction The behaviour of different types of cost was described in Module 9. You will remember that the share of manufacturing overhead was deemed to be £2. routine procedures. Provided the two categories of costs are kept separate useful managerial information can readily be provided. day-by-day. for example on break-even points and the impact on profit of changing sales mixes. This calculation is required before actual production and sales take place so that management can make decisions on output levels and prices. the special sales order. Fundamental management choices must be made on which costing system is appropriate for each business. £5. namely keeping fixed costs in a lump sum while calculating unit costs expressed in variable costs only.00 per cabinet. variable costs plus a portion of fixed cost.2 The Dilemma of the Denominator Cast your mind (or eye) back to Module 8 and to the cost profile of the timbershelved hi-fi cabinet. that is. There we saw that most costs of a business can be broken into variable costs (those that change in magnitude with production or sales levels) and fixed costs (those that do not change as production or sales move up or down).Module 11 / Costs for Decision Making • the – – – – – application of relevant costs to: the make or buy decision. Most costing systems are designed for routine ‘housekeeping’ procedures and when special decisions have to be made management must understand which costs and revenues are relevant for the decision and which costs and revenues can be ignored. 11. But the typical costing system tangles up the relevant with the non-relevant so the manager must be equipped with a conceptual framework to select only those that matter. 11. Module 10 described various procedures for spreading these costs using plantwide and departmental overhead rates based on a predetermined level of output expressed either in units produced or appropriate activity bases. sunk cost. and calculating the full cost per unit.

(The setting and monitoring of standards will be the subject of Modules 12 and 13. casing. management salaries. Budgeted total £100 000/10 000 Full production cost 20 30 50 10 60 Here the allocation of fixed production overheads was based on the budgeted total expenditure and the budgeted volume of output of pens for 20x2. alternatively. But provided the estimation process has been handled carefully the variations at the end of the period are usually small. etc. namely 10 000. reservoir mechanism Direct labour Craftsmen. R&D. the fluctuations may be pronounced but when these are netted off for one year’s activities. say four-week cycles. maintenance. administrative and financial costs would be deducted. If in 20x2 everything went according to plan the business would produce a profit and loss account like this: Accounting Edinburgh Business School 11/3 . Assume these costs to amount to £200 000.Module 11 / Costs for Decision Making Such a calculation must be made in advance of production so that the desired selling price can be calculated (even though the business may be unable to achieve it because of market pressures). machine minders Variable costs of production Fixed production costs Depreciation. Likewise with direct materials and direct labour. an estimated or standard cost per unit is calculated before the production and selling process commences. an unforeseen shortage in raw materials could reduce production to 800 units. a figure determined by market research exercises and production capacity. However fixed and predictable the majority of the overheads tend to be. Business may plan to produce and sell 1000 units per year based on experience. But a sudden upsurge in demand can cause the actual number produced and sold to go to 1200 units. Each pen sells for £100 yielding a gross profit of £40 per pen from which selling. If the periods are small.) The determination of both numerator and denominator is fraught with problems. Costs of manufacture per pen were: £ Direct material Nib. Example A business manufacturing designer fountain pens planned to produce and sell 10 000 in 20x2. some will fluctuate if for no other reason than that market prices for the individual overhead costs may vary during the accounting period. the total fluctuation amount should be relatively insignificant. Such an outcome would cause the predetermined rate already used to allocate overhead to be either too low or too high. The determination of the denominator is not so readily predictable.

Module 11 / Costs for Decision Making

Sales 10 000 pens @ £100 Less: Full cost of sales 10 000 @ £60 Gross profit Other expenses Net profit

£ 1 000 000 600 000 400 000 200 000 200 000

This form of accounting is called full or absorption cost accounting because each unit is asked to absorb its share of fixed production overhead, a not-unreasonable requirement. However, let us assume that management’s freedom of pricing was severely restricted because of competitive forces in the designer fountain pen market; in addition because of uncertainty of demand the business produced only what was required and therefore made no attempt to allocate fixed production overhead to each product. If, during 20x2, the company achieved exactly the same outcome, that is, producing and selling 10 000 pens with the same costs the profit and loss account would look like this: £ Sales 10 000 pens @ £100 Less: Variable cost of sales 10 000 @ £50 Contribution margin Fixed production costs Other expenses Net profit £ 1 000 000 500 000 500 000 300 000 200 000

100 000 200 000

This form of accounting is called variable or direct costing because it accounts for fixed costs in a lump sum. The net profit under both methods is identical and, in such circumstances as postulated where actual production equals planned production, and where sales equals production, the managerial insights gained from one method of costing as opposed to the other are limited. But we know that actual production hardly ever matches exactly planned production, and it is rare to find a business where all production is sold by the end of the accounting period. As soon as commercial reality is introduced into the model, the two costing systems produce different numbers.

Example
Assume that the absorption costing method is applied to the fountain pen business described above. Planned production was 10 000 but actual production was 11 000 due to a desire to keep operatives busy throughout the year. The excess will be sold next year. Throughout the year each pen will be allocated £10 fixed production costs as before but in the light of actual production level achieved this should have been: £100 000 11 000 = £9.09

Each unit has over-absorbed £0.91, a total of £10 000 (11 000 × £0.91) for the year. This sum has been caused by the wrong denominator volume being selected and

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must be corrected at the end of the year, otherwise the production would be seen to be absorbing more costs than had been incurred. Absorption profit and loss account Sales 10 000 pens @ £100 Less: Full cost of sales 10 000 @ £60 Gross profit Denominator volume variance Other expenses £ £ 1 000 000 600 000 400 000 190 000 210 000

(10 000) 200 000

Note that the denominator volume variance helps to reduce production costs in the profit and loss account which otherwise would be overstated by the over-absorption of fixed production costs. The variable (or direct) costing profit and loss would be identical to the one already produced. We set out the two methods side by side. Absorption costing Sales Less: Full cost of sales Gross profit Denominator volume variance Other expenses Net profit £ £ 1 000 000 600 000 400 000 Variable costing £ Sales Less: Variable cost of sales Contribution margin Fixed production expenses 100 000 Other expenses 200 000 Net profit £ 1 000 000 500 000 500 000

(10 000) 200 000

190 000 210 000

300 000 200 000

The two systems of accounting are reflecting identical transactions for a year but two different profit figures are determined. Why the difference of £10 000? Note that 1000 pens have been produced which have not been sold; these pens have been placed in inventory, each one valued, under absorption costing, at £60, i.e. £60 000. Under variable costing the same 1000 pens are valued at £50 each, i.e. £50 000. Therefore under absorption costing an extra £10 000 of cost has been held back in inventory for release in the next period. Note that the difference in bottom-line profit has nothing to do with the denominator volume variance. We move our example one year on and keep all facts and figures the same except that production is reduced to 9000 pens even though the estimate at the beginning of the year was again 10 000. For 20x3 the two profit and loss accounts would be: Absorption costing Sales Less: Full cost of sales Gross profit Denominator volume variance Other expenses Net profit £ £ 1 000 000 600 000 400 000 Variable costing £ Sales Less: Variable cost of sales Contribution margin Fixed production expenses 100 000 Other expenses 200 000 Net profit £ 1 000 000 500 000 500 000

10 000 200 000

210 000 190 000

300 000 200 000

Again there is a difference of £10 000 in bottom-line profit and again a denominator volume variance of £10 000. And again the two figures are unrelated.

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Denominator volume variance is caused by the fact that the 9000 pens manufactured only absorbed £90 000 fixed production expenses while £100 000 was incurred in 20x3. The shortfall must be written off at the end of the year. Difference in profits is due to the value of inventory needed to satisfy 20x3’s sales. Production was 9000; sales were 10 000; therefore 1000 pens were taken from inventory. Under absorption costing these units emerge from inventory at £60 instead of £50 under variable costing. Profits therefore fall by 1000 × £10 (the difference in inventory value per pen which itself is the fixed production costs per pen).

To summarise: • A denominator volume variance arises when actual production = planned / production. • Bottom-line profit difference arises when sales = actual production. / In order to reinforce the principles set out above we recommend that readers complete the following table which works a number of permutations on the above data. We supply the numbers for three columns and the full solution is provided at the end of the text of this module. The commentary which follows the table is based on a correct completion of the table! As a reminder, the data are as follows. Cost of fountain pen Direct material Direct labour Fixed production costs* Full cost £ 20 30 10 60

* Based on budgeted total fixed production costs of £100 000 and a budgeted level of production of 10 000 pens per annum. Ignore ‘other expenses’ for the purposes of completing this table.

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Absorption and variable costing compared Column 1 2 3 4 5 6 Sales (000s) 10 8 11 9 7 10 Production (000s) 10 8 11 10 8 11 Sales revenue 1 000 1 000 Absorption costing Cost of sales 600 – – – – 600 Gross profit 400 400 Volume variance – – – – – 10 Net profit 400 410 Variable costing Cost of sales 500 – – – – 500 Contribution 500 500 margin Fixed costs 100 – – – – 100 Net profit 400 400 Production Production = Sales > Sales

7 12 10

8 9 8 900 540 360 (20) 340 450 450

9 13 11

– –

– –

100 – 350 Production < Sales

Check your solution with the table at the end of this module. A word of caution: you may have the right answers but perhaps are not sure why! Attempt to answer the following two questions before proceeding. 1 2 In column 5, why is there a difference in profits of £10 000? In column 9, why is there a difference in profits of £20 000 when the denominator volume variance is only £10 000?

Answers
1 In column 5 the business has sold 7000 pens but produced 8000. The 1000 pens placed in inventory are valued at £60 000 under absorption costing and £50 000 under variable costing. Therefore the variable costing profit and loss account must bear £10 000 more cost. This is a trick question! The two figures are unconnected. The favourable denominator volume variance arises because the business has produced 11 000 pens instead of 10 000 as planned and has therefore over-absorbed £10 000 of fixed production expenses. The difference in the two bottom-line profits is due to the fact that 2000 pens had to be taken from inventory to satisfy the buoyant sales of 13 000. Each pen taken from inventory was £10 more expensive under absorption costing than under variable costing.

2

11.3 Managerial Implications of Absorption versus Variable

Costing
Which method of costing should be selected? It is sometimes argued that such a choice is not open to a business by virtue of the fact that many tax authorities
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insist on absorption costing (because inventory valuations are consistently higher and therefore taxable profits are higher). But with the advent of highly flexible and powerful information systems the requirements of special user groups (e.g. the tax authorities) can be catered for separately from managerial requirements. The sole criterion for choice must be: which method flags up the clearer set of signals? Managers who appreciate the distinction between variable and fixed costs and the role of contribution margin will favour thevariable costing method. But the risks attached to such a method are clear: the sales people in an organisation, if supplied with variable cost information, may be tempted to shave quotations in order to secure more orders. This of course will result in consistent under-recovery of fixed costs and lead to long-term financial damage. Absorption costing would avoid this, but it would also prevent price reductions in a situation of competitive stress where variable cost sales are better than no sales at all. Another ‘attribute’ of absorption costing is the potential it gives to managers to influence the bottom-line profit. Consider the table again: the only scenario in which profits are the same under the two cost systems is when production equals sales (columns 1, 2 and 3), a highly unrealistic commercial scenario. Much more likely are the situations mirrored in columns 4, 5 and 6 where production exceeds sales or columns 7, 8 and 9 where sales exceed production. Indeed a typical company will bounce from one situation to another. Under variable costing, profit is a function of sales, that is, when sales rise, so do profits. But with absorption costing, profit is influenced not only by sales but also by production levels. By stepping up production beyond sales, management can increase profits (columns 4, 5 and 6) because more fixed production expenses are ‘parked’ in inventory. But this action must inevitably be reversed because of cash flow problems (cash required for production not being restored by sales); then the profits profile of columns 7, 8 and 9 emerges when the fixed production expenses come tumbling out of the inventory warehouse under absorption costing and hit the profit and loss account. As the table shows, the difference between absorption and variable costing is simply a question of timing of fixed production expenses. Variable costing recognises them all every accounting period; absorption costing tucks away some into inventory but then must eventually release them in a succeeding accounting period. At the end of the day the two profit profiles of the same business will be identical. But managers must decide which one provides them with the maximum amount of information period by period.

11.4 Cost Information for Management Decisions
The first part of this module described two major cost systems, absorption and variable, and explored some of the issues surrounding management’s decision on which system to select for routine planning and control purposes. Now the focus turns to the use of specific parts of cost systems to support managerial decision making outside the routine, ‘housekeeping’ functions. The material which follows is equally pertinent to decision making based on information stemming from absorption costing systems and variable costing systems.
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Managements constantly make decisions which are intended to contribute towards the ultimate goal of wealth creation for shareholders (of a company) or owners/partners (of a business). Cost information cannot replace the exercise of initiative and judgement but it can assist, nevertheless, in the decision making process by providing the manager with all the relevant costs and revenues. The issue which will be confronted in this section is: which costs and revenues are relevant and which are not relevant (and possibly damaging) to the manager in his task of making decisions? Before the relevant costs can be identified, it is essential to identify the types of decisions which must be made. Clearly this is a very difficult task: decisions are unique to individual companies, and even to individual circumstances within individual companies. An infinite variety of decisions confronts managers. It is possible, however, to group together many of the more typical decisions confronting management in order to study the type of cost information that is required to assist the decision maker.

11.5 Routine and Non-Routine Decisions
In general terms, two major categories of decision can be identified, routine decisions and special, or non-routine, decisions (though it is admitted that many managers would argue that there is no such thing as a routine decision). Routine decisions are those a manager takes in the normal course of events, for example, sorting out disruptions to production caused by machine failure, labour problems or breakdown of supplies, dealing with awkward customers, or discussing future plans with bankers or proprietors. For these types of decision, the manager’s own personality and facility for dealing with people is very often the most important aspect of the negotiations. Cost information, if required at all, will be extracted from the various routine cost systems described earlier in this module. Non-routine decisions, on the other hand, usually require less personal, direct negotiation on the part of the manager. Rather, they require logical analysis of the facts and alternatives in a cool and rational manner, with the manager taking the decision after much thought. Routine decisions tend to be made on the spur of the moment. Cost data tend to play a significant part in the information which the manager needs for non-routine decisions. Examples of non-routine decisions might include deciding whether or not to shut down a department or a product; whether or not such a shut-down should be temporary or permanent; whether to continue making a component or to purchase the required volume from an outside supplier; or whether to switch to machinery-based production from manual methods. Almost by definition, non-routine decisions require nonroutine, or special, cost information which is not easily gathered from the routine cost systems described in earlier modules.

11.6 Developing an Analytical Framework
It is often thought that non-routine decisions are approached in a non-routine manner. This is not so. It is essential that managements construct a framework
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within which ‘one-off’ decisions can be analysed in a thoroughly disciplined manner. It is only by eliminating the random, haphazard approach implied by the notion of non-routine problems that the quality of management decisions will improve. The following list of tasks is often used by management. 11.6.1

Task One: Define the Problem and List All Feasible Alternatives
Without doubt, this initial task is the most difficult. It is not easy either to understand fully what the real problem is or to set out all possible alternatives which should be considered. Consider first the task of defining the problem with the following scenario. Last year the management of a wholesale butchery business was confronted with a continuing trend of losses being incurred on every ton of shin beef and leg beef sold. Losses were running at such a level that the accountants suggested that these cuts of beef should be deep frozen until such time as the market demand for cheaper portions picked up. Management accepted their advice. The problem facing management now is the shortage of deep frozen facilities and the proposal to build a new cold storage facility to stock these cuts, which are still not selling well. On the face of it this scenario describes a fairly typical investment decision. Should the company invest a substantial sum in a new cold storage plant and if so, how should the company seek to finance the project? Two other suggestions were made by members of the company’s management. First, wouldn’t it be less costly to destroy surplus cheap cuts on a First In First Out basis than to build the new factory? Second, shouldn’t the company engage in a massive advertising campaign to persuade the consumer of the advantages of these cheaper cuts (good for meat loaves and for producing stock with high nutritional value) and in so doing raise the price of the cuts in an effort to cover losses? The problem and the alternatives seem well stated and clear-cut. But the real problem lies in the costings of the various cuts of beef. On investigation, management discovers that the abattoir labour and overhead costs have been allocated to the different cuts on the basis of weight before preparation for sale. Thus the relatively heavier parts of the animal, e.g. the leg and shin, bear a relatively higher portion of the abattoir costs without any consideration of the market value of these parts. The problem for this company is to devise a more appropriate allocation key for costs so that the various cuts of meat bear the overheads in a way that would not affect the decision to sell (but which would affect the internally reported contribution on the other, relatively lighter parts of the animal). This management problem, once identified, is much less complex or costly than the prospect of having to build new plant to store overpriced inventory. Second, management must identify all feasible alternatives. Like the first part of the problem, this step is not as easy as it sounds. There are usually many more alternatives than first meet the eye. For example, suppose that the management of this butchery business reallocated costs in such a way that all cuts of meat sold at competitive prices. The proposal for building a new cold storage plant was dropped; instead management was presented with a suggestion that a fully automated vacuum packer be purchased to replace a manual system. The

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manager of the packing department had already received a quotation from a reputable equipment manufacturer for the purchase and installation of a suitable machine. Management is therefore faced with two alternatives: to buy this piece of plant and save some labour costs, or to keep packing the meat in the same way as before. A closer study of the problem will show that management has many more alternatives that it should explore before making a decision. Here are a few possibilities. It could: (a) buy an alternative fully automatic machine from a different supplier; (b) lease the equipment instead of buying it; (c) acquire a semi-automatic machine which allows the company to keep some skilled operatives to cope in times of machine breakdown or peak demand; (d) examine present operating techniques to see if they could be made more cost effective; (e) subcontract packing operations to a specialist meat packer. All of these alternatives would need to be examined closely before management made a decision which could have an effect on the profitability of the company for some years to come. 11.6.2

Task Two: Cost the Alternatives
Each alternative identified above would need to be measured in terms of cost, that is, cost outlays and cost savings. For example, consider the alternative to acquire a semi-automatic machine and keep some labour against the alternative to purchase a fully automated machine. The relevant costs may be expressed as follows: Purchase price Labour costs Power costs Fully automatic £10 000 1 000 500 £11 500 Semi-automatic £6 000 5 500 300 £11 800

The difference in favour of the fully automatic machine is £300. The relevant costs in this example – indeed in every situation requiring a management decision – are those that differ for the alternatives under review. For instance, it would be pointless to list all the costs associated with the packing process if they are not affected by the decision to switch: administrative, rent, heat and light costs would be unlikely to be affected. It would therefore be more helpful to management to list the relevant costs in terms of the differences in amount.

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Increase in purchase price for fully automated plant Saving in labour cost Increase in power cost Net savings in fully automated plant

Fully automatic versus semi-automatic £(4000) 4500 (200) £300

The appropriate way of analysing these relevant costs will be dealt with in Module 15. 11.6.3

Task Three: Assess the Qualitative Factors
Unfortunately management cannot rely exclusively on ‘the bottom line’, that is, what the cost figures tell them. There are plenty of considerations which cannot be reduced to money terms but which, nevertheless, will weigh heavily in the ultimate decision. In the example above certain features which cannot be measured in terms of cost may influence the decision, particularly in the light of the very small cost differential in favour of the fully automated plant. Even before considering the qualitative factors, management may have come to the conclusion that the cost savings of £300 are immaterial and that it should seek to differentiate on some other grounds. One major qualitative factor could lie in the relationship management enjoys with the workforce. If the business is a relatively small family concern with a small, loyal workforce, the temptation to select the semi-automatic machine which permits the retention of some workers may be overwhelming. On the other hand, a large impersonal company with a constant employee turnover may not be so concerned with such human issues. Another issue which may arise is the choice of supplier: does the company wish to buy a British model if cost minimisation is its top priority? We have already stressed that cost information cannot replace the exercise of initiative and judgement by management. Such initiative and judgement is exercised in this non-quantitative area of decision making.

11.6.4

Task Four: Make the Decision
The function of management is to make things happen in accordance with its plans. Therefore management is constantly making decisions, both special decisions like the one facing the management of this wholesale butchery business and routine decisions. Decisions cannot be fudged; they must be made, even if they prove to be wrong. A perfectly valid decision of course is to do nothing. The butchers may decide to shelve the proposal meantime and retain the manual workers. But the decision must be made and intimated clearly to those parties concerned. Note that a decision can be put off only on the grounds that more background information is required. Management must balance the costs of producing this additional information (such costs perhaps including the uncertainty and tension

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created in the workforce) with the benefits which may be derived from the information obtained.

11.7 Finding the Relevant Costs
This part of the course is concerned with management accounting for decision making: it is therefore natural that Task Two: Cost the Alternatives, receives most attention. (This is not to belittle the other tasks in the analytical framework.) When alternative courses of action are being costed (from both the revenue and cost angles) management is concerned only with the relevant costs, not the total costs, of each alternative. A relevant cost is one that changes as a result of the decision being contemplated. Sometimes a relevant cost is called a differential cost because it is a cost that differs when management changes the scheme of operations. It is pointless to produce a list of individual costs and revenues for the alternatives under consideration if only a few of them will change: management should be asked to focus only on the ones that differ among alternatives. The problem facing the accountant is how to recognise when a cost is a relevant cost. It is not an easy exercise which can be reduced to a few straightforward procedural rules. Different managerial decisions require different relevant costs. The remainder of this section will explain some basic issues which should help separate relevant costs from non-relevant, and the remainder of the module will illustrate these points in operation by means of some typical managerial problems.

11.8 The Pitfalls of Full Costing
Full costing, as described in Module 10, is an accounting system which is concerned with allocating all costs, direct and indirect, to the units of output which are to be sold. Every unit not only incurs the direct cost of raw material and labour required to manufacture it but also is allocated some of the indirect costs of both the manufacturing and administrative sectors of the business. Some of these indirect costs are fixed costs. The danger of allocating fixed costs to individual units of production is that, once allocated, fixed costs assume the appearance and characteristics of variable costs, that is, the more volume that is produced, the higher the costs. We repeat the illustration used in Module 9: Possible volume levels Variable costs in total Fixed costs in total Variable cost per unit Fixed cost per unit 100 £100 £600 £1 £6 200 £200 £600 £1 £3 300 £300 £600 £1 £2

Notice that when costs are ‘unitised’, the trend in costs belies the label given to individual components. For example, a variable cost should vary but it can be seen to remain fixed per unit; again, a fixed cost should remain fixed but when converted into a fixed cost per unit the cost appears to vary. Great care therefore has to be taken in interpreting full cost information: if fixed costs are
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kept in ‘blocks’, that is, they are not allocated over production units, the patterns of total costs are consistent with the labels ‘fixed’ and ‘variable’. When choosing between alternative courses of action, management should ignore those costs which will not change. Often fixed costs will remain fixed in total regardless of alternatives and can therefore be ignored. But this is only possible if management is aware of how costs behave and of the components of unit costs. It should be stressed, however, that while the emphasis in examining relevant costs is on variable, or marginal costs, this should not preclude a consideration of fixed costs too. For example, one alternative could involve the acquisition, on lease, of a computer which would require a specially constructed air-conditioned facility. The lease payment, depreciation and rental charges associated with such a decision alternative are all relevant even although they are fixed costs.

11.9 Opportunity Costs
By taking a decision to implement a specific option, management automatically forgoes the opportunity of embarking on alternative options. It may be possible to identify certain costs of not choosing one alternative which may be relevant in the decision making process. For example, in the butchery example, it may be recognised that the labour required to be retained if the semi-automatic machine is acquired would be under-used for at least three months each year. It is also thought that their services could be subcontracted to competitors during this time for £80 per month. Thus £240 becomes an opportunity cost of choosing the fully automated machine and if taken into account as a relevant cost it would serve to close the gap even further between the two alternatives. Total relevant costs Opportunity cost of forgoing purchase of semi-automatic Fully automated £11 500 240 £11 740 The difference in favour of a fully automated machine is £60. Alternatively the opportunity ‘revenue’ of £240 could be deducted from the relevant costs of £11 800 for the semi-automatic machine – the result would be the same. Accountants are uncomfortable with opportunity costs because (a) these costs cannot be determined from the accounting system and (b) they are highly subjective and uncertain. But managers should make every effort to quantify such costs because they could have a profound impact on the other relevant costs and therefore on the decision to be taken. Semi-automatic £11 800

£11 800

11.10 Department versus Company
In deciding on the costs which are relevant to the decision under review, it is essential that a company-wide, not purely a departmental, stance is adopted. This
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point can best be understood with an example, a variation of the scenario of the butchery business described above.

Example
Consider that the surplus labour capacity could be allocated to other departments during the three slack months instead of to an outside firm. Is there still an opportunity cost associated with such a shift in resources?

The answer is no, unless this saves the other departments having to employ additional people from outside. Although the meat-packing department will be able to reduce its annual wages bill (by having some other department charged for the labour ‘subcontracted’), the company’s wages bill is not affected one way or the other. This internal charge is not relevant. Such a charge or cost only becomes relevant if the company’s overall financial position is affected.

11.11 Sunk Costs
Management decisions concern the future. True, it is of some interest (often macabre!) to review old decisions to see if one can learn from one’s mistakes but no amount of analysis or recrimination can alter old decisions. Relevant cost analysis must not be confused by mixing costs which have been incurred from old decisions with costs which will be incurred in the future. Costs which have been incurred are called sunk costs and should be ignored when looking for relevant costs. It is sometimes very difficult to ignore past costs because management tends to become emotionally attached to past decisions either because of the success (or failure) of the projects or because of the magnitude of the sum of money involved.

Example
In the example about the decision confronting the management of the wholesale butchery business one director reminds his colleagues of the expensive wrapping machine that was purchased the previous year and which would have to be scrapped if a new vacuum packer was purchased. (There would now be no market for such a technically obsolete machine in the butchery trade.) His argument is that the annual depreciation charge (£1000 per year, based on a five-year straight-line depreciation charge on a £5000 machine) would be saved if a new vacuum packer is purchased and is therefore a relevant cost saving. Another director, however, expresses surprise at this conclusion: his contention is that because only £1000 has been written off the obsolete machine, the relevant cost is £4000, being its book value. Which of the directors is correct?

The answer is: neither of them! The wrapping machine is a sunk cost. However large a sum of money expended, and however regrettable and inappropriate the investment has turned out to be, nothing can alter the decision taken last year. Regardless of whether the fully automated machine, the semi-automated machine or neither is acquired and the one-year-old wrapping machine remains operational, the £4000 book value will be written off one way or another. If the
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machine is scrapped the write-off will be immediate; if it is not scrapped the write-off will be over four years. In either case the total cost will be the same and is therefore not relevant to the decision confronting the directors. The only relevant cost (income or negative cost) would be any sales proceeds from the disposing of the wrapping machine. Relevant costs are future costs; relevant costs involve cash spent or cash saved.

11.12 Management Decisions in Action
It would be impossible to describe all the varieties of non-routine decisions which confront the management of a typical manufacturing enterprise. Even if space were not a constraint in a course of this nature, such a grand objective would be frustrated by the nature of the moving target: each day brings a countless number of new non-routine decisions, many of which possess unique features. It is possible, however, to select a number of types of decision which are confronted frequently and consider how management should, and should not, attempt an analysis. The replacement of labour by machine, and the associated cost implications, has already been analysed in the foregoing material in this section. We now select three further scenarios for analysis but first we set out the analytical framework so far developed. Relevant costs are: • • • • future costs; cash costs; avoidable costs; costs which differ among alternatives.

Future Costs
Old costs cannot be influenced by future decisions. A manager must not ‘cry over spilt milk’!

Cash Costs
Because relevant costs are all future costs these, by definition, involve cash flows. Be concerned with the real money implications of a decision, not the accounting implications such as depreciation or asset write-offs.

Avoidable Costs
If a cost is unavoidable, even if it is a future cash cost, it is not relevant for the decision under review because it will be incurred whatever the option selected. Only take into the relevant cost calculations those costs which would not be incurred if another option is selected.

Those Which Differ Among Alternatives
Costs which differ among alternatives is another way of looking at avoidable costs. If the same cost is going to crop up under all options, you are only cluttering the calculations, and losing the focus of the critical numbers, by including it.
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11.13 Closing Down a Unit
Management is frequently confronted with the alternative of shutting down, either temporarily or permanently, a product line, or department, or factory, or subsidiary which is experiencing trading difficulties. Its task is to identify the relevant costs of such an alternative. Usually the best approach to such a problem is to ask: how long should operations be kept going? If products make a contribution towards fixed costs then production should continue. However, fixed costs may be reduced if operations were shut down, for example administrative salaries could be avoided, while some special shut-down costs may be incurred like plant maintenance, security guards’ fees, redundancy and retraining costs. In such a situation, the term ‘fixed costs’ should be interpreted carefully.

Example
The Clydeside Anchor Co. specialises in forging anchors and manufacturing ancillary equipment for oil-rigs. A world glut of oil had caused a slowing-down of oil-rig building which has had an immediate effect on all product lines of Clydeside. Particularly badly hit has been its chain division. The directors are considering whether this division, consisting of one factory, should be closed until the glut has eased. A flexible budget has been compiled. Production capacity (Fixed costs + Variable costs) 60% 80% 100% 360 000 480 000 640 000 300 000 400 000 500 000 220 000 240 000 260 000 140 000 150 000 160 000 160 000 180 000 200 000 40 000 50 000 60 000 1 220 000 1 500 000 1 820 000 Fixed costs Closedown – – 120 000 80 000 80 000 20 000 300 000 Normal – – 160 000 120 000 120 000 20 000 420 000

Direct material Direct labour Factory overheads Administration Selling and distribution Miscellaneous

40% 240 000 200 000 200 000 130 000 140 000 30 000 940 000

Some additional information is available. 1 2 3 Present sales of 50 per cent capacity are estimated at £600 000 per annum. Estimated costs of closing down are £90 000. In addition, maintenance of plant and machinery is expected to amount to £16 000 per annum. Costs of reopening after being closed down would be approximately £40 000 for overhauling machines and getting ready and £28 000 for training of key personnel. Economic indicators suggest that sales should take an upward swing to around 70 per cent capacity at prices which would reflect a dramatic uplift, producing revenue of £2 000 000 in 12 months’ time.

4

The management of Clydeside must select the relevant costs and other information which will allow it to reach a decision on whether to keep the chain division open during the recession or to shut down and wait for the economic upturn.

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It can be seen that there are only three relevant levels of operations: zero per cent (i.e. close down and reopen), 50 per cent (present level), and 70 per cent (post-recession level). Revenues and costs should therefore be set out for all three levels. 0% Sales Marginal costs Contribution Fixed costs Special costs Gain/(Loss) Level of operations in £ 50% – £600 000 – 660 000 – £(60 000) 420 000 £474 000 (£474 000) £(480 000) 70% £2 000 000 940 000 £1 060 000 420 000 £640 000

£300 000 174 000

Calculations
Marginal costs are calculated by: (a) interpolation, i.e. for 50 per cent, the mid-point between 40 per cent and 60 per cent; for 70 per cent, the mid-point between 60 per cent and 80 per cent; then (b) deducting the fixed components of factory overheads, administration, selling and distribution and miscellaneous from the total figures to determine the marginal cost component. Details are set out below. Marginal costs of operations Mid-point of flexible budget: @ 50% £1 220 000 – £940 000 @ 70% £1 500 000 – £1 220 000 Deduct fixed costs @50% £1 080 000 420 000 £660 000 £1 360 000 420 000 £940 000 @70%

The special costs of closing down and reopening are as follows. £90 000 + £16 000 + £40 000 + £28 000 = £174 000.

Conclusions
By focusing on contribution (sales revenue less variable (marginal) costs incurred in generating sales revenue), management can gain a useful picture of these costs which vary with volume changes, and those that do not. Note, however, that just because fixed costs do not change, management cannot afford to ignore them altogether; they must be deducted from contribution to produce a realistic gain or loss figure. The danger facing management in the table of figures given to them initially is that it might have ignored the fixed component of the factory overheads, administration, selling and distribution, and miscellaneous costs and treated all costs as variable costs. This would have produced totally different figures and would have led to wrong decisions being taken. It is fundamental that variable costs are kept separate from fixed costs in decisions concerning the suspension of activities. It is far from certain whether, on the basis of the figures of gains and losses above, management would decide to shut down the chain division during the
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Module 11 / Costs for Decision Making oil glut. Example The Highland Shortbread Company was experiencing a decline in sales due to the economic recession in the home market. Hence the cost to manufacture one carton was £12 (£120 000/10 000). To confirm his belief he called for a copy of the previous year’s income statement which revealed the following picture: Sales Manufacturing cost of goods sold Gross margin Selling and administrative expenses Operating income £150 000 120 000 £ 30 000 20 000 £ 10 000 This income statement was based on sales of 10 000 cartons of shortbread. their offer of £10 does not even cover the cost of manufacturing the stuff. 11. far less the cost. The sales director believed the price of £10 per carton was lower than even the cost of manufacturing one carton of shortbread. they can jolly well pay £15 per carton like everyone else. If the experiment met with customer approval the airline would seek to enter into a long-term contract with the Highland Shortbread Company. The sales director therefore recommended an outright rejection: ‘There is no way we can subsidise the airline on these figures. The special order was for 1000 cartons of shortbread at £10 per carton. If they want our shortbread. We would lose £2000 on the deal.’ Accounting Edinburgh Business School 11/19 . the division would incur only £6000 greater loss. Regardless of underlying trading and legal positions.14 The Special Sales Order It is not unusual for a company to be approached by a potential customer with an offer to buy a large quantity of product at an advantageous price. companies need a framework for analysing this type of offer. a cost which the management of Clydeside may well be prepared to incur to ensure harmonious industrial relations. There might also be difficulty in price discrimination (but this can often be overcome by reworking discount arrangements for bulk orders). consumers were buying only basic provisions for their families and were consequently giving the supermarkets’ confectionery displays a wide berth. An increase in sugar prices had also caused a fairly steep increase in the retail price of shortbread. If the division is kept open at a 50 per cent level of operations. A British national airline approached the company with an offer to buy a special order of shortbread to enable them to serve passengers with a complimentary cup of coffee and finger of shortbread on overseas flights terminating in Scotland. particularly if it is not experiencing difficulty in selling the product or in using the capacity of the machinery and plant. taking into account the cost of selling and distribution. What does the management of the producing company do? Its natural reaction may be to reject the offer immediately.

Since the fixed costs of £45 000 would not be affected by the airline’s order. £14 per carton) must be at least equalled by the sales price if the company is to survive. Hence the full cost. only £9 (£90 000/10 000). since there would be no selling costs associated with the special order (as the airline’s catering division had undertaken to wrap the fingers of shortbread) each carton sold for £10 would provide a contribution to fixed costs of £1. that the ‘full cost’ income statement used by the sales director is useful for long-term pricing purposes. This is what he found: Sales Variable expenses Manufacturing Selling and administration Contribution margin Fixed expenses Manufacturing Selling and administration Operating income £150 000 £90 000 5 000 95 000 £55 000 30 000 15 000 45 000 £10 000 The variable cost of manufacturing one carton of shortbread was. plus the selling and administration costs (£20 000/10 000 cartons = £2 per carton. he called for a detailed breakdown of the income statement. as he privately admitted. If these by-products become as valuable as the main product. in fact. The relevant costs in this example are only the variable costs. in the petroleum industry where the refining of crude oil is undertaken to produce high-quality petroleum oil. the company’s overall profit would be increased by £1000. namely the absorption cost (£120 000/10 000 cartons = £12 per carton). they are called joint products.e. i.15 Should we Process Further? Here we extend the discussion in Module 10 on joint costs allocation. Processing products beyond split-off is a typical management problem in industries where the production process produces more than one product. But management should not confuse costs required for long-term pricing strategies with those required to deliberate on special orders. however. Allocation of costs among joint products is a difficult and potentially misleading exercise. Note. Even without studying the figures he would have been happy to accept the special order because of the prospect of concluding a long-term contract with the airline. 11. 11/20 Edinburgh Business School Accounting . The company must recover all of its costs. For example. Therefore. eventually and must price accordingly. he would have given the airline the shortbread at no charge just to get the long-term business!) However. fixed and variable.Module 11 / Costs for Decision Making The managing director was not happy with the sales director’s conclusions. The special order would therefore provide a total contribution of £1000. (Indeed. the process also produces a variety of valuable byproducts which can be sold or processed further.

Module 11 / Costs for Decision Making

Example
Extending the wholesale butchery business example used earlier in this module, imagine that a food scientist, newly employed by the company, has suggested that the cheap cuts of shin beef and leg beef should be processed into both dog food and pie meat. He claims that both products would sell well, much better than selling the unprocessed cuts of meat. The processing costs, and separate sales prices are given in Figure 11.1.

1000 kg of pie meat @ selling price £0.50 per kg Processing costs £1000

£ 500

2000 kg of dog meat @ selling price of £0.40 per kg Split-off point Total sales value at split-off point

800 £1300

Figure 11.1

Processing costs and selling prices

Accountants deliberate long and hard about how to allocate the processing costs of £1000. As we saw in Module 10 two methods are usually used. The weight method would allocate one-third of £1000 to the pie meat and two-thirds to the dog meat. The sales value technique would allocate five-thirteenths of £1000 to the pie meat and eight-thirteenths to the dog meat. This allocation procedure would be necessary for calculating inventory costs and therefore profit for the accounting period. Depending on the method chosen, different answers are produced. Weight Pie meat £500 333 £167 £300 Dog meat £800 667 £133 Pie meat £500 385 £115 £300 Sales value Dog meat £800 615 £185

Sales Allocation of joint cost Profit

Plenty of arguments can be found to support either method and in the long term, it is argued, it does not matter which method is chosen because the profit is the same in both cases. As the following example will show, this is misleading. Consider a further proposal by the food scientist that the company should make the pies instead of selling the pie meat to an outside pie-maker. His proposal envisages 1-kg plate pies, requiring £220 of pastry and further labour, which would sell for £0.60 each. If these new facts are fed into the income statements above, the following picture emerges.

Accounting

Edinburgh Business School

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Module 11 / Costs for Decision Making

Plate Pies By weight Sales @ £0.60 Joint costs Additional costs Profit/(Loss) £600 £333 220 553 £47 £385 220 By sales value £600 605 £(5)

This outcome is plainly ridiculous given that the same pie meat is to be processed in an identical manner. The only approach to the problem of further processing is the incremental approach where one compares the additional, or incremental revenue from sales with the incremental costs involved. Incremental revenue 1000 pies @ £0.10 Incremental costs Net loss £100 220 (£120)

The decision would be taken, therefore, to sell the pie meat in its bulk form to the outside pie-maker. No technique for allocating joint product costs is applicable to management decisions of whether a product should be sold at the split-off point or processed further. Such decisions can be aided only by incremental or relevant cost analysis.

11.16 Summary
When management is faced with choosing one course of action from among a variety of possibilities, which includes the possibility of doing nothing, the relevant costs and revenues are the differential costs, the costs and revenues which will change if the alternative course of action is selected. The most attractive alternative will be the one with the lowest differential costs. But cost calculations alone rarely provide the answer to any management problem; qualitative factors often play the decisive role.

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Edinburgh Business School

Accounting

Module 11 / Costs for Decision Making

Solution to table on absorption and variable costing Column Sales (000s) Production (000s) Sales revenue Absorption costing Cost of sales Gross profit Volume variance Net profit Variable costing Cost of sales Contribution margin Fixed costs Net profit 1 10 10 1 000 600 400 – 400 2 8 8 800 480 320 (20) 300 3 11 11 1 100 660 440 10 450 4 9 10 900 540 360 – 360 5 7 8 700 420 280 (20) 260 6 10 11 1 000 600 400 10 410 7 12 10 1 200 720 480 – 480 8 9 8 900 540 360 (20) 340 9 13 11 1 300 780 520 10 530

500 400 550 500 400 550 100 100 100 400 300 450 Production = Sales

450 350 500 450 350 500 100 100 100 350 250 400 Production > Sales

600 450 650 600 450 650 100 100 100 500 350 550 Production < Sales

Review Questions
11.1 Management has several reasons for requiring to know the total cost per unit of production. The principal reasons relate to decisions on: (i) (ii) inventory valuation; levels of planned production;

(iii) fixing selling prices; (iv) salesmen’s commission levels. Which of the following is correct? (a) (c) (i) and (ii) only. (ii) and (iii) only. (b) (i) and (iii) only. (d) (ii), (iii) and (iv) only. 11.2 The composite elements of a predetermined overhead allocation rate mean that there is limited scope for accuracy because: (i) (ii) applied overheads differ from actual overheads; budgeted overheads differ from actual overheads;

(iii) budgeted output differs from applied output; (iv) budgeted output differs from actual output. Which of the following is correct? (a) (c) (i) only. (ii) and (iii) only. (b) (i) and (iii) only. (d) (ii) and (iv) only.

Accounting

Edinburgh Business School

11/23

Module 11 / Costs for Decision Making

11.3 The principal difference between absorption costing and variable costing lies in the treatment of fixed manufacturing overhead which is included in product costs in absorption costing, but excluded from product costs in variable costing. True or false? 11.4 In a situation where production equals sales and planned production equals actual production, which of the following is correct? (a) The contribution margin under variable costing equals the gross profit under absorption costing.

(b) The net profit under absorption costing equals the net profit under variable costing. (c) The variable cost of sales under variable costing equals the full cost of sales under absorption costing.

(d) The full cost of sales under absorption costing equals the fixed production costs under variable costing. The following information applies to Questions 11.5–11.9. Energy Products Limited has prepared its cost budget for next year. Based on sales and production of 2000 units projected costs are: Direct materials Direct labour Direct power Variable manufacturing overhead Fixed manufacturing overhead Variable selling overhead Fixed administrative overhead Each unit sells for £150. 11.5 If variable costing is used, what is the inventory cost per unit? (a) (c) £48. £73. (b) £58. (d) £87. 11.6 If absorption costing is used, what is the inventory cost per unit? (a) (c) £58. £73. (b) £65. (d) £82. 11.7 If absorption costing is used, what is the gross profit per unit? (a) (c) £77. £87. (b) £82. (d) £92. £ 46 000 34 000 16 000 20 000 30 000 10 000 18 000 174 000

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Edinburgh Business School

Accounting

Module 11 / Costs for Decision Making

11.8 If variable costing is used, what is the total contribution margin? (a) (c) £154 000. £184 000. (b) £174 000. (d) £204 000. 11.9 If only 1800 units were sold out of 2000 manufactured, which of the following is correct? (a) Net profit under absorption costing exceeds net profit under variable costing by £2000.

(b) Net profit under variable costing exceeds net profit under absorption costing by £2000. (c) Net profit under absorption costing exceeds net profit under variable costing by £3000.

(d) Net profit under variable costing exceeds net profit under absorption costing by £3000. The following information applies to Questions 11.10–11.12. Glendevon Springs Limited plans to produce and sell 20 000 bottles of a special whisky blend in the coming month. Forecast costs are: Fixed £ 50 000 10 000 Variable £ 40 000 10 000

Manufacturing Selling and administrative

The selling price is £10 per bottle. 11.10 If variable costing is used, what is the contribution margin per bottle? (a) (c) £5.00. £8.00. (b) £7.50. (d) £8.25. 11.11 If absorption costing is used, what is the inventory cost per bottle? (a) (c) £4.50. £5.25. (b) £5.00. (d) £5.50. 11.12 If actual production exceeds planned production by 10 per cent, what is the ‘denominator volume variance’? (a) (c) (£5000). (£5940). (b) £5000. (d) £5940.

Accounting

Edinburgh Business School

11/25

Module 11 / Costs for Decision Making

The following information applies to Questions 11.13–11.14. Kent Transformers Limited produces a single product, which sells for £250 per unit. Cost data have been estimated on the expectation of 10 000 units per year. Variable manufacturing costs Variable selling costs Fixed manufacturing overhead Fixed administration overhead £ 500 000 125 000 600 000 350 000

However, actual output was only 9000 units, of which 7500 units were sold. There was no opening stock. 11.13 If variable costing is used, what is the profit for the year? (a) (c) £306 250. £381 250. (b) £362 500. (d) £456 250. 11.14 If absorption costing is used, what is the profit for the year? (a) (c) £496 225. £546 250. (b) £515 000. (d) £596 250. 11.15 In comparing absorption costing and variable costing, it is vital for managers to appreciate that: (i) (ii) bottom-line differences in profit occur where sales quantities equal actual production quantities; bottom-line differences in profit occur where sales quantities differ from actual production quantities;

(iii) a denominator volume variance occurs where actual production differs from planned production; (iv) a denominator volume variance occurs where sales quantities differ from actual production quantities. Which of the following is correct? (a) (c) (i) and (iii) only. (ii) and (iv) only. (b) (ii) and (iii) only. (d) (iii) and (iv) only. 11.16 In selecting between absorption costing and variable costing, there are clear risks in adhering to a variable costing approach alone. The hazards include: (i) (ii) a potential for consistent under-recovery of fixed costs; an over-emphasis on short-term pricing to cover variable costs only;

(iii) an encouragement to manufacture for inventory;

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Edinburgh Business School

Accounting

Module 11 / Costs for Decision Making

(iv) an effect in turning profits into a function of production levels. Which of the following is correct? (a) (c) (i) and (ii) only. (ii) and (iii) only. (b) (i) and (iii) only. (d) (iii) and (iv) only. 11.17 When managers are faced with non-routine decisions, they should adopt similarly non-routine approaches in arriving at these decisions. True or false? 11.18 Which of the following is correct? (a) Management accountants attempt to present data for decision making which is both relevant and exact, although it is more important that it is exact. In any decision situation, quantitative factors will always outweigh qualitative factors.

(b) In making decisions about the future, all historical costs are relevant. (c)

(d) In making decisions, relevant information is the forecast data that will differ amongst the available alternatives. 11.19 In developing an analytical framework for non-routine decisions, management needs to pay attention to: (i) (ii) the assessment of qualitative factors; the accumulation of relevant historic cost data;

(iii) the costing of the alternatives; (iv) the effect on product quality. Which of the following is correct? (a) (c) (i) and (ii) only. (ii) and (iii) only. (b) (i) and (iii) only. (d) (ii) and (iv) only. 11.20 In comparing between alternatives under review, it is sensible to list all costs involved, even if some are common to every option. True or false? 11.21 Which two of the following are examples of qualitative factors which may influence the final choice amongst alternative courses of action? (a) (c) Return on capital employed. Medium-term marketing policy. (b) Industrial relations considerations. (d) Bonus schemes for increases in output. 11.22 There are some general guidelines available to assist management in identifying relevant costs. These include the following: (i) Management should ignore fixed costs, unless they are specifically affected by the alternatives.

Accounting

Edinburgh Business School

11/27

Module 11 / Costs for Decision Making

(ii)

Management should focus on costs which are common to all options.

(iii) Management should be alive to any costs arising as a result of the nonselection of a particular alternative. (iv) Management should concentrate on costs incurred to date before deciding on future options. Which of the following is correct? (a) (c) (i) and (iii) only. (iii) and (iv) only. (b) (ii) and (iii) only. (d) (iv) only. The following information applies to Questions 11.23–11.24. Stonehaven Forest Products Limited produces three ranges of high-quality pine furniture – beds, tables and chests. Its Management Accountant has prepared a draft budget for 20x0: Beds £000 45 15 20 5 9 49 (4) Tables £000 35 10 15 12 5 42 (7) Chests £000 40 10 5 5 6 26 14 Total £000 120 35 40 22 20 117 3

Sales Materials Labour Variable overhead Allocated fixed overhead Profit/(loss)

In view of this forecast, the directors are considering closing down the production of both beds and tables since they are incurring losses. 11.23 If the directors close down only the production of beds, what is the effect on profit? (a) (c) Profit increases by £4000. Profit decreases by £9000. (b) Profit decreases by £5000. (d) Profit increases by £14000. 11.24 If the directors close down only the production of tables, what is the effect on profit? (a) (c) Profit increases by £2000. Profit increases by £700. (b) Profit decreases by £5000. (d) Profit increases by £17 000. The following information applies to Questions 11.25–11.26. Wessex Glass Limited produces paperweights for the gifts sector. A leading chain store has approached the company and indicated an interest in placing an order for 3000 paperweights at a special price of £11 each.

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Edinburgh Business School

Accounting

Module 11 / Costs for Decision Making

Fixed costs are £36 000 and total variable costs amount to £108 000 for current production of 12 000 paperweights per period. However, the company has the capacity to manufacture up to 16 000 paperweights in each period. 11.25 What is the relevant cost per paperweight in considering the chain store’s potential order? (a) (c) £3.00. £9.00. (b) £7.20. (d) £9.60. 11.26 If the company accepts the order at the price proposed, what is the effect on profit? (a) (c) Profit increases by £3000. Profit decreases by £4500. (b) Profit decreases by £3000. (d) Profit increases by £6000. 11.27 Management faces a difficult decision in assessing the acceptability of a special order at the price below their usual selling price. Major considerations in their decision are: (i) (ii) the use of absorption costing to price the product; the minimum requirement of generating a contribution by covering variable costs;

(iii) the minimum requirement of generating a gross margin by covering product cost for inventory valuation; (iv) the potential effect on other regular customers. Which of the following is correct? (a) (c) (i) and (ii) only. (ii) only. (b) (i) and (iii) only. (d) (ii) and (iv) only. 11.28 Exact Machining Limited acquired a laser system three years ago for £20 000. The company has the option of either using it for a one-year special contract or selling it at a loss of £4000 against a net book value of £6000. At the end of the contract, the laser system would incur £1500 disposal costs with no resale value. During the contract, consumables for the laser system will amount to £3500. In deciding whether to accept the contract and use the laser system for the year, what is the amount of relevant cost? (a) (c) £3500. £9000. (b) £7000. (d) £11 000.

Accounting

Edinburgh Business School

11/29

Module 11 / Costs for Decision Making

The following information applies to Questions 11.29–11.31. Castle Alarms Limited manufactures three components which are used by its assembly division in producing burglar alarms. The internal costing for each component is K1 £ 2 5 3 10 20 K2 £ 6 9 5 6 26 J5 £ 3 8 4 5 20

Materials Labour Variable overhead Fixed overhead

Management is considering the cessation of the manufacture of these components and the acceptance of quotes from a reliable, local subcontractor who has offered to supply K1 for £10, K2 for £18 and J5 for £18. 11.29 If management accepts the subcontractor’s quote for the supply of component K2, what is the effect on its relevant cost? (a) (c) No change. Increase of £4 per component K2. (b) Decrease of £2 per component K2. (d) Decrease of £8 per component K2. 11.30 If management accepts the subcontractor’s quote for component K1, what is the effect on its relevant cost? (a) (c) No change. Increase of £3 per component K1. (b) Increase of £2 per component K1. (d) Decrease of £10 per component K1. 11.31 If management accepts the subcontractor’s quote for the supply of component J5, what is the effect on its relevant cost? (a) (c) No change. Increase of £3 per component J5. (b) Decrease of £2 per component J5. (d) Increase of £7 per component J5.

Case Study 11.1
Holmes and Grant Limited is a producer of specialist opto-electronic components for motor vehicle manufacturers. Following extensive technical discussions which have generated an agreed specification, the motor vehicle manufacturer has offered a contract for the supply of 2500 components over the next six months at a price of £190 each.
11/30
Edinburgh Business School Accounting

Module 11 / Costs for Decision Making

The following data are available on the specification of the product. (a) Labour specification Each component will need six hours of skilled labour and five hours of semi-skilled labour. Skilled labour is available and is paid £6 per hour. However, an additional employee will have to be recruited at a rate of £5 per hour for the work which would otherwise be carried out by the skilled labour. The current rate of pay for semi-skilled labour is £4 per hour and it will be essential to appoint an additional semi-skilled employee to perform this work. (b) Materials specification There are three elements to the materials specification: 1 Part No. 542A – two per component It is estimated that this special part can be purchased for £30 each, but the supplier will require a minimum order for 5500 parts. The company has no other use for this part. 2 Material K6 – 4 kg per component Material K6 is continuously used by the company in other products. Current stockholdings amount to 4000 kg, purchased at £2.35 per kg. The supplier has indicated that a price rise is imminent to £3.00 per kg. 3 Material J4 – 2 kg per component Current stockholdings amount to 5000 kg, acquired originally for £5.00 per kg. However, material J4 has not been in use for three years and it has been written down to a book value of £2.50 per kg. There is a proposal that, if J4 is subject to some extra processing at a cost of £2.00 per kg, then it could be used to substitute for another material L5 (in current use), which would otherwise have to be purchased for £4.50 per kg. (c) Overheads Holmes and Grant Limited operates with an overhead allocation rate of 250 per cent on direct labour cost. Of 250 per cent total, 100 per cent is regarded as being a variable overhead and the remainder as fixed overhead. The particular requirements of this contract necessitate some extra fixed costs of £5000. Required From the information available, assess whether this contract is acceptable. Pay particular attention to the relevant costs and support your view with a quantitative presentation to management.

Case Study 11.2
Hasting Bros Ltd is a small manufacturing company which produces a range of three special cashmere sweaters under the brand-names of Alpine, Border and Island. For April, the Management Accountant has prepared the following forecast of trading results:
Accounting Edinburgh Business School

11/31

Module 11 / Costs for Decision Making

Sales Variable costs Direct materials Direct labour Works overhead Fixed overhead (apportioned) Net Profit/(Loss)

Alpine £000 1 000 350 50 200 300 900 100

Border £000 960 300 80 180 270 830 130

Island £000 320 100 30 110 100 340 (20)

Total £000 2 280 750 160 490 670 2070 210

The following information is also available: 1 Although there are other materials which are required for the manufacture of the cashmere sweaters, the major material is cashmere, purchased directly from China. Unfortunately, due to delays in shipment from China, April production will be limited by the availability of cashmere supplies. The Purchasing Manager believes that he will be able to increase the current stockholding of 61 000 kg by a delivery of 31 000 kg in mid-April. There are no substitute suppliers in the short term. 2 The Production Manager advises that the different products absorb different quantities of cashmere, as follows: Alpine Border Island 3 Cashmere per unit 8 kg 4 kg 1 kg

The Sales Manager confirms that the current unit prices of the products are: Alpine Border Island £ 100 120 80

4

5

He is convinced that sales of the Border product could be substantially increased beyond the current forecast, although he is unable to quantify the effect. Extra advertising of £80 000 would be required to achieve this increase, together with a 10 per cent reduction in the price of the Alpine product. The current forecast of trading results does not include this view. The Managing Director has reviewed the forecast for April and believes that results can be improved immediately through stopping the manufacture of the Island product. Neither the Sales Manager nor the Production Manager agrees with his view, but they are not certain why they disagree. Fixed overhead is apportioned over the product lines on the basis of an allocation by space occupied on the factory floor.
Edinburgh Business School Accounting

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Module 11 / Costs for Decision Making

The Managing Director is confused by the different proposals being put forward and he calls on your services as the company’s external financial consultant to assist him in drawing up a sensible plan of action. Required 1 Assuming that the full sales forecast for April can be achieved, assess the impact of the Managing Director’s proposal to drop the entire Island range and advise on its desirability. 2 In view of the shortage of cashmere, assist the company by preparing: (a) an optimal production plan for April; (b) a revised forecast of trading results for April. 3 In light of 2 above, assess the viability and effects of the Sales Manager’s plans to increase sales of the Border range through extra advertising expenditure. 4 What other points of commercial interest would you wish to draw to the attention of the Managing Director?

Accounting

Edinburgh Business School

11/33

Module 12

Budgeting
Contents
12.1 12.2 12.3 12.3.1 12.3.2 12.3.3 12.3.4 12.3.5 12.3.6 12.4 12.4.1 12.4.2 12.4.3 12.4.4 12.4.5 Introduction Why Bother with Budgets? Why Budgeting Gets a Bad Name Time Taken Lack of Top Management Commitment A Form of Punishment Responsibilities Are Blurred Moving Goalposts Budgeting Rewards Inefficiency 12/2 12/2 12/4 12/4 12/5 12/5 12/5 12/6 12/7 12/8 12/13 12/13 12/14 12/15 12/16 12/16 12/17 12/17 12/18 12/19 12/20 12/23 12/24 12/32

Budgeting in Action: The Go-Straight Trolley Company Sales Budget for Year Ending 31 March 20x4 (Schedule 1) Production Budget for Year Ending 31 March 20x4 (Schedule 2) Direct Materials Budget for Year Ending 31 March 20x4 (Schedule 3) Direct Labour Budget for Year Ending 31 March 20x4 (Schedule 4) Manufacturing Overhead Budget for Year Ending 31 March 20x4 (Schedule 5) 12.4.6 Selling and Administrative Budget for Year Ending 31 March 20x4 (Schedule 6) 12.4.7 Closing Inventory Budget for Year Ending 31 March 20x4 (Schedule 7) 12.4.8 Cash Budget for Year Ending 31 March 20x4 (Schedule 8) 12.4.9 Budgeted Profit and Loss Account for Year Ending 31 March 20x4 (Schedule 9) 12.4.10 Budgeted Balance Sheet for Year Ending 31 March 20x4 (Schedule 10) 12.5 12.6 Discretionary Expenditure and Zero-Base Budgeting Summary

Review Questions Case Study 12.1

Accounting

Edinburgh Business School

12/1

This predictive step in the management process we call budgeting. We hope to show that they can be translated into the business environment without undue difficulty. large numbers of people. This module will set out the procedures for constructing the budget and Module 13 will consider the mechanism available to management to monitor the actual performance against the plan. and the requirement to identify only relevant costs for decision making. the problems surrounding budgets and how to solve these problems. A word of comfort for those readers who have perhaps glanced at the contents of this module only to see pages comprising tables of numbers: budgeting is the most intuitively straightforward topic covered by this course. traceable or common. In the first seven modules we considered the arrangement of accounting numbers into financial statements for use by people external to the organisation. month or year as we set out to match our income from whatever source against our outlays. The signals that we receive from such an exercise – usually danger signals as we realise that outlays will exceed income – lead to some form of corrective action which is designed to prevent us from becoming bankrupt. It is a discipline practised by each one of us each week. the techniques of preparing a master budget and supporting schedules. But people are not automatons. the problems of allocating common costs to individual jobs and processes. Management must give thought to the future in order to plan to meet its threats and opportunities. without direction or purpose. These personal procedures are automatic. it will be the subject of this module and the next. 12.1 Introduction Throughout this course the focus of attention has been on interpreting accounting numbers which have been generated by the underlying cost-gathering and allocating systems.Module 12 / Budgeting Learning Objectives By the end of this module you should understand: • • • • the role played by budgets in an organisation. programmed to carry out every task in a prescribed manner at a given time and location. ongoing and not complex. Little space has been devoted so far to predicting the accounting numbers which will emerge from the systems in place. all doing a job which they regard as being a useful contribution to the well-being of the business that employs them. and so on).2 Why Bother with Budgets? Business is made up of people. the nature of discretionary expenditure and how zero-base budgeting can assist in allocating resources. how these costs can be combined to yield useful managerial information such as break-even points and contribution margins. Each of us tends to 12/2 Edinburgh Business School Accounting . Without this planning the business will bob about like a cork in a turbulent sea. 12. We have considered how costs behave (variable or fixed.

each of us prefers to work at our own pace. for no two individuals share the same values. raw material purchases and recruitment of workforce personnel will be geared to production requirements. Planning It encourages planning. megalomaniac personality of one senior official is countered by the pragmatic realism of the marketplace. provided it has been set within achievable limits. The budget will identify whether the aspirations of the sales team can be realised by the production department or whether these should be trimmed in order to match the limited output resources of production. But without a coherent plan to work towards. managers have no concept of resource requirements nor can they form a view on the actual performance of the business month by month. The budgeting process should help to achieve this. directed and controlled. Without some idea of where the organisation is heading. The sales plan will dovetail with production. capital investment decisions will be phased to be aligned with new product launches and cash availability. Without this motivation. will provide a personal motivation throughout the period. An investment in replacement production equipment may be vetoed if a new generation of products will require different facilities. performance is likely to be lacklustre and the organisation will lose its competitive edge. Employees’ efforts and motivation need to be harnessed. Co-ordination It co-ordinates activities within the same organisation. Motivation It promotes motivation. Only through a careful analysis of actual performance will managers and their colleagues be Accounting Edinburgh Business School 12/3 . the budget will flush out surplus resources being devoted to marketing and promotional activities in the light of reduced sales targets. usually a year. the budget will permit a recruitment programme for scientists or engineers to be put in place so that the R&D activities can be moved forward to ensure a healthy supply of innovative products. each person in the organisation has a target to shoot at which. Budgeting then has the following attributes. For example. they are like athletes in training without a stopwatch – they think they are performing satisfactorily but have no way of confirming this. Control It provides a control benchmark against which to measure actual performance. By planning. or view the world in the same way or work towards the same goal at the same pace. a proposed twofold increase in the marketing budget for next year may not be sanctioned if sales targets are under pressure due to overseas competition or perceived quality issues. year by year.Module 12 / Budgeting have an unshakeable confidence in our own judgement and sense of propriety. Once the business’s budget is broken down into its constituent parts. individual departmental heads obtain a clear picture of the route ahead for the next period. By further subdivision. the forceful. this rich mixture in personal behaviour is a recipe for disaster. Without a budget managers do not know how well their departments have done. A detailed plan sets out the targets for the entire organisation to aim for.

so that these can be co-ordinated and formulated into a cohesive plan. managers will disregard the early steps in the process and supply unsubstantiated guesses which will require amendment as the year progresses. 12. The budget process should start as late as possible in the current year consistent with getting agreement by the start of the new year. To enable the new financial year to start with the budget having been agreed and communicated to all participants. To allow for second (and third and fourth) thoughts time is needed. Strategic planning is the managerial exercise which attempts to ensure that a business accomplishes a sufficient process of innovation and change by allocating scarce resources (cash. A budget. then. critical management talent and technological know-how) by adapting to environmental opportunities and threats and by co-ordinating activities so as to reflect the business’s strengths and weaknesses. Our discussion on budgeting will assume that the strategic planning exercise has been carried out. A good budget process is an iterative one where first thoughts (on sales or production or staffing levels or new markets) need to be amended by other managers’ first thoughts. must precede the budget exercise. how accurate last year’s budget is proving to be) before being asked for an assessment of next year.3 Why Budgeting Gets a Bad Name Given the positive attributes of budgeting which have so far been described. and worth achieving.Module 12 / Budgeting able to amend the next budget to make the target tough but achievable. is a plan of action. 12/4 Edinburgh Business School Accounting . Planning of a business’s future. 12. There can be no firmer basis for next year than what happens this year. But note that a budget is only a numerical expression of a plan.e. to allow for the circulation of meaningful figures time must be set aside. usually expressed in numbers and amounts. The reasons for this early start are clear to HQ but may not be clear to managers and departmental heads working far removed from the centre. sometimes referred to as strategic planning. if this year is only a matter of a few months old. it is not the plan itself. Strategic planning is the subject of a separate course in the Heriot-Watt Distance Learning MBA programme. why is it that the words ‘budget’ or ‘budgeting’ arouse so many negative and hostile reactions by those in businesses who are meant to derive benefit from the process? We suggest below a few of the reasons which must be overcome if the business is to use budgets as a significant management tool. which sets targets for individuals and for the business over a defined future time-frame.1 Time Taken As a company grows in size so too do the budget problems. corporate headquarters often start the process before the current financial year is six months old. Face-to-face meetings and budget conferences towards the end of the planning period must be arranged for the key players.3. thereby undoing the advantage of an early start. The demoralising feature of the length of time involved is caused by managers not knowing how the current year is panning out (i.

3. Corporate expenditure should be allocated to a budget holder who can be held responsible – even if this is the chairman or chief executive.3. Only if the whole management team shares the ideal of constant improvement in operating performance will the commitment of lower-level staff be ensured. Managers in operating divisions are happy to be held responsible for those costs and revenues over which they have control but feel aggrieved when corporate or centrally incurred costs. These managers will feel as if they ‘own’ part of the budget which will in turn generate a pride in performance and achievement in meeting the targets set. 12.3. it is unfair and demotivating to lower-level budget holders to assess their performance on managing the unmanageable. 12. surplus staff are removed and the remainder required to work in sweat-shop conditions! If this perception of budgets is widespread top management deserves to be removed from office. A less-than-professional approach to their own responsibilities by top management will ultimately lead to a breakdown of the budget process where managers do whatever pleases them. very often resent the effort and self-control required of them as individuals to ‘keep within the budget’ only to see apparent profligate spending on the part of senior management personnel. executive salaries and other expenses such as the corporate fleet of aircraft. Their suspicion is that either this level of spending is not required to carry out the functions of the individuals involved or that the spending continues to be incurred even after the budgeted resources given over to that activity have been consumed.2 Lack of Top Management Commitment Budget holders. all discretionary expenditure such as entertaining and travel are stripped out. disregarding previously agreed targets and limits. Budgets. A budget holder should have responsibility only over controllable costs and controllable revenues.4 Responsibilities Are Blurred Budgets are a means whereby all costs and revenues are planned for over the next accounting period.3 A Form of Punishment Too often managers regard budgets as a form of thumb-screw torture practised by the top echelons of a company. not autocratic diktats from on high. devices for screwing down activities (and individuals) to the absolute minimum amount of resources required to do a mediocre job. By means of open consultation with those employees who will be required to implement the budget – and by consultation we mean listening and acting upon advice rather than a cynical process of seeking advice then ignoring it – top management can guarantee support of those managers who had a hand in the construction of the budget. are seen to be for control purposes only. and centrally located R&D laboratories.Module 12 / Budgeting 12. Budgets are the principal vehicle for planning and control in an organisation. Planning requires consultation and co-ordination with all levels. are allocated to them. that is managers and departmental heads in the operating divisions removed from head office. in this context. Necessary as most of these heads of expenditure are deemed to be. Examples of such costs would be group-wide marketing and promotional activities. over which they have no control whatsoever. Accounting Edinburgh Business School 12/5 .

The supervisor of the tasting department may even argue that the scientists are unreliable as tasters and that if he had authority in keeping with his budget responsibility he would get rid of the scientists and hire his part-timers who were experienced in tasting. the resultant comparisons with actual performance are meaningless. ‘If I can hire tasters at 100 Francs a day only when needed. should the budget be adjusted to reflect extraneous factors – sometimes several times during the year – the initial effort which was invested in the preparation of the original figures is seen to be misplaced. But the company should resist the temptation to term this surplus account an asset. Spare scientific capacity) since the problem has been caused by a top-level decision to retain scarce scientific expertise.3. The ‘Spare scientific capacity’ account balance should be charged to the senior executive (perhaps the chief executive himself) who took the decision to retain the scientific manpower.g. the collapse of a major customer or supplier). Companies can avoid these managerial misgivings in one of two ways. Example A multinational food company based in central Europe found itself with a temporary surplus of nutritional scientists in the R&D labs. ‘I don’t give a hoot for company policy. Consider the following problem. why should I be stuck with 300 Francs each day per scientist whether they’re needed as tasters or not? The R&D lab can take back the difference between this month’s charge and what I would have paid out in normal circumstances. In an effort to retain their services (lest they be poached by a competitor to whom they might reveal recipes and formulae for new products) the company transferred these scientists to the tasting department of a nearby production plant. This would be a highly speculative definition of the word ‘asset’ and is unlikely to find favour with the auditors. Equally. He clearly does not have the authority to discharge or transfer the scientists that he might ordinarily possess over his regular staff.’ This scenario is not untypical of situations where a budgeting system attempts to reflect managerial responsibilities. this surplus was due to a temporary downturn in a specific sector of the market. The accountant who authorised this crosscharge may agree that only 100 Francs per active hour be charged to the tasting department and that the difference be charged to a central account (e.Module 12 / Budgeting Even among peer-level colleagues responsibility for costs can sometimes be blurred. The supervisor of the tasting department welcomed the scientists for the first month until he read from his cost report that his budget for temporary tasters had been exceeded by three times due to the salaries of the R&D scientists. 12/6 Edinburgh Business School Accounting .g. They complain that if their numbers are not updated in the light of the changed circumstances (e.5 Moving Goalposts Another complaint often levelled at the budget process by managers is that circumstances can change early in the year that can invalidate the premises and numbers which were so carefully prepared a few months earlier.’ he protested. an argument which could be mounted around the fact that the decision to keep scarce skills implies a future cost savings in hiring and training new recruits when business turns up. 12.

it may be argued that careful analysis in the first instance should have predicted the extraneous events. particularly in companies which have had a track record of satisfactory profits – irritates many managers who regard it as a technique for rewarding inefficiency. Similarly if the blanket percentage adjustment is downwards. as the current month expires. Budget controller to production director: ‘We want to boost sales by 10 per cent next year.Module 12 / Budgeting 1 2 They can adopt a rigid view towards the original budget.6 Budgeting Rewards Inefficiency Underpinning the accusation that budgeting rewards inefficiency is the notion that costs and revenues are very often budgeted to increase by a constant percentage. Accounting Edinburgh Business School 12/7 . Regardless of environmental disturbance the original numbers remain the benchmark against which subsequent performance will be measured. another month is added on to the budget 12 months away. In this way the budget is always a 12-months’ view of the future and can be amended as soon as the ‘disturbing’ events become known. well-managed departments are penalised accordingly.’ or Chief executive to marketing manager: ‘If we were to increase your budget by 10 per cent next year. And of course the tightly run. the accounting staff first strip out the variance caused by the external event before highlighting those variances which can be viewed as the responsibility of the managers involved. Work out your production budget accordingly and let us know what extra resources you will need. what would you do with the extra resources – people or promotions?’ This approach to budget uplifts – all too common in the non-public sector. the inefficient department is only asked to cope with a reduction in resources which may not even remove all the inefficiencies while the efficient departments must make substantive cuts which will have a negative effect on their ability to deliver a quality service. But in reporting variances between actual and budget. In this way the managers’ performance is assessed on the up-to-date expectation but the company does not lose sight of the original view of the future as represented by the beginning-of-year budget. If this is the view then the budget process needs to be tightened up the following year. After all. They can implement a rolling budget whereby. This will result in even more corporate resources being squandered by these departments. They argue that departments or divisions which have allowed slackness to creep into their operating procedures will be given an additional percentage uplift on this element of slackness. say 10 per cent. 12.3. Both of these methods have the advantage of maintaining the integrity of the budget process by signalling to managers that their investment of effort in preparation will be rewarded by reporting visibility.

It should encourage competition for surplus resources within the organisation while. let us use the case of a successful company which has completed its financial year to 31 March 20x3 and is planning for the next 12 months. to mastermind the whole process.g. At the outset of the budget process the chief executive would issue general guidelines to the principal heads of departments. We will consider the problems caused by discretionary costs in a later section. his view on the potential for growth. a supermarket trolley that can be pushed by the customer without effort and in a straight line. The management of the company is keen to grow slowly without overreaching the company’s resources. The guidelines would contain a commentary by the chief executive on the year just finishing. the production director.4 Budgeting in Action: The Go-Straight Trolley Company Instead of setting out the steps for the preparation of a budget in a sequential and theoretical manner removed from any commercial context. chaired by the chief executive. 12. In a larger organisation a more formal budget committee may be convened. at the same time. Clearly the exercise would commence several months before the year-end but so that we can use figures from the end-of-year balance sheet for the next year’s budget we imagine that what follows transpires over the space of a few days at the end of March 20x3. finance director and personnel director. R&D laboratories. the relevant economic indicators to the business (in 12/8 Edinburgh Business School Accounting . A company making hi-fi cabinets knows how much to expect by way of material costs. the managers have read too many stories of similar sized companies expanding too quickly with borrowed money only to go into liquidation when the market turned against them. particularly in areas where the benchmarks of performance are blurred and ill-defined. reasons for the superior (or inferior) performance against budget. marketing and administration. Such a committee would comprise the key players in the organisation. The special wheels and bearings which permit such easy motion are the result of careful research over the past three years of the company’s trading history. and they are determined to avoid such a fate. labour costs and energy costs but it does not really know how much it should spend on its personnel department. together with their respective chief operating officers. including personnel and legal services. The financial controller would probably be appointed budget officer whose task it would be to drive the exercise forward to final approval by the budget committee on behalf of the board of directors. not recoiling from taking allocation decisions even if these are based on nothing more substantial than intuition and ‘gut-feel’ where the competitive claims are broadly similar in financial terms. Top management must adopt an altogether tougher and more rigorous approach to budget uplifts and cuts than the blanket percentage method. a report on the expected product launches in the forthcoming year. The Go-Straight Trolley Company manufactures and sells a much sought-after product. We call these discretionary costs.Module 12 / Budgeting Driving out inefficiencies from budgets is one of the most difficult managerial tasks. sales director. e. which can be contrasted with engineered costs – which are those costs directly associated with the products or services being made.

Quite the reverse. It would be futile for lowerlevel managers to budget for a much higher rate of expansion than the chief executive considered prudent. rate of construction of supermarkets and shopping centres and family expenditure patterns). Eventually consumer pressure will make them change over to our product but I do not want us to contemplate a drop in either price or quality.3. Accounting Edinburgh Business School 12/9 .Module 12 / Budgeting the case of the Go-Straight Trolley Company these would include indicators of consumer spending. But there is still a reluctance on the part of many supermarket chains to buy the product due to its relatively high cost of £65. But most significant of all would be the chief executive’s view on growth. The Chief Executive’s report may look like this: Memorandum from Chief Executive To all Functional Managers: Budget Preparation for year to 31 March 20x4 As a background to the forthcoming budget process I should like to sketch in a few indicators which I should like you all to keep in mind in the next few weeks as we work towards closure on the budget for year ending 31.3. together with the ongoing good work of our R&D engineers in keeping our product technologically superior. An assessment of expected earnings per share may also be given.04.03 will reveal a healthy profit and a strong balance sheet which is reproduced below: Go-Straight Trolley Company: Balance sheet as at 31 March 20x3 Fixed assets Plant and equipment Less: Accumulated depreciation Current assets Inventories: Metal: 600 metres @ £1 Finished trolleys: 480 @ £55 Debtors Cash Total assets Owner’s equity Share capital Retained earnings Creditors £ 75 000 25 000 £ 50 000 600 26 400 27 000 7 500 17 500 52 000 102 000 30 000 69 500 99 500 2 500 102 000 This performance is a tribute to our carefully targeted growth in specialised sectors of the market. This is some 30 per cent higher than our nearest competitor and although they recognise the advantages of trolleys which move without steering effort they nevertheless are prepared to purchase inferior products. He or she is the best placed person to weigh the potential for growth in output against the company’s ability to support this growth from its own resources or from borrowings. I want us to consider a modest increase in price in order that we retain the image of quality and service which sets us apart from the competition. The final unaudited figures for the year ended 31.

As we had held our prices stable for nine months they were expecting – and I suggest would not have complained at – a price rise. The chief engineer is currently working on a device which will save the customer and check-out operator from having to unload and reload the trolley at the check-out. A modest growth in household spending stores (grocery stores and the like) can be expected.’ Sales District Manager: ‘But not all of them! Qualityrama expressed surprise to me that in their latest order. We must keep ourselves technologically in the forefront. £70 seems reasonable but we may have to be prepared to discount this to some of our larger customers who show reluctance. We can expect some movement in 20x5. trolleys were invoiced at £65.6 per cent rise against Bonecrusher’s 12 per cent rise and Wibbly Wobbly’s 10 per cent rise.’ Sales Director: ‘OK. And the much heralded developments in UK megacentres for shopping have not yet materialised. I’m a little disappointed at the request to raise prices because even at £65 some of our principal customers were complaining. So I want to allocate 3 per cent of sales revenue to R&D. coach stations and rail stations. The continued high interest rates are having an effect on disposable incomes. But I don’t think we should flag this up in the budget because it is not going to be a big amount. Please let the financial controller have your first thoughts on next year’s budget by the end of the week. This would be a 7. therefore we can expect fewer orders from the electrical stores and furnishing outlets. The sales team would be called together by the Sales Director to plan their numbers for the following year: Sales Director: ‘You have all received a copy of the boss’s guidelines.Module 12 / Budgeting I know many of you want to expand production so that we can attack other markets such as airports. I therefore want you to consider only a modest increase in units sold this year. It is far better that we build a secure platform for growth both in terms of market share and financial soundness rather than charge ahead for new sales just to improve our turnover ratios. Now what about the quarter-by-quarter sales profile?’ Sales Executive: ‘I have done some preliminary figures at £70 per trolley which have been based on this year’s profile and I’ve allowed for a 5 12/10 Edinburgh Business School Accounting . £70 per trolley would be the figure which I think could be accepted by our customers. We have commissioned a marketing study on such possibilities which will not be available before September. Those who harbour such feelings should remember that our company’s history is based on a unique design of wheel and bearing. But this design and prototype stage costs money. The economic indicators which I have studied indicate a slowing down in consumer spending next year. Had it not been for our early investment in R&D we would not be working for this company today. One final word: I have detected some resentment among some of you about the high level of spending on R&D engineering. Those of you who grumble at such expense should contemplate the future for this company when our competitors catch up with us and we have nothing new to offer the market. We can then have a meeting to iron out different views and go firm on the numbers by 1 April. The designs are still in their infancy but we anticipate significant demand for this if we can be first-to-market.

say.’ The production team would have a similar meeting: Production Director: ‘Given the chief executive’s view on not wanting to ramp up production next year in advance of sales I suspect we should examine the sales team’s view on units to be sold and cost our production activity on these. to 30 September 20x3 3. So the cost per metre will be £1 on average for next year.’ Production Controller: ‘The cost per hour for our skilled labour will increase marginally but I anticipate this will be offset by increased speed of operations due to the new equipment we purchased last year. From the experience of this year I think we should have finished goods inventory equal to 20 per cent of expected sales next quarter. the variable costs and fixed costs should look like this: Accounting Edinburgh Business School 12/11 . Here are my numbers: Quarter 1. And another thing. But after Christmas we can expect a replacement programme to be embarked on and for this to be carried forward. I should like to argue for having raw material inventories on hand equivalent to 10 per cent of next quarter’s requirement. All in all.’ Production Controller: ‘A word of caution here. into the first quarter of next year. to 30 June 20x3 2.’ Advertising Manager: ‘I really think we want to step up the spend on advertising this year.’ Purchasing Officer: ‘The price of wire metal will go up midway through the year but I’ve negotiated a 12-month purchasing bulk discount with our principal suppliers. I agree that the current campaign is having an effect although we were taking a risk in portraying a housewife being pinned against a freezer by one of our competitor’s trolleys. I should like to argue for similar funding to R&D. a 5 per cent spend linked to sales revenue in addition to the £3000 per quarter fixed salaries. As our customers are stocking up for Christmas their cash flow prevents any significant outlay on such items as trolleys. the sales people are always wanting rush orders put through because they have messed up their forecasting. Our suppliers are still fairly erratic despite our best efforts to signal demand to them in plenty of time. to 31 March 20x4 5. to 31 December 20x3 4.Module 12 / Budgeting per cent increase in sales units due to the impact of our new advertising material. to 30 June 20x4 Estimated sales units 2 500 2 800 1 700 3 000 3 000 ‘The anticipated drop in units in Quarter 3 follows the trend in previous years. despite these apparently well thought out sales figures. together with new business.

I suggest that raw material purchases should be paid for 60 per cent in the quarter of purchase and 40 per cent in the next quarter. Without sales the company’s other functions are superfluous. Not only is this an exercise in budgeting but it allows readers to test themselves on the fundamentals of financial accounting again. All other selling.5 hours @ £20 per hour Variable overhead (absorbed by direct labour hours) 1. so we should not predict any for next year. will be paid for. including administrative salaries of £2000.] The fulcrum on which the entire budget is balanced is the sales budget.5 hours @ £10 per hour Variable cost per trolley Fixed manufacturing overhead (includes depreciation on plant and equipment Consumables per trolley £ 10 30 15 55 £2 400 per quarter £1 500 per quarter) £2 000 per quarter The finance and administration team would also discuss the forthcoming year: Financial Controller: ‘We must attempt to tighten up on debtors’ collection next year. We should plan for 70 per cent of sales being collected in the quarter of sales with the balance being collected in the next quarter. tracing the numbers back into the data given above and following the calculations given below each schedule. 12/12 Edinburgh Business School Accounting .’ Financial Director: ‘We should be careful then about not paying our creditors too quickly.Module 12 / Budgeting Direct material 10 metres of wire metal @ £1 per metre Direct labour 1.’ These reports and supporting schedules would be submitted to the financial controller whose task it would be to draw up the company’s master budget for the year to 31 March 20x4. advertising and administration costs. This master budget would comprise the build-up schedules from production and sales and culminate in the budgeted cash flow statement for the year together with the budgeted profit and loss account and balance sheet. as usual. It is important not only to track the profile of sales but to convert these sales which would appear in the financial accounts into cash receipts. in the quarter they are incurred. Yet again we had no bad debts this year due to the quality customers our sales team is targeting. [Readers should carefully follow each of the schedules set out in the next few pages.

will be collected in Quarter 1 and the balance. For Quarter 1 this amounts to 20 per cent × Q2’s 2800 units = 560. 70 per cent of this amount. will be collected in Quarter 1 together with the £122 500 from Quarter 1’s sales. £122 500. Quarter 4’s sales will be collected: £147 000 in Quarter 4 and £63 000 next year which will be the debtors figure for the budgeted balance sheet at 31 March 20x4. 12.2 Production Budget for Year Ending 31 March 20x4 (Schedule 2) Q1 2 500 560 3 060 480 2 580 Q2 2 800 340 3 140 560 2 580 Q3 1 700 600 2 300 340 1 960 Q4 3 000 600 3 600 600 3 000 Total 10 000 600 10 600 480 10 120 Sales units Add: Planned units in closing inventory Less: Units in opening inventory Units required The sales targets of Schedule 1 would then be converted into production numbers which would take account of the production controller’s observation that inventory of finished units should be carried to meet the uncertainties of demand. £7500.Module 12 / Budgeting 12. next quarter. But the cash flow impact of these sales must be assessed. Readers will remember from their study of the first seven modules in this text that accountants are prepared to record sales even though the cash has not been received provided all effort has been completed and that there is no evidence to suggest that customers will default. Take Quarter 1’s sales of £175 000.4. for cash is more important to a business day by day than is a profit figure. Therefore in the budgeted profit and loss account for the year to 31 March 20x4 the turnover will be given as £700 000. We learn from the Accounting Edinburgh Business School 12/13 . By the same token the opening debtors figure in the balance sheet at 31 March 20x3. But the opening balance of inventory of finished units would reduce this requirement.1 Sales Budget for Year Ending 31 March 20x4 (Schedule 1) Q1 2 500 × £70 £175 000 Q2 2 800 × £70 £196 000 Q3 1 700 × £70 £119 000 Q4 3 000 × £70 £210 000 Total 10 000 × £70 £700 000 (a) Turnover in units Price Recorded sales (b) Cash inflow from sales Last quarter’s collection This quarter’s collection £7 500 122 500 £130 000 £52 500 137 200 £189 700 £58 800 83 300 £142 100 £35 700 147 000 £182 700 £154 500 490 000 £644 500 The upper schedule sets out the sales turnover figures as they would appear in the financial accounts of the Go-Straight Trolley Company. therefore in Q1 3060 units should be manufactured. £52 500. To the planned sales units is added the requirement to hold 20 per cent of next quarter’s sales.4.

And again Q1’s opening inventory figure of 600 metres is taken from the closing balance sheet as at 31 March 20x3. The production unit’s budget must now be converted into a cost budget. being based on the production schedule just calculated.Module 12 / Budgeting opening balance sheet that 480 units were in inventory at the beginning of Q1.3 Direct Materials Budget for Year Ending 31 March 20x4 (Schedule 3) (a) Consumption of direct material Q1 Units required 2 580 Direct materials metres of metal × 10 Metres of metal required 25 800 Cost per metre £1 Total cost of metal consumed £25 800 Q2 2 580 × 10 25 800 £1 £25 800 Q3 1 960 × 10 19 600 £1 £19 600 Q4 3 000 × 10 30 000 £1 £30 000 Total 10 120 × 10 101 200 £1 £101 200 This schedule is self-explanatory. Note that we have assumed that the desired closing direct material inventory for Q4 is planned to be the same as at the end of Q3. and the payment to creditors profile. direct labour and manufacturing overhead. the purchases required to meet the production schedule. 12/14 Edinburgh Business School Accounting . This profile would allow for a rise in price to be recorded midway through the budget year if necessary. the consumption of metal. But again the production controller’s wishes for inventory must be built in to the figures. therefore only 2580 units need be made in Q1.4. 12. comprising direct materials. There are three components to the direct materials budget. this time 10 per cent of the next quarter’s production must be added to this quarter’s requirements but the opening inventory balance reduces the metres of metal which need to be purchased. (b) Purchases budget Direct materials required (in metres) Add: Planned closing inventory Less: Planned opening inventory Metres required Cost per metre Total cost of metal purchased 25 800 2 580 28 380 600 27 780 × £1 £27 780 25 800 1 960 27 760 2 580 25 180 × £1 £25 180 19 600 3 000 22 600 1 960 20 640 × £1 £20 640 30 000 3 000 33 000 3 000 30 000 × £1 £30 000 101 200 3 000 104 200 600 103 600 × £1 £103 600 The starting point for the purchases budget is the number of metres of metal required to manufacture the units to be made (from Schedule 2).

for example. Therefore creditors at the end of the year will be £12 000.4 Direct Labour Budget for Year Ending 31 March 20x4 (Schedule 4) Q1 2 580 × 1. Accounting Edinburgh Business School 12/15 . The direct labour budget presents no difficulties because labour cannot be ‘inventoried’.Module 12 / Budgeting (c) Cash outflow for purchases Creditors end 20x3 Purchases: Q1 £ 2 500 16 668 Q2 £11 112 15 108 Q3 Q4 Total £ 2 500 27 780 25 180 20 640 18 000 £94 100 Q1 Q2 Q3 Q4 £10 072 12 384 £22 456 £19 168 £26 220 £ 8 256 18 000 £26 256 Readers will notice that the total column in this schedule bears a resemblance to the quarter-by-quarter profile in the previous one.5 3 870 × £20 £77 400 Q2 2 580 × 1. the company will pay outstanding creditors from the end of last year. and (b) the depreciation element of the fixed manufacturing overhead is deducted from the total manufacturing overhead to give a final figure which represents the quarterly outflow of cash for overheads. The manufacturing overhead budget is equally straightforward except that (a) variable and fixed overhead are kept separate. Q4’s purchases of £30 000 will be paid for: £18 000 in Q4 and £12 000 in next year’s Q1.4. of labour hours Cost per hour Total cost of direct labour The actual cash outlays for labour will match exactly the calculations of this schedule. In Q1. £2500 (see closing balance sheet). Schedule 4 is based on the production units calculated in Schedule 2.5 3 870 × £20 £77 400 Q3 1 960 × 1.5 2 940 × £20 £58 800 Q4 3 000 × 1. 12.5 15 180 × £20 £303 600 Units required Hours per unit Total no. will be paid for in Q2. £11 112.5 4 500 × £20 £90 000 Total 10 120 × 1. The cash outflow schedule splits up the purchase budget into the quarters which match the cash payments. and 60 per cent of £27 780 purchases made in Q1. The balance of Q1’s purchases.

50 £38 700 2 400 £41 100 1 500 £39 600 Q2 £77 400 £0.50 £29 400 2 400 £31 800 1 500 £30 300 Q4 £90 000 £0. both raw materials and finished goods.50 £38 700 2 400 £41 100 1 500 £39 600 Q3 £58 800 £0. The fixed elements of overhead are all traceable in the text of the case and the entire budget is paid quarter by quarter as it is incurred. variable Advertising 5% R&D 3% Fixed Salaries Consumables Advertising Total selling and admin.50 £151 800 9 600 £161 400 6 000 £155 400 Total cost of direct labour Absorption rate for variable overhead Variable overhead Fixed overhead Total manufacturing overhead Less: Depreciation (non-cash) Management would expect a detailed analysis of variable and fixed overhead and would not accept the formula of 50 per cent of direct labour cost (or £10 per direct labour hour) without such an analysis.5 Manufacturing Overhead Budget for Year Ending 31 March 20x4 (Schedule 5) Q1 £77 400 £0. 12.4. The variable component of this budget for Advertising and R&D is based on the quarterly sales revenue figure as entered in the financial accounts (not as received in the form of cash). 12/16 Edinburgh Business School Accounting .50 £45 000 2 400 £47 400 1 500 £45 900 Total £303 600 £0.4. Now that all the detailed schedules are compiled the financial controller would pull the various components together in the form of a cash budget and budgeted profit and loss account and balance sheet. But first he would monitor the quarterly closing balances for inventory.6 Selling and Administrative Budget for Year Ending 31 March 20x4 (Schedule 6) Q1 £175 000 £8 750 5 250 2 000 2 000 3 000 £21 000 Q2 £196 000 £9 800 5 880 2 000 2 000 3 000 £22 680 Q3 £119 000 £5 950 3 570 2 000 2 000 3 000 £16 520 Q4 £210 000 £10 500 6 300 2 000 2 000 3 000 £23 800 Total £700 000 £35 000 21 000 8 000 8 000 12 000 £84 000 Total sales Selling and admin.Module 12 / Budgeting 12.

£55 each. The closing cash balance of £17 500 in the balance sheet as at 31 March 20x3 forms the opening figure in the above schedule. 12.7 Closing Inventory Budget for Year Ending 31 March 20x4 (Schedule 7) Q1 Q2 £1 960 340 × £55 £18 700 Q3 £3 000 600 × £55 £33 000 Q4 £3 000 600 × £55 £33 000 Total £3 000 600 × £55 £33 000 Direct materials Units × £1 per unit Finished goods Units × variable cost £2 580 560 × £55 £30 800 Readers will remember that businesses carry inventory in their balance sheets ‘at the lower of cost or market value’. Notice also that the finished goods inventory valuation is.8 Cash Budget for Year Ending 31 March 20x4 (Schedule 8) Q1 £17 500 130 000 £147 500 £19 168 77 400 39 600 21 000 £157 168 £(9 668) Q2 £(9 668) 189 700 £180 032 £26 220 77 400 39 600 22 680 £165 900 £14 132 Q3 £14 132 142 100 £156 232 £22 456 58 800 30 300 16 520 £128 076 £28 156 Q4 £28 156 182 700 £210 856 £26 256 90 000 45 900 23 800 £185 956 £24 900 Total £17 500 644 500 £662 000 £94 100 303 600 155 400 84 000 £637 100 £24 900 Opening balance Cash from sales Cash inflows Direct materials Direct labour Manufacturing overhead Selling and administrative Closing balance The cash budget comprises those elements from the previous schedules which have an impact on the inflows and outflows of cash over the next 12 months. that is the variable cost of manufacture. Should the position reverse the company would be required to write off the difference immediately to the profit and loss account. To this sum is added the cash received from sales in Q1 (see Schedule 1(b)). If the company were to switch to full absorption costing. The closing balance in Q4.Module 12 / Budgeting 12. manufacturing overhead (Schedule 5) and selling and general overhead (Schedule 6). a deficit of £9668. Accounting Edinburgh Business School 12/17 . forms the cash balance in the budgeted balance sheet as at 31 March 20x4. a portion of the fixed manufacturing overhead would be included in inventory but the selling and administrative budget would continue to be written off in full in the profit and loss account. Outlays of cash comprise direct materials (Schedule 3(c)). The closing cash balance in Quarter 1. direct labour (Schedule 4). £24 900.4.4. and so on. The costs inserted in Schedule 7 imply that the market values for both metal and finished trolleys are greater than the cost. forms the opening balance in Quarter 2.

4. Could the company contemplate a better strategic use of this amount? Investment in more R&D? Purchase of more capacity? Acquisition of another business – a competitor or supplier? This kind of analysis would only be undertaken when it became obvious that a cash mountain was building up.9 Budgeted Profit and Loss Account for Year Ending 31 March 20x4 (Schedule 9) Q1 2 500 £ 175 000 (137 500) (14 000) 23 500 (2 400) (7 000) 14 100 Q2 2 800 £ 196 000 (154 000) (15 680) 26 320 (2 400) (7 000) 16 920 Q3 1 700 £ 119 000 (93 500) (9 520) 15 980 (2 400) (7 000) 6 580 Q4 3 000 £ 210 000 (165 000) (16 800) 28 200 (2 400) (7 000) 18 800 Total 10 000 £ 700 000 (550 000) (56 000) 94 000 (9 600) (28 000) 56 400 Sales units Sales revenue Variable cost of sales manufacturing Selling and administrative Contribution margin Fixed costs of manufacturing Selling and administrative Profit before tax 12/18 Edinburgh Business School Accounting . and it provides a cushion against which the company can fall in times of hardship. Apart from the deficit balance in Quarter 1 caused by a low debtors figure to collect from the end of 20x3 (see Schedule 1(b)) which would provoke the financial director to arrange bridging facilities with the company’s bankers. but it is not productive in the real meaning of the word. Cash is not an asset that works well for a business. The layout of these statements should now be familiar to our readers: 12. the build-up of cash needs to be addressed. The construction of the budgeted profit and loss account and balance sheet follows the principles enunciated in Modules 1 to 6. True it earns interest.Module 12 / Budgeting The managerial significance of Schedule 8 should not be ignored.

to this is added the profit figure from the profit and loss account quarter by quarter.4. is the figure paid out in the subsequent quarter. would form the basis of a review by the chief executive and a meeting with his functional managers. This then is the creditors figure at the end of Q1. The paragraphs below Schedule 1 explain where the closing debtors figure in Q4 comes from. Therefore the figure of £52 500 collected in cash in Q2 serves as the debtors figure for Q1. Creditors. the sums of money collected in the next quarter are the debtors for the current quarter. Fixed costs come from two schedules: manufacturing from Schedule 5 (£2400 per quarter includes £1500 depreciation) and selling and administration from Schedule 6. Debtors are drawn from Schedule 1(b).10 Budgeted Balance Sheet for Year Ending 31 March 20x4 (Schedule 10) Q1 75 000 (26 500) 2 580 30 800 52 500 (9 668) 124 712 30 000 83 600 11 112 124 712 Q2 75 000 (28 000) 1 960 18 700 58 800 14 132 140 592 30 000 100 520 10 072 140 592 Q3 75 000 (29 500) 3 000 33 000 35 700 28 156 145 356 30 000 107 100 8 256 145 356 Q4 75 000 (31 000) 3 000 33 000 63 000 24 900 167 900 30 000 125 900 12 000 167 900 Total 75 000 (31 000) 3 000 33 000 63 000 24 900 167 900 30 000 125 900 12 000 167 900 Plant and equipment Accumulated depreciation Inventory: Raw materials Finished goods Debtors Cash Total assets Ordinary shares Retained earnings Creditors Total equity and liabilities The sales revenue line in the profit and loss account is taken from Schedule 1(a). particularly Schedules 8. hence from Schedule 3(c) we see that £11 112 paid in Q2 refers to purchases made in Q1. agreement Accounting Edinburgh Business School 12/19 . like debtors. 3 4 The schedules. Retained earnings are old profits not distributed. The opening figure for 20x3/x4 is £69 500. Contribution margin is the result of subtracting all variable costs from sales revenue. Adjustments may be called for and the numbers reworked (a computer-based spreadsheet makes such amendments an easy process). Variable selling and administrative costs are derived from Schedule 6 (the addition of variable advertising costs and variable R&D costs).Module 12 / Budgeting 12. 9 and 10. Variable cost of sales is the product of the quarterly sales units and £55 per unit. The items in the balance sheet need little explanation: 1 2 Accumulated depreciation’s opening balance of £25 000 is added to at the rate of £1500 per quarter. For the purposes of illustration we have ignored the impact of taxation. Eventually. In reality tax would be calculated for 20x3/x4 on the final budgeted profit of £56 400 but not paid until the next year.

Seldom does a title of a topic in accounting display its contents so well as the term zero-base budgeting (ZBB).Module 12 / Budgeting would be reached and the budget distributed to the various departmental heads and other officials. at least in the short term. although it is not easy for non-scientists to penetrate the technical description of proposed work. aspects of administration. on the other hand. R&D. For instead of adopting the normal 12/20 Edinburgh Business School Accounting . marketing. It would therefore be wrong to measure output in terms only of successful experiments. What is the output of an R&D lab. Set against these problems we must place the perception held by many budget holders of engineered costs that much slack exists in discretionary budgets. 12. for the research scientist such an outcome is as valid as one which leads to the development of a new drug. machine maintenance and legal services are all examples of costs the level of which each year depends largely on managerial discretion. in a pharmaceutical company’s R&D lab a successful piece of research may culminate in the conclusion that a certain mixture of compounds would be harmful or ineffective. Likewise in a legal department. Engineered costs are those costs directly associated with the unit of output. the temptation to measure output in terms of lawsuits defended or activated must be resisted when one considers that perhaps the most successful legal work is done behind the scenes and is that which prevents any public action being taken. if care is not taken. Research and development tends to be subject to this breakdown in communication. Careful toplevel scrutiny of the budget is essential to overcome this problem. pockets of scientific expertise can beaver away in areas of investigative work which mirror individual interest rather than the strategic thrust of the company. that the R&D managers or directors of legal services hide behind the mystique of their disciplines to grab more and more scarce corporate resources which are squandered on needless work and generous staffing levels. Why are discretionary costs so difficult to budget for and to manage? The principal difficulty surrounds the measurement of output. The third major issue concerning discretionary expenditure is that it is not necessarily easy to control on an annual basis. One technique designed to counter this fear is zero-base budgeting. Another problem associated with some discretionary areas is that the budget holders are not sure of the corporate objectives and are therefore unsure of where their efforts should be focused. For instance. costs without which the unit of output would cease to exist. This will be the subject of Module 13. or of a legal department in a company? Sometimes the outputs of these activities are best measured negatively. Quarter-by-quarter actual performance would be measured against budget and reasons for variances sought. A year is a short time in science. are those that do not need to be incurred. for instance. costs which have been engineered into the unit. Some R&D programmes run over several years and it is not possible to terminate these without major disruption and upset to the morale of the staff involved. Discretionary costs.5 Discretionary Expenditure and Zero-Base Budgeting In an earlier section of this module we drew a distinction between engineered costs and discretionary costs.

with engineered costs. however. These packages of discrete activities are costed and. Top management must take a view on whether another fully qualified recruit to legal services. were the resources to be made available. Accounting Edinburgh Business School 12/21 . Example Consider the following packages which have been presented to the top management of an electronics company whose discretionary budget has been set at £250 000. New requests for increased spending must be given a priority against existing commitments. management invites certain activities to bid for their resources as if they were starting from scratch (or from a zero base). ZBB also requires corporate functions to identify minimum levels of expenditure below which their activities cannot really operate. when placed alongside packages from other discretionary activities. starting with the most fundamental activity and building up to the activity which. These decisions are extremely difficult but the secret of ZBB is that the decisions are made by top management and not by budget holders whose vested interests are inextricably bound up with their budget proposals. ZBB involves the analysis of an activity such as R&D or legal services or machine maintenance into packages of work which can be separated from each other. to handle the growing problem of intellectual property rights. it would be beneficial to undertake.Module 12 / Budgeting incremental approach to annual budgeting (‘Let’s aim for a 3 per cent reduction in costs across the board’). the sole criterion of level of spend is the production output required. ranked in order of top management priority. This tool can only be adopted in areas of discretionary expenditure where management must decide the level of expenditure that is appropriate for the business at the current time. is more desirable for the company in its current position than another maintenance engineer the addition of whom to the staff of the maintenance department would provide 24-hour cover and thereby prevent costly breakdown of machines on the night shift.

A likely scenario may be as follows: 1 Each Package 1 would be accepted as representing the absolute minimum activity required to keep alive R&D and legal services. that management could decide to close down either function and allow the other function to go ahead with all packages. Two further lawyers to handle all contracts and property transactions. (It is possible. altering the designs as required. £80 000 Package 2 of 3. On the basis that the budget limit is indeed the maximum amount. amounts used so far – £150 000. however. Legal Package 2 provides a minimum level of in-house legal service which can be built on in future years. Two electronic engineers to design and build own prototypes. Equally it could be argued that a buoyant R&D activity represents the lifeblood of the company in the future. Development engineer to test bought-in components and prototypes. Package 2 of 4. Two software scientists to design and write customised operating systems. Package 1 of 3. £30 000 Package 1 of 4. possible packages worth £90 000 will have to be dropped.Module 12 / Budgeting (Read the table below from the bottom to the top): Research and development Legal services Package 4 of 4. One lawyer to handle legal aspects surrounding intellectual property rights. Can a company afford to turn its back on technology at the expense of legal services? But can the company be assured of receiving value for money for the £70 000 to be spent on the 2 3 12/22 Edinburgh Business School Accounting . to work with electronic engineers in design of new products. £180 000 £10 000 £160 000 Management of this electronics company is faced with packages totalling £340 000 to be fitted into a budget of £250 000. there is little point in keeping an in-house legal service to negotiate contracts if there are no new products to sell and no contracts to negotiate! Both Level 2 packages could be accepted. The next layer of ranking becomes more difficult and depends on a top-level strategic view of the future of the company. Further computer facilities. £40 000 Package 3 of 3. £70 000 Database purchase in support. copyrights and trademarks. External consultant still to handle £70 000 complex contracts. It also represents less than half the commitment of R&D Package 2.) Amount used £50 000. Fully qualified lawyer to handle routine contractual problems. Partially qualified assistant to liaise with external consultant lawyers who £40 000 undertake all legal work. Package 3 of 4.

thereby releasing funds for use in more deserving parts of the business. 2 12. can management be certain that no further support costs will emerge before the next budget round? A likely outcome could be agreement on R&D Level 3 (amount used so far. Too often senior executives who have generalist backgrounds fail to wrestle with expert fields such as R&D and law. receive the full backing of top management. Zero-base budgeting is a device which can be used in discretionary areas of a business which helps to remove some of the managerial subjectivity and self-interest. Then the ranking process could adjudicate on these top-up packages. helps planning. The sheer effort involved in implementing ZBB in some companies has been a barrier to extending the technique to further areas. is the involvement of top management in the allocation of discretionary funds. Good budgeting procedures shorten the lead time between starting the budgeting exercise and the beginning of the budget period. 1 The process of cutting up relatively homogeneous activities into discrete. ZBB however suffers from two significant drawbacks.6 Summary Regardless of commercial environment. inevitably. £220 000) and the two departments invited to resubmit packages totalling £30 000 each. Top management may need to seek external expert opinion on the definitions if it is in doubt about the requests being made. The vested interest locked up in the process must leave some questions hanging over the packages and the order in which they are presented. The definition of packages is left. and engender a feeling of ‘ownership’ of the budget numbers among the managers who helped to construct them. The temptation with ZBB is to define the packages in such a way that the status quo is maintained. as seen from the above example. budgets tend to be ‘nodded through’ without any scrutiny. Engineered budgets are easier to construct than discretionary budgets because the outputs from discretionary activities such as marketing and R&D are not easily measurable. budgeting co-ordinates diverse activities.Module 12 / Budgeting proposed software initiative? If a positive decision is made for the R&D Level 3 package. The principal advantage of ZBB. separately costed packages is fraught with problems and involves considerable effort (and therefore cost) on the part of the staff of the functions involved. to the management of the function under review. This can be achieved by submitting a fulsome Level 1 package. promotes employee motivation and provides a benchmark against which to measure actual performance. Accounting Edinburgh Business School 12/23 . ZBB forces top management to become involved and to relate the budget expectations of experts with the strategic direction of the business. in these circumstances.

True or false? 12. (i).2 The budgeting process is vital to a company because it is a financial statement which focuses on a comparison of historical costs. (b) (i). (b) A cash flow forecast. (b) (ii) and (iii) only.1 The task of budget preparation produces clear benefits to companies.5 Unfortunately. These opinions are misguided.4 If middle management has confidence in the achievability of the budget. (iii) an explanation of the details in last year’s profit and loss account. Which of the following is correct? (a) (c) (i) and (ii) only. then it is wholly irrelevant if senior management chooses to ignore the entire budget process. 12/24 Edinburgh Business School Accounting . True or false? 12. compatible with obtaining full agreement before the beginning of the next year. (iv) improved co-ordination of activities between departments. any existing inefficiencies in budgets are driven out when resources are reduced. 12. These include: (i) (ii) increasing the motivation of individual heads of departments. (ii) and (iv) only. (iii) the budget process begins as late as possible in the current year. 12. Which of the following is correct? (a) (c) (i) and (ii) only. but have to be tackled by taking steps to ensure that: (i) (ii) managers in operating divisions are held responsible for costs and revenues over which they have no control. (d) (iii) and (iv) only. (iv) budgets restrict individuals and activities to the absolute minimum level of resources needed to perform an average job. (d) (ii). (d) A numerical expression of a plan of action. (iii) and (iv) only. (ii) and (iii) only. (iii) and (iv) only. the provision of a benchmark against which to measure actual performance. A review of management performance.Module 12 / Budgeting Review Questions 12.3 Which of the following describes a budget? (a) (c) A strategic plan. (ii). many members of management teams hold adverse views on the budgeting process.

(b) (i) and (iii) only. (ii) and (iii) only.13. 12. 12. The negative effects of such changes can be sensibly minimised if management: (i) (ii) introduces a rolling budget system.11–12. (d) Receipt of cash from debtors. but does not affect cash flows? (a) (c) Revaluation of property.7 If a company operates in a market with unlimited demand for its product. authorises a general increase in budgeted costs without demanding an equivalent rise in budgeted sales. (iii) eliminates the financial effect of such external changes to focus on variances arising where managers are clearly accountable. The following information applies to Questions 12. (iv) permits surplus personnel to be transferred to other departments. had a good experience in debt collection. Depreciation of plant. (d) Purchases budget. which of the following is the first budget to be prepared? (a) (c) Production budget.8 Which of the following is a discretionary budget? (a) (c) Direct labour cost budget. in the past.9 Which of the following is an engineered cost budget? (a) (c) Direct labour cost budget. (b) Cash budget. (b) Cash budget.6 One of the problems of the budgeting process is that external circumstances can change significantly at an early stage in the year. (d) Legal department cost budget. Customers have paid as follows: Accounting Edinburgh Business School 12/25 . Overdraft interest budget. (d) Advertising and promotions budget. 12. with the result that the original budget figures become meaningless. The company has.Module 12 / Budgeting 12. (b) Research and development cost budget. Exhibitions cost budget.10 Which of the following accounting adjustments is included in a profit and loss account. 12. Granby Drilling Services Limited provides goods and services to oil companies operating in the North Sea. Which of the following is correct? (a) (c) (i) and (ii) only. (d) (iii) and (iv) only. (b) Leasing charge for equipment. Sales budget.

15. (b) £43 200. 12. £58 200. (d) £66 200.14–12.11 What is the budgeted cash inflow in April? (a) (c) £39 600.Module 12 / Budgeting Month 1 Month 2 Month 3 50% (received in the month of invoicing) 30% 20% In preparing its budget for the year to 31 March 20x1 the company has taken the view that high interest rates will result in some slippage in customers’ payment performance on sales in the new year. £47 000. (b) £45 600. (d) £68 000. the Plant Manager for Product R2 has been asked to take into account the following data: Product R2 (units) 1 000 2 000 10 000 Raw materials (kg) 30 000 10 000 – Opening inventory Planned closing inventory Budgeted sales 12/26 Edinburgh Business School Accounting . 12. (b) £53 200. Actual January February March April May June £65 000 £75 000 £50 000 £64 000 £52 000 £72 000 Budgeted 12. £56 200. Forecast cash collection of sales is: Month 1 Month 2 Month 3 40% 35% 25% Debtors at 1 April 20x0 are £40 000. In planning the next quarter’s production. (d) £55 600.13 What is the amount of budgeted debtors at 30 June? (a) (c) £36 000. The following information applies to Questions 12.12 What is the budgeted cash inflow in May? (a) (c) £30 800.

16 Product Omega requires four machine-hours to manufacture. (d) 13 000.Module 12 / Budgeting Each unit of Product R2 requires 5 kg of raw material. making use of an agreed maximum overdraft facility of £1000 if necessary. The company’s policy is to take as much settlement discount as possible as a first priority. The remaining suppliers are paid on 30 days’ terms (the month after purchase). 12. (b) 11 000. Early payments to suppliers result in a 5 per cent settlement discount. (b) 310 800.19. 50 000 kg. (b) 35 000 kg.17–12. although only 30 per cent of purchases qualify for this. 311 580.14 How many units of Product R2 have to be manufactured in the next quarter? (a) (c) 10 000. Ben Palmer Golf Accessories Limited is organising its schedule of payments to its materials suppliers. with any shortfall becoming the first priority for the succeeding month. and then to accommodate suppliers’ payment terms as far as possible within the agreed overdraft limit.15 How many kg of raw material have to be purchased to meet the manufacturing target for Product R2? (a) (c) 30 000 kg. Next year’s budgets are as follows: Units 6 000 72 600 7 400 Opening inventory of finished goods Budgeted sales of Omega Planned closing inventory of finished good What is the machine-hours budget for next year? (a) (c) 296 000. 12. (d) 65 000 kg. 12 000. The following information applies to Questions 12. There is a stringent quality check on completed products which results in a 5 per cent rejection rate. (d) 320 000. Relevant budgeted data are as follows: January £10 000 £7 600 February £18 000 £2 300 March £8 600 £9 200 Purchases Cash inflows from debtors Accounting Edinburgh Business School 12/27 . 12.

17 What is the bank position at 31 January? (a) (c) Overdraft balance = £650.18 What are budgeted payments to suppliers in March? (a) (c) £9 200. 12/28 Edinburgh Business School Accounting . £15 051. 12. Planned opening inventory £ 4 300 16 600 Planned closing inventory £ 6 100 10 200 £460 000 £60 000 £70 000 £6 per direct labour hour £60 000 £50 000 Raw materials Finished goods Sales Direct labour cost (15 000 hours) Raw materials purchases Manufacturing overhead absorption rate Selling and distribution overhead Administrative overhead 12. (d) £235 000. (b) Overdraft balance = £800. (b) £218 200.Module 12 / Budgeting There is an opening balance of £2200 in Cash at bank. (d) £15 180.19 What are budgeted payments to suppliers in February? (a) (c) £9 250.21 What is the budgeted manufacturing cost of sales for the first quarter? (a) (c) £216 400. £224 600. £12 130. Cash at bank = £6800. The management accountant of Grantown Woollens Limited has produced the following budgeted data for the first quarter of the new financial year. (b) £10 250. True or false? The following information applies to Questions 12. (d) £12 400.20 If an organisation does not manufacture or sell products or services.21–12. (b) £10 250. 12. 12. (d) Cash at bank = £6950. 12. then it is not possible to operate a budgeting process.22.

23–12. (d) £215 400.29.25–12.24 What was the total manufacturing overhead absorption rate per direct labour hour? (a) (c) £10. (d) £52 400. 12. £12.23 What were the total budgeted fixed manufacturing overheads for the six-month period? (a) (c) £40 000.24. the following data have been accumulated: Variable manufacturing overheads Fixed manufacturing overheads Direct labour costs (4000 hours) Under-absorption of fixed manufacturing overhead £ 9 200 43 200 24 000 3 200 Actual overhead expenditure equalled budgeted overheads. The following information applies to Questions 12. £43 200. (b) £42 000. (d) £12. but there was a shortfall of 200 in direct labour hours worked. (b) £10.Module 12 / Budgeting 12. the summary balance sheet of Peterhead Soups Limited was as follows: Plant and equipment Less: Aggregate depreciation Inventory Debtors Share capital Reserves £ 140 000 60 000 80 000 25 000 75 000 180 000 75 000 49 250 Accounting Edinburgh Business School 12/29 . Over the past six months. 12. £133 600. The following information applies to Questions 12. At 1 July.80.22 What is the budgeted profit for the first quarter? (a) (c) £125 400.30. (b) £131 800.00. Tayside Crafts Limited manufactures a wide range of products for the tourism industry. allocating manufacturing overhead on a direct labour hour basis. The company has adopted a full absorption costing approach.00.

12. 12/30 Edinburgh Business School Accounting .26 What is the total cash inflow for August? (a) (c) £17 500. (d) Cash at bank = £87 000. Cash at bank = £52 250. the following budgets have been prepared: July £ 30 000 45 000 20 000 August £ 50 000 35 000 22 500 September £ 20 000 70 000 25 000 Purchases Sales Expenses Inventory levels are not expected to alter over the quarter. Sales are split 50/50 between cash and credit with the credit sales paid in the month after delivery. 12. (b) Overdraft balance = £45 250. (d) Cash at bank = £23 250. 12.28 What is the bank balance on 30 September? (a) (c) Overdraft balance = £3 750. (d) £97 500.25 What is the bank balance on 31 July? (a) (c) Cash at bank = £44 750. Cash at bank = £15 750.27 What is the total cash outflow for September? (a) (c) £63 000. (b) £22 500. Expenses are paid in the month of incurrence. Suppliers are also paid in the month after delivery. £72 500.Module 12 / Budgeting Secured loan stock (10%) Creditors Proposed dividend (payable 1 August) Bank overdraft 20 000 144 250 17 750 7 500 10 500 180 000 For July to September. but include a monthly charge of £3000 for depreciation on plant. £37 000. Overdraft interest can be ignored. 12. (b) £72 000. Loan interest is paid quarterly on 30 September. (b) Cash at bank = £15 250. (d) £40 000.

12. (iv) the absence of an appropriate output measure for such nonmanufacturing departments. (b) Budgeted loss = £4 000. who are in full possession of all relevant information. Which of the following is correct? (a) (c) (i) and (ii) only. (b) Flexible budgeting.31 Which two of the following are correct? (a) Discretionary cost budgets are determined by the level of manufacturing output required. (iii) departmental managers’ reluctance to be the subject of any external scrutiny and criticism. Incremental budgeting.30 Managements tend to experience considerable difficulty in budgeting for and managing discretionary costs. (b) (i). the doubtful relevance of a year-based budgeting control on programmes of several years’ duration. There are several reasons for this difficulty. (d) Engineered cost budgets are determined by management’s view of the level of expenditure appropriate at the current time. (c) Discretionary cost budgets are determined by management’s view of the level of expenditure appropriate at the current time. True or false? Accounting Edinburgh Business School 12/31 . (ii) and (iii) only. (d) (ii).32 Which of the following describes the term applied to the budgeting technique which insists upon the evaluation of all activities at each budget preparation? (a) (c) Zero-based budgeting. Budgeted loss = £17 500. 12. including: (i) (ii) a breakdown in the communication of corporate objectives to the departmental managers of discretionary cost functions. (ii) and (iv) only. (b) Engineered cost budgets are determined by the level of manufacturing output required. 12. 12.33 One of the principal benefits of zero-based budgeting is that the ultimate ranking decisions are taken by departmental managers. (d) Annual budgets. (i). (iii) and (iv) only.29 What is the budgeted trading result for the quarter to September? (a) (c) Budgeted profit = £4 000.Module 12 / Budgeting 12. (d) Budgeted loss = £18 000.

basic salary costs will be £35 000 per month. (b) ZBB involves top management in the allocation of discretionary funds. early collection experience indicates that 80 per cent of the credit sales are settled in the month after invoicing.34 Which of the following is a disadvantage of the zero-based budgeting (ZBB) approach? (a) (c) ZBB is expensive and time-consuming to implement. Other variable selling costs will amount to 5 per cent of sales value.Module 12 / Budgeting 12. with the balance cleared in the following month. In addition. It has been decided that its purchasing policy will be geared towards acquiring sufficient inventory in one month to feed the following month’s sales. Gross margins are budgeted to be 40 per cent on sales. The customers are mainly government agencies and health authorities. so there is little likelihood of any bad debts. The subsidiary buys all its products from the parent company in USA. ZBB requires the usual incremental approach to budgeting. inclusive of £2000 in depreciation. of USA opened a subsidiary in Scotland to distribute its products in Europe. 12/32 Edinburgh Business School Accounting . In November. the subsidiary is committed to acquiring additional motor vehicles. costing £40 000. You have been employed as management accountant in the subsidiary with the primary task of implementing financial controls on its activities. (d) ZBB insists upon no involvement whatsoever by departmental managers. All purchases are to be settled in the month after purchase. Case Study 12. Monthly fixed costs amount to £40 000. Investigation of the sales position reveals: Actual sales July August September October November December £200 000 £250 000 £500 000 £300 000 £300 000 £200 000 Forecast sales Although 90 per cent of sales are on a credit basis. plus a commission of 10 per cent on sales. All of the foregoing costs will be paid in the month of incurrence.1 In July Medi-Tech Instrumentation Inc. The parent company has insisted that the subsidiary maintains a minimum cash at bank balance of £10 000 at all times – even if the consequence is that payments to the parent company are deferred in whole or part.

Accounting Edinburgh Business School 12/33 . 2 Budgeted profit and loss account. Comment on any problems highlighted by this statement.Module 12 / Budgeting The summary balance sheet of the subsidiary at 31 August comprises: Fixed assets Inventory Debtors Cash at bank Share capital Creditors (due to parent company) £ 70 000 300 000 261 000 11 000 642 000 342 000 300 000 642 000 Required From the information available for the quarter to 30 November prepare: 1 Budgeted cash flow statement.

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1 13. the motivational aspects of standards. how to calculate the principal variances surrounding material.4 13. Accounting Edinburgh Business School 13/1 . the possible reasons for variances and when to investigate them.Module 13 Standard Costing Contents 13.3 13.6.2 13.10 Introduction Setting Standards A Word about Motivation Flexible Budgets The Anatomy of Variances: Materials and Labour Responsibility for Variances Do-it-Yourself Example in Materials and Labour Variances Variable and Fixed Overhead Analysis Do-it-Yourself Example in Variable and Fixed Overheads Investigation of Variances Sales Variances Summary 13/2 13/2 13/5 13/5 13/7 13/9 13/10 13/12 13/15 13/18 13/19 13/22 13/23 13/30 Review Questions Case Study 13. how standard costs are set.1 13.6 13. labour and overhead costs.8 13.7 13.5 13.7.1 13. the role of flexible budgets.1 Learning Objectives By the end of this module you should understand: • • • • • • • the relationship between budgeting and standard costing.9 13. how to calculate sales variances and the managerial significance of the numbers produced.

1 Introduction Budgeting. As we read in Module 12 the master budget for the business is built up from various functional budgets. While it would be imprudent on the part of the company to disclose its budgeted profit. inter alia. 13. Standard costs are budgeted costs for individual cost items. usually 12 months. Take the materials budget for the Go-Straight Trolley Co. There can be no better benchmark to judge actual performance than the plan for the period – provided that plan was carefully worked out. administration and so on. Put another way. Total figures are sufficient for this. All of these budgets tend to focus on global figures. for example. facilities negotiated in a planned manner are always on more advantageous terms than sudden requests.2 Setting Standards We have gained a glimpse of standard costing on more than one occasion in the modules so far. nevertheless it must be in a position to respond to the analysts’ leading questions.Module 13 / Standard Costing 13. R&D. Top executives of quoted companies must equip themselves to deal with the probing questions from professional investment analysts whose job is to advise investors and potential investors about the prospects in certain companies. is concerned with planning the activities of an organisation for a specific time period. if necessary. sales. We use standard costs for this control process. This is not surprising when one considers two factors: 1 Management is keen to gain a forward picture of cash flow. the subject of the previous module. This permits the business. But for this purpose the global numbers of the budget are not sufficient. If performance is not up to scratch then remedial managerial action can be taken to put things right. a budget is built up from many standard costs. Remember the cost profiles of the timber-shelved hi-fi cabinet and the supermarket trolley? Each of these products was costed in some detail with the hi-fi cabinet being allocated a share of the manufacturing and non-manufacturing overhead: 13/2 Edinburgh Business School Accounting . Management needs detailed costs and revenues of individual components of the business so that corrective action can be taken at the source of the problem. 2 Once constructed the budget should be used to control the actual operations of the business for the accounting period under review. an indication of profit level for the forthcoming financial year. quarter by quarter. although the base figure for the budget was the number of metres of wire metal required to make each trolley the budget was ultimately expressed in total numbers. production.. These analysts pay regular visits to companies and are searching for. Standard costs are compared with actual costs and explanations are sought for any differences between the two. The total picture of the company’s future as portrayed by the master budget arms the management with much of the information required for these meetings. to negotiate facilities with their bankers.

The resultant figure will be the ideal or engineered standard.50 2. workers make mistakes or operate at faster or slower speeds than planned.Module 13 / Standard Costing From Module 10 Standard full cost of hi-fi cabinet £ Direct material Chipboard Veneer Metal trim 10.00 30. Such a study will take into account the complexity of design of the product. and perhaps for years before. it would be wasteful to assume a usage of 11 metres per trolley if this year.00 3.50 22. the quality of raw materials varies even when purchased from the same supplier. the skill of labour required to make the product. Equally. that amount of material which should be required if every aspect of production works to maximum efficiency.00 15.00 2. and from time to time during the product’s life cycle in production.00 Consider first the matter of setting standards for materials and labour. this number included inefficiencies in selection of correct lengths and the consequent trimming of sizeable ends of metal which could not be used for any purpose other than sale for scrap. a detailed engineering study is required to establish precisely how much material is required.00 From Module 12 Standard variable cost of trolley £ Direct material 10 metres of metal @ £1 per metre Direct labour 1. When a firm puts a prototype into production. Most companies recognise these realities of production in their standards by relaxing marginally the stringencies which underpin the engineering standard.5 hours @ £20 per hour Variable overhead 1.00 5. the availability of the required quality of material. and the engineering precision of the production machinery. The normal or operating standards are those which could Accounting Edinburgh Business School 13/3 . If each trolley consumed 11 metres of wire metal this year it would be pointless to set a standard for next year at 10 metres unless the company could demonstrate an ability to save one metre due to new processes or techniques.5 hours @ £10 per hour Standard variable cost 10 30 Direct labour 1. Without doubt the best indicator of material usage per unit of product will be the consumption records of the previous period. But of course this seldom happens in reality: machines break down or require recalibration.50 25.5 hours @ £5 per hour Prime cost Manufacturing overhead Manufacturing cost Share of non-manufacturing overhead Standard full cost 15 55 7.

labour rates tend to be the easiest to establish of the four standards so far described. If 400 000 machine-hours is anticipated next year a budgeted fixed overhead rate of £0. overhead comprises those costs which a business incurs in support of production but not necessarily directly related to production. oil or precious metals. the normal standard would reflect the time taken for refreshment breaks.g. Remember the nature of overhead. or rate of pay. The standards for both variable and fixed overhead depend on three components: (a) the budgeted cost of each overhead. e. A business whose raw material inputs are subject to significant fluctuations in price. commodities such as cocoa beans. External economic indicators are a useful supplement to the judgement of the purchasing executives. may choose to reduce their budget period to a length of weeks or months over which management has some confidence of price movement. A change in either (b) or (c) will have the effect of altering the standard overhead cost per unit even if (a) remains the same.50 for next year. assume budgeted fixed overhead amounts to £100 000 for next year and the allocation key to be used is machine-hours for all fixed overhead. Labour usage and price standards are set in similar manner to those for materials. The engineering study already described should be able to measure the time required by a skilled operative to manufacture. Note that such a study would describe the quality of operative and the nature of training to be undertaken before production commences. casual conversations with supervisors and colleagues. 13/4 Edinburgh Business School Accounting . A product that uses 10 machine-hours will have a standard fixed overhead rate of £2. for direct labour input is calculated by having regard to current rates and any anticipated uplift during the budget period due to negotiated cost-of-living or time-served increments and anticipated bonus payments for superior effort. Labour usage is usually measured in units of time. wheat. and (c) the volume expected of each allocation key to be used. fetching raw material and consumables and carrying finished components to the next workspace or collection point. For example. Module 10 described in detail the methods used to allocate overheads to products. As for materials price.25 per machine-hour will be used. the suppliers’ estimates of price movements. Unless the business is located in a heavily unionised industry with a poor record of industrial relations. (b) the allocation key to be used to allocate overhead to product. Again. Overhead standards tend to be determined by reference to one of the four standards already described.Module 13 / Standard Costing be expected to be achieved by a productive operation operating carefully and efficiently but which also reflect the normal perils which surround a process where so many things can go wrong. The standard price. the standard selected for the year will be based on the expected purchase pattern. and the quality of raw material required. quantity discounts negotiated. assemble and test the product.

is in motivating the workforce to perform at their highest level of achievement. more conducive work environments – all combine to lead. better-quality materials. and that of his or her colleagues. Hence the use of ideal. it is desirable to review continuously the production processes from a technical point of view. to a tightening of standards expected. the purchasing director is the person most knowledgeable about the procedures of purchasing and the likely deals that the company will be able to enter into over the next 12 months. But if the worker’s performance. provided there has been built into it an element of ‘stretch’ and rigour.Module 13 / Standard Costing 13. For instance. But perhaps their greatest role. is going to be judged and perhaps rewarded on the basis of the standards set. a normal standard. On the other hand. serve as devices to assist in planning and controlling the operations of the business. Without this regular review a company may allow inefficiencies to creep into its procedures which will have a negative effect on its competitive position in the marketplace. 13. If employees are presented with a budget which is well beyond their reach they will not attempt to come anywhere near the level expected. prima facie. to ensure the necessary element of ‘stretch’ within the standard. will give the incentive to well-intentioned employees to strive to reach the level expected. and their unitary equivalent standards. if the budget is slack. and to reward them for so doing. Budgets and standards should not be used as sticks to beat recalcitrant workers into shape. The setting of budgets and standards is therefore a task which must involve every level of the organisation and ‘external observers’ alongside those employees who know most about the processes under review. higher levels of training. there is little incentive for an employee to sharpen performance.3 A Word about Motivation Budgets. engineered standards is a short-sighted demotivational device which should be resisted. New technologies.4 Flexible Budgets Imagine a quarterly report on production cost performance along the following lines: Third quarter ended 31 March 20x4 Units produced Cost of materials Cost of labour Cost of overhead Total production cost Budget 2 000 £ 8 000 6 000 2 000 16 000 Actual 1 800 £ 7 380 5 310 2 050 14 740 Accounting Edinburgh Business School 13/5 . they are best used as carrots to encourage and reward superior performance. Additionally. if properly used. it is important that someone from outside the function ensures that these standards are not too slack.

’ After such a comment the only savings the production team are likely to see is that of their production manager’s salary when he is fired! True. The net effect of these overruns and underruns was £240. And it is a bleak picture. dangerously misleading. if not resolved. 13/6 Edinburgh Business School Accounting . It is therefore futile to compare the actual costs of making 1800 with the budgeted costs of making 2000. an explanation of why the production level had fallen from 2000 to 1800 would be necessary.50 = £900). This report now gives a better picture of the activities of production over the third quarter to 31 March 20x4.65 per cent over budget. (Flexing the actual costs to the 2000 level would leave management comparing two columns neither of which reflected reality!) A far more meaningful presentation would use a flexible budget presentation: Third quarter ended 31 March 20x4 Planned production in units Actual production in units Cost of materials Cost of labour Cost of overhead** Budget 2 000 1 800 £ 7 200 5 400 1 900 14 500 Actual 1 800 £ 7 380 5 310 2 050 14 740 Variance* £ (180) 90 (150) (240) * The term ‘variance’ means the difference between the budgeted (or standard) cost and actual cost. ** Overhead comprises a fixed component of £1000 and a variable component of £0. the production facility has spent £1260 less than budgeted but the production level was reduced from 2000 to 1800.50 per unit produced (1800 × £0. One more quarter like this and the production team will be wanting to share in the savings by way of a year-end bonus.Module 13 / Standard Costing Commentary by production manager to chief executive: ‘Yet again we’ve had a good quarter by coming in £1260 below budgeted cost. The metaphor of comparing apples with oranges is apposite in this context. in fact. This could reflect some serious production difficulties (machine unreliability or raw material supply problems?) which. This style of report is much more informative than the earlier one which was. management would need to decide whether these variances from budget required investigation. could lead to customer supply problems in Quarter 4 and beyond as finished goods inventory levels decline. But even in the preferred report. or 1. Materials and overhead exceeded budget while labour was less than budget. But which column should be adjusted? Should we flex the budget column down to the 1800 level or the actual column up to the 2000 level? The answer is that we must flex the budgeted column of costs down to the level of output actually achieved so that management can compare the actual costs of producing 1800 with those which should have been incurred in producing 1800.

against a budgeted production cost of £3000 it reported a production cost of £2860. (You should revise Module 9 if you are unsure of the risk of unitising fixed costs. Take materials: for management of the production facility to be told that £180 more was spent in Quarter 3 than anticipated tells them that something did not go according to plan. Last month.00 0. More detail is required. The flexed budget above explains how the overhead is included in the total amount for overhead. A combination of these two reasons leads us to split them out for individual analysis: Material efficiency variance = [Standard quantity − Actual quantity] × [Standard price per unit price] = (SQ − AQ)SP Material price variance = [Standard price per unit − Actual price per unit] × [Actual quantity used] = (SP − AP)AQ Example A kilt-making firm in London makes 50 kilts per month.50 0. You determine that the standard cost of each kilt contains four metres of tartan tweed purchased in bales from a company Accounting Edinburgh Business School 13/7 .00 3.5 The Anatomy of Variances: Materials and Labour The variances column in the flexible budget is informative but only to a degree. but gives them no indication of where the problem is. Management has called for an explanation. simply because the fixed overheads amount to £1000 regardless of volume produced.Module 13 / Standard Costing Note that the flexible budget for 1800 units was based on the standard cost of the unit.) 13. Material costs can be more (or less) than standard for only two reasons: (a) actual production used more (or less) material than planned.00 * Based on the planned production level of 2000 units per quarter. Material Labour Variable overhead Fixed overhead* £ 4. Beware the temptation to multiply the fixed overhead per unit (£0.50) by units produced (1800) to calculate fixed overheads in total. Note that the per-unit fixed overhead component of standard cost is only valid if 2000 units are made.50 8. and/or (b) the price to purchase the material was more (or less) than planned.

Last month each kilt consumed 4.4)]£15 = (200 − 220)£15 = £300 adverse Material price variance = (SP − AP)AQ = (£15 − £13)220 = £440 favourable Total material variances = £300 adverse + £440 favourable = £140 net favourable An adverse variance is one where actual cost is above standard cost. and/or (b) the labour rates actually paid were more (or less) than planned. A combination of these two reasons leads us to split them out for individual analysis: Labour efficiency variance = [Standard time allowed − Actual time taken] × [Standard rate per hour] = (ST − AT)SR Labour rate variance = [Standard rate per hour − Actual rate per hour] × [Actual time taken] = (SR − AR)AT 13/8 Edinburgh Business School Accounting . Material price = £440 favourable change of supplier (although this looks unlikely given the facts supplied). Calculation of variances is of little value unless it prompts investigation into possible reasons for them.4 metres and each metre cost £13. Application of the above formulae produces the following variances: Material efficiency variance = (SQ − AQ)SP = [(50 × 4) − (50 × 4. poor-quality material (see below). Labour cost variances are caused by a combination of the same two reasons: (a) actual production requiring more (or less) time than planned. a favourable variance is one where actual cost is less than standard cost. mismatch or excessive hems. quantity discounts given being more generous than planned for. inexperienced staff leading to waste. each metre costed at £15. end-of-tartan bales which are supplied at a lower price. inferior quality of tweed (which leads to more metres being used). use of sewing machines which require maintenance. pilferage among staff leading to inventory losses. Here are a number of possible reasons for the variances so far calculated: Material efficiency = £300 adverse • • • • • • • • • faulty bale of tweed which prevented easy matching of pattern.Module 13 / Standard Costing in the Outer Hebrides.

5)]20 = (150 − 175)20 = £500 adverse Labour rate variance = (SR − AR)AT = (20 − 17. less overtime paid than budgeted for. Labour rate = £500 favourable • • • lower calibre of staff used during the month leading to more time required. Also. In the month under review 175 hours were used. Application of the above formulae produces the following variances: Labour efficiency variance = (ST − AT)SR = [(50 × 3) − (50 × 3. a price rise in material is difficult to control in the short term.g. or bulk discounts with the current one but. Each kilt’s standard time to cut and sew is three hours. in general. untrained staff or faulty equipment. anticipated pay settlement deferred until later in the year. or held responsible. Example At the end of the same month as above.14)175 = £500 favourable Total labour variances = £500 adverse + £500 favourable = Nil Management would be well advised to ignore the fact that labour variances net to Nil because both efficiency and rate require investigation and possible managerial remedy action. Perhaps the purchasing department could negotiate a better deal with another supplier. Initially management is pleased with this outcome until you investigate the standard costs and produce the variances which follow. Sometimes ‘price’ is used for both variances. for variances which lie outside their control. each hour being paid at the standard rate of £20. 13. the kilt makers’ production department reported its actual labour costs equalling the budgeted labour costs at £3000. For instance. costing £2999.Module 13 / Standard Costing Note that the term ‘rate’ is used here for labour variances and ‘price’ is used for material. uncertain supply of material leading to broken runs and downtime. inexperienced staff. Labour rate variances AT(SR − AR).50. we can assume that externally imposed price rises fall outside company control.6 Responsibility for Variances As in the preparation and monitoring of budgets (see Module 12) it is imperative that personnel are not judged. Accounting Edinburgh Business School 13/9 . the formulae are sometimes laid out as follows: e. Possible explanations? Labour efficiency = £500 adverse • • • • use of faulty material requires more time spent per kilt.

00 20.6.38)) £20 = (2400 − 2280) £20 = £2400 favourable Labour efficiency = (ST − AT)SR = ((6 000 × 2) − (6000 × 1. Material variances Material efficiency Labour variances = (SQ − AQ)SP Labour efficiency = = = = (ST − AT)SR = = = = (SR − AR)AT = = Possible explanations? Material price = (SP − AP)AQ Labour rate = = Worked solution Material efficiency = (SQ − AQ)SP = ((6000 × 0.4 sq m metal @ £20 per sq m Direct labour 2 hours @ £10 per hour Actual statistics for last month were: Cases produced Square metres of metal purchased @ £22 per sq m Square metres of metal used Direct labour @ £10.Module 13 / Standard Costing 13. The material variances should recognise the responsibilities of the production manager and purchasing manager respectively.10 per hour £ 8. • change in design since setting of standard.10) 11 100 = £1110 adverse 13/10 Edinburgh Business School Accounting .4) − (6000 × 0. calculate the material and labour variances and consider possible reasons for these variances.85)) £10 = (12 000 − 11 100) £10 = £9000 favourable • better calibrated cutting equipment. Material = (SP − AP)AQ price = (£20 − £22)2100 = £4200 adverse • greater motivation. • use of more appropriate sheets of metal.00 28. • result of increased training. Labour rate = (SR − AR)AT = (£10 − £10. • superior quality of metal. • improved mechanisation.00 6 000 2 100 sq m 2 280 sq m 11 100 hours Using the pro forma analysis sheet below.1 Do-it-Yourself Example in Materials and Labour Variances Consider the following standard cost data for a business making cases for carriage clocks: Direct material 0.

in the casing department above. the variance would have been: (SP − AP)AQ = (£20 − £22)2280 = £4560 adverse 2 3 4 Variances should be calculated at the stage when they arise and the products should be passed on to the next department or process at standard cost.Module 13 / Standard Costing • price rise due to world shortage. We have used simple formulae above to calculate four variances. The price variance’s ‘actual quantity’ is deemed to be the number of square metres purchased (as opposed to the number issued to production).85 hours per clock actually achieved above is excessive in comparison with what could be achieved at normal efficiency. it may be seen that a sizeable favourable variance in labour efficiency occurs every month. Consistent variances arising in the same area of operations may indicate that the standard is no longer appropriate and needs adjustment. On the other hand the purchasing manager is responsible for the price obtained for the quantity purchased. Had the production manager also been held responsible for the material price variance. Take the material variances: Efficiency = (SQ − AQ)SP Price = (SP − AP)AQ Why do we use standard price outside the brackets with efficiency and actual quantity outside the brackets with price? Careful thought about what is being examined will give a satisfactory answer: with the efficiency variance formula we are analysing the financial impact on the business of the manufacturing or assembly process taking more or less material than standard to do the job. • change of supplier. the carriage clock casings will be passed to the assembly department. In our experience managers understand the identities inside the brackets but are unsure of those outside the brackets. Notes 1 The production manager is responsible only for volume of raw material used. This variance is the responsibility of the casing department’s manager. For example. For example. • more overtime. hence we use the square metres of metal drawn from stores into production. We would caution readers against memorising these without fully understanding the concepts behind them. • superior level of operatives. it would be inappropriate to ‘pass on’ the £2400 favourable material efficiency variance arising in the casing department. A detailed study could conclude that 1. • unforeseen wages settlement. If this is so then the labour input process needs further engineering study to establish the new standard time in the light of improved machining and automated techniques. The physical quantity Accounting Edinburgh Business School 13/11 .

direct labour cost. the purchasing manager would be penalised with a higher adverse variance than he incurred.or under-spending. the gain or slippage in price achieved for raw materials used or purchased is multiplied by the actual quantity used or purchased. Imagine that at the beginning of the year the management of the company planned to make 60 000 casings and that each casing would take two hours to make. repairs and maintenance linked to machine use.6. and how much was incurred? 13/12 Edinburgh Business School Accounting . otherwise the combined sum would be a hotch-potch of two variances. or machine-hours). direct labour hours. In a manufacturing environment these typically comprise electricity and power associated with productive equipment. or £3 per unit. each one £2 more than standard.50 per direct labour hour. Variable overhead analysis starts with the simple question: how much variable overhead should have been incurred. In the example we could argue that he kept the purchasing of metal to a minimum so as to minimise the impact of the increase in unit price. Variable overheads move up and down in volume in proportion to productive output as measured by the allocation key used (e. the examination of the difference between how much overhead was incurred and how much should have been incurred.1). by definition. Were we to use the standard quantity we would produce a figure which bore no resemblance to reality. management can gain an insight into the efficiency of production. If the standard quantity of 2400 square metres were used. consumables and supplies. direct labour hours. The price variance recognises this foresight by using actual quantity outside the brackets. in the worked example above the purchasing department actually purchased 2100 square metres of metal. comprise those costs which a business incurs in support of production but not necessarily directly related to production. If then there is a close linkage between variable overhead incurrence and. Variable overheads for 120 000 direct labour hours were budgeted at £180 000. Variance analysis. indirect labour.7 Variable and Fixed Overhead Analysis In an earlier paragraph in this module we reminded readers that overheads. is based on the allocation keys used to spread overhead. given that 6000 units were produced. or £1. In the month under review variable overheads amounted to £17 200 when 6000 cases were manufactured and 11 100 direct labour hours were recorded. On the other hand.g. downtime due to stock-outs or breakdowns. Consider first variable overheads. By holding all prices at standard. 13. Accountants must therefore use an allocation key to spread overhead over the products in a manner which best reflects the products’ usage of the overhead resources. we can use efficiency and price as the criteria for our analysis of over. efficiency and price. with the price variance.Module 13 / Standard Costing of material beyond standard is valued at standard price. say. Example Consider the carriage clock business again (see Section 13. thus.

therefore the efficiency variance must be treated with some caution. the level of overhead allowed for in the flexible budget given the actual number of direct labour hours incurred). Of course this can only be expected to portray commercial reality if the allocation key (in this case direct labour hours) is directly correlated to the components comprising variable overheads. But it conceals two components which merit further examination. The variable overhead spending variance is potentially a more interesting variance than the efficiency. Failure to go behind the single £800 favourable variable overhead variance would have concealed from management a serious overspending on some items making up variable overhead.50) £16 650 = = = = Standard cost of actual time taken for units produced 11 100 × £1. Accounting Edinburgh Business School 13/13 . Nine hundred fewer direct labour hours have been recorded in the production of the monthly output than allowed for in the flexible budget using a standard time of two hours per unit.50 £16 650 £550 adverse Less Actual costs incurred − £17 200 The efficiency variance should not surprise management given that direct labour hours is the allocation key for variable overhead and that a favourable efficiency variance for direct labour has already been calculated. or £550 too much. Here management is told that instead of incurring £16 650 in variable overhead (that is. Superb efficiency in the use of direct labour may not necessarily lead to a proportionate reduction in variable overhead. we can break down this overall variance of £800 into efficiency and price (usually referred to as spending). Variable overhead Efficiency variance = = = = Variable overhead Spending variance Standard cost of flexible budget time allowance for units produced (6000 × 2 × £1. The fact that the reasons may be difficult to detect does not invalidate the managerial requirement to attempt an analysis. the business spent £17 200. This could be caused by either an increase in prices paid for the components comprising variable overhead or poor control (inefficiency!) over the use of these items. fewer direct labour hours leads to fewer variable overheads being incurred.50) £18 000 £1350 favourable Less − − Standard cost of actual time taken for units produced (11 100 × £1.50) = £18 000 = £800 favourable Less Actual cost of variable overheads − £17 200 For many managements the level of analysis of this variance would be sufficient.Module 13 / Standard Costing Standard cost of variable overheads (6000 × 2 hours × £1. This is unlikely. Because the business is employing direct labour hours as an allocation key.

e. Fixed overhead is to be allocated using direct labour hours. Example We now provide further extension of the example portraying the standard costing system of the casing department of the carriage clock business (see Section 13.Module 13 / Standard Costing Consider next fixed overheads. Actual fixed overhead amounted to £32 500. again using the budgeted amount of £30 000 as one of the elements: Fixed overhead denominator variance = = = = Budgeted amount £30 000 £30 000 £6 000 favourable Less Amount applied to units produced (6 000 × 2 × £3) £36 000 − − 13/14 Edinburgh Business School Accounting . Therefore the predetermined fixed overhead rate for this year is: £360 000 120 000 hours = £3 per direct labour hour The denominator volume level of 120 000 is based on the planned output of 60 000 cases. Such items as depreciation of productive plant and equipment. does not reveal the full picture (unlike the total variance of £800 calculated for variable overhead). But it ignores the fact that more fixed overheads were applied to the product than were budgeted for. exactly 5000 units were produced (leading to 10 000 standard direct labour hours being incurred) and £30 000 was the actual level of monthly spend on fixed overhead. This seldom happens! Again the straightforward analytical question would be: how much fixed overhead was incurred against how much was budgeted for? Budgeted amount £30 000 = £2 500 adverse Less − Actual amount £32 500 But this analysis. given the fact that a production-based allocation key is used to spread fixed costs over production the impression may be given by the accounting system that fixed costs do in fact vary with output. On a monthly basis this would read: £30 000 10 000 hours = £3 per direct labour hour If. each taking two direct labour hours to produce. Remember: fixed overheads do not vary with production levels within the relevant range of output. Management expect 120 000 direct labour hours to be incurred annually. during the month under review. True it yet again leads management to investigate the apparent cost overruns in the elements comprising fixed overheads (e. £30 000 per month.g. i. We must therefore calculate another variance. usually termed the fixed overhead spending variance. But. then no fixedoverhead variances would arise.6. an increased outlay for factory rent or unforeseen recruitment in supervisory services).1): the budgeted fixed overheads for the year were £360 000 to be incurred evenly through the year. supervisory salaries and space costs typically comprise fixed overheads.

13. If each recorded hour is used to allocate fixed overhead then 2000 × £3 = £6000 more fixed overhead has been allocated to production than was budgeted for. This is deemed to be a favourable variance because volume of output is greater than budgeted. therefore 2000 more direct labour hours were recorded than planned. be sure that you understand the concepts and explanations underpinning the numbers.1 Do-it-Yourself Example in Variable and Fixed Overheads A company uses a standard cost system to plan and control its manufacturing process of compact discs. Readers should now attempt the following example. this does not mean that the fixed overhead spend is more or less. the cost of sales figure includes a fixed overhead component lower than actual volume would indicate) but have this reduced significantly by adverse denominator variances. But beware of appearances! At the beginning of the budget period. actual machine-hours recorded were 4 100 000. 60 000 cases were produced consuming 120 000 direct labour hours. based on a denominator volume of one million discs per annum. Thus a firm could report satisfactory gross profit percentages (that is. a predetermined overhead allocation rate of £3 per direct labour hour was calculated. Actual output for the year under review was 1. the individual monthly denominator variances netted to zero. The standard cost of a disc. Each casing uses two direct labour hours. rather they would want to see if. This could negatively impact the business’s market share even though the actual outlays on fixed overhead are exactly as budgeted. Accounting Edinburgh Business School 13/15 . actual variable overhead was £1 900 000.e. units of production are allocated more or less fixed overhead than budgeted for. management must stay alert to monthly variances if they indicate a consistent pattern.2 million discs.Module 13 / Standard Costing Here we see fixed overhead appearing to behave like variable overheads. If everything went exactly according to plan. (Note the words ‘are allocated’. actual fixed overhead was £39 000 000. But when the actual volume of output used in the denominator moves away from budget. includes four machine-hours of variable overhead at £0. i. Conversely where management’s assumption on volume level is excessive the business will consistently report adverse denominator variances which have to be written off in the profit and loss account.7. This would indicate that the original budgeted denominator production level of 120 000 direct labour hours (or 60 000 casings) was seriously understated. there would be no denominator variance because the actual and budgeted denominator would be the same. However. over the year. and market prices being perhaps set at too high a level.50 per hour and four machine-hours of fixed overhead at £10 per hour. each is asked to bear too high a share of fixed overheads).) In our example the business has made 1000 more casings in the month than budgeted. It is unlikely that management would be prompted to take action in any one month. Take the situation where the monthly denominator variances were always generously favourable. In checking your solutions do not be satisfied by getting the right numerical answer. Such an understatement could lead to the perceived cost of the product being higher than it really is (that is.

Alternatively.50) = £2 400 000 = £350 000 favourable Less [Standard cost of actual time taken for units produced] (4 100 000 × £0.Module 13 / Standard Costing Variable overhead variances Efficiency = [Standard cost of flexible budget time allowance for units produced] = = = Possible explanation? Spending = [Standard cost of actual time taken for units produced] = = = Possible explanation? Less [Standard cost of actual time taken for units produced] Less [Actual costs incurred] Fixed Overhead Variances Predetermined fixed overhead application rate = £ machine-hours = £10 per machine-hour = Budgeted amount = = Possible explanation? Denominator = Budgeted amount = = = Possible explanation? Spending Less Actual amount Less Amount applied to units produced Worked Solutions Variable overhead variances Efficiency = [Standard cost of flexible budget time allowance for units produced] = (1 200 000 × 4 × £0.2 million compact discs were 700 000 less than anticipated. the standard time of four machine-hours per disc needs to be tightened up. 13/16 Edinburgh Business School Accounting .50) £2 050 000 − − Possible explanation? The number of hours budgeted for downtime did not materialise and therefore the machine-hours recorded in manufacturing 1.

Denominator = Budgeted amount = £40 000 000 = £40 000 000 = £8 000 000 favourable Less − − Amount applied to units produced 1 200 000 × 4 × £10 £48 000 000 Possible explanation? Production was running at 20 per cent higher than budgeted. Accounting Edinburgh Business School 13/17 .5 per cent) and would be perhaps due to slightly less expensive machines being acquired. This inevitably led to 20 per cent more fixed overhead being applied to the production than budgeted. Fixed Overhead Variances Predetermined overhead rate = £40 000 000 4 000 000 machine-hours = £10 per machine-hour Spending = Budgeted amount = £40 000 000 = £1 million favourable Less − Actual amount £39 000 000 Possible explanation? The sheer magnitude of fixed overheads may be surprising.50) = £2 050 000 = £150 000 favourable Less − − Actual costs incurred £1 900 000 £1 900 000 Possible explanation? Given the variable overhead allowed for every machinehour recorded. This could indicate tighter operational control over the components of variable overhead or more advantageous prices negotiated than budgeted for. But in high-technology industry with a high level of automation and high level of research and development expenditure. thereby lowering the fixed annual depreciation charge or to an extended view on machine life cycles (which would have a similar effect on depreciation). this proportion between variable and fixed overhead can be expected. the company was entitled to spend £2 050 000 on variable overhead. (Note: the increased production would have no impact on the amount of fixed overhead actually spent.) If this increase in output is viewed as normal then the denominator volume has to be increased for next year’s predetermined overhead rate thereby reducing the cost of each unit of product. instead it spent £1 900 000. The difference between the two amounts is small in percentage terms (2.Module 13 / Standard Costing Spending = Standard cost of actual time taken for units produced = (4 100 000 × £0.

Determining a percentage limit is a useful start: for example. only the big numbers – with a brief comment on possible reasons for these. Some computer-based management information systems which permit graphical displays of variances. on a strict interpretation of the individual variances. Variances from budget. Limits may have to be reviewed as a result of experience and cost/benefit analyses.Module 13 / Standard Costing 13. If direct labour is used to apply variable overhead then the variable overhead efficiency variance will be of the same magnitude as the labour efficiency variance even although there may exist a tenuous link between labour efficiency and the consumption of resources comprising variable overhead. A favourable labour rate variance caused by employing less-skilled operatives may be counterbalanced by adverse variances in labour and material efficiency. a decision to investigate one variance may lead to additional work on others. should be of interest to managers. which should provoke an investigation into raw material usage but because the monthly percentage falls below the limit. But a rigid interpretation of this limit may lead to important control information being suppressed. all material variances below 4 per cent are not reported. they can learn immediately where there may be problems and take remedial action. The same inferior-quality raw materials may lead to an adverse labour efficiency variance because more time has to be spent selecting suitable batches of material. This form of reporting is called exception reporting or management by exception where managers receive information only on items which appear to be out of control. that is.8 Investigation of Variances Management needs clear. A business may consistently report a 3. the cumulative impact of this variance escapes managerial attention. Here is a selection of possible linkages: 1 An adverse materials efficiency variance may be caused by the use of inferior-quality materials which would be reflected in favourable material price variance. they do not want to be pestered by sheets of detailed numbers revealing that everything is under control! What they want is a well-presented report revealing the most significant variances only. not the workings behind the variances.8 per cent adverse variance on material efficiency. can be programmed to alert managers to consistently underperforming operations even though. Conversely the search for one common reason could explain two or more variances. reporting would not be triggered. month after month. Edinburgh Business School Accounting 2 3 4 13/18 . in principle. The limits must be determined over time and through experience. perhaps on a daily or weekly basis. and in consultation with the engineering staff. relevant and up-to-date information to control ongoing operations. Defining ‘out of control’ is not easy. can the cost of variance calculation and investigation be justified in terms of the savings implemented by executive action? Another difficulty experienced by managers in investigating variances is the interdependencies among the variances. But good managers are busy people.

Ace’em. the company needs to quantify the impact on profit of achieving sales of 60 units of Product X and 100 units of Product Y. the total ‘price’ is derived by dividing the total figures of revenue and bought-in costs by 20 000. Plodder.00 £2. The figures of £16. But this would have a negative impact on inventory levels (high) and cash levels (low). sales. and a cheaper version for less athletic individuals. £12.00 £4. Budgeted figures Ace’em Units Price Total 2 000 £50.50 180 000 £45 000 Total Units Price 20 000 £16.25. From the information contained therein he learns that his contribution margin on tennis shoes rose by £25 000 from the budgeted level of £85 000 even though he is aware that volume of sales has fallen. direct labour.50. He sells two varieties. Management must be given an insight into the consequences of not achieving the sales volumes and sales mix planned for in the budget. And for this discussion we relax the one-product assumption that has characterised the variance analysis carried out so far. each product contributing differently to the overall profits. 13.00 and £4. if the budget provided for sales of 100 units of Product X and 60 units of Product Y. Accounting Edinburgh Business School 13/19 .00 60 000 £40 000 Plodder Units Price Total 18 000 £12.25 20 000 20 000 12. The budgeted and actual figures for May are given below (a pair of shoes = 1 unit).00 £100 000 2 000 30. Most businesses manufacture and sell many products in differing proportions. selling for £50. variable and fixed overhead.25 Total £325 000 240 000 £85 000 Sales Bought-in cost Contribution margin 2 000 £20. Now we turn our attention to the top line of businesses’ profit and loss accounts. a top-of-the-range pair. selling for £12.50 £225 000 18 000 18 000 10.9 Sales Variances So far we have focused our attention on the cost of sales figure surrounding production.00 Note that the total columns comprise the additions of the units sold and revenue and bought-in costs for both styles of shoes. encompassing direct material.25 are therefore weighted average numbers (heavily influenced by the preponderance of the cheaper Plodder shoe).Module 13 / Standard Costing 5 A favourable denominator variance in fixed overhead may provoke the production staff to aim for even higher levels. Case The manager of a sports goods chain of shops is delighted at the monthly management accounting report for the month of May.

Ace’em.50 − £2.50 = 13/20 Edinburgh Business School Accounting .Module 13 / Standard Costing Actual results Ace’em Units Price Total 4 000 £51.50 100 000 £25 000 Total Units Price 14 000 £23.154% 33.25 − £20. The very significant positive impact of this increase in contribution from Ace’em is reduced by a serious decline in the Plodder line. Even the least promising tennis player is prepared to spend money on upmarket clothes and equipment. Budget Actual Ace’em 40% 41.00 120 000 £85 000 Plodder Units Price Total 10 000 £12.25 per pair from the customers.71 £7.57 14 000 14 000 15.25 £205 000 4 000 30.50 £125 000 10 000 10 000 10.193 per cent. Total contribution earned from sales depends on contribution per unit and volume. Contribution variance Ace’em Plodder = Difference in × contribution margin per unit Actual sales in units £5 000 favourable Nil £5 000 favourable × Budgeted contribution Margin per unit £40 000 £20 000 £20 000 favourable adverse favourable = (£21.25 He asks for your help in analysing the increase in contribution of £25 000 in the face of a decline in sales volume.00 £2.00 = = (10 000 − 18 000) × £2. Sales variance analysis enables the manager to gain detailed insight beyond the casual view afforded above.463 per cent increase on a high base of 40 per cent lifts the combined contribution margin percentage by 7. A more detailed calculation of line contributions reveals the following pattern in contribution margin percentages (contribution margin as a percentage of sales price).347% Note the gearing effect of the Ace’em contribution where a modest percentage of 1.00) × 4 000 = = (£2. has doubled in sales volume and he has managed to squeeze an extra £1. The manager believes that this drop is due to an increase in consumer spending power with a consequent increase in leisure outlays.86 Total £330 000 220 000 £110 000 Sales Bought-in cost Contribution margin 4 000 £21.463% Plodder 20% 20% Total 26.50) × 10 000 = = (Actual sales less Budgeted sales) Volume variance Ace’em Plodder = (4 000 − 2 000) × £20. An initial glance at the numbers in the case shows that the high-ticket item.

because not only did the individual number of units sold per line differ from budget but so did the internal mix anticipated.25) = £31 500 favourable = (10 000 − 18 000) × (£2.Module 13 / Standard Costing The manager can therefore see that the increase in sales price of the Ace’em line had a much less significant impact on total contribution than the switch in product sales. Sales quantity for both lines of shoes is priced at the weighted average contribution margin per unit drawn from the initial data in the case. This information may lead him to drop the Plodder line and take on another superior brand but perhaps not so exclusive as the Ace’em line. This variance therefore treats one pair of Ace’em shoes as being equal to one pair of Plodder shoes.25 × Check: The sales quantity variance and the sales mix variance require explanation. but note that margins are already tighter on this line than on Ace’em.50 pair). The sales mix variance proceeds to value the increase or drop in units sold per line by the difference between the actual contribution margin per line and the budgeted weighted average contribution line. Sales quantity Ace’em Plodder Sales mix variance Ace’em Plodder [Budgeted weighted average contribution margin per unit] = = £ 8 500 favourable = = £34 000 adverse £25 500 adverse = [Actual sales less × [Budgeted contribution margin per unit less budgeted sales] budgeted weighted average contribution margin per unit] = (4 000 − 2 000) × (£20 − £4.50 − £4. quantity and mix. Therefore for a business to sell fewer than budgeted units at a contribution margin lower than average (the situation with the Plodder line) is as beneficial as selling more than the number Accounting Edinburgh Business School 13/21 .25 (10 000 − 18 000) × £4. excessive floor space given over to the tennis shoes and surplus sales assistants (because it takes the same effort to sell a £50 pair of shoes as a £12. the evidence for which should have been observable to an informed salesperson. A significant drop in volume also indicates either an excessively optimistic view of the future when the budget was drawn up or a failure to predict a decline in volumes. Even greater insight is possible by exploding the volume variance into its two constituents. A drop in volume perhaps indicates fewer customers entering the floor space (which may have other goods on display).25) = £14 000 favourable = £45 500 favourable [Sales quantity variance + Sales mix variance] = Sales volume variance £25 500 adverse + £45 500 favourable = £20 000 favourable = [Actual sales less budgeted sales] (4 000 − 2 000) × £4.25 per unit) of £25 500. In future months he will have to get rid of the Plodder inventory by reducing the price. A drop in overall volume in sales of 6000 units will produce an adverse variance (at £4. For any manager this is not good news. If the Ace’em sales can be maintained at this level during the summer months the sports chain may be able to negotiate volume discounts with its suppliers thereby increasing contribution margin per pair sold.

on the other hand. Actual costs are compared with standard costs and variances can be calculated and explained. Readers should ponder the managerial significance of this analysis. seeking explanation for these variances and taking necessary remedial action is the more important function. The signals given by variance analysis may be counter-intuitive. On the one hand. the answer must be ‘Yes’ because the position is starkly clear from the original data. they may report a variance as being favourable (or adverse) when one’s visual inspection of the underlying data would lead one to the opposite conclusion. Care must be exercised in setting standards. Readers should revise the deeper analysis of sales volume variances to gain confirmation of this issue. Material and labour variances can be split into price (or rate) variances and quantity (efficiency) variances.Module 13 / Standard Costing of budgeted units of a line whose contribution margin is higher than average (the situation with the Ace’em line). the deeper layer of analysis will provide more useful information. variable overhead variances comprise spending and efficiency while fixed overhead variances can be divided into spending and denominator variances. 13/22 Edinburgh Business School Accounting . Only the most significant variances should be investigated. that is. The manager of the sports goods chain may be confused by the signals coming from these numbers. Budgets are therefore broken down into standard costs so that detailed parts of an organisation can be controlled. When the number of products increases and the switch in mix is more subtle than in this case. the sales mix variance tells him that the fewer Plodder shoes he sells the better (an intuitively unreasonable message). What is he going to make of this information? Wouldn’t he be better with the volume variance on its own which gave him the big picture? For this case. standards which reflect perfect operating conditions and which are unlikely to be encountered in practice are demotivating and demoralising for managers who are asked to meet them.10 Summary A standard cost is the budgeted cost for one unit of output. The calculation of variances represents only one step in variance analysis. Standard costs per unit are used to ‘flex’ annual budgets so that actual costs may be compared with the budget for a similar volume of output. the sales quantity variances indicate that a decline in overall sales volume has caused a decline in total contribution margin (an intuitively reasonable message). 13.

4 Which of the following is correct? (a) A flexible budget permits comparisons between actual and budgeted results at all levels of output. (d) (iii) and (iv) only. which of the following standards should be used? (a) (c) A basic standard. A historical cost standard. Which of the following is correct? (a) (c) (i) and (ii) only. whereas standards are prepared as plans for the coming year.8. True or false? 13. The following information applies to Questions 13. (ii) and (iv) only.5–13. (iii) the need to build in allowances for significant unpredictable inefficiencies.Module 13 / Standard Costing Review Questions 13. The management accountant has prepared a comparison of actual and budgeted results for the quarter. (b) An ideal standard. (b) (i). (c) A flexible budget means that budgeted costs for budgeted output are compared with actual costs for actual output. Mugs produced Costs Material Labour Variable overhead Budget 5 000 £ 10 000 2 500 3 750 16 250 Actual 4 600 £ 9 400 2 600 3 600 15 600 Accounting Edinburgh Business School 13/23 . (b) A flexible budget permits management some scope in case of failure to meet its objectives. (d) A flexible budget means that actual costs for budgeted output are compared with budgeted costs for budgeted output.1 Budgets are used to control day-to-day revenue and costs. These include: (i) (ii) the effects of the introduction of new machinery.2 In setting standards. 13. 13.3 If management wishes to motivate employees to produce their best performances for the company. the results of any relevant engineering studies. (iii) and (iv) only. (d) An attainable standard. (i). (iv) their experience of the accuracy of recent standards. Argyll Mugs Limited has completed its first quarter of manufacturing ceramic mugs. management should take various factors into account.

The following information applies to Questions 13.7 What is the total variance between actual costs and the flexed budget? (a) (c) Favourable variance of £550. (d) Favourable price. using a standard costing system to monitor actual performance. Adverse variance of £650. favourable efficiency. 13/24 Edinburgh Business School Accounting . (d) £10 870.99.50 per kg. favourable efficiency.6 What is the variance on labour costs between actual costs and the flexed budget? (a) (c) Nil variance. the company produced 10 000 units of Product A3. (d) A higher manufacturing output than budgeted for.5 What are the flexed materials costs? (a) (c) £9200.11–13.8 What is the standard cost of each mug? (a) (c) £2. £3. (d) £3.50. 13. adverse efficiency. 13. the standard specification requires 5 kg of raw material with a standard cost of £4 per kg.39. (b) Adverse price. Which of the following combinations of material price variance and material efficiency variance is not possible? (a) (c) Adverse price. In January. To produce one unit of A3. Galloway Products plc manufactures Product A3. £10 120. 13. A decrease in materials losses.Module 13 / Standard Costing 13. 13. (d) Adverse variance of £750.9 Which of the following would explain an adverse materials efficiency variance? (a) (c) An improvement in quality assurance checks.10 Abbey Road Limited recorded an adverse total variance on materials. using 48 500 kg of raw material at an actual price of £3. (b) Favourable variance of £650. adverse efficiency. Adverse variance of £200.25. 13. (b) Adverse variance of £100. (b) £2. Favourable price. (b) £9400. (b) The use of poorer-quality materials than specified in the standard.12. (d) Adverse variance of £300.

11 What is the raw materials efficiency variance in January? (a) (c) Favourable variance of £6000.14 What is the materials efficiency variance in June? (a) (c) Adverse valiance of £1750. (b) Favourable variance of £6000. efficiency = £1000 adverse. The company’s budget for June plans output of 10 000 units. (b) Adverse variance of £2000. efficiency = £16 000 favourable.15. Favourable variance of £22 500. Accounting Edinburgh Business School 13/25 .12 What is the raw materials price variance in January? (a) (c) Adverse variance of £6000. An adverse labour efficiency variance is indicative of the use of better quality materials than standard.16 Which of the following is correct? (a) (c) An adverse materials price variance is indicative of inefficient direct labour.Module 13 / Standard Costing 13. Omega plc manufactures a single product with a specification which requires the input of 3 kg of raw material K4 per unit. What are the materials price and efficiency variances in July? (a) (c) Price = £1000 adverse. (b) Adverse variance of £19 000. (b) A favourable labour rate variance is indicative of efficient direct labour. output of only 8000 units is achieved. efficiency = £16 000 favourable. Favourable variance of £7000. (d) A favourable materials efficiency variance is indicative of very efficient direct labour. 13.15 In July. which uses 28 000 kg of K4 at an actual cost of £1. (b) Price = £16 000 adverse. Favourable variance of £15 500. However. (d) Favourable variance of £22 500. 13. The standard cost of K4 is £2 per kg. (d) Favourable variance of £24 250.75 per kg.13–13. The following information applies to Questions 13. but 16 000 kg of K4 are used at a cost of £3 per kg. 13. (d) Price = £16 000 favourable. Price = £16 000 favourable. 13. Favourable variance of £5000. actual output is only 9000 units. (d) Favourable variance of £6750.13 What is the materials price variance in June? (a) (c) Favourable variance of £5000. (d) Favourable variance of £11 000. 13. (b) Favourable variance of £8750. efficiency = £16 000 adverse.

The following information applies to Questions 13. In November.17 Which of the following would contribute to a favourable labour efficiency variance? (a) (c) An increase in direct labour training. The following information applies to Questions 13.18–13. Adverse variance of £810. direct labour costs incurred were £15 680 in manufacturing 1100 rear axles in 3200 direct labour hours.25. Favourable variance of £20. Actual direct labour amounted to £900.20 What is the materials efficiency variance? (a) (c) Adverse variance of £9. An error in setting standard labour efficiency at an unjustifiably high level. 13. 13/26 Edinburgh Business School Accounting . at £4. (b) Adverse variance of £490. It employs a standard costing system which has identified that rear axles require three hours of direct labour per unit. (d) Repeated breakdowns in plant and machinery. 13. Normal monthly output comprises 1200 rear axles. From the records of PQE Company Limited the following standard information has been extracted.19 What is the labour rate variance in November? (a) (c) Adverse variance of £320. (d) Favourable variance of £20. (b) A high level of absenteeism among direct labour.19.80 per hour. Standard per unit Quantity Cost Materials 1 kg £2.20–13. 13.21 What is the materials price variance? (a) (c) Nil variance. (b) Adverse variance of £11.00/kg Labour 2 hours £5.00/hour PQE produced 100 units using 110 kg of materials which cost £209. Favourable variance of £480.Module 13 / Standard Costing 13. (d) Adverse variance of £20. (d) Adverse variance of £1280. (b) Adverse variance of £320. (d) Favourable variance of £1600. Romulus Foundries Limited produces steel castings for the automotive industry. requiring 150 hours. Adverse variance of £11. (b) Favourable variance of £11. 13.18 What is the labour efficiency variance in November? (a) (c) Nil variance.

Adverse variance of £1920. (b) Favourable variance of £100. (b) Use of better-quality materials at a higher price. (d) Adverse variance of £200. with each case requiring two machine-hours to produce. Use of less-efficient labour at lower rates.25 Which of the following may explain the reasons for the labour variances? (a) (c) Use of less-efficient labour at higher rates.Module 13 / Standard Costing 13. (d) Adverse variance of £2400. (b) Use of more-efficient labour at higher rates. 13. True or false? The following information applies to Questions 13. 11 000 cases were produced. (b) Favourable variance of £920. 13. (d) Use of more-efficient labour at lower rates.27–13. 13. During the month. (d) Favourable variance of £250.26 A key feature of a standard costing system is the passing on of variances from one department to another to match the flow of work-in-progress through the manufacturing process. Budgeted variable overheads are £24 000.23 What is the labour efficiency variance? (a) (c) Adverse variance of £100.24 Which of the following may explain the reasons for the materials variances? (a) (c) Use of poorer-quality materials at a higher price.28. Adverse variance of £150. using 21 600 machine-hours. Use of better-quality materials at a lower price. Actual variable overheads amounted to £25 000. (b) Adverse variance of £1000. (b) Favourable variance of £100. 13. giving rise to an overhead allocation rate of £1. Nairn Pet Foods Limited plans to make 10 000 cases of dog food per month. Favourable variance of £200. Adverse variance of £1000. (d) Use of poorer-quality materials at a lower price. (d) Adverse variance of £2400. 13.20 per machine-hour. 13.22 What is the labour rate variance? (a) (c) Adverse variance of £100.27 What is the variable overhead efficiency variance? (a) (c) Favourable variance of £480.28 What is the variable overhead spending variance? (a) (c) Adverse variance of £920. Accounting Edinburgh Business School 13/27 .

29–13. Fixed overheads are to be allocated into output on the basis of machine-hours. (d) Favourable variance of £1875.29 What is the fixed overhead spending variance in May? (a) (c) Favourable variance of £375. no matter how small individual variances are. 13. (d) The numerator value needs to be decreased in order to increase product cost per unit.33–13. 13.Module 13 / Standard Costing The following information applies to Questions 13. Findhorn Sweaters Limited expects annual fixed overheads to be £247 500. Actual fixed overhead incurred in May was £22 500. incurred evenly across the year.30 What is the fixed overhead denominator variance in May? (a) (c) Favourable variance of £375. actual production amounted to 28 000 sweaters in 7000 machine-hours. 13. budgeted to be 82 500 for the year. (b) The denominator volume needs to be decreased in order to reduce product cost per unit. (d) Adverse variance of £5500. what is the implication for setting next year’s predetermined overhead rate? (a) The denominator volume needs to be increased in order to reduce product cost per unit.30. (b) Adverse variance of £1500. True or false? The following information applies to Questions 13. Adverse variance of £1875. 13. Planned production is 330 000 sweaters with each sweater requiring 15 minutes of machine time. In May. (b) Favourable variance of £1500.32 If a company operates a standard costing system. then it will only maximise the benefits if management receives regular reports of detailed variance analysis.31 If favourable fixed overhead denominator variances are incurred throughout the year. (c) The denominator volume needs to be decreased in order to increase product cost per unit. Adverse variance of £1875. The directors of Solway Systems Limited prepared the following budget for the first quarter of next year: 13/28 Edinburgh Business School Accounting . Solway Systems Limited acts as a UK distributor for the security alarm products of Chicago Incorporated and the fire alarm systems of Stuttgart Werke GmbH.36.

33 What is the sales contribution variance? (a) (c) Favourable variance of £2500. (b) Favourable variance of £500. Adverse variance of £5625. 200 £ 100 000 55 000 45 000 Stuttgart Werke 300 £ 225 000 165 000 60 000 Total 500 £ 325 000 220 000 105 000 250 £ 127 500 68 750 58 750 325 £ 235 625 178 750 56 875 575 £ 363 125 247 500 115 625 13. Favourable variance of £15 625.Module 13 / Standard Costing Units Sales Variable costs Contribution margin Actual results were as follows: Units Sales Variable costs Contribution margin Chicago Inc. (d) Adverse variance of £8125. (b) Adverse variance of £5175.34 What is the sales volume variance? (a) (c) Favourable variance of £11 250.35 What is the sales quantity variance? (a) (c) Adverse variance of £5 250. Accounting Edinburgh Business School 13/29 .36 What is the sales mix variance? (a) (c) Favourable variance of £375. (b) Favourable variance of £15 075. 13. (d) Favourable variance of £750. Favourable variance of £15 750. (d) Favourable variance of £16 250. Adverse variance of £500. 13. 13. (d) Favourable variance of £16 250. (b) Favourable variance of £11 750.

00) Direct materials K1 – 18 000 kg at £1 per kg B3 – 8500 kg at £3. The first quarter of the financial year has just been completed with the following results: £ Sales (9000 units at £85.50 per hour) Variable overheads Contribution margin £ 765 000 18 000 29 750 126 000 165 000 338 750 426 250 The management is modestly pleased with the actual results for the quarter. together with any relevant sales variances.00 18. suggest possible explanations for the variances identified.Module 13 / Standard Costing Case Study 13. The standard cost for Alphastar is: £ Direct materials Raw material K1 – 2 kg at £1 per kg Raw material B3 – 1 kg at £3 per kg Direct labour – 3 hours at £4 per hour Variable overheads – 3 hours at £6 per direct labour hour 2.00 each.1 Inverfrost Products Limited manufactures a single product – a special chemical – Alphastar.00 3. others are significantly different from those laid down in the standard. but is disappointed that sales have fallen short of the budgeted level. Required Prepare a full variance analysis of all variable cost elements.00 12. From the information available. It is also concerned that whereas some costs seem under control.00 The company’s annual budget envisages sales of 40 000 units of Alphastar at £80.00 35.50 per kg Direct labour (28 000 hours at £4. The company has always operated a standard costing system to control the variable cost aspects of the product. spread evenly over the year. 13/30 Edinburgh Business School Accounting .

1 14.6 14.11 The International Dimension 14.7 14.2 14.12 Summary Review Questions Case Study 14. the advantages and shortcomings of divisionalisation.1 Learning Objectives By the end of this module you should understand: • • • • the reasons for divisionalisation.11. the types of divisional structures.2 14.1 Market Prices 14.9 Introduction Why Divisionalise? Advantages for Divisions Disadvantages for Divisions Types of Divisions Defining Profits and Investments Asset Base Valuation Net Book Value Current Replacement Cost Residual Income: An Alternative to ROI The Imputed Rate of Interest Does Matter! Do-it-Yourself Case Study Solutions and Comments A Cautionary Note about Performance Measures Transfer Pricing 14/2 14/3 14/3 14/4 14/5 14/6 14/9 14/9 14/10 14/10 14/11 14/12 14/14 14/16 14/17 14/17 14/18 14/19 14/20 14/21 14/22 14/23 14/23 14/31 14. 14/1 Accounting Edinburgh Business School .10.2.3 14.11.1 14.10 Criteria for Establishing a Transfer Price 14.1 Do-it-Yourself Case Study 14.1 14.5.7.5 14.4 14.2 Cost-Based Prices 14.7.2 14.2. the role of return on investment and the difficulties in measuring both return and investment.Module 14 Accounting for Divisions Contents 14.10.2 Solution and Comment 14.5.8 14.1 14.2 14.

5/35) we can see that its operations are structured around four principal sectors: • • • • Communications Systems Capital Electronic Systems This wide spectrum of research and manufacturing activity is conducted all over the world and reported in the Annual Report in four major blocks. Our interest lies in the problems which arise when one division of a company sells products to another division of the same company instead of to outside customers. Take MBA plc as an example of a divisionalised company. The cost items used for illustrative purposes have been discrete products to which costs can be either traced directly or allocated using one of the many available procedures.1 Introduction Throughout this series of modules on Management Accounting for Decision Making we have focused on the costing and decision making processes surrounding individual products. Rest of Europe. 14/2 Edinburgh Business School Accounting . A division is sometimes a wholly owned company. United Kingdom. – the role of transfer pricing in divisionalised companies and the difficulties inherent in selecting suitable bases. From its 20x2 Annual Report (see Module 5. 14. These products were manufactured or assembled by the businesses in whose accounting and control systems we were interested and were sold to external customers.Module 14 / Accounting for Divisions • the weaknesses of ROI: – how residual income is calculated and the differences between RI and ROI. Note 1 on p. Can we use the same procedures for evaluating divisions as we use for entire companies? Accounting for divisions focuses on the activities of whole divisions rather than individual products or processes although the same cost definitions will apply in our discussion that have been used in earlier modules. Now we turn our attention to the accounting issues surrounding internal transfers of goods and services in organisations whose activities are sufficiently diverse to lead to separate divisions being set up. Asia and Australasia. Do the same prices apply? Can the selling division be allowed to make a profit from the transaction? What would happen if the buying division could source the product from an external supplier more cheaply? Additionally we will consider how to evaluate the overall performance of individual divisions. – how well-managed companies have a wide variety of performance measures. The Americas and Africa. the same principles apply.

Even in one-product companies – if they actually exist – the magnitude of the problems confronting central management may become so great that it makes sense to separate the activities into divisions. 14. A feeling of ‘ownership’ and pride can be engendered for the benefit of the whole company by a divisionalised structure where individual divisions are instructed to treat themselves like companies operating on their own account and be judged according to their own performance. Far better for the Indian telecoms operations to be set up as a division and its managers told to run their own affairs.Module 14 / Accounting for Divisions 14. These operations must therefore be separated from the other parts of the company and given their own management team. Local solutions can be sought and implemented so much more quickly than if the headquarters staff had to review the matter.2 Why Divisionalise? Businesses grow in two ways. borrowed cash or issue of own shares. the acquiring company would hope to ‘learn the business’ and eventually add value to its operations. make the decision and communicate the decision to the local team. Employees working away from the centre of an organisation can become demotivated and demoralised by having decisions made about their activities by a remote management in headquarters. Managers on the ground see problems emerge long before central headquarters staff would detect potential trouble. Size. Sheer size and complexity of operations prevent the head office management team from exercising a sufficiently rigorous scrutiny of day-to-day operations. produce quick growth into areas in which the company is perhaps less certain. The speed with which commercially sensitive problems emerge exceeds the speed of modern communication devices and can be overcome by having 14/3 2 3 4 Accounting Edinburgh Business School . Motivation. Such growth is usually slow but the risks attached are relatively small due to the detailed knowledge possessed by the company in the areas earmarked for expansion. In this way. financed either by own cash. perhaps on a geographical basis. perhaps on a customer basis. consult with the local manager. organically or through acquisition.1 Advantages for Divisions 1 SpecialisationThe sheer complexity of MBA’s group activities makes the point rather cogently for specialised management in different parts of the company. Organic growth is driven by more and more sales of more and more products where the increasing cash flow and profits are used to invest in more productive capacity. Such separation is called divisionalisation for which many advantages (and a few disadvantages) are claimed. Sharper decisions.2. Acquisitions. The senior executives of MBA based in corporate headquarters in London do not know as much about the sales potential of telecoms switching gear in India as the local management team located in that country. detailed knowledge can be brought to bear immediately on local problems. Whichever form of growth a company chooses – and the two are not mutually exclusive – it is faced with managerial problems of control. By retaining the management of the enterprise bought.

in effect. Individuals respond to challenges and rewards for success. or quarterly review meetings to which divisional heads report. a company on its own. a divisional structure is advantageous.If divisions are set up with a performance measurement system which can highlight superior managerial performance. 14. Division A makes components for sale. and so on. perhaps R&D. Divisions provide the testing ground for managerial talent. A system of territorial directors. For example.Module 14 / Accounting for Divisions 5 a management in situ being evaluated as if it were running a stand-alone company. Divisionalisation therefore is seen to cost more money. Additionally. Once a division has been set up and its management team given the task of ‘running its own ship’. one division may be reluctant to share market intelligence with other divisions Edinburgh Business School Accounting 2 3 14/4 . To allow the headquarters team (who are typically handling critical strategic planning decisions which impact the long-term success of the entire group) to be drawn from the best available managerial talent. Success at one level will lead to a more challenging appointment. Should B be allowed to buy outside even though the variable costs for A to make the component are less than the outside price? From Division B’s point of view. can overcome this perceived disadvantage. One component is sold to Division B as well as to outside customers. training. Career mobility. Internal rivalries. Here individuals can be given limited managerial freedom and judged according to the way they cope with the problems and pressures. No longer can it participate in the detailed day-to-day decisions nor can it necessarily influence the strategic direction the division may take. A company like MBA has many layers of individuals and many layers of problems and decisions to be made. computing. Headquarters must therefore design a structure for reporting and discussion which allows them to maintain control over the major decisions while encouraging local management to run the routine operations. Division B complains that it could purchase this component from an external supplier more cheaply than the price at which A is selling it. headquarters has lost a measure of control. from the company’s point of view the internal cost is the better. Some companies accept these additional costs as a necessary outlay to reap the benefits of divisionalisation. others wield the cost-cutting axe to headquarters overheads on the basis that a significantly reduced set of services will be expected from HQ now that the divisions have their own support.2 Disadvantages for Divisions 1 Lack of control. When people are selected for the headquarters team.If a division is set up to be.2. whose task it is to travel away from the centre to the various divisions under their control. Cost. the external price is the better one. a spirit of competition and internal rivalry may be created which is dysfunctional to the overall objectives of the company. it will require support services such as personnel. their skills have already been well tested and the disruption involved in any team move is minimised. Many of these will be duplicates of those already supplied by headquarters.

From the accounting stance. great