Business Accounting Study Guide

Study Guide
BUSINESS ACCOUNTING
Content
This module deals primarily with the study of the two main branches of business accounting
which are financial accounting and management accounting. The first part of the course
covers the basics of financial accounting. Topics included here are double entry bookkeeping and the preparation of basic financial statements and financial analysis. The second
part of the course covers management accounting techniques for planning, control and
decision-making.
Module Aims
The aims of this module are to:
1.
Introduce the accounting cycle and how accounting data impacts on business
decisions.
2.
Give an understanding to participants on the preparation and analysis of financial

statements.
3.
Develop participants abilities to use accounting methods within specific enterprises

for the purposes of managerial control and decision making.
Learning Outcomes
On completion of this module, a participant will typically be able to:
1.
Show a detailed knowledge and understanding of:
i)
ii)
iii)
iv)
v)
The accounting equation and accounting rules.

The classification of accounts.
Bookkeeping and the accounting cycle.
The relation between the principal financial statements.
The interpretation of financial statements, the analysis of profitability, of solvency
and gearing.
Cost behavior and product costs under competing assumptions.
The construction and use of budgets inside enterprises.
vi)
vii)
2.
Demonstrate module specific skills with respect to:
i)
ii)
Preparing a simple balance sheet from financial information.

Forecasting financial statements for simple cases and adjusting financial statements
for transactions.
Citing, explaining, selecting, and applying formats/models to solve numerical
problems in such areas as: analysis of financial statements; cost assignment and
allocation; pricing and production decisions; and developing budgets.
iii)
3.
Show cognitive skills with respect to:
i)
ii)
iii)
Integrating and synthesizing between module topics to discuss coherent approaches to

the key issues faced in planning and controlling a business from the accounting
perspective.
Developing familiarity and confidence with accounting / financial arithmetic.
Applying accounting models in a real world context.
4.
Demonstrate transferable skills in:
i)
ii)
iii)
iv)
v)
vi)
Information retrieval and numerical analysis.

Analytical reasoning.
Communication and presentation.
Accounting in context.
Problem formulation and decision making.
Working with others.
Delivery of Module and Lesson Plan

Session
Topics
Session Learning Outcomes
Prescribed
Text,
At the completion of this session, Readings
participants will be able to:
and/or
Activities
1.
Introduction to
Accounting
1. Explain the nature and role of

accounting and finance.
2. Explain the role of accounting in
planning and controlling a
business.
3. Distinguish between financial and
management accounting.
4. Explain the accounting equation
and accounting rules.
McLaney and
Atrill,Chapter
1
2.
Bookkeeping and the

Accounting Cycle
1. Explain the major groups of

accounts (invested capital, retained
earnings, revenue, expenses,
owners withdrawal).
2. Complete the accounting cycle:
journalize entries, post to general
ledger, check accuracy by use of a
trial balance, adjust accounts, and
close of accounts.
3. Explain the nature and purpose of
the three financial reports.
4. Discuss the accounting
conventions underpinning the
balance sheet.
5. Discuss the limitations of the
balance sheet in portraying
financial position.
McLaney and
Atrill, Chapter
2
3.
Measuring and
Reporting Financial
Performance
1. Discuss the nature and purpose of

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

4.
Accounting for
Limited Companies
1. Discuss the nature of a limited

company.
2. Explain the role of directors of
limited companies.
3. Describe the main features of
owners claim of limited
companies.
4. Draw up a set of financial
statements for a simple limited
company.
5. Explain how the income statement
and balance sheet of a limited
company differ from that of sole
proprietorships and partnerships.
McLaney and
Atrill, Chapter
4
5.
Reporting for
Limited Companies
1. Describe the responsibilities of

directors and auditors concerning
the annual financial statements
provided to shareholders and
others.
2. Outline the statutory regulations
surrounding accounting for limited
companies.
3. Outline the non-statutory
regulations surrounding
accounting for limited companies.
4. Prepare an income statement,
balance sheet and statement of
changes in equity for a limited
company in accordance with
International Financial Reporting
Standards.
McLaney and
Atrill, Chapter
5
6.
Measuring and
Reporting Cash
Flows
1. Explain the role that cash plays in

enterprise.
2. Explain the nature of the statement
of cash flows and how it can help
in identifying cash flow problems.
3. Draw up a simple cash flow
statement.
4. Interpret a statement of cash
flows.
McLaney and
Atrill, Chapter
6
7.
Analysis of Financial
Statements
1. Establish the usefulness of

financial reports to various interest
groups.
2. Identify the major categories of
ratios which may be used for
McLaney and
Atrill,
Chapter 7
analysis.
3. Calculate a range of accounting
ratios and explain their
significance and limitations.
4. Explain the importance of gearing
to an enterprise and its owners.
8.
Budgeting
1. Define a budget and show how

budgets, corporate objectives and
long-term plans are related.
2. Explain the interlinking of the
various budgets within a business.
3. Indicate the uses of budgeting and
construct various budgets,
including the cash budget.
4. Discuss the criticisms that are
made of budgeting.
McLaney and
Atrill, Chapter
12
9.
Accounting for
Control
1. Discuss the role and limitations of

budgets for performance
evaluation and control.
2. Undertake variance analysis and
discuss possible reasons for the
variances calculated.
3. Discuss the issues that should be
taken into account when designing
an effective system of budgetary
control.
4. Explain the nature, role and
limitations of standard costing.
McLaney and
Atrill, Chapter
13
10.
Full Costing and

Marginal Costing
1. Deduce the full (absorption) cost

of a unit of output in a single
product environment.
2. Deduce the full (absorption) cost
of a unit of output in a multiproduct environment.
3. Discuss the problems of deducing
full (absorption) costs in practice.
4. Distinguish between full
(absorption) and variable costing.
5. Discuss the usefulness of full
(absorption) cost information
(versus variable costing) to
managers.
McLaney and
Atrill, Chapter
10
11.
Cost-profit-volume
Analysis
1. Bearing in mind the distinction

between fixed costs and variable
costs, explain the relationship
between costs, volume and profit.
McLaney and
Atrill, Chapter
9
2. Use cost-volume-profit analysis to

establish the break-even point for
some activity.
3. Discuss the weaknesses of breakeven analysis.
4. Demonstrate the way in which
marginal analysis can be used
when making short-term decisions.
12.
Costing and Pricing

in a Competitive
Environment
McLaney and
1. Discuss the nature and
practicalities of activity-based
Atrill,
costing.
Chapter 11
2. Explain how new developments
such as total life-cycle costing and
target costing can be used to
control costs.
3. Discuss the importance of nonfinancial measures of performance
in managing a business and the use
of the Balanced Scorecard to
integrate financial and nonfinancial measures.
4. Explain the term shareholder
value and describe the role of
EVA in measuring and delivering
shareholder value.
5. Explain the theoretical
underpinning of pricing and
discuss the issues in reaching a
pricing decision in real-world
situations.
Teaching and Learning Methods

Participants will learn through a combination of lectures and practice exercises.
Participants will be expected to learn independently by carrying out reading and directed
study beyond that available within taught classes.
Indicative Readings
Textbooks required
McLaney E and Atrill, P (2008), Accounting, An Introduction,

FT Prentice Hall, Harlow.
Supplementary reading
Gowthorpe, C. (2005), Business Accounting and Finance for

Non-Specialists, Mason, Ohio: Thomson Learning.
Ross, S.A., Westerfield, R.W. and Jordan B.D. (2008),
Fundamentals of Corporate Finance, Columbus, Ohio:

McGraw-Hill Irwin.
Online Journals
Use of online databases like EBSCO and references to:

Financial Management, the Journal of Chartered Institute of
Management
Accountants,
Journal
of
Accounting,
Accountancy, Journal of the Institute of Chartered Accountants
in England and Wales, Accounting Review and Harvard
Business Review.
Assessment/Coursework
All assessments must comply with the SIM Rules and Regulations. To satisfy module
requirements, students must:
1) Satisfactorily complete and present on due dates their completed assignment. A
penalty of 20% of the total marks will be imposed for late submission. More than one
calendar will get zero marks.
2) Complete all assignments and the final examination in a satisfactory manner.
3) Must reference all their work and observe SIMs policy on plagiarism. Students found
guilty of plagiarism will be dealt with severely.
4) Adopt either the Harvard or APA (American Psychological Association) Referencing
Styles.
5) Spend at least 100 hours (including class attendance and assignments) on the module
in order to fare reasonably.
Specific for this module are the following requirements:
Weighting between components A and B - A: 70% B: 30%
Element Description
Element Type
% of Assessment
Component A (Controlled
Conditions)
Examination (180 minutes)
Component B (Assignments)
1. Class test.
Summative
70%
Summative
2.
Summative
15%
Session 7
15%
Due: Session 10
100%
Exercises/scenarios in financial
accounting.
Total
ACKNOWLEDGEMENTS
The following notes (from session 1 to session 12) are abridged, adapted and customized from the textbook
and its accompanying instructors manual: Eddie McLaney and Peter Atrill (2008), Accounting: An
Introduction, NJ: Pearson Education.
Session 1
Introduction to Accounting and Finance
At the end of the session, students should be able to:
1. Explain the nature and role of accounting and finance.
2. Distinguish accounting users and characteristics of accounting information.
3. Distinguish between financial and management accounting.
4. Explain different business structures
_____________________________________________________________________
1.1
WHAT IS ACCOUNTING AND FINANCE?

Accounting is concerned with collecting, analyzing and communication financial
information. The information is useful for businesses to make decisions and to plan.
The accounting information system has features that are common to all valid
information systems. These are:
a)
b)
c)
d)
identify and capturing relevant information

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

c) the risks associated with each form of finance
d) the role the financial markets in supplying finance
1.2
ACCOUNTING USERS AND ACCOUNTING INFORMATION

The users of accounting information can be internal or external to the company. The
following are possible users you can consider.
a)
b)
c)
d)
e)
f)
g)
Owners
Managers
Employees
Customers
Suppliers
Competitors
Government
Are you able to think of reasons why each of the above is keen to have the accounting
information?
Good accounting information must have some characteristics or key qualities to be of
value to the users. The 4 main key characteristics are:
a) Relevance means the ability to influence decision making. This implies the
information must be available and sufficiently critical to change a decision e.g. to
invest or not to invest in a company. For information to be relevant, it has to be
timely as well.
b) Reliability means that the information should be free from significant errors or
bias. However, a reliable information may not be relevant for decision making and
a relevant information may be unreliable
c) Comparability this is a quality that enables a user to identify changes in the
business over a time frame. Making accounting procedures used to measure and
present information the same each year will allow easy comparison
d) Understandability Accounting reports should be expressed as clearly as
possible and should be understood by the users of the information.
While good information should have the above characteristics, it must also satisfy two
other criteria for information recording. The first is materiality whether omission or
misrepresentation of the information would lead to a change in decision making. The
second is the cost-benefit ratio this considers the benefit gained by the effort in
gathering the data. If the cost is greater than the benefit, it is not reasonable to be
accurate with no benefit to the users.
1.3
DIFFERENCE
BETWEEN
MANAGERIAL ACCOUNTING
FINANCIAL
ACCOUNTING
AND
Financial accounting seeks to meet the needs of all the users (both internal and
external) already identified above and to assist them in their decision making.
Managerial accounting is targeted at internal users such as the managers who will
need the information for business decision making.
The following summarized the differences:
1.4
Financial Accounting
Managerial
Accounting
Users
External users
Internal users
Time focus
Historical perspective
Future emphasis
Verifiability versus
relevance
Emphasis on
verifiability
Emphasis on relevance
Precision versus
timeliness
Emphasis on precision
Emphasis on timeliness
Subject
Focus on the whole

organization
Focus on segments of a
company
GAAP
Must follow GAAP
Need not follow GAAP
Requirements
Mandatory
Not Mandatory
Types of business ownership

The form of business ownership is important for accounting and it is useful to know
the main forms of ownership that exists.
The three basic arrangements are:
a) Sole proprietorship
b) Partnership
c) Limited company
Characteristics of a sole-proprietorship
Single owner
Limited capital requirements
Small scale of operations
Combined ownership and management
Legal or professional restrictions (must operate as sole trader or partnership)
Professional responsibility (in terms of unlimited liability)
Minimal regulation and minimal external record keeping requirements
Taxation advantages
Unrestricted ability to sell
10
Characteristics of a partnership
Access to additional capital
Complementary skills and services
Flexible management
Economies of scale
Limited scale of operations
Legal or professional restrictions (must operate as sole trader or partnership)
Professional responsibility (in terms of having unlimited liability)
Tax sharing advantages
Moderate regulation
Minimal external record keeping requirements
Characteristics of Limited Company:
Access to significant capital (type and amount)
Separation of ownership and management
Continuity of operations
Limited liability
Possible taxation advantages
Unlimited level of activity
While one can memorized the above as characteristics for each of the business entity,
it will be worth your learning process to view the information as advantages or
disadvantages for each business structure
Review Questions
Source: Atrill , McLaney, Harvey, Jenner (2006): Accounting : An Introduction, NJ: Pearson
Education.
1)
What is the purpose of producing accounting information?
2)
Relevance and reliability are two key characteristics of accounting information. Explain
what they mean and are they in conflict?
3)
Distinguish between financial accounting and management accounting.
4)
A sole proprietor converts to a limited liability company. What are the potential
advantage to the owner and the potential disadvantage to the suppliers of the company?
5)
Discuss the advantage and disadvantages of companies compared to other entity

structures.
11
Session 2
Bookkeeping and the Accounting Cycle
1. Explain the nature and purpose of major financial statements.
2. Prepare a simple balance sheet
3. Understand accounting conventions
_____________________________________________________________________
2.1
THE MAJOR FINANCIAL STATEMENTS

The major financial statements aim to provide an overall picture of the health of a
company. They present the financial position and financial performance of a business.
The three major statements are a) the Balance Sheet (also known as Financial Position
Statement), b) the Income Statement (also known as the Profit and Loss Statement or
Financial Performance Statement and the c) the Cash Flow Statement.
The Balance Sheet shows the financial position of a company at a point in time. It
presents what the business possess as assets, the amount it owes to outside lenders and
the value of the business belonging to the owners of the business
The Profit and Loss Statement presents the annual (or semi-annual, quarterly or
monthly) performance of the company in generating profits for the business.
The Cash Flow Statement explains the where the cash comes from and how it is used
during the year. At this point, understand that the profit earned is not equal to the cash
for the year.
2.2
PREPARING A SIMPLE BALANCE SHEET

The balance sheet is made up of three major items. They are the Assets, the
Liabilities and the Equity (also referred to as Capital)
These 3 items form what we call the Accounting Equation.
Assets = Liabilities + Equity (Capital)
The Balance Sheet can be presented in the Horizontal Format or Vertical Format.
12
The Horizontal Format
Liabilities
Assets
Equity
(Capital)
A=L+E
The Vertical Format
Assets
Total Assets
Liabilities
Equity (Capital)
Total Liabilities + Equity
Now let us focus on each category. It is important that you know the definition of
each category because this will enable you to place items into their respective group
for presentation.
13
Assets
These are essentially a resources held by the company.
To be an asset, the following characteristics should exist;
a) A probable future economic benefit implies it is expected to generate some
future monetary value
b) Business has exclusive right or control over the benefit implies that while the
business may not fully own the asset, it can use it to generate future monetary
benefit for itself
c) Economic benefit must arise from past event or transaction implies that a
transaction or event must have occurred to allow the business to enjoy the benefit.
d) It must be capable of being measured in monetary terms implies the possibility
of placing a value to it.
Note that assets can be either short term or long term. Accountants use one year (12
months) as the general accepted time frame for classifying assets as either short term
(we call them Current Assets) or long term (Non-Current Assets)
Current assets are basically assets that meet any of the following conditions:
a) held for sale or consumption in the normal course of business operating cycle
b) expected to be sold within the next year
c) are held primarily for trading
d) are cash or near cash items such as marketable short term investments
Examples of current assets are cash, accounts receivables, inventory, prepayments etc.
Non-Current Assets (also called Fixed Assets) are those that do not meet the
conditions of a current asset. Generally speaking, they are held for long term
operations.
Examples of non-current assets are machinery, building, property, vehicles, fixtures
etc.
Most non-current assets have physical substance. This means that one can see and
touch the assets. However, some assets do not have physical substance and we term
them as Intangible Non-current assets. Examples of such assets are copyrights,
goodwill, trademarks etc.
Liabilities and Equity (Capital)

While the company has control of the assets (whether current or non-current), the
financing came from the liabilities and equity (capital). Liabilities and Equity
(Capital) are sources of financing provided by parties outside the business entity.
These are the Claims by outside parties on the company.
So a claim is an obligation on the part of the business to provide cash or some other
form of benefit to these outside parties.
14
Equity or Capital are the claims by the business owners. Why? The business owners
are the ones who contributed either cash (most common) or personal assets into the
company to start the business operations.
Besides the owners, the business also has claims by third parties other than the
business owners. We called them Liabilities. Liabilities must arise from past
transactions or events such as supplying goods or lending money to the business.
Once a liability is settled, it will normally be through an outflow of assets (usually
cash)
Like assets, liabilities are also classified as short term (current liabilities) or long term
(non-current liabilities).
Short term liabilities should meet any of the following criteria:
a) they are expected to be settled within the normal course of the business operating
cycle
b) they are due to be settled within 12 months following the date of the balance sheet
on which they appear
c) they are held primarily for trading purposes
d) there is no right to defer settlement beyond 12 months following the date of the
balance sheet on which they appear
Non-current liabilities represent amounts due to third parties but doe not meet the
definition of current liabilities.
Examples of current liabilities are account payables, unearned revenue (income), bank
overdraft.
Examples of non-current liabilities are long term loans, mortgage etc.
A sample of a balance sheet in horizontal format
Balance sheet as at 31 December 2009
$
Non-current assets
Vehicles
Premises
Plant - cost
50,000
Less acc. depreciation (8,000)
42,000
Current assets
Inventories
Trade receivables
Cash at bank
23,000
21,000
11,000
30,000
46,000
173,000
$
Capital
Balance at 31 December 2009
102,000
Non-current liabilities
Borrowings from Commercial
Loan Company
45,000
Current liabilities
Trade payables
26,000
173,000
15
Note: One can also present the current asset above the non-current assets, the
liabilities above the capital.
2.3
ACCOUNTING CONVENTIONS AND THE BALANCE SHEET

Accounting has a number of rules or conventions and we will focus on the following
few listed below.
Business Entity Convention this convention implies there is a legal separation
between businesses and the owners. For limited companies, there is a clear legal
distinction between the owners (investors) and the company. However, for sole
proprietorship and partnerships, the law does not make any distinction.
Historical Cost Convention indicates that the value of assets shown on the balance
sheet should be based on their acquisition cost (that is, historical costs).
Prudence Convention this convention holds that caution should be exercised when
making accounting judgments. Example: Income is considered earned only when they
actually occur and not when discussions are held. This convention allows reporting to
be fairly presented for users.
Going Concern Convention this convention indicates that the financial statements
should be prepared on the assumption that the business will continue operations into
the foreseeable future, unless this is known to be untrue.
Dual Aspect Convention This convention asserts that every transaction will have
two aspects and both will affect the balance sheet. Thus a purchase of a vehicle with
cash payments will result in an increase in the non-current asset (a vehicle) but a
decrease in the current asset (cash outflow). A settlement of a loan will result in a
decrease in an asset (cash outflow) and a decrease in a liability (loan is settled and
now owe the third party less).
While accounting conventions exist, there will be circumstances where a firm may
deviate slightly in order to present the financial statements in a manner for the
investors can understand the firm better.
16
Review Questions
1)
Discuss the main characteristics of assets? What do we mean by current in the

classification?
2)
The balance sheet indicates that there are two types of claims on the assets of a firm.
What are the two types of claims and how are they different?
3)
Discuss two accounting conventions discussed in this session.
4)
Using a vertical format, prepare a balance sheet with the following information.
Inventory
Property
Accounts Receivables
Accounts Payables
Vehicles
Bank Loan
Bank Overdraft
Heavy Equipment
$208,000
$350,000
$135,000
$180,000
$110,000
$200,000
$120,000
$150,000
17
Session 3
Measuring and Reporting Financial Performance
1. Explain the nature and purpose of the profit and loss statement
2. Prepare a simple profit and loss statement
3. Understand the recognition and measurement of income
4. Understand main accounting convention for the income statement
_____________________________________________________________________
3.1
THE NATURE AND PURPOSE OF THE PROFIT AND LOSS STATEMENT

OR THE INCOME STATEMENT
The purpose of the profit and loss statement is to measure and report how much
wealth (in terms of profit) the business has generated over a period. We term this
period as the accounting period and while is usually reported using a year, it can also
be monthly, quarterly or semi-annually.
What is accounting profit? Profit is the difference between revenue and total expenses
for the accounting period under consideration.
In short, the income statement is made up of the following 3 major items.
Revenue
Less Expenses
Profit or Loss
Revenue is the measure of the inflow of economic benefits arising from ordinary
activities of the firm and Expenses are essentially the opposite of revenue. They
measure the economic outflow of benefits arising from ordinary business activities. If
the revenue is larger than expenses, the result is PROFIT which will increase the
wealth of the owners and this amount will enhance (increase) the equity (capital) in
the balance sheet. If the revenue is lesser than expenses, it will result in a loss which
will reduce the total value of the equity in the balance sheet.
Examples of revenues are sale of goods by a manufacturer, providing a service by a
lawyer, subscriptions collected by a club or earning interests from an investment or
bank deposit.
Expenses can be further detailed into several groups. The first group is the Cost of
Sales (sometimes referred to as Cost of Goods Sold). This will exist mainly for
manufacturers or retailers. Then we have the Operating Expenses which are incurred
to run the business. Examples of operating expenses are salary, rental, insurance,
utilities, telephone and postage, printing and stationery. The following section shows
the appropriate presentation.
18
3.2
PREPARING A PROFIT AND LOSS STATEMENT

The format of the statement takes the following form and it is important that you
remember the format well.
Less
Less
Less
Less
Less
Add
Revenue (Sales)
Cost of Goods Sold
Gross Profit
Operating Expenses
(e.g. salary, rental)
Marketing Expenses
(e.g. commission, advertisement)
Administrative Expenses
(e.g. postage, utility)
Financial Expenses
(e.g. interests expense)
Operating Profit (Net Profit before Tax)
Other Income
(e.g. interests earned)
Profit for the year
From the format above, gross profit is the net earnings from sales after deducting the
costs of the items sold. Profit for the year is the Operating income together with
other income through activities which are not the normal day to day operations.
For the sole proprietor or the partnership, the profit for the year is taxed at their
marginal tax rate and thus taxes will not appear in the statement. The profits are then
their residual earnings. This will increase the wealth of the owners. If the owners did
not do any withdrawals from the earnings (i.e. not distributed back to the owners), the
earnings amount will increase the equity (capital) values in the balance sheet.
Cost of Sales (or cost of goods sold): If the cost of sales is not given, we can derive
the cost of sales from other information provided.
Illustration: On the 1st Jan 2009, the company has $30,000 worth of inventory which
was purchased the year before. They are acquired for the purpose of trading to make a
profit. During different months in 2009, the company purchased additional $75,000
worth of inventory. During the year, the accountant recorded each sale as it occurred.
Inventories were exchanged for the sales. At the end of the year, a stock-count was
conducted and the amount left in the warehouse is $29,000. What is the cost of goods
sold? If the total revenue is $120,000, what is the gross profit?
Thought process: The company has $30,000 worth of inventory at the beginning and
it bought $75,000 more. This means that the company has a total of $30,000 +
$75,000 = $105,000 worth of stocks on hand to sell during the year.
Note that while the sales are recorded, the cost of the items sold were not. Firms
usually do a stock-take at year end (can also be monthly or quarterly) which
determines what is left in the warehouse. Those in the warehouse remains your assets
and those that are not are assumed SOLD.
Thus, the COGS is ($105,000 - $29,000) = $76,000.
So the
COGS = Beginning Inventory + Purchases Ending Inventory
(Note: Beg Inventory + Purchases = Amount Available for Sale)
19
Presentation of a Profit and Loss Statement
3.3
Total Revenue (Sales)
$120,000
Beg Inv
$ 30,000
Purchases
$ 75,000
Less End Inv ($29,000)
COGS
Gross Profit
$ 76,000
$ 44,000
RECOGNITION AND MEASUREMENT OF PROFIT

In the profit and loss, the key issue is the measurement of profit and so it is important
to the point where revenue is considered earned and when expenses are considered
incurred.
Recognizing Revenue
There are three points where associated revenue could be recognized:
a) at the time that the order is placed by the customer
b) at the time the purchased item is collected by the customer (or services enjoyed by
the customer)
c) at the time the customer pays for the purchased item or services.
While these points can be far apart, the main criteria for recognizing revenue are that:
a) the amount of revenue can be measured reliably
b) it is probable that the economic benefits will be received.
c) Ownership and control of the items is passed to the buyer
It is important to know that revenue is considered earned (realized) and must be
recorded in the profit and loss statement when the above criteria are met. This means
that even if cash is not paid yet, the revenue is earned as the items are collected by the
buyer or the services are already provided. An example is a Credit Sale which is a
completed sale but the client is allowed to pay at a later date.
Recognizing Expenses
The matching convention in accounting provides guidance concerning the
recognition of expenses. This convention states that the expenses should be matched
to the revenue that they help to generate.
20
Example: A company incurred $50,000 of salesmen salary and commission in

January to generate sales. Based on the matching convention, the salary must be
deducted as expenses against the revenue generated when computing the profits
earned. Note that we recognize the full amount as January expenses even if a portion
of the salary or commissions are paid the following month.
The above example will result in the expenses recorded in the profit/loss statement is
more than the cash paid during the period. Accountants termed it as Accrued
Expenses (Accrued payables). If the company pays $45,000 of the $50,000 in
January, it would have owed the remaining $5,000. The records will show a $50,000
expense with a $45,000 outflow of cash payment and a $5,000 liability (accrued
expense) in the balance sheet.
Example: A company pays $12,000 for insurance premiums for the full year of 2009.
This means that monthly insurance expense is $1,000.
Based on the transaction, the cash outflow is $12,000. But the company cannot
recognize the full $12,000 as January insurance expense immediately because it is for
the full year and not January only.
As the amount was paid in advance before the expenses are incurred, accountants
termed these types of transactions as Prepaid Expenses (prepayments). For January,
we will record $1,000 as insurance expense, $11,000 as Prepaid Expenses (Current
Asset) and an outflow of $12,000 cash payments.
3.4
ACCOUNTING CONVENTION FOR PROFIT/LOSS STATEMENT

There are several accounting convention required to calculate expenses that affect the
performance statements. These affect the non-current asset like machinery and the
current assets such as the inventory and the account receivables. We will consider
them now.
Depreciation Expenses
Non-current assets like machinery, vehicles etc will last a long period while
generating revenue for the firm. As they are used to generate the revenue, their values
will decline due to usage, age, wear and tear. Accounting termed this decline in
values for the non-current assets as depreciation expenses.
Depreciation is defined as the rational allocation of cost over the period where the
asset is used to generate revenue.
Calculating Depreciation Expenses
To calculate a depreciation charge for a period, four factors are considered:
The cost (or fair value) of the asset includes the purchased price plus all costs
incurred to make the asset ready for use. This includes delivery, installation,
testing, legal costs etc.
The useful life of the asset A non-current asset has physical and economic life.
Physical life will be exhausted through the effects of wear and tear but economic
life is decided by the effects of technology.
21
The residual value of the asset this is the disposal value when the asset is no
more required. Past sale value of similar assets can be a guide to estimating the
residual value.
The depreciation method we will discuss two methods listed below.
Depreciation Methods: Straight Line Method and Reducing Balance Method.

The Straight Line method allocates the cost of the asset equally over the time it is
used to generate revenue. It is based on the following formula:
Depreciation Exp Per Year = (Cost of Asset Residual Value) / Useful life
The Reducing Balance method uses a fixed percentage to calculate the yearly
depreciation expense based on the reduced asset value at the beginning of each year.
Example: An asset costs $40,000 and is expected to have a useful life of 4 year. The
estimated residual value is $1,024. A fixed percentage of 60% is used for the reducing
balance method. Calculate the depreciation expense per year under both methods.
Using Straight Line, the depreciation expense per year will be
($40,000 -$1,024) / 5 = $9,744 per year
So, the depreciation expense from years 2 to 4 will also be $9,744 per year.
Using Reducing Balance method To use this method, one must determine the Net
Book Value (NBV) of the asset at the beginning of each accounting period. The
depreciation expense for each year is calculated by using the (NBV x fixed
percentage).
The NBV is the computed using (Cost Accumulated Depreciation) and
Accumulated Depreciation is the total of depreciation expense incurred to date.
Year 1
Year 2
Year 3
Year 4
NBV at Beg
40,000
16,000
6,400
2,560
Dep Exp
(40,000 x 0.6) = 24,000
(16,000 x 0.6) = 9,600
(6,400 x 0.6) = 3,840
(2,560 x 0.6) = 1,536
Acc Dep
24,000
33,600
37,440
38,976
The final net book value (residual value) will be ($40,000 $38,976) = $1,024
22
Costing Inventory It is important to know that different methods of costing

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

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

1,000 x $11 = $11,000
9,000 units = $107,000
The ending inventory is 4,000 units from the first purchase and 1,000 in the
beginning inventory. So the ending inventory cost is (4,000 x $11) + (1,000
x$10) = $ 54,000
23
c) Weighted Average Cost (AVCO)

First, find the average cost per unit.
The total inventory cost = $161,000
The total number of units = 14,000 units
So the average cost is $11.50 per unit
Thus, the cost of goods sold is 9,000 x $11.50 = $103,500
And the ending inventory is 5,000 x $11.50 = $ 57,500
Trade receivables issues
Businesses usually sell their products or provide services on credit. With this
arrangement, there will be a volume of accounts receivables outstanding at each
accounting year end.
With the outstanding receivables, there are risks that customers may not settle the
amounts due. When it becomes reasonable certain that the client will never pay, the
debt owed is considered bad and must be written off in the income statement as bad
debts expense.
Since the accounts receivables cannot be collected anymore, it will have to be reduced
in the balance sheet.
Example: Current Accounts Receivables outstanding is $135,000. A client who owes
$6,000 is determined a bankrupt.
The accountant will record the $6,000 as bad debt expense (affect PL statement) and
reduce the AR by $6,000 giving a final AR outstanding of $129,000.
There is also the Allowance Method which estimates an amount of uncollectible in
the coming year. The estimate can be based on outstanding AR or Sales.
Example: Current AR outstanding is $135,000 at year end. The company estimates
that 4% of the AR may be uncollectible in the coming year. Compute the bad debts
and show the balance sheet presentation.
Using 4%, the estimated bad debts is ($135,000 x 0.04) = $5,400
As in the above, the profit and loss will show $5,400 of bad debt expense.
The balance sheet will be presented as follows:
Allowance for trade receivables
Net Account Receivables
$135,000
($ 5,400)
$129,600
Note : Under the Allowance Method, the provision of $5,400 is shown as it is only an
estimated amount and not a definite uncollectible. The AR is not directly reduced.
24
Review Questions
1)
What does the word income means in acccounting ? Discuss the condition of
recognition.
2)
Explain the meaning of costs and differentiate it with the word expense in
accounting.
3)
An equipment was purchased at the beginning of the year at a cost of $160,000.

Straight line method is used and the equipment is expected to have a useful life of 15
years and residual value of $17,500.
a)
b)
4)
What is the depreciation for the first year?

If the equipment is sold for $90,000 at the end of the sixth year, determine the
profit or loss on the sale of the equipment.
Ex 3.4 of recommended text.
25
Session 4
Accounting for Limited Company
1. Discuss the nature of the limited company
2. Explain the role of directors of limited companies
3. Describe the main features of the owners claim in a limited company
4. Explain how the income statement and the balance sheet of a limited company differ from
other business structure
_____________________________________________________________________
4.1 DISCUSS THE NATURE OF THE LIMITED COMPANY

A limited company has features that do not exist in sole proprietorship or partnership.
The following section will examine and discuss each feature of a limited company.
Legal Nature: A limited company can be deemed to be an artificial person that has
been created by law. This means that it has as many rights and obligations as a person
and therefore can sue others or be sued by others, can enter into contracts in its own
name. The owners of the limited company are considered as the shareholders
(investors) and own the shares of the company. There are generally two types of
shares ordinary shares and preferred shares.
Perpetual Life: A business entity is considered to be an on-going concern unless
proven otherwise. But unlike a sole proprietorship or a partnership that ends when the
owner or a partner dies, a limited company is granted perpetual existence and will
continue as an entity when a shareholder dies.
This is possible as the shares of the deceased can be transferred to his/her
beneficiaries. The ownership can also be transferred through buying and selling of the
shares and these transactions will not affect the company status.
Limited Liability: A sole proprietor or partners are personally responsible for the
liabilities and claims on the business. The limited company as a legal person in its
own right is also responsible for the third party claims. As it is legally separated from
the owners of the shares, the liabilities do not extend to the personal assets of the
shareholders. Once the shareholders agree to pay for the shares, their obligation to the
company or its creditors are limited to the amount paid.
While limited liability is a good feature for the shareholders, it is a disadvantage to
those who may have claims on the company. Supplies for example would have to
carefully consider the amount of credit extended to the limited companies as there
will not be payments if the company pays only what is available within the
organization. This is why some suppliers insist on cash payments or limit the credit
limits.
To limit their risks, lenders to the firms (suppliers or banks) can place restrictions on
the ability of shareholders to withdraw their investment from the company. Example
26
is to limit the amount of dividends paid to shareholders. Another procedure is to

require limited company to present their annual statements and make them publicly
available. This allows anyone interested to deal with the organization an opportunity
to assess the firm before entering into any business relationships.
Taxation: As a limited company, it will be accountable to the tax authorities for the
taxes on their profits and gains. The profits earned are not tax to the shareholders at
their personal marginal tax rates.
4.2 EXPLAIN THE ROLES OF DIRECTORS
A limited company is a legal entity but it is not a human being capable of making
decisions and running the operations on a daily basis. There is then the need to have
individuals to undertake the management duties and planning. The most senior level
of management is the Board of Directors.
Who elect the board of directors? The shareholders will elect the board to manage
the company on a daily basis on their behalf. Depending on the size of the limited
company, the board can be one director to several directors elected. It is not necessary
for the directors to be shareholders.
Why the need for a board of directors? The owners (investors) of the firms owns
the shares but are not personally involve in the running of the business or actively
contributing to the strategic planning of the firm. As the control of the business
activities are managed by senior management or managers, there is the need to have
the board of directors to ensure the best interests of the owners are protected.
While the objective is for the Board to protect the investors, this main objective may
not be met in practice as the Board may pursue their own interests through high
salaries or benefits in the form of perks.
What are the guidelines to monitor directors? The guidelines and rules to monitor the
directors are based on the following principles.
a) Principle of Disclosures this is the heart of good corporate governance. Proper
disclosures by board of directors on the firm and providing adequate and timely
information about corporate performance will allow investors to make inform
buy-sell decisions and help the market to value the firm under the current
management. Thus, investing in made a little more transparent.
b) Principle of Accountability This requires the directors to act in the best interest
of the shareholders. They are not to use their position and knowledge of the firm
to benefit themselves at the expense of the shareholders. They are also required to
have the financial statements audited and report the performance of the entity in a
true and fair manner.
c) Principle of Fairness As the board of directors, they have privileged
information on the firm. We deemed their status as insiders and having insider
information, they can reap abnormal benefits at the expense of the shareholders.
27
To ensure this does not happen, restrictions are placed on the board of directors
ability to sell or buy the firms shares.
4.3 DESCRIBE THE MAIN FEATURES OF THE OWNERS CLAIM

Similar to the balance sheet of a sole proprietor or a partnership, the EQUITY section
represents the value owned by the shareholders.
In the equity section of a limited company, the likely items shown are the Share
Capital, the Reserves (or Retained Earnings).
Let us focus on each of this independently.
Share Capital: shares are the basic units of ownership of a business. Ordinary shares
(OS) are usually issued and are known as equity. The number of ordinary shares
issued will depend on a per-share value and the total amount of financing raised
through ordinary shares.
If a firm wants to raise $10,000 through ordinary shares, it will be to issue 10,000
shares if each share is $1/share, or issue 20,000 shares if each share is $0.50/share or
just 1 share if the only share issued is $10,000 per share.
Besides ordinary shares, some companies have preferred shares (PS) which are
guaranteed a dividend payment when dividends are declared. They have priority
claims above ordinary shares. This means that if the company liquidates, the preferred
shares must be paid first before the ordinary shareholders are paid. Thus, the ordinary
shareholders have higher risks in their ownership of the firm.
The following show how the equity section of the balance sheet is presented.
Equity
Share capital: 100,000 shares at $1 each
Share premium
Revaluation Reserve
Retained Earnings
Total Equity
$100,000
$ 30,000
$ 40,000
$ 60,000
$230,000
Share Premium: While the share basic or par value is $1 each, the issued price can
be higher resulting in a premium collected. Based on the above illustration, the
premium per share is $0.30 ($30,000 / 100,000 shares)
Reserves:
The first type of reserves is the Retained Earnings which are the profits and gains that
the company has made since its inception. As they are not distributed to the
shareholders as dividends, they remain in the balance sheet. The reserves are the
claims of the shareholders since the profits earned are for them. Do note that while
reserves (retained earnings) can be reduced through dividend payments, it can also be
28
reduced because the firm has losses instead of profits during the year. Earning related
reserves are also classified as Revenue Reserves.
A second type of reserve is known as Capital Reserve. It arises out of issuing shares
at above their nominal or par value or a revaluation upwards of non-current assets.
Revaluation Reserve occurs when the firm revalues the non-current assets upwards.
This usually applies to property held by the firm.
A share with a nominal value of $0.50 cents can be issued to the public at $0.70. If
10,000 shares are issued, the equity section with a revenue reserve of $2,000 will look
as follows:
Share capital
10,000 shares at 0.50 each
Capital Reserve
Revenue Reserve
Total Equity
$5,000
$1,000
$2,000
$8,000
Other issues related to share capital

Stock split a stock split is basically breaking each share into smaller numbers.
Example: a $1 share is split 5 for 1 implies that if I own 1 share before the split, I will
be holding an equivalent of 5 shares at $0.20 per share. Note that the total value I own
still remains at $1.00
Cash Dividends firms usually pays cash dividends on a yearly basis and this is the
normal inducement to attract investors. To distribute cash dividends, the firm must
have strong cash flows to initiate the payment. Cash dividends, however, can only be
paid out of revenue reserve (thus reducing the amount) and not from the capital
reserves in the balance sheet.
Bonus shares firms usually pays cash dividends to their shareholders. However,
some firms can give bonus shares instead of cash as dividends. In this case, the
number of shares in the market will increase. Like cash dividends that reduces the
revenue reserves, bonus shares also affect the revenue reserve in the same way.
29
4.4 HOW THE INCOME STATEMENT AND BALANCE SHEET DIFFER FROM
OTHER BUSINESS STRUCTURES
Generally, the financial statements are of limited companies are based on the same
principles as those of the sole proprietor or partnership. There are some differences
which we will highlight below.
The Income Statement:
The income statement has three measures of profit displayed after the gross profit.
They are the operating profit, the net profit before tax and the net profit after tax (or
net profit for the year)
There is also the audit fee and the corporation tax on the profits for the year
Example of presentation:
Revenue
Cost of sales
Gross Profit
$123,000
($56,000)
$ 57,000
Administration expenses
Distribution expenses
Net Profit before tax
Taxation
Net Profit after tax
($28,000)
($ 9,000)
$ 30,000
($ 12,000)
$ 18,000
Attributed to:
Equity holder of the parent
Minority interest
$ 16,000
$ 2,000
The net profit after tax is split between the parent company and minority interest (if it
exists).
The Balance Sheet:
While the assets and liabilities are similar to the sole proprietorship and partnerships,
the equity section has more detailed items. Instead of just capital, the share capital,
the revenue reserves and the capital reserves are shown.
Unlike the sole proprietorship and partnership, payment of dividends will not appear
as drawings in the equity section for the limited company. This is because it is
summarized in the Statement of Changes in Equity.
Statement of Changes in Equity.
Beginning Retained Earnings 1/1/2010
Net Profit after tax for the year ended 31/12/2010
Dividends declared
Ending Retained Earnings 31/12/2010
$100,000
$ 50,000
($ 20,000)
$ 30,000
30
Review Questions
1)
Limited liability is the key feature of a limited company. Is it necessary an advantage?
2)
Discuss the guidelines and rules that govern the actions of directors.
3)
A firm has 50,000 shares at $1.00 each. During the initial issue, a premium of $0.20 per
share is collected. For the first year, the gross profit is $80,000 which is 40% of sales.
The operating expenses are 35,000. The tax rate is 20%.
In the middle of the year, there is a stock split of 1:2. A property the firm owns was
revalued upward by $30,000. At year end, there is a dividend of $0.30 per share
declared and paid.
Present the Income Statement and the Equity Section of the firm
4)
Differentiate between bonus shares and cash dividends. Explain how the balance sheet
will be affected.
31
Session 5
Reporting for Limited Company
1. Describe the responsibilities of directors and auditors concerning the annual financial
statements provided to shareholders and others.
2. Outline the statutory regulations surrounding accounting for limited companies.
3. Outline the non-statutory regulations surrounding accounting for limited companies.
4. Prepare an income statement, balance sheet and statement of changes in equity for a
limited company in accordance with International Financial Reporting Standards
_____________________________________________________________________
5.1
DESCRIBE THE RESPONSIBILITIES OF AUDITORS AND DIRECTORS

Shareholders while owning the firm through their shares do not get involve with the
day to day operations of the companies. The appointed directors are to act in the
interests of the shareholders. The separation of ownership and control requires this
appointment.
Stewardship is the prime responsibilities of the directors. The law requires the
directors to (a) maintain appropriate accounting records and (b) prepare annual
financial statements with a directors report and (c) make these reports available to the
shareholders and the public.
To maintain accounting records, the need for a framework of rules regarding how
statements should be prepared is required. While accounting framework assists in
making statements comparable and understood by users, directors can adopt policies
and practices that present an unrealistic position of the company. Regulations cannot
possibly eradicate all manipulations or concealment of truths but can, at least, reduce
the possibility.
To enhance understanding and to help investors appreciate accounting reports of
different companies across different countries, the trend towards international
harmonization on reporting prevails.
These rules, known as International Accounting Standards or International Financial
Reporting Standards, deal with the following key issues:
what information should be disclosed
how information should be presented
how assets should be valued
how profit should be measured
The responsibility of the auditors is to report whether in their opinion, the financial
statements presents a true and fair view of the firm according to the relevant
accounting rules and policies.
32
To make such an opinion, auditors are to scrutinize the statements and the evidence
upon which they are based. Their opinion and statement must be in the financial
statements presented to the shareholders and the Registrar of Companies.
While the directors are elected by the shareholders to give account of the company,
the auditors are elected by the directors to give an independent view of the firm to the
shareholders.
5.2
STATUTORY REGULATIONS FOR LIMITED COMPANIES

The auditors report provides and opinion by an independent auditor concerning
whether the financial statements provide a true and fair view of the financial health of
the business. They are to present an independent view of the firm to the shareholders.
The directors report contains information of both financial and non-financial nature
which goes beyond that contained in the financial statements. Some information may
be details of the directors, their financial interests in the firm, employment policies or
donations etc. The auditors do not audit the directors report.
5.3
NON-STATUTORY REGULATIONS FOR LIMITED COMPANIES

Segmental reports disaggregate information on the financial statements to help users
better understand the information contained in the statements. Segment reports can be
classified according to products or services and according to geographical regions.
IASB requires listed companies to disclose segment information according to each
business unit and to each geographical region.
Why is the business segmentation of the reports important? This is important to users
as it is a part of the business that can be separately identified and which provides a
certain product or services or a group of product or services.
Why is geographical region important? Like business segment, a geographical region
also is a separately identified area where a particular product or service is provided
under certain economic environment. Region can be a country or a group of countries.
Basis of reporting: To report a business segment or a region, it must be of a
significant size. A 10 percent or more of the businesss revenue, operating income or
total revenue is used to determine whether a segment is considered significant.
Directors are to decide whether the report is to be presented based on the products or
services offered or based on the geographical region. The one that has greater impact
is the primary segment. This shows the risks transparently and the users can assess the
company accordingly.
33
Segmental Disclosures:
The standards require the following items to be presented:
Revenue separate revenue from external customers and revenue from other
segments
Total Assets
Capital Expenditure for the period
Depreciation, impairment losses and other non-cash items
Segment operating results
Total Liabilities
5.4
PREPARING THE INCOME STATEMENT, THE BALANCE SHEET AND

THE CHANGES IN EQUITY FOR A LIMITED COMPANY
According to the International Accounting Standard IAS 1, Presentation of Financial
Statements, the financial statements consists of (a) an income statement, (b) a balance
sheet, (c) a statement of changes in equity (d) a cash flow statement and (e) notes on
accounting policies and other explanatory notes.
To do all the above, the overriding requirement is for the financial statements to
provide a true and fair view of the companys financial performance, position and
cash flows. The IAS presumes this will be achieved if statements are drawn based on
the IAS standards issued. Only under unusual circumstances, the standards do not
result in a fair presentation of the company.
Besides the true and fair view, there are other contrasting considerations in preparing
financial reports. These include the concept of relevance, the feature of timeliness of
information, the degree of details required and the quality of understandability of
financial data.
The financial report preparation process largely depends on who are the users and
why the report is being prepared. Thus, some trade offs will inevitably be required to
meet the needs of the users.
The Income Statement:
The IAS sets out the minimum that must be reported on the face of the income
statement. The items include: Revenue, Finance costs, gains or losses on sale of
assets, settlements of liabilities arising from discontinued operations, tax expenses and
profit or loss.
There are two recommended ways to present expenses. They can be presented
according to their natures e.g. interests, salaries, depreciation or their function e.g.
marketing costs, financial costs, selling costs, administrative costs etc.
The standards also require separate disclosure of material items. Material items are
those will affect the decision of an investor. They do not have to be on the face of the
income statement and can appear as notes to the financial statements.
Examples of material information that require separate disclosures are:
write-down of inventories to net realizable value
34
write-down or disposal of property, plant or equipment

disposal of investments
restructuring costs
discontinued operations
litigation settlements
The Balance Sheet

The IAS does not have a prescribed format for the Balance Sheet but state the
minimum information required. This includes the following:
Property, Plant and Equipment

Investment Property
Intangible assets
Financial assets
Inventories
Trade and other receivables
Cash and cash equivalents
Trade and trade payables
Provisions
Financial liabilities not included in the above
Tax liabilities
Issued share capital and reserves
Assets and liabilities normally are presented in their Current and Non-current format
in the balance sheet. However, the firm is also permitted to present the assets and
liabilities according to liquidity if it considers that this format presents a more reliable
and relevant position of the firm.
The Statement of Changes in Equity
This statement is useful for users to understand the changes in share capital and the
reserves that took place during the accounting period. As capital and reserves can be
increased or decreased, this statement reconciles the beginning balance to the closing
balance of the year.
While the income statement shows the realized gains and losses, there are unrealized
gains and losses that do not go through the operating income. Example of unrealized
gains and losses are currency exchange effects. A firm can revalue the assets, e.g. a
property, upwards or downwards and asset revaluation reserve is affected in the
equity.
You are encouraged to access the audit report of a listed company on the stock
exchange and understand how the equity section of the balance sheet is presented for
investors.
The Cash Flow Statement
The IAS 7 states the requirements for presenting the cash flow statement. This
statement explains how the firm generates or access funds and how it uses the cash
35
during the accounting period. Thus, it helps the users to access the liquidity of the
firm.
The details workings of the statements will be covered in detail during the next
lecture.
Besides the above, explanatory notes also help users to understand the financial
statements. Explanatory notes normally contain the following information:
a statement that the financial statements comply with the relevant IFRS
summary of the measurement bases and accounting policies used.
Supporting information to the three major statements
Other disclosures e.g. future contractual obligations not recognized yet or
managements objectives and policies
Review Questions
Source : Eddie McLaney and Peter Atrill (2008), Accounting : An Introduction, NJ: Pearson Education.
1)
The size of annual financial reports published by listed companies has increased
steadily over the years. What are likely reasons that cause this apart from the increasing
volume of accounting regulations?
2)
What problems are likely to be encountered when preparing summary financial

statements for shareholders?
3)
Prepare an income statement according to the requirement of IAS.

Interest payable
Cost of sales
Distribution costs
Revenue
Administrative costs
Other expenses
40,000,000
460,000,000
110,000,000
943,000,000
212,000,000
25,000,000
The corporate tax is 25% of the profits available to the shareholders.

4)
Visit www.sgx.com and select a company that has segment reporting. Present a brief
summary of the company.
5)
Explain the purpose of the auditors report and the directors report in the financial
statements
36
Session 6
Measuring and Reporting Cash Flows
1. Explain the role of cash in an enterprise
2. Explain the nature of the cash flow statement and its usefulness
3. Prepare a simple Cash Flow Statement
4. Interpreting a Statement of Cash Flows
_____________________________________________________________________
6.1 THE ROLE OF CASH IN AN ENTERPRISE
While cash is a current asset and is like any other assets the company has, it is
critically important as it allows the company to function well. With all purchases,
cash is required for payments. Suppliers who are unfamiliar with the firm will require
cash for transactions. Even it credit is given, the time frame will be short and cash
will still be needed to meet obligations. Thus, the use of cash is transactional.
When unexpected opportunities occur, the firm can only take advantage of them if
cash is required for payment and the firm has sufficient funds at that point.
Cash allows the firm to be sustainable and most businesses failed because of cash
flow problems.
6.2 THE NATURE OF THE CASH FLOW STATEMENT AND ITS USEFULNESS
The cash flow statement summarizes the cash receipts and payments over the period
concern. It explains the firms sources of cash and how they are used during the year.
The net cash flow which is the total receipts less the payments explains the change in
the cash position for the year. This figure is the reconciling amount between the
beginning cash and the ending cash in the balance sheet. This will be illustrated later.
The accounting standards define cash as notes and coins on hand and deposits in
banks. Cash equivalents are short-term, highly liquid investments that can be easily
converted to cash without significant changes in values. Cash equivalents are held for
the purpose of meeting short term obligations and not for long term investments.
The cash flow statement focuses on the receipts of cash from sales and other income
and payments of cash to creditors and for operational expenses. It is different from
the principle of accrual where revenues are recorded when earned and expenses are
recorded when incurred.
6.3 A SIMPLE CASH FLOW STATEMENT
The standard cash flow statement consists of three main sections. They are Cash Flow
from Operating Activities, Cash Flow from Investing Activities and the Cash Flow
from Financing Activities. The individual subtotal of each of the sections may be
positive or negative depending on the flow of cash.
37
The total of the three sections shows the net increase or decrease in cash and cash
equivalents over the period.
Cash Flow from Operating Activities: Operating activities are the transactions that
attempt to increase the profits of the company. Therefore, revenue and expenses
which result in receiving cash or payment of cash will be included in this section of
the cash flow statement.
Note that this section records the amount of cash received from sales or accounts
receivables and not the actual sales recorded. Likewise, the cash paid for operational
costs is determined here.
As operating activities will affect the current asset or current liability, the balance
sheet is out source of working out the cash flow.
This section is generally presented in the following format:
Net Profit before tax
Add back non cash expenses
(e.g. depreciation, bad debts)
Add back loss on sale of NCA
Minus gain on sale of NCA
XXX
XXX
XXX
(XXX)
Changes in Current Assets (e.g. AR, Inventory, Prepayments)

If CA increases from last year to this year (XXX)
If CA decreases from last year to this year XXX
Changes in Current Liabilities (e.g. AP, Accrued Expenses)
If CL increases from last year to this year
XXX
If CL decreases from last year to this year
(XXX)
.
Net cash flow from Operating Activities
XXXXX
Cash Flow from Investing Activities: This section focus on cash used to pay for
acquiring non-current assets and cash received from the sale of non-current assets. So,
if the company purchases a $10,000 machine, we will be recording the $10,000 as a
cash outflow.
If an equipment costing $35,000 and net book value of $7,000 was sold for $5,000,
the cash received from the sale i.e. $5,000 will be recorded as cash inflow. The
$2,000 loss on the sale ($5,000 - $7,000) is not cash and will not be considered in the
cash flow statement here.
Cash Flow from Financing Activities: Financing activities focus on how the firm
raise funds or settle their long term obligations. Firms can raise funds through noncurrent liabilities (e.g. long term loans) or issue new shares (where investors pay cash
for the shares). These are inflow of cash.
38
Repayment of loan results in cash outflows. Similarly paying dividends is another

cash outflow and it is considered as a financing activity since it is a return of cash to
the investors. Note that while a $10,000 dividend may be declared, the cash paid may
be different if $2,000 is recorded as dividend payable. In this case, the actual cash
paid for dividends is only $8,000
Example: Preparing a simple cash flow statement
Cash
Accounts receivable
Inventory
Prepaid Expense
Premises
Plant and machinery
Accumulated Depreciation
Accounts Payable
Mortgage loan
Share Capital
Retained Earnings
31 Dec 2010
$
91,000
90,000
62,000
12,000
90,000
320,000
(92,000)
573,000
31 Dec 2009
$
20,000
65,000
58,000
10,000
80,000
280,000
(60,000)
453,000
38,000
200,000
240,000
95,000
573,000
35,000
160,000
210,000
48,000
453,000
Additional information:
There was no disposal of premises during the year.
A machine costing $50,000 with accumulated depreciation of $20,000 was sold
for $25,000.
Net Profit for the year after interest and tax was $117,000.
Mortgage loan of $25,000 was settled through issue of shares.
A dividend of $70,000 was paid during the year.
39
Solution:
ABC Ltd
Statement of Cash Flows
For the year ended December 31, 2010
$
Cash flows from operating activities:
Net income
117,000
Adjustments to reconcile net income to net cash flow from
operating activities:
Depreciation
52,000
Loss on sale of machine
5,000
Changes in current operating assets and liabilities
Increase in accounts receivables
(25,000)
Increase in inventories
(4,000)
Increase in prepaid expense
(2,000)
Increase in accounts payable
3,000
Net cash flow from operating activities
146,000
Cash flow from investing activities:

Cash paid for purchase of premises
Cash received from sales of machine
Cash paid for purchase of machine
Net cash flow used for investing activities
Cash flows from financing activities:
Cash received from sale of common shares
Cash paid for dividends
Cash received from mortgage loan
Net cash flow provided by financing activities
Increase in cash
Cash at the beginning of the year
Cash at the end of the year
(10,000)
25,000
(90,000)
(75,000)
5,000
(70,000)
65,000
0
71,000
20,000
91,000
6.4 INTERPRETING A CASH FLOW STATEMENT

The cash flow statement tells us how the business has generated cash during the
period and where the cash has gone. Thus, the statement tells us the lifeblood of the
company.
Understanding and interpreting the cash flows allow one to make judgments about the
future behavior of the firm.
40
Using the above example, we can see the following:

The cash flow from operating activities of $146,000 is strong. This indicates that
while there are increases in accounts receivables and inventories, the firm is still
collecting most of the sales and managing the payment of operational expenses very
well.
The cash flow from investing activities of ($75,000) should not be a large concern as
the information shows that company is renewing their non-current assets for future
growth. While there is no indication of business expansion, renewal of assets is a
positive sign.
The cash flow from financing activities with zero effect shows an increase in funding
through loans and most of the amounts were used to fund the dividend payments.
Overall, the company is healthy with an overall net increase of $71,000
Review Questions
1)
In accounting, there are non-cash transactions. Give examples.
2)
A business owner cannot understand the low amount of cash balance at the end of
accounting period when there are high revenues and profits reported in the income
statement. Explain the apparent discrepancies
3)
Which segment of the cash flow statement is affected by the following transactions?
a)
b)
c)
d)
e)
f)
g)
h)
4)
Depreciation expense for the year

Purchasing of a new equipment
Issue dividends through bonus shares
The bank extends another $100,000 loan to the firm
Selling an old asset at a gain of $5,000. The selling price is $50,000
Accounts receivables decrease by $10,000
The firm issue new shares in exchange for a piece of land
Decrease in accounts payable by $7,000
Aquatech Pte Ltd is a supplier of water purification equipment for home and
commercial use. The company is in an aggressive expansion program and will continue
to expand if adequate financing can be obtained from its bank. The companys balance
sheets for the last 2 years are as follows:
41
Balance sheets
December 31, 2009 and 2010
Assets
Current Assets
Cash
Accounts receivable, net
Inventory
Prepaid expenses
Total current assets
2010
2009
(9,000)
140,000
300,000
7,000
438,000
21,000
100,000
250,000
9,000
380,000
700,000
180,000
520,000
42,000
620,000
150,000
470,000
50,000
Total Assets
1,000,000
900,000
Liabilities and Stockholders Equity

Current Liabilities
Accounts payable
Accrued Liabilities
Total current liabilities
190,000
10,000
200,000
163,000
17,000
180,000
Long term debt
100,000
90,000
Shareholders equity
Common stock
Retained earnings
Total stockholders equity
300,000
400,000
700,000
285,000
345,000
630,000
Total Liabilities and stockholders equity
1,000,000
900,000
Plant and equipment

Less accumulated depreciation
Net plant and equipment
Goodwill
The companys income statement for the year ended 2010 is given below:
Sales
$1,500,000
Cost of goods sold
900,000
Gross margin
600,000
Operating expenses
510,000
Net income
$ 90,000
The following additional information is available for 2010.
Equipment that had cost $60,000 new and on which there was accumulated
depreciation of $42,000 was sold for its book value of $18,000.
The goodwill is being amortized against earnings.
The company declared and paid $35,000 in cash dividends.
After seeing the negative position in Aquatechs cash account, the companys bank asked for
a cash flow statement in order to determine why cash dropped so sharply during the year.
You are to prepare the statement for the bank.
42
Session 7
Analysis of Financial Statements
1. Establish the usefulness of financial ratios to various interest groups
2. Identify the major categories of ratios
3. Calculating ratios and explaining their significance
4. Explain the importance of gearing to an enterprise and owners
5. Limitations of ratios
_____________________________________________________________________
7.1 ESTABLISH THE USEFULNESS OF FINANCIAL RATIOS
While different users may have different needs, financial ratios can be used to
examine various aspects of the performance and position of companies and are widely
used in planning and control purposes.
Ratios provide a quick and simple way to assess the health status of firms. This
allows users to use them without requiring too much of in-depth knowledge.
Ratios also allow users to compare companies of different industries as well as size of
establishments. It uses a common denominator for comparison. Example, the revenue
in dollar may vary a lot but using percentages make all amounts relatively
comparable.
Ratios can be presented in different form percentages, ratio or number of times
relative to a key figure. The only requirement is consistency in usage so that
reasonable comparison can be achieved.
7.2 THE MAJOR CATEGORIES OF RATIOS
Ratios are grouped into categories with each relating to a particular aspect of financial
performance or position. There are five broad categories as follows:
Profitability Ratios since businesses exist for profits, these ratios provide
insights the firms success in achieving its primary goal. The expressed profits in
terms of other key figures in the financial statements
Efficiency Ratios as assets are invested to achieve the primary goal of profit
making, these ratios analyze how efficient is the firm in using the assets or
resources within the organization. They are also referred to as activity ratios.
Liquidity Ratios firms collapse when they become illiquid. The liquidity ratios
examine the ability of the firm to pay their obligations when they are due and
show the relationship of liquid assets to liabilities.
Financial Gearing Ratios a firm gets its financing source from shareholders
(owners of business) and outside parties in the form of loans. This result in the
43
relationship between liability and equity term as leverage or gearing. The level of
gearing shows the extent the firm borrows and with higher leverage, there are
higher risks.
Investment Ratios these are concern with assessing the returns and
performance of shares in a particular business.
Different users will have different needs and thus the analyst need to be clear who are
the target users and why they need the information. We will consider the computation
of the ratios in the next section.
7.3 CALCULATING RATIOS AND THEIR SIGNIFICANCE
To understand the ratios, their computations and the interpretations, we will use the
following statements as illustration. All figures are from the statements.
44
Balance Sheet of Amazing Action Pte Ltd

As at 31 December (amounts in thousands)
31-Dec-08
31-Dec-09
Current Assets
Cash
Inventories
Prepayments
Total Current Assets
18
32
24
28
102
12
32
60
4
108
Non-Current Assets
Land and Building
Machinery
Equipment
Total Non-Current Assets
290
70
100
460
290
82
100
472
Total Assets
562
580
35
7
42
17
3
20
Non Current Liabilities

Long Term Loan due 2013
160
160
Total Liabilities
202
180
Equity
Share Capital ($1 par)
Retained Profits
Total Equity
200
160
360
200
200
400
Total Liabilities and Equity
562
580
Current Liabilities
Accounts Payables
Accruals
Total Current Liabilities
45
Profit and Loss Statement of Amazing Action Pte Ltd

For the years ended 31 December (amounts in
thousands)
31-Dec-08
31-Dec-09
Revenue
less Cost of Goods Sold
Gross Profit
380
227
153
415
235
180
Selling Expenses
Administrative Expenses
Operating Profit
Interest Cost
Profit before tax
less tax
Net Profit
68
31
54
18
36
5
31
66
30
84
14
70
10
60
Dividends declared
16
20
$1.60
255
1250
100
$1.85
280
1350
125
Other information
Market Price per share
Average Credit Purchases
Number of employee
Cash flow from operations
Profitability Ratios: The 4 basic profitability ratios are return on shareholders

funds, return on capital employed, gross profit margin and operating profit
margin.
Return on shareholders funds
Profit for the year less preference dividend (if any) x 100
Average [ Ordinary share capital + Reserves ]
= $60 / ($ 360 + $ 400) = 15.6%
This ratio implies that for each dollar invested, the return is $0.156 cents per
dollar.
Return on capital employed
Operating profit x 100
.
Average [Share capital + Reserves + Non-current liabilities]
46
= $60 / ($ 562 + $ 580) = 10.5%

The computed ratio of 10.5% means that for each dollar invested, the firm is able
to generate $ 0.105 cents of operating profit.
Gross profit margin
Operating profit x 100
Sales revenue
= $84 / $415 = 20.2 %
For a firm, one would naturally prefer this number to be large. At 20.2%, the firm
is having a $0.202 cents return for every dollar sale generated.
Operating profit margin
Gross profit x 100
Sales revenue
= $180 / $415 = 43.3 %
The gross profit is computed by deducting the cost of goods sold. So a high
43.3% implies that for each dollar of sale, the net after cost of sale is $0.433 cents
per dollar. The higher the figure is naturally better for the firm.
Efficiency Ratios the efficiency ratios measures how well the resources are
used and thus the basic efficiency ratios are average inventory turnover period,
average trade receivables turnover period, average trade payables turnover period,
sales revenue to capital employed and sales revenue per employee.
Average Inventories turnover period
Average inventories held x 365
Cost of sales
= ($24 + $60) / $235 x 365 days = 65.23 days
This ratio measures how long the firm is keeping its raw material, work in process
or finished goods before selling them. The longer the time frame implies slow
moving stocks.
Average settlement period for trade receivables
Average Trade receivables
Credit sales revenue
x 365
= ($32 + $32 ) / $415 x 365 days = 28.14 days

This ratio computes the number of days before an accounts receivable is
collected. The firm will prefer shorter time frame as it means they are collecting
47
faster from the customers, have better cash flow and avoid possibility of bad
debts.
Average trade payables turnover period
Average Trade payables x 365
Credit purchases
= ($35 + $17) / $280 x 365 days = 33.89 days
Cash flow is affected by how fast the firm pays others too. While we prefer to
collect our accounts receivables fast, paying suppliers is managed for cash flow
purposes. Having a very long payable turnover period can be bad for the firms
reputation too.
Sales revenue to capital employed
Sales revenue
Share capital + Reserves + Non-current liabilities
= $ 415 / $580 = 71.6 %
The firm gets its funds from long term liabilities and shareholders equity. This
ratio measures how much sale for each dollar of financing raised by the firm. In
the above computation, every dollar of financing can generate $0.716 cents of
revenue.
Sales revenue per employee
Sales revenue
Number of employees
= $ 415 / 1350 employees = 0.307 per employee
The sales revenue per employee ratio measures efficiency of staff in generating
sales for the firm.
Liquidity Ratios the 3 fundamental liquidity ratios are the current ratio, the
quick ratio and the operating cash flows to maturing obligations.
Current ratio
Current assets
Current liabilities
= $ 102 / $ 108 = 0.94
The current ratio measure the ability of the firm to pay off its short term liabilities
when they become due. In the above computed ratio, the firm has only 0.94 cents
48
of current asset to back each dollar of liability. We prefer the figure to be greater
than 1.
Quick ratio
Current assets (excluding inventories and prepayments)
Current liabilities
=
($ 18 + $ 32) / $108 = 0.463
The quick ratio is very similar to the current ratio in the purpose of measure.
However, it only considers the liquid current assets. Thus, the less liquid current
assets like inventories and prepayments are ignored.
Operating cash flows to maturing obligations

Cash generated from operations
Current liabilities
= $ 125 / $108 = 1.19
This ratio compares the amount of cash generated from operations to the current
obligations. Since the firm will need cash to pay off the liabilities, the cash
generated from operations is the basic source of funds.
Financial Gearing Ratios Gearing ratios measures the contribution of long

term lends to the long term capital structure of the business. With gearing, there
are interest costs. Thus, the two basic ratios are gearing ratio and the interest
cover ratio.
Gearing ratio
Long-term (non-current) liabilities x 100
Share capital + Reserves + Long-term (non-current) liabilities
= $160 / $580 = 0.276
The firm needs to be constantly aware of the sources of funding. Having too
much long term debt would be over leveraging and risky for the firm. This ratio
shows the relationship of long term debt to total funding. One would prefer this
figure to be less than 50%.
Interest cover ratio

Operating profit
Interest payable
= $ 60 / $14 = 4.29
49
Interest cover ratio shows the ability of the firm to pay off the interest incurred in
the borrowing process. Based on the figure computed, it implies that the firm has
4.29 years of operating income to pay off the interest incurred.
Investment Ratios these for investors to assess the return on their investments.
The basic ratios are dividend payout ratio, dividend yield ratio, earnings per
share, price earnings per share and operating cash flow per share.
Dividend payout ratio
Dividends announced for the year
Earnings for the year available for dividends
x 100
= $20 / $60 x100 = 33%

All shareholders look forward to dividends. The payout ratio indicated what
percentage of each years earnings is distributed to the shareholders.
Dividend yield ratio
Net Dividend per share/(1 tax rate) x 100
Market value per share
= 0.10 per share / $1.85 x 100 = 5.4 %
This ratio calculates the yield for holding the shares. It is similar to the return of
investment measurement.
Where gross dividend per share = $20 / 200 shares = 0.10 per share.
Note that the numerator is to convert net dividend to gross dividend. As the
dividend is applied at gross value, there is no need to further divide it by (1 tax
rate) again.
Earnings per share
Earnings available to ordinary shareholders
Number of ordinary shares in issue
= $60 / 200 shares = $ 0.30 per share
The earnings per share measures the net earnings available to each share after
paying the operating expenses, the interests, the taxes and the preferred share
dividends. This shows the residual value belonging to the equity owners.
Price earnings per share
Market value per share
Earnings per share
50
= $1.85 per share / $ 0.30 per share = 6.16

This ratio shows the relationship between the current market share price to the
earnings per share. A high PE indicates potential future growth prospects of the
firm.
Operating cash flow per share
Cash
generated from operations less preference

Number of ordinary shares in issue
dividend
(if
any)
$125 / 200 shares = $0.625 per share
While not often used, this ratio shows the cash flow generated from the business
operations on a per share basis.
7.4 IMPORTANCE OF GEARING TO AN ENTERPRISE AND OWNERS
A firm gets its sources of funds from either the owners or from other lenders. A firms level
of gearing is the extent to which the firm is required to pay a fixed return to the lender. This
is an important factor to consider in assessing its risk.
The fixed payment is the interest on the borrowing and if cash-flow if not properly
managed, the firm will enter into liquidity problems.
With the risks, why do firms still want to borrow? First, it could be because the firm lacks
funds and need to borrow from others to adequately finance the firm. Second, gearing can
provide returns to the owners when the cost of funds is lower than the return generated.
The following example shows three firms with different levels of gearing. every firm,
despite different gearing, makes $60,000 net operating profit on the same $400,000 asset
means return of assets are the same at 15%. However, the return on equity is larger for firm
(b) and (c) as the gearing increases. When the return is greater than the interest costs, the
returns to equity becomes larger and benefit the owners.
51
(a)
All equity
$
400,000
Equity
Debt
(b)
50% debt
50% equity
200,000
(c)
75% debt
25 % equity
100,000
200,000
300,000
Total Assets
400,000
400,000
400,000
Debt/Equity ratio
1:1
3:1
Net operating Income
60,000
60,000
60,000
20,000
30,000
Interest (at 10%)

Net Income
60,000
40,000
30,000
Return on Assets
15%
15%
15%
Return on Equity
15%
20%
30%
EPS
EPS =0.15
EPS =0.20
EPS =0.30
7.5 LIMITATIONS OF RATIOS

While ratios are easy to understand or use, users must be aware of their limitations
and constraints.
a) Quality of underlying statements: The quality of the ratios largely depends on the
quality of the statements upon which they are relying on for comparison. Thus, a
misleading statement will not lead to useful financial ratios for decision making
purposes.
b) Effects of inflation: The financial statements are based on historical basis.
Inflation will cause assets to be of less value and expenses will be relatively
understated when comparing one year with another.
c) Restricted vision of ratios: Ratios are discrete in the computation and
interpretation. It is thus important for users to recognize the importance of using
several ratios to assess the firm.
d) Basis of comparison: Ratios do not take into account the differences in
companies. No two firms are alike in size, in number of years in operation or the
variety of products/ services. This will make the basis of comparison
questionable. There is also the differences in accounting policies e.g. depreciation,
inventory methods.
e) Snapshot of a firm: Ratios that uses the balance sheet only present the position of
the firm on that date but it will not reflect the firm throughout the year or the
coming year. Firms with seasonable business are likely to have end the financial
52
year with lower activity. Thus, their trade receivables or inventories are likely to
be low showing little liquidity.
Review Questions
1)
What are the advantages of debt financing for a firm?
2)
A newbie to accounting who just learnt ratio is applying them to a financial report. What
will you caution this person on the limitations of ratios?
3)
What do profitability ratios explain?
4)
Do Ex 7.3 from the recommended text.
5)
Select a listed company on the stock exchange and read its report. Provide an analysis of
the ratios you have covered in this session.
53
Session 8
Budgeting
1. Define a budget and show how budgets and corporate objectives are related
2. Explain how various budgets within a business interlink
3. Appreciate the uses of budgets and constructing various types of budgets
4. Discuss the criticisms of budgets
_____________________________________________________________________
8.1 BUDGETS AND CORPORATE OBJECTIVES
A budget is a business plan for the short term typically one year. It is likely to be
expressed in financial terms and the role is to convert the strategic plans into actions
for the immediate future.
Since budgets are plans the business wants to achieve, the managers who are involved
are aware of the direction and will be more likely involve themselves to achieve the
corporate goals.
The development of plans involves the following key steps:
Establish mission and objectives a mission statement states the broad objective
of the business
Undertake a positive analysis this assess the current position, where the firms
wants to be based on the mission and objectives
Identify and assess the strategic options this defines the ways the firm wants to
move from where it is now to where it wants to be in the future
Select the strategic option this involves selecting the best action plan and
formulating a strategic plan. The process will include all the different budgets the
firm has to co-ordinate closely for success
Perform, review and control feedback via comparing actual outcome from
budgets (goals) will allow managers and top management to assess what has gone
wrong, what was done right and have greater control for future successes.
Budgets can be prepared on a periodic or continual basis. Periodic budget is prepared
for a particular period e.g. once a year. This is done once a year and managers allow
the budgets to run its course. It may be necessary to revise the periodic budget
occasionally.
Continual budgets (also known as rolling budgets) are continually updated. A
company can plan a 12 month budget and as each month passed, a new month is
planned to replace the month that has just passed. This ensures that the firm is
constantly looking at a 12-month target plan at all times. Management may review the
budgets when necessary.
Since budgets are critical to a firms success, it is usually approached in a methodical

and formal manner. The budget setting process involves the following steps:
54
Step 1: Establish who will take responsibility

Step 2: Ensure communication of budget guidelines to managers
Step 3: Identify the key or limiting factors
Step 4: Prepare the budget for the area of the limiting factor
Step 5: Prepare the draft budget for all other areas
Step 6: Review and co-ordinate budgets
Step 7: Prepare the master budget
Step 8: Communicate the budgets to all interested parties
Step 9: Monitor actual performance and compare with budget
8.2 THE DIFFERENT TYPES OF BUDGETS IN A FIRM
A firm will prepare more than one budget for a particular period. Each budget relates
to a specific area of the business the sales manager will prepare the sales budget
while production manager will plan the production budget to meet the sales
requirement. The HR manager will plan the human resource requirements while
approval for capital investments are done by top management. It is recommended that
the managers of each department propose their respective budgets as they know their
area best.
All the budgets and their contents are summarized into the Master Budget which
usually consists of the planned income statement and the balance sheet.
Note that all the budgets are interlinked as they affect each other in the planning
process. The sales budget is usually the first to be prepared as this determines the
overall business activity for the coming period.
The sales budget will then affect the production budget which requires support for the
raw materials budget, the labor and overheads budget. If additional investment is
required to meet the production, the capital expenditure budget needs to be proposed.
While purchases are made for raw materials and labor, sales are expected to be
generated during the year. Cash flow is important here as there is the need to pay for
the materials (trade payable budget) and the operational expenses (labor and
overheads). The cash used has to come from the sales through the collection budget
or other planned sources of funding. The accountant is usually the one in charge of
the cash budget which detail the inflows and outflows of cash.
The results of all the budgets combined will project the targeted income statement
and the balance sheet for the firm.
55
Trade
receivables
budget
Sales
budget
Finished
inventories
budget
Trade payables
budget
Cash
budget
Overheads
budget
Capital
expenditure
budget
Production
budget
Direct
labour
budget
Raw materials
purchases
budget
Raw materials
inventories
budget
8.3 THE USEFULNESS OF BUDGETS

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

original plans. With the budgets, management can then compare actual
performance to expected and determine the reasons behind non-performance for
improvements.
Provide a system of authorization this relates to the limit a manager can spend
on a particular activity. For example, the senior management may allocated a
fixed amount of funds for research and development and the person authorized to
managed this area should work within the guidelines.
56
8.4 PREPARING DIFFERENT BUDGETS

There are several types of budgets to prepare. Using the information from the sales
budget, one can prepare the inventory budget to determine how many units need to be
purchased or make.
The sales on cash or credit will require collection of cash. This is the collection
budget. The purchases and operational costs such as salaries, rental etc. must be paid
and this result in the payment budget.
The following section shows the process with an example.
Example:
Jan
Sales in units
5,000
Sales at $10/unit
50,000
Operating Expenses 10,000
Feb
7,000
70,000
12,000
Mar
10,000
100,000
14,000
Apr
12,000
120,000
15,000
The firm begins its business on 1st January with $5,000 cash balance. It has no
beginning inventory and requires ending inventory to be 20% of the following
months sales and the cost of goods is 40% of sales. Assuming no bad debts, all sales
are collected 40% in the month of sale and the remainder the following month. 50%
of the purchases are made in the month of purchase and the remainder the following
month.
a) Preparing the inventory budget and payment budget for Jan to Mar.
The inventory budget is based on the same concept when we the cost of goods sold.
Jan
Feb
Mar
Beg Inv
0
1,400
2,000
Purchases
6,400
7,600
10,400
Unit sold
(5,000)
(7,000)
(10,000)
Ending Inv
1,400
2,000
2,400
From the information, the cost per unit is $4 (40% of sales price $10)
So, the purchases in dollars will be
Payment Budget
Jan
Feb
Mar
Purchases in $
25,600
30,400
41,600
$ paid on purchase 12,800
$ paid 1 month after
0
Monthly Payment
12,800
Collection Budget from sales
Sales at $10/unit
40% collected on sale
60% collected 1 month after
Cash collections
15,200
12,800
28,000
20,800
15,200
36,000
Jan
50,000
20,000
0
20,000
Feb
70,000
28,000
30,000
58,000
Mar
100,000
40,000
42,000
82,000
57
The Cash Budget

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

While budgets are good tools for effective management, they have their limitations
and constraints. Some criticisms against budgets include the following.
a) Budgets cannot deal with fast changing environment and they are often out of
date before the start of the accounting period
b) Budgets focus on managements short term financial goals but managers should
focus on creating value for the business. For example, building brand loyalty,
innovation etc.
c) Budgets when implemented through a top-down approach create command and
control by management and prevent junior executives from exercising autonomy.
d) Enormous of time is incurred to prepare budgets. The same amount of time can be
used to improve the company through proactive activities.
e) Budgets focus on department functions. The actual focus should be looking into
processes that cut across boundaries and meet the needs of the customers.
f) Budgets are usually based on previous years performance for planning. Thus,
managers cannot think out of the box for new ideas or strategies that may be
necessary in the new economy.
g) Budgets protect costs rather than reduce costs. Most managers fear that the
amount allocated to them will be taken away the following year if it is not spent.
Thus, their response will be to spend the full amount instead of attempting to
reduce it.
h) Budgets create slacks in the planning processes. To meet the target set,
managers will try to negotiate lower sales and higher allocation for expenses. This
allows them to build slacks in the budget so that the meetings become easier to
conclude.
58
Review Questions
1)
Define a budget. Explain how budgets are used in planning.
2)
How important are the behavioral aspects of a budgetary control system?
3)
ABC Private Limited produces food products for cats. The expected forecast is as
follows:
Unit Sales
Dollar Sales
January
100,000
$50,000
February
120,000
$60,000
March
110,000
$55,000
April
100,000
$50,000
The firm has inventory policy that requires the ending inventory for each month is to be
20% of next months sales. The beginning inventory for the year is 20,000 cans.
a) Prepare the production budget for the first quarter.
b) If sales each month is based on 40% cash sales and credit sales are given 30 days
credit, prepare the collection schedule from January to March.
c) Each can of cat food require 5 oz of material and each oz cost $0.02 cents. The firm
has ending material requirement of 15% of next months production. The firm
requires a quarterly inventory balance is 100,000 oz. Compute the quantity purchased
and its related costs.
4)
Prepare the cash budget using the following information.
Cash balance on January 2010 is $1,000

Actual cash sales for November and December 2009 are $10,000 and $15,000
respectively. The credit sales are $25,000 for November and $35,000 for
December.
The firm collection experience shows that 50% of the credit sales are collected
in the month of sale, with 30% in the following month and 15% in the third
month. The remaining sales are uncollectible.
Inventory purchases average 60% of a months total sales. The firm pays 40%
cash in the month of purchase and settles all payables by the following month.
Salaries and wages amount to $8,000 a month and rental is $1,000 a month.
Taxes for 2009 payable in February is $5,000
The projected January cash sales is $20,000 and credit sales is $40,000.
59
Session 9
Accounting for Control
1. Discuss the role and limitations of budgets for performance evaluation and control
2. Understand variance analysis and possible reasons for the variances
3. Explain the issues in designing effective budgetary control systems
4. Explain the nature, role and limitations of standard costing
_____________________________________________________________________
9.1 ROLE AND LIMITATIONS OF BUDGETS
Budgets are useful tools for evaluation and exercising control over a business.
What is evaluation in this case? As the budgets are the planned goals, the actual
performance is likely to be different from them. The measurement of variances i.e.
the difference between the actual and planned goals is the process of evaluation.
What is control in this case? Control is the act of making events conform to the plan
and if variances occur, there is a need to manage them. The manager can either
improve on the processes or review the plan to determine if it is achievable and
practical.
There are two types of control. The first is feedback control where steps are taken to
get operations back on track immediately upon a signal that procedures have gone
wrong.
The second type is feedforward control where predictions are made as to what can
go wrong and steps are taken to avoid the undesirable outcomes. Thus, feedforward
controls are anticipative and forward looking. Thus, they are more preferred.
9.2 VARIANCE ANALYSIS AND EXPLANATIONS
Variances occur when actual performance is different from budgeted plans.
Static Budget
Actual Result
Output
1,000 units
900 units
Sales revenue
Raw materials
Labour
Fixed Overheads
Operating Profit
$100,000
(40,000) (40,000 metres)
(20,000) (2,500 hours)
(20,000)
20,000
$92,000
(36,900) (37,000 metres)
(17,500) (2,150 hours)
(20,700)
16,900
Based on the above, it is inappropriate to compare the costs and revenues expected
for 1,000 units production with the costs of 900 units. To ensure comparability, it will
be necessary to equate the costs and revenue of the budget to the number of units
actually produced i.e. 900 units
60
Creating the Flexible Budget

Output
Static Budget
1,000 units
Flexible Budget
900 units
Sales revenue
Raw materials
Labour
Fixed Overheads*
Operating Profit
$100,000
(40,000) (40,000 metres)
(20,000) (2,500 hours)
(20,000)
20,000
$90,000
(36,000) (36,000 metres)
(18,000) (2,250 hours)
(20,000)
16,000
* Fixed costs do not change with volume.
Now that both the flexible budget and actual performance are based on the same 900
units, we can make reasonable analysis on the variances.
Output
Flexible Budget
900 units
Actual Result
900 units
Sales revenue
Raw materials
Labour
Fixed Overheads
Operating Profit
$90,000
(36,000) (36,000 metres)
(18,000) (2,250 hours)
(20,000)
20,000
$92,000
(36,900) (37,000 metres)
(17,500) (2,150 hours)
(20,700)
16,900
Analyzing Variances
Sales Volume Variance is the difference between the profits in the static
budget and the flexible budget. The sales volume variance for the above is
$4,000 as the firm sold 100 units less than planned. Since the effect is
negative, it is an adverse or unfavorable variance. A positive effect will be
known as favorable variance.
Sales Price Variance is $2,000 and is the difference in revenue between

flexible and actual sales. A favorable variance is the result of a higher selling
price than originally budgeted. The original budget planned a sales price of
$100 per unit but the actual sale price per unit is $102.22 ($92,000 divide by
900 units)
Total Material Variances is the difference between flexible and actual material
used. The above example has an unfavorable total material variance of $900.
The production used more material and also spent more on purchasing them.
This implies that material variance is made up of two possible components:
The material usage variance and the material price variance. The firm has an
unfavorable material usage variance of 1,000 metres x $1 per meter i.e.
$1,000 unfavorable.
For price variance, the firm pays $100 less ($37,000 -$36,900) than expected
for the 37,000 metres. This results in a favorable variance of $100.
61
Total Labor Variances is the difference between flexible and actual labor
used. The above example has a favorable total labor variance of $500. The
firm actually incurs lesser hours and lower labor costs to achieve the 900
units.
Like material variance, labor variance is also made up of two possible
components: The labor efficiency variance which measures the difference
between the actual direct labor hours worked and numbers of labor hours in
the flexible budget. The firm has a favorable efficiency variance of 100 hours.
With per hour rate of $8, this will result in a favorable labor efficiency
variance of $800.
The labor rate variance measures the cost per hour incurred between actual
and budgeted. For the 2,150 hours used, the budgeted labor cost should have
been $17,200 (2,150 hours x $8 per hour). However, the firm spends $17,500
resulting in a unfavorable labor rate variance of $300.
9.3
Fixed overhead variance is the difference between the actual fixed overhead
costs incurred and the budgeted fixed overhead. Noting that fixed overhead
costs should not change with volume, the firm is expected to incur $20,000.
As there is a $20,700 fixed overhead incurred, this result in a unfavorable
$700 variance.
ISSUE IN EFFECTIVE BUDGETARY CONTROL SYSTEMS

Effective budgetary control systems should contain certain features. These include:
All levels of management must be committed to the budgets proposed. A good
budgetary control requires establishing systems and routines. There is a clear
distinction between the individual managers areas of responsibilities.
Routines should include the frequency and relevant variance reporting as well
as establishing senior management commitment.
Budgets should be challenging and yet achievable. Unachievable targets are
counter productive and produce de-motivating effects.
The budget reports should be focus and aimed at individual managers instead
of general reporting which waste more of the managers time to search for
what is relevant to them.
Ensure effective data collection and analysis process and these should be part
of the periodic reporting procedures. This will save time as they are
automatically produced each month.
Variance reporting should be provided to the managers shortly after the month
ended and not long after. Early reporting allows the managers to response to
the variances and implement changes immediately.
9.4
NATURE, ROLE AND LIMITATIONS OF STANDARD COSTING

Standard costing used in measuring either the quantity or costs are the basic building
blocks for budgets. The basic objective or role of standard costing is to have a means
of measuring the actual performance with the budgeted costing standards.
62
It is important to note that there are two basic types of standards: the ideal standards
and the practical standards. As the term implies, ideal standard assumes perfect
operating conditions and inefficiency does not exists. Its role is to encourage
employees to meet the standard of excellence.
The practical standards considers down time of machines or labor and other
challenges of operations management. While lowering the expected performance
slightly, the objective is still to set a high and achievable goal for the employees. The
practical standard is preferred by most as one would consider it difficult to measure
performance under perfect condition. It also may discourage managers as goals are
perceived as unattainable, thus, becomes counter productive.
While standard costing is a good tool, there are obvious limitations. These are listed
as follows:
a) Large companies and businesses do not have a clear direct relationship between
inputs and outputs. There are expenses of discretionary nature. Examples are
advertising and training.
b) The fast changing pace of the environment and competition may very quickly
make initial standards set by management out of date. Thus, constant monitoring
of the standards set is required.
c) While management can set the costing standards, there are many factors or
variables that are not within the control of the manager. Yet, he may be
responsible for any negative variances.
d) Standards do not consider the contribution by different managers who work
together for the common goal. The line of responsibility between the managers
becomes unclear.
63
Review Questions
1)
How would you explain the meaning of standard costs to a non-accounting person.
2)
What is the difference between the static budget and the flexible budget
3)
Suggest some possible causes of unfavorable labor efficiency variance.
4)
Wonderful Comfort produces footwear. The firm uses as standard cost system and has
set the following standard for materials and labor for one pair of boots.
Leather (3 units at $10)
Direct labor (2 hours at $12)
$30
$24
During the year, the firm produces 2,000 pairs of leather boots, The actual leather
purchased was 6,200 units at $9.96. There were no beginning and ending inventories of
leather. Actual direct labor was 4,200 hours @ $12.50
You are to prepare the following:
(a) Compute the costs of leather and direct labor that should have been incurred for the
production of the 2,000 pairs of leather boots.
(b) Compute the total budget variances for leather and labor
(c) Break the material variance into price variance and usage variance
(d) Break the labor variance into rate variance and efficiency variance.
Describe the fundamentals for budgeting process.
64
Session 10
Full Costing and Marginal Costing
1. Determine the full cost (absorption) of a single product environment
2. Determine the full cost (absorption) of a multiple product environment
3. Understand the problems with full costs (absorption) in practice
4. Distinguish between full (absorption) and variable costing
5. Discuss the usefulness of full (absorption) cost information to managers
_____________________________________________________________________
10.1 WHAT IS FULL COSTING (ABSORPTION COSTING)?
Until this point, the cost of goods sold is either given or computed from available
information so that we can present the profit and loss statement.
A product is made of different inputs that cost the firm resources to produce it. We
have not covered the process of accumulating these costs incurred to a unit of
product.
Full cost is the total amount of all resources measured in monetary terms sacrificed to
produce a unit of product or services. For example, materials are used in production
and rental is incurred for the factory. These are element of costs of each unit of
output.
The following sections focus on how we apply full costing to single-product
companies and multiple product companies.
All products are made up of two categories of costs: the Direct Costs and the
Indirect Costs.
The direct costs are costs that make up a great portion of the cost of the products and
their values are easily calculated or traceable to the products. Direct costs are the
direct material and direct labor.
In producing a table, wood is an obvious direct material as it is clearly a major part of
the product and the accounting records for purchases is used to value it. Similarly, the
carpenters salary is a major part of the production costs for without them, the tables
will not be made. The payroll records determine the direct labor costs. So the two
main elements of direct costs are direct material and direct labor.
To produce tables, there is indirect cost as well. Indirect costs are the incurred
expenses that are not easily traced to the products. Example of indirect costs in
making tables are the glue used, the nails used or cooling liquids for the machinery.
We termed these indirect costs as overheads (OH).
All products have three important elements: Material, Labor and Overheads (OH).
The first two are direct costs and the last element is indirect costs.
65
10.2 FULL
(ABSORPTION)
ENVIRONMENT
COSTING
OF
SINGLE
PRODUCT
In a single product company, the products are usually identical or near identical units
of outputs or services. We call them homogenous in nature and one cannot
differential one product from another. Examples of homogenous products are
producing bag of rice or flour. This costing process for homogenous products is
known as Process Costing.
To compute the full cost of a single product company, we add all the production costs
(e.g. incurred during the period and divide it by the total number of units produced.
Example: Fancy Food Services only supply one type of soup noodles. In January,
the firm sold a total of 8,500 bowls and generated $25,500 revenues. The total costs
incurred during the month are as follows:
Ingredient (noodles and fishballs)
Chefs salaries
Rental for the store
Utilities and other support costs
Depreciation of fixed assets
Full cost per unit is
$4,000
$7,500
$5,000
$1,500
$1,125
= (Total production costs) / units produced.

= ($19,125) / 8,500 bowls
= $2.25 per bowl
10.3 FULL (ABSORTPION)

ENVIRONMENT
COSTING
OF
MULTIPLE
PRODUCT
Most companies supply multiple products. A carpentry firm is likely to supply chairs,
tables, beds, wardrobes and other products. These products are totally different and
the amount of time and material to produce a chair is different from producing a table.
Therefore, to assign cost equally across obviously different products will distort the
costing process and makes setting of selling price difficult.
As the products are uniquely different, the process of costing is term Job Order
Costing. This would require each job (say for chairs) will have its own records for
materials, labor and fair share of overheads incurred.
In a multiple product business, the firm has no problem allocating the cost of direct
material and direct labor to each product type since accounting records determine the
values incurred.
The difficulty or problem lies in allocating or apportioning overheads to the different
products.
66
10.4 PROBLEMS WITH FULL COSTING IN PRACTISE

A) Multiple products with single department
Example:
A firm ABC that produces tables and chairs estimates the following costs for the
coming year.
Overhead costs
Direct labor hours
Machine hours
$600,000
140,000
60,000
When the year ended, 20,000 tables and 60,000 chairs are produced. The direct costs
incurred are as follows
Direct material costs

Direct labor cost
Direct labor hours used
Machine hours used
Tables
$100,000
$ 80,000
75,000
35,000
Chairs
180,000
70,000
60,000
20,000
What is the full cost per unit for each table and chair?
Solution Process
Step 1 is to determine an overhead cost driver. To do this, the manager must

determine what activity will drive or push overhead costs up. It can be units
produced, number of labor hours, number of machine hours etc. Some products
are labor intensive, so direct labor hours would be a good overhead cost driver. If
production is machine intensive, then machine hours would be a good choice. The
manager has to decide on the cost driver.
For the purpose of this example, let us assume the manager determines that
machine hour is the cost driver.
Step 2 is to compute an overhead recovery rate. The computation format is:

Overhead recovery rate =
Estimated Overheads
Estimated cost driver
For this example, the OH recovery rate

= ($600,000 / 60,000 ) machine hour
= $10 / machine hour
Step 3 is to allocate or apply overhead cost to each product

The Applied OH = OH recovery rate x cost driver used
For this example, the Applied OH for tables is
= $10/machine hour x 35,000 machine hours
67
= $350,000
And the Applied OH for chairs is
= $10/machine hour x 20,000 machine hours
= $200,000
To determine the cost per unit for each table and chair, we add all the direct and
allocated overhead costs i.e. the sum of direct materials, direct labor and the allocated
overhead costs.
Total costs of tables = $100,000 + 80,000 + $350,000 = $430,000
Total cost for chairs = $180,000 + $70,000 + $200,000 = $450,000
Cost per table = $430,000 / 20,000 tables = $21.50 per table
Cost per chair = $450,000 / 60,000 chairs = $7.50 per chair
B) Multiple products with multiple departments

Another firm XYZ produces tables and chairs estimates the following costs for the
coming year. Each product will go through two different departments: the Assembly
and Painting Department.
Overhead costs
Direct labor hours
Machine hours
Assembly
$400,000
80,000
40,000
Painting
$200,000
60,000
20,000
Total
600,000
140,000
60,000
When the year ended, 20,000 tables and 60,000 chairs are produced. The direct costs
incurred are as follows
Direct material costs

Direct labor cost
Direct labor hours used
Machine hours used
Tables
$100,000
$ 80,000
35,000
38,000
Chairs
180,000
70,000
15,000
10,000
Assume the manager already determines that labor hour and machine hour are the
cost drivers for the assembly department and painting department respectively.
What is the applied overhead cost for tables and chairs?
Solution Process
a) Overhead Recovery rate
=
Assembly
Painting
$400,000
80,000
$5/labor hour
$200,000
20,000
= $10/machine hour
68
b) Apply overhead for tables:
Overhead for tables

=
=
Overhead for chairs

=
=
Assembly
($5/labour hr
x 35,000 labor hours) +
$165,000 + $150,000
$315,000
Painting
($10/machine hour
x 15,000 machine hours)
Assembly
($5/labour hr
x 38,000 labor hours) +
$190,000 + $100,000
$290,000
Painting
($10/machine hour
x 10,000 machine hours)
What would be the cost per unit for each table and chair? Are you able to calculate it?
B) Multiple products with product cost centre and service cost center
With most manufacturing environment, there are the product cost centres (or
departments) or service cost centres (or departments). Product cost centres are
departments where the direct labor and materials are added to manufacture the
products. The service centres are support departments and their costs must be charged
to the product costs and become part of the products overhead costs.
The process of allocating overheads between departments falls into two categories.
The first one is Cost Allocation where specific costs are allocated to a particular
department. Rent, electricity, salaries of workers are specifically linked and related to
a specific department. The second category is Cost Apportionment. This applies to
general overheads that relate to more than one department. For example, utilities are
not separately metered will need to be apportioned to each product based on the
benefit derived. Rental can be apportioned according to square metres.
The steps to apportion the overheads are as follows:
a) Allocate specific department overheads to the relevant department
b) Apportion general overheads among department
c) Total the allocated and apportioned overheads to determine the total for each
department
d) Apportion service department costs to product cost centres
e) Total or sum up the product department overheads
f) Calculate a departmental overhead absorption rate for each department
g) Cost units absorb overheads as they pass through product centres or departments.
1.0.5 FULL COSTING AND VARIABLE COSTING

We have covered full costing which includes all costs (direct material, direct labor
and overheads) incurred in the product. These forms the product costs in our
inventory. When the unit is sold, these costs are then expensed in the profit and loss
statement as cost of goods sold. Full costing does not consider the behaviors of the
costs.
69
Variable costing that will be covered in the next lesson breaks costs into their
behaviors i.e. variable costs and fixed costs. In variable costing, all variable costs
(direct material, direct labor and variable overheads) are linked to the product and
will be expensed only when the product is sold. All fixed costs (i.e. fixed overheads)
are expensed in the period in which they are incurred.
Supporters of full costing argue that the method allocates costs to each sale and gives
a complete picture of the income generated. Variable costing supporters state that the
method is more relevant to decision making and is useful for managers.
Review Questions
1)
Explain the difference between process costing and job order costing.
2)
What is the meaning of full costing?
3)
All products have both direct and indirect costs. How do we differentiate them?
4)
Faber Technologist has the following information for the year 2010.
Budgeted Overhead
Budgeted Direct Labour Hours
Budgeted Direct Machine Hours
Actual Direct Labour Hours Used
Actual Direct Machine Hours Used
Actual Overheads costs Incurred
Equipment Rental costs
Depreciation on factory
Indirect Labour
Utilities for factory
Other factory overheads
$180,000
15,000
20,000
15,400
22,000
$ 5,000
$ 20,000
$100,000
$ 15,000
$ 45,000
The company has identified that direct labour hour is the main cost driver for overheads
costs. During the year, JOB No: K 001 is completed with the following costs information.
Actual direct material costs used
Actual direct labor costs incurred
Average wage per hour per worker
$2,340
$3,600
$10 per hour
REQUIRED:
(a) Calculate the overhead rate for the year.
(b)
Calculate the total costs for JOB K001 using application rate.
(c)
Why might a company use a plant wide overhead rate instead of a departmental
overhead rate?
70
5) Donald Aeronautics Co. uses a budgeted overhead rate in applying overhead to individual
job orders on a machine-hour basis for Department A and on a direct-labor-hour basis for
Department B. At the beginning of 19X8, the companys management made the
following budget predictions:
Direct-labor cost
Factory overhead
Direct-labor hours
Machine-hours
Department A
$1,500,000
$2,170,000
90,000
350,000
Department B
$1,200,000
$1,000,000
125,000
20,000
Cost records of recent months show the following accumulations for Job Order
No. M89:
Material placed in production

Direct-labor cost
Direct-labor hours
Machine-hours
Department A
$12,000
$10,800
900
3,500
Department B
$32,000
$10,000
1,250
150
REQUIRED:
(a) What is the budgeted overhead rate that should be applied in Department A? and in
Department B?
(b)
What is the total overhead cost of Job Order No. M89?
(c)
If Job Order No. M89 consists of 200 units of product, what is the unit cost of this job?
71
Session 11
Cost-Volume-Profit (CVP) Analysis
1. Understand cost behaviors
2. Calculating break-even point with C-V-P Analysis
3. Understand the weaknesses in the C-V-P Analysis
4. Using Marginal Analysis for short-term decisions.
_____________________________________________________________________
11.1 UNDERSTAND COST BEHAVIORS
The profit and loss statement shows a list of expenses incurred to generate the income
for the year. For greater detail, the accountant can classify the expenses by function
i.e. production, sales, marketing, administration and finance.
However, the listing of expenses is not sufficient for a manager to make business
decisions. It is important to understand how expense and costs behave so that he can
manage them.
Costs can be broken down into fixed costs or variable costs behavior.
Fixed costs can be shown graphically.
As the volume
of activity
increases, the
fixed costs stay
the same
Based on the diagram, fixed costs remain the same within the relevant range of
production. An example will be rental which remains constant regardless of the
production quantity. Other examples are fixed staff salary, insurance for the year or
road tax for vehicles.
Some fixed costs are regarded as stepped fixed costs (see diagram below). This
indicates that at lower volume of production, an initial fixed cost is incurred.
However, with expansion or larger volume required, another unit of fixed cost is
necessary to meet the production needs. For example, a machinery can produce
50,000 per month will have a fixed depreciation cost. If the firms need to produce
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80,000 units, it will require another machine which results in extra depreciation
expense.
Step Fixed cost can be presented as follows:
Variable costs are costs that vary with the volume of activity. This implies that with
greater volume, the firm will need more of this cost. An example for a manufacturing
firm will be the raw materials used in production. While the cost of material may
remain constant on a per unit basis, the total variable costs will increase with larger
production volume.
Variable costs are presented diagrammatically as follows.
As the volume
of activity
increases, the
total variable costs
increases
the same
It is likely that business have costs that have some element of both fixed and variable
cost. These are known as the semi-fixed (semi-variable) costs. The diagram below
shows how a certain amount is fixed and as volume increases, an additional amount is
charged on a per unit basis. An example will be the sales person having a fixed salary
per month but is also paid commission on the sales he generates for the firm.
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11.2 CALCULATING BREAK-EVEN POINT

Knowing how costs behave allows a manager to use the information to determine the
break even point for the business. The information can also be used to make business
decisions such as special order sales, make-or-buy decisions, keep or drop decisions
and limited resources constraints.
Break even point is where the firm makes zero profit and thus, it concludes that the
total revenue is equal to total cost (both fixed and variable costs)
So
Total Sales
Total Sales
=
=
Total Costs
Total Fixed Costs + Total Variable Costs
If B represents the units of output, SP is the selling price while VC is the variable cost
per unit, the above formula will be
B x SP per unit = Total FC + B(VC per unit)
B
Total FC / (SP per unit VC per unit)
Note that (SP per unit VC per unit) is also known as the contribution margin per
unit. Contribution Margin is the excess of the selling price after deducting the
variable costs and this amount will be used to reduce the total fixed costs for
determining the profit.
Example: Fun Parties Pte Ltd has projected the profit for 2011.
Sales ($10/unit)
Variable Expenses
Contribution Margin
Fixed Expenses
Profit
$180,000
$108,000
$ 72,000
$ 40,000
$ 32,000
What is the break even point?
74
Solution Process:
Based on the above, the firm plans to sell ($180,000 /$10/unit) = 18,000 units
The variable cost per unit = $108,000 / 1,800 units = $6/unit
Therefore the contribution margin per unit = $10 - $6 = $4 per unit
(Alternate way is to use total contribution / units sold)
The break even point = ( Fixed cost + zero profit )
Contribution margin per unit
= $40,000 / $4 per unit = 10,000 units
So, 10,000 units must be sold to break even i.e. cover all variable and fixed costs with
no profit.
Other concepts related to the break even point analysis are the Margin of safety and
the concept of Gearing.
The margin of safety is the difference between the planned volume of output or sales
and the break even point in output or sales. Based on the above example, the break
even point is 10,000 units and $100,000 (10,000 units x $10/unit) of total sales. The
planned volume is 18,000 units and $180,000 sales. So the margin of safety in units is
8,000 (18,000 -10,000) and the margin of safety in sales is $80,000 ($180,000 $100,000).
What does the $8,000 units in the margin of safety implies? Since the business knows
its break-even point at 10,000 units, the 8,000 units is what the firm may fall short in
achieving its target and still break even. Any volume larger than 8,000 units will
result in a loss.
The concept of operating or operational gearing shows the relationship between
contribution and the fixed costs. An activity with relatively high fixed costs relative to
variable costs is said to have high operating gearing. A higher level of operating
gearing makes profit more sensitive to changes in the volume of activity.
Illustration: Consider a company with the following cost information.
Units
300
600
1,200
Sales ($10 per unit)
3,000
6,000
12,000
Less Variables costs
1,200
2,400
4,800
Contribution Margin
1,800
3,600
7,200
Less Fixed Costs
1,000
1,000
1,000
Profit
800
2,600
6,200
Increase in profit
2.25x
1.38x
Assuming a machine with additional fixed cost of $500 can reduced the variable cost
by 50%, the new statements will be as follows.
Units
Sales ($10 per unit)
Less Variables costs
300
3,000
600
600
6,000
1,200
1,200
12,000
2,400
75
Contribution Margin
Less Fixed Costs
Profit
Increase in profit
2,400
1,500
900
4,800
1,500
3,300
2.67x
9,600
1,500
8,100
1.48x
The comparison shows that doubling the unit sales results in faster growth in the
profit when the additional machine with the additional fixed costs is used in the firm.
11.3 WEAKNESSES IN THE C-V-P ANALYSIS

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

With marginal analysis concept, managers can make short term decisions such as the
Accept/reject special order, Make/buy decisions, Keep/Drop a business unit and
efficient use of scarce resources. We will illustrate these with examples.
Accept/reject special contracts this is a situation where an external party requests
to buy from the firm its products at a lower price than existing clients.
Example: A firm XYZ with the detailed statement is approached by a potential
overseas client to sell them 10,000 units at $4 per unit. Should firm XYZ agree to the
proposal?
Profit and Loss of XYZ
Sales (10,000units)
Less all variable costs
Less all fixed costs
Profit for the year
$70,000
$25,000
$20,000
$25,000
Based on the above, the current selling price per unit is $7 ($70,000/10,000 units).
The cost of per unit is $4.50 ($25,000+20,000)/10,000 units. One would think the
firm will lose $0.50 per unit ($4.00 - $4.50) if the proposal is accepted.
76
Note that while the fixed cost of $20,000 is incurred, remember that fixed cost does
not change with volume. By accepting the 10,000 units will not increase the fixed
costs. So the only cost the 10,000 units have is the variable cost per unit of $2.50
So, if the firm accepts the offer, it will make $15,000 in additional profits since the
selling price $4 per unit is higher than the $2.50 per unit cost of production.
Closing or continuation of business (Keep/Drop)
This type of decision usually occurs when a manager faces a department or product
that is showing a loss each month. To decide if the department or product should be
drop from the business, the manager has to consider the effects of fixed costs on the
operations.
Example:
Selling
Variable cost
Contribution margin
Less fixed cost
Profit and Loss
Product A
$ 25,000
$ 12,000
$ 13,000
$ 5,000
$ 8,000
Product B
$ 10,000
$ 6,000
$ 4,000
$ 5,000
$ (1,000)
The firm has a common fixed cost of $4,000 that is equally shared between the two
products. The firm profit and loss is $7,000
Based on the above, it is likely a manager will choose to drop product B believing
that without the $1,000 loss, the firm will improve its profit. This thinking process is
flawed as the manager overlooked the nature of fixed costs.
Note that fixed costs can be directly related to the product these are direct fixed
costs which will be saved (avoidable) if the product is dropped. There is also
common fixed cost these are costs such as rental, CEO salary that will not change
if the product is dropped. Thus, in making such decision, ONLY marginal costs are to
be considered.
The decision process is to consider only direct fixed costs.
Product A
Product B
Selling
$ 25,000
$ 10,000
Variable cost
$ 12,000
$ 6,000
Contribution margin
$ 13,000
$ 4,000
Less direct fixed cost
$ 3,000
$ 3,000
Product Profit and Loss
$ 10,000
$ 1,000
Product B is actually making a profit and thus contributing to covering part of the
common fixed cost. So it should not be dropped.
Another way is to consider the overall profit from product A alone if product B is
dropped
Product A
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Selling
Variable cost
Contribution margin
Less direct and common fixed cost
Product Profit and Loss
$ 25,000
$ 12,000
$ 13,000
$ 7,000*
$ 6,000
* Original fixed cost of $5,000 plus $2,000 of common costs transferred from B
Make-or-buy decisions
A make or buy decision occurs when a firm is making a product but a supplier
proposes to supply the firm the same products at a certain price. Once again, a
manager is likely to compare the current cost against the supplier price but he has to
consider the fixed costs effect again.
Example: A firm with the following cost information needs to determine if it is better
to produce 10,000 units of a component in-house or buy from a supplier at $2.40 per
unit.
Direct material
Direct labor
Variable overhead
Fixed overhead
Total Cost
Total Cost
$ 9,000
$ 8,000
$ 4,000
$ 7,000
$28,000
Total cost per unit $2.80
To accept the offer by comparing the offer price of $2.40 and the production costs of
$2.80 thinking there is a saving of $0.40 is a flaw.
First, the manager has to consider if the fixed overheads are avoidable or
unavoidable. Avoidable fixed overheads means the costs is entirely not required if the
decision is to buy from the supplier. Unavoidable costs remain regardless of the
decision.
If the fixed cost is unavoidable (i.e. $7,000 has to be paid regardless of decision), the
comparison is made on the avoidable costs only
Direct material
Direct labor
Variable overhead
Total Cost
Total Cost
$ 9,000
$ 8,000
$ 4,000
$21,000
Avoidable cost per unit $2.10
So it is cheaper to make the product in-house and the offer should be rejected.
If a portion of the fixed cost is avoidable (e.g. $3,000 of rental can be saved because
we do not need the space), the decision will be as follows.
Direct material
Direct labor
Total Cost
$ 9,000
$ 8,000
78
Variable overhead
Fixed overhead
Total Cost
$ 4,000
$ 4,000
$25,000
Avoidable cost per unit $2.50
Now it is cheaper to buy from the supplier at $2.40 per unit.

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

hours is a constraint, we need to calculate the maximum we can make per hour.
Contribution margin per hour
$6.50
$8
Based on the above, the firm should use the resource to produce product B first until
all demands are made before allocating resources to product A. This will achieve
maximum contribution margin for the firm.
79
Review Questions
1)
Your non-accounting friend says that fixed costs will decline as volume increases.
Explain whether you agree or disagree with this statement.
2)
Contribution Margin is the excess of sales over fixed costs. Explain if you agree or
disagree with this statement.
3)
You plan to own a hair salon with 5 barbers. Each barber is paid $3.00 per hour and is
required to work 40 hours a week for 50 weeks per year regardless of the number of
haircuts. For each service provided, they are paid additional $4.00. The rental is
expected to be $2,500 per month. The target price per haircut is $12.
a) What is the contribution margin per haircut?
b) Determine the number of haircuts to break even.
c) If the firm can provide 10,000 haircuts per year, what will be the operating income?
d) What will be the margin of safety?
4)
Your company provides the following performance budget when it sold 2,000 units of
its products.
Sales
Manufacturing cost of goods sold
Gross Profit
Less selling and admin expenses
Net profit
$10,000
$ 6,000
$ 4,000
$ 3,300
$ 700
Other information: Fixed manufacturing costs are $2,400 and fixed selling
administrative expenses are $2,500.
a) What is the break even point for the company?
b) Assume the company has idle capacity and a foreign firm requests for 500 units at a
selling price of $3 per unit. Should your company accept the special order?
c) If a supplier offer to sell you the same product at a cost of $2.50 per unit, will you
take up the offer to buy from him if all your fixed costs will be incurred regardless
of your decision.
5)
Your firm manufactures and sells two products: A123 and B456. The selling prices for
both products are $6.00 and $4.00 respectively while their variable costs are $3.00 and
$1.40. Product A123 requires 0.5 machine hour to produce each unit and B456 requires
0.33 machine hour per unit.
80
a) If the company has only 1,000 machine hours per week, which product should be
produced first?
b) If the company has only 1,000 machine hours per week and each product has a
weekly demand of 2,100 units, how would you allocate the machine hours and how
many units of each product can you produce?
6)
A firm has the following three departments. You are to make a decision as to whether
the Kids department should be dropped.
Amounts in thousands
Sales
Variable Costs
Fixed Costs
Mens
$400
$200
$ 50
Ladies
$5,000
$3,500
$ 750
Kids Department
$600
$390
$310
Other information
If the Kids department is dropped, $100,000 of the fixed costs is eliminated as the
service staff are no longer required.
a) Show computation to explain your decision on keeping or dropping the Kids
department.
b) Now assume that the space vacated by the Kids department can be used by the
Ladies Department. Your estimated that a salary of $25,000 per year is required for
an assistant manager and the sales is expected to increase by $300,000. Should you
still drop the Kids Department?
81
Session 12
Costing and Pricing in a Competitive Environment
1. Discuss the nature of activity-based costing (ABC)
2. Understand total life cycle costing and target costing
3. Discuss the importance of non-financial performance measurements
4. Understand shareholder value and EVA for the income statement
5. Explain the theoretical underpinning of pricing and issues with pricing decision
_____________________________________________________________________
12.1 NATURE OF ACTIVITY BASED COSTING (ABC)
We have covered the traditional method of calculating overheads based on a specific
cost driver. While the methodology makes sense, we can over or under estimate the
applied overhead as the chosen cost driver may not be a true representation of the link
between the costs and the event where the cost driver appears.
Accountants recognize that overhead cost do not just occur but are incurred due to the
activities of production. The Activity Based Costing as the terminology implies states
that it is the various activities that drive overhead costs up.
Thus, the more time an activity occurs, more overhead cost should be applied to the
product. Setting up is an activity in making a product. A production process that
requires more set ups for manufacturing will be allocated more overheads.
Under the ABC, an overhead cost pool is first determined. This is where each activity
and its related overhead costs are placed together to form the cost pool.
The manager looks at the operations and observes the types of activities that occur and
the frequency of the activities. An example of a cost pool is shown as follows:
Estimated Overhead Costs
Set up costs
Lifting costs
Invoicing cost
Quality costs
$100,000
$ 50,000
$ 70,000
$ 80,000
Cost driver
Number of set-ups
Number of times forklifts are used
Number of invoices
Number of quality checks
Every method has its own supported and critics. Those who oppose the ABC method
argues that the process of identifying the activities that increases the overhead costs is
too time consuming. While the process may make the costing more accurate, they
argue that the cost benefit ratio is not justified. The critics also argue that process does
not provide relevant information for decision making.
82
12.2 TOTAL LIFE CYCLE COSTING AND TARGET COSTING

Besides Activity based costing, other approaches are developed to meet new
competitive environment. New concepts include Life Cycle Costing and Target
costing.
What is life cycle costing? The term implies costing the product over the three specific
phases of production. The first is the pre-production phase where research and
development and market research are conducted. The phase will end with the final
setting up of the production facilities, the delivery facilities and the initial advertising
and promotion activities to create product awareness.
The second phase is the production phases. Here the actual making and selling of the
product or service occurs.
The final phase is the post production phase where any cost required to correct faults
are incurred. This is where after sales service costs are measured.
The life cycle costing considers all aspects of production from development to after
sales service.
Example: A firm can consider the following are part of the product life cycle
Design: Creation of the product
Manufacturing: Use material, labour and overhead in production
Marketing: Creating awareness of firm and product
Distribution: Transfer of product from warehouse to clients
Total estimated costs
$ 100,000
$ 500,000
$ 300,000
$ 400,000
$1,300,000
Another method to the traditional costing is target costing. The traditional costing
approach is the cost plus approach. This method computes the cost incurred on the
product and using the cost as the base measurement, a percentage of profit is added to it
to determine the selling price.
Target costing meets the objective from the opposite direction. The first step is to
determine a market acceptable selling price. This is done through market survey or
research. Using the selling price as the benchmark, a percentage of profit is deducted to
determine the costs for making the product or service.
This is known as the cost gap and now the focus of design and production is to work
around these costs to ensure efficient means of providing the product or service to the
market.
Note that target costing is related to life cycle costing because savings are sought
during the initial phase of production. This is the point where focus on efficiency and
cost reduction begins.
83
12.3 IMPORTANCE OF NON-FINANCIAL MEASUREMENTS

All firms are measured in monetary terms because the numbers give investors a sense
of financial performance and positional strength of the company. Although numerical
measurement is critical, the trend is to also focus on non-financial measurements.
The value of a firm is also created by non-financial drivers. Examples are employee
satisfaction, customer satisfaction and loyalty, high level of product innovation, good
after sales service, high quality of the product and social responsibility.
The modern era recognizes that happy employees are more productive and good service
or products keep customers and retain their loyalty. Thus, these non-financial
measurements are leading indicators of how the firm is performing and creating wealth
for the shareholders.
The Balance Scorecard
The balance scorecard developed by Robert Kaplan and David Norton attempts to
integrate both financial and non-financial measurements. The objective is to create a
system that both measures as well as manage the firm.
The Balance Scorecard set the objectives into the following four areas:
a) Financial this measures the returns for shareholders and therefore, financial ratios
like return on capital employed, net profit margin, total asset turnover etc. are useful
indicators.
b) Customer this focus on the type of customers the firm wishes to serve. It also
establishes measurement for customer satisfaction and growth levels of customer
base.
c) Internal business process successful business need to focus on processes to keep
up with the change economic environment and competition. Thus, areas like
innovation, after sales service, response time, product life cycle are important
business processes that need continual observation.
d) Learning and growth this area focus on long term growth and the specific areas
are the people, the system and the procedures. Measurements like employee
motivation, satisfaction, loyalty together with their skills and profiles are important
growth ingredients for the firm.
12.4 SHAREHOLDER VALUES AND EVA
The key objective of a business is to increase the shareholders value or wealth. This
implies that management must act in the interest of the shareholders and their
management decisions focus on this fundamental objective.
With all objectives, one would need to set up some basic processes. The following list
the processes for value creation.
The four stage process for creating shareholder value:
a) Set objectives that recognize the supremacy of shareholders intent of this is to
create a clear focus for management.
84
b) Select an appropriate measure of shareholder return the traditional measurement

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

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

R is the required returns of investors
C is the capital invested (also mean the net assets of the firm)
85
The higher the EVA, the greater is the increase in the shareholder wealth and this
means that the EVA has to be positive.
Problems with the EVA and adjustments required
The EVA computation depends on the financial statements to compute the wealth
created for the shareholders. So the reliability of the profit and loss statements and the
Balance Sheet are critical to the process.
Since EVA starts with the net operating profit after tax from the income statement,
advocates suggested that the income together with the capital invested are understated
due to accounting biases and policies. Therefore, some adjustments should be made to
present a clearer position of wealth creation.
In computing profits, some expenses are based on managerial judgment and are
deducted as expenses within the accounting period. This results in understating the
profits used in measuring EVA.
Examples of such expenses are goodwill written off, research and development
expenses, provision for doubtful debts. Therefore, these should be added back to profit
after tax amount before EVA is computed.
With capital, some assets are presented at lesser than invested amounts because of
depreciation. This resulted in understatement of invested capital.
Examples are the restructuring costs and marketable securities. In accounting,
restructuring costs are expensed but advocates of EVA argue that these amounts should
be considered as investment as they placed the firm into better position for future
challenges and growth. Similarly, marketable securities (shares and bonds investments)
are not part of invested capital because the income from these investments are added in
the income statement after operating profit is calculated.
12.5 PRICING THEORY AND ISSUES IN DECISION MAKING
In economics, the price of a product is dependent on the supply and demand of the
product. Depending on the market structure, firm that are monopoly are price makers
and competitive markets are price takers.
While economics use the supply and demand to determine the equilibrium price of a
product, accountants uses different pricing methods for costing product. The following
section discusses the different methods which are also covered in earlier sections
a) Full cost (cost plus) pricing
As discussed in earlier chapters, full costing consider the cost of production in
direct material, direct labor and overheads. With a target profit to achieve, the firm
works out the target selling price.
86
Consider a firm with production cost per unit of $20 and incurred direct and indirect
cost of $100,000. The firm wants to have a target profit of $40,000. How is the
selling price computed?
If the $40,000 profit is to be earned, the ratio of profit to cost is calculated as
($40,000 / $100,000) = $0.40 per one dollar of cost.
Since the per unit cost is $20, the prorated profit will be (0.40 x $20) = $8 per unit.
Therefore the selling price is $20 + $8 = $28 per unit
b) Cost Plus Method
This method is useful for price takers within a competitive market where buyers
dictate the price they are willing to pay. So the manufacturer has to consider
effective ways to reduce costs in order to sell at the market price and still make a
profit.
Assume the market is willing to pay $70 for a service provided by firm XYZ. As a
price taker, the firm is unable to increase the selling price. Therefore, the firm
decides on the profit it wants to make. Assume the firm is targeting a profit of $20
per service, it concludes that the cost of production or providing the service must be
at the highest of $50 (Selling price less profit).
Now that the firm has determined the cost, it works towards cost saving techniques
to achieve this in order to make the target profit.
c) Marginal Cost Pricing (Variable Cost Approach)
As discussed in earlier chapters, marginal cost approach focus on the contribution
margin per unit or service provided. As contribution margin is sales less variable
costs, the firm would want to maintain the contribution to cover the fixed costs.
With the basic assumption that fixed costs remain constant regardless of volume,
the firm manages the sales volume to cover operational costs.
The airline industry uses this method to sell unsold seats before the flight takes off.
While fixed cost remains constant, any unsold seat would not generate any income
to the firm. So the company offer these seats are promotional prices or during off
peak season to cover the variable costs and the remaining to cover the fixed costs or
increase their profits. The hotel industry does the same with the room rates during
off peak season as well.
d) Other pricing strategies
Penetration pricing and price skimming are other strategies used by firms to enter
the markets.
While market forces determine the price of a product, the firm can lower the selling
price to make it relatively cheaper to other complement products. This allows the
firm to gain a larger percentage of the market share. Making the selling price low
87
also dissuade competitors from entering the similar market. This is penetration
pricing and firms use this method to gain in the long run.
Price skimming is the opposite of penetration pricing. Firms that use this strategy
believe that the market segments who want their products are broken into different
stratum. The firm initially sets the selling price high to capture those buyers within
the group of buyers in the highest stratum who are unconcerned about high prices.
Once this group of buyers is saturated, the firm adjusts the selling price slowly
downward to capture the next group of buyers.
New products are cost in this manner to cover the cost of research and development
and manage the demand as production capacity improves. New technology gadgets
are good examples of this type of pricing.
Review Questions
1)
Explain how the traditional costing approach and the activity based costing
approach differ.
2)
While activity based costing (ABC) is a good concept, what are some possible
limitations in this method?
3)
Explain the main focus of the Balance Scorecard. What are the basic objective
areas?
4)
A firm has revenue of $190,000. The total operating expenses is $70,000. The fir
tax rate is 20%. The total net assets shown on the balance sheet is $80,000. The
management has decided that the required rate of return is 8%. Based on this
information, calculate the economic value added measurement.
5)
Illustrate with an example how cost plus pricing works and how is it different
from target pricing.
March 2010
88

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Business Accounting Study Guide

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Study Guide

Give an understanding to participants on the preparation and analysis of financial

Develop participants abilities to use accounting methods within specific enterprises

Show a detailed knowledge and understanding of:

The accounting equation and accounting rules.

Demonstrate module specific skills with respect to:

Preparing a simple balance sheet from financial information.

Show cognitive skills with respect to:

Integrating and synthesizing between module topics to discuss coherent approaches to

Demonstrate transferable skills in:

Information retrieval and numerical analysis.

Delivery of Module and Lesson Plan

Session Learning Outcomes

1. Explain the nature and role of

Bookkeeping and the

1. Explain the major groups of

1. Discuss the nature and purpose of

profit and loss account.

1. Discuss the nature of a limited

1. Describe the responsibilities of

1. Explain the role that cash plays in

1. Establish the usefulness of

1. Define a budget and show how

1. Discuss the role and limitations of

Full Costing and

1. Deduce the full (absorption) cost

1. Bearing in mind the distinction

2. Use cost-volume-profit analysis to

Costing and Pricing

Teaching and Learning Methods

McLaney E and Atrill, P (2008), Accounting, An Introduction,

Gowthorpe, C. (2005), Business Accounting and Finance for

Fundamentals of Corporate Finance, Columbus, Ohio:

Use of online databases like EBSCO and references to:

WHAT IS ACCOUNTING AND FINANCE?

identify and capturing relevant information

b) the costs and benefits of each form of finance

ACCOUNTING USERS AND ACCOUNTING INFORMATION

Focus on the whole

Must follow GAAP

Need not follow GAAP

Types of business ownership

What is the purpose of producing accounting information?

Distinguish between financial accounting and management accounting.

Discuss the advantage and disadvantages of companies compared to other entity

THE MAJOR FINANCIAL STATEMENTS

PREPARING A SIMPLE BALANCE SHEET

The Horizontal Format

Liabilities and Equity (Capital)

ACCOUNTING CONVENTIONS AND THE BALANCE SHEET

Discuss the main characteristics of assets? What do we mean by current in the

Discuss two accounting conventions discussed in this session.

THE NATURE AND PURPOSE OF THE PROFIT AND LOSS STATEMENT

PREPARING A PROFIT AND LOSS STATEMENT

Presentation of a Profit and Loss Statement

Total Revenue (Sales)

RECOGNITION AND MEASUREMENT OF PROFIT

Example: A company incurred $50,000 of salesmen salary and commission in

ACCOUNTING CONVENTION FOR PROFIT/LOSS STATEMENT

Depreciation Methods: Straight Line Method and Reducing Balance Method.

Costing Inventory It is important to know that different methods of costing

1,000 units at $10 per unit

8,000 x $12 = $96,000