01 technical

the tort of
Relevant to ACCA Qualification Paper f4 (Irl), (SCT) and (UK)

If there’s one area of the F4 Torts are legal wrongs that one party suffers at the hands of However, the House of Lords These are:

some types of loss or damage occur between parties that have

syllabus that students appear decided to create a new principle ¤ the defendant owed them a
to struggle with, it’s the tort
another. Negligence is a form of tort which evolved because of law that stated everyone duty of care
of negligence. (For Paper F4 has a duty of care to their ¤ the defendant breached that
(SCT) a tort is a delict.) The neighbour, and this enabled duty of care, and
examiners’ reports indicate that Donoghue to successfully sue the ¤ they suffered loss or damage
students do not understand the manufacturer for damages. as a direct consequence of
subject very well – in particular, Let’s consider a hypothetical the breach.
the various elements that a case and use it to demonstrate
claimant must prove in order how the tort of negligence works. Even if negligence is proved, the
for the defendant to be found Harry is involved in an accident defendant may have a defence
negligent. This article addresses in which his car is hit by one that protects them from liability,
each of the key elements in turn, driven by Alex. As a consequence or reduces the amount of
but we begin with an explanation of the accident Harry breaks damages they are liable for.
of why tort developed. a leg and is unable to work for
Torts are legal wrongs that two months. Can Harry sue Alex Element 1 – The duty of care
one party suffers at the hands for damages? As we saw earlier, the concept
of another. Negligence is a form On the face of things the of  a duty of care was created
of tort which evolved because answer seems obvious. Harry in the Donoghue case. The
some types of loss or damage was injured as a result of Alex House of Lords stated that every
occur between parties that have driving into his car and so it person owes a duty of care to
no contract between them, and seems fair that he should be their neighbour. The Lords went
therefore there is nothing for one able to sue him. However, think on to explain that ‘neighbour’
party to sue the other over. of the situation from Alex’s actually means ‘persons so
In the 1932 case of Donoghue point of view, is it fair that Harry closely and directly affected by
v Stevenson, the House of Lords should be able to sue him just my act that I ought reasonably
no contract between them.

decided that a person should be like that? People have accidents to have them in contemplation
able to sue another who caused everyday – should they all be as being so affected’. This is
them loss or damage even if there able to sue each other for every a very wide (and complicated)
is no contractual relationship. little incident? If they are then definition that could include
Donoghue was given a bottle the courts would be overwhelmed almost anyone – if still in
of ginger beer by a friend, who with cases. operation today the courts
had purchased it for her. After Thankfully, in order to prove would most certainly be overrun
drinking half the contents, she negligence and claim damages, with cases.
noticed that the bottle contained a claimant has to prove a The later cases of Anns v
a decomposing snail and suffered number of elements to the court. Merton London Borough Council
nervous shock as a result. Under (1977) and Caparo Industries plc
contract law, Donoghue was v Dickman (1990) restricted the
unable to sue the manufacturer definition a little by introducing
because her friend was party to ‘proximity’ and ‘fairness’.
the contract, not her.
 student accountant 12/2009
02
Studying Paper F4?
Law, regulation and compliance are integrated through appropriate performance objectives

negligence
Proximity simply means that This ‘reasonable’ standard ¤ The defendant is a professional

duty of care exists between the defendant and the claimant. The
the parties must be ‘sufficiently may be adjusted given the actual carrying on their profession.
close’ so that it is ‘reasonably circumstances of the case. If they were, then the court
foreseeable’ that one party’s For example, if the claimant will judge their actions against
In many cases brought before the courts it is evident that a

negligence would cause loss or is vulnerable, such as being a reasonable professional in

damage to the other. Fairness disabled or frail, it is reasonable their line of work, rather than
real issue is whether or not the actions of the defendant
means that it is ‘fair, just and to expect the defendant to have just any ordinary person. If
reasonable’ for one party to owe paid them special attention or professional guidelines are
the duty to another. taken extra care over them as in place then the court will
What does this mean for Harry? compared to someone who is fit judge the defendant’s actions
I think you’ll agree that Alex and healthy. against these rather than its
owes him a duty of care. There is Other circumstances which own expectations.
sufficient proximity (ie Alex drove may be taken into account
into Harry’s car); it is reasonably include whether: Back to the case of Harry and
foreseeable that a collision ¤ The actions the defendant Alex. In determining whether or
between the cars could cause took are in line with not Alex broke his duty of care,
Harry some injury, and it seems common practice or industry a court will consider whether or
fair, just and reasonable for Alex recommendations. If they not, given the circumstances,
to owe a duty of care to Harry were, then it is likely that the he drove as a reasonable person
(and indeed all other road users). defendant will be found to would have. For example, if it
have met their duty unless was foggy or wet at the time,
Element 2 – Breach of duty of care the common practice itself is he would be expected to show
were sufficient to meet their duty.

In many cases brought before the found to be negligent. that he drove cautiously. In
courts it is evident that a duty of ¤ There was some social benefit determining whether Alex’s
care exists between the defendant to the defendant’s actions. actions were reasonable, evidence
and the claimant. The real issue If there was, then the court may have to be taken from
is whether or not the actions of may consider it inappropriate witnesses and expert analysis of
the defendant were sufficient to for them to be found to have the crash may be required. For
meet their duty. To determine this, breached their duty. now, let’s assume Alex was not
the court will set the standard of ¤ The defendant’s actions had a driving reasonably.
care that they should have met. high probability of risk attached
This standard consists of the to them. If they did, then the
actions which the court considers court will expect them to show
a ‘reasonable person’ would have they took extra precautions to
taken in the circumstances. If the prevent loss or damage.
defendant failed to act reasonably ¤ There were practical issues
given their duty of care, then they that prevented reasonable
will be found to have breached it. precautions being taken, or
unreasonable cost would have
been involved in taking them.
If there were, then the court is
unlikely to expect the defendant
to have taken them in order to
meet their duty of  care.
03 technical
Res ipsa loquitur
In extraordinary cases, the facts
may be so overwhelmingly in
favour of the claimant that the
court decides the defendant
should prove that they were not
negligent. The legal term for this
is res ipsa loquitur (meaning the
facts speak for themselves). It
applies in circumstances where
the cause of the injury was under
the control of the defendant
and that the incident would not
have occurred if they had taken
proper care. It is often applied
in medical cases, for example
in Mahon v Osborne (1939), a
surgeon had to prove it was not
negligent to leave a swab inside
a patient.
Element 3 – Loss or damage as a
result of the breach
In this element the claimant
simply has to prove that the
loss or damage was a direct
consequence of the defendant’s
breach of duty of care. In other
words that there is a chain of
causality from the defendant’s
actions to the claimant’s loss or
damage. A simple test, called the
‘but for’ test is applied. All the
claimant has to prove is that if
it were not ‘but for’ the actions
of the defendant then they
would not have suffered the loss
or damage.
claimant that the court decides the defendant should prove that they were
In extraordinary cases, the facts may be so overwhelmingly in favour of the
not negligent. The legal term for this is res ipsa loquitur (meaning the
Where there is more than Novus actus intervieniens
one possible cause of the loss Other events, which are outside
or damage, the defendant will the control of the defendant, may
only be liable if it can be proved intervene in the chain of causality
that their actions are the most – adding some confusion to the
likely cause. outcome of a case. The good
A good case which illustrates news is that there are some
how the ‘but for’ test operates is simple rules to remember that
Barnett v Chelsea and Kensington deal with them.
HMC (1969) – another medical At all times you should bear
case. A casualty department in mind that the defendant will
doctor negligently sent a patient only be liable if their actions
home – the patient died. However, are the most probable cause of
the doctor was not found liable the loss or damage. They will
for damages because the patient not be liable if an intervening
was suffering from arsenic act becomes the real cause.
poisoning and would have died no Examples of intervening acts
matter what the negligent doctor which remove liability from the
could have done. defendant include:
The loss itself must not be ¤ Actions of the claimant which
‘too remote’. It is an important are unreasonable, or outside
principle that people should only what the defendant could have
be liable for losses which they foreseen in the circumstances.
should have reasonably foreseen ¤ Actions of a third party which
as a potential outcome of their become the real cause of the
actions. The Wagon Mound loss or damage. The defendant
facts speak for themselves).
(1961) is a case often cited in is only liable for damages up
explanation of this principle. Oil until the point when the third
leaked out of the defendant’s party intervened.
boat within Sydney harbour and ¤ Unforeseeable natural
came into contact with some events – natural events which
cotton waste which had fallen the defendant could have
into the water. The oil was of a reasonably foreseen do not
particular type which would not affect things.
foreseeably catch fire on water.
However, the cotton ignited and
this in turn set the oil ablaze
causing damage to the claimant’s
wharf. The defendants were not
found liable for fire damage as
the actual cause of the fire was
held too remote.

Let’s return to Harry and Alex.
It is entirely possible for the
accident to be caused by a
third party driving into Alex,
forcing him into Harry. It is also
possible that Harry himself was
an intervening factor – maybe he
was driving erratically. Either of
these factors could mean that
Alex’s breach of duty is not the
real cause of Harry’s injuries.
For now, let’s assume that no
third party is involved and that
any actions Harry took are not
enough to take the blame for the
cause of the accident away from
Alex. The court will therefore
find Alex liable for negligence
to Harry.
Defences
There are two defences a
defendant can use where they
are found liable for negligence.
One will exonerate them
completely; the other reduces
the level of damages they are
liable for.
student accountant 12/2009
Volenti non fit injuria simply
means the voluntary acceptance
of the risk of injury. If a
defendant can prove the claimant
accepted the risk of loss or
damage, they will not be liable.
Acceptance can be express
(usually by a consent form being
signed) or implied through the
claimant’s conduct.
Contributory negligence takes
part of the blame away from the
defendant if it can be proved the
claimant contributed in some
way to their loss or damage. The
defendant is still liable, but will
face a reduced damages payout.
In Harry and Alex’s case, volenti is
not an issue – in no way did Harry
consent to the accident. However,
if his actions contributed in some
way to his injuries, maybe by not
wearing a seatbelt, then he may
find the amount of damages he
receives is reduced.
Use of cases in exam answers
Finally, a brief word about using
cases in exam answers. Students
are often concerned about how
many cases they should quote,
or what happens if they cannot
remember a case name. The
simple fact is that students fail
this exam because they do not
know the law – not because they
cannot remember a case name.
04
or what happens if they cannot remember a case name. The simple fact is that
Students are often concerned about how many cases they should quote,
students fail this exam because they do not know the law – not because
My advice on cases is:
1 Get to grips with the
principles of law first, then
learn case names if you have
time. By learning the law
you will probably find that
you remember the major
cases anyway.
2 Don’t try to learn every case
in your textbook – the majority
are there to illustrate how the
law was applied in a particular
set of circumstances. Instead,
go for the major ones in each
syllabus area and learn those.
3 All you need to learn is the
case name and the principle
of law it created – you do not
need to learn and regurgitate
all the background to the case
they cannot remember a case name. in the exam.
4 If you forget a case name
in the exam, don’t let this
stop you from explaining the
principle of law, just write ‘In a
case it was decided that…’
and continue with the principle.
As an example, consider
this article – only six cases
were mentioned. See if you can
remember their names.
Stephen Osborne is a technical
author at BPP Learning Media
01
The purpose of this article is to identify the reasons
why sitting the Paper F5 exam seems to cause such
a problem for students and try and improve
performance in the future.
technical
approaching
questions: Relevant to ACCA Qualification Paper F5
It is not uncommon to see
students recoil in horror at
the mention of Paper F5,
Performance Management. The
purpose of this article is to
identify the reasons why sitting
the Paper F5 exam seems
to cause such a problem for
students and try and improve
performance in the future.
As you are aware, Paper F5
builds on the blocks of knowledge
gained from sitting the Paper F2
exam. Although the pass rates for
Paper F2 tend to be on the low
side when compared with some
of the other Knowledge papers,
they are still significantly higher
than the Paper F5 pass rates.
Therefore, although poor pass
rates could be blamed on the
fact that Paper F5 covers an area
that most ACCA students have no
experience of and find it difficult
to relate to, the same could be
said of Paper F2. Why then,
does Paper F5 seem to invoke
such fear and poor performance
from students?
One of the reasons why I think
the problem arises is because the
Skills papers, of which Paper F5
is one, are often the first time
that students have had to tackle
written questions. No longer is it
sufficient to simply learn material
and churn out calculations. With
the Knowledge papers, ability
to write clearly and set out
workings logically and neatly
is not required; the papers are
in the form of sets of objective
test questions. Instead, the skills
involved become fourfold, with
candidates being required to do
all of the following:
¤ correctly interpret requirements
¤ actively read sometimes
scenario-based questions,
highlighting the information
that is relevant for each part of
the requirement
¤ use that information to perform
calculations that are carefully
structured and clearly set out,
with all workings shown in an
easy-to-follow layout
¤ write accurately and coherently,
using simple English rather
than long, rambling sentences
that have no structure and no
real content.
Another reason why problems
arise is because candidates do
not take the time to understand
the differences between Paper
F2 and Paper F5. Some subject
areas are obviously included in
both syllabuses, but you can
be sure that where subjects are
repeated in Paper F5, the skills
required of you are over and
above the knowledge required
in Paper F2. (Read the January
2010 issue of Student Accountant
to read an article explaining the
differences between Papers F2
and F5.)
I am going to concentrate on
a brief step by step approach
to the exam on the day and then
on a more detailed explanation
of how you should interpret
all the different ‘instructions’
contained within question
requirements. The points made
in this article about interpreting
requirements in questions are
equally valid for interpreting
the depth of the Paper F5 Study
Guide which is attached to the
Syllabus, since this too is written
in terms of ‘instructions’
such as discuss, describe and
so forth.

written
paper F5
READING TIME
The Paper F5 exam, as with all
three-hour exams, starts with
15 minutes of reading time. This
time should be spent by quickly
allocating your 180 minutes to
each question and reading all the
requirements and the questions
so that you can think about your
answers and decide the order
in which you will answer your
questions. Remember, always
start with your best question
first. It is important to build
your confidence up so that you
perform your best.
When it comes to answering
the question, be sure that you are
strict with your time allocation.
If you are spending too long on
one question, it is either because
you can’t do it anyway (in which
case move on and come back
to it later) or you are saying too
much and going beyond what the
examiner expected of you. How
much an examiner expects you
to write is directly linked to the
marks available and therefore the
time available.
student accountant 12/2009
02
reading time. This should be spent by quickly allocating your 180 minutes
The Paper F5 exam, as with all three-hour exams, starts with 15 minutes of
to each question and reading all the requirements and the
To spend half an hour, for As regards the content, you
questions so that you can think about your answers.
example, on Part (c) of a have either studied the area
question, which is only worth and can tackle it, or not. This
five marks is madness: the instruction could be a whole
examiner expected you to spend variety of verbs ranging from
nine minutes on it. As well as numerical requirements such
allocating time to individual as calculate, produce, derive
questions, you should allocate and apply; or more wordy
time to individual requirements requirements such as describe,
in questions. interpret, outline, compare,
In the reading time, you identify, discuss, explain,
should get a chance to have a evaluate, suggest and justify.
good look at the requirements The possibilities are endless and
of all five questions. Remember: the one thing you can be sure of
the requirement should always is that the verb used has been
be the first thing that you look at carefully thought about by the
in a question. What is the point examiner, obviously taking into
in reading a question if you account any restrictions imposed
don’t know what you are looking by the syllabus. If you don’t read
for? When you read each part of and understand the instruction
the requirement, underline the carefully, then you will find that
‘content’ – what the question you are not actually answering
is about, for example target the question. If you are not
costing, and the ‘instruction’ – answering the question, then
what it is telling you to do. This you are not earning marks. For
helps you to focus your mind on example, being asked to justify
answering the actual question the use of target costing as
rather than answering what you opposed to traditional absorption
thought the question was going costing is different from
to ask you. being asked to explain target
costing. Each of the common
exam ‘instructions’ are dealt
with below.
03 technical
ANSWERING
NUMERICAL QUESTIONS
‘Calculate’ and ‘derive’
Some instructions are easier
to understand than others.
For example, there can be no
confusion as to what the word
‘calculate’ means; if you are
asked to calculate a number,
you just have to work it out.
Similarly, ‘derive’ should pose
little problem. In the context
of Paper F5, you might have
to derive an equation showing
the relationship between price
and quantity or derive a target
cost for a product. Being able
to ‘derive’ a figure sometimes
requires more than simply being
able to calculate a figure, as
a candidate may have to use
their powers of deduction to
derive something. However,
the mechanics of ‘deriving’ or
‘calculating’ would actually be
very similar in most cases.
distinct areas of the syllabus and ignore the rest. Study ALL of the Paper F5
candidates’ knowledge as students would then simply be able to learn
If exam papers were predictable, they would not be a true test of ‘Estimate’
If a question asks you to
‘estimate’ a figure it suggests
that the answer cannot be
calculated with certainty. For
example, if you are asked to
estimate the time taken to
syllabus or you are not giving yourself a real chance.
produce a batch of items where
an 80% learning curve has been
shown to exist, you are making
an estimate rather than an exact
calculation. This is due to the
fact that the learning rate itself
reflects what a business THINKS
will happen but it is not certain
until it has happened. Once
again, however, as with a ‘derive’
instruction, the mechanics of
‘estimating’ are much the same
as ‘calculating’. There is a set
approach to the question (tabular
or algebraic, in the case of
learning curves).
Why, then, do candidates
often still perform poorly on the
numerical parts of the Paper
F5 exam paper? In my opinion,
poor numerical answers often
arise merely as a result of
candidates failing to study the
whole syllabus well enough in the
first place. Anyone who thinks
they can question spot exam
questions for a particular sitting,
based on topics that have been
examined or not examined in
recent papers, is sadly mistaken.
Certain publications publish ‘top
tips’ which should most certainly
be ignored.
If exam papers were this
predictable, they would not
be a true test of candidates’
knowledge as students would
then simply be able to learn
distinct areas of the syllabus
and ignore the rest. Study all
of the Paper F5 syllabus or
you are not giving yourself a
real chance.
The other reason why
candidates score poorly on
numerical questions is because
they approach the question in
a disorganised fashion, with
no logical progression through
the calculations and no clear,
numbered workings. You
should go into the exam with
a metaphorical management
accounting toolbox, full of
all the tools that are going to
help you answer the questions.
So, for example, if it is a
linear programming question,
go in your toolbox and pull
out your five-step guide for
linear programming:
¤ define the variables
¤ state the objective function
¤ state the constraints
¤ draw the graph
¤ find the solution.
To give another example, if it
is a pricing question that can
be solved algebraically, pull
your pricing tool out of your
management accounting toolbox
and follow your five-step guide:

manner are a big issue in Paper F5. often, candidates appear unable to grasp
Requirements that necessitate candidates writing in a coherent, organised
¤ establish the demand function:
what to write and how much to write, ie they don’t understand
P = a - bQ
¤ establish marginal cost
¤ state marginal revenue by
doubling the gradient, b
¤ equate marginal cost and
marginal revenue to find
optimum quantity
¤ substitute quantity into the
demand function to find
optimum price.
The problem with Paper F5 is
that students go into the exam
with only a few tools in their
‘box’. If you put the work in, you
will reap the rewards.
ANSWERING
‘WORDY’ QUESTIONS
Requirements that necessitate
candidates writing in a coherent,
organised manner are also a big
issue in Paper F5. Candidates
are not penalised for the fact
that English may be their second
language, and I do not think it is
this that causes the real problem.
The issue is often that candidates
appear unable to grasp what to
write and how much to write,
ie they don’t understand the
instruction. Further clarification
of all the main instructions you
the instruction.
would expect to find in a Paper
F5 exam is given below.
student accountant 12/2009
Studying Paper F5?
Performance objectives 12, 13 and 14 are linked
Describe
When you are asked to
‘describe’ something you are
expected to give some sort of
narrative about it. For example,
if you were being asked to
describe suitable non‑financial
performance indicators for a
hospital, you would be expected
to describe indicators such as
number of patient complaints,
bed occupancy rate, number
of admissions per employee.
It would not be enough to merely
‘list’ these indicators. You
would have to go a step further
and describe how they might
be calculated. As always, you
should be guided by the mark
allocation in deciding how much
time you spend answering the
requirements and therefore what
level of detail you should go into.
Interpret
When you are asked to ‘interpret’
something, for example, the
balanced scorecard approach,
you are being asked to explain the
approach in your own words and
give your opinion about it. It is
quite a high-level requirement that
will usually be reflected with higher
marks than, for example, ‘outline’.
04
Outline
As suggested previously, this is
quite a straightforward, low-level
requirement. An outline should
be fairly brief and well organised.
It is simply an overview, without
the level of detail that would
be required by the ‘describe’
instruction, for example. Since
it requires less detail, you could
be asked to outline a bigger
topic than you would have time
to describe. In Section C of
the Study Guide, you are asked
to ‘outline the objectives of
a budgetary control system’.
This is something that could
be discussed at length but the
Study Guide is clear in that it only
expects your knowledge to be
sufficient enough to outline.
Compare
The instruction ‘compare’
requires you to discuss
similarities between two or more
things and draw conclusions.
For example, if you are asked
to compare product costs using
activity-based costing as opposed
to traditional costing, you need
to say why the costs are different.
This will involve looking in detail
at the activity-based costs and
ascertaining the reason why the
overheads absorbed into one
product are, for example, higher
under activity-based costing than
traditional absorption costing. In
this kind of question, ‘comparing’
needs to be preceded by a degree
of analysis.
05 technical
Identify
This means to pinpoint and
list. It can be quite a simple
requirement, requiring knowledge
rather than skill. For example,
in the Study Guide, it states
that candidates must be able
to ‘identify and explain the
interrelationship between
price, mix and yield’. This
simply requires candidates to
understand what the relationship
is and then state it and explain
it. Sometimes, however,
candidates may have to identify
points from within a question
scenario, and this can be a more
demanding requirement because
it requires more skill.
Discuss
This is a higher level skill and
requires a candidate to give
their own thoughts on a subject,
supporting it with facts and
logical reasoning.
For example, you could be
asked to discuss the effect
that variances have on staff
motivation. You would need to
discuss the fact that they can
be demotivational, for example,
if they lead to managers being
assessed for cost increases that
were beyond their control. The
material price variance may
be adverse but this could be
because the market price for
materials increased. This will be
demotivational unless the price
variance is broken down into its
controllable and uncontrollable
aspects, ie planning and
operational variances
are calculated.
hard paper, just one where students need to work hard to gain knowledge.
writing and understanding of ‘instructions’ within requirements that was not
essential for Paper F2. Contrary to popular belief, it is not a disproportionately
the step up from Paper F2 to F5 is a big one, with a sudden need for clarity of
The opinions you give in Justify
any discussion must be sound With this requirement, you need
and well reasoned. It is no to tell the reader why a particular
good saying that variances are answer or position makes sense.
demotivational without explaining For example, if you had to justify
why. Also, you are expected to the use of backflush accounting
look at both sides of the story. within an organisation, you would
The ‘discuss’ instruction is have to mention the relative
always a good test of candidates immateriality of inventory
real understanding. balances, presuming this was
in fact the case (otherwise you
Explain would struggle to justify the use
This means that you need to of backflush accounting in the
give a reason for something; first place).
say why it is as it is rather than
just stating that it is. It is a CONCLUSION
very common requirement and To conclude, the step up from
appears many times in the Study Paper F2 to F5 is a big one, with a
Guide. It requires understanding sudden need for clarity of writing
as well as knowledge. and understanding of ‘instructions’
within requirements that was not
Evaluate essential for Paper F2. Contrary
This requirement would not to popular belief, it is not a
be expected to arise much in disproportionately hard paper.
Paper F5. Most of the evaluation It does require students to work
work is reserved for Paper P5. hard in order to gain knowledge of
If you are asked to evaluate areas that they have not practised.
something, you are being asked All written papers require the
to decide on the merits of it. It is organised approach set out above,
most definitely a higher level skill. whereby you underline the content
and instruction of all requirements
Suggest at the beginning of each question.
The use of the word ‘suggest’ Keep referring back to them,
itself suggests that there may particularly on wordy questions, to
be more than one answer to the make sure that you are not going
question being asked. It means off on a tangent. And remember,
give a suitable idea or solution, practice makes perfect. Keep
bearing in mind that there will practising past questions until
probably be more than one. For your approach and layout becomes
example, you might be asked to second nature, leaving you with
suggest how a target cost gap plenty of time to think about the
can be closed. Your answer could issues in the question.
only ever be a suggestion as there
will be many possible ways to Ann Irons is examiner for
close a cost gap. Paper F5
 01 technical
the use of
comparisons in RELEVANT to ACCA QUAlification paper F8
In the Paper F8 exam you may be asked to
interpret the key ratios used in analytical procedures at
compute and interpret the key ratios used in
In the Paper F8 exam you may be asked to compute and
both the audit planning stage and when collecting
analytical procedures at both the audit planning
stage and when collecting audit evidence. Ratios
and comparisons can be used to identify where the
accounts might be wrong, and where additional
auditing effort should be spent.
Calculating a ratio is easy, and usually is little
more than dividing one number by another. Indeed,
the calculations are so basic that they can be
programmed into a spreadsheet. The real skill
comes in interpreting the results and using that
information to carry out a better audit. Saying
that a ratio has increased because the top line
in the calculation has increased (or the bottom
line decreased) is rather pointless: this is simply
translating the calculation into words. Use the
mnemonic RATIO to remind yourself to keep asking
the following questions:
¤ Reason – why has this change occurred?
¤ Accident – is the change real or simply an
accident of timing?
¤ Test – what can be done to test our conclusions?
What other work should we do?
¤ Implications – what does this change mean?
Liquidity crisis? Poor management etc?
¤ Other information – is this consistent with
other information?
audit evidence.
You should not write this out in the answer as this
will waste time and will not gain you marks, but
the five classes of question should always be at the
back of your mind.
There is a huge variety of businesses and
this diversity will be reflected in their financial
statements. To judge whether a figure or ratio
is worth investigating, it is absolutely necessary
to compare it to its equivalent in either the
same company in the previous period, or other
companies in the same industry. Comparisons
provide benchmarks.
To look at some of the techniques and
interpretations, we will use the financial statements
of Ocset Co, shown on page 7.
COMPARISON OF TWO CONSECUTIVE YEARS
Perhaps the first thing to do is simply to compare
the two sets of financial statements. Here we have
results from 2009 and 2008. Look down the figures,
comparing like with like, and see what queries or
hypotheses you might be able to generate. The
mnemonic RATIO will be used formally for the first
comparison. Here are some first thoughts:
Non-current Substantial increase in goodwill.
assets: intangible Reason: acquisition? Is it real or
an accident of timing? How can the
amount be checked, verified, and
tested? Implications: What was
bought? How was it paid for?
What type of business? When is
the year-end of the business
aquired? Who are the auditors?
Is this consistent with other
information, such as additional
non-current assets, increased
finance and so on?
 student accountant 12/2009
02

ratios and
auditing
Non-current Substantial increase. Some might Revenue Very substantial increase

two figures have moved consistently with one another.

assets: tangible result from the acquisition, some (around 15%). How much is

Ratio analysis is useful because it allows you to see if

might be organic (or true growth). organic (or true growth) and how
How were they paid for? much because of acquisition?
How can we test it? We would expect changes in
Inventory Relatively small increase. Will be inventory and payables.
interesting to compare to sales. Cost of sales An increase roughly in line with
Receivables Relatively small increase. Will be the increase in sales.
interesting to compare to sales. Commercial and Substantial increase. Perhaps
Cash Large increase. Why? Where has administrative temporary after the takeover
that come from? costs and before rationalisation. Might
You should be concerned if they haven’t.

Trade payables About a 15–20% increase. Why? indicate poor cost control.
Large compared to receivables Tax Fairly consistent.
and cash. Compare to cost of
sales later. How can we verify If you were now told that the financial statements
these liabilities? are modelled on a supermarket business, then
Short-term Doubled, but could be brought you might be able to make more sense of some
borrowings back to 2008 levels by using of the figures – particularly the net current
some of the cash. Why have cash liabilities. Supermarkets have low receivables and
and an overdraft at the same time? low inventory (much of it is perishable) yet can
Current (Current assets less current squeeze their suppliers hard. They can, therefore,
assets compared liabilities.) About the same both survive well on large trade payables, confident that
to liabilities years. Alarmingly, both years inventory will steadily turn into cash. However, now
show net current liabilities. that we know we are dealing with a supermarket, we
However, the business has should be interested in why they have substantial
survived a year like this. receivables at all.
Share capital No material change.
Retained earnings Increased, presumably by RATIO ANALYSIS
retained profit. Ratio analysis is useful because it allows you to
Long-term Substantial increase. Presumably, see if two figures have moved consistently with one
liabilities this is a major source of funding another. You should be concerned if they haven’t.
for non-current assets. Expect an There are three main groups of ratios:
increase in financing costs. Need profitability, liquidity, and risk.
to verify that the liabilities are
indeed long-term.
03 technical

It is important to realise that roce is the first ratio we have calculated that
makes use of a balance sheet figure. Balance sheet figures are taken at only
Profitability ratios

one point in time, and this can lead to distortions in the ratios.
2009 2008
Gross profit percentage Gross profit x 100 4,218 x 100 = 7.8% 3,230 x 100 = 6.8%
Sales revenue 54,327 47,198

Comments on gross profit percentage

This is a significant increase (15%) and an impressive performance in recessionary times. Apart from

Changes might be little more than accidents of timing.

accounting errors, possible explanations include:
¤ a different sales mix (possibly because of the acquisition implied by the increase in goodwill)
¤ squeezing better prices from suppliers (test by looking at correspondence?)
¤ better inventory management and less wastage (test inventories carefully).

Net profit percentage Operating profit x 100 3,206 x 100 = 5.9% 2,450 x 100 = 5.2%
Sales revenue 54,327 47,198

Comments on net profit percentage

Reasonably good cost control has been maintained despite the substantial increase in sales. To test this, it
is worth comparing the commercial and administrative costs to sales.

Operating expenses Operating expenses x 100 1,012 x 100 = 1.86% 780 x 100 = 1.65%
to sales Sales 54,327 47,198

Comments on operating expenses

These costs are low compared to revenue. Does that make sense, or should we worry about expenses being
understated? Supermarkets rely on high volumes and low margins and this could explain the relatively
low operating costs:revenue ratio, indicating that huge volumes of sales are efficiently pushed through
the business.
However, efficiency of the operation has deteriorated and it is important to try to determine why this has
happened. Obvious causes are:
¤ the operations of the acquired business are not as efficient as the holding company’s
¤ disruption costs arising from the takeover
¤ overstretched management.

These theories need to be tested. There might be other implications too. If management hopes to reduce
operating expenses, are they, for example, planning warehouse closures and redundancies? Is some sort of
provision needed?

Return on capital Operating profit x 100 3,206 x 100 = 11.8% 2,450 x 100 = 12.0%
employed (ROCE) Capital employed 27,165 20,417

Comments on ROCE (capital employed is the total equity plus long-term borrowing)
It is important to realise that this is the first ratio we have calculated that makes use of a figure from
the statement of financial position. Such figures are taken at only one point in time, and this can lead to
distortions in the ratios. Changes might be little more than accidents of timing. Compare a company where
capital was raised and an expansion took place in the first month of the period, to one where this happened
 student accountant 12/2009
04

in the last month of the year. The final capital of both companies will include the additional finance, but

and cash. A quick ratio of less than one is often worrying, but
only the first company is likely to enjoy a significant increase in its operating profit. The second company’s

The quick ratio is useful when inventory is turned over slowly,

ROCE is likely to show a decline from one year to the next.

as the payment of current liabilities will depend on receivables

This effect may have caused the decrease in ROCE seen in Ocset Co, and it would be useful to know when
any expansion or acquisition took place.

2009 2008
Asset turnover Sales revenue x 100 54,327 = 2.0 47,198 = 2.3
Capital employed 27,165 20,417

it again depends on the business and comparatives.

Comments on asset turnover
This shows how many $ of sales are generated by each $ of assets. It’s sometimes described as ‘how
hard the organisation works its assets’. The decline in the ratio shows that although capital (and therefore
assets) have increased, sales have not increased proportionately – but that could simply be an accident
caused by the date of the asset increase.

Note: ROCE = Net profit% x Asset turnover 11.8% = 5.9% x 2.0 12.0 = 5.2% x 2.3

LIQUIDITY RATIOS
2009 2008
Current ratio Current assets 9,209 = 0.73 5,889 = 0.63
Current liabilities 12,582 9,362

Comments on the current ratio

Normally, current assets are used to pay current liabilities. A current ratio of less than one is often
considered alarming as there might be going concern worries, but you have to look at the type of business
before drawing conclusions. In a supermarket business, inventory will probably turn into cash in a stable
and predictable manner, so there will always be a supply of cash available to pay the liabilities. The
company survived 12 months from the date of the 2008 statement of financial position until the present
one (and the current ratio has improved), so there should be no particular alarm.

Quick (or acid Current assets (minus inventory) 9,209 – 2,669 = 0.52 5,889 – 2,430 = 0.37
test) ratio Current liabilities 12,582 9,362

Comments on the quick ratio
The quick ratio is useful when inventory is turned over slowly, as the payment of current liabilities will
depend on receivables and cash. A quick ratio of less than one is often worrying, but it again depends on
the business and comparatives. Here, the quick ratio is much more generous on the 2009 statement of
financial position than on the 2008 one. Why? Has interest income increased too?
05 technical

much better if sales could be split into cash and credit sales and the true
In a supermarket, most sales are for cash, and comparing receivables to
sales that have no impact on receivables is rather pointless. It would be
Receivable Receivables 1,798 = 12 1,311 = 10
collection period Sales/day 54,327/365 47,198/365

Comments on the receivables collection period

In a supermarket, most sales are for cash, and comparing receivables to sales that have no impact on
receivables is rather pointless. It would be much better if sales could be split into cash and credit sales
and the true collection period for credit sales worked out.
However, there does seem to have been a disproportionate increase in the collection period. Possible
reasons are:
¤ a different sales approach – perhaps offering customers credit facilities
¤ a different range of products – perhaps offering customers a credit card (look at board minutes)
¤ poor management so that credit control deteriorates
¤ economic problems causing customers to pay more slowly, and presumably an increased risk of bad

collection period for credit sales worked out.

debts (there might be implications for bad debt provision).

We should check other information too. For example, if customers are taking longer to pay (or a credit card
is offered), is the company earning interest on the balances? A receivables circularisation will be important
to test the accuracy of the receivables figure.

Payables Payables 8,522 = 62 7,277 = 60

payment period Cost of sales/day 50,109/365 43,968/365

Comments on the payables payment period

There’s nothing remarkable here. The increase could be evidence of pressurising suppliers and could be
consistent with the improvement in gross profit percentage. We should check that there will be no future
supply difficulties, by looking at correspondence and board minutes.

Days of inventory Inventory 2,669 = 19 2,430 = 20

Cost of sales/day 50,109/365 43,968/365

Comments on the days of inventory

This is a 5% fall and would appear to suggest tight inventory control. However, always go through (at least
in your mind) the RATIO list:
¤ Reason – accidental or deliberate? How was the decrease achieved?
¤ It could be an accident of timing, for example, where a weekend falls with respect to the year end.
¤ Inventory always needs to be carefully verified – existence, quantity valuation etc.
¤ Implications. If there are fewer days of inventory, are customer service levels being adversely affected? If
so, could there be going concern implications if customers were to take their business elsewhere. Going
concern doesn’t seem to be a serious issue within this company, but the auditor should always be aware
of the risk – even if only to dismiss it quickly. Is inventory wastage reduced?
¤ Other information. For example, has the company invested in new IT systems which allow better inventory
control? Has the distribution system changed? Have more trucks been bought to allow the company to
operate with lower inventory?
 student accountant 12/2009
06

Risk ratios

Ratio analysis and comparison are invaluable tools which help

A company’s indebtedness is obvious from its financial statements, so the risk analysed by external users is
normally the risk related to borrowing – the gearing risk. Borrowing causes risk because interest has to be

auditors understand what might have happened in a business.

paid irrespective of profits made. A rise in interest rates, or a fall in profits, can make the payment of interest
very difficult, and lead a business into receivership and liquidation (going concern difficulties). Risk from
borrowing can also arise when capital repayment is required, either on demand (in the case of overdrafts)

However, the initial calculation of ratios and percentage

or at the end of a fixed term. It is very important to understand how any repayment could be financed.

2009 2008
The gearing ratio Long-term loan finance x 100 14,170 x 100 = 109% 8,602 x 100 = 73%
Equity finance 12,995 11,815

Comments on the gearing ratio

The gearing ratio can also be defined in other ways, particularly by comparing long-term loan finance
to total finance. As gearing increases so does the risk that the interest can’t be paid. But it is difficult to
define a ‘safe’ level of gearing. For example, a property company with properties leased to tenants will have
fairly predictable rental income. Such a company can probably safely sustain substantial borrowings (though
it could be in trouble if interest rates increased significantly). A company with volatile streams of income
would have to keep its gearing lower as it must ensure that interest can be paid during the lean times.
Supermarkets could be expected to have reasonably predictable income: people have to keep eating, so
will keep buying food. The gearing ratio calculation shows that there is a large increase in the company’s
gearing. You should ask the following questions:
¤ Reason: deliberate financial planning or problems?

changes is easy and mechanical.

¤ Is there any reason to suppose that the effect is temporary or an accident of timing?
¤ Loan agreements need to be verified for term and security.
¤ If the loan period is relatively short, how will it be repaid?
¤ We would expect the amount of interest paid to increase (unless the additional loan was taken out very
close to year end).

Interest cover Operating profit before interest 3,206 = 6.7 2,450 = 9.8
Interest 478 250

Comments on interest cover

Interest cover shows how many times interest can be paid out of earnings. Neither of these ratios would
give cause for concern. The fall from 2008 to 2009 is consistent with the rise in borrowing that was
identified earlier. The interest amounts would have to be tested to see that they were reasonable, given
interest rates and when the additional borrowings were made.

CONCLUSION
Ratio analysis and comparison are invaluable tools which help auditors understand what might have happened
in a business. However, the initial calculation of ratios and percentage changes is easy and mechanical. The real
skill comes in interpreting the results, and nearly always the results should give rise to more queries than they
answer. Turn the page for the Ocset Co statment of financial position and statement of comprehensive income.

Ken Garrett is a freelance lecturer and author

07 TEChNICAl

NUMbER bY ANOThER. INdEEd, ThE CAlCUlATIONS ARE SO bASIC ThAT ThEY CAN bE
TAblE 1: OCSET CO STATEMENT OF FINANCIAl POSITION

PROgRAMMEd INTO A SPREAdShEET. ThE REAl SkIll COMES IN INTERPRETINg ThE

30/9/2009 30/9/2008
$m $m

CAlCUlATINg A RATIO IS EASY, ANd USUAllY IS lITTlE MORE ThAN dIVIdINg ONE
Assets
Non-current assets
Intangible – goodwill 4,027 2,336
Tangible 26,511 21,554

RESUlTS ANd USINg ThAT INFORMATION TO CARRY OUT A bETTER AUdIT.

30,538 23,890
Current assets
Inventory 2,669 2,430
Receivables 1,798 1,311
Cash and cash equivalents 4,742 2,148
9,209 5,889
Total assets 39,747 29,779

Equity and liabilites

Share capital 395 393
Reserves 12,600 11,422
Total equity 12,995 11,815

Non-current liabilities – long-term borrowings 14,170 8,602

Total non-current liabilities 14,170 8,602

Current liabilities
Trade payables 8,522 7,277
Short-term borrowings 4,060 2,085
Total current liabilites 12,582 9,362

Total liabilities 26,752 17,964

Total equity and liabilities 39,747 29,779

TAblE 2: OCSET CO STATEMENT OF COMPREhENSIVE INCOME

Y/e Y/e
30/9/2009 30/9/2008
$m $m
Revenue 54,327 47,198
Cost of sales 50,109 43,968
Gross profit 4,218 3,230
Commercial and administrative costs (1,012) (780)
Operating profit before financing 3,206 2,450
Financing income 116 187
Finance costs (478) (250)
(Loss)/profit before tax 2,844 2,387
Income tax expense (780) (670)
(Loss)/profit after tax 2,064 1,717
(886) (870)
Total comprehensive income for the year 2,064 1,717

FOCUS ON per
po 14: monitor And control budgets
Once budgets have been
implemented, they need to
be monitored and controlled.
Accounting teams analyse and
interpret financial data to help
organisations and departments
identify how closely performance
is aligned to budgets over a
defined period.
This amounts to much more
than simply whether sales are
down or up – monitoring and
controlling includes the regular
examination of costs, cash,
working capital and assets. As
an accountant, you’ll be charged
with responsibility for chasing the
information needed to identify
variances between budgeted and
actual figures, tracking relevant
trends and communicating your
findings to senior management or
department heads.
In order to do this, you’ll need
to have systems in place to
record figures on a timely basis
and allow meaningful comparison
against budgets as swiftly and
accurately as possible (especially
where managers in the field rely
on them for driving individual
and team performance, or for
focusing sales activity). Where
variations arise, you’ll need to
find the right questions to ask in
order to explain and make any
relevant recommendations for
actions arising from them. And
it’s crucial that your findings are
presented to management in a
way that’s easy to understand,
particularly by those who are not
used to financial terminology.
That means ‘translating’
accounting-speak for end
student AccountAnt 12/2009
67
For PER support and advice on answering challenge questions
www.accaglobal.com/students/acca/per/support
users in plain language that ¤ Who is involved and to what
informAtion needed to identify vAriAnces between budgeted And
leaves no doubt as to what’s extend must you obtain ‘buy-in’
being communicated. to the monitoring process in
ActuAl figures, trAcking relevAnt trends And communicAting
Your work will assist with order for it to be successful?
ongoing resource allocation and ¤ How have those budgets
your findings to senior mAnAgement And depArtment heAds.
overall financial performance, affected your day-to-day role?
As An AccountAnt, you’ll be responsible for chAsing the
as the organisation makes ¤ Consider how information you
any necessary operational collate for budgetary purpose
changes arising from reported might inform your other
variances or from indications that responsibilities within the team.
sales forecasts are being met ¤ In what ways does budget
or exceeded. activity (preparation, actions
Examples of relevant from variations, amendments)
activities include: change the time you can give
¤ Preparing regular variance other responsibilities? What
analysis reports, clearly adjustments do you have to
demonstrating significant make and how does this radiate
differences or trends requiring out to include your day-to-day
closer examination or which interaction with others?
may cause alarm. ¤ With some examples, how have
¤ Giving explanations and making you used these budgets to help
recommendations based others within your organisation?
on variance analysis, including ¤ It might be that you alerted
further data collection or management in a particular
research into company region to adverse sales
or industry-related factors. figures that bucked a wider
¤ Incorporating significant trend – and which led to
variances in future identifying deficiencies in local
budget planning. management or poor recording
of data that could be corrected,
The next step is to answer or even financial wrongdoing.
the challenge questions for ¤ Perhaps your monitoring work
this objective in the trainee revealed aspects of outstanding
development matrix (TDM): operational performance
¤ Describe your role that led to successful sales
in monitoring and techniques or cost-saving drives
controlling budgets. being adopted throughout
¤ How do you plan frequency the company.
and method of monitoring?
What factors, such as accepted Performance objective 14 is
business cycles or the ease linked to Paper F2, Management
with which information can be Accounting, Paper F5,
initially gathered, are taken Performance Management,
into consideration? and Paper P5, Advanced
Performance Management.
 student accountant 12/2009
01
For PER support and advice on answering challenge questions
www.accaglobal.com/students/acca/per/support

FOCUS ON per
po 13: contriBute to Budget planning and production

Budgeting is a critical process Examples of relevant ¤ Explain, having developed

or revenue-generating. accountants play an important role in

for any organisation, large or activities for demonstrating your the budget, how you have
small, and in almost every competence might include: made sure that it has been
department, whether spending or
or small, and in almost every department, whether spending ¤ Contributing to budget implemented correctly.
Budgeting is a critical process for any organisation, large

revenue-generating. Accountants meetings, from preparation ¤ Think about instructions or

play an important role in work, such as analysis of guidelines that need to be
planning and producing budgets. relevant figures from previous provided to end users, and how
Alongside making reasoned, periods, to follow-up actions, they’ll seek clarifications or
often complex calculations such as chasing data from further help.
and informed forecasts to other teams or delivering ¤ What steps have you or
help ensure organisations and new budgetary messages your team taken to ensure
departments can effectively to colleagues. that budgets are monitored
plan, budgeting responsibilities ¤ Devising plans for budget appropriately?
may be just as likely to involve preparation, from analysis of ¤ What would be the impact on
communication, negotiation and existing information, through your department or organisation
even conflict resolution. taking stock of current if the budgets you supplied were
Effective budget planning starts circumstances, to collecting not properly prepared?
with supplying sufficient and data on a timely basis. ¤ Consider not just the effects
correct information for creating ¤ Preparing forecasts, balancing of over-expenditure by
detailed and accurate budgets the optimism of sales spending departments, but
and cashflow forecasts, as well managers with rational, also the impact on financial
as understanding the wider evidence-based calculations, performance, should adherence
planning and producing Budgets.

impact of those forecasts. Once and allowing for sensitivity to incorrect sales budgets
budgets have been agreed, they’ll to sudden or unexpectedly result in falling revenues being
need to be communicated with dramatic changes. masked or cash positions being
stakeholders, from colleagues artificially inflated.
tracking sales revenues to The next step is to answer ¤ How might confidence in you
department heads who authorise the challenge questions for and your team be impacted if
expenditure. And when the this objective in the trainee budgets are ill-prepared? For
accounting period is underway, the development matrix (TDM): instance, if department heads
budgets will need to be kept under ¤ Describe how you have been observe budgetary constraints,
review, where necessary updating involved in budget planning and only to discover they were
or adjusting in the context of production. working under false pretences,
changes to the organisation or the ¤ How do your budgeting how would that affect their
markets in which it operates. responsibilities follow on from willingness to cooperate in
You’ll need to call on your others? What happens to the future, especially if an indirect
knowledge and understanding of work you produce? result was a fall in sales and/or
performance measurement and ¤ Who must you communicate individual sales commissions?
management accounting skills with, and what information
to identify, describe, calculate must you convey? What data Performance objective 13 is
and forecast business costs and must you use, where do you get linked to Paper F2, Management
revenues and their behaviour, this from? Accounting, Paper F5,
and to plan, monitor, and Performance Management,
control the use of business and and Paper P5, Advanced
financial resources. Performance Management.