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Part 1 Financial Planning, Performance and Control 30%

Unit 9
Budgeting Concepts, Methodologies and Preparation
1- A budget is a plan for the future expresses in quantitative terms.
A budget promotes goal congruence among operating units. A
budget is a planning, communication and coordination, control,
motivation and allocation tool. The budget sets specific goals for
income, cash flows and financial position. Budgets are primarily
quantitative not qualitative and they incorporates non-financial
measures as well as financial measures into its outputs.
2- Planning is a process of charting the future to attain desired goals.
Planning consists of selecting organization goals, predicting results
under various alternative ways to achieve those goals, deciding
how to attain the desired goals and communicating the goals and
how to attain them to the entire organization.
3- Good planning helps managers to attain goals, recognize
opportunities, provide basis for controlling operations, forces
managers to consider expected future trends and conditions,
checking progress towards the objectives of the organization and
minimize the negative effects of unavoidable events.
4- Strategy is the starting point in preparing the organization plans
and budgets. It's the organization's plan to match its strength with
the opportunities in the market place to achieve its desired goals
over the short and long term. The strategy is the path chosen by
the organization to attain its long term goals.
5- Strategy, plans and budgets are interrelated and affect one
Strategy shows how an organization matches its strength with
opportunities to attain its desired goals in the market place in short
and long-run planning. These plans lead to the formulation of
budgets. Budgets provide feedback to managers about the likely
effects on their strategic plans. Managers use this feedback to
revise their strategic plans, and that may lead to changes in the
6- Budgeting (Targeting) is the steps involved in preparing the

7- Pro forma statements is a budgeted financial statements

(budgeted income statements, budgeted balance sheet and
budgeted cash flows), are forecasts of goals for a future period that
assist in the allocation of resources.
8- Strategic plan and strategic budget
- An organization must complete its strategic plan before the
beginning of any budgeting process.
- Strategic budget is a form of long-range planning identifying
and specifying the organization goals and objectives (usually 5
9-The external environment in planning and budgeting
An organization must interact with the external environment in
which it operates, as this external environment factors affects the
company's plans and budgets.
- Three interrelated environments affect management's
planning and budgeting:
1. The industry in which the company operates, including the
company's current market shares.
2. The country or national environment in which the company
operates, including governmental regulatory measures, labor
market and the activities of competitors.
3. The wider macro environment in which the company
operates. For instance, if the economy entering a period of
lower demand.
10Budget cycle
The budget cycle includes the following elements:
1- Planning the performance of the company as a whole, as well as
planning the performance of its subunits.
2- Providing a frame of reference, a set of expectations can be
compared against actual.
3- Investigation variations from plans.
4- Planning again, in light of feedback and changed conditions.
11Advantages of budget (PCCMA)
1-As a planning tool budget forces managers to think ahead.
Without budget the organization will operate in retroactive
instead of proactive manner.
2- Budgets promote coordination and communication among
operating units.
- Budgets promote goal congruence among operating units.
Budgets require departmental managers to make plans in

conjunction with other interdependent units. If a firm doesn't

have an overall budget, each department will set its own
objectives without regards to what is good for the firm as a
3- As a control tool budget provides a frame of reference for
measuring performance and provide a means for controlling
- The budget provides a formal benchmark to be used in feedback
and performance evaluation.
- Budgeted performance is a better criterion than past
performance for judging managers.
4- The budget is a motivational tool. Challenging budgets
improve employee performance because no one wants to fail.
The budget should be challenging but achievable.
5- The budget promotes efficient allocation of organization
resources among operating units.
12Types of plans:
1-Strategic plans (long-term plans): are broad, general and longterm plans (usually 5 years or longer), it's done by the
company's top management. This type of planning doesn't focus
on detailed financial targets, but looks at strategies, objectives
and goals of the company by examining the internal and external
factors affecting the company.
2- Intermediate plans (Tactical plans): are designed to implement
specific parts of the strategic plan. It's made by upper and
middle manager (one to 5 years).
3- Short-term or operational plans are the primary basis of
budget: refine the overall objectives from the strategic and
tactical plans in order to develop the programs, policies and
performance expectations required to achieve the company's
long-term goals.
13Characteristics of successful budget:
The common factors in a successful budget include:
1- The budget must be aligned with the organization strategy.
2- The budget must have the support of management at all levels.
3- The budget should be motivating devise.
4- The budget should be coordinated.
5- People who are charged in carrying out the budget need to feel
ownership of the budget.

6- The budget should be flexible.

7- The budget shouldn't be rigid.
8- To be useful, the budget should be an accurate representation of
what is expected.
9- The time period of a budget should reflect the purpose of the
14Time frames for budgets
- Annual Budget: The budget generally prepared for a set period
of time, commonly one year, and the annual budget subdivided
into months or quarters.
- Rolling or Continuous Budget: Budgets can also be prepared
in continuous basis. The budget covers a set number of months,
quarters or years into the future. Each month or quarter just
completed is dropped and a new month or quarter's budget is
added to the end of the budget. At the same time the other
periods can be revised to reflect any new information available.
Thus, the budget is being updated continuously and always
covers the same amount of time in the future.
15Who should participate in the budget process? (Budget
1. Board of directors: The budget begins with the mission
statement formulated by the board of directors. The board of
directors doesn't create the budget, but responsible for reviewing
and the approval of the budget or send it back to revision. The
board usually appoints the members of the budget committee.
2. Top management: Senior management translates the mission
statement to a strategic plan, they involvement doesn't extend
to dictating the numerical contents of the budget since they
lacks the detailed knowledge of daily operations.
- Importance of top management involvement
1.Reviewing and the approval of the budget ensure top
management that the budget guideline is being followed.
2.Top management active involvement in reviewing and
approving the budget discourage lower-level managers from
playing budget games.
3.The active top management involvement also motivates lowermanagers to attain the company goals and objectives because
they know the manager cares about the budget.

4.The single most important factor in assuring successful budget

is for upper management to demonstrate that they take the
project seriously and considers it vital to the organization's
3. Budget committee: (The highest authority for all matters
related to the budget). The committee directs budget
preparation, approves departmental budgets submitted by
operating managers, rules on disagreements, monitoring the
budget, reviewing results, approving revisions, draft the budget
calendar and budget manual.
4. Middle and lower management: Once the middle and lower
managers receive their budget instructions, they draw up their
departmental budgets in conformity with guideline and submit
them to the budget committee
16Authoritative budget (Top-down budget, Imposed
The top management sets the overall goals of the organization and
prepares the operational budget to attain those goals.
1.Provides better decision making than participative approach.
2.Increase coordination among operating units.
3.Reduces the time required to prepare for budgeting.
4.Facilitates implementation of strategic plan.
1.Reduces communication between employee and managers.
2.May limit the acceptance to goals and objectives.
3.May result in a budget not possible to achieve.
4.Often lacks the commitment of lower managers and employee
responsible for implementing the budget.
17Participative budget (bottom-up budget, self-imposed
Lower managers are participants in budget preparation.
Advantages of participative budget:
1. Managers are more motivated to achieve budgeted goals.
2. Greater support for budget.
3. Greater understanding of what to be accomplished.
4. Greater accuracy of budget estimates. Managers with direct
operational responsibilities have a better understanding of what
results can be achieved and at what costs.

5. Managers can't blame unrealistic objectives as an excuse for not

achieving budget expectations, since they are participants in
preparing those objectives.
Disadvantages of participative budget:
1. Without a review, self-imposed budgeting may be too slack,
resulting in suboptimal performance. Suboptimal decision
making is not likely to occur when guidance is given to subunit
managers about how standers and goals affect them.
An effective budgeting process combines both top down
and bottom up budgeting approaches. Divisions prepare
their budget based on the budget guidance submitted by
the firm's budget committee. Senior managers review and
make suggestions to the proposed budget before sending it
back to divisions for revision.
18The budget development process:
1.Budget guidelines are set and communicated.
2.Initial budget proposals are prepared by responsibility centers.
3.Negotiations, reviewing and approval.
5.Reporting on variances.
6.Use of the variance reports.
19Best practice guidelines for the budgeting process
include the following:
1. The development of the budget should be linked to corporate
2. Communication is vital.
3. Funding resources should be allocated strategically.
4. Managers should be evaluated on performance measures other
than meeting budget targets.
5. Reduce budget complexity and budget cycle time.
6. Link cost management effort to budgeting.
7. Reviewing the budget on regular basis throughout the year.
8. The strategic use of variance analysis.
For a budget to be useful, it must be finalized before the
fiscal year begins.
20Budget planning calendar: is the schedule of activities for
the development and adoption of the budget.
21Budget manual: is the details of the budget process and who
can the departmental managers prepares their own budgets.

22Goal congruence: Refers to the aligning of goals of the

individual managers with the goals of the organization as a whole.
23Budgetary slack and its impact on goal congruence:
- Budgetary slack or padding the budget: is a serious ethical
issue in budgeting. It describes the practice of underestimating
budget revenues or overestimating budgeted costs, to make
budget targets easier to achieve.
- On the positive side Budgetary slack can provide managers an
excuse against unforeseen circumstances.
- On the negative side budgetary slack misrepresents the true
profit potential of the company, and can lead to inefficient
resources allocation and poor coordination of activities among
the company.
24Avoiding problems of budgetary slack: The best way to
avoid problems of budgetary slack is to use the budget as a
planning and control tool, but not for managerial performance
25Standard costs: are costs for direct materials, direct labor
and manufacturing overhead that are estimated to apply under
specific conditions.
- Four reasons for using standard costing
1.Cost management (costing inventory).
2. Pricing decisions.
3. Budgetary planning and control.
4. Financial statement preparation.
26Ideal standard costs vs. Practical standard costs
1. Ideal (Theoretical, Perfection, Maximum efficiency,
tight) standard costs
- Attainable only under the best possible conditions.
- Based on no allowance for waste, spoilage, machine breakdown,
or other downtime.
- Encourages continuous improvement.
2. Practical (Currently attainable) standard costs
- Challenging but attainable.
- Based on allowance for normal waste, spoilage and downtime.
- Serve as a better motivating target for manufacturing personnel.
- Discourages continuous improvement.
When the level of outputs (denominator) is low in
absorption costing, that means that high amount of

overhead will be inventoried in finished goods,

consequently result in higher income.
27Setting standard costs: standard costs can be derived from
several resources:
1. Activity analysis:
- Activity analysis is the most accurate way to estimate standard
costs. It's a team development approach performed by people
from several different areas, based on investigating all factors
involved in producing a product.
- The cost of Activity analysis itself can be so high
2. Historical data:
- Historical data based on using the data of costs involved in
similar product in prior periods to determine standard costs.
- Standard costs based on past data may make inefficiencies to
3. Benchmarking:
- Based on using the best performance company or unit as a
Factors affecting the selection of budget methodology:
1.Types of business.
2.Organizational structure.
3.Complexity of operations.
4.Management philosophy.
Budgeting systems/approaches:
1- Master budget. 2- Flexible budget. 3- Project budget. 4Continuous (rolling budget). 5- Kaizen budget. 6- Activity-based
budget. 7- Zero-based budget.
1-Master/Static/Comprehensive Budget (Annul business plan):
Is made up of several deferent budgets, and some budgets can't be
developed until other budgets have already been completed.
The development of master budget:
- Sales budget: Shows the expected sales in units and its
expected selling price.
- Production budget: Follows the sales budget, and it shows the
resources needed to carry out the manufacturing operations that
allow the firm to satisfy its sales goals and desired amount of
inventory at the end of the budget period.
Budgeted sales (units)
+ Ending finished goods inventory (units)

Beginning Finished goods inventory (units)


Budgeted production (units)

- Direct labor budget

- Factory overhead budget
- Ending inventory budget
Direct material used
+ Direct labor
+ Manufacturing overhead
= Cost of goods manufactured
Beginning finished goods inventory
+ Cost of goods manufactured
= Goods available for sale
Ending finished goods inventory
= Cost of goods sold
Sales revenue
Cost of goods sold

Gross margin

Other expenses

Operating income

- Cash budget: Shows cash flows (receipts, disbursement and

cash balances) for a firm over a specified period.
Master budget based on one level of activity (one year).
The relationship between strategic goals, objectives,
budgets, operations and control:
- The budget expresses the strategy by describing the sales plan,
the costs needed to achieve sales goals and cash flows needed.
The master budget reflects the impact of operating budget
and financial budget.

The benefits of master budget: Master budget is relatively easy

to prepare, and ensure that comprehensive attention is given to
resources requirement.
The limitation of master budget: Master budget amounts are
confined to one year at one level of activity. Budget amounts may
be much different from actual results.
2-Flexible budget: Is prepared for many levels of activity. Flexible
budgets represent budgets that provide the ability to
accommodate comparison with many levels of actual sales or
production volume.
- Benefits of flexible budget:
1.Can be displayed on any number of volume levels within the
relevant range.
2.Offer managers more realistic comparison of budgeted and
actual revenue and cost items under their control.

3.Most appropriate for firms facing a significant level of

uncertainty in unit sales volume for next year.
- Limitation of flexible budget:
1.Flexible budgets are highly dependent on the accurate
identification of fixed and variable costs and the determination
of the relevant range.
2.Errors in determination of the relevant range or misestimates
in anticipated outputs expected from variable costs could
distort performance evaluation.
3-Project budget: Is used when a project is completely separated
from other elements of a company, or is the only element of the
4-Continuous/Rolling/Perpetual budget: Add budgeted month or
quarter, as each current month or quarter expires.
5-Kaizen (Continuous improvement) budget: Depends on
continuous improvement not only from the organization but also
from the suppliers.
6-Activity based budget (ABB): Focuses on costs of activities or
cost drivers necessary for operations.
7-Zero-based budget: Requires justification of all expenditures
every year.
8-Incremental budget: Starts with prior year's budget and uses
projected changes to estimate the future budget.
9-Life cycle budget: Estimates a product's revenue and expenses
over its entire life (value chain), which includes:
a.Upstream costs (researches and development).
b.Manufacturing costs (production costs).
c. Downstream costs (marketing, distribution and customer
10Probabilistic budget: Based on expected values and their
Unit 8
Analysis and Forecasting Techniques
Forecasting Techniques

Causal forecasting







Quantitative methods of forecasting rely on managers experience.

Quantitative methods use mathematical models and graphs.
1-Causal forecasting (regression analysis)(least-squares
analysis): Looks for a cause and effect relationship between the

dependent variable we trying to forecast and one or more

independent variables, if it's a linear relationship within the
relevant range.
a. Simple linear regression: Is the linear relationship
between one dependant variable and one independent
variable. (y = a + b x )
Y= value of the dependent variable, estimated cost.
A= the y intercept ( fixed cost).
B= the slop of the regression line (unit variable cost, the coefficient of
independent variable measuring the increase in y for each unit
increases in x).

X= the independent variable.

The regression analysis is almost necessary for computing the fixed and
variable portion of mixed costs.
Regression doesnt determine causality.

Correlation analysis
- Coefficient of correlation (R): Is the strength of the linear
relationship between tow variables.
A value of 1 indicates perfect inverse linear relationship
between x and y.
A value of 0 indicates no linear relationship between x and y.
A value of + 1 indicates direct linear relationship between x
and y.
- Coefficient of determination (R2) (coefficient of
correlation square): Is the explanatory power of the regression
that measures the percentage of the total variance in cost that
can be explained by the regression equation.
- T value: Measures if the independent variable has a valid longterm relationship with dependent variable.
- Standard error of the estimate (SE): A measure of the
accuracy of the regression's estimate.

b. Multiple regression analysis: It's also possible for one

dependant variable to be affected by more than one
independent variable.
Advantages or benefits of regression analysis:
1.Regression analysis is the only way to compute the fixed and
variable portions of costs that contain mixed costs.
2.The results from the regression equation can be used in
conclusions and forecasts.
Disadvantages, limitations or shortcomings of regression
1.To use regression analysis, historical data is required for the
dependent variable or independent variable. If historical data is
not available, regression analysis can't be used.
2.If there has been significant change in the conditions
surrounding historical data, the use of the regression in
estimating the future will be questionable.
3.Analysis is valid only with relevant range.
4.If the choice of the independent variable is inappropriate, the
results will be misleading.
2-Time series methods: forecasts the pattern of the desired
variable's activity in the future by looking at its patterns in past
Patterns (components) of Time series:
a. Trend (secular) pattern: Resulting from long-term, multiyear
b.Cyclical pattern: Resulting from long-term, multiyear, cyclical
movement in the economy.
c. Seasonal pattern: resulting from factors within one day or one
d.Irregular (Random) pattern: resulting from short-term,
unanticipated factors.
Using time series methods:
1. Simple moving average: = total amount of sales number of

2.Weighted moving average: the more recent data is assigned

a greater weight. This method can be used to remove seasonal
fluctuations from data.
Example: Forecasting May sales from actual sales of 4
months sales (1+2+3+4 = 10)

3.Exponential smoothing: requires less data than moving

average method.
Forecasts month = percentage X actual of last month +
(Percentage 1) X forecasts of last month.
In January, ABC Corporation began using exponential
smoothing to forecast sales for each month. Actual and
forecasted sales, in millions, for ABC for the months of
January, February, March and April are as follows. Forecasted
sales for January through April have been calculated using
.exponential smoothing and an alpha of .1

.Forecasts for May = (.1 * 20) + (.9 * 21.6)

3-Learning curve: Describes that the more experience people

have in doing a task, the more efficient they become in doing
this task.
Benefits of learning curve analysis:
- Can be used in life-cycle costing decisions.
- Can be used in development a production plans and labor
Limitation of learning curve analysis:
- Appropriate only in labor-intensive operations involving repetitive
- The learning rate assumed to be constant.
1-Expected value: is the sum of the conditional profit (loss) for
each event times the probability of each event's occurrence.
The decision alternative is under the managers control.
The state of nature is the future events will occur.
The payoff is the financial results of the combination of
the managers decision and the actual state of nature.

Benefits of expected value: Expected value analysis
forces managers to think of all the possibilities that could
happen with each decision, and to evaluate decisions in a
more organized manner.
Criticisms of expected value: It depends on repetitive
trials, but in reality, most business decisions involve only one
4-Expected value of perfect information (EVPI): is the
difference between the expected profit under certainty and the expected
monetary value of the best act under uncertainty.
- EVPI = EVwPI EvwoPI.
- EVPI = Expected value of perfect information.
- EVwPI = Expected value with perfect information.
- EVwoPI = Expected value without perfect information.
The dealer is not willing to pay more than the EVPI to obtain
information about future demand.

Section C: Cost management 20%

Unit 4

Cost management terminology and concepts

1-Management accounting (Internal reporting): Measures
and reports financial and nonfinancial information that helps
managers make decisions to attain an organization's goals.
2-Financial accounting: External reporting based on generally
accepted accounting principles (GAAP).
3-Cost accounting: Provides information for management
accounting and financial accounting.
4-Cost management: Describe approaches and activities of
managers in short-run and long-run planning, and control
decisions that increase value for customers and lower costs of
products and services.
5-Cost, Cost Pool and Cost object:
1. Cost: is a resource sacrificed or forgone to achieve a specific
2. Cost pool: Costs are often collected into meaningful groups.
3. Cost object: Anything for which a measurement of costs is
desired (product, service, customer, activity or organization
6-Cost accumulation and Cost assignment:
1. Cost accumulation: is the collection of cost data in some
organized way by an accounting system.
2. Cost assignment: After accumulating costs
a. Tracing: Accumulated costs that have a direct relationship
with a cost object.
b.Allocating: Accumulated costs that have an indirect
relationship with a cost object.
7-Direct cost of a cost object: Easily traced (direct row material
and direct labor).
8-Indirect cost of a cost object: Not easily traceable to a cost
pool or cost object (Indirect material, indirect labor, other indirect
costs (Common costs)).
Overhead allocation using allocation bases (Cost driver):
When direct tracing isn't possible management accountants uses
allocation bases (cost drivers).
9-Cost drivers: Are Activities that cause costs increase as the
activity increases.

10- Cost allocation is necessary for:

Product costing.
Investment and disinvestment decisions.
Managerial performance measures.
Make-or-buy decision.
Determination of profitability.
Measuring income and assets for external reporting.
11- Manufacturing costs (Product costs):
1-Direct materials (traced).
2-Direct manufacturing labor costs (traced).
3-Indirect manufacturing costs (Factory over head)
12- Prim costs: (DM&DL).
13- Conversion costs: (DL&MOH).
14- Nonmanufacturing costs (Period costs): Selling, general
and administrative costs.
15- Types of inventory in manufacturing firms
1. Direct material inventory.
2. Work-in-process inventory.
3. Finished goods inventory.
16- Cost behavior:
1. Variable cost: (fixed per unit, variable in total).
2. Fixed cost: (variable per unit, fixed in total in shortterm and within a relevant range).
Relevant range: Is the range for which the cost relationships hold
Marginal cost: is the cost incurred by a one-unit increase in the
activity level of a particular cost driver (constant within the
relevant range).
3. Simi-variable costs (Mixed costs): It includes both fixed
and variable costs.
Methods of estimating mixed costs:
a.High- low method.
b.Regression method.
17- Cost of goods sold in merchandising firms:
Beginning inventory
+ Purchases
_ Ending inventory
= Cost of goods sold

18- Cost of goods sold in manufacturing firms:

Beginning row materials inventory
+ Purchases
_ Returns and discounts
+ Fright-in
----------= Row materials available for use
_ Ending Row materials inventory
----------= Direct materials used in production
+ Direct labor
---------= Total manufacturing costs
+ Beginning work-in process inventory
_ Ending work-in process Inventory
---------= Cost of goods manufactured
+ Beginning finished goods inventory
---------= Goods available for sale
_ Ending finished goods inventory
----------= Cost of goods sold
19- Cost classification for decision making:
1. Controllable Vs. Non controllable costs:
a. Controllable are those that are under discretion of a
particular manager.
b. Non controllable are those that are committed to another
level of the organization.
Controllability of a given cost differs according to the levels of the
organization. A given cost may be controllable to some level of the
organization, and non controllable to another levels.
2. Avoidable Vs. Committed costs:
a.Avoidable are those that may be eliminated by not
engaging in an activity, or performing it more efficiently
(Direct materials).
b.Committed is the cost that governed mainly by past
decision, and can't be eliminated in the short-run. It
arises from holding property, plant or equipment.
(Insurance, real estate taxes, lease payment and

depreciation). They are by nature long-term and can't be

reduced by lowering the short-term level of production.
3. Incremental Vs. Differential cost:
a. Incremental is the additional cost inherent in a given
b. Differential is the difference in total cost between two
4. Engineered Vs. Discretionary costs:
a. Engineered are those that have a direct, observable
cause-and-effect relationship between the level of output
and the quantity of resources consumed (Direct material
and direct labor).
5.Discretionary is the cost that management decides to incur in
the current period. It's a periodic cost that has no strong
impact input-output relationship (advertising and research &
6. Outlay (explicit) Vs. Opportunity (Implicit) cost:
a. Outlay (explicit, accounting, and out-of-pocket costs)
requires actual cash disbursements.
b. Opportunity (implicit) is the benefit lost when choosing
one option that stops receiving the benefits from
alternative option.
7. Economic Vs. Imputed cost:
a. Economic is the sum of explicit and implicit costs.
b. Imputed are those that should be involved in decision
making even though no transaction has occurred. They
may be explicit or implicit).
8. Relevant Vs. Sunk cost:
a. Relevant costs are those future costs that will vary
depending on the decision taken when choosing between
two or more options to determine the best option that
offers the highest benefit to the organization.
Relevant cost has two properties:
- It differs for each decision option.
- It will be incurred in the future.
b. Sunk cost is the cost that incurred in the past, thus, it has
no impact on the decision (irrelevant cost).
9. Joint costs, separable costs and by-product:

Split-off point: Is the point that multiple end products become

separately indentified from the input of a single product.
a.Joint cost is the cost incurred before the split-off point.
Since it's not traceable it must be allocated.
b.Separable cost is the cost incurred beyond the split-off
c. By products are products of relatively small total value
that produced from the same process of manufacturing
products with greater value and quantity (Joint products).

Normal Vs. abnormal spoilage:

a. Normal spoilage is the spoilage that occurs under normal
operating conditions. It's essentially uncontrollable in the
short-run. It's treated as product cost.
b. Abnormal spoilage is the spoilage that not expected to
occur under normal, efficient operating conditions. The
cost of abnormal spoilage should be separately identified
and reported to management.
Abnormal spoilage thought to be more controllable by
production management than normal spoilage. Abnormal
spoilage treated as period cost (loss).
Rework, scrap and waste:
a.Rework consists of products that need more efforts to
meet salable conditions.
b.Scrap consists of row materials left over from the
production cycle, but can be used in other production or to
be sale to customers for a nominal price.
c. Waste consists of row materials left over from the
production cycle, but can't be reused, and is not saleable
at any price. It must be discarded.
Carrying cost: Is the cost of storing or holding the
Transferred in cost: Is the cost incurred in a department
before transferring the product to another department.
Value adding cost: Is the cost of activities that adds a
value to the customer and can't be eliminated without
reducing the quality or quantity of the output required by the
20- Capacity levels in production:

1. Ideal capacity (Theoretical): Don't allow for any plant

maintenance, holidays or downtime.
2. Practical capacity: = theoretical capacity normal holidays.
21- Capacity levels in demand:
1. Master-budget capacity: Is the expected level of demand
for the current budget period.
2. Normal capacity: Is the long-term average level of masterbudget capacity.
22- Costing techniques:
1. Absorption Vs. variable costing;
a. Absorption costing (inventory costing) treats all
manufacturing costs as production costs (required for
reporting under GAAP).
b. Variable costing considers only variable manufacturing
costs as product costs.
c. Super variable (throughput) costing considers only
material costs as a production costs.
Absorption (inventory)
Sales revenue
_ Cost of goods soled
(DM+DL+Fix OH+Vari OH)

Gross margin
_ Period cost

Operating income

Variable costing
Sales revenue
_ Cost of goods soled
(DM+DL+ Vari OH)

Manufacturing Contribution
margin XXX
_ nonmanufacturing variable costs

Contribution margin
_ Fixed MOH
_ Fixed non MOH

Operating income

Horngreen equation:
The difference in operating income between
absorption and variable costing = Fixed cost per unit X
the inventory per unit.
The difference in operating income between
absorption and variable costing = Fixed manufacturing
cost per unit X (beginning inventory ending
Actual Vs. normal costing and budgeted cost:
a. Actual costing = Actual DM+ Actual DL+ Actual OH
- Overhead = Actual rate X Actual allocation base
b. Normal costing = Actual DM+ Actual DL+ Applied OH
- Applied OH = Budgeted rate X Actual allocation base.
- Budgeted rate = Budgeted OH Budgeted allocation base.
- Over-applied O.H.: Applied O.H. > Actual O.H.
c. Standard costing
- Overhead = budgeted rate X standard allocation base
If the over-applied overhead balance is immaterial:
Dr. Applied O.H.
Cr. Cost of good soled
Cr. Actual O.H.
If the over-applied overhead balance is material:
Dr. Applied O.H.
Cr. Work-in-process inventory
Cr. Finished goods inventory
Cr. Cost of goods soled
Cr. Actual O. H.
- Under-applied O.H.: Applied O.H. < Actual O.H.
If the under-applied overhead balance is
Dr. Applied O.H.
Dr. Cost of goods soled
Cr. Actual O.H.
If the under-applied overhead balance is material:
Dr. Applied O.H.
Dr. Work-in-process inventory
Dr. Finished goods inventory
Dr. Cost of goods soled
Cr. Actual O.H.
d. Budgeted cost: is what expected to occur.


Cost accumulation:
a. Traditional costing:
1-Job-order costing: appropriate for customized
(heterogeneous) product (single or departmental rate).
2-Process costing: appropriate for similar (mass,
homogeneous) product (single or departmental rate).
3-Operation costing: appropriate for organizations that
uses both job-order and process costing (e.g., leather
and fabric bags).
b.Activity based costing (ABC): every activity has its own
cost pool.
c. Life-cycle costing (value chain): R&D and design
(Upstream cost), manufacturing costs and marketing,
distribution and customer service (down-stream cost).
Standard costing, flexible budgeting, and variance
a. Standard costing estimates what should be.
b. Flexible budgeting is the calculation of the cost that should
have been consumed given the achieved level of production.
c. Variance analysis is the difference between standard and
flexible budget.
Cost allocation:
a. Allocating joint cost.
b. Allocating service departments costs.
Target costing: market price of the product taken as a

Unit 5
Cost accumulation systems
Standard cost represents what costs should be.
Budgeted cost represents expected actual costs.
Product costing is the process of accumulating, classifying
and assigning direct material, direct labor and factory
overhead costs to products or services.
Types of product costing systems:
(1) Cost accumulation methods: The nature of the industry
forces managers to use job, process or operation costing
(2) Cost measurement methods (management decision):
actual, normal or standard costing systems.
(3) Overhead allocation methods (management decision):
traditional (peanut-butter) or activity-based costing

1-Process costing accounting: is used to assign costs to

inventoriable goods or services, it's applicable for homogenous
(mass) products. Process costing accumulates costs by process or
department and then assigns them to large number of nearly
identical products.
- Steps in process costing:
1. Accounting for all units (physical flow of quantities):
important to determine any normal spoilage, ignores the %
percentage of completion.
1Account for all units (same for FIFO and
weighted average)

Beginning WIP
+ Started units this period

Total units to account for

2. Computing equivalent units of production:
(1) First in first out (FIFO) costing:
Total units completed and transferred
_ Beginning WIP (regardless % of completion)

Units started and completed this period

+ Amount needed to complete BWIP
+ Amount completed on EWIP

EUP under FIFO


If materials added at the beginning of the process

Total Units Completed
+ Amount of materials needed to Complete BWIP
+ Amount of materials added to Date on EWIP

EUP for Materials
If materials added at the end of the process
Total Units Completed
+ Amount of materials needed to Complete BWIP
+ Amount of materials added to Date on EWIP
EUP for Materials
(2) Weighted average costing:
Material Conversion
Total units completed and transferred
+ Amount added to EWIP

EUP under weighted average

3. Compute unit cost:
A. Under FIFO
(1) DM:
Current cost EUP (FIFO) = unit cost
(2) Conversion:
Current cost EUP (FIFO) = Unit
(3) Total unit cost under (FIFO) = (1) + (2)
B. Under weighted average:
DM: BWIP cost + Current manufacturing cost
EUP (WA) = Unit cost
Conversion: BWIP + Current MC EUP (WA) =
Unit cost

Total unit cost = (1) + (2)
Accounting for spoilage: For costing the finished goods
inventory and there are normal spoilage, we add the
number of good units to the number of normal spoilage
units, then multiplying this number by the unit cost, then
dividing the total amount by the number of good units to
have the cost of finished goods inventory.
2-Operation costing: is mixed from job and process costing.
3-Activity-based costing (transaction-based costing): is a cost
accounting system based on the activity level as a cost object.
- Characteristics of ABC:
1.ABC applies more focused and detailed approach for gathering
2.ABC can be part of job order or process costing systems.
3.ABC can be used in manufacturing or service businesses.
4.ABC treats production costs as variable.
5.The costs driver in ABC is often a non-financial variable.
6.ABC may be used for internal and external purposes.
4-ABC (volume-base) Vs. traditional (peanut-butter) (nonvolume-based) costing:
1. Traditional costing involve:
- Accumulating costs in general ledger accounts.
- Using a single cost pool to combine the costs from all the related
- Selecting a single cost driver to use for the entire indirect cost
- Allocating the indirect cost pool to final cost object using a single
rate or departmental rate.
The effect is an averaging of costs that may result in
significant inaccuracy when products or service units don't
use similar amounts of resources. All overhead costs don't
fluctuate with volume.
2. Activity-based costing involves:
- Identifying the organization's activity that constitutes O.H. and
defining activity cost pools and activity measures (resource cost
- Assigning the costs of resources consumed to activity centers.
- Calculating activity rates by dividing total cost of each activity by
its cost driver.
- Assigning overhead costs to cost object.

5-ABC terms:
- Activity: is a work performed within an organization.
- Resource: is an economic element used to perform activities.
- Resource cost driver: is a measure of the amount of resources
consumed by an activity. It's used to assign resource cost
consumed by an activity to a particular cost pool (percentage of
total square feet required to perform an activity).
- Activity cost driver: measures how much activity used by a
cost object. It's used to assign cost pool costs to cost object
(machine hours required to produce product).

6-Benefits of ABC costing:

1. Helps reduce distortion caused by traditional cost
2. Provides more accurate product cost.
3. Provides more accurate measurement of activity-driving

4. Provides managers easier access to relevant costs for

making business decisions.
7-Limitations of ABC:
1. Even if activity data are available, for some costs it might be
not practical to find a specific activity that caused the
incurrence of the cost.
2. ABC reports are not GAAP.
3. ABC system is time and money consuming.
4. ABC usually requires more than a year for successful
development and implementation.
5. ABC generates vast amount of information. Too much
information can mislead managers.
Unit 6
Cost allocation techniques
1-Four purposes for cost allocation:
1. To provide information for economic decisions.
2. To motivate managers and employees.
3. To justify costs or compute reimbursement.
4. To measure income and assets for reporting to external
2-Criteria to guide cost allocation decisions:
1. Cause an effect (most preferred): Identifies the
variables that cause resources to be consumed.
2. Benefits received (used when a cause-and-effect
relationship can't be determined): Identifies the
beneficiaries of the outputs of the cost object. The costs
are allocated among the beneficiaries in proportion to the
benefits each received.
3. Fairness or equity (least preferred): This criterion is
often used in government contracts when cost allocation is
the base for establishing a price satisfactory to the
government and its suppliers.
4. Ability to bear (least preferred): This criterion
allocates costs to the cost object according to its ability to
absorb costs allocated to it.
3-Joint cost allocation:
- Joint costs are those costs incurred before the split-off point.
1. Physical measure at split-off point: weight or volume.

- Weight or volume of product Y Total weights or

volumes of all joint products X joint costs = Amount
allocated to joint product Y
- Advantages:
Easy to use.
The criterion for the allocation of the joint costs is
- Limitations:
Each product can have its own unique physical
Focusing on physical nature of the products can lead
to cost distortion of products.
2. Sales value at split-off point: values at split-off point.
- Sales value of product Y Total sales value of all joint
products X joint costs = Amount allocated to joint
product Y
- Advantages:
Easy to calculate.
Costs are allocated according to the individual
product's value.
- Limitations:
Market prices for some industries change constantly.
Sales price at split-off point might be not available,
because additional processing is necessary for sale.
3. Net realizable value (NRV):
- Estimated NRV = Final sales value after adding
separable costs Added processing costs (separable
costs that incurred after split-off point).
- Estimated NRV of product Y *Total NRV of all joint
products X joint costs = Amount allocated to joint
product Y
* If one of the two products is not processed further,
we will add the NRV of the further processed product
to the sales value at split-off point of the other
- Advantages:
It produces an allocation that yields an incremental
profit among products.
Selling price at spilt-off point doesn't have to be

- Limitations:
More difficult to calculate than the other two
Based on an estimated value.
The by-product: when using any method of joint cost
allocation, the sales revenue of by-products if
inventoried, treated as a reduction of the costs of
production of the main product, and the remaining
costs are allocated to the main products not to the byproduct, and at any way no joint costs are allocated to
4-Inventory costing choices: Absorption (Full) Vs.
Variable (Direct) costing:
1. Absorption costing (GAAP costing):
- Advantages:
Absorption costing is GAAP.
The Internal Revenue Service requires the use of
absorption costing in financial reporting.
- Limitations:
(1) The level of inventory affects net income because
fixed costs are component of product costs.
(2) The net income reported under absorption method is
less reliable than under variable method (especially for
use in performance evaluation) because the level of
inventory affects the net income as it includes fixed
costs into its components.
2. Variable costing (Direct costing): Variable costing is a
management tool used to calculate breakeven point CPV
(Cost volume profit analysis).
- Advantages:
Variable costing attains the objective of management
control systems as costs are listed separately so that they
may be easily traced and controlled by managers.
The net income reported under contribution method is
more reliable than under absorption method (especially
for use in performance evaluation) because the cost of the
product doesn't include fixed costs into its component,
and therefore the level of inventory doesn't affect net

The contribution margin yield from variable costing
aids in decision making.
- Limitations:
Variable costing is not GAAP.
The Internal Revenue Service doesn't allow the use of
variable costing in financial reporting.

5-Service cost allocation:

1. Direct method: costs of services between service
departments are ignored, and all costs are allocated
directly to production departments.
2. Step-down method: Service department costs are
allocated to other service departments and to production
departments, starting with service department that
provides the greatest amount of services to other
3. Reciprocal method: Service department costs are
allocated to each other; this will generate new overhead

costs for service departments to be allocated to other

6-Allocating service department costs to production
departments by Dual rate for SBU evaluation: The cost
allocation method that separates fixed and variable costs.
Variable costs are allocated to production units by
multiplying budgeted rate times the actual usage of
allocation base, and fixed costs are allocated by multiplying
budgeted fixed costs times the capacity demanded.
Dual-rate example:
Fact Pattern: Longstreet Companys Photocopying Department
provides photocopy services for both Departments A and B and has
prepared its total budget using the following information for next
Fixed costs $100,000
Available capacity 4,000,000 pages
Budgeted usage
Department A 1,200,000 pages
Department B 2,400,000 pages
Variable cost $0.03 per page
Assume that Longstreet uses the dual-rate cost allocation
method, and the allocation basis is budgeted usage for fixed
costs and actual usage for variable costs. How much cost
would be allocated to Department A during the year if actual
usage for Department A is 1,400,000 pages and actual usage
for Department B is 2,100,000 pages?
A. $42,000
B. $72,000
C. $75,333
Answer (C) is correct. Based on budgeted usage,
Department A should be allocated 33 1/3% [1,200,000
pages (1,200,000 pages + 2,400,000 pages)] of
fixed costs, or $33,333 ($100,000/3). The variable
costs are allocated at $.03 per unit for 1,400,000
pages, or $42,000. The sum of the fixed and variable
elements is $75,333.
Single rate example:
Assume that Longstreet uses the single-rate method of cost
allocation and the allocation base is budgeted usage. How

much photocopying cost will be allocated to Department B in

the budget year?
A. $72,000
B. $122,000
C. $132,000
Answer (D) is correct. Department B is budgeted to
use 66 2/3% of total production (2,400,000
3,600,000), so it should be allocated fixed costs of
$66,667 ($100,000 66 2/3%). The variable cost
allocation is $72,000 (2,400,000 pages $.03 per
page), and the total allocated is therefore $138,667
($66,667 + $72,000).
Unit 7
Operational efficiency and business process
1-Just-in-time system(JIT) (demand pull): A comprehensive
production and inventory system that purchases or produces
materials and parts only as needed and just in time to be used
at each stage of the production process.
- Just-in-time production (lean production): A demandpull manufacturing system that produces each component of
a production line as soon as and only when needed by the
next step in the production line.
- Just-in-time purchasing: the purchase of goods or
materials so that they are delivered just as needed for
- JIT (demand pull) systems vs. traditional (demand
push) systems: Lot sizes based on immediate need
are typical of just-in-time systems, while lot sizes
based on formulas are characteristics of traditional
inventory management systems.
- Benefits:
1.Reduces carrying costs and non-value adding activities.
2.Increases inventory turnover (cost of goods sold average
3.Decreases setup costs.
4.Lower investments on space.
5.Greater emphasis on improving quality.
- Limitations:

1. Increases stock-out costs.

2. Not appropriate for high-mix manufacturing environments.
JIT system depends on reliable suppliers which can
ensure on-time deliveries of high quality goods for justin-time use.
- Wok cells: describes multi-skilled workers that can do
multi-tasks. The employee in work cells in a strong need to
have a strong training.
2-Enterprise resources planning (ERP)(Demand Push):
- A material requirement planning (MRP) is an approach that
uses computer software to help manage a manufacturing
- MRP system translates the finished goods when entered to
the system into row materials needed and the time required
to deliver it.
- Benefits of MRP systems:
1. Less coordination required between functional areas.
2. Lower setup time.
3. Lower inventory carrying cost.
4. Reduces idle time.
5. Better manufacturing process control.
- Limitations:
- Potential inventory accumulation. Workstations may receive
parts that they are not ready to process.
- MRP basic goals is: Right part, right time, and right
3-Manufacturing resource planning (MRP II):
- MRP II system translates the finished goods when entered to
the system into row materials needed and time required to
deliver it and cash flows.
4-Enterprise resource planning (ERP):
a.ERP is a software program that is used to plan and keep
records of resources, including
1. Finances,
2. Labor capabilities and capacity,
3. Materials, and
4. Property.
b.MRP is a common function contained in ERP.
1. Although ERP and MRP are similar, they are not
interchangeable since ERP includes functions not included in

2. An ERP system would allow a company to determine what

hiring decisions might need to be made or whether a company
should invest in new capital assets.
a) A company that only need to maintain inventory and
materials levels would only need to implement a MRP
c. Operational benefits of ERP:
Reducing operational costs through improved
communication across departments.
Facilitating inventory management.
Facilitating day-to-day operations through real-time
5-Outsourcing: Is a process of purchasing goods or services
from outside rather than producing it within the organization.
- Benefits:
1.Can be cheaper.
2.Having a reliable service, reduced cost.
3.Can improve efficiency and effectiveness by gaining
outside expertise.
- Limitations:
1. Can result in a loss of in-house expertise and capabilities.
2. Can reduce process control.
3. May reduce control over quality.
4. It depends on outside parties.
6-Theory of constraints (TOC) and throughput costing:
Throughput margin = Sales revenue DM cost
material handling cost.
Inventory = (Material costs in direct material, work-inprocess, and finished goods inventories) + (R&D costs)
+ (costs of equipment and buildings).
Operating expenses = All costs of operations, not
including direct materials.
The basic principle of TOC is to maximize the
throughput contribution margin through the constraint .
- Definition: It describes methods to maximize operating
income when faced with some bottleneck and some nonbottleneck operations.
- It's a means of making decisions for a company to be
competitive when it needs to be able to respond quickly to
customer orders. Theory of constraint is an important way

for a company to speed up its manufacturing time so it can

improve its customer response time and its profitability.
- Manufacturing cycle time (manufacturing lead time)
(throughput time):
It's the amount of time between receiving customer's order
and the shipment of the order.
- Drum-buffer-rope system: Is a TOC system that
balancing the flow of production through the constraint
so reducing the amount of inventory at the constraint and
improving overall productivity.
- The drum is the constraint, the buffer is the minimum
amount of work-in-process input needed to keep the drum
busy, and the rope is the sequence of processing and
including the constraint.
- The steps in TOC analysis:
1. Identifying the constraint.
2. Determine the most profitable product mix given the
3. Maximize the flow through the constraint.
4. Increase the capacity at the constraint.
5. Redesign the manufacturing process for greater flexibility
and speed.
7-Capacity management:
1. Capacity planning:
a.Capacity planning is an element of strategic planning that
is closely related to capital budgeting.
8-Value-chain analysis: Is a strategic analysis tool used to
identify the value added activities to be increased and nonvalue added activities to be decreased.
1.Upstream activities (research & development, design).
2.Manufacturing activities.
3.Downstream activities (marketing and distribution,
customer service).
Value adding cost: is the cost of activities that adds value to
the customer (material and labor for regular repairs).
Non-value adding cost: is the cost of activities that don't
add value to the customer (rework and warehousing costs),
and can be eliminated without affecting the end products.
9-Value-chain analysis:

1. The value chain: R&D, design, production, marketing,

distribution, and customer service.
2. Value chain analysis: is a strategic tool that allows the
firm to focus on the activities that add value and reduce
The first step in the value chain analysis is to identify
the firms value-creating activities.
The second step is to determine how each valuecreating activity can produce competitive advantage for
the firm.
3. The supply chain (the supplier, the firm, and the
customer): describes the flow of goods, services and
information from their original sources of materials and
services to the delivery of products to customers, regardless
of whether those activities occur in the same organization or
in other organizations. It usually encompasses
more than one firm.
Supply chain management: refers to the
coordination of business processes across companies to
better serve end customer.
Customers want companies to use the value chain
and supply chain to deliver products that are:
- Lower cost with increased efficiency.
- High level of quality.
- Constant innovation.
Supply chain analysis should extend to all parties in the
Goals of supply chain management:
1. Maximizing customer value.
2. Achieving sustainable competitive advantages.
Supply chain activities involves:
- Product development.
- Sourcing.
- Production.
- Logistics.
- Information system needed to coordinate these
Benefits of effective supply chain management:
1. Generally improve performance and reduce costs.
2. Reduces stock-out costs and carrying costs.

Issues and problems in supply chain
1. Communication problems between companies.
2. Trust issues.
3. Incompatible information system.
4. Required increases in personnel resources and
financial resources.
10Activity based management (ABM): Is the
management decisions and activity analysis that use activitybased costing information to satisfy customers and improve
operational control, management control and profitability.
ABM applications can be classified into two categories:
1. Operational ABM:
- Enhances operation efficiency and asset utilization and
lowers costs. Its focuses are on doing things right and
performing activities more efficiently.
- Operational ABM applications use management techniques
such as activity management, business process
reengineering, total quality management, and performance
2. Strategic ABM:
- Its focuses are on choosing appropriate activities for the
operation, eliminating nonessential activities and selecting
the most profitable customers.
- Strategic ABM applications use management techniques
such as process design, customer profitability analysis, and
value chain analysis.
Advantages of ABM:
1. Uses continuous improvement to maintain the firm's
competitive advantages.
2. Eliminates non-value-added activities.
3. Works well with just-in-time processes.
4. Allocates more resources to activities, products that add
Disadvantages of ABM:
1. Not used to external financial reporting.
2. Implementing ABC/ABM is expensive and time-consuming.
3. Changing to ABC/ABM will result in different pricing, process
design, manufacturing technology, and product design

11Process analysis and business process

- Reengineering: Is the process innovation and core process
design. Instead of improving existing products.
- Business process reengineering (BPR) involves
changes that are:
1. Fundamental.
2. Radical.
3. Dramatic.
12Benchmarking: Is the continuous, systematic process of
measuring products, services, and practices against the best
level of performance. Thus helping the organization to be
13Best practice analysis: Refers to the collective steps in
a gap analysis.
- A gap analysis is the space between what is and what an
organization hopes to be.
14Cost of quality analysis (COQ): Refers to the costs
incurred to prevent, or arising as a result of producing lowquality product.
a. Conformance costs: Preventive costs and appraisal costs.
b.Non conformance costs: Internal failure costs and
external failure (lost opportunities) costs.

15Efficient accounting processes: benefits of improving

accounting processes that it increases companys ability to
minimize the costs of these processes and maximize the
1. Areas for improvement:
1) Accounts payable.

2) Cash cycle.
3) Closing and reconciliation processes.
4) Data analysis.
2. Techniques for creating future vision for finance
1) Benchmarking.
2) Current use assessment (customer-centered
3. Steps needed to improve accounting processes:
1) Process walk-throughs (understanding current
a. Benefits of process walk-throughs:
1. Identifying waste and over-capacity
(duplication of effort, tasks done are not necessary,
output not being done).
2. Identify the root cause of errors.
2) Process design: to cover every aspect of the
internal users need.
3) Risk-benefit evaluation:
The greater the changes being made, the less the firm can
be sure of a successful outcome.
If the risks are determined to be too great, a return to the
process design step may be necessary.
4) Planning and implementing the redesign (topdown implementation):
5) Process training:
4. Reducing the accounting close cycle: soft closes can
be used for month-end closes, and more detailed closing
for quarter-end and year-end closes.
To speed up the closing:
A standardized chart of account should be used
across all company locations.
Bank reconciliation can be done daily.
Depreciation can be calculated a few days
before the closing.
Standardized accounting procedures.
5. Centralization of accounting as a shared service:
Benefits of shared service:
Utilizing a smaller number of highly trained
The result is usually fewer errors.

Greater efficiency can be generated by
assigning tasks to a smaller number of managers.
Accounting errors can be searched more easily.

Unit 10
Cost and variance measures
Performance evaluation is the process by which managers at
all levels gain information about the performance of tasks
within the firm and judges that performance against preestablished criteria as set out in budgets, plans, and goals.
- Operational control (management-by-exception
approach): means the evaluation of operating level
employees by middle-level managers.
- Operational control
Focuses on detailed short-term performance measures.
Has a management-by-exception approach that is identifies
units or individuals whose performance does not comply with
expectations so that the problem can be promptly corrected.
The use of standards:
- To set performance expectations.
- To evaluate and control operations.
- To motivate employees.
- To manage by exception.

The use of variances:

- Variance analysis enables management by exception.
- Variance analysis assigns responsibilities.
- Variance will guide managers to seek explanations and take
early corrective action.
- Sometimes variances suggest a change in strategy.
- Variances may signify that standards need to be
Effectiveness and efficiency:
- An operation is effective if it attained or exceeded its goals
(can be measured by the sales volume variance).
- An operation is efficient if it has not wasted resources (can
be measured by the flexible budget variance).
We can assess the effectiveness of a company by
comparing the actual results with its master budget.
To be able to calculate variances we need to calculate 3
1-Actual amount column = actual price/cost X actual
2-Static/master-budget = budgeted price/cost X budgeted
3-Flexible budget = budgeted price/cost X actual output.
1-Static-budget variance (operating income variance) =
Actual result static-budget amount.
A flexible budget will help in evaluating efficiency: the
flexible budget calculates budgeted revenues and budgeted
costs based on actual output level in the budgeted period.
2-We can calculate flexible budget depending on
budgeted selling price, budgeted variable OH and
budgeted fixed OH multiplied by actual output.
3-Flexible budget variance = actual amounts flexible
budget. (Measures the efficiency of resources).
4-Sales volume variance = flexible budget static budget.
(Inaccurate forecasting of output units sold) (As the
only different is in the amount of sales volume).
5-Static budget variance = flexible budget variance +
sales volume variance (the difference due to the
performance of the company)

6-Sales volume variance for operating income = budgeted

contribution margin per unit X (actual units sold
budgeted units to be sold).
The three elements causes the flexible budget variance
1. Selling price variance.
2. Variable cost variance (DM, DL, and variable O.H.
3. Fixed cost variance
7-Selling price variance = (actual selling price budgeted
selling price) X Actual units sold.
Direct costs variance (DM & DL): we can investigate the
favorable/unfavorable variance in DM or DL by calculating the
price variance (the difference between actual and budgeted
input price costs), and efficiency variance (the difference
between the actual and budgeted input quantity).
8-Price variance (input-price variance) (rate variance) =
(Actual price standard price) X Actual quantity of
9-Efficiency variance (usage variance) = (actual quantity
of input budgeted quantity of input that should have
been used to produce the actual output){standard
material X actual output} X standard price.

Variable and fixed manufacturing overhead variance.

To be able to calculate variances we need to calculate 4
1-Actual amount = actual per unit cost X actual allocation
2-Budget according to normal costing = budgeted rate X
actual allocation base.
3-Flexible budget = standard per unit cost X actual output
X budgeted rate.
4-Applied O.H. according standard costing = standard per
unit cost X actual output X budgeted rate.

Variable manufacturing overhead variance:

1. Calculating allocated (applied) V. M.O.H. according to

standard costing.
- Applied O.H. = budgeted V.O.H. rate X standard
allocation base for actual output.
- Standard allocation base for actual output =
budgeted (standard) per unit rate X actual output.
When comparing allocated input allowed for actual
output according to standard costing (4) with flexible
budget (3), there will be never variance because they
are the same.
2. Calculating V.M.O.H. variance (variable O.H. flexible
budget variance) = actual amount flexible budget
amount (applied O.H.).
3. Efficiency variance = (actual quantity of allocation
base budgeted quantity for actual output) X
budgeted O.H. rate.
4. Spending variance = (actual rate per unit budgeted
rate per unit) X actual allocation base.
Under/over applied V.O.H. = flexible budget variance =
efficiency variance + spending variance.
If O.H. is applied based on amount of the allocation
base used for the actual units of output rather than
standard amount allowed, there will be no variable O.H.
efficiency variance.
11Fixed manufacturing overhead variance:
1. Calculating allocated (applied) fixed M.O.H.
according standard costing.
- Applied O.H. = budgeted F.O.H. rate X standard
allocation base for actual output.
- Standard allocation base for actual output =
budgeted (std.) per unit allocation base X actual
2. Calculating F.M.O.H. variance = actual amount
applied O.H.
Flexible budget (F.M.O.H. in the flexible budget is the
same budgeted F.M.O.H.).
3. Calculating production volume variance
(denominator-level variance) = budgeted O.H.
applied O.H. (Uncontrollable).

4. Calculating spending (budget) variance = actual

F.O.H. flexible (budgeted) F.O.H.
Under/over applied F.O.H = production volume variance
When comparing between budgeted amount and
flexible budget there will be no variance because
flexible budget with respect to F.M.O.H. depends on
budgeted amount.
Efficiency variance for materials or labor can be divided
into mix variance and yield variance.
12Two-way analysis (volume and controllable):
- Overhead variance = (Budgeted V.O.H. rate X Standard
allocation base allowed for actual output) + budgeted F.O.H
Actual total O.H.
13Three-way analysis (spending, efficiency, and
- Spending variance = (Budgeted V.O.H. rate X actual
allocation base) + budgeted F.O.H Actual total O.H.
14Sales volume, mix, and quantity variances:
1. Sales volume variance = sales mix variance + sales
quantity variance.
2. Sales volume variance = Budgeted contribution
margin per unit X (actual units sold budgeted units
to be sold).
3. Sales mix variance = (actual sales mix ratio for a
product budgeted sales mix ratio for a product) X
actual units sold for the two products X budgeted
contribution margin per unit for a product.
4. Mix ratio for actual input = sum of (actual quantity X
standard price total actual quantity.
5. Mix ratio for budgeted input = sum of (standard
quantity X standard price) total standard quantity.
15Yield variance = (total standard quantity total
actual quantity) X budgeted sales ratio.
16Partial and total factor productivity:
1. Total productivity = total output total input.
2. Partial productivity for materials = total output
total material costs.
3. Partial productivity for labor = total output total
labor costs.

Unit 11
Responsibility accounting and performance measures
CMA EXAM: The performance measurement portions focus on a few
performance measures, specifically Return on Investment (ROI) and

Residual Income (Rl). For these measurements you need to know what
they are, how they are calculated and how they are used. You also
need to be able to identify the weaknesses that are inherent in each
one. Responsibility accounting is the breaking down of costs into
those costs that can be controlled by the manager and those that
cannot be controlled by the manager. There are a number of different
cost classifications and allocation methods within this section that you
need to be aware of.
Transfer pricing is a topic that you need to know from both a
theoretical standpoint and a numerical one as well. The questions
may require you to understand the issues that company faces in
establishing the transfer price as well as being able to calculate an
acceptable transfer price under certain situations.
The final topic covered in this Section is performance feedback,
and more specifically the balanced scorecard, you need to know
conceptually what the balanced scorecard is and how it works as
well as be familiar with Its application.
The objective of this unit is (management control)
which provide variety of tools that top managers (such
as CFOs) use to evaluate middle-level managers (such
as plant managers, product-line managers, heads of
(R&D) departments, and regional sales managers) and
the organization as a whole. The mid-level managers
have a significant responsibility in helping the
organization achieve its strategic goals.
Management control: refers to the evaluation by upperlevel managers to the performance of mid-level
Management control:
- Focuses on higher level managers and long-term, strategic
- Is more consistent with management-by-objectives.
The objectives of management control:
1. Motivate managers to exert more effort to achieve the
organization's goals.
2. Promotes goal congruence among the organization.
3. Determine fairly the rewards earned by manager's effort
and skills and the effectiveness of their decisions.
Management control issues:

Responsibility centers (strategic business units).

Contribution and segment reporting.
Common costs.
Transfer pricing.
Performance measures & financial measures (ROI, RI and
- The balanced scorecard.
1-Responsibility centers (strategic business units)
(SBUs): consists of a well-defined set of controllable operating
activities over which the SBU manager is responsible
Responsibility accounting: is a system measures the plansby-budgets and actions-by-actual results of each responsibility
- Types of responsibility centers:
1. Cost center: the manager is accountable for costs only.
- Cost SBU: is the production or support SBUs within the firm
that have the goal of providing the best quality product or
service at the lowest cost. (E.g. maintenance
Strategic issues related to implementing cost SBUs:
- Cost shifting.
- Excessively focusing on short-term objectives.
The criteria to choose the cost allocation method, are
the same objectives for management control:
- To motivate managers to exert more effort.
- To promote goal congruence.
- To provide a bases for fairly evaluation for managers
Responsibility and controllability:
- Controllability: is the degree of influence that a specific
manager has over costs, revenues and related items for
which he/she is responsible for.
- Controllable cost: is any cost that primarily subjected to
the influence of a given responsibility center manager for a
given period.
In practice, controllability is difficult to pinpoint for two
1. Few costs are under the sole influence of one manager.

2. With a long enough time, all costs will come under

deferent manager's control. A current manager may be
affected by the previous manager's decisions.
2. Revenue center: the manager is accountable for revenues
- Revenue SBU: is SBU that responsible for sales, defined
either by product line or geographical area.
3. Profit center: the manager is accountable for revenues and
- Profit SBU: is the SBU that generates revenues and incurs
the major portion of the costs for producing these revenues.
Strategic role of profit SBUs:
- Three strategic issues cause firms to choose profit
SBUs rather than cost or revenue SBUs:
1. It provides incentive for desired coordination
among the marketing, production, and support
functions. (The handling of rush orders is a good
2. It motivates managers to consider their product
as marketable to outside customers.
3. It motivates managers to develop new ways to
make profit from their products and services.
4. Investment center: the manager is accountable for
investments, revenues and costs.
- Investment SBU: is the SBU that includes assets employed
by the SBU as well as profits in performance evaluation. (Is
most like an independent business).
Products that have little need to coordination between
manufacturing and selling functions are good
candidates for cost centers (e.g. food and paper
Products that need close coordination between
manufacturing and selling functions are good
candidates for profit centers (e.g. high-fashion
Firms that have many profit SBUs because of its many
different product lines; its preferred approach is to use
investment SBUs.

2-The contribution income statement for performance

evaluation purposes:
- Gross margin = sales revenue variable M. costs fixed M.
- Manufacturing contribution margin = sales revenue
variable M. costs.
- Contribution margin = sales revenue variable M. costs
variable selling& administration expenses.
- A segment is a product line, geographical area, or any
meaningful subunit of the organization.
- Segment margin = contribution margin fixed costs
(controllable & non-controllable.
- Segment operating income = segment margin allocated
common costs.
- Economic performance = Revenue all costs except fixed
manufacturing costs allocated to the segment.
3-Common costs: are the indirect joint costs that allocated to
operating units in some logical way.
- Two specific approaches in common cost allocation:
1. Stand-alone method: the costs are allocated according
to the percentage.
2. Incremental method: the primary party receives the
stand-alone costs and the second party receives the
balance of the common costs.
4-Financial measures:
1. Product profitability analysis allows management to
determine whether a product is providing any coverage of
fixed costs.
2. Business unit profitability analysis performs the same
function on the segment level.
3. Customer profitability analysis enables a firm to make
decisions about whether to continue servicing a given
5-Performance measures:
Types of performance measures:
A) Financial measures:
1)Internal financial measures (such as operating income).
2)External financial measures (such as stock price).
B) Non-financial measures:

1)Internal non-financial measures based on internal nonfinancial information (such as defect rates and
manufacturing lead time).
2)External non-financial measures based on external nonfinancial information (such as customer satisfaction
ratings and market share).
Return on investment (ROI), accounting rate of return,
or accrual accounting rate of return:
- ROI = Income (profit) investment = (income revenue) X
(revenue investment).
- Or ROI = return on sales (ROS) (profit margin) X
investment turnover.
- Or ROI = [(revenue cost) / revenue] X revenue /
- ROS: Tells how much of each revenue dollar becomes
income; the goal is to get higher income per revenue dollar.
- ROS: measures the manager's ability to control expenses
and increase revenues to improve profitability.
- Investment turnover: Tells who many revenue dollars are
generated by each dollar of investment, the goal is to make
each investment dollar work harder to generate more
- In investment SBUs managers can increase ROI in
basically 3 ways:
1.Increase sales.
2.Reduce expenses.
3. Reduce assets.
Residual income (RI) = Income (required rate of return
X investment).
- Required rate of return is the imputed cost of the
- Goal congruence is more likely to be achieved by
using RI rather than ROI as a measure of the subunit
manager's performance.
Advantages and Limitations of ROI and Residual Income

Easily understood
Comparable to interest
rates and to rates of returns
on alternative investments

Disincentive for
high ROI units to
invest in projects
with ROI higher than

Widely used


Supports incentive to accept

all projects with ROI above the
rate of return
Can use the minimum rate of
return to adjust for differences
in risk
Can use a different
minimum rate of return for
different types of assets


Congruent with top

management goals for
return on assets
Comprehensive financial
measure. Includes all elements
important to top
management revenues,
costs, and investment
Comparability ,expands top
management's span of control
by allowing
comparison of business

the minimum rate of

return but lower than
the unit's current
Favors large units
when the minimum
rate of return is low
Not as intuitive as
Can be difficult to
obtain a minimum
rate of return

Can mislead
strategic decision
making, not as
comprehensive as
the balanced
scorecard, which
includes customer
satisfaction, internal
processes and
learning as well as
financial measures,
the balanced
scorecard is linked
directly to strategy.
Variations in the
measurement of
inventory and longlived assets and in
the treatment of
nonrecurring items,
income taxes.

Foreign exchange
effects, and the
use/cost of shared
Short-term focus;
investments with
long-term benefits
might be neglected
Economic value added (EVA): is a more specific version of
residual income.
- Economic value added (EVA) = after tax operating
income [weighted average cost of capital (WACC) X
(total assets current liabilities)].
- When a company's EVA is positive then it has added
to shareholders value.
6-Transfer pricing: is the price of the product transferred from
one subunit (department or division) to another unit in the
organization or to the outside customer.
- Motivation and performance evaluation: The transfer
price creates revenue for the selling subunit and purchase
cost to the buying subunit affecting each subunit's operating
income. This operating income can be used to evaluate
subunit performance and to motivate their managers.
- Intermediate product: is the product or service
transferred between subunits of an organization.
Objectives of transfer pricing:
1. Motivate subunit's managers to exert a high level of
2. Goal congruence.
3. Reward managers fairly.
Transferred pricing methods:
1. Market-based transfer prices (the price of a similar
2. Cost of production plus opportunity cost.
3. Full absorption cost (there is no motivation to the
seller to minimize costs).
4. Variable cost (should be used only when the selling
division has excess capacity).

5. Negotiated transfer prices.

Dual pricing: For example the seller could record the
transferred product at the market price. However, the buyer
could record the purchases at the variable price.
Choosing the right transfer-pricing method: (exhibit
19.10 page 26)
A general guideline (formula) for transfer pricing
- Minimum transfer price when working at full capacity
= incremental cost per unit incurred up to the point
of transfer + opportunity cost per unit to the selling
7-Balanced scorecard: is a single report includes financial and
non-financial performance measures for subunits.
Organizations can translate its strategy into a set of
performance measures by developing a balance scorecard.
Balance scorecard measures performance from four
2.Customer satisfaction.
3.Internal business process.
4.Learning and growth.
The balance scorecard is an accounting report that connects
the firm's key performance indicators to measurement of
its performance.
Key performance indicators (KPIs): are specific
measurable financial and non-financial factors that are critical
to the success of the organization.
Balance scorecard should include lagging indicators
( such as output and financial measures)
and leading indicator ( such as many types
of non-financial measures).

Unit 12
Internal control
Important introduction:
- The shareholders make the election of the board of
directors, which establishes the overall policies.

- The board of directors makes the selection

(appointment) of the officers (management).
- The management responsibility is to run day-to-day
operations and reporting the financial statements.
- The traditional rule to the external independent
auditor is to express his opinion about the fairness of
the financial statements according to GAAP, and to
address this report to the board of directors or the
- The internal auditor department rule is to audit the
management performance, financial and nonfinancial, and address his report to the board of
- The audit committee is a sub-committee from the
board of directors, and its responsibility is the
appointment of the internal and external auditors,
review internal and external auditor's reports.
IMA definition of internal control (IC): The whole system
of control (financial and otherwise) established by
management to:
1.Carry on the business of the organization in a regular and
efficient manner.
2.Ensure adherence to management policies, and safeguard
the assets.
3.Ensure as far as possible the completeness and accuracy of
the records.
Benefits of strong internal control system:
1. Lower external control cost.
2. Better control over the assets.
3. Reliable information for use in decision making.
A company with weak internal control system putting
itself at risk for employee theft, loss of control over the
information relating to operations, and other
inefficiencies in operation and decision-making that can
damage business.
As a process, internal control is a means to an end, not
an end in itself. Internal control can provide a
reasonable assurance not a guarantee.

The concept of internal control is based on two

1. Responsibility: Management and the board of directors are
responsible for establishing and maintaining the internal
control process. External and internal auditors are
responsible for internal control process, but the final and
ultimate responsibility for the control remains with
management and the board of directors.
2. Reasonable assurance: Management shouldn't spend
more on control than the benefits received. Management
must exercise its judgment to attain reasonable assurance
that its control objectives are being met.
Objectives of internal control according to (COSO
model): (COSO) defines IC framework in the following
categories (FOCS):
1. Effectiveness and efficiency of operations.
2. Reliability and integrity of financial reporting.
3. Compliance with lows, regulation, and
4. Safeguarding assets.
- The effective internal control reduces the need of
management to review exception report on day to day basis.
Major component of internal control according to COSO
(1) Control Environment.
(2) Risk assessment.
(3) Control procedures.
(4) Information and communication.
(5) Monitoring.
1-Control environment (the tone at the top): establishes
the foundation for an internal control system by providing
discipline and structure. It encompasses the attitude of the
board of directors and upper management regarding the
significance of control.
Environment control components (IC HAMBO):
(1) I - Integrity and ethical values.
(2) C - Commitment to competence.
(3) H - Human resource policies and practices.
(4) A - Assignment of authority and responsibility.
(5) M - Managements philosophy and operating style.

(6) B - Board of directors or audit committee participation.

(7) O - Organizational structure.
1. Integrity and ethical values:
- Integrity and ethical values are essential because they affect
all aspects of control. Management creates an atmosphere
leads to better risk management by:
Removing incentives for dishonest, illegal, or
unethical behaviors.
Setting an example in its own behavior.
C)Communicate entity values and behavioral standard by
means of codes of conduct.
The following would increase material misstatement.
- Excessive interest in increasing stock price, unduly
aggressive forecast, interesting in minimizing profit
for tax purpose, and the decision dominated by one
individual or small group.
2. Commitment to competence:
- Competence consists of knowledge and ability necessary by
members of the organization to complete tasks. In the final
analysis, it's the quality and competence of the employees
that ensure the ability to carry out the control process.
3. Human resource policies and practices:
- This component concern, among other things, hiring,
training, evaluating, promoting, and compensating
- Personnel are the key component of any control system, so
supervision is necessary to ensure that duties are being
carried out as assigned. Supervision becomes very
important in small firms, or where segregation of duties is
not possible.
- Job rotation and forced vacation allow employees to check
the operations of other employees by performing their
duties for a period of time.
4. Assignment of authority and responsibility:
- This component of control environment pertains to the
authority and responsibility of the operations as well as to
determination of reporting relationships and authorization of
5. Management's philosophy and operating style:

- Management philosophy and operating style represents the

attitude toward business risk in every action in areas such as
financial reporting, accounting estimates, and the selection
of accounting principles.
- Effective control in an organization begins with and
ultimately rests with management philosophy.
6. Board of directors and audit committee
The board of directors consists of inside (officers and
employees) and outside members (nonemployees who held
the company's stock).
1)The board is the governing authority of the corporation and
is responsible for establishing overall corporate policy. Day-today operations are delegated to management.
2) The directors have a fiduciary duty to the organization and
its shareholders. They must exercise reasonable care in the
performance of their duties.
3)Director will not be responsible for honest error of judgment
or act in good faith.
4)Directors typically:
b. Select and remove officers and set the compensation of
c. Determine the capital structure.
d. Add, amend, and repeal bylaws.
e. Initiate fundamental changes, such as mergers.
f. Declare dividends.
The audit committee is a subcommittee made up of outside
directors (not employee) who are independent of
management. Its purpose is to keep external and internal
auditors independent of management.
- The effectiveness of audit committee may be limited by the
close personal and professional relationship between the
directors and the management.
- The audit committee plays important role in maintaining the
control environment by approving the charter and
overseeing the work of internal audit activities.
- A strong audit committee insulates both external and
internal auditors from influences that may affect their
independence and objectivity.

7. Organizational structure:
- Key areas of authority, responsibility, and lines of reporting
should be reflected in the organizational structure.
2-Risk assessment: is the process of identifying, analyzing,
and managing the risks that have the potential to prevent
the organization from achieving its objectives. Assessment of
risk involves determining consequences as well as
Management is responsible for the assessment of the
risk. Organizations accept the fact that risk can only be
mitigated not eliminated.
The risk: is anything that endangers the achievement of an
The expected value of a loss due to a risk exposure is
the maximum value that should be spent on controls
designed to minimize the risk.
Types of risk:
1. External risks.
2. Internal risks.
Component of audit risk (AICPA audit risk model):
1. Inherent risk (IR): is the susceptibility of an
organization's objective to material misstatement arising
from the nature of the objective. This risk is greater in some
objectives than for others. (E.g. cash has greater inherent
risk than property, plant, and equipment, new, and
complex transactions).
2. Control risk (CR): is the risk that the controls will not
prevent or detect material misstatement in a timely manner.
It's the responsibility of the management.
- This risk depends on the effectiveness of the design and
operation of those controls. Control risk can't be eliminated
because of the inherent limitation of internal control.
3. Detection risk (DR): is the risk that material misstatement
of an element can't be detected by the auditor. It's the
responsibility of the auditor.
The level of detection risk is the only one of the three
components that subject to auditor's control.
4. Total audit risk (AR) = (IR) X (CR) X (DR).
3-Control procedures (control activities):

- Control activities are designed to manage or limit risk that

threatens the achievement of organizational objectives.
Internal control can be classified as:
1. Detective control: to discover the occurrence of unwanted
2. Preventive control: to prevent the occurrence of
unwanted event.
3. Directive control (is a special type of preventive
control): to ensure the occurrence of a desirable event.
4. Corrective control: to correct an occurrence of an
undesirable event.
5. Compensating control: to compensate the weakness in
Methods of internal control:
a. Organizational control (control over departments): the
primary organizational control is the segregation of duties.
b.Operational control (control over operations): includes
Inherent limitations in internal control:
1. Management override.
2. Employee collusion.
3. Misjudgment in decision making.
4. The cost of internal control shouldn't exceed the
5. Employee error.
Segregation of duties: involves assigning deferent
employees to perform tasks.
- A proper segregation of duties reduces the person's
opportunities to perpetrate and conceal fraud or error.
- Four types of responsibilities must be segregated:
1. The authority to perform transactions.
2. The recording of transactions.
3. Custody of the assets affected by the transaction.
4. Periodic reconciliation of the physical assets to the
recorded amount.
4-Information and communication: support all other control
components by communicating control responsibilities to
employees, and providing information in a form and time
frame that allow people to carry out their responsibilities.
5-Legal aspects of internal control (monitoring):

The Foreign Corrupt Practices Act
1. All domestic concerns are prohibited from corrupt
payment to any foreign official, foreign political
official party, candidate for a political office in a
foreign country (only political payments to foreign
officials are prohibited). Doing this is a criminal
2. Regardless of whether they have foreign
operations, all public companies (companies under
Securities Exchange Act) must make and keep
books, records, and accounts in reasonable detail,
and must devise and maintain a system of internal
controls sufficient to provide reasonable assurance
that (1) transactions are executed according to
appropriate authorization, (2) transactions are
recorded according to GAAP, (3) access to assets is
permitted only to specific authorization (custody),
and (4) the recorded assets are compared with the
existing assets (independent reconciliation). The
responsibility to initiate and maintain the internal
control system is assigned to the company as a
3. The independent auditor has to attest to the
financial statements.
The Sarbanes-Oxley Act:
Section 201: services out the scope and practice of
external auditor:
1)An auditor cannot function in the role of management.
2)An auditor cannot audit his own work.
3)An auditor cannot serve as an advocacy role for his client.
Section 203: audit partner rotation:
PCAOB requires audit firm rotation every 5 years.
Section 302: corporate responsibility for financial
Each report must include a certification by CEO and CFO that
signing officers has reviewed the report, and the report does
not contain any untrue material misstatement.

Section 404: management assessment of internal
1. The act applies to issuers of publicly traded securities.
2. The act requires each member of audit committee, including
at least one who is financial expert, to be an
independent member of the issuer's board of directors.
3. The audit committee must be directly responsible for
appointing, compensating, and overseeing the work of
the public accounting firm (external auditor) employed by
the issuer. This auditor must report directly to the audit
committee not to the management.
4. Establishing the internal control system is the
responsibility of the management. The act requires
publicly traded companies to issue an annual report
a. That the management takes responsibility for
establishing and maintaining the firm's system of
internal control; and
b.That the system has been functioning effectively
over the reporting period.
c. Identification of the framework used to evaluate
the effectiveness of internal control system.
d.Any corrective actions taken.
e. That the external auditor has issued an attestation
report on management's assessment in two
opinions includes:
1. If the structure and procedures accurately and
fairly reflects the firm's transactions.
2. Reasonable assurance that transactions are
recorded according to GAAP.
- The external auditor's report must describe any
material weaknesses in internal control.
PCAOB issued its audit standard (AS) NO. 5: (An
audit of internal control over financial reporting that is
integrated with financial statements).
- AS 5 requires the external auditor to express an
opinion on both the system of internal control and
the fair presentation of financial statements.

- AS 5 focuses on the material weaknesses of internal

- AS 5 focusing on internal controls as financial
Audit approaches:
1. The risk-based approach (top-down): the auditor is
required to focus on the entity and its environment when
making risk assessment, this known as top-down approach.
"Top" refers to the day-to-day operations of the entity and
the environment in which it operates; "down" refers to the
financial statement of the entity.
2. The balance sheet approach: the auditor focus on
balance sheet accounts.
3. The system-based approach: requires the auditor to
assess the effectiveness of internal control, and then focus
on the areas where considered that system objectives will
not be met.
4. The substantive approach: the audit tests large volume
of transactions and account balances without any particular
focus on specified areas of the financial statement.
Top-down approach Vs. bottom-up approach:
The auditor who approaches the bottom-up audit of
internal control would first focus on performing
detailed test of controls of the process, transactions,
and application levels. It's important for the auditor to
use top-down approach, because when he uses the
bottom-up approach he often spends more time and
effort than is necessary to complete the audit.
Spending more effort on low-risk areas can reduce the
effectiveness of the audit, because it may prevent
higher-risk areas from receiving the audit attention
that it should receive.
- The top-down approach ensures that the controls that
address the assessed risk of material misstatement
to each relevant assertion are tested. If the bottomup approach is used, those controls that address the
risk of material misstatement may not be tested.
6-Internal auditing:

According to institute of internal auditors (IIA), internal

auditing: is an independent, objective assurance and
consulting activity designed to add value.
Responsibility and authority of internal audit function
according to IIA's guidance at both organizational and
individual auditors:
1. Responsibility and scope of work:
Evaluating adequacy and effectiveness of
control system.
Evaluating the reliability and integrity of
financial and operating information.
Evaluating the effectiveness and efficiency of
Evaluating the safeguarding of assets.
Evaluating compliance with lows and regulations.
Preventing and detecting material
Incidents that should be reported:
1. Fraud.
2. Illegal acts.
3. Material weakness.
4. Significant penetrations.
- The internal auditor should evaluate fraud indicators
and decide if any additional investigation is needed.
Types of audit conducted by internal auditor:
- Financial, operational, performance, electronic data
processing, compliance, and specific investigation auditing
(such as fraud).
1. Compliance (function) auditing: (may be essay
- Internal auditors should assess compliance in specific
areas as part of their role in organizational
- They also should conduct follow-up and report on
management's response to regulatory body review.
2. Operational (performance) audit: (may be essay
- A review and assessment of the efficiency and economy
of the operations and the effectiveness in achieving
the objectives.

3. Financial auditing:
- Involves safeguarding assets and the reliability and
integrity of information.
- Other types of engagement:
1. Program-result audit: program is a funded activity, not
continuing or normal operation of the organization. The
auditor obtains information about the costs, output,
benefits, and effect of the program.
2. Privacy engagement: address the security of personal
information, not the accuracy.
Corporate governance: is the joint responsibility of the board
of directors and management. It involves the relationship
between participants and stakeholders in the corporation, such
as CEO, shareholders, and management.

Unit 13
Internal control II and ethics for management
Systems controls:
1-The segregation of accounting duties:

- Segregation of duties minimize the opportunity of perpetrate

and conceal error or fraud.
- EX. The analysis, programmer, and operator should be
deferent persons.
2-Three goals of information security:
1. Availability: the ability of the authorized person to
access computer.
2. Confidentiality: the assurance that the information is
3. Integrity: preventing unauthorized or accidental
3-Threats of information system:
1. Input manipulation.
2. Program alteration by the programmer.
3. Direct file alteration .
4. Data theft.
5. Sabotage .
6. Viruses.
7. Logic bombs.
8. Worms.
9. Trojan horse.
10. Phishing: A scam that uses spam e-mail.
Viruses, worms, Trojan horses, etc., are often referred to
as malicious software or malware. The most preventive
control against them is to allow only authorized software
from known source.
11. Back doors.
4-System development controls:
- The proper control of the systems development process
enhances accuracy, validity, safety, security, and
adaptability of the new system's input, output, process, and
1. The system development requires the settings of
priorities which can be achieved by the steering
committee composed of managers from both the IT
function and the end user function.
2. The steering committee ensures that the request for the
new system is aligned with the overall strategic plan of
the organization.

3. Changes to existing system should be subject to the same

controls, and the changes should be requested by the end
user and authorized by management or the steering
The changes should be made to a working copy of the
All changes should be tested by correct and incorrect
data and accepted by the user who requested the changes
before being placed in production.
4. Changed program code should be stored in a secure
5. Unauthorized changes to programs can be detected by
code comparison.
6. Program documentation (program run manual):
consists of operating instructions.
5-Physical control: the company develops a computer
security plan so it can select the set of control
policies and procedures that optimize computer
security relative cost.
1. Physical access: only operators should be allowed
unmonitored access to computer center.
2. Environmental control: the computer center should be
equipped with cooling and heating system.
6-Logical control:
1. Authentication: is the act of assuring that the person
attempting to access the system is the authorized
person. This can be achieved by using IDs and
IDs: must be unique.
Password optimization:
Passwords should be difficult to guess.
The system should force the password to change
Password fatigue: results when users must log on several
systems in the course of the day. Users are likely to write
down their IDs and passwords, this defeats the purpose of
automated authentication.
Single-sign-on can be the solution in well-managed system

2. Authorization: is the practice of ensuring that the

user in the system can only access the programs and
data necessary to his duties. Sometimes the user
should be able to view data fields but not able to
change them.
- Compatibility test is an access control used to determine
whether an acceptable user is allowed to proceed.
Compatibility test require a storage of authorization table or
matrices which includes user code number, passwords,
files, and programs maintained on the system.
7-Input, processing, and output controls:
- Input controls provide reasonable assurance that data
submitted for processing are authorized, complete, and
1. Online input controls (real time operation): can be
used when data are keyed into an input screen.
Pre-formatting: the data entry screen shows the
old hard copy documents applied with blanks, forcing
data entry to fill in all necessary fields.
Edit checks: the data entry screen prevents
certain types of incorrect data from entering the
c) Limit (reasonableness) check: the system can only
accept the appropriate range.
Check digits: an algorithm applied to any kind of
serial identifier to derive a check digit. If the system
uses sum-of-digits, check digit will not be able to
detect transposition errors.
Promoting (asking question of): permits
interaction between the system and the user,
especially when the user is inexperienced.
f) Echo check: is an input control over transmissions
among communication lines.
Redundant check: requires transmission of
additional data to check a previously received data.
Sign check: checks the positive or negative sign.
i) Key verification: inputting the information again and
comparing the two results.

2. Batch input controls: data are grouped and processing

in batches.
Management release: a batch is not released for
processing until a manager review and approves it.
Record count: a batch is not released to
processing unless the number of records counted by
the system matches the number counted by the user.
c) Financial total: a batch is not released to processing
unless the sum dollar amount of the individual items
reported by the system matches the amount calculated
by the user.
Hash total: the arithmetic sum of numeric fields
that it has no meaning by itself, but can serve as a
check that the same records that should have been
processed were processed.
3. Processing controls: provides reasonable assurance
that all data submitted to processing are processed, and
only approved data are processed.
Limit check and control totals: just like input
Validation: identifiers are matched against master
files to determine existence.
c) Completeness: any records with missing data are
Arithmetic controls: a comparison between
Sequence check: data are processed in logical
f) Run-to-run control totals: the batches of data are
checked after each stage of processing.
Key integrity: Key fields are not able to alter.
4. Output controls: provide assurance that processing was
complete and accurate.
- The user is the most qualified person to judge the adequacy of
processing the proper treatment to errors in transaction.
- Errors should be corrected and resubmitted by the user.
- Turnaround documents: are generated by the computer
and return to it.
8-Storage controls:

1. Dual writes routines: data can be stored in two

separate physical devices.
2. Validity checks.
3. Physical controls.
9-Types of audit:
1. Generalized audit software: a standard component of
software package permits the auditor to audit through the
2. Concurrent audit: used to collect audit evidence at the
same time when the processing of data is running. Ex.
Integrated test facility by establishing a set of dummy
files and enter transaction to test the program.
Security measures
1-Inherent risks of the internet:
1. Password attack:
a) Brute-force attack used password cracking
software to try large numbers of letter and number
combinations to access the network.
Spoofing: is identity misrepresentation in a
cyberspace by using a fake website to obtain information
about visitors.
c) Sniffing: is using software to eavesdrop on
information sent by use. Ex. Trojan horses.
2. A man-in-the-middle attack:
- May be used to steal data, obtain access to network during
rightful user's active session.
- Cryptography is the effective response to man-in-the-middle
3. A denial-of-service attack: is an attempt to overload an
organization's network with so many massages so that it can't
2-Use of data encryption:
- Encryption is a technology converts data into a code.
1. Public-key or asymmetric: the more secure as it requires
two keys. (Rivest, Shamir, and Adelman) (RSA).
2. Private-key or symmetric. Data Encryption Standard

1.Firewalls is a combination of hardware and software that

separates internal network from external network and
prevents unauthenticated login from outside users.
2. A proxy server: maintain copies of web pages to be
accessed by specific users.
3. A firewall alone is not adequate defense against
computer viruses. Anti-virus virus software is a must
(vaccine). A vaccine works only for a known viruses and
may be ineffective for new viruses.
4. Intrusion detection system: uses sensors to examine
certain signatures on the network.
4-Routine backup and offsite rotation:
1. Grandfather-father-son: one of the most widely used
backup rotation schedules to avoid storing all files in one
5-Disaster recovery planning (contingency planning):
1.The disaster recovery planning should focus on the
prevention of the disaster.
2. Automatic failover: involves automatically offloading
tasks to a standby system. It's an integral part of critical
systems that must be constantly available.
- Two major types of contingency planning:
Data center is physically available: Ex. Power
Data center is physically not available (more
serious): Ex. Natural disasters or fires. This requires the
existence of alternate processing facility.
An alternate processing facility: is a physical location
maintained by an outside contractor.
1. Hot site: is a fully operational processing facility that is
immediately available.
2. Warm site: is a facility with limited hardware.
3. Cold site: is a shell facility lacking most infrastructure
but available for quick installation of hardware.
6-Business continuity planning is the continuation of
business by other means during the period in which
computer processing is unavailable or less than normal.
7-Flowcharting: Flowcharting is the representation of a
process using pictorial symbols; it is a graphic portrayal.

Flowcharts can be useful in obtaining an understanding

of internal control such as the segregation of duties and
in systems development through providing visual
depiction of the activities as it a representation of
system or series of sequential process.
10.3IMA statement of ethical professional practices:
1-Four principles (HFOR):
1. Honesty.
2. Fairness.
3. Objectivity.
4. Responsibility.
2-Four standards (CCIC):
1. Competence:
Maintain an appropriate level of professional
expertise by continually developing knowledge
and skills.
Perform professional duties in accordance
with relevant lows, regulations, and technical
c) Provide decisions support information and
recommendations that are accurate, clear, and
Recognize and communicate limitations that
can affect judgment or performance.
2. Confidentiality:
Keep information confidential except when
disclosure is authorized or legally required.
Inform all relevant parties regarding
appropriate use of confidential information.
c) Refrain from using confidential information for
unethical or illegal advantages.
3. Integrity:
Mitigate actual conflicts of interest.
Refrain from engaging in any conduct that
would affect carrying out duties ethically.
c) Abstain from engaging in or supporting any
activity that might discredit profession.
4. Credibility:
Communicate information fairly and


Disclose all relevant information that could
reasonably expected to influence user's
understanding of reports, analysis, or
c) Disclose delays or deficiencies in information,
processing, or internal control in conformance
with organization's policy and/or applicable lows .
Violation should be reported to immediate superior, if
he's involved the matter should be reported to the next
level of management, and if the CEO is involved then
the matter should be reported to audit committee or
the board of directors.