ACCOUNTING NOTES

Gordon Dawson
December 2001
MODULE 1

AN INTRODUCTION TO ACCOUNTING AND THE ACCOUNTING EQUATION

Module 1

Definition - is a series of processes and techniques used to identify, measure and

communicate economic information which users find helpful in making
decisions.

Internal Users -

1. Directors - Has the company earned maximum profit

Has it been a god corporate citizen?

2. Senior Executives are we managing money efficiently i.e. are we

borrowing when there is no requirement to do so.
Is our remuneration competitive and promoting
commitment?

3. Managers Are we producing efficiently and at engineered cost

4. Employees how much can the company afford in pay rises and is
they’re a future with the organisation

5. Shareholders should we invest in this company or sell our share.

How much should our dividend be?

External Users

1. Analysts Is the company competitive in its field

Should we advise that stock be bought or sold

2. Creditors Can this company afford to pay its creditors

Will this company continue to supply us with business?

3. Tax Authorities How much can we expecting tax

4. The Public Any interested party consumer and environmental

groups

The Accounting Equation

Assets = Owners Equity + Liabilities

Or

Assets - Liabilities = Owners Equity

Sole Trader - liable for all debts incurred, can be sued for the shirt on his back
Partnership - two or more people equally liable for the debts of the company

Company - Limited in that it has a limited number of share equal to the initial
investment of the company (this can be increased as the company grows-see later
modules). The shareholders can be sued for the par or face value of the original share
not its current value which trades higher or lower dependant on the value placed by
the market.

MODULE 2

THE PROFIT AND LOSS ACCOUNT

Profit is the difference between sales and the cost of sales.

Cost of sales include -

 Direct costs- labour and material (production costs)
 Indirect costs - support staff, advertising etc

Profit can be measured as the difference between -

Measure of Accomplishment - is measured as the first point in the Operating cycle

when the following are satisfied -

1. The principle revenue producing service has been performed (the goods are made
and shipped to a firm order.
2. All production cost have been incurred or those that have not are negligible or can
be predicted within an n acceptable degree of accuracy.
3. The amount to be received can be predicted within an acceptable degree of error.

This is the shipping and invoicing method of accomplishment. The other 3 are -

1. Time of Sales - salesman sees the sale as time of order. Ice cream vendor.
Failings are that the order may be cancelled leaving specially ordered goods
unsold.
2. Time of Production - Gold mining. Engineering
3. Time of Collection - Cars large electrical equipment

Accounting Conventions dictate how the sales will be recorded in the P&L account -

Realisation Convention - Only sold goods are recognised as Sales

Accruals Convention - Revenues and costs are accrued (recognised as they are
earned or incurred) and matched with one another in the Profit and Loss Account for
the period to which they relate (rent paid for the year is split between the P&L
account for the 2 periods that it covers).

And

Measure of Effort - What Sales have cost. These too are subject of conventions -

Matching Convention - matches costs to the units shipped and invoiced during the
accounting period - not the goods produced (this is used later in accounting for
managers)

Cost Convention - the cost used is the historical cost I.e. the cost when the inventory
or machine was acquired.

Allocation Convention - firstly determine how much of the means of production is

used in producing the goods made and then allocated for the accounting period (raw
materials labour electricity etc.). Secondly, how much of each means of production
should be matched with sales revenue, closing inventory of both unfinished and
finished goods.

Determining Means of Production Costs -

1. Labour
2. Depreciation of fixed assets
3. Use of Raw Materials

Labour costs - these can be determined from the payroll

Depreciation costs. There are several ways to calculate depreciation but the there
must be regard to the original (historic cost), resale or scrap value and length of
useful life.

Method 1 - Straight Line

Equal amounts are deducted for depreciation over the life of the machine -

Cost - scrap value / useful life

Method 2 - Reducing Balance

Here large amounts of depreciation are deducted in the first few years when the
machine is at its most productive and the costs of maintenance are lower acting as a
counterbalance to higher maintenance costs in later life. Finding a % for the annual
depreciation charge and deducting that from the balance over the period calculate this.

*Remember to multiply the annual % by the life before inputting it to the calculator*

Method 3 - Consumption Method

Here it is based on the number of hours consumed i.e. the greater the use the greater
the wear and tear and the greater the depreciation should be.

(Annual Running Hours) / Total number of Running Hours) X Total Net Cost
(Purchase Price less Residual Value)

Comparison of Methods

1. Depreciation is the allocation of the cost of an asset purchased in 1 period spread

over the periods the asset is used.
2. It is a cost of production (but not a use of cash)
3. The method used determines the amount of depreciation in each accounting
period
4. It does not provide cash for a replacement but the effect is to reduce the loss of
cash as it lowers profit, which in turn lowers the tax demand and dividend
demand.
Determining the Value of Closing Work in Progress and Inventories

The costs involved in producing goods plays an important part in how much profit is
shown in the P&L account. This is because of the allocation of costs to unfinished
and unsold goods - inventories. The more costs allocated to unsold /unfinished
goods, the cheaper the cost to produce finished goods will appear and the greater the
profit on the P&L account.

Starting Inventory + Purchases - Closing Inventory = Cost of Goods charged in

the P&L account

Inventory consists of -

1. Finished Goods - ready for sale

2. Work in Progress - where work has started but they are not yet finished
3. Raw materials - to be used in the manufacture

The higher the Inventory value, the higher the reported profit.

Inventory Valuation Methods

Once counted is valued either by the Cost or Conseratism convention.

Cost - sum of expenditure either directly or indirectly incurred

Conservatism - if the goods are not sold and a reduced price is to be realised, the sale
price less the cost of the sale gives the value for the inventory.

FIFO - oldest units purchase/produced are sold/used first. This means that in times of
inflation, the higher costs of the later goods are reflected in the inventory price. This
method produces a Higher reported profit. This in turn attracts higher taxes, dividend
payments and lowers the ability to replace stock

LIFO - most recently produced units produced /purchased are sold/used first. This
means that lower profits are reported and the cost of replacing stock is is made easier.
This attracts lower taxes and dividends and allows stock to be replaced.

Average Method - the average cost of inventory is found by taking the total cost of
materials and dividing it by the number of goods purchased to provide the average
cost per unit.

Valuation of Work in Progress and Finished Goods

Product Costs - Raw materials, labour and factory overheads are allocated to the
Cost of sales, which is included in the P&L account, and Closing inventory, which is
incluede in the Balance Sheet.
Period Costs - Selling Administration and Finacial costs (costs not incurred directly
in the manufacture but are required to sell the product) are included in the P&L
account.
The more a company includes product costs in the valuation of inventory, the higher
the valuation and the higher the reported profit.

Interpreting Profit

Gross Profit- Sales less Cost of sales measures efficiency of the transformation
process.

Net Profit before Taxes and Interest - Gross profit less Product costs measures overall
managerial efficiency.

Net Profit after Interest - measures the financial efficieny of the company

Net Profit after taxes and interest - tells very little.

Summary

The Profit and Loss account or Income statement therefore measures the Sales less
the Cost of Sales.

MODULE 3

THE BALANCE SHEET

The Balance sheet gives a view of the worth of a company on specific date, normally
the end of the financial year. The balance sheet consists of Assets, fixed and current
fewer liabilities.

Fixed Assets - are things that are used in the production not for production - land
machinery buildings.

Depreciation is the allocation of the outlay for the asset, operating and is deducted
from the Balance Sheet over the life of the asset. Expenses for maintaining the asset
are deducted from the profit in the P&L as account.

Land - costs of preparation of the land should be capitalised and added to the value in
the Balance sheet.

Fixed assets not owned by the company-

Operating Lease- ownership remains with the finance company. The leased item does
not have to appear, as an asset not does the payments have to appear as a liability,
though these cost are charged to the P&L account.
Finance Lease - Where ownership reverts to the company after the lease term the
value is shown in the Balance sheet and the future payments appear as a liability
under creditors.

Advantages are -
 Avoids large outflow of cash for purchase
 Spreads cash flow over a period
 Replacement of the asset without sale and purchase
 Maintenance cost are normally covered in the lease
 Payments are charged to the P&L account and therefore deductible before tax is
incurred

Current Assets - are those assets that are expected to be used or consumed within 1
year.

Inventories -
 Valued at lower of cost or market value.
 Cost is direct manufacturing cost plus a share of factory overheads, excluding
period costs.
 Valuation effects level of profit.

Debtors -
A provision is made for bad debt in the P&L account based on
 Risks attached to each customer
 Severity with which non payment will be pursued
 General economic environment

Any actual bad debt is taken from the P&L account. The provision is increased each
year by an agreed amount and this is also taken from the profit in the P&L account.
Current Liabilities - are those debts that require to be paid in 1 year such as
creditors, overdrafts taxes payable and dividends payable, also accruals and deferred
revenue (prepayments for goods).

Net Current Assets and Net Assets

Net current assets (Liabilities) = Current assets - Current liabilities and gives the
ability of the company to meet liquid commitments from liquid resources.

Financing Net Assets - assets are acquired from internally generated funds (profit) or
external funds (loans), which can be secured. Secured loans have a right to payment
before any payment to shareholders.

The ling between the owners’ equity and loans is called gearing. This is calculated -

Long Term Debt / Total Assets

The % for the long-term debt allows the annual debt to be calculated. This is then
subtracted from the annual profit (loss) to give that amount available for equity. The
return on equity can be calculated by dividing the profit before interest by the original
equity invested by the owner (not debt).

The higher the gearing (higher amount of total equity is by loan), the higher the
amounts for equity payments will be when profits are high. When profits are low,
highly geared companies have a lower return as more money is paid in interest.

MODULE 4

THE CASH FLOW STATEMENT

The Cash Flow Statement reflects only those economic events that affect cash flows.
Cash = cash balances, short-term stocks / investments.
The importance of cash is -
1. Is there sufficient cash to pay dividends
2. Is the cash used from dividends from profits or borrowings
3. Where did the money for asset purchase come from profits or borrowings
4. Is the company solvent - sufficient funds to meet short term obligations
5. Is the company borrowing when there is a sufficiency of cash profits

Sources of Cash

1. Profit from Operations - this does not include depreciation which is added back in
the Cash Flow statement. Equally it does not include provision for bad debt. This
is recorded as a charge against profits in the P&L account.
2. Capital Introduction
3. Increase in Creditors
4. Sale of Fixed Assets
5. Loans
6. Decrease in Inventories - this releases cash tied up in inventories
7. Decrease in debtors

Uses of Cash

1. Loss from Operations - if after adjustments for depreciation bad debt and sale of
assets is made in the P&L account the figure is still negative then there is deemed
to be a cash loss consumed by operations
2. Capital Repayments - purchase of own shares this increases ownership and
reduces the amount of dividends to be paid.
3. Decrease in Creditors
4. Purchase of Fixed Assets
5. Repayment of Loans
6. Increase in Inventories
7. Increase in Debtors

Eight Major Categories of Cash Flow

The flow of cash is recorded in the Cash Flow statement under the following 8
headings -

1. Cash Flow from Operating Activities - the primary source of cash. If you do
not produce cash from operations in the long term, the business will be run on
borrowed money that will have to be repaid. This category includes increases and
decreases from inventories, debtors and creditors and is called ‘working capital’.
2. Cash Flow from Returns on Investments and Servicing of Finance - this
reflects the returns from investments in other entities and cash paid out in
dividends to non-equity shareholders; minority interest paid on borrowed money.
3. Taxation - this normally relates to the agreed tax to be paid from the previous
Fiscal year.
4. Capital Investment - receipts fro the sale or purchase of plant
5. Acquisitions and Disposals - cash flows from the purchase or sale of subsidiaries
and joint ventures
6. Equity Dividends paid to Shareholders
7. Management of Liquid Resources - current asset investments such as short term
bonds that can be realised quickly without upsetting the business
8. Financing - this includes cash flow movements in debt (except the overdraft) and
the receipt and payment of shareholders funds

MODULE 5

THE FRAMEWORK FOR FINANCIAL ACCOUNTING

Disclosure - protects investors (creditors and share holders) in Limited companies

from unscrupulous traders in that it requires that certain information be reported in a
certain manner at ceratin times of the year.
A limited company is liable for the amount of the initial investment at the par value
of each share.
A sole trader is liable for everything to the shirt on his back and the tools of his trade.
Companies do not want to disclose for fear of providing competitors and predators
with useful information and for fear of interference from out with.

Sources of Disclosure -

The Companies Act 1985 and 1989

That the companies P&L account will give a true and fair view of the profit and loss
for the year, and the financial state of the company (ie that the fiancial statements
have been drawn up in accordance with Accounting Standards).

Accounting Standards
This sets out the methods that must be adopted in compiling a companies accounts -
ie methods of recording stock LIFO or FIFO, and, any change in the recording
method must be explained and a comparison of the change given.

The Stock Exchange List Agreement

Any listed company must publish -
 Half yearly profit reports
 Directors interest in subsidiaries contracts/ dividends waived
 Reasons for departures from accounting standards
 Holdings of more than 20% in opther companies
 Geographical breakdown of profit

Group Accounts -
Holding company owns more than 50% of the subsidiary and must produce
consolidated or group P&L and Balance sheet along with its own balance sheet.

The balance sheet will show minority interest being the shareholding left in the
merged company not owned by the parent company. This is then deducte from the
consolidated P&L account for the group.

Accounting Policies
 True and fair view - financial statements and how they are made up should be
representative
 External auditors - must approve the accounts and how the information is arrived
at.
 Consistency - once the selection has been made of making up the accounts it must
be consistently applied from year to year.

Balance Sheet

Called up Share capital - companies have a limit on the amount of shares they can
issue. These are not always sold and the company can issue these shares up to the its
authorised limit, when this limit is reached, the company petitions the court for an
increase.
Share Premium Account - this is the difference between the nominal price and the
value achieved when the extra shares are sold.

Revaluations - some fixed assets are revalued during their lifetime and this has to be
entered in the notes for the Balance sheet.

Fundamental Accounting Concepts

1. Going Concern - that the company will continue to trade for the foreseeable
future.
2. Accruals Concept - revenue is recognised when the sale is made by shipping and
invoicing and all costs can be anticipated within a reasonable amount.
3. Consistency Concept - no change from year to year without a very good reason
4. Prudence Concept - revenue is not recognised until all effort has been expended
(in production) and the customer is likely to pay; that any losses are recognised
immediately.

The External Auditor

1. Appointed by the shareholders they are responsible for examining the companies’
accounts and methods for gathering financial information and ensuring that there
is no fraud or malpractice.
2. The auditors check the system of bookkeeping, internal controls and accounting
practices to ensure that that it is appropriate for the business.
3. Comparisons are made of the accounts with the figure used for their compilation.
4. Assets have to be verified along with proof of ownership or title.
5. Liabilities are verified with invoices
6. Verify that the results in the P&L account are fairly stated
7. Confirm that the statutory requirements have been complied with.

MODULE 6

INTERPRETATION OF FINANCIAL STATEMENTS

Ratio Analysis allows the following -

1. Comparison of performance between this period and the last
2. Comparison between the company and competitors
3. Comparison between actual performance and expected
4. Detect areas of managerial weakness.
Liquidity Ratios - are designed to measure the companies’ ability to meet its,
maturing short-term obligations and ensuring the short run survival of the company.

The ratios are

Current ratio - Current Assets / Current Liabilities.

This tells us the ability of the company to meet its short-term debts. A ratio of 2 is
considered to be good however; stock may not have a marketable value and give a
false picture.

Quick Ratio (or Acid Test) - Current Assets- Inventory / Current Liabilities.
This accepts that the inventory may not move quickly or be realised at the valued
price. The acceptable ratio is 1 i.e., the company will have enough current assets to
meet its obligations.

Profitability Ratios - are designed to measure managements overall effectiveness and

gives an insight into long-term survival. Profitability is the measure of the
managerial decisions.

Gross Profit Margin - Gross Profit / Sales

This is the first critical measure of profit, before anything is taken away. Gross Profit
is Sales less Cost of sales and measures efficiency of the transformation process.

Profit Margin - Profit before Interest and taxes / Sales

Taxes are historic (earned the previous year) Net Profit before Taxes and Interest is
Gross profit less Product costs measures overall managerial efficiency. Net Profit
after Interest measures the financial efficiency of the company.

Return on Total Assets - Profit before Interest and taxes / Total Assets
This is an indicator as to how the company employs its assets in generating profit.

Return on Specific Assets - Profit before Interest and taxes / The Specific Asset
This allows a return on the specific asset to be measure if it is considered a critical in
the management of the company. In the example, if the Quick Ratio indicates that
too much inventory is being held, this can be used as the denominator to return ratio.

Return on Capital Employed - Profit before Interest and taxes / Capital employed,
this is the total assets of the company less the current liabilities or the owners equity
plus the long-term loans. This gives an indication of amount of resources locked into
the business and providing a return for the shareholders and loan providers.

Return on Owners Equity - Profit Attributable to Shareholders / Owners Equity.

This figure gives the return for investment to shareholders.

Capital Structure Ratios - these are split into two groups, those that measure the
asset structure of the company (measure of fixed to current assets), and, those that
measure the financing of the company i.e. debt.
Fixed to Current Asset Ratio - Fixed Assets / Current Assets. This indicates value
of fixed assets compare to $1 of current assets.

Debt Ratio - Total Debt / Total Assets. The resultant answer is how much of each $1
the invested in the company is in fact from borrowing - debt. If the company is
highly geared i.e. has a lot of debt, in times of poor profits, the debtor have first call
on the profit before dividends are paid to shareholders. The gearing that gives the
return on equity is found = Profits before interest - Interest Charge (=amount
available to equity) / Equity.
If the owners equity is high then this figure is low and the return on the amount
invested is lower than if the owners equity is low and the company has a higher
gearing (more debt).

Times Earned Interest - Profit before taxes + Interest Charges / Interest Charges.
This figure gives the amount that profit can decline before the company cannot meet
its interest payments.

Efficiency Ratios - or activity or turnover ratios measure how efficiently the company
manages its assets. It involves the comparison between sales figures and the various
assets and assumes that mangers keep a sensible balance between sales and such
items.

Inventory Turnover - Sales / Inventory. The figure is then divide into 12 to give
how long in months the company keeps inventory and can be compared to its
competitors. This is a historic figure given on the year end figure of inventory and
must be checked in management terms against the year to see if it is the common
length for keeping stock. Inventory can act as a buffer for a sudden demand and it
may be cyclical that this occurs at the year end/beginning of next and this is the
reason if the figure is high. Equally ’just in time’ inventory and the rapidly changing
market for electronic goods makes large inventory a danger for some companies.

Average Collection Period - days sales outstanding. Debtors/Sales per day. This
tells us the length of time the company waits for debtors to pay for goods.
Remember, debtors are being financed by you!

Fixed Assets Turnover - Sales / Fixed Assets. This relates the investment in fixed
assets to the sales generated therefrom.

The Dupont Chart

This chart provides the Return on Total Assets or ROTA. It is achieved thus

Inventories + Debtors + Investments + Cash + Fixed Assets = Total Assets

are divided by Sales to give Total Asset Turnover.

Cost of Sales + Distribution Costs + R&D + Administration Costs = Operating Costs

are then subtracted from Sales to give Trading Profit which is divided by Sales to
give Return.

Total asset Turnover and Return are multiplied to give the ROTA.

100% Statement

Sales are treated as 100. All cost of sales are then turned to a percentage of this
figure as is the Trading profit (Sales less cost of sales). This provides a percentage
indicator for any increase or decrease in each of the costs over the corresponding
period.

Basic Stock Market Ratios

Earnings Per Share Ratio (EPS) - Net Profit / Number of Ordinary Share issued.

Price Earnings Per Share (PE) - Market Price / EPS. This figure represents the
purchase of the number of years profit to achieve it. It could be taken as an indicator
of whether or not to invest in the company.

Dividend Yield - Dividend per Share / Market Value per Share. This tells the
investor what the return is on the share based on the market value of the share not the
ordinary share price.
As tax is paid before the dividend is paid, companies add the tax paid onto the
Dividend figure before dividing it. These figures allow investors to compare
companies to see who give the best return on their shares.

Dividend Cover - Net Profit for the year / Dividend Payout. This figure allows an
investor to see if profits are being paid from profit or from reserves.

MODULE 7

EMERGING ISSUES AND MANAGERIAL OPTIONS IN FINANCIAL REPORTING

Managers are under pressure to increase profits and growth for the company. This
will increase the value of shares and the desire for people to invest and the company
to grow and so on.
Analysts advise investors where to put their monies and they rely on predictions for
profits at the end of each reporting cycle. If the management meets the predicted
profit, share price will stay the same as it went to at the time the prediction was
published. If it is higher, share price may increase. If it is lower the price will
undoubtedly fall.

It is in this environment that manager’s look to improve their returns though not
always by improving their operating profit.

Research & Development.

This cannot be capitalised even though it may be an investment for the future. This is
because of the uncertainty of it the research proving to be viable; many tests will be
made before the solution is found.
Development can be capitalised (value added to the Balance sheet) if -
1. There is a clearly defined project
2. The related expenditure is separately identifiable
3. The outcome has been assessed with reasonable certainty with regard to technical
feasibility and commercial viability in light of market conditions, public opinion,
consumer and environmental legislation.
4. The aggregate of deferred development costs, further development costs and
related production selling and administration costs is reasonably expected to be
exceeded by future sales or other revenues.
5. Adequate resources exist or will be available to complete the project and provide
working capital.

Off Balance Sheet Transactions

High gearing ratios in the UK attract attention because it is seen as risky to be long
term loans or many short term loans. Equally, a company who is highly geared is
suspected of being about to issue a shares option (sell more of its authorised level of
shares) to reduce the gearing.

To cover borrowings that will give the appearance of being highly geared, companies
may attempt the following Off Balance Sheet Transactions -

Quasi Subsidiaries -
1. Here the parent company attempts to cover he fact that it is the controlling
interest in a smaller company. If it declared it’s controlling interest the subsidiary
would require to be consolidated in the group P&L account and Balance Sheet. Thus
any borrowings would be part of the consolidated group.

The parent company can hold all the ordinary shares but its bank or investment
managers can hold a number of other shares that on paper give them the controlling
interest. The parent company however controls the board so controls the company.
On paper the investment bank holds more shares and the subsidiary is not considered
to be owned.

2. In this example, the parent company sets up another company and sell it some
of its assets. The other company is funded by loans from and by purchasing from the
parent company is putting money back into it.
The parent company then manages the assets for the subsidiary and if the subsidiary
sells the assets, it pays the money back to the parent company through some
management charge.
3. Where a parent company sets up in a joint venture and leases back its assets
from the subsidiary that has purchased the asset, this is shown as an investment in an
associated company. If,
 The parent company is the lead partner and exerts a dominant role, or
 Can take back its asset under beneficial terms (not full market value), or
 There is an unequal share of profits, losses, dividends and or loan guarantees,
Then the parent company must register the company as a subsidiary under FRS 5
because in all the scenarios, the parent company has control.

Consignment Inventories - Here the parent company sends the subsidiary goods for
sale but does not charge for them until they are sold. The subsidiary needs neither
show the goods as an asset or a debt.
FRS 5 requires that
 When the goods can be returned without penalty, they need not be recorded as an
asset
 When the goods must ultimately be paid for, they must be recorded as an asset.

Sale and Repurchase Agreements - here the company sells part of its assets that
never leaves its control and buys them back at a later date plus interest. This is a loan
and should be shown as such in the balance sheet with the accrued interest being
entered in the P&L account.

Debt Factoring - debt can be sold to factoring houses to improve cash flow. If the
factor has no right of recourse on the selling company should they be unable to
collect the debt then this is a straightforward sale of debt.
If the factor has s right of recourse then, FRS5 require the parent company keeps a
proportion on the balance sheet.
The prudent approach is to keep the full amount on and show the factored debt as a
cash loan. When the debt is recovered and the liability ceases, the debt is removed
and any shortfall (the difference between the debt and the a=mount paid by the factor)
is recorded in the P&L.

Accounting for Acquisitions and Mergers

Acquisition - this is where one company takes over another buy purchasing more
than 50% of the shares. If the predator raises its share capital to purchase the other
company, the difference between the par value and the share price goes into the Share
Premium Account.
Anything paid over the Net Asset value for the company is Goodwill and will show
on the consolidated balance sheet.

Mergers presume agreement and goodwill will not feature as both companies are
joining in mutual agreement. FRS6 sets out the guidelines for mergers -
1. Neither party should be seen to be acquiring the other
2. Neither part should dominated the management of the combined entity
3. Each should be of comparative size that neither dominates because of its size
4. Each of the parties receives equal share in the new entity
5. No equity shareholders retain any material interest in only one of the combined
company

Goodwill

Goodwill is the excess over the book value that a company is prepared to pay for
another.
It is an intangible asset and has to be accounted for by either
1. Writing off the purchased goodwill at the moment of acquisition again the group
reserves; or
2. Capitalise the amount paid as an asset and amortise (depreciate) the asset over its
useful economic life.

The first method reduces the overall value of the group and has a negative effect on
the shareholders stake in the combined company.

The second method requires that the asset is written off over the lower of its
economic use and 20 years. To go beyond this period it must be demonstrated that
there is good economic reason and in any event, the period must not exceed 40 years.

The period of amortisation must be subject to an impairment test. This is a detailed

consideration of the inherent value of the goodwill. If there is no value then it must
be written off.

Brands

Brands are the name of consumer products which, because they are so well known,
can be seen as having value to the companies that own them.

The construction of brands value on the balance sheet can have the following effects
fro a company
 The brand value on the balance sheet raise the overall value of the company and
can ward off predators
 The added value can drive up the share price making their shares more attractive
when issuing shares for another company.
 It raises the overall value of total assets. This allows the gearing to change and
increases the owners equity
 Brands are a component of goodwill and can be taken from this figure and
capitalised separately on the balance sheet. This lessens the impact on reserves or
profits as the goodwill is written off.

Brands are valued at historic cost or Earnings Method

Historic Cost - all the money spent on developing and maintaining the brand are
capitalised. R&D and marketing costs which have previously been written off are
written back into the value of the brand.
Earnings Method - Management attribute the actual earnings of the company to
specific brands and then apply a multiplier which reflects the brand strength. This the
guess upon guess method.

Operating and Financial Review

Environmental Reporting

MODULE 9

COST CHARACTERISTICS AND BEHAVIOUR

Variable and Fixed Costs -

Variable costs are those which vary directly with the level of output i.e. materials,
direct labour.
Fixed costs are those that remain constant regardless of output i.e. managerial
salaries, rent rates etc.
*Whilst fixed costs remain constant regardless of output, the amount of fixed costs
per unit produced varies with output*

Direct and Indirect Costs -

Direct costs are those that can be traced in full to the item produced i.e. material and
direct labour. This is also known as the Prime Cost
Indirect costs are those that cannot be directly attributed to the item produce and
include such items as supervisors wages, cleaning materials and rent- these are
support costs which if not incurred the item could not be produced.

Traceable and Common Costs

Traceable costs are those costs that can be directly traced into the item being
produced. Common costs are those costs that are indirect and incurred to support the
business

Period and Product Costs

Period costs are those costs that are incurred in support of the production but are
accounted for in time periods such as some types of inventory that cannot be
accurately measured per item produced - Foundry sand
Product costs are those that can be directly attached to the product.

Controllable and Non Controllable Costs

Controllable costs are those that the manager has direct control over such as overtime.
Non-controllable costs are those that the manger has no control over such as the share
of rent apportioned to his unit or the interest rates charged by banks on loans.

Standard and Actual Costs

Standard cost is the benchmark cost for the item, the expected cost.
Actual cost is the cost to manufacture, which is measured period by period.

Engineered and Discretionary Costs

Engineered costs are those that must be incurred in the production of the item such as
machining costs.
Discretionary costs are those, which must be accounted for but need not be included
in all time periods or all items produced. These include R&D admin and machine
maintenance.

Break Even Analysis

On a graph, it is the point where the Sales revenue line crosses the Total costs line.
Profit is the difference between the Sales revenue and the total costs. * Remembering
that in plotting the graph, total costs start at the point of fixed costs.

Profit / value ratio - this measures the impact of volume on profit. It is also the
method of measuring contribution to fixed costs.
P/V ratio = Profit/Sales Price (Sales Price - variable costs / Sales Price)

Calculating the Break Even Point in Sales

Sales = Fixed Costs + Variable Costs + Profit
Break Even Sales = Fixed Costs + Variable Costs

Calculating the Break Even Point in output

Contribution Margin = Sales Revenue - Variable costs
BEP = Fixed Costs/ Contribution Margin Ratio (see above P/V ratio)

Break Even Analysis and the Multi Product Firm

In this scenario, the contribution margin ratio is calculated by weighting the 2
products and using the above formula to get the ratio

MODULE 10

ALLOCATING COSTS TO JOBS AND PROCESS

Plant wide versus Departmental Rates

Plant wide overheads come from both manufacturing - screws, maintenance factory
lighting and heating etc.; non manufacturing overheads come from all the ancillary
tasks such as administration.
These overheads are gathered into cost centres and then totalled. This is then divided
by the number of units to be produced to give the overhead allocation per unit
produced. If the actual overheads incurred are more than that budgeted for then the
shortfall is charged to the profit and loss account.

Departmental overheads reflect the products actual use of each department and takes
an share of the overhead.

The Direct Method

The service departments overheads are emptied into each of the production
departments based on an appropriate activity i.e. Personnel’s overhead dumped into
each of the production departments by apportioning the share by the number of
employees in the department divided by the total number of employees in production.
This figure is then divided by an appropriate activity base for production i.e. the
number of machine hours to be used in the year to give a pre determined overhead
rate. Every product that passes through each of the production departments will be
allocated their overhead rate.

The Step Method

This works in a similar manner to the Direct Method however, recognises that not
only do the production departments use the services of the service departments but so
to do the service departments themselves.
The sequence used is either to select the service department with the largest overhead
and allocated in descending order or; select the service department that renders the
highest percentage of services to other service departments and end with the lowest.

Remember - when allocating the costs, ignore the consumption of its own resources
i.e. for personnel, the total number of employees does not include their staff; and
when the departments overheads have been reallocated, they are closed down.

Joint Products and By-Products

A Joint Product is one that is produced alongside the intended and is planned for -
Aircraft fuel and petrol.
A By Product is one which emerges from a process designed to produce another
product - woodchips from a wood yard. There is no production overhead for this
product as it has not been a planned production. If sold, is additional revenue that can
be deducted from the cost of sales and improve the gross profit margin.
Any unsold by product would have no value as inventory.

The problem is how to allocate costs to the Joint products.

Equal Shares - each product takes an equal proportion of the overhead costs

Physical Characteristics - the overhead is apportioned according to some physical

characteristic such as weight or volume

Sales Value at Split Off - the overhead is apportioned according to the sales value
for each product.

Ultimate Net Sales Value - if the products are processed further, after the additional
process costs are taken from the new sales value leaving the ultimate net sales value.
This in turn is divided by the total for the products and multiplied by the original
production costs to provide individual production costs.

Process Costing

This is the method of costing items that are continually produced and cannot be
costed as an individual item such as paint, oil etc..
Process Costing and the Equivalent Unit

An equivalent unit is an assessment of the degree of completion of a unit under each

major component of cost. How many units have been completed in the cost of
materials and how many have been completed in the cost of Labour/conversion.
1. Opening work in progress has to be finished and this is the material and work
required to finish the Opening work in progress
2. The volume of units delivered during the period has the number of units
unfinished deducted from it to give the number of units started and completed.
3. Closing work in progress has to be finished and this is the material and work used
to get them to the stage of completion at the end of the period.
4. The three are totalled for Material and Labour/conversion costs and this gives the
Equivalent Units of Production.

Cost per Equivalent Unit

This converts the volume of goods to cost of goods through the process.
1. Complete the Equivalent Units statement
2. Total the Costs to be accounted for - Value of opening work in progress and the
costs incurred during the year.
3. The Costs to be accounted for is the divided by the Equivalent Units of
Production to give the cost per equivalent unit, which are added together to give
the Total cost per equivalent unit.
4. The individual cost per equivalent unit is multiplied by the Opening work in
progress, Units started and completed and Closing work min progress; these are
then added up and down and across.
5. The totals across give the Value of Units shipped out and closing inventory
(closing work in progress).

Activity Based Costing

ABC focuses on the activities that cause the overhead costs rather than the products.
The product consumes a percentage of the activities of departments and these
activities cause the costs to be incurred. Rather than each product share the cost of
the activities, the product cost should reflect the proportion of these activity costs it
incurs.

Advantages -
1. Cost of product becomes the principal goal and is not subservient to inventory
valuation.
2. Different activities have different cost drivers i.e. costs fall on the product that
consumes the cost driver.
3. ABC covers all activities - not only in the production process but also the design
as some products incur more design (driver) than others.
4. Allows products to be loaded with the costs they incur reflecting their true cost
5. Provides accurate product costs which may lead to strategic planning of products.

Methodology -
1. Identify the cost drivers from the information available - this is the total cost of an
 area of the manufacture process from design to shipping.
2. Calculate the cost for each driver - this is the total cost incurred by the department
divided by the total amount of it’s uses i.e. machine hours, to give the cost driver.
3. Divide the individual usage of the product per driver by the total output per
product then multiply this by the total cost for the driver (from 2 above).
4. Carry this out for all cost drivers and products.
5. Add the cost of material, labour and each cost driver for each product to give the
total cost per product.

MODULE 11

COSTS FOR DECISION MAKING

The Dilemma of the Denominator

Here the problem of the numerator and denominator is what figure to use to calculate
the cost of the product is it the budgeted or actual manufacturing (or non
manufacturing ) overhead that is divided by the budgeted or actual output to give the
cost of the product.

The numerator - the cost of overhead can be determined more easily as prices tend
not to fluctuate over short periods and can be predicted if costs are subject to contract
(the price you buy in your goods at).

The denominator can fluctuate from month to month as you cannot guarantee to
produce the same amount every month or sell the goods produced. Downtime can
result in shortfalls of production.

Absorption or Full Costing -

Each product has the fixed production cost absorbed into its overall cost. If the
product is over produced then there is said to have been a over absorption of the fixed
production costs by each unit (more units mean that the fixed cost per unit is
reduced). This variance in the denominator (number produced) has to be accounted
for and is done so by deducting the variance from the other expenses in the P&L
Account.

The extra products are put into the inventory. Each is valued at the full cost of
production

If, in the next period production is less to account for the over production and the
goods produced plus the goods in inventory are sold, the variance is added back to the
expenses in the P&L account thus reducing the profit.

Variable Costing
Fixed production costs are not added to the individual product but deducted from the
gross profit in the P&L account after sales at the end of the period under review. The
goods sold after the variable cost of sales is deducted, are said to leave a Contribution
Margin (to fixed and other costs).

From the Contribution Margin, fixed and other expenses are deducted to leave a
profit.

If there is an over production, these goods are put into inventory at the cost of
production without a share of fixed production costs.

If in the next period there is an under production and the goods are removed from
inventory for sale, then the total sales less Variable costs gives the contribution to
fixed and other costs which is again deducted to give the profit.

Managerial Implications of Abortion and Variable Costing

This is often not a choice for managers but decided by fiscal policy. As absorption
costing has a higher inventory cost and therefore gives higher profits (which are
taxable) then this has to be the method used.
Absorption costing influences bottom line profit. Profit is influenced not only by
sales but by production because any over production adds to inventory as more fixed
costs are parked in inventory.
Cash however stored in inventory does not replenish stocks for production and when
inventory is used because sales exceed production, profits fall as the variance has to
be taken account of.

Variable costing on the other hand is sales driven, when sales rise, so do profits.

Developing an Analytical Framework

Non routine decisions re best approached in a analytical manner using a framework

1. Define the problem and list all feasible alternatives.

2. Cost the Alternatives - the relevant costs are those that differ between the
alternatives under review - these should be listed
3. Assess the Qualitative Factors - not always the bottom line remember staff and
 social implications
4. Make the Decision

Opportunity Costs

This is the opportunity forgone and it may be possible to identify costs for not
choosing the alternative that may be relevant in the decision making process. These
are costs that if incurred would afford the opportunity to undertake other work which
may prove profitable also.

Department versus Company

Cost decisions must take into account the effect on the company as a whole not just
the department concerned.

Sunk Costs

Costs which have been incurred are Sunk Costs and should not be taken into account
looking for relevant costs. These costs have to be written off, the only Relevant costs
are future costs and involve cash spent or cash saved.

Management Decisions in a Action

Relevant costs are -

 Future costs - because old costs cannot influence decisions
 Cash costs - because these effect the cash flow and the real money implications of
a decision.
 Avoidable costs - costs that differ among alternatives. If a cost is unavoidable it
is not relevant for the decision under review because it will be incurred whatever
option is selected. Only those costs that would not be incurred if another option is
selected should be taken into account
 Costs which differ among alternatives - is another way of looking at avoidable
costs. If the same cost is incurred in all options, ignore it as it causes confusion.

Closing Down a Unit

When faced with the alternative of closing a plant either temporarily or permanently,
the following must be considered before coming to the decision -
1. How long should the shut down be permanent or temporary
2. Does the plant contribute to fixed costs
3. What are the costs associated with closure

The Special Sales Order

It is important to establish the variable cost of production for the special sales order.
The other costs not incurred such as Selling and Administration that are not incurred
must not be included in the cost of production. The figure attained for the variable
cost is deducted from the revenue the order generates to give the contribution to fixed
costs.

A full cost of production is necessary for long term costing as all fixed and variable
costs must be recovered and this is accounted for by using the absorption method.

Further Processing

The incremental approach must be used to calculate if further processing is cost

effective. This is done by subtracting incremental costs from incremental revenue.

MODULE 12

BUDGETING

Why Bother with Budgets?

Co ordination - of the various departments. Everyone has to focus on working

towards a common and agreed goal that is attainable within budgetary constraints.

Planning - ensures that there is adequate resources and that all departments are
utilising those resources in a cost efficient manner within the agreed budget.

Motivation - Once agreed and broken down into departments, it acts as a target for
everyone to aim for.

Control - allows managerial control over departments by providing a benchmark for

departmental managers to achieve.

The budget is an action plan over an agreed time frame

Why Budgeting gets a Bad Name!

Time Taken - because of the process budgeting must go through several departments
and drafts before it is finally agreed. This can result in it being out of date and not
what the department manager originally proposed.

Lack of Top Management Commitment - the corporate expense account and senior
management social functions that are extravagant are resented by department
managers who are under pressure to work within limited budgets and resent this
spending.

Punishment - managers often see reductions in their budget as control methods only,
used to minimise resources whilst expecting to maintain or increased productivity.
This can be alleviated by consultation to establish the needs of a department before
any reduction in budget.

Responsibilities are Blurred - a departmental manager should be responsible for

costs in his or her own area. Shares of corporate expenditure or R & D over which he
has no control should come from a central budget with a person responsible for the
budget.

Moving Goalposts - when there is a major change in circumstances over which the
budget holder has no control, the plan can fail. The budget holder should not be held
responsible and the company should
1. Stick with the original budget but report the variance between the planned and
actual budget. This variance is removed from the figure and only any variance
over which the manager has control should be used to assess performance (see
Module 13)
2. Implement a rolling budget whereby as each month expires, anther is added 12
months on.

Budgeting Rewards Inefficiency - budgets should not be increased by a blanket

percentage each term as inefficient departments get an increase on their inefficient
processes. Instead, departments whose costs are not engineered but are discretionary,
should produce detailed bids for their increase.

Budgeting in Action

From the reports submitted by each department, prepare a Sales Budget for the year
by quarters
1. Multiply the Turnover by Price to obtain the Recorded Sales
2. Add the cash inflow from the previous period to the cash collected this period

This provides the quarter and annual sales, the cash collected each quarter and for the
year and the debtors.

The Production Budget is then created. From the reports submitted -

1. Add the planned inventory for each quarter to the planned number of units to be
sold
2. From this total, take away the previous quarters inventory (found in the balance
sheet) to give the total number of units to be produced each quarter and in total.

The Direct Materials Budget can now be created as we know the number of units to
be produced.
1. Multiply the units required each quarter by the amount of material required in
each unit.
2. Multiply this by the cost of the material per quarter to give the total cost of
materials consumed.
3. Subtract the planned inventory of materials per quarter and the total cost of
materials purchased is given

The Cash Outflow Budget can now be constructed.

1. The cost of materials purchased per quarter is divided into the amount to be paid
to creditors each quarter
2. This first figure is then subtracted from the creditors at the end of the last
financial period to give the cash outflow for the first quarter
3. The balance of the quarters outgoings is added to the amount calculated for the
next quarter and so on for the year to give the total cash outflow per quarter

The Direct Labour budget can then be constructed.

1. The units required to be produced is multiplied by the hours to produce each unit
to give the total number of labour hours
2. This figure is then multiplied by the cost per hour to give the total cost of direct
labour

The Manufacturing Overhead Budget can now be constructed -

1. The total cost of direct labour is multiplied by the Absorption Rate for Variable
Overhead (this is found in the production report and this either the variable
overhead rate multiplied by the number of planned units in closing inventory or;
as in the module, the variable rate is divided by the labour rate to give the cost per
hour for variable overheads). This gives the total Variable Overhead.
2. The fixed overhead is then added to this figure
3. And the depreciation is subtracted to give the final figure for Manufacturing

The Selling and Administration Budget can now be created. Total sales is found from
previous calculations for each quarter and headed at the top of the table -
1. The Selling and Administration variable costs are added (this is the planned
increase in expenditure) to R & D costs
2. Fixed costs - salaries, consumables and advertising are then added to give the total
cost of Selling and administration.
This total at the bottom of the column gives an indication of the costs incurred in
selling and administration by sales.

The Closing Inventory Budget is then calculated.

1. The direct material required in inventory for each quarter is found from previous
calculations and multiplied by the cost
2. The number of finished goods kept in inventory is found for each quarter and
multiplied by the variable cost per unit
Inventory is valued at the lower of - cost to produce or market value. If to is market
value and the market price drops, the difference must be written off in the P & L
account

The Cash Budget or Cash Flow Statement for the year can now be calculated -
1. The cash generated from Sales for the quarter is added to the opening balance
from the previous period to give the cash inflow
2. The cost of Direct materials, Direct Labour, Manufacturing then Overhead Selling
and Administration overhead is all deducted to give the closing balance for the
period.

The Budgeted Profit and Loss Statement can now be calculated -

1. Starting with Sales Unit’s the sales revenue has the variable cost of Sales
Manufacturing deducted
2. The Selling and administration costs are deducted to give the Contribution Margin
3. Fixed cost of sales - Manufacturing and Selling and Administration - are then
deducted from the Contribution margin to give the profit (or loss) before tax.

The Budgeted Balance Sheet can now be constructed -

1. Starting with Plant and equipment, accumulated depreciation is deducted
2. Inventory - raw materials and finished goods are added
3. Debtors are added
4. Cash in hand is added (or subtracted if a negative balance)
This gives the Total assets for the company
1. Ordinary Shares value has the retained earnings and creditors added to give the
Total equity and Liabilities

Discretionary Expenditure and Zero Based Budgeting

Engineered costs are those that are directly associated with the production of the
goods. Discretionary costs are those costs that do not need to be incurred but those
such as R & D, marketing legal services etc..

These costs are difficult to account for and control as they are incurred over several
accounting periods.

Accounting for these costs is ZBB. This allows senior management the opportunity
to identify an amount available for discretionary spending and have the non
production departments present bids for same.

These bids are then scrutinised by senior managers who decide as to where the money
is spent in keeping with the companies objectives.
 MODULE 13

STANDARD COSTING

Standards are set from the following -

 Normal or Operating Standard - those that could be expected to be achieved if

every thing went efficiently and taking into account that things can go wrong
 Materials Standard - Quantity, quality and price agreed for materials
 Labour usage and price standards - Engineering study to ascertain how long it
takes to produce the goods and the cost and quality of labour
 Overhead Standard - both variable and fixed overheads depend on 3 components
1. Budgeted cost of each overhead
2. The allocation key used to allocate the overhead to the product
3. The volume expected of each allocation key to be used

Flexible Budgets

Where actual production does not match budgeted production, a flexible budget is
constructed to compare the variance with the actual budget.
Here the flexible budget is the cost to produce the actual amount produced using the
budgeted figures. The actual costs incurred are subtracted from the flexible budget to
give the variance.
This figure will show the amount of over or under spend incurred and can be
investigated further.
Variances: Materials and Labour

Material costs can be more or less than budgeted for only 2 reasons -
1. Material Efficiency Variance - Actual production used more or less than planned
and/or
2. Material Price Variance - The purchase price of the material was more or less
than budgeted for.

This can be analysed -

Material Efficiency Variance = (Standard Quantity - Actual Quantity) X Standard

Price per unit = (SQ - AQ)SP

Material Price Variance = (Standard Price per Unit - Actual Price per Unit) X Actual
quantity Used = (SP - AP)AQ

If the resultant figure is negative then the variance is adverse (cost above standard)
with positive favourable. The total material variance is found by subtracting the MP
from the MV.

Once the variances have been found they have to be explained (qualified)

Labour Cost variances are caused by only 2 reasons -

1. Labour Efficiency Variance - Actual production requiring more or less time than
planned
2. Labour Price Variance - Actual rates paid were more or less than planned.

Labour Efficiency Variance = (Standard Time Allowed - Actual time taken ) X

Standard rate per hour = (ST - AT)SR

Labour Price Variance = (Standard Rate per Hour - Actual Rate per Hour) X Actual
Time Taken = (SR - AR)AT

If the resultant figure is negative then the variance is adverse (cost above standard)
with positive favourable. The Total Labour Variance is found by subtracting the LP
from the LV.

Once the variances have been found they have to be investigated and explained
(qualified). It is important to remember when calculating variances to remember to
use figures (costs) that reflect the managers responsibility.

Efficiency Variance measures the financial impact by using more or less material or
labour to produce the goods. Hence the reason that a standard price is used to
calculate the variance.
Price Variance measures the change in price in relation to the actual quantity used.
Hence the Actual quantity is the multiplier.

Variable and Fixed Overhead Analysis

Variable overheads - those that vary with the rate of production - can be subjected to
variance analysis to examine the difference between actual overhead and how much
should have been incurred based on the allocation key (allocation rate).

How much overhead should have been incurred?

The Standard Cost of the variable overhead is found by multiplying the number of
goods produced by the number of hours required to produce the good and the
allocated overhead rate (allocation key - the rate per hour overhead is applied).

This figure then has the Actual Cost of the variable overhead subtracted from it.

As an allocation key (direct labour hours) has been used to apply variable overheads,
the Efficiency and Price (or Spending Variance can be analysed further -

Efficiency Variance = Standard Cost of flexible budget time allowance for units
produced (number of goods produced X hours to produce X overhead rate) minus
Standard cost of actual time taken to produce units

Fixed Overheads are budgeted based on planned production over the year and
allocated using the allocation key chosen i.e. direct labour hours. When the budgeted
overhead does not match the actual overhead, ten this must be investigated.

The actual overhead incurred is subtracted from the budgeted overhead to give the
Spending Variance. This must be investigated further to establish where the
overheads have been incurred. It ignores the fact that more fixed overheads have
been applied to the product than were budgeted for - unless the overheads themselves
have increased, the increase is due to the fact that more products have been produced
and the cost has included the fixed pre determined overhead rate for the planned
production volume.

To calculate the variance, the overhead rate applied to the units produced is
subtracted from the budgeted fixed overhead. A negative figure (actual overhead is
greater than budgeted because output is greater), is seen to be favourable as output is
greater than planned.

Carry out the exercises in the Module.

Sales Variances

Sales variances show the effect of sales mix and volume to the contribution margin
when it deviates from the budgeted plan. The total contribution earned from sales
depends on the contribution per unit and the volume of the unit sold.

Contribution Variance = Difference in contribution margin (actual - planned)

multiplied by Actual Sales in units.

The Lower price goods variance is subtracted from the higher to give the actual
variance.
Volume Variance = (Actual Sales - Budgeted Sales) X Budgeted Contributing
Margin per Unit. Again the lower priced item is subtracted from the higher to give
the variance.

By comparing the Contribution and the Volume Variance, the manager can assess
which has had the greater effect on contribution margins.

It is possible to take this further by investigating the Sales Volume Variance (how
many goods have been sold compared to those budgeted) and the Sales Mix Variance .

Sales Quantity Variance = (Actual Sales - budgeted sales) X Budgeted weighted

average contribution margin per unit. Again the lower is subtracted from the higher.
This treats all goods sold as equals and shows the effect of an overall increase or
decrease in sales on the contribution margin.

Sales Mix Variance = (Actual Sales - budgeted sales) X (Budgeted contribution

margin per unit - weighted average contribution margin per unit). Again the lower is
subtracted from the higher.

By subtracting the Sales Mix Variance from the Sales Quantity you can check that it
matches that figure achieved from the earlier calculations.
 MODULE 14

ACCOUNTING FOR DIVISIONS

Divisions - Advantages

 Specialisation - dedicated areas or departments where skills are harnessed to the

particular problem or job
 Size - scale of an organisation allows local management to react to local problems
with their knowledge which does not come from the centre
 Motivation - working away from the centre permits decisions to be made locally
giving autonomy and a sense of control of ones destiny
 Sharper decisions - these are made locally at the time, not going to the centre by
way of report for a decision before coming back down
 Career mobility - skills can be learned within the division that can be taken to
other parts of the organisation particularly management.

Disadvantages

 Lack of Control - the division must have control of its day to day management.
It may also have some strategic control which might not be in keeping with the
organisation as a whole but more with bettering the division and its profitability
 Cost - the division may incur other costs such as R & D or HR these may be
available at head office and duplicate the work being done there
 Internal Rivalries - any performance measurement system may result in the
division looking for cheaper suppliers out with the organisation to better its profit
margin but to the detriment of the organisation as a whole

Types of Divisions
1. Cost Centres - are only responsible for the incurrence of costs and have nothing
to do with the manufacturing process and generation of revenue - auditing office
or further processing plant
2. Revenue Centres - are only responsible for the generation of funds without any
responsibility for the underlying costs of the or how they are made up - ticket
sales offices
3. Profit Centres - are assessed on profit, that costs are matched by sales
4. Investment Centres - where net assets are taken into account when evaluating
performance. This allows not only profitability to be assessed but the use of
assets also. This is found by establishing what is the Return on Investment
(assets) i.e. what percentage of assets is the profit returned = Profit / Assets X 100

Defining Profit and Investment - only those revenues costs and net assets over
which the manger has control should he be held accountable for and should be
included in the calculations.

Asset Base Valuation - as plant etc is subject to depreciation, so the value of the net
assets fall every year. If profit remains the same then the ROI will show an increase
each year. This is in fact a false increase but may inhibit managers from replacing
assets.

Residual Income - a company will charge each division interest on its invested
capital, at the rate of interest being the companies cost of capital. Profit must exceed
the R.I. Investment decisions that offer a return that exceeds the companies imputed
(assigned) rate.

1. Controllable profit is divided by Investment in net assets and multiplied by 100 to

give the R.O.I.
2. The R.I. is calculated by establishing the return on Investment in net assets from
the imputed rate (Net assets X Imputed rate)
3. This figure is subtracted from the controllable profit to give the R.I.

R.I. Allows management to look at investment opportunities to ascertain if they

exceed the return of imputed rate of interest -

1. The cost of the investment opportunity is added to the net assets and the
anticipated profit to the profit.
2. The R.O.I. Is calculated before and after the additions to compare the ROI
3. The R.I. Before investment is calculated
4. The R.I. after the investment is calculated
5. This gives a monetary value as to the R.I. that can be compared to establish if the
investment will generate more profit.

The ROI allows the organisation to ascertain the effective use of assets by the
division. The RI allows the use of the assets to be compared to other divisions and to
establish the viability of investment opportunities.

Criteria for Establishing a Transfer Pricing

 Market Price - where the price on the market is competitive for a good of
comparable quality
 Cost Based Price -
Full cost - fixed and variable costs though this may cause problems if the
receiving department had to drop its fixed costs for a special sale, then why
should the preceding department have its full costs covered?
Variable Cost - here the receiving department pays only the variable cost for
the product and can sell it on adding its full costs but is this fair?

 Negotiated Cost - fight it out and decide a price

The International Dimension

Taxation - this varies from country to country and can effect the profit of a division
as it pays tax for the country where it is based. Where one country has markedly
lower tax rates than another, and the company wishes to minimise tax paid, it can sell
products to the country in the high taxation country at over inflated prices. This has
the effect of increasing profit in the low tax paying country and maximising profit
after taxes. In the other country, it has the opposite effect, high price of goods bought
in reduces profit and lowers tax liability.

When the department in the country with high tax rate is transferring the goods to the
country with the low tax rate; it sells them at a low transfer price. This reduces the
earnings from sales and so tax paid is lower. The receiving country with the low tax
rate has a low cost of goods bought in, profit from sales is maximised and tax paid is
lower.
 MODULE 15

INVESTMENT DECISIONS

The Investment Process

 Search - finding suitable alternatives to invest in

 Evaluation - the process of deciding which option is the most economically
viable
 Control - normal financial budgetary procedures to establish that the project is
within budget - both capital and cash flow

Concept of Present Value

A sum of money toady, invested in a bank at an interest rate will have a value of the
sum plus interest for the term that it received the interest. By calculating the return,
we can ascertain what this future value will be and technically spend the return today,
invest the money in and the interest covers the spend today.

Net Present Value

NPV > 0 - The rate of return is greater than the cost of financing the project - accept
NPV < 0 - The rate of return is less than 0, the cost of financing is less than the cost
of the project - reject
NPV = 0 - The rate of return is the same as the cost of financing the project -
reconsider

The amount to be invested will offer a return on the investment. If this is greater than
a zero return, we could borrow the total amount (investment + interest accrued),
spend it and invest the original sum to cover the cost.

Discounted Cash Flow Rate of Return (Internal Rate of Return)

This calculates the interest rate at which a project will break even - what return would
we need to get to cover the cost of borrowing.

DCF RR > Cost of capital: accept the project

DCF RR < Cost of capital: reject the project
DCF RR = Cost of capital: reconsider as this is the breakeven point

By calculating the DCF RR we can see what interest rate the project is returning.
This has to be greater than the cost of the borrowing over the period involved.

NPV gives a return as a cash value whilst DCF RR gives the return as a percentage.
When comparing 2 projects it is important to remember the scale involved and then
analyse the projects. This is done by establishing the difference between the 2
projects and calculating the NPV and DC RR.

The difference has to be appraised, the higher costing and returning project will
provide all that the lower provides plus the difference (at a cost of the difference
also). The difference on the investment can be calculated for the NPV and DCF RR.
The NPV when calculated is subtracted from the NPV of the lower project to
ascertain how much more if any, the higher project returns. The DCF RR shows the
rate of return if the investments were the same level.

Risk

The evaluation of risk has many models however all require judgement of
management. The 2 covered for the course are -

 Do no further analysis as all estimates are prepared on the best information

available. Management then has to make its decision based on the relevant
evidence.
 Apply the ‘high hurdle’ approach where projects are graded high medium and low
risk. The higher risk projects have to have a higher rate of target return.

Pay Off or Payback Period

This is the time taken to recover the original investment - when we get our money
back.

In its simplest form, the initial investment has the cash flow added cumulatively. The
interest can be deducted from the cash flow using the Present Value table to give an
accurate cash flow.

The risk can be classified in terms of the length of the payback period and should be
used in conjunction with the DCF RR and PV.

Sensitivity Analysis

This looks at varying the factors in the investment such as varying the cash flow by a
positive and negative amount to see the effect on the overall return. All the variables
can be altered in some way and it is important that they all are not varied as the
original project can become obscured.

Risk Analysis

This is getting a range of values that are likely to occur for some variable such as the
selling price. These are given a probability, multiplied by the selling price to give an
expected value. The values are added to give a most likely value

Key Investment Factors

1. Capital Investment - is the total amount of fixed (the loan) and working capital
(on going costs both outgoing and incoming) required for the project. It is critical
that the timing of cash flow requirements are correct as delays in completion of
the project, delay any income to be generated and put the projected budget off
course.
2. Operating Cash Flow - this is the cash generate from the project and its cash
outflows. It is not depreciation but must include tax and associated cash
expenses.
3. Investment Life - the determinants are
 Wear and tear
 Technical obsolescence
 Market - the product is no longer in demand
4. Cost of Capital - NPV / DCF RR

Projected Average Cost of Capital

1. Fixed Interest Loan - cost of the loan or debenture plus the cost of servicing the
loan or debenture plus tax.
2. Fixed Interest Dividend Shares - preference shares . The cost of is the net interest
payable plus an allowance for raising the shares plus tax.
3. Residual equity Shares - a new issue of ordinary shares. The dividend will that
determined by the board, however there will be an assigned rate of return that the
company must seek to achieve.
4. Retained Earnings - profits

The average cost of capital is calculated by proportioning the sources of finance to

get an estimated cost for each source. These are added to give the average cost of
financing the capital.

Opportunity Cost, Risk and the Cost of Capital - is applied when a company
decides that irrespective of what it costs to raise capital, they should only be used
internally if the return is at least as good as that which could be achieved if the funds
were invested out with the company.
 MODULE 16

NEW DEVELOPMENTS IN MANAGEMENT ACCOUNTING

Target Costing - the product is costed at a price the market will accept and costs to
manufacture are adjusted accordingly.

Life Cycle Costing - the cost of the product includes all costs that will be incurred in
the life of the product such as development, support the production of spare parts
after the product is no longer being produced etc..

Throughput Accounting - takes into account the rate at which cash is generated and
measures the performance.
 Depreciation and similar costs that are fixed should be excluded from measuring
performance.
 Inventory is not a measure of performance it is a cost
 Volume of sales not contribution to fixed costs generates more cash for the
company. Through put should identify a bottleneck and calculate using ratio
analysis to establish which product earns money. This is carried out by
calculating-
1. Return per Factory hour = (sales Price - Material cost) / Time spent at bottleneck
2. Cost per Factory Hour = Total factory Cost / Total Time Available at the
Bottleneck
3. Throughput Accounting Ratio = Return per Factory hour / Cost per Factory Hour

If it is greater than 1 then the product earns money.

Costing for Competitive Advantage

1. Production Facilities - capacity and ability to meet specification

2. Labour skills
3. Sourcing of Supplies
4. Introduction of TQM, JIT
5. Outsourcing
6. Suppliers limitations