Accounting Academic Leveling Course

Course Sections and Subsections

1. Financial Statement Analysis
a. Basic Analytical Procedures
b. Solvency Analysis
c. Profitability Analysis
d. Summary of Analytical Measures
e. Corporate Annual Reports
2. Capital Investment Analysis
a. Nature of Capital Investment Analysis
b. Methods of Evaluating Capital Investment Proposals
c. Factors That Complicate Capital Investment Analysis
d. Capital Rationing
3. Basic Accounting Concepts
a. Elements of an Accounting System
b. Recording a Corporation’s First Period of Operations
c. Financial Statements for a Corporation’s First Period of Operations
d. Recording a Corporation’s Second Period of Operations
e. Financial Statements for a Corporation’s Second Period of
Operations
4. Sarbanes-Oxley, Internal Control, and Cash
a. Sarbanes-Oxley Act of 2002
b. Internal Control
c. Cash Controls over Receipts and Payments
d. Bank Accounts
e. Bank Reconciliation
f. Special-Purpose Cash Funds
g. Reporting Cash on Financial Statements
5. Budgeting and Standard Cost Systems
a. Nature and Objectives of Budgeting
b. Master Budget
c. Standards
d. Budgetary Performance Evaluation
e. Variance from Standards
f. Standards for Nonmanufacturing Expenses
g. Nonfinancial Performance Measures
Learning Outcomes
At the conclusion of this course, students will be able to:
1. Describe basic financial statement analytical procedures.
2. Apply financial statement analysis to assess the solvency of a
business.
3. Apply financial statement analysis to assess the profitability of a
business.
4. Summarize the uses and limitations of analytical measures.
5. Describe the contents of corporate annual reports.
6. Explain the nature and importance of capital investment analysis.
7. Evaluate capital investment proposals using the following methods:
average rate of return, cash payback, net present value, and internal
rate of return.
8. Describe factors that complicate capital investment analysis.
9. Explain the capital rationing process.
10. Describe the basic elements of a financial accounting system.
11. Summarize transactions for a corporation’s first period of operations.
12. Summarize transactions for a corporation’s second period of
operations.
13. Describe the Sarbanes-Oxley Act of 2002 and its impact on internal
controls and financial reporting.
14. Explain the objectives and elements of internal control.
15. Explain the use of a bank reconciliation in controlling cash.
16. Describe the nature and objectives of budgeting.
17. Describe the master budget for a manufacturing business.
18. Explain how standards are used in budgeting.
19. Interpret the basic variances for direct materials and direct labor.
20. Describe examples of nonfinancial performance measures.
Section 1 Financial Statement Analysis
Financial Investments
Assume Apple Inc.’s common stock is trading at $125 per share. If you had funds to invest, would you
invest in Apple common stock? Apple is a well-known company. However, some other well-known
companies, including United Airlines, Kmart, Polaroid, and Planet Hollywood, share the common
characteristic of having once declared bankruptcy!

Obviously, being well known is not necessarily a sufficient basis for an investment decision. Knowledge
that a company has a good product, by itself, may also be an inadequate basis for investing in the
company. Even with a good product, inadequate financing and a variety of other reasons could cause a
company to be unprofitable or even go bankrupt.

How, then, does one decide upon companies in which to invest? Investors can improve decision making
by considering, understanding, and analyzing financial data and other information included in financial
statements and corporate reports.

The basic financial statements provide information that is useful for making investment and other
economic decisions about businesses. Investors can use analytical procedures to examine relations
between items included with a single company’s financial statements. Analytical procedures are also
widely used to examine financial statement information across time and across companies. Common
analytical measures are not ends in themselves, but tools for evaluating financial and operating data.
Many other factors, such as industry trends and general economic conditions, can play important roles
in making investment decisions.

Basic Analytical Procedures: Horizontal Analysis

Although financial statement line items can be analyzed as dollar amounts, expressing amounts as
percentages can facilitate comparison and interpretation. Analysis of percentage increases and
decreases in financial statements items across time is called horizontal analysis. In horizontal analysis,
the amount of each line item on the most recent statement is compared with the related item on earlier
statements, and expressed as a percentage change. When horizontal analysis is used to compare data
from two or more dates or periods, amounts from the earliest statement are used as the base for
computing percentage increases and decreases. While computing the percentage change in various
financial statement line items is straightforward, interpreting the significance of the increases and
decreases usually benefits from additional information. The example below illustrates a horizontal
analysis of the current asset section of Grand Company’s balance sheet.
 Grand Company
Comparative Schedule of Current Assets
December 31, 20X1 and 20X2
20X2 20X1 Increase (Decrease)
or Percent
Amount
Cash $90,500 $64,700 $25,800 39.9%
Marketable 75,000 60,000 15,000 25.0
Securities
Accounts Receivable 115,000 120,000 (5,000) (4.2)
(net)
Inventories 264,000 283,000 (19,000) (6.7)
Prepaid Expenses 5,500 5,500 200 3.8
Total Current Assets $550,000 $533,000 $17,000 3.2%

Basic Analytical Procedures: Vertical Analysis

Percentage analysis may also be used to show the relationship of each component to the total within a
single statement. This type of analysis is called vertical analysis. In vertical analysis, the balance sheet is
analyzed by stating each asset item as a percent of total assets. Each liability and stockholders’ equity
item is stated as a percent of total liabilities and stockholders’ equity. Although vertical analysis is a
technique that is applied to an individual statement, comparative vertical analyses are useful. The
exhibit below is a comparative vertical analysis of Grand Company’s balance sheet.

Like horizontal analysis, vertical analysis may be applied to financial statements in either detailed or
condensed form. In the latter case, additional details of the changes in individual items may be
presented in supporting schedules. In supporting schedules, the percentage analysis may be based on
either the total of the schedule or the statement total.

Grand Company
Comparative Balance Sheet
December 31, 20X1 and 20X2
20X2 20X1
Amount Percent Amount Percent
Current Assets $550,00 48.3% $533,000 43.3%
Long-term Investments 95,000 8.3 177,500 14.4
Property, Plant & Equipment (net) 444,500 39.0 470,000 38.2
Intangible Assets 50,000 4.4 50,000 4.1
Total Assets $1,139,500 100.0% $1,230,000 100.0%
Basic Analytical Procedures: Common-Size Statements
Horizontal and vertical analyses are useful in assessing trends and relationships in financial conditions
and operations of a business. Vertical analysis is also useful in comparing one company with another, or
with industry averages. Such comparisons are easier to make with the use of common-size statements
where all items are expressed as percentages of statement totals.

This following exhibit is a comparative common-size income statement for two businesses.

Grand Company and Noble Company

Condensed Common-Size Income Statement
For the Year Ended December 31, 20X2
Grand Co. Noble Co.
Sales, net 100.0% 100.0%
Cost of Goods Sold 82.6 70.0
Gross profit 17.4 30.0
Selling & Administrative Expenses 2.8 15.6
Income from Operation 14.6 14.4
Other Expense 1.4 0.2
Income before Income Tax 13.2 14.2
Income Tax Expense 4.8 5.3
Net Income 8.4% 8.9%

Solvency and Profitability Analysis

Two major areas of financial performance include solvency and profitability. Stakeholders may have
more interest in one area of financial performance than others. Creditors, for example, may be most
concerned about an entity’s ability to repay debts (i.e. solvency). Shareholders may focus on the ability
to generate income (i.e. profitability), but will likely be interested in all dimensions of financial
performance including solvency.

Many techniques for financial statement analysis involve ratio analysis. By computing ratios, financial
statement amounts can be scaled, so that more meaningful comparisons can be made across entities of
different sizes. Ratio analysis also exploits meaningful economic relationships between financial
statement items to provide insights about several dimensions of financial performance. Ratio analysis
can be used to assess both solvency and profitability.

Although solvency and profitability may be analyzed separately, these dimensions of financial
performance are interrelated. For example, a business that cannot pay its debts on a timely basis may
experience difficulty in obtaining credit. A lack of available credit may, in turn, lead to a decline in the
business’s profitability.
Solvency Analysis
Solvency analysis focuses on the ability of a business to pay or otherwise satisfy its current and
noncurrent liabilities. It is normally assessed by examining balance sheet relationships.

Analyses used in assessing solvency include the following:

1. Current position or liquidity analysis including working capital, current ratio, and the acid-test
ratio or quick ratio
2. Accounts receivable analysis including accounts receivable turnover and number of days’ sales
in receivables
3. Inventory analysis including inventory turnover and number of days’ sales in inventory
4. Ratio of fixed assets to long-term liabilities
5. Ratio of liabilities to stockholders’ equity
6. Number of times interest charges are earned

Current Position Analysis: Working Capital

Metrics that are useful in assessing solvency must relate to a business’s ability to pay or otherwise
satisfy its liabilities. Using metrics to assess a business’s ability to pay its current liabilities is called
current position analysis or liquidity analysis. Current position analysis is relevant for many stakeholders,
but may be of special interest to short-term creditors.

An analysis of a firm’s current position normally includes determining the working capital, the current
ratio, and the quick ratio. The current and quick ratios are most useful when analyzed together and
compared to previous periods and other firms in the industry.

The excess of the current assets of a business over its current liabilities is called working capital. Working
capital is generally expressed as a dollar amount, not a ratio, that is used in evaluating a company’s
ability to meet currently maturing debts. When expressed as a ratio, the current ratio is generally the
one being referenced. Various forms of this ratio are used in the computation of liquidity ratios. Working
capital is especially useful in making monthly or other period-to-period comparisons for a company.
However, amounts of working capital are difficult to assess when comparing companies of different
sizes or in comparing such amounts with industry figures. For example, working capital of $250,000 may
be adequate for a small local hardware store, but it would be inadequate for a much larger retailer such
as Home Depot.

Current Position Analysis: Current Ratio

The current ratio is another way to express the relationship between current assets and current
liabilities and assess liquidity. This ratio, sometimes called the working capital ratio or bankers’ ratio, is
computed by dividing total current assets by total current liabilities. For Grand Company, working capital
and the current ratio for 20X2 and 20X1 are as follows:
 Grand Company
20X2 20X1
Current Assets $550,000 $533,000
Current Liabilities 210,000 243,000
Working Capital $340,000 $290,000
Current Ratio 2.6 2.2

Although both working capital and the current ratio are computed using the same components (i.e.,
current assets and current liabilities), working capital is an unscaled metric and does not control for size.
Thus, the current ratio can be a more useful indicator of liquidity when making comparisons across
companies or with industry averages.

To illustrate, assume that as of December 31, 20X2 one of Grand Company’s competitors has $1 million
of working capital and a current ratio of 1.3. Grand Company’s much higher current ratio suggests that
despite having less working capital, Grand Company will be able to more easily repay its short-term debt
and will be in a more favorable position to obtain short-term credit than this competitor.

Current Position Analysis: Quick Ratio

Neither working capital nor the current ratio considers the makeup of the current assets. A ratio that
measures the “instant” debt-paying ability of a company is called the quick ratio or acid-test ratio, which
is the ratio of the total quick assets to total current liabilities. Quick assets are cash and other current
assets that can be quickly converted to cash. Quick assets normally include cash, marketable securities,
and receivables. The quick ratio is a more stringent measure of liquidity than the current ratio.

Included in Grand Company’s current assets, the quick assets are cash, marketable securities, and
accounts receivables that can generally be converted to cash rather quickly to pay current liabilities.
Relevant financial statement data can be used to compute Grand Company’s Quick ratio as follows:

Grand Company
20X2 20X1
Cash $ 90,500 $ 64,700
Marketable Securities 75,000 60,000
Accounts Receivable (net) 115,000 120,000
Total Quick Assets $280,500 $244,700
Current Liabilities $210,000 $243,000
Current Ratio 1.3 1.0

Accounts Receivable Analysis

The amount and makeup of accounts receivable changes constantly during business operations. Sales on
account increase accounts receivable, whereas collections from customers decrease accounts
receivable. Firms that grant long-term credit usually have larger accounts receivable balances than those
granting short-term credit. Increases or decreases in the volume of sales and changes in credit policies
also affect the balance of accounts receivable.

For many reasons, it is desirable to collect receivables as promptly as possible. The cash generated by
prompt collections from customers may be used to pay or avoid current liabilities and be used in
operations for such purposes as purchasing merchandise in large quantities at lower prices. Cash has
many uses including investing and financing purposes. Prompt collection also reduces the risk of loss
from uncollectible accounts.

Accounts Receivable Analysis: Accounts Receivable

Turnover
Turnover ratios generally reflect activity and are sometimes referred to as activity ratios. Accounts
receivable turnover is a ratio that expresses the relationship between sales and accounts receivable. It is
computed by dividing net sales by the average net accounts receivable. It is desirable to base the
average on monthly balances, which allows for seasonal changes in sales. When such data are not
available, it may be necessary to use the average of the accounts receivable balance at the beginning
and the end of the year. If there are trade notes receivable as well as accounts receivable, the two may
be combined. The accounts receivable turnover data for Grand Company are as follows:

Grand Company
20X2 20X1
Net Sales $1,489,000 $1,200,000
Accounts Receivable (net):
Beginning of year $120,000 $140,000
End of year 115,000 120,000
Total $235,000 $260,000
Average Accounts Receivable (Total ÷ 2) $117,500 $130,000
Accounts receivable turnover 12.7 9.2
(net sales ÷ average accounts receivable)

The 20X2 increase in accounts receivables turnover indicates that collection of receivables improved.
This may be due to a change in credit policies, collection practices, or both.

Accounts Receivable Analysis: Number of Days’ Sales in

Receivables
Another metric that relates sales and accounts receivable is the number of days’ sales in receivables.
This ratio is computed by dividing the average accounts receivable by the average daily sales which is
determined by dividing net sales by 365 days. The number of days’ sales in receivables is an estimate of
the length of time (in days) that the accounts receivables have been outstanding. Comparing this
measure with the credit terms provides information on the efficiency in collecting receivables. A
comparison with other firms in the industry and with prior years also provides useful information. Such
comparisons may indicate efficiency of collection procedures and trends in credit management. The
number of days’ sales in receivables is computed for Grand Company as follows:

Grand Company
20X2 20X1
Average Accounts Receivable $117,500 $130,000
Net Sales $1,498,000 $1,200,000
Average Daily Sales (Net Sales ÷ 365) $4,104 $3,288
Number of Days' Sales in Receivables 28.6 39.5
(average accounts receivable ÷ average daily sales)

Grand company improved its collections of accounts receivable by 10.9 days in 20X2 measured in days
that receivables have been outstanding.

Inventory Analysis: Inventory Turnover

A business needs to keep enough inventory on hand to meet the needs of its customers and operations.
However, an excessive amount of inventory reduces solvency by tying up funds. Excess inventories also
increase insurance expense, property taxes, storage costs, and other expenses. These expenses use
funds that otherwise could be used to improve operations. Finally, excess inventory also increases the
risk of losses due to price declines or inventory obsolescence.

Two useful measures for evaluating inventory management are inventory turnover and the number of
days’ sales in inventory. The relationship between the cost of the goods (merchandise or inventory) sold
and the inventory remaining may be stated as the inventory turnover. It is computed by dividing the cost
of goods sold by the average inventory. If monthly data are unavailable, the average of the inventories
at the beginning and the end of the year may be used. For each business or department within a
business, there is a reasonable turnover rate. Turnover below this rate could mean that inventory is not
being properly managed. Grand Company’s inventory turnover is computed as follows:

Grand Company
20X2 20X1
Cost of Goods Sold $1,043,000 $820,000
Inventories:
Beginning of year $283,000 $311,000
End of year 264,000 283,000
Total $547,000 $594,000
Average Inventory (Total ÷ 2) $273,500 $297,000
Inventory turnover 3.8 2.8
(cost of goods sold ÷ average inventory)
Inventory Analysis: Number of Days’ Sales in Inventory
Another measure of the relationship between the cost of goods sold and inventory is the number of
days’ sales in inventory. This measure is computed by dividing the average inventory by the average
daily cost of goods sold (cost of goods sold divided by 365). The number of days’ sales in inventory for
Grand Company is computed as follows:
Grand Company
20X2 20X1
Average Invertory $273,500 $297,000
Cost of Goods Sold $1,043,000 $820,000
Average Daily Cost of Goods Sold (COGS ÷ 365) $2,858 $2,247
Number of Days' Sales in Inventory 95.7 132.2
(average inventory ÷ average daily cost of goods sold)

The number of days’ sales in inventory is a rough measure of the length of time it takes to acquire, sell,
and replace the inventory. Grand Company reduced the time it held inventory by nearly 28% in 20X2, as
measured in days the inventory was held in warehouses. However, a comparison with earlier years and
similar firms would be useful in assessing Grand Company’s overall inventory management.

Ratio of Fixed Assets to Long-Term Liabilities

Long-term notes and bonds are often secured by fixed assets. The ratio of fixed assets to long-term
liabilities is a solvency measure that indicates the margin of safety for noteholders and bondholders. It
also indicates the ability of a business to borrow additional funds on a long-term basis. Grand
Company’s ratio of fixed assets to long-term liabilities is as follows:
Grand Company
20X2 20X1
Fixed Assets (net) $444,500 $470,000
Long-term Liabilities 210,000 200,000
Ratio of Fixed Assets to Long-term Liabilities 2.1 2.4

The increase in Grand Company’s ratio of fixed assets to long-term liabilities indicates that it decreased
the margin of safety in financing fixed assets. A review of the changes in the two components of this
ratio suggests that Grand Company achieved this outcome primarily by increasing its outstanding long-
term debt. If the company needs to borrow additional funds on a long-term basis in the future, it will be
in a weaker position to do so.

Ratio of Liabilities to Stockholders’ Equity

Claims against the total assets of a business are divided into two groups: (1) claims of creditors and (2)
claims of owners. The relationship between the total claims of the creditors and owners – the ratio of
liabilities to stockholders’ equity – is a solvency measure that indicates the margin of safety for
creditors. It also indicates the ability of the business to withstand adverse business conditions. When the
claims of creditors are large in relation to the equity of the stockholders, there are usually significant
interest payments. If earnings decline to the point where the company is unable to meet its interest
payments, the business may be taken over by the creditors. The ratio of liabilities to stockholders’ equity
for Grand Company is as follows:
Grand Company
20X2 20X1
Total Liabilities $310,000 $443,000
Total Stockholders' Equity 829,500 787,500
Ratio of Liabilities to Stockholders' Equity 0.37 0.56

Grand Company’s balance sheet shows that the major factor explaining the change in the ratio was the
$133,000 increase in long-term liabilities during 20X2. The ratio at the end of both years shows a large
margin of safety for the creditors.

Times Interest Earned

In some industries, (e.g. airlines) corporations normally have high ratios of debt to stockholders’ equity.
One way to measure the relative risk of the debt-holders is the times interest earned ratio, sometimes
called the fixed charge coverage ratio. The higher the ratio, the lower the risk that interest payments will
not be made if earnings decrease. In other words, the higher the ratio, the greater the assurance that
interest payments will be made on a continuing basis. This metric also indicates the general financial
strength of the business, which is of interest to many stakeholders including stockholders, employees,
and creditors.

Because interest is deductible in determining taxable income, the amount available to meet interest
charges is not affected by income taxes. The times interest earned ratio is computed by dividing the sum
of Income before Taxes and Interest Expense (i.e., the amount available to meet interest charges) by
Interest Expense as shown below:

Grand Company
20X2 20X1
Income Before Income Tax $900,000 $800,000
Interest Expense 300,000 250,000
Amount Available to Meet Interest $1,200,000 $1,050,000
Charges
Times Interest Earned 4.0 4.2

This analysis indicates that Grand Company generates income sufficient to cover its interest costs 4
times each year. A similar analysis can also be applied to dividends on preferred stock by dividing net
income by the amount of preferred dividends to yield the number of times preferred dividends are
earned, a metric indicating the risk that dividends to preferred stockholders may not be paid.
Profitability & Market Analysis
The ability of a business to earn profits depends on the effectiveness and efficiency of its operations as
well as the resources available to it. Profitability analysis, therefore, focuses primarily on the
relationship between operating results as reported in the income statement and resources available to
the business as reported in the balance sheet. Market analysis focuses on how well a company is doing
from a financial market perspective.

Major analyses used in assessing profitability include the following:

1. Return on Sales
2. Return on Assets
3. Return on Stockholders’ Equity
4. Return on Common Stockholders’ Equity
5. Earnings per share on Common Stock

Analyses regarding the market include the following:

1. Price-earnings Ratio
2. Dividends per Share
3. Dividend Yield

Return on Sales
The ratio of net income to net sales is a profitability measure that is is often called net profit margin.
This ratio shows how much of each dollar in sales flows through to net income after all expenses are
subtracted. The basic data and the computation of this ratio for Grand Company are as follows:

Grand Company
20X2 20X1
Net Income $91,000 $76,500
Net Sales $1,498,000 $1,200,000
Return on Sales 6.1% 6.4%

Although Grand Company’s sales increased in 20X2, its return on sales decreased. There are several
possible explanations for this observation. For example, net profit margin might have declined due to
increasing costs or expenses. Grand Company managers will want to further investigate to determine
the explanation for declining return on sales.

Return on Assets
Return on assets measures the profit generated on investments in assets, without considering how the
assets are financed. The return on assets is computed by adding interest expense to net income and
dividing this sum by the average total assets. Adding interest expense to net income eliminates the
effect of whether the assets are financed by debt or equity, however, it is important to note that the
adding of interest is not always done. Grand Company’s return on assets is computed as follows:

Grand Company
20X2 20X1
Net Income $91,000 $76,500
Plus Interest Expense 6,000 12,000
Total $97,000 $88,500
Assets:
Beginning of Year $1,230,500 $1187,500
End of Year 1,139,500 1,230,500
Total $2,370,000 $2,418,000
Average (Total ÷ 2) $1,185,000 $1,209,000
Return on Assets 8.2% 7.3%

As with any ratio, it can be helpful to compare it to that of similar companies and industry averages. In
some instances, it may be desirable to adjust the way this ratio is computed. For example, if net income
includes significant amounts of non-operating income and expenses, it may be helpful to compute the
ratio of income from operations to total assets. Since income from operations is before tax, using this
for the numerator also eliminates the effect of tax. When income from operations is used for the
numerator, any assets related to the non-operating income and expense items should be excluded from
the denominator. Because ratios can be computed in different ways, it is important to understand the
specific way a ratio has been computed when using published ratios.

Return on Stockholders’ Equity

Another measure of profitability is return on stockholders’ equity which is computed by dividing net
income by average total stockholders’ equity. In contrast to return on assets, this metric emphasizes the
rate at which income is earned relative to the amount invested by the stockholders.

The stockholders’ equity balance may vary throughout a period. For example, a business may issue or
retire stock, pay dividends, and earn net income. If monthly amounts are not available, the average of
the stockholders’ equity at the beginning and the end of the year is normally used to compute this ratio.
For Grand Company, return on stockholders’ equity is computed as follows:
Grand Company
20X2 20X1
Net Income $91,000 $76,500
Stockholders' Equity:
Beginning of Year $787,500 $750,000
End of Year 829,500 787,500
Total $1,617,000 $1,537,500
Average (Total ÷ 2) $808,500 $768,750
Return on Stockholders' Equity 11.3% 10.0%
Leverage
For most businesses, return on equity is usually higher than return on assets. This occurs when the
amount earned on assets acquired with creditors’ funds is more than the interest paid to creditors. This
difference in the rate of return on stockholders’ equity and the rate of return on assets is called
leverage.
The example below demonstrates that Lincoln Company’s leverage of 3.1% for 20X2 compares favorably
with the 2.7% leverage for 20X1.

Return on Common Equity

A corporation may have both preferred and common stock outstanding. In this case, the common
stockholders have the residual claim on earnings. Return on common equity focuses only on the profits
earned on the amount invested by common stockholders. It is computed by subtracting preferred
dividend requirements from net income and dividing this amount by average common stockholders’
equity. The return on common equity for Grand Company is computed as follows:
Grand Company
20X2 20X1
Net Income $91,000 $76,500
Preferred Dividends 9,000 9,000
Income available to Common Shareholders $82,000 $67,500
Common Stockholders' Equity:
Beginning of Year $637,000 $600,000
End of Year 697,500 637,500
Total $1,317,000 $1,237,500
Average (Total ÷ 2) $658,500 $618,750
Return on Common Stockholders' Equity 12.5% 10.9%

The concept of leverage can also be applied to the use of funds from the sale of preferred stock as well
as borrowing. Funds from both sources can be used in an attempt to increase the return on common
equity.
Earnings Per Share
One of the profitability measures often quoted by the financial press is earnings per share (EPS). It is also
normally reported in the income statement in corporate annual reports. As a result, corporate managers
closely monitor the impact of decisions on earnings per share. Thus, one of the many factors that
influences the decision of whether to finance operations using debt or equity is the effect of each
alternative on earnings per share.
If a company has only one class of stock outstanding, earnings per share is computed by dividing net
income by the number of shares of stock outstanding. If preferred and common stock are outstanding,
earnings per share is normally computed to reflect earnings per share of common stock. In this case, net
income is first reduced by preferred dividends. If the number of shares of stock outstanding varies, it is
common to use a weighted average number of shares outstanding. For Grand Company, earnings per
share of common stock is computed as follows:

Grand Company
20X2 20X1
Net Income $91,000 $76,500
Preferred Dividends 9,000 9,000
Income available to Common Shareholders $82,000 $67,500
Shares of Common Stock Outstanding 50,000 50,000
Earnings Per Share of Common Stock $1.64 $1.35

Grand Company earned more for each share of common stock in 20X2 than it did in 20X1.

Price-Earnings Ratio
Another profitability measure often quoted by the financial press is the price-earnings (P/E) ratio on
common stock. The price-earnings ratio is an indicator of a firm’s future earnings prospects. It is
computed by dividing the market price per share of common stock at a specific date by the annual
earnings per share. Assume the market prices per common share are 41 at the end of 20X2 and 27 at
the end of 20X1. The price-earnings ratio on common stock of Grand Company is computed as follows:

Grand Company
20X2 20X1
Market Price Per Share of Common Stock $41.00 $27.00
Earnings Per Share of Common Stock ÷ 1.64 ÷ 1.35
Price-Earnings Ratio for Common Stock 25 20

The price-earnings ratio indicates that a share of common stock of Grand Company was selling for 20
times the amount of earnings per share at the end of 20X1. At the end of 20X2, the common stock was
selling for 25 times the amount of earnings per share. The stock price has increased as a multiple of its
earnings on common stock. This suggests that investors believe that Grand Company has good prospects
for growth!
Dividends per Share and Dividend Yield
Ordinary dividends represent a distribution of earnings to stockholders and are one of the primary ways
that a company can return value to its owners. Thus, dividend-related metrics including dividends per
share and dividend yield are commonly used by investors to evaluate equity investment alternatives.

Dividends per share is computed by dividing the dividends distributed to common stockholders during
the period by the number of common shares outstanding. For Grand Company, dividends per share was
$0.80 ($30,000 ÷ 50,000 shares) in 20X2 and $0.60 ($30,000 ÷ 50,000 shares) in 20X1.

Dividends per share can be reported along with earnings per share to indicate the relation between
dividends and earnings. The comparison of the two per share amounts suggests the extent to which a
company is retaining its earnings for internal uses and investments. The following exhibit illustrates
these relations for Grand Company.

Dividends per Share and Dividend Yield

The dividend yield on common stock is a profitability measure that shows the rate of return to common
stockholders in terms of cash dividends. It is of special interest to investors whose main investment
objective is to receive current returns (dividends) on an investment rather than an increase in the
market price of the investment. The dividend yield is computed by dividing the annual dividends paid
per share of common stock by the market price per share on a specific date. Assume that the market
price was 41 at the end of 20X2 and 27 at the end of 20X1. The dividend yield on common stock of
Grand Company is as follows:

Grand Company
20X2 20X1
Dividends Per Share of Common Stock $0.80 $0.60
Market Price Per Share of Common Stock ÷ 41.00 ÷ 27.00
Dividend Yield on Common Stock 1.95% 2.22%
The dividend yield reflects the proportion of the common stock’s market value that is distributed as
dividends. For Grand Company, the 20X2 decrease in dividend yield relates to a stock price that rose
more than the company’s dividend.

Summary of Analytical Measures

Meaningful analytical measures can be computed for most businesses. While solvency and profitability
can be considered two broad categories of financial analysis, characteristics generally evaluated in ratio
analysis include liquidity, profitability, and solvency. Depending on the specific business being analyzed,
some measures might be omitted or additional measures could be developed. The type of industry, the
capital structure, and the diversity of the business’s operations usually affect the choice of metrics used.
For example, analysis for an airline might include metrics that include nonfinancial components such as
revenue per passenger mile and cost per available seat. Likewise, analysis for a hotel might focus on
occupancy rates.

Percentage analyses, ratios, turnovers, and other measures of financial position and operating results
are useful analytical measures. They are helpful in assessing a business’s past performance and
predicting its future. They are not, however, a substitute for sound judgment. In selecting and
interpreting analytical measures, conditions peculiar to a business or its industry should be considered
as well as the influence of the general economic and business environment.

In determining trends, the interrelationship of the measures used in assessing a business should be
carefully studied. Comparable indexes of earlier periods should also be studied. Data from competing
businesses may be useful in assessing the efficiency of operations for the firm under analysis. In making
such comparisons, however, it is important to consider the effects of any differences in accounting
methods.

Corporate Annual Reports

Corporations normally issue annual reports to their stockholders and other interested parties. Such
reports summarize the corporation’s operating activities for the past year and plans for the future. A
major component of annual reports are the financial statements and accompanying notes.

In order to enhance investor confidence, the publicly held corporations are subject to a number of
requirements with respect to their financial statements. All publicly held corporations are required to
have an independent audit (examination) of their financial statements. Certified Public Accountants are
responsible for conducting these audits and rendering an opinion on the extent to which the financial
statements are presented in accordance with appropriate accounting standards. In addition, the
independent auditor must provide an additional report attesting to management’s assessment of
internal control.

The Management Discussion and Analysis (MD&A) is a required disclosure within the annual report filed
with the Securities and Exchange Commission. The MD&A provides critical information in interpreting
the financial statements and assessing the future of the company. It includes an analysis of the results of
operations and discusses management’s opinion about future performance. It compares the prior year’s
results of operations with the current year’s to explain changes in sales, significant expenses, gross
profit, income from operations and other items reported on the income statement. For example, an
increase in sales may be explained by referring to higher shipment volume and/or stronger prices. The
MD&A also includes an analysis of the company’s financial condition. It compares significant balance
sheet items between successive years to explain changes in liquidity and capital resources. In addition,
the MD&A discusses the company’s exposure to significant risks.
Section 2 Capital Investment Analysis
The Importance of Capital Investment Analysis
Why are you spending time and money on a higher education? Most people believe that the money and
time spent now will return them more income in the future. In other words, a higher education is an
investment in future earning ability. How would you know if this investment is worth it? One method
would be to compare the cost of a higher education against the estimated future increased earning
power. The more your expected future increased earnings exceed the investment, the more attractive
the investment.

In the same sense, business organizations analyze potential capital investments by using various
methods that compare investment costs to future earnings and cash flows. Analyses are useful for
making investment decisions, which may involve thousands, millions, or even billions of dollars. A
business person will need to understand the similarities and differences among the most commonly
used methods of evaluating investment proposals, as well as the uses of diverse methods.

It is important to know the qualitative considerations affecting investment analyses, as well as

understand the considerations complicating investment analyses. Allocating available investment funds
among competing proposals is a critical decision in a capital investment program.

The Nature of Capital Investment Analysis

How do companies decide to make significant investments such as the following?

Should General Electric invest $100 million in improving efficiency in an aircraft engine facility, spend
$50 million for a new household appliance factory, or invest $75 million in research and development
related to wind energy?

Companies use capital investment analysis to help evaluate long-term investments and compare
alternatives. Capital investment analysis (or capital budgeting) is the process by which management
plans, evaluates, and controls investments in fixed assets. Capital investments involve the long-term
commitment of funds and affect operations for many years. Thus, these investments must earn a
reasonable rate of return, so that the business can meets its obligations to creditors and provide
dividends to stockholders. Because capital investment decisions are some of the most important
decisions that management makes, capital investment analysis must be carefully developed and
implemented.

A capital investment program should encourage managers to submit proposals for capital investments.
It should communicate to employees the long-range goals of the business, so that useful proposals are
submitted. All reasonable proposals should be considered and evaluated with respect to economic costs
and benefits. The program may reward those whose proposals are accepted.
Methods of Evaluating Capital Investment Proposals
Capital investment evaluation methods can be grouped into the following categories:

1. Methods that do not use present values

2. Methods that use present values

Two methods that do not use present values are the average rate of return method and the cash
payback method. These methods are often used to initially screen proposals and are useful for proposals
with relatively short useful lives because the timing of cash flows is less important.

The two methods that use present values are the net present value method and the internal rate of
return method. These methods consider the time value of money. The time value of money concept
recognizes that an amount of cash invested today will earn income and, therefore, has value over time.

Management often uses a combination of methods in evaluating capital investment proposals. Each
method has advantages and disadvantages. In addition, some of the computations are complex.
Computers, however, can perform the computations quickly and easily. Computers can also be used to
analyze the impact of changes in key estimates in evaluating capital investment proposals.

Average Rate of Return Method

The average rate of return and the cash payback methods are easy to use. As already stated, these
methods are often initially used to screen proposals. Management normally sets minimum standards for
accepting proposals, and those not meeting these standards are dropped from consideration; if a
proposal meets the minimum standards, it is often subject to further analysis.

The average rate of return method focuses on accounting income rather than cash flows. In computing
the average rate of return, the numerator is the average of the annual income expected to be earned
from the investment over the investment life, an amount that is net of depreciation. The denominator is
the average book value of the investment over the investment life. Thus, if straight-line depreciation and
no residual value are assumed, the average investment over the useful life is equal to one-half of the
original cost.

The average investment is the midpoint of the depreciable cost of the asset. Since a fixed asset is never
depreciated below its residual value, this midpoint is determined by adding the original cost of the asset
to the estimated residual value and dividing by 2.

The average rate of return, sometimes called the accounting rate of return, is a measure of the average
income as a percent of the average investment in fixed assets as shown in this example: Assume
management is considering purchasing a machine for $500,000. The machine has a 4-year useful life
with no residual value and is expected to yield total income of $200,000.
The 20% average rate of return for this project should be compared with management’s minimum rate
for such investments. If the average rate of return equals or exceeds the minimum rate, the analysis
suggests that machine should be purchased or further analyzed by applying additional methods.

When several capital investment proposals are considered, they can be ranked by their average rates of
return. The higher the average rate of return, the more desirable the proposal. In addition to being easy
to compute, the average rate of return method has several advantages. One advantage is that it includes
the amount of income earned over the entire life of the proposal. In addition, it emphasizes accounting
income, which is often used by investors and creditors in evaluating management performance. Its main
disadvantage is that it does not directly consider the expected cash flows from the proposal and the
timing of these cash flows.

Cash Payback Method

Cash flows are important because cash is necessary for both operations and investments. Very simply,
capital investment uses cash and must, therefore, return cash in the future in order to be successful. The
expected period of time that will pass between the date of an investment and the complete recovery in
cash (or equivalent) of the amount invested is the cash payback period. The more rapidly that an
investment generates enough cash to cover its cost, the less risky the investment. The excess of the cash
flowing in from revenue over the cash flowing out for expenses is termed net cash flow. The time
required for the net cash flow to equal the initial outlay for the fixed asset is the payback period.

Assume management is considering a proposed $200,000 investment in a fixed asset with an 8-year life.
Annual cash revenues are $50,000 and annual cash expenses are $10,000, so the annual net cash flow is
expected to be $40,000. The estimated cash back period for the investment is 5 years.

In this illustration, the annual net cash flows are the same each year ($40,000 per year).

If annual cash flows are not equal, the cash payback period is determined by adding the annual net cash
flows until the cumulative sum equals the amount of the proposed investment. To illustrate, in the
below example, the cumulative net cash flow equals the initial $400,000 investment at the end of year
4, so the payback period for this investment is 4 years.
This example shows net cash flow in year 1 of $60,000; year 2 of $80,000; year 3 of %105,000; year 4 of
$155,000; year 5 of $100,000; and year 6 of $90,000. Adding the years together for cumulative net cash
flow we reach the initial investment in year 4. It took 4 years to regain the initial investment.

The cash payback method is widely used to evaluate proposals for investments in new projects. A short
payback period is desirable, because the sooner the cash invested is recovered, the sooner it becomes
available for reinvestment in other projects. In addition, when the payback period is short, there is less
risk of loss due to obsolescence, changing economic conditions, and other factors. The cash payback
period is important to bankers and other creditors who may depend on net cash flow for repayment of
debt used to fund the investment. The sooner the cash is recovered, the sooner the debt or other
liabilities can be paid. Thus, the cash payback method is especially useful to managers whose primary
concern is liquidity.

A disadvantage of the cash payback method is that it ignores cash flows occurring after the payback
period and the time value of money.

Present Value Methods

An investment in fixed assets may be viewed
as the acquisition of a series of net cash flows
over a period of time. The period of time over
which these net cash flows will be received
may be an important factor in determining the
value of an investment. Present value
methods use both the amount and the timing
of net cash flows in evaluating an investment.
Present value concepts can be divided into the
present value of an amount and the present
value of an annuity.

Present value of an amount: If you were given the choice, would you prefer to receive $1 now or $1
three years from now? You would prefer to receive $1 now because you could invest the $1 today and
earn interest for three years. As a result, the amount you would have after three years would be greater
than $1.
To illustrate, assume that on January 1, 20X1, you invest $1 in an account that earns 12% interest
compounded annually.After 1 year, the $1 will grow to $1.12 because interest of $.12 is added to the
investment. The $1.12 earns 12% interest for the second year. Interest earning interest is called
compounding. By the end of the second year, the investment has grown to $1.254; by the end of the
third year to $1.404. Thus, if money is worth 12%, you would be equally satisfied with $1 on January 1,
20X1, or $1.404 three years later.

Present value of an annuity: An annuity is a series of equal cash flows at fixed time intervals. Annuities
are very common in business. Monthly rental, salary, and bond interest cash flows are all examples of
annuities. The present value of an annuity is the sum of the present values of each cash flow. In other
words, the present value of an annuity is the amount of cash that could be invested today to yield a
series of equal net cash flows at fixed time intervals in the future.

Present Value of $1 at Compound Interest

Year 6% 10% 12% 15% 20%

1 0.943 0.909 0.893 0.870 0.833
2 0.890 0.826 0.797 0.756 0.694
3 0.840 0.751 0.712 0.658 0.579
4 0.792 0.683 0.636 0.572 0.482
5 0.747 0.621 0.567 0.497 0.402
6 0.705 0.564 0.507 0.432 0.335
7 0.665 0.513 0.452 0.376 0.279
8 0.672 0.497 0.404 0.327 0.233
9 0.592 0.424 0.361 0.284 0.194
10 0.558 0.386 0.322 0.247 0.162

To illustrate, a $100 annuity for three periods at 12% is a series of three annual $100 payments
assuming a 12% interest rate. The present value of this annuity can be computed by utilizing present
value factors from this chart. Each $100 net cash flow could be multiplied by the present value of $1 at
12% factor for the appropriate period and summed to determine a present value of $240.20 at the end
of a three-year period. [(100*0.893) + (100*0.797) + (100*0.712) = 240.20] Alternatively, the $100
annual cash flow could be multiplied by the sum of the three individual present value of $1 factors at
12%, or (0.893 + 0.797 + 0.712 = 2.402) to compute the $240.20 present value of the annuity.

Net Present Value Method

The net present value method analyzes capital investment proposals by comparing the initial cash
investment with the present value of the expected net cash flows generated by the investment. It is
sometimes called the discounted cash flow method. The interest rate (minimum desired rate of return)
used in net present value analysis is set by management. This rate, sometimes called the hurdle rate, is
typically based on such factors as the nature of the business, the purpose of the investment, the cost of
securing funds for the investment, and the minimum desired rate of return. If the present value of the
cash flows expected from a proposed investment exceeds the amount of the initial investment, the
investment will generate a return that is greater than management’s hurdle rate, and the proposal is
deemed desirable.

To illustrate, assume a proposal to invest $200,000 in equipment with a 5-year expected useful life and a
minimum desired rate of return of 10%. The present value of the net cash flow for each year is
computed by multiplying the net cash flow for the year by the present value factor of $1 at the 10% rate
of return for that year. For example, the $70,000 net cash flow expected on December 31, 20X1, is
multiplied by the present value of $1 for 1 year at 10% (0.909) yielding a $63,630 present value for this
cash flow. Likewise, the $60,000 net cash flow on December 31, 20X2, is multiplied by the present value
of $1 for 2 years at 10% (0.826) to yield $49,560, and so on. The initial investment, $200,000, is then
subtracted from the $202,900 total present value of the net cash flows, to determine the net present
value of $2,900, as shown in the diagram below. Since net present value is greater than zero, the
proposal is expected to recover the initial investment and provide more than the 10% minimum rate of
return.

Present Value Index

When capital investment funds are limited and the alternative proposals involve different amounts of
investment, it is useful to prepare a ranking of the proposals by using a present value index. The present
value index is calculated by dividing the total present value of the net cash flow by the amount to be
invested. The present value index for the investment in the previous example is calculated as follows:

If a business is considering three alternative proposals and has determined their net present values, the
present value index for each proposal is as follows:
 Proposal A Proposal B Proposal C
Total present value of $107,000 $86,400 $93,600
net cash flow
Amount to be invested 100,000 80,000 90,000
Net present value $7,000 $6,400 $3,600
Present value index 1.07($107,000 ÷ 1.08($86,400 ÷ 1.04($93,600 ÷
$100,000) $80,000) $90,000)

Although Proposal A in the previous example has the largest net present value, the present value
indexes indicate that it is not the most desirable proposal. Proposal B returns $1.08 present value per
dollar invested, whereas Proposal A returns only $1.07. In addition to the present value index, the initial
investment amounts should also be considered. Proposal B requires an $80,000 investment, an amount
that is less than the $100,000 required for Proposal A. Although Project A has a higher present value
index, management should consider the possible uses for the $20,000 difference between proposal A
and Proposal B investments before making a final decision.

An advantage of the net present value method is that it considers the time value of money. A
disadvantage is that the computations are more complex than those for the methods that ignore
present value. In addition, the net present value method assumes that the cash received from the
proposal during its useful life can be reinvested at the rate of return used in computing the present
value of the proposal. Because of changing economic conditions, this assumption may not always be
reasonable.

Internal Rate of Return Method

The internal rate of return method uses present value concepts to compute the expected rate of return
for capital investment proposals. This method is sometimes called the time-adjusted rate of return
method. It is similar to the net present value method, in that it focuses on the present value of the net
cash flows. However, rather than establishing a minimum return on investment, the internal rate of
return method starts with the net cash flows and, in a sense, works backward to determine the rate of
return expected from the proposal.

To illustrate the intuition underlying the internal rate of return method, assume that a manager is
evaluating a proposal to invest in equipment costing $33,530. The equipment is expected to provide net
cash flows of $10,000 per year for 5 years. If we assume a 12% discount rate, we can use the
appropriate factor from a present value of an annuity table to calculate the present value of the net
cash flows, as follows:

Annual net cash flow (at the end of each of 5 $10,000

years)
Present value of an annuity of $1 at 12% for 5 X 3,605
years
 Present value of annual net cash flows $36,050
Less amount to be invested 33,530
Net present value $2,520
The $36,050 present value of the cash flows, based on a 12% rate of return, is greater than the $33,530
to be invested. Therefore, the internal rate of return must be greater than 12%. Through trial-and-error
procedures, a manager could determine that a 15% rate of return equates the $33,530 cost of the
investment with the present value of the expected net cash flows. Thus, the internal rate of return is
15%.

When equal annual net cash flows are expected from a proposal, the calculations to determine the
internal rate of return can be simplified by determining a present value factor for an annuity of $1 by
dividing the amount to be invested by the equal annual net cash flows as follows:

To illustrate, assume that a manager is evaluating a proposal to purchase equipment costing $97,360.
The equipment is expected to provide equal annual net cash flows of $20,000 for 7 years. We can
compute a present value factor for an annuity of $1 as follows:

By consulting a table for the present value of an annuity of $1, using a financial calculator, or using
spreadsheet software, we can determine that for a period of 7 years, the present value of an annuity of
$1 factor of 4.868 is related to a 10% discount rate. Thus, 10% is the internal rate for this proposal. If the
minimum acceptable internal rate of return for similar proposals is 10% or less, then the proposed
investment should be considered acceptable. When several proposals are considered, management
often ranks the proposals by their internal rate of return. The proposal with the highest rate is
considered the most desirable.

The primary advantage of the internal rate of return method is that the present values of the net cash
flows over the entire useful life of the proposal are considered. In addition, by determining a rate of
return for each proposal, all proposals are compared on a common basis and application of the method
does not require an assumption about a minimum rate of return.

The primary disadvantage of the internal rate of return method is the complexity of the computations
relative to those required for some other methods. However, spreadsheet software has internal rate of
return functions that simplify the calculation.

Like the net present value method, this method assumes that the cash received from a proposal during
its useful life will be reinvested at the internal rate of return. Because of changing economic conditions,
this assumption may not always be reasonable, and it may represent a limitation of both methods.
Factors That Complicate Capital Investment Analysis
Additional factors may affect the outcome of a capital investment decision. Some of the most important
of these factors that may warrant consideration include the following:

• Income tax
• Proposals with unequal lives
• Lease versus capital investment
• Uncertainty
• Changes in price levels
• Qualitative considerations

Income Tax
In many cases, federal income tax may have a material impact on capital investment decisions. For
example, in determining depreciation for federal income tax purposes, statutory useful lives are often
much shorter than actual useful lives. Since depreciation is deductible in determining taxable income,
accelerated depreciation allowed under tax regulations can affect a project’s expected cash flows.

The total cost subjected to depreciation is the same for tax and book purposes, but rules for tax
depreciation often result in the acceleration of depreciation. Thus, depreciation for tax purposes often
exceeds the depreciation for financial statement purposes in the early years of an asset’s use. Tax
reductions in early years of an assets life are offset by higher taxes in the later years when depreciation
is lower. Thus, accelerated depreciation does not result in a long-run saving in taxes but it can affect the
timing of cash flows.

The timing of the cash outflows for income taxes can have a significant impact on capital investment
analysis.

Proposals with Unequal Lives

Previous discussions of alternative methods of analyzing capital investment proposals were based on
the assumption that all investments had the same useful lives. In practice, however, alternative
proposals may have unequal lives. Ignoring differences in the useful lives of alternative investments can
distort the present value analysis and adversely affect decisions. The difference in useful lives can be
addressed by adjusting the cash flow assumptions of the proposals to end at the same time.

To illustrate, assume that alternative investments, a truck and computers, are being compared. The
truck has a useful life of 8 years, and the computer network has a useful life of 5 years. Each proposal
requires an initial investment of $100,000, and the company desires a rate of return of 10%. To equate
the investment periods, we assume that the truck will be sold at the end of 5 years. The residual value of
the truck at the end of five years, i.e., the proceeds that would be generated by selling the truck, is
estimated and this value is then included as a cash flow at that date. Both investments will then have 5-
year lives, and net present value analysis can be used to compare the proposals over the same 5-year
period.
If the truck’s estimated residual value is $40,000 at the end of year 5 but the computers have no residual
value, the net present value for the truck will exceed the net present value for the computers. Using the
10% rate and using residual values to analyze the projects over 5 years, the net present value of the
truck is $18,640 and the net present value of the computers is $16,805. The net present value of the
truck exceeds the net present value for the computers by $1,835. Thus, the truck may be viewed as the
more attractive proposal.

Lease versus Capital Investment

Leasing fixed assets is common in many industries. For example, hospitals often lease diagnostic and
other medical equipment. Leasing allows a business to use fixed assets without tying up the large
amounts of cash that would be needed to purchase them. Leasing may be particularly attractive when
managers believe that a fixed asset has a high risk of becoming obsolete. When compared to purchasing
an asset, leasing may provide an opportunity to manage and reduce the obsolescence risk. Certain
provisions of the tax law can also make leasing assets more attractive.

Normally, leasing assets is more costly than purchasing because the lessor must charge a rental price
that includes not only the costs associated with owning the assets but also a profit. In many cases,
however, it makes sense for management to consider leasing assets before a final purchase decision is
made. The ability to deduct lease payments from taxable income, costs of borrowing and other factors
may affect the economics of lease versus buy decisions. Applying methods for evaluating capital
investment proposals can help management consider whether it is more profitable to lease rather than
purchase an asset.

Uncertainty in Capital Investment Analysis

Analyzing capital investment alternatives requires assumptions and estimates, and these require
judgment. For example, the expected net cash flows from an investment are usually estimated.
Estimates and assumptions are necessary, but regardless of skill and knowledge of managers, they also
introduce uncertainty. Capital investments typically have relatively long lives. The need to forecast cash
flows and make other assumptions about the future increases uncertainty when investments have long
lives.

Uncertainty cannot be eliminated, but managers can work to reduce and/or analyze its effects.
Uncertainty may be reduced by incorporating the best available information. The risks associated with
uncertainty can be analyzed and considered by subjecting capital investment analyses to sensitivity
analysis. This might involve re-computing a net present value under several different assumptions
and/or using alternative discount rates. Comparing results of analysis that incorporate assumptions that
are more and less conservative than the manager’s best estimate will help determine how sensitive the
investment analysis is to uncertainty and the assumptions used.
Price Levels and Exchange Rates
In performing investment analysis, management must be concerned about changes in price levels. Price
levels may change due to inflation, which occurs when general price levels are rising. Thus, while general
prices are rising, the returns on an investment must exceed the rising price level, or else the cash
returned on the investment becomes less valuable over time.

Price levels may also change for foreign investments as the result of currency exchange rates, which are
the rates at which a foreign currency can be exchanged for U.S. dollars. If the amount of foreign
currency that must be exchanged for one U.S. dollar increases, then the foreign currency is said to be
weakening to the dollar. Thus, if a U.S. company made an investment in another country where the local
currency was weakening, the return on the investment expressed in U.S. dollars would be would
adversely affected. Even if the expected amount of the foreign currency returned on the investment is
realized, the change in exchange rates would mean that fewer U.S. dollars could be purchased.

Managers should consider potential future price level changes and consider their effects on the
estimates used in capital investment analyses. Changes in assumptions about price levels and foreign
currency exchange rates can significantly affect analyses.

Qualitative Considerations
Some benefits of capital investments are qualitative in nature and cannot be easily measured or
expressed in terms of dollars. Since these qualitative factors can’t readily be incorporated into methods
commonly used to evaluate investment alternatives, they will be ignored if managers do not take an
additional step to consider possible qualitative factors.

Qualitative considerations in capital investment analysis are most appropriate for strategic investments.
Strategic investments are those that are designed to affect a company’s long-term ability to generate
profits. Strategic investments often have many uncertainties as well as potential intangible benefits.
Unlike capital investments that are designed to cut costs, strategic investments may have few “hard”
cost savings. Instead, they are more likely to affect future revenues, which are difficult to estimate. A
well known example of a strategic investment is Nucor’s decision to be the first to invest in new
continuous casting technology that had the potential to make thin gauge sheet steel and thus open new
product markets. Nucor’s investment was justified more on the strategic importance of the investment
than on the economic analysis. As it turned out, the investment was very successful.

Improvements that increase competitiveness are often difficult to quantify. Qualitative considerations
that may influence capital investment analysis include product quality, reduction in the number of
defective units, manufacturing flexibility, reduced inventories needed to operate efficiently, employee
morale, manufacturing productivity, reduction or elimination of the need for inspection to determine
product quality, and market opportunity. Many of these qualitative factors may be as important, if not
more important, than the results of quantitative analysis. Thus, considering both economic analysis and
qualitative factors is often appropriate when making strategic decisions.
Capital Rationing
Funding for capital projects may be obtained from issuing stock, borrowing, or operating cash. Most
companies have some limitations in the amount of capital available for investment. Capital rationing is
the process by which management makes choices and allocates available funds among competing
capital investment proposals. In this process, management often uses a combination of the methods
discussed thus far.

In capital rationing, alternative proposals are often screened by establishing minimum standards for the
cash payback and the average rate of return. The proposals that survive this screening are further
analyzed using the net present value and internal rate of return methods. Throughout the capital
rationing process, qualitative factors related to each proposal should also be considered. The acquisition
of new, more efficient equipment that eliminates several jobs could lower employee morale to a level
that could decrease overall plant productivity. Alternatively, new equipment might improve the quality
of the product and thus increase consumer satisfaction and sales.

The final steps in the capital rationing process are ranking proposals according to management’s criteria,
comparing the proposals with the funds available, and selecting the proposals to be funded. Funded
proposals are included in the capital expenditures budget to assist planning and financing for
operations. Unfunded proposals may be reconsidered if funds become available later. The decision
process for capital rationing is diagramed on the following slide.

Decision Process for Capital Rationing

This flow chart begins with Alternative Capital Investment Proposals. The first decision is the ask if the
minimum cash payback and average rate of return standards met? If the answer is no, reject the
proposal. If the answer is yes, conduct further analysis. Question 2 is has the net present value and
internal rate of return standards been met? If the answer is no, reject the proposal. If the answer is yes,
further analysis. Question 3is do qualitative considerations change the decision? If the answer is yes,
reject the proposal. If the answer is no, accept the proposal. Next step is to rank the proposals. Question
4 is are capital funds available? If answer is yes, fund the proposal. If answer is no, reconsider if funds
subsequently become available. With question 1 and 2 leading to rejecting the proposals, before a final
rejection of the proposal, consider question 3, do qualitative considerations change the decision? If no,
the rejected the proposal. If yes, accept the proposal. Rank the proposal and determine if capital funds
are available. Ending with funded proposals or unfunded proposals for later consideration.
Section 3 Basic Accounting Concepts
Elements of an Accounting System
A financial accounting system is designed to collect and record data from economic transactions and
produce financial statements. Basic financial statements include the income statement, retained
earnings statement, balance sheet, and statement of cash flows. Each of these individual financial
statements provides different information, but all of the basic financial statements are inter-connected.
Accountants refer to this connection between financial statements as the articulation of financial
statements.

The basic elements of a financial accounting system include (1) standards for determining what, when,
and the amount that should be recorded for economic events, (2) a framework for preparing financial
statements, and (3) controls to determine whether errors may have arisen in the recording process.
These basic elements are found in all financial accounting systems.

In the United States, the standards for determining what, when, and the amount that should be
recorded for an entity's economic events are derived from concepts that form the foundation for
Generally Accepted Accounting Principles (GAAP). International Financial Reporting Standards (IFRS) are
used by companies domiciled in many countries. In recent years standard setting bodies have made
progress to converge GAAP and IFRS standards.

Elements of an Accounting System: The Income Statement

Although financial statements can be prepared on a cash basis, publicly traded companies must use
accrual accounting. In accrual accounting, the effects business transactions are recorded when the
economic effect occurs regardless of the timing of the related cash flows. For example if a customer
purchases merchandise on credit, the sale is recorded in the period the goods are delivered even though
the customer is not required to make payment until the next period. This results in financial statements
that are more useful since profit, resources, and claims to resources are reported.

The income statement reports results of operations for a period of time. Investors and creditors use
income statements to assess past performance and predict future performance. The income statement
starts with revenue, deducts expense, and finally adds the effects of gains, and losses for a period of
time, ending with the resulting net income. Net income is a measure of profitability. Investors are
particularly interested in this summary measure of performance. The exhibit illustrates an income
statement prepared for Capital Company for the year ended 20xx.

Capital Company
Income Statement For the Year Ended December 31, 20XX
Sales $20,345
Cost of Goods Sold $15,442
Gross Profit $4,903
Operating Expenses $2,674
 Income from Operations $2,229
Other revenue & gains $142
Other expenses & losses $755
Income before tax $1,616
Income tax expense $485
Net Income $1,131

Elements of an Accounting System: The Balance Sheet

The balance sheet reports the resources, obligations, and claims of owners at a particular date.

A balance sheet is organized to reflect the accounting equation, e.g. that assets equal the sum of
liabilities and stockholders’ equity. It shows the assets available to the organization and the debt and
equity used to acquire the assets. The accounting equation organization of the balance sheet also
demonstrates the equality of the claims of owners, stockholders’ equity, and the organization’s net
assets (assets less liabilities).

The exhibit illustrates Capital Company’s balance sheet at December 31, 20XX. Note that current assets
are listed first. These are assets expected to be converted to cash within a year. Cash is the first asset
listed, with other assets listed in order of liquidity, e.g. the ability to be converted to cash. Liabilities are
listed in order of the payment due date beginning with current liabilities, e.g., those due within a year.

Capital Company
Balance Sheet December 31, 20XX
Current Assets
Assets
Cash $9,235
Accounts Receivable $12,652
Inventories $18,583
Total Current Assets $40,470
Property Plant & Equipment $49,292
Intangible Assets $7,828
Total Assets $97,590
Liability & Stockholders’ Equity
Current Liabilities
Accounts Payable $9,396
Accrued Expenses $1,035
Short-term notes payable $565
Total Current Liabilities $8,996
Long-term Notes Payable $26,500
Total Liabilities $35,496
Stockholders’ Equity
Common Stock $2,000
 Additional Paid-in Capital $42,000
Retained Earnings $17,854
Accumulated Other Comprehensive Income $240
Total Stockholders’ Equity $62,094
Total Liabilities & Stockholders’ Equity $97,550

Elements of an Accounting System: The Statement of Cash

Flows
The statement of cash flows explains the changes in cash occurring over the financial statement period.
It reports the cash balance at the beginning of the period, sources and uses of cash during the period,
and the cash balance at the end of the period. The ending cash balance reported on the cash flow
statement will equal the balance reported for cash on the balance sheet at that date.

The statement of cash flows presents cash flows organized by type of activity so that cash flows
generated by core business activities can be distinguished from those related to investing and financing
activities.

The exhibit illustrates Capital Company’s statement of cash flows for the year ended December 31,
20XX. Note that cash at the end of the year equals the cash reported on the Capital Company’s balance
sheet on the previous slide.

Capital Company
Statement of Cash Flows For the Year Ended December
31,20XX
Operating Activities
Net Income $1,131
Adjustments to Reconcile Net Income to Net Cash
Provided by Operating Activities:
Depreciation Expense $545
Changes in Operating Assets & Liabilities:
Decrease in Accounts Receivable $237
Decrease in Accounts Payable $(193) $44
Net Cash Provided by Operating Activities $1,720
Investing Activities
Purchase of Property, Plant & Equipment $(5,255)
Net Cash Used by Operating Activities $(5,255)
Financing Activities
Payment of Cash Dividends $(330)
Proceeds from Long-Term Debt $10,000
Net Cash Provided by Financing Activities $9,670
Net Increase in Cash $6,135
 Cash at Beginning of Period $3,100
Cash at End of Period $9,235

Elements of an Accounting System: The Statement of

Retained Earnings
The statement of retained earnings explains the changes in retained earnings over the financial
statement period. It reports the retained earnings balance at the beginning of the period, items that
increase or decrease retained earnings during the period, and the retained earnings balance at the end
of the period. The ending retained earnings balance reported on the retained earnings statement will
equal the balance reported for retained earnings on the balance sheet at that date.

Retained earnings represents internally generated capital. It is increased by net income and decreased
by dividends distributed to owners.

The exhibit illustrates Capital Company’s statement of retained earnings for the year ended December
31, 20XX. Note that retained earnings at the end of the year equals the cash reported on the Capital
Company’s balance sheet presented on a previous slide.

Capital Company
Statement of Retained Earnings For the Year Ended December
31,20XX
Retained Earnings, January 1 $17,053
Add Net Income $1,131
Less Cash Dividends $330 $801
Retained Earnings, December 31 $17,854

Elements of an Accounting System

In order to prepare financial statements, transactions must be analyzed, recorded, and summarized
using a framework. The accounting equation provides a starting point for designing such a framework.
The accounting equation is expressed as follows:

Assets = Liabilities + Stockholders’ Equity

To illustrate an accounting system, we use an integrated financial statement approach. This approach
facilitates analyzing, recording, and summarizing transactions by expanding the accounting equation. As
illustrated on the next page, this approach reveals the points of articulation between financial
statements, and establishes the balance sheet as the nexus among the basic financial statements. The
integrated financial statement approach is a useful aid in analyzing the financial condition and changes
in financial condition of a company. This is because, without understanding how a company’s financial
statements are prepared and integrated, important trends or events could easily be missed.
The integrated financial statement approach has built-in controls that help ensure that transactions are
analyzed, recorded, and summarized correctly. Specifically, the accounting equation ensures that total
assets must equal total liabilities plus total stockholders' equity on the balance sheet. If at the end of the
period this equality does not hold, then it is clear that an error has occurred in either recording or
summarizing transactions. The integrated financial statement approach provides two additional
controls. First, the ending cash amount shown in the statement of cash flows column must agree with
the amount of cash reported under assets on the balance sheet. Second, the net income or loss
reported on the income statement must agree with the net effects of revenues and expenses on
retained earnings.

Integrated Financial Statements

Integrated Financial Statement Framework: Starting Family

Health Care, P.C. & Recording First Period
On September 1, 20X1, Lee Landry, M.D., organizes a professional corporation to practice general
medicine. The business will be known as Family Health Care, P.C., where P.C. refers to “professional
corporation,” and a bank account is opened in this name.

In this example, Family Health Care’s transactions will be recorded using an integrated financial
statement framework. The first transaction (a) occurs when Dr. Landry deposits $6,000 into Family
Health Care’s bank account in return for shares of the corporation’s stock. Owners of corporations are
known as stockholders, and stock issued to owners is known as capital stock. This transaction increases
cash from financing activities by $6,000 under the statement of cash flows column of the worksheet.
Increases are recorded as positive numbers, and decreases are recorded as negative numbers in the
worksheet. This transaction also increases assets (cash) by $6,000 in the left side of the accounting
equation under the balance sheet column. To record Dr. Landry’s interest in Family Health Care’s net
assets and balance the equation, stockholders' equity (capital stock) on the right side of the equation is
increased by the same amount. Since the transaction does not affect revenues or expenses, there are no
entries in the income statement column.

Note that the framework reflects only the business’ (Family Health Care, P.C.) transactions. Dr. Landry's
personal assets (i.e., a home or personal bank account) and personal liabilities are excluded. The
business is treated as an entity that is separate from its owner.

Integrated Financial Statement Framework: Borrowing

Money
Transaction (b): Family Health Care's next transaction is to borrow $10,000 from Community Bank to
finance its operations. To borrow the $10,000, Lee Landry signed a note payable in the name of Family
Health. The note payable is a liability or a claim on assets that Family Health must satisfy (pay) in the
future. In addition, the note payable requires the payment of $100 of interest each month until the note
is due and repaid in full on September 30, 20X4. The effect of this transaction is to increase cash from
financing activities by $10,000 under the statement of cash flows column. In addition, both cash and
liabilities (notes payable) are increased under the balance sheet columns. Observe how this transaction
changed the mix of assets and liabilities on the balance sheet but did not change Family Health Care's
stockholders' equity. That is, assets minus liabilities still equals the stockholders' equity of $6,000 on the
balance sheet. Since no revenues or expenses are affected, no entries are made under the income
statement column on September 1. At the end of September 20X1, the $100 interest payment will be
recorded.
Integrated Financial Statement Framework: Buying Land
Transaction (c): Next, Family Health Care buys land for $12,000 cash. The land is located near a new
suburban hospital that is under construction. Lee Landry plans for Family Health Care to rent office
space and equipment for several months and build on the land when the hospital is completed. The
effect of this transaction is an outflow of cash as an investing activity. Thus, a negative $12,000 is
entered in the statement of cash flows column as an investing activity. On the balance sheet, the
purchase of the land changes the makeup of assets, but it does not change the total amount of assets
because cash is decreased and land is increased by $12,000.

Transactions (b) and (c) have not changed the stockholders' equity of Family Health Care. They have
simply changed the mix of assets and increased the liability, notes payable. However, the objective of
businesses is to increase stockholders' equity through operations.

Integrated Financial Statement Framework: Earning Fees

Transaction (d): During the first month of operations, Family Health Care earns patient fees of $5,500,
receiving this amount in cash. The effect of this transaction is a $5,500 inflow of cash flows from
operating activities. Thus, a positive $5,500 is entered in the statement of cash flows column as an
operating activity. Since cash has been received, cash is increased by $5,500 under the balance sheet
column for assets. Fees earned of $5,500 is a revenue item that is entered in the income statement
column as a positive amount. Since net income retained in the business increases stockholders' equity
(retained earnings) and since revenues contribute to net income, $5,500 is also entered as an increase in
retained earnings in the stockholders' equity column of the balance sheet. Entering the increases of
$5,500 for cash and retained earnings in the balance sheet columns maintains the equality of the
accounting equation.

Integrated Financial Statement Framework: Paying

Expenses
Transaction (e): Family Health Care, paid the following expenses during the month: wages, $1,125; rent,
$950; utilities, $450; interest, $100; and miscellaneous, $275. Miscellaneous expenses include small
amounts paid for such items as postage due and newspaper and magazine purchases. The effect of this
transaction is an outflow of cash of $2,900 for operating activities. Thus, a negative $2,900 is entered in
the statement of cash flows column as an operating activity. Expenses reduce net income and retained
earnings. As a result, each of the expenses is listed as a negative amount in the income statement
column. Finally, a negative $2,900 is also entered in the cash and retained earnings columns of the
balance sheet.
Integrated Financial Statement Framework: Paying
Dividends
Transaction (f): At the end of the month, Family Health Care pays $1,500 to stockholders (Dr. Lee
Landry) as dividends. Dividends are distributions of business earnings to stockholders. The effect of this
transaction is an outflow of cash of $1,500 for financing activities. Thus, a negative $1,500 is entered in
the statement of cash flows column as a financing activity. In addition, the cash and retained earnings
are each decreased under the balance sheet column, by $1,500. The effect of this transaction on Family
Health Care's financial statements is summarized below. Be careful not to confuse dividends with
expenses. Dividends are not an expense since they do not represent assets consumed or services used in
the process of earning revenues. The decrease in stockholders' equity from dividends is listed in the
equation under "Retained Earnings” because dividends are considered a distribution of retained
earnings to the owners.

Family Health Care: September Transactions

In the schedule below, Family Health Care’s September transactions are identified by letter, and the
balances are shown as of the end of September. Note that under the balance sheet columns, the
accounting equation balances. That is, total assets of $17,100 ($5,100 cash + $12,000 land) equals total
liabilities plus stockholders' equity of $17,100 ($10,000 payable + $6,000 capital stock + $1,100 retained
earnings).

Stockholders’ Equity
Capital Stock and Retained Earnings are components of Stockholders’ Equity. The effects of the various
transactions on the two components of stockholders’ equity are summarized below.
Capital stock is increased by stockholder’s investments.

Retained earnings are increased by revenues and decreased by expenses and dividends.

Preparation of Financial Statements

The September transactions for Family Health Care were recorded in the order that they occurred. This
organization of transactions is not very user-friendly or helpful in analysis since it does not group and
summarize like transactions together.

The income statement is normally prepared first using the income statement column. The income
statement is prepared first because the net income or loss is needed to prepare the retained earnings
statement. The retained earnings statement is prepared second because the ending balance of retained
earnings is needed for preparing the balance sheet. The retained earnings statement is prepared using
the income statement and the amount recorded for dividends for the period. The balance sheet is
prepared next using the balances as of September 30. The statement of cash flows is normally prepared
last using the statement of cash flows column.

Each financial statement includes a title that identifies the name of the business, the title of the
statement, and the date or period of time.

Preparation of Financial Statements: Income Statement

The income statement for Family Health Care reports fee revenue of $5,500, total operating expenses of
$2,900, and net income of $2,600. The $5,500 of fee revenue was taken from the income statement
column. Likewise, the expenses were summarized from the income statement column. The expenses are
listed in order of size, beginning with the largest expense. Miscellaneous expense is usually shown as the
last item, regardless of the amount. The total expenses are subtracted from the fees earned to arrive at
the net income of $2,600. This net income will increase retained earnings (and thus total stockholders'
equity) on the balance sheet.

FAMILY HEALTH CARE, P.C.

Income Statement
For the Month Ended September 30, 20X1
Fee Revenue $5,500
Expenses:
Wage Expense $1,125
Rent Expense $950
Utilities Expense $450
Interest Expense $100
Miscellaneous Expense $275
Total Expense $2,900
Net Income $2,600

Preparation of Financial Statements: Retained Earnings

Statement
Since Family Health Care has been in operation for only one month, it has no retained earnings at the
beginning of September 20X1. The ending September balance thus equals the change in retained
earnings that results from the month’s net income and dividends. This balance, $1,100, will be the
beginning retained earnings balance for October 20X1.

FAMILY HEALTH CARE, P.C.

Retained Earnings Statement
For the Month Ended September 30, 20X1
Net Income $2,600
Less Dividends $1,500
Retained Earnings, September 30, 20X1 $1,100

Preparation of Financial Statements: Balance Sheet

The amount of Family Health Care's assets, liabilities, and stockholders' equity as of September 30 are
reported on the balance sheet. In the liabilities section of Family Health's balance sheet, notes payable is
the only liability. When a company has two or more categories of liabilities, each should be listed in the
order that they will be paid and the total amount of liabilities reported. For Family Heath, the
September 30, 20X1 Stockholders’ Equity balance consists of $6,000 of Capital Stock and Retained
Earnings of $1,100. Note that the balance sheet equation holds because total assets equals total
liabilities and stockholders’ equity, and this is readily apparent on the face of the Balance Sheet. The
Retained Earnings balance is also reported on the Retained Earnings Statement.

FAMILY HEALTH CARE, P.C.

Balance Sheet
September 30, 20X1
Assets
Cash $5,100
Land 12,000
Total Assets $17,100
Liabilities
Notes Payable 10,000
Stockholders' Equity
Capital Stock 6,000
Retained Earnings 1,100 7,100
Total Liabilities & Stockholders' Equity $17,100

Preparation of Financial Statements: Statement of Cash

Flows
Family Health Care’s Statement of Cash Flows for September is prepared from the statement of cash
flows column of the framework worksheet. Cash increased from a zero balance at the beginning of the
month to $5,100 at the end of September. A number of cash flows contributed to this net change in
cash. Cash inflows from operating totaled $2,600. Family Health Care’s cash outflows for investing
activities totaled $12,000 spent to acquire land. This purchase was financed by net cash inflows from
financing activities including $6,000 contributed by Dr. Landry and $10,000 borrowed on a note payable
less the $1,500 distributed in cash dividends.

FAMILY HEALTH CARE, P.C.

Statement of Cash Flows
For the Month Ended September 30, 20X1
Cash Flows From Operating Activities:
Cash received from customers: $5,500
Deduct cash payments for expenses 2,900
Net Cash Flow from Operating Activities $2,600
Cash Flows From Investing Activities:
Cash payments from acquisition of land (12,000)
Cash Flows From Financing Activities:
Cash received from sale of capital stock 6,000
Cash received from notes payable 10,000
16,000
 Deduct cash dividends 1,500
Net Cash Flow from Financing Activities 14,500
Net Increase in Cash $5,100
Cash Balance, September 1, 20X1 0
Cash Balance, September 30, 20X1 $5,100

Integration of Financial Statements

This exhibit illustrates the integration of Family Health Care's financial statements for September and
identifies the points of articulation. The ending cash balance of $5,100 on the balance sheet equals the
ending cash balance reported on the statement of cash flows. Since all revenues and expenses were
received and paid in cash during September, the cash flows from operating activities of $2,600 reported
on the statement of cash flows equals net income on the income statement. Net income is reported on
the income statement and the retained earnings statement. The ending retained earnings balance of
$1,100 is reported on both the retained earnings statement and the balance sheet.

Recording a Corporation’s Second Period of Operations

To reinforce the understanding of recording transactions and preparing financial statements, we
continue with Family Health Care's October transactions. During October, Family Health Care entered
into the following transactions:

Performed patient services and received fees of $6,400 in cash.

Paid expenses in cash, as follows: wages, $1,370; rent, $950; utilities, $540; interest, $100; and
miscellaneous, $220.
Paid dividends of $1,000 in cash.

These transactions have been analyzed and entered into a summary of transactions for October. The
balance sheet columns begin with the ending balances as of September 30, 20X1. This is because the
balance sheet reports the cumulative total of assets, liabilities, and stockholders' equity since the
entity’s inception.

In other words, as of October 1, Family Health Care has cash of $5,100, land of $12,000, notes payable
of $10,000, capital stock of $6,000, and retained earnings of $1,100. The October transactions are
combined with these beginning balances. In contrast, the income statement and the statement of cash
flows report only transactions for the period. While the retained earnings statement covers a period of
time, it reconciles the beginning balance to the ending balance.

Summary of October Transactions

Family Health Care Financial Statements, Second Period

The income statement for October reports net income of $3,220. This is an increase of $620, or 23.8%
($620/$2,600), from September's net income of $2,600. This increase in net income was due to fees
increasing from $5,500 to $6,400, a $900, a 16.4% ($900/$5,500) increase from September. At the same
time, total operating expenses increased only $280, or 9.7% ($280/$2,900). This suggests that Family
Health Care's operations are profitable and expanding.

The retained earnings statement reports an increase in retained earnings of $2,220. This increase results
from the addition of net income ($3,220) less dividends ($1,000) paid to Dr. Landry.
The balance sheet shows that total assets increased from $17,100 on September 30, 20X1, to $19,320
on October 31. This increase of $2,220 was due to an increase in cash from operations of $3,220 less the
dividends of $1,000 that were paid to Dr. Landry. Total liabilities remained the same, but retained
earnings and stockholders' equity increased by the same amount $2,220 as the increase in total assets.

The statement of cash flows shows net cash receipts from operations of $3,220 and a cash payment for
dividends of $1,000. The ending cash balance of $7,320 reported in the statement of cash flows also
appears on the October 31 balance sheet.

Integrated Financial Statements for October

Section 4 Sarbanes-Oxley, Internal Control,
and Cash
Sarbanes-Oxley Act of 2002
In the early 2000s investors and creditors lost millions of dollars in a series of financial reporting
scandals involving companies including Enron, WorldCom, Tyco, and Adelphia. The resulting public
outcry and loss of investor confidence led Congress to pass the Sarbanes-Oxley Public Company
Accounting Reform and Investor Protection Act in July 2002. Commonly known as the Sarbanes-Oxley
Act or SOX, the Act’s objective was to restore public confidence in securities markets and to reduce the
risk of corporate fraud.

Many view SOX as the most significant securities law since the Securities and Exchange Acts of 1933 and
1934 were passed in the wake of the great depression. SOX has a variety of provisions, including ones
that address responsibility for and reliability of financial statements. While SOX applies only to
companies whose stock is traded on public exchanges in the United States, it’s internal control
provisions have become the standard for assessing financial controls of all companies and it has had
widespread influence.

Internal control is broadly defined as the procedures and processes used by a company to safeguard its
assets, reliably process and report information, and ensure compliance with laws and regulations. These
controls are important because they can deter fraud and prevent misleading financial statements. SOX
requires companies to maintain strong and effective internal controls over recording transactions and
financial statement reporting.

SOX not only requires companies to maintain effective internal controls, but it also requires companies
and their independent accountants to report on the effectiveness of the company’s internal controls.
These reports must be filed with the company's annual 10-K report with the Securities and Exchange
Commission.

The Sarbanes-Oxley Act is considered one of the most significant laws affecting publicly held companies
in recent history.
Issues in businesses such as Enron, Tyco or WorldCom prior to the passage of Sarbanes-Oxley included
fraud and theft, leaving investors, stockholders and creditors without funds. After these companies
declared bankruptcy, the federal government enacted the Sarbanes-Oxley law. Since the passage of
Sarbanes-Oxley no businesses have closed due to fraud and theft threats, leaving investors, stockholder
and creditors in a better place.

Internal Control
Effective internal controls are required by Sarbanes-Oxley. In addition, effective internal controls help
businesses guide their operations and prevent theft and other abuses. Internal control will be described
using the framework developed by the Committee of Sponsoring Organizations (COSO), which was
formed by five major business associations. The committee's deliberations were published in Internal
Control-Integrated Framework. This framework has become the standard by which companies design,
analyze, and evaluate internal control.

The COSO framework covers reporting, operating and compliance objectives. More specifically, it
describes the objectives of internal control as providing reasonable assurance that (1) financial and
nonfinancial reporting is reliable, timely, and transparent, (2) assets are safeguarded and operations are
effective and efficient, and (3) employees comply with laws and regulations. Effective internal control
supports decision making by generating reliable information and reduces the risk of theft, fraud, and
misuse of assets.

Employee fraud is the intentional act of deception for personal gain, and often involves a breach of
internal controls. Examples of employee fraud may range from purposely overstating expenses on a
travel expense report to embezzling millions of dollars through complex schemes. Employee fraud
illustrates the interconnections between objectives related to reliable information, safeguarding assets,
and compliance with regulations. Employees attempting to defraud a business will likely seek to both
improperly divert assets from the business and adjust the accounting records in order to hide their
illegal behavior.

Elements of Internal Control

Management is responsible for designing and applying five elements of internal control to meet the
three internal control objectives. The elements are (1) the control environment, (2) risk assessment, (3)
control procedures, (4) monitoring, and (5) information and communication. These elements form an
umbrella over the business to protect it from control threats. The business's control environment is
represented by the size of the umbrella. Risk assessment, control procedures, and monitoring are the
fabric that keeps the umbrella from leaking. Information and communication link the umbrella to
management.

Control Environment
A business's control environment is the overall attitude about
the importance of controls and it forms the foundation for the
system of internal controls. The control environment is
influenced by the tone at the top that is set by management's
philosophy and operating style. A management that
overemphasizes operating goals may indirectly encourage
employees to ignore controls. For example, management pressure to achieve revenue targets may
motivate employees to fraudulently record sham sales. On the other hand, management’s emphasis of
ethical values and internal controls will likely encourage adherence to control policies and create an
effective control environment.

The COSO Framework identifies the following five principles regarding the control environment:

1. The organization demonstrates commitment to integrity and ethical values.

2. The board of directors demonstrates independence from management and exercises oversight
of the development and performance of internal control.
3. Management establishes, with board oversight, structures, reporting lines, and appropriate
authorities and responsibilities in the pursuit of objectives.
4. The organization demonstrates a commitment to attract, develop, and retain competent
individuals in alignment with objectives.
5. The organization holds individuals accountable for their internal control responsibilities in the
pursuit of objectives.

Risk Assessment
All organizations face risks, and risk is often related to opportunities and returns. A business’ reporting,
operating, and compliance objectives are all subject to risk. Examples of risks include changes in
customer demands, competitive threats, regulatory changes, changes in economic conditions, and
employee violations of policies and procedures.

Risk assessment processes identify and respond to risks. Identifying and controlling risk will help
management achieve the objectives of the business.

Once identified, risks can be analyzed to estimate their significance, assess their likelihood of occurring,
and determine actions that will minimize them. For example, the manager of a warehouse operation
may analyze the risk of employee back injuries, which might give rise to lawsuits. If the manager
determines that the risk is significant, the company may introduce employee training programs to
reduce the risk of injury.

The COSO Framework identifies the following four principles related to an entity’s risk assessment
process: specifying objectives with clarity, identifying and analyzing risks related to objectives how to
manage them, considering the potential for fraud, and identifying and assessing changes that could
affect the system of internal control.

Control Activities
Control activities are policies and procedures that help ensure that management’s directives are
followed to address risks and provide reasonable assurance that business objectives are achieved.
Control activities include a variety of activities and occur at all levels and functions of an organization.
Control procedures include competent personnel, rotating duties, and mandatory vacations; separating
responsibilities for related operations; separating operations custody of assets and accounting; and
proofs and security measures.

Segregation of duties: To decrease the possibility of inefficiency, errors, and fraud, responsibility for
custody of assets, authorization of transactions, and recording transactions should be separated so that
one person cannot perpetuate and hide a fraud. With proper segregation of duties, collusion among
multiple employees may be required for a fraud to be perpetrated and go undetected.

Competent Personnel, Rotating Duties, and Mandatory Vacations: Procedures that ensure that
employees are adequately trained and supervised, rotating duties and mandate vacations encourage
employees to adhere to prescribed procedures and help detect errors or fraud. Numerous cases of
employee fraud have been discovered after a long-term employee, who never took vacations, missed
work because of an illness or other unavoidable reasons.

Physical Controls: Physical controls safeguard assets and ensure reliable accounting data. These controls
include various dimensions of securing assets including restricting access to authorized individuals,
approval procedures, and periodical reconciliations of assets on hand with the accounting records.

Information Processing Controls: Information processing controls help ensure that data recorded in
systems is complete, valid, and accurate. These controls relate to both the overall information
processing environment and to the way data is captured and recorded.
Performance Reviews: These include a variety of reviews of performance such as the comparison of
actual to budgeted results or the relation between financial and nonfinancial data.

Monitoring
Monitoring assesses the performance of the internal control system and improves control effectiveness
by identifying weaknesses, evaluating and communicating deficiencies to responsible parties, and taking
appropriate corrective actions. The internal control system can be monitored either through ongoing
efforts by management or by separate evaluations. Ongoing monitoring efforts may include observing
both employee behavior and warning signs from the accounting system.

Separate monitoring evaluations are generally performed when there are major changes in strategy,
senior management, business structure, or operations. In large businesses, internal auditors who are
independent of operations normally are responsible for monitoring the internal control system.

Internal auditors can report issues and concerns to an audit committee of the board of directors, who
are independent of management.

In addition, external auditors also evaluate internal control as a normal part of their annual financial
statement audit.
Indicators of Internal Control Problems
These indicators may be clues to internal control problems.
1. Abrupt change in lifestyle (without
winning the lottery).
2. Close social relationships with
suppliers.
3. Refusing to take vacation.
4. Frequent borrowing from other
employees.
5. Excessive use of alcohol or drugs.
1. Missing documents or gaps in transaction
numbers (could mean documents are being
used for fraudulent transactions).
2. An unusual increase in customer refunds
(refunds may be phony).
3. Differences between daily cash receipts
and bank deposits (could mean receipts are
being pocketed before being deposited).
4. Sudden increase in slow payments
(employee may be pocketing the payment).
5. Backlog in recording transactions (possibly
an attempt to delay detection of fraud).
Information and Communication
Information and communication are essential elements of
internal control. Information about the control environment,
risk assessment, control procedures, and monitoring is
needed by management to guide operations and ensure
compliance with reporting, legal, and regulatory
requirements.

Management can also use external information to assess

events and conditions that impact decision making and
external reporting. For example, management uses
information from the Financial Accounting Standards Board
(FASB) to assess the impact of possible changes in reporting
standards.

Control of Cash Receipts

Cash includes coins, paper money, checks, money orders, and deposits that are available for withdrawal
from banks and financial institutions. Because of its transferability, cash is the asset most likely to be
diverted and used improperly by employees. In addition, many transactions either directly or indirectly
affect the receipt or the payment of cash. Businesses must therefore design and use controls that
safeguard cash and control the authorization of cash transactions.

To protect cash from theft and misuse, a business must control cash from the time it is received until it
is deposited in a bank. Businesses normally receive cash from two main sources: (1) customers
purchasing products or services and (2) customers making payments on account.

Cash Received from Cash Sales: Every business must properly safeguard and record its cash receipts. The
following discussion provides an example of common controls over cash receipts in a retail setting.
While business to business transactions would rarely be paid in cash, there would nevertheless be
control procedures.

In a retail setting, a cash register is an important control protecting cash received in over-the-counter
sales. When a clerk (cashier) enters the amount of a sale, the cash register normally displays the
amount. This is a control to ensure that the clerk has charged the customer the correct amount. The
customer also receives a receipt to verify the accuracy of the amount.

At the beginning of a work shift, each cash register clerk is given a cash drawer that contains a
predetermined amount of cash for making change for customers. At the end of the shift, the clerk and
the supervisor count the cash in that clerk's cash drawer. The amount of cash should equal the
beginning amount plus cash sales for the day. Differences will occur if errors are made in recording cash
sales or making change, and any differences would be recorded.
At the end of the accounting period, a
negative balance in the cash short and over
account is included in Miscellaneous Expense
in the income statement. A positive balance
is included in the Other Income section. If a
clerk consistently has significant cash short
and over amounts, the supervisor may
require the clerk to take additional training
or take other corrective actions.

After a cash register clerk's cash has been

counted and recorded on a memorandum
form, the cash is then placed in a store safe
in the Cashier's Department until it can be
deposited in the bank. The supervisor
forwards the clerk's cash register receipts to
the Accounting Department, where they
serve as the basis for recording the
transactions for the day.

Some retail companies use debit card

systems to transfer and record the receipt of cash. In a debit card system, a customer pays for goods at
the time of purchase by presenting a card that authorizes the electronic transfer of cash from the
customer's checking account to the retailer's bank account.

Cash Received in the Mail: Cash is received in the mail when customers pay their bills. This cash is
usually in the form of checks and money orders. Most companies' invoices are designed so that
customers return a portion of the invoice, called a remittance advice, with their payment. The employee
who opens the incoming mail should initially compare the amount of cash received with the amount
shown on the remittance advice. If a customer does not return a remittance advice, an employee
prepares one. Like the cash register, the remittance advice serves as a record of cash initially received. It
also helps ensure that the payment is accurately posted to the customer's account. Finally, as a control,
the employee opening the mail normally also stamps checks and money orders "For Deposit Only" in the
bank account of the business.

All cash received in the mail is sent to the Cashier’s Department where an employee combines it with
the receipts from cash sales and prepares a bank deposit ticket. The remittance advices and their
summary totals are delivered to the Accounting Department. An accounting clerk then prepares the
records of the transactions and posts them to the customer accounts. When cash is deposited in the
bank, the bank normally stamps a copy of the deposit ticket with the amount received. The bank receipt
is returned to the Accounting Department, where a clerk compares the receipt with the total amount
that should have been deposited. This control helps ensure that all the cash is deposited and that no
cash is lost or stolen on the way to the bank. Any shortages are thus promptly detected.

Segregating the duties of the Cashier's Department, which handles cash, and the Accounting
Department, which records cash, is a control. An employees who both handles and records cash could
steal cash and change the accounting records to hide the theft.
Cash Received by EFT: Cash may also be received from customers through electronic funds transfers
(EFTs). For example, customers may authorize automatic electronic transfers from their checking
accounts to pay monthly bills for such items as cell phone, cable, Internet, and electric services. In such
cases, the company sends the customer’s bank a signed form from the customer authorizing the
monthly electronic transfers from the customer’s checking account to the company’s bank account.
Each month, the company electronically notifies the customer’s bank of the amount of the transfer and
the date the transfer should take place. On that due date, the company records the electronic transfer
as a receipt of cash to its bank account and posts the amount paid to the customer’s account.

Most companies encourage automatic electronic transfers by customers for several reasons. First,
electronic transfers are less costly than receiving cash payments through the mail since it eliminates the
handling of cash by employees. Second, electronic transfers enhance internal controls over cash since
the cash is received directly by the bank without the handling of cash by employees. Thus, the potential
for loss or theft of cash is reduced. Finally, electronic transfers reduce late payments from customers
and speed up cash receipts processing.

Controls over cash payments should provide reasonable assurance that payments are made for only
authorized transactions. In addition, controls should ensure that cash is used efficiently. For example,
controls should ensure that all available discounts, such as purchase discounts, are taken. In a small
business, an owner/manager may authorize payments based upon personal knowledge of goods and
services purchased. In a large business, however, the duties of purchasing goods, inspecting the goods
received, and verifying the invoices are usually performed by different employees. These duties must be
coordinated to ensure that checks for proper payments are made to creditors. One system used for this
purpose is the voucher system.

Voucher System: A voucher system is a set of procedures for authorizing and recording liabilities and
cash payments. A voucher is any document that serves as proof of authority to pay cash or issue an
electronic funds transfer. For example, an invoice properly approved for payment could be considered a
voucher. In many businesses, however, a voucher is a special form for recording relevant data about a
liability and the details of its payment. A voucher system may be either manual or computerized. In a
computerized system, properly approved supporting documents (such as purchase orders and receiving
reports) would be entered directly into computer files. At the due date, the checks would be
automatically generated and mailed to creditors. At that time, the voucher would be automatically
transferred to a paid voucher file.

Cash Paid by EFT: Cash can also be paid by electronic funds transfer systems by using computers rather
than paper money or checks. A company may pay its employees by means of EFT and many companies
are using EFT systems to pay their suppliers and vendors. Electronic funds payments are becoming more
widely accepted by individuals. TeleCheck Services Inc. and PayPal offer online real-time check payment
options for purchases made over the Internet.

Use of Bank Accounts

A business often maintains several bank accounts. For example, a business with multiple branches or
retail outlets such as Target or The Gap Inc. will often maintain a bank account for each location. In
addition, businesses usually maintain a separate bank account for payroll and other special purposes.
A major reason that businesses use bank accounts is for control purposes. Use of bank accounts reduces
the amount of cash on hand at any one time. For example, many merchandise businesses deposit cash
receipts twice daily to reduce the amount of cash on hand that is susceptible to theft.

In addition to reducing the amount of cash on hand, bank accounts provide an independent record of
cash transactions that can be used to verify the business's records of transactions. That is, the use of
bank accounts provides a double recording of cash transactions. The company's recorded cash account
balance corresponds to the bank's liability (deposit) account for the company. This double recording of
cash transactions allows for a reconciliation of the cash account on the company's records with the cash
balance recorded by the bank.

Finally, the use of bank accounts facilitates the transfer of funds. For example, electronic funds transfer
systems require bank accounts for the transfer of funds between companies. Within a company, cash
can be transferred between bank accounts through the use of wire transfers. In addition, online banking
allows companies to transfer funds and pay bills electronically as well as monitor cash balances on a
real-time basis.

Bank Statement
Banks usually maintain a record of all checking account transactions. A summary of all transactions,
called a bank statement, is mailed to the depositor or made available online, usually each month.

The bank statement shows the beginning balance, additions, deductions, and the balance at the end of
the period. A typical bank statement is shown in the exhibit.
Banks may issue a debit or credit memorandum to make adjustments to the bank account balance for
items that are not initiated by the account holder. One example of a memorandum entry is a customers’
checks returned for not sufficient funds. Often called NSF checks, these are checks that were initially
deposited and recorded, but were not paid when they were presented to the customer’s bank for
payment. Since the bank initially increased the depositor’s account when the check was deposited, the
bank decreases the depositor’s account when the check is returned without payment.

The reasons for any credit or debit memoranda are indicated on the bank statement. Some common
types of credit and debit memorandum entries include:

EC – Error correction to correct a bank error

NSF – Not sufficient funds check

SC - Service charge

ACH – Automated clearing house entry for electronic funds transfer

MS - Miscellaneous item such as collection of a note receivable on behalf of the account holder
Some of the items on the preceding list always result in reduction in the bank balance. These include
NSF checks and service charges. Other items may results in either an increase or a decrease in the
account balance. ACH is a network for clearing electronic funds transfers among individuals, companies,
and banks. Because electronic funds transfers may be either deposits or payments, ACH entries may
indicate either an increase or a decrease in the account balance. Similarly, entries to correct bank errors
and miscellaneous items may involve an increase or a decrease to the bank account balance.

Bank Accounts as a Control over Cash

Bank accounts are one of the primary tools that companies use to control cash. Companies often require
that all cash receipts are deposited in a bank account. Except for very small amounts, companies usually
use checks or bank account transfers to make all cash payments. This ensures that there are two records
of cash transactions - one kept by the company and the other by the bank.

Using a bank statement, a company can compare the cash transactions recorded in its accounting
records to those recorded by the bank. The cash balance shown on a bank statement is usually different
from the cash balance in the company’s accounting records. This difference is often due to factors that
cause a company and their bank to record the same transaction at different times. For example, there is
often time lag of a day or more between the date a company writes a check and the date that it is
presented to the bank for payment. In this case, the company records the check when it is written, but
the bank does not record it until the check is presented for payment. If the company mails deposits to
the bank or uses the night depository, there will usually be a time lag between the date of the company
records the deposit and the date that it is recorded by the bank. Similarly, a bank may also increase or
decrease the company’s account for transactions about which the company will not be informed until
later. Examples include interest on account balances and bank service fees.

A difference could also be the result of errors made by either the company or the bank. For example,
the company might incorrectly post $450 to cash in the accounting records when the check was written
for $4,500. Likewise, a bank might incorrectly record the amount of a check.

Power Networking's Records and Bank Statement

Bank Reconciliation
For effective control, the reasons for the difference between the cash balance on the bank statement
and the cash balance in the accounting records should be analyzed by preparing a bank reconciliation. A
bank reconciliation is an analysis of the items and amounts that cause the cash balance reported in the
bank statement to differ from the balance of the cash account in the company’s ledger in order to
determine the proper (adjusted) cash balance.

A bank reconciliation is usually divided into two sections. The first section, referred to as the bank
section, begins with the cash balance according to the bank statement and ends with the adjusted
balance. The second section, referred to as the company section, begins with the cash balance according
to the company's records and ends with the adjusted balance. The two amounts designated as the
adjusted balance must be equal. The objective of reconciling bank accounts is to control cash by
reconciling the company’s records to the records of an independent source, the bank. In doing so, errors
or misuse of cash may be detected.

For effective control, the bank reconciliation should be prepared by an employee who does not take
part in or record cash transactions. When these duties are not properly separated, mistakes are more
likely to occur, and it is more likely that cash will be stolen or otherwise misapplied. For example, an
employee who takes part in all of these duties could prepare and cash an unauthorized check, omit it
from the accounts, and omit it from the reconciliation.

Bank Reconciliation for Power Networking

POWER NETWORKING
Bank Reconciliation
July 31, 20XX
Cash balance according to bank $ 3,359.78
statement
Add deposit of July 31, not recorded by 816.20
bank
$ 4,175.98
Deduct outstanding checks:
No. 812 $ 1,061.00
No. 878 435.39
No. 883 48.60 1,544.99
Adjusted balance $ 2,630.99 ←
Cash balance according to Power $ 2,549.99
Networking records
Add not and interest collected by bank 408.00
$ 2,957.99
Deduct: Check returned because of $ 300.00
insufficient funds
Bank service charge 18.00
Error in recording Check No. 879 9.00 327.00
Adjusted balance $ 2,630.99 ←

Power Networking bank reconciliation begins with the cash balance according to the bank statement.
Add any deposits not recorded by the bank, usually because they were made after the statement closed.
Deduct any outstanding checks to get an adjusted balance.

Look at the cash balance according to Power Networking records. Add note and interest collected by the
bank. Deduct check returned for insufficient funds, bank service charge or errors in recording checks.
This gives an adjust balance that should match the bank balance.

Special-Purpose Cash Funds

It is usually not practical for a business to write checks to pay small amounts, such as postage. Yet, these
small payments may occur often enough to add up to a significant amount. Thus, it is desirable to
control such payments. A special cash fund, called a petty cash fund, is used for this purpose.
A petty cash fund is established by first estimating the amount of cash needed for payments from the
fund during a period, such as a week or a month. After necessary approvals, a check is written and
cashed for this amount. The money obtained from cashing the check is then given to an employee,
called the petty cash custodian, who is authorized to disburse cash from the fund. For control purposes,
the company may place restrictions on the maximum amount and the types of payments that can be
made from the fund. Each time a payment is made from petty cash, the custodian records the details of
the payment on a petty cash receipt form. The petty cash fund is normally replenished at periodic
intervals or when it is depleted or reaches a minimum amount. When a petty cash fund is replenished,
the accounts are adjusted by summarizing the petty cash receipts. A check is then written for this
amount, payable to petty cash.

In addition, businesses often use other cash funds to meet special needs, such as travel expenses for
salespeople. Retail businesses use change funds for making change for customers. Finally, most
businesses use a payroll bank account to pay employees. Such cash funds are called special-purpose
funds. Just like a petty cash fund, any of these other special-purpose cash fund is initially established by
first estimating the amount of cash needed for payments from the fund during a period, such as a week
or a month. After necessary approvals, a check is written and cashed for this amount. The money
obtained from cashing the check is then given to an employee, called the custodian, who is authorized
to disburse money from the fund. For control purposes, the company may place restrictions on the fund.

Reporting Cash on Financial Statements

Cash is the most liquid asset, and therefore it is listed as the first asset on the balance sheet. Most
companies present only a single cash amount on the balance sheet that represents the total of all their
bank and cash fund accounts. A company may have cash in excess of its immediate operating needs. In
such cases, the company may invest in highly liquid investments in order to earn interest. These
investments are called cash equivalents. Examples of cash equivalents include U.S. Treasury Bills, notes
issued by major corporations (referred to as commercial paper), and money market funds. Companies
that have invested excess cash in cash equivalents usually report cash and cash equivalents as one
amount on the balance sheet. Large corporations often disclose the details of their cash and cash
equivalents in the notes to the financial statements, an example of which follows:

(in millions) June 30, June 30,

20X1 20X2
Cash and cash equivalents
Cash $ 4,020 $ 4,128
Money market mutual funds 247 400
Commercial paper 189 2,250
U.S. government and agency 40 12
securities
Corporate notes and bonds 3500 –
Munincipal securities 452 16
$ 8,448 $ 6,806
Banks may require companies to maintain minimum cash balances in their bank accounts. Banks may
impose require such a compensating balance as a part of a loan agreement or line of credit. A line of
credit is a preapproved amount that the bank is willing to lend to a customer upon request. If significant,
compensating balances should be disclosed in notes to the financial statements.
Section 5 Budgeting and Standard Cost
Systems
Objectives of Budgeting
A budget charts a course for a business by outlining its plans in monetary terms. The budgeting process
requires planning, establishing and communicating goals, monitoring and evaluating performance, and
taking corrective action. This makes budgets an important tool that helps businesses navigate through
the budget period and manage risk.

Budgets are used by all types of entities including profit-making businesses, governments and non-profit
entities. There are a variety of budgeting approaches, but in general budgeting involves (1) establishing
specific goals for the overall entity and its units, (2) executing plans to achieve the goals, and (3)
periodically comparing actual results with the goals and (4) considering appropriate actions in response.
Establishing specific goals for future operations relates to management’s planning function, while
executing actions to meet the goals is part of management’s directing function. Periodically comparing
actual results with these goals and taking appropriate action is the controlling function of management.
The relationships of these functions are illustrated below.

Human Behavior and Budgeting

Business, team, and individual goals are established in the budgeting process. Since organizations are
composed on individuals, human behavior is an important consideration when establishing budget
goals. Employee behaviors may not maximize odds of achieving the organization’s goal if (1) a budget
goal is unachievable (too tight), (2) a budget goal is very easy to achieve (too loose), or (3) budget goals
of the business conflict with the objectives of employees (goal conflict).

People can become discouraged if performance expectations are set too high. If employees view budget
goals as unrealistic or unachievable, the budget may actually discourage employees from working hard
or internalizing the goals. On the other hand, aggressive but attainable goals can inspire employees to
achieve the goals. Therefore, participative budgeting, where employees participate in the budget
process may be helpful in establishing appropriate budget goals.

Although employees can be incentivized by attainable goals, it is undesirable to set goals that are far
below what is possible. Such budget "padding” is termed budgetary slack. Managers may incorporate
slack into budgets in order to provide a "cushion" for unexpected events or to improve the appearance
of operations. Budgetary slack may be an unintended consequence of participative budgeting, but it can
be reduced or avoided by requiring lower and mid-level managers to support their spending
requirements with operational plans.

Goal conflict occurs when an individual’s self interest differs from business objectives. This can happen
when budget goals for individual units conflict with overall business objectives. Such conflicts can be
subtle. For example, the Sales Department manager may be given a sales goal, while the Manufacturing
Department manager may be given a cost reduction goal. It may be difficult to satisfy both goals since
selling more will likely require that more goods are manufactured. When designing goals, considering
consistency across the organization can reduce goal conflict.

Budgeting Systems
Budgeting systems vary among businesses because of such factors as organizational structure,
complexity of operations, and management philosophy. Differences in budget systems are even more
significant among different types of businesses, such as manufacturers and service businesses.

The budgetary period for operating activities usually includes the fiscal year of a business. A year is short
enough that future operations can be estimated fairly accurately, yet long enough that the future can be
viewed in a broad context. However, to achieve effective control, annual budgets may be subdivided
into shorter time periods, such as quarters, months, or weeks.

Two examples of budget periods that do not have a fixed length include life cycle budgeting and
continuous budgeting. In life cycle budgeting, the full length of a project defines the budget period. This
method can incorporate all phases of a product from R&D through phase-out and recycling. Life cycle
budgeting typically spans multiple years. Continuous budgeting is a variation of fiscal-year budgeting
that maintains a rolling 12-month period. The 12-month budget is continually revised by removing the
data for the month just ended and adding estimated budget data for the same month next year, as
shown below:
Developing budgets for the next fiscal year usually begins several months prior to the end of the current
year. This responsibility may be assigned to a budget committee that often consists of the budget
director and such high-level executives as the controller, the treasurer, production managers, and sales
managers. Once the budget has been approved, the budget process is typically monitored, summarized,
and communicated to the committee by accountants. There are several approaches for developing
budgets.

In incremental approaches, last year's budget is revised based on actual results and expected changes
for the coming year. Two types of budgets using an incremental approach are the static budget and the
flexible budget.

In minimum level approaches, a base budget amount is established for specific items, and budgeting
more than this amount requires justification. One variant of this method, zero-based budgeting,
requires managers to estimate sales, production, and other operating data as though operations are
being started for the first time. This approach is often used by governmental units and has the benefit of
taking a fresh view of operations each year.

In activity-based approaches, activities that incur costs are identified, costs drivers are established for
the various activities, and these are used to compile budgeted amounts based on expected activity
levels. This approach often involves detailed cost planning and strong links between budgets and the
entity’s goals, but it is also costly when compared to other more traditional budgeting approaches.

Static Budgets
A static budget shows expected results for only one activity level. Once the budget is determined, it is
not changed, even if a unit’s level of activity changes. This is a disadvantage of static budgets. Static
budgeting is used by many service companies and some administrative functions of manufacturing
companies, such as purchasing, engineering, and accounting. The following is an example of a static
budget.

Acme Manufacturing Company

Assembly Department Budget
For the Year Ended July 31, 20XX
Direct labor $40,000
Electric power 5,000
Supervisor salaries 15,000
Total Department Costs $60,000

Budgeting Systems: Flexible Budgets

Unlike static budgets, flexible budgets show the expected results of a responsibility center for several
activity levels. A flexible budget is thus a series of static budgets for different levels of activity. Flexible
budgets are especially useful for estimating and controlling factory costs and operating expenses. The
example below is a flexible budget for Acme Manufacturing Company’s Assembly Department.
 Acme Manufacturing Company
Assembly Department Budget
For the Year Ended July 31, 20XX
Units of Production 8,000 9,000 10,000
Variable Costs:
Direct labor ($5 per unit) $40,000 $45,000 $50,000
Electric power ($0.50 per unit) 4,000 4,500 5,000
Total Variable Costs $44,000 $49,500 $55,000
Fixed Costs
Electric Power $1,000 $1,000 $1,000
Supervisor Salaries 15,000 15,000 15,000
Total Fixed Costs $16,000 $16,000 $16,000
Total Assembly Department Costs $60,000 $65,000 $71,000

With the flexible budget, the Assembly Department’s performance can be evaluated by comparing
actual costs to amounts budgeted for the actual level of activity. For example, if the department
produced 10,000 units and spent $70,000, the department would be $1,000 under the $71,000
budgeted for this level of activity. If a static budget had been prepared at the 8,000 unit level of activity,
the department would have been $12,000 over the $60,000 budgeted. A flexible budget is much more
helpful in evaluating performance relative to activity level.

Budgeting Systems
Computerized budgeting systems are commonly used in developing budgets. Such systems can help
businesses prepare a budget more quickly and at a lower cost. Computerized systems facilitate the
timely comparison of actual results with budgeted amounts. Computers can play a particularly
important role in continuous budgeting.

Managers often use computer spreadsheets or simulation models to analyzed operating and budget
relationships. By using computer simulation models, the impact of various operating alternatives on the
budget can be assessed. For example, the budget can be revised to show the impact of a proposed
change in wage rates. Likewise, the overall budgetary effect of a proposed product line can be
estimated.

A common objective of using computer-based budgeting is to tie all the budgets of the organization
together. Some budgeting and planning systems accomplish this by using Web-based applications to tie
thousands of employees together.

Master Budget
Organizations prepare a series of budgets that are linked together in a master budget that facilitates
coordination of operations and preparation of budgeted financial statements. Many types of
organizations use master budgets. This example illustrates the budgeting process for a manufacturer.
The major parts of the master budget for a manufacturer:

Budgeted Income Statement Budgeted Balance Sheet

Sales budget Cash budget
Cost of goods sold budget: Capital expenditures budget
Production budget
Direct materials purchases budget
Direct labor cost budget
Factory overhead cost budget
Selling and administrative expenses budget

The budgeting process begins by estimating sales for a sales budget. The sales budget is then provided
to the various units as the basis for estimating production and selling and administrative expenses for
budgets. The production budgets are used to prepare the direct materials purchases, direct labor cost,
and factory overhead cost budgets. These three budgets are used to develop the cost of goods sold
budget. Once all these budgets have been completed, the budgeted income statement can be prepared.

After the budgeted income statement is developed, the budgeted balance sheet can be prepared. Two
major budgets related to the budgeted balance sheet are the cash budget and the capital expenditures
budget.

Income Statement Budgets

This exhibit illustrates the relationship among the various income statement budgets. A small
manufacturing business, Elite Accessories Inc., will be used as the basis to illustrate the major elements
of the income statement budget.
Sales Budget
The sales budget forecasts sales revenues. For each product, it normally includes (1) the estimated
quantity of unit sales and (2) the expected unit selling price. These data are often reported by regions or
by sales representatives.

In estimating the quantity of sales for each product, past sales volumes are often used as a starting
point. These amounts are revised for factors expected to affect future sales, such as the following:

• Backlog of unfilled sales orders

• Planned advertising and promotion
• Expected industry and general economic conditions
• Productive capacity
• Projected pricing policy
• Findings of market research studies

Once an estimate of the sales volume is made, the expected sales revenue is determined by multiplying
the volume by the expected unit sales price.

For control purposes, management can compare actual sales and budgeted sales by product, region, or
sales representative. Management would investigate any significant differences and take possible
corrective actions.
Sales Budget for Elite Accessories Inc.
ELITE ACCESSORIES INC.
Sales Budget
For the Year Ended December 21, 20XX
Product and Region Unit Sales Unit Selling Total Sales
Volume Price
Wallet:
East 287,000 $12.00 $ 3,444,000
West 241,000 12.00 2,892,000
Total 528,000 $ 6,336,000
Handbag:
East 156,400 $25.00 $ 3,910,000
West 123,600 25.00 3,090,000
Total 280,000 $ 7,000,000
Total revenue from $ 13,336,000
sales

Production Budget
Production should be carefully coordinated with the sales budget to ensure that production and sales
are kept in balance during the period. The number of units to be manufactured to meet budgeted sales
and inventory needs for each product is set forth in the production budget. The budgeted volume of
production is determined as follows:

Below is the production budget for Elite Accessories Inc.

ELITE ACCESSORIES INC.

Production Budget
For the Year Ended December 31, 20XX
Units
Wallet Handbag
Expected units to be sold 528,000 280,000
 Plus desired ending inventory, Dec. 31, 20XX 80,000 60,000
Total 608,000 340,000
Less estimated beginning inventory, Jan. 1, 20XX 88,000 48,000
Total units to be produced 520,000 292,000

Direct Materials Purchases Budget

The production budget is the starting point for determining the estimated quantities of direct materials
to be purchased. Multiplying these quantities by the expected unit purchase price determines the total
cost of direct materials to be purchased.

In Elite Accessories Inc.’s production operations, leather and lining are required for wallets and
handbags. The direct materials purchases budget is prepared. As shown in the budget, for Elite
Accessories Inc. to produce 520,000 wallets, 156,000 square yards (520,000 units x 0.30 square yard per
unit) of leather are needed. Likewise, to produce 292,000 handbags, 365,000 square yards (292,000
units x 1.25 square yards per unit) of leather are needed. We can compute the needs for lining in a
similar manner. Then adding the desired ending inventory for each material and deducting the
estimated beginning inventory determines the amount of each material to be purchased. Multiplying
these amounts by the estimated cost per square yard yields the total materials purchase cost.

The direct materials purchases budget helps management maintain inventory levels within reasonable
limits. For this purpose, the timing of the direct materials purchases should be coordinated between the
Purchasing and Production Departments.

Direct Materials Purchases Budget for Elite Accessories Inc.

Direct Materials
Leather Lining Total
Square yard required for
production
Wallet (Note A) 156,000 52,000
Handbag (Note B) 365,000 146,000
Plus desired inventory, Dec. 31, 20,000 12,000
20XX
Total 541,000 210,000
 Less estimated inventory, Jan. 1, 18,000 15,000
20XX
Total square yards to be 523,000 195,000
purchased
Unit price (per square yard) ×$4.50 ×$1.20
Total direct materials to be $2,353,500 $234,000 $2,587,500
purchased

Note A:Leather: 520,000 units × 0.30 square yard per unit = 156,000 square yards

Lining: 520,000 units × 0.10 square yard per unit = 52,000 square yards

Note B:Leather: 292,000 units × 1.325 square yard per unit = 365,000 square yards

Lining: 292,000 units × 0.50 square yard per unit = 146,000 square yards

Direct Labor Cost Budget

The production budget also provides the starting point for preparing the direct labor cost budget. As
shown in the budget, for Elite Accessories Inc. to produce 520,000 wallets, 52,000 hours (520,000 units X
0.10 hour per unit) of labor in the Cutting Department are required. Likewise, to produce 292,000
handbags, 43,800 hours (292,000 units X 0.15 hour per unit) of labor in the Cutting Department are
required. In a similar manner, we can determine the direct labor hours needed in the Sewing
Department to meet the budgeted production. Multiplying the direct labor hours for each department
by the estimated department hourly rate yields the total direct labor cost for each department. The
direct labor needs should be coordinated between the Production and Personnel Departments. This
ensures that there will be enough labor available for production.

ELITE ACCESSORIES INC.

Direct Labor Cost Budget
For the Year Ended December 31, 20XX
Cutting Sewing Total
Hours required for production:
Wallet (Note A) 52,000 130,000
Handbag (Note B) 43,800 116,800
Total 95,800 246,800
Hourly Rate ×$12.00 ×$15.00
Total direct labor cost $1,149,600 $3,702,000 $4,851,600

In this example the total direct labor cost is $4,851,600.

Note A: Cutting Department for 520,000 units × by .10 hour per unit = 52,000 hours
 The Sewing Department for 520,000 units × by .25 hour per unit = 130,000 hours

Note B: Cutting Department for 292,000 units × by .15 hour per unit = 43,800 hours

The Sewing Department for 292,000 units × by .40 hour per unit = 116,800 hours

Factory Overhead Cost Budget

The estimated factory overhead costs necessary for production make up the factory overhead cost
budget. This budget usually includes the total estimated cost for each item of factory overhead, as
shown below.

ELITE ACCESSORIES INC.

Factory Overhead Cost Budget
For the Year Ended December 31, 20XX
Indirect factory wages $ 732,800
Supervisory salaries 360,000
Power and light 306,000
Depreciation of plant and equipment 288,000
Indirect materials 182,800
Maintenance 140,280
Insurance and property taxes 79,200
Total factory overhead cost $ 2,089,080

A business may prepare supporting departmental schedules, in which the factory overhead costs are
separated into their fixed and variable cost elements. Such schedules enable department managers to
direct their attention to those costs for which they are responsible and to evaluate performance.

Cost of Goods Sold Budget

The direct materials purchases budget, direct labor cost budget, and factory overhead cost budget are
the starting point for preparing the cost of goods sold budget.

These data are combined with the desired ending inventory and the estimated beginning inventory data
to determine the budgeted cost of goods sold shown below.
This example shows the starting point is the beginning inventory, add net purchases equals the goods
available for sale. Factor in the cost of goods sold and the result is your ending inventory.

ELITE ACCESSORIES INC.

Cost of Goods Sold Budget
For the Year Ended December 31, 20XX
Finished goods inventory $ 1,095,600
Jan. 1, 20XX
Work in process $ 214,400
inventory, Jan. 1, 20XX
Direct materials:
Direct materials $ 99,000
inventory Jan. 1, 20XX
(Note A)
Direct materials 2,587,500 ←— Direct materials
purchases (from Exhibit purchases budget
9)
Cost of direct materials $2,686,500
available for use
Less direct materials 104,400
inventory, Dec. 31, 20XX
(Note B)
Cost of direct materials $2,582,100
placed in production
Direct Labor 4,851,600 ←— Direct labor cost
budget
 Factory overhead 2,089,080 ←— Factory overhead
cost budget
Total manufacturing 9,522,780
costs
Total work in process $9,737,180
during period
Less finished goods 220,000
inventory, Dec. 31, 20XX
Cost of goods 9,517,180
manufactured
Cost of finished goods $10,612,780
available for sale
Less finished goods 1,565,000
inventory, Dec. 31, 20XX
Cost of goods sold $9,047,780
Note A: Leather 18,000 sq. yds. X $4.50 $81,000
per sq. yd.
Lining: 15,000 sp. yds. X $1.20 18,000
per sq. yd.
Direct Materials $99,000
inventory, Jan. 1, 20XX
Note B: Leather 20,000 sq. yds. X $4.50 $90,000
per sq. yd.
Lining: 12,000 sp. yds. X $1.20 14,400
per sq. yd.
Direct Materials $104,400
inventory, Dec. 31, 20XX

Looking at an example, the cost of goods sold budget for Elite Accessories Inc begins with a finished
goods inventory of $1,095,600 as of Jan 1st.

We show a work in process inventory, as of Jan 1st of $214,400.

We take the direct materials, which shows a direct materials inventory of $99,000 and direct materials
purchased of $2,587,500 (from the direct materials purchases budget) for a total cost of direct materials
available for use of $2,686,500.

We take out the material inventory as of Dec 31 of $104,400, giving us a total cost of direct materials
placed in production of $2,585,100. We add in direct labor of $4,851,600 and factory overhead of
$2,089,080 ( both come from their respective budgets). Our total manufacturing cost is $9,522,780, (the
total of cost of direct materials, direct labor and factory overhead). We add in the work in process
inventory of Jan 1 which gives us a total work in process during the period of $9,737,180.

Subtract the work in process inventory Dec 31 of $220,000, leaving a cost of goods manufactured of
$9,517,180. We add the beginning finished goods inventory Jan 1 to the cost of good manufactured for a
total of $10,615,780, which is our cost of finished goods available for sale. Subtract the less finished
good inventory Dec 31 of $1,565,000 for a cot of goods sold of $9,047,780.

We see Note A regarding Leather of 18,000 square yards multiplied by $4.50 per square yard totally
$81,000; and lining of 15,000 square yards multiplied by $1.20 per square yard totally $18,000. The sum
of these two are the direct materials inventory on Jan 1st of $99,000.

Note B shows leather of 20,000 square yards multiplied by $4.50 per square yard totally $90,000; and
lining of 12,000 square yards multiplied by $1.20 per square yard totally $14,400. The sum of these two
are the direct materials inventory on Jan 1st of $104,400.

Selling and Administrative Expenses Budget

The sales budget is often used as the starting point for estimating the selling and administrative
expenses. For example, a budgeted increase in sales may require more advertising. Below is a selling and
administrative expenses budget for Elite Accessories Inc.

ELITE ACCESSORIES INC.

Selling and Administrative Expenses Budget
For the Year Ended December 31, 20XX
Selling expenses:
Sales salaries expense $715, 000
Advertising expense 360,000
Travel expense 115,000
Total selling expenses $1,190,000
Administrative expenses:
Officers' salaries expense $360,000
Office salaries expense 258,000
Office rent expense 34,500
Office supplies expense 17,500
Miscellaneous administrative expense 25,000
Total administrative expense 695,000
Total selling and administrative expenses $1,885,000

Detailed supporting schedules are often prepared for major items in the selling and administrative
expenses budget. An advertising expense schedule for the Marketing Department should include the
advertising media to be used (newspaper, direct mail, television), quantities (column inches, number of
pieces, minutes), and the cost per unit. Effective control results from assigning responsibility for
achieving the budget to department supervisors.

Budgeted Income Statement

The budgets for sales, cost of goods sold, and selling and administrative expenses, combined with the
data on other income, other expense, and income tax, are used to prepare the budgeted income
statement. Below is a budgeted income statement for Elite Accessories Inc. The budgeted income
statement summarizes the estimates of all phases of operations. This allows management to assess the
effects of the individual budgets on profits for the year. If the budgeted net income is too low,
management could review and revise operating plans in an attempt to improve income.

ELITE ACCESSORIES INC.

Budgeted Income Statement
For the Year Ended December 31, 20XX
Revenue from sales $13,336,000 ← Sales budget
Cost of goods sold 9,047,780 ← Cost of goods sold
Gross profit 4,288,220 budget

Selling and
administrative
expense:
Selling expense $1,190,000 ← Selling and
administrative
Administrative 695,000
expenses budget
expenses ←
Total selling and 1,885,000
administrative
expenses
Income from $2,403,220
operations
Other income:
Interest revenue $98,000
Other expense:
Interest expense 90,000 8,000
Income before $2,411,220
income tax
Income tax 600,000
Net income $1,811,220

Cash Budget
Managers use balance sheet budgets to plan their firm’s objectives related to financing, investing, and
cash. The cash and capital expenditure budgets for Elite Accessories Inc. will be used to illustrate
balance sheet budgets. The cash budget is one of the most important elements of the budgeted balance
sheet. The cash budget presents expected cash receipts (inflows) and cash payments (outflows) for a
period of time. Information from the various operating budgets, including the sales budget, direct
materials purchases budget, and selling and administrative expenses budget, affects the cash budget. In
 addition, the capital expenditures budget, dividend policies, and plans for equity or long-term debt
financing affect the cash budget.

In this example, the Elite Accessories Inc.’s monthly cash budget for January, February, and March 2009
are prepared by developing the estimated cash receipts and estimated cash payments portion of the
cash budget. Estimated cash receipts are planned additions to cash from sales and other sources, such
as issuing securities or collecting interest. A supporting schedule can be used to estimate collections
from sales.

Elite Accessories Inc. expects to sell 10% of its merchandise for cash. Of the remaining 90% of sales that
made on account, 60% are expected to be collected in the month of the sale and the remainder in the
next month. This information is used to prepare Elite Accessories’ schedule of collections from sales
presented on the following slide. The cash receipts from sales on account are determined by adding
amounts expected to be collected from credit sales made the current period (60%) and the receipts
from credit sales made in the previous period (40%) that would have been accrued as accounts
receivable.

Schedule of Collections from Sales

ELITE ACCESSORIES INC.
Schedule of Collections from Sales
For the Three Months Ended March 31, 20XX
January February March
Receipts from cash sales:
Cash sales (10% × current month's sales– $108,000 $124,000 $97,000
Note A)
Receipts from sales on account:
Collections from prior month's sales $370,000 $388,800 $446,400
(40% of previous month's credit sales–
Note B)
Collections from current month's sales 583,200 669,600 523,800
(60% of current month's credit sales–
Note C)
Total receipts from sales on account $953,200 $1,058,400 $970,200
Note A: $124,000 = $1,240,000 × 10%

$97,000 = $970,000 × 10%

Note B: $388,800 = $1,080,000 × 90% × 40%

$446,400 = $1,240,000 × 90% × 40%

Note C: $669,600 = $1,240,000 × 90% × 60%

$523,800 = $970,000 × 90% × 60%

Cash Budget
Estimated cash payments are planned cash expenditures for manufacturing costs, selling and
administrative expenses, capital expenditures, and other uses such as buying securities or paying
interest or dividends. Elite Accessories estimates $24,000 per month for depreciation expense on
machines, and this amount was included in manufacturing costs. Accounts payable were related to
manufacturing costs and Elite Accessories expects to pay 75% manufacturing costs in the month in
which they are incurred and the balance in the next month. Elite Accessories’ cash payments are
determined by adding the amounts paid for the current period’s costs (75%) and amounts accrued as a
liability from costs in the previous period (25%) that will paid in the current period. The $24,000 of
depreciation must be excluded all budgeted amounts, since depreciation is a noncash expense that
should not be included in the cash budget.

ELITE ACCESSORIES INC.

Schedule of Payments for Manufacturing Costs
For the Three Months Ended March 31, 20XX
January February March
Payments of prior month's $190,000 $204,000 $189,000
manufacturing costs
{[25% × previous month's
manufacturing costs
(less depreciation)] – Note A}
Payments of current month's 612,000 567,000 591,000
manufacturing costs
{[75% × current month's manufacturing
costs
(less depreciation)] – Note B}
Total payments $802,000 $771,000 $780,000
Note A: $190,000, given as of January 1, 2009, Accounts Payable balance
$204,000 = ($840,000 - $24,000) × 25%
$446,400 = ($780,000 - $24,000) × 25%
Note B: $612,000 = ($840,000 - $24,000) × 75%
$567,000 = ($780,000 - $24,000) × 75%
$591,400 = ($812,000 - $24,000) × 75%

To complete the cash budget for Elite Accessories Inc., assume that Elite Accessories Inc. is expecting the
following related cash:

• Cash balance on January $280,000

• Quarterly taxes paid on March 31 150,000
• Quarterly interest expense paid on January 10 22,500
• Quarterly interest revenue received on March 21 24,500
• Equipment purchased for cash in February 274,000
In addition, monthly selling and administrative expenses are paid in the month incurred and are
expected to be: January ($160,000), February ($165,000), and March ($145,000).

The minimum cash balance protects against variations in estimates and for unexpected needs for cash.
For effective cash management, much of the minimum cash balance should be deposited in income-
producing securities that can be readily converted to cash. U.S. Treasury Bills or Notes are examples of
such securities.

Using the cash budget prepared for Elite Accessories, Inc. that is presented on the next slide, we can
compare the estimated cash balance at the end of the period with the minimum balance required by
operations. Assuming that the minimum cash balance for Elite Accessories Inc. is $340,000, we can
determine any expected excess or deficiency.

Cash Budget for Elite Accessories Inc.

ELITE ACCESSORIES INC.
Cash Budget
For the Three Months Ended March 31, 20XX
January February March
Estimated Cash receipts from:
Cash sales $108,000 $124,000 $97,000 ← Schedule of
Collections 953,200 1,058,400 970,200 collections
← from sales
of accounts
receivable
Interest 24,500
revenue
Total cash $1,061,20 $1,182,40 $1,091,70
receipts 0 0 0
Estimated cash
payments for:
Manufacturi $802,000 $771,000 $780,000 ← Schedule of
ng costs cash
payments for
Selling and 160,000 165,000 145,000 manufacturin
administrative g costs
expenses
Capital additions 274,000
Interest expense 22,500
Income taxes 150,000
Total cash $984,500 $1,210,00 $1,075,00
payments 0 0
Cash increase $76,700 $(27,600) $16,700
(decrease)
 Cash balance at 280,000 356,700 329,100
the beginning of
the month
Cash balance at $356,700 $329,100 $345,800
the end of the
month
Minimum cash 340,000 340,000 340,000
balance
Excess $16,700 $(10,900) $5,800
(deficiency)

Capital Expenditures Budget

The capital expenditures budget summarizes plans for acquiring fixed assets. Such expenditures are
necessary as machinery and other fixed assets wear out, become obsolete, or for other reasons need to
be replaced. In addition, it may be necessary to expand plant facilities when demand for a company's
product increases. The useful life of many fixed assets extends over long periods of time, and
expenditures for fixed assets may vary from year to year. It is normal to project capital expenditures for
a number of periods into the future in preparing the capital expenditures budget. The exhibit below is a
5-year capital expenditures budget for Elite Accessories Inc.

ELITE ACCESSORIES INC.

Capital Expenditures Budget
For the 5 Years Ended March 31, 20X4
Item 20XX 20X1 20X2 20X3 20X4
Machinery-Cutting $400,000 $280,000 $360,000
Department
Machinery-Sewing 274,000 260,000 560,000 200,000
Department
Office equipment 90,000 60,000
Total $674,000 $350,000 $560,000 $480,000 $420,000

The capital expenditures budget should be considered in preparing the other operating budgets. For
example, the estimated depreciation of new equipment affects the factory overhead cost budget. Plans
for financing capital expenditures may also affect the cash budget.

Budgeted Balance Sheet

The budgeted balance sheet estimates an entity’s financial condition at the end of the budget period.
The budgeted balance sheet assumes that all operating budgets and financing plans are met. It has a
format similar to a balance sheet based on actual data in the accounts. For this reason, a budgeted
balance sheet for Elite Accessories Inc. is not illustrated.
If the budgeted balance sheet indicates a weakness in financial position, it may be advisable to revise
the financing plans or other plans. For example, a large amount of long-term debt in relation to
stockholders’ equity might require revising financing plans for capital expenditures. Such revisions might
include issuing equity rather than debt.

Standards
Standards are performance goals. Service, merchandising, and manufacturing businesses may all use
standards to evaluate and control operations. For example, long-haul drivers for the United Parcel
Service are expected to drive a standard distance per day. The Limited’s sales associates are expected to
meet sales standards.

Manufacturers normally use standard costs for each of the three manufacturing costs: direct materials,
direct labor, and factory overhead. Accounting systems that use standards for these costs are called
standard cost systems. These systems enable management to determine how much a product should
cost (standard cost), how much it actually costs (actual cost), and the reasons for any difference (cost
variances). When actual costs are compared with standard costs, only the exceptions or variances are
reported for cost control. This reporting by the principle of exceptions allows management to focus on
correcting the variances. Thus, using standard costs assists management in controlling costs and in
motivating employees to focus on costs.

Setting standards is both an art and a science. The standard-setting process normally requires the joint
efforts of accountants, engineers, and other management personnel. Setting standards often begins
with analyzing past operations. However, standards are not just an extension of past costs, and caution
must be used in relying on past cost data. For example, inefficiencies may be contained within past
costs. In addition, changes in technology, machinery, or production methods may diminish the relevance
of past costs for future operations.

Types of Standards
Standards imply an acceptable level of production efficiency. One of the major objectives in setting
standards is to motivate workers. To achieve the most benefit from standard costing, standards should
be attainable. Standards that are too loose may not motivate employees to perform their best since the
standard level of performance can be reached easily. As a result, operating performance may be lower
than what is possible. Tight, unrealistic standards may also negatively affect performance. Workers may
become frustrated with an inability to meet standards and may give up trying to do their best. Ideal
standards, also known as theoretical standards, can be achieved only under perfect operating
conditions, such as no idle time, no machine breakdowns, and no materials spoilage. Although ideal
standards are not widely used because they are often unattainable, a few firms use ideal standards to
motivate changes and improvement. This approach is termed "Kaizen costing.” Kaizen is a Japanese
term meaning "continuous improvement.”

Most companies use currently attainable standards (sometimes called normal standards). These
standards represent performance that can be attained with reasonable effort. Attainable standards
allow for normal production difficulties and mistakes, such as materials spoilage and machine
breakdowns. Attainable standards may help motivate employees to become more focused on costs and
more likely to put forth their best efforts.

Issues with Standards

Standard costs should be continuously reviewed and should be revised when they no longer reflect
operating conditions. Inaccurate standards may distort management decision making and may weaken
management's ability to plan and control operations.

Standards should not be revised just because they differ from actual costs. They should be revised only
when the standards no longer reflect the operating conditions that they were intended to measure. For
example, the direct labor standard would not be revised simply because workers were unable to meet
properly determined standards. On the other hand, standards should be revised when prices, product
designs, labor rates, or manufacturing methods change. For example, when aluminum beverage cans
were redesigned to taper slightly at the top of the can, manufacturers reduced the standard amount of
aluminum per can because less aluminum was required for the top piece of tapered cans.

Standards are used to value inventory and to plan and control costs. Companies are also using standards
to assess performance at lower levels of the organization, for shorter accounting periods, and for an
increasing number of costs.

Using standards for performance evaluation has been criticized by some. For example, critics assert that
standards limit improvement of operations by discouraging improvement beyond the standard.
Regardless of this criticism, standards are widely used. Most managers strongly support standard cost
systems and regard standards as critical for running large businesses efficiently.

Budgetary Performance Evaluation

The master budget assists a company in planning, directing, and controlling performance. The control
function includes budgetary performance evaluation and compares the actual performance against the
budget. This comparison is typically shown in a budget performance report.

We illustrate budget performance evaluation using Western Rider Inc., a manufacturer of blue jeans.
Western Rider Inc. uses standard manufacturing costs in its budgets. The standards for direct materials,
direct labor, and factory overhead are separated into two components: (1) a price standard and (2) a
quantity standard. Multiplying these two elements together yields the standard cost per unit for a given
manufacturing cost category, as shown for style XL jeans.

Manufacturing Costs Standard × Standard = Standard

Price Quantity Cost per
per Pair Pair
of XL
Jeans
Direct materials $5 per square 1.50 square $7.50
yard yards
Direct labor $9 per hour 0.80 hour per 7.20
pair
Factory overhead $6 per hour 0.80 hour per 4.80
pair
Total standard $19.50
cost per pair

The standard price and quantity are separated because the means of controlling them are normally
different. For example, the direct materials price per square yard is controlled by the Purchasing
Department, and the direct materials quantity per pair is controlled by the Production Department.

Budgeted costs at planned volumes are included in the master budget at the beginning of the period.
Standard amounts budgeted for materials purchases, direct labor, and factory overhead are determined
by multiplying the standard costs per unit by the planned level of production. At the end of the month,
the standard costs per unit are multiplied by the actual production and compared to the actual costs.

To illustrate, assume that Western Rider produced and sold 5,000 pairs of XL jeans. It incurred direct
materials costs of $40,150, direct labor costs of $38,500, and factory overhead costs of $22,400. The
budget performance report shown below summarizes the actual costs, the standard amounts for the
actual level of production achieved, and the differences between the two amounts. These differences
are called cost variances. A favorable cost variance occurs when the actual cost is less than the standard
cost (at actual volumes). An unfavorable variance occurs when the actual cost exceeds the standard cost
(at actual volumes).

WESTERN RIDER INC.

Budget Performance Report
For the Month Ended June 30, 20XX
 Manufacturing Costs Actual Standard Cost
Costs Cost at Variance—
Actual (Favorable)
Volume (Unfavorable)
(5,000 pairs
of
XL Jeans)*
Direct materials $40,150 $37,500 $2,650
Direct labor 38,500 36,000 2,500
Factory overhead 22,400 24,000 (1,600)
Total $101,050 $97,500 $3,550
manufacturing costs

* 5,000 pairs × $7.50 per pair = $37,500

5,000 pairs × $7.20 per pair = $36,000
5,000 pairs × $4.80 per pair = $24,000

Based on the information in the budget performance report, management can investigate significant
differences and take corrective action. In the exhibit presented below, for example, the direct materials
cost variance is an unfavorable $2,650.
There are two possible explanations for this variance: (1) the amount of blue denim used per pair of blue
jeans was different than expected, and/or (2) the purchase price of blue denim was different than
expected.
WESTERN RIDER INC.
Budget Performance Report
For the Month Ended June 30, 20XX
Manufacturing Costs Actual Standard Cost
Costs Cost at Variance—
Actual (Favorable)
Volume (Unfavorable)
(5,000 pairs
of
XL Jeans)*
Direct materials $40,150 $37,500 $2,650
Direct labor 38,500 36,000 2,500
Factory overhead 22,400 24,000 (1,600)
Total $101,050 $97,500 $3,550
manufacturing costs

* 5,000 pairs × $7.50 per pair = $37,500

5,000 pairs × $7.20 per pair = $36,000
5,000 pairs × $4.80 per pair = $24,000
Variances from Standards
The total difference between actual costs and standard costs for a period is normally made up of several
variances, some of which can be favorable and some unfavorable. There can be variances from
standards in direct materials costs, in direct labor costs, and in factory overhead costs. The relationship
of these variances to the total manufacturing cost variance is shown below. Illustrations and analyses of
these variances for Western Rider Inc. are presented in the following slides.

The example shows the total manufacturing cost variance is made up of direct materials cost variance,
direct labor cost variance and factory overhead cost variance.

Direct Materials Variances for Western Rider Inc.

What caused Western Rider Inc.’s unfavorable materials variance of $2,650? The total unfavorable cost
variance of $2,650 ($40,150 - $37,500) results from the combination of an excess price per square yard
of $0.50 and using 200 fewer square yards of denim. As illustrated below, these two factors can be
reported as two separate variances: the direct materials price variance and the direct materials quantity
variance.

Standard Price = $5 per yard

Actual Price = $5.50 per yard
Standard Quantity = 1.5 yards/pair of jeans (7,500 yards for 5,000 pairs)
Actual Quantity = 7,300 yards

Standard Actual Variance

 Direct Materials 7,300 yards × $5 7,300 yards × $3,650
Price Variance per yard = $5.50 per yard = Unfavorable
$36,500 $40,150
Direct Materials 7,500 yards × $5 7,300 yards × $5 $1,000
Quantity per yard = per yard = Favorable
Variance $37,500 $36,500

Direct Materials Variances

The direct materials price variance is the difference between the actual price per unit ($5.50) and the
standard price per unit ($5.00), multiplied by the actual quantity used (7,300 square yards). If the actual
price per unit exceeds the standard price per unit, the variance is unfavorable, as shown for Western
Rider Inc. If the actual price per unit is less than the standard price per unit, the variance is favorable.

The direct materials quantity variance is the difference between the actual quantity used (7,300 square
yards) and the standard quantity at the actual production level (7,500 square yards), multiplied by the
standard price per unit ($5.00). If the actual quantity of materials used exceeds the standard quantity
budgeted, the variance is unfavorable. If the actual quantity of materials used is less than the standard
quantity, the variance is favorable. The direct materials variances can be illustrated by making the three
calculations shown below.

Materials price variance Materials quantity variance

$40,150 – $36,500 = $36,500 – $37,500 =
$3,650 U $(1,000) F
Total direct materials cost variance
$40,150 – $37,000 = $2,650 U

The materials price variance is $40,150 minus $36,500 equally $3,650 which is unfavorable. The price of
materials was higher than expected.
The materials quantity variance is $36,500 minus $37,500 equally negative $1,000 which is favorable.
The materials needed was less than expected.
The total direct materials cost variance is $40,150 - $37,500 which equals $2,650. since the direct
materials cost was higher than expected, this is unfavorable.

Material
Material Price
Quantity
Variance
Variance
Reporting Direct Materials Tells us if too
Tells us if
Variances many or not
materials cost
enough
The direct materials quantity variance should be reported more or less
materials were
to the proper operating management level for corrective than allowed.
action. For example, an unfavorable quantity variance used.
could be caused by malfunctioning equipment that has

⇓
not been properly maintained or operated. However,
unfavorable materials quantity variances are not always
caused by Operating Departments. For example, the
excess materials usage may be caused by purchasing
inferior raw materials. In this case, the Purchasing Total Materials Variance
Department should be held responsible for the variance.
The materials price variance should normally be reported to the Purchasing Department, which may or
may not be able to control this variance. If materials of the same quality could have been purchased
from another supplier at the standard price, the variance was controllable. On the other hand, if the
variance resulted from a market- wide price increase, the variance may not be controllable.

Direct Labor Variances for Western Rider Inc.

Western Rider Inc.’s direct labor cost variance can also be separated into two parts. The total
unfavorable cost variance $2,500 ($38,500 - $36,000) results from an excess rate of $1.00 per direct
labor hour and using 150 fewer direct labor hours. These two reasons can be reported as two separate
variances.

Standard Rate = $9 per hour

Actual Price = $10 per hour
Standard Hours = 0.80 hours/pair of jeans (4,000 hours for 5,000 pairs)
Actual Hours = 3,850

Standard Actual Variance

Direct Labor 3,850 hours × $9 3,850 hours × $10 $3,850
Rate Variance per hour = per hour = Unfavorable
$34,650 $38,500
Direct Labor 4,000 hours × $9 3,850 hours × $9 $1,350
Time Variance per hour = per hour = Favorable
$36,000 $34,650

Direct Labor Variances

The direct labor rate variance is the difference between the actual rate per hour ($10.00) and the
standard rate per hour ($9.00), multiplied by the actual hours worked (3,850 hours). If the actual rate
per hour is less than the standard rate per hour; the variance is favorable. If the actual rate per hour
exceeds the standard rate per hour, the variance is unfavorable.
The direct labor time variance is the difference between the actual hours worked (3,850 hours) and the
standard hours at actual production (4,000 hours), multiplied by the standard rate per hour ($9.00). If
the actual hours worked exceed the standard hours, the variance is unfavorable. If the actual hours
worked are less than the standard hours, the variance is favorable. The direct labor variances are
illustrated by making the three calculations shown below.

Reporting Direct Labor Variances

Controlling direct labor cost is
normally the responsibility of the Quantity
production supervisors. To aid Price (Rate)
(Efficiency)
them, reports analyzing the Variance
Variance
cause of any direct labor variance
may be prepared. Differences
between standard direct labor
Rate per hour Incurred too
hours and actual direct labor is more or many or less
hours can be investigated. For less than than allowed
example, a time variance may be allowed. hours.
incurred because of the shortage
of skilled workers. Such variances
may be uncontrollable unless
they are related to high turnover
rates among employees, in which
Total
Labor
Variance
➞ Price Variance + Quantity
case the cause of the high
Variance
turnover should be investigated.
Likewise, differences between the rates paid for direct labor and the standard rates can be investigated.
For example, unfavorable rate variances may be caused by the improper scheduling and use of workers.
In such cases, highly paid skilled workers might have been used in jobs normally performed by unskilled,
lower-paid workers. In such cases case, the unfavorable rate variance should be reported for corrective
action to the managers responsible for scheduling work assignments.
Standards for Nonmanufacturing Expenses
Using standards for nonmanufacturing expenses, such as service, selling, and administrative expenses, is
not as common as using standards for manufacturing costs. This is because many nonmanufacturing
expenses do not directly relate to a unit of output or other measure of activity. For example,
administrative expenses associated with the work of the office manager are not easily related to a
measurable output. In these cases, static budgets are often used to control nonmanufacturing expenses.

When nonmanufacturing activities are repetitive and produce a common output, standards can be
applied. In these cases, the use of standards is similar to that described for a manufactured product. For
example, standards can be applied to the work of customer service personnel who process sales orders.
A standard cost for processing a sales order (the output) could be developed. The variance between the
actual cost of processing a sales order and the standard cost could then be used to control sales order
processing costs.

Nonfinancial Performance Measures

Many managers supplement financial performance measures, such as variances from standard, with
nonfinancial measures of performance. Measuring both financial and nonfinancial performance helps
employees consider multiple, and sometimes conflicting, performance objectives. For example, one
company had a machining operation that was measured according to a direct labor time standard.
Employees did their work quickly in order to create favorable direct labor time variances. Unfortunately,
the fast work resulted in poor quality that, in turn, created difficulty in the assembly operation. To
encourage employees to consider both the speed and quality of their work, the company decided to use
both a labor time standard and a quality standard
In the preceding example, nonfinancial performance measures brought additional perspectives, such as
quality of work, to evaluating performance. Some additional examples of nonfinancial performance
measures are as follows:
• Inventory turnover
• On-time delivery
• Elapsed time between a customer order and product delivery
• Customer preference rankings compared to competitors
• Response time to a service call
• Time to develop new products
• Employee satisfaction
• Number of customer complaints

Nonfinancial measures can be linked to either the inputs or outputs of an activity or process. A process
is a sequence of activities linked together for performing a particular task. For example, the
procurement process consists of the "create purchase order" and "select vendor" activities that are
performed in procuring materials.
To illustrate nonfinancial measures for a single activity, consider the counter service activity of a fast-
food restaurant. The outputs of the counter service activity include the customer line wait, order
accuracy, and service experience. The inputs that impact these outputs include the number of
employees, level of employee experience and training, reliability of the french fryer, menu complexity,
fountain drink supply, and the like. Note that the inputs for one activity could be the outputs of another.
For example, fryer reliability is an input to the counter service activity, but is an output of the french
frying activity. Moving back, fryer maintenance would be an input to the french frying activity.
Thus, a chain of inputs and outputs can be developed between a set of connected activities or
processes. The fast-food restaurant can develop a set of linked nonfinancial performance measures
across the chain of inputs and outputs. The output measures tell management about performance of
the activity, such as keeping the line wait to a minimum. The input measures are the factors that affect
the activity's performance. Thus, if the fast-food restaurant line wait is too long, input measures might
indicate a need for more training, more employees, or better fryer reliability.
 1. An analysis in which all the components of an income statement are expressed as a
percentage of net sales is called blank___________ .
A horizontal analysis
B liquidity analysis
C sales analysis
D vertical analysis

2. The ability of a business to repay its debts and to earn income is referred to
as blank___________ .
A solvency and leverage
B solvency and profitability
C solvency and liquidity
D solvency and equity

3. _______ is NOT used in assessing a company's ability to pay current liabilities.

A The quick ratio
B Current position analysis
C Return on equity
D Working capital

4. Accelerating the collection of receivables will tend to cause the accounts receivable
turnover to blank___________ .
A decrease
B remain the same
C either increase or decrease
D increase

5. The times interest earned ratio is computed as blank___________ .

A net income plus interest expense divided by interest expense
B income before tax plus interest expense divided by interest expense
C net income divided by interest expense
D income before income tax divided by interest expense

6. The primary advantages of the average rate of return method are its ease of computation
and the fact that blank_______ .
A it is especially useful to managers whose primary concern is liquidity
B there is less possibility of loss from changes in economic conditions and obsolescence
when the commitment is short-term
C it emphasizes the amount of income earned over the life of the proposal
D rankings of proposals are necessary

7. When analysis of an investment proposal by the net present value method indicates that
the present value exceeds the amount to be invested, blank___________ .
A the proposal is desirable and the rate of return expected from the proposal exceeds the
minimum rate used for the analysis
B the proposal is desirable and the rate of return expected from the proposal is less than the
minimum rate used for the analysis
C the proposal is undesirable and the rate of return expected from the proposal is less than
the minimum rate used for the analysis
D the proposal is undesirable and the rate of return expected from the proposal exceeds the
minimum rate used for the analysis

8. When several alternative investment proposals involve different amounts of investment,

it is useful to prepare a relative ranking of the proposals by using blank____________ .
A an average rate of return
B a consumer price index
C a present value index
D a price-level index

9. The process by which management allocates available investment funds among

competing investment proposals is called blank_______ .
A investment capital
B dividend rationing
C cost-volume-profit analysis
D capital rationing

10. In capital rationing, alternative proposals that survive initial and secondary screening are
normally evaluated in terms of blank_______ .
A net income
B qualitative factors and management's criteria
C maximum cost
D net cash flow

11. ________ is NOT an element of the financial accounting system.

A A set of rules for determining the recording of economic events
B A framework for preparing financial statements
C A set of rules for the stock exchange
D Controls to determine whether errors occur during recording

12. In accrual accounting, the effects of business transactions are blank________ .

A ignored in preparing financial statements
B reflected on no more than one individual financial statement
C recorded when the economic effect occurs
D recorded only when cash flows occur

13. When Anderson, Inc. paid rent expense of $4,000 for the month of October, the effects
on its accounts include blank________ .
A a $4,000 increase in cash and a $4,000 increase in retained earnings
B a $4,000 increase in cash and a $4,000 decrease in retained earnings
C a $4,000 decrease in cash and a $4,000 decrease in retained earnings
D a $4,000 decrease in cash and a $4,000 increase in retained earnings

14. When Anderson, Inc. receives $5,000 in cash for fees earned, the effects on its financials
statements include blank________ .
A no change in total assets
B a decrease in cash flows reported on the statement of cash flows
C an increase in net income
D no change in retained earnings

15. In the first month of operations, a company's net cash flows from operating activities is
$3,760, net cash flows from investing activities is ($5,415), and the ending cash balance
to be $2,425. The net cash from financing activities must be blank________ .
A 770
B 4080
C -11600
D 11600

16. The Sarbanes-Oxley Act of 2002 requires companies and their independent accountants
to blank_________ .
A report on the financial activities of the company
B report on any fraud and theft detected in the company
C report on the state of the economy
D report on the effectiveness of the company’s internal controls
 17. Cash does not include blank_________ .
A coins
B checks
C money orders
D commercial paper

18. A bank reconciliation should be prepared periodically because blank_________ .

A the depositor’s records and the bank’s records are always in agreement
B the bank always records transactions before a the depositor
C it is a part of effective controls over cash
D the bank must make sure that its records are correct

19. The amount of the outstanding checks is included on the bank reconciliation as
a(n) blank_________ .
A deduction from the balance per depositor’s records
B addition to the balance per bank statement
C deduction from the balance per bank statement
D addition to the balance per depositor’s records

20. _________ is a special cash fund used to make small payments that occur frequently.
A An operating expenses fund
B A change fund
C A market fund
D A petty cash fund

21. The budget process does not involve blank____________ .

A establishing specific goals
B executing plans to achieve the goals
C periodically comparing actual results with the goals
D dismissing all managers who fail to achieve operational goals specified in the budget

22. Production budgets are used to prepare blank____________ budgets.

A selling and administrative expense
B direct materials purchases, direct labor cost, and factory overhead cost
C sales
D capital expenditure
 23. The first budget customarily prepared as part of an entity’s master budget is
the blank____________ .
A production budget
B cash budget
C sales budget
D direct materials purchases

24. If the actual direct labor hours spent producing a commodity exceed the standard hours,
the variance is blank____________ .
A unfavorable
B favorable
C avoidable
D variable

25. Variances from standard costs are usually reported to blank____________ .

A suppliers
B stockholders
C management
D creditors