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TEChniCal

RElEvanT To aCCa QualifiCaTion PaPER f4 (iRl), (SCT) and (uK)


ToRTS aRE lEgal wRongS ThaT onE PaRTy SuffERS aT ThE handS of anoThER. nEgligEnCE iS a foRm of ToRT whiCh EvolvEd bECauSE SomE TyPES of loSS oR damagE oCCuR bETwEEn PaRTiES ThaT havE no ConTRaCT bETwEEn ThEm.
If theres one area of the F4 syllabus that students appear to struggle with, its the tort of negligence. (For Paper F4 (SCT) a tort is a delict.) The examiners reports indicate that students do not understand the subject very well in particular, the various elements that a claimant must prove in order for the defendant to be found negligent. This article addresses each of the key elements in turn, but we begin with an explanation of why tort developed. Torts are legal wrongs that one party suffers at the hands of another. Negligence is a form of tort which evolved because some types of loss or damage occur between parties that have no contract between them, and therefore there is nothing for one party to sue the other over. In the 1932 case of Donoghue v Stevenson, the House of Lords decided that a person should be able to sue another who caused them loss or damage even if there is no contractual relationship. Donoghue was given a bottle of ginger beer by a friend, who had purchased it for her. After drinking half the contents, she noticed that the bottle contained a decomposing snail and suffered nervous shock as a result. Under contract law, Donoghue was unable to sue the manufacturer because her friend was party to the contract, not her. However, the House of Lords decided to create a new principle of law that stated everyone has a duty of care to their neighbour, and this enabled Donoghue to successfully sue the manufacturer for damages. Lets consider a hypothetical case and use it to demonstrate how the tort of negligence works. Harry is involved in an accident in which his car is hit by one driven by Alex. As a consequence of the accident Harry breaks a leg and is unable to work for two months. Can Harry sue Alex for damages? On the face of things the answer seems obvious. Harry was injured as a result of Alex driving into his car and so it seems fair that he should be able to sue him. However, think of the situation from Alexs point of view, is it fair that Harry should be able to sue him just like that? People have accidents everyday should they all be able to sue each other for every little incident? If they are then the courts would be overwhelmed with cases. Thankfully, in order to prove negligence and claim damages, a claimant has to prove a number of elements to the court. These are: the defendant owed them a duty of care the defendant breached that duty of care, and they suffered loss or damage as a direct consequence of the breach. Even if negligence is proved, the defendant may have a defence that protects them from liability, or reduces the amount of damages they are liable for. Element 1 The duty of care As we saw earlier, the concept of a duty of care was created in the Donoghue case. The House of Lords stated that every person owes a duty of care to their neighbour. The Lords went on to explain that neighbour actually means persons so closely and directly affected by my act that I ought reasonably to have them in contemplation as being so affected. This is a very wide (and complicated) definition that could include almost anyone if still in operation today the courts would most certainly be overrun with cases. The later cases of Anns v Merton London Borough Council (1977) and Caparo Industries plc v Dickman (1990) restricted the definition a little by introducing proximity and fairness.

the tort of

STudEnT aCCounTanT 12/2009


Studying Paper F4? law, regulation and compliance are integrated through appropriate performance objectives

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negligence
in many CaSES bRoughT bEfoRE ThE CouRTS iT iS EvidEnT ThaT a duTy of CaRE ExiSTS bETwEEn ThE dEfEndanT and ThE ClaimanT. ThE REal iSSuE iS whEThER oR noT ThE aCTionS of ThE dEfEndanT wERE SuffiCiEnT To mEET ThEiR duTy.
Proximity simply means that the parties must be sufficiently close so that it is reasonably foreseeable that one partys negligence would cause loss or damage to the other. Fairness means that it is fair, just and reasonable for one party to owe the duty to another. What does this mean for Harry? I think youll agree that Alex owes him a duty of care. There is sufficient proximity (ie Alex drove into Harrys car); it is reasonably foreseeable that a collision between the cars could cause Harry some injury, and it seems fair, just and reasonable for Alex to owe a duty of care to Harry (and indeed all other road users). Element 2 breach of duty of care In many cases brought before the courts it is evident that a duty of care exists between the defendant and the claimant. The real issue is whether or not the actions of the defendant were sufficient to meet their duty. To determine this, the court will set the standard of care that they should have met. This standard consists of the actions which the court considers a reasonable person would have taken in the circumstances. If the defendant failed to act reasonably given their duty of care, then they will be found to have breached it. This reasonable standard may be adjusted given the actual circumstances of the case. For example, if the claimant is vulnerable, such as being disabled or frail, it is reasonable to expect the defendant to have paid them special attention or taken extra care over them as compared to someone who is fit and healthy. Other circumstances which may be taken into account include whether: The actions the defendant took are in line with common practice or industry recommendations. If they were, then it is likely that the defendant will be found to have met their duty unless the common practice itself is found to be negligent. There was some social benefit to the defendants actions. If there was, then the court may consider it inappropriate for them to be found to have breached their duty. The defendants actions had a high probability of risk attached to them. If they did, then the court will expect them to show they took extra precautions to prevent loss or damage. There were practical issues that prevented reasonable precautions being taken, or unreasonable cost would have been involved in taking them. If there were, then the court is unlikely to expect the defendant to have taken them in order to meet their duty of care. The defendant is a professional carrying on their profession. If they were, then the court will judge their actions against a reasonable professional in their line of work, rather than just any ordinary person. If professional guidelines are in place then the court will judge the defendants actions against these rather than its own expectations. Back to the case of Harry and Alex. In determining whether or not Alex broke his duty of care, a court will consider whether or not, given the circumstances, he drove as a reasonable person would have. For example, if it was foggy or wet at the time, he would be expected to show that he drove cautiously. In determining whether Alexs actions were reasonable, evidence may have to be taken from witnesses and expert analysis of the crash may be required. For now, lets assume Alex was not driving reasonably.

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in ExTRaoRdinaRy CaSES, ThE faCTS may bE So ovERwhElmingly in favouR of ThE ClaimanT ThaT ThE CouRT dECidES ThE dEfEndanT Should PRovE ThaT ThEy wERE noT nEgligEnT. ThE lEgal TERm foR ThiS iS RES iPSa loQuiTuR (mEaning ThE faCTS SPEaK foR ThEmSElvES).

Res ipsa loquitur In extraordinary cases, the facts may be so overwhelmingly in favour of the claimant that the court decides the defendant should prove that they were not negligent. The legal term for this is res ipsa loquitur (meaning the facts speak for themselves). It applies in circumstances where the cause of the injury was under the control of the defendant and that the incident would not have occurred if they had taken proper care. It is often applied in medical cases, for example in Mahon v Osborne (1939), a surgeon had to prove it was not negligent to leave a swab inside a patient.
Element 3 loss or damage as a result of the breach In this element the claimant simply has to prove that the loss or damage was a direct consequence of the defendants breach of duty of care. In other words that there is a chain of causality from the defendants actions to the claimants loss or damage. A simple test, called the but for test is applied. All the claimant has to prove is that if it were not but for the actions of the defendant then they would not have suffered the loss or damage.

Where there is more than one possible cause of the loss or damage, the defendant will only be liable if it can be proved that their actions are the most likely cause. A good case which illustrates how the but for test operates is Barnett v Chelsea and Kensington HMC (1969) another medical case. A casualty department doctor negligently sent a patient home the patient died. However, the doctor was not found liable for damages because the patient was suffering from arsenic poisoning and would have died no matter what the negligent doctor could have done. The loss itself must not be too remote. It is an important principle that people should only be liable for losses which they should have reasonably foreseen as a potential outcome of their actions. The Wagon Mound (1961) is a case often cited in explanation of this principle. Oil leaked out of the defendants boat within Sydney harbour and came into contact with some cotton waste which had fallen into the water. The oil was of a particular type which would not foreseeably catch fire on water. However, the cotton ignited and this in turn set the oil ablaze causing damage to the claimants wharf. The defendants were not found liable for fire damage as the actual cause of the fire was held too remote.

novus actus intervieniens Other events, which are outside the control of the defendant, may intervene in the chain of causality adding some confusion to the outcome of a case. The good news is that there are some simple rules to remember that deal with them. At all times you should bear in mind that the defendant will only be liable if their actions are the most probable cause of the loss or damage. They will not be liable if an intervening act becomes the real cause. Examples of intervening acts which remove liability from the defendant include: Actions of the claimant which are unreasonable, or outside what the defendant could have foreseen in the circumstances. Actions of a third party which become the real cause of the loss or damage. The defendant is only liable for damages up until the point when the third party intervened. Unforeseeable natural events natural events which the defendant could have reasonably foreseen do not affect things.

STudEnT aCCounTanT 12/2009

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Lets return to Harry and Alex. It is entirely possible for the accident to be caused by a third party driving into Alex, forcing him into Harry. It is also possible that Harry himself was an intervening factor maybe he was driving erratically. Either of these factors could mean that Alexs breach of duty is not the real cause of Harrys injuries. For now, lets assume that no third party is involved and that any actions Harry took are not enough to take the blame for the cause of the accident away from Alex. The court will therefore find Alex liable for negligence to Harry. defences There are two defences a defendant can use where they are found liable for negligence. One will exonerate them completely; the other reduces the level of damages they are liable for.

Volenti non fit injuria simply means the voluntary acceptance of the risk of injury. If a defendant can prove the claimant accepted the risk of loss or damage, they will not be liable. Acceptance can be express (usually by a consent form being signed) or implied through the claimants conduct. Contributory negligence takes part of the blame away from the defendant if it can be proved the claimant contributed in some way to their loss or damage. The defendant is still liable, but will face a reduced damages payout.
In Harry and Alexs case, volenti is not an issue in no way did Harry consent to the accident. However, if his actions contributed in some way to his injuries, maybe by not wearing a seatbelt, then he may find the amount of damages he receives is reduced. use of cases in exam answers Finally, a brief word about using cases in exam answers. Students are often concerned about how many cases they should quote, or what happens if they cannot remember a case name. The simple fact is that students fail this exam because they do not know the law not because they cannot remember a case name.

STudEnTS aRE ofTEn ConCERnEd abouT how many CaSES ThEy Should QuoTE, oR whaT haPPEnS if ThEy CannoT REmEmbER a CaSE namE. ThE SimPlE faCT iS ThaT STudEnTS fail ThiS Exam bECauSE ThEy do noT Know ThE law noT bECauSE ThEy CannoT REmEmbER a CaSE namE.

My advice on cases is: 1 Get to grips with the principles of law first, then learn case names if you have time. By learning the law you will probably find that you remember the major cases anyway. 2 Dont try to learn every case in your textbook the majority are there to illustrate how the law was applied in a particular set of circumstances. Instead, go for the major ones in each syllabus area and learn those. 3 All you need to learn is the case name and the principle of law it created you do not need to learn and regurgitate all the background to the case in the exam. 4 If you forget a case name in the exam, dont let this stop you from explaining the principle of law, just write In a case it was decided that and continue with the principle. As an example, consider this article only six cases were mentioned. See if you can remember their names. Stephen Osborne is a technical author at BPP Learning Media

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teChniCal

approaching questions:
Relevant to aCCa QualifiCation PaPeR f5
One of the reasons why I think the problem arises is because the Skills papers, of which Paper F5 is one, are often the first time that students have had to tackle written questions. No longer is it sufficient to simply learn material and churn out calculations. With the Knowledge papers, ability to write clearly and set out workings logically and neatly is not required; the papers are in the form of sets of objective test questions. Instead, the skills involved become fourfold, with candidates being required to do all of the following: correctly interpret requirements actively read sometimes scenario-based questions, highlighting the information that is relevant for each part of the requirement use that information to perform calculations that are carefully structured and clearly set out, with all workings shown in an easy-to-follow layout write accurately and coherently, using simple English rather than long, rambling sentences that have no structure and no real content. Another reason why problems arise is because candidates do not take the time to understand the differences between Paper F2 and Paper F5. Some subject areas are obviously included in both syllabuses, but you can be sure that where subjects are repeated in Paper F5, the skills required of you are over and above the knowledge required in Paper F2. (Read the January 2010 issue of Student Accountant to read an article explaining the differences between Papers F2 and F5.) I am going to concentrate on a brief step by step approach to the exam on the day and then on a more detailed explanation of how you should interpret all the different instructions contained within question requirements. The points made in this article about interpreting requirements in questions are equally valid for interpreting the depth of the Paper F5 Study Guide which is attached to the Syllabus, since this too is written in terms of instructions such as discuss, describe and so forth.

the PuRPose of this aRtiCle is to identify the Reasons why sitting the PaPeR f5 exam seems to Cause suCh a PRoblem foR students and tRy and imPRove PeRfoRmanCe in the futuRe.

It is not uncommon to see students recoil in horror at the mention of Paper F5, Performance Management. The purpose of this article is to identify the reasons why sitting the Paper F5 exam seems to cause such a problem for students and try and improve performance in the future. As you are aware, Paper F5 builds on the blocks of knowledge gained from sitting the Paper F2 exam. Although the pass rates for Paper F2 tend to be on the low side when compared with some of the other Knowledge papers, they are still significantly higher than the Paper F5 pass rates. Therefore, although poor pass rates could be blamed on the fact that Paper F5 covers an area that most ACCA students have no experience of and find it difficult to relate to, the same could be said of Paper F2. Why then, does Paper F5 seem to invoke such fear and poor performance from students?

student aCCountant 12/2009

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Reading time The Paper F5 exam, as with all three-hour exams, starts with 15 minutes of reading time. This time should be spent by quickly allocating your 180 minutes to each question and reading all the requirements and the questions so that you can think about your answers and decide the order in which you will answer your questions. Remember, always start with your best question first. It is important to build your confidence up so that you perform your best. When it comes to answering the question, be sure that you are strict with your time allocation. If you are spending too long on one question, it is either because you cant do it anyway (in which case move on and come back to it later) or you are saying too much and going beyond what the examiner expected of you. How much an examiner expects you to write is directly linked to the marks available and therefore the time available.

To spend half an hour, for example, on Part (c) of a question, which is only worth five marks is madness: the examiner expected you to spend nine minutes on it. As well as allocating time to individual questions, you should allocate time to individual requirements in questions. In the reading time, you should get a chance to have a good look at the requirements of all five questions. Remember: the requirement should always be the first thing that you look at in a question. What is the point in reading a question if you dont know what you are looking for? When you read each part of the requirement, underline the content what the question is about, for example target costing, and the instruction what it is telling you to do. This helps you to focus your mind on answering the actual question rather than answering what you thought the question was going to ask you.

the PaPeR f5 exam, as with all thRee-houR exams, staRts with 15 minutes of Reading time. this should be sPent by QuiCkly alloCating youR 180 minutes to eaCh Question and Reading all the ReQuiRements and the Questions so that you Can think about youR answeRs.

written paper F5

As regards the content, you have either studied the area and can tackle it, or not. This instruction could be a whole variety of verbs ranging from numerical requirements such as calculate, produce, derive and apply; or more wordy requirements such as describe, interpret, outline, compare, identify, discuss, explain, evaluate, suggest and justify. The possibilities are endless and the one thing you can be sure of is that the verb used has been carefully thought about by the examiner, obviously taking into account any restrictions imposed by the syllabus. If you dont read and understand the instruction carefully, then you will find that you are not actually answering the question. If you are not answering the question, then you are not earning marks. For example, being asked to justify the use of target costing as opposed to traditional absorption costing is different from being asked to explain target costing. Each of the common exam instructions are dealt with below.

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if exam PaPeRs weRe PRediCtable, they would not be a tRue test of Candidates knowledge as students would then simPly be able to leaRn distinCt aReas of the syllabus and ignoRe the Rest. study all of the PaPeR f5 syllabus oR you aRe not giving youRself a Real ChanCe.

answeRing numeRiCal Questions Calculate and derive Some instructions are easier to understand than others. For example, there can be no confusion as to what the word calculate means; if you are asked to calculate a number, you just have to work it out. Similarly, derive should pose little problem. In the context of Paper F5, you might have to derive an equation showing the relationship between price and quantity or derive a target cost for a product. Being able to derive a figure sometimes requires more than simply being able to calculate a figure, as a candidate may have to use their powers of deduction to derive something. However, the mechanics of deriving or calculating would actually be very similar in most cases.

estimate If a question asks you to estimate a figure it suggests that the answer cannot be calculated with certainty. For example, if you are asked to estimate the time taken to produce a batch of items where an 80% learning curve has been shown to exist, you are making an estimate rather than an exact calculation. This is due to the fact that the learning rate itself reflects what a business THINKS will happen but it is not certain until it has happened. Once again, however, as with a derive instruction, the mechanics of estimating are much the same as calculating. There is a set approach to the question (tabular or algebraic, in the case of learning curves). Why, then, do candidates often still perform poorly on the numerical parts of the Paper F5 exam paper? In my opinion, poor numerical answers often arise merely as a result of candidates failing to study the whole syllabus well enough in the first place. Anyone who thinks they can question spot exam questions for a particular sitting, based on topics that have been examined or not examined in recent papers, is sadly mistaken. Certain publications publish top tips which should most certainly be ignored.

If exam papers were this predictable, they would not be a true test of candidates knowledge as students would then simply be able to learn distinct areas of the syllabus and ignore the rest. Study all of the Paper F5 syllabus or you are not giving yourself a real chance. The other reason why candidates score poorly on numerical questions is because they approach the question in a disorganised fashion, with no logical progression through the calculations and no clear, numbered workings. You should go into the exam with a metaphorical management accounting toolbox, full of all the tools that are going to help you answer the questions. So, for example, if it is a linear programming question, go in your toolbox and pull out your five-step guide for linear programming: define the variables state the objective function state the constraints draw the graph find the solution. To give another example, if it is a pricing question that can be solved algebraically, pull your pricing tool out of your management accounting toolbox and follow your five-step guide:

student aCCountant 12/2009


Studying Paper F5? Performance objectives 12, 13 and 14 are linked

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ReQuiRements that neCessitate Candidates wRiting in a CoheRent, oRganised manneR aRe a big issue in PaPeR f5. often, Candidates aPPeaR unable to gRasP what to wRite and how muCh to wRite, ie they dont undeRstand the instRuCtion.

establish the demand function: P = a - bQ establish marginal cost state marginal revenue by doubling the gradient, b equate marginal cost and marginal revenue to find optimum quantity substitute quantity into the demand function to find optimum price. The problem with Paper F5 is that students go into the exam with only a few tools in their box. If you put the work in, you will reap the rewards. answeRing woRdy Questions Requirements that necessitate candidates writing in a coherent, organised manner are also a big issue in Paper F5. Candidates are not penalised for the fact that English may be their second language, and I do not think it is this that causes the real problem. The issue is often that candidates appear unable to grasp what to write and how much to write, ie they dont understand the instruction. Further clarification of all the main instructions you would expect to find in a Paper F5 exam is given below.

describe When you are asked to describe something you are expected to give some sort of narrative about it. For example, if you were being asked to describe suitable non-financial performance indicators for a hospital, you would be expected to describe indicators such as number of patient complaints, bed occupancy rate, number of admissions per employee. It would not be enough to merely list these indicators. You would have to go a step further and describe how they might be calculated. As always, you should be guided by the mark allocation in deciding how much time you spend answering the requirements and therefore what level of detail you should go into. interpret When you are asked to interpret something, for example, the balanced scorecard approach, you are being asked to explain the approach in your own words and give your opinion about it. It is quite a high-level requirement that will usually be reflected with higher marks than, for example, outline.

outline As suggested previously, this is quite a straightforward, low-level requirement. An outline should be fairly brief and well organised. It is simply an overview, without the level of detail that would be required by the describe instruction, for example. Since it requires less detail, you could be asked to outline a bigger topic than you would have time to describe. In Section C of the Study Guide, you are asked to outline the objectives of a budgetary control system. This is something that could be discussed at length but the Study Guide is clear in that it only expects your knowledge to be sufficient enough to outline. Compare The instruction compare requires you to discuss similarities between two or more things and draw conclusions. For example, if you are asked to compare product costs using activity-based costing as opposed to traditional costing, you need to say why the costs are different. This will involve looking in detail at the activity-based costs and ascertaining the reason why the overheads absorbed into one product are, for example, higher under activity-based costing than traditional absorption costing. In this kind of question, comparing needs to be preceded by a degree of analysis.

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teChniCal
the steP uP fRom PaPeR f2 to f5 is a big one, with a sudden need foR ClaRity of wRiting and undeRstanding of instRuCtions within ReQuiRements that was not essential foR PaPeR f2. ContRaRy to PoPulaR belief, it is not a disPRoPoRtionately haRd PaPeR, Just one wheRe students need to woRk haRd to gain knowledge.

identify This means to pinpoint and list. It can be quite a simple requirement, requiring knowledge rather than skill. For example, in the Study Guide, it states that candidates must be able to identify and explain the interrelationship between price, mix and yield. This simply requires candidates to understand what the relationship is and then state it and explain it. Sometimes, however, candidates may have to identify points from within a question scenario, and this can be a more demanding requirement because it requires more skill. discuss This is a higher level skill and requires a candidate to give their own thoughts on a subject, supporting it with facts and logical reasoning. For example, you could be asked to discuss the effect that variances have on staff motivation. You would need to discuss the fact that they can be demotivational, for example, if they lead to managers being assessed for cost increases that were beyond their control. The material price variance may be adverse but this could be because the market price for materials increased. This will be demotivational unless the price variance is broken down into its controllable and uncontrollable aspects, ie planning and operational variances are calculated.

The opinions you give in any discussion must be sound and well reasoned. It is no good saying that variances are demotivational without explaining why. Also, you are expected to look at both sides of the story. The discuss instruction is always a good test of candidates real understanding. explain This means that you need to give a reason for something; say why it is as it is rather than just stating that it is. It is a very common requirement and appears many times in the Study Guide. It requires understanding as well as knowledge. evaluate This requirement would not be expected to arise much in Paper F5. Most of the evaluation work is reserved for Paper P5. If you are asked to evaluate something, you are being asked to decide on the merits of it. It is most definitely a higher level skill. suggest The use of the word suggest itself suggests that there may be more than one answer to the question being asked. It means give a suitable idea or solution, bearing in mind that there will probably be more than one. For example, you might be asked to suggest how a target cost gap can be closed. Your answer could only ever be a suggestion as there will be many possible ways to close a cost gap.

Justify With this requirement, you need to tell the reader why a particular answer or position makes sense. For example, if you had to justify the use of backflush accounting within an organisation, you would have to mention the relative immateriality of inventory balances, presuming this was in fact the case (otherwise you would struggle to justify the use of backflush accounting in the first place). ConClusion To conclude, the step up from Paper F2 to F5 is a big one, with a sudden need for clarity of writing and understanding of instructions within requirements that was not essential for Paper F2. Contrary to popular belief, it is not a disproportionately hard paper. It does require students to work hard in order to gain knowledge of areas that they have not practised. All written papers require the organised approach set out above, whereby you underline the content and instruction of all requirements at the beginning of each question. Keep referring back to them, particularly on wordy questions, to make sure that you are not going off on a tangent. And remember, practice makes perfect. Keep practising past questions until your approach and layout becomes second nature, leaving you with plenty of time to think about the issues in the question. Ann Irons is examiner for Paper F5

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TEChNICAl

the use of comparisons in


RElEVANT TO ACCA QUAlIFICATION PAPER F8
You should not write this out in the answer as this will waste time and will not gain you marks, but the five classes of question should always be at the back of your mind. There is a huge variety of businesses and this diversity will be reflected in their financial statements. To judge whether a figure or ratio is worth investigating, it is absolutely necessary to compare it to its equivalent in either the same company in the previous period, or other companies in the same industry. Comparisons provide benchmarks. To look at some of the techniques and interpretations, we will use the financial statements of Ocset Co, shown on page 7. COMPARISON OF TWO CONSECUTIVE YEARS Perhaps the first thing to do is simply to compare the two sets of financial statements. Here we have results from 2009 and 2008. Look down the figures, comparing like with like, and see what queries or hypotheses you might be able to generate. The mnemonic RATIO will be used formally for the first comparison. Here are some first thoughts: Non-current Substantial increase in goodwill. assets: intangible Reason: acquisition? Is it real or an accident of timing? How can the amount be checked, verified, and tested? Implications: What was bought? How was it paid for? What type of business? When is the year-end of the business aquired? Who are the auditors? Is this consistent with other information, such as additional non-current assets, increased finance and so on?

IN ThE PAPER F8 ExAM YOU MAY bE ASkEd TO COMPUTE ANd INTERPRET ThE kEY RATIOS USEd IN ANAlYTICAl PROCEdURES AT bOTh ThE AUdIT PlANNINg STAgE ANd WhEN COllECTINg AUdIT EVIdENCE.

In the Paper F8 exam you may be asked to compute and interpret the key ratios used in analytical procedures at both the audit planning stage and when collecting audit evidence. Ratios and comparisons can be used to identify where the accounts might be wrong, and where additional auditing effort should be spent. Calculating a ratio is easy, and usually is little more than dividing one number by another. Indeed, the calculations are so basic that they can be programmed into a spreadsheet. The real skill comes in interpreting the results and using that information to carry out a better audit. Saying that a ratio has increased because the top line in the calculation has increased (or the bottom line decreased) is rather pointless: this is simply translating the calculation into words. Use the mnemonic RATIO to remind yourself to keep asking the following questions: Reason why has this change occurred? Accident is the change real or simply an accident of timing? Test what can be done to test our conclusions? What other work should we do? Implications what does this change mean? Liquidity crisis? Poor management etc? Other information is this consistent with other information?

STUdENT ACCOUNTANT 12/2009

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ratios and auditing


RATIO ANAlYSIS IS USEFUl bECAUSE IT AllOWS YOU TO SEE IF TWO FIgURES hAVE MOVEd CONSISTENTlY WITh ONE ANOThER. YOU ShOUld bE CONCERNEd IF ThEY hAVENT.
Non-current assets: tangible Substantial increase. Some might result from the acquisition, some might be organic (or true growth). How were they paid for? How can we test it? Relatively small increase. Will be Inventory interesting to compare to sales. Relatively small increase. Will be Receivables interesting to compare to sales. Cash Large increase. Why? Where has that come from? Trade payables About a 1520% increase. Why? Large compared to receivables and cash. Compare to cost of sales later. How can we verify these liabilities? Short-term Doubled, but could be brought borrowings back to 2008 levels by using some of the cash. Why have cash and an overdraft at the same time? Current (Current assets less current assets compared liabilities.) About the same both to liabilities years. Alarmingly, both years show net current liabilities. However, the business has survived a year like this. Share capital No material change. Retained earnings Increased, presumably by retained profit. Long-term Substantial increase. Presumably, liabilities this is a major source of funding for non-current assets. Expect an increase in financing costs. Need to verify that the liabilities are indeed long-term. Revenue Cost of sales Commercial and administrative costs Tax Very substantial increase (around 15%). How much is organic (or true growth) and how much because of acquisition? We would expect changes in inventory and payables. An increase roughly in line with the increase in sales. Substantial increase. Perhaps temporary after the takeover and before rationalisation. Might indicate poor cost control. Fairly consistent.

If you were now told that the financial statements are modelled on a supermarket business, then you might be able to make more sense of some of the figures particularly the net current liabilities. Supermarkets have low receivables and low inventory (much of it is perishable) yet can squeeze their suppliers hard. They can, therefore, survive well on large trade payables, confident that inventory will steadily turn into cash. However, now that we know we are dealing with a supermarket, we should be interested in why they have substantial receivables at all. RATIO ANAlYSIS Ratio analysis is useful because it allows you to see if two figures have moved consistently with one another. You should be concerned if they havent. There are three main groups of ratios: profitability, liquidity, and risk.

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IT IS IMPORTANT TO REAlISE ThAT ROCE IS ThE FIRST RATIO WE hAVE CAlCUlATEd ThAT MAkES USE OF A bAlANCE ShEET FIgURE. bAlANCE ShEET FIgURES ARE TAkEN AT ONlY ONE POINT IN TIME, ANd ThIS CAN lEAd TO dISTORTIONS IN ThE RATIOS. ChANgES MIghT bE lITTlE MORE ThAN ACCIdENTS OF TIMINg.

PROFITAbIlITY RATIOS gross profit percentage Gross profit x 100 Sales revenue 2009 4,218 x 100 = 7.8% 54,327 2008 3,230 x 100 = 6.8% 47,198

Comments on gross profit percentage This is a significant increase (15%) and an impressive performance in recessionary times. Apart from accounting errors, possible explanations include: a different sales mix (possibly because of the acquisition implied by the increase in goodwill) squeezing better prices from suppliers (test by looking at correspondence?) better inventory management and less wastage (test inventories carefully). Net profit percentage Operating profit x 100 Sales revenue 3,206 x 100 = 5.9% 54,327 2,450 x 100 = 5.2% 47,198

Comments on net profit percentage Reasonably good cost control has been maintained despite the substantial increase in sales. To test this, it is worth comparing the commercial and administrative costs to sales. Operating expenses to sales Operating expenses x 100 Sales 1,012 x 100 = 1.86% 54,327 780 x 100 = 1.65% 47,198

Comments on operating expenses These costs are low compared to revenue. Does that make sense, or should we worry about expenses being understated? Supermarkets rely on high volumes and low margins and this could explain the relatively low operating costs:revenue ratio, indicating that huge volumes of sales are efficiently pushed through the business. However, efficiency of the operation has deteriorated and it is important to try to determine why this has happened. Obvious causes are: the operations of the acquired business are not as efficient as the holding companys disruption costs arising from the takeover overstretched management. These theories need to be tested. There might be other implications too. If management hopes to reduce operating expenses, are they, for example, planning warehouse closures and redundancies? Is some sort of provision needed? Return on capital employed (ROCE) Operating profit x 100 Capital employed 3,206 x 100 = 11.8% 27,165 2,450 x 100 = 12.0% 20,417

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

STUdENT ACCOUNTANT 12/2009

04

Asset turnover

Sales revenue x 100 Capital employed

2009 54,327 = 2.0 27,165

2008 47,198 = 2.3 20,417

Comments on asset turnover This shows how many $ of sales are generated by each $ of assets. Its sometimes described as how hard the organisation works its assets. The decline in the ratio shows that although capital (and therefore assets) have increased, sales have not increased proportionately but that could simply be an accident caused by the date of the asset increase. Note: ROCE = Net profit% x Asset turnover lIQUIdITY RATIOS Current ratio Current assets Current liabilities 2009 9,209 = 0.73 12,582 2008 5,889 = 0.63 9,362 11.8% = 5.9% x 2.0 12.0 = 5.2% x 2.3

Comments on the current ratio Normally, current assets are used to pay current liabilities. A current ratio of less than one is often considered alarming as there might be going concern worries, but you have to look at the type of business before drawing conclusions. In a supermarket business, inventory will probably turn into cash in a stable and predictable manner, so there will always be a supply of cash available to pay the liabilities. The company survived 12 months from the date of the 2008 statement of financial position until the present one (and the current ratio has improved), so there should be no particular alarm. Quick (or acid test) ratio Current assets (minus inventory) Current liabilities 9,209 2,669 = 0.52 12,582 5,889 2,430 = 0.37 9,362

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

ThE QUICk RATIO IS USEFUl WhEN INVENTORY IS TURNEd OVER SlOWlY, AS ThE PAYMENT OF CURRENT lIAbIlITIES WIll dEPENd ON RECEIVAblES ANd CASh. A QUICk RATIO OF lESS ThAN ONE IS OFTEN WORRYINg, bUT IT AgAIN dEPENdS ON ThE bUSINESS ANd COMPARATIVES.

in the last month of the year. The final capital of both companies will include the additional finance, but only the first company is likely to enjoy a significant increase in its operating profit. The second companys ROCE is likely to show a decline from one year to the next. This effect may have caused the decrease in ROCE seen in Ocset Co, and it would be useful to know when any expansion or acquisition took place.

05

TEChNICAl
IN A SUPERMARkET, MOST SAlES ARE FOR CASh, ANd COMPARINg RECEIVAblES TO SAlES ThAT hAVE NO IMPACT ON RECEIVAblES IS RAThER POINTlESS. IT WOUld bE MUCh bETTER IF SAlES COUld bE SPlIT INTO CASh ANd CREdIT SAlES ANd ThE TRUE COllECTION PERIOd FOR CREdIT SAlES WORkEd OUT.

Receivable collection period

Receivables Sales/day

1,798 = 12 54,327/365

1,311 = 10 47,198/365

Comments on the receivables collection period In a supermarket, most sales are for cash, and comparing receivables to sales that have no impact on receivables is rather pointless. It would be much better if sales could be split into cash and credit sales and the true collection period for credit sales worked out. However, there does seem to have been a disproportionate increase in the collection period. Possible reasons are: a different sales approach perhaps offering customers credit facilities a different range of products perhaps offering customers a credit card (look at board minutes) poor management so that credit control deteriorates economic problems causing customers to pay more slowly, and presumably an increased risk of bad debts (there might be implications for bad debt provision). We should check other information too. For example, if customers are taking longer to pay (or a credit card is offered), is the company earning interest on the balances? A receivables circularisation will be important to test the accuracy of the receivables figure. Payables payment period Payables Cost of sales/day 8,522 = 62 50,109/365 7,277 = 60 43,968/365

Comments on the payables payment period Theres nothing remarkable here. The increase could be evidence of pressurising suppliers and could be consistent with the improvement in gross profit percentage. We should check that there will be no future supply difficulties, by looking at correspondence and board minutes. days of inventory Inventory Cost of sales/day 2,669 = 19 50,109/365 2,430 = 20 43,968/365

Comments on the days of inventory This is a 5% fall and would appear to suggest tight inventory control. However, always go through (at least in your mind) the RATIO list: Reason accidental or deliberate? How was the decrease achieved? It could be an accident of timing, for example, where a weekend falls with respect to the year end. Inventory always needs to be carefully verified existence, quantity valuation etc. Implications. If there are fewer days of inventory, are customer service levels being adversely affected? If so, could there be going concern implications if customers were to take their business elsewhere. Going concern doesnt seem to be a serious issue within this company, but the auditor should always be aware of the risk even if only to dismiss it quickly. Is inventory wastage reduced? Other information. For example, has the company invested in new IT systems which allow better inventory control? Has the distribution system changed? Have more trucks been bought to allow the company to operate with lower inventory?

STUdENT ACCOUNTANT 12/2009

06

The gearing ratio

Long-term loan finance x 100 Equity finance

2009 14,170 x 100 = 109% 12,995

2008 8,602 x 100 = 73% 11,815

Comments on the gearing ratio The gearing ratio can also be defined in other ways, particularly by comparing long-term loan finance to total finance. As gearing increases so does the risk that the interest cant be paid. But it is difficult to define a safe level of gearing. For example, a property company with properties leased to tenants will have fairly predictable rental income. Such a company can probably safely sustain substantial borrowings (though it could be in trouble if interest rates increased significantly). A company with volatile streams of income would have to keep its gearing lower as it must ensure that interest can be paid during the lean times. Supermarkets could be expected to have reasonably predictable income: people have to keep eating, so will keep buying food. The gearing ratio calculation shows that there is a large increase in the companys gearing. You should ask the following questions: Reason: deliberate financial planning or problems? Is there any reason to suppose that the effect is temporary or an accident of timing? Loan agreements need to be verified for term and security. If the loan period is relatively short, how will it be repaid? We would expect the amount of interest paid to increase (unless the additional loan was taken out very close to year end). Interest cover Operating profit before interest Interest 3,206 = 6.7 478 2,450 = 9.8 250

Comments on interest cover Interest cover shows how many times interest can be paid out of earnings. Neither of these ratios would give cause for concern. The fall from 2008 to 2009 is consistent with the rise in borrowing that was identified earlier. The interest amounts would have to be tested to see that they were reasonable, given interest rates and when the additional borrowings were made. CONClUSION Ratio analysis and comparison are invaluable tools which help auditors understand what might have happened in a business. However, the initial calculation of ratios and percentage changes is easy and mechanical. The real skill comes in interpreting the results, and nearly always the results should give rise to more queries than they answer. Turn the page for the Ocset Co statment of financial position and statement of comprehensive income. Ken Garrett is a freelance lecturer and author

RATIO ANAlYSIS ANd COMPARISON ARE INVAlUAblE TOOlS WhICh hElP AUdITORS UNdERSTANd WhAT MIghT hAVE hAPPENEd IN A bUSINESS. hOWEVER, ThE INITIAl CAlCUlATION OF RATIOS ANd PERCENTAgE ChANgES IS EASY ANd MEChANICAl.

RISk RATIOS A companys indebtedness is obvious from its financial statements, so the risk analysed by external users is normally the risk related to borrowing the gearing risk. Borrowing causes risk because interest has to be paid irrespective of profits made. A rise in interest rates, or a fall in profits, can make the payment of interest very difficult, and lead a business into receivership and liquidation (going concern difficulties). Risk from borrowing can also arise when capital repayment is required, either on demand (in the case of overdrafts) or at the end of a fixed term. It is very important to understand how any repayment could be financed.

07

TEChNICAl
CAlCUlATINg A RATIO IS EASY, ANd USUAllY IS lITTlE MORE ThAN dIVIdINg ONE NUMbER bY ANOThER. INdEEd, ThE CAlCUlATIONS ARE SO bASIC ThAT ThEY CAN bE PROgRAMMEd INTO A SPREAdShEET. ThE REAl SkIll COMES IN INTERPRETINg ThE RESUlTS ANd USINg ThAT INFORMATION TO CARRY OUT A bETTER AUdIT.

TAblE 1: OCSET CO STATEMENT OF FINANCIAl POSITION 30/9/2009 $m Assets Non-current assets Intangible goodwill Tangible Current assets Inventory Receivables Cash and cash equivalents Total assets Equity and liabilites Share capital Reserves Total equity Non-current liabilities long-term borrowings Total non-current liabilities Current liabilities Trade payables Short-term borrowings Total current liabilites Total liabilities Total equity and liabilities 4,027 26,511 30,538 2,669 1,798 4,742 9,209 39,747 395 12,600 12,995 14,170 14,170 8,522 4,060 12,582 26,752 39,747 30/9/2008 $m 2,336 21,554 23,890 2,430 1,311 2,148 5,889 29,779 393 11,422 11,815 8,602 8,602 7,277 2,085 9,362 17,964 29,779

TAblE 2: OCSET CO STATEMENT OF COMPREhENSIVE INCOME Y/e 30/9/2009 $m 54,327 50,109 4,218 (1,012) 3,206 116 (478) 2,844 (780) 2,064 (886) 2,064 Y/e 30/9/2008 $m 47,198 43,968 3,230 (780) 2,450 187 (250) 2,387 (670) 1,717 (870) 1,717

Revenue Cost of sales Gross profit Commercial and administrative costs Operating profit before financing Financing income Finance costs (Loss)/profit before tax Income tax expense (Loss)/profit after tax Total comprehensive income for the year

student AccountAnt 12/2009


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67

FOCUS ON per
po 14: monitor And control budgets
Once budgets have been implemented, they need to be monitored and controlled. Accounting teams analyse and interpret financial data to help organisations and departments identify how closely performance is aligned to budgets over a defined period. This amounts to much more than simply whether sales are down or up monitoring and controlling includes the regular examination of costs, cash, working capital and assets. As an accountant, youll be charged with responsibility for chasing the information needed to identify variances between budgeted and actual figures, tracking relevant trends and communicating your findings to senior management or department heads. In order to do this, youll need to have systems in place to record figures on a timely basis and allow meaningful comparison against budgets as swiftly and accurately as possible (especially where managers in the field rely on them for driving individual and team performance, or for focusing sales activity). Where variations arise, youll need to find the right questions to ask in order to explain and make any relevant recommendations for actions arising from them. And its crucial that your findings are presented to management in a way thats easy to understand, particularly by those who are not used to financial terminology. That means translating accounting-speak for end users in plain language that leaves no doubt as to whats being communicated. Your work will assist with ongoing resource allocation and overall financial performance, as the organisation makes any necessary operational changes arising from reported variances or from indications that sales forecasts are being met or exceeded. Examples of relevant activities include: Preparing regular variance analysis reports, clearly demonstrating significant differences or trends requiring closer examination or which may cause alarm. Giving explanations and making recommendations based on variance analysis, including further data collection or research into company or industry-related factors. Incorporating significant variances in future budget planning. The next step is to answer the challenge questions for this objective in the trainee development matrix (TDM): Describe your role in monitoring and controlling budgets. How do you plan frequency and method of monitoring? What factors, such as accepted business cycles or the ease with which information can be initially gathered, are taken into consideration?

As An AccountAnt, youll be responsible for chAsing the informAtion needed to identify vAriAnces between budgeted And ActuAl figures, trAcking relevAnt trends And communicAting your findings to senior mAnAgement And depArtment heAds.

Who is involved and to what extend must you obtain buy-in to the monitoring process in order for it to be successful? How have those budgets affected your day-to-day role? Consider how information you collate for budgetary purpose might inform your other responsibilities within the team. In what ways does budget activity (preparation, actions from variations, amendments) change the time you can give other responsibilities? What adjustments do you have to make and how does this radiate out to include your day-to-day interaction with others? With some examples, how have you used these budgets to help others within your organisation? It might be that you alerted management in a particular region to adverse sales figures that bucked a wider trend and which led to identifying deficiencies in local management or poor recording of data that could be corrected, or even financial wrongdoing. Perhaps your monitoring work revealed aspects of outstanding operational performance that led to successful sales techniques or cost-saving drives being adopted throughout the company. Performance objective 14 is linked to Paper F2, Management Accounting, Paper F5, Performance Management, and Paper P5, Advanced Performance Management.

student accountant 12/2009


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01

FOCUS ON per
po 13: contriBute to Budget planning and production
Budgeting is a critical process for any organisation, large or small, and in almost every department, whether spending or revenue-generating. Accountants play an important role in planning and producing budgets. Alongside making reasoned, often complex calculations and informed forecasts to help ensure organisations and departments can effectively plan, budgeting responsibilities may be just as likely to involve communication, negotiation and even conflict resolution. Effective budget planning starts with supplying sufficient and correct information for creating detailed and accurate budgets and cashflow forecasts, as well as understanding the wider impact of those forecasts. Once budgets have been agreed, theyll need to be communicated with stakeholders, from colleagues tracking sales revenues to department heads who authorise expenditure. And when the accounting period is underway, the budgets will need to be kept under review, where necessary updating or adjusting in the context of changes to the organisation or the markets in which it operates. Youll need to call on your knowledge and understanding of performance measurement and management accounting skills to identify, describe, calculate and forecast business costs and revenues and their behaviour, and to plan, monitor, and control the use of business and financial resources.

Budgeting is a critical process for any organisation, large or small, and in almost every department, whether spending or revenue-generating. accountants play an important role in planning and producing Budgets.

Examples of relevant activities for demonstrating your competence might include: Contributing to budget meetings, from preparation work, such as analysis of relevant figures from previous periods, to follow-up actions, such as chasing data from other teams or delivering new budgetary messages to colleagues. Devising plans for budget preparation, from analysis of existing information, through taking stock of current circumstances, to collecting data on a timely basis. Preparing forecasts, balancing the optimism of sales managers with rational, evidence-based calculations, and allowing for sensitivity to sudden or unexpectedly dramatic changes. The next step is to answer the challenge questions for this objective in the trainee development matrix (TDM): Describe how you have been involved in budget planning and production. How do your budgeting responsibilities follow on from others? What happens to the work you produce? Who must you communicate with, and what information must you convey? What data must you use, where do you get this from?

Explain, having developed the budget, how you have made sure that it has been implemented correctly. Think about instructions or guidelines that need to be provided to end users, and how theyll seek clarifications or further help. What steps have you or your team taken to ensure that budgets are monitored appropriately? What would be the impact on your department or organisation if the budgets you supplied were not properly prepared? Consider not just the effects of over-expenditure by spending departments, but also the impact on financial performance, should adherence to incorrect sales budgets result in falling revenues being masked or cash positions being artificially inflated. How might confidence in you and your team be impacted if budgets are ill-prepared? For instance, if department heads observe budgetary constraints, only to discover they were working under false pretences, how would that affect their willingness to cooperate in future, especially if an indirect result was a fall in sales and/or individual sales commissions? Performance objective 13 is linked to Paper F2, Management Accounting, Paper F5, Performance Management, and Paper P5, Advanced Performance Management.