1.

Introduction
• Accounting is a series of processes and
techniques used to identify, measure and
communicate economic information, in
support of making business decisions.
• Internal users: directors, senior executives,
managers and employees.
• External users: shareholders, analysts,
creditors, tax authorities, the public
 The Accounting Equation
• Balance Sheet: Assets – Liabilities =
Owner’s Equity
• The British convention is to organize the
balance sheet as: Fixed Assets + Net
Current Assets = Owner’s Equity –
Creditors
• Owner’s Equity is described as Capital
Introduced +/- Profits earned (and retained)
 Definitions
• Fixed assets + net current assets = Owners’
equity + long-term debt
• ‘Current’ is used in the sense that the assets
or liabilities are expected to be converted to
cash on the next operating period.
• ‘Fixed assets’ are relatively long life (more
than the current operating period) and used
in production rather than being for resale.
 More definitions
• Items of expenditure accounted for on the Profit
and Loss Account (= Income Statement) are called
revenue expenditure. Those accounted for on the
Balance Sheet are called capital expenditure.
• A third accounting statement, the Cash Flow
Statement, portrays only those economic events of
a business that affect cash flows.
 Cash Flow Statement
• Shows sources and uses of cash.
• The first source of cash should be the
operations of the business.
• Items charged in the profit and loss account
that did not affect cash – such as
depreciation – are added back in.
• An increase in creditors is a source of cash;
the reverse is true of an increase in debtors.
 Financial Reporting
• Financial reporting derives from the legal
obligation on directors and managers to
report to the owners of the business
(shareholders) how they have used the
resources at their disposal during the
accounting period under review (usually
one year).
 2. Profit and Loss Account
• Profit is the difference between the sales
made during the period and the costs (direct
and indirect) incurred to bring the goods
sold to the market place ready for sale.
• Accomplishment for the accounting period
is measured by the number of products
shipped and invoiced to customers: sales or
turnover.
 Accomplishment
• Accomplishment is generally measured at the first
point in the operating cycle that the following
conditions are satisfied:
• The principal revenue-producing service has been
performed.
• All costs have been incurred or remaining costs are either
negligible or highly predictable.
• The amount ultimately collectable in cash can be estimated
within an acceptable range.
• The time of shipping and invoicing is typically the
first that these criteria have been met.
 Accounting Conventions
• Realization Convention: Only products that have actually
(and not prospectively) been sold are measured as sales.
• Accruals Convention: Revenues and expenditures are
recognized in the periods that the corresponding
production effort is made.
• A credit sale made this period is accrued to sales, even if
payment does not occur until the next period.
• A tax liability on profits is accrued for this period, even if not
payable until the next period.
• A lease payment that covers portions of this period and next
period is accrued accordingly.
 Measurement of Effort
• Matching Convention:
• Profit is arrived at by matching the costs to the units
shipped and invoiced (sold) during the period.
• Allocation Convention:
• How much of each means of production was consumed in
the present period and how much remains?
• Of that consumed, how much is attributable to sales and
how much to work in progress?
• Cost Convention:
• These use the historical (or acquisition) costs of the means
of production.
 Depreciation
• Depreciation, by itself, does not provide cash for
the replacement of assets.
• Cash cost was incurred in advance. This is afterward
an exercise in allocation.
• The periodic charge for depreciation is calculated
having regard to three factors:
• Acquisition cost, including installation charges
• Estimated residual value upon disposal
• Estimated useful life
 Depreciation Methods
• Straight-Line
• Reducing Balance
• Creates a greater charge earlier in the asset’s life, in
recognition of its greater (mechanical and economic)
efficiency and lower maintenance costs.
• Annual charge: 1 – nth root of (Scrap value / Book value),
where n is the number of years remaining
• Consumption
• Based on this period’s usage over the estimated total life,
thus allocating costs to the periods in which there is
greater wear and tear.
 Inventory
• Beginning inventory + Purchases – Ending
Inventory = Cost of Goods Sold
• Types of manufacturing inventory:
• Finished goods
• Work-in-progress
• Raw materials and supplies
 Inventory Valuation
• Generally, goods in inventory are priced at the lower
of cost and net realizable value. Costs include direct
material and direct labor, and expenditures bringing it
to its current condition and location.
• Most managers believe that the best valuation
method is the one that best matches the sales pricing
policy of the company.
• FIFO
• LIFO
• Average
 Not Inventory Valuation
• Product costs – indirect labor, materials and
factory overhead – may or may not be allocated to
inventory. Those that are not become part of the
current period’s Cost of Goods Sold.
• Period costs – SG&A and financial costs – do not
contribute directly to the value of the products and
are written off each year.
• There is some latitude in definition, and thus some
ability to have these costs allocated to inventory.
Selling costs, however, are never such an item.
 Interpreting Profit
• As both revenues and costs can be measured in
many ways, great care must be taken in
interpreting Profit & Loss figures.
• Consistent treatment of depreciation or inventory
prevents management from switching between
methods solely to influence reported profits.
• Profit can be calculated at a number of levels,
before and after overheads, and before and after
interest and taxes. Managers must select the
figure that best suits their purpose.
 Inflation Adjusted Depreciation
• This method requires that the depreciation charge
be based on the replacement value of the asset
(and perhaps its updated residual value).
• It also contemplates that, based on the new
replacement value, additional depreciation should
have been charged in one or more prior periods:
• The sum of these is ‘top-up depreciation’.
 Inflation Adjusted COGS
1. Take the simple average of the period’s opening and
closing costs.
2. Revise the opening and closing inventory amounts, based
on the average cost.
3. Using actual purchases, calculate the new COGS amount.
4. The difference between the previous and adjusted COGS
amounts is the COGS adjustment.
5. The Profit & Loss has the same opening and closing
inventory values as previously. Q: if we raise the COGS,
what is the offset to that expense of not closing inventory?
 3. The Balance Sheet
• The Balance Sheet is often described as a
snapshot of a company’s resources on a
given date.
• This contrasts with the Profit & Loss
Account, which could be described as a
video.
 Assets, generally
• Assets could be characterized as:
• The untransformed means of production, like
buildings, machinery and raw materials, or
• The transformed means of production, like work-in-
progress or finished goods, but not yet released to the
Profit and Loss account. Once so released, these costs
become expenses.
• The fixed assets are those long-term assets that
the company intends to use in the course of its
business.
 Land
• Land has infinite life and does not typically
diminish in value. These costs, together
with those (capitalized) of putting it in
service, are not depreciated.
• To reflect its current value, land may be
revalued from time to time. The increased
Balance Sheet value is offset with a revaluation
reserve in owners’ equity. Profits are
unaffected.
 Leases
• Many companies operate fixed assets that they do
not legally own.
• A finance lease is one in which the property reverts to
the lessee at expiration. Leased assets are shown on the
Balance Sheet as fixed assets and the future lease
obligations under creditors. Interest is charged to P&L
and the capital portion deducted from the reported
obligation.
• An operating lease is one in which ownership remains
with the lessor. These are not capitalized. The entire
lease payment is charged to P&L.
 Bad Debt
• A time lag between a debt arising (in the
accounting period of sale) and the debt being
written off (in a succeeding period) breaches the
matching convention.
• The Balance Sheet may show a reduced amount
for ‘Debtors less provision’. The P&L account is
charged with an initial provision for estimated bad
debt. In succeeding periods, P&L records only an
incremental adjustment.
 Liabilities
• If a company has received payment in advance of
providing the service, the cash debit is offset with an
Owner’s Equity section credit for deferred revenue.
• The British convention is to group short-term
liabilities (expected to be settled in the next period)
with short-term assets, and produce a ‘Net current
assets’ total for the Balance Sheet. Another such
convention is the summing of fixed assets and net
current assets to arrive at the Net assets of the
enterprise.
 Financing Net Assets
• Assets can be financed with sources that are
internally generated:
• From the original equity of the owner, or
• From profitable operations, where those profits have
not been distributed (i.e., retained earnings).
• External sources are long-term loans, usually
arising from a need to purchase fixed assets or to
expand operations. These are often secured.
 Gearing
• The relationship between owners’ equity and
long-term loans is called gearing or leverage:
• Gearing = Long-term debt / Total assets
• A highly-geared company will show greater
variance in its returns on equity than one lowly-
geared or ungeared. Its returns will be lower in
unfavorable markets and greater in more favorable
ones.
 4. Cash Flow Statement
• The Cash Flow Statement provides a
reconciliation between profits and cash.
• Profits  Cash
• Cash equals cash balances, bank balances and
‘cash equivalents’ – investments readily
convertible to cash or otherwise maturing into
cash within three months.
• An overdraft is merely a negative bank balance.
• An overdraft is not a negative current asset, but a
current liability.
 Sources of Cash
1. Profit from • Note that depreciation is
operations not a source of cash. It is
2. Capital introduction added back to the profit
figure to get cash from
3. Increase in creditors operations.
4. Sale of assets • A gain on the sale of an
5. Loans asset sale is subtracted
6. Decrease in from profit, and its full
inventories price shown as a cash
source.
7. Decrease in debtors
 Uses of Cash
1. Loss from operations • In general, these are
2. Capital repayments the opposites of the
3. Decrease in creditors sources, above.
4. Purchase of fixed
assets
5. Repayment of loans
6. Increase in
inventories
7. Increase in debtors
 Eight Major Categories
1. Cash flow from operations: working capital accounts
for debtors, creditors and inventories are included
here.
2. Returns on investments and servicing of finance:
including dividends received, interest paid and
received, and dividends paid to minority shareholders.
3. Taxation
4. Capital investment: Receipts from sales or
expenditures to acquire property, plant and
equipment.
 Eight Major Categories
5. Acquisitions and mergers: of subsidiaries,
associated companies or joint ventures.
6. Equity dividends paid to shareholders.
7. Management of liquid resources: the costs
of managing the cash account.
8. Financing: receipt and refunding of
shareholders’ funds or debt (except
overdrafts).
 Deriving the Cash Flows
• Four requirements:
• Balance Sheet at the beginning of the period
• Balance Sheet at the end of the period
• Profit & Loss Statement for the period
• The supplementary notes to these financial
statements
 5. Financial Reporting
• The law requires a certain amount of financial
disclosure from corporations in order to afford a
measure of protection to creditors and
shareholders.
• The desire to operate with a low level of external
interference and to protect sensitive commercial
information drives company management to
disclose to minimum required.
 The Disclosure
• The Company must publish a Profit & Loss
Statement and Balance Sheet that give a fair and
true view of, respectively, the profit or loss for the
financial year, and the state of affairs as at the end
thereof.
• So far as possible, figures must be accurate (or
reasonable estimates used), and methods give
reasonable assurance that the financial statements
are free from deliberate bias, manipulation or
concealment of material facts.
 Accounting Standards
• In Britain, Statements of Standard Accounting
Practice (SSAPs) and later Financial Reporting
Standards (FRSs) were produced by accounting
bodies or boards.
• The jurisdictions’ corporations statutes, current
accounting standards and the listing agreements of
stock exchanges shape the disclosures; generally
accepted accounting principles provide a
methodology.
 Accounting Policies
• Amongst the disclosures is a statement of how
accounting standards were applied to the business
(Accounting Policies).
• The company still has some latitude in the selection of
its Accounting Policies, so long as:
• The statements give a ‘true and fair view’
• The company can obtain the approval of the external auditor
• The policies are consistently applied. A change of
circumstances that would prevent an application from
producing a true and fair view would justify a new policy.
A change and its impact must be documented.
 Consolidation
• When a company owns more than 50% of other
companies, it must also report its results on a
consolidated basis.
• The excess paid for a company’s shares over their book
value is called good will, and appears on the holding
company’s (unconsolidated) statement as an intangible
asset. It reflects a belief that the asset acquired has a
greater inherent value.
• The Minority Interest is shown in the consolidation
with Owners’ Equity, as a stake in the total net assets of
the group.
 Exceptional Items
• An exceptional item is one that is material in
amount but derives from events or transactions that
are outside the ordinary activities of the company:
• Profits or losses on the sale or termination of an operation
• Costs of restructuring or reorganization designed to have
a material affect on the nature and focus of company
operations.
• Profits or losses on the disposal of fixed assets.
• This isolates the performance of the core business,
without exceptional items masking the numbers.
 Accounting Concepts I
• Going Concern: An assumption that the
company will continue to operate for the
foreseeable future. A contrary indication
must be disclosed, and may result in
accelerated write-downs of assets.
• Accruals: Revenues and costs are
recognized when the activity is completed,
save for settlement.
 Accounting Concepts II
• Consistency
• Prudence
• Non-Aggregation: In determining the aggregate
amount of any item, the amount of each individual
asset or liability that falls to be taken into account
shall be determined separately. For example, a
company would not be permitted to report Net
Current Assets without also calculating Current
Assets and Current Liabilities.
 The External Audit
• An examination of the system of bookkeeping,
accounting and internal control
• Comparison of the financial statements with other
company records for consistency
• Verification of the title, existence and value of assets
• Verification of the amount of liabilities
• Verification of the Profit & Loss results
• Confirmation that the company has complied with
accounting standards and statutory requirements
 Audit Report
• In addition to reporting on whether the company
has met statutory and accounting requirements,
and that the financial statements provide a true and
fair view, the report will indicate if the auditor is
unsatisfied that:
• Required information and explanations were obtained
• Proper books of account have been kept
• Proper returns were received from offices not visited
• Accounts are in agreement with the books
 Auditor’s Opinion
• Unqualified: nothing was found that would
detract from a view that the reports provide
a true and fair view.
• Qualified: with specifics as to why the
auditor in unsatisfied, and the effects on
accounts and amounts.
 6. Interpretation of Financial
Statements
• Absolute figures are not helpful by themselves. A
ratio reduces the data to a workable form and makes
it more meaningful.
• Percentages or ratios permit easy comparison
between periods or different corporate entities.
• Ratios may suppress poor absolute figures.
• Differences in definition are ultimately less
important than consistent application.
• Trends are usually more meaningful than a single
period analysis.
 Financial and Ratio Analysis
• Four types of ratios
• Liquidity: Measure a company’s ability to meet its
maturing short-term obligations
• Profitability: Measure management’s overall
effectiveness.
• Capital Structure: Examine the asset structure of the
company; analyze the company’s dependence on debt
(gearing ratios).
• Efficiency (activity or turnover): Indicate the
company’s effectiveness in managing its assets.
 Ratios I
1. Current ratio = Current assets / Current
Liabilities
2. Quick Ratio (Acid Test) = (Current Assets –
Inventory) / Current Liabilities
3. Profit Margin = Net profit before interest and
taxes / Sales
4. Return on Total Assets = Net profit before
interest and taxes / Total Assets
5. Return on Owners’ Equity = Net profit before
interest and taxes / Owners’ Equity
 Ratios II
6. Fixed to Current Asset Ratio = Fixed Assets /
Current Assets
7. Debt Ratio = Total Debt / Total Assets
 Creditors look to the owners’ equity to provide a
margin of safety.
 Companies with low gearing ratios have less risk of
loss in economic downturns, but also have lower
returns when the economy performs well.
8. Times Interest Earned = (Profit before tax +
Interest Charges) / Interest Charges
 Ratios III
9. Inventory Turnover = Sales / Inventory
10. Average Collection Period = Debtors /
Sales per day
11. Fixed Assets Turnover = Sales / Fixed
Assets
One Hundred Percent Statement
• In relation to profitability and cost control,
a favorite technique is the One Hundred
Percent Statement.
• Sales are set at 100%
• Each item of cost is calculated as a percentage
of sales.
 Stock Market Ratios
• Earnings per Share = Net Profit / # of common
shares issued
• Price Earnings Ratio (PE) = Market Price /
Earnings per share
• Dividend Yield = (Dividend per share / Market
Value per share) x 100. This calculation may be
modified by “grossing up” the dividend to account
for a tax credit. If the credit were 20%, the dividend
should be multiplied by 100/80.
• Dividend Cover = Net Profit / Dividend Payout.
 7. Emerging Issues
• There is extraordinary pressure on listed
companies to show earnings growth (short-
termism). One response is to adopt accounting
principles that give the appearance of an upward
trend in performance.
• As much Research & Development (R&D) is of
uncertain value, companies take the view that it is
prudent to write off the expenditure as it is
incurred rather than capitalize outlays that may
turn out to be worthless.
 Capitalizing R&D
• Development costs can be capitalized if:
• There is a clearly defined project
• Expenditure is separately identifiable
• There is reasonable certainty of technical
feasibility and commercial viability
• The costs are reasonably expected to be
exceeded by future sales
• Adequate resources exist for the project to be
completed
 Off-Balance-Sheet Transactions
• A highly-geared company may be inclined
to drive further borrowings off the Balance
Sheet in such a way as to avoid disclosure.
This is sometimes accomplished with:
• Quasi-subsidiaries
• Consignment inventories
• Sale and repurchase agreements
• Debt factoring
 Quasi-subsidiaries
• An investing company can engineer the share capital and
voting rights of another company or a joint venture so as to
avoid 50+% ownership but maintain effective control.
This company’s debt, then, is not on the investor’s Balance
Sheet.
• Under Financial Reporting Standard (FRS) 5, to avoid
consolidation:
• The risks and rewards of ownership must be in the company or
JV (no beneficial terms)
• Influence and management must be evenly balanced
• Profits, losses, dividends and/ or loan guarantees must be shared
equally.
 Consignment Inventories
• Sometimes a manufacturer will deliver goods to a
dealer on consignment, typically not requiring
payment (including financing) until the goods are
sold.
• If the dealer is ultimately obliged to pay for the goods,
whether or not sold, this risk is an indication that the
goods are the dealer’s inventory.
• If the goods can be returned without significant penalty,
then the dealer can avoid recording it as inventory, with
the attendant obligation .
Sale and Repurchase Agreements
• Goods are sold for cash, with part of the
consideration being the subsequent repurchase of
the goods, at a price that embeds a finance charge.
• FRS 5 would examine the substance of the
transaction. Is it:
• An arm’s length sale (did the risk and benefit of
ownership pass?)
• A financing deal with the goods held as security?
 Debt Factoring
• Accounts receivable can be ‘sold’ at a discount to their face
value to a finance house, who then attempts to collect the
full value.
• The critical question is whether the finance house has any
recourse to the vendor if the debts are not recoverable.
• If so, FRS 5 requires the vendor to recognize the potential
liability.
• The A/R might remain on the Balance Sheet and the cash
received matched with a short-term loan from the finance house.
If there is no subsequent liability, the A/R and loan are
eliminated, with the loss from factoring then transferred to P&L.
 Acquisition and Merger I
• Under UK law, amounts paid for shares (including
any premium) cannot form part of a dividend.
• If a company ‘acquires’ another for shares:
• Any premium paid over Net Assets is shown as good will.
• Any distributable reserves of the acquired company lose
this quality
• A ‘merger’ presumes instead that the parties have
agreed to pool their interests:
• There is no good will or share premium
• The distributable reserves are pooled
 Acquisition and Merger II
• Merger accounting is required when:
• Neither party sees itself as ‘acquiring’ or ‘acquired’
• Neither party dominates the management of the combined
entity
• A party does not dominate the combination due to relative
size
• Each party receives primarily equity shares
• No shareholders retain a material interest in only part of the
combined entity
• In general, it will be difficult to meet all these criteria
to qualify for merger accounting.
 Good Will I
• Acquisition accounting requires that the assets of
the acquired company be recorded at fair value
rather than historical cost
• This decreases the amount of good will when there is
significant disparity between the cost bases.
• This also returns good will to its essence: something
‘extra’ for the value locked up in the acquired company.
• If good will is written off in the current period, this
may suggest that the net worth of the combination
is declining when the opposite is probably true.
 Good Will II
• The combined entity can capitalize the asset, but it
is difficult to determine the amounts to write off as
it diminishes in value.
• Professional opinion favors the lesser of useful
economic life or 20 years, unless there is compelling
evidence otherwise.
• The speed of write-off need not be constant, and its
estimated useful economic life should be periodically
reviewed by management.
 Brands I
• Brands are the names of consumer products that, if
well-known, could be seen as having value to the
companies that own them.
• This increases the size of the assets on the Balance
Sheet – with implications for gearing or mere size
– but also reduces return on assets.
• A purchased brand would seem to stand on
different ground, assuming that its cost (in a larger
transaction) could be isolated.
 Brands II
• For home-grown brands, the value might be
based on:
• Historic costs of developing and maintaining
the brand, resurrected from prior periods’
expenses to become an intangible asset
(WorldCom!).
• An estimate of its power to increase earnings,
with an appropriate multiplier based on its
durability.
 Operating & Financial Review
• The OFR is optional in the UK, and appears to
have the same purpose as the Management
Discussion portion of SEC filings.
• International harmonization of accounting
standards is inevitable in a global economy. The
International Accounting Standards Committee is
sponsored by 50 countries, and may have some
role in the transition to an international standard.
 8. Intro to Management
Accounting
• The accounting information contained in a set of
corporate financial accounts is historic: reflecting
trading activities and the resources on hand at the
beginning and end of the period.
• The forward-looking branch of the discipline is
called management accounting. It is not an
objective, well-defined discipline, nor must it take
account of the different informational needs.
 Managerial Responsibility
• A manager wishes to ensure that things get
done efficiently and on time. These are
usually determined by comparison to the
company’s plans, which he made have had
a hand in developing.
• The sum of the managers’ plans must be a
realistic and practical proposition.
 Planning and Control Loop
• Planning
• Broad objective of the function or company
• Alternatives to achieving objectives
• Work out costs and revenues of alternatives
• Select the favored alternative and commence
operations
• Control
• Track actual performance against the plan Feedback
• Take remedial steps to solve problems.
 Mgmt accounting information
• No formal structure
• No externally imposed rules
• Not compulsory (although certainly necessary)
• Not just money terms: may consider labor hours,
materials used, energy consumed
• Tends to be forward looking, and therefore with less
emphasis on precision
• May consider business segments rather than the whole
• No formal audit, although the auditors will be
interested in its control aspects
 Costs relevant to mgmt decisions
• Direct material is material that is easily
identified in the finished product, in contrast
to supplies, which are consumed in the
process but less traceable (glue, screws).
• Direct labor (measured in time and price) is
directly traceable to the product, contrasted
with supervision and head office.
• Prime cost = Direct Material + Direct labor
 9. Cost Characteristics
• Cost in one of the most fundamental control
mechanisms in a management information system.
With a knowledge of cost, managers can:
• Control actual performance against planned
performance
• Plan next year’s costs
• Determine a desirable selling price
• Track the consumption of the organization’s resources
• Choose among alternative courses of action
 Variable and Fixed Costs
• Variable costs vary directly with the level
of production; fixed costs are unaffected by
the level of production.
• Depreciation is treated as a fixed cost:
• Although we would expect machinery to
depreciate with usage, the most prominent
criterion in the depreciation of value is the
passage of time, which brings with it
technological obsolescence.
Beware the Unitizing of Fixed Costs!
• The allocation of fixed costs per unit vary
with the production level.
• By dropping a product line, for example,
the fixed costs previously borne by that
product now have to be allocated amongst
those remaining.
 Direct and Indirect Costs
• Costs that are incurred simply because an item is
produced are direct costs; all others are indirect costs.
• The indirect costs are incurred in support of
production, rather than being production themselves.
• A less-used categorization is traceable and common
costs.
• Traceable costs are, by definition, those costs that can be
traced into the cost item.
• Common costs are those incurred by a business to support
all production.
 Product and Period Costs
• The significance of this cost category is in valuing
inventory for financial reporting purposes.
• Product costs (raw materials, direct labor,
depreciation, factory overhead) are allocated at
period end to either COGS or inventory.
• Period costs (selling, administration, financial)
are written off to the Profit & Loss account
without any prior allocation.
Controllable/ Non-Controllable Cost
• The term ‘controllable’ refers to the person
who can be held accountable for the costs
being measured.
• The concept of control is also influenced by
the time scale.
• A shift supervisor cannot be accountable for the
loss of machinery during a shift, but is
accountable for the maintenance budget over a
year.
 Standard and Actual Costs
• By means of an engineering study and
through experience, a company will set
standard costs:
• These are the budgeted costs for one cost item,
both variable and a share of fixed.
• Against this benchmark, actual costs are
measured period by period. Management
would seek explanation for significant
variances.
Engineered and Discretionary Costs
• A business cannot avoid the costs that are
engineered into the product.
• They do, however, have a discretion
around items such as Research &
Development, or the levels of
administrative support or machine
maintenance.
 Break-Even Chart
• The sales revenue line climbs from zero (no sales:
no revenue) at the rate of revenue earned per unit
sold. Its point of intersection with the total cost
curve is the break-even point.
• The difference between the break-even point and
the actual level of sales, if greater than break-even,
is called the margin of safety.
 Calculating Break-Even Points
• The Profit/ Volume Ratio measures the contribution
to fixed costs per unit:
• P/V ratio = Contribution / Sales Price
• Equation Method: Break-even Sales Amount =
Fixed Costs + Variable Cost (expressing the latter
term as a proportion of sales)
• Contribution Margin Method (gives units): BEP =
Fixed Costs / Contribution margin
• Contribution Margin Ratio Method (gives value):
BEP = Fixed Costs / Contribution Margin Ratio
 Limiting Factors of Production
• A limiting factor is the ultimate bottleneck
that limits production quantities: space,
machine hours or skilled labor.
• Optimization depends on obtaining the
maximum contribution per unit of limiting
factor.
 10. Allocating Costs
• Businesses develop costing systems that are unique
to them and that attempt to reflect their particular
(and changing) production characteristics.
• Materials are perhaps the easiest cost to trace to a
cost item because of their visible, physical nature.
• Rather than using an inventory system (LIFO, FIFO,
average) based on actual costs, it is more likely that a
standard price would be used. Any variance between
this estimate and actual would be accounted for in the
Profit & Loss at the end of the period.
 Labor Costs
• Labor cost is a multiple of time spent on the
job and rate of pay earned by the operatives
involved.
• Due to differing rates of pay, the calculation
uses a standard wage rate, as for materials.
• The rate goes beyond wages to include benefits
and employer-paid payroll taxes.
 Overheads I
• Manufacturing and non-manufacturing overheads
are indirect costs.
• Before spreading the overheads to units of
production, these costs must first be gathered into
cost centers, for which individual managers will
be responsible.
• A predetermined overhead rate will allocate
overheads across units of production:
• Allocation Rate = Budgeted overhead / Budgeted
production units
 Overheads II
• Cost accountants search for causal factors or
activity bases – the one particular factor related to
most of the heads of cost that comprise overhead.
Typical activity bases are direct labor hours, direct
labor cost or machine-hours.
• Estimated overhead is divided by the estimated quantity
of the causal factor. The resulting predetermined rate is
applied to the individual products using these products’
consumption of the causal factor.
• Variances are accounted directly to Profit & Loss.
 Overheads III
• Departmental overhead rates attempt to avoid the
problem of the differing activity bases, first, by
allocating overheads to individual departments, and
second, by identifying the activity base most
appropriate for each department.
• Since products flow through production departments
and not service departments, the first step in the
allocation process must be to transfer service
department overheads to the production departments
so that they can be ‘attached’ to the products as they
go through.
 Direct and Step Allocation
• The direct method empties overheads from the service
departments into the production departments. Each
service department is taken in turn using a suitable
activity base.
• No accounting for inter-departmental service.
• The step method recognizes this interdependency. The
sequence may based on:
• Descending order of magnitude of overhead spend
• Descending percentage of service to other departments
• The activity base does not consider services provided to
itself or to ‘emptied’ departments
 Joint Products
• The true characteristic of a joint product is that it must
appear during the processes involved in producing the main
product.
• If the product need not emerge from the process, the products
cannot be deemed to be joint.
• Allocation possibilities:
• Equal shares
• Physical characteristics: weight, volume or difficulty in handling
cause certain costs to be incurred.
• Sales value at split-off
• Ultimate sales value: deducts post-split-off processing costs, and
allocates on the net amount.
 Why Allocate These Costs?
• For product management: understanding the
resources being consumed by the product
• Inventory valuation
• Price-setting under cost-plus pricing
 By-Products
• A by-product is one that emerges from a production
process that is designed to produce another product.
• This usually has low commercial value compared to the
main product.
• No attempt is made to allocate costs between the
products.
• Revenues from the by-product are deducted from the
processing costs.
• Unsold by-products are carried in inventory at zero cost,
and allow no deduction from processing cost.
 Process Costing
• Job costing is characterized by separate products
that incur separate costs.
• Process costing is applied in industries where no
uniqueness is identifiable in the products produced
and where the process is almost continuous.
• An equivalent unit of production is an assessment
of the degree of completion of a unit under each
major component of cost.
 Cost per Equivalent Unit
• The costs to be accounted for by a production
activity in any accounting period comprise two parts:
• Those attaching to the opening work-in-process at the
beginning of the period but were incurred in the previous
period
• Those incurred during this accounting period in order to
finish the opening work-in-process, make units started and
completed in the period, and start work on the units left in
the closing work-in-process.
• Only the costs of the current period are used to calculate
the cost per equivalent unit of production.
 Activity-Based Costing (ABC)
• Activity-Based Costing is based on a belief that
activities (e.g., production planning, quality inspection),
rather than products, cause costs to be incurred. The
products consume activities, and thereby costs.
• Different activities have different cost drivers.
• ABC permits products to be loaded up with those costs they
incur.
• Product diversity causes problems for traditional costing
systems. Products with low resource consumption may bear
a more than their share of costs and vice versa, thus creating
cross-subsidies.
 11. Costs for Decision-Making
• Absorption costing:
• Based on the planned production volume, absorption
costing allocates a share of the fixed production cost to
each production item.
• This cost does not change if production volumes are
greater than or less than forecast. Instead, an
adjustment is made to a P&L line item “Denominator
volume variance” to represent the over-collection or
under-collection of fixed costs.
• When production does not equal sales, the incremental
cost component is sent to or drawn from inventory cost.
 Variable Costing
• Variable costing is the more traditional
method:
• The pool of fixed costs is deducted as COGS
from current period sales, regardless of
additions to or draws from inventory.
• Inventory volume carries its variable costs only.
 Absorption v. Variable
• The main difference is in the timing of fixed
production expenses:
• Variable recognizes them all in every accounting period.
• Absorption, through inventory valuation, allows some
portion of fixed costs to be drawn from a previous period
or sent to a subsequent period.
• Profit:
• Under variable, is a function of sales.
• Under absorption, profit is influenced by sales and by
production levels.
 An Analytical Framework
• Task One: Define the problem and list all feasible
alternatives.
• Task Two: Cost the alternatives.
• The relevant costs are those that differ for the alternatives under
review. It may be useful to list just the cost differences rather than the
full cost of each.
• Task Three: Assess the qualitative factors.
• Task Four: Make the Decision.
• To do nothing is a valid decision.
• A decision can be put off in order to gather more information,
if the benefits of doing so would outweigh the costs.
 Costing Alternatives I
• Relevant costs are:
• Future costs: Old costs (i.e., sunk costs) cannot be
influenced by future decisions
• Cash costs: must involve cash flows and not
accounting devices such as depreciation or write-offs
• Avoidable costs: an unavoidable cost will be incurred
whatever option is selected.
• Differential costs: the reallocation of a resource within
the company is relevant only if the company’s overall
financial position is affected.
 Costing Alternatives II
• Opportunity costs: Just as there may be certain costs and
benefits attendant upon choosing one alternative, there
may also be relevant revenues or benefits foregone by not
choosing the other.
• In interpreting full cost information:
• A variable cost should vary but it can be seen to remain fixed
per unit
• A fixed cost should remain fixed, but when converted into a
fixed price per unit, the cost appears to vary (beware the
unitizing effect!)
• In a shut down decision, certain variable costs may be
unavoidable (thus acting like fixed).
 Costing Alternatives III
• Management should not confuse the costs required
for long-term pricing strategies with those
required to deliberate on special orders.
• No technique for allocating joint product costs is
applicable to management decisions of whether a
product should be sold at the split off point or
processed further.
• Such decisions can be aided only by incremental or
relevant cost analysis.
 12. Budgeting
• Budgeting is the predictive step in the management
process. It has the following attributes:
• Co-ordination of activities
• Planning: Without some idea of where the organization is
heading, it is impossible to anticipate resource requirements
or gauge performance.
• Motivation: the provision of individual and collective
targets
• Control: measurement against those targets
• The budget is only a numerical expression of the plan
– it is not the plan itself.
 Budgeting Obstacles I
• Time Taken
• A good budget process is an iterative one, thus requiring
sufficient time for discussion and feedback.
• There can be no firmer basis for next year than what
happens this year. Therefore, the budget process should
start as late as possible in the current year consistent with
getting agreement by the start of the new year.
• Lack of Top Management Commitment
• Only if the whole management team shares the ideal of
constant improvement in operating performance will the
commitment of lower-level staff be ensured.
 Budgeting Obstacles II
• Top-down Control
• Perceptions that the process is intended to minimize
resources or is devised without consultation is unlikely
to have the support of the management level charged
with implementation.
• Blurred responsibilities
• It is unfair and de-motivating to lower-level budget
holders to assess their performance on managing costs
over which they have no control.
 Budgeting Obstacles III
• Moving goalposts
• A change in circumstances can invalidate the premises
of the budget projections. Rolling twelve-month
budgeting or adherence to the original budget are
usually favored over budget amendment. The portion
over which management has control can be isolated.
• Rewarding Inefficiency
• Management must adopt a more rigorous and analytical
approach to uplifts or cuts in budgets than blanket
percentages.
 Zero-Based Budgeting
• ZBB bundles discretionary costs – e.g., R&D, machine
maintenance and legal services – into discrete packages,
starting with the most fundamental and receding in
priority.
• These activities bid for resources as if they were new projects,
i.e., from a zero base.
• ZBB forces management to relate the budget expectations
of experts with the strategic direction of the company.
• It is difficult to break homogeneous activities into such
packages, and the budget owner is motivated to size them
to maintain the status quo.
 13. Standard Costing
• Management needs detailed costs and
revenues of individual components of the
business so that corrective action can be
taken at the source of the problem.
• We use standard costs for this control process.
• Standard costs are budgeted costs for individual
cost items.
 Setting Standards
• An engineering study might consider the amount
of material required, complexity of the design,
material form and quality, skill of labor required
and the precision of the machinery used. This
results in an engineering or ideal standard.
• Since the engineering standard is not going to be
consistently attainable, we consider the normal
perils of the process to arrive at a normal or
operating standard.
 Motivation
• One can neither manage nor work to an
unattainable standard.
• A properly designed standard will motivate
employees to strive to meet the standard
and reward them for so doing.
• The standard may have to be periodically
revisited to ensure that it still provides a
stretch target.
 Flexible budgets
• Budget numbers are flexed to the level of
output actually achieved, so that
management can compare the costs incurred
with those that would have been established
for that level of output.
 Variance, generally
• Standard cost = direct materials + direct labor + variable
overhead
• An adverse variance is one where actual cost is above
standard cost; a favorable variance is one where actual
cost is less than standard cost.
• Exception reporting allows management to focus on
those aspects of the operation that are outside of a
defined tolerance. Difference should be sufficient to
justify the cost of investigation and management action.
• Investigation may be hampered by interdependencies.
 Variances, materials
• Material efficiency variance: [std quantity used –
actual quantity] x std price per unit
• Material price variance: [std unit price – actual
unit price] x actual quantity used (or purchased)
• Process may consume less of a higher quality (and
usually higher price) material; or more of a lower
quality (and usually lower price) material. This
can also directly affect the amounts of labor or
variable overheads required.
 Variances, labor
• Labor efficiency variance: [std time allowed
– actual time taken] x std rate
• Labor rate variance: [std rate per hour –
actual rate] x actual time taken
• Labor may be more or less skilled; aided or
hampered by materials, equipment; become
more expensive with overtime/ downtime
 Variances, variable overhead
• Efficiency variance = [std cost of flexible
budget time for units produced] – [std cost
of actual time taken for units produced]
• Spending variance = [std cost of actual time
taken for units produced] – actual costs
incurred
 Variances, fixed overhead
• Spending variance = Budgeted amount –
Actual amount
• Denominator variance = Budgeted amount
– Amount applied to units produced
 Variances, sales
• Sales contribution variance = (individual margin
x units sold)
• Sales volume variance = (individual sales volume
@ budgeted margin)
• Sales quantity variance =  total volume x average
margin
• Sales mix variance = (individual sales volume x
(budgeted margin – average margin)
• Check: Sales volume variance = Sales quantity
variance – Sales mix variance
 14. Accounting for Divisions
• Whether it grows organically or by
acquisition, the size of a corporation may
prevent the management team from
exercising sufficient scrutiny of day-to-day
operations.
 Advantages and Disadvantages
• Advantages: • Disadvantages:
• Specialization • Diminished control
• Local knowledge can be • Duplicated costs
brought to bear immediately • Internal rivalries
on local problems. • Local versus corporate
• Motivation: running their interest
own shop
• Speed of implementation
• Career mobility: training
ground for managerial talent
 Types of Divisions
• Cost center: responsible for managing costs but
not associated revenues
• Revenue Center: responsible for generating
revenues without reference to underlying costs
• Profit Center: performance is assessed based on
the bottom line
• Investment Center: Net assets are taken into
account, to assess efficiency as well as
profitability
 Controllable Revenues and Costs
• The profit and loss account can be
restructured to show the only those costs
and profits that are within the control of the
division.
• Any portion of the division’s share of head
office costs that does not benefit the
division is excluded.
 Asset Base Valuation
• Replacement Cost: reference to market
prices for similar assets. When there is a
market, this values assets fairly.
• Net Book Value: The difference between
the purchase price and accumulated
depreciation, whether or not this
approximates true value. Despite its
shortcomings, this is the preferred metric.
 Assessing Performance
• Return on investment: the ratio of profit to net book value
of fixed assets, expressed as a percentage. A division’s net
book value (asset base), in the absence of replacement, is
falling year by year. A steady profit, in such a situation, is
producing increasingly larger returns on investment (ROI).
• Residual income: a division is charged interest on its assets
at the company’s cost of capital (therefore, there is no
depreciation). Any opportunity yielding a positive RI
should be accepted.
• Top management must distinguish between divisional
performance and managerial performance.
 Imputed Interest Rate
• Low rates favor divisions with high
investment in net assets. When the rates are
higher, there is a higher imputed interest
charge on the assets.
 Transfer Pricing
• Where a market price is available, this is by far
the best method.
• Cost-based: but are these variable costs alone or
include the absorption rate for fixed costs? What if
the production capacity would be otherwise idle?
• Negotiated costs: a euphemism for management
imposition. The Company may temporarily book
the difference to a reserve, but not rely on such a
price distortion in the longer term.
 International Divisions
• Transfer pricing can be geared to produce
the profit in the lower-tax jurisdiction.
• Whether this simple tactic will be used may
also depend on the repatriation of profits
from the transferring country.
 15. Investment Decisions
• An investment decision is one whose impact
extends beyond the immediate operating period.
• A decision that has its impact within the operating
period is an operating decision.
• Restrictions on capital spend will be imposed by the
market or by the Board.
• Investment decisions always require forecasts –
explicit or implicit – and future profits are directly
related to the success or otherwise of investment
decisions.
 Investment Process
1. Search: All managers have a responsibility to
search for worthwhile investments.
2. Evaluation: according to the corporation’s
chosen metrics.
3. Control: Once an investment has been
undertaken, the financial control of it will follow
the normal budgetary control procedures.
 Present Value
• Present value is based on the ability to earn
interest or the need to pay interest on investments.
• This is a separate consideration than the effects of
inflation/ deflation or the risk of loss (which
should be evaluated as any other variable).
• PV is the value today of a sum receivable
sometime in the future at a given rate of interest.
It is given by dividing the receivable by (1 + i)n,
where i is the interest rate and n is the number of
times the amount is compounded.
 Net Present Value
• Net Present Value takes all of the cash flows
associated with a project and reduces (discounts)
them to a common denominator (present value) by
using an appropriate interest rate (usually the cost
of capital or the cost of finance).
• Cash outflows are often described as negative cash
flows, and cash inflows as positive cash flows.
• NPV shows whether a project is profitable and
whether the rate of return is above or below the
imputed cost of capital.
 Internal Rate of Return
• IRR is also known as the discounted cash flow rate of
return.
• Instead of discounting by the cost of capital, IRR finds
the interest rate that reduces all of the associated cash
flows to an NPV of zero.
• This is usually calculated by an interpolation of two rates
providing a positive and negative NPV.
• While IRR does provide a relative measure of
profitability, it does not readily lend itself to comparison
with an income/ expenditure stream with different cash
flows.
 Appraisal in Non-Revenue Situations

• Cash flows are discounted to NPV in the

usual way. The project with the lower NPV
is the cheaper.
 Risk and Uncertainty
• The important variables in an investment
appraisal are:
1. Capital expenditure: the amounts and timing of fixed
and working capital required. One of the common
reasons for profitability to fall short of estimates is the
time required to complete capital works and become
operational.
2. Operating income and expenditure, including taxation.
3. Investment life: a race amongst physical deterioration,
market demand and obsolescence.
4. Cost of capital: actual, deemed or average.
 Payback Period
• Payback is the time taken for positive cash flows
to recoup the original investment.
• It ignores one of the most important factors in
investment: profit. It also treats all cash flows the
same, regardless of timing. The latter could be
corrected by discounting the cash flows or by
adding an interest charge to the amounts carried
forward.
• Payback also lacks a ready market comparison.
 Sensitivity Analysis
• Sensitivity analysis consists of changing the
value – quantity or price – of a key variable to
assess its impact on the final result.
• It is normally assumed that management is
aware of the likely critical or key factors and
will concentrate attention on these.
• Sensitivity analysis does not build into the
evaluation the likelihood of variation from the
estimate (expected value).
 Risk Analysis
• We can incorporate sophisticated techniques of
probability analysis, but they cannot create
objectivity out of subjective judgments.
• The risk can be regarded as the spread or range
around an estimated value. The greater the spread,
the greater the risk.
• A high-hurdle test subjects a project to a more
rigorous test of acceptability. This forces the
investor to an examination of the factors that make
investments more or less risky.
 Cost of Capital
• A company may weight the costs of capital,
including the cost of service, in its
optimum proportions. A loan, since tax
deductible, has a net cost calculated by
multiplying by (1 – tax rate).
• Opportunity cost: the return achieved must
be at least as good as that achieved by
investing outside of the organization.
 Post-Assessment of Capital Projects

• This is a series of interim audits in which all the

key investment factors are reviewed against the
forecast, and an assessment made of the effect of
deviations on the profitability of the project and
the company.
• This may be a useful tool in the evaluation of
future prospects.
• There is the implication of a real option before
completion: abandonment.
 16. Developments in Mgmt Acct
• In a high-technology environment, competition on
price is intense and the demand for a management
accounting system to identify accurate product
costs becomes more pressing.
• The marketing edge is often derived from having
critical information about customers – their
requirements, their problems, and their own plans
for development.
 Target Costing
• Target costing has been developed to help
companies manage their costs in circumstances
where the selling price is known.
• The desired margin is deducted from the target
price to determine the target cost beyond which
the company would consider it uneconomic to
produce and sell the product.
• Value engineering involves a complete reappraisal
of every aspect of the manufacture and
distribution.
 Target Costing, 2
• There is often an emphasis on design: to
have fewer components, or less material, or
to require less labor or machine time.
• It is only once the model or process has
gone into (stable) production would it be
possible to establish the standard costs
against which actual costs would be
controlled.
 Life Cycle Costing
• Life cycle costing gathers all revenues and costs
associated with a product or service over its whole
lifespan (prototype design to withdrawal of
maintenance) so that its ultimate profitability can
be measured and management decisions taken
thereon.
• Does not differentiate between capital and revenue
expenditure (i.e., limits the constraints of annual
accounting dates).
 Throughput Accounting
• This is a concept intended to optimize sales when
there is a constraint (“bottleneck”) in inputs or
production facilities.
• A business can only earn profits if the rate at
which it earns money from sales is greater than the
rate at which it spends money on production.
• Depreciation and other fixed costs are considered
“sunk”.
• There is value in finished inventory only if it can be
readily sold.
 Throughput Accounting Formulae
• Return per factory hour = (Sales price – Material
cost) / (Time spent at the bottleneck per product)
• Cost per factory hour = (Manufacturing overhead
+ direct labor cost) / Total time available at
bottleneck
• Throughput accounting ratio = Return per factory
hour / Cost per factory hour
• A ratio of less than one indicates that the product is
losing money.
 Costing for Competitive Advantage
• Strategy: a course of action, including a
specification of resources required, to achieve a
specific objective.
• A production strategy might be:
• A productivity percentage increase to be achieved in the
next budget period
• To build production capacity for a new product line
• To improve the quality of finished goods to an acceptable
level of rejects
• To buy components rather than make them, or vice versa