AC100: FINANCIAL ACCOUNTING HIGHLIGHTS

Government: How much to tax? Economic policy

decisions? Profits and expenses, CAPEX

(1) Introduction: The role and context of accounting

Usefulness of accounting information
Role of accounting standards

Comparability, consistency, reliability, accuracy,

transparency, quality, integrity, understandability,
uniformity

Prevent against irregularities: Disclose and boost

user confidence

Functions of accounting

Record*: Record and classify data to produce

summarized financial statements showing results
and current state of affairs

Measure: Measure economic results of financial

activities for end users

Stewardship: Show what, why and how entrusted

funds are used by managers

Monitor, plan and control: Past results allow

management to take current action and formulate
future plans

Information for decision making

Communicate

(2) Accounting and decision making

Relevance: Information that is relevant to

predicting
future
events/affect
decision.
Accounting provides a good basis for assessing
the future

Dual aspect: Double-entry bookkeeping

Trial balance: Simple listing of the accounts in the

general ledger with their balances

Money measurement: Resources reflected in

statements must be measured reliably monetary
terms

Monetary stability: Inflation is not recognized,

value of money remains constant

Financial statements: Statement of financial

position (accumulated wealth over a period),
income statement (wealth generated over a
period), cash flow statement (cash movements
over a period)

Matching: Expenses should be matched to

revenue generated. Accruals and prepayments

Reliability: Free from significant errors and bias,

neutral and complete representation, prudent

Comparability: Changes in performance over time,

relative performance with counterparts

Convergence of accounting standards

Understandability: Clear and understandable,

readily available, not to be sacrificed for simplicity

For
Uniform framework:
Enhanced comparability,
easier flow of capital

Relevance vs reliability

Timeliness: Reliable information

timely information is less reliable

Objectivity: Relevant information is based on

managerial or market estimates, rather than
objective and verifiable information

is

Rules-based (US GAAP) vs principles-based

(IFRS)

outdated,

Against
Inhibit change: Lack of
freedom to experiment
and innovate stifles the
development of new and
better procedures

Reputation: Systematic check of forecasts against

ex-post realizations restraints managers from
issuing forecasts to intentionally mislead users

Users of financial accounts

Running the business orderly and efficiently,

adherence to policies, safeguarding resources,
ensure completeness and accuracy of records

(5) Statement of financial position/Balance sheet

Conventions: Money measurement, historic cost, dual
aspect, going concern
Purpose

How is the business financed and how are funds

deployed: How much is contributed by owners
and outside lenders? What assets are acquired?

Assess business value: Limited to tangible assets

only

Consensus-seeking:
Standards may be
influenced more by the
need to achieve
consensus than technical
considerations

Relationships between assets and claims: Short

term assets vs liabilities, liquidity and solvency

Assess performance: How effective is the

business in generating wealth, ie. Profit generated
vs investment involved

Costly: High costs of

complying, borne by
shareholders

Asset: A resource held by the entity

False conformity: May not

reflect the individual
characteristics of different
businesses

Other conflicting characteristics: Reliability vs

comparability, reliability (neutral) vs neutral
(prudent)

Internal control

(3) Financial accounting standards and conventions

Shareholders: Continue investing? How to vote?

How has the money been used? Distributable
profits, dividends, performance ratios, future
plans, budgets

Accounting framework

IASB: Financial statements should provide a fair

presentation of information about the financial
position, performance and changes in financial
position of an entity that is useful to a wide range
of users in making economic decisions

Creditors: How much to lend? When and how to

repay? Current and future cash flows, outstanding
loans

Customers: Ability to survive in the long run?

Continue doing business? Profitability, future
plans, going concern

Management: How to plan future investment?

How to monitor and control current investment?
Operating information

Accounting conventions

Complex: Statements are

becoming too complex to
be useful to the average
user

Key issues: How and what information should be

disclosed, how should assets be valued, how
should profits be measured?

(4) The generation of accounting data

Accounting records

Employees: Prospects? Wage increases? Current

and future profitability, employment policy, going
concern
Competitors: Relative position and performance?
Competitive strength and future plans? Position,
performance, future investment plans

Business entity: Personal and business accounts

are kept separate

Historic cost: Assets are reflected at their

acquisition costs

Prudence: Not understating losses/obligations

and not exaggerating profits/resources

Going concern: Assumption that operations will

continue in the foreseeable future

Probable future benefits: Entity must have future

monetary value ie. Even obsolete scraps sold
have residual value

Exclusive right to control the benefit: A common

resource (e.g. managers) is not an asset

Benefit arises from some past transaction:

Transactions giving rise to the benefit must have
already occurred

Money measurement: Asset must be capable of

measurement in monetary terms ie. Selfestablished brands are not assets

Source documents: Original records detailing the

transactions (e.g. sales invoices, receipts)

Books of prime entry: Journals describing the

transactions based on source documents (e.g.
sales invoice, purchase daybooks). Most relevant
for keeping track of credit sales, prevention
against overdrawing and VAT and income tax
purposes

Liabilities

Ledger: Records for a group of related accounts

(e.g. sales, purchases, general ledgers)

Equity

Definition: Present obligation arising from past

transactions, the settlement of which is expected
to result in an outflow from the entity of resources,
usually cash, embodying economic benefits

!
1

Definition: Claims of the owners in respect of the

money that they have invested in the entity and for
all subsequent profit earned that have been
reinvested in the entity

Performance measure:
Better measure for
evaluating future
performance

(8) Asset valuation and profit measurement 1

Useful economic life (UEL, n)

Bad and doubtful debts

Subsequent measurement: Routine/maintenance

expenses are reflected in the income statement
(e.g. repairs), whereas expenditure extending the
useful life of PPE is reflected in the SFP (e.g.
refitting)

Recognizing intangible non-current assets on SFP

Some benefits are purchased: Intangible assets

cannot be recognized on the SFP unless some of
its benefits are purchased (e.g. trademarks are
recognized only if they were purchased)

Physical life: Asset is exhausted through wear and

tear/time

Goodwill: Difference between an entitys purchase

price and the sum of its NBV

Economic life: Effects of progress in technology

(obsolescence), changes in demand

Inventory valuation (consistency convention)

General accounting equation

NCA + CA = CL + NCL + Equity
(6) Double entry bookkeeping
(7) Income statement
Conventions:
Accounting
matching, prudence

period,

realization,

Write off: Certain that the customer will never pay

(e.g. customer went bankrupt)

Provision: Debts which seem unlikely to be

collected

Depreciation (consistency convention)

Revenue

Inventory

Reliable measurement: Amount of revenue can be

measured reliably
Realization: Probable that the economic benefits
will be received
Ownership: Ownership and control should be
transferred to the buyer post transaction

Income statement
Flow statement linking
the balance sheets at the
beginning and end of an
accounting period

Balance sheet
Snap shot of financial
position at the beginning
and end of an accounting
period

Accruals accounting

Why accruals accounting: Relevant and better

predictive ability on future profitability expenses
will be charged to expenses when incurred (not
when paid), yielding items that are included in the
SFP of the current period while relating to the next
period income and cash flow statements
Why not cash: Cash accounting likely to distort
the matching of revenues and expenses, leaves
less room for accounting choices reduced
scope for regulation

Accounting for inventory:

periodic method

Managerial incentives to overstate profits

Write down is not recognized: Future profits will

still be affected, users may still deduct the write
down through alternative information sources,
return-on-capital is unaffected by write down

Type of inventory: Perishable goods (e.g. fashion

goods, food) write down are recurring

Type of business: Smaller amount of inventory

kept implies less recurring write downs

Reducing-balance method: Decreasing charge

over UEL

Depreciation+charge = Initial'cost Residual)value

Last in, first out (LIFO): Goods bought or sold last

are sold first (not for external reporting)

Average cost (AVCO): Goods entering

business lose their separate identity

Share capital: Number of shares each having a

nominal/par value

Ordinary shares: No fixed dividend; dividend is

received from net profits after preference
dividends. Voting rights, but holders receive
proceeds after lenders, creditors and preference
shareholders

Preference shares: Fixed rate of dividend per year.

No voting rights, but holders receive proceeds
before ordinary shareholders

Bonus shares: Transfer of equity from reserves

(e.g. revenue reserves) to share capital,
subsequently followed by share splitting.

Gain/loss)on)PPE = Net$disposal$proceeds NBV

Choice between depreciation methods

Short term effect on profits: Total profits over the

economic life of the asset remains unaffected
regardless of depreciation method
Ordinary revision of UEL: Could reflect an attempt
to adapt to constantly changing economic
conditions, a lack of management skills to
accurately predict the UEL, or an attempt to
temporarily inflate or deflate reported profitability

Share&premium = Issue%price Par$value !"New"shares

Altering share nominal/par value

Splitting: Increase in aggregate number of shares,

each shareholder holds more shares of lower
nominal value (total nominal value remain
unchanged)

Consolidation: Reduction in aggregate number of

shares, each shareholder holds fewer shares of
higher nominal value (total nominal value remain
unchanged)

(10) Preparation of accounting statements

Definition: Purchases of goods or services (e.g.

non-current assets) that are expected to create
benefits for the entity on more than the current
accounting year

(11) Valuation of assets

Valuing non-current assets

Property, plant and equipment (PPE)

Definition: Tangible assets that are held for use in
the production of goods and services and are
expected to be used for more than one
accounting period

Net book value (NBV)/carrying value: Depreciated

cost or fair value

Net realizable value (NRV): Amount obtainable

from the sale of an asset, less cost of
disposal/transaction costs

the

(12) Financing organizations (internal financing)

Sum of the years digits: A charge based on the

expected use of the asset

Disposal: Gives rise to gains or losses

(9) Asset valuation and profit measurement 2

Initial'cost Residual)value
n

Residual)value = Initial'cost!!(1 Depreciation+rate)n

Inventory write down and recurring costs

Inside information:
Information giving the
company a competitive
advantage may be given
away

First in, first out (FIFO): Goods bought or

produced first are sold first

Straight-line method: Even depreciation over UEL

Depreciation+charge =

Failure to recognize inventory write down

For
Forward looking: More
relevant for investment
decisions; better
forecasting techniques
lead to more efficient
business decisions
Inside information: Inside
information about the
future can be better
conveyed

method,

Write down: Net realizable value of inventory is

less than its initial costs (e.g. obsolescence,
seasionality)

Capital expenditure (CAPEX)

Unreliable: Impossible to
verify via audit. Easily
manipulated by managers

Perpetual

Valuation: Lower of carrying amount (FIFO or

AVCO) or recoverable amount (selling price less
transaction costs)

Earnings forecast vs income statement

Against
Subjective

Depreciable*amount = Initial'cost Residual)value

Company reserves

Share capital: Can be issued via rights issue

(issues to existing share holders), public issues
(IPO) or private placings (issues to select
individuals) (undistributable)

Impairment*loss = Recoverable*amount NBV

!
3

Capital reserve: Share premium and revaluation

reserve (undistributable)

Revenue reserve: Retained earnings, may also be

retained for reinvestment (distributable)

Margin of safety: Total undistributable reserves ie.

Share capital and capital reserve

Stake
Priority
Risk

Fully paid shares: Issued shares that have been

paid in full

Called-up share capital: Part of total issue price

that has been called (ie. Payment requested)

Paid-up share capital: Part of total issue price that

has been called and paid

Dividends

Definition: Profits distributed to ordinary and

preference shareholders. Dividends are not tax
deductible; ordinary dividends are declared (by
directors) out of profits after taxation and
preference dividend

Owners
Lowest priority
Higher risk

Cash flow from investing activities: Cash collected

from acquiring or disposing of non-current assets

Cash flow from financing activities: Cash collected

from borrowing or issuing securities and cash
released to pay creditors and owners

External financing is less costly: Interest is tax

deductible whereas dividends are not, lenders
require a lower rate of return as ordinary shares
have a higher risk premium

Operating
Cash from sales
Cash purchases
Cash expenses
Income tax

Internal financing is more flexible: No costs of

issuing debt, managers have greater control over
equity than debt financing, no fixed maturity unlike
external financing

(14) Taxation
Types of taxes

Direct tax: Income tax, corporation tax, capital

gains tax, stamp duty, inheritance tax

Indirect tax: VAT

Taxable'profit = Profit'before'tax'and'dividends
+ Non$tax$deductibles
Tax$deductibles
Non$taxable$income
Capital'allowance

Tax deductible: Interest

on loan is tax-deductible
Higher EPS: Due to
higher gearing ratio

Against
Periodicity: Interest is
paid on a periodic basis

Non-deductible expenses
Depreciation
Provisions
Entertainment
CAPEX
Disposal loss

(15) Cash flow statement

Purpose
How is cash generated and spent?

How has the entity financed its growth?

Gearing

Difference between profit and cash?

Earning quality: Association between profit and

cash flow

Is the entity capable of meeting its short-term

obligations?

Definition: Extent of internal financing of the entity

(through equity) relative to its external financing
(through long-term borrowing)

Loans vs shares

Payout
Legal

Loans
Interest
Obligation

Shares
Dividends
N/A

Classifying activities

Equity statement
Unrealized gains & losses
Revaluation gains

Fairness: Fairness in reporting (no exploitation of

inside information)

Improves quality of financial information: Greater

transparency in corporate affairs

Boosting investor confidence: Sustaining growth,

corporate performance, investors willing to pay a
premium for shares

Board of directors

Planning

Control: Formulating a strategic plan, ensuring the

integrity of financial statements, risk management,
determining directors remuneration

External relations
Roles
Manages board meetings
Provides relevant and reliable information

Chairman
Ensure that the boards procedures are
transparent (to both EDs and NEDs)
Develops and maintains management
controls and risk management
CEO

Liaises with the Chairman

Directors report: Operating and financial review,

share ownership, directors and stake in entity,
changes in the board, dividend recommendation,
AGM, corporate governance
Operating and financial review: Nature of the
business (objectives and strategy), business
performance (returns to shareholders, business
dynamics, investments), resources and risks (risks
and uncertainties, resources on and off the SFP),
financial review (capital structure, cash flows,
current liquidity, going concern)
Auditors report: Basis of preparation of the
financial
statements,
audit
qualifications,
consistency of directors report

Develops and maintains an effective

organizational structure

Provide objective and independent advice

(new insights and enhanced monitoring
action due to detachment from company)
Monitor and control the entitys activity
NED

Participate in the audit, remuneration and

nomination committees
Raise the profile of the company
Appointed by shareholders and EDs, only
paid fair salaries to retain independence

(17) Corporate governance

Separating the roles of Chairman and CEO

Principles of corporate governance

Do not separate
Responsibilities may
become hazy, resulting in
a lack of direction

Disclosure: Disclosing corporate performance

Accountability: Defining directors roles

Cash flow from operating activities: Revenueproducing activities of the entity

Notes to the accounts: Statement of compliance

with IFRS/IAS, statement of measurement bases
and accounting policies, supporting information
for items in SFP and I/S

Supplementary reports

Non-taxable income
Disposal gains
UK dividends

Principle: Must be paid at

maturity
Liquidity: Entity with weak
liquidity may face
difficulty making interest
payment when earnings
are low

Statement of changes in equity: Shows the effect

on capital and reserves of all revenue and
expenses and of share issues and purchases

Income statement
Realized gains & losses

Computation of taxable profit

Income'tax = Corporate(tax(rate!!Taxable'profit

For
No share dilution

Financing
Share issuance
Bond issuance
Cash repayment

IAS1 disclosure requirements (in addition to 3 financial

statements)

(13) Financing organizations (external financing)

Long-term borrowing: Bank loans, bonds, debentures
etc.

Investing
NCA disposal
Interest
received

(16) Corporate financial disclosure and regulation

Not all profits are paid out as dividends as

managers may decide to retain them for future
investment or financing short term working capital

Benefits of good corporate governance

Evaluating external and internal financing

Share capital

Creditors
First priority
Low risk

Chairman and CEO may

have conflicting

Separate
Smoothening the path of
succession, providing a
sense of continuity during
a period of leadership
transition

!
5

personalities/views over
how the company should
be run power struggle

Too much power may be

concentrated in the
hands of a single
individual, may be used
to marginalize the
contributions of others or
exploit resources

Fixed element: Base salary and benefits

Variable component: Short-term and long-term

performance rewards

Directors share options: Giving directors the right,

but not the obligation to buy shares in the
company at an agreed price to be exercised
when market value of share exceeds agreed price

Distributable+profit = Closing(rev. Equity'maintained

EDs vs NEDs
ED
May withhold or fail to
provide important
information
May try to expropriate
company resources

NED
May not have sufficient
knowledge
May not be sufficiently
committed

For
Align directors interests
with shareholders
(incentive to increase
value of company shares)
Golden handcuffs for
talented directors

Act like watchdogs

Audit committee
Roles
Liaison between external and internal
auditors

Recommends the appointment and

removal of external auditors
Reviews and monitors the
independence, objectivity and
effectiveness of the external auditor

External
audit

For
Relevant: Reflect current
market conditions,
providing timely
information about current
value of assets/liabilities

Can only provide

information in the form of
supplementary
information

Current/fair value accounting: Valuing assets at

current market conditions

Internal audit

Directors remuneration

ROCE =

Maintains money
measurement convention
(measures in pounds)
Pointless in maintaining
operating capacity if
demand for goods was
falling

Profit'after'tax
100~
Total&shareholder&equity

EBIT/Operating/profit
100~
Total&assets Current'liabilities

Operating*profit*margin =
Gross%profit%margin =

Operating*profit
100~
Sales&revenue

Gross%profit
100~
Sales&revenue

Change in gross profit margin may be larger than

change in operating profit margin due to a greater
change in other expense relative to COGS

Efficiency/activity ratios: Measures efficiency with

which particular resources are used within the
business
I"turnover"period =

Inventory
365~
COGS

Inventory)turnover =

TR#settlement#period =

More transparent and

comparable values
across time

(19/20) Analysis of accounts

Unreliable: Based on
managerial estimates

Key ratios

Increasing the scope of financial disclosure: More

frequent, detailed and narrative reports

Change in non-current assets

Change in net current assets/working capital

Change in cash balance

Change in debt capacity

Change in operating profit/EBIT

Common size financial statements

Problems of inflation: Equity base erosion is not

recognized, assets (and therefore financial
position) are often understated, gains and losses
from holding monetary items is not recognized

Definition: Figures in the income statement can be

expressed as a percentage of one of the key
figures (e.g. revenue). Can be vertical (across
businesses) or horizontal (across time)

Compound annual growth rate (CAGR): The yearover-year growth rate over a specified period of time

Equity'maintained = 1 + ! !!Opening'equity

TP#settlement#period =

Sales&revenue
~
Trade&receivables

Trade&payables
365~
COGS

Trade&payables&turnover =

Asset%turnover =

COGS
~
Inventory

Trade&receivables
365~
Sales&revenue

Trade&receivables&turnover =
Against
Irrelevant and misleading:
For assets that are held
for a long period of time;
prices can also be
distorted by market
inefficiencies

Inflation accounting
Monitors the effective running of
internal operations and processes

CCA
Relevant but may not be
reliable (especially when
there is no market for the
good)

Value!
1
Value!

Profitability ratios: Provide insights relating to the

degree of success in creating wealth for owners
ROE =

Current cost accounting (Physical capital

maintenance): Maintain the scale of operations by
adjusting items for their specific price changes
using replacement cost

Abandons money
measurement convention
(measures in
pounds/current
purchasing power)

Ensures the effective running of

companys internal controls
Ensures the effective functioning of the
accounting systems

RPI!
!!Value!!!
RPI!!!

CPP
Reliable but may not be
relevant (price index may
not reflect the particular
cost of goods for
individual owners)

!! !!!

Ratio analysis

Value! = %!Replacement*cost + 1 !!Value!!!

Accounting for decision making

Assess the effectiveness of the

companys internal controls

Ensure that the directors report is

consistent with the financial
statements

Directors may restrict

dividend payment so as
to retain profits to fuel
share price growth

Increasing regulatory intervention: Sizeable

business failures, frauds and manipulation of
financial data

Ensure that information required is

disclosed

Movement away from stewardship function to

decision making/predicting: Due to separation of
ownership from control, the increasing role of
capital markets and need to reduce information
asymmetry

Assess the reliability of financial

statements

Current purchasing power accounting (Financial

capital maintenance): Maintain the general
purchasing power of the owners investment by
adjusting accounting figures by a change in
general price index
Value! =

Recent trends

Reviews the efficiency of internal

controls
Audit
committee

Against
Incentive to take
excessive risks (ie.
Having nothing to lose)

(18) Increasing the scope of financial reporting

CAGR =

Approaches to equity maintenance

COGS
~
Trade&payables

Sales&revenue
~
Total&assets Current'liabilities

Sales&revenue/employee =

Sales&revenue
~
Number'of'employees

Operating cash cycle: Time period between paying for

goods and receiving the cash from the sale of those
goods
Operating*
! = Inventory)holding)period
cash%cycle
+ TR#settlement#period
TP#settlement#period#

!
7

Operating*profit*margin!!Asset%turnover%ratio = ROCE

Liquidity ratios: Assessment of liquidity (shortterm ability to generate cash for working capital
needs and immediate debt repayments) and
solvency (long-term ability to generate cash to
satisfy capacity needs, fuel growth and repay
debts)
Current'ratio =
Acid/quick)ratio =

Current'assets
!~2
Current'liabilities

Financial gearing ratios: Relationship between the

contribution to financing the business made by
internal and external sources. Higher gearing ratio
is related to higher risk

Debt!equity'ratio =

Non$current$liabilities
~
Total&equity + NCL
OR
Total&assets Current'liabilities

Interest'cover'ratio =

Low average trade receivable settlement period:

Need to chase credit customers more vigorously
to improve cash flows

High average trade payable settlement period:

Need to delay payments due to liquidity problems

EBIT/Operating/profit
~
Interest'expenses

Quality of financial statements: Ratio results are

dependent on the underlying statements.
Therefore intangible elements, while significant,
may not be reflected in ratios such as ROE, ROCE

Inflation: Reported value of assets and expenses

will be understated while reported profits will be
overstated in periods of inflation

Ordinary(dividends
100~
Profit'after'tax

Dividend'cover =

Profit'after'tax
~
Ordinary(dividends

Basis for comparison: No two businesses are

identical the greater the difference, the greater
the limitations of ratio analysis

Inherent flaws in balance sheet ratios: Ratios

taken from snapshots may not be representative
of the business overall financial position (e.g.
seasonal businesses might experience low activity
which coincides with the end of the financial year).
Additional measurements over the course of the
financial year need to be taken as well

Profit'after'tax
100~
Number'of'ordinary'shares

P/E =

Refer to spreadsheet

Purpose of acquiring other companies: Growth by

acquisition, economies of scale and scope,
eliminate competition, acquire new supply
sources, diversification, overseas expansion

Definition of control: Power to govern financial

and operating policies under agreement, 50% or
more voting rights, power to appoint or remove
the majority of the board of directors

Market'price'per'share
~
EPS

Overtrading: Operating at a level of activity that

cannot be sustained by the amount of finance that has
been committed

Low current ratio: Indicates lack of liquidity

Low average inventory turnover period: Low

inventory levels are maintained due to difficulty
financing them

Revaluation reserve (RR): Revaluation of assets

before including them on the CBS
!! = !"!"#!!"# Value!"#!!"#$"!!"#

Intercompany balances: Payments/trade balances

made to/received from P to S vice versa; creation
of cash-in-transit account cancel trade
balances, excess is termed as cash in transfer

Unrealized profits on intercompany sales: Adjust

profits for sales made to P/S
!"! = Remaining(stock

Mark%up%
100 + Mark%up%

Reduce& Cr !inventory)by)PUP
Reduce! Dr !!"!by!!%!"!!and!!"#!by! 1 !% !"!

Homogenizing accounting policies between P and

S (e.g. S to follows Ps depreciation method):
Find the difference in depreciation expenses
based on 2 depreciation policies adjust to Ps

Consolidated retained earnings: Adjust Ps RE

with change in S RE, Ps share of depreciation
change, RA and PUP

!" = !!! + !!! !"!!% Goodwill Dep!%

(21/22) Accounting for groups of companies

Dividend'per'share
100
Dividend'yield = 1 Dividend'income'tax'rate
~
Market'price'per'share
EPS =

Restricted view of ratios: Ratios only measure

relative performance; it would be useful to
consider absolute profits as well as other
intangible factors

Investment ratios: Assessing the returns and

performance of shares from the perspective of
shareholders
Dividend'payout' =

!"# = 1 !% Share&cap + Premium + 1 !% !"!"#

(1 !%)(!!)

Limitations of ratio analysis

Current'assets Inventory
~1
Current'liabilities

Operating*cash*flows
Cash%ratio =
!~1
Current'liabilities

Consideration = Investment(in(S

Goodwill: Premium, over fair value, paid by the

parent company in recognition of synergies,
technology and innovation
Goodwill = Consideration !% Share&cap + Premium
!% !"!"#$" !%(!!)

Goodwill! NBV = Goodwill Impairment*loss

Non-controlling interests (NCI): Minority of shares

and share of net profits attributable to outsiders

!
9

10

AC100: FINANCE HIGHLIGHTS

(1) Introduction to the financial system

Financial system: Markets, intermediaries, service

firms and other financial institutions that can be
used to implement the financial decisions of
households, businesses and governments through
financial contracting and exchange of assets and
risks
Financial institutions: A firm whose primary
business is to provide financial services and
financial
products
(e.g.
commercial
and
investment banks, insurance companies, pension
and hedge funds)

(2) The financial system

Transfer resource across time and space: Transfer

through time (interest), across geographic regions
(international capital flows) and amongst
industries
Managing risk: Providing ways to manage,
transfer and share risks (e.g. transfer of risk
through securitization and derivatives)
Clearing and settling payments: A platform to
clear and settle payments to facilitate the
exchange of goods, services and assets
Pooling resources and dividing ownership of large
assets: Pooling of funds to undertake large-scale
investments, subdividing shares in large
companies amongst share holders

Interest rate: Promised rate of return for sacrificing

a unit of consumption today. Dependent on
maturity period and default risk higher risk,
higher interest rates. Yield spreads measure the
difference between bond yield and T-bills
Return =

!"# = 1 +

Dealing with incentive problems: Open transfer of

information and corporate governance to counter
asymmetric information and moral hazard

Time preferences: More positive time preferences,

higher returns

Risk: Higher risk, higher returns

!"#! = !"! +

!"!
!"!
+
1+!
1+!

!"!
!"!
+
1+!
1+!

Choose&A&over&B&if&

Where%Annuity'factort =

Money market: Short term, highly liquid debt

instrument mostly issued by governments and
corporations
Capital market: Long term, relatively illiquid debt
instruments (e.g. equities and debt instruments)

!"! =

!
!
+
1+!
1+!

1
1
1
1+!
1+!
!"! = !
1
1
1+!

++

!"!
1+!

+ +

+ +

!"!
1+!
!"!
1+!

> 0 Do

Cash only: Do not account for depreciation

expense, but account for associated tax benefits

Incremental: If a project cannibalizes another

account for the associated decrease; if a sunk
cost has already been incurred do not account for
any decrease; account for opportunity costs

< 0 Don't&

(5) 2007-2008 global financial turmoil

!

= 0 Neutral

Long-term context

Great moderation: Liberalized and globalized

capital flows, financial innovation, lax regulation

Global imbalances: Low savings and interest rates

in the western world, high savings rate in Asia.
Weak USD and trade deficit at the expense of
Chinas surplus

1
1
+
1+!
1+!

++

1
1+!

Consequences

!"!
!"!
+
1 + !""
1 + !""

+ +

!"!
1 + !""

Global credit boom: Increase in household debt,

leverage and liquidity

Yield-searching/risk-taking: Subprime lending,

excessive leverage, securitization and masking of
risk (CDOs and MBS)

Solve&for&IRR

Mis-functioning of the financial system

Contagion: Easy geographical transfer

resources enhance interdependence

Risk: Excessive risk undertaken

Gridlock: Counterparty risk lead to inability to

clear and settle payments

Pooling of resources: Opaque instruments

through securitization and mispriced ABS

Information: Not visible in times of market

uncertainty/lack of trading and pricing activity

Incentive problems: Bailout and risk of moral

hazard vs allow to fail

Do#project#if#! < !""

!

++

=!

!
1+!

1
1

! ! 1+!

Problems with IRR: Does not consider timing of

cash flows, scale and mutually exclusive nature of
projects

Payback period

PV of perpetuity
!"! =

!"!
1+!

+ +

Internal rate of return (IRR)

!!"! = 0 = !"! +

!"!
!"!
+
1+!
1+!

!"!!.!
!"!!.!
<"
Annuity'factor! Annuity'factor!

Discounting cash flows

!"! = !"! +

Cash%flows = (Annual'cash'flows Depreciation)%tax

!!!"#$%"&!!"#$
Annualized*capital*cost =
Annuity'factor

Compounding

!"
1+!

Cash%flow = Revenue Cash%expense Tax!(+Tax$benefits)

Net present value: Contribution of the project to

the value of shareholders wealth

PV of ordinary annuity (GP)

Debt (e.g. fixed-income securities, bonds and
loands obligation for fixed future payment),
equities (e.g. shares, stocks residual claim on an
asset), derivatives (e.g. options, futures values
are derived from other securities)

!"!
!"!
+
1+!
1+!

!
!

Financial market rates

Definition: Risk premium added to the minimum

rate of return used in NPV computation. Risk is
project specific, market and cash flows-relevant

Calculating cash flows

!"

Projects with different lives

(3) The time value of money

Financial markets

!"#! = !"! +

Productivity: Higher productivity of capital goods,

higher returns
Uncertainty: Higher uncertainty, higher returns

1! !! ! ! 1

Decision criteria

!!"! = !"! +

!" =

!
!

Problems with payback period: Ignores cash flows

after payback period, difficult to compare
projects, no objective benchmark

Risk-adjusted discount rate

(4) Capital budgeting

Nominal: Prices and rates expressed in terms of

currency. Real: Prices and rates expressed in
terms of purchasing power (ie. Accounted for
inflation)

!
!

!"#n"macroepriods = 1 +

Exchange rates: Relative price of two currencies

expressed as a domestic currency per unit of
foreign currency

Providing information: Provides price information

to coordinate decentralized decision-making (e.g.
rating agencies)

!"# = !

Determinants of return

!"! 1 + !

1+! !

Compounding frequency, AER, APR

!!
1+!

Discrete(compounding: !" = !" 1 + !

!"!
!"! =
1+!

!!"# !!"#$" + Cash%Dividend

!!"#$"

Real%rate%of%return, ! =

Role of the financial system

Interest in inflationary environment

Definition: The project life resulting in NPV=0 (ie.

The year where positive cash flows first contribute
to 0/positive PV)

of

!
11

12

AC100: MANAGERIAL ACCOUNTING HIGHLIGHTS

(1) Introduction to managerial accounting

Fixed costs: Costs that remain unchanged

regardless of changes in activity levels (e.g. PPE
rent, supervisors salary)

Financial vs managerial accounting

Cost traceability: Direct costs (clearly identified

with a specific cost object), indirect cost (cannot
clearly identified with a particular cost object).
Supervisor salary can be both direct and indirect.
Needed to compute the full cost per unit of output

Cost-volume profit analysis (CVP)

Financial
For decision-making and
stewardship

Managerial
To meet organizational
goals

External users

Internal users

Historical data
Backward-looking

Forecasts
Forward-looking

Regulated and
standardized, subject to
audit

Unregulated and
unstandardized, costbenefit analysis

Financial data based on

accounting systems

Non-financial data based

on production processes

(2) Defining costs and investigating cost behavior

Operating*profit = !" !" !"

Definition: Amount of resources, usually measured

in monetary terms, sacrificed to achieve a
particular objective

Function: Determines price and production levels,

introduction of new production methods,
investment in new projects, make or buy

Cost object: Can be a product, process, activity

anything that requires a separate measurement of
costs

Relevant costs: Costs

that vary with decision

Irrelevant costs: Costs

that do not vary

Future outlay costs:

Resources that will have
to be spent in the future
to achieve an objective,
not recorded until realized

Sunk cost: Costs which

have previously been
incurred

Opportunity costs:
Monetary value of the
next-best alternative
foregone
Other relevant factors
include non-financial
quantitative and
qualitative data

Actual cost: Incurred and

measurable, shown in
balance sheets as assets
or expenses
Future outlay costs:
Costs that do not vary
with the decision

Contribution)margin)ratio =

Variable costs: Costs that change in direct

proportion to changes in output (e.g. wages, costs
of raw inputs)

Full/absorption costing

Contribution)margin
Sales&revenue

Breakeven point (BEP): Level of production where

profit is zero. Used to compare planned activity
level with associate risk. Change 0 to sales target
when computing associated production level
! !"# !"# !"# !" = 0

Operating leverage/gearing: Relative mix of VC

and FC, indicates sensitivity of operating profit to
changes in sales (risk). Higher operating leverage
means greater risk and greater sensitivity of
operating profits in relation to change in sales

Function: Analyzes the impact of scenarios (sales

volume, costs) on operating profit, make decisions
on short-term prices, product mix and resource
allocation

Limitations: Assumes linear cost behavior,

unchanged operating efficiency, one product,
ignores time value of money and stepped FC

Functions: Pricing and output decisions,

exercising control, assessing relative efficiency,
assessing performance

Limitations: Use of past costs restricts

consideration of future costs to outlays, ignores
opportunity costs

Step-down method

Determining the step-down sequence: Allocate

service departments with the highest % of service
provided to other service departments first,
allocate service departments with the highest
costs first, allocate service departments with the
highest cost of services provided to other service
departments first

Total&overheads
Direct'base
Cost%allocation%base

Cost allocation base can be direct labor hours,

machine hours, units of output etc.

Direct labor hours are most commonly used:

Length of time proxy to relative size, overheads
and processes are related to time, practical and
easily measured for each job

Allocating overheads as service renderers

Contribution)margin
Operating*profit

Job$cost = Direct'cost +

Expected(sales(volume BEP
BEP

Operating*leverage =

Full costing systems: Job costing (unique, specific

orders), batch costing (group of similar or identical
units), process costing (large number of similar or
identical units)

Job costing: Normal (budgeted) vs actual

Margin of safety: Extent to which planned

production levels lie above the BEP. Higher
margin of safety indicates less risk
Margin'of'safety =

VC
FC

Direct! prime !costs + Overheads) conversion = Total&product&cost

Contribution)margin
Unit%contribution%margin =
Units&of&output

Cost centres: Product and service

Direct allocation method

(3) Allocating costs I: Principles of cost allocation and

job costing

Contribution margin: Amount that remains after

VC is deducted from sales ie. Total contribution of
revenue towards FC and operating profits
Contribution)margin = !" !"

Costs

Behavior

! ! ! !"# !"

Traceability
Direct
Indirect
Raw inputs
Utilities
Managers pay
Insurance

Cost concepts: Capitalized costs (recognized as

assets on SOFP), expensed costs (recognized on
IS), product costs (total cost of producing goods
e.g. COGS, inventory)

(4) Allocating costs II: Activity-based costing

Actual overhead
absorption rate

Budgeted overhead
absorption rate

!
13

14

Calculates value of workin-progress and finished

products

implement, requires thorough understanding of

business,
management
conservatism
and
principal-agent, not suitable for businesses with
similar products

Estimated the start of the

period
Used in planning and
budgeting

Not available before the

end of the period

3000 + 74000
= 15.524
4960

(5) Allocating costs III: Process costing

Actual costs are irrelevant

Budgeted'overhead'absorption=

Basis for comparison with

actual costs

Process costing

Underallocated or
overallocated indirect
costs due to
over/underestimation of
overheads or cost
allocation base

Value of work-in-progress: Estimate degrees of

completion of individual units in the production
process by equivalent (complete) units

Prime costs and conversion costs: Direct costs

(usually raw materials introduced) and overheads
(treatment of materials to produce)

Budgeted'total'indirect'cost'pool
Budgeted'total'cost'allocation'base

Inventory costing: Weighted average (weighted

average unit costs of beginning inventory and
inventory produced in the period), FIFO (separates
product costs from different periods)

Single-product vs multi-product businesses

E.g.$

Traditional cost allocation allocates overheads to

cost units using one cost driver. Difficult to do in
multi-product businesses, where products may be
highly specialized (ie. less labor hours) and
overcosted

Weighted average method

FIFO method

Unlike the weighted average method, all WIP

(beginning) must be completed first

Traditional vs modern production

Modern productive methods are more capitalintensive and requires increases in overheads. A
globally-competitive market also demands better
cost information for decision making
Under/overcosting: Erroneous pricing decisions
(e.g. undercosting may exaggerate profits, high
prices may reduce earnings as market share is
lost). Undercosting of one product means
overcosting of another suboptimal product mix

Activity-based costing (ABC)

Traditional costing
Views overheads as
rendering a service to
cost units

ABC
Views overheads as being
caused by activities and
associated cost units

Overheads are
apportioned to product
cost centres, usually by
direct labor hour

Divided into different cost

pools one for each
cost-driving activity.
Charged to outputs via
activity cost driver

Indirect cost allocation

bases may or may not be
cost drivers
Indirect allocation bases
are usually financial
variables
Risk over and
undercosting

Activity'cost'driver'rate=

Total&costs&in&activity&cost&pool
Number'of'times'activity'occurs

!"#!"# = !"#!"#$" + Production Transferred)out

Indirect cost allocation

base are likely to be cost
drivers
Indirect allocation bases
are non-financial
variables
More accurate costing

Functions: Pricing (more accurate insight into cost

structures of various products lead to accurate
pricing), product-mix decisions (costs absorbed
by complex products are better reflected), cost
reduction and process improvement

!"#!"#$" + !"#!"#
WAVG%unit%materials%cost =
Equivalent+units+of+material

FIFO$unit$materials$cost =

E.g.$

Limitations: Assumes linear cost behavior, single

cost driver, and separable costs. Costly to

!"#!"#
Equivalent+units+of+material

74000
= 15.226
4860

!
15

16

FIFO transferred-in costs

Weighted average transferred-in costs

Always treat all transferred-in costs as complete

Inputs are measured at

their acquired prices,
reflecting production
realities such as stepwise processes, quality
changes and time

Always treat all transferred-in costs as complete

Managers apparent
performance is not
influenced by conditions
in the preceding period
provides a more reliable
basis for decision making

Fluctuating cost
differences across
multiple purchase periods
will lead to varying cost
differences between time
periods however,
identical results can be
obtained under both FIFO
and WAVG when no
ending stock remains
Strictly for one-way
production processes

income generated from

sales of each unit

Unlikely to be affected by choice: If the level of FC

stays roughly constant and closing inventories do
not vary greatly from year to year, reported profit
will be similar regardless of costing method

Implications for income statement

Refer to spreadsheet
Standard'unit'cost'(full) = !" +

!"#!"# = !"#!"#$" + Production Completed

While contractual agreements may fix prices,

conversion and variable costs will always be
subject to change. Final costs are unlikely to
remain constant in two time periods

Process costing
Job/batch costing
Same basic purpose: To assign material, labor and
material costs to products so as to compute unit cost

!"#!"# = !"#!"#$" + Production Completed

Same basic cost accounts: Utilizes manufacturing

overheads, raw materials, WIP, completed goods
Same flow of costs
Units: Single, identical
products produced either
on a continuous basis or
for long periods of time

WAVG%unit%transferred%in%cost =

E.g.$

!!"#! + !!"#!
!!"! + !!"!

6000 + 45000
=3
2000 + 15000

FIFO$unit$transferred$in$cost =

E.g.$

Advantages of FIFO

Cost accumulation: By
processing department
the department
production report shows
accumulation and
disposition of costs by a
department

!!"#!
!!"!

45000
=3
15000

Unit cost: Computed by

department on the
department production
report

Undesirable stock
building
Failure to meet delivery
schedules

Revise incentives and

managers performance
evaluation

Delayed maintenance
Redesign operating
systems: Just-in-time
management (not holding
on to excess inventory;
supplies are delivered for
production at the latest
possible time)

Cost accumulation: By
individual job the job
cost sheet shows the
accumulation of costs by
a job
Unit cost: Computed by
job on the job cost sheet

Counter
Change internal
accounting systems:
Materials requirement
planning (using predicted
sales demand to plan
production levels, and
only the optimal quantity
of input is obtained to
achieve that)

Production-volume variance (PVV)

!"" = (!"#!"#$%& !"#!"#$%&%# )

Fixed&manufacturing&cost
Budgeted'production'

Favorable)for)(+),"unfavorable"for"(!)

(6) Income reported under variable (marginal) costing

and full (absorption) costing

PVV arises due to actual level of production

deviating from budgeted level of production

Variable costing
Fixed manufacturing
costs are excluded from
inventoriable costs and
charged to P&L as period
costs

Full costing
All variable and fixed
manufacturing costs are
included as inventoriable
costs

PVV indicates whether actual production is above

or below the predicted volume budgeted volume
> actual volume (Insufficient unit fixed cost
absorbed), budgeted volume < actual volume (too
much unit fixed cost absorbed)

Both FC and VC included

in product costs and
treated as expenses
when product is sold

(7) Planning and budgeting

Only variable product

costs are considered, FC
is treated as an expense
when incurred

Disadvantages of FIFO

Units: Many unique jobs

worked on during each
period, with each job
having different
production requirements

Undesirable effects of
absorption costing
Operational inefficiencies:
Increase short-term
operational profit by
eroding FC through
increased number of units
produced

!"!"#$%"&'$()#*
Budgeted'production

Definition: The quantitative expression of a

proposed plan of action by management for a
specific time period an aid to coordinate the

Complete measure of

!
17

18

implementation of that plan contains both

financial and non-financial data

Function: Strategic planning, performance and

measurement, communication and coordination,
employee motivation

Benefits
Promote forward thinking
and identification of
short-term problems
Motivate managers to
perform
Provides a basis for a
system of control
Coordinate various
sections of a business
Establishes a system of
authorization

Limitations
Principal-agent problem
and conflicting objectives
Concentrates power to
senior management
Demotivate (e.g.
unrealistic goals)
Myopia: Matching budget
to match only current
conditions cannot deal
with fast-changing
environment
Narrow: Focus only on
short-term financial
targets, non-measurable
activities get overlooked

(expected revenues and expenses to aid

operating decisions) and financial budgets (to aid
investment and financing decisions)

Compiled based on analysis of past performance,

economic forecasts and organizational strategy

Budget can be reviewed and coordinated topdown or bottom-up

Should be quantified, functionally and temporally

integrated, period-content-process formalized

However conflicts exist between tightness of

integration, frequency and detail of updates, topdown vs bottom-up approach etc.

Assumes independence
amongst operating
entities
Stifles creativity and
innovation

Plan: Establish objectives, undertake a position

analysis, identify and assess strategic options,
select strategy and formulate long-term plans
Control: Perform and collect information on actual
performance, respond to variances and exercise
control, revise plans and budgets if necessary

Types of budgets

Periodic: Traditional budget set within a budget

period of one year

Continual: Modern budget set on a rolling basis

always available for a specified future period

More forward-looking

Integrating budget with organization strategy, shift

from cost reduction to value creation

Definition: Consolidation of the organizations

financial information into budgeted financial
statements. It contains operating budgets

Hopwoods uncertainty matrix the impact of

uncertainty on objectives and outcomes
Uncertain objectives
Low
High
Computation
Bargaining
Answers
Ammunition

Uncertain
outcomes

Increased awareness to non-financial measures

Greater cooperation between operating entities,
building on trust and communication

High

(8) Budgeting and wider organizational processes

Precise forecast
possible in
addition to data
collection

Data collection
and modeling
influenced by
political
interests

Learning
Scenarios

Rationalization
Inspiration

Optimum
outcome can be
checked
against various
scenarios

Accounting is
uncoupled from
task
performance

Problems in budgeting

Conflicting objectives: Motivating budget (realistic

yet stimulating) vs planning budget (most likely
outcomes), central coordination vs local autonomy

Pressure device: Budgets act as pressure

devices which exerts a negative effect on people,
generating forces that decrease long-run
efficiency

Reaction to budgets: Personal success if met,

personal failure and embarrassment if not met.
Overall decrease in human efficiency

Antagonistic groups: Workers suspicious of

management (e.g. management view workers as
inherently lazy), middle management demotivated
as they try to shirk responsibility, supervisors
become defensive

Accounting cannot be
organizational context

isolated

from

Simple high-low dichotomy, but does not consider

medium
situations,
internal
organizational
processes and interactions with external parties

(9/10) Variance analysis

How budgets are shaped: Social relations (junior

vs senior budget holders), degree of participation
(involvement in compiling budget) motivation
(involvement of members in decision making) and
uncertainty (market and economic uncertainty)

Flexible budget: Expected amounts for a range of

output levels represented as the budget function
(ie. a line)
Flex%budget%variance = Actual'amount Flex%amount
Unit!!!"#$%& !!"#$%& Unit!!!"# !!"#$%&
Price&variance + Efficiency(variance

Favorable)for)(+),)unfavorable)for)(!),!vice%versa%for%costs
Flex%amount = Actual'units

Static&amount
Static&units&sold

E.g$Flex$budget$revenue = Actual'units
E.g.$Flex$budget$VC = Actual'units

Static&revenue
Static&units&sold

Static&VC
Static&units&sold

Sales!volume'variance = Flexible'amount Static&amount

Budgeting for control

Standards: Predetermined quantity and price of

inputs used in manufacturing or providing a good
or service. It is used a benchmark for measuring
performance against actual results

Management by exception: Managerial practice of

not concentrating on areas that are operating as
expected and focusing on those that are not

Feedback control: Constantly comparing actual

performance in with budget and taking action on
deviations as soon as they are observed

Argyris: The impact of budgets on people

Master budget

The budget is a reflection of the underlying

political structure of the organization, as well as
economic constraints and opportunities and the
technical procedures out of which it arose

Low

Budgeting and control process

Emerging practices

Imperfect information
Time-consuming

Hopwood: Organizational and behavioral aspects of

budgeting and control

Static and flexible budgets

Static budget: Expected amounts for a single level

of planned output represented as a point on the
budget axes (ie. a point)

Static&budget&variance = Actual'amount Static&amount

its

Favorable)for)(+),)unfavorable)for)(!),!vice%versa%for%costs

Static budget variance

Does not differentiate
between variances
caused by change in
price/cost or change in
output

Flexible budget variance

Adjusts budgeted
standards for actual
output distinguishes
between variances
caused by changes in
price/cost and those

!
19

20

caused by output

Direct labor variances

Variable overhead variances

Fixed overhead variances

Fixed&overhead&spending&variance = !"!"#$%& !"!"#

Levels of variance analysis

Efficiency variance for fixed overheads do not

exist FC cannot be used more or less efficiently

In this case, flexible budget variance = fixed

overhead spending variance

Production-volume variances (PVV)

!"" = (!"#!"#$%& !"#!"#$%&%# )

Fixed&manufacturing&cost
Budgeted'production'

Sales and revenue variances

Sales!volume'variance = Flexible'amount Static&amount

Explaining unfavorable variances

Level 3 price and efficiency variances are

concerned with the actual and budgeted prices
and quantities of inputs used
Price&variance = (Unit!!!"#$%& Unit!!!"# )!!"#$%&
Favorable)for)(!),#unfavorable#for#(+)
Efficiency(variance = (!!"#$%& !!"#$ )Unit!!!"#

Variance
Sales
volume

Explanation
Poor performance by sales staff
Deterioration in market conditions
Lack of goods to sell

Sales
price

Poor performance by sales staff

Deterioration in market conditions

Direct
materials

Poor performance by production staff

resulting in high levels of wastage
Substandard materials leading to high
levels of wastage
Faulty machinery wastes materials
Possible collusion with supplier?

Direct
materials
price

Poor
performance
by
purchasing
department staff
Use of higher quality (more expensive)
materials
Change in market conditions

Labor
efficiency

Poor supervision
Low-skilled labor
Substandard materials leading to wasted
materials and labor time
Machine errors
Dislocation of materials supply

Labor rate

Poor performance by HR
Use of high-quality labor
Change in labor market conditions
New technology and learning (affects
efficiency)
Nature of the job and talent retention

Fixed
overheads

Poor supervision of overheads

General increases in costs of overheads
not reflected in budget

Favorable)for)(!),#unfavorable#for#(+)
Direct materials variances
Efficiency(variance = (!!"#$%& !!"#$ )Unit!!!"#
!!"#$%& ! Actual'qty!of#overhead#allocation#base#for#actual#output
!!"#$ Std$qty$of$overhead$allocation$base$for$actual$output

Unit!!!"# Std$overhead$absorption$rate
Total&std&variable&overheads
=
Std$qty$of$overhead$allocation$base$for$std$output

OR#Flexible#budget#variance = 24,000 120

1302.550
130

Spending(variance = (Unit!!!"#$%& Unit!!!"# )!!"#$%&

Management uses of variances

!
21

22

Function: To evaluate performance by first

identifying the causes of a variance. Due to
tradeoffs that exist between variances, possible
interdependencies need to be considered.
Managers should not interpret variances in
isolation

Problems of standards
Time: Standards quickly
become outdated
Exogenous factors:
Factors beyond the
managers control may
affect a variance
Definition: Difficult to
distinguish areas of
managerial responsibility
Incentives: No incentive
to achieve beyond the
standard. Warped
incentives may be
created

Improvements
Time: Short and timely
variance reports so that
prompt action can be
taken
Demarcation: Clearly
defining areas of
managerial responsibility
to better ascribe
accountability

Profit-conscious style: Flexible use of budget

information, possibly with other data, to improve
the long-term effectiveness of each subordinate

Non-accounting style: Budget information plays

no significant role in evaluating subordinate
performance

(11) Performance
organizations

Systems: Establish data

collection, analysis and
reporting routines

Significantly adverse variances: Should be

investigated, as their continuation could be
extremely costly usually significant is defined as
deviating 5% from the budgeted figure
Significantly favorable variances: Could mean that
targets in budget are set unrealistically low
should be relooked to determine long-term
competitiveness
Insignificant variances: Should still be kept under
review, as the cumulative sum of variances over
any period can still be substantial should the
variances be caused by systemic factors (ideally,
the cumulative sum should be zero, with small
adverse variances being nullified by small positive
ones)

Problems with accounting measures of performance

Lacking: Not all relevant dimensions of managerial

performance are included, as no comprehensive
standards and measures have been developed
Approximation: Organizations economic cost
function
cannot
be
precisely
measured.
Accounting information only serves as a proxy

Transfer pricing
Management motivation:
Greater influence over
divisional decisions mean
greater commitment

Budget-constrained style: Rigid focus on

subordinates ability to meet the budget other
factors not given serious consideration

Targets: Challenging, yet

achievable to motivate
and create a sense of
ownership

Unreasonable to expect budget targets to be met

precisely every month investigating a particular
variance should be evaluated via CBA

successors

Management styles

measurement

in

Compare contribution margin however profit

measures ignore differences in the size of
investments made across divisions

Return on investment (ROI): Allows for investmentfactored comparison across divisions

ROI =

decentralized

Centralized: Authority to make

restricted to senior management

decisions

is

Local managers have

specialized knowledge

Risk avoidance:
Managers may decide
against undertaking risky,
large-scale (profitable)
projects for fear of losing
their jobs

Exploiting market
information: Local
managers are better able
to obtain and utilize onthe-ground intelligence
Strategic role for top
managers: Freeing top
management up from
day-to-day operations
Management
development: Develop
specialist skills, identify

Net$operating$profit
Total& operating assets%(OR%Investment)

Approaches:
Market-based,
negotiated-transfer prices

Objectives: Align managers activities with overall

organizational strategy and objectives. Allocate
divisional recourses, minimize taxes, maintain
divisional independence (divisional autonomy and
managerial
motivation),
assess
divisional
performance, optimize business profits

Potential conflict: Managers might strive to

maximize the divisions benefit at the expense of
the organization. Setting transfer prices that will
maximize business profits may require centrally
imposed prices, which compromise divisional
independence. Transfer price creates revenues for
the selling subunit and costs for the buying
subunit operating profit for both subunits are
affected. Overall business profits, however, should
not affected

Residual income (RI): Relates the measure of

divisional income to a pre-defined minimum
acceptable level of income, focusing managers
efforts to maximize this difference (aka residual)

Behavioral effects of ROI

Measure is enhanced
when investment is low
Short-term perspective:
Sacrifice long-term
investments for current
ones

Divisional interests should be aligned with

organizational goals. Similarly, organizations need
to develop a unique set of performance measures
to match their specific situations
Disadvantages to
decentralization
Top-down, authoritarian
management

Definition: A subunit charges another subunit

within the organization for providing a good or
service

RI = Income Required(rate(of(return(!Investment

Decentralized: Decision-making responsibilities

are delegated to lower level managers
(responsibility centres: including cost, revenue,
profit and investment centres)

Advantages to
decentralization
Timely decisions can be
made: Divisional
managers can implement
changes without first
seeking permission from
top management

Divisional performance measurement

Organizational structure

Investigating variances

Process vs outcome: Accounting data represents

outcomes, whereas managerial activity is
concerned with the processes giving rise to these
outcomes

Distorted incentives:
Managers may take
measures to increase
divisional ROI in the short
run but harm the
company in the long run

Goal conflicts between

divisions: E.g. conflicts in
client interest?

Behavioral effects of RI
Measure is enhanced
when cost of capital is
low or if revenues have
increased
Short-term perspective:
Sacrifice long-term
investments for current
ones
Normalize incentives:
Remove managers
incentives to increase
leverage through
excessive debt financing

Divisions that have

above-average ROI may
reject investments whose
ROI is good, but
comparatively low

(12) Innovations in performance measurement

Limitations of financial accounting based performance
measures

Lack of timeliness

Backward (lagging) orientation

Failure to incorporate non-financial (leading)

items that drive performance

Risk experiencing negative long-term effects due

to short-termism (e.g. under-investment, gaming
with accruals)

Innovations in performance measurement

The information age and decentralization of

organizations have shifted the focus of
performance measurement from monitoring and
control (financial-focused) to business support
(financial, strategic and operation-focused)

Comparing performance

Managerial perks: Abuse

of organization funds ad
monies for self-benefit
Costly to decentralize:
Overlapping of similar
roles in other divisions
may be duplicative

cost-based,

Other divisions within the business: Different

divisions different industries and risks different
expectations and returns. Not useful

Non-financial measures present a broader set of

information a more complete picture in uncertain
market environments

Past performance: Adjustments need to be made

to account for differing economic environments

Similar businesses in the industry

Traditional financially-focused systems are used

to improve economic value measures and
complete non-financial measures (e.g. R&D, staff
training and morale, product quality, market share,
environmental and social concerns)

Budgeted performance

!
23

24

Shareholder approach (e.g. EVA): Construction of

economic value measures based on cost of
capital to show how the organization is adding
value to shareholders

Implementation forces
strategic clarity

Not linking measures to

strategy

Focus on value drivers

Too many measures

create confusion

Integrated performance management (e.g. BSC):

Incorporates financial and non-financial measures
to assess overall performance

Alignment between
operating units

Not validating the

causality of links

Thought processes
Shareholder value-based performance measurement

Definition: Measuring and rewarding activities that

create value and enhance shareholders wealth.
Profit measured thus needs to reflect cost of
capital employed to generate it

Creating shareholder value: Set objectives that

recognize the supremacy of shareholders, select a
measure of shareholder return, generate
shareholder
returns
through
focused
management, measure returns to see if objectives
are met

Not setting the right

performance target
Unbalanced: Different
value drivers are
weighted differently
Lack of timeliness

(13) Management
change

accounting

and

organizational

Strategic management accounting

!"# = Net$profit !"##!!Capital'employed

Linear value metrics framework: Value drivers,

financial indicators, intrinsic value, market value

Management accounting research and practice

has become more outward-looking, long-term
oriented and integrated with non-financial aspects

Benefits
Familiar accounting
numbers

Limitations
Complex accounting
adjustments

Providing information that will support the

strategic plans and decision made within a
business

Consideration of
intangibles

Short-term

More forward-looking: Greater consideration given

to understanding the operating environment,
performance of competitors as well as customer
profitability

Develop and implement methods: Transform cost

determination and control techniques to boost
operating efficiency

Monitor inter-business strategies and bring them

to a successful conclusion: Greater emphasis on
long-term planning issues and performance
measures so as to meet business objectives

Current techniques: ABC, ABM, competitor

analysis, customer profitability analysis, trend
analysis, target costing, value chain analysis

Challenges: Difficult implementation with low

uptake rate and little success

Looking ahead: Inclusion of additional dimensions

such as economy, institutions and society while
being mindful of the complexities of real
organizations

Purely financial
Focus on cost of capital

Integrated measurement: Balanced scorecard

Definition: A management and measurement

system that translates the aims and objectives of
a business into a series of key performance
measures and targets. It enables organizations to
clarify their vision and strategy and translate them
into action

Integrates financial and non-financial measures:

Retains measures of financial performance but
supplements them with measures on the drivers
of future financial performance (i.e. financial,
internal processes, customer, learning and
growth)

Cause-and-effect relationships: Learning and

growth (e.g. investing in staff development)
improves internal business processes (e.g.
improved after-sales services), which boosts
customer satisfaction and by extension finances
(e.g. increase in sales and profits)

Benefits: Behavioral tool

Limitations: Paralysis
without analysis

!
25