Professional Documents
Culture Documents
Functions of accounting
Communicate
For
Uniform framework:
Enhanced comparability,
easier flow of capital
Relevance vs reliability
is
outdated,
Against
Inhibit change: Lack of
freedom to experiment
and innovate stifles the
development of new and
better procedures
Consensus-seeking:
Standards may be
influenced more by the
need to achieve
consensus than technical
considerations
Internal control
Accounting framework
Accounting conventions
Liabilities
Equity
!
1
Performance measure:
Better measure for
evaluating future
performance
period,
realization,
Revenue
Inventory
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
the
Initial'cost Residual)value
n
Inside information:
Information giving the
company a competitive
advantage may be given
away
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,
Unreliable: Impossible to
verify via audit. Easily
manipulated by managers
Perpetual
Company reserves
!
3
Stake
Priority
Risk
Dividends
Owners
Lowest priority
Higher risk
Operating
Cash from sales
Cash purchases
Cash expenses
Income tax
(14) Taxation
Types of taxes
Taxable'profit = Profit'before'tax'and'dividends
+ Non$tax$deductibles
Tax$deductibles
Non$taxable$income
Capital'allowance
Against
Periodicity: Interest is
paid on a periodic basis
Non-deductible expenses
Depreciation
Provisions
Entertainment
CAPEX
Disposal loss
Gearing
Loans vs shares
Payout
Legal
Loans
Interest
Obligation
Shares
Dividends
N/A
Classifying activities
Equity statement
Unrealized gains & losses
Revaluation gains
Board of directors
Planning
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
Do not separate
Responsibilities may
become hazy, resulting in
a lack of direction
Supplementary reports
Non-taxable income
Disposal gains
UK dividends
Income statement
Realized gains & losses
Income'tax = Corporate(tax(rate!!Taxable'profit
For
No share dilution
Financing
Share issuance
Bond issuance
Cash repayment
Investing
NCA disposal
Interest
received
Share capital
Creditors
First priority
Low risk
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
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
Audit committee
Roles
Liaison between external and internal
auditors
External
audit
For
Relevant: Reflect current
market conditions,
providing timely
information about current
value of assets/liabilities
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
Inventory
365~
COGS
Inventory)turnover =
TR#settlement#period =
Unreliable: Based on
managerial estimates
Key ratios
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!
Abandons money
measurement convention
(measures in
pounds/current
purchasing power)
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
Recent trends
Against
Incentive to take
excessive risks (ie.
Having nothing to lose)
CAGR =
COGS
~
Trade&payables
Sales&revenue
~
Total&assets Current'liabilities
Sales&revenue/employee =
Sales&revenue
~
Number'of'employees
!
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
Debt!equity'ratio =
Non$current$liabilities
~
Total&equity + NCL
OR
Total&assets Current'liabilities
Interest'cover'ratio =
EBIT/Operating/profit
~
Interest'expenses
Ordinary(dividends
100~
Profit'after'tax
Dividend'cover =
Profit'after'tax
~
Ordinary(dividends
Profit'after'tax
100~
Number'of'ordinary'shares
P/E =
Refer to spreadsheet
Market'price'per'share
~
EPS
Mark%up%
100 + Mark%up%
Reduce& Cr !inventory)by)PUP
Reduce! Dr !!"!by!!%!"!!and!!"#!by! 1 !% !"!
Dividend'per'share
100
Dividend'yield = 1 Dividend'income'tax'rate
~
Market'price'per'share
EPS =
Current'assets Inventory
~1
Current'liabilities
Operating*cash*flows
Cash%ratio =
!~1
Current'liabilities
Consideration = Investment(in(S
!
9
10
!"# = 1 +
!"#! = !"! +
!"!
!"!
+
1+!
1+!
!"!
!"!
+
1+!
1+!
Choose&A&over&B&if&
Where%Annuity'factort =
!"! =
!
!
+
1+!
1+!
1
1
1
1+!
1+!
!"! = !
1
1
1+!
++
!"!
1+!
+ +
+ +
!"!
1+!
!"!
1+!
> 0 Do
< 0 Don't&
= 0 Neutral
Long-term context
1
1
+
1+!
1+!
++
1
1+!
Consequences
!"!
!"!
+
1 + !""
1 + !""
+ +
!"!
1 + !""
Solve&for&IRR
++
=!
!
1+!
1
1
! ! 1+!
Payback period
PV of perpetuity
!"! =
!"!
1+!
+ +
!"!
!"!
+
1+!
1+!
!"!!.!
!"!!.!
<"
Annuity'factor! Annuity'factor!
!!!"#$%"&!!"#$
Annualized*capital*cost =
Annuity'factor
Compounding
!"
1+!
!"!
!"!
+
1+!
1+!
!
!
!"
Financial markets
!"#! = !"! +
1! !! ! ! 1
Decision criteria
!!"! = !"! +
!" =
!
!
!
!
!"#n"macroepriods = 1 +
!"# = !
Determinants of return
!"! 1 + !
1+! !
!!
1+!
!"!
!"! =
1+!
Real%rate%of%return, ! =
of
!
11
12
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
Opportunity costs:
Monetary value of the
next-best alternative
foregone
Other relevant factors
include non-financial
quantitative and
qualitative data
Contribution)margin)ratio =
Full/absorption costing
Contribution)margin
Sales&revenue
Step-down method
Total&overheads
Direct'base
Cost%allocation%base
Contribution)margin
Operating*profit
Job$cost = Direct'cost +
Expected(sales(volume BEP
BEP
Operating*leverage =
VC
FC
Contribution)margin
Unit%contribution%margin =
Units&of&output
Costs
Behavior
! ! ! !"# !"
Traceability
Direct
Indirect
Raw inputs
Utilities
Managers pay
Insurance
Budgeted overhead
absorption rate
!
13
14
3000 + 74000
= 15.524
4960
Budgeted'overhead'absorption=
Process costing
Underallocated or
overallocated indirect
costs due to
over/underestimation of
overheads or cost
allocation base
Budgeted'total'indirect'cost'pool
Budgeted'total'cost'allocation'base
E.g.$
FIFO method
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
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
Activity'cost'driver'rate=
Total&costs&in&activity&cost&pool
Number'of'times'activity'occurs
!"#!"#$" + !"#!"#
WAVG%unit%materials%cost =
Equivalent+units+of+material
FIFO$unit$materials$cost =
E.g.$
!"#!"#
Equivalent+units+of+material
74000
= 15.226
4860
!
15
16
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
Refer to spreadsheet
Standard'unit'cost'(full) = !" +
Process costing
Job/batch costing
Same basic purpose: To assign material, labor and
material costs to products so as to compute unit cost
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
Undesirable stock
building
Failure to meet delivery
schedules
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)
Fixed&manufacturing&cost
Budgeted'production'
Favorable)for)(+),"unfavorable"for"(!)
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
Disadvantages of FIFO
Undesirable effects of
absorption costing
Operational inefficiencies:
Increase short-term
operational profit by
eroding FC through
increased number of units
produced
!"!"#$%"&'$()#*
Budgeted'production
Complete measure of
!
17
18
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
Assumes independence
amongst operating
entities
Stifles creativity and
innovation
Types of budgets
More forward-looking
Uncertain
outcomes
High
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
Accounting cannot be
organizational context
isolated
from
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
Master budget
Low
Emerging practices
Imperfect information
Time-consuming
its
Favorable)for)(+),)unfavorable)for)(!),!vice%versa%for%costs
!
19
20
caused by output
Fixed&manufacturing&cost
Budgeted'production'
Variance
Sales
volume
Explanation
Poor performance by sales staff
Deterioration in market conditions
Lack of goods to sell
Sales
price
Direct
materials
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
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$output
1302.550
130
!
21
22
Problems of standards
Time: Standards quickly
become outdated
Exogenous factors:
Factors beyond the
managers control may
affect a variance
Definition: Difficult to
distinguish areas of
managerial responsibility
Incentives: No incentive
to achieve beyond the
standard. Warped
incentives may be
created
Improvements
Time: Short and timely
variance reports so that
prompt action can be
taken
Demarcation: Clearly
defining areas of
managerial responsibility
to better ascribe
accountability
(11) Performance
organizations
Transfer pricing
Management motivation:
Greater influence over
divisional decisions mean
greater commitment
successors
Management styles
measurement
in
decentralized
decisions
is
Risk avoidance:
Managers may decide
against undertaking risky,
large-scale (profitable)
projects for fear of losing
their jobs
Exploiting market
information: Local
managers are better able
to obtain and utilize onthe-ground intelligence
Strategic role for top
managers: Freeing top
management up from
day-to-day operations
Management
development: Develop
specialist skills, identify
Net$operating$profit
Total& operating assets%(OR%Investment)
Approaches:
Market-based,
negotiated-transfer prices
RI = Income Required(rate(of(return(!Investment
Advantages to
decentralization
Timely decisions can be
made: Divisional
managers can implement
changes without first
seeking permission from
top management
Organizational structure
Investigating variances
Distorted incentives:
Managers may take
measures to increase
divisional ROI in the short
run but harm the
company in the long run
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
Lack of timeliness
Comparing performance
cost-based,
Budgeted performance
!
23
24
Implementation forces
strategic clarity
Alignment between
operating units
Thought processes
Shareholder value-based performance measurement
(13) Management
change
accounting
and
organizational
Benefits
Familiar accounting
numbers
Limitations
Complex accounting
adjustments
Consideration of
intangibles
Short-term
Purely financial
Focus on cost of capital
Limitations: Paralysis
without analysis
!
25