Financial Accounting                       Page 1
DefinitionAccounting is the process of•identifying,•measuring•and communicating•financial information about an entity•to p...
The Accounting EquationAssets minus Liabilities equals EquityA       -        L         =      EAssets equals Liabilities ...
Power of Accounting“Accounting provides a very selective but powerfulrepresentation of the corporate identity..” “The deta...
Creative Accounting?“Things may exist independently of our accounts, but theyhave no human existence until they become acc...
You will discoverThat accounting is subjective, partial and potentiallymisleadingAccountants use language / numbers in a h...
And there’s more….The tribe of accountants takes many forms and liveswithin all organisationsNo such thing as a correct ‘c...
Roles of AccountingImprove problem solving / decision makingManage risksTrust, AssuranceEducational - learn about organisa...
Roles of AccountantsAssisting the internal management of organisationsComplying with external financial reporting, control...
Financial Accounting   Accounting conceptsProfit and Cash distinction    Financial statements  Organisational impact      ...
Hierarchy of Accounting Qualities                           Decision Makers and their characteristics                     ...
Transactions  Buy materials on credit  from suppliers                     Sell goods or services on                     cr...
When is profit reported?When goods or services are soldNOTwhen cash is paid or received                                  P...
Example: Antiques dealerBuy 10 chairs for cash Rs 200 eachSell 6 chairs on credit Rs 300 each   Profit 6 x 100 each = Rs.6...
Profit, not cashMatching Concept – match revenues received withthe costs incurred to generate them Goods received but not ...
Profit, not cash contdCustomers pay in advance for services extendingbeyond the accounting period      Company agrees with...
Change over a periodstart   Assets - Liabilities = EquityDuring the period             Profit/loss end    Assets - Liabili...
Contents of annual report Financial highlights                     Company overview Chairman’s statement               Chi...
The main financial statementsBalance                       Balance                           BalanceSheet 1               ...
Balance sheet horizontal• Fixed assets     • Liabilities• Current assets   • Shareholders’ funds                          ...
Balance sheet verticalFixed assetsCurrent assetsLessCurrent liabilitiesLess long term liabilitiesEqualsShareholders’ funds...
Profit and loss accountRevenue (sales)Less Expenses (costs)Equals Profit                             Page 22
Cash flow statement      Operating cash flows              plus       Investing cash flows             plus      Financing...
Creative accounting         What do we want to create?  More profit?       Less profit?    More assets?          Fewer ass...
Creative Accounting PracticesIncome smoothing – move profit from one year toanotherChanging accounting policies, particula...
Off-balance sheet financing , e.g leasing, Saleand buyback, special purpose vehicles Recognising profits that aren’t reall...
Corporate crime / fraudDirectors are responsible for preventing crime andfraud They are required to have a system of inter...
Corporate crime/ fraud contd. Creating fictitious contracts        Fictitious Assets, inaccurate valuationsOmitting Liabil...
Analysis and Interpretation ofFinancial Statements                       Page 29
First Steps BC                (before calculation)•   Why are you analysing accounts?•   Who are you interpreting for?•   ...
Always bear in mind• Preparers of accounts know how people will interpret  their accounts• Be cynical – assume the account...
However….• Accounts are main source of systematically produced  regulated information• Good as it gets• Usually reliable –...
Analyse Accounts to determine  Is the company:•Growing?                •Profitable?•Managing its assets effectively?•Suffi...
Financial ratios• Quick and simple check on financial health• Small number of ratios gives a picture of the  business. Eas...
Key areas for analysis•   Profitability•   Liquidity•   Asset management•   Debt management (financial structure)•   Marke...
Success in making profitReturn on capital employedprofit          sales          Profit_____      x _______        = _____...
Managing liquidity•   Can we pay the bills as they fall due?•   Can we pay the wages of employees?•   Buy stock (inventory...
Asset management•   Use fixed assets to earn sales revenue•   Manage working capital•   stocks (inventory)•   debtors (acc...
Financial structure• Is it a good idea to borrow?• Creates greater risk - interest payments and  capital repayments• Benef...
Advantages of ratios•   Comparisons are relative to other figures•   Compare businesses of different size•   Gives picture...
Reasons for using ratios•   Gives summary statistics•   Helps identify industry benchmarks•   Input to formal decision mod...
Applications of analysis• Predictions of corporate earnings• Construct projected financial statements• Predict corporate f...
Problems with ratio analysis• No agreement on definitions or specific set of  ratios• Accounting estimation• Data not avai...
Limitations of ratio analysis• Diverts attention from the underlying information• May not give sufficient attention to the...
Creative accountingCould involve:• Inflating reported profits and EPS• Accounting for losses via balance sheet reserves  a...
Survival Tips for Accounting Jungle• Read the accounts backwards• Read the accounting policies and compare• Screen account...
Return on Capital Employed      Profit before interest and taxation x 100      Shareholders’ funds plus long term debt• Of...
Return on Capital EmployedTop line questions• What increases/ decreases profit?• Sales? Operating Costs?Bottom line questi...
Return on Shareholders Funds(also called Return on Equity)             Net profit after taxes x 100              Sharehold...
Return on Shareholders FundsTop line questions• What increases/ decreases profit?• Sales? Operating Costs?• Interest charg...
Net Profit Percentage          Net profit after taxes x 100                      Sales    • Often shown as ‘Profit attribu...
Net Profit PercentageTop line questions• Is gross profit high or low?• What are the admin and selling costs?• What are the...
Gross Profit Percentage              Gross profit x 100                    SalesGross profit = Sales minus cost of salesCo...
Gross Profit PercentageTop line questions• Have sales volumes or prices changed?• Have costs of sales changed?• Are costs ...
Current Ratio              Current Assets             Current LiabilitiesSolvency = Ability to meet obligations asthey fal...
Current RatioTop line questions• What affects levels of stocks, debtors, cashBottom line questions• What affects levels of...
Quick Ratio (Acid Test)          Current Assets less Stock           Current LiabilitiesSolvency = Ability to meet obligat...
Quick Ratio (Acid Test)Top line questions• How is the company managing debtors and cash?Bottom line questions• How is the ...
Stock Holding Period (days)                 Stock x 365                 Cost of Sales• Change 365 to 12 for a calculation ...
Stock Holding Period (days)Top line questions• Year-end stock or average stock? Use year-end  for ease of calculation but ...
Debtor Payment Period (days)               Trade Debtors x 365                     Sales• Debtors = Accounts receivable (c...
Debtor Payment Period (days)Top line questions• Average or year-end? Year-end is less  trouble but check there are no majo...
Creditor Payment Period (days)              Trade Creditors x 365            Purchases or cost of sales•Trade creditors = ...
Creditor Payment Period (days)Top line questions• Average or year-end?Bottom line questions• Opening stock + purchases - c...
Gearing             Long Term Debt        Long Term Debt plus Equity• Look carefully at balance sheet and usenotes to acco...
GearingTop line question• What are the sources of finance that create fixed  commitments to pay interest and repay capital...
Interest Cover             Profit before interest and tax                 Interest expense• EBIT = Earnings Before Interes...
Interest CoverTop line questions• What is the amount of profit available to ‘cover’  interest payments?• Is the company ge...
Concepts, Cost and Costing                             Page 69
Management accounting•   Integral part of management•   identify, present and interpret information•   for strategy, plann...
Management accounting (contd)•   Internal use within organisation•   No regulation by law•   Projections for future•   Ana...
Measuring and            analysing            performanceImplementing                Examining futureplans                ...
Importance of costing• Many organisational decisions rely on costings• Costing is complex but essential• “An accountant kn...
Describing costs• Direct (identified with a saleable unit)• Indirect (spread across saleable units)• Indirect costs = Over...
Confusing terminology• Allocate = give all cost to one unit or centre• Apportion = share across units or centres• Absorb (...
Terminology (contd)• What are the direct costs? Allocate these to units  of output• What are the indirect costs? Allocate ...
Absorption basesAbsorb as• cost per unit• cost per labour hour• cost per £ of labour• cost per kilo of material• cost per ...
Cost behaviourPairs of classifications• Direct or indirect?• Fixed or variable?• Period or product?Case: Bus company sends...
Direct or indirect?Direct for each school:Driver’s working time, fuel for bus, bridge tollsIndirect to spread across all j...
Fixed or variable?Variable change with activity levelFuel, repairs, bridge tollsFixed regardless of activity levelDrivers’...
Period or product?What is the product?A person-mile.Product costsDriver’s time, fuel, bridge tollsPeriod costsInsurance, L...
Examples of decisions•   Price setting, tendering for contracts•   Product profitability analysis•   Product design modifi...
Short-term decisionsIn the short term business can continue if the selling  price covers variable costs and makes a  contr...
Contribution analysisBreak even point =                      Fixed costs                 Contribution per unitPay £1,000 r...
Contribution analysis (contd)Sell 500 at £8 = £4,000.Variable cost 500 x £6 = £3,000Add fixed costs £1,000Neither profit n...
Scarce resourcesSell gardening services and house cleaning.Contribution per job £10 and £8.Gardening needs 2 hours per job...
Short term decisions•   Make internally or buy externally•   Hire own staff or pay agency for outsourcing•   Keep a busine...
Other factors in decisionsNot just an accounting matter. Consider• organisation’s objectives• relationship with employees•...
Get the costs wrong and...•Set prices too high - lose sales;    too low - sell products at loss•Lose potentially profitabl...
Get the costs wrong and...•R & D to create ‘better’ product when noneneeded•Product Design Modifications not done whenneed...
Different Costs for Different               PurposesNot a single, universal ‘true’ cost.Appropriate cost is governed by:  ...
Different Costs for Different PurposesActivity Based   Failure Cost    Planned CostCostAverage Cost     Full Cost       Pr...
Costing Problem•In contemporary organisations the fixed/variableclassification is not relevant•Logical impossibility of at...
Activity ‘Solution’Costs don’t drive activities, activities cause costsOrganisations do things that consume resourcesand (...
Activity Based Costing• What are the activities of the organisation?• What resources are used by each activity?• How much ...
Money          cost                    Resources             consume                                 Non-financialCollectD...
Benefits of ABC• Makes visible the activities that drive the costs• Prevents misallocation of costs• Links costs more clos...
Activity costing is...•Not based on accounting coding structures•Not based on accounting time frames•Not based on techniqu...
Short term planning  Budgets andBudgetary Control                      Page 99
What is a budget?•   Quantified format•    management plans and strategies•   for decision making•   communication medium ...
Mission/ goals  Financial plans                      Corporate objectives                                        Assumptio...
Long term strategy                  Long term planningMarketopportunities                          Forecasting            ...
Budget process•   Formalises planning and control•   Defines goals•   Goal congruence - brings goals together•   Authority...
operating                              financial                    Master budget Sales budget                   Capital b...
Budget preparation•Start with sales budget (demand driven)•Then match with cost of sales•Is this a production organisation...
Budget preparation (contd)• Is this a service organisation?    Plan service programme, labour needs, materials  needed• Pl...
Cash budget• Most important part of budget cycle• Monthly, quarterly?• Cash receipts from operations• Cash payments for op...
Fixed and flexible budgets• Fixed means that budget is not adjusted later if  volumes start to vary• Flexible budgets mean...
Fixed and flexible (contd)Budget variable costs of £200,000 for 5,000 units of outputActual variable costs are £195,000 fo...
Fixed and flexible (contd)Appears to have saved £5,000But budgeted cost = £4 per unitSo flexible budget for 4,500 is £180,...
Alternative approachesEasy approach = Last year plus inflationZero-based budgeting• Start with a clean sheet• Justify ever...
Alternative approaches (contd)Activity based budgeting• Extension of activity based costing• Focus on cost of each activit...
Not-for-profit organisations• Goals and objectives measured differently• Need to be cost effectivePlanning programming bud...
Behavioural aspectsBudgets can motivate employees to achieve goals of  the organisation. What helps?• degree of difficulty...
Not foolproofWhy might budgets fail?• Fail to understand changing environment• using unsuitable existing structures• fail ...
Are budgets necessary?What matters is PLANNINGThis does not have to use budgets. Essential:• Set targets: to maximise long...
Are budgets necessary?•   Co-ordination: manage cause and effect•   Cost management: challenge all costs•   Forecasting: u...
Performance Measurement                          Page 118
Strategic planningFive year plan, rolling forward.• Profitability• Growth of sales, profit• Market share• Customer satisfa...
Accounting-based performance              measuresProfit?• Could compare actual profit against budget, but  companies don’...
Accounting-based performance          measures (contd)Profitability• A relative measure, better for comparison.• Calculate...
Return on capital employed          Profit before interest and taxes    Fixed assets plus current assets less current     ...
Return on shareholders’ funds        Net profit after interest and taxation               Shareholders’ fundsCan only be c...
Residual incomeAsk: What is the income (profit) remaining after deducting a notional interest charge for the use of capita...
Residual income (contd)Suppose cost of capital is 10% for both.                           X         Z   £000’s  Operating ...
Economic Value Added (EVA)Companies should deliver value that exceeds the  cost of capital.                               ...
Performance of a divisionDivisions are created by decentralisation• Gives greater responsiveness• Allows faster decisions•...
Performance of a division (contd)Problems of decentralisation• Focus on division, not on total organisation  (Called ‘dysf...
Performance of a division (contd)Cost centre• Manager is responsible for costsDiscretionary cost centre• Manager has some ...
Performance of a division (contd)Profit centre• Manager is responsible for revenues and costs• Target profit is setInvestm...
Transfer pricingWhat price is charged for transfers between  divisions within an organisation?• Variable cost?• Variable c...
Financial Performance              Measurement• Success / Failure often determined by accounting  numbers• Growth in profi...
Financial Performance Measurement                   (contd)•   Achieving outcome at or under budget•   Adverse / Favourabl...
Problem with financial measuresA Simple Scenario.Division in large company enjoyed major growth in profitability over two ...
Financial measures (contd)Top line answer• Division’s market share dropped• Costs were reduced by reducing maintenance of ...
Problems with financial information• Complexity /mystery and the method of  calculation• Arbitrary treatment of some cost ...
Problems with financial information               (contd)• Managers need to convert data into meaningful  information.• Im...
Value of Financial Performance            Measurement• Managers accept importance of financial outcome  of their function ...
Value of Financial Performance        Measurement (contd)• Need information on relationships between  activities they cont...
Information Managers UseUS study concluded information used for dailyoperating control did not come from the budgetingsyst...
Indicators for managers level of finished goods level of orders (demand) key production limiting factors simple counts...
Indicators for managers (contd) scrap quantities, rework rates. capacity utilisation physical production requirements ...
Non-Financial MeasuresNon-financial is any information not valued in £s.  It has the following advantages:• Expressed in t...
Non-Financial Measures (contd)• Potentially quicker, relevant• Relates to events, activities, actual observable  performan...
Integrating Non-£ and £ measures•   Activity Based Accounting•   Benchmarking•   Performance Scoring•   Balanced Scorecard...
Financial                                 Perspectiv                                              eer Perspe          ctiv...
Balanced Scorecard• systematic attempt to design performance  measurement system that integrates   – organisational object...
Balanced Scorecard (contd)• reflect the organisation’s understanding of the  causes of successful performance.• monitoring...
Balanced Scorecard (contd)BS performance measures should• be clearly understood by all employees• link manufacturing perfo...
Balanced Scorecard (contd)BS performance measures should• be able to identify cause-effect relations to enable  employees ...
Not-for-profit organisations• Economy   Cost at which resources are acquired• Efficiency   Compare inputs and outputs• Eff...
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Accounting

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Accounting

  1. 1. Financial Accounting Page 1
  2. 2. DefinitionAccounting is the process of•identifying,•measuring•and communicating•financial information about an entity•to permit informed judgments and decisions•by users of the information. Page 2
  3. 3. The Accounting EquationAssets minus Liabilities equals EquityA - L = EAssets equals Liabilities plus EquityA = L + E Equity Capital Ownership claim Shareholders’ funds Page 3
  4. 4. Power of Accounting“Accounting provides a very selective but powerfulrepresentation of the corporate identity..” “The detailed language of assets, liabilities, costs, profits provide a range of corporate imagery and vocabulary …….”“Accounting provides the categories through whichorganisational participants perceive both themselves andthe organisation.” Mike Powers Page 4
  5. 5. Creative Accounting?“Things may exist independently of our accounts, but theyhave no human existence until they become accountable.They may not exist, but they take on human significance bybecoming accountable..”“Accounts define reality and at the same time they are thatreality….”“Accounts do not more or less accurately describe things.Instead they establish what is accountable in the setting inwhich they occur”“Whether they are ACCURATE OR INACCURATE by some otherstandards, accounts define reality for a situation in the sensethat people act on the basis of what is accountable in thesituation of their action.” Ruth Hines Page 5
  6. 6. You will discoverThat accounting is subjective, partial and potentiallymisleadingAccountants use language / numbers in a highly technicalwayAccounts are a highly stylised story, representation,description of organisational eventsDifferences between the ‘Accounting World’ and the‘Organisational World’Problematic nature of accounting numbers Page 6
  7. 7. And there’s more….The tribe of accountants takes many forms and liveswithin all organisationsNo such thing as a correct ‘cost’, ‘value’, ‘profit’..itall depends on contextThe value of accounting in managingorganisations Page 7
  8. 8. Roles of AccountingImprove problem solving / decision makingManage risksTrust, AssuranceEducational - learn about organisationsLanguage of businessConstruct, define, measure success/failure Page 8
  9. 9. Roles of AccountantsAssisting the internal management of organisationsComplying with external financial reporting, controls and with taxation regulationsExpert consultants on financial and organisational performance Page 9
  10. 10. Financial Accounting Accounting conceptsProfit and Cash distinction Financial statements Organisational impact Page 10
  11. 11. Hierarchy of Accounting Qualities Decision Makers and their characteristics Benefits > Costs Understandability Decision-Usefulness Relevance ReliabilityPredictive Timeliness Verifiability Representationalvalue Faithfulness Comparability & Feedback consistency Neutrality Value Materiality Page 11
  12. 12. Transactions Buy materials on credit from suppliers Sell goods or services on credit to customersPay suppliers Receive cash Page 12
  13. 13. When is profit reported?When goods or services are soldNOTwhen cash is paid or received Page 13
  14. 14. Example: Antiques dealerBuy 10 chairs for cash Rs 200 eachSell 6 chairs on credit Rs 300 each Profit 6 x 100 each = Rs.600 Cash flow = minus 2,000 Page 14
  15. 15. Profit, not cashMatching Concept – match revenues received withthe costs incurred to generate them Goods received but not paid for –Creditors (Payables) Goods or services supplied but no cash yet - Debtors (Receivables)Prudence concept – providing for known / probablelosses – e.g. Doubtful debts, Depreciation of fixed assets Page 15
  16. 16. Profit, not cash contdCustomers pay in advance for services extendingbeyond the accounting period Company agrees with supplier to buy materials at fixed price for 5 years Home currency euros, borrow in dollars Increase in valuation of fixed assets Page 16
  17. 17. Change over a periodstart Assets - Liabilities = EquityDuring the period Profit/loss end Assets - Liabilities = Equity Page 17
  18. 18. Contents of annual report Financial highlights Company overview Chairman’s statement Chief Executive’s review Audit report Financial statementsNotes to the accounts Page 18
  19. 19. The main financial statementsBalance Balance BalanceSheet 1 Sheet 2 Sheet 3AS AT AS AT AS AT31 Dec Year 1 31 Dec Year 2 31 Dec Year 3 Profit and Loss Profit and Loss Account Account For period For period Cash Flow Report Cash Flow Report Page 19
  20. 20. Balance sheet horizontal• Fixed assets • Liabilities• Current assets • Shareholders’ funds Page 20
  21. 21. Balance sheet verticalFixed assetsCurrent assetsLessCurrent liabilitiesLess long term liabilitiesEqualsShareholders’ funds Page 21
  22. 22. Profit and loss accountRevenue (sales)Less Expenses (costs)Equals Profit Page 22
  23. 23. Cash flow statement Operating cash flows plus Investing cash flows plus Financing cash flowsEquals change in cash and bank loans Page 23
  24. 24. Creative accounting What do we want to create? More profit? Less profit? More assets? Fewer assets?More liabilities? Fewer liabilities? Page 24
  25. 25. Creative Accounting PracticesIncome smoothing – move profit from one year toanotherChanging accounting policies, particularlydepreciation, asset valuationsOverstating costs, particularly in regulated industriesMaking expenses into Assets - ‘capitalisation’ Page 25
  26. 26. Off-balance sheet financing , e.g leasing, Saleand buyback, special purpose vehicles Recognising profits that aren’t really there – foreign exchange rates affecting values of assets and loansCorporate takeovers – ACCOUNTINGMINEFIELD adjusting policies, fair values,goodwill, brands, reorganisation costs……... Page 26
  27. 27. Corporate crime / fraudDirectors are responsible for preventing crime andfraud They are required to have a system of internal controlsWho controls executive directors for honesty/?Audit committees, Non-executive Directors,Supervisory Board Page 27
  28. 28. Corporate crime/ fraud contd. Creating fictitious contracts Fictitious Assets, inaccurate valuationsOmitting Liabilities, misleading valuations Raid the employees’ pension fund Page 28
  29. 29. Analysis and Interpretation ofFinancial Statements Page 29
  30. 30. First Steps BC (before calculation)• Why are you analysing accounts?• Who are you interpreting for?• When are you interpreting?• What are you intending to interpret?• Limitations of Financial Accounts Page 30
  31. 31. Always bear in mind• Preparers of accounts know how people will interpret their accounts• Be cynical – assume the accounts are the best possible picture• Analysis only as good as original data –• Never just use accounts – check from many different sources• Accounting terms are different from general understandings Page 31
  32. 32. However….• Accounts are main source of systematically produced regulated information• Good as it gets• Usually reliable – 3rd party verified• Follow the same basic rules• Most of the information is there (in the small print)• You can never eliminate the risk of fraud / criminal misrepresentation Page 32
  33. 33. Analyse Accounts to determine Is the company:•Growing? •Profitable?•Managing its assets effectively?•Sufficiently liquid? •Financed properly? •Able to meet its financial obligations? •Viewed favourably by financial markets? Page 33
  34. 34. Financial ratios• Quick and simple check on financial health• Small number of ratios gives a picture of the business. Easy to calculate, harder to interpret.• Provide a starting point for further investigation. Page 34
  35. 35. Key areas for analysis• Profitability• Liquidity• Asset management• Debt management (financial structure)• Market value Page 35
  36. 36. Success in making profitReturn on capital employedprofit sales Profit_____ x _______ = __________sales total assets total assetsprofitability x efficiency = ROCE Page 36
  37. 37. Managing liquidity• Can we pay the bills as they fall due?• Can we pay the wages of employees?• Buy stock (inventory) on credit• Sell on credit = accounts receivable• Pay suppliers = accounts payable• Ideally, match cash flows in and out Page 37
  38. 38. Asset management• Use fixed assets to earn sales revenue• Manage working capital• stocks (inventory)• debtors (accounts receivable)• creditors (accounts payable)• working capital cycle Page 38
  39. 39. Financial structure• Is it a good idea to borrow?• Creates greater risk - interest payments and capital repayments• Benefits to shareholders when profits are rising• Risks to shareholders when profits are falling Page 39
  40. 40. Advantages of ratios• Comparisons are relative to other figures• Compare businesses of different size• Gives picture of company strategy• Financial and trading performance• Compare with industry averages• Simple summary of complex information Page 40
  41. 41. Reasons for using ratios• Gives summary statistics• Helps identify industry benchmarks• Input to formal decision model• Standardise for size Page 41
  42. 42. Applications of analysis• Predictions of corporate earnings• Construct projected financial statements• Predict corporate failure• Indicators of financial distresse.g. Altman’s models, combination of ratios Page 42
  43. 43. Problems with ratio analysis• No agreement on definitions or specific set of ratios• Accounting estimation• Data not available• Timing of data does not match• Differing accounting policies• Negative numbers and small divisors Page 43
  44. 44. Limitations of ratio analysis• Diverts attention from the underlying information• May not give sufficient attention to the notes to the accounts• Accounting policies may affect comparison• Industry differences Page 44
  45. 45. Creative accountingCould involve:• Inflating reported profits and EPS• Accounting for losses via balance sheet reserves and all profits through P & L• Reporting profits without generating equivalent cash• Reporting lower borrowings Page 45
  46. 46. Survival Tips for Accounting Jungle• Read the accounts backwards• Read the accounting policies and compare• Screen accounts using filters – e.g. high profit low tax, changing depreciation policies• Cash is King (or Queen)• Assess risk: If in doubt, keep out (or get out) Page 46
  47. 47. Return on Capital Employed Profit before interest and taxation x 100 Shareholders’ funds plus long term debt• Often called ‘Operating profit’Assets minus Liabilities = Equity• Total assets minus current liabilities equalsShareholders’ funds plus long term loans Page 47
  48. 48. Return on Capital EmployedTop line questions• What increases/ decreases profit?• Sales? Operating Costs?Bottom line questions• Recent increases in assets may not yet have created profit• Is there any debt ‘off balance sheet’? Page 48
  49. 49. Return on Shareholders Funds(also called Return on Equity) Net profit after taxes x 100 Shareholders’ funds Page 49
  50. 50. Return on Shareholders FundsTop line questions• What increases/ decreases profit?• Sales? Operating Costs?• Interest charges? Taxes?Bottom line questions• Is the company high/ low geared? Page 50
  51. 51. Net Profit Percentage Net profit after taxes x 100 Sales • Often shown as ‘Profit attributable to ordinary shareholders’• Sales also called ‘turnover’ Page 51
  52. 52. Net Profit PercentageTop line questions• Is gross profit high or low?• What are the admin and selling costs?• What are the effects of interest and taxation?Bottom line questions• Is the measurement of sales explained? Page 52
  53. 53. Gross Profit Percentage Gross profit x 100 SalesGross profit = Sales minus cost of salesCost of sales = making ready for sale Page 53
  54. 54. Gross Profit PercentageTop line questions• Have sales volumes or prices changed?• Have costs of sales changed?• Are costs of sales mainly variable or fixed?Bottom line questions• Is the measurement of sales explained? Page 54
  55. 55. Current Ratio Current Assets Current LiabilitiesSolvency = Ability to meet obligations asthey fall dueWorking capital = CA minus CL Page 55
  56. 56. Current RatioTop line questions• What affects levels of stocks, debtors, cashBottom line questions• What affects levels of bank borrowing, trade creditors, other short term creditorsOverall - How does the company manage its working capital? Page 56
  57. 57. Quick Ratio (Acid Test) Current Assets less Stock Current LiabilitiesSolvency = Ability to meet obligations asthey fall dueCash flow: How does the company manageinflows and outflows of cash? Page 57
  58. 58. Quick Ratio (Acid Test)Top line questions• How is the company managing debtors and cash?Bottom line questions• How is the company managing trade creditors and bank overdraft? Page 58
  59. 59. Stock Holding Period (days) Stock x 365 Cost of Sales• Change 365 to 12 for a calculation in months.• Sales minus cost of sales equals gross profit Page 59
  60. 60. Stock Holding Period (days)Top line questions• Year-end stock or average stock? Use year-end for ease of calculation but check there are no significant changes from start.Bottom line questions• May have to make some approximations to get cost of sales Page 60
  61. 61. Debtor Payment Period (days) Trade Debtors x 365 Sales• Debtors = Accounts receivable (customers who buy on credit terms)•Use notes to the accounts to find trade debtors. Page 61
  62. 62. Debtor Payment Period (days)Top line questions• Average or year-end? Year-end is less trouble but check there are no major changes.Bottom line questions• Are all sales made for credit? Think about the nature of the business. Page 62
  63. 63. Creditor Payment Period (days) Trade Creditors x 365 Purchases or cost of sales•Trade creditors = Accounts payable(suppliers who provide goods on credit terms)• Use notes to the accounts for detail.• Page 63
  64. 64. Creditor Payment Period (days)Top line questions• Average or year-end?Bottom line questions• Opening stock + purchases - closing stock = Cost of goods sold.• Should be Purchases but Cost of goods sold is Ok if stocks are constant. Page 64
  65. 65. Gearing Long Term Debt Long Term Debt plus Equity• Look carefully at balance sheet and usenotes to accounts.•Add Preference shares to Debt•Omit Provisions Page 65
  66. 66. GearingTop line question• What are the sources of finance that create fixed commitments to pay interest and repay capital?Bottom line question• What is the total long-term financing of the business, based on borrowings and equity? Page 66
  67. 67. Interest Cover Profit before interest and tax Interest expense• EBIT = Earnings Before Interest and Taxation• Interest expense: either in profit and loss account or in detailed notes. Page 67
  68. 68. Interest CoverTop line questions• What is the amount of profit available to ‘cover’ interest payments?• Is the company generating sufficient wealth to meet interest payments?Bottom line questions• What is the cost of servicing borrowings? Page 68
  69. 69. Concepts, Cost and Costing Page 69
  70. 70. Management accounting• Integral part of management• identify, present and interpret information• for strategy, planning and control,• for decision taking and use of resources• for disclosure to employees• to safeguard assets Page 70
  71. 71. Management accounting (contd)• Internal use within organisation• No regulation by law• Projections for future• Analysis of past• Directing attention, planning and control• Solving problems Page 71
  72. 72. Measuring and analysing performanceImplementing Examining futureplans environmentAction plans and budgets Developing objectives Operating plans Formulating strategy Page 72
  73. 73. Importance of costing• Many organisational decisions rely on costings• Costing is complex but essential• “An accountant knows the cost of everything but the value of nothing” Oscar Wilde Page 73
  74. 74. Describing costs• Direct (identified with a saleable unit)• Indirect (spread across saleable units)• Indirect costs = Overheads• How to find a fair way of spreading the overheads? Page 74
  75. 75. Confusing terminology• Allocate = give all cost to one unit or centre• Apportion = share across units or centres• Absorb (Absorption) Soak up into the units of outputSee page 142 of text book Page 75
  76. 76. Terminology (contd)• What are the direct costs? Allocate these to units of output• What are the indirect costs? Allocate to cost centres if we know where they belong.• Otherwise Apportion (share) across cost centres.• Absorb costs from production centres into products. Page 76
  77. 77. Absorption basesAbsorb as• cost per unit• cost per labour hour• cost per £ of labour• cost per kilo of material• cost per machine hourDifferent bases give different answers Page 77
  78. 78. Cost behaviourPairs of classifications• Direct or indirect?• Fixed or variable?• Period or product?Case: Bus company sends buses to 10 schools fortaking children home each day. How does thecompany describe the costs? Page 78
  79. 79. Direct or indirect?Direct for each school:Driver’s working time, fuel for bus, bridge tollsIndirect to spread across all journeys:Insurance, repairs, maintenance, licences, depreciation, driver’s idle time, holiday pay Page 79
  80. 80. Fixed or variable?Variable change with activity levelFuel, repairs, bridge tollsFixed regardless of activity levelDrivers’ wages, Insurance, Licences,Maintenance checks, Depreciation Page 80
  81. 81. Period or product?What is the product?A person-mile.Product costsDriver’s time, fuel, bridge tollsPeriod costsInsurance, Licences, routine maintenance, depreciation Page 81
  82. 82. Examples of decisions• Price setting, tendering for contracts• Product profitability analysis• Product design modifications• R & D management• Value Engineering• General Cost Management• Contracting out / Buying in• Plant / Department Closure Page 82
  83. 83. Short-term decisionsIn the short term business can continue if the selling price covers variable costs and makes a contribution to fixed costs.Contribution = Selling price - variable cost Page 83
  84. 84. Contribution analysisBreak even point = Fixed costs Contribution per unitPay £1,000 rent for market stall. Buy toys for £6 each, sell for £8 each. What is breakeven volume?£1,000/£2 = 500 toys Page 84
  85. 85. Contribution analysis (contd)Sell 500 at £8 = £4,000.Variable cost 500 x £6 = £3,000Add fixed costs £1,000Neither profit nor lossHow many toys to sell for profit of £4,000?£(1,000 + 4,000)/£2 = 2,500 toys Page 85
  86. 86. Scarce resourcesSell gardening services and house cleaning.Contribution per job £10 and £8.Gardening needs 2 hours per job, House cleaning needs 1 hour per job.Shortage of labour. Which has priority?House cleaning £8 per hour, Gardening £4 per hour.Contribution per unit of limiting factor Page 86
  87. 87. Short term decisions• Make internally or buy externally• Hire own staff or pay agency for outsourcing• Keep a business activity going• Take on a special order at lower price Page 87
  88. 88. Other factors in decisionsNot just an accounting matter. Consider• organisation’s objectives• relationship with employees• marketing• corporate goodwill/ image• customer reactions• government policies Page 88
  89. 89. Get the costs wrong and...•Set prices too high - lose sales; too low - sell products at loss•Lose potentially profitable contracts, win lossmaking contracts•Don’t know where we are making / losing money•Continue with loss making products, cut profitmaking products, sub-optimal product mix Page 89
  90. 90. Get the costs wrong and...•R & D to create ‘better’ product when noneneeded•Product Design Modifications not done whenneeded•Contracting out production that costs more thaninternal production•Making products that could be cheaper to buy in•Close profit-making Plant / Keep open lossmaking plant Page 90
  91. 91. Different Costs for Different PurposesNot a single, universal ‘true’ cost.Appropriate cost is governed by: Needs of management Specific organisational situations Specific problem to be solved Available information - pragmatics Page 91
  92. 92. Different Costs for Different PurposesActivity Based Failure Cost Planned CostCostAverage Cost Full Cost Product CostAvoidable Cost Historic Cost Quality CostBudgeted Cost Incremental Relevant Cost CostControllable Indirect Cost Step CostCostCurrent Cost Joint Cost Sunk CostDirect Cost Marginal Cost Standard CostEnvironmental Opportunity Total CostCost CostEngineered Overhead Transfer CostCost CostFixed Cost Period Cost Variable Cost Page 92
  93. 93. Costing Problem•In contemporary organisations the fixed/variableclassification is not relevant•Logical impossibility of attributing all costs toproducts•Wrong approach to the problem•‘Solution’ based in the ‘accounting world’ not the‘organisational world’ Page 93
  94. 94. Activity ‘Solution’Costs don’t drive activities, activities cause costsOrganisations do things that consume resourcesand (should) create valueCosting should start with what the firm does -activities in organisational world Page 94
  95. 95. Activity Based Costing• What are the activities of the organisation?• What resources are used by each activity?• How much does each resource cost?• Collect cost in ‘cost pools’• How does each product or service make use of each activity?• Share cost from the cost pools. Page 95
  96. 96. Money cost Resources consume Non-financialCollectData Activities Performance Analysis produce Outputs creates Value Page 96
  97. 97. Benefits of ABC• Makes visible the activities that drive the costs• Prevents misallocation of costs• Links costs more closely to responsibility for causing costsBUT does not save money or generate profit. It only gives more accurate information Page 97
  98. 98. Activity costing is...•Not based on accounting coding structures•Not based on accounting time frames•Not based on techniques designed to makethe accountants life easier•Not based on producing FinancialStatements Page 98
  99. 99. Short term planning Budgets andBudgetary Control Page 99
  100. 100. What is a budget?• Quantified format• management plans and strategies• for decision making• communication medium Page 100
  101. 101. Mission/ goals Financial plans Corporate objectives AssumptionsAssessed market Long term on criticalopportunities/ strategy factorsorganisationalcapability Long term plans Page 101
  102. 102. Long term strategy Long term planningMarketopportunities Forecasting assumptions Short term strategyOrganisationalcapability Budget/ short term Modify planning assumptions Page 102
  103. 103. Budget process• Formalises planning and control• Defines goals• Goal congruence - brings goals together• Authority and responsibility are clear• Framework to judge performance Page 103
  104. 104. operating financial Master budget Sales budget Capital budget + Cost of goods sold budget + Cash budget Development /design budget + Marketing budget + Budgeted Distribution budget + balance sheet Administration budgetBudgeted profit and loss Budgeted statementaccount of cash flow Page 104
  105. 105. Budget preparation•Start with sales budget (demand driven)•Then match with cost of sales•Is this a production organisation? Plan: inventories of raw materials, finished goods purchases to cover sales and inventories Page 105
  106. 106. Budget preparation (contd)• Is this a service organisation? Plan service programme, labour needs, materials needed• Plan all other operating expenses• Plan capital expenditure• Bring together in cash budget, budgeted profit and loss account, balance sheet. Page 106
  107. 107. Cash budget• Most important part of budget cycle• Monthly, quarterly?• Cash receipts from operations• Cash payments for operations• Other cash receipts (new finance, sale of fixed assets)• Other cash payments (tax, dividends, interest) Page 107
  108. 108. Fixed and flexible budgets• Fixed means that budget is not adjusted later if volumes start to vary• Flexible budgets means that budget is adjusted to take account of change in volumes of activity over the period Page 108
  109. 109. Fixed and flexible (contd)Budget variable costs of £200,000 for 5,000 units of outputActual variable costs are £195,000 for 4,500 units of outputHow has manager performed against budget? Page 109
  110. 110. Fixed and flexible (contd)Appears to have saved £5,000But budgeted cost = £4 per unitSo flexible budget for 4,500 is £180,000Performance is £15,000 worse than flexible budget. Page 110
  111. 111. Alternative approachesEasy approach = Last year plus inflationZero-based budgeting• Start with a clean sheet• Justify every item• Focus on goals and objectives Page 111
  112. 112. Alternative approaches (contd)Activity based budgeting• Extension of activity based costing• Focus on cost of each activityKaizen budgeting• continuous improvement• budget is achieved if improvements are met Page 112
  113. 113. Not-for-profit organisations• Goals and objectives measured differently• Need to be cost effectivePlanning programming budget system• Focus on outputs rather than inputs• ‘joined-up’ government Page 113
  114. 114. Behavioural aspectsBudgets can motivate employees to achieve goals of the organisation. What helps?• degree of difficulty• top management participation• perceived fairness• feeling of ownership• avoid discontent about preparation Page 114
  115. 115. Not foolproofWhy might budgets fail?• Fail to understand changing environment• using unsuitable existing structures• fail to understand business systems• lack of senior management support• fail to understand central role of budgeting Page 115
  116. 116. Are budgets necessary?What matters is PLANNINGThis does not have to use budgets. Essential:• Set targets: to maximise long term value• Strategy: Make development continous• Growth and improvement: challenge staff• Resource management: wealth creation Page 116
  117. 117. Are budgets necessary?• Co-ordination: manage cause and effect• Cost management: challenge all costs• Forecasting: use rolling forecasts• Measurement and control: key indicators• Rewards: unit rewards not individuals• Delegation: give managers freedom to act Page 117
  118. 118. Performance Measurement Page 118
  119. 119. Strategic planningFive year plan, rolling forward.• Profitability• Growth of sales, profit• Market share• Customer satisfaction• Rate of innovationHow to measure achievement of strategy? Page 119
  120. 120. Accounting-based performance measuresProfit?• Could compare actual profit against budget, but companies don’t give information• An absolute measure, needs ratios for comparison.• Affected by choice of accounting policies• Measured differently in different countries Page 120
  121. 121. Accounting-based performance measures (contd)Profitability• A relative measure, better for comparison.• Calculate for subdivisions of an organisation.Methods• Return on capital employed• Residual income• Economic value added Page 121
  122. 122. Return on capital employed Profit before interest and taxes Fixed assets plus current assets less current liabilitiesCan be used for divisions of a company if assets and liabilities can be allocated. Page 122
  123. 123. Return on shareholders’ funds Net profit after interest and taxation Shareholders’ fundsCan only be calculated for the company as a whole, not subdivided for divisions of organisation. Page 123
  124. 124. Residual incomeAsk: What is the income (profit) remaining after deducting a notional interest charge for the use of capital? X Z £000’sOperating profit (EBIT) 18 1,500Capital employed 100 10,000ROCE 18% 15% Page 124
  125. 125. Residual income (contd)Suppose cost of capital is 10% for both. X Z £000’s Operating profit (EBIT) 18 1,500 Less interest charge (10) (1,000) Residual income 8 500 Company Z gives higher income to shareholders Page 125
  126. 126. Economic Value Added (EVA)Companies should deliver value that exceeds the cost of capital. X ZProfit after tax (before interest) 13 1,050Interest charge (net of tax) (7) (700)EVA 6 350Z gives higher EVA than does X Page 126
  127. 127. Performance of a divisionDivisions are created by decentralisation• Gives greater responsiveness• Allows faster decisions• Motivates managers• Uses specialist experience of managersBut needs a measure of performance Page 127
  128. 128. Performance of a division (contd)Problems of decentralisation• Focus on division, not on total organisation (Called ‘dysfunctional decision making)• More information is needed, cost involved• Duplication of activities Page 128
  129. 129. Performance of a division (contd)Cost centre• Manager is responsible for costsDiscretionary cost centre• Manager has some choices in cost budgetRevenue centre• Manager is responsible for generating planned sales Page 129
  130. 130. Performance of a division (contd)Profit centre• Manager is responsible for revenues and costs• Target profit is setInvestment centre• Manager is responsible for resources and profit, target return to be achieved Page 130
  131. 131. Transfer pricingWhat price is charged for transfers between divisions within an organisation?• Variable cost?• Variable cost plus a profit margin?• Variable cost plus portion of fixed cost?• Variable + fixed + profit margin?• Negotiated price? Reflect market? Page 131
  132. 132. Financial Performance Measurement• Success / Failure often determined by accounting numbers• Growth in profit, ROCE, Sales• Reduction in costs, headcount, errors, stock• Financial Ratio Analysis Page 132
  133. 133. Financial Performance Measurement (contd)• Achieving outcome at or under budget• Adverse / Favourable variance analysis• Project NPV – cost overruns• OBJECTIVE APPROACH TO Performance measurement Page 133
  134. 134. Problem with financial measuresA Simple Scenario.Division in large company enjoyed major growth in profitability over two years ..manager promoted.New manager ….drop in profits.WHY ? Page 134
  135. 135. Financial measures (contd)Top line answer• Division’s market share dropped• Costs were reduced by reducing maintenance of cuttingmachine, reducing staff training•build up of stocks (inventory) of unsold goodsBottom line answer• Reduced investment in new technologyFinancial System did not pick up the BAD Events Page 135
  136. 136. Problems with financial information• Complexity /mystery and the method of calculation• Arbitrary treatment of some cost items• Time lag between event and the financial ledger• No direct observable relationship between activities and reported costs• Irrelevant to managers Page 136
  137. 137. Problems with financial information (contd)• Managers need to convert data into meaningful information.• Implied assumption that control costs will control activities.• Focus on cost minimisation, not on effectiveness or value- adding. Could be valid reasons for costs increasing.• Simplification of organisational activities, by reducing everything into a single £ value. Page 137
  138. 138. Value of Financial Performance Measurement• Managers accept importance of financial outcome of their function (especially if linked to pay / prospects).• Managers will try to increase their profitability.• Managers often devise their own budget systems’. Page 138
  139. 139. Value of Financial Performance Measurement (contd)• Need information on relationships between activities they control and financial outcome• Ignore formal budget reports / spend time and effort proving official budget is wrong• Do not assume that managers can "translate" £s into actual activities Page 139
  140. 140. Information Managers UseUS study concluded information used for dailyoperating control did not come from the budgetingsystem.Managers information needs are affected by:•the resources most significant to their process, interms of cost, quality, availability•the time frame in which this information is needed Page 140
  141. 141. Indicators for managers level of finished goods level of orders (demand) key production limiting factors simple counts of output per hour / shift / day, physical quantities of materials / labour used, down-time Page 141
  142. 142. Indicators for managers (contd) scrap quantities, rework rates. capacity utilisation physical production requirements (long - medium and short-term) Page 142
  143. 143. Non-Financial MeasuresNon-financial is any information not valued in £s. It has the following advantages:• Expressed in terms/language understandable to managers (non-accountants)• Requires very little "translation" by managers Page 143
  144. 144. Non-Financial Measures (contd)• Potentially quicker, relevant• Relates to events, activities, actual observable performance• Can be used to make sense of financial budgets• Better reflects the "reality" of the situation, not confused by strange accounting rules/conventions Page 144
  145. 145. Integrating Non-£ and £ measures• Activity Based Accounting• Benchmarking• Performance Scoring• Balanced Scorecard• Strategic Management Accounting• Many other – multiple criterion decision making, data envelopment analysis, etc… Page 145
  146. 146. Financial Perspectiv eer Perspe ctiv e Vision and Internal B usiness Strategy Perspectiv e Learning & Growth Perspectiv e Balanced Scorecard Page 146
  147. 147. Balanced Scorecard• systematic attempt to design performance measurement system that integrates – organisational objectives, – co-ordination of individual decision making – need for organisational learning.• create an environment that facilitates continual improvement Page 147
  148. 148. Balanced Scorecard (contd)• reflect the organisation’s understanding of the causes of successful performance.• monitoring performance and what managers believe are drivers of good performance• performance measure system should measure the most critical aspects of organisational performance. Page 148
  149. 149. Balanced Scorecard (contd)BS performance measures should• be clearly understood by all employees• link manufacturing performance and financial performance• be linked to ensure constancy of purpose. Page 149
  150. 150. Balanced Scorecard (contd)BS performance measures should• be able to identify cause-effect relations to enable employees to deal with poor performance and continue good practices.• be based on critical success factors• identify trends and rate of change Page 150
  151. 151. Not-for-profit organisations• Economy Cost at which resources are acquired• Efficiency Compare inputs and outputs• Effectiveness How resources are usedValue for Money Page 151

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