accounting mba eb

AccountingThe Accounting programme is written by Niall Lothian, Professor at Edinburgh Business School, Heriot-Watt University, and John Small, Professor Emeritus at Heriot-Watt University. Both have previously occupied chairs in the Universitys Department of Accountancy & Finance. Professor Lothian has taught at IMEDE (now IMD) in Lausanne and is currently a member of the visiting faculty of INSEAD, Fontainebleau. He has conducted seminars and managerial briengs in Europe, Africa and China, the latter under the auspices of the United Nations Industrial Development Organisation. Professor Lothian has been consultant to British government agencies such as the Ministry of Defence and the Cabinet Ofce and to a number of international companies including IBM, Nokia, Philips, Roland Berger, Swire and ScottishPower. His current research and consulting interests include the study of managerial controls over R&D expenditure, a eld in which he has published widely, and the accounting implications of exible manufacturing systems. A chartered accountant by professional training, he is a Past President of the Institute of Chartered Accountants of Scotland. Professor Small is a member of the board of Scottish Homes. He was from 1982 to 1991 Chairman of the Accounts Commission in Scotland. The Accounts Commission is responsible for arranging the audit of local government in Scotland and ensuring the proper steps are taken to achieve economy, efciency and effectiveness. He is a member of the Council of the Chartered Association of Certied Accountants and was its President in 1982/83. He has been Chairman of the Education Committee of the International Federation of Accountants and a member of the executive Board of the Union Europeenne des Experts Comptables, Economiques et Financiers. He is an honorary member of the Arab Society of Certied Accountants. He has also held visiting professorships and external examinerships at various universities and business schools. His special interest is in the use of nancial information in decision making for planning and control. In this area he is a consultant to a number of organisations and has advised companies and government agencies in the UK and abroad. Professor Small was made a Commander of the Order of the British Empire in the Queens Birthday Honours, 1991.

Release AC-A1.2

ISBN 0 273 60916 5

HERIOT-WATT UNIVERSITY

AccountingNiall LothianProfessor, Edinburgh Business School

John SmallProfessor Emeritus, Heriot-Watt University

Edinburgh Gate, Harlow, Essex CM20 2JE, United Kingdom Tel: +44 (0) 1279 623112 Fax: +44 (0) 1279 623223 Pearson Education website: A Pearson company www.pearsoned-ema.com

First published in Great Britain in 2003 c Niall Lothian and John Small 1991, 1998, 2001, 2003 The right of Niall Lothian and John Small to be identied as Authors of this Work has been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. ISBN 0 273 60916 5 British Library Cataloguing in Publication Data A CIP catalogue record for this book can be obtained from the British Library. Release AC-A1.2 All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without the prior written permission of the Publishers. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published, without the prior consent of the Publishers. Typesetting and SGML/XML source management by CAPDM Ltd. Printed and bound in Great Britain. (www.capdm.com)

The publishers policy is to use paper manufactured from sustainable forests.

ContentsPART ONEModule 1

FINANCIAL ACCOUNTING FOR MANAGERSAn Introduction to Accounting and the Accounting Equation1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11 Approaching Accounting The Reality of Accounting What Accounting Is Focus on Prot-Seeking Businesses Who Are the Users of a Companys Accounting Information? For what Sort of Decisions Do these Users Value Accounting Information? Common Information Requirements among Users The Accounting Equation The Accounting Statements Sole Trader versus MBA Accounting: The External and Internal Functions 1/1 1/2 1/2 1/3 1/5 1/6 1/6 1/8 1/8 1/11 1/19 1/20 2/1 2/2 2/3 2/4 2/8 2/9 2/10 2/12 2/16 2/17 2/18 2/20 2/22 2/23 3/1 3/2 3/3 3/3 3/8 3/9 3/10 3/13 3/15 4/1 4/1

Module 2

The Prot and Loss Account2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 2.12 2.13 Introduction What Is Prot? The Measurement of Accomplishment Another Reason for Opting for Ship and Invoice Conventions Underlying Measurement of Sales Accomplishment The Measurement of Effort Task One: Determining the Consumption of the Means of Production Task Two: Determining the Value of Closing Work-in-Progress and Inventories Types of Inventory in a Manufacturing Company Inventory Valuation Methods Valuation of Work-in-Progress and Finished Goods Interpreting Prot Summary

Module 3

The Balance Sheet3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 Introduction The Anatomy of the Balance Sheet Fixed Assets Current Assets Current Liabilities Net Current Assets and Net Assets Why Does a Balance Sheet always Balance? Summary

Module 4

The Cash Flow Statement4.1 Introduction

Accounting

Edinburgh Business School

5

Contents

4.2 4.3 4.4 4.5 4.6 4.7 4.8

Why Are Cash Flow Statements Needed? What Is Cash in a Cash Flow Statement? Cash: Where Does it Come from? Where Does it Go to? Eight Major Categories of Cash Flow Worked Example with Commentary Do-it-Yourself Example Summary

4/2 4/3 4/3 4/6 4/7 4/10 4/14 5/1 5/2 5/3 5/4 5/4 5/5 5/6 5/6 5/6 5/9 5/9 5/11 5/13 5/15 5/16 5/18 5/20 5/20 5/21 5/25 6/1 6/2 6/4 6/5 6/6 6/8 6/12 6/14 6/15 6/16 6/18 6/18 6/20 7/1 7/2 7/3 7/6

Module 5

The Framework for Financial Reporting5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 5.10 5.11 5.12 5.13 5.14 5.15 5.16 5.17 5.18 5.19 Introduction The Concept of Disclosure Sources of Disclosure Requirements The Companies Acts 1985 and 1989 Accounting Standards The Stock Exchange Listing Agreement Financial Reporting in Action An Introductory Note on Groups of Companies Abstract of Annual Reports: MBA plc and Award Ltd The Accounting Policies The Consolidated Prot and Loss Account The Consolidated Balance Sheet (and Parent Companys Balance Sheet) A Concluding Note on MBAs Balance Sheet Statement of Group Cash Flow Detailed Disclosure Requirements for Selected Items The Lessons to Be Learned Fundamental Accounting Concepts The External Auditor Summary

Module 6

Interpretation of Financial Statements6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 6.10 6.11 6.12 Introduction Ratio Analysis Group 1: Liquidity Ratios Group 2: Protability Ratios Group 3: Capital Structure Ratios Group 4: Efciency Ratios Other Possible Ratios Window Dressing Putting it all Together: The Dupont Chart A One Hundred Per Cent Statement Basic Stock Market Ratios Summary

Module 7

Emerging Issues and Managerial Options in Financial Reporting7.1 7.2 7.3 Introduction Research and Development (R&D) Off-Balance-Sheet Transactions

6


Accounting

Contents

7.4 7.5 7.6 7.7 7.8 7.9 7.10 7.11 7.12

Accounting for Acquisitions and Mergers Goodwill Brands Operating and Financial Review Environmental Reporting Impairment of Fixed Assets and Goodwill Provisions and Contingencies International Harmonisation of Accounting Standards Summary

7/11 7/13 7/16 7/19 7/20 7/21 7/22 7/23 7/24

PART TWOModule 8

MANAGEMENT ACCOUNTING FOR DECISION MAKINGAn Introduction to Cost and Management Accounting8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8 8.9 8.10 8.11 8.12 8.13 What Accounting Is: A Refresher Management Accounting Looks Forward Where Accounting Fits into a Company A Brief Note on what a Manager Does The Role of Accounting Information Management Accounting in MBA plc Differences between Management Accounting and Financial Accounting Management Accounting and Cost Accounting Where Costs Come from and an Overview of the Modules to Follow Process Costing Costs Relevant to Management Decisions Other Topics in the Management Accounting Course Summary 8/1 8/2 8/3 8/4 8/4 8/7 8/7 8/11 8/12 8/14 8/15 8/16 8/17 8/18 9/1 9/2 9/3 9/3 9/6 9/9 9/10 9/10 9/11 9/12 9/12 9/12 9/15 9/16 9/17 9/20 9/22 9/23 9/26

Module 9

Cost Characteristics and Behaviour9.1 9.2 9.3 9.4 9.5 9.6 9.7 9.8 9.9 9.10 9.11 9.12 9.13 9.14 9.15 9.16 9.17 9.18 Introduction Cost: A Deceptively Simple Word Variable and Fixed Costs Beware the Unitising of Fixed Costs! Direct and Indirect Costs Traceable and Common Costs Product Costs and Period Costs Controllable and Non-Controllable Costs Standard and Actual Costs Engineered and Discretionary Costs Another Look at Variable and Fixed Costs: The Break-Even Chart Prot from Different Cost Structures The Break-Even Chart: An Alternative Display Other Ways of Calculating Break-Even Points Break-Even Analysis and the Multi-Product Firm Contribution and Limiting Factors of Production Assumptions Underpinning Cost-Volume-Prot Analysis Summary

Accounting


7

Contents

Module 10

Allocating Costs to Jobs and Processes10.1 10.2 10.3 10.4 10.5 10.6 10.7 10.8 10.9 10.10 10.11 Introduction Cost Gathering Where Do these Costs Come from? Plantwide versus Departmental Rates Joint Products and By-Products Process Costing Process Costing and the Equivalent Unit Cost per Equivalent Unit Activity-Based Costing Traditional Costing versus ABC Summary

10/1 10/2 10/3 10/3 10/8 10/12 10/17 10/17 10/19 10/24 10/24 10/32 11/1 11/2 11/2 11/7 11/8 11/9 11/9 11/13 11/13 11/14 11/14 11/15 11/16 11/17 11/19 11/20 11/22 12/1 12/2 12/2 12/4 12/8 12/20 12/23 13/1 13/2 13/2 13/5 13/5 13/7 13/9 13/12 13/18

Module 11

Costs for Decision Making11.1 11.2 11.3 11.4 11.5 11.6 11.7 11.8 11.9 11.10 11.11 11.12 11.13 11.14 11.15 11.16 Introduction The Dilemma of the Denominator Managerial Implications of Absorption versus Variable Costing Cost Information for Management Decisions Routine and Non-Routine Decisions Developing an Analytical Framework Finding the Relevant Costs The Pitfalls of Full Costing Opportunity Costs Department versus Company Sunk Costs Management Decisions in Action Closing Down a Unit The Special Sales Order Should we Process Further? Summary

Module 12

Budgeting12.1 12.2 12.3 12.4 12.5 12.6 Introduction Why Bother with Budgets? Why Budgeting Gets a Bad Name Budgeting in Action: The Go-Straight Trolley Company Discretionary Expenditure and Zero-Base Budgeting Summary

Module 13

Standard Costing13.1 13.2 13.3 13.4 13.5 13.6 13.7 13.8 Introduction Setting Standards A Word about Motivation Flexible Budgets The Anatomy of Variances: Materials and Labour Responsibility for Variances Variable and Fixed Overhead Analysis Investigation of Variances

8


Accounting

Contents

13.9 Sales Variances 13.10 Summary

13/19 13/22 14/1 14/2 14/3 14/5 14/6 14/9 14/10 14/11 14/16 14/17 14/17 14/20 14/23 15/1 15/2 15/3 15/4 15/6 15/6 15/9 15/11 15/12 15/14 15/14 15/15 15/18 15/20 15/22 15/25 15/26 15/27 15/29 15/30 15/31 16/1 16/1 16/3 16/11 16/15 16/18 16/23 16/31

Module 14

Accounting for Divisions14.1 14.2 14.3 14.4 14.5 14.6 14.7 14.8 14.9 14.10 14.11 14.12 Introduction Why Divisionalise? Types of Divisions Dening Prots and Investments Asset Base Valuation Residual Income: An Alternative to ROI The Imputed Rate of Interest Does Matter! A Cautionary Note about Performance Measures Transfer Pricing Criteria for Establishing a Transfer Price The International Dimension Summary

Module 15

Investment Decisions15.1 15.2 15.3 15.4 15.5 15.6 15.7 15.8 15.9 15.10 15.11 15.12 15.13 15.14 15.15 15.16 15.17 15.18 15.19 Introduction The Investment Process Concept of Present Value Discounted Cash Flow Approach Net Present Value (NPV) Discounted Cash Flow (DCF) Rate of Return Comparison of Net Present Value and DCF Rate of Return Investment Appraisal in Non-Revenue and Not-for-Prot Situations Risk and Uncertainty and Ination Risk and Uncertainty Payoff or Payback Period Sensitivity Analysis Risk Analysis The Key Investment Factors Projected Average Cost of Capital Average Cost of Capital Opportunity Cost, Risk and the Cost of Capital Investment Appraisal and Ination Post-Assessment/Continuous Post-Audit of Capital Expenditure Projects 15.20 Conclusion

Module 16

New Developments in Management Accounting16.1 16.2 16.3 16.4 16.5 16.6 16.7 Introduction Target Costing Life Cycle Costing Throughput Accounting Costing for Competitive Advantage The Balanced Scorecard Summary

Accounting


9

Contents

Appendix 1 Appendix 2 Appendix 3 Index

Answers to Review Questions and Worked Solutions to Case Studies Practice Final Examinations and Worked Solutions Glossary

A1/1 A2/1 A3/1 I/1

10


Accounting

PART ONE

Financial Accounting for ManagersModule 1 Module 2 Module 3 Module 4 Module 5 Module 6 Module 7 An Introduction to Accounting and the Accounting Equation The Prot and Loss Account The Balance Sheet The Cash Flow Statement The Framework for Financial Reporting Interpretation of Financial Statements Emerging Issues and Managerial Options in Financial Reporting

Accounting


Module 1

An Introduction to Accounting and the Accounting EquationContents1.1 1.2 1.3 1.3.1 1.3.2 1.3.3 1.3.4 1.4 1.5 1.6 1.7 1.8 1.9 1.9.1 1.9.2 1.10 1.10.1 1.10.2 1.10.3 1.11 Approaching Accounting The Reality of Accounting What Accounting Is Accounting Is a Service Function Accounting Deals with Economic Information Economic Activity Must Be Identied, then Measured Accounting Is a Communication Device Focus on Prot-Seeking Businesses Who Are the Users of a Companys Accounting Information? For what Sort of Decisions Do these Users Value Accounting Information? Common Information Requirements among Users The Accounting Equation The Accounting Statements Do-it-Yourself Example Worked Solution Sole Trader versus MBA Sole Trader Partnership Company Accounting: The External and Internal Functions 1/2 1/2 1/3 1/4 1/4 1/4 1/5 1/5 1/6 1/6 1/8 1/8 1/11 1/14 1/16 1/19 1/19 1/19 1/20 1/20 1/21 1/25

Review Questions Case Study 1.1

Learning ObjectivesBy the end of this module you should understand: the value to various groups in society of a knowledge of accounting; the role of accounting in management; the need for, and use of, accounting information in decision making within any organisation;1/1

Accounting


Module 1 / An Introduction to Accounting and the Accounting Equation

the accounting equation; the basic layout of the prot and loss account (sometimes called the income statement), the balance sheet and the cash ow statement; the distinction between nancial accounting and management accounting.

1.1

Approaching AccountingFew subjects in a Masters degree course in Business Administration are approached by students with a greater sense of awe than accounting. Put another way, of all the subjects typically on offer in an MBA programme, accounting is the one which students would most prefer to avoid! Why should this be? Here are some reasons which may reect the readers thinking as he or she embarks on this course. Unlike many other MBA disciplines, such as marketing, economics and organisational behaviour, which are viewed as being intuitive, that is the reader has a fairly good idea of what the subject is about without prior study, accounting is non-intuitive, requiring the mastery of rules from the outset. Accounting is seen to deal exclusively with numbers; many people prefer to deal with words and ideas. Because of its concentration on numbers, accounting is considered to be concerned with precision and accuracy, both of which require a highly developed mathematical mind. Readers know friends and relatives who have studied for a degree or professional qualication in accounting; since these people spent many years studying, how can an MBA course deal with complexities so quickly? Accounting and accountants are treated by society as being dull and boring! The image, bolstered by the perceived obsession with numbers and accuracy, is picked up by TV scriptwriters and producers who stereotype the accountant as being humourless, repetitive, pedantic, unimaginative and incapable of forming close personal relationships!

In an effort to put the readers mind at ease at the outset of the course, two points should be made. 1 2 Virtually everyone (whether studying for an MBA or not) who is not a trained accountant views accounting and accountants as set out above. They are all wrong!

1.2

The Reality of AccountingAll business disciplines, including marketing, economics and organisational behaviour, are based on fundamental concepts and relationships which must be appreciated from an early stage. The fact that a novice believes he knows what is involved in these subjects does not remove the need to study the underlying principles in as rigorous a manner as he would require to do in accounting.

1/2


Accounting


Accounting is indeed concerned with numbers but it is concerned with many more aspects besides; the presentation and communication of nancial information is just as important as the numbers themselves. More attention is being paid today to the use of accounting numbers in the decision making process than ever before. Major companies currently issue to shareholders an abbreviated set of annual accounts (perhaps only a few pages) instead of the full set; companies web sites often display shortened versions of their annual reports. Indeed some US companies have stopped circulating automatically their annual reports to shareholders; instead shareholders are supplied the web address at which they can access the main features of the years results. They are doing this not to save money but in recognition of the fact that the important accounting numbers, such as turnover, prot for the year and dividends payable, are not easily discernible in the full set. Shareholders need this information so that they can assess the performance of the company in which they have a stake. A simple presentation and the medium of communication are as important to accounts as the nancial message. Accounting numbers attempt to reect economic activity in an organisation. But there is no one given view of this activity; two people can form different views. It follows that there can be no one given set of accounting numbers which must be used. Choice, judgement and the reconciliation of vested interest prevent the accountant from ever becoming dull and boring.

ExampleA company purchased a residential house in 1991 in the Georgian New Town of Edinburgh for use by its senior executives when on company business in Scotland. It cost 100 000. In 2001 the companys property advisers consider the house would sell for 1 000 000. The companys insurers require buildings insurance to be based on its replacement value of 1 750 000. Which value should the companys accountant select for recording the asset in the 2001 accounts?

Precision, accuracy and the need for a mathematical turn of mind may be desirable but not essential. So often these attributes are confused with numeracy, the skills of reading and handling numbers and applying to them the basic arithmetical rules of addition and subtraction. A modestly priced calculator will prove to be invaluable! This course is written not only for those studying for a degree by distance learning but also for managers and others who need to use accounting numbers in their work. The underlying methodology of accounting will be explained only where it is essential to the readers understanding of the concepts and his or her appreciation of how to apply the techniques in the world of business.

1.3

What Accounting IsAccounting may be dened as a series of processes and techniques used to identify, measure and communicate economic information which users nd helpful in making decisions.

Accounting


1/3


A denition is like a completed jigsaw: the whole picture is readily visible but it is not nearly as interesting as the process of tting all the pieces together. What are the constituent pieces of the denition? 1.3.1

Accounting Is a Service FunctionAccounting is not an end in itself: it provides information to decision makers. Whether an entity is oriented towards making prots, like a company, a partnership or a sole trader, or towards meeting goals other than prots like a political party, a charity, a club or a church, accounting information is universally employed by decision makers.

ExampleA cathedral is planning to replace its organ. The organ committee has asked the treasurer for the following nancial information: the range of competitive tenders in money terms; the potential impact of exchange rates on overseas organ builders tenders; the cost of old organ removal and preparatory site works; and the impact on power and maintenance costs as compared with the existing organ. But this information is only one factor in the committees decision making process; ultimately the decision will also take into account musical and liturgical issues.

1.3.2

Accounting Deals with Economic InformationWithin organisations there exists a bewildering range of information on all sorts of subjects. Accounting connes itself to economic information and is usually expressed in money values. However, accountants also deal with such things as tons of raw materials used, number of hours worked, capacity of machinery used, and units of output produced.

ExampleThe governments defence procurement establishment is weighing up the potential of placing a long-term contract with one of three civilian suppliers of laser equipment. Alongside the results of the militarys experiences with the prototypes under simulated battleeld conditions, the accountants will lay their estimates of costs of production, the suppliers requirements for capital equipment to build the production models, the rate at which equipment will depreciate and the pricing formulae being used by the suppliers.

1.3.3

Economic Activity Must Be Identied, then MeasuredSome economic events, like the sale of a unit of production, e.g. a car, are relatively easy to identify and to measure. Others are easy to identify but are difcult to measure: the robotic equipment used in the car-assembly process depreciates through use and the passage of time but accountants can only guess at how quickly this cost should be recognised; each guess produces a different cost gure which, in turn, produces a different prot gure. Of course, the range of guesses is curtailed by the exercise of commercial judgement and professional

1/4


Accounting


precedent. Some events may have an economic impact on the organisation which are so difcult to identify and measure that they escape the accountants attention.

ExampleThe charismatic founder and chief executive of a recently Stock Exchange quoted company suffered a near-fatal coronary thrombosis while golng two weeks before the end of the nancial year-end. On the same day one of the companys sales reps replaced the two rear tyres on his company car. Because the accountant can identify and measure the economic impact of the latter event, it is accounted for, while the former event, one which could have a long-term negative effect on the performance of the company, escapes recording.

1.3.4

Accounting Is a Communication DeviceAccounting information can help decision makers reach their objectives. It follows that accountants must know what sort of economic information decision makers want: accounting information must be relevant for the purposes for which it is designed. Then, of course, the accountant must communicate the information in such a way that the users can understand it.

ExampleA national charity is about to launch a fund-raising campaign. The nancial controller compiles nancial information in pie-chart format which reveals that all but a small percentage of income is spent directly on the charitys objectives; on the other hand the information required by the governments tax authorities, the Inland Revenue, require accounting numbers to be presented in a totally different manner. It would not be unfair to say that accountants have a lot of work still to do to improve their communications skills: too often accountants forget that users cannot understand accounting numbers as easily as they can.

1.4

Focus on Prot-Seeking BusinessesWhat have the following persons in common? the chairman of a football club a chief executive in the local brewery the Chancellor of the Exchequer a nancial controller of a university the senior partner of a law rm the medical director of a hospice.

AnswerThey are all concerned with the raising and spending of money and the control of scarce resources through budgets. To this extent, accounting is a universally applicable management tool employing universally applicable principles. But the detailed procedures and rules governing, say, a brewery and a governmentAccounting Edinburgh Business School

1/5


department are so diverse that it would be wise to focus on only one sector during this course. We have selected the prot-seeking private sector, and specically manufacturing industry within this sector. We do this for three reasons. 1 Managers and other readers who work for the not-for-prot sector very often have personal investments in prot-seeking private sector companies and are interested in tracking the performance of their investments. The thrust of governments nancial management in many countries today is towards privatisation, i.e. adopting the techniques and performance measures of the private sector. We believe that a manufacturing industry setting enables students to grasp the principles and procedures of accounting more easily than any other. Once these principles are understood they can be applied in other commercial and social settings. Reference will be made to other settings where appropriate.

2

3

1.5

Who Are the Users of a Companys Accounting Information?Take MBA plc as an example of a manufacturing company. We will use the ctitious nancial statements of MBA plc throughout the text for analytical use and for illustration. MBA plc is based on one of the worlds largest engineering and communications companies. It has a presence in every continent and its activities span every aspect of technology and systems. Who are the users of the MBAs accounting information? They can be grouped as internal users and external users. Internal users Directors Senior executives Managers Employees (and trade unions) External users Shareholders Analysts Creditors Tax authorities The public

1.6

For what Sort of Decisions Do these Users Value Accounting Information?All the users of company accounting information are faced with the choices among alternative courses of action. If they make decisions without adequate information (which happens all too often), they are likely to nd that their expectations are not fullled.

1/6


Accounting


Directors

Senior executives

Managers

Employees

Shareholders

Has the company been employing its resources in the most effective way to maximise the prot earned for our shareholders? Is it maximising shareholder value? Has the company been a good corporate citizen, i.e. have all our industrial processes been friendly to the environment? If not, how much is being spent on improving the awed processes? Are we managing our money efciently? For example, are we condent that a subsidiary company in Australia is not borrowing money at 20 per cent to fund an expansion when the subsidiary in Japan is building up a cash balance in the bank earning 12 per cent interest? Is our manager remuneration scheme sufciently rigorous to promote effort and commitment while at the same time being competitive with other multinationals? Would it be cheaper to make a component ourselves or buy it in from an outside supplier? Are all our lines protable? How much should we claim in the next wage round? What are the security and prospects of employment in this company? Should we buy (or sell or hold) shares in this company? How much dividend has been paid last year compared with prots earned?

MBA provides a breakdown of its shareholders in 20x2 as follows. Size of holding Number of ordinary shareholders accounts 4 770 41 386 69 002 475 275 187 335 116 430 Number of shares (millions) 1 25 285 76 100 133 2 057 2 677 Percentage of issued share capital 0.9 10.7 2.8 3.7 5.0 76.9 100

1100 1011000 1001100 000 100 001250 000 250 001500 000 500 0011 000 000 Over 1 000 000 All holdings

The law recognises all shareholders as being equal, but note that the 335 shareholders (institutional investors like pension funds) who own over one million shares each combine to own just under 77 per cent of the entire share capital while the 4770 shareholders who each own less than 100 shares possess insufcient to be measured on this scale! Analysts Should we advise shareholders and potential shareholders to buy or sell or hold shares in the company?Accounting Edinburgh Business School

1/7


Creditors

Tax authorities

The Public

Is the performance of the company this year superior to its competitors? Should we advise a switch of holding to a company with a more promising prospect? Should we extend our credit to this company, or should we press to recover our debts? In the longer term will the company be able to supply us with business? How much tax can we expect to receive from the company? Note that a multinational company will le tax returns in every country in which it operates. The public is a loose phrase which includes inter alia environmental pressure groups and consumer groups. Such parties ask a variety of questions, including ones directed at a companys protability, efciency, contributions to political organisations and transactions with overseas governments. Is the company fullling its obligations to society by, for instance, minimising environmental pollution, or by abiding by international guidelines for trading in Third World countries?

Sound answers to these questions require accounting information, sometimes of a most sophisticated kind.

1.7

Common Information Requirements among UsersAnswers to all the questions above require knowledge of a companys prots and cash position. Providing information about protability and liquidity (the professional jargon for cash position) is seen by many to be the goal of the accounting system. Although the emphasis in this course will be on the informational requirements of managers, a good manager should be concerned with all the questions posed by all the interest groups set out above. He should be as concerned with shareholder value as the shareholders, as aware of the companys debt-paying abilities as the creditors and as sensitive to environmental matters as either the directors or the external consumer lobby. The course is designed to assist the manager in interpreting and understanding accounting information, not to instruct him in how to prepare it. However, each manager should be familiar with the basic mechanics of the accounting process before he tries to gain an appreciation of what the accounting numbers mean.

1.8

The Accounting EquationBefore proceeding to a more detailed analysis of the concepts and objectives of accounting, we will examine the accounting recording system which produces information on prots and cash.

1/8


Accounting


The accounting recording system is based on the simple, not to say selfevident, notion that all economic resources acquired by an entity must be funded from somewhere. Entities do not simply acquire resources out of thin air: resources must be provided by someone (usually the owner) in the rst instance. Later, other people such as creditors or banks may put up money to provide further resources for the company. The relationship between resources and the funds provided to acquire these resources is expressed in accounting like this:ASSETS = OWNERS EQUITY + LIABILITIES or ASSETS LIABILITIES = OWNERS EQUITY

This accounting equation underpins the entire accounting recording system. A simple example will show how this equation works by examining a series of actions through a period of time. For illustration, we use the economic events associated with an individual starting up in business rather than using the more complex world of companies like MBA. But exactly the same accounting equation would be used to record the activities of MBA or any company or partnership as the ones we will employ below. Action 1 An individual commences his business on 1 January with 20 000 cash. The accounting equation of the business would record: Assets (Cash) 20 000 = Owners equity 20 000

The amount of owners equity signies the owners claim over the assets of the enterprise. At the conclusion of this action, the individuals stake in the business is worth 20 000, represented by cash of 20 000. Action 2 Out of these cash resources he purchases plant and equipment for 12 000. Only one side of the equation needs adjustment: Cash 8000 + Plant 12 000 = Owners equity 20 000 Inventories of raw materials are purchased on credit for 6000. = Owners equity 20 000 + Cash 8000 + Plant 12 000 + Raw material inventories Creditors 6000 6000

Action 3

Here we see an acquisition of another asset, inventories, nanced by the suppliers of the inventories. Eventually the business will have to pay this amount in cash; until it does, the creditors remain a liability. How much is the owner now worth? Still 20 000, represented by assets totalling 26 000 less 6000 owed to his creditors. Action 4 500 worth of inventory is processed through the machines at a labour cost of 20 to form nished goods inventory. Cash 7980 + Plant 12 000 = Owners equity 20 000 + + Raw material inventory Creditors 6000 5500 + Finished goods inventory 5201/9

Accounting



Here, the 20 cash spent on labour is assumed to add value to the raw material inventory of 500 all of which the business would hope to recover in the eventual selling price. Action 5 The accountant, an employee of the business, is paid his wage of 10 in cash. Cash 7970 + Plant 12 000 = Owners equity 19 990 + + Raw material inventories Creditors 6000 5500 + Finished goods inventories 520

It is important to distinguish between the wages paid to production workers in Action 4 (which increase the value of the inventory to be sold) and those of an administrative nature (which do not increase the value of assets and which do not vary with output). This overhead is a charge against prots which have not yet been earned, so it is deducted from the original capital in the interim. At the end of this action the individuals stake in his business has been reduced by 10 to 19 990. When prot is made, it will be added to the owners equity. Action 6 The entire nished goods inventory is sold for 750 on credit. Cash 7970 + Plant 12 000 = Owners equity 20 220 + + Raw material inventories Creditors 6000 5500 + Debtors 750

The nished goods inventory has been reduced to zero. The company has made 230 prot on this transaction, which increases the owners equity. An asset called debtors is created because cash has not yet been received for the sales. On its own the above transaction looks like this:Change in nished goods inventories (520) + Change in debtors (+750) = Change in owners equity (+230)

Action 7

3000 of the amount due to suppliers is paid along with an advertising bill of 10. At this point the machine which has an effective working life of 24 000 hours has been used for 100 hours. = Owners equity 20 160 + Cash 4960 + Plant 11 950 + Raw material inventories Creditors 3000 5500 + Debtors 750

The payments to suppliers are a straightforward matter, reducing cash and creditors by the amount 3000 paid over. The advertising bill is paid in cash too and must reduce the owners equity this is an expense of being in business, just like the accountants fee. The use of machinery implies that the machine wears out, a process known as depreciation, yet another expense of operations. Since the effective working life was 24 000 hours and the equipment cost 12 000, for every hour used the machine will cost 0.50. (This method of calculating depreciation is known as the consumption method; there are others.) For 100 hours the depreciation charge is 50: the value of the plant is reduced by 50 and the owners equity1/10Edinburgh Business School Accounting


is reduced by 50. Note that no cash outlay is involved with the depreciation charge. Depreciation is examined in Module 2. At this stage, or any earlier one for that matter, it is possible to determine the prot made by comparing the owners equity at the beginning of the period under review with the balance on the owners equity at the end of the period. If it has increased the owner has made a prot; if it has decreased he has made a loss. In the example the prot is 160 (20 160 less 20 000). The accounting equation is a collection of balances after each transaction has been completed and recorded. Note that the accounting entries involve a mixture of cash-driven items and judgement-driven items. This equation can also be laid out in a more meaningful fashion called a balance sheet.

1.9

The Accounting StatementsBalance sheet at the end of Action 7 Assets Cash 4 960 Plant and equipment 11 950 Inventories 5 500 Debtors 750 23 160

Owners equity

20 160

Creditors

3 000 23 160

The layout of this balance sheet could be improved to give a clearer picture of the nancial position of the company at the end of Action 7. Fixed assets Plant and equipment at cost Less: Depreciation Current assets Inventories Debtors Cash Less: Current liabilities Creditors Net assets of the company Represented by: Capital introduced Prots earned Owners equity 12 000 50 11 950

5 500 750 4 960 11 210 3 000 8 210 20 160

20 000 160 20 160

This layout highlights some fundamental points that should be noted.Accounting Edinburgh Business School

1/11


1

2

The owners equity of a company is represented by the net assets (xed assets + net current assets) of the company; the original cash introduced by the owners is consumed in the purchase of assets and in the trading activities for which the company was set up. (NB: Net current assets are dened as current assets less current liabilities.) Assets of the company can be split into xed assets, which are of relatively long life and are generally used in the production of goods and services rather than being held for resale, and current assets, which are either currently in the form of cash or are close to being converted into cash within a short period of time, usually a year. Current liabilities are those obligations which a company must meet, in cash, within a short time, again usually one year.

The straight comparison of owners equity gures provides an arithmetically accurate gure of prot but it does not tell how that prot was made, i.e. how many sales were recorded, what the cost of these sales was, or what expenses were incurred on the accounting period. The detailed items which affected owners equity were: Action 5 6 7 7 Net increase Accountants wage Prot on sale of nished goods Advertising bill Depreciation charge on plant in equity 10 +230 10 50 +160

An accounting statement which is more meaningful than the accounting equation is constructed. This accounting statement is called the prot and loss account (or the income statement) for an accounting period: Prot and loss account for the period Actions 17 Sales Less: Cost of sales Materials Labour Depreciation Gross prot Less: Selling and administrative costs Advertising Salaries Net prot 500 20 50 750

570 180

10 10

20 160

As can be seen, prot is simply the excess of sales revenue over costs incurred in generating the revenue. Items of expenditure accounted for via the prot and loss account we call revenue expenditure; items of expenditure accounted for via the balance sheet we call capital expenditure. In the example the prot and loss account has been created from the preceding data relatively easily. However, this procedure can become very complex in a multi-product, multiplant company engaging in thousands of transactions daily. Accountants have1/12Edinburgh Business School Accounting


therefore devised a continuous recording system based on the double-entry procedure encountered in the previous section which eliminates the need to calculate the effect on prot and owners equity after every transaction but which will continue to provide the useful information in prot and loss account format whenever it is required. These detailed procedures of bookkeeping are the accountants job, not the managers. So far the two accounting statements have produced information on: (a) the protability of the company for the seven actions listed; and (b) the nancial position of the business at the end of Action 7. Neither statement, however, reveals anything about the cash position which is important to many users of nancial information: Directors Senior executives Managers Employees Shareholders Creditors Tax authorities Money spent on major process improvements Cross-national money switching Cash saved in buying in components Wage increases Dividends Payment of debts Payment of taxes

Prot is not the same as cash. There are many reasons for this: one such reason can be readily understood by considering the nature of the sales gure of 750 which gives rise to the reported prot. The business has not received payment for the sales at the time the prot and loss account is drawn up. But, provided the owner believes the debtors will pay the amount shortly, it is an accounting convention that recognises this gure as if the money has been received when calculating prot. Also, depreciation is a deduction from sales revenue before prot is determined but has no effect on cash. A third accounting statement, the cash ow statement, portrays only those economic events of a business which affect cash ows. For the example above the cash ow statement would be as follows: Cash ow statement for the period to Action 7 Sources of cash Prot from operations Adjusted for non-cash items: depreciation Capital introduction Increase in creditors Uses of cash Purchase of plant Increase in debtors Increase in inventories Closing balance of cash 160 50 20 000 3 000

210 23 000 23 210

12 000 750 5 500

18 250 4 960

Accounting


1/13


Note the following points. 1 The rst source of cash should always be the operations of the business. (If it is not so then sooner rather than later the business will go bust!) In a start-up situation, such as in the example, the main source of cash is usually by way of original capital injection or by bank borrowings. 2 The prot gure is the most useful starting point for determining the amount of cash generated by operations. Items which were charged in the prot and loss account and which did not affect cash, i.e. depreciation, are added back to this gure. 3 An increase of creditors is a source of cash. For the short period the business is owing the money, it is able to use the money for other business purposes. Therefore the businesss creditors can be seen to provide cash to the business. 4 The reverse is true with the increase in debtors. When customers dont pay cash for goods and services this weakens the nancial state of the business for a short period. The business is therefore paying out cash to support its credit customers businesses for a short period of time. 5 The signicance of the cash ow statement is that it breaks down the accounting conventions which separate economic events into either the balance sheet or the prot and loss account. Cash is cash whether the event affects the balance sheet or the prot and loss account. In another situation a company can report healthy prots in the prot and loss account but the cash ow statement can reveal a rapidly deteriorating liquidity position. 6 Despite the emphasis on the prot and loss account and balance sheet, many managers and analysts consider the cash ow statement to be equally informative. Note that the layout of the cash ow statement above, and the prot and loss account and balance sheet before it, are skeletal and simplistic. Readers will be guided through more realistic layouts of the three nancial statements in the next three modules. 1.9.1

Do-it-Yourself ExampleIn the space provided below each action for Forth Enterprises you should construct the accounting equation which reects the transaction(s). At the end of Action 12 draw up a balance sheet, prot and loss account and cash ow statement adopting the layouts given in the text.

Action 1Fred Forth commences business with 40 000 from his own savings and a further 10 000 cash from his cousin. His cousin informs Forth that he is not looking for interest or early repayment.

1/14


Accounting


Action 2Forth buys the following assets: plant and equipment 5000 cash, factory and warehouse 25 000 cash, and raw materials 8000 (half by cash, half by credit).

Action 3Before the equipment can function properly, it requires a post-installation lubrication costing 200. Forth pays for this in cash. Raw materials worth 4000 are then processed into nished goods through the equipment at a labour cost of 400.

Action 4Forth pays his creditors in full and sells half of the nished goods (recorded at cost of 2200) for 4000 credit.

Action 5Forth buys a second-hand delivery van for 3000 on credit and a typewriter for his secretary for 200 cash.

Action 6Forth sells the remainder of the nished goods (recorded at a cost of 2200) for 3900 cash, and receives payment of 3900 from his debtors.

Action 7The delivery van breaks down and requires 100 of repairs which Forth pays for in cash. He buys further raw materials for 6000 cash and processes the remainder of his rst batch of raw materials (which had cost 4000) at a cash cost for labour of 300.

Action 8At Christmas, Forth buys his wife a foodmixer costing 100 and his secretary a fur jacket costing 1200. He pays for both items using his credit card.

Accounting


1/15


Action 9He sells his second batch of nished goods (which are recorded at a cost of 4300) for 6000, receiving half of the money in cash and giving credit for the other half. He pays off his creditors.

Action 10Forth pays 400 cash for advertising and 200 cash for audit fees; he also has all of his raw materials (cost 6000) processed, his labour force incurring 1000 wages in so doing.

Action 11His auditors advise him that he should write off the debt of 100 which has been outstanding since Action 4; in their opinion this debt is now irrecoverable. They also recommend that he provides for depreciation on plant and equipment at a rate of 10 per cent and on motor vehicles at 25 per cent.

Action 12Forth considers that one-fth of his factory and warehouse space is excessive for his needs; he sells that part for 7000 in cash. He withdraws 2000 in cash for personal needs.

1.9.2

Worked Solution

Action 1Cash 50 000 = Owners equity (OE) 40 000 + Long-term loan (LTL) 10 000.

Action 2Plant and equipment (P&E) 5000 + Factory and warehouse (F&W) 25 000 + Raw material inventory (RMI) 8000 + Cash 16 000 = OE 40 000 + LTL 10 000 + Creditors 4000.

Action 3P&E 5200 + F&W 25 000 + RMI 4000 + Finished goods inventory (FGI) 4400 + Cash 15 400 = OE 40 000 + LTL 10 000 + Creditors 4000. Note that the post-installation lubrication has been capitalised. We can gather from the action that the equipment would not work without this lubrication and so we can add this cost to the original purchase price. Any further maintenance on this equipment would be expensed, i.e. written off against Owners equity.1/16Edinburgh Business School Accounting


Action 4P&E 5200 + F&W 25 000 + RMI 4000 + FGI 2200 + Debtors 4000 + Cash 11 400 = OE 41 800 + LTL 10 000 + Creditors 0.

Action 5P&E 5400 + F&W 25 000 + Motor vehicles (MV) 3000 + RMI 4000 + FGI 2200 + Debtors 4000 + Cash 11 200 = OE 41 800 + LTL 10 000 + Creditors 3000.

Action 6P&E 5400 + F&W 25 000 + MV 3000 + RMI 4000 + FGI 0 + Debtors 100 + Cash 19 000 = OE 43 500 + LTL 10 000 + Creditors 3000.


Action 8No change from Action 7. This action represents personal expenditure and does not affect Freds business records.


Action 10P&E 5400 + F&W 25 000 + MV 3000 + RMI 0 + FGI 7000 + Debtors 3 100 + Cash 11 000 = OE 44 500 + LTL 10 000.

Action 11P&E 4860 + F&W 25 000 + MV 2250 + FGI 7000 + Debtors 3000 + Cash 11 000 = OE 43 110 + LTL 10 000.

Action 12P&E 4860 + F&W 20 000 + MV 2250 + FGI 7000 + Debtors 3000 + Cash 16 000 = OE 43 110 + LTL 10 000.

Accounting


1/17


Prot and loss account for the period to Action 12 Sales Less: Cost of sales Raw materials Labour Depreciation on plant and equipment 8 000 700 540 100 400 750 100 200 9 240 4 660 13 900

Motor repairs Advertising Depreciation on motor vehicles Bad debt Audit Net prot from operations Extraordinary prot from sales of factory (see note) Net prot

Gross prot General expenses

1 550 3 110 2 000 5 110

Note: The sale of a xed asset produces a gain (or loss) when the proceeds received by the business exceed (or are less than) net book value, that is, purchase price less depreciation charged to date. Such gains (or losses) are not part of the normal prots from operations and should be shown separately in the prot and loss account. Balance sheet at the end of Action 12 Fixed assets Factory and warehouse Plant and equipment Motor vehicles Current assets Finished goods Debtors Cash Less: Current liabilities Net assets of the company Represented by: Capital introduced Prot Less: Drawings Owners equity Long-term loan 20 000 4 860 2 250

27 110

7 000 3 000 16 000

26 000

26 000 53 110

40 000 5 110 45 110 2 000 43 110 10 000

53 110

1/18


Accounting


Cash ow statement for the period to Action 12 Sources of cash Prot from operations Adjusted for non-cash items depreciation Capital introduction Long-term loan Sale of factory and warehouse Uses of cash Purchase of assets 3 110 1 290 40 000 10 000

4 400 50 000 7 000 61 400

Factory and warehouse Plant and equipment Motor vehicles Increase in inventories Finished goods Increase in debtors Drawings Closing balance of cash

25 000 5 400 3 000 7 000 3 000

33 400 10 000 2 000 45 400 16 000

1.10 Sole Trader versus MBABusinesses can be set up in a number of forms. Each is different but all use the same accounting equation. 1.10.1

Sole TraderA sole trader like the individual in the example (Actions 1 to 7) can start trading at any time with assets at his disposal. He must, however, distinguish between the transactions that pertain to his business and those that are domestic in nature. For example he would record as business expenditure petrol for his delivery van but his weekly groceries would not go through his books of account. The link between the two would be the drawings or salary he paid himself out of the business prots. In law he has unlimited liability. This means that if a customer or supplier or other person connected with his business sues him for poor workmanship or providing goods which are dangerous, not only are his business assets at risk but so too are his personal assets such as his home and domestic possessions. Because his creditors can pursue him beyond the limit of his business there is no requirement for him to make public his prot and loss account and balance sheet each year. He will, of course, make an annual tax return to the tax authorities and be taxed on his yearly prot.

1.10.2

PartnershipA partnership is very similar to the situation of a sole trader. Here a number of individuals agree to set up business together, bringing to the partnership

Accounting


1/19


assets in varying proportions. Before they start trading they will normally draw up a partnership agreement which sets out, inter alia, how they will share the annual prot. As with the sole trader, a partnership need not make public its annual results because its creditors can pursue the partners beyond the limit of their equity in the partnership. Some worldwide accounting partnerships are facing legal actions from clients which, if successful, may put in jeopardy the continuance of the partnerships. Various defences are currently being mounted by the Big Six including pressing governments to permit proportional liability and limited liability partnerships. 1.10.3

CompanyA company structure avoids the risk of unlimited liability described above by limiting the liability of the owners (called shareholders) to the amount of equity (called share capital) paid into the company. In the event of legal action being taken against the company, shareholders cannot lose any more money than the sum paid for the shares (provided the full face value of the shares has been called up by the company). To protect creditors and others against abuse of this legal privilege companies must make public their annual accounts which must be audited by a registered rm of auditors. This is an expensive procedure and forces disclosure of business activities which sole traders and partnerships do not experience. A companys owners equity is termed share capital and is split into individual shares usually expressed in small units of, say, 1. This small amount is the face value of the share, called the par value, or nominal value (MBAs nominal value is 5 pence). When a company grows in size and number of shareholders, its accounting equation is unaffected by any market transaction in its shares, even though the price struck between buyer and seller is considerably in excess of par value. The company still has access to the original paid-in capital.

1.11 Accounting: The External and Internal FunctionsThe accounting statements depicted in the previous section report the total picture of the rm for an accounting period: total sales, total costs, total prots, and total asset structure. This information is compiled after the accounting period is over and the books of account have been closed. This part of accounting is called nancial accounting or nancial reporting and derives from the legal obligation on directors and managers to report to the owners of the business (the shareholders) how they have used the resources at their disposal during the accounting period under review (usually annual). Most of the needs of the users described earlier are largely satised by the information contained in nancial accounts. One major exception is managements needs. While nancial reporting and an analysis of nancial accounts are important for managers for a variety of decisions they have to make, the information contained therein is of little value in helping them to plan and control the day-to-day activities of the business. The secret of good management lies in predicting the future, in plotting a course today which will steer the business1/20Edinburgh Business School Accounting


through the turbulent seas of uncertainty lying ahead. To enable them to do this, management need detailed and relevant information. From the accounting process they need actual and projected costs and prices of individual products, actual and projected costs of individual departments and individual processes, projected sources and uses of cash, proposals for major investment in plant and equipment, and many other details. This information is called management accounting. The rst seven modules of this course are devoted to nancial accounting for managers; the following nine modules address management accounting for decision making.

Review Questions1.1 There are several views of the role of accounting. (i) (ii) Accounting provides information for decision makers. Accounting demands a high degree of mathematical precision.

(iii) Accounting handles only economic information. (iv) Accounting requires only the mastery of a strict set of rules. Which of the following is correct? (a) (c) (i) and (ii) only. (ii) and (iv) only. (b) (i) and (iii) only. (d) (iii) and (iv) only. 1.2 Accounting information is used by different groups of people for different primary purposes. They are: (i) (ii) shareholders concerned with the level of employee remuneration; managers concerned with the protability of product lines;

(iii) creditors concerned with the companys ability to settle debts on time; (iv) analysts concerned with the companys environmental record. Which of the following is correct? (a) (c) (i) and (ii) only. (ii) and (iii) only. (b) (i) and (iv) only. (d) (ii) and (iv) only. 1.3 Which of the following reects the effects on the accounting equation of a payment to creditors? (a) (c) Assets decrease; owners equity decreases. Assets increase; liabilities decrease. (b) Assets decrease; owners equity increases. (d) Assets decrease; liabilities decrease.

Accounting


1/21


1.4 Which of the following reects the effect on the accounting equation of a sale of nished goods inventory, on credit? (a) (c) Assets decrease; owners equity unchanged. Assets increase; owners equity increases. (b) Assets decrease; owners equity increases. (d) Assets increase; owners equity decreases. 1.5 Which of the following reects the effect on the accounting equation of a purchase of an item of plant, for cash? (a) (c) Assets increase; owners equity decreases. Assets decrease; owners equity unchanged. (b) Assets unchanged; owners equity increases. (d) Assets unchanged; owners equity unchanged. 1.6 Which of the following economic actions reduces the amount of owners equity? (a) (c) A payment of administration wages. A receipt of a loan from the owners brother. (b) A receipt of cash from debtors. (d) A payment for production wages. 1.7 Which of the following economic actions increases the amount of owners equity? (a) (c) A purchase of raw material inventory, on credit. A payment for a motor vehicle. (b) A sale of nished goods, on credit. (d) A payment to creditors. 1.8 Which of the following economic actions increases the amount of current assets? (a) (c) A receipt of cash from debtors. A purchase of raw material inventory, for cash. (b) A purchase of raw material inventory, on credit. (d) A payment to creditors. 1.9 Which of the following economic actions decreases the amount of current assets? (a) (c) A payment for production wages. A purchase of plant, for cash. (b) A purchase of plant, on credit. (d) A receipt of cash, from debtors. The following information applies to Questions 1.10 to 1.22. Action 1 T. Harding & Co. has commenced business with a start-up cash balance of 15 000, comprising the initial owners equity. His rst actions are to purchase a van, costing 5000, for cash; he then acquires 8000 of raw materials inventory, on credit.

1/22


Accounting


1.10 What is the amount of current assets after Action 1? (a) (c) 5000. 15 000. (b) 8000. (d) 18 000. 1.11 What is the amount of owners equity after Action 1? (a) (c) 10 000. 23 000. (b) 15 000. (d) 28 000. Action 2 Plant is purchased at a cost of 4000, on credit, and 200 is paid in wages to the production staff for the conversion of the raw materials into nished goods inventory, half of which is sold for cash of 7000. 1.12 What is the amount of cash after Action 2? (a) (c) 8800. 21 800. (b) 16 800. (d) 24 800. 1.13 What is the amount of xed assets after Action 2? (a) (c) 4000. 9000. (b) 5000. (d) 24 000. 1.14 What is the amount of owners equity after Action 2? (a) (c) 17 900. 27 000. (b) 22 000. (d) 29 900. Action 3 Payment of 5000 is made to creditors. The van breaks down, incurring repair costs of 350, paid for in cash. Depreciation of 400 on plant is to be taken into account. 1.15 What is the amount of nished goods inventory after Action 3? (a) (c) 3700. 4500. (b) 4100. (d) 4850.

Accounting


1/23


1.16 What is the amount of xed assets after Action 3? (a) (c) 3650. 5350. (b) 4400. (d) 8600. 1.17 What is the amount of owners equity after Action 3? (a) (c) 12 150. 18 650. (b) 17 150. (d) 23 650. Action 4 The remaining nished goods inventory is sold for 8500, on credit. Payments of administration wages of 500 are made, together with a further 2000 to creditors. 1.18 What is the amount of cash after Action 4? (a) (c) 8950. 17 050. (b) 9350. (d) 22 450. 1.19 What is the amount of owners equity after Action 4? (a) (c) 14 500. 19 050. (b) 16 550. (d) 21 050. 1.20 What is the amount of current assets after Action 4? (a) (c) 17 050. 17 650. (b) 17 450. (d) 18 000. 1.21 What is the amount of creditors after Action 4? (a) (c) 1000. 5000. (b) 3000. (d) 7900. 1.22 If a prot and loss account were to be prepared at the end of Action 4, what should be the amount of sales? (a) (c) 7000. 8500. (b) 8200. (d) 15 500.

1/24


Accounting


1.23 Which of the following is equal to owners equity? (a) (c) Current assets + Current liabilities. Fixed assets + Current liabilities. (b) Fixed assets + Current assets. (d) Fixed assets + Net current assets. 1.24 Which of the following denes gross prot in a manufacturing company? (a) (c) Sales less Selling costs. Sales less Cost of sales. (b) Sales less Material costs. (d) Sales less Administrative costs. 1.25 Which of the following should be the primary source of cash in the preparation of a cash ow statement? (a) (c) Prot from operations. Increase in creditors. (b) Decrease in debtors. (d) Introduction of capital. 1.26 In which of the following is owners equity divided into individual shares with a nominal value? (a) (c) A university. A company. (b) A partnership. (d) A sole trader.

Case Study 1.1Peter Brown opened his business for trading on 1 January with 25 000 cash from his own resources. During his rst six months of trading, the following economic actions occurred. 1 2 3 4 5 6 Paid six months rent of 2000 for the premises. Purchased equipment for 10 000 and an estate car for 6000. Acquired 8000 of manufacturing materials, on credit, half of which was paid in June. Paid 2000 in manufacturing wages in converting 75 per cent of the materials into nished goods. Sold 60 per cent of the nished products for 12 000, of which only 7500 was received in cash. Paid 600 for ofce staff wages and 300 for petrol.

Further information The equipment is estimated to have a useful life of ve years, and the estate car requires to be depreciated over three years.

Accounting


1/25


Required 1 Prepare the accounting equations after each of these economic actions; include depreciation with Action 6. 2 Prepare a prot and loss account for the six months to 30 June and a balance sheet as at that date.

1/26


Accounting

Module 2

The Prot and Loss AccountContents2.1 2.2 2.3 2.3.1 2.3.2 2.3.3 2.4 2.5 2.6 2.6.1 2.6.2 2.6.3 2.7 2.7.1 2.7.2 2.7.3 2.7.4 2.7.5 2.7.6 2.8 2.9 2.10 2.10.1 2.10.2 2.10.3 2.10.4 2.11 2.12 2.13 Introduction What Is Prot? The Measurement of Accomplishment Time of Sales Orders Time of Production Time of Collection Another Reason for Opting for Ship and Invoice Conventions Underlying Measurement of Sales Accomplishment The The The The Measurement of Effort Matching Convention Allocation Convention Cost Convention 2/2 2/3 2/4 2/6 2/6 2/7 2/8 2/9 2/10 2/10 2/11 2/11 2/12 2/12 2/13 2/13 2/14 2/14 2/15 2/16 2/17 2/18 2/18 2/19 2/19 2/20 2/20 2/22 2/23 2/23 2/27 2/32

Task One: Determining the Consumption of the Means of Production Use of Raw Materials Labour Depreciation of Fixed Assets Method 1: Straight-line Depreciation Method 2: Reducing Balance Depreciation Method 3: Consumption Method Task Two: Determining the Value of Closing Work-in-Progress and Inventories Types of Inventory in a Manufacturing Company Inventory Valuation Methods First In, First Out (FIFO) Last In, First Out (LIFO) Average Method Which Method Should Be Chosen? Valuation of Work-in-Progress and Finished Goods Interpreting Prot Summary

Appendix 2.1: The Impact of Changing Money Values Review Questions Case Study 2.1

Accounting


2/1

Module 2 / The Prot and Loss Account

Case Study 2.2 Case Study 2.3

2/32 2/33

Learning ObjectivesBy the end of this module you should understand: the role of the prot and loss account in the measurement of corporate accomplishment and effort; the timing of revenue and expense and the role of accounting conventions; the impact on prot of different stock valuation methods and depreciation methods; the principal features of depreciation; the distinction between product costs and period costs; the implications of gross prot and net prot.

2.1

IntroductionIn Module 1, three nancial statements were drawn up at the end of the sole traders Action 7, his balance sheet, prot and loss account and cash ow statement. Over the next two modules we shall be examining these statements in greater depth so that readers are aware of: where the underlying information in these statements comes from; the conventions employed by accountants in constructing the statements; and the various techniques used to measure aspects of business activity.

A word of warning: although the material has been split up over two modules, readers should not think that the techniques of measuring prot (the subject of this module) can be divorced from those surrounding the valuation of assets and liabilities (the subject of Module 3). The two issues are closely related (remember: the prot and loss account is a more detailed picture of all activities which affect owners equity in the balance sheet) and there will be considerable overlap between the two modules. For ease of reference the prot and loss account and balance sheet of the sole trader encountered in Module 1 are reproduced below:

2/2


Accounting


Profit and loss account for the period to Action 7 Sales Less: 750 Cost of sales Materials Labour Depreciation 500 20 50

Gross profit Less: Selling and administrative costs Advertising Salaries Net profit

570 180

10 10

20 160

Balance sheet at the end of Action 7 Fixed assets Plant and equipment at cost Less: Depreciation Current assets Stocks Debtors Cash

50

12 000 11 950

5 500 750 4 960 11 210 3 000 8 210 20 160

Less: Current liabilities Creditors Net assets of the companyRepresented by: Capital introduced Profits earned Owners equity

20 000 160 20 160

2.2

What Is Prot?A glance at the prot and loss account will reveal that prot is the difference between the sales which the enterprise made during the period under review and all the costs which had been incurred to bring the goods sold to the market place ready for sale. These costs include: (a) the direct costs of manufacture or preparation (the purchases of raw materials used, the wages of the workforce involved in the transformation process, and the costs of using up the equipment, namely depreciation); and (b) the indirect costs (advertising and salaries of service support staff).

Accounting


2/3


For many managers of companies and other prot-seeking organisations, prot serves as the prime indicator of overall effectiveness. The problems faced by accountants and managers in measuring the components of prot need to be examined closely. The main purpose of the prot and loss account is to show the results of the transformation process over a given period, such a process being dened as the functions which are necessary to convert raw materials into a saleable product. The chain of functions could be described as shown in Figure 2.1.

Sale Storage Transformation

Accomplishment: Revenue less Efforts: Costs

Storage

equals

Purchase

Profit

Figure 2.1

Accomplishments less Efforts

The result (prot) of the entire transformation process over a given period can be viewed as the difference between: (a) a measure of accomplishment (what has been achieved in sales); and (b) a measure of effort (what these sales have cost).

2.3

The Measurement of AccomplishmentWhat can be considered as a measure of accomplishment in the transformation process in an accounting period? A simple example can be used to consider this question.

Example Total production for one accounting period of Product ABC: 300 units. Number of Product ABC shipped and invoiced to customers: 250 units.

The difference between the two measures is the units of products which have been produced but not yet sold at the end of the period: these units of product would be stored in the warehouse.

2/4


Accounting


In the prot and loss account, accomplishment for the accounting period is measured by the number of products shipped and invoiced to customers during the period. The events of shipping and invoicing the products are viewed as being critical in measuring accomplishment because at this time, and not before, the business can be reasonably certain that the customers have accepted the products and thus are liable to pay for them. The main reason for not taking total production as a measure of accomplishment is based on the consideration that normally the company cannot be sure that nished products in the warehouse will be accepted by customers in the future. And even if there is no doubt about the sale in the future, often the selling price which can be obtained is not known with certainty. The 50 units of nished product left in the warehouse may be monochrome monitors for a personal computer the latest version of which boasts a colour graphic screen. If the 50 units were to sell in the future surely an unlikely event the sales price would require to be reduced. While the measure of accomplishment described above can be applied by all companies, different measures are used in practice, depending on the specic circumstances in which operations take place. 1 The measurement of accomplishment in a South African gold mine is often viewed as occurring at the point the gold is extracted from the rock simply because the world demand for gold is so buoyant that the mining company can be assured of selling it within a predictable price range. For an ice cream seller, a sale occurs when the customer hands over his money in return for an ice cream cone. The vagaries of weather make an earlier recognition of accomplishment unwise!

2

Accomplishment is generally measured at the rst point in the operating cycle at which all the following conditions are satised. 1 2 The principal revenue-producing service has been performed, i.e. the product has been made and delivered against a rm order. All costs that are necessary to create the revenue have either been incurred or, if not yet incurred, are either negligible or can be predicted within an acceptable degree of accuracy. The amount ultimately collectable in cash can be estimated within an acceptable range of error. Remember that, as we saw in the case of the sole trader in Module 1, the cash does not necessarily have to be received.

3

The justication of the shipping and invoicing measure of accomplishment is simple: in most cases it is the rst point in the cycle at which all three criteria are met and reects what management have achieved by way of sales, not what they think they might achieve. Such a measure, although the most popular, need not be used if some other recognition basis meets the criteria better. Three other possible choices need to be examined briey.

Accounting


2/5


2.3.1

Time of Sales OrdersAsk a sales rep when a sale occurs and the answer will be, When I receive an order. This reects not only an intuitive understanding of a measure of his accomplishment but the method by which his performance is assessed by his superiors the more orders he books, the better job he has done. But in some businesses there exists a delay between order and shipment (perhaps due to the manufacturing process) during which time the customer can change his mind or change the specication. And the business incurs costs which are not predictable at the time the order was received.

ExampleA knitwear company received an order to supply high-quality sweaters to the Britain/Europe Ryder Cup golf team for their next match against the USA. A rm order? Yes. A customer who will pay? Yes. Certain production costs? No. The world price of cashmere is volatile and may change signicantly between order and delivery. Orders would only be recognised as a measure of accomplishment if: (a) the goods which are ordered are in inventory when the order is received, (b) all major costs have already been incurred, and (c) the number and timing of cancelled orders are known not to vary signicantly. These conditions are likely to hold only when the interval between order receipt and shipment is so short that the distinction is of no practical importance.

2.3.2

Time of ProductionConsider a business that devotes its entire attention to manufacturing in one accounting period, that is, building up inventories but making no sales. In the next period the position is reversed; it does no manufacturing but sells the entire inventory that had been built up in the preceding accounting period. The danger of recognising accomplishment in period 1 is clear the sales may never materialize. It is a more accurate reection of economic reality that the business records the costs in storage for period 1 (i.e. the inventory of nished goods) in the balance sheet for period 1. In period 2 these costs are moved into the prot and loss account of period 2 as cost of sales to be set off against the revenue generated from sales. However, in some industries like shipbuilding, civil engineering and construction, the time of production is used for recognising accomplishment when no signicant amount of services is required following the production effort, when the amount of collection is reasonably certain and when the timing of shipping is more uncertain than the timing of production.

ExampleXY Construction plc is in the process of building a bridge linking two Scottish Hebridean islands. The job will take two years. At the end of the rst year, which is the same date as the companys nancial year-end, one-third of the contract of 12 million had been completed, although the client had paid only one-sixth, namely,

2/6


Accounting


2 million. The company expected to make 3 million prot on the bridge and at the end of Year 1 costs were being incurred on a predictably even basis. How many sales and prots should XY recognise at the end of Year 1? Observe that: 1 2 One-third of the contract, namely 4 million, could be deemed to be sales in Year 1 provided this proportion could be conrmed by an independent surveyor. Total costs anticipated by the company are 9 million; one-third of 9 million is 3 million.

AnswerProvided the payment to account of 2 million is not indicative of a difculty in paying on the part of the client, it would be acceptable to record sales as 4 million and cost of sales as 3 million at the end of Year 1; prot 1 million. Because only 2 million had been received by the year-end the balance of sales revenue, i.e. 2 million, would be recorded in XYs balance sheet as a debtor. In Year 2, XYs sales would be 8 million and cost of sales 6 million, giving a Year 2 prot of 2 million. Using the timing of production method of measuring accomplishment allows XY plc to record prot in both years of the contract rather than to wait for its completion in Year 2. Although readers need not concern themselves with the various rules accountants have developed to implement the production basis for measuring accomplishment, it is important to appreciate that it is applied only when the company is producing to an order, not in the hope of getting one.

2.3.3

Time of CollectionEven when goods are shipped and invoiced there are occasions when the market is such that the likelihood of receiving payment cannot be predicted accurately, so the critical point becomes the time of collection. For example, many companies sell large items of merchandise (such as cars, TV sets, video and hi- equipment) on instalment plans. The usual provisions of an instalment plan are: (a) a relatively small down payment is required; (b) the payment period is long and requires monthly or weekly payments of principal and interest; and (c) the seller retains conditional title to the goods. The effect of these provisions is that there is a relatively high risk of reclaims of the merchandise because of non-payment. In such circumstances revenue is recognised as the cash is collected; the costs of the merchandise sold on instalment contracts are carried in inventory in the balance sheet and transferred to cost of sales in the prot and loss account in proportion to the amount of the payments received.

Accounting


2/7


When Is a Sale a Sale?1. Enquiry Too early order may not emerge.

6. Cash received Unnecessarily late unless there is evidence that customer won't pay for goods.

5. Invoice About right goods are normally invoiced at the time of shipment.

2. Order Too early costs too uncertain; customer may walk away before delivery.

4. Ship

3. Inventory of finished goods Too early unsold goods may never sell. Also, the ultimate sales price may be unknown.

Figure 2.2

A typical manufacturing cycle

2.4

Another Reason for Opting for Ship and InvoiceConsider the example given in Module 1: The sole trader recorded sales during the period of 750. All sales were on credit, that is, he received no cash for them at the time of sale. By the time the accounts were drawn up at the end of Action 7 no customers had paid for the goods. On the understanding that the trader is condent that all customers would pay for the goods within the agreed credit period (e.g. 30 days after sale), the business recognises the full gure of 750 as the measurement of accomplishment at the end of Action 7, that is the outcome of the economic effort which has been expended during the period. Were the business to delay recognition of sales to the next period when the cash would have been received, then the measurement of accomplishment in the second period would be a mixture of: (a) sales made in the second period and paid for in the second period; and (b) cash of 750 received for sales made in the rst period, and would thereby fail to measure accomplishment correctly in either of the two periods.

ProblemA manufacturer of sports bags supplies major retail sports outlets. The relevant gures for production and sales for one year are as follows: Orders received during the year by the manufacturers sales force Sports bags manufactured Sports bags shipped and invoiced Faulty bags returned and not yet repaired How many sports bags were sold during the year?2/8Edinburgh Business School Accounting

15 000 10 000 12 000 1 000


Comment and Answer1 Orders are buoyant but have not yet been satised. Although the gure of 15 000 can be used to measure the sales forces performance during the year, and to gauge the backlog build-up between orders and production output, it cannot be used to measure accomplishment. Dont forget, the customers could walk away at any time (change of mind or change of supplier) if their orders are not satised on time, and we dont know what the loss would be. The gure of 10 000 bags manufactured again fails to portray economic reality, which is that 2000 bags have been drawn from inventory (last years unsold production) to satisfy the orders actually shipped. Therefore the best measure of accomplishment for the year is 12 000. But because 1000 bags have been returned as faulty the retail sports outlets will not have paid the manufacturer for these goods the gure of 12 000 must be reduced by 1000. Sales will be recorded for the year at 11 000 bags, each valued at the selling price charged by the manufacturer to the retailer. The 1000 faulty bags will be returned to inventory or written off.

2

3

2.5

Conventions Underlying Measurement of Sales AccomplishmentAccounting is a series of techniques and procedures which have been developed by accountants over many years. We call them conventions. Two such conventions are adopted in measuring the sales gure: 1 The realisation convention: Only products that have been sold are measured as sales. Products which are completed or partially completed and have not realised value for the business are not included. The accruals convention: Cash does not have to be received to create value; an obligation from a creditworthy customer is good enough to be called a sale. The accruals convention also covers the situation where a sole trader, or company or any other entity pays an invoice for a product or service which covers a period stretching beyond the date he/she draws up the nancial statements. For example, if he pays his annual insurance premium on his assets on 1 October 20x1 for the following 12 months and draws up accounts on 31 December 20x1, the prot and loss account for the year would include only three months worth of this premium (and presumably nine months worth of the premium paid on 1 October 20x0), and the balance sheet would record the nine months balance of premium not recognised in the prot and loss account as a current asset called Prepayments. Similarly, where the sole trader pays his property tax in arrears annually on 1 March 20x2, he would accrue two months worth of the expected payment at 31 December 20x1. That is, he would pretend he had paid it so that his prot and loss account for the year to 31 December 20x1 would reect the time consumption of resource in the 12 months of the accounts and the balance sheet would show this ten months unpaid tax as a current liability called Accruals.2/9

2

Accounting



2.6

The Measurement of EffortProt equals the measurement of accomplishment (sales) minus the measurement of effort (costs). The measurement of effort is governed by three conventions, namely the matching convention, the allocation convention and the cost convention.

2.6.1

The Matching ConventionProt is arrived at by matching the effort (or costs) with the units shipped and invoiced to the customers (sales) during the period. Identifying the costs of the units sold is not so easy as it sounds because the volume of units manufactured in any accounting period seldom equals the volume of units sold. When production volume exceeds sales volume, or when it is smaller than sales volume, the efforts of the period are not equal to the efforts linked to sales. In these situations the inventory of work-in-progress and/or nished goods is added to, or dipped into. Consider the following examples.

Example(a) When sales volume exceeds the volume of units produced for a period (as in the sports bag example but ignoring faulty goods): Sales for year Cost of sales: (a) Costs of manufacturing Plus: (b) Costs attaching to bags taken from nished goods inventory Bags 12 000 10 000 2 000 12 000

(b) When production volume exceeds the units sold (reverse the numbers of the sports bag example, i.e. sold 10 000, made 12 000): Sales for year Cost of sales: (a) Costs of manufacturing Less: (b) Costs attaching to bags put into nished goods inventory Bags 10 000 12 000 2 000 10 000

2/10


Accounting


Without the matching convention the effort of producing 12 000 bags would be set against the accomplishment of selling 10 000.

What is meant by efforts? Efforts are all the costs involved in producing saleable products, and the costs involved in actually selling the products which are recognised in the measurement of sales accomplishment. Some typical costs of production: raw materials labour depreciation of production plant and machinery overheads directly related to the production cycle. Typical costs of selling and administration: advertising and promotion packaging and distribution staff salaries non-production overhead expenditure research and development. 2.6.2

The Allocation ConventionThe rst task is to determine how much of each means of production, expressed in money terms, was consumed during the accounting period, that is, the companys total purchases of means of production (e.g. raw materials, power, wages of production workers) have to be allocated over the accounting period. (This process is known as cost determination and recognises that not all purchases made during the period are consumed by production.) The second task is to determine how much of each means of production, again expressed in money terms, should be matched with sales revenue and how much should be added to the closing work-in-progress (inventory of unnished goods) and to the inventory of nished goods (on the assumption that goods remain unnished at the end of the accounting period and that the business produces more nished units than it sells). It will be noted that the second task is similar to the procedures adopted under the matching convention.

2.6.3

The Cost ConventionIt was stated above that the means of productio

accounting mba eb

Documents