audit article

8/2/2019 Audit Article

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If theres one area of the F4

syllabus that students appearto struggle with, its the tortof negligence. (For Paper F4(SCT) a tort is a delict.) Theexaminers reports indicate thatstudents do not understand thesubject very well in particular,the various elements that aclaimant must prove in orderfor the defendant to be found

negligent. This article addresseseach of the key elements in turn,but we begin with an explanationof why tort developed.

Torts are legal wrongs thatone party suffers at the handsof another. Negligence is a formof tort which evolved becausesome types of loss or damageoccur between parties that have

no contract between them, andtherefore there is nothing for oneparty to sue the other over.

In the 1932 case of Donoghuev Stevenson, the House of Lordsdecided that a person should beable to sue another who causedthem loss or damage even if thereis no contractual relationship.Donoghue was given a bottle

of ginger beer by a friend, whohad purchased it for her. Afterdrinking half the contents, shenoticed that the bottle containeda decomposing snail and sufferednervous shock as a result. Undercontract law, Donoghue wasunable to sue the manufacturerbecause her friend was party tothe contract, not her.

However, the House of Lords

decided to create a new principleof law that stated everyonehas a duty of care to theirneighbour, and this enabledDonoghue to successfully sue themanufacturer for damages.

Lets consider a hypotheticalcase and use it to demonstratehow the tort of negligence works.

Harry is involved in an accident

in which his car is hit by onedriven by Alex. As a consequenceof the accident Harry breaksa leg and is unable to work fortwo months. Can Harry sue Alexfor damages?

On the face of things theanswer seems obvious. Harrywas injured as a result of Alexdriving into his car and so it

seems fair that he should beable to sue him. However, thinkof the situation from Alexspoint of view, is it fair that Harryshould be able to sue him justlike that? People have accidentseveryday should they all beable to sue each other for everylittle incident? If they are thenthe courts would be overwhelmed

with cases.Thankfully, in order to provenegligence and claim damages,a claimant has to prove anumber of elements to the court.

These are:

the defendant owed them aduty of care the defendant breached that

duty of care, and they suffered loss or damage

as a direct consequence ofthe breach.

Even if negligence is proved, thedefendant may have a defence

that protects them from liability,or reduces the amount ofdamages they are liable for.

Eemet 1 Te ty creAs we saw earlier, the conceptof a duty of care was createdin the Donoghue case. TheHouse of Lords stated that everyperson owes a duty of care to

their neighbour. The Lords wenton to explain that neighbouractually means persons soclosely and directly affected bymy act that I ought reasonablyto have them in contemplationas being so affected. This isa very wide (and complicated)definition that could includealmost anyone if still in

operation today the courtswould most certainly be overrunwith cases.

The later cases of Anns vMerton London Borough Council(1977) and Caparo Industries plcv Dickman (1990)restricted thedefinition a little by introducingproximity and fairness.

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Proximity simply means that

the parties must be sufficientlyclose so that it is reasonablyforeseeable that one partysnegligence would cause loss ordamage to the other. Fairnessmeans that it is fair, just andreasonable for one party to owethe duty to another.

What does this mean for Harry?I think youll agree that Alex

owes him a duty of care. There issufficient proximity (ie Alex droveinto Harrys car); it is reasonablyforeseeable that a collisionbetween the cars could causeHarry some injury, and it seemsfair, just and reasonable for Alexto owe a duty of care to Harry(and indeed all other road users).

Eemet 2 brec ty creIn many cases brought before thecourts it is evident that a duty ofcare exists between the defendantand the claimant. The real issueis whether or not the actions ofthe defendant were sufficient tomeet their duty. To determine this,the court will set the standard ofcare that they should have met.

This standard consists of theactions which the court considersa reasonable person would havetaken in the circumstances. If thedefendant failed to act reasonablygiven their duty of care, then theywill be found to have breached it.

negligenceThis reasonable standard

may be adjusted given the actualcircumstances of the case.For example, if the claimantis vulnerable, such as beingdisabled or frail, it is reasonableto expect the defendant to havepaid them special attention ortaken extra care over them ascompared to someone who is fitand healthy.

Other circumstances whichmay be taken into accountinclude whether: The actions the defendant

took are in line withcommon practice or industryrecommendations. If theywere, then it is likely that thedefendant will be found tohave met their duty unless

the common practice itself isfound to be negligent. There was some social benefit

to the defendants actions.If there was, then the courtmay consider it inappropriatefor them to be found to havebreached their duty.

The defendants actions had ahigh probability of risk attached

to them. If they did, then thecourt will expect them to showthey took extra precautions toprevent loss or damage.

There were practical issuesthat prevented reasonableprecautions being taken, orunreasonable cost would havebeen involved in taking them.If there were, then the court is

unlikely to expect the defendantto have taken them in order tomeet their duty of care.

The defendant is a professional

carrying on their profession.If they were, then the courtwill judge their actions againsta reasonable professional intheir line of work, rather thanjust any ordinary person. Ifprofessional guidelines arein place then the court willjudge the defendants actionsagainst these rather than its

own expectations.

Back to the case of Harry andAlex. In determining whether ornot Alex broke his duty of care,a court will consider whether ornot, given the circumstances,he drove as a reasonable personwould have. For example, if itwas foggy or wet at the time,

he would be expected to showthat he drove cautiously. Indetermining whether Alexsactions were reasonable, evidencemay have to be taken fromwitnesses and expert analysis ofthe crash may be required. Fornow, lets assume Alex was notdriving reasonably.

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Res ipsa loquiturIn extraordinary cases, the factsmay be so overwhelmingly infavour of the claimant that thecourt decides the defendantshould prove that they were notnegligent. The legal term for thisis res ipsa loquitur(meaning thefacts speak for themselves). Itapplies in circumstances wherethe cause of the injury was under

the control of the defendantand that the incident would nothave occurred if they had takenproper care. It is often appliedin medical cases, for examplein Mahon v Osborne (1939), asurgeon had to prove it was notnegligent to leave a swab insidea patient.

Eemet 3 lss r mge s rest te recIn this element the claimantsimply has to prove that theloss or damage was a directconsequence of the defendantsbreach of duty of care. In otherwords that there is a chain ofcausality from the defendantsactions to the claimants loss or

damage. A simple test, called thebut for test is applied. All theclaimant has to prove is that ifit were not but for the actionsof the defendant then theywould not have suffered the lossor damage.

Where there is more thanone possible cause of the lossor damage, the defendant willonly be liable if it can be provedthat their actions are the mostlikely cause.

A good case which illustrateshow the but for test operates isBarnett v Chelsea and KensingtonHMC (1969) another medicalcase. A casualty department

doctor negligently sent a patienthome the patient died. However,the doctor was not found liablefor damages because the patientwas suffering from arsenicpoisoning and would have died nomatter what the negligent doctorcould have done.

The loss itself must not betoo remote. It is an important

principle that people should onlybe liable for losses which theyshould have reasonably foreseenas a potential outcome of theiractions. The Wagon Mound(1961)is a case often cited inexplanation of this principle. Oilleaked out of the defendantsboat within Sydney harbour andcame into contact with some

cotton waste which had falleninto the water. The oil was of aparticular type which would notforeseeably catch fire on water.However, the cotton ignited andthis in turn set the oil ablazecausing damage to the claimantswharf. The defendants were notfound liable for fire damage asthe actual cause of the fire was

held too remote.

novus actus itervieiesOther events, which are outsidethe control of the defendant, mayintervene in the chain of causality

adding some confusion to theoutcome of a case. The goodnews is that there are somesimple rules to remember thatdeal with them.

At all times you should bearin mind that the defendant will

only be liable if their actionsare the most probable cause ofthe loss or damage. They willnot be liable if an interveningact becomes the real cause.Examples of intervening actswhich remove liability from thedefendant include: Actions of the claimant which

are unreasonable, or outside

what the defendant could haveforeseen in the circumstances. Actions of a third party which

become the real cause of theloss or damage. The defendantis only liable for damages upuntil the point when the thirdparty intervened.

Unforeseeable naturalevents natural events which

the defendant could havereasonably foreseen do notaffect things.

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Lets return to Harry and Alex.It is entirely possible for theaccident to be caused by athird party driving into Alex,forcing him into Harry. It is alsopossible that Harry himself wasan intervening factor maybe hewas driving erratically. Either ofthese factors could mean thatAlexs breach of duty is not thereal cause of Harrys injuries.

For now, lets assume that nothird party is involved and thatany actions Harry took are notenough to take the blame for thecause of the accident away fromAlex. The court will thereforefind Alex liable for negligenceto Harry.

deeces

There are two defences adefendant can use where theyare found liable for negligence.One will exonerate themcompletely; the other reducesthe level of damages they areliable for.

Volenti non fit injuria simplymeans the voluntary acceptanceof the risk of injury. If adefendant can prove the claimantaccepted the risk of loss ordamage, they will not be liable.Acceptance can be express(usually by a consent form beingsigned) or implied through theclaimants conduct.

Contributory negligencetakespart of the blame away from thedefendant if it can be proved theclaimant contributed in someway to their loss or damage. Thedefendant is still liable, but willface a reduced damages payout.

In Harry and Alexs case, volenti isnot an issue in no way did Harry

consent to the accident. However,if his actions contributed in someway to his injuries, maybe by notwearing a seatbelt, then he mayfind the amount of damages hereceives is reduced.

use cses exm swersFinally, a brief word about usingcases in exam answers. Students

are often concerned about howmany cases they should quote,or what happens if they cannotremember a case name. Thesimple fact is that students failthis exam because they do notknow the law not because theycannot remember a case name.

My advice on cases is:1 Get to grips with the

principles of law first, thenlearn case names if you havetime. By learning the lawyou will probably find thatyou remember the majorcases anyway.

2 Dont try to learn every casein your textbook the majorityare there to illustrate how the

law was applied in a particularset of circumstances. Instead,go for the major ones in eachsyllabus area and learn those.

3 All you need to learn is thecase name and the principleof law it created you do notneed to learn and regurgitateall the background to the casein the exam.

4 If you forget a case namein the exam, dont let thisstop you from explaining theprinciple of law, just write In acase it was decided thatand continue with the principle.

As an example, considerthis article only six caseswere mentioned. See if you can

remember their names.

Stephen Osborne is a technicalauthor at BPP Learning Media

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It is not uncommon to seestudents recoil in horror atthe mention of Paper F5,Performance Management. Thepurpose of this article is toidentify the reasons why sittingthe Paper F5 exam seemsto cause such a problem forstudents and try and improveperformance in the future.

As you are aware, Paper F5builds on the blocks of knowledgegained from sitting the Paper F2exam. Although the pass rates for

Paper F2 tend to be on the lowside when compared with someof the other Knowledge papers,they are still significantly higherthan the Paper F5 pass rates.Therefore, although poor passrates could be blamed on thefact that Paper F5 covers an areathat most ACCA students have noexperience of and find it difficult

to relate to, the same could besaid of Paper F2. Why then,does Paper F5 seem to invokesuch fear and poor performancefrom students?

One of the reasons why I thinkthe problem arises is because theSkills papers, of which Paper F5is one, are often the first timethat students have had to tacklewritten questions. No longer is itsufficient to simply learn materialand churn out calculations. Withthe Knowledge papers, abilityto write clearly and set outworkings logically and neatlyis not required; the papers arein the form of sets of objectivetest questions. Instead, the skills

involved become fourfold, withcandidates being required to doall of the following: correctly interpret requirements actively read sometimes

scenario-based questions,highlighting the informationthat is relevant for each part ofthe requirement

use that information to perform

calculations that are carefullystructured and clearly set out,with all workings shown in aneasy-to-follow layout

write accurately and coherently,using simple English ratherthan long, rambling sentencesthat have no structure and noreal content.

Another reason why problemsarise is because candidates donot take the time to understandthe differences between PaperF2 and Paper F5. Some subjectareas are obviously included inboth syllabuses, but you canbe sure that where subjects arerepeated in Paper F5, the skillsrequired of you are over andabove the knowledge requiredin Paper F2. (Read the January2010 issue of Student Accountantto read an article explaining the

differences between Papers F2and F5.)I am going to concentrate on

a brief step by step approachto the exam on the day and thenon a more detailed explanationof how you should interpretall the different instructionscontained within questionrequirements. The points made

in this article about interpretingrequirements in questions areequally valid for interpretingthe depth of the Paper F5 StudyGuide which is attached to theSyllabus, since this too is writtenin terms of instructionssuch as discuss, describe andso forth.

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your confidence up so that youperform your best.When it comes to answering

the question, be sure that you arestrict with your time allocation.If you are spending too long onone question, it is either becauseyou cant do it anyway (in whichcase move on and come backto it later) or you are saying too

much and going beyond what theexaminer expected of you. Howmuch an examiner expects youto write is directly linked to themarks available and therefore thetime available.

writtenpaper F5

To spend half an hour, forexample, on Part (c) of aquestion, which is only worthfive marks is madness: theexaminer expected you to spendnine minutes on it. As well asallocating time to individualquestions, you should allocatetime to individual requirementsin questions.

In the reading time, youshould get a chance to have agood look at the requirementsof all five questions. Remember:

the requirement should alwaysbe the first thing that you look atin a question. What is the pointin reading a question if youdont know what you are lookingfor? When you read each part ofthe requirement, underline thecontent what the questionis about, for example targetcosting, and the instruction

what it is telling you to do. Thishelps you to focus your mind onanswering the actual questionrather than answering what youthought the question was goingto ask you.

As regards the content, youhave either studied the areaand can tackle it, or not. Thisinstruction could be a wholevariety of verbs ranging fromnumerical requirements suchas calculate, produce, deriveand apply; or more wordyrequirements such as describe,interpret, outline, compare,identify, discuss, explain,evaluate, suggest and justify.The possibilities are endless andthe one thing you can be sure of

is that the verb used has beencarefully thought about by theexaminer, obviously taking intoaccount any restrictions imposedby the syllabus. If you dont readand understand the instructioncarefully, then you will find thatyou are not actually answeringthe question. If you are notanswering the question, then

you are not earning marks. Forexample, being asked to justifythe use of target costing asopposed to traditional absorptioncosting is different frombeing asked to explain targetcosting. Each of the commonexam instructions are dealtwith below.

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answeRingnumeRiCal QuestionsCc rSome instructions are easierto understand than others.For example, there can be noconfusion as to what the wordcalculate means; if you areasked to calculate a number,you just have to work it out.Similarly, derive should poselittle problem. In the contextof Paper F5, you might haveto derive an equation showingthe relationship between priceand quantity or derive a targetcost for a product. Being ableto derive a figure sometimesrequires more than simply beingable to calculate a figure, asa candidate may have to usetheir powers of deduction toderive something. However,the mechanics of deriving orcalculating would actually bevery similar in most cases.

eIf a question asks you toestimate a figure it suggeststhat the answer cannot becalculated with certainty. Forexample, if you are asked toestimate the time taken toproduce a batch of items wherean 80% learning curve has beenshown to exist, you are makingan estimate rather than an exactcalculation. This is due to thefact that the learning rate itselfreflects what a business THINKSwill happen but it is not certainuntil it has happened. Onceagain, however, as with a deriveinstruction, the mechanics ofestimating are much the sameas calculating. There is a setapproach to the question (tabularor algebraic, in the case oflearning curves).

Why, then, do candidatesoften still perform poorly on thenumerical parts of the PaperF5 exam paper? In my opinion,poor numerical answers oftenarise merely as a result ofcandidates failing to study thewhole syllabus well enough in the

first place. Anyone who thinksthey can question spot examquestions for a particular sitting,based on topics that have beenexamined or not examined inrecent papers, is sadly mistaken.Certain publications publish toptips which should most certainlybe ignored.

If exam papers were thispredictable, they would notbe a true test of candidatesknowledge as students wouldthen simply be able to learndistinct areas of the syllabusand ignore the rest. Study allof the Paper F5 syllabus oryou are not giving yourself areal chance.

The other reason whycandidates score poorly onnumerical questions is becausethey approach the question ina disorganised fashion, withno logical progression throughthe calculations and no clear,numbered workings. Youshould go into the exam witha metaphorical managementaccounting toolbox, full ofall the tools that are going tohelp you answer the questions.So, for example, if it is alinear programming question,go in your toolbox and pullout your five-step guide forlinear programming: define the variables state the objective function state the constraints

draw the graph find the solution.

To give another example, if itis a pricing question that canbe solved algebraically, pullyour pricing tool out of yourmanagement accounting toolboxand follow your five-step guide:

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establish the demand function:P = a - bQ

establish marginal cost state marginal revenue by

doubling the gradient, b equate marginal cost and

marginal revenue to findoptimum quantity

substitute quantity into thedemand function to findoptimum price.

The problem with Paper F5 isthat students go into the examwith only a few tools in theirbox. If you put the work in, youwill reap the rewards.

answeRingwoRdy QuestionsRequirements that necessitatecandidates writing in a coherent,organised manner are also a bigissue in Paper F5. Candidatesare not penalised for the factthat English may be their secondlanguage, and I do not think it isthis that causes the real problem.The issue is often that candidatesappear unable to grasp what towrite and how much to write,ie they dont understand theinstruction. Further clarificationof all the main instructions youwould expect to find in a PaperF5 exam is given below.

dcrbWhen you are asked todescribe something you areexpected to give some sort ofnarrative about it. For example,if you were being asked todescribe suitable non-financialperformance indicators for ahospital, you would be expectedto describe indicators such asnumber of patient complaints,bed occupancy rate, numberof admissions per employee.It would not be enough to merelylist these indicators. Youwould have to go a step furtherand describe how they mightbe calculated. As always, youshould be guided by the markallocation in deciding how muchtime you spend answering therequirements and therefore whatlevel of detail you should go into.

irprWhen you are asked to interpretsomething, for example, thebalanced scorecard approach,you are being asked to explain theapproach in your own words andgive your opinion about it. It isquite a high-level requirement thatwill usually be reflected with highermarks than, for example, outline.

oAs suggested previously, this isquite a straightforward, low-levelrequirement. An outline shouldbe fairly brief and well organised.It is simply an overview, withoutthe level of detail that wouldbe required by the describeinstruction, for example. Sinceit requires less detail, you couldbe asked to outline a biggertopic than you would have timeto describe. In Section C ofthe Study Guide, you are askedto outline the objectives ofa budgetary control system.This is something that couldbe discussed at length but theStudy Guide is clear in that it onlyexpects your knowledge to besufficient enough to outline.

CprThe instruction comparerequires you to discusssimilarities between two or morethings and draw conclusions.For example, if you are askedto compare product costs usingactivity-based costing as opposedto traditional costing, you needto say why the costs are different.This will involve looking in detailat the activity-based costs andascertaining the reason why theoverheads absorbed into oneproduct are, for example, higherunder activity-based costing thantraditional absorption costing. Inthis kind of question, comparingneeds to be preceded by a degree

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iThis means to pinpoint andlist. It can be quite a simplerequirement, requiring knowledgerather than skill. For example,in the Study Guide, it statesthat candidates must be ableto identify and explain theinterrelationship betweenprice, mix and yield. Thissimply requires candidates tounderstand what the relationshipis and then state it and explainit. Sometimes, however,candidates may have to identifypoints from within a questionscenario, and this can be a moredemanding requirement becauseit requires more skill.

dcThis is a higher level skill andrequires a candidate to givetheir own thoughts on a subject,supporting it with facts andlogical reasoning.

For example, you could beasked to discuss the effectthat variances have on staffmotivation. You would need todiscuss the fact that they canbe demotivational, for example,if they lead to managers beingassessed for cost increases thatwere beyond their control. Thematerial price variance maybe adverse but this could bebecause the market price formaterials increased. This will bedemotivational unless the pricevariance is broken down into its

controllable and uncontrollableaspects, ie planning andoperational variancesare calculated.

The opinions you give inany discussion must be soundand well reasoned. It is nogood saying that variances aredemotivational without explainingwhy. Also, you are expected tolook at both sides of the story.The discuss instruction isalways a good test of candidatesreal understanding.

expThis means that you need togive a reason for something;say why it is as it is rather thanjust stating that it is. It is avery common requirement andappears many times in the StudyGuide. It requires understandingas well as knowledge.

eThis requirement would notbe expected to arise much inPaper F5. Most of the evaluationwork is reserved for Paper P5.If you are asked to evaluatesomething, you are being askedto decide on the merits of it. It ismost definitely a higher level skill.

sThe use of the word suggestitself suggests that there maybe more than one answer to thequestion being asked. It meansgive a suitable idea or solution,bearing in mind that there willprobably be more than one. Forexample, you might be asked tosuggest how a target cost gap

can be closed. Your answer couldonly ever be a suggestion as therewill be many possible ways toclose a cost gap.

JWith this requirement, you needto tell the reader why a particularanswer or position makes sense.For example, if you had to justifythe use of backflush accountingwithin an organisation, you wouldhave to mention the relativeimmateriality of inventorybalances, presuming this wasin fact the case (otherwise youwould struggle to justify the useof backflush accounting in thefirst place).

ConClusionTo conclude, the step up fromPaper F2 to F5 is a big one, with asudden need for clarity of writingand understanding of instructionswithin requirements that was notessential for Paper F2. Contraryto popular belief, it is not adisproportionately hard paper.It does require students to workhard in order to gain knowledge ofareas that they have not practised.All written papers require theorganised approach set out above,whereby you underline the contentand instruction of all requirementsat the beginning of each question.Keep referring back to them,particularly on wordy questions, tomake sure that you are not goingoff on a tangent. And remember,practice makes perfect. Keeppractising past questions untilyour approach and layout becomessecond nature, leaving you withplenty of time to think about the

issues in the question.

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In the Paper F8 exam you may be asked tocompute and interpret the key ratios used inanalytical procedures at both the audit planningstage and when collecting audit evidence. Ratiosand comparisons can be used to identify where theaccounts might be wrong, and where additionalauditing effort should be spent.

Calculating a ratio is easy, and usually is littlemore than dividing one number by another. Indeed,the calculations are so basic that they can beprogrammed into a spreadsheet. The real skillcomes in interpreting the results and using thatinformation to carry out a better audit. Sayingthat a ratio has increased because the top linein the calculation has increased (or the bottomline decreased) is rather pointless: this is simplytranslating the calculation into words. Use themnemonic RATIO to remind yourself to keep askingthe following questions: Reason why has this change occurred? Accident is the change real or simply an

accident of timing? Test what can be done to test our conclusions?

What other work should we do? Implications what does this change mean?

Liquidity crisis? Poor management etc? Other information is this consistent with

other information?

You should not write this out in the answer as thiswill waste time and will not gain you marks, butthe five classes of question should always be at theback of your mind.

There is a huge variety of businesses andthis diversity will be reflected in their financialstatements. To judge whether a figure or ratiois worth investigating, it is absolutely necessaryto compare it to its equivalent in either thesame company in the previous period, or othercompanies in the same industry. Comparisonsprovide benchmarks.

To look at some of the techniques andinterpretations, we will use the financial statementsof Ocset Co, shown on page 7.

COMPARISON OF TWO CONSECUTIVE YEARSPerhaps the first thing to do is simply to comparethe two sets of financial statements. Here we haveresults from 2009 and 2008. Look down the figures,comparing like with like, and see what queries orhypotheses you might be able to generate. Themnemonic RATIO will be used formally for the firstcomparison. Here are some first thoughts:

Non-current Substantial increase in goodwill.assets: intangible Reason: acquisition? Is it real or

an accident of timing? How can theamount be checked, verified, andtested? Implications: What wasbought? How was it paid for?What type of business? When isthe year-end of the businessaquired? Who are the auditors?Is this consistent with otherinformation, such as additionalnon-current assets, increasedfinance and so on?

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01 TEChNICAl


11/18

Non-current Substantial increase. Some mightassets: tangible result from the acquisition, some

might be organic (or true growth).How were they paid for?How can we test it?

Inventory Relatively small increase. Will beinteresting to compare to sales.

Receivables Relatively small increase. Will beinteresting to compare to sales.

Cash Large increase. Why? Where hasthat come from?

Trade payables About a 1520% increase. Why?Large compared to receivablesand cash. Compare to cost ofsales later. How can we verifythese liabilities?

Short-term Doubled, but could be broughtborrowings back to 2008 levels by using

some of the cash. Why have cashand an overdraft at the same time?

Current (Current assets less currentassets compared liabilities.) About the same bothto liabilities years. Alarmingly, both years

show net current liabilities.However, the business hassurvived a year like this.

Share capital No material change.Retained earnings Increased, presumably by

retained profit.Long-term Substantial increase. Presumably,liabilities this is a major source of funding

for non-current assets. Expect anincrease in financing costs. Needto verify that the liabilities areindeed long-term.

Revenue Very substantial increase(around 15%). How much isorganic (or true growth) and howmuch because of acquisition?We would expect changes ininventory and payables.

Cost of sales An increase roughly in line withthe increase in sales.

Commercial and Substantial increase. Perhapsadministrative temporary after the takeovercosts and before rationalisation. Might

indicate poor cost control.Tax Fairly consistent.

If you were now told that the financial statementsare modelled on a supermarket business, thenyou might be able to make more sense of someof the figures particularly the net currentliabilities. Supermarkets have low receivables andlow inventory (much of it is perishable) yet cansqueeze their suppliers hard. They can, therefore,survive well on large trade payables, confident thatinventory will steadily turn into cash. However, nowthat we know we are dealing with a supermarket, weshould be interested in why they have substantialreceivables at all.

RATIO ANAlYSISRatio analysis is useful because it allows you tosee if two figures have moved consistently with oneanother. You should be concerned if they havent.

There are three main groups of ratios:profitability, liquidity, and risk.

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STUdENT ACCOUNTANT 12/2009 02


12/18

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PROFITAbIlITY RATIOS 2009 2008gross proft percentae Gross profit x 100 4,218 x 100 = 7.8% 3,230 x 100 = 6.8%

Sales revenue 54,327 47,198

Comments on ross proft percentaeThis is a significant increase (15%) and an impressive performance in recessionary times. Apart fromaccounting errors, possible explanations include: a different sales mix (possibly because of the acquisition implied by the increase in goodwill) squeezing better prices from suppliers (test by looking at correspondence?) better inventory management and less wastage (test inventories carefully).

Net proft percentae Operating profit x 100 3,206 x 100 = 5.9% 2,450 x 100 = 5.2%Sales revenue 54,327 47,198

Comments on net proft percentaeReasonably good cost control has been maintained despite the substantial increase in sales. To test this, itis worth comparing the commercial and administrative costs to sales.

Operatin expenses Operating expenses x 100 1,012 x 100 = 1.86% 780 x 100 = 1.65%to saes Sales 54,327 47,198

Comments on operatin expensesThese costs are low compared to revenue. Does that make sense, or should we worry about expenses beingunderstated? Supermarkets rely on high volumes and low margins and this could explain the relativelylow operating costs:revenue ratio, indicating that huge volumes of sales are efficiently pushed throughthe business.

However, efficiency of the operation has deteriorated and it is important to try to determine why this hashappened. Obvious causes are: the operations of the acquired business are not as efficient as the holding companys disruption costs arising from the takeover overstretched management.

These theories need to be tested. There might be other implications too. If management hopes to reduceoperating expenses, are they, for example, planning warehouse closures and redundancies? Is some sort ofprovision needed?

Return on capita Operating profit x 100 3,206 x 100 = 11.8% 2,450 x 100 = 12.0%empoye (ROCE) Capital employed 27,165 20,417

Comments on ROCE (capita empoye is te tota equity pus on-term orrowin)It is important to realise that this is the first ratio we have calculated that makes use of a figure fromthe statement of financial position. Such figures are taken at only one point in time, and this can lead todistortions in the ratios. Changes might be little more than accidents of timing. Compare a company wherecapital was raised and an expansion took place in the first month of the period, to one where this happened

03 TEChNICAl


13/18

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in the last month of the year. The final capital of both companies will include the additional finance, butonly the first company is likely to enjoy a significant increase in its operating profit. The second companys

ROCE is likely to show a decline from one year to the next.This effect may have caused the decrease in ROCE seen in Ocset Co, and it would be useful to know when

any expansion or acquisition took place.

2009 2008Asset turnover Sales revenue x 100 54,327 = 2.0 47,198 = 2.3

Capital employed 27,165 20,417

Comments on asset turnoverThis shows how many $ of sales are generated by each $ of assets. Its sometimes described as how

hard the organisation works its assets. The decline in the ratio shows that although capital (and thereforeassets) have increased, sales have not increased proportionately but that could simply be an accidentcaused by the date of the asset increase.

Note: ROCE = Net profit% x Asset turnover 11.8% = 5.9% x 2.0 12.0 = 5.2% x 2.3

lIQUIdITY RATIOS2009 2008

Current ratio Current assets 9,209 = 0.73 5,889 = 0.63Current liabilities 12,582 9,362

Comments on te current ratioNormally, current assets are used to pay current liabilities. A current ratio of less than one is oftenconsidered alarming as there might be going concern worries, but you have to look at the type of businessbefore drawing conclusions. In a supermarket business, inventory will probably turn into cash in a stableand predictable manner, so there will always be a supply of cash available to pay the liabilities. Thecompany survived 12 months from the date of the 2008 statement of financial position until the presentone (and the current ratio has improved), so there should be no particular alarm.

Quic (or aci Current assets (minus inventory) 9,209 2,669 = 0.52 5,889 2,430 = 0.37test) ratio Current liabilities 12,582 9,362Comments on te quic ratioThe quick ratio is useful when inventory is turned over slowly, as the payment of current liabilities willdepend on receivables and cash. A quick ratio of less than one is often worrying, but it again depends onthe business and comparatives. Here, the quick ratio is much more generous on the 2009 statement offinancial position than on the 2008 one. Why? Has interest income increased too?



14/18

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Receivae Receivables 1,798 = 12 1,311 = 10coection perio Sales/day 54,327/365 47,198/365

Comments on te receivaes coection perioIn a supermarket, most sales are for cash, and comparing receivables to sales that have no impact onreceivables is rather pointless. It would be much better if sales could be split into cash and credit salesand the true collection period for credit sales worked out.

However, there does seem to have been a disproportionate increase in the collection period. Possiblereasons are: a different sales approach perhaps offering customers credit facilities a different range of products perhaps offering customers a credit card (look at board minutes) poor management so that credit control deteriorates economic problems causing customers to pay more slowly, and presumably an increased risk of bad

debts (there might be implications for bad debt provision).

We should check other information too. For example, if customers are taking longer to pay (or a credit cardis offered), is the company earning interest on the balances? A receivables circularisation will be importantto test the accuracy of the receivables figure.

Payaes Payables 8,522 = 62 7,277 = 60payment perio Cost of sales/day 50,109/365 43,968/365

Comments on te payaes payment perioTheres nothing remarkable here. The increase could be evidence of pressurising suppliers and could beconsistent with the improvement in gross profit percentage. We should check that there will be no futuresupply difficulties, by looking at correspondence and board minutes.

days o inventory Inventory 2,669 = 19 2,430 = 20Cost of sales/day 50,109/365 43,968/365

Comments on te ays o inventoryThis is a 5% fall and would appear to suggest tight inventory control. However, always go through (at leastin your mind) the RATIO list: Reason accidental or deliberate? How was the decrease achieved? It could be an accident of timing, for example, where a weekend falls with respect to the year end. Inventory always needs to be carefully verified existence, quantity valuation etc. Implications. If there are fewer days of inventory, are customer service levels being adversely affected? If

so, could there be going concern implications if customers were to take their business elsewhere. Goingconcern doesnt seem to be a serious issue within this company, but the auditor should always be awareof the risk even if only to dismiss it quickly. Is inventory wastage reduced?

Other information. For example, has the company invested in new IT systems which allow better inventorycontrol? Has the distribution system changed? Have more trucks been bought to allow the company tooperate with lower inventory?

TEChNICAl05


15/18

RISk RATIOSA companys indebtedness is obvious from its financial statements, so the risk analysed by external users is

normally the risk related to borrowing the gearing risk. Borrowing causes risk because interest has to bepaid irrespective of profits made. A rise in interest rates, or a fall in profits, can make the payment of interestvery difficult, and lead a business into receivership and liquidation (going concern difficulties). Risk fromborrowing can also arise when capital repayment is required, either on demand (in the case of overdrafts)or at the end of a fixed term. It is very important to understand how any repayment could be financed.

2009 2008Te earin ratio Long-term loan finance x 100 14,170 x 100 = 109% 8,602 x 100 = 73%

Equity finance 12,995 11,815

Comments on te earin ratioThe gearing ratio can also be defined in other ways, particularly by comparing long-term loan financeto total finance. As gearing increases so does the risk that the interest cant be paid. But it is difficult todefine a safe level of gearing. For example, a property company with properties leased to tenants will havefairly predictable rental income. Such a company can probably safely sustain substantial borrowings (thoughit could be in trouble if interest rates increased significantly). A company with volatile streams of incomewould have to keep its gearing lower as it must ensure that interest can be paid during the lean times.

Supermarkets could be expected to have reasonably predictable income: people have to keep eating, sowill keep buying food. The gearing ratio calculation shows that there is a large increase in the companysgearing. You should ask the following questions: Reason: deliberate financial planning or problems? Is there any reason to suppose that the effect is temporary or an accident of timing? Loan agreements need to be verified for term and security. If the loan period is relatively short, how will it be repaid? We would expect the amount of interest paid to increase (unless the additional loan was taken out very

close to year end).

Interest cover Operating profit before interest 3,206 = 6.7 2,450 = 9.8Interest 478 250

Comments on interest coverInterest cover shows how many times interest can be paid out of earnings. Neither of these ratios wouldgive cause for concern. The fall from 2008 to 2009 is consistent with the rise in borrowing that wasidentified earlier. The interest amounts would have to be tested to see that they were reasonable, giveninterest rates and when the additional borrowings were made.

CONClUSIONRatio analysis and comparison are invaluable tools which help auditors understand what might have happenedin a business. However, the initial calculation of ratios and percentage changes is easy and mechanical. The realskill comes in interpreting the results, and nearly always the results should give rise to more queries than theyanswer. Turn the page for the Ocset Co statment of financial position and statement of comprehensive income.

Ken Garrett is a freelance lecturer and author RATIO

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16/18

TAblE 1: OCSET CO STATEMENT OF FINANCIAl POSITION30/9/2009 30/9/2008

$m $mAssetsNon-current assets

Intangible goodwill 4,027 2,336Tangible 26,511 21,554

30,538 23,890

Current assetsInventory 2,669 2,430Receivables 1,798 1,311Cash and cash equivalents 4,742 2,148

9,209 5,889Total assets 39,747 29,779

Equity an iaiitesShare capital 395 393Reserves 12,600 11,422

Total equity 12,995 11,815

Non-current liabilities long-term borrowings 14,170 8,602Total non-current liabilities 14,170 8,602

Current liabilitiesTrade payables 8,522 7,277Short-term borrowings 4,060 2,085Total current liabilites 12,582 9,362

Total liabilities 26,752 17,964Total equity and liabilities 39,747 29,779

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30/9/2009 30/9/2008$m $m

Revenue 54,327 47,198Cost of sales 50,109 43,968Gross profit 4,218 3,230Commercial and administrative costs (1,012) (780)Operating profit before financing 3,206 2,450Financing income 116 187Finance costs (478) (250)(Loss)/profit before tax 2,844 2,387Income tax expense (780) (670)(Loss)/profit after tax 2,064 1,717 (886) (870)Total comprehensive income for the year 2,064 1,717

TEChNICAl07


17/18

Once budgets have beenimplemented, they need to

be monitored and controlled.Accounting teams analyse andinterpret financial data to helporganisations and departmentsidentify how closely performanceis aligned to budgets over adefined period.

This amounts to much morethan simply whether sales aredown or up monitoring and

controlling includes the regularexamination of costs, cash,working capital and assets. Asan accountant, youll be chargedwith responsibility for chasing theinformation needed to identifyvariances between budgeted andactual figures, tracking relevanttrends and communicating yourfindings to senior management or

department heads.In order to do this, youll need

to have systems in place torecord figures on a timely basisand allow meaningful comparisonagainst budgets as swiftly andaccurately as possible (especiallywhere managers in the field relyon them for driving individualand team performance, or for

focusing sales activity). Wherevariations arise, youll need tofind the right questions to ask inorder to explain and make anyrelevant recommendations foractions arising from them. Andits crucial that your findings arepresented to management in away thats easy to understand,particularly by those who are notused to financial terminology.That means translatingaccounting-speak for end

users in plain language thatleaves no doubt as to whats

being communicated.Your work will assist with

ongoing resource allocation andoverall financial performance,as the organisation makesany necessary operationalchanges arising from reportedvariances or from indications thatsales forecasts are being metor exceeded.

Examples of relevantactivities include: Preparing regular variance

analysis reports, clearlydemonstrating significantdifferences or trends requiringcloser examination or whichmay cause alarm.

Giving explanations and makingrecommendations based

on variance analysis, includingfurther data collection orresearch into companyor industry-related factors.

Incorporating significantvariances in futurebudget planning.

The next step is to answerthe challenge questions for

this objective in the traineedevelopment matrix (TDM): Describe your role

in monitoring andcontrolling budgets.

How do you plan frequencyand method of monitoring?What factors, such as acceptedbusiness cycles or the easewith which information can beinitially gathered, are takeninto consideration?

Who is involved and to whatextend must you obtain buy-in

to the monitoring process inorder for it to be successful?

How have those budgetsaffected your day-to-day role?

Consider how information youcollate for budgetary purposemight inform your otherresponsibilities within the team.

In what ways does budgetactivity (preparation, actions

from variations, amendments)change the time you can giveother responsibilities? Whatadjustments do you have tomake and how does this radiateout to include your day-to-dayinteraction with others?

With some examples, how haveyou used these budgets to helpothers within your organisation?

It might be that you alertedmanagement in a particularregion to adverse salesfigures that bucked a widertrend and which led toidentifying deficiencies in localmanagement or poor recordingof data that could be corrected,or even financial wrongdoing.

Perhaps your monitoring work

revealed aspects of outstandingoperational performancethat led to successful salestechniques or cost-saving drivesbeing adopted throughoutthe company.

Performance objective 14 islinked to Paper F2, ManagementAccounting, Paper F5,Performance Management,and Paper P5, AdvancedPerformance Management.A

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po 14: monitor And control budgets

For PER support and advice on answering challenge questionswww.aaa.//aa//

FOCUS ON per

67student AccountAnt 12/2009


18/18

Budgeting is a critical processfor any organisation, large or

small, and in almost everydepartment, whether spending orrevenue-generating. Accountantsplay an important role inplanning and producing budgets.Alongside making reasoned,often complex calculationsand informed forecasts tohelp ensure organisations anddepartments can effectively

plan, budgeting responsibilitiesmay be just as likely to involvecommunication, negotiation andeven conflict resolution.

Effective budget planning startswith supplying sufficient andcorrect information for creatingdetailed and accurate budgetsand cashflow forecasts, as wellas understanding the wider

impact of those forecasts. Oncebudgets have been agreed, theyllneed to be communicated withstakeholders, from colleaguestracking sales revenues todepartment heads who authoriseexpenditure. And when theaccounting period is underway, thebudgets will need to be kept underreview, where necessary updating

or adjusting in the context ofchanges to the organisation or themarkets in which it operates.

Youll need to call on yourknowledge and understanding ofperformance measurement andmanagement accounting skillsto identify, describe, calculateand forecast business costs andrevenues and their behaviour,and to plan, monitor, andcontrol the use of business andfinancial resources.

Examples of relevantactivities for demonstrating your

competence might include: Contributing to budget

meetings, from preparationwork, such as analysis ofrelevant figures from previousperiods, to follow-up actions,such as chasing data fromother teams or deliveringnew budgetary messagesto colleagues.

Devising plans for budgetpreparation, from analysis ofexisting information, throughtaking stock of currentcircumstances, to collectingdata on a timely basis.

Preparing forecasts, balancingthe optimism of salesmanagers with rational,evidence-based calculations,

and allowing for sensitivityto sudden or unexpectedlydramatic changes.

The next step is to answerthe challenge questions forthis objective in the traineedevelopment matrix (TDM): Describe how you have been

involved in budget planning and

production. How do your budgeting

responsibilities follow on fromothers? What happens to thework you produce?

Who must you communicatewith, and what informationmust you convey? What datamust you use, where do you getthis from?

Explain, having developedthe budget, how you have

made sure that it has beenimplemented correctly.

Think about instructions orguidelines that need to beprovided to end users, and howtheyll seek clarifications orfurther help.

What steps have you oryour team taken to ensurethat budgets are monitored

appropriately? What would be the impact on

your department or organisationif the budgets you supplied werenot properly prepared?

Consider not just the effectsof over-expenditure byspending departments, butalso the impact on financialperformance, should adherence

to incorrect sales budgetsresult in falling revenues beingmasked or cash positions beingartificially inflated.

How might confidence in youand your team be impacted ifbudgets are ill-prepared? Forinstance, if department headsobserve budgetary constraints,only to discover they were

working under false pretences,how would that affect theirwillingness to cooperate infuture, especially if an indirectresult was a fall in sales and/orindividual sales commissions?

Performance objective 13 islinked to Paper F2, ManagementAccounting, Paper F5,

Performance Management,and Paper P5, AdvancedPerformance Management.B

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po 13: contriBute to Budget planning and production

For PER support and advice on answering challenge questionswww.b.m////

FOCUS ON per

01student accountant 12/2009

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