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Module 1: Introduction to accounting and Finance To give an overview of the importance of accounting information to the firm and its providers of capital. §
Shares represent the basic units of ownership of the business.
All companies issue ordinary shares (the main risk-bearing shares issued) while some issue other types of shares such as preference shares
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Business Organisation:
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Sole Proprietorships
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Advantages:
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Minimum reporting regulations
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Cost of establishment is minimal.
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Owner share all the profits and decision making can be more flexible.
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Disadvantages:
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No Separate Legal entity, i.e. the owner has unlimited liability over the activities of the business.
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Limited life, life of the biz restricted to the period the owner continues in that position.
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Limited access to funds (restricted to the personal resources of the single owner).
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Partnerships
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Advantages:
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Increased regulations, e.g. Partnership Acts in relation to the activities, rights and responsibilities of partnerships.
However, still low requirements compared with the company.
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Cost of establishment is lower than company.
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Greater access to funds (i.e. partners could share their resources)
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Disadvantages:
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No Separate Legal entity, i.e. the owners have unlimited liability over the activities of the business.
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Limited life, life of the biz restricted to the period the owner continues in that position.
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Limited access to funds (restricted to the personal resources of the single owner).
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Mutual agency, the partners are jointly and separately responsible for the business actions of other partners.
Also means the co-ownership of assets (spreading of risk) and profits (reduced profits for the individual owners).
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Limited Companies
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Listed and unlisted companies:
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Listed companies have shares which can be traded in the stock market exchange.
They are usually bigger companies with a global perspective.
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Unlisted companies are generally smaller and there is less liquidity in its shares.
Note, memberships for unlisted companies are restricted to 50, while it is unlimited for listed companies.
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Characteristics:
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Separate legal entity, an Ltd company has the legal capacity of a person.
There is also limited liability for the owners.
That is, the liabilities are limited to the amount of money outstanding, i.e. what the shareholders have initially invested.
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Unlimited life span & extensive membership
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Company ownership of assets
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Company profits belong to the shareholders
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Separation of ownership and management.
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Extensive regulations, especially needed as the shareholders are widely removed from the day-to-day activities of the business and its management.
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Advantages of Ltd public companies:
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Liquidity, shares can be traded easily on the stock market
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Continuity of existence for the corporation.
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One could be a passive investor.
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Relative ease to finance operations:
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Selling shares, issue of debts and retained profits (profits not paid out as dividends).
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Groups and Parents
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Group accounts are required if a parent company controls a subsidiary company, while the parent only includes the account of itself only.
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A listed company’s annual report
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4 main statements:
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Statement of financial position, what we own and owe, net position of the owners.
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Statement of financial performance, a summary of the profits and losses accounts
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Statement of movements in equity, show how the net position of the owner changed
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Statement of cash flows, how we got the cash and how we spent it
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NB: Accompanying Notes, explains the numbers in the statements in more detail, such as breaking them down into component parts (categories of fixed assets) and also discusses the use of accounting choices, including what principles were followed and what estimates made.
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Difference between the reported equity and the market capitalization:
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Statements only show reliable information, thus intangible assets such as human resources that cannot be accurately measured are not included.
Also means that statements rely on historic cost
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Statements are based on past information while market value takes into account of the future.
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Note that the financial statements are guided by the GAAP, generally accepted accounting practices.
Also the director must declare that the accounts are “true and fair” and that the company can pay its debts and they fall due.
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The audit report
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A report issued by independent accountants which gives an opinion (usually unqualified) on the accuracy of the financial statements.
Found in the annual report, it only covers the financial statements and notes to the accounts.
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An unqualified opinion – the statement of the auditor was arrived by their own judgment, free from any outside interference.
Auditors opine that the financial statements reflect a true and fair view of the company.
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This does not guarantee the accuracy of the statements and that there was no fraud.
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For listed company, this is required by law.
The report addresses the shareholders; hence, it is important to promote public trust in capital markets.
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Financial accounting, mangement accounting and finance
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Difference between financial and management accounting:
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Nature of reports – FA is general purpose.
Useful for broad range of users and decisions.
MA are more specific reports, useful for a particular decision/manager (planning and control decisions).
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Level of detail – FA reports, info is aggregated and less detail.
MA provides more detail.
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Restrictions – FA subject to accounting regulations, standardized form.
No restrictions for MA as it is internal.
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Reporting interval – FA produced annually, semi-annually or quarterly.
MA are produced when required.
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Time horizon – FA is backward looking.
MA provides insight to future performance as well as the past.
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Range of information – FA emphasizes reliability while MA is more based on relevance.
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Finance, two main functions:
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Investment, which assets to invest.
Objective to maximize shareholder wealth while minimizing the associated risk.
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Obtaining funds, debt and/or equity (shares, dilute profit and control).
I.e. minimizing the cost of capital.
Module 2: Financial Position To discuss the Statements of Financial Position and Movements in Equity. §
Statement of Financial Position
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A summary of a listing of the balances in all of the detailed accounts.
It is a snapshot of the financial position of a company at a particular moment in time.
It also gives:
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Liquidity: ability for companies to meet its short-term obligations.
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Asset mix: current and non-current
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Financial structure, e.g. leverage
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Accounting conventions
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Business entity concept – The transactions of the owner’s personal expenses are separate from the transaction of the business.
Hence, report includes biz and subsidiary companies.
Assets & personal transactions of the owner(s) are excluded.
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Money measurement – All assets recorded must be reliably measure in monetary terms.
Reliable – an agreed price when transaction takes place.
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Historic cost – Record assets at their acquisition costs.
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Continuity – The biz will carry on forever, hence, an asset’s liquidation value is irrelevant.
This provides support for the historic cost convention as there will be no need to know the real value of non-current assets.
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Conservatism –The financial reports should err on the side of caution.
This results in the recording of both actual and anticipated losses in full, while profits are not recognized until they are realized.
This also causes what is known as the net realizable value, i.e. inventory are recorded at their lower values, until they have been sold at a higher price.
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Dual aspect – There are two aspects for each transaction, both of which will affect the statement of financial position.
This is to balance the accounting equation of Assets = Owner’s Equity + Liability.
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Stable monetary unit – Money will not change in value over time.
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Objectivity/reliability – Financial repots should be based on object, verifiable evidence rather than on matter of opinion.
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Relevance – Information is useful for making financial decisions.
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Accounting period – the life of an enterprise is divided up into equal time intervals, as a result of this arbitrary subdivision, there is a need for subjective allocation of the consumption of the future economic benefits embodied in long-term assets during each period (depreciation and amortisation).
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Accounting equation:
Assets = OE + L à Assets = OEbeg + revenues + contributions – expenses – distributions + L
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Assets – Resources, arising from past transactions, controlled by the company, providing future economic benefits that can be reliably measured.
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Current assets: Cash or other assets (such as inventory, prepayments, accounts receivable, taxation receivable) which can be used or realized within 12 months.
Shows the liquidity of the biz and its ability to pay off current-liabilities.
(Note, current assets less current liabilities = Working Capital)
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Receivables: Monies owned by customers for services previously provided by a company.
The company expects to receive the payment within the next twelve months.
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Prepayments: Amounts paid in advance by a company that will become an expense during the next 12 months.
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Non-current assets: Assets cannot be used or realized within 12 months.
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Fixed assets (PP&E): cost of asset – depreciation
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Investment, at net realisable value, reflects conservatism.
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Associated companies, cost of shares and proportion of OE
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Intangible assets:
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Goodwill: Arises when the purchase price is higher than the market value for the tangible assets less any liabilities acquired.
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Franchise fees: payment to obtain the rights to operate businesses under an international brand name.
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Liabilities – Present obligations arising from past transactions (causing the sacrifice of future economic benefits) that must be quantifiable in dollars.
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Current liabilities (payable within 12 months) like trade creditors and non-current liabilities (not payable within 12 months) like loans.
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Owners’ equity – The owner’s residual (what is left over after debts are paid) claim to assets
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Share capital: Owner’s direct investment into the company.
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Retained profits/earnings: Profits kept in the company: Profits – dividends (reduction OE resulting form asset distribution to owners) = retained profits. Causes general increase assets.
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Reserves: Amounts reflecting increases in OE.
These can include retained profits, asset revaluation reserves (increase in the value of the asset).
These reserves can always be turned into capital, known as bonus shares.
Also takes into account of contingent liabilities, i.e. an existing condition of which the outcome depends on some future event (this liability only found in notes as it is not reliable).
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Movements in equity
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Shows how total owner’s equity has changed from the beginning to the end of the period.
Common changes include:
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Sale and repurchase of shares; changes in revaluation reserve; dividends and net profit or loss
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Follows the fundamental formula of OEend
= OEbeg + contributions + revenues – expenses – distributions:
Beginning Equity
$
Add:
Profit
###
Additional capital
###
Less
Withdrawals
###
Closing Equity
###
Module 3: Financial Performance & Cash Flows To discuss the Statement of Financial Performance and the Statement of Cash Flows. §
Statement of Financial Performance
Shows the profit/loss account of the organization.
Profit is the difference between the increases in capital attributable to operations or trading (Revenue) and the decrease in owner’s equity attributable to operation or trading (expenses).
Thus: P=R-E OR P=Change in net assets – Owner’s contributions + Owner’s distributions
Formats of financial performance:
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Simple:
Revenues
XXX
Expenses
YYY
Profit
ZZZ
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Larger organizations:
Sales
###
Less cost of sales
###
Gross Profit
###
Revenue
###
A
Less Expenses:
Selling and distribution (ads, commission, salary)
XXX
Admin and general (salary, rates, telephone, depreciation)
XXX
Financial (interests, bad debts)
YYY
B
Net Profit
A-B
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Cash and Accrual accounting systems & Revenue and expense recognition
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Accrual accounting – compulsory for listed companies:
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Transactions are recorded when revenues are earned or expenses are incurred, whether or not cash has been received or paid.
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As we live in a credit society and transactions have a long-term effect (e.g. prepaid expenses such as insurance), accrual accounting can better accommodate these and thus will be a better reflection of economic reality.
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Revenue Recognition rules (realization convention): When sale takes place, when service is performed.
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Expense recognition rules:
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Payment or increase in liability and there is no reliable measurement of future benefit, e.g. wages, rent, advertising, training cost.
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Expenditure previously recorded as an asset and the future benefit has been consumed or lost during the accounting period at hand.
E.g. cost of goods sold, depreciation, amortization (depreciation for intangible assets), prepayment used up.
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Cash accounting – similar to the statement of cash flows, benefits of simplicity and liquidity.
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Revenue = cash received, expenses = cash paid.
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The accounting period assumption
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The accounting period assumption separates the life of an enterprise into equal time intervals, as a result of this arbitrary subdivision, there is a need for subjective allocation of the consumption of the future economic benefits embodied in long-term assets during each period (depreciation and amortisation).
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This is also necessary so that the financial position, owner’s equity change and profit/loss can be measured at various points during the lifetime of the business.
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Depreciation
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Depreciation is the allocation of the cost of a depreciable non-current asset over its useful life.
NB we are not recognizing the reduction in market value of the asset, instead, we are recognizing the part of the future benefits that we have utilized.
i.e., reducing the book-value of the asset over multiple accounting periods.
There are four factors that need to be considered:
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Cost of the asset (C): Includes all costs incurred by the business to bring the asset to its required location and make it ready for use.
E.g. delivery cost, installation cost and legal cost.
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Useful life of the asset (n): Either the asset has become technologically or commercially obsolete.
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Residual value (R): worth in dollars of the asset when it is disposed.
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Depreciation method
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Straight line method: Allocate the amount to be depreciated (purchase price-residual value) equally over each year of the useful life of the asset.
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Diminishing value method: Fixed percentage rate of depreciation to the written down value of an asset each year.
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Profit measurement:
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Valuation of inventory:
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First in, first out (FIFO):
the earlier inventory held is the first to be sold.
In a time of rising cost, this would give higher net income, vice versa for a time of decreasing costs.
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Last in, last out (LIFO): the latest inventory held is the first to be sold.
Note this is rarely used in Australasia.
In a time of rising cost, this would give lower net income, vice versa for a time of decreasing costs.
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Weighted average cost: an average cost will be determined which will be used to derive both the cost of the sales and the cost of the remaining inventory held.
This would give the moderate value no matter what the costs are.
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Bad and doubtful debts: When the account receivable cannot be realized as the customers would not pay, the debt becomes “bad”.
The bad debt write-off can be done by Reducing accounts receivable and Increase expenses
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Content of Statement of Cash Flows.
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A summary of the cash receipts and payments over the period concerned.
All payments of a particular type are added together to give just one figure.
There are three major ways that cash can change form the beginning to the end of the year:
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Operation activities: the net inflow from operations.
The sum from cash receipts from trade debtors less the sums paid to buy inventory, pay deny, pay wages etc.
This is the day-to-day transactions of the business.
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Investing activities: cash payment made to acquire additional non-current assets and cash receipts form the disposal of such assets.
Include fixed assets and investment.
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Financing activities: Financing the business, concerned with procuring long-term finance from debts and equity sources.
E.g. Shares/equity, sale shares, buy back shares, pay dividends. And debt, taking out a new loan and paying back a long.
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Format of the statement of cash flows:
Cash flow from operating activities
x
Cash flows from investing activities
x
Cash flows from financing activities
x
Net increase in cash held
x
Cash at beginning at the financial year
x
Cash s at the end of the financial year
x
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Uses of Statement of Cash Flows:
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Trends in cash inflows and outflows, and level of cash held.
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Difference in cash and accrual profits
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Extent of non-cash transactions
Module 4: Financial Statement Analysis (I) To introduce the tools of financial statement analysis (FSA) and discuss certain caveats before proceeding. §
Financial Statement Analysis Tools
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We are trying to assess:
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Company profitability and different aspects of it
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Financial risk (health), i.e. can debts be paid
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Sustainability and prediction of future profits.
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Horizontal analysis:
Compares figure over time: i.e. it takes and difference between this year and last year’s figure and divides it by a previous period’s number (this is the base year).
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This method asses the same company over time
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Vertical analysis:
Compares items in the same period, and expresses them as percentages of some total.
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The method assesses how significant items are and if their significance has changed over time.
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Ratios:
used to express relationships among various items from the financial statements and sometimes from market data.
Note, ratios in isolation are useless without a basis for comparison.
E.g. compare with intertemporal (past performance), budget (planned performance and intra-industry (other similar industries).
E.g. Current ratio can be used to investigate our ability to pay short-term debts (current assets/current liability).
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Profitability – Expresses profits made in relation to other key figures.
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A Typical Events
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An atypical event is a non-recurring, abnormal and extraordinary event.
We focus on them as we want to compare companies over time, thus, we can ignore the one-offs; we also focus on them as classifying the event as atypical or not will affect the market confidence, hence the share price.
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E.g. discontinued operations, one-off gains, and changes in accounting policies.
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Accounting Choices
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Money measurement: Assets must be reliably measured. Thus, goodwill is only recorded when the business is sold, this is a problem if we are comparing companies, some of which will have goodwill recorded.
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Historic cost and going concern: Record assets at acquisition cost.
Thus, comparing old companies with new ones will result in different values in the same asset depending on how long ago the asset was purchased (note, in NZ, fixed assets are revalued periodically).
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Revenue recognition: Revenues are recorded even if they may not collect.
There is thus a choice in estimating the bad debt expense i.e. net realizable value.
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Expenditure could be an expense or an asset
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If the expenditure was capitalized (turned in to an asset) then:
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Intangible assets: amortisation, turns the cost of an intangible asset into an expense to be recognized over time.
The choice is the estimate of the useful life.
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Fixed assets: Choices such as method , estimate of useful life, estimate of salvage (residual) value.
Module 5: Financial Statement Analysis (II) To apply the tools of financial statement analysis (FSA) in assessing profitability and financial risk. §
Financial ratios
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Ratios are used to reflect the financial health of different aspects of a business.
They need to be compared with a benchmark ratio, such as past performances, planned results and similar business ratios.
They can be grouped into the following major categories:
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Profitability – Expresses profits made in relation to other key figures.
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Return on assets= [1] Fundamental measure of business performance as it assesses the effectiveness with which assets have been utilized.
Note the net profit figure used in before interest and taxation, as interest is a financing expense (not operating) and taxation is subject to fluctuation.
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Note,
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Return on OE=
Amount of profit available to the owners with the owner’s stake in the business.
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Net profit margin=
Most appropriate measure of operational performance for comparison purposes.
(Note, before interest and tax as it represents the raw profit).
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Gross profit margin=
A measure of profitability in buying in buying and selling goods before other expenses are taken into account.
The ratio can vary between types of businesses.
E.g. supermarket operates on low profit margins to stimulate sales so increase the total amount of profit.
A jeweler, however, have a high net profit margin but a lower level of sales volume.
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Common-size statements=Useful in comparing statements of different sizes.
Figures are stated at a percentage of the total assets.
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Efficiency – Measurement of asset utilization within the business.
These ratios referred to as turnover ratios.
Note, for the period, then it would be .
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Average inventory turnover=
.
A measure of how effectively the inventory is being sold.
The business prefer high inventory turnover to a low one as inventory tie up funds, thus it cannot be used for other profitable purposes.
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Accounts Receivable turnover=
a measure of how effective are the customers in their payment for the amount owning to the company.
High average settlement better than low ones. Note this is only an average, and is subject to distortion by extreme cases.
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Accounts Payable turnover=
a measure of how effective the business is in paying its trade creditors.
Trade creditors are a free source of finance.
However, excess credits could mean a loss of goodwill from suppliers.
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Fixed Asset turnover=
Examines how effectively the fixed assets of the business are being employed at generating sales revenue.
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Asset turnover ratio=
Examines how effectively the assets of the business are being employed at generating sales revenue.
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Financial risk analysis: Analyzing the risk that a company will not have adequate cash flow to meet fixed payment obligations (such as interest).
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Short-term financial risk, liquidity – Measurement of liquid resources available to meet maturing obligations.
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Current ratio=
the higher the ratio the more liquid the business is considered to be.
As liquidity is of vital importance to the survival of a business, a higher current ratio is normally preferred to a lower ratio.
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Acid test (liquid or quick) ratio=
For many businesses, inventory on hand cannot be converted into cash quickly, as a result, it may be better to exclude this particular asset from any measure of liquidity.
Also, prepayments cannot be turned into cash.
Rule of thumb: 1:1
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Cash flows from operations=
the higher the ratio, the better the liquidity.
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Free Cash flow=Operating cash flow – fixed asset replacements – dividends payments.
There are cash to be used on discretionary spending.
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Long term financial risk – examining a firm’s ability to meet interest and principal payments on long-term debt.
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Gearing=
Gearing is the existence of fixed-payment-bearing securities (e.g. loans) in the capital structure of a business.
I.e. it is a measure of debt to equity level.
Higher gearing usually mean higher longer term financial risk.
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Interest coverage=
This ratio measures the amount of profit available to cover interest expense.
Rule of thumb: greater than 2.
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Investment –These help investors assess the returns and performance of shares held in a business.
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Earnings per share=
this is a fundamental measure of share performance (note we exclude the effect of preference shares).
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Price earnings ratio (P/E)=
The ratio is a measure of market confidence concerning the future of a company. The higher the P/E ratios means good expected prospects,
that is, the greater the confidence in the future earning power of the company, thus, more investors are prepared to pay for more shares.
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Dividends per share=
The ratio provides an indication of the cash return that an investor receives from holding shares in a company.
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Dividend payout=
Measures the proportion of earnings that a company pays out to shareholders in the form of dividends.
For ordinary shares, the earnings for dividends will be net profit after taxation and after any preference dividends have been announced.
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Dividend yield=
t=company tax rate.
Dividends are divided by (1-t) to compensate avoid the double taxation on dividends.
This ratio relates the cash return for a share to its current market value.
Module 6: Cost-Volume-Profit (CVP) Analysis To discuss the theory and applications of cost-volume-profit analysis. §
Cost Behaviour
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How expenses respond to a change in activity (e.g. number of goods sold).
NB, Activity=cost driver.
This is done so that future costs can be predicted via extrapolation.
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Fixed Costs (FC): Costs which stays constant irrespective of the level of activity in the relevant range. E.g. Rent
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Variable Costs (VC): Costs which change in proportion to the level of activity.
Variable costs per unit of activity stay constants irrespective of the level of activity concerned.
E.g. Raw material used to make goods sold.
VC can be calculated using the high-low method.
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Mixed/Semi-variable Costs (MC): Costs which exhibit both fixed and variable elements.
E.g. Electricity and phone bills (line rental + per min charge).
A line of best fit is sometimes used to find a trend.
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Relevant Range
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Relevant range is the expected range of activity given the existing facilities.
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We make two important assumptions about costs per unit of activity:
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Fixed cots in total and variable cost per unit of activity are constant.
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All costs can be accurately estimated as either fixed or variable in relation to volume
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CVP
Model
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CVP model predicts revenues and expenses as a function of sales volume (activity).
NB, we assume both costs and revenues change linearly with respect to sales volume.
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For multi-product companies, we use “sales-mix”, i.e. calculating weighted average revenue of VC per unit by predicting % sales of each product.
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Contribution Margin:
Revenues residual after variable costs are paid (hence, it contributed to Fixed Costs and profit).
CM/unit=Sales price/unit-variable costs/unit.
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Fixed cots in total and variable cost per unit of activity are constant.
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CVP equation:
Sales Volume (Q) =
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All costs can be accurately estimated as either fixed or variable in relation to volume
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Breakeven analysis: sales volume (b) required to make zero profit.
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Operating Risk
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Operating risk is the exposure (vulnerability) of business having sales being lower than expected.
We measure operating risk in two ways:
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Margin of safety: Planned Volume less Breakeven volume
or the ratio is
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Operating leverage/gearing: The sensitivity of profits to changes in sales.
It refers to the extent of fixed costs relative to variable costs in the total costs of some activity.
When the fixed costs form a high proportion of the total costs, we say that the business is highly geared.
Module 7: Budgeting and Projected Financial Statements To introduce operations budgeting and pro-forma financial statements. §
Benefits of Budgeting
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A budget is a financial plan for a future period of time.
NB: a budget is not a forecast, which predicts future events.
The budget committee usually supervise and take responsibility for the budget setting process. The budgeting process concludes with the projected statement of financial positions.
·
Budget can be used for both planning and control decisions:
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Planning:
Long-term strategy (e.g. what products and market to enter); tactical decisions (how to staff, what to buy/make/lease and method of financing, debt or equity); operations budgeting (An implementation plan with budget preparation outlining the effects of projected sales volume).
Generally, they are “What if” analyses, where the effect of alternative decisions are analyzed.
We usually start with project sales volume.
·
Control: is making actual events conform to a plan.
We can compare our projected figures with the actual figures, the differences are known as variance (explained in the next module).
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Top-down and Bottom-up Budgeting
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Top-down: The senior management of each budget area originates the budget targets and impose it on the lower levels.
·
Advantage: Management will have more control over the budget goals, therefore, preventing from the budget being padded.
·
Disadvantage: May demoralize the employee as an unrealistic budget can mean the employees may lose the incentive to work toward the budget goal.
·
Bottom-up: Also known as participative budgeting.
The budget targets are fed upwards from the lowest level.
E.g. the junior sales managers will be asked to set their own sales targets which then become incorporated into the budgets of higher levels of management.
·
Advantage: There will be better communication; coordination and motivation, as manager at all levels become involved in budget preparation.
Also, the budget predictions are more likely to be more accurate and the managers are more likely to accept the budgeting process.
The increased responsibility and communication for the employees will provide a better motivation to achieve the budget goals.
·
Disadvantage:
Causes budgetary slack (to make the managers look better and to accommodate unforeseen circumstances).
This results in underestimated outcomes which create inefficiency and waste.
·
By using both top-down and bottom-up, a more realistic and overall better budget can be achieved.
§
Projected Financial Statement of Position and Performance
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Uses of Projected financial statements (PFS):
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PFS identify problems that CVP does not, such as shortfall in cash.
We can also use financial statement analysis, such as ratios, to further increase the meaning of the statements.
·
Therefore, PFS lend themselves to “what if?” analysis, i.e. the effect of changes in independent variables, such as sales volume on dependent variables, such as revenue.
·
Often sensitivity analysis is used here, a technique involving taking a ingle variable and examining the effects of the changes in the chosen variable on the performance and position of the business.
·
PFS also provide targets and standards for operations budgeting.
·
PFS are usually used internally; however, they are sometimes presented to outsiders, such as convincing lenders to lend or investors to invest.
·
NB: PFS are not audited as there is no reliable measurement of its derivation.
§
Operation Budgets and its Benefits
·
Master budget force planning:
·
Goals and targets give purpose to employees
·
Identify trouble points, production requirements and financial shortfalls
·
A combination of bop-down and bottom-up budgeting improves morale as employees have input and direction, they become team players
·
Master budgets promote better coordination and communication, both vertically and horizontally within the organization as the managers gain better understanding of how their decisions affect others in the company.
·
Master budget sets performance standards that help in evaluating performance.
However, managers need to be cautious when basing promotion/bonuses on performance as there will be behavioural implication.
·
E.g. Success could be caused by budgetary slack, criticism for falling short can demotivate, and one department could achieve target at the expense of another, e.g. sales manager at the expense of the production department.
·
Formats of particular budgets:
·
Cash Budget: Receipts
Sales
Payments
Net cash flows
Opening balance
Closing balance
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Note, in preparing cash budgets, we must ask ourselves 2 questions:
·
Is the transaction a cash transaction?
·
When did the cash transaction take place?
Inventory Budget: Opening Inventory
+ Production
- Sales
Closing inventory
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Creditors Budget: Opening Balance
+ Purchases
- Cash payment
Closing Balance
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Debtors Budget: Opening Balance
+ Sales
- Cash received
Closing Balance
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Module 8: Budgetary Control To show how flexible budgeting and variance analysis can help in controlling operations. §
The Flexible Budget
·
A flexed budget a budget which is modified to reflect costs that would have been expected for the actual activity.
The flexible budget is therefore created when the actual sales are known.
·
Flexed budgets allow a more informative comparison to be made as it takes into account of the differences between planned and actual production levels.
By adjusting the sales volume, we can analyse those variances which are the responsibility of the production managers.
·
The only difference between master budget and flexed budget is sales volume, therefore, only sales volume and sales volume related figures (such as variable costs) change.
§
Budget Variance:
·
Variance the financial effect, on the budgeted profit, of the particular factor under consideration, being more or less than budgeted.
·
A variance is classified as favourable or adverse depending on its effect on profit.
If it increases profit, then F, and vice versa.
·
Overall budget variance is the profit difference between budgeted amounts at planned sales and the actual amounts at actual sales figures.
We wish to further disaggregate this variance, such as sales level, unexpected changes, and inefficiencies in system.
Overall budget variance is broken into two further variances:
·
Sales Volume Variance (SVV):
profit difference between the original budget and the sales budget.
SVV holds variable cost/unit and selling price/unit constant and measures the effect of selling more/fewer units than planned.
·
Flexed Budget Variance (FBV): profit difference between the flexed budget and actual budget.
FBV consists of price (rate) and usage (efficiency) variances only by holding sales volume constant at the actual level achieved.
·
·
·
·
·
·
§
Investigation of Variances
·
Given that small variances are almost inevitable and that investigating variances can be expensive and time consuming, management needs to establish a policy on which variances to investigate and which put under review. Therefore, management by exception means managers should investigate all material differences, either adverse or favourable.
·
We must investigate adverse or favourable variances as not all favourable variances are what they seem to be:
·
Budgets might be padded, i.e. budgetary slack might be introduced, which would let it appear to be favourable
·
Results might be padded, for example, expenses (e.g. maintenance and repairs) might be delayed and revenues could be hurried up (invoices sent earlier to customers).
·
One variance could have crossover effect on the other, i.e. variances interact, e.g. favourable materials price variance causes adverse materials quantity variance.
·
Favourable variances might also indicate that managers are delaying expenditure, such as repairs and maintenance so that they can remain under budget and are using inferior materials to cut costs.
Module 9: Costing To discuss the importance of costs and cost assignment in planning and control decisions. §
Costing methodology and assignment
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The primary purpose of costing is “cost control”
·
A cost object is any end to which a cost is assigned.
In activity-based costing, cost object is the reason for performing an activity. The object itself does not directly create the cost but requires an activity that has an associated cost.
·
Almost anything can be a cost object. E.g. a product, service, department or other entity
·
We can then assign costs to the cost object consistent with the purpose of controlling costs. E.g. salaries and depreciation
·
There are two ways of assigning costs to a cost objects.
·
Direct assignment: Direct costs are those that can be traced easily and conveniently to the cost object under consideration.
This is an allocated cost. Direct costs include direct materials, direct wages and direct expenses. Indirect Assignment: indirect costs are those assigned to cost objects based on some attribute of the cost objects (these are known as cost drivers). The cost objects are seen as causing the indirect costs, we do this because:
·
Direct assignment is not practical, it may be too costly to compute the exact direct costs, e.g. IT department works for all the faculties in the university.
·
Direct assignment is not possible, e.g.
how much overhead is consumed by a particular cost object.
·
Flexed budgets are a better idea for comparison enabled a more informative comparison to be made as the sales volume figures will be equal.
We can therefore break down overall budget variance into components for better analysis.
Also, by doing this, we are only left with the cost and efficiency variances, which would be the responsibility of the production managers.
·
The only difference between master budget and flexed budget is sales volume, therefore, only sales volume and sales volume related figures (such as variable costs) change.
§
Full cost of a system:
·
The full cost of a system is defined as the sum of is direct cost + fair share of indirect costs or FC + VC. Note that the two definitions are independent of each other.
·
Job costing system is a technique for assigning the full cost per unit of output where the output is not similar.
This costing system assigns costs to a distinct, identifiable job or service.
·
Process costing system is a technique for deriving the full cost per unit of output, where the units of output are exactly similar, or it is reasonable to treat them as being so.
§
Costing Systems:
·
Traditional Costing system: A costing system whereby the indirect costs have few indirect allocations rates (i.e. less cost drivers) and often incorporate into those rates some costs that could have been directly assigned.
There is often a doubtful cause and effect relationship, i.e. relationship between “cost driver” and “cost pool”.
·
Refined Costing system: A costing system that uses more direct cost assignment and has more indirect allocation rates.
There are more “cost pools” and more relevant “cost drivers”.
This system also reflects how the cost objects use the company’s resources.
There are potential benefits of:
·
Allocation of floor space decisions: Profitability is the main factor
·
Pricing decisions: More accurate profit margins will help the managers to decide whether to lower prices due to competition.
·
Cost control: Allows managers to focus on cost-cow activities.
·
Cost prediction (budgeting): more accurate numbers mean more accurate budgets.
·
However, it may sometimes prove to be too costly to apply the refined costing system or that the traditional system yields similar results, thus, rendering the refined system an unnecessary step.
§
Assigning relevant costs to non-routine decision:
·
When making non routine decision, such as: make or buy, accept or deny one-time offer, discontinuing with product line, we must be wary of two things:
·
Indirect cost assignment can mislead, this is because some indirect costs are unavoidable, i.e. they are not incremental.
If a cost is present under all alternatives, then it is not relevant.
·
Only costs or cost saving that differ across alternative choices have an impact on the decision, therefore, only these are relevant.
·
VC may not always be relevant, e.g. direct materials for cost objects not under consideration.
·
FC may not always be irrelevant, e.g. discretionary fixed costs might be relevant are they are avoidable.
Module 10: Time Value of Money & Capital Investment To show how the time value of money and risk can be incorporated into long-term decision-making. ·
Money today is worth more than money later, e.g. forgone interest, effects of inflation and risk.
Therefore, in order to add current and future dollars together, they have to be standardized to a common measure.
§
Standardisation of future dollars
·
Standardisation is to make things comparable; we do this by working out all values as at a single point in time.
·
We need three pieces of information in order to standardise:
·
The amount of cash flow
·
The timing of cash flow
·
The appropriate discount rate, r.
This will be a percentage rate, it mainly takes three elements into consideration:
·
Compensation for the time value of money, this is compensation for waiting, unless the opportunity to invest will offer similar return from interest, opportunity cost will be incurred.
It is the cost of the best alternative strategy (note the interest rates also includes the effects of inflation).
E.g. Government bond.
·
Compensation for risk, hence the greater the risk, the greater the r.
E.g. in buying a new machine, it might not work as well as expected, breakdowns might occur, sales of the produce may not reach targets, labour costs may be higher than expected.
·
Compensation for inflation, or the decrease in the purchasing power of money.
·
These can be summarised by the formula:
Note, is the discount factor.
·
PV=present value; FV=future value; R=discount rate; N=number of periods
·
Alternatively,
·
There are two possible scenarios for standardisation:
·
Annuity: Scenario will be an annuity if:
·
Same solar amount each period
·
Equally spaced periods
·
Same r per period
·
Must have an end.
·
Formula to use is:
OR
·
If the above scenarios are not met, then the present value formula must be used.
Module 11: Capital Budgeting To learn how to evaluate capital budgeting proposals. ·
All capital investment decisions have in common the following criteria:
·
A choice among two or more alternatives (e.g. status quo or change)
·
A significant investment in assets
·
A long-term effect
·
Examples of capital investment decisions include:
·
Expansion decisions, such as expanding into a new product line or geographical area
·
Equipment replacement decision, such as equipment replacement cost
·
Lease versus purchase decision, choosing the cheapest and most effective alternative.
·
The correct choice of alternatives will ultimately be reflected in the financial statements and thus the share price.
As the chief objective of a listed company is the maximization of shareholder wealth, the decisions are very important.
§
Relevant Cash flows
·
We emphasis on cash flows instead of profit as cash is real and focuses on wealth created.
Profit is a result only of dividing up life of the business into periods.
·
Revenues and Expenses:
Only the incremental revenues/expenses that are relevant to the decisions are taken into account. I.e., those that changes across periods.
·
Sunk costs are costs that are not recoverable and are expenditure prior to considering the investment.
Therefore they are never relevant.
·
Overheads could be relevant, if they change across periods
·
Changes in working capital must be taken into account as they tie up cash.
WC have to be paid in the beginning of the project and can be recovered at the end of the project.
·
Note: there are two report formats: total costs VS incremental.
Although each method leads to the same answers, the former is the most common practice.
·
Tax effects of gains and losses
·
Taxes must be paid on incomes as well as on expenses.
This means that the real cost to the company of an expense would be expense* (1-tax rate)
·
Depreciation is also relevant, for two reasons:
·
Although it is not a cash flow, it is a tax deductible expense, therefore, reduces tax burden and creates a tax saving.
Cash inflow(from depreciation)=(depreciation expense)*(tax rate)
·
The profit/loss on the sale of fixed assets will have been affected by depreciation process - the tax paid on taxable gain or saved from taxable losses.
§
Investment Appraisal Methods - Best way to practice is to do examples here!
·
Net Present Value (NPV): NPV=PVinflows – PV outflows
NPV represents the value of cash inflows added to the present value of cash outflows (including the initial investments)
·
If NPV is greater then zero (as shareholder’s expectations are met), then the project is financially viable.
We should choose the alternative with the highest NPV regardless of others.
·
NPV incorporates all of the following:
·
Amount and timing of cash flows
·
All relevant cash flows over the life of the project
·
Clear decision rule (i.e. > or = zero)
·
In line with the objective of the business of maximizing the shareholder wealth.
·
It does however rely on the rate of return, r, which is difficult to estimate and error prone.
·
Internal rate of return (IRR):
The rate of return at which PVinflows = PV outflows.
It is an annual rate of return promised by an investment project over its useful life.
·
If IRR is greater then the required rate of return, then project is acceptable.
·
IRR however, ignore the magnitude of the cash flows.
·
Payback method: Time when cash inflow=cash outflow.
The payback period is the time taken for the project to generate sufficient cash to cover the original investment.
·
Choose the alternative with the shortest payback period or compare with some predetermined minimum standard.
·
There are, however, major weaknesses:
·
It ignore the time value of money
·
Cash flows after the payback period are ignored
·
Could be used in evaluating extremely risky investments (also easy to understand).
·
Accounting rate of return: (ARR): .
·
The idea is similar to return on assets (EBIT/Av. Total assets).
Thus, if ARR >ROA, then accept.
Or we could choose the highest ARR alternative.
·
There are, however, major weaknesses:
·
It focuses on profit, not cash flows.
·
It ignores the time value of money.
·
ARR is used as it is similar to ROA, which is commonly used to evaluate a company’s profitability. Also, many bonus schemes for management are tied to ARR.
§
Weighted Average Cost of Capital (WACC)
·
The rate of return is the rate at which the company must earn to satisfy the providers of capital (debt and equity) – or the WACC.
It is calculate by:
·
where p=proportion of total assets, and r= after-tax cost.
Module 12: Financial Management To explain the costs and benefits of debt versus equity financing and to discuss working capital management.
§
Debt vs Equity
·
One of the two most important topics covered by finance is capital structure.
That is, getting the money to pay for the investments.
These funds can have two general sources: debt and/or equity.
Nearly all companies are comprised in a combination of the two.
·
Debt:
·
Advantages of Debt:
·
The cost of long-term borrowing (interest) is usually lower than the return demanded by shareholders.
·
Lenders face less risk than shareholders:
·
Lenders are entitled contractually to interest and principal, while dividends and capital gain are not guaranteed – they are declared by board of directors.
·
Lenders have priority in bankruptcy over equity
·
Lenders may negotiate over favourable contract terms
·
Secured debt – a debt secured over company assets, in default, the lender can sell the asset and take the proceeds.
E.g. Mortgage.
·
Convertible debt – debt that can be converted into equity, a nice incentive for startup companies where the share price is expected to increase
·
Restrictions placed on the company by creditors. E.g. financial ratios, lenders may require full payment if a ratio falls below a certain level; dividends, lenders could say no dividends or min. dividends.
·
Interest is tax deductible (not so for dividends as they are not an expense, but a distribution of the business’ assets to the owners/shareholders).
Net cost of borrowing = interest rate ×(1 - tax rate)
·
Issuing debt avoids dilution of control of the business: lenders are not owners.
·
Greater variety of debt choices available in the type of debts and the contract terms that govern the debt instruments.
Repayment terms/interest rates/security.
Types of debts include:
·
Bank, debentures (individual contracts) and leasing (effectively owing the rights to use the asset while paying ‘rent’)
·
For a listed company, issuing shares are usually more expensive than borrowing as shares are usually issued through investment banks who charge large transaction costs.
·
Effects of financial leverage.
RoE is increased as gearing is increased IF the interest rates < ROA).
I.e., use borrowings to buy assets à make money on the assets à more money than interest à profit.
·
Equity:
·
Advantages of equity
·
No obligation to pay dividends or repay principal
·
No debt covenants
·
Interest payment fixed, there will be increased financial risk.
Also ROE will decrease if RoA < interest rate.
·
Share capital à equity funds, however, retained earnings are the best way to finance an operation:
·
No costs in raising the finance
·
No dilution of control
·
Less public scrutiny
·
Optimal capital structure:
·
The capital structure helps determine the WACC rate.
As a major goal of the financial manger is to minimise this rate, optimizing the debt/equity mix, hence, the capital structure, is very important.
·
Initially, increased borrowing decreases the WACC rate, but as borrowing increases past a certain amount, the WACC rate levels off and then increases.
This is caused by:
·
Initially WACC decrease caused by the after-tax cost of the borrowing being lower than the shareholders’ required rate of return.
·
Later WACC increases as large amounts of debt increase the risk of financial stress, thus, both debt and equity require higher return (more risk) WACC increases.
§
Working Capital (WC) Management
·
WC management is part of finance that is short-tern.
Good WC management improves net profit, e.g. inventory management, while bad WC management might ruin the business as there will be no money to pay debt when they fall due.
·
Good WC management also is another source of internal equity funds as:
·
Extra funds saved by reducing inventory or A/C receivable or delay paying A/C payable.
·
This is done in an aim to optimize the operating cash cycle (OCC) as this will result in cash held by the business.
Also, there will be increased net profits as costs are minimized with A/C receivable, A/C payable and inventory holdings.
·
Operating Cash Cycle is the time take from the payment for goods until the cash received from debtors.
i.e. the cash “out” to the cash “in” period.
OCC= AAI + ACP + APP
·
AAI = Average age of inventory
·
ACP = Average collection period
·
APP = Average Payment Period
·
OCC is important as is has a significant influence on the financing requirements of the business.
The longer the cash cycle, the greater the financing requirements and the greater the financial risks.
Thus, a business should minimise the OCC
·
Optimising OCC:
·
Inventory Management: If a business has a proportion of its assets in the form of inventory, there is an opportunity cost as the funds tied up cannot be used for more profitable opportunities.
However, a business must ensure there is also sufficient inventory to met likely future sales demand, failure to do so will result in higher freight costs and prices for goods (rush order), lost customer goodwill, lost sales. Inventory levels can be optimized by:
·
Sales forecasting to predict the likely demands for goods
·
Monitor the inventory turnover period, thus identify the economic order quantity for the goods
·
Just-in-time approach to minimise inventory holding, a close relationship with the supplier and a very efficient system is needed.
·
Accurate inventory recording systems, proper authorization procedures for ordering inventory and appropriate levels of security.
Regular physical stock checks can back this.
·
Debtor: Goods are usually sold on credit as it is convenient for customers (and caused impulsive buying), thus, increased in sales.
This, however, may also result in bad debts, financing charges and costs of collection.
·
The debtors levels can be optimized by:
·
Clear policies concerning who should receive credit and the term of the credit.
·
System for investigation creditworthiness
·
Invoice customers promptly and statements and reminders are sent as appropriate stages.
·
Systems for monitoring and controlling debtors e.g. ageing schedules, average settlement period rate.
·
Procedure for dealing with slow payers.
·
The potential costs of Debtor level depend on the approach:
·
Tightening credit policies, e.g. lost sales, increased collection costs.
·
By offering a prompt payment discount.
The cost of prompt payment discount is =
·
D=discount % in whole numbers, N=the number of days shortened in cash received due to the
discount
Generic Glossary
Note: The study of accounting should not be based on glossaries, but rather, on the concepts.
If you wish, you may add more to the list below.
Accounting
| The process of identifying, measuring and communicating information to permit informed judgments and decisions by users of the information.
| Accrued expenses
| Expenses which are outstanding at the end of the accounting period
| Asset
| A resource controlled by the company, providing future economic benefits that can be reliably measured.
| Auditors
| Professionals who make a report as to whether, in their opinion, the accounting statements of a company show a true and fair view and comply with statutory and accounting standard requirements.
| Claim
| An obligation on the part of the business to provide cash or some other benefit to an outside party.
| Control
| Compel events to conform to plan
| Debentures
| A long-term loan, usually made to a company, evidenced by a trust deed.
| Dividends
| Transfer of assets made by a company to its shareholders.
| Expense
| A measure of the outflow of assets (or increase in liabilities) which is incurred as a result of generating revenues in a period.
| Gross profit
| The difference between sales and cost of sales.
This is also known as mark-up.
Gross profit provides the basis for covering other expenses and generating profit.
A business must have an adequate gross profit margin to survive.
| Leverage
| Or known as gearing, it is a measurement of how much the company relies upon external financing.
| Cost of sale
| = Beginning inventory + cost of goods purchased - minus the ending inventory
| Profit
| The difference between the increases in capital attributable to trading (revenue) and the decreases in capital attributable to trading (expenses)
| Owner’s equity
| The owners claim to a business.
OEend
= OEbeg + contributions + revenues – expenses – distributions
| Accounting Equation
| Assets = Liabilities + Owner’s Equity, when expanded:
Assets + expenses + drawings = Liabilities + OEbeg + investments + revenues
| Reserves
| Profits made by the company that form part of the OE.
These include retained profits, revaluation reserves.
These reserves can always be turned into capital, known as bonus shares.
.
| Working Capital
| Current assets minus current liabilities. Working capital measures how much in liquid assets a company has available to build its business. Also known as net current assets or current capital.
|
[1] EBIT=Earning Before Interest and Tax.
This is also known as net profit before interest and tax.
|
发表于 2009-6-14 11:55:28
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变色卡
竟然有101的。。貌似我第一年的东西全丢了 
