Paper 1.

1
Chapter 1

the Definition, Purpose, and the Regulatory Framework of accounting

well, this report isn’t an introduction to accounting as it may seem to be. It’s more like
a summary to the purpose of studying paper 1.1.

Accounting is a way of recording, analyzing, and summarizing transactions of a

business.

Transactions are recorded in books of prime entry, and then analyzed and posted to
the ledgers and finally they are summarized in the financial statements.

Yet, the term ‘Accounting’ not only refers to Financial Accounting, but moreover,

a) Management Accounting
b) Financial Management
c) Auditing

The Purpose, of going through the process of preparing financial statements, may not
be required or needed by most companies, yet some must comply to do so by law.
Nonetheless, they are prepared so that owners, managers, lenders and other
interested parties can see how the business is doing. In other words, to provide
information about the financial position, performance and financial adaptability of an
enterprise that is useful to a wide range of users.

Depending on the users of financial statements, many may require access to different
information, but all share some basic needs. Some of the basic users of financial and
accounting information are:

a) Managers
b) Shareholders
c) Trade contacts
d) Providers of Finance
e) Governments and their Agencies, e.g. Inland Revenue and Registrar of
Companies
f) Employees
g) Financial Analysts and Advisors
h) Investors/ Public

As one may imagine, it may be very hard to satisfy all of the different users, yet, the
basic financial statements at the end of the day, are:

a) The Profit and Loss Account

b) The Balance Sheet

Furthermore, some companies may be required to produce annual reports, which

contain :
Non-Financial Statements, such as:
a) Director’s Report
b) Auditors’ Report
c) Chairman’s Report

Limited companies are required by law to prepare and publish accounts annually. The
form and content of the accounts are regulated primarily by the Companies Act 1985,
but must also comply with accounting standards.

The Regulatory System

Basically the Company Law requires that all companies must comply with the
Companies Act. Of the many requirements and regulations, it must be brought to one’
s attention, that the Financial Statements are required to represent a True and Fair
view of the state of affairs and Profit and Loss.

The Accounting Standard’s Board, previously known as the Accounting Standard’s

Committee, has issued the Accounting Standards, such as FRS’s and SSAP’s. The
accounting standards were developed with the aim of narrowing the areas of
difference and variety in accounting practice.

The Urgent Issues task force is an important part of the ASB in that it is required to
tackle urgent matters not covered by existing standards. The review panel is
concerned with the examination and questioning of departures from accounting
standards by large companies.

Furthermore, the companies are required to follow the Accounting Policies, set out in
FRS 18 and the Companies’ Act. Those policies are summarized in the diagram
above, but it must be noted that there is a distinction between the accounting policies
and accounting estimates.

The accounting policy is concerned with:

a) the recognition
b) Selection of measurement base and
c) Presentation

Of assets, liabilities, gains and losses of an entity. E.g. ‘Prudence or Accruals’? The
choice must be based on which may provide the most true and fair view.

The accounting estimate is the method used to establish the monetary value of
assets, liabilities, gains and losses using the measurement base selected by the
accounting policy,
e.g. depreciation (straight line or reducing balance?)

The ASB also developed a Statement of Principles, which is concerned by:

a) the objective of financial statements

b) the reporting entity
c) The qualitative characteristics of financial information.

Basically the statement of principles provided a Conceptual Framework, which forms

the theoretical basis for determining which events should be accounted for, how they
should be measured and how they should be communicated to the user. A conceptual
framework is a statement of generally accepted theoretical principles, which form the
frame of reference for financial reporting. These theoretical principles provide the
basis for the development of new reporting standards and the evaluation of those
already in existence. In other words, they are there to provide consistency, clarity and
information.

Furthermore, companies are required to comply with the regulations of the European
Union, and various international bodies, and any stock exchange requirements
depending on their circumstances.

In addition to the Financial Statements, limited companies are required to provide

certain notes and disclosures to the accounts, such as:

1. Statement of movements in reserves

2. Details of Fixed Assets
3. Details of post balance sheet events
4. Details of contingent liabilities and contingent assets
5. Details of research and development expenditure.
6. Statement of total recognized gains and losses.
7. Note on historical cost profits and losses.

The following are the important features of Financial Statements

1- Relevance 3-Reliability 5-Objectivity 7-Comparability

2-Comprehensibility 4-Completeness 6-Timeliness

The Qualitative Characteristics of Financial Statements

Content
a) Relevance – Info that has the ability to influence decisions, Predictive Value,
Confirmatory Value.
b) Reliability – Info that is complete and faithful representation. Free from material
error, faithful representation, neutral, complete, and prudence.

Presentation
a) Comparability – similarities and differences can be discerned and evaluated.
Consistency and Disclosure.
b) Understandability – the significance of the information can be perceived. Users’
abilities, Aggregation
And classification
 Paper 1.1

Chapter 2
The Accounting Concepts – Part 1 (The Summary)

Just a basic summary of those little things that we always tend to forget.
The Going Concern Concept implies that a business is a going concern, i.e. that
there is no reason to expect the liquidation of assets. Thus, the business may be
valued at its historical, or current cost, rather than its break-up or replacement
value. A further example to illustrate the application of the Going Concern concept,
may be clearly seen, when stock is valued. It is a practice to value stock at the lower
of its net realizable value or cost of purchase, this is because the going concern
concept implies that the stock is held to be sold at a future date.

The Accruals Concept is based on several ‘ideas’ or practices, which may be clearly
illustrated, if summarized in the following form:

1. Revenue and Costs must be recognized as they are earned or incurred.

2. Revenues must be matched with costs, and vice versa, and dealt with in the profit
and loss account of the period to which they relate.

It is for this reason, that we actually disclose the value of the creditors in the Balance
Sheet, and the value of debtors. Furthermore, although we may have paid rent of
BD 1000, for the next two years for example, we may only note the amount relevant
to this year’s profit and loss account, and the remaining balance, as a prepayment in
the Balance Sheet.

Furthermore, this is the reason why it is required to account for sales and purchases
when made, even though on credit, rather than when they are paid for.

As well as this, the figure for closing stock is also deducted from the figure of
purchases because the figure of closing stock relates to the opening stock figure of
next year’s accounts.

The Prudence Concept

1. a) Where there are alternative procedures

b) Or alternative valuations
c) The one selected should be the one which gives the most cautious
presentation of the business’s financial position or results.

2. a) Revenues and profits are not anticipated but are related to the period in
which they occur. E.g. when a sale is made.
b) Provision is made for all known expenses or losses whether these are known
for certain or just estimates.

What definition means in layman’s terms is simply, if the company is in doubt about
an expense or a liability that it may have, it should create a provision for it
immediately, and if the company anticipates any future gains or profits, from a future
sale for example, it should ignore it, unless realized.
Examples:

1. Provisions for Bad & Doubtful Debts

2. Stock should be valued at the lower of net realizable value or cost

Sales Revenue could be realized, if the following circumstances apply:

1. The transaction is for a specific quantity of goods at a known price.

2. The sales transaction is completed or it is known for certain that it will be
completed.
3. Cash is received for a purchase, or it is virtually certain that cash will eventually be
received.

Consistency Concept states that similar items within a single set of accounts should
be similarly accounted for and that they are treated the same from one period to
another.

The Entity concept states that a business must be regarded as a separate entity
distinct from its owners or managers.

Money Measurement, states that accounts will only deal with those items to which a
monetary value can be attributed, which means that subject matter such as staff is
ignored.

Separate Valuation Principle refers to the amount/cost attributable to an asset /

liability, since the valuation should deal with each component separately. E.g. an
independent valuation should be obtained for each item of stock, and their net
realizable values should then be aggregated to obtain the total value of stock.

The Materiality Concept refers to the following:

Only items material in amount or in their nature affect the true & fair view given by a
set of accounts. In other words, immaterial items are not paid that much attention.
But this is obviously based on a subjective judgment in deciding whether an item is
immaterial or not. Either way, the amount of the item and its context must be
considered.

Historical Cost Convention states that transactions should be recorded at their cost.

Stable Monetary Unit states that the Financial Statements must be expressed in
terms of a monetary unit, e.g. $.

Objectivity Concept states that accounts must be free from bias or subjectivity as
much as possible.

Time Interval, states that the activities of an entity must be split up into blocks of time,
e.g. daily, monthly or annually.

Substance over Form refers to a transaction in two distinct ways, ‘subject’ and
‘form’. Thus, the transaction should be accounted for and presented in accordance
with their economic ‘substance’ not their legal ‘form’. E.g. assets required on a hire
purchase are not legally owned by the buyer even though the substance of the
transaction refers to the buyer as the owner.

The Realization Concept states that revenues and profits are recognized when they
are realized. Basically the Realization Concept refers the question of when does an
entity realize a profit or a gain?
Simply, revenue may be recognized at the point of sale, when the following
conditions are satisfied:

1. The product or service has been provided to the buyer

2. The buyer recognized his liability to pay for the goods
3. The ownership of the goods has passed from the seller to the buyer.
4. The buyer has indicated his willingness to pay.
5. The monetary value of the goods has been established.

Revenue or profits may also be recognized at other situations even if a sale hasn’t
been established, such as:

1. Long term Contracts, where profits/revenues are recognized when the production
on a section of the total contract is complete, rather than when the entire project is
complete.
2. Retail & Hire Purchase, where an actual sale isn’t made unless the buyer finishes
all of his installments. In this case, profit would be the interest added to the cost of
the asset sold.
Paper 1.1
Chapter 3
The Accounting Concepts - Part 2 (The Statement of Principles)

The accounting concepts and conventions are based on years of practice and
judgment. But that doesn’t necessarily mean that they are fool-proof. FRS 18
recognizes this fact, and it provided us with a conceptual framework to base our
accounting standards on. In the previous paper I have explained some of the
accounting concepts which we may have to deal with day in day out, but there are only
two accounting standards that have been emphasized by FRS 18, which are Going
Concern, and the Accruals Concept.

The conceptual framework mentioned above is the theoretical basis for determining
which events should be accounted for, how they should be measured and how they
should be communicated to the user.

Yet, prior to the ASB’s release of the Statements of Principles, the lack of a conceptual
framework created some of the following problems,

1. Fundamental principles were tackled more than once in different standards, which
have caused contradictions, ambiguity and as a result, affected the true & fair
view of Financial Reporting.
2. In the USA for example, the highly detailed number of standards created a set of
rules rather than general principles.

As a result, a basis now exists for reducing the no. of alternative accounting treatments
permitted by accounting standards and company law. Furthermore, the problems
tackled or associated due to the lack of a conceptual framework are now avoided.

Although, many argue that the release of the statement of principles doesn’t
necessarily make things easier or clearer for its users, but I believe that a future
framework for the development of accounting standards now exist, and auditors may
now confirm whether financial statements are based on accountancy standards or not.

The BPP, suggests, that the end-result of the Statement of Principles is that Objectivity
now exists, which decreases the scope of manipulation. Uniformity means that there’s
less scope for disagreement between current conventions and new ones, and finally
Familiarity means that the more people use the accounts, the more they’ll get used to
them.
Paper 1.1
Chapter 4
the Accounting Concepts - Part 3 (Why does the ASB hate Prudence?)

Through time and age, men always seemed to be in contradiction with women, and
that’s how it is with Accruals and Prudence. The puzzled look on every man’s mind
when the lady asks “Do I look fat?” is very similar to that of an accountant, when
asked “Should we report the worst possible situation, prudence? Or the most likely
position, matching?!”

On a more serious note,

1. Prudence is in a conflict with the going concern concept because it may not be
prudent to assume that the business is a going concern.
2. Furthermore, prudence makes it difficult to treat items consistently because at one
period, an item may require different treatment than it did in a previous period.
E.g. prior year adjustments.
3. The prudence concept also contradicts the objectivity concept in that it requires
subjective judgment in prudent situations.
4. It is also difficult to value assets at anything but the historical cost convention
because it wouldn’t be prudent to recognize a gain in revaluation for example.
Seems short, and incomplete doesn’t it? Well any suggestions are welcomed!
Paper 1.1
Chapter 5
The Accounting Concepts - Part 4 (Historical Cost Accounting vs. CPP vs. CCA)

Traditionally, accounts were prepared to fulfill the needs of the owners of the business
and to assist the managers’ for the business to make decisions about the future.
Yet, it was later made clear that the accounts prepared under the historical cost
convention provided misleading information because of the inability to reflect the
changing price levels.

Examples

1. When property appreciates in value, the historical cost convention which values it
at its purchase cost wouldn’t reflect its true and fair value. This means that unrealized
holding gains are not recognized until the period in which the asset is realized, rather
than spread over the period during which it was owned.
2. Depreciation based on a Fixed Assets Historical Cost may be inadequate to
finance the replacement of the Fixed Asset if the appreciation in value is larger than
the depreciation charged!
3. Furthermore, the depreciation charge wouldn’t fully reflect the value of the asset
consumed during the accounting period.
4. The following example applies to stock appreciation during a period of inflation.
During Inflation No Inflation
Sales (100 Units) $ 500 $ 500
Less: Cost of Sales
Opening Stock (100 Units) $ 200 $ 200
Purchases (100 Units) $ 200 $ 200
Closing Stock (100 Units) ($300) ($100) ($200) ($200)

Gross Profit $ 400 $ 300

Basically, the trading account above compares the gross profit of a certain company at
two different accounting periods, one being inflationary whilst the other excludes
inflation. At the beginning of the year the trader had 100 units of stock at a cost of
$200, during the year the trader purchased 100 units at a cost of $200, and at the
year end, the Historical Cost of the 100 units remaining after the sale of $100 units is
$300 due to the appreciation in stock, and thus, inflating profit by $100.

5. HCA ignores any holding gains or losses of net monetary items during a period of
a change in prices/
6. The effect of inflation on capital maintenance is not known. Capital maintenance
is the amount of sufficient retained profit to ensure that the net assets at the end of
a period are at least equal to those at the beginning of the period. I.e. to keep the
capital intact.

As a result of all the previous examples, one can see that over time, the inability of the
HCA to account for changes in price level means that one cannot obtain realistic, true
and a fair view of the company’s accounts from one period to another.

Reasons for Continued Use

1. Easier and cheaper to record transactions, and analyze them based on their HC.
2. The figures are easy to obtain and they are objective and readily verifiable, being
tied to actual transactions, whereas other methods seem to be subjective.
3. HC is easier to understand and users are aware of its limitations.
4. Since revaluations of fixed assets are permitted, the problems associated with
understating the value of property are avoided.

The Current Purchasing Power

The use of the CPP means that the profit for the year is calculated after an adjustment
designed to reflect the effect of general price inflation on the purchasing power of
equity shares. In other words, if you refer back to the example concerning the
appreciation in the price level of the closing stock, you’d find, that previously, $200
would be adequate to purchase 100 units of stock, whereas, now, the 100 units cost
$300 to purchase, thus the purchasing power has dropped by $100, or by 1/3rd.

The Current Cost Accounting

This method of accounting doesn’t attempt to cater for general prince inflation, instead,
profit for the year is to be calculated after allowing for the effects of price increases,
specifically on the operating capability of the particular business.

a) In other words, assets are stated at current value, which is what we do when we
revalue property.
b) Holding gains are excluded from profit in the P&L. how? Well its very simple,
lets just look at the example below.
Paper 1.1
Chapter 6
the Accounting Concepts - Part 5 (Should we depreciate buildings?)

Those Who Say Yes

1. The value of the assets at the start of the period is the same at the year end, thus
no depreciation is necessary.
2. The buildings are well maintained.
3. The value exceeds its cost at the year end, since it appreciates in price, and when
the asset is sold, the sales proceeds would be greater than cost.

Those Who Say No

1. Freehold buildings do not last forever!
2. The depreciation charge is a means of matching the cost of the asset with the
revenue earned over its useful life. This is called the Accruals Concept.
Paper 1.1
Chapter 7
FRS 3
The Structure of the Profit & Loss Account

I have always found this topic to be hard to understand and quite tedious on my brain,
until I began writing about it. So probably, that maybe the best option for those
finding difficulty regarding FRS 3 or any of the other theoretical materials. This
article will cover most of the areas required by Paper 1.1 (as far as I know!).

Well, let’s begin.

If we go back through our mind and reorganize the information we have regarding the
concepts behind accounting and the ASB’s brief history, we’d find that FRS 3 is the
natural step forward after the statement of principles, even if they didn’t necessarily
come in that order.

To put it simply, one of the aims of FRS’s and accounting conventions is to provide a
true and fair view of the company’s financial reports, but to the question is, to whom?
The obvious answer is simply the users of the financial information. As such, FRS 3
was developed to enable the users of financial reports to obtain information of higher
quality by concentrating on the following matters:

- Continuing, Discontinuing Operations and New Acquisitions

- Exceptional and Extraordinary Items
- Disclosures by way of notes e.g. STRGL and Historical Cost Profit/Losses

Continued, Discontinued Activities and New Acquisitions

FRS 3 requires an analysis of the P&L A/C as far as the figure of profit on ordinary
activities before interest, into 3 elements.

1. Continuing Operations, which are activities that will continue to next year.
2. Discontinuing operations, which are activities that have ceased during the year.
3. New Acquisitions, which are new activities that did not exist last year.

What do those things mean again?

Well, if we consider any kind of business during one accounting period, we might
find that the business may acquire new assets, dispose of old ones, and obviously
keep the ones it already uses for the next accounting period.

So basically, the ones it disposes of are referred to as ‘discontinuing operations’, the

ones it keeps are ‘continuing operations’ and the new acquired assets are under the
heading ‘new acquisitions’.

Yet, these three elements do not only relate to the purchase, sale of fixed assets, they
relate to the entire activities of the business. Further examples may be provided at the
end of this article. At the moment let us focus on the reasons why FRS 3 requires that
companies go through this kind of trouble.
Well, to make realistic comparisons between one year and another, FRS 3
emphasizes the need to differentiate between the turnover, cost of sales and the
profit of the three different elements, because in comparing like with like, someone
needing to forecast next year’s turnover and profit can now see how much of this year’
s operations will continue into the future.

The following format of the Profit & Loss Account is a simplified version of that
found in FRS 3, which relate to discontinuing, continuing and new acquisitions:
19x1 19x1 19x0
$m $m $m
Turnover
Continuing Operations 600 400
Acquisitions 50
650
Discontinued Operations 50 25
700 425
Cost of Sales (400) (300)
Gross Profit 300 125
Net Operating Expenses (140) (85)
Operating Profit
Continuing Operations 110 30
Acquisitions 60 30
170 60
Discontinued Operations (10) (20)
160 40
Profit on sale of properties in continuing operations 10 5
Loss on disposal of discontinued operations (15) (10)
Profit on ordinary activities before interest 155 35

The profit and loss account seems very had to grasp at first, but that should be
remedied through practice questions.
Paper 1.1
Chapter 8
FRS 3
Exceptional & Extraordinary Items

when we previously discussed the structure of the profit and loss account as regards
to the continuing, discontinued operations and new acquisitions, the format we drew
up ended with ‘Profit on ordinary Activities Before Interest.’ We will now continue
from there.

Profit on ordinary activities before interest X

Interest Payable (X)
Profit on ordinary activities before taxation X
Tax on profit on ordinary Activities (X)
Profit on ordinary activities after taxation X

Well, what should strike you whilst taking a look at the previous profit and loss
account statements is the use of ‘ordinary activities’. The reason simply being is that
if there exists a profit on ordinary activities, there may be profits or losses on ‘not so
ordinary activities’. But are there?

Well FRS 3 states that there are two types of ‘out of the ordinary items’, which are:

A) Exceptional Items
B) Extraordinary Items

Basically Exceptional items are those items that occur during the ordinary course of
the business but need to be disclosed due to their size or incidence. E.g. a main
customer goes bankrupt, which may increase our bad debts by 50%. This event is
ordinary in that, many of our debtors’ accounts return unpaid, which is why we create
a bad debts provision. Yet, this event is classified as an exceptional item because of
its shier size.

Furthermore, exceptional items, maybe divided into the following categories:

A) Profit or loss on sale or termination of an operation

B) Cost of fundamental reorganization
C) Profit or loss on the disposal of fixed assets.
D) Other items, if they are sufficiently material.

Extraordinary items are those that posses a high degree of abnormality which arise
from events or transactions that fall outside the ordinary activities of the business.
They are so abnormal, that the ASB doesn’t even provide us with an example!

Finally, much has been left unsaid, but the basic information has been motioned, and
it is up to most of us to enquire further and to obtain more information. Yet, at the end
of the day, FRS 3 has put an end to the manipulation of the Profit and Loss account
by limiting the usage of extraordinary items, and providing us with a strict definition of
exceptional items.
Paper 1.1
Chapter 9

FRS 3
Note of the Historical Cost Profits and Losses

I have found this note difficult to understand and follow, perhaps due to the difficulty
of the terms used to describe this note. But who needs this kind of formality?
Simply this note says, okay you’ve revalued your assets in the past, you’ve made
some profits, some losses, you may have disposed some of them too, if that is so,
suppose that the revaluations did not take place, what would the profit or loss be if
they were based on the historical cost figure?

We may answer that question by taking the following steps:

Step 1
Find out the profit on ordinary activities before taxation.

Step 2
a) Calculate the depreciation charges of all assets based on their revaluation
figures.
b) Then calculate the depreciation charges but based on their original historical
cost figure.
c) Find the difference between a) and b), and note it down.

Step 3
Were there any disposals of F.A that have been previously revalued? (There must be
or else, this note wouldn’t be needed in the first place).

a) Well, if the answer is yes, we should calculate the profits/losses made on the
revalued figure. E.g. the revalued cost of the F.A is 200,000, and the sales
proceeds are 300,000. Then the profit would be 100,000. Simple Right?!
b) Now we should calculate the profits/losses that would have made if we used
the asset’s historical cost figure rather than the revaluation cost. E.g. if the
Historical cost of the fixed asset was 100,000 rather than 200,000 (revalued
amount), then the profit would be 200,000. Get it?!
c) We will now simply calculate their difference; in this case the difference
between the two profits is 200 less 100, which are 100,000.

Step 4
we now simply add up the figures obtained in step 2c) and 3c) and the profit before
tax to obtain the historical cost profit on ordinary activities before taxation.

FRS 3, requires that we note down the steps taken from 1 to 4 in a way of note to be
disclosed in the financial statements, and this should be done as per the following
format:

Reconciliation of Profit to Historical Cost Profit

For the year ending 31 December 20x3
$’000
Reported profit on ordinary activities before taxation Step 1
Realization of property revaluation gains Step 3
Differences between historical cost depreciation charge
and the actual depreciation charge of the period calculated
on revalued amounts. Step 2
Historical cost profit on ordinary activities before taxation xxx

now, we know why we do it, how to do it, but the next question is why did we do it
this way?

Step 1
Profits before tax were used because taxation levels may vary from year to year.

Step 2
it is known that the larger the depreciation charges, the lower the profit before tax
would be, since depreciation is an ‘operating expense that is deducted before arriving
at the profit before tax.

As such, revaluing an asset means that, the depreciation charge based on the
revalued amount would change, and thus, affecting the value of the net profit before
tax.

Therefore, to arrive at the Historical cost profit, one must reconcile the current profit
before tax, with any changes of depreciation charged due to revaluations.

This is done, by finding the differences between the historical based depreciation
charges and the revaluation based depreciation charges. Their difference is added
back to the net profit before tax, (if the revaluation depreciation charges are larger
than the historical ones), or subtracted from the net profit, (if the revaluation
depreciation charges are lower than the historical ones.)

Step 3
once an asset is revalued, the difference between the historical cost and the revalued
figure is transferred to the Revaluation Reserve. If at a later period, the asset is
disposed of, any profits or losses would be calculating the difference between the
book value of the asset (Revaluation figure less accumulated depreciation), and the
Sales proceeds.

Thus, the amounts transferred to revaluation reserve remain untouched.

If however, the asset remained at its historical cost figure, rather than revalued, the
profit or loss on its disposal would be the book value (historical cost less accumulated
depreciation), and the sales proceeds.

If an asset was revalued upwards, the profit or loss on the asset would be much lower,
and the opposite is correct if the asset was revalued downwards. This profit or loss, is
transferred to the P&L A/C, which in turn increases or decreases the net profit before
tax.

Therefore, to arrive at the historical cost profit, one must follow the steps in Step 3.
Paper 1.1
Chapter 10
FRS 3
Statement of Total Recognized Gains and Losses

Up until this section, FRS 3 has restructured the P&L, defined the difference between
ordinary, exceptional and extraordinary activities. Now, FRS 3 takes us a step further.
Let us suppose that we have made a holding gain of $50,000, which means that we
have purchased an asset, and through time, it appreciated in terms of value, and now it
is worth $50,000 more than it used to at the time of purchase.

Well, anyone who studied how to revalue assets, which they should before reaching
this topic in their studies, knows that revaluation gains are only recognized if a
professional external value valued the asset. The holding gain would then be
transferred to the revaluation reserve (subject to the deduction of any related
accumulated depreciations).

So now, we have $50,000 in a revaluation reserve. How do we know that this 50,000
relates to this year? Furthermore, what about other reserves, and other holding gains
or holding losses? Would an average user understand these terminologies and how
they affect the financial position of the company as a whole?

Well, to answer these questions, as well as other reasons, FRS 3 introduced the idea
of a Statement of Total Recognized Gains and Losses, which brings together the
information from the profit and loss account, the balance sheet and other supporting
notes for asset revaluations. The following format demonstrates how this is done:

Statement of Total Recognized Gains and Losses

Profit for the financial year $M

(I.e. profit after tax and extraordinary items if any) 29

Unrealized surplus on revolution of properties 4
Unrealized loss on trade investment (3)
30
Foreign currency translation differences (2)
Total gains and losses recognized since last annual report 28
Paper 1.1
Chapter 11
Post Balance Sheet Events

The previous topics dealt mostly with the reasons for accounting standards, their
concepts, how they’re regulated and some of their limitations. Along with FRS 3 and
FRS 18, we will now be discussing further accounting issues which are the subject of
standards.

FRS 3 introduced the idea of disclosure in the form of notes, the reason being is that in
order for the financial statements to provide a true and fair view of the company’s
activities they must include all the information necessary for an understanding of the
company’s position.

Yet, up until now, we have only dealt with those events that have occurred during the
current accounting period. But what about activities that occur after the balance sheet
date? Well, prudence would have us provide a provision for it, wouldn’t it? The accruals
would say if it’s affecting the position of the company at the balance sheet date, then a
provision too should be provided.

E.g. suppose that at the 10th of January, the company decides to go into liquidation and
the company is yet to publish its accounts for the year up to 31/12/2003. Would the
company go ahead and publish its financial statements with any adjustments or
disclosure? Please bear in mind that the accounts were initially prepared on the basis of
the going concern concept.

I believe that you got the idea now. Well, SSAP 17 says okay, any event that occurs
after the b/s date is called a post balance sheet event, some of which may need to be
disclosed without adjusting the balance sheet, while some may need to be disclosed
whilst adjusting the balance sheet.

Post Balance Sheet Events are those events, both favorable and unfavorable, which
occur between the balance sheet date and the date on which the financial statements
are approved by the board of directors.

Well, now that we know what post balance sheet events are, we need to know when the
accounts may need adjustments, or when disclosure in the form if notes is adequate
enough.

Those events, that may need adjustments, are referred to as ‘Adjusting Events’, and
they are defined as:

Adjusting Events are post balance sheet events which

a) Provide additional evidence of conditions existing at the balance sheet date.

b) They include events which because of statutory or conventional requirements are
reflected in financial statements.

Well, if there are adjusting events, then there must be non-adjusting events, right? Yes!
Non-Adjusting Events are events which
a) Arise after the b/s date and concern conditions which did NOT exist at that time.
b) They do not result in changes in amounts in financial statements.
c) Yet they may however, be of such *materiality that their disclosure is required by way
of notes to ensure that financial statements are not misleading.

*An example of the significance of the materiality concept.

Suppose for example a company decides to issue shares after the b/s date, i.e. in the
next accounting period, whilst it is doing so, the accountants are still busy preparing the
financial statements.

Think with me, do we need to disclose the information?

Well, yes! But subject to the following conditions

1) If they are material enough, which they are!

2) If they do not affect the amounts in the previous financial statement.

Finally, a list of examples of Adjusting and Non-Adjusting Events:

Adjusting Events:

1 Resolutions relating to proposed dividends and amounts appropriated to reserves

2 The effects of changes in taxation rates
3 The declaration, by subsidiaries or associated companies, of dividends relating to
periods prior to the balance sheet date of the holding company.
4 The subsequent determination of the purchase price or of sale proceeds of assets
purchased or sold before the year end.
5 The valuation of a property which provides evidence of a permanent diminution in
value
6 The receipt of a copy of the financial statements or other information in respect of
an unlisted company which provides evidence of a permanent diminution in the
value of a long-term investment.
7 The receipt of proceeds of a sale or other evidence after the balance sheet date
concerning the net realizable value of stock
8 The receipt of evidence that the previous estimate of accrued profit on a long term
contract was materially inaccurate
9 The renegotiation of amounts owing by debtors, or the insolvency of a debtor
10 Amounts received or receivable in respect of insurance claims which were in the
course of negotiation at the balance sheet date.
11 The discovery of errors or frauds which show that the financial statements were
incorrect

Non-Adjusting Events

1 Issue of Shares and debentures

2 Purchases and sales of fixed assets and investments
3 Losses of fixed assets or stocks as a result of a catastrophe such as fire or flood
4 Opening new trading activities or extending existing trade activities
5 Closing a significant part of the trading activities if this was not anticipate at the
year end
6 Decline in the value of property and investments held as fixed assets, if it can be
demonstrated that the decline occurred after the year end
7 Government action, such as nationalization
8 Strikes and other labor disputes.
Paper 1.1
Chapter 12
FRS 12: Provisions, Contingent Liabilities and Contingent Assets

As with the requirements of all financial reporting standards, financial statements

must provide all the information necessary for an understanding of the company’s
financial position, in order for them to present a true and a fair view of the company’s
affairs.

As a continuation to the previous standards, such as FRS 3, the statement of principles

and SSAP 17, FRS 12 takes things further by tackling the subject of provisions,
contingent liabilities and contingent assets.

According to FRS 12, a provision is a:

a) Liability of uncertain timing or amount.

b) Liability is an obligation of an entity to transfer economic benefits as a result
of past transactions or events.

According to ME, or in layman’s terms, a provision is a liability that we are uncertain

of, which we may be obliged to settle.

E.g. If a company is obliged to incur clean up costs for environmental damage that
has already been cause, should a provision be made?

Yes, because we incurred the liability of the cleaning costs during a period of time in
the past, and we are now obliged to settle it, but we don’t know when or its amount.
Thus a provision should be made.

But, when are provisions recognized?

1) When a business has a PRESENT obligation as a result of a past event.

2) It is probable that a transfer of economic benefits will be required to settle the
obligation.
3) A reliable estimate can be made of the obligation.

Good, now we know when to recognize them, but what is their accounting treatment?

Well, once a provision is recognized, the company can do one of three things, one is
to provide for the provision and disclose it in our accounts, the next choice is simply
disclose it by way of notes, or to simply ignore it.

If there is a high probability of a transfer of economic benefits and a reliable estimate

could be made for the amount, the company should provide for the provision.

Otherwise, whether there is a remote transfer of economic benefits or not, the inability
to provide a reliable estimate, means that we could do is to disclose the provision by
way of notes.

Worked Example
This example is provided by FRS 12 concerning the costs of restructuring, and it
defines it as a program that is planned and controlled by management and materially
changes either:

a) The scope of a business undertaken by an entity

b) The manner in which the business is conducted.

Such as:

• Sale or termination of a line of business

• Closure of business locations
• Changes in the management structure.

Well, should a provision be made for any of these events, knowing that FRS 12 was
mainly introduced to target abuses of provisions for restructuring?

If there is a present obligation, in a form of a contract or a sale agreement, in which a

reliable estimate can be made for the provision, then a provision should be provided
for, but the costs of the following items should NOT be included:

• Marketing Costs
• Retraining of New Staff
• The cost of investing in new systems.

FRS 12: Provisions, Contingent Liabilities and Contingent Assets

FRS 12 refers to n obligation that arises from a past event, which we discussed earlier,
as a Contingent Liability.

FRS 12 takes the definition further to include the following:

1) A possible obligation that arises from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain
future events not wholly within the entity’s control, OR
2) A present obligation that arises from past events but is not recognized because,
a) It is not probable that a transfer of economic benefits will be required
to settle the obligation.
b) Or the amount of the obligation cannot be measured with sufficient
reliability.

In other words, a contingent liability is an event that may occur subject to uncertain
events beyond the company’s control or it arises from a present obligation from past
events, but couldn’t be recognized due to points 2 a) and 2 b) above.

This means that contingent liabilities should not be recognized in financial statements,
they should only be disclosed.

The required disclosures for a contingent liability are:

• A brief description of the nature of the contingent liability

• An estimate of its financial effect
• An indication of the uncertainties that exist
• The possibility of any reimbursement.
FRS 12: Provisions, Contingent Liabilities and Contingent Assets

A contingent asset, as a oppose to a contingent liability is:

A possible asset, which arises from past events and whose existence will be confirmed
by the occurrence of one or more uncertain future events not wholly within the
entity’s control.

Therefore, a contingent asset should not be recognized at all, in fact they could only
be disclosed.

In conclusion, one can obviously see the application of the prudence concept in
dealing with provisions, contingent liabilities and contingent assets, and as such there
is no surprise as to the accounting treatment of these items. One must also note that
the accounting limitations of the prudence concept also apply.
Paper 1.1
Chapter 13
The Preparation of Financial Statements
The Application of the Accounting & Business Equations

The first article in this site is basically about the definition and importance of
accountancy, its purpose and its role. We will now go further to discuss what the
actual accounts look like and what they are based on.

But before we do so, one must realize the distinction between the preparation of the
final accounts and the bookkeeping process. The bookkeeping process is the
steppingstone of accounting, as it is the process by which the transactions are
recorded in the business, and the preparation of the final accounts begins from there.

Therefore one must learn the mechanics of bookkeeping first, and this is the aim of
the following article.

Setting up a business

Okay, suppose we are required to set up a business, the first thing that we need to do
is to take a loan from the bank, or to save enough money before we actually buy any
premises or whatever.

Well, the money we raised through a loan or through any other way is called the
Capital. The premises that we have purchased is called an Asset, the loan from the
bank is called a Liability.

Capital, Assets and Liabilities are the basis of accounting and they form the
Accounting Equation:

Assets = Capital + Liabilities

So basically, an asset is what a business owns, and a liability is what a business owes
(in this case to the bank), and capital is the investment of money with the intention of
earning a return.

Strictly, capital is the money owed to the proprietor of the business, due to the ‘entity
concept’, which basically means that the business is considered distinct from the
owner, i.e. it is considered as a separate entity. Therefore, it isn’t surprising when we
say ‘the business decided to do this’ rather than the owner or the manager.

Okay, now the company is set up, we bought premises or most likely rented it or
leased it. Now we need to purchase some furniture, maybe a teller, and most
importantly goods to sell!

Well, any expenses in relation to assets such as premises, furniture or teller machines
are referred to as Capital Expenditure which results in the purchase or improvement
of fixed assets, which are assets that will provide benefits to the business in more than
one accounting period, and which are not acquired with a view to being resold in the
normal course of trade.
On the other hand, the expenditure incurred in relation to the purchase of goods is
referred to as Revenue expenditure, which is expenditure incurred for the purpose of
the trade of the business, such as selling and distribution expenses, administration
expenses and finance charges.

The distinction between the two types of expenditure is extremely important, since
each is treated differently in accounting.

To summarize what we have just discussed, any transactions that a business

undertakes may either be classified as capital or revenue transactions, (income or
expenditure), and our capital is made up of assets and liabilities.
Paper 1.1
Chapter 14
the Bookkeeping Process

The process of bookkeeping begins by the issue or the receipt of source documents,
such as invoices, purchase orders or sales orders. Once invoices are issued or
received, the details of that particular invoice are recorded in the appropriate book of
prime entry.

The books of prime entry are summarized above with the inclusion of the journal, which
is shown separately for illustrative reasons only. Well, whenever a sale is made, the
details of the sales are recorded in the sales day book, and similarly for purchases.
Sales returns or purchase returns are similarly recorded in their own books of prime
entry. Any cash related payments or receipts are recorded in the cash day book, which
includes bank related transactions as well.

A separate book is kept for petty cash since most businesses keep a small amount of
cash on the premises to make occasional small payments in cash, e.g. postages, taxi
fares, etc. the petty cash account can also be the resting place of occasional small
receipts, such as cash paid by a visitor to make a phone call, etc. As one may imagine,
although the amounts involved are small, petty cash transactions still need to be
recorded, otherwise the cash float could be abused for personal expenses!

Furthermore, under what is called the imp rest system, the amount of money in petty
cash is kept at an agreed sum or ‘float’. The imp rest system is a system where a refund
is made of total cash paid out in a period. E.g. if the float is agreed to be at $250, then
at the end of the period, whatever is spent, would be refunded back from the cash
account.

Sales or purchases on credit are not only recorded in books of prime entry, such as the
sales or purchase day books, but they are also recorded in what is known as
memorandum accounts or personal accounts. As such, these accounts contain the
balances outstanding for each personal debtor or creditor. These books aren’t a part of
the accounting system, but they are necessarily kept for the company to know who to
pay, and how much, and who to expect payment from, etc.

In addition, on a periodic basis, (daily, weekly, monthly), the business would begin to
summaries the transactions recorded in the books of prime entry, and it would record
them in the nominal ledger, which consists of a large number of accounts, each account
having its own purpose or ‘name and an identity or code. E.g. we could have a ledger
account for rent, in which all rent payments are recorded, similarly for telephone
expenses, etc.

On a monthly basis, or during another periodic basis, the business might begin a
process of bank reconciliation, which is basically a way of making sure that the amounts
reflected in the cash book are equivalent to that found in the bank statement.

The company may also keep a set of control accounts, which refer to an account in the
nominal ledger in which a record is kept of the total value of a number of similar but
individual items. Control accounts are used chiefly for debtors and creditors.
For example, a debtors control account is maintained in which records of transactions
involving all debtors in total are kept so that the balance on the debtors control account
at any time will be the total amount due to the business at that time from its debtors.

Basically control accounts are impersonal ledger accounts that will appear in the
nominal ledger.

At the end of the year, any necessary adjustments to the accounts, either due to error
or change in accounting policy, or for whatever reasons are recorded in a journal,
which is one of the books of prime entry. Hence, the journal entries and the ledger
account balances are summarized in a trial balance, which is a list of ledger balances
shown in debit and credit columns. The journal entries and the trial balances are then
used to formulate the profit and loss account and the balance sheet.
Paper 1.1
Chapter 15
Preparing Financial Statements
The Cost of Sales
The Trading Profit & Loss Account

At the end of the accounting period, when the accountants begin to close off accounts
in preparation for the financial statements, there are a few important tasks to do first.
The first of which is to calculate the closing stock of the period, to prepare the
Trading, Profit & Loss Account, Bank Reconciliation, etc.

Stocktaking

On the bases of the accruals concept, revenues should be matched with their relevant
cost as per the corresponding period. As such, any stock that remains unsold at the
end of the accounting period isn’t included as a part of the cost of sales for that
period. Get it? Well, it’s like a prepayment, u don’t actually account for it during the
current period, because it is relevant only to the following period.

Well, for this reason, the company should find out how much stock it has on hand at
the end of the accounting period, this stock is called closing stock, and the process of
finding out how much you have of it is called stocktaking.

This process is easy if the company is a relatively small where it could actually
physically count each item of stock. Yet as the business grows larger the quantity of
stock held becomes harder to determine.

Therefore a business may wish to close down for a short period for a stock take, or a
business may prefer to keep a detailed record of stock movements whilst baring the
large related costs and headaches!

In more complicated cases, a business may wish to maintain continuous stock records.
This means that a card is kept for every item of stock, showing receipts and issues
from the stores, and a running total.

The Cost of Goods Sold

Now that we figured out what the closing stock value is, all we simply need to do is to
deduct it from the cost of sales during a period to determine the profit. The cost of
sales, or cost of goods sold is simply the expense incurred purchasing stock during the
period. It is calculated using the following formula:

Cost of Sales:

Opening Stock
Add: Purchases
Add: Carriage In
Less: Returns Inwards / Purchase Returns
Less: Damaged or Stolen goods
Less: Closing Stock
Please note that the cost of goods manufactured or purchased is adjusted to allow for
increases or reduction in stock levels during the period. This is why purchases,
opening stock and closing stock are used in the formula.
The next step is to draw up the Stock Account and the Trading, Profit & Loss
Account.

These accounts are usually drawn up at the end of the accounting period once the
stocktaking process has ended, and all adjustments to the accounts and corrections
have been made.

The trading profit and loss account has allowed us to calculate the net
profit and the gross profit for the period. If you would look at the date entries, you’d
notice that aside from the opening stock, all are at the year-end.

Other expenses would include selling and distribution expenses, administration

expenses, such as depreciation, bad debts, wages, etc.

Paper 1.1
Chapter 16
Stocks and How To Value Them

In this article we would briefly explain how to determine the purchase cost of stocks, the
problems associated in determining how they are valued, and the basic methods used
to solve these problems.

The Purchase Cost of Stocks

basically, when a company purchases stock from a creditor, whether by cash or on

credit, the company would gather the source documents, and enter the details in the
books of prime entry. Thus, the cost paid for each purchase is the purchase cost of
stock, right?

Not necessarily, because first of all, the cost paid for each item purchased may differ
during each purchase, either due to discounts, sale, inflation, etc. In addition, imagine
purchasing 100 items of stock every month, and at each month the amount paid for
each item differs slightly, how is it possible to calculate which item was sold and how
much money we made on each item?

Furthermore, imagine items being returned others being damaged or stolen. The
process of thinking about it is tedious enough imagine trying to record it!

NRV, Current Replacement Costs and the Selling Price of Stocks

basically, before we proceed, Stock is valued at the lower of its net realizable value and
its historical cost value. The net realizable value is the expected selling price for each
item of stock less any costs still to be incurred in getting them ready for sale. The
Current Replacement Cost is the amount it would cost to replace each item of cost.
Historical Cost is simply the cost at which they were originally bought.

The reason why stock is valued at the lower of the net realizable value and historical
cost is due to the prudence concept. The selling price is avoided because it would
include a profit figure for the business before the stock is even sold!

Furthermore, SSAP 9 encourages the use of two methods FIFO and AVCO, and
discourages the use of LIFO whilst valuing stock.

FIFO, AVCO and LIFO

FIFO stands for, First in, First Out, and it assumes that materials are issued out of
stock in the order in which they were delivered into stock. In other words, the first item
supplied is the first item sold. Hence, issues are priced at the cost of the earliest
delivery remaining in stock.

LIFO stands for Last in, First Out, and it assumes that materials are issued out of stock
in the reverse order to which they were delivered. In other words most recent deliveries
are issued before earlier ones, and are priced accordingly.

AVCO stands for Cumulative Weighted Average Pricing, which calculates a weighted
average price for all units in stocks. This could be very helpful in determining the cost
of consignment stock. Basically a new weighted average price is calculated whenever a
new delivery of materials into store is received.

Well basically it says that at the particular date we either had a receipt of goods into the
company, or we issued some goods. In other words receipts are purchases and issues
are sales (I used the terms receipts and issues as it was used in the BPP example). The
number of units received or issued, their corresponding unit price and their market
value on the date of transaction are also presented.

The problem is to put a valuation on the issues of materials, and the closing stock, and
how they would be

valued using FIFO, LIFO and Average Cost.

FIFO

First, entering and calculating the details as per the requirements of each header. As
you can see, whenever units are issued, we select the balance of the first remaining

LIFO

The process of calculating the closing stock value in terms of LIFO is very similar to
FIFO except for a major difference, in that whenever units are issued we select the
pricing of the latest units received.

AVCO

The process of using AVCO is slightly more complicated. A new cumulative weighted
average cost per unit is calculated whenever units are received/purchased/supplied. It
is calculated by dividing the Closing Stock Value by the total balance of units remaining.

Furthermore, whenever items of stock are issued, the cost per item is the cumulative
weighted average cost calculated previously. This cost is also used to calculate the new
cumulative average cost whenever units are later received.
Let us now take this example a little further, in order to realize how the closing stock
figure affects the cost of goods sold and the company’s gross profit.

Remember the sale price per unit in the table that includes the summary of the
transactions above?

Well, each unit was uniformly sold for a price of $20, thus since total issues (sales) are
1000 units, the figure for sales is $22,000.

To calculate the cost of sales (COGS), we need to obtain the values for opening stock,
closing stock, and purchases. The first two are already available. But what about
purchases?

A well purchase is simply calculated, by adding up the value of each receipt. Now let us
summarize all this information, into the following profit and loss account:

FIFO LIFO AVCO

Sales 22,000 22,000 22,000
Less Cost of Sales
Opening Stock 3600 3600 3600
Purchases 16600 16600 16600
Closing Stock (6000) (14200) (5700) (14500) (5874) (14326)
Gross Profit 7800 7500 7674

Now, although these calculations may look difficult at first, practicing selected questions
make them seem really easier. Yet, in reality the calculations may actually be much
more complicated and more difficult to manage.

The next point that I would like to bring to your attention is how the gross profit differs
when each method is selected. Yet, the continuous use of each method, would mean
that the profit differences are only temporary, since the closing stock values would be
the next period’s opening stock values, which would affect the cost of sales and profits
in the future so that the inequalities of the cost of sales each month will even
themselves out.
Paper 1.1
Chapter 17
Defining, Finding and Correcting Bookkeeping Errors
the Trial Balance, Reconciliation and Control Accounts

whilst maintaining records during the bookkeeping process, human error could occur
quite easily, and as such, it becomes necessarily important to spot the errors and
correct them accordingly.

There are various types of errors that may occur, and each is classified under one of
the following categories:

1. Omission – a transaction is not recorded at all

2. Error of commission – an item is entered to the correct side of the wrong account.
3. Error of principle – an item is posted to the correct side of the wrong type of
account.
4. Error of original entry – an incorrect figure is entered in the records and then
posted to the correct account
5. Reversal of entries – the amount is correct, the accounts used are correct, but the
account that should have been debited is credited and vice versa.
6. Addition Errors – figures are incorrectly added in a ledger account.
7. Posting Error
a) an entry made in one record is not posted at all
b) an entry in one record is incorrectly posted to another
8. Compensating errors – two equal and opposite errors leave the trial balance
balancing
9. Trial balance errors – a balance is omitted, or incorrectly extracted, in preparing
the trial balance.

The Correction of Errors

The Trial Balance

Many of us believe that the trial balance forms the bases of summarizing all the debits
and credits of the company’s nominal ledger and journal entries in order for us to simply
pull out the data to reproduce the profit and loss account and the balance sheet. While
that is so, it is further used to spot any errors that usually cause the trial balance not to
balance. In other words we find that the debits are larger than the credits or vice versa.
The following methods are often used to find and correct these errors and to further
test the accuracy of the accounts. Obviously compensating errors are the hardest to
spot since they couldn’t affect the balance of debits and credits on the trial balance.

Suspense Accounts

Errors are often corrected by the use of journal accounts or through the use of a
suspense account when the trial balance does not balance. Basically a suspense
account is a temporary account that may be used to correct any mistakes at the year-
end or whilst preparing the draft accounts. An accountant may also use it when he is
not sure of where to post a transaction. Errors 6, 7, and 8, mentioned above, require a
suspense account to correct them; otherwise only a journal entry is necessary. Trial
balance errors do not require journal entries or a suspense account, it is simply
amended.

Suppose a company revalued an asset and the accountant wasn’t sure whether he had
to create a revaluation reserve or not. The accountant may open a suspense account
and debit it with the balance on the provision for depreciation account. Once the
accountant realizes that he should actually create a revaluation reserve account, he
would simply credit the suspense account and debit the revaluation reserve. As such
the suspense account is closed off, and the error is corrected.

When tackling examination questions involving the correction of errors, one must pay
attention to the following points.

1. Deal with the errors in order and mark those that affect the balancing on the trial
balance, as these would require a suspense account.
2. Then open a suspense account, if the trial balance shows that debits are more than
credits, one must credit the suspense account with the difference, otherwise debit
the suspense account with the difference.
3. Adjust the suspense account with the necessary amendments until the debits equal
the credits on both sides of the account. Please note however, that it is necessary to
make sure that you debit or credit the right side of the suspense account!

Bank Reconciliation
It is not surprising to find that the balances on the bank statement do not match those
found in the cashbook. There are many reasons for this, and not necessarily only do to
errors.

The circumstances that may affect the cashbook are:

1. Interest, Dividends charged or received may not be recorded in the cashbook as

these things are usually automated.
2. The company might have a standing order, which the accountant may have
forgotten to record.
3. A bounced cheque.

The circumstances that may affect the bank statement from representing the correct
picture shown in the cashbook are:

1. Errors – the least possible reason

2. Unprotected Cheques, i.e. customers yet to present their cheques to the bank, and
as such the company’s bank account is yet to be debited.
3. Timing differences. These may occur frequently since the company records a
transaction in its book as soon as a sale is realized, not necessarily when cash is
received. Suppose that two days prior to the receipt of the statement, we sell some
goods, and we deposit the customer’s cheque in the bank. This cheque would take
a few days more prior to having the money actually credited to the bank account.

This process is called ‘clearing’, and as such we receive a bank statement that
doesn’t mention any cheques being deposited, even though it had.

It is therefore necessary to reconcile the cashbook with the bank statement to make
sure that the differences are due only because of Unprotected Cheques or Timing
Differences,
because otherwise, the closing balance in the cashbook may include bad debts in the
form of bounced cheques, or any form of error.

This process of reconciliation is fairly simple, but may be confusing at start. The first
thing one does is to spot the errors, and the reasons for difference. The reasons are
then divided in the form shown above. The balance on the cashbook and bank
statements are then corrected accordingly, and hopefully they would both match. The
balance on the cashbook will always be the balance shown in the balance sheet.

Debtors and Creditors Control Accounts

another way of checking the accuracy of the bookkeeping process and to locate the
errors is through the use of Control Accounts. Control accounts are impersonal
accounts that will appear in the Nominal Ledger.

A debtor’s control account is an account in which records are kept of transaction

involving all debtors in total. In other words the balance on the debtors control account
at ay time will be the total amount due to the business at the time from its debtors. Does
BPP explanations make sense? NOPE. This is why I’m writing this article.

Whenever a business makes a sale on credit, the bookkeeper will send out an invoice to
the debtor, and the details of the transaction would be recorded in the debtor’s personal
account. Well, imagine trying to aggregate the total of the outstanding balances of all
debtors at the year end? Imagine the room for error?

Therefore, the bookkeeper may simultaneously open a debtors control account in the
nominal ledger, where the accountant would summarize the entire transactions of the
day, week or month, depending on the volume of credit sales.

Obviously at the year end when the bookkeeper decides to double check whether the
balance on the debtors account is correct, he may add up the balances on the personal
accounts, if they both match, then obviously the debtors control account is correct.
Otherwise, there’s an error that must be corrected.

Furthermore, the multiple-choice questions really test your ability to understand the
topics mentioned above. I have just summarized them but without serious practice,
Paper 1.1
Chapter 18
Suspense Accounts and Journal Entries

Suspense accounts have been a troubling issue whilst studying Paper 1.1 maybe it just
requires more practice. As such, I have decided to present some tips that I found to be
extremely helpful:

1. You must have a very good understanding of the errors, especially those that
require the use of suspense accounts.
2. Obviously a sound knowledge of the double entry system.
3. Even when journal entries aren’t required, please make sure to prepare them
for each error, as it will indefinitely lead you to solving the problem correctly.

Furthermore, if you follow the following steps, you shouldn’t go wrong:

Step 1

Identify the type of each error or adjustment, if it requires a suspense account,

mark it with an ‘S’, if it requires a journal entry mark it with a ‘JE’, otherwise, mark it
with an X. Nearly all errors require journal entries, even those that need suspense
accounts such as:

a) Casting Errors
b) Posting Errors (only those affecting the balance). Those not affecting the
balance only require journal entries.
c) All trial balance errors that affect the balance, e.g. something is omitted or
incorrectly extracted to the trial balance, etc.
d) Deliberate errors, these are due to the accountant deliberately trying to make
the trial balance ‘balance’.

Step 2

Once you’re done with step 1, try to picture the affect of the error in your mind, try to
tell yourself for example “the result of this error is that the sum of the debits of the
trial balance is larger than the sum of credits”, which means that to correct this error,
you need to do the opposite.

Step 3

If the debits are greater than the credits, then you immediately know that we need
more credits to balance the account, so we need to CREDIT the suspense account
with the difference.

Remember, if:

a) DR>CR then CR the suspense account with the difference

b) CR>DR then DR the suspense account with the difference
Let us look at the following situations, remember you need to think about three
important matters regarding each error:
1. Do they affect the trial balance?
2. What kind of account are they affecting?
a) Assets or Expenses?
b) Capital, Liabilities or Income?
3. What kind of error is it?

Now for the situations, taken from various question papers to give you a good
understanding of the errors.

Situation 1

A creditor’s account had been debited with a $300 sales invoice (which had been
correctly recorded in the sales account).
‘Sales’ is an income account, it should have therefore been credited, as such, a
debtor’s account should have been debited. This error does not affect the suspense
account, because although the transaction was posted to the wrong account, the
account was debited with the correct amount.

As such, the journal entry would be

Debit Debtor’s $300

Credit Creditor’s $300

Situation 2

the heat and light account had been credited with gas paid $150.

The heat and light account, is an expense account, it should have been debited rather
than credited. This error therefore increases the credits rather than increasing the
debits, as such it involves the use of a suspense account, but how?

Well, let us start by using journal entries first.

Debit Heat and Light $300

Credit Suspense Account $300

Situation 3

G Gordon had been credited with a cheque received from G Goldman for $800. Both
are debtors.

Wow, is this slightly confusing or what? Well we are told that both are debtors, so I
assume that instead of crediting G Goldman for $800 we credited the wrong debtor.
That’s all. Therefore the transaction doesn’t affect the trial balance, only a journal
entry is needed to correct the error, which is:

Debit G Gordon $800

Credit G Goldman $800

Situation 4

The insurance account contained a credit entry for insurance prepaid of $500, but the
balance had not been carried down and hence had been omitted from the trial
balance.

This means that a trial balance wasn’t debited with $500, which affects the balance.
As such, a suspense account is needed. The journal entries would look like:

Debit Insurance Account $500

Credit Suspense Account $500

Remember a prepaid account is a debit account, and an accrued account is a credit

account!

Situation 5

The purchase returns account had been over-cast by $700.

Remember a purchase returns account is a credit account, if it has been over-cast by

$700, this means, that the credits on the account have been added incorrectly,
whereby the credits have been increased by $700. Therefore, the transaction affects
the trial balance, and needs a suspense account to correct it. The journal entries are:

Debit Purchase Returns $700

Credit Suspense Account $700

Situation 6

$8,980, the total of the sales returns book for September 20x8, had been credited to
purchase returns account.

We said a purchase returns account is a credit account, and sales returns book is a
debit account. Therefore in this case we credited the purchase returns instead of
debiting the sales returns, in which we increased our credits. Thus a suspense account
is needed, as well as two transactions!

Debit Sales Returns $8980 (this is done to post the correct entry)
Credit Suspense Account $8980

Debit Purchase Returns $8980 (this is done to cancel out the error made)
Credit Suspense Account $8980

Situation 7

$9600 paid for an item of plant purchased on 1 April 20x8 had been debited to plant
repairs account.

Instead of debiting plant at cost with 9600, we debited plant repairs account, this is an
error of principle, it doesn’t affect the trial balance, and it therefore doesn’t need a
suspense account. The journal entry would be:

Debit Plant at cost $9600

Credit Plant Repairs Account $9600
Paper 1.1
Chapter 19
FRS 1 – Cash Flow Statements

Cash flow statements concentrate on the sources and uses of cash and are a useful
indicator of a company’s liquidity and solvency. In other words it is about a page long
and it summarizes the inflows and outflows of cash under specific sections. Most
importantly though, a cash flow statement distinguishes between profit and cash.

Why?

Well, it has been argued that the figure for profit in the profit and loss account is
misleading because it is calculated after numerous non-cash deductions or additions
such as depreciation, profit on disposal of assets and accruals, whereas a cash flow
statement simply says, let’s just discuss what the company paid or received in terms
of cash only.

To illustrate this further, suppose a company made a profit of 1 million pounds, does
this necessarily mean that it has that amount of money in its bank account? As such,
the survival of a business depends not so much on profits as on its ability to pay its
debts when they fall due.

Obviously a company’s net cash flow within a specific period may be measured by
deducting the opening cash balance from the closing cash balance. However, would
not one prefer to know the details of the transactions? Or what their effects are?

Without disclosing much information, it is recommended that a cash flow statement

summarizes the inflows and outflows of cash under the following categories:

1. Net Cash Flow from Operating Activities

2. Returns on Investments and Servicing of Finance
3. Taxation
4. Capital Expenditure and Financial Investment
5. Acquisitions and Disposals
6. Equity Dividends Paid
7. Cash Flow before Management of Liquid Resources and Financing
8. Management of Liquid Resources
9. Financing

Okay, but what do these headlines mean, and where do we get the information to
find the net cash flow for each of these categories?

Operating Activities

operating activities refer to the company’s trading activities and day-to-day

operations, such as selling, distribution, administration expenses, etc. The cash flow
statement attempts to summarize the net cash flow of these transactions, and this
may be done in two distinct ways:

1. The Direct Method

2. The Indirect Method
The direct method of calculating the net cash flow from operating activities is done in
the following way:

Cash received from customers

Less: Cash paid to suppliers
Cash paid to and on behalf of employees
Equals: Cash flow from operating activities

The indirect method calculates the net cash flow from operating activities using the
information from both the balance sheet and the profit and loss account, and it does
so in the following way:

Operating Profit before Interest and Tax

Add: Depreciation
Loss on sale of fixed assets
Decrease in stocks and debtors
Increase in creditors
Less: Profit on sale of fixed assets
Increase in stocks and debtors
Decrease in creditors
Equals: Net cash flow from operating activities

Please Note

1. Depreciation is not a cash expense, similarly for the loss or profits on disposal.
2. Increase in stocks or debtors means that the company paid more money during the
period to do so.
3. An increase in creditors means that the company paid less money during the year
for its purchases.

Returns on Investments and Servicing of Finance

this section includes cash received resulting from the ownership of investments other
than those invested in joint ventures and payments made to providers of finance
other than equity finance. It also includes where appropriate, the interest element of
payments made under finance leases.

E.g. interest paid for loans, or dividends paid to preference shareholders

Taxation

any taxation paid in respect to the profits of the company less any tax rebates or
returns in respect of overpayments.

Capital Expenditure and Financial Investment

These include the sales proceeds or the payments to purchase fixed assets such as
plant, buildings, equipment, motor vehicles, etc, including long-term investments
made in the shares or debentures of other companies, unless the acquisition of
other companies is involved.

Acquisition and Disposals

Cash flows in respect of acquisition and disposals are only related to parent
undertakings, such as the acquisition or disposal of any investment in a subsidiary,
associate or joint venture.

Equity Dividends paid

these are simply the amount of dividends paid to equity shareholders.

Management of Liquid Resources

Liquid resources are current asset investments that are held as disposable stores of
value. They are either

a) readily convertible into known amounts of cash at, or close to, its carrying amount
b) traded in an active market

E.g. treasury bills and shares on the stock exchange.

Financing

these represent amounts received from providers of finance, both debt and equity
finance, less principal amounts repaid. This section also covers the capital elements
of payments made under finance leases.

E.g. Receipts from issues of shares or debentures, and any repayments of amounts
borrowed.
Paper 1.1
Chapter 20
An Example of a Cash Flow Statement & Accompanying Notes

Cash flow Statement for the Year Ended 31st December 20x3
$000 $000
Cash Flow From Operating Activities (note 1) 15672

Returns on Investments and servicing of finance:

Interest Received 858
Interest paid (1939)
Preference dividend paid (450)
Interest element of finance lease rentals (358)
(2239)
Taxation (2887)

Capital expenditure and financial investment:

Purchase of tangible fixed assets (3512)
Sale of trade investment 1595
Sale of plant and machinery 1052
(865)
Acquisitions and disposals: (not required for Paper 1.1 Students)
Purchase of subsidiary undertaking (12705)
Net overdrafts acquired with subsidiary (5516)
Sale of business 4208
Purchase of interest in a joint venture (3811)
(17824)
Equity dividends paid (2606)
Cash outflow before use of liquid resources and financing (10399)

Management of liquid resources:

Cash withdrawn from 7 day deposit 200
Purchase of government securities (5000)
Sale of government securities 4300
Sale of corporate bonds 1200
700
Financing:
Issue of ordinary share capital 600
Increase in short term borrowings 2006
Repayment of secured loan (850)
New secured loan repayable in 20x7 1091
New unsecured loan repayable 20x5 1442
Capital element of finance lease repayments (1342)
2947
Decrease in cash (6752)

Note 1 – Reconciliation of operating profit to operating cash flows

Operating Profit 17213

Depreciation Charges 3488
Increase in stocks (11840)
Increase in debtors (3774)
Increase in creditors 10585
Net cash flow from operating activities 15672
Paper 1.1
Chapter 21
Share and Business Valuation

Breakup Valuation is based on the forced sale of individual assets in the second hand
market. Basically, the current values of all assets are added up together.

The Advantages

1. It represents the minimum value at which the company can be sold

2. If company ignores breakup value, an opportunity exists for asset-strippers
3. An indication of the min amount of capital that could be obtained for investment

elsewhere.

The Disadvantages
1. Ignores that the company is a going-concern
2. Values on assets are estimates
3. Sale value of fixed assets is hard to ascertain.

Book Value: Original Share Capital + Reserves

the Advantages

1. The figures are factual as they are based on historical cost

2. They are easily obtainable
3. The figures for debtors and non-equity liabilities are accurately reflected.

The Disadvantages

1. Inflation means that historical cost is not an accurate measure of current value
2. Historical costs aren't very accurate due to inaccurate measures of depreciation.
3. The book value of stock is unlikely to reflect its current value, because market values
often include an element of profit.
4. Ignores the existence of intangible assets such as goodwill.

Replacement Cost: Replacement Cost of Assets less: All Liabilities

The Advantages

Assets are valued at their replacement cost!

The Disadvantages

1. The cooperation of the company is needed to identify assets

2. Intangible assets such as goodwill aren't recognized
3. Replacement cost may overvalue the company.

Earnings Yield 100 = Annual Earnings Yield X 100 or 1 X 100

Required Earnings Yield P/E Ratio
The value of a company on the earnings-yield basis is the value of the stream of profit,
or earnings which the company is expected to generate.

The Disadvantages

1. It is based on predictions, assumptions and estimates.

2. Micro/Macro economic factors may cause distortions in present/future value of
shares.
3. Dependant on access to inside information.
4. Results achieved in the past don't necessarily reflect future earnings.

Price Earnings = Market Price of One Share (from Stock Exchange)

Earning per share (profit after tax/Issued shares )

An unlisted company can therefore be valued by multiplying its earnings by the P/E
ratio of a similar company.

The Disadvantages

1. The P/E ratio of an unlisted company is expected to be less than that for a
corresponding listed company and so the use of unadjusted quoted ratios can results
in overvaluation on
2. High trading may cause overvaluations of share prices.

Dividend Yield =Dividend for the year (Including Interim Dividend) X 100
Quoted Market Price ( In Pence )
Paper 1.1
Chapter 22
Solvency & Financial Strength

Short-Term Solvency

Working Capital (Current) Ratio = Current Assets: 1

Current Liabilities

1. The ability to pay debts as they fall due

2. The rate of stock turnover must be considered, since the lower it is, the more
stock there is.
3. The average ratio for the industry and the economy must also be considered.
4. A ratio below 1 means that a company may not be able to pay its short term debts

Liquidity (Quick) Ratio = Current Assets - Stock:1

Current Liabilities

1. One must carefully consider which of the current assets to include or omit.
2. Stocks should be normally excluded, as well as prepayments.
3. All liabilities should be included, but one must understand the significance of
including tax which is usually paid within 9 months, and an overdraft, which is a
revolving source of finance.
4. A ratio below 1:1 usually causes a company great difficulty in meeting its debts as
they fall due.
5. An excess of 1:1 means that the company is in possession of surplus cash,
although solvent, there must be some doubt whether it is making the best use of
available resources.

Longer-Term Financial Strength

Proprietorship Ratio = Shareholders' Equity X 100

Total Sources of Finance

1. The proportion of business assets financed by shareholders.

2. The larger the proportions of business activity financed by shareholders the
smaller are the creditors' claims against the company.
3. This said Equity finance is normally repaid only when the company is wound up,
and only when there is sufficient finance, although dividends are paid, the company
is not legally obliged to do so.
4. One normally expects shareholders to provide at least half the finance.
5. It represents, to the creditors, the extent to which a company can stand a fall in the
value of its assets before the creditor's position is prejudiced. E.g. 75% means that
assets must fall by 25% before the creditors' position on liquidation is jeopardized.

Interest Cover = Net Profit before Interest And Tax

Interest Charged

1. It stresses the importance of a company to meet its interest charges out of

revenue, and this is expressed as a multiple of operating profits.
2. A low figure indicates that interest payable imposes a heavy burden on the
company's finances, thereby increasing the risk of insolvency.
3. It is expected that it will fall immediately following a loan issue, e.g. Debentures.
4. Interest charges are usually fixed per year, so one should also consider the
possibility of a fall in profits; a low interest cover could basically make a company
insolvent.
Paper 1.1
Chapter 23
Asset Turnover Ratios

Stock Turnover Period = Avg. Stock Level X 365

Cost of Goods Sold

1. Measures the speed with which a company turns over its stock
2. Multiplying the ratio by 365 represents this ratio in terms of days that elapse
between the date that goods are delivered by suppliers and dispatched to customers.
I.e. the stock holding period.
3. Companies must strive to keep the stock holding period as low as possible in order
to minimize associated costs.
4. A reduction in the average period for which stocks are held, suggests that the
purchasing, distribution, and selling functions have been streamlined
5. Higher sales and market activity, usually increases the stock figure to ensure that
additional consumer requirements can be met without delay.
6. An increase in sales without a similar increase in stock means that resource which
would otherwise be tied up in stock, is available for use elsewhere in the business.

Rate of Collection of Debtors (Debtor’s Payment Period)

Avg. Trade Debtors X 365
Credit Sales

1. The higher the figure, the more it is assumed that money tied up in debts are
resources that are yielding no return and also losing value during a period of inflation.
2. Therefore the reasons for the change should be carefully investigated, to find out
whether
a) There was an increase in the credit period to generate more sales
b) There is slackness in the credit-control department.
3. Please note that the sales figure in the P&L is exclusive of VAT but the debtor’s
figure is inclusive.

Rate of Payment of Creditors = Avg. Trade Creditors X 365

Credit Purchases

1. Measures the average period of time taken by companies to pay their suppliers.
2. A change in the rate of payment may well reflect an improvement or decline in
liquidity.
3. Normally it is expected that rate shouldn't vary very much from year to year.
The Cash Operating Cycle:

Stock Turnover of Raw Materials

Add: Turnover of Work in Progress
Turnover of Finished Goods
Rate of Collection of Debtors
Less: Rate of Payment of Creditors

1. A period of time elapses between the payment for goods or raw materials received
into stock and the collection of cash from customers in respect of their sale. The gap
is known as the Cash Operating Cycle' and, during this period of time, the goods
acquired, together with the value added in the case of a manufacturer, must be
financed by the company.
2. The shorter the length of time between the initial outlay and the ultimate collection
of cash, the smaller is the value of working capital to be financed.

Fixed Asset Turnover = Sales: 1

Avg. Fixed Assets

1. Measures the degree of fixed asset utilization

2. The ratio is likely to reveal excess capacity from time to time during the life of a
business.
3. The excess capacity may be unavoidable for a number of reasons, e.g. acquisition
of new assets
4. Similarly, the Total Asset Turnover may indicate the same assumptions; it is
calculated by calculating the figure for Total Assets rather tan the Avg. Fixed Assets.
Paper 1.1
Chapter 24
Profit Ratios

Gross Profit Margin = Gross Profit X 100

Sales

1. Since all costs that are deducted when computing the gross profit are directly
variable with sales, it is assumed that the gross profit margin should remain
unchanged.
2. Yet this view is less popular for a manufacturer because the COGS includes fixed
costs such as factory lighting and heating, factory rent and rates, and semi-variable
costs.
3. The change may occur due to: Price cuts, cost increases, changes in mix, under- or
overvaluation of stocks.

Net Profit Percentage = Net Profit before interest and tax X100
Sales

1. It is designed to focus attention on the net profit margin arising from business
operations.
2. Net profit, like gross profit, increases with sales, and this increase occurs as a
percentage of sales.

Rate of Return on Gross Assets = Net profit before interest and tax X 100
Avg Gross Assets(Total Assets less Current Liabilities)

Or = Total Asset Turnover x Net Profit Percentage

Sales X Profit Before Interest & Tax

Capital Employed Sales

1. Also known as the Rate of Capital Employed, Shareholder's Equity, Long-Term

Capital Employed.
2. It measures the extent at which the management makes the most effective use of
available resources
3. Since Total Asset Turnover multiplied by the Net Profit Percentage is equivalent to
the Return on Gross Assets, one must note that lower asset utilization must be
compensated by the profit margins, or vice versa, to effectively manage the Rate on
Gross Assets. This is why this ratio is described as the primary accounting ratio.
Therefore, it may be necessary to calculate the asset turnover ratio and the net profit
margin to find out why the ROCE is high or low.
4. As such there’s a tradeoff between the net profit percentage and the total asset
turnover, the reasons being, a high net profit percentage, means a higher price per
unit, which may not generate a high number of sales, hence, a lower asset turnover.
Rate of Return on Shareholder's Equity = Earning (Pre or Post) X 100
Avg. shareholder's Equity (Share Capital + Reserves)
1. Measures whether the rate of return on the shareholder's funds is adequate
enough to continue with their investment or not, the earnings yield and dividend yield
should also be examined.
2. A popular view is to compare the rate of return with current interest rates.
3. Whilst there might be a significant drop in the rate of return on gross assets,
similarly, the same may be expected with the rate of return on shareholder's equity.
Yet, the difference is that the return earned for shareholder's is dependant on 3 key
factors, profit margins, asset utilization and capital structure, whereas the return on
Gross Assets ignores the last factor.

Earnings per Share = Earnings (Post Tax Profit less Preference Dividends) X 100
Number of equity shares issued(less: Preference Shares)

1. Applies only to listed companies.

2. When a loss is suffered the EPS is negative.
Gearing Debt ratios are concerned with how much the company owes in relation ot its
size, whether it is getting into heavier debt or improving its situation, and whether its
debt burden seems heavy or light.

The debt ratio is the ratio of a company’s total debts to its total assets

Debt Ratio = Total Debts (Total Creditors) X 100

Total Assets

Capital Gearing Ratio = Prior charge capital (Capital carrying right to fixed return) X 100
total capital (Total Assets less Current Liabilities)

When a loan is raised, the effect is to introduce an element of gearing or leverage

into the capital structure of the company. The debt: equity ratio is perhaps the most
commonly used, and it maybe calculated in either of two ways:

1. These ratios are used to assess whether the rate earned on the additional funds
raised exceeds that payable to the providers of the loan.
2. In other words to increase the return on gross assets and on shareholder's equity.
3. The shareholder's of a highly-geared company reap disproportionate benefits when
earnings before interest and tax increase. This is because interest payable on a large
proportion of total finance remains unchanged.
4. The converse is also true; a highly geared company is likely to find itself in severe
financial difficulties if it suffers a succession of trading losses.
Paper 1.1

Chapter 25
Sole traders vs. Partnerships vs. Limited Companies

Sole traders

whoever opens up a business is a sole trader as long as he is the single owner of the
business. Legally, the business and the owner are not separate entities; they are one
and the same. However, accounting views the business as a separate entity to be
distinguished from its owner. Nevertheless, the sole trader is still personally liable for
the debts of the business.

Partnership

A partnership is an unincorporated business that is owned by two or more persons

known as partners. A partnership is governed by the Partnership Act 1890, and it is
formally established by means of a partnership agreement, which specifies such
matters as the distribution of profits, salaries, etc.

As with sole traders, accounting views the partnership as a separate business entity to
be distinguished from its owners. Similarly, each partner is responsible for the debts of
the business. This means that each partner has what is called an unlimited liability.

Limited Companies

Limited companies are governed by the Companies Act 1986, and the owners of a
limited company are its members or shareholders.

There are two classes of a limited company, which are:

- Private Companies, they are owned by members and they cannot invite members
of the public to invest in their equity (ownership).
- Public Companies, they are owned by shareholders, who may purchase further
shares or sell the ones they own to the general public on a Stock Exchange.

As with Sole Traders and Partnerships, a limited company is also viewed as a separate
entity from its shareholders. Yet, shareholders benefit from what is known as a limited
liability. This means that their liability extends as far as the capital they invested, and
nothing more. Hence the term ‘limited’ in reference to limited companies.

The following table summarizes the advantages and disadvantages of being a sole
trader, having a partnership or a limited company.

Sole Traders Partnerships Limited Companies

Advantages

sole traders partnerships Limited companies

1. Easier to set up 1. Risks are spread over a large number of partners 1. Limited
Liability
2. The owner is the manager of the business.
2. Easier to raise finance from external sources such as banks.
2. Easier to
raise capital through the issue of shares.

Disadvantages

1. Unlimited Liability 1. Unlimited Liability 1. Compliance with the Companies Act,

Accounting Standards.
2. Harder to raise capital. 2. Profits are spread over a large number of people 2.
Prepare annual audited accounts, and keep accounting records which are sufficient to
show and explain the company’s transactions.
3. Control is diluted over the business amongst several partners
3. Disclose a lot of information which may not be
advantageous to disclose to competition
4. Partners may have disputes 4. Must keep statutory books
5. At a partner’s death, insolvency or mental incapacity, the partnership must go
through what is known as dissolution
5. Formation and annual registration costs.
paper 1.1
Chapter 26
Partnerships

Capital Accounts

When a partnership is formed each partner puts in some capital to the business, and
each is recorded separately in a series of capital accounts, so that a record I skept of
how much is owed to whom.

Current Accounts

each partner will also have a current account, which is used to record the profits
retained in the business by the partner and it differs from the capital account in that
the later remains ‘static’ from year to year whereas a current account is continually
changing due to the making of profits and drawings.

Basically any income transferred to the current account, is a credit entry, and any
expense charged to the current account is a debit entry.

Interest on Capital

a partnership agreement also provides for interest on the balance of the partner’s
capital account NOT the current account. The interest received by each partner is
transferred to the current account.

Drawings

whenever a partner makes any drawings, the transaction is recorded in a drawings

account as with sole traders. Yet, in addition, at the year end the drawings will be
cleared to the current accounts.

Loan to the Partnerships

Partners may loan the business some money, whilst earning interest from the
business too. This loan is treated as a current or long term liability rather than a
partners’ fund.

The interest received by each partner on the loan is transferred to their current
account and it is treated as an expense in the profit and loss account. In addition, if
there’s no interest rate specified, the Partnership’s Act 1890 provides for interest to
be paid at 5% p.a.

Appropriation of Net Profits

In preparing the final accounts of the business, we would normally arrive at the net
profit of the business at the end of the profit and loss account. Since each partner
may share a different amount of profit in what is known as a profit sharing ratio, the
net profit should be appropriated to each of the partner’s current account. This
process is done as follows:
Step 1 – Arriving at the Net Profit figure.
Operating Profit
Less: Drawings
Salaries
Interest payable to partners’ (Except those payable on loans)
Add: Interest on Drawings (These are deducted from the current account)
Equals: Residual Profit

Step 2 – The Profit Sharing Ratio

The Residual Profit is now divided amongst the partners in proportion to the profit
sharing ratio.

Please Note
1. Drawings, interest on capital and salaries are NOT expenses in the P&L.
2. Interest on loans ARE expenses, therefore they are not deducted from the
Operating Profit.
Paper 1.1
Chapter 27
Group Accounts & Consolidated Balance Sheets

Group accounts are required when a company acquires another company. The first
company is called the holding or parent company and it controls the latter company,
which is called the subsidiary.

Group accounts basically consist of a consolidated balance sheet, which is a balance

sheet that shows the net assets that the Holding Company controls and the
ownership of those assets.

The Group’s Capital and Reserves consist of the holding company’s capital and
reserve and the group share of post-acquisition retained reserves of the subsidiary
company. It also consists of what is called Minority Interest.

The Preparation of the Group’s Consolidated Balance Sheet

Step 1

you must first make sure at what date the acquisition took place. The reason for this
is to have a clear picture in your mind concerning the events that occurred at the
acquisition date and those of which occurred since.

Step 2

the next step is to find out whether other parties hold a minority interest of the
subsidiary’s consolidated net assets. This is done by dividing the amount of shares
acquired by the subsidiary’s total share capital. The percentage of minority interest
should be noted down.

Step 3

when separate calculations of post acquisition profits, goodwill or minority interest

are needed rather than all of them, just take a look at the column of each category
to find out how to calculate it.

Going through the calculations in this manner ensures that the possibility of your
errors is minimal, and if they do occur you can systematically find out where they did.
80% Total of Total Equity
 Paper 1.2
Chapter 1
The Purpose of Cost Accounting

Cost accounting is part of management accounting, and its purpose arises due to
the management’s need for specific or more detailed information as oppose to that
provided by financial statements. Hence cost accounting will provide information to
assist the management with planning, control and decision making as well as
accumulating historical costs to establish stock valuations, profits and balance sheet
items. All of this is done with the help of a Management Information System, which is
simply a general term for the computer systems in an enterprise that provide
information for management.

Therefore the key points of cost accounting are:

• The recording and analysis of actual costs

• The forecast of future costs
• Cost control

Cost Classifications

As such, it is necessary to be able to understand the basic cost classifications and

behavior to manage a cost accounting system.

Costs may be classified as either of the following:

1. Direct or Indirect Costs

2. Function Costs
3. Fixed or Variable Costs
4. Product Costs or Period Costs
5. Available or Unavailable
6. Controllable, Uncontrollable, or Discretionary Costs

Direct or Indirect Costs

A direct cost is a cost that can be traced in full to the product, service or department
that is being coasted. These costs consist of direct labor, direct materials, and any
other direct costs.

Whereas an indirect cost is a cost that is incurred in the course of making a product,
providing a service or running a department, but which cannot be traced directly
and in full to the product, service or department. These costs consist of the following:

a) Production overheads: indirect materials, indirect wages and indirect

expenses
b) Administration overheads: e.g. depreciation and office salaries
c) Selling Overheads: e.g. commissions, advertising, market research, sales
promotion
d) Distribution Overheads: e.g. cost of packing cases, insurance charges.

The two definitions mean that every product, service or department will incur a direct
and indirect cost. Furthermore the total cost of every product, service or department
is the sum of the relative direct and indirect costs.

Total Cost = Direct Cost + Indirect Cost

Function Costs
Costs may also be classified by their function, i.e. what kind of service was the cost
incurred to do? The answer to this question may be categorized in any one of these
classifications:

a) Production Costs
b) Administration Costs
c) Selling Costs
d) Distribution Costs
e) Research & Development Costs
f) Financing Costs

Fixed or Variable Costs

A fixed cost is a cost which is incurred for a particular period of time and which, within
certain activity levels, is unaffected by changes in the level of activity. A variable cost
however is a cost which tends to vary with the level of activity.

Product Costs or Period Costs

Product costs are those identified with a finished product, as a part of the value of
stock. They become expenses in the form of cost of goods sold. Whereas period
costs are costs that are deducted as expenses during the current period without
ever being included in the value of stock held.

Avoidable or Unavoidable
simply costs are avoidable, if the company could avoid them, and similarly for
unavoidable costs.

Controllable or Uncontrollable
Controllable costs are those that can be controlled by the company whereas
uncontrollable costs are those outside the scope of the business.

Discretionary Costs
These costs are likely to arise from decisions made during the budgeting process.
They are likely to be fixed amounts of money over fixed periods of time. E.g.
Advertising, R&D, training budgets.

Cost Units
once costs are recorded, i.e. the total costs of department ‘A’ are $100,000; one
may prefer to analyze the cost per each unit. This is referred to as a cost unit, and it
could be cost per kg, cost per machine hour, etc.

Cost Objects
what if the manager comes up to you and says, what’s the cost of operating
department ‘A’? This cost is referred to as a cost object, or objective, and it is any
activity for which a separate measurement of costs is required, e.g. the cost of a
product or the cost of a service, etc.

Responsibility Centers
A responsibility centre basically involves analyzing costs, profits or revenues and
attributing them to specific managers or ‘centers’. In other words, the costs of
department ‘A’ are the responsibility of Manager ‘A’, whereas the costs of Machine
‘A’ is attributed to the operator of Machine ‘A’. Basically, responsibility centers maybe
categorized as follows:

a) Cost Centers
b) Profit Centers, where profit centre managers should normally have control of
how revenue is raised and how costs are incurred.
c) Revenue centers, whose responsibility is revenue only.
d) Investment centers, whose responsibility is that of a profit centre with
additional responsibilities for capital investment and possibly for financing, and
whose performance is measured by its return on investment.

Conclusion

1. We know what information is, why it is needed and that it is managed within a
Management Information System.
2. We said that an MIS is needed to enable the management to have sufficient
information to do their job.
3. Cost Accounting is a part of MIS and it basically helps us with
a) the classification of actual costs incurred
b) the preparation of budgets of planned costs
c) The comparison of actual costs and budgeted costs

4. This system involves the classification of costs into several categories such
as direct and indirect costs, function costs or fixed and variable costs.
5. Costs are based on cost units and cost incurred is allocated to a cost centre
such as a department or a machine.
Paper 1.2
Chapter 2
Cost Behavior

The knowledge of cost behavior is essential for the tasks of budgeting, decision making
and control accounting, whose importance was established in the previous article. Cost
behavior is the way in which costs are affected by changes in the volume of output. In
other words, this article will attempt to describe the behavior of various costs with the
volume of output.

The principle of cost behavior is simple, as the level of activity rises, cost will usually
rise, but the difficulty arises when one needs to determine the way in which cost rise
and by how much as the level of activity increases.

A Cost Behavior Pattern could be established for certain costs that ‘behave’ in a
‘predefined’ or ‘usual’ way, which we may illustrate graphically. In the course of this
article we will discuss the cost behavior of the following items:

1. Fixed costs
2. Step costs
3. Variable costs
4. Semi-variable costs
5. Total costs and unit costs

Fixed Costs

these costs are not generally related to the volume of output or to the level of activity
within a firm, although they do increase with time. As such, they will not follow the
principle of cost behavior mentioned earlier (costs rising as level of activity rises), e.g.
the salary of a managing director, or the straight line depreciation of a machine.

Cost
Volume of Output
As you could see, fixed
costs are not affected by the
volume of output
Fixed Costs
Step Costs

These costs are fixed in nature but only within certain activity levels, e.g. if you employ
100 employees their salaries would be a fixed amount of $100k per year, yet, if you
increase the number of employees to 150, the fixed amount of salaries would naturally
increase.

Variable Costs

A variable cost tends to vary directly with the volume of output. As such it is natural to
expect that they have a ‘linear’ or uniform relationship with output.

Cost of raw materials, direct labor and sales commission may behave in this way
subject to price per unit of materials or labor is constant.
Cost
Volume of Output
As you can see, each extra
unit of output causes a
proportionate increase in
cost.
Variable
Costs

Cost
Volume of Output
Notice how costs remain
fixed until a specific volume
of output is reached, which
causes costs to immediately
Step Costs rise.

Semi-Variable Costs

A semi-variable cost is a mixed cost, which consists of both a variable and a fixed cost,
therefore they are partly affected by the volume of output. A typical example could be
electricity, where a fixed fee is paid per month as well as a charge per unit of electricity
consumed. Semi-variable costs could behave in either of the following two ways:
The Cost Behavior of Unit Costs and the Volume of Output

The total fixed costs incurred by a business is constant with the level of output, whereas
variable costs behave in a ‘variable’ way, whereas the total costs (Sum of all costs),
behave as semi-variable costs. Yet, what if we considered the fixed cost per unit
produced, or the variable cost per unit produced, what would the cost behavior
pattern

as you could see, the variable cost per unit remains constant because it will always cost
the same to produce one unit. Fixed costs per unit will gradually decrease with output
because fixed costs remain constant regardless of output, yet as output increases the
FC/unit which is FC/volume of Output, becomes smaller. Total costs are the sum of the
VC and FC graphs.

Cost
Volume of Output
Each extra unit in A causes
a less than proportionate
increase in cost whereas in
B, each extra unit of output causes a more than
proportionate increase in cost.
Semi-Variable
Cost A
Semi-Variable
Cost B
Variable Cost
Fixed Cost Total Cost

Assumptions and Conclusions

1. Within the normal or relevant range of output, costs are often assumed to be either
fixed, variable or semi-variable.
2. Variable costs have a linear relationship with the volume of output
3. Fixed costs are constant
4. Semi-variable costs have a curvilinear relationship
5. When activity levels rise, variable costs per unit remain constant, the fixed costs
per unit falls and the total cost per unit falls.
Paper 1.2
Chapter 3
Understanding the Correlation between Total Costs and the Volume of
Output

Although the cost behavior pattern of fixed, variable and semi-variable costs seem to
be straightforward, the mere cost behavior pattern isn’t sufficient enough to enable us
to control or anticipate future costs in order for us to set budgets, or to base
management decisions on them. It is necessary, to determine the correlation between
total costs and volume of output.

This article will focus on the various methods available, how to use them for
forecasting purposes and their limitations. It is important however to realize that each
of the following methods is only an estimate and each of them will produce different,
but rather similar results. The following methods are available:

1. High-low method (with or without inflation)

2. Scatter graph method and the line of best fit
3. Regression analysis
4. Least squares method

The High-Low Method

The high-low method may be used to determine and differentiate betw

Paper 1.2
Chapter 4
Direct and Indirect Materials: Part 1 - The control of stock items.

The purpose of this article is to develop an understanding of how cost accountants deal
with stocks, how they are valued and most importantly, how they are controlled.

Remember that costs may either be an expense, which would be written off in the profit
and loss account, or a cost may be an asset, which would be carried forward in the
balance sheet. This is due to the application of the accruals concept. It is therefore
necessary to classify costs in the most appropriate manner, so that they are valued,
accounted for, and controlled as efficiently as possible.

As such, this article would answer the following questions:

1. How are items of stock, such as materials, controlled within a cost accounting
system?
2. What are the reasons for holding stock and what are the limitations of doing so?
3. What are the appropriate methods of establishing reorder levels whilst
minimizing the cost of holding stock trough the interpretation of optimal reorder
quantities?

How are items of stock, such as materials, controlled within a cost accounting system?

1. Stocks are controlled using what is known as a stock control system. This
system should cover the following functions:

a) The ordering of stock

b) The purchase of stock
c) The receipt of goods into store
d) Storage
e) The issue of stock and maintenance of stock at the most appropriate level.

The reasons are due to the following points:

a) Holding costs of stock may be expensive
b) Production will be disrupted if we run out of raw materials
c) Unused stock with a short shelf life may incur unnecessary expenses.

2. Furthermore, proper records must be kept regarding the ordering, receipt and
issue of stock using the following process:

a) When stocks reach the reorder level, the stores department issues a purchase
requisition to the purchase department to order further stock.
b) The purchase department then issues a purchase order to the supplier
c) Once the stock is delivered, the storekeeper signs a delivery note. The stocks
are then further inspected for deficiencies. If all is okay, the store keeper prepares a
goods received note (GRN) to the accounts department that check it with the purchase
order. The supplier is paid.

The reasons are to ensure that:

a) Enough stock is held
b) There is no duplication of ordering
c) Quality is maintained
d) There is adequate record keeping for accounts purposes.

3. Storage of Raw Materials; Storekeeping involves storing materials to achieve the

following objectives:
a) Speedy issue and receipt of materials
b) Full identification of all materials at all times
c) Correct location of all materials at all times
d) Protection of materials
e) Efficient use of storage space
f) Maintenance of correct stock levels
g) Keeping up to date records

This is done through the use of:

a) Bin Cards – kept with the actual stock and updated whenever items are issued
or received.
b) Stores Ledger Accounts
c) Stock Codes – materials held in stores are coded and classified

4. Stocktaking – this process involves counting the physical stock on hand at a

certain date and matching it with the balance shown in the stock records. This process
should enable us to avoid discrepancies, check our records, and make sure that we
know the free stock balance, which is actual stock that is available for future use.
Stocktaking may be periodic or continuous, in which the later involves using a perpetual
inventory system.

Remember that:
• Materials in stock plus Order from Suppliers less materials requisitioned equals
free stock balance.

5. An Order Cycling Method may be used, where quantities on hand of each stores
item are reviewed periodically.
6. A Two-bin system may also be used whereby each stores item is kept in two
storage bins. When the first bin is emptied, an order must be placed for re-supply.
7. Materials may be classified as expensive, inexpensive or middle-cost range.
Whilst the last two items are stored in large quantities, the expense items are subject to
careful stores control procedures.
8. Computerization, whereby stock masters file is maintained concerning all the
transactions and details of stock movement. This will ensure the following:

a) Easier process
b) Better maintenance of records
c) Backup copies could be made.

What are the reasons for holding stock and what are the limitations of doing so?

The main reasons for holding stock are:

1. To ensure that sufficient goods are available to meet expected demand.

2. To provide a buffer between process (in cases where output stock is the input
stock for another process.
3. To meet any future shortages
4. To take advantage of any bulk purchasing discounts
5. To absorb seasonal fluctuations and any variations in usage and demand.
6. To allow production process to flow smoothly and efficiently.
7. Holding stock is necessary due to fermentation, e.g. wine.
8. As a deliberate investment policy, e.g. in times of inflation or shortages.

There are two kinds of limitations arising due to stock holding

A) If stocks are held at a high level:

1. Cost of storage and stores operations increase

2. Insurance costs arise
3. Risk of obsolescence – stock being damaged or going out of fashion
4. Opportunity costs – instead of purchasing stock and holding them you could
have invested the money elsewhere.

B) If stocks are held at a low level:

1. Cost of obtaining stock may increase – if stocks are kept too low, every time a
new order is needed, the firm must incur cost of obtaining stock, such telephone calls,
transportation, etc.
2. Stock out costs- whereby items of stocks run out. This may result in a lost
contribution from sales, or a loss of future sales from disappointed customers, or worse,
cost of production stoppages.

Paper 1.2
Chapter 5

Direct & Indirect Materials: Part 2 – Stock Reorder Levels

What are the appropriate methods of establishing reorder levels whilst minimizing the
cost of holding stock?

Step 1
An analysis should be made regarding past stock usage and delivery times, whereby a
series of control levels can be calculated and used to maintain stock at their optimal
level.

Step 2
Basically, stock control levels are established, such as:

a) Reorder levels
b) Reorder quantity
c) Maximum level
d) Minimum level
e) Average stock level

a) When stocks reach the reorder level, an order should be placed to replenish stocks.
The level is determined by the following formula:
Reorder level = Maximum level x Maximum Lead time
Where maximum lead-time refers to the time between placing an order with a supplier
and the stock becoming available for use.
b) The reorder quantity is the quantity of stock to be ordered when stocks reach the
reorder levels.
c) Maximum levels could lead to unnecessary holding costs, and this level may be
established by the following formula:
Maximum level = Reorder level + Reorder Qty – (Minimum level x Maximum lead time)
d) When stocks reach the minimum level, stakeouts may occur, and the level may be
established by applying the following formula:
Minimum level = reorder level – (Avg. Stock Level x Average Lead Time)
e) The average stock level refers to the average stock held within an accounting
period.
The following formula assumes that stock levels fluctuate evenly between the
minimum stock level and the highest possible stock level.

Average Stock = Minimum Stock + ½ Reorder Quantity

Step 3: Economic Order Quantity

Now it is necessary to calculate the Economic Order Quantity. This is the order quantity
that minimizes the total costs of holding and ordering stock.

Usually the economic order quantity is found at the point where holding costs equal
ordering costs, which will be demonstrated by the following graph:

As you could see, as the average stock level or the order quantity increases, the
holding costs increases proportionately or variably, yet the cost of ordering stock
gradually decreases. The total cost curve is the sum of both the ordering and holding
costs. As one could obviously see, the point where holding costs equal ordering costs,
is the same point where the total costs are at the lowest level. This is referred to as the
economic order quantity, i.e. the point where it is most efficient to order stock items.

This could also be demonstrated, or calculated using the following formula

(Refer to Mathytpe)

Step 4: Economic Batch Quantity

In step 3, we assumed that the re-supply of stocks is instantaneous, i.e. whenever we

need the stock we order that amount exactly. Yet, what if re-supply is gradual rather
than instantaneous, i.e. an order of units is received gradually in batches?

This situation requires an amendment to the economic order quantity, to what is known
as the Economic Batch Quantity.

Where:
If you compare this formula to that for the EOQ, you would notice that the amendment
involved replacing ….
Ordering Costs
Holding Costs
Total Costs
Actual Costs ($)
Order Quantity (Units)
Average Stock Level (Units)
So if the annual demand per year is 100 units, and the annual rate of production is 200
units, then we are selling half of what we’re producing. As such the costs of holding will
drop by one half because we aren’t storing all of our productions, get it?

As you could see … is used because total stocks held per annum aren’t ‘Q’ but ….
This is due to batch productions and as such there is a gradual resupply.

Step 5: Economic Order Quantity and Discounts

Obviously the EOQ must be modified if bulk discounts are available. This is done to
decide whether it would be worthwhile to take a discount and ordering large quantities,
or not.

Obviously the deciding factor will be the lower of total costs when
a) Discounts are taken (minimum order size needed to take the discount)
b) Pre-discount EOQ level.
This is simply calculated as follows:
Total Costs of a) =
Purchases
Less: Discounts
Add: Holding Costs
Add: Ordering Costs

Total Costs of b) are found using the EOQ formula. The lower of a) or b) wins the vote!
Paper 1.2
Chapter 6
Overheads and Absorption Costing: Part 1 - Apportionments

In accounting, there are various methods in dealing with direct and indirect costs,
some of which have been explained in previous articles, such as direct/indirect
materials and labor costs. The following series of articles aim to define and explain
the different methods of dealing with overheads.

Overheads are by nature, indirect costs. They are defined as a cost incurred in making
a product or a service, but cannot be traced directly and in full to the product or
service.

Overheads may be classified as manufacturing or non-manufacturing overheads for

the purpose of this article.

Manufacturing overheads being those costs related to the product or service as defined
above, and non-manufacturing overheads are those that cannot be directly allocated to
particular units of output.

Absorption Costing

In absorption costing, overheads will be added to each unit of output of products

manufactured and sold. It is a method for sharing overheads between different
products on a fair basis.

In other words, it says, look at all those manufacturing overheads incurred, and let’s
add them to the cost of sales!

SSAP 9 recommends this method because cost of all stocks should consist of all costs
incurred in the normal course of business in bringing the product to its ‘present
location and condition.’ Overhead costs are incurred to produce the finished
product(s) including administration and directors’ wages, without them the products
wouldn’t exist! Therefore it is justifiable to charge each unit of output with some of
the overhead costs.

There are also various practical reasons for using absorption costing:

1. Stock Valuations – Closing and Opening Stock would consist of manufacturing

overheads, as such, increasing the value of gross profit, by carrying forward the cost in
the balance sheet as a current asset, rather than writing it off as an expense in the
profit and loss account.
2. Pricing Decisions – If you were to provide a service or a product for a customer, you
would like to know the full cost to be incurred, including no manufacturing costs as
well. This will enable you to determine how much of this cost should be bared by the
customer. Capuche?
3. Profitability of different products – Since overheads are shared on a fair basis and
charged to the cost of sales of each product/department/service, one could ascertain
the profitability of each product/department/service.
The Process of Absorption Costing

Simply, there are three stages:

1. Allocation
2. Apportionment
3. Absorption

Allocation involves allocating manufacturing and non-manufacturing overheads to

various cost units or cost centers. Apportionment is the process by which general
overheads are shared out on a fair basis between each cost center. In other words, it’s
a process of taking all the non-manufacturing overheads and distributing them to
those involved in production. Absorption is the process by which the costs calculated
for each cost center is finally added to unit, job or batch costs. Thus, establishing the
cost per each unit produced, which would enable us to value both opening and closing
stocks, the cost of sales, and the gross profit of the business.

Allocation

this step is very simple. First we establish the various cost centers within the
business, e.g. Production Department A and B, Services Department C and D. We
then allocate all relative costs to each of these departments.

Apportionment

The process of apportioning overheads is based on what is called Basis of

Apportionment. This means that overhead costs are shared out on a fair basis which
could be the floor area occupied by each cost center, when rent, rates heating and light
repairs are concerned, or cost or book value of equipment when depreciation of
equipment is concerned, etc.

Once a basis for apportionment for each service or non-manufacturing cost is

established, the overheads should be apportioned in either one of the following ways:

1. Direct Apportionment
2. Reciprocal method of apportionment
3. Step Method of Apportionment
Direct Method of Apportionment

Suppose that we have four departments within an organization, two of which are
production departments, whereas the other two are non-manufacturing departments,
they provide a service for example, such as repairs, etc. Production department A
requisitioned materials from department C to the value 12,000 and B requisitioned
materials worth 8000. Service department D provided 500 hours of work to
department A and 750 hours to department B. The following costs are incurred:

Production Departments Service Departments A B C D

Allocated Costs 6000 4000 1000 2000
Apportioned Costs 2000 1000 1000 500
Total Overheads 8000 5000 2000 2500

The process of apportionment means that we should distribute the total costs of
service departments C and D on a FAIR basis to production departments A and B.
The first step would be to establish the apportionment basis for each overhead.
Obviously, the costs incurred by department C would be apportioned on the basis of
requisitions that it provided to departments A and B. The costs incurred by
department D would be apportioned on the basis of the hours of service provided to
both department A and B.

Therefore, the costs of departments C and D would be apportioned in the following

way:
Production Departments Service Departments Total
ABCD
Value of Requisitions 12000 8000 20000 % Of requisitions 60% 40%
Work Hours 500 750 1250 % Of work hours 40% 60%
Overhead Costs 8000 5000 2000 2500 17500
Apportionment of C 1200 800
Apportionment of D 1000 1500
Total Overheads 10200 7300 17500
Did you see what happened?
To apportion the costs of C, its overheads are apportioned to each department
depending on the percentage of requisitions supplied, and the overheads of
department D have been apportioned to each department depending on the
percentage of work hours received.

The Reciprocal Method of Apportionment

The reciprocal method of apportionment is useful when services are not only provided
to manufacturing departments, but to service departments as well. Therefore, costs are
apportioned between all departments, rather than just the manufacturing ones.

Let us suppose that, in the previous example, department D requisitioned materials

and provided hours of service to department C. The following table summarizes the
transactions and the solution:

Production Departments Service Departments Total

ABCD
Value of Requisitions 12000 6000 2000 20000 % Of requisitions 60% 30% 10%
Work Hours 500 650 100 1250 % Of work hours 40% 52% 8%
Overhead Costs 8000 5000 2000 2500 17500
Apportionment of C 1200 600 (2000) 200
Apportionment of D 1080 1404 216 (2700)
Apportionment of C 129.6 64.8 (216) 21.6
Apportionment of D 8.64 11.232 1.728 (21.6)
Apportionment of C 1.728 0 (1.728) 0
Total Overheads 10420 7080 0 0 17500

As you could see, using the reciprocal method, overheads are repeatedly apportioned
until the final cost to be apportioned becomes so small and immaterial in value.

One could also determine that the total costs of department C consists of a proportion
of the total costs of department D, and vice versa.

Therefore, as an alternative to using repeating the appropriations of each of the

service departments, simultaneous equations may be used to establish the total cost of
C and the total cost of D, which we could then directly apportion to departments A
and B.

Total Cost of C = 2000 + 8% of department D overheads

Hence C = 2000 + 0.08*D
Total Cost of D = 2500 + 10% of department C overheads
Hence D= 2500 + 0.1*C
Apply C to D
C = 2000 + 0.08(2500 + 0.1C)
Hence, C= 2000 + 200 + 0.008C
Hence, 0.992C = 2200
Therefore C=2217.7419
Hence, D= 2500 + 0.1*2217.7419 = 2721.7741
Therefore the solution would now be
Production Departments Service Departments Total
ABCD
Value of Requisitions 12000 6000 2000 20000 % Of requisitions 60% 30% 10%
Work Hours 500 650 100 1250 % Of work hours 40% 52% 8%
Overhead Costs 8000 5000 2000 2500 17500
Apportionment of C 1330.6451 665.3225 (2217.7419) 221.7741
Apportionment of D 1088.7096 1415.3225 217.7419 (2721.7741)
Total Overheads 10419 7081 0 0 17500

Notice what happened? Instead of apportioning the 2000 and 2500 overhead costs, the
overhead costs apportioned where those found in the simultaneous equations above.

The same result is obtained either way; the slight difference shown is due to rounding
off only.

The Step Method

The step method is very similar to the reciprocal method but the apportionments
aren’t repeated since costs are not reapportioned to the service departments again.
Thus, whatever is apportioned first will affect the results obtained. If we apply it to
the above example, the following results are obtained:

Production Departments Service Departments Total

ABCD
Value of Requisitions 12000 6000 2000 20000 % Of requisitions 60% 30% 10%
Work Hours 500 650 100 1250 % Of work hours 40% 52% 8%
Overhead Costs 8000 5000 2000 2500 17500
Apportionment of C 1200 600 (2000) 200
9200 5600 0 2700

Now the 2700 will be distributed to A and B only, based on work hours.
Apportionment of D 1173.69 1526.04
Total Overheads 10374 7126 17500

Please notice how the apportionment basis percentages were recalculated to distribute
the overheads to A and B only, similarly if D was apportioned first. Yet in the later
case, the results would differ. Try it yourself.
Paper 1.2
Chapter 7
Overheads and Absorption Costing: Part 2 - Absorption

after allocating and apportioning overheads to cost units or cost centers, we need to
add the costs calculated for each cost center to unit, job or batch costs. This is called
overhead absorption or overhead recovery. Therefore, the production overheads
calculated using absorption costing would be included in the following formula:

Direct Materials
Plus: Direct Labor
Plus: Direct Expenses
Plus: Overheads (based on recovery rate)
Equals: Actual Costs of Production

The previous formula is known as normal costing. The actual costs of production are
necessary to calculate the cost of sales, hence, the profits of the organization.

Opening Stock
Plus: Production Costs
Less: Closing Stock
Equals: Cost of Sales

yet, the final process of absorbing the overhead costs into unit and batch costs aren’t
based on actual costs incurred during the course of the business. Absorption costing
is based on a predetermined absorption rate, which is established from a budget for a
forthcoming period.

This could be illustrated using the following example. Suppose that a company makes
two products, A and B, each respectively taking 2 and 5 hours to make. If the total
estimated overheads are $50,000 and the estimated labor hours would be 100,000
hours, what would the absorption rate be?

Calculation Result
Absorption Rate 50/100 $0.5 per labor hour
Overhead absorbed per unit A 2 x 0.5 $1 per unit
Overhead absorbed per unit B 5 x 0.5 $2.50 per unit

The results obtained above mean that whatever the cost of producing one unit of A or
B is, the overhead absorbed per unit should be added to it. Suppose further that the
direct labor, materials and expenses are $12 per unit, and we produce 1000 units of
A and 2000 units of B during the year. We have no opening stock, and no closing
stock, we simply sold all the stock of A and B produced during the year for $30 per
unit. What would the Profit and loss account look like?

Calculation $000 $000

Sales 3000 x 30 90000
Cost of Sales
Opening Stock 0
Closing Stock 0
Production Costs: Direct Overheads 12 x 3000 36000
Overheads ‘A’ 1 x 1000 1000
Overheads ‘B’ 2.5 x 2000 5000 (42000)
Gross Profit 48,000

In the previous example we assumed that a separate absorption rate is used for each
product, and this could be similarly applied to other cost centers and cost units.
However, the predetermined absorption rate may not always be distinguishable for
each product. Sometimes, a blanket absorption rate is used, in which a single
absorption rate is used throughout a factory and for all job units of output irrespective
of the department in which they were produced.

The result of using a blanket absorption rate may drastically affect the costing of
products and units or services manufactured or offered to customers. This can be
illustrated by slightly modifying the previous example:

Previously we said that the overhead absorption rate of A is $1 per unit, and $2.5 per
unit of B. These are separate valuations. Suppose now, that we alternatively use a
blanket absorption rate, calculated as follows:
Total Overheads: 50,000
Total Labor Hours: 100,000
Absorption Rate: 50/100 = $0.50 per labor hour.
Total Units Produced = 3000
Taking 7 hours to make a unit of both A and B, thus Total Labor Hours is 21000,
(7*3000).
Production Overheads = 21*0.5 = $10, 500
Therefore:
Calculation $000 $000
Sales 3000 x 30 90000
Cost of Sales
Opening Stock 0
Closing Stock 0
Production Costs: Direct Overheads 12 x 3000 36000
Production Overheads 21000 x 0.5 10500 46500
Gross Profit 43,500

As you could easily see, the gross profit changed dramatically, from 48,000 to a mere
43,500.

Furthermore, one may still be confused as I have whilst trying to understand why I
have divided 50/100 to calculate the absorption rater per labor hour, and then
multiply that with the total labor hours taken to produce 3000 units, which resulted
in a total cost of 10,500. Especially since we didn’t do that when we used separate
absorption rate, because we calculated the absorption rate per unit at the time.

I have done what I have done because I believe the costs associated with producing
unit of ‘A’ are different to those taken producing unit of ‘B’, because each takes a
different number of hours to produce. Therefore, it is essential to absorb the costs
the way I have.

Another reason for the discrepancy may be due to what is known as over/under
absorption. The problem is that normal costing (refer to the formula on the first page!)
is based on overheads absorbed at a predetermined rate, which is based on budgets
and estimates, rather than what is actually incurred. This would lead to either one of
the following:
1. Over Absorption – overheads charged to the cost of sales are greater than the
overheads actually incurred.
2. Under Absorption – insufficient overheads have been included in the cost of
sales.

To solve this problem, an adjustment to reconcile the overheads charged to the actual
overheads incurred is necessary, in which the under/over absorbed overheads will be
written as an adjustment to the profit and loss account, at the end of the accounting
period.

At the moment, the budget for the previous example says that the production
overheads should be 46,500, but what if at the end of the year, we find that the actual
costs incurred, weren’t 46,500 but only $30,000. This means that we over-charged our
cost of sales by $16,500. This is referred to as over-absorption.

To correct this problem we simply add the bold line below to the cost of sales
account:
Calculation $000 $000
Sales 3000 x 30 90000
Cost of Sales
Opening Stock 0
Closing Stock 0
Production Costs: Direct Overheads 12 x 3000 36000
Production Overheads 21000 x 0.5 10500
Under / Over absorption 46500 - 30000 (16500) 30000
Gross Profit 43,500

Remember over-absorption is due to overcharging the cost of sales, as such; we have

to deduct it from the cost of sales, whereas under-absorption is the opposite.
Paper 1.3
Chapter 1
Organizations

How they are defined and classified, their differences and why we need them.

Basically an organization is a group of individuals operating together in a systematic

way to achieve a set of objectives. Therefore, the three characteristics of an
organization are:

1. People
2. Purpose
3. Structure

Organizations may also be defined as a machine. It receives inputs from its

environment in the form of resources and converts them into outputs, which satisfy
demand.

Inputs -> Organization Processes -> Outputs

why are organizations needed?

Organizations enable objectives to be achieved that could not be achieved by the

efforts of individuals on their own, therefore they exist to:

1. Overcome people’s individual limitations

2. Enable people to specialize
3. Save time
4. Enable people to pool their expertise
5. They are power centers – organization may be able to influence events on a
large scale by influencing demand, winning orders and creating wealth.
6. Enable synergy: i.e. 1+1=3! By bringing together two individuals their
combined output will exceed their output if they continued working separately?

How do organizations differ?

The differences between organizations are so large that it may be quite impossible
to list them all; yet, one may classify their differences into the following categories:

1. Structure: Formal or Informal?

2. Classification by size: e.g. number of employees, volume of output
3. Classification by profit motive: Profit or non-profit oriented
4. Classification by legal form: sole traders, partnerships or limited companies
5. Ownership: Public vs. private?

Formal and informal organizations

the difference between formal and informal organizations is in the way they are
structured. An organization structure is the grouping of people into departments or
section and the allocation of responsibility and authority. As such the structure
affects the communication process within the organization.

Within a formal organization, a hierarchical structure exists, reflecting

communication flowing downwards from top management to the departments further
down the organization.

Stein defines a formal organization as ‘the planned co-ordination of the activities

of a number of people for the achievement of some common, explicit purpose or
goal, through division of labor and function, and through a hierarchy of authority
and responsibility.’

Within an informal organization however, communication tends to be horizontal,

between individuals and departments, rather than the upwards or downward flow.
This is known as the Matrix Structure, whereby levels of power or authority are
difficult to define and the person taking the lead at any one time will vary.

Furthermore, within a formal organization, an informal organization may exist, as it

arises from the interaction of people working together.

Paper 1.3
Chapter 2

The role of management

Classical theories

Scientific

• Planning
• Standardizing
• Improving human effort at the operative level
• To maximize output with minimum input

Administrative

Fayol divides the activities into six main groups:

• Technical – production, manufacturing

• Commercially – buying, selling, exchange
• Financial – obtaining and using capital
• Security – protection of people and property
• Accounting – stocktaking, costing, statistics, balance sheet
• Managerial – planning, organizing, commanding, coordinating and controlling

Fayol’s fourteen rules of management conduct are:

1. division of work
2. Authority
3. Discipline
4. Unity of command
5. Unity of directors
6. Subordination to the
general interest
7. Remuneration
8. Centralization
9. Scalar chain
10. Order
11. Equity
12. Tenure of personnel
13. Initiative
14. esprit de corps

Bureaucratic

• Rational – legal authority

• Traditional – based upon custom & practice
• Charismatic – the individual has some special personal quality

Rosemary Steward summarizes the four main features of bureaucracy as:

• Specialization
• Hierarchy of authority
• System of rules
• Impersonality

She explains the high growth of bureaucracy as due to:

• Increasing size of the organization

• Greater complexity
• Scientific management stresses rationale and prescribed processes
• Demands for equality of treatment

The change!

Elton Mayo’s Hawthorne experiment brought about the human relations movement,
which emphasizes social factors at work, groups, leadership, the organization and the
behavior of people.

Modern writer’s contribution to management

behaviorally

this is concerned with the personal adjustment of the individual within the work
organization and the effects of group relationships and leadership styles, such as
Mallow (hierarchy of needs) and McGregor (theory X and theory Y).

Contingency approach

It adapts management behavior to suit the particular circumstances. It could therefore

result in an approach being formed which has features at several different schools of
organizational thought. (T Burns and G.M Stalker – page 16)

Systems approach

Views an organization as a social system consisting of individuals who co-operate

within a formal framework, drawing resources from their environment and putting back
into that environment their products or services. (Handy – page 17/18)

Peter Drucker

He identified five basic operations in the work of a manager:

• Set objectives
• Organize
• Motivate and communicate
• Establish yardsticks
• Develop people

Ouch’s theory Z

Within a formal hierarchy there is an emphasis on interpersonal skills and building

trust through informal democratic relationships.

Peters and Waterman’s Seven-S’s formula:

• Structure
• Strategy
• Systems
• Style of management
• Skills
• Staff
• Shared values

Mint berg

He says that an organization is more complicated than a simple hierarchical structure,

it consists of several components, which he refers to as ‘building blocks of an
organization’.
Paper 1.3
Chapter 3
the role of the manager

what is management?

Peter Drucker ‘management is tasks. Management is a discipline. But management

is also people’.

McFarland defines management as ‘the process by which responsible persons in an

organization combine resources in achieving given ends’.

Therefore, management is needed to reach objectives, maintain a balance between

conflicting goals and to achieve efficiency and effectiveness.

Following from the above, an effective manager could be defined as ‘one who
achieves the results required by the organization in an efficient manner to motivate
staff’.

In conclusion, management may be looked at from the point of view of:

• Function: what is responsible for directing & running of an org

• Process: the management of various activities and resources
• Discipline: management as a science and art
• Profession – occupational status providing a definite services after
advanced training and education.

Furthermore, managerial work may be classified by activity or level of operation.

Activity

a functional manager will generally specialize in one major area of organizational

activities such as finance, and a general manager is responsible for all the functional
activities within an enterprise, division, etc.
Level of operation

this refers to top managers, senior managers, middle managers, and supervisory
managers.

The role of the manager in the organization of work

Fayol: to forecast and plan, to organize, to command, to control and to co-ordinate

Breech: Planning, organizing, commanding, coordinating, controlling, leading,

motivating, creating, communicating and staffing.

Mint berg: Interpersonal roles: figurehead, leader, liaison

Information roles: monitor, disseminator, spokesperson
Decision making roles: entrepreneur, disturbance handler,
resource allocate and negotiator

Paper 1.3
Chapter 4
Individual and group behavior

Explain the concept of organizational culture:

What are cultures?

• It is the way we do things, the way we work

• Beliefs, attitudes, values, norms of behavior, practices shared by members

Strong cultures

We find: core values, intensity held, widely shared, innovative & dynamic operating
company.

Weak cultures:

We find: lack of unity & commitment

According to Handy there are:

• Power cultures: 1 man, 1 king

• Role culture: where people describe their jobs by its duties not its purpose
• Task culture: tasks and results
• Person culture: to satisfy requirements of particular individuals involved.

Discuss the differences between individual and group behavior

• Behavior is a way of acting: Cause->Needs------(Behavior)----->Goal

Factors affecting Individual behavior:

• Psychological factors: Motivation, perception, attitudes and personality

• Personality traits: Authoritarianism, dominance, introverts and extroverts

Factors affecting Group behavior:

• Group norms
• Synergy
• Cohesive groups: atmosphere, participation, commitment, communication,
leadership and progress
• Teamwork

Understand perception and role theory

• Role theory is concerned with the roles that individuals adopt. A role is the
expected pattern of behavior associated with members occupying a particular
position with the structure of the organization.
• As such, the perception of other people and interactions with other people will
be influenced by the different roles
o Role ambiguity – people unsure of what role they are to play
o Role conflict – individuals find a clash between the different roles they’ve
adopted
o Role incompatibility – other people’s role expectations different than that having
the role
o Role signs – e.g. uniform, visible indications of the role
o Role behavior – type of behavior associated with the role
Paper 1.3
Chapter 5
Team management

Objectives:

• Define the purpose of a team

• Explain the role of the manager in building the team and developing individuals
• Outline the composition of successful teams: Berlin – Peters and Waterman
• Explain the development of a team: Tuckman
• List team building tools
• Examine ways of rewarding a team
• Identify methods of evaluating team performance

Define the purpose of a team

• A team is any group of people who must significantly relate with each other in
order to accomplish shared objectives
• A team is a formal group, the purpose of a team is to solve complex problems
because a team is more than the sum of its individual team members
• The key difference between groups and teams is their behavior.
• In a team, we find:

o More openness and trust

o Feelings are expressed freely
o There are common objectives
o Process issues are part of work
o Conflict is worked out; and
o Commitment is very high

Explain the role of the manager in building the team and developing individuals

• This process can be:

o Inward looking: team members evaluating themselves

o Outward looking – team leader sets out to focus the team’s efforts on real and
existing problems

• Team building is needed where any of the following are negatively affected:

o Efficiency
o Effectiveness
o Performance

• The role of the manager in developing a team is to satisfy (Adair’s action-

centered leadership model):

o Task needs: the purpose and completion of the task must be fulfilled by

Setting objectives♣
 Planning tasks♣
♣ Allocation of responsibilities
Setting performance♣ standards

o Group needs: the manager must maintain spirit and morale by:

Communication♣
Team building♣
♣ Motivation
Discipline♣

o Individual needs: managers must try to motivate and satisfy each individual’s
needs by:

Coaching♣
Counseling♣
Development♣
♣ Motivation

• According to Woodcock you must first identify the blockages to team-building

and then decide on the building blocks to be used by:

o Identifying blockages to an effective team

o Identifying the building blocks
o Putting ideas into action

• Teambuilding is the process of removing obstacles that prevent the team from
working effectively and planning how to improve overall team performance

Outline the composition of successful teams: a) Beblin b) Peters and Waterman

a) According to Beblin:

• The composition of successful teams depends upon the balance of individual

skills and personality types within the team
• There are eight different personality types and the absence of one of these
functions can mean a reduction in effectiveness of the team
• The eight types are:

o Leader – coordinating the team

o Shaper – committed to the task, aggressive, challenging
o Plant – thoughtful
o Monitor-evaluator – criticizes others’ ideas, brings group down to earth
o Resources- investigator – picks up others’ ideas and adds to them
o Company worker – forms general ideas into specifics
o Team worker – supportive, diffuses potential conflict
o Finisher – makes sure timetables are met.

• A person may hold one or more of these personality types.

b) According to Peters and Waterman:

• The key aspects of successful teams are:

o Small numbers
o Time-limited duration
o Voluntary membership
o Information communication
o Orientation towards action

Explain the development of a team: Tuckman

According to Tuckman group development goes through four stages, and may reach
a fifth stage called doming, as follows:

• Forming – the group just started, individuals are defining their purpose and
how they’ll operate.
• Storming – this is a conflict stage, where perceptions are challenged, members
compete for their chosen roles
• Norming – the establishment of the ‘norms’, how the group will take decisions,
behavior patterns, etc.
• Performing – at this stage the group will operate at its full potential
• Dorming – where a group operates for a long time it may reach a stage where it
loses its ability to make good decisions, and a process called ‘Groupthink’ occurs. At
this stage, team building may be required.

List teambuilding tools:

• Identify difficulties and/or blockages

• Use the following teambuilding:

o Events
o Activities; and
o Exercises

To help group members change individual♣ behavior and improve team

performance

Rewarding a team

• Companies are increasingly attempting to relate pay to performance, where

group or team incentive schemes offer a bonus to the team where they have
achieved or exceeded targets.
• This may be done in the following way:

o Long-term and large group incentive plans:

By tying the performance of the entire company to♣ individual groups or teams

o Value added schemes – if the team’s performance exceeds expected returns,

the team may share the surplus profits

Identify methods of evaluating team performance

• These involve measures on:

o Effectiveness
o Efficiency
o Team-member satisfaction

• The company may focus on:

o The quantity of work performed

o The quality of work performed
o Work performed vs. time allowed

• When objective measures of evaluation are not available, subjective evaluation

based on the following may be made:

o Observe and rate team behavior against a set of agreed criteria

o Interview all who may have a view about the team’s performance
o Administer a pre-prepared questionnaire to team members and their managers.
Paper 1.3
Chapter 6
Objective setting

Introduction

Organizations are more than a set of departments, functions or activities; they

involve people taking part in various aspects of the organization, and most
importantly, the objective setting process.

Objectives are specific targets that the organization is committed to achieve. For
objectives to be successful they must be Specific, Measurable, Attainable and
Timely, this is often known as SMART.

Objectives are set at various levels of an organization, and must importantly at its
strategic level, as it defines the direction the organization is moving in. Objectives
set at both the tactical and operational levels must therefore conform to the overall
strategic objective. This is the reasoning behind John Humble Management by
Objectives. (See below).

The importance of objective setting:

• Planning
• Monitoring
• Controlling
• Decision making

The objective setting process

• At a strategic level
o Setting mission & vision
o Setting goals and objectives
o Setting overall strategy
• At a tactical level
o Monitoring and control
• At an operational level
o Task oriented

Behavioral theories of objective setting:

• Cert. & March, believed

o Organizations make decisions based on very small proportions of the total
information
o The decision process concerns three characteristics of the organization:
Organization goals♣
Expectations♣
♣ Choice
o The decision process has our additional features explaining how decisions
are arrived at, which are:
♣ Quasi-resolution of conflict – org mixture of conflicting interest
♣ Uncertainty
Problematic search♣
Organization♣ learning

Ethics and social responsibility

Companies are now developing a social conscious and new factors such as
pollution control, conservation of natural resources, environmental disfigurement
and accepting employee pressure, all add to the responsibility faced by companies.

Corporate objectives vs. personal objectives

corporate objectives are often based on financial terms, such as sales, profits and
growth. But organizations are made up of groups of people, and those have
personal objectives such as the fulfillment of their needs and aspirations. This
creates a conflict of needs, which falls under the Consensus theory by Cert. &
March. As such, there are a number of possible relationships between organization
objectives and individual objectives, such as:

• Totally opposing
• Partially opposing
• Neutral
• Compatible
• Identical

Management role in identifying performance standards and accountability

• MBO: management by objectives:

o Establish objectives to enable individuals to determine their contribution to
the corporate objective as well as their personal ones
This is developed by John Humble, and it’s a system for:♣
• Implementing strategic plans
• Improving management performance
• Providing criteria for performance appraisal
• Management responsibility: different objectives for each manager, middle vs.
lower-level managers.

Advantages of objective setting

• Commitment
• Results
• Establish & control network
• Clear task/job description
• Measure output – align short term and long term objectives
• Monitor mgt’s effectiveness
• Measure the output of groups & teams

Disadvantages

• Too result focused

• Too focused on short-term objectives that we lose sight of our long term
objectives
• Communication problems
• Conflict between corporate & personal objectives
• Management slow to change short term objectives
Paper 1.3
Chapter 7
Authority, responsibility and delegation

Objectives:

• Describe, recognize and understand the importance of organizational

structure
• Compare and contrast classical and modern approaches to organizational
structure:
o Burns and Stalks
o Contingency theory
o Fayol
o Mint berg
o Tryst and Bam forth
o Urwich
o Weber
o Woodward
• Define the terms authority, responsibility and delegation
• Explain the term legitimized power: Weber
• Describe the process of determining authority and responsibility
• Examine the case of responsibility without authority

Describe, recognize and understand the importance of organizational structure

Describe and recognize

• Organizational structure means grouping people into departments or sections

and allocating responsibility and authority
• The structure can be presented in organization charts, by position and job
descriptions and by rules and procedures
• It is also concerned with patterns of authority, communication and workflow
• The organizational structure will determine the direction of responsibility and
the rela6ti8onship between line, functional and staff organization
• A structure may be analyzed by reference to the level at which decisions are
made.
o Centralized: the upper level of an org hierarchy retain the authority
o Decentralized: the authority to take decisions is passed down to units and
people at lower levels in the organization’s hierarchy
o The choice between the two will depend on the preference of the
organization’s top management and the size and scale of the organization’s
activities

the importance of the organizational structure

Entrepreneurial structure

• Reflects the position of the owner-manager who makes all key decisions
• All power and authority resides in one person
• It has the benefits of quick decision making and short lines of communication
• The success depends on the abilities of the owner/manager

Functional structure

• It is the most widely used

• Specialization and the division of labor is based on the type of activities
taken by the staff
• The organization may usually be divided into selling, production and finance
departments/functions
• The benefits of this structure are:
o Employee’s work can be much more effectively controlled and coordinated
o Specialized departments can provide clear promotional and staff
development.

Product-oriented structure

• A variety of specialists grouped in a department that focuses on a product or

product range.
• The main functions of production, sales, people and finance are apportioned
to the relative products
• such an organization allows considerable delegation by top management and
clear profit accountability by division heads.
• The benefits are:
o The focus of attention is on product performance and profitability
o Encourages growth and diversity of products
o A number of skills and abilities are combined together on the development of
a particular product.
• BUT:
o Its difficult to maintain centralization of services such as accounting and R&D
economically
o Success is dependant on the ability of the people in charge of the product

Geographical structure

• Divides the enterprise into regions or countries

• The geographic unit can itself be organized by function or product
• The benefits are:
o The organization can identify and respond quickly to local opportunities
o The profitability for each region can be clearly identified and managed
o The interaction with local communities

Matrix structures

• Is a structure where employees from various departments form a group to

achieve a specific target, they usually have dual reporting roles.
• It combines a job based group with a project based structure
• Provides greater flexibility and coordination of tasks and people
• Team members become customer oriented
• Motivational, requires employees’ participation and control

Compare and contrast classical and modern approaches to organizational structure:

Classical writers looked at structure in terms of division of work, chain of command,

span of control and reporting relationships:

• They focused on the requirements of the formal organization and the search
of a common set of principles applicable to all circumstances.
• The organization structure was designed for the most efficient allocation and
coordination of activities
• The position in the structure, not people, had the authority and responsibility
of setting tasks done.

Fayol – the functional organization

• People are placed into formal groups which may be further sub-divided by
sections and departments.
• Formal groups will vary in the degree of cohesion and size, but all will have a
common purpose and a set of rules, which govern relationships.

Lynda Urwich – the 8 classical management principles

1. Scalar concept
a. Hierarchy of clearly defined posts
b. Authority moves from top to bottom

2. Unity of command
a. Orders are received from one person~!

3. Exception principle
a. Delegation maximized
b. Decisions taken at the lowest possible level

4. Span of control concept

a. Optimum number of sub-ordinates per hierarchical superior

5. Scientific method
a. Observation
b. Hypothesizing
c. Experimentation
d. The formulation of laws should be used in arriving at decisions

6. Specialization

7. Principle of the objective

a. Every part of the org to be needed for the purpose of the org

8. Principle of correspondence
a. In every position, authority and responsibility should correspond

Weber – the bureaucratic model

• Great emphasis on formal relationships

• Discouraging upward communication to the superior
• Orders are given and obeyed!
• Clearly defined duties and responsibilities for all org members
• Hierarchically arranged staff
• Elaborate system of rules
• Staff motivated by sense of duty and career prospects
• No regards to personal, family or emotional commitments

Tryst & Bam forth – Socio-technical systems approach

• Emphasized the interrelationships of subsystems and multiple channels of

interaction
• Individuals are outlived by the system, therefore the mgt should concentrate
attention on improving the system
• People can adapt to a new system

The Contingency approach

• May be seen as a development of the system’s approach in restating the

environment and other variables to specific structures of the organization
• Due to the large number of variables that influence operations, flexibility and
acceptance of change are more than necessary within an organization
• This reflects the need for co-ordination, often by the use of matrix systems

Joan Woodward

• Organizational patterns were found to be more related to similarity of

objectives and production techniques than to size, type of industry or to the
business success of the firm.
o e.g. unit of production -> flatter structures
o e.g. process production -> taller and narrower pyramids

Burns & Stalker – Mechanistic and organization structures

• Organizational structures could be placed in a continuum, from mechanistic

(based on order, clear definitions, stability and rigidity) to organic (flexibility).
• Mechanistic, appropriate for stable environment, with the ability to resist
pressure to change
• Organic, unstable ones, with a high level of change, requiring a responsive
organizational structure
• Ability to respond promptly and appropriately to change.

Mint berg – structure exists to coordinate activities of different people and work
pressures.

• Nature of coordination changes with size of organizations

• There are six configurations which determine the importance and the relative
size of the organization’s building blocks:
o Simple structure – entrepreneurial org
Simple structure♣
Flexible♣
Able to cope♣ with dynamic environment
o Machine bureaucracy – no speedy reaction to change
o Professional bureaucracy – focus on orgy’s operating core
o Divisionalised form – powerful middle managers
E.g. medical♣ staff in hospital
o Adhocracy
Complex♣
♣ Disorderly
Informal structure♣
Best used for♣ dynamic environment
o Missionary organizations
Formed on a♣ basis of a common set of benefits
Valued shared by all workers in♣ the org
Unwilling to compromise or change.♣
The org can♣ only prosper in simple, static environments

Define the terms authority, responsibility and delegation

Authority & Power – according to Fayol

• Authority is the right to exercise powers such as hiring and firing or buying
and selling on behalf of the organization
• Power can be defined as the ability to influence the action of others
• Authority in an org is the right in a position to exercise direction in making
decisions affecting others. Therefore it is one type of power. Yet it is possible to
have authority without power (weak supervisor) or power without authority (strong
individual)
• Authority can arise from any of three main sources
o Formal – org bestows authority – e.g. job title
o Technical – due to personal skills or expertise
o Personal informal – not recognized in org chart as it exists because person is
accepted and respected

Responsibility

• The obligation placed on a person who occupies a certain position

• ‘liable to be called to account, answerable’
• It is an obligation owed
• Superior cannot escape responsibility for actions of subordinates, and
subordinates have a responsibility back to their superior

Delegation

• Fayol explains it as ‘The act by which a person or group of persons

possessing authority transfers part of that authority to subordinate person or group’
• Delegation is an important aspect of org and effective management. Without
it, formal org could not exist, because the person with the authority is the only one
who could make decisions
• It is needed for the following
o Lack of time or energy
o Need for specialists
o Need for training of future managers
• Principles of delegation
o Authority must be understood by both parties
o Mgr responsibility to make sure employee has the ability to do the work
o Resources to do the work are available
Explain the term ‘Legitimized Power’, according to Weber

• Legitimized power is based on agreement and commonly held values, which

allow one person to have power over another person
• It normally arises from position and derives from our cultural system of rights,
obligations and duties in which a ‘position’ is accepted by people as being
legitimate.
• Weber identified three grounds on which legitimate authority could exist:
o Charisma – the individual has some special quality of personality
o Traditional – authority based upon custom and practice
o Rational-legal (classic bureaucracy)
It is♣ rational because its goal is to achieve certain objectives with max
efficiency
It is legal because authority is recognized by a♣ system of rules and
procedures.

Describe the process of determining authority & responsibility

• The process of determining authority and responsibility may be distinguished

on the bases of power, which are:
o Legitimate
o Reward – Gives X power over Y because X can mediate rewards
o Coercive – through the mediation of punishments
o Referent – where a person wants to be like another
o Expert – where X perceives Y has an expert knowledge on things
• The process may also be described by the way in which a manager or
supervisor would delegate the authority:
o Determine results expected
o Allocate duties to subordinates
o Grant them authority to enable those duties to be carried out
o Holds them responsibility for the completion of the work and achievement of
results
• An organization chart may be used!

Examine the case of responsibility without authority

• Responsibility must be3 supported by authority and by the power to influence

the areas of performance for which the subordinate is to be held responsible
• The principle of correspondence states that in any position, authority and
responsibility should correspond
• Therefore, a person who has authority without responsibility is unaccountable
• Difficulties can arise when an individual has responsibility for some aspect of
work but lacks authority associated with it.
Paper 1.3
Chapter 8
Standard setting and performance management

Objectives

• Define the term performance management

• Identify a process for establishing work standards and performance
management
• Outline a method to establish performance indicators
• Illustrate ways of applying performance management
• Describe management contribution to personal development planning
• Explain the term ‘performance related pay’

Define the term performance management

Performance management is a means of getting better results by understanding

and managing performance within an agreed framework of planned goals, standard
and competence requirements.

• It is an ongoing communication process that involves both the performance

manager and the employee in:
o Identifying and describing essential job functions
o Developing realistic and appropriate performance standards
o Giving and receiving feedback
o Performance evaluations
o Planning education and development

Identify a process for establishing work standards and performance management

The performance management process provides an opportunity for the employee
and performance manager to create a plan for achieving development goals:

• Strategic plans and annual goals

o Job description and essential functions
Standard of performance♣
• Performance observation and feedback
o Performance development plan

It must also consider the emerging environment with five main areas:

1. Economy
2. government
3. social
4. technology
5. competition

Outline a method to establish performance indicators

• Standards should be written in clear and understandable language

o Describing the specific behaviors and actions required for work performance
o They should also be:
♣ Consistent
Realistic♣
Specific♣
♣ Measurable
Challenging♣
Dynamic♣
o The org reporting system should be able to measure and report any
quantitative data applicable and an acceptable margin for error should be specified
o The standards should be developed using the collaborative approach where
possible as oppose to the directive approach

Illustrate ways of applying performance management

• Performance related pay:

o Measuring the performance of individuals and rewarding them accordingly,
yet it will motivate only if the prospective payment is significantly large in relation to
the normal income of that person.
o These include incentives such as:
♣ Piecework or payment by results
Measured day work♣
♣ Commission
Productivity plans♣
Profit sharing♣
o Obviously such rewards cannot be set without establishing the standards and
criteria for work performance
• Performance evaluation – it is a process of:
o Assessing
o Summarizing; and
o Developing the work performance of employees
• Performance development plan – it is a process of developing the employee’s
work related skills, knowledge and experience

The above should enable the org to:

• Get better results

• Continuous communication between the employees and the management
o Hence getting feedback to evaluate plan/set standards/solve problems
• Constructive, enabling the employees to make decisions

Describe the management’s contribution to personal development planning

• Assessment: assess needs of employee and org

o Set career goals, which are consistent with the employee’s:
Skills, knowledge, experience and interests♣
• Providing information: informing employee about far and possible barriers to
career movement
• Referral – referring employees to others who assist them
• Guidance – encouraging them to focus on clear and specific and attainable
career goals
• Development – delegating responsibilities, training and other learning and
development opportunities.

Paper 1.3
Chapter 13 & 14
Selection

Objectives

• The selection process in outline

• Application forms
• Selection methods in outline
• Interviews
• Tests
• Other selection methods
• Which selection method is best
• Evaluating and improving recruitment and selection practices

The selection process in outline

• Deal with responses to job advertisements.

• Assess each application against key criteria in the job advertisement and
specification
• Sort applications, from which a shortlist for interviews may be drawn up
• Interview them
• Reinforce interviews with selection testing
• Review un-interviewed ‘possible’ and archive them for future reference
• Send standard letters to unsuccessful candidates ‘Sorry…’ and potential
candidates ‘should any vacancy arise’
• Make a provisional offer to the recruit

Application forms

Job advertisement usually ask candidates to fill in a job application form, or to send a
CV along with a covering letter briefly explaining why they think they are qualified to do
the job.

Application forms are used to:

• Obtain all essential information

• Eliminates unsuitable candidates
• Identify possible candidates
• It gives information about the candidates’:
o Underlying personality
o Neatness
o Literacy
o The ability to communicate in writing

Although there may be some design faults in application forms they still have:

• The merit of being standardized, so all candidates are asked the same
information
• It may form the basis for a biodata questionnaire (Biodata is the term given to
techniques which aim to score and structure biographical information about a
candidate in order to predict work performance)

Selection methods in outline

• Interviewing
o One to one
o Interview panels
o Selection boards
o Assessment centers

• Biodata selection tests

o Intelligence
o Aptitudes
o Personality
o Proficiency
• Work sampling
• Group selection methods

Interviews

Interviews are conducted to find the best person for the job by assessing the
applicants’ interpersonal communication skills.

• It could be used to make sure applicants understand what the job and career
prospects are
• Provides the best impression and suitable information about the company
• Assess appearance, verbal ability and social skills of the applicant
• Opportunity for the candidate to learn about the job and organization

Types of interviews:

• Individual and one-to-one interviews:

o Advantages
Direct face to face♣ communication
Rapport between candidate and the interviewer♣
o Disadvantages
Candidate may be able to disguise lack of♣ knowledge in a specialist area of
which the interviewer knows little
The interviewer’s perception may be selective or♣ distorted
Rapport could cause a weakening of the interviewer’s♣ objective judgment

• Successive interviews
o Those are based on a series of face-to-face interviews. Although this is more
costly and can be more wearing on the candidate, it may enable a more balanced
judgment to be made.

• Panel interviews
o Advantages
A number of people see candidates and share info♣ about them at a single
meeting, thus the advantage of sharing judgments
o Disadvantages
Thro of candidates, not allowed♣ to expand on answers
One member may influence the judgment of♣ others
Research shows that members rarely agree♣

Limitations of interviews

• Scope
o An interview is too brief
o It is an artificial situation, candidates may be on their best behavior or too
nervous
• The halo effect
o A tendency for people to make an initial general judgment about a person
based on a single obvious attribute
• Contagious bias
o The interviewer changes behavior of applicant by suggestion
• Stereotyping
o It assumes some people share certain characteristics
• Incorrect assessment
o Qualitative factors such as motivation, honesty or integrity are very difficult to
assess in an interview
• Inexperienced interviewers
• Lack of preparation by interviewer

The remedy:

• Careful choice of:

o Open
o Probing
o Problem solving; and
o Closed questions
• Avoiding multiple and leading questions
• Candidates should be allowed and given the opportunity to ask questions and
they should be listened to carefully
• Candidates should be given the opportunity to learn about the organization
• The interview room, manner and tone, and physiological effects of the interview

Tests

Along with the interview, the group of potential employees may be required to sit some
tests. Types of test commonly used in practice are:

• Intelligence test
• Aptitude tests – potential for perform a job
• Personality tests
• Proficiency tests – ability to do work involved
• Medical examinations

Tests must be sensitive, standardized, reliable and valid

Limitations include
• No direct relationship between ability to do the test and the ability to do the job
• The interpretation of the test results
• Needs constant revision – no cheating!
• People can guess ‘the right answer’
• Could be misleading

Evaluating and improving recruitment and selection practices

• Ineffective recruitment may arise from many factors:

o Inadequate job analysis
o Unattractive terms; or
o Failure in the media chosen to attract candidates
• Ineffective selection may arise from:
o Poor job analysis
o Bad interviewing
o Inadequate advertising
o Ignorance of the job
o Lack of a validation system
• Recruitment and selection practices can be reviewed in these ways:
o Performance indicators – assess each stage
o Cost effectiveness
o Monitoring the workforce
o Attitude surveys
o Actual performance
• Improving the effectiveness of recruitment and selection
o Specifying more carefully what is expected from employee
o Employing a variety of methods of selection rather than just interviews