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ACCT1511

ACCOUNTING & FINANCIAL MANAGEMENT 1B SEMESTER 2 2008 COURSE NOTES

Last Revised: 26 th October 2008

kaheiyeh.web.officelive.com

Contents

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Page 3: Accounting for Owner’s Equity

Page 7: Cash Flow Statements

Page 12: Interpreting the Cash Flow Statement

Page 14: Financial Statement Analysis

Page 22: Accounting Policy Choice

Page 24: Management Accounting & Cost Concepts

Page 30: Cost Behaviour & Cost-Volume-Profit Analysis

Page 34: Costing Systems

Page 36: Budgeting

Page 37: Corporate Governance & Professional Ethics

Accounting & Financial Management 1B Course Notes Semester 2 2008

2

Accounting for Owner’s Equity

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The Difference between Owner's Equity & Shareholder's Equity

Owner's Equity should only be used if there is only one owner (one shareholder). Shareholders Equity may be used if there is more than one owner (partnerships etc.).

A corporation is a device used to obtain profit without individual responsibility. That is, they only have limited liability whereas a sole owner or partnership has unlimited liability.

The Components of Owner's Equity

Shareholder's Equity is divided into:

Share Capital This does not have to be listed if the firm is 100% owned by one shareholder (owner). It is listed and split if there is more than one shareholder.

Retained Profits/Accumulated Losses This is how much the company has made for shareholders in terms of profit.

Reserves These are direct adjustments to the equity account. They are financial transactions that affect the firm.

Contributed Equity

Contributed equity is money that is given to the firm in the form of contributions by the owners/shareholders. Contributed equity is raised through the issuance of shares.

Share Issues & Share Capital

Companies raise capital through the issuance of shares. A prospectus must be issued, by law, if shares are to be issues EXCEPT to institutional investors. However, a simplified version can be produced for them.

Institutional Investors These are investors who represent institutions (investment funds) such as superannuation. They easily understand the risks and returns in their investment in a firm. They do not require a full prospectus. This is also a good way if the firm does not have the resources that are required for investment banking teams. It can also be a good way for firms which are young (and have a lot of risk and low profitability) to get capital and the general public does not fully understand the risks involved whereas these investors do.

Journal entry: DR Cash and CR Share Capital.

Accounting & Financial Management 1B Course Notes Semester 2 2008

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Accounting for Owner’s Equity

Initial Public Offering (IPO) This is done immediately before the firm is listed onto the stock exchange. They may wish to issue shares publicly if they want to be listed on the stock exchange, find new investors or to get out of venture capital. However, this requires a full prospectus, underwriting and due diligence. This can be a costly process and is called the "floating requirements".

Journal entries: DR Trust Account and CR Application (To record the cash received on application). DR Cash and CR Trust Account (This is when the cash becomes yours along with the issuance of shares). DR Application and CR Share Capital (To record the issuance of shares.).

For the issuance of shares in instalments, the firm can call the rest of the cash later with these entries: DR Call and CR Share Capital (to record the call). DR Cash and CR Call (to record the receipt of cash).

A firm can forfeit the shares if a shareholder has defaulted. Significant costs are incurred with IPOs and transactions costs which arise from the issuance of shares must be recorded in Owner's Equity.

Retained Profits or Accumulated Losses

Retained Profits or Accumulated Losses are generated by:

Closing Balance

=

Opening Balance + Profits + Transfers from reserves - Dividends - Transfers to reserves.

Dividends

Dividends are a distribution of retained profits to shareholders. They can be paid in the interim or final. Middle or end of year respectively.

Journal entry: DR Dividends Declared and CR Dividend Payable. This is only the declaration of dividends to be paid. Later DR Dividend Payable and CR Cash when cash is given.

Interim only requires one entry as both declaration and payment occur in the same year, whereas declaration and payment occur in different years for final.

Dr Retained Profits and CR Dividend Paid and CR Dividend Declared are the closing entries.

Accounting & Financial Management 1B Course Notes Semester 2 2008

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Accounting for Owner’s Equity

Reserves

Reserves are not defined in any Act or any accounting standard and thus, they simply reflect where gains and losses have come from, or "adjustments to equity". Some examples of reserves are:

Asset Revaluation Reserve This is a reserve that is recognised when an asset is revalued upwards.

Foreign Currency Translation Reserve This is created as direct adjustments to equity as a result of translating foreign currencies with relation to assets and liabilities.

General Reserve The journal entry for this is a very simple process of crediting this account and debiting the retained profits. This is just transferring capital between retained profit and the general reserve. Firms may want to do this so that less money is in the retained profits for dividends. This is a way of limiting the amount of dividends. It may also signal the fact the firm wants to set some money aside for future investment/projects or to pad against times when profits are low or there are losses.

Statement of Changes in Equity

This statement discloses the changes in equity (reserves). It shows:

The profit or loss for the period

Each reserve item

Total income and expense for the period

Effects of changes in accounting policies and corrections

It also shows, in the notes:

Transactions with equity holders

Balance of retained earnings

Reconciliation processes

Bonus Issues

These are also known as stock dividends or share dividends. They are simply giving away shares based on how much the shareholder currently holds as a form of dividend (a non-cash dividend). It comes at no cost to the shareholder. There is no effect on the Balance Sheet apart from some rearranging of owner's equity.

Companies may do this to capitalize long-term reserves, signal that it expects a good future or to satisfy shareholders. However, it leads to a fall in share price per share and makes shares more accessible.

Accounting & Financial Management 1B Course Notes Semester 2 2008

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Accounting for Owner’s Equity

Share Buy-Backs

This is the reverse of the issuance of shares. Reasons to do this include:

The company is undervalued

Managing the capital structure by reducing equity

Wanting to spend money on things other than dividends etc. Journal entry: DR Share Capital and CR Cash.

Debt/Equity Trade-Off

We end up with the question: How much should a firm finance itself with equity capital or debt capital?

We must consider a few things here:

Voting Rights With equity capital, shareholders gain voting rights when appointing the CEO and the management team.

Temporary vs. Long-term Needs Temporary needs should be financed by debt while long-term needs should be financed by equity.

Contracts With debt financing, contracts must be signed which hold the firm liable to paying the sum back.

Interest vs. Dividends With equity capital, dividends may need to be paid but they are not an obligation. Interest on debt, however, is an obligation to pay.

Tax Interest payments are tax deductible whereas dividend payments are not.

Expected cash flows If cash flows are to be good, debt can be used to finance. If not, equity is a better option.

The choice between equity and debt financing should be made based on these factors.

Accounting & Financial Management 1B Course Notes Semester 2 2008

6

Cash Flow Statements

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What is Cash?

Cash includes:

Cash on hand

Cash equivalents (such as overdrafts etc.)

Cash Flows

Cash flows are transactions that involve the movement of the above. They can be further split into:

Operating activities Flows generated from normal activities (sales, purchase of inventory etc.)

Investing activities Flows associated with the movement of non-current assets.

Financing activities Activities including the paying of debts/dividends and the issuing of shares/loans.

There may be issues with timing due to the difference in time between recognition and collection of cash.

The Cash Flow Statement

With knowledge of all the above, we can conclude that the Cash Flow Statement is a statement which examines the movement of cash and cash equivalents in and out of the firm in terms of operating, investing and financing activities.

The purpose of the Cash Flow Statement is to produce a measure of performance of cash in the firm. It examines cash profits (otherwise known as "cash flow from operations") and non- operating cash flows from investment in assets and the issuing of dividends as such. It, however, does not imply that the accrual profit is an invalid method of determining a firm's position. It only serves to determine a firm's solvency and liquidity.

The Cash Flow Statement is a vital part of the firm's financial statements because it varies greatly from the accrual profit or loss. In most cases, a firm will not receive cash when the transaction is made (which is when accrual profit recognises revenue), and thus the accrual profit would not be a good way of measuring the true solvency and liquidity of the firm.

Accounting & Financial Management 1B Course Notes Semester 2 2008

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Cash Flow Statements

Format of the Cash Flow Statement

The standard format of the Cash Flow Statement is as follows:

Operating Activities Investing Activities Financing Activities Change in cash (and cash equivalents) for the period Cash (and cash equivalents) at the beginning of the period Cash (and cash equivalents) at end of the period

The Direct Method

There are two ways to work out the cash flow in the direct method:

T-Account reconstruction

Formula

Formulae differ between different accounts. For example, the formula for Accounts Receivable is:

Opening Balance + Credit Sales - Cash Received from Customers - Bad Debts Written-Off = Closing Balance

Since it differs between different accounts, it may not be the most optimal way of finding the cash flow. The T-Account reconstruction method is recommended and should be used if the formula is forgotten.

T-Account Reconstruction is basically using the T-Accounts of each account in the firm and, by using the Balance Sheet and Income Statement, reconstructing them according to cash transactions in and out of the firm.

Using the T-Account Reconstruction Method

Before we begin, we must make some assumptions. These assumptions only apply unless it specifically states to use other assumptions.

All sales and purchases of inventory are on credit.

Changes in the General Reserve are linked to Retained Earnings.

All sales and purchases of Non-Current Assets are with cash.

Other Expenses include all expenses for the firm unless they have their own expense account on the income statement.

Accounting & Financial Management 1B Course Notes Semester 2 2008

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Cash Flow Statements

To find cash flows for each account is basically the same, thus, I will only present one example. Apply this example to all accounts in the firm such as:

Accounts Receivable

Inventory

Prepaid Insurance

Wages Payable

Interest Payable

Provision for Income Tax Etc.

The following is an example of Accounts Receivable.

First, draw up the T-Account for that specific account. Then, always go through the income statement first. Examine each line and see if it applies to the account. In this case, we see "Sales" applies to Accounts Receivable (Remember we assume all sales are on credit if not told). Then, think of any other possible accounts (such as contra-accounts) that could impact on the account. In this case, "Bad Debts Written Off" impacts on the statement.

Thus, we get a T-Account that looks like the below with unknown figures written in XXX.

looks like the below with unknown figures written in XXX. Since we assume all sales are

Since we assume all sales are on credit, filling these blanks is as easy as copying the figures from the Income Statement. After filling in all known values, we should be left with a "Cash Collection" account; this is the balancing account. The side it goes on depends which side needs to be balanced out so that the T-Account is balanced.

needs to be balanced out so that the T-Account is balanced. In this case, $60 must

In this case, $60 must be put in to balance off the account, and thus, $60 is the net cash flow into the firm.

Accounting & Financial Management 1B Course Notes Semester 2 2008

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Cash Flow Statements

Lost? Methodology and Efficiency in Constructing a Cash Flow Statement using the Direct Method

Constructing the Cash Flow Statement is a tedious process. A good method to follow if you have not developed your own or get easily stuck in your one is to follow this:

Have two blank A4 pages side by side (This works with an A4 book with two blank pages open in front).

On the left page, draw up every single T-Account the firm has in order that it is presented on the Balance Sheet provided.

On the right page, draw up the cash flow statement with all the titles etc. and any figures that you know (such as cash opening and closing balance)

Put in the opening and closing balances of each account.

Start scanning through the Income Statement from top to bottom and input any data there into the T-Accounts. If you cannot do something with a certain piece of data, circle/highlight it etc. and come back to it later when you can. Any immediate cash dealings here can go straight onto the cash flow statement if there is no account for it (DO NOT MAKE NEW ACCOUNTS).

Input data from the additional information that you are given. These might help in solving some problems with numbers from the Income Statement.

Finally, start balancing all the accounts starting with Allowance for Doubtful Debts and ending with Retained Earnings.

Some Extra Hints

The opening balance of the Final Dividends Declared account is the cash the firm will pay that year; the closing balance is not.

The Interim Dividend paid (if there is any) is actually the balancing figure of the Retained Earnings account.

The balancing figure for Share Capital is treated as an issuance of shares (cash inflow).

Other Expenses is tied to Accrued Expenses; however, there may be other expenses listed here that go in other T-Accounts; especially if Depreciation Expense is not listed on the Income Statement.

The Indirect Method

The Indirect Method is used to reconcile Net Profit After Tax (NPAT) and Cash from Operations (CFO). The purpose of it is the find out why NPAT and CFO are different. These differences are split into two types:

Permanent Differences

These are differences caused by non-cash items. They affect net profit but not cash. Such differences include depreciation expense and gains or losses from disposals of assets.

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Cash Flow Statements

Timing Differences

These are differences caused by the use of accrual and cash base accounting in calculating NPAT and CFO respectively. These differences will reverse over time as the movement of cash catches up to the recognition of revenues and expenses.

Format of the NPAT and CFO Reconciliation Statement

Net Profit

List of Permanent Differences

Changes in Assets and Liabilities

List of Timing Differences

Net Cash from Operations

Finding the Values

You should have completed the Cash Flow Statement under the Direct Method as mentioned above and it is assumed you have constructed it correctly.

For Permanent Differences, we simply take these values from the Accumulated Depreciation accounts of the firm and we find the gains or losses through the Income Statement and/or additional information given.

For Timing Differences, we simply take all current asset and liability accounts shown in the Balance Sheet that contribute to the calculation of CFO, and subtract the closing balance from the opening balance for each account. For example:

from the opening balance for each account. For example: Accounts Receivable : Here we take the

Accounts Receivable: Here we take the opening balance ($128,000) and subtract the closing balance from it ($145,000). Thus we have: $128,000 - $145,000 = -$17,000. The timing difference here is -$17,000 and should be written on the reconciliation statement as:

Less: Increase in Accounts Receivable

(17000)

Accounting & Financial Management 1B Course Notes Semester 2 2008

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Interpreting the Cash Flow Statement

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Take a look at the following example. Imagine you were only given data for Net Profit. Would you invest in this firm? You probably might but once you take a look at its CFO, you would not.

Company

100 50 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 -50 -100
100
50
0
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
-50
-100
-150
-200
-250
-300
-350
AUD (Millions)

Net Profit

CFO

The Cash Flow Statement here shows that CFO is continually declining since after 2004. If the company cannot support itself with money from its operations, then it is not self-sustaining.

Interpreting the Cash Flow Statement

Cash flow information is important to assess a firm’s ability to generate future cash flows, continual liquidity and solvency and the ability to pay future dividends to its shareholders. We cannot just look at a firm’s balance sheet and income statements to conclude that the firm is stable.

Five Important Questions

This raises 5 very important questions:

Where the cash flow going to and from and what is its purpose?

How much cash inflow or outflow is there?

Are cash flows recurring?

When does cash flow occur?

Will some cash flows affect other cash flows?

Accounting & Financial Management 1B Course Notes Semester 2 2008

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Interpreting the Cash Flow Statement

Analysing the Cash Flow Statement

So how can we analyse the cash flow statement?

1. Relate the Cash Flow Statement to the Balance Sheet. For example: If Accounts Receivable goes up but Sales Revenue is steady, then we should check what is happening to cash from customers.

2. Examine Cash from Operations (CFO) and net cash flows.

A

company with extended periods of negative CFO is in trouble. See the above example.

If

it has a positive CFO, we should check to see if it is repaying debts or investing.

3. Examine the relationship between operating, financing and operating cash flows. This involves looking at the business life cycle. The business life cycle goes from inception to growth to maturity and finally to decline. Cash flows in these periods from operations, investing and financing differ. The following table depicts this relationship:

 

Operating Cash Flow

Investing Cash Flow

Financing Cash Flow

Inception/Growth

Low

Negative

Positive

Maturity

High

Zero

Zero

Decline

Low

Positive

Negative

Overall, a firm’s free cash flow should become positive in the late growth stage.

4. Calculate cash flow ratios.

Free Cash Flow = CFO Capital Expenditure / Maintenance Free Cash Flow is a measure of financial slack.

Solvency and Liquidity Ratios These ratios measure the ability of the firm to generate enough cash to pay all their expenses on time.

Operating Cash Flow Ratio = CFO / Current Liabilities Cash Current Debt Ratio = (CFO Cash Dividends) / Current Debt

Viability as a Going-Concern These ratios measure the ability for the firm to stay in operations for the foreseeable future.

Capital Expenditure Ratio = CFO / Capital Expenditures

Cash Flow to Total Debt Ratio = CFO / Total Debt

Accounting & Financial Management 1B Course Notes Semester 2 2008

13

Financial Statement Analysis

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Financial Statement Analysis (FSA) is a method of assessing the performance of an entity. However, FSA can never be used as a standalone device to assess this. We need to take into account the entity’s context, goals, strategies and accounting policy choice.

FSA is used by a wide range of people to assess the entity’s position:

Shareholders

Creditors

Managers

Auditors

Government Departments (ATO, ASIC)

Analysts

Suppliers

Customers

Intelligent Analysis

Before we commence with FSA, we must first establish five things:

Your objective to doing FSA.

The firm’s industry.

Economic conditions

Firm’s policies, management and past.

Decide which analytic tools are appropriate.

Analytical Tools

So what tools can we use to analyse financial statements? We can use the following:

Common Size Analysis

Trend Analysis

Ratio Analysis

Specialised Analysis

Pricing and Valuation Based Analysis

Comparative Analysis

We will only go in depth about the first three.

Common Size Analysis

This analysis removes the effect of a firm’s size. This allows comparisons between firms of different sizes. The common size is the percentage.

Balance Sheet items are seen as a percentage of total assets and Income Statement items are seen as a percentage of total sales.

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Financial Statement Analysis

The following is an example of the Income Statement with Common Size Analysis completed.

 

2007

% of Sales

Sales

$2,000,000

100%

COGS

$800,000

40%

Gross Profit

$1,200,000

60%

Expenses

$600,000

30%

Net Profit

$600,000

30%

Trend Analysis

Trend Analysis is similar in form to a Common Size Analysis. However, we take this over a period of time, as suggested by the word “trend”. We set one normal year as the base year and relate all analysis to that year.

Quantitatively:

Normal Year: A year without any abnormalities such as disasters, large product releases etc.

Current Year Amount Base Year Amount

*You can divide the above by the Base Year Amount.

Example:

We set the base year to 2006.

 

2006

2007

Change

Sales

$1,000,000

$2,000,000

100%

COGS

$200,000

$800,000

300%

Gross Profit

$800,000

$1,200,000

50%

Expenses

$200,000

$600,000

200%

Net Profit

$600,000

$600,000

0%

Ratio Analysis

Ratio analysis is the use of various types of ratios to analyse a firm’s financial performance. It must be noted that some ratios can be calculated differently. Some rules of thumb apply to ratio analysis. We need to be aware of the context in which the business is operating in. That is its: business strategy, business mix, product mix, industry averages and the current state of the economy etc. We must take these into account before we can

make an informed decision about the firm. It must also be noted that ratio analysis cannot be used by itself! Ratios are grouped into a few categories:

Note: Some textbooks classify ratios differently. This poses no issue, but it is generally suggested that you follow the classification your course gives.

Accounting & Financial Management 1B Course Notes Semester 2 2008

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Financial Statement Analysis

Profitability Ratios

These ratios provide us with an indication of the firm’s profitability. In general, these values should also be stable or increasing.

Return on Equity

Net Profit After Tax / Shareholders’ Equity

This ratio calculates the return on an investment in the firm that a shareholder might expect.

Return on Assets

Earnings before Interest & Tax / Total Assets

This ratio calculates the return on assets under the firm’s control.

Profit Margin

NPAT / Sales Revenue

Note: Both ROE and ROA can be calculated with the use of NPAT, NPBT, EBIT, EBITDA for the numerator.

This ratio calculates the ratio at which sales ends up being retained profits for the firm. If the ratio was 10%, it means that for every dollar of sales revenue the firm gets, 10c ends up being net profits.

Gross Margin

Gross Margin / Sales Revenue

This ratio calculates the ratio between the gross profit and sales revenue. Thus, it provides us with an insight into the firm’s COGS, pricing mix and average mark-up price.

Cash Flow to Total Assets

CFO / Total Assets

*Note: Lecture Slides list this as (CFO + Interest Paid + Tax Paid) / Total Assets.

However, interest paid and tax paid is already a part of CFO, so I believe it should not be included.

This ratio allows us to assess the firm’s ability to generate cash from its assets. It is a useful comparison to Return on Assets as this ratio focuses on cash profit and ROA focuses on accrual profit.

Accounting & Financial Management 1B Course Notes Semester 2 2008

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Financial Statement Analysis

Activity Ratios

These ratios provide us with insight into the firm’s efficiency. It is also known as Turnover

Ratios.

Asset Turnover

Sales Revenue / Total Assets

This ratio shows us how well the firm used its assets to generate profits. It is not to be confused with the same “turnover” as inventory has; it is not the sale of assets.

Inventory Turnover

COGS / Average Inventory

This ratio looks at the level of inventory in relation to activity. Low inventory turnover may indicate that the firm’s inventories are becoming obsolete and that there may be excess storage costs.

Days Inventory on Hand

365 / Inventory Turnover

This ratio translates inventory turnover into days.

Debtors Turnover

Credit Sales / Average Trade Debtors

This ratio is also known as the Accounts Receivable Turnover. It looks at how frequently that accounts receivable is cleared. Credit sales is usually not disclosed on the financial statements and thus, must be estimated based on the type of firm.

Days in Debtors

365 / Debtors Turnover

This ratio translates debtors turnover into days. A large days in debtors value indicates problems with the firm’s debt collection policy or that there is a significant amount of bad debt.

Accounting & Financial Management 1B Course Notes Semester 2 2008

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Financial Statement Analysis

Creditors Turnover

COGS / Average Accounts Payable

This ratio looks at how fast the firm is paying creditors back. These are basically interest free forms of money that can be invested for a very short time before being paid back to the creditor. However, paying back creditors quickly can entail discounts. Thus, this ratio depends on the type of firm.

Days in Creditors

365 / Creditors Turnover

This ratio translates creditors turnover into days.

Cash Flow Cycle

(Days in Inventory + Days in Debtors Days in Creditors)

While not strictly a ratio, this is a combination of 3 different turnover ratios. It shows how fast a firm can get cash from the beginning (buying inventory) to the end (selling it).

Liquidity Ratios

These ratios measure the ability of the firm to pay off its short term liabilities as they fall due.

Current Ratio

Current Assets / Current Liabilities

This measures the ability of the firm’s ability to cover it short term liabilities with short term assets. A ratio above 1 means the firm has positive working capital. A ratio of 2 is considered a comfortable and stable position for the firm.

Quick Ratio

(Current Assets Inventory) / Current Liabilities

This is a stricter ratio in comparison to the current ratio. It takes out inventory before calculating the ratio. This ratio is more useful for firms who cannot convert inventory to cash quickly.

Too high of a current or quick ratio can be seen as a problem. The firm has a lot of current assets lying around doing nothing when it can be invested and a return gained from it. However, this differs due to context. A firm may be looking to expand with cash.

Accounting & Financial Management 1B Course Notes Semester 2 2008

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Financial Statement Analysis

Financial Structure Ratios

These ratios look at the balance between debt and equity used to finance the firm’s assets.

Debt to Equity

Total Liabilities / Total Equity

This shows the amount of debt, relative to equity that the firm is using. A higher ratio means there is more risk as there is more debt.

Debt to Assets

Total Liabilities / Total Assets

This shows the amount of liabilities to assets. However, we know that assets will always be larger than liabilities through the accounting equation.

Leverage

Total Assets / Shareholder’s Equity

This ratio considers how much assets are financed by equity. A high ratio means a smaller portion is funded by shareholder’s equity and more by debt.

Interest Coverage

Earnings before Interest & Tax / Interest Expense

This ratio basically looks at how easily a firm can meet interest payments. Specifically, it looks at how many times it can pay over its interest expense for the period. This becomes an issue if it gets close to or below 1. This means the firm cannot generate enough money to even meet its own interest payments.

Integrative Ratio Analysis

Ratios cannot be considered on their own. We must look at them together and see how they link. One way of linking ratios is the Du Pont System.

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Financial Statement Analysis

Du Pont System

Financial Statement Analysis Du Pont System Specialised Analysis Specialised analysis is when an analysis is changed

Specialised Analysis

Specialised analysis is when an analysis is changed and specially tailored for a specific industry, firm and such. We could have analysis of specific segments of the financial statements or segments of those statements.

For example, it may be wise to look at the free cash flow of capital intensive firms. It may also be good to look at capacities of planes, empty seats and such for airlines. It follows on that, Same Store Analysis may be suited for retailers.

Same Store Analysis is a method of removing profits caused by acquisition of new stores/assets by looking at the same stores from the year before.

Pricing & Valuation Based Analysis

These ratios look at the price of the firm in relation to other things such as growth, earnings

etc.

Price to Earnings Ratio (PER)

Price / Earnings per Share

Price to Growth Ratio (PEG)

Market to Book Ratio

Price / Growth (%)

Market Value of Equity / Book Value of Equity

The PER looks at the market price of the firm (equity) instead of looking at the share price of the firm. This ratio can help identify when a firm is undervalued.

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Financial Statement Analysis

Comparative Analysis

The comparative analysis is actually a combination of the previous analyses. We use the information we have gathered in the previous methods and compare those to other firms that are similar to the firm in which we are interested in. For example: Myer would compare it’s ratios with David Jones.

Sensitivity Analysis

This analysis basically takes the “what if?” approach. We look at certain ratios as ask, “What if we increased such and such?” It shows how sensitive a firm is to changes in it’s business.

Limitations

There are limitations to FSA. Some include:

We use estimated figures (Such as for credit sales)

Assets are normally valued at historical cost (Is this relevant now?)

Different Accounting Policy Choice (Such as for depreciation)

Off Balance Sheet Financing (Such as leases, guarantees and contingent liabilities)

Classification issues (Is a hybrid security a liability or equity?)

Lack of Disclosure by firms (Some firms don’t want you to know everything)

Accounting & Financial Management 1B Course Notes Semester 2 2008

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Accounting Policy Choice

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Accounting Policy Choice (APC) is a decision my management for which the firm’s financial statements will follow. The firm’s decision must be one which is allowed under the Generally Accepted Accounting Principles (GAAP), Australian Accounting Standards Board (AASB), International Financial Reporting Standards (IFRS) and the Corporations Law. Companies that are listed on the ASX must also have a choice that satisfies the ASX Listing Rules.

There are things that must be considered before a choice is made.

What are the accounting standards?

How is the recognition and measurement of revenues and expenses defined?

Changes in APC can cause changes in the amount of reported assets, liabilities and profit. This can have a drastic effect on the financial ratios.

Examples of Accounting Policy Choice

Depreciation Straight-line, Reducing Balance etc.

Inventory FIFO, Weighted Average (Note LIFO is not allowed in Australia)

Amortisation If amortisation is to have a separate account or will just deduct from the actual asset.

Revenue Recognition Point of sale or delivery, during production, on completion of production, when cash is received, at some point after cash has been received.

Expenditure on Assets Capitalising or expensing an expenditure on an asset.

Classification Is something current or non-current?

Recording of events When do we recognise something and do we disclose it?

Estimations Historical Cost? Market Value? Revaluations?

Why do choices exist?

APC exists because not all firms are the same. Some are more relevant for some industries than others. Different policies also exist for tax and accounting purposes. Most companies have different tax and accounting profits as Australia allows much faster depreciation on tax profits that normal accounting procedures, such that less tax has to be paid.

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Accounting Policy Choice

Incentives

Management may have an incentive to report a higher or lower amount of assets, liabilities and/or profits for the sake of:

Meeting analyst expectations

Management bonuses Management is usually paid bonuses based on the performance of the firm. They’d want a

higher profit here.

Share issues Management wants the public to see that the company is a good place to invest in and will thus, raise assets and profits and lower liabilities.

Mergers & Acquisitions

A firm who is against a merger or acquisition may want to post a higher profit so that the

firm that wishes to buy them will see that they are very well off on their own or would be too costly for them to buy.

Reshuffling following the appointment of a new CEO Management may intentionally change profits when a new CEO is appointed under the guise that they are “fixing all the things that the old CEO did not”.

Disclosure

Any significant accounting policy choice must be disclosed in the financial statements. It is usually the first note to the statements.

If there are any changes to the policies, the following must be disclosed:

Nature and reason for change

Financial effect because of the change

Any voluntary change in APC must also be retrospectively applied to all previous years. That is: the firm must go through its old financial statements and redo them according to the new policies.

Accounting & Financial Management 1B Course Notes Semester 2 2008

23

Management Accounting

MMaannaaggeemmeenntt AAccccoouunnttiinngg && CCoosstt CCoonncceeppttss

Up until now, all our work has been on financial accounting. Here, we take a turn and look at management accounting.

What is Management Accounting?

Management accounting is a subset of accounting that is concerned with providing information to management (all levels of it from top to bottom). Its goal is to provide management with useful information so that they can plan, direct, motivate and control the business.

It differs from financial accounting in that it looks at the future, is not aggregated, and does

not have to conform to any accounting standard (It is only used internally and not externally).

Functions of Management

Management itself basically has 4 stages and is a cycle:

Planning: Creating short and long term plans for the business.

Directing and Motivating: Implementing those plans into the business.

Measuring: Measuring performance of the firm.

Controlling: Comparing actual performance to the planned performance.

The cycle then repeats itself over again and is never ending.

A management accounting system should always include, support and incorporate:

Costing and Cost management systems

Budgeting systems

Performance measurement systems

Strategic goals and objectives.

The management accounting system requires these to help perform the functions of management listed above.

The Changing Business Environment

The business environment constantly changes. It is becoming increasingly competitive and some factors behind this are:

Technological advancement

Scale of operations

Lowering prices and costs

Time compression

Demand for higher quality goods and services

Globalisation

Capital markets

Regulation

E-Commerce

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Management Accounting

Some very notable advancement that you should be aware of are:

Total Quality Management (TQM) The management approach and belief that goods and services can be continually improved in quality and that no product can be “100%”. Here, the business aims for continuous improvement on its goods and services. Everyone in the firm is responsible for the quality of the product.

Just-In-Time Inventories (JIT Inventory) Inventories arrive just in time to be used in the production process. This inventory uses a pull approach where customer orders “pull” production to start. The usual system uses a push approach where completed inventory is “pushed” into the market to be sold.

Customer Relationship Management (CRM)

Activity Based Costing (ABC) [Not assessed for the purposes of this course.]

The Benefits of Just-In-Time Systems

Just-In-Time systems provide many benefits for a firm provided they are able to meet the follow requirements:

Improved plant layout

Reduced setup times

An aim for no defects

Flexible workforce

Purchasing from a small number of reliable suppliers that can deliver many small and frequent deliveries with no defectives.

If the firm can meet the above criteria, then they can possibly gain the following by adopting a JIT system:

Reduced inventory costs as there is no need to store stock.

Less warehousing as inventory is bought in at the last minute.

Reduced rework costs as work is not done in bulk.

Higher quality goods resulting from small batches.

Improved customer response times due to the fast production process.

Increased customer satisfaction as the product can be customised for the customer.

Customer Relationship Management

The relationship between customer and business must be held on to as long as possible. It costs a lot to attract new customers than it does to keep existing customers, so it is within the business’s interests to retain existing customers.

The Balanced Scorecard

A business should use performance measures that support strategy and they should ask

questions such as, “How do we look to customers and owners?”, “How can we grow?” and “Which

areas can we excel at?”

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Management Accounting

Performance should be assessed across a wide variety of business activities but they should be kept balanced. Measures should be both quantitative and qualitative and look into the past, present and future.

More importantly, management must be able to translate these performance measures into incentives and targets that employees can achieve in a reasonable amount of time. There is no use in telling employees to increase net profit by 100% in one day; such a feat is practically not feasible.

Cost Concepts & Classification

Cost is the value that is sacrificed when we bring in goods or services that are expected to bring in current of future economic benefit. This cost can either be expensed or capitalized depending on how it affects the business.

Types of costs include:

Differential: The cost between two alternatives.

Controllable: A cost which is controllable by the manager.

Non-Controllable: A cost which is not as easily controllable by the manager.

Direct: Costs that can be traced to a certain cost object.

Indirect: Costs that cannot be reliably traced to a certain cost object.

There are other costs such as opportunity cost, out-of-pocket cost and sunk cost, but these are not required.

Costs can be classified into the two broad categories of functional and behavioural.

Cost Classification
Cost
Classification
of functional and behavioural . Cost Classification Functional Behavioural Mixed Manufacturing Non-
of functional and behavioural . Cost Classification Functional Behavioural Mixed Manufacturing Non-
of functional and behavioural . Cost Classification Functional Behavioural Mixed Manufacturing Non-
of functional and behavioural . Cost Classification Functional Behavioural Mixed Manufacturing Non-
Functional
Functional
and behavioural . Cost Classification Functional Behavioural Mixed Manufacturing Non- Manufacturing Selling
and behavioural . Cost Classification Functional Behavioural Mixed Manufacturing Non- Manufacturing Selling
Behavioural
Behavioural
behavioural . Cost Classification Functional Behavioural Mixed Manufacturing Non- Manufacturing Selling &
behavioural . Cost Classification Functional Behavioural Mixed Manufacturing Non- Manufacturing Selling &

Mixedbehavioural . Cost Classification Functional Behavioural Manufacturing Non- Manufacturing Selling & Admin

Manufacturing
Manufacturing
Classification Functional Behavioural Mixed Manufacturing Non- Manufacturing Selling & Admin Fixed Variable
Classification Functional Behavioural Mixed Manufacturing Non- Manufacturing Selling & Admin Fixed Variable
Non- Manufacturing Selling & Admin
Non-
Manufacturing
Selling &
Admin
Manufacturing Non- Manufacturing Selling & Admin Fixed Variable Direct Labour Materials Indirect Overhead
Fixed
Fixed
Variable
Variable
Direct Labour
Direct
Labour
Materials
Materials
Selling & Admin Fixed Variable Direct Labour Materials Indirect Overhead Accounting & Financial Management 1B
Indirect Overhead
Indirect
Overhead
Fixed Variable Direct Labour Materials Indirect Overhead Accounting & Financial Management 1B – Course Notes

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26

Management Accounting

We now take a look at manufacturing costs. These costs are those that are associated with turning raw materials into finished goods. These are further classified into direct and indirect costs. (The definitions of these are shown in the previous page.)

Raw materials and labour are easily traced back to their cost objects; they can easily be associated with a product and are direct costs.

Manufacturing
Manufacturing
with a product and are direct costs. Manufacturing Direct Indirect Overhead Labour Materials However, overheads
with a product and are direct costs. Manufacturing Direct Indirect Overhead Labour Materials However, overheads
with a product and are direct costs. Manufacturing Direct Indirect Overhead Labour Materials However, overheads
with a product and are direct costs. Manufacturing Direct Indirect Overhead Labour Materials However, overheads
Direct
Direct
Indirect
Indirect
Overhead
Overhead
Labour
Labour
Materials
Materials

However, overheads such as indirect labour (such as security personnel), indirect materials and other costs (electricity, rent etc.) may not be as easily traced back to a cost object hence they are allocated to a cost object instead. We automatically include any cost in indirect costs if it cannot be included as a direct cost.

Manufacturing costs can also be further combined to create prime costs (Direct Labour and Direct Materials) and indirect costs (Direct Labour and Overhead).

Cost Flow

Cost flows differ depending on the type of business the firm is. Here, we only differentiate between manufacturers and retailers. A manufacturing firm has a much larger cost flow as it has to also make its product whereas a retailer does not.

Finished Goods Manufacturer Cash, Other Asset & Liability Accounts Raw Materials, Wages, WIP Inventory COGS
Finished Goods
Manufacturer
Cash, Other
Asset & Liability
Accounts
Raw Materials,
Wages,
WIP Inventory
COGS
Inventory
Overhead
Merchandise
Retailer
Cash
COGS
Inventory

If there is more than one WIP account for a manufacturing firm, any extra accounts can be added between Raw Materials Inventory and Finished Goods Inventory.

Balance Sheet Presentation and Calculation of COGS

Presentation on the balance sheet would only differ in one way between manufacturers and retailers. Retailers would have merchandise inventory but manufacturers would have inventories for raw materials, work in progress and finished goods.

The rest of the balance sheet would be the same.

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Management Accounting

COGS differ in that for a retailer, it usually comes in the form of:

COGS = Opening Inventory + Purchases Ending Inventory

For manufacturing firms, we find the Finished Goods Inventory opening and closing balances instead to finds COGS. We do not look at the other inventories such as raw materials and WIP. Instead of purchases, we have cost of goods manufactured as the firm does not buy products; rather, it makes them.

Cost Concepts

Some cost concepts associated with the way to measure COGS are:

Costs incurred to manufacture a product are product costs.

Portions of costs assigned to products in a period are COGS expenses.

The remaining portions are assigned as Inventory.

Product Cost = COGS + Inventory = Direct Materials + Direct Labour + Overhead

Schedule of Cost of Goods Manufactured

The schedule of Cost of Goods Manufactured basically finds and shows which components contributed to COGM. It usually follows this format:

Beginning Inventory Add: Purchases Raw Materials Available Less: Closing Inventory Direct Materials Used Direct Labour Manufacturing Overheads Indirect Materials Indirect Labour Rent Depreciation Total Manufacturing Costs Add: Opening WIP Total Cost of WIP Less: Closing WIP Cost of Goods Manufactured

COGS Statement

The COGS statement finds out the COGS for the period with the use of COGM. Format:

Beginning Finished Goods Inventory Add: Cost of Goods Manufactured Goods Available for Sale Less: Closing Finished Goods Inventory Cost of Goods Sold

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Management Accounting

Non-Manufacturing Costs

Non-Manufacturing costs are those that do not fit into product costs. These include Selling, General & Administrative Costs (SG&A).

They are assumed to not be a part of inventory in ACCT1511; it is not necessarily true but we assume it to be.

These costs are associated with a time period rather than a product since they cannot be easily traced back to a cost object. These costs are deducted from revenues in the period in which they were incurred.

Non- Manufacturing Selling & Admin
Non-
Manufacturing
Selling & Admin

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Cost Behaviour and Cost-Volume-Profit Analysis

CCoosstt BBeehhaavviioouurr aanndd CCoosstt--VVoolluummee--PPrrooffiitt AAnnaallyyssiiss

In the previous section, we discussed cost functions. In this section, we look at cost behaviour, its assumptions and concepts.

Cost behaviour is used to support:

Decision Making

Pricing

Product Mix

Make or Buy

Performance Evaluation

Financial Planning

Behaviour
Behaviour
Performance Evaluation  Financial Planning Behaviour Mixed Fixed Variable Costs can be split into four different
Performance Evaluation  Financial Planning Behaviour Mixed Fixed Variable Costs can be split into four different
Performance Evaluation  Financial Planning Behaviour Mixed Fixed Variable Costs can be split into four different
Performance Evaluation  Financial Planning Behaviour Mixed Fixed Variable Costs can be split into four different

MixedPerformance Evaluation  Financial Planning Behaviour Fixed Variable Costs can be split into four different

Fixed
Fixed
Variable
Variable

Costs can be split into four different categories but first, we must make a few assumptions:

There are no economies of scale. Everything progresses in a straight line.

Cost behaviour is defined with respect to a single cost object.

Time span must be specified.

Capacity is not an issue.

Fixed Costs

Fixed costs are costs that remain constant regardless of how much activity goes on in the business. As a result of this, fixed cost per unit decreases as units produced rises since the same cost goes across more units.

Fixed costs are defined as:

y = a

Variable Costs

600

400

200

0

1 2 3 4 5 Total Costs Per Unit Cost
1
2
3
4
5
Total Costs
Per Unit Cost

Variable costs are those that vary depending on the level of activity in the firm. Variable costs per unit will stay the same no matter the level of activity but total variable costs will increase with increases in activity.

Variable costs are defined as:

y = bx

3000

2000

1000

0

1 2 3 4 5 Total Costs Per Unit Cost
1
2
3
4
5
Total Costs
Per Unit Cost

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Cost Behaviour and Cost-Volume-Profit Analysis

Semi-Fixed Costs

Semi-Fixed costs are those that do not perfectly fit the description of a fixed cost
Semi-Fixed costs are those that
do not perfectly fit the description of a
fixed cost but do have a fixed level
associated with them. These costs are
2000
1000
0
fixed over a certain range of activity
and change to new level(s) later.
1
2
3
4
X1
X2
X3
Semi-Variable Costs
Semi-Variable costs are those
that do not fit the description of a
variable cost exactly. They have a fixed
component within them and rise in
cost depending on the level of activity.
600
500
400
300
200
Unlike variable costs, these do
not start at zero, but rather, they start
at a fixed cost amount.
100
0
1
2
3
4
5
y = a + bx

Relevant Range

The relevant range is the range at which the relationship between cost and activity can be approximated by a straight line. This is to simplify calculations and discussion. However, our analysis will only be relevant to that range. Any of our calculations may be wrong for any activity or cost level outside this range.

Cost-Volume-Profit (CVP) Analysis

CVP analysis looks at a firm’s cost and volume and how these determine the firm’s profits. First, we must make some assumptions:

Behaviour of costs and revenues are linear over the relevant range. (Explained above)

Costs are fixed or variable.

Selling prices are constant, they do not change.

Only changes in activity affect costs; nothing else.

All produced units are sold. We do not take into account if such a volume can be all sold.

The sales mix is constant in multi-product firms.

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Cost Behaviour and Cost-Volume-Profit Analysis

CVP Concepts

We must familiarize ourselves with the contribution margin first before tackling anything else in CVP analysis. Contribution Margin is defined as:

Contribution Margin = Total Revenue Total Variable Costs

In essence, this basically shows us how much money is left over to cover our fixed costs. We can look at this through a “per unit” analysis. To do this, we simply calculate revenue per unit and variable costs per unit instead.

Contribution Margin per Unit = Unit Selling Price Unit Variable Costs

However, it’s usually better to find the ratio of this instead as it allows us to compare periods. Hence, our formula becomes:

Break-Even Analysis

Contribution Margin Ratio = Contribution Margin per Unit Unit Selling Price

Break-even analysis (BEA) is used to determine the level of activity at which net profit equals to zero. That is:

Total Revenue = Total Fixed Costs + Total Variable Costs

It can be computed by drawing a graph however, we will not delve into this matter as we will look into the equation method.

The equation method simply finds where:

Profit = Total Revenue- Total Costs

Given that we know total revenue is the amount of units we sell multiplied by the price and that total costs are equal to all fixed costs and variable costs, our formula becomes:

π = P∙x - UVC∙x – FC

Where: P is the unit selling price, x is the amount of units, UVC is the unit variable cost and FC is total fixed costs.

Since we know that profit should be zero when we break even, we simply set π = 0 and solve for x. Solving for x does require algebraic manipulation so you should get used to doing them. Rearranging, we get the following:

x =

FC

(P-UVC)

Notice that we do not have π here anymore as it is zero and that there is no tax. This is obvious because at zero profit, you would not have to pay any tax.

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Cost Behaviour and Cost-Volume-Profit Analysis

Sales Mix

The sales mix is used in multi-product firms; firms that sell more than one product. To do calculations on these firms, we use the weighted average contribution margin (WACM) instead. This simply weights the products depending on how many are produced by the firm.

Say is a company produced:

30% of produced goods are Product X and sell at $5 each.

70% of produced goods are Product Y and sell at $2 each.

We get a formula like this:

WACM = (5 x 0.3) + (2 x 0.7) = 2.9

Target Profit

Most of the time, firms do not want to just break even, they want to make a profit. This differs in that a target profit formula will need to take into account tax. Thus, from our formula above, we have:

Profit BT = P∙x - UVC∙x – FC

To take into account tax, we need to use the following:

Profit AT = Profit BT Profit BT r Simplifying to:

Profit AT = Profit BT (1-r)

By combining these two formulae, we can determine the exact amount of after tax profit that is required provided we know the selling price, unit variable cost, fixed costs and tax rate.

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Costing Systems

CCoossttiinngg SSyysstteemmss

In this section, we look at how costs can be measured, job orders and process costing.

Measuring Cost

So how can costs be measured?

We can use actual rates such as:

Direct Labour

Direct Materials

Overhead

Direct Machine Hours

And so on …

The problem with this is that there are timing issues. You would usually only know your total direct labour and direct materials cost after the period has ended. Overhead can possibly be calculated at the beginning of the period.

So how can we measure costs at the beginning of a period? Well we would see how much we expect to make and thus, base costs on that.

Normal Costing

There are three types of ways to define costing:

 

Actual Costing

Normal Costing

Budgeted Costing

Direct Costs

Actual

Actual

Pre-Determined

Indirect Costs

Actual

Pre-Determined

Pre-Determined

As such, as normally look at normal costing. Since Overheads are pre-determined (these are indirect costs), at the end of the period, we must have some way of correcting the figure if it is too high or too low.

We have an account known as the overhead control account which is temporary and is used to control the WIP account. This means the opening and closing balances should be zero at the end of each period.

Differences between pre-determined overhead and actual overhead can either be material or immaterial. If they are immaterial, we can correct this through journal entries.

The journal entry depends on whether the account is Under-applied (Actual > Applied) or Over-applied (Actual < Applied). For an Over-applied difference we use the following:

Dr Overhead Control Cr COGS We simply swap this around if it is under-applied.

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Costing Systems

If the difference is material, we adjust WIP, Finished Goods Inventory and COGS on a pro- rata basis. We only need to know how it is adjusted; we do not need to know the journal entries for these.

Job Order vs. Process Costing

Job Order Costing

Process Costing

Distinct, identifiable products or services

Masses of similar goods or services

Many jobs are works on simultaneously

Identical products are produced continuously

Cost is accumulated by job

Cost is accumulated by department

Job Cost Sheet is the main document to control costs

Department Production Report is the main document to control costs

Unit costs are calculated by job

Unit costs are calculated by department

As we can see, job order and process costing are on two opposite ends of the spectrum of cost systems. The use of either system depends on the type of business.

Allocating Costs

In Job Order Costing, actual direct labour and direct material costs are all allocated to each job. However, manufacturing overheads are applied to jobs, as these costs are estimated before the period.

Under Process Costing all costs enter each department and as the goods/services move through departments (multiple WIP accounts), this cost builds up until it enters Finished Goods Inventory. Here, our unit cost is found by dividing the total cost divided by the total amount of produced goods/services.

Limitations of Product Costing

Times have changed and since, overhead cost was traditionally based on volume. For many firms, direct labour costs have decreased due to increased mechanization of the workforce. Other changes include:

Increased competition

Obsolescence of old costing systems

Adoption of new management policies (such as JIT and TQM)

Advances in information technology

Management dissatisfaction at older cost systems

Generally, management’s aim is to get the best possible estimate of costs incurred during the production process.

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Budgeting

BBuuddggeettiinngg

Budgets are formal documents made by an organisation that states their plans to achieve their physical or financial goals; usually in the short term.

Budgets have many benefits in that they allow planning, communication, coordination and motivation of the organisation. Employees will be more coordinated in what they do as they have set goals and motivations usually come in the form of pay rises and/or bonuses.

It must be noted that budgets are used to measure the amount of expected profits and costs etc. and do not provide actual amounts. Actual amounts at the end of the period can be compared with estimated figures to evaluation the performance for that period.

Behavioural Aspects

Effective budgets require:

A well-defined organisational structure so that each department knows its responsibilities clearly. There should be no overlap of responsibility.

An efficient accounting and reporting system whereby actual figures can easily be drawn from each department for comparison.

It must be flexible in that the budget should be able to be changed if circumstances arise that call for it.

It must motivate employees positively towards a common goal. Employees should be allowed to voice concerns with management.

Goals should be realistic targets that can be achieved.

Feedback should be provided and it should be useful and constructive.

There must be good evaluation methods to evaluate the budget.

Master Budget

While there are many budgets, the master budget is the main set of interrelated budgets. It comprises of the operating, cash and financial budgets. The following are included:

Sales Budget

Sales & Administration Expense Budget

Production Budget

Direct Materials Budget

Direct Labour Budget

Overhead Budget

Finished Goods (Ending Inventory) Budget

Cost of Goods Sold Budget

Capital Expenditure Budget

Cash Budget

Budgeted Cash Flow Statement/Income Statement/Balance Sheet

Production, Direct Materials, Direct Labour & Overhead are omitted for retailing businesses.

Explaining the budget here is too complex. For a detailed example, refer to Week 11 lecture notes.

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Corporate Governance & Professional Ethics

CCoorrppoorraattee GGoovveerrnnaannccee && PPrrooffeessssiioonnaall EEtthhiiccss

Corporate Governance is defined as “the framework of rules, relationships, systems and processes within and by which authority is exercised and controlled in corporations,” by the ASX.

Objectives of Corporate Governance

The objectives of corporate governance are to:

Create value through innovation, development and different values for different companies.

Provide Accountability and Control Systems in that, we want to know who is responsible for the firm, to whom, in what ways, how and why they are.

Hierarchy of the Corporation

The hierarchy of a corporation follows a simple Principal-Agent relationship.

The Board of Directors acts as the mediator between the shareholders and management, usually because management considers what is best for them, and not what is best for the shareholders. The Board of Directors acts to protect the interests of shareholders by exerting a controlling force inside the corporation.

The Board of Directors

The Board of Directors is further split into the following:

Audit Committee To ensure audits are fair and provide a good view of the corporation.

Nomination Committee To nominate the Chairperson.

Remuneration Committee To decide on the pay the Chairperson will receive.

Other Committees (such as Social or Environmental etc.)

The ASX only provides guidelines to establish an audit, nomination and remuneration committee. The guidelines should be followed but if a corporation decides not to, it must provide a fair and reasonable reason as to why it will not.

Management itself does not get to decide or participate on any of the above committees or be part of the board.

Accounting & Financial Management 1B Course Notes Semester 2 2008

Shareholders (Owners)
Shareholders
(Owners)
Board of Directors
Board of
Directors
Management
Management

37

Corporate Governance & Professional Ethics

Composition of the Board of Directors

The Board of Directors is comprised of a chairperson and a following of executive and non- executive directors. Both types of directors have their own advantages and disadvantages and thus, there is no one right composition for a corporation. However, to preserve the integrity of financial reporting, the following apply:

The Chairperson should be independent

The CEO should not be the Chairperson.

The majority of the board should be independent.

 

Executive Directors

Non-Executive Directors

Advantages

They are within the company and thus, they know much about the business and its operations.

They are independent and outside the firm. They are not managers so they work for the shareholder.

Disadvantages

They are similar to managers after all and thus, may work against the shareholders.

They work on the best intentions but usually have no single clear idea about the inner workings of the business.

Generally, all committees should be run by non-executive directors however, there are issues with the balance of independence and knowledge. Some boards may run with a mix of executive and non-executive directors. Some members may even be members of more than one committee.

Professional Ethics

On paper, being professional means you have:

Integrity

Objectivity

Professional Competence and Due Care

Confidentiality

Professional Behaviour

The ten most common ethical problems are:

1. Tax Evasion

2. Financial Statement Manipulation

3. Presenting Financial information to deceive users

4. Conflict of Interest

5. Technical Incompetence

6. Asking a subordinate to do something unethical

7. Admitting mistakes or not

8. Insider trading

9. Maintaining confidentiality

10. Whether to accept gifts or favours.

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